Macroeconomics

Lecture 2
The Keynesian Cross Model
Outline of this lecture
The national accounting identity.
Planned and unplanned expenditure.
Demand-side equilibrium in the
Keynesian Cross model.
The Keynesian Multiplier.

Goods market
Keynesian
Cross (IS)
Financial
markets (LM)
IS-LM
(r, Y)
AD
Labour market
(AS)
AD-AS
(r,P,Y)
Foreign
exchange
markets
AD
*

(r*,Y,e, CA)

Phillips Curve
(t,u)
Y
given r and P
Y and r
given P
Y, r and P
The national accounting identity
Z X G I C Y + + +
Total expenditure
Total income
What guarantees this?
Investments may include an undesired component.
U P
I I +
Planned
Unplanned
Example
Suppose there is a boycott of exports.
Before:
0
0 0
= => = AE Y AE Y
After:
X AE Y gap = =
1
For unchanged spending plans and taxes,
the gap is filled by firms being forced to invest
in the form of unplanned inventory build-up
U
I AE Y + =
1
Demand-side equilibrium
The economy is at equilibrium when there are
no unplanned expenditures (investments), that is
when
An equilibrium is a situation in which no agent
would want to change behavior and the behavior
of all agents is consistent.
Planned expenditure
=
Actual expenditure
=
Income (output)
Actual
expenditure
C
Consumption
+ I
p
Planned investment
+ I
U

Unplanned investment
+G
Government expenditure
+ X-Z
net exports
Planned expenditure

C
Consumption
+ I
p

Planned investment
+G
Government expenditure
+ X-Z
net exports
Income Y =
= Output
Only holds in equilibrium!
Income determination
Assume that all prices (P, r, e) are fixed
(and that P=e=P*=1).
Z X G I C Y + + + ) 1 (
| | T Y t c c C + = ) 1 ( ) 2 (
1 0
r i i I
P
1 0
) 3 ( =
Y z z
1 0
Z ) 4 ( + =
1 t 0 , T T , G ) 6 ( < s = = G
f
Y
1 0
X ) 5 ( _ _ + =
Planned demand
Behavioral relations
Government behavior
Planned aggregate expenditure
Z X G I C AE
P
+ + + =
( ) ( )
( ) ( ) Y z z Y
G r i i T Y t c c
f 1 0 1 0
1 0 1 0
) 1 (
+ + +
+ + + =
_ _
( ) A Y z t c + =
1 1
) 1 (
( ) ( ) ( ) T c c z Y r i i G A
f 1 0 0 0 0 1 0
+ + + + = _ _
income
output, Y
P
l
a
n
n
e
d

e
x
p
e
n
d
i
t
u
r
e
,

A
E


( ) A Y z t c AE + =
1 1
) 1 (
A
AE
1 1
) 1 ( z t c
1
1
(1-t) c
1
(1-t)
z
1
B
C
Flat if
z
1
large
c
1
small
t large
slope less than 1
income
output, Y
A
AE
AE
Actual Expenditure=Y
Expenditure
exceeds output
Output exceeds
expenditure
*
Y
*
AE
0
Y
0
AE
a
AE
0 >
u
I
1
Y
2
Y
1
AE
2
AE
Equilibrium: Y
*
=AE(Y
*
)
Equilibrating mechanism
Actual demand > planned demand
Unplanned inventory build up
Firms want to change their production
plans to avoid this
Reduction in output and income (actual demand)
Reduction in planned demand, but
Gap between planned and actual reduced.
Equilibrium
( ) A Y z t c + =
1 1
) 1 (
AE Y =
( )
A
z t c
Y
e
1 1
) 1 ( 1
1

=
Autonomous
expenditures
The Keynesian
multiplier
The Keynesian Multiplier
The effect on an endogenous variable of
a one unit change in an exogenous variable
CETERIS PARIBUS
The change in equilibrium income (Y
e
) when
autonomous expenditure (A) increases by 1
(keeping all prices fixed)
Why is this important?
Determines the impact of economic policy
Determines the impact of shocks
Planned
expenditure
Y A
d
Y A C A
Initial impact
Import leakage
z
1
Tax
leakage
t
Savings leakage
Large multiplier
if leakages are small
c
1
A A d
Y A
C A
Y A
1
2
3
4
z
1
=0
1
1
t 1
) 1 (
1
t c
) 1 (
1
t c
2
1
) 1 ( t c
2 2
1
) 1 ( t c
2 2
1
) 1 ( t c
3 2
1
) 1 ( t c
3 3
1
) 1 ( t c
3 3
1
) 1 ( t c
.... ) 1 ( ) 1 ( ) 1 ( 1
3 3
1
2 2
1
1
1
+ + + + = A

=
t c t c t c Y
i
i
1
) 1 ( 1
1
1
>

=
t c
for
1 ) 1 (
1
< t c
income
output, Y
AE
0

AE
Actual expenditure=Y
0
A
0
Y
1
Y
AE
1

1
A
A A
A A
Y A
( )
1 1
) 1 ( 1 z t c
A

A
Y A =
2
Y
How large is it?
z
1
=0.22
t=0.3
c
1
=0.8-0.9
( )
1 1
) 1 ( 1
1
z t c
MP

=
MP=2.7
Back of the envelope
The multiplier debate
Fender in the Royal economic

Paper that Pontus discussed.
What is next?

Fiscal policy in the Keynesian model
The balanced budget
Automatic stabilisers

Comparison between Classical and Keynesian
model

The IS curve
Expenditure
Income
Leakages
Injections
Taxes
Savings
imports
Exports
Investments
Government
expenditure
G
T
I Z
S X
G
o
v
e
r
n
m
e
n
t

s
e
c
t
o
r

R
e
s
t

o
f

t
h
e


w
o
r
l
d

Y
C S T Y =
Z C
Z C
T Y
Z X G I C + + +
Z X I C + + Z X C +
How to Pay for the War?
(Keynes, 1940)
Question: How can Great Britain meet the economic efforts required by
the Second World War without generating inflation?
5520
1938
= Y
6345 = Y
825 = AY
How much can government spending be raised?
???? 825 = AG
( )
1 1
) 1 ( 1 z t c
G
Y

A
= A
0
1
~ z
14 . 0
5520
770
= = ~
Y
T
t
79 . 0
5520
4380
1
= = ~
Y
C
c
( ) ) 14 . 0 1 ( 79 . 0 1
825

A
=
G
265 = AG