Keynesian cross

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Keynesian cross diagram

The Keynesian cross diagram is a formulation of the central ideas in Keynes' General Theory. It first appeared as a central component of macroeconomic theory as it was taught by Samuelson in his textbook, Economics: An Introductory Analysis. The Keynesian Cross plots aggregate income (labelled as Y on the horizontal axis) and planned total spending or aggregate expenditure (labelled as AD on the vertical axis).

<i>The General Theory of Employment, Interest and Money</i> book by John Maynard Keynes

The General Theory of Employment, Interest and Money of 1936 is the last and most important book by the English economist John Maynard Keynes. It created a profound shift in economic thought, giving macroeconomics a central place in economic theory and contributing much of its terminology – the "Keynesian Revolution". It had equally powerful consequences in economic policy, being interpreted as providing theoretical support for government spending in general, and for budgetary deficits, monetary intervention and counter-cyclical policies in particular. It is pervaded with an air of mistrust for the rationality of free-market decision making.

Samuelson is an English-language patronymic surname meaning "son of Samuel". There are alternative spellings such as the Scandinavian-origin Samuelsson and Samuelsen. It is uncommon as a given name. Samuelson may refer to:

Economics is an introductory textbook by American economists Paul Samuelson and William Nordhaus. It was first published in 1948, and has appeared in nineteen different editions, the most recent in 2009. It was the best selling economics textbook for many decades and still remains popular, selling over 300,000 copies of each edition from 1961 through 1976. The book has been translated into forty-one languages and in total has sold over four million copies.



In the Keynesian cross diagram, the upward sloping blue line represents the aggregate demand for goods and services by all households and firms as a function of their income. The 45-degree line represents an aggregate supply curve which embodies the idea that, as long as the economy is operating at less than full employment, anything demanded will be supplied. Aggregate expenditure and aggregate income are measured by dividing the money value of all goods produced in the economy in a given year by a price index. The resulting construct is referred to as Real Gross Domestic Product.

The sum of all incomes earned in the economy in a given period of time is identically equal to the sum of all expenditures, an identity resulting from the circular flow of income. But not all expenditures are planned. For example, if an automobile plant produces 1,000 cars, but not all of them are sold, the unsold cars are labelled as inventory investment in the GDP accounts. The income earned by the people who produced those cars is part of aggregate income and the value of all of the cars produced is part of total expenditure. But only the value of the cars that are sold is part of planned aggregate expenditure.

Circular flow of income

The circular flow of income or circular flow is a model of the economy in which the major exchanges are represented as flows of money, goods and services, etc. between economic agents. The flows of money and goods exchanged in a closed circuit correspond in value, but run in the opposite direction. The circular flow analysis is the basis of national accounts and hence of macroeconomics.

Inventory investment is a component of gross domestic product (GDP). What is produced in a certain country is naturally also sold eventually, but some of the goods produced in a given year may be sold in a later year rather than in the year they were produced. Conversely, some of the goods sold in a given year might have been produced in an earlier year. The difference between goods produced (production) and goods sold (sales) in a given year is called inventory investment. The concept can be applied to the economy as a whole or to an individual firm.

In the diagram, the equilibrium level of income and expenditure is determined where the aggregate demand curve intersects the 45-degree line. At this point there is no unintended accumulation of inventories. The equilibrium point is labelled as Y'. Under standard assumptions about the determinants of aggregate expenditure, the AD curve is flatter than the 45-degree line and the equilibrium level of income, Y', is stable. If income is less than Y', aggregate expenditure exceeds aggregate income and firms will find that their inventories are falling. They will hire more workers, and incomes will increase causing a movement back towards Y'. Conversely, if income is greater than Y', aggregate expenditure is less than aggregate income and firms will find that inventories are increasing. They will fire workers, and incomes will fall. Y' is the only level of income at which there is no desire on the part of firms to change the number of people they employ.

