| Part of a series on |
| Macroeconomics |
|---|
 |
The Keynesian cross diagram is a formulation of the central ideas in Keynes' General Theory of Employment, Interest and Money. It first appeared as a central component of macroeconomic theory as it was taught by Paul Samuelson in his textbook, Economics: An Introductory Analysis. The Keynesian cross plots aggregate income (labelled as Y on the horizontal axis) and planned total spending or aggregate expenditure (labelled as AD on the vertical axis).
YouTube Encyclopedic
-
1/3Views:202 969115 130144 102
-
Keynesian Cross
-
Keynesian cross and the multiplier | Macroeconomics | Khan Academy
-
Connecting the keynesian cross to the IS curve | Macroeconomics | Khan Academy
Transcription
What I want to introduce you to in this video is the idea of a Keynesian Cross. This is one of the tools of analysis of Keynesian thinking which is really the idea that maybe every now and then the GDP, when it's at equilibrium, isn't at an optimal state. It's operating well below potential and the way that we might be able to get. If you are a follower of Keynesian thinking, the way that we can get it closer to, potential closer to full employment is by somehow affecting aggregate demand in some way. What we'll see is, we're going to build up our Keynesian Cross analysis based on what we understand from the consumption function. We're going to first start thinking about planned expenditures. We're going to think about what happens when planned expenditures deviates from actual output, from actual expenditures, right over here. This is very similar to what we're done before but we're actually thinking of it in terms of planning. Let's say we have planned expenditures, expenditures planned and we could just write the components of aggregate expenditure here. Well, you're going to have consumer spending, you're going to have investment. I'm going to be careful here, I'm going to call it planned investment. This is exactly what firms are looking to produce. The reason why I differentiate this here is because, if for whatever reason, aggregate expenditure is less than they expect then they might build up inventories and those inventories get counted as investments. Those would be excess inventories above and beyond the planned inventories. If actual demand is higher than expended then it might eat in to inventories and when inventories are eaten into it actually takes away from planned investments there would actually be kind of a, you would be eating into the total investment in that situation. That's why I'm going to differentiate between planned investment and actual investment. Then of course, you have government spending and then finally you have net exports. For the sake of the analysis of the Keynesian Cross, once again, this is a super over simplification, we're going to assume that at any given level of GDP or aggregate output that these are all constant. That these are not really dependent on aggregate output or GDP which is of course a huge over simplification. If we were to plot any of these versus aggregate income we'd say that they are really a flat line. Maybe planned investment might look something like that. Maybe government spending would look something like that. No ways at some level that's preplanned, it's exogenous to our model. It's not dependant in any way. It's an external factor. Assuming it's fixed, it's not dependent on aggregate income. So government spending looks something like that and net exports, maybe it looks something like that. The one factor that you can imagine because I said we're going to build on top of the consumption function that we're going to assume is driven by aggregate income is consumption right over here. The way that this thing will look, the way that this thing will look is you have ... So let me draw another plot right over here, draw another plot. We have aggregate income, that is going to be our independent variable and then over here we can just view this as expenditure. If we were just to plot consumer spending, we've seen that before especially if we assume a linear consumption function. What we've studied in the last few videos is all linear consumption functions and depending on how you write it, but they all look something like this. They have a positive vertical axis intercept and they have upward slope that is less than 1. Consumption by itself would look something like this, this would be consumer spending as a function of aggregate income. Then if you all all of these constants to it then your graph for aggregate planned expenditures would look something like this. if you added just in net exports it would get a little bit higher because these are constant. Any point you would add this much, if you add government a little higher than that and if you add all of them including planned investments you might get something that looks, and I'll do it in this color right over here, you might get something that looks like this. I'm just starting off with consumer spending. I'm using a linear consumption function, you don't have to, but it makes the Keynesian Cross analysis a lot more cross like and easier to analyse. If you add all what we assumed to be constant things and aggregate expenditures is going to be up here. This right over here is aggregate planned expenditures I should say. Now, we know from the circular flow in the economy that when an economy is at equilibrium, your aggregate output is equal to your aggregate expenditures or your aggregate expenditures is equal to your aggregate income. Really, at an equilibrium, these two things are going to be equal. We can actually plot a line that shows all the points that those are equal. That would be a line that has essentially a slope of 1 where Y is always equal to expenditures. It might look something like this. This is where the name Keynesian cross comes from because essentially you have planned expenditures and then right over here you have the equilibrium line or what I call the equilibrium line because these are all points