PROBLEM: The simple Keynesian model (SKM) implies that the government can boost GDP in the short-run by raising planned expenditure (E) on “G” since output (Y) must equal E = C+I+G. Keynes recognised that additional E from any sources would increase the demand for money. Consequently, he had a separate money market to show how a fiscal expansion would increase the interest rate. A theoretical problem arises if we also allow the negative feedback from a higher interest rate (r) on private investment expenditure by setting I = I (r) such that if r increases, then I decrease. It concerns potential inconsistency between balancing E and Y in the SKM and ensuring the money market balance. Identify the theoretical problem precisely in your words. Explain how the Hicksian IS-LM model solves this theoretical PROBLEM.
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