Introducing the Keynesian Model: The Goods Market and Keynesian Cross graph (This sheet prints on 6 landscaped

This sheet prints on 6 landscaped pages)

The fundamental goal is to understand short-run fluctuations (boom and bust behavior) in a market economy.

Organization
There are so many pieces to the model, that it gets confusing. Here's a handy map:

ISLMADAS.
xls
ISLMADAS Model
(Y, r, P endo)

AD AS

ISLM Model
(Y, r endo; P exo)
ISLM.x
ls

IS LM

You Goods Market Money Market

are (Y endo; r, P exo) (r endo; Y, P exo)
here.
KCross MoneyMarket.
.xls xls
Fundamental Pieces of the Model

Y stands for both Output (GDP) and Income. This amazing trick of one letter representing two variables is courtesy of the circular flow. The sum of
of all output purchased by consumers, firms, and government must exactly equal the income received as payments to owners of all inputs.

CONSUMERS (C)
The Consumption Function expresses consumption as a function of a variety of variables such as income, the interest rate, and so on.
The simplest Consumption Function expresses consumption as a linear function of disposable income.
General Linear Simplification
C = C(Y-T C = C0 + C1*(Y-T), where 0 < C1 < 1 T = Taxes - Transfer Payments
Taxes reduce disposable income, while transfer payments (e.g., social security payments and unemployment compensation) increase Y - T.
C1 is the Marginal Propensity to Consume (MPC), which determines what fraction of additional income is spent by consumers.

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FIRMS (I)
Investment has three components:
1) Business fixed investment: the purchase of new plant and equipment by firms
2) Residential investment: the purchase of new housing (homes and apartment buildings)
3) Inventory investment: goods produced, but not sold yet and, therefore, added to inventories
If inventory falls (more goods are sold than produced in a given time period), then inventory investment is negative.
Inventories play a critical role in equilibrating the model. The idea is that there is a target level of inventories. An unexpected surge
in buying will lower inventories (there will always be enough output for buyers in this model) and firms will then increase output
to return inventories to the target level.
Conversely, if less is sold than expected, inventories rise above the target level and firms decrease output.
Investment is not the trading of already produced assets (homes or stocks) with an eye toward making money.
Like the consumption function, an investment function expresses Investment as a function of various factors, but we'll simplify tremendously
and our investment function will be completely determined by the real interest rate (r).
General Linear Simplification
I = I(r) I = I0 + I1*r, where I1 < 0
The slope of the investment function is negative because higher interest rates make it more expensive for firms to borrow (since loans
are used to finance investment projects).

GOVERNMENT (G)
Remember that transfer payments (social security, unemployment compensation, and so forth) are government outlays, but are not part of G.
G counts only government purchases of output (such as roads, schools, and missiles).
Our simple model will treat G as a fixed constant.
G=G

NET EXPORTS (NX)

We will assume away other countries! No exports or imports for this basic, closed economy model.
If you add foreign trade, the model is called the Mundell-Fleming Model.

The Model
Putting together C, I, and G from above, our closed-economy model of how real GDP is determined in the short run has three equations:
C = C0 + C1*(Y-T)
I = I0 + I1*r
G=G

We can add the purchases of output by consumers, firms, and government together into a single equation called Planned Expenditures (PE):
PE = C0 + C1*(Y-T) + I0 + I1*r + G
The sum of C, I, and G is also called Aggregate Demand. In a more complicated version of the model, there is another relationship
called Aggregate Demand so Planned Expenditures helps minimize confusion.
The Y in the consumption function is income.

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We complete the model by adding an equilibrium condition:
Y = PE
Y in the equilibrium condition is output measured by actual expenditures by consumers, firms, and government.
The idea is that there is an equilibrium value of Y where actual expenditures equals planned expenditures.

The equilibration process itself is based on a feedback mechanism logic, just like a basic supply and demand graph where prices are pushed up by
shortages and down by surpluses.
Here are the steps:
1) Start with an initial, arbitrary Y, which represents a level of output and income.
2) Given the exogenous variables, PE = C(Y-T) + I + G is then determined.
3) PE, total planned expenditures by consumers, firms, and government, is then compared to the existing amount of output, Y.
If PE > Y, Y rises. In this situation, inventories are falling and firms respond by increasing output to increase inventories.
If PE < Y, Y falls. Inventories are rising because less was sold than was expected, so firms will lay off workers and decrease Y.
If PE = Y, inventories remain unchanged and the same output will be produced. This is the equilibrium position.
When inventories do not change, Y is stable and the system is in equilibrium.

