The Keynesian Cross is a model of the economy that focuses on the relationship between aggregate demand and income to determine equilibrium.
Consumption The relationship between income and consumption is given by the consumption function: Where: c 0 represents autonomous consumption, consumption that is independent of income. c′ is the marginal propensity to consume. y is income.
The 45-Degree Line We gain additional insight into the consumption function when we compare it to a 45-degree reference line. At all points along this line, consumption and income are equal.
Figure A12.2(a) The 45-degree Line and the Consumption Function
Figure A12.2(b) The 45-degree Line and the Consumption Function
Investment The investment function shows the relationship between planned investment and income in the economy: Investment is independent of income.
Figure A12.3 Adding the Investment Function to Aggregate Demand
The Aggregate Demand Function in a World with Government and Trade To complete the model, we assume that both government spending and net exports are exogenous. That is, they are determined by outside factors.
The Aggregate Demand Function in a World with Government and Trade (cont’d) We can now add all of the components of aggregate demand to get the overall aggregate demand function.
Figure A12.4 Adding Government Expenditures and Net Exports to the Aggregate Demand Function
The Keynesian Cross and Overall Macroeconomic Equilibrium The 45-degree line is interpreted as the aggregate supply function for the economy. Everywhere along that line, total production equals total demand. Equilibrium occurs where the aggregate demand function intersects the aggregate supply function. The Keynesian Cross
Figure A12.5 Equilibrium in the Keynesian Cross Model
The Keynesian Cross and Overall Macroeconomic Equilibrium (cont’d) Suppose that net exports increase. The aggregate demand function would shift up. Aggregate demand now exceeds aggregate supply, so inventories fall. As inventories fall, firms increase output. Increased production leads to increased income and consumption. Real GDP ultimately increases by a multiplied amount.
Figure A12.6 The Impact of an Increase in Net Exports
Can we do it? (number 5) If the consumption function is $100+0.5y, the investment function =$80, the government spending function = $200, and the net export function = $10, what would be the amount of aggregate expenditures be if income were $1000, $2000, and $3000? AE=C+I+G+(X-M) 890 1390 1890
Chapter 12 Appendix Homework Numbers 1, 2, and 6
The Goals of Fiscal Policy Intentional use of the government’s power to tax and spend to alter AD and quickly achieve the full employment level of output. Goals are to correct either: An underperforming economy, or An overheating economy.
Expansionary Fiscal Policy Increased government spending Decreased taxes To increase AD and real GDP.
Figure 13.1 Curing the Underperforming Economy with Expansionary Fiscal Policy
Expansionary Fiscal Policy As a result: AD increases. If increases by the “right amount”, full employment level of output will be met Price level increases. Unemployment rate falls. Real GDP increases
The Multiplier Principle Changes in any component of AD will lead to a magnified change in the level of real income in the economy. Gives policy makers a tool to determine the correct change in AD needed to close a recessionary or expansionary gap.