Tuesday, December 2, 2014

The Keynesian Cross

The figure below shows a simplified representation of an economy with a fixed price level, no government, no net exports, and a fixed interest rate. The simplification is done to illustrate the relationship between consumption and business spending in investment. At all points on the blue line, aggregate expenditure equals the planned aggregate expenditure that in this model equals GDP. The red line is the planned aggregate spending, represented by the consumption function (fixed spending plus the marginal propensity to spend times free cash). It is a line with a slop that is the MPC with a non-zero Y-intercept that is the fixed spending plus planned investment (Krugman & Wells p. 330).
Figure 3 adapted from Krugman & Wells p. 330

            These two lines only intersect at point E, and the spending at point E is known as Y* or the “income-expenditure equilibrium GDP”. At all other levels of real GDP, there will be an adjustment that businesses have to make. They will have to adjust their investment with an unplanned component. This unplanned component can be positive or negative, as represented on the graph by letters A and B on the x-axis.
            At point A, the level of planned business investment is greater than the 45-degree line, or real GDP. This will cause the unplanned component to be negative, and it will force real GDP to rise, as businesses have to replenish their inventories. Conversely, at point B, the level of planned business investment is below the 45-degree line, meaning the unplanned component of business spending is positive. Businesses are creating a surplus. In both situations, there will be a move towards equilibrium. If the economy is at point A, then businesses will have to replenish their inventories and that will grow the real GDP. If the economy is at point B, then the economy will have to slow down, lowering the level of real GDP as it moved back to point E, where the aggregate spending and the GDP are the same (Krugman & Wells p. 330).