The exogenous variables in the system establish a framework within which the endogenous variable, Y, is determined.

Exogenous Variables
cons_intercept
cons_slope
inv_intercept Equilibrium Condition Endogenous Variable
inv_slope
r + Y=PE Y (output/income)
G
T

What makes it a Keynesian Model?

That is an interesting and difficult question. To answer it, we need a little history of economic thought.
In the 1930s, during the Great Depression, John Maynard Keynes abandoned the prevailing orthodoxy. He ends the preface of The General
Theory of Employment, Interest, and Money with these thoughts:

"The composition of this book has been for the author a long struggle of escape, and so must the reading of it be for most readers
if the author’s assault upon them is to be successful — a struggle of escape from habitual modes of thought and expression.
The ideas which are here expressed so laboriously are extremely simple and should be obvious. The difficulty lies, not in the new ideas,
but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.
J M Keynes, December 13, 1935
http://www.marxists.org/reference/subject/economics/keynes/general-theory/preface.htm

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How were economists "brought up" and what were the "habitual modes of thought and expression" that Keynes worked so hard to overcome?
Everyone knew that a market economy exhibited cyclical behavior, with periods of strong growth followed by downturns followed by recovery and so on.
The stylized graph below shows a market economy's actual performance (the thin squiggly line) moving around its long run path, the thick curve
known as Potential GDP. This is the output that would be produced with the economy humming at its optimal state, consistently at full employment.

Real GDP
Potential

Actual

years

Before Keynes, the standard story was that downturns were due to mismatches between what was produced and what consumers wanted.
These coordination problems resulted in too much production of some goods and workers in those industries would be laid off, but they would eventually
be hired elsewhere and the economy would self-adjust and lurch forward.

The adjustments in the mix of output and the movement of workers and capital would be guided by changes in prices (and wages) via supply and demand.
Down and upturns were disequilibrium situations that would reverse themselves as the economy moved around its long run path.
Permanent depression was impossible because the market system has automatic stabilizers that will eventually lead to an upswing.
Since the market system was self-correcting, there was no need for government intervention.

These ideas are the "habitual modes of thought and expression" that Keynes was struggling to escape. He called this Classical economics.
To this day, Classical or New Classical is associated with the view that markets self-adjust and no government intervention is needed.

But the Great Depression was so bad for so long that Keynes argued something else was going on and he created a new model of the macroeconomy.
(In fact, Keynes did not actually create the model implemented in these Excel workbooks, but it has Keynesian features.)

One thing Keynes strongly believed was that price and wage adjustment was insufficient to fix the Great Depression (in a reasonable period of time).
Today, we say that a Keynesian model has sticky prices.

Another feature of Keynesian models is a focus on the purchases, or demands, of consumers, firms, and government. Keynes thought that it was
a deficiency of demand that made a market economy nosedive. Similarly, he viewed strong demand, especially by firms making investment in new tools
and equipment, as driving economic growth.

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Unlike the classicals, who saw the economy pushed by supply, Keynes believed it was pulled by demand in the short run and swings in demand
produced swings in the economy. Keynes thought that the Great Depression was a special situation in which the economy had become stuck in a bad
equilibrium from which it would not emerge without help. He argued the government could and should shock the system to reverse the downward spiral.
It would be like rebooting a computer or applying defibrillator paddles to shock a patient whose heart had stopped.

During the Great Recession, triggered by the financial crisis in 2008, these ideas were debated and discussed. To Keynesians, this most recent episode
in the repeated boom bust cycle was fairly common and had been seen before. A fast-growing economy reversed course and went into a free fall (as
housing prices collapsed) and demand for goods and services crashed. As unemployment rose and rose, demand for goods and services fell and fell.
The economy was mired in a deep slump.

The debate rages on, but government attempts to stimulate the economy during the Great Recession were completely Keynesian -- fiscal and monetary
policy tools were used to fuel aggregate demand and restore confidence. The Fed, in particular, took unprecedented steps to revive the economy.
Ben Bernanke, Chair of the Fed and an expert on the Great Depression, was not going to stand by and wait for self-correcting market forces to stabilize
the economy.

So the end of this long answer to the question of "What makes it a Keynesian model?" is
(1) a rejection of the price mechanism alone as a solution to a depressed economy,
(2) a focus on the demand side pulling the economy (not supply pushing it), and
(3) a call for government intervention to stimulate a slumping economy.