In economics, economic equilibrium is a situation in which economic forces such as supply and demand are balanced and in the absence of external influences the (equilibrium) values of economic variables will not change. For example, in the standard textbook model of perfect competition, equilibrium occurs at the point at which quantity demanded and quantity supplied are equal. Market equilibrium in this case is a condition where a market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. This price is often called the competitive price or market clearing price and will tend not to change unless demand or supply changes, and the quantity is called the "competitive quantity" or market clearing quantity. However, the concept of equilibrium in economics also applies to imperfectly competitive markets, where it takes the form of a Nash equilibrium.

Aggregate employment is determined by the demand for labor as firms hire or fire workers to recruit enough labor to produce the goods demanded to meet aggregate expenditure. In Keynesian economic theory, equilibrium is typically assumed to occur at less than full employment, an assumption that is justified by appealing to the empirical connection between employment and output known as Okun's law.

Okuns law Economic relationship

In economics, Okun's law is an empirically observed relationship between unemployment and losses in a country's production. The "gap version" states that for every 1% increase in the unemployment rate, a country's GDP will be roughly an additional 2% lower than its potential GDP. The "difference version" describes the relationship between quarterly changes in unemployment and quarterly changes in real GDP. The stability and usefulness of the law has been disputed.

Aggregate expenditure can be broken down into four component parts. These consist of consumption expenditure C, planned investment expenditure, Ip, government expenditure on goods and services, G and exports net of imports, NX. In the simplest exposition of Keynesian theory, the economy is assumed to be closed (which implies that NX = 0), and planned investment is exogenous and determined by the animal spirits of investors. Consumption is an affine function of income, C = a + bY where the slope coefficient b is called the marginal propensity to consume. If any of the components of aggregate demand, a, Ip or G rises, for a given level of income, Y, the aggregate demand curve shifts up and the intersection of the AD curve with the 45-degree line shifts right. Similarly, if any of these three components falls, the AD curve shifts down and the intersection of the AD curve with the 45-degree line shifts left. In the General Theory, Keynes explained the Great Depression as a downward shift of the AD curve caused by a loss of business confidence and a collapse in planned investment. [1] .

Autarky is the characteristic of self-sufficiency; the term usually applies to political states or to their economic systems. Autarky exists whenever an entity can survive or continue its activities without external assistance or international trade. If a self-sufficient economy also refuses all trade with the outside world then economists may term it a closed economy. The term "closed economy" is also used technically as an abstraction to allow consideration of a single economy without taking foreign trade into account – i.e. as the antonym of "open economy". Autarky in the political sense is not necessarily an economic phenomenon; for example, a military autarky would be a state that could defend itself without help from another country, or could manufacture all of its weapons without any imports from the outside world.

Animal spirits (Keynes)

Animal spirits is the term John Maynard Keynes used in his 1936 book The General Theory of Employment, Interest and Money to describe the instincts, proclivities and emotions that ostensibly influence and guide human behavior, and which can be measured in terms of, for example, consumer confidence. It has since been argued that trust is also included in or produced by "animal spirits".

In economics, the marginal propensity to consume (MPC) is a metric that quantifies induced consumption, the concept that the increase in personal consumer spending (consumption) occurs with an increase in disposable income. The proportion of disposable income which individuals spend on consumption is known as propensity to consume. MPC is the proportion of additional income that an individual consumes. For example, if a household earns one extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of that dollar, the household will spend 65 cents and save 35 cents. Obviously, the household cannot spend more than the extra dollar.

Original formulation

The Keynesian cross is a simplification of the ideas contained in the first four chapters of the General Theory. It differs in several significant ways from the original formulation. In its original formulation, Keynes envisaged a pair of functions that he referred to as an aggregate demand and an aggregate supply function. But unlike the formulation in Samuelson's textbook, these were not relationships between real aggregate expenditure and real aggregate income. They were envisaged as relationships connecting GDP and the volume of employment. Keynes devoted an entire chapter of the General Theory, chapter 4, to the choice of units. In the book, he uses only two units: money units and labor hours. GDP can be unambiguously measured in monetary units such as dollars or Euros, but we cannot add up tons of steel and kilos of oranges. Keynes acknowledged that labor is not homogenous, but he proposed to solve that problem by arguing that if a brain surgeon is paid ten times more than a garbage collector then the brain surgeon is supplying ten times as many effective units of labor. This construction leads to an alternative formulation of the measurement of GDP that can be constructed by dividing the dollar value of all the goods and services produced in a given year by a measure of the money wage. [2]

In the original formulation of Keynesian economics in the General Theory, Keynes abandoned the classical concept that the demand and supply of labor are always equal and instead, he simply dropped the labor supply curve from his analysis. [3] The failure of Keynes to provide an alternative micro-foundation to his theory led to widespread disagreement about the intellectual foundations of Keynesian Economics.


