The Keynesian Cross Chapter 9 Appendix McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

The Keynesian Cross The Keynesian cross focuses on the relationship of total spending to the value of output, with no explicit distinction between price levels and real output Aggregate expenditure: The rate of total expenditure desired at alternative levels of income, ceteris paribus

The Consumption Shortfall Say the consumption function is: With full employment output of $3 trillion, consumption at full employment is

The Consumption Shortfall ZF $3000 Total output 2350 CF 2000 Output not purchased by consumers Expenditure 1500 1000 Consumption function (C= $100 + 0.75YD) 500 45° YF 1000 2000 3000 Income (Output)

Non-consumer Spending Investors, governments, and net export buyers add to consumer spending to equal aggregate expenditure Aggregate expenditure still might not reach full employment

Aggregate Expenditure At Income (output) of Consumers Desire to Spend + Investors Desire to Spend Governments Desire to Spend Net Export Spending = Aggregate Expenditure $ 500 $ 475 $ 150 $ 200 $ 50 $ 875 1,000 850 150 200 50 1,250 1,500 1,225 1,625 2,000 1,600 2,500 1,975 2,375 3,000 2,350 2,750 3,500 2,725   3,125

Aggregate Expenditure Y = AE 3500 YF Aggregate expenditure (AE = C + I + G + (X – M)) 3000 g f EXPENDITURE 2500 e 2000 d Consumer spending (C= $100 + 0.75Y) c 1500 b 1000 a 500 Investment spending = $150 Government spending = $200 Net exports = $50 $500 $1000 $1500 $2000 $2500 $3000 $3500 INCOME (OUTPUT)

A Recessionary Gap In this case, we end up with less aggregate expenditure ($2,750 billion) than the value of full-employment output Recessionary gap: The amount by which aggregate spending at full employment falls short of full-employment output

Recessionary Gap Expenditure Income (Output) $3500 Output at YF AE = Y 3000 g Recessionary gap 2750 f Desired spending at YF 2500 Equilibrium 2000 E Expenditure 1500 Aggregate expenditure 1250 1000 500 45° Y1 YE YF $500 1000 1500 2000 2500 3000 Income (Output)

A Single Equilibrium Expenditure equilibrium: The rate of output at which desired spending equals the value of output The point where the AE and 45 degree lines meet Producers have no incentive to change the rate of output, since are selling all they produce

Expenditure Equilibrium Income (Output) Expenditure AE = Y $500 1000 1500 2000 2500 3000 $3500 500 Equilibrium 45° Aggregate expenditure E YE

Expenditure Equilibrium At Income (output) of Consumers Desire to Spend + Investors Desire to Spend Governments Desire to Spend Net Export Spending = Aggregate Expenditure $ 500 $ 475 $ 150 $ 200 $ 50 $ 875 1,000 850 150 200 50 1,250 1,500 1,225 1,625 2,000 1,600 2,500 1,975 2,375 3,000 2,350 2,750 3,500 2,725   3,125

Macro Failure Market participants’ spending desires could also exceed the economy’s full-employment potential Inflationary gap: The amount by which aggregate spending at full employment exceeds full-employment output

Two Paths to the Same Conclusion Both the Keynesian cross and the AD/AS framework lead to the same conclusion about macro instability The former focuses on total spending, the product of output and prices The latter distinguishes separate effects of macro instability on prices and real output

The Keynesian Cross End of Chapter 9 Appendix McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.