The model implemented in these Excel workbooks exhibits all of these features. In the explanation of the equations of the model above, prices were
never mentioned. This is because they are implicitly held constant. Thus, they are sticky and will not be used to self-correct the economy. Notice also
the focus on the expenditures, or demands, of the consumers, firms, and government. The amount produced will be determined by PE, planned
expenditures, and supply is not mentioned. Finally, you will see that this model can settle at an equilibrium that is not at full-employment (on the long run,
potential GDP path). In that case, the model calls for increasing government spending or cutting taxes to stimulate the economy.
Because the model exhibits these features, this is a Keynesian model.

"I am not a Keynesian."

This famous quote, uttered by Keynes near the end of his life, is intriguing and thought provoking. What could have possessed him to say that?
Source, p. 23: http://www.iea.org.uk/sites/default/files/publications/files/KEYNES%20VERSUS%20THE%20KEYNESIANS.pdf

Well, in one crucial way, the model presented here is most decidedly unkeynesian--it does not include anything about what Keynes called animal spirits.
He was interested in group psychology and how crowd behavior worked. How could some periods be characterized by euphoria and others by deep
pessimism? How and why do stock markets produce rallies where confidence seems to spread amongst traders, sometimes even producing bubbles
where assets are priced much higher than fundamental valuations?

Keynes knew investment depended on interest rates, but he thought expectations played a critical role in determining investment and changes in mood
explained the volatility of investment. The study of how we individually and collectively form opinions about future prospects, whether we are manic or
depressed about the future, is a high priority item for economists. It is fairly obvious that once an economy starts to slide, a self-fulfilling process of
doubt and negativity unfolds that intensifies the downturn. It works in the other direction on the upswing.

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Thus, Keynes understood that reading an economy was about more than just numbers. He rejected simple models (like the ones we will build) and
did not believe that an economy could be engineered and steeered according to an algorithm.

Angry at how the textbook ISLM model was a caricature of what Keynes really meant, Joan Robinson famously called the model that bore his name
"bastard Keynesianism" (see the link above for a citation).

And what about the economy itself? Is the wild roller coaster ride of panics and manias simply part of the market system or can it be tamed by careful
observation and appropriate interventions?
That is an open problem in economics. There is no consensus answer.

For a fun approach to the contentious issues involved in Keynesian versus classical macroeconomics, see
http://econstories.tv/2011/04/28/fight-of-the-century-music-video/

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This workbook has three screencasts.
Each screencast has an associated question. Watch the screencast, then do the task.

1. Introduction to the Keynesian Cross

vimeo.com/econexcel/introkcross

Task 1: Click the Rand button in the Model sheet to generate your own economy.
Choose a value of Y > Ye and explain (in a text box on the sheet) why this particular value of Y is not the equilibrium solution.
Explain what will happen to the value of Y--will it rise or fall--and why this will happen.
Make sure you explicitly include the role of changing inventories in your answer.

2. Comparative Statics in the Keynesian Cross

vimeo.com/econexcel/compstaticskcross

Task 2: If you have not done so yet, click the Rand button in the Model sheet to generate your own economy.
Compare your initial solution with an economy that has two times the interest rate. In other words, whatever your initial r, new r is twice that va
What happens to Ye? Explain in a text box on the sheet why r has this effect on Ye.

3. G and T Multipliers
vimeo.com/econexcel/multiplierkcross

Task 3: If you have not done so yet, click the Rand button in the Model sheet to generate your own economy.
The screencast explains the G and T multipliers.
There is another multiplier called the Balanced Budget Multiplier. It works like this: G and T are changed by the same amount (which explains
and the effect on equilibrium Y is computed.
Can you figure out the value of the Balanced Budget Multiplier in this simple model? Explain your result.
librium solution.

our initial r, new r is twice that value.

he same amount (which explains its name)

Use Excel's Solver to find an equilibrium solution, which is illustrated via the Keynesian Cross chart
(Install Solver if needed with the Add-ins Manager.)