where income is equal to expenditure. Right over here, income is equal to expenditure. Income is equal to expenditure. When you look at aggregate planned expenditures or you can even view this as aggregate demand as a function of aggregate income. This is actual point where the actual economy is at equilibrium where expenditures are actually equal to, where expenditures are actually equal to output. Actually, it's a little bit skewed the way I drew it but these actually should be like a square. Actually, let me see if I can draw a little bit clearer than that. Just so it will actually looks like a 45 degree line. It should really be a 45 degree line like that. That seems a little bit better. That's the point at which we are at equilibrium. Actually, I don't like that because it makes it a little bit harder to analyse. But hopefully you get the idea. This should be a line that's where expenditures is equal to aggregate income. Like this so it intersects at a point that's a little bit easier for me to analyse. Now, this is where the Keynesian Cross becomes a kind of interesting tool because we could start to think about what happens in situations. This is an equilibrium level of GDP. What happens if for whatever reason that aggregate income is higher than that equilibrium level? Let's think about scenario. Let's say we're over here. Let me do that in magenta. Let's say we're over here. Let's call that Y1. What is going on? What is going on right over here at Y1? Over here, the aggregate output which is the same thing as aggregate income is right over here. Well, this is the actually planned expenditures, is right over here. All of these excess. All of these excess above the planned demand, these are essentially going to be inventories building up. The economy is producing more than it actually needs, inventories are going to build up. Firms are not selling all of their products and that excess built up inventory is going to be reflected in investment. In this case, this delta. This delta is going to be added to your planned investment to get what the actual investment might be. When an economy is at that state then firms would say, "Oh my god! "We're building inventory more than we expected. "We're not selling our products. "We're going to lower output "so there's a natural feedback mechanism for the GDP "to go back to equilibrium." Let's think about what happens if it's below that equilibrium point. Let's say that GDP is, let's call that right over here. This is Y2. Actually, I could write it as a subscript. I don't know, I wrote a superscript there. We could call this Y2. Over here, aggregate demand at this level of output is more than what's actually being output. People want more goods and services. Right over here, this is a deficit of output and so this shows that people will be digging into inventory. That the existing inventories or the existing investment was not enough. Or, I guess another way to think it, essentially, inventories will be contracting. Let's say business was constant. I had a lemonade stand, I just keep an inventory of 5 cups of lemonade on hand and I sell a cup every hour. If all of a sudden people start buying 2 cups an hour my inventory is going to start getting depleted and so this is what's reflected. Actual output is below what's demanded. When firms start seeing that their inventories get depleted, they say, "Oh my god! "I don't want to run out of my goods and services. "Let me start producing more." Then when we're talking about inventories we're really talking about goods. So let me produce more. So output will once again want to naturally go to that feedback point. Hopefully that makes a little bit of sense. In the next few videos we'll be using the Keynesian Cross to think about the Keynesian line of reasoning. If you change one of these, how that might affect the new equilibrium level of GDP.
Overview
In the Keynesian cross diagram, the upward sloping blue line represents the aggregate expenditure for goods and services by all households and firms as a function of their income. The 45-degree line represents an aggregate supply curve which embodies the idea that, as long as the economy is operating at less than full employment, anything demanded will be supplied. Aggregate expenditure and aggregate income are measured by dividing the money value of all goods produced in the economy in a given year by a price index. The resulting construct is referred to as Real Gross Domestic Product.
The sum of all incomes earned in the economy in a given period of time is identically equal to the sum of all expenditures, an identity resulting from the circular flow of income. But not all expenditures are planned. For example, if an automobile plant produces 1,000 cars, but not all of them are sold, the unsold cars are labelled as inventory investment in the GDP accounts. The income earned by the people who produced those cars is part of aggregate income and the value of all of the cars produced is part of total expenditure. But only the value of the cars that are sold is part of planned aggregate expenditure.
In the diagram, the equilibrium level of income and expenditure is determined where the aggregate demand curve intersects the 45-degree line. At this point there is no unintended accumulation of inventories. The equilibrium point is labelled as Y'. Under standard assumptions about the determinants of aggregate expenditure, the AD curve is flatter than the 45-degree line and the equilibrium level of income, Y', is stable. If income is less than Y', aggregate expenditure exceeds aggregate income and firms will find that their inventories are falling. They will hire more workers, and incomes will increase causing a movement back towards Y'. Conversely, if income is greater than Y', aggregate expenditure is less than aggregate income and firms will find that inventories are increasing. They will fire workers, and incomes will fall. Y' is the only level of income at which there is no desire on the part of firms to change the number of people they employ.