The Keynesian cross produces an equilibrium under several assumptions. First, the AD (blue) curve is positive. The AD curve is assumed to be positive because an increase in national output should lead to an increase in disposable income and, thus, an increase in consumption, which makes up a portion of aggregate demand. [4] Second, the AD curve is assumed to have a positive, vertical intercept. The AD curve must have a positive, vertical intercept to cross the AD=Y curve. If the curves do not cross, there is no equilibrium and no equilibrium output can be determined. The AD curve will have a positive, vertical intercept as long as there is some aggregated demand—from consumer spending, investment, net exports, or government spending—even if there is no national output. [4] The slope of the AD curve is steeper given a high multiplier value. [5]

See also


  1. My Quiz for Wannabee Keynesians
  2. Farmer, Roger E. A. (2010). Expectations Employment and Prices. New York, USA: Oxford University Press. p. 69. ISBN   978-0-19-539790-1.
  3. Farmer, Roger E. A. (2008). "Aggregate Demand and Supply". International Journal of Economic Theory. 4 (1): 77–93. doi:10.1111/j.1742-7363.2007.00069.x.
  4. 1 2 Suranovic, Steven M. "Chapter 50-7: The Keynesian Cross Diagram." International Finance Theory and Policy. Last Updated on 1/20/05
  5. Snowdon, Brian; Vane, Howard R. (2005). Modern Macroeconomics : Its Origins, Development and Current State. Cheltenham, UK: Edward Elgar. p. 61. ISBN   978-1-84542-467-1.

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Demand-pull inflation type of inflation where aggregate demand increases faster than aggregate supply

Demand-pull inflation is asserted to arise when aggregate demand in an economy outpaces aggregate supply. It involves inflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips curve. This is commonly described as "too much money chasing too few goods." More accurately, it should be described as involving "too much money spent chasing too few goods," since only money that is spent on goods and services can cause inflation. This would not be expected to happen, unless the economy is already at a full employment level. It is the opposite of cost-push inflation.

Keynesian economics is a group of various macroeconomic theories about how in the short run – and especially during recessions – economic output is strongly influenced by aggregate demand. In the Keynesian view, named for British economist John Maynard Keynes, aggregate demand does not necessarily equal the productive capacity of the economy; instead, it is influenced by a host of factors and sometimes behaves erratically, affecting production, employment, and inflation.

Macroeconomics branch of economics that studies aggregated indicators

Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies.

Supply and demand economic model of price determination in microeconomics

In microeconomics, supply and demand is an economic model of price determination in a market. It postulates that, holding all else equal, in a competitive market, the unit price for a particular good, or other traded item such as labor or liquid financial assets, will vary until it settles at a point where the quantity demanded will equal the quantity supplied, resulting in an economic equilibrium for price and quantity transacted.

IS–LM model Keynesian macroeconomic model about interest rates and assets markets that places general equilibrium (simultaneous equilibria in goods/asset markets) at the intersection of “investment–saving” (IS) and “liquidity preference–money supply” (LM)

The IS–LM model, or Hicks–Hansen model, is a macroeconomic tool that shows the relationship between interest rates (ordinate) and assets market. The intersection of the "investment–saving" (IS) and "liquidity preference–money supply" (LM) curves models "general equilibrium" where supposed simultaneous equilibria occur in both the goods and the asset markets. Yet two equivalent interpretations are possible: first, the IS–LM model explains changes in national income when price level is fixed short-run; second, the IS–LM model shows why an aggregate demand curve can shift. Hence, this tool is sometimes used not only to analyse economic fluctuations but also to suggest potential levels for appropriate stabilisation policies.

