nat
hif The Keynesian Cross
nor ln Tc Gencral Thcory; Keynes proposed that an
to
economy's total
he short run, determined largely by the desire to spend by income was, in
andthe government. The more people want to spend, the households, firms,
the more goods and ser
rices firms can sel. The nmore firms can sell, the more
output they will choose to
1ts produce and the more workers they will choose to hire. Thus, the problem dur
ing recessions and depressions, according to Keynes, was
nts
The Keynesian cross is an attempt to model this insight. inadequate spending.
Planned Expenditure We begin our derivation of the Kevnestan
cross by
drawing a distinction between actual and planned expenditure. .Actual
is the amount households, firms, and the expenditure
government spend on goods and ser
Vices, and as we first saw in Chapter 2, it equals the cconomy's gross
domestIC
product (GDP). Planned expenditure is the amount houscholds, tirms, and che
government would like to spendon goods andservices.
Why would actual expenditure ever differ from planned
SWer s that firms might engage in unplanned inventory investCItexpend1ture? The an
becauac
Saes do not meet their expectations. When firns sell les of their product ther than
diey planhed, their stock of inventories automaically rises; coverely, when
5Sell more than planned, their stock of inventories talls Becsse thee un
Peicd changes in invenwory are counted as invesuient peiahng by tirms, c
tua expenditure can be either above or below planncd
expenditure
NOW consider the determinants of planned expeuditure. Asunung that che
iOny is closed, so chat net exports are zero, we write plauicd cxpciture Ea
the sun of
consumpion Cplanned investuneu 1, asni goveunsnt puchasey Ci
E=C+ It G.
The
John R.IS-LM model was introduced in a class1w artacde by cçe Nobel Pie- wnng ccosouisE
147-159. Hicks,"Mr. Keynes and the Classics: ASuggested luterp1etation," Eonomctua 5(193)
260 PART IV
Business Cycle Theory: The Economy in the Short Run
lo this equation, we add the consumption function
C= C(Y- T).
This equation states that consumption depends on
disposable
simple,inforcomenoW (Ywe-T
which is total income Y minus taxes 1. lo keep things
planned investment as exogenously fixed:
tak.
I=1.
And as in Chapter 3, we assume that fiscal poicy the levels of gover
chases and taxesis fixed:
G=G,
T=T.
Combining these five equations, we obtain
E=C(Y- T) + Î+ G.
This equation shows that planned expenditure is a
level of planned investment I,and the fiscal policy function of income Yh.
variables G and T.
Figure 10-2graphs planned expenditure as a function of the level of
This line slopes upward because higher income leads to income
thus higher planned expenditure. The slope of this line is higher consumption and
to consume, the MPC: it shows how much the marginal propensity
planned expenditure increases when
income rises by $1.This planned-expenditure function is the first
model called the Keynesian cross. piece of the
The Economy in Equilibrium The next piece of the
Keynesian cross is the as
sumption that the economy is in equilibrium when actual expenditure equas
planned expenditure. This assumption is based on the idea that when peoples
plans have been realized, they have no reason to change
what they are doiny
figure 10-2
Planned
expenditure, E Planned Expenditure as a
Planned expenditure, E=(Y-T) +i+ã Function of Income Planned
expenditure depends on
income because higher income
leads to higher consumption,
of planned
which is partThe
MPC
expenditure. slope ofthis
$1 planned-expenditure function
IS the marginal
propensity to
Consume, MPC.
Income, output, Y
CHA PTER 10 Aggregate Demand I 26
Recall1ng
that Yas GDP equals not only total income but also total actual ex-
penditureongoods and services, we can write this equilibrium condition as
Actual Expenditure = Planned Expenditure
Y=E.
The45-degree linein Figure 10-3 plots the points where this condition holds.
Withtheaddition of the planned-expenditure function, this diagram becomes
the Keynesian cross. The equilibrium of this economy is at point A, where the
ed-expenditure function crosses the 45-degree line
How does the economy get to the equilibrium? In this model, inventories
play an mportantrole in the adjustment process. Whenever the economy is not
equilibrium, firms experience unplanned changes in inventories, and this in-
ducesthem to change production levels. Changes in production in turn influ-
ence total income and expenditure, moving the economy toward equilibrium.
figure 10-3
Planned The Keynesian Cross The equi
Actual expenditure, librium in the Keynèsian cross
expenditure, E Y=E
is at point A, where income
(actual expenditure) equals
Planned expenditure, planned expenditure.
A E=C+|+G
45°
Income, output, Y
Equilibrium
income
at a level
For example, economy were ever to find itself with GDP
Suppose the in Figure 10-4. In this case,
greater than the equilibrium level, such as the level Y, are selling less than they
planned expenditure E is lessthan production Y,so firms
inventories.This un-
are goods to their stock of
producin g. Firms add the unsold
induces firms to lay off workers and reduce production,
plandanned rise in inventoriesreduce GDP This process of unintended inventory accu-
these actions in turn income Yfalls tothe
equilibrium level.
mulation andSuppose
falling income continues until
lower than the equilibriumlevel,
such as
Similarly,
the level Y, in
Figure
GDP were at a level
expenditure E, is greater than pro-
10-4. In this case, planned drawing down theirinventories.
ducion Y. Firms meet the high level of sales by
figure 10-4 The Adjustment to
Actualexpenditure
Equilibrium
the Keynesian Cross If
producing at level Y,, firms were
expenditure E, wouid then
Expenditure, E
Unplanned
production, and firns fall
wouidshortplannedof
accumulate inventories. This
Y drop in Planned expenditure inventory accumulation would
induce fims to
Similarly, if firnsreduce
inventory
E Causes
income to rise.
level Y2, then planned
were prprooduciductngion.
at
Unplanned E, would l expenditure
exceed production, ,and
: inventory frms would run down their
accumulation
inventories. This fall in
Causes
income tofall. would induce firms to raise
production. In both cases,the
inventories
45°
Y Income, output, Y Grms' decisions drve the economy
Y toward equilibrium.