Aggregate employment is determined by the demand for labor as firms hire or fire workers to recruit enough labor to produce the goods demanded to meet aggregate expenditure. In Keynesian economic theory, equilibrium is typically assumed to occur at less than full employment, an assumption that is justified by appealing to the empirical connection between employment and output known as Okun's law.
Aggregate expenditure can be broken down into four component parts. These consist of consumption expenditure C, planned investment expenditure, Ip, government expenditure on goods and services, G and exports net of imports, NX. In the simplest exposition of Keynesian theory, the economy is assumed to be closed (which implies that NX = 0), and planned investment is exogenous and determined by the animal spirits of investors. Consumption is an affine function of income, C = a + bY where the slope coefficient b is called the marginal propensity to consume. If any of the components of aggregate demand, a, Ip or G rises, for a given level of income, Y, the aggregate demand curve shifts up and the intersection of the AD curve with the 45-degree line shifts right. Similarly, if any of these three components falls, the AD curve shifts down and the intersection of the AD curve with the 45-degree line shifts left. In the General Theory, Keynes explained the Great Depression as a downward shift of the AD curve caused by a loss of business confidence and a collapse in planned investment.[1]
Original formulation
The Keynesian cross is a simplification of the ideas contained in the first four chapters of the General Theory. It differs in several significant ways from the original formulation. In its original formulation, Keynes envisaged a pair of functions that he referred to as an aggregate demand and an aggregate supply function. But unlike the formulation in Samuelson's textbook, these were not relationships between real aggregate expenditure and real aggregate income. They were envisaged as relationships connecting GDP and the volume of employment. Keynes devoted an entire chapter of the General Theory, chapter 4, to the choice of units. In the book, he uses only two units: money units and labor hours. GDP can be unambiguously measured in monetary units such as dollars or euro, but we cannot add up tons of steel and kilos of oranges. Keynes acknowledged that labor is not homogenous, but he proposed to solve that problem by arguing that if a brain surgeon is paid ten times more than a garbage collector then the brain surgeon is supplying ten times as many "effective units" of labor. This construction leads to an alternative formulation of the measurement of GDP that can be constructed by dividing the dollar value of all the goods and services produced in a given year by a measure of the money wage.[2]
In the original formulation of Keynesian economics in the General Theory, Keynes abandoned the classical concept that the demand and supply of labor are always equal and instead, he simply dropped the labor supply curve from his analysis.[3] The failure of Keynes to provide an alternative micro-foundation to his theory led to widespread disagreement about the intellectual foundations of Keynesian Economics.
Assumptions
The Keynesian cross produces an equilibrium under several assumptions. First, the AD (blue) curve is positive. The AD curve is assumed to be positive because an increase in national output should lead to an increase in disposable income and, thus, an increase in consumption, which makes up a portion of aggregate demand.[4] Second, the AD curve is assumed to have a positive, vertical intercept. The AD curve must have a positive, vertical intercept to cross the AD=Y curve. If the curves do not cross, there is no equilibrium and no equilibrium output can be determined. The AD curve will have a positive, vertical intercept as long as there is some aggregated demand—from consumer spending, investment, net exports, or government spending—even if there is no national output.[4] The slope of the AD curve is steeper given a high multiplier value.[5]
See also
Notes
- ^ My Quiz for Wannabee Keynesians
- ^ Farmer, Roger E. A. (2010). Expectations Employment and Prices. New York, USA: Oxford University Press. p. 69. ISBN 978-0-19-539790-1.
- ^ Farmer, Roger E. A. (2008). "Aggregate Demand and Supply" (PDF). International Journal of Economic Theory. 4 (1): 77–93. doi:10.1111/j.1742-7363.2007.00069.x. S2CID 17567943.
- ^ a b Suranovic, Steven M. "Chapter 50-7: The Keynesian Cross Diagram." International Finance Theory and Policy. Last Updated on 1/20/05 http://internationalecon.com/Finance/Fch50/F50-7.php
- ^ Snowdon, Brian; Vane, Howard R. (2005). Modern Macroeconomics: Its Origins, Development and Current State. Cheltenham, UK: Edward Elgar. p. 61. ISBN 978-1-84542-467-1.
External links
- The Keynesian Cross includes an applet that demonstrates the Keynesian cross and how it responds to changes in underlying parameters
- Keynesian Cross Diagram by Fiona Maclachlan, The Wolfram Demonstrations Project.
- My Quiz for Wannabee Keynesians, Roger Farmer's Economic Window.
This page was last edited on 20 July 2023, at 12:24