Exogenous Variables
cons_intercept 0.4 trillion $ C0
cons_slope 0.8 C1, MPC (marginal propensity to consume) Additional Exogenous Variables
inv_intercept 4.5 trillion $ I0 I
inv_slope -50 I1 r elasticity of I
r 5% real interest rate Budget (T - G)
G 3 trillion $ government spending
T 2.5 trillion $ taxes - transfers

Endogenous Variables Additional Endogenous Variables

Y 5 trillion $ Output/Income C

Equilibrium Condition: Y = C + I + G
Y 5 trillion $ Actual output (GDP produced)
PE = C + I + G 7.4 trillion $ Planned expenditures (GDP demanded by consumers, firms, and government))
Difference (Y - PE) -2.4 trillion $ excess demand or excess supply
Excess demand (Y < PE) met by drawing down inventories; excess supply (Y > PE) adds to
Step Equilibrium is where Y - PE = 0
2
The Keynesian Cross
Y PE=C+I+G Difference (Y - PE)
1
3
4.2
5.8
-3.2
-2.8
Expansion
Expansion 40 Keynesian Cross
5 7.4 -2.4 Expansion
7 9 -2 Expansion
9 10.6 -1.6 Expansion
trillion $

11 12.2 -1.2 Expansion 30 17

13 13.8 -0.8 Expansion
15 15.4 -0.4 Expansion
17 17 0 Equilibrium
19 18.6 0.4 Contraction
20
21 20.2 0.8 Contraction
23 21.8 1.2 Contraction
25 23.4 1.6 Contraction
27 25 2 Contraction
29 26.6 2.4 Contraction 10 7.4
31 28.2 2.8 Contraction
33 29.8 3.2 Contraction 45o
5
0 Y as Income (trillion $)
0 5 10 15 20 25 30 35 40
A Second Version of the Keynesian Cross with I = S
Y Investment (I) Savings (Y-C-G) Difference (I - S)
1 2 -1.2 3.2 Expansion
3 2 -0.8 2.8 Expansion
20 Keynesian Cross I = S
trillion S

10
17
2
 5 2 -0.4 2.4 Expansion
20 Keynesian Cross I = S
7 2 0 2 Expansion
9 2 0.4 1.6 Expansion

trillion S
11 2 0.8 1.2 Expansion 10
13 2 1.2 0.8 Expansion 17
15 2 1.6 0.4 Expansion 2
17 2 2 0 Equilibrium 17
0
19 2 2.4 -0.4 Contraction
0 5 10
-0.4 15 20 25 30 35 40
21 2 2.8 -0.8 Contraction
23 2 3.2 -1.2 Contraction
25 2 3.6 -1.6 Contraction -10
27 2 4 -2 Contraction
29 2 4.4 -2.4 Contraction
31 2 4.8 -2.8 Contraction Y as Income (trillion S)
33 2 5.2 -3.2 Contraction
-20

Investment
Savings

The I = S version of the Keynesian Cross gives the same

it simply subtracts C and G from Y, giving S, and subtrac
The I = S version was originally used as the Goods Marke
 Rough approximations for US macro aggregates (trillion $) circa 2014:
C 12 Line 2, NIPA Table 1.1.5 http://www.bea.gov/iTable/iTableHtml.
Additional Exogenous Variables I 2 Line 7, NIPA Table 1.1.5
2 trillion $ Investment G 3 Line 22, NIPA Table 1.1.5
-1.3 responsiveness of I to Dr T 2.5 Line1 - Line 17, Table 3.1 http://www.bea.gov/iTable/iTableHtml.
-0.5 trillion $ + surplus; - deficit Y 17 C+I+G

Model Equations:
C = C0 + C1(Y - T) 0 < C1 <
1
Additional Endogenous Variables I = I0 + I1r I1 < 0
2.4 trillion $ Consumption G=G
PE = C + I + G

Equilibrium Condition:
Y = PE

mers, firms, and government))

inventories; excess supply (Y > PE) adds to inventories

Keynesian Cross

17
Zoom Amount
2

7.4

5
Y as Income (trillion $)
5 10 15 20 25 30 35 40

Keynesian Cross I = S

17
2
Keynesian Cross I = S

17
2 Zoom Amount
17 2

5 10
0.4 15 20 25 30 35 40

Y as Income (trillion S)

2 trillion S
-0.4 trillion S
PE  Y
sion of the Keynesian Cross gives the same answer as the Y = PE version because
--> I  G  Y
racts C and G from Y, giving S, and subtracts the same C and G from PE, giving I, as shown to the right. C
sion was originally used as the Goods Market graph and it is the IS part of the name of the ISLM model. I  Y  C  G

I S
$) circa 2014:
http://www.bea.gov/iTable/iTableHtml.cfm?reqid=9&step=3&isuri=1&903=5

http://www.bea.gov/iTable/iTableHtml.cfm?reqid=9&step=3&isuri=1&903=86