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The Keynesian cross diagram is a formulation of the central ideas in Keynes' General Theory of Employment, Interest and Money . It first appeared as a central component of macroeconomic theory as it was taught by Paul 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).
In the Keynesian cross diagram, the upward sloping blue line represents the aggregate expenditure 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.
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.
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.
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]
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 euro, 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]
Keynesian economics are the various macroeconomic theories and models of how aggregate demand strongly influences economic output and inflation. In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy. Instead, it is influenced by a host of factors – sometimes behaving erratically – affecting production, employment, and inflation.
Labour economics, or labor economics, seeks to understand the functioning and dynamics of the markets for wage labour. Labour is a commodity that is supplied by labourers, usually in exchange for a wage paid by demanding firms. Because these labourers exist as parts of a social, institutional, or political system, labour economics must also account for social, cultural and political variables.
Macroeconomics is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole—for example, using interest rates, taxes, and government spending to regulate an economy's growth and stability. This includes regional, national, and global economies.
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. The concept of supply and demand forms the theoretical basis of modern economics.
IS–LM model, or Hicks–Hansen model, is a two-dimensional macroeconomic tool that shows the relationship between interest rates 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 the price level is fixed in the 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 there is no cyclical or deficient-demand unemployment. Full employment does not entail the disappearance of all unemployment, as other kinds of unemployment, namely structural and frictional, may remain. For instance, workers who are "between jobs" for short periods of time as they search for better employment are not counted against full employment, as such unemployment is frictional rather than cyclical. An economy with full employment might also have unemployment or underemployment where part-time workers cannot find jobs appropriate to their skill level, as such unemployment is considered structural rather than cyclical. Full employment marks the point past which expansionary fiscal and/or monetary policy cannot reduce unemployment any further without causing inflation.
The Phillips curve is an economic model, named after William Phillips, that predicts a correlation between reduction in unemployment and increased rates of wage rises within an economy. While Phillips himself did not state a linked relationship between employment and inflation, this was a trivial deduction from his statistical findings. Paul Samuelson and Robert Solow made the connection explicit and subsequently Milton Friedman and Edmund Phelps put the theoretical structure in place.
The General Theory of Employment, Interest and Money is a book by English economist John Maynard Keynes published in February 1936. It caused 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.
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 amount of goods and services that will be purchased at all possible price levels. Consumer spending, investment, corporate and government expenditure, and net exports make up the aggregate demand.
In classical economics, Say's law, or the law of markets, is the claim that the production of a product creates demand for another product by providing something of value which can be exchanged for that other product. So, production is the source of demand. 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.
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.
The neoclassical synthesis (NCS), neoclassical–Keynesian synthesis, or just neo-Keynesianism was a neoclassical economics academic movement and paradigm in economics that worked towards reconciling the macroeconomic thought of John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936). It was formulated most notably by John Hicks (1937), Franco Modigliani (1944), and Paul Samuelson (1948), who dominated economics in the post-war period and formed the mainstream of macroeconomic thought in the 1950s, 60s, and 70s.
In macroeconomics, a multiplier is a factor of proportionality that measures how much an endogenous variable changes in response to a change in some exogenous variable.
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 (AD) and aggregate supply (AS).
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.
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.
This glossary of economics is a list of definitions of terms and concepts used in economics, its sub-disciplines, and related fields.
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.
Crowding-in is a phenomenon that occurs when higher government spending leads to an increase in economic growth and therefore encourages firms to invest due to the presence of more profitable investment opportunities. The crowding-in effect is observed when there is an increase in private investment due to increased public investment, for example, through the construction or improvement of physical infrastructures such as roads, highways, water and sanitation, ports, airports, railways, etc. According to Post – Keynesian macroeconomics views, in a modern economy operating below capacity, government borrowings can increase demand by generating employment, thereby encouraging private investment, thus leading to crowding-in.