Full employment is a situation in which everyone who wants a job can have work hours they need on fair wages. Because people switch jobs, full employment involves a positive stable rate of unemployment. An economy with full employment might still have underemployment where part-time workers cannot find jobs appropriate to their skill level. In macroeconomics, full employment is sometimes defined as the level of employment at which there is no cyclical or deficient-demand unemployment.

In macroeconomics, Aggregate Demand (AD) or Domestic Final Demand (DFD) is the total demand for final goods and services in an economy at a given time. It is often called effective demand, though at other times this term is distinguished. This is the demand for the gross domestic product of a country. It specifies the amounts of goods and services that will be purchased at all possible price levels.

In classical economics, Say's law, or the law of markets, states that "Supply creates its own demand", or that production necessarily increases aggregate demand by an equal amount. Say's Law is sometimes incorrectly said to state that production inherently creates consumption. In his principal work, A Treatise on Political Economy, Jean-Baptiste Say wrote: "A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value." And also, "As each of us can only purchase the productions of others with his own productions – as the value we can buy is equal to the value we can produce, the more men can produce, the more they will purchase."

In economics, effective demand (ED) in a market is the demand for a product or service which occurs when purchasers are constrained in a different market. It contrasts with notional demand, which is the demand that occurs when purchasers are not constrained in any other market. In the aggregated market for goods in general, demand, notional or effective, is referred to as aggregate demand. The concept of effective supply parallels the concept of effective demand. The concept of effective demand or supply becomes relevant when markets do not continuously maintain equilibrium prices.

Aggregate supply

In economics, Aggregate Supply (AS) or Domestic Final Supply (DFS) is the total supply of goods and services that firms in a national economy plan on selling during a specific time period. It is the total amount of goods and services that firms are willing and able to sell at a given price level in an economy.

In economics, the Pigou effect is the stimulation of output and employment caused by increasing consumption due to a rise in real balances of wealth, particularly during deflation. The term was named after Arthur Cecil Pigou by Don Patinkin in 1948.

In economics, aggregate expenditure (AE) is a measure of national income. Aggregate expenditure is defined as the current value of all the finished goods and services in the economy. The aggregate expenditure is thus the sum total of all the expenditures undertaken in the economy by the factors during a given time period. It is the expenditure incurred on consumer goods, planned investment and the expenditure made by the government in the economy. In an open economy scenario, aggregate expenditure also includes the difference between the exports and the imports.

Inflationary gap

An inflationary gap, in economics, is the amount by which the actual gross domestic product exceeds potential full-employment GDP. It is one type of output gap, the other being a recessionary gap.

In economics, Aggregate behavior refers to economy-wide sums of individual behavior. It involves relationships between economic aggregates such as national income, government expenditure and aggregate demand. For example, the consumption function is a relationship between aggregate demand for consumption and aggregate disposable income.

In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1, or for money in the broader sense of M2 or M3.

AD–AS model Keynesian macroeconomic model that explains price level and output through the relationship of aggregate demand and aggregate supply

The AD–AS or aggregate demand–aggregate supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand and aggregate supply.

Demand-led growth

Demand-led growth is the foundation of an economic theory claiming that an increase in aggregate demand will ultimately cause an increase in total output in the long run. This is based on a hypothetical sequence of events where an increase in demand will, in effect, stimulate an increase in supply. This stands in opposition to the common neo-classical theory that demand follows supply, and consequently, that supply determines growth in the long run.

History of macroeconomic thought

Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.

John Hicks's 1937 paper Mr. Keynes and the "Classics"; a suggested interpretation is the most influential study of the views presented by J. M. Keynes in his General Theory of Employment, Interest, and Money  of February 1936. It gives “a potted version of the central argument of the General Theory ”   as an equilibrium specified by two equations which dominated Keynesian teaching until Axel Leijonhufvud published a critique in 1968. Leijonhufvud's view that Hicks misrepresented Keynes's theory by reducing it to a static system was in turn rejected by many economists who considered much of the General Theory  to be as static as Hicks portrayed it.