Keynesian Model of National Income

Central idea of Keynesian cross

In The General Theory Keynes proposed that an economy’s
total income was, in the short run, determined largely by the
spending plans of households, businesses, and government.
The more people want to spend, the more goods and services
firms can sell. The more firms can sell, the more output they
will choose to produce and the more workers they will choose
to hire. So ultimately output / GDP/ Income rises.
Planned or desired expenditure and Actual
expenditure

• Planned expenditure: (Desired expenditure) (PE)

Planned expenditure is the amount households, firms, and the
government would like to spend on goods and services
• Actual expenditure (AE)
Actual expenditure is the amount households, firms, and the
government spend on goods and services.
Developing the Keynesian model of national
income
•   Assuming that the economy is closed, so that net exports are zero, we
write planned expenditure PE as the sum of consumption C, planned
investment I, and government purchases G:

PE=C+I+G
we add the consumption function,
C=C(Y-T)
And the investment function: I = , We also have G = and T =
Combining these five equations we have
••   PE =C(Y-)++……. (6)
• C= +MPC (Y-) PE = +MPC (Y-) + +
• PE = +MPC.Y –MPC. + +
• PE = ( - MPC. + +) + MPC.Y……… (7)
• planned expenditure as a function of the level of income.

• PE Planned expenditure function is linear and upward sloping

• Slope of PE function is MPC.

• Y (Income /GDP /Output)

The Economy in Equilibrium

Keynesian cross is the assumption that the economy is in equilibrium

when actual expenditure equals planned expenditure. when people’s
plans have been realized, they have no reason to change.

Actual Expenditure = Planned Expenditure

Y = PE
45 degree line that passes through point of origin is the graph of Actual
expenditure line. Equation for AE : Y=C+I+G
Graph of short- run equilibrium
Q1. Explain Keynesian cross in diagram.
• PE and Actual Expenditure
AE

• E Planned expenditure
•
• E= Keynesian cross
• 45o
• 0 YE Y (Income/GDP/Output)
The Adjustment to Equilibrium in the Keynesian Cross
Q2. How does adjustment in inventory investment help attain equilibrium in
SR?
• PE & AE
• AE
• A
• PE
planned drop in inventory E B

F unplanned inventory
accumulation = AB =positive inventory
• G investment. FG= Negative inventory I.

• 0 Y1 YE Y2 Y(Income /GDP/Output)

•
• If firms are producing at level Y1, then planned expenditure PE falls
short of production, and firms accumulate inventories. This inventory
accumulation induces firms to decrease production. Similarly, if firms
are producing at level Y2, then planned expenditure PE exceeds
production, and firms run down their inventories. This fall in
inventories induces firms to increase production. In both cases, the
firms’ decisions drive the economy toward equilibrium.
Q3. Derive expression for government
purchase multiplier
• An increase in government purchase of ΔG immediately raises
planned spending line by ΔG and, therefore, the economy moves
into new Keynesian cross. The equilibrium income also increases.

• The planned-expenditure schedule shifts upward by ΔG. The

equilibrium of the economy moves from point A to point B.
Graph of G multiplier
• Actual & planned Actual Expenditure

expenditure
B New PE line
Original PE Line
△G A
△Y = Increase in equilibrium income
45
0 Y1 Y2 Income/GDP/Output
•Increase
  in income in 1st round = △G (Increase in planned G)
Increase in income in 2nd round = MPC × △G
Increase in income in 3rd round = MPC (MPC × △G) = MPC2× △G
And the process continues………..
Total change in Income = Summation of change in income in all rounds
△Y= △G + MPC × △G + MPC2×△G + MPC3× △G +………
= [ 1+ MPC + MPC2+ MPC3+........... ]
△Y / △G = [ 1+MPC+MPC2+……..]
= = = G multiplier =
• Since the value of MPC lies between 0 and 1. The value of G multiplier is
always greater than ‘1’.

• Suppose the value of G multiplier = 2.5, Give its economic interpretation.

• If Govt increases its purchase by 1 $ , equilibrium income rises by 2.5 dollars
(MORE than 1 dollar).

• Important conclusion: Greater the value of MPC the larger the value of G
multiplier.
• Verify this result using your own choice of MPC values.
• AE & PE MPC=0.3 MPC=0.7
• PE line is flatter New PE Line AE & PE PE line is steeper
• Old PE line

• Y1 Y2 Income 0 Y1 Y2 Income