Keynesian Cross

Wong Wei Kang

Do not circulate or distribute without permission
Goods Market Equilibrium
and the Keynesian Cross
 Goods Market Equilibrium
•  Y = Cd + Id + G ↔ Keynesian Cross Framework
–  To derive the IS curve, ask how Y should adjust to
clear the goods market given a hypothetical ↑ r
•  Sd = Id ↔ Loanable Funds Framework
–  To derive IS, ask how r should adjust to clear the
goods market given a hypothetical ↑ Y
–  Sd = supply of loanable funds; Id = demand for
loanable funds; r = price of loanable funds

3
 The Keynesian Cross
•  A simple closed economy model in which income is
determined by expenditure.
(due to J.M. Keynes)

•  Notation:
Id = planned investment
E = C + Id + G = planned expenditure
Y = real GDP = actual expenditure
•  Difference between actual & planned expenditure:
unplanned inventory investment

4
Elements of the Keynesian Cross
Consump(on func(on: C = C (Y −T )
Govt policy variables: G = G , T =T
For now,
d
investment is exogenous: I =I
Planned expenditure: E = C (Y − T ) + I + G
Equilibrium condi(on:
Actual expenditure = Planned expenditure
Y = E
5
Graphing planned expenditure
E
planned

expenditure E =C +Id +G

MPC
1

income, output, Y

6
Graphing the equilibrium condition
E
planned E =Y

expenditure

45º

income, output, Y

7
The equilibrium value of income
E
planned E =Y

expenditure E =C +Id +G

income, output, Y
Equilibrium
income
8
 An Increase in Government Purchases
E
At Y1, E =C +Id +G2
there is now an
unplanned drop E =C +Id +G1
in inventory…

ΔG
…so firms
increase output,
and income rises Y
toward a new
equilibrium E1 = Y 1 ΔY E2 = Y 2

9
 Solving for ΔY
Y = C + Id + G equilibrium condition

ΔY = ΔC + ΔI d + ΔG in changes

= ΔC + ΔG because Id exogenous

= MPC × ΔY + ΔG because ΔC = MPC ΔY

Collect terms with ΔY Finally, solve for ΔY :
on the left side of the
equals sign: ⎛ 1 ⎞
ΔY = ⎜ ⎟ × ΔG
(1 − MPC) ×ΔY = ΔG ⎝ 1 − MPC ⎠

Because assume I exogenous → no crowding out effect.

You get crowding out effect because I(r) endogenous 10
 Why the multiplier is > 1

•  Initially, the increase in G causes an equal increase in

Y: ΔY = ΔG.
•  But ↑Y ⇒ ↑C
⇒ further ↑Y
⇒ further ↑C
⇒ further ↑Y
•  So the final impact on income is much bigger than the
initial ΔG.

11
 The IS curve
Definition: A graph of all combinations of r and Y that
result in goods market equilibrium,
i.e. actual expenditure (output)
= planned expenditure

The equation for the IS curve is:

d d
Y = C + I (r) + G
12
 Deriving the IS curve
E E =Y
E =C +Id (r2 )+G
E =C +Id (r1 )+G
↓r ⇒ ↑Id
⇒ ↑E ΔI

⇒ ↑Y Y1 Y2 Y
r
r1

r2
IS
Y1 Y2 Y

13
 Understanding the IS curve’s slope

•  The IS curve is negatively sloped.

•  Intuition:
A fall in the interest rate motivates firms to increase
investment spending, which drives up total planned
spending (E ).
Note: A fall in the interest rate also drives up desired
consumption in Abel and Bernanke.
To restore equilibrium in the goods market, output
(a.k.a. actual expenditure, Y ) must increase.

14
 Shifting the IS curve: ΔG
E E =Y E =C +Id (r )+G
1 2
At any value of r, ↑G
⇒ ↑E ⇒ ↑Y E =C +Id (r1 )+G1
…so the IS curve
shifts to the right.

The horizontal Y1 Y2 Y
r
distance of the
r1
IS shift equals
1 ΔY
ΔY = ΔG IS2
1 − MPC IS1
Y1 Y2 Y

15
 Summary
1.  Keynesian Cross
§  basic model of income determination
§  takes fiscal policy & investment as exogenous
§  fiscal policy has a multiplied impact on income.
2.  IS curve
§  comes from Keynesian Cross when planned investment
depends negatively on interest rate
§  shows all combinations of r and Y that equate planned
expenditure with actual expenditure on goods & services

16