According to Keynesian theory, how does an increase in money supply affect real GDP?

In Keynesian theory, an increase in the money supply leads to a more substantial increase in real GDP compared to the initial change in investment. This concept is rooted in the idea of the multiplier effect, which suggests that an increase in spending (in this case, driven by a higher money supply) can lead to a chain reaction of economic activity.

When the central bank increases the money supply, interest rates typically decrease, making borrowing cheaper. This encourages businesses to invest more due to lower costs of financing, as well as consumers to spend on big-ticket items. The initial surge in investment then stimulates further economic activity—such as increased production, employment, and income in the economy.

As businesses expand, they hire more workers, who then spend their income on goods and services, leading to further increases in demand. This successive cycle of spending and income generation causes the overall increase in real GDP to outpace the initial change in investment. Therefore, the correct understanding aligns with the notion that the increase in real GDP is larger than the initial investment changes, reflecting the potency of the multiplier effect in Keynesian economic theory.