Equilibrium
income
But when firms see their stock of inventories dwindle, they hire more worker snd
increase production. GDP rises. and the economy approaches the cquilibrium.
Insummary, the Keynesian cross shows how income Yis determined for given
levels of planned invest1nent I and fiscal policy G and T. We can use this model to
show how income changes when one of these exogenous variables changes.
Fiscal Policy and the Multiplier: Government Purchases Consider how
changes in government purchases affect the economy. Because government pur
chases are one component of expenditure, higher government purchases result in
higher planned expenditure for any given level of inconme. If government pur
chases rise by AG, then the planned-expenditure schedule shifts upward by AG,3
in Figure 10-5.The equilibrium of the economy moves from point A to pont D.
This graph shows that an in
Crease in government purchases
Fradon leads to an even greater Increase
Reserved.in income. That is, AY is larger
Dana 4Y/AG
than AG. The ratio
1992 called the government-
Rights
it tells
Collection.
All purchases multiplier;
us how much income r1ses
bank.com.
Yorker tesponse to a $1 increase in gor
implia-
New
cartoon
ernment purchases. An 1s Cross
The Irom tion of the Keynesian
O
that the government-purchase
"Your Majesty, my voyage will not only forge a
newroute multiplier is larger than 1. havea
the East but also create over three thousand new iobs » to the spices of Why does fiscal onpolicy
incone
multiplied efect
ligure10-5
Ependiture,
t
An Increase in Government
Actual expenditure Purchases in the Keynesian Cross
Planned An increase in government
expenditure purchases of AG raises planned
expenditure by that amount for any
given level of income. The
1. An increase equilibrium moves from point Ato
in government point B,and income rises from Y
purchases shifts to Y2. Note that the increase in
planned expenditure income AY exceeds the increase in
upward,... government purchases AG. Thus,
fiscal policy has a multipliedeffect
on income.
450
AY Income, output, Y
2.... which increases E, = Y
equilibrium income.
The reason is that, according to the consumption function C= C(Y- T), higher
income causes higher consumption. When an increase in government purchases
raises income, it also raises consumption, which further raises income, which fur
ther raises consumption,and so on. Therefore, in this model, an increase in gov
ernment purchases causes a greater increase in income.
How big is the multiplier? To answer this question, we trace through each step
of the change in income. The process begins when expenditure rises by AG,
which implies that income rises by AG as well. This increase in income in turn
raises consumption by MPCXAG, where MPC is the marginal propensity to
cOnsume. This increase in consumption raises expenditure and income once
gin. This second increase in income of MPC x AG again raises consumption,
aus ame by MPC × (MPC × AG), which again raises expenditure and income,
and so on. This feedback from consumption to income to consumption contin
Ues ndefinitely. The total effect on income is
AG
Initial Change in Government Purchases =
= MPC X AG
First Change in Consumption
= MPCxAG
Second Change in Consumption
= MPCÝ x AG
Third Change in Consumption
+)G.
AY=(1 + MPC +MPC + MPC
The
government-purchases multiplier is
MPC +MPC' + MPC+
AY/AG=1+
The Econ
PART Iv Business Cycle Theory:
254|
an
multiplieris an example of infinite geometric
This expression for
the themultiplier ag2
sultfrom algebra
allows usto write
AY/AG= 1/(1- MPC).
sernes.A te-
example, if the1marginal propensity to
Consume 1s 0.6.
the multiplier is
Por
AY/AG;=1+0.6 + 0.6 + 0.6+...
=1/(| 0.6)
= 2.5.
purchases raises equilibrium
increase in government
In this case, a$1.00
by $2.50, 1ncome
Taxes Consider now how
Fiscal Policy and the Multiplier:
aftect cquilibriunm incomc. A
taxes of
decrease in
therefore,
AT
increases consumption by
immediatelychanges in tae
raises dispor-
able income Y- Tby AT and,
For any given level of income Y, planned expenditure is
now higher.
10-6shows, the planned-expenditure schedule shifts upward by MPCxAsAT.FigurTh.
MPCST
cquilibrium of the economy moves trom point A to point B.
2Mathcmatical note: We prove this algebraic result as follows. Let
z=1+xtx+
Multiply both sides of this equation by x:
XZ=X+x*+
Subract the second cquation from the first:
z-N=1.
Rcarrange this last cquation to obain
z(l - x) =1,
whuch mples
Tus
z= /(1- x).
cOipletes the proof.
lus
Matlct.aal oc The govemen-purchases uluplier is lost casily derived using 4lirdecak
Begn with he cqualOI
Y=
C(Y- T) +I+ G.
Holdug Tand Iixcd,
difterCAUate (o obtain
and then Icallaigr to tud dY= CdY + dG,
Ths is he sait as
the dY/dG= 1/(1 C).
equauon in he text.
