C H A P T E R 1 0 Aggregate Demand I | 259

demand, it is the variable that links the two halves of the IS–LM model. The
model shows how interactions between these markets determine the position
and slope of the aggregate demand curve and, therefore, the level of national in-
come in the short run.1

10-1 The Goods Market and the IS Curve

The IS curve plots the relationship between the interest rate and the level of in-
come that arises in the market for goods and services. To develop this relation-
ship, we start with a basic model called the Keynesian cross.This model is the
simplest interpretation of Keynes’s theory of national income and is a building
block for the more complex and realistic IS–LM model.

The Keynesian Cross

In The General Theory, Keynes proposed that an economy’s total income was, in
the short run, determined largely by the desire to spend by households, firms,
and the government.The more people want to spend, the more goods and ser-
vices firms can sell.The more firms can sell, the more output they will choose to
produce and the more workers they will choose to hire.Thus, the problem dur-
ing recessions and depressions, according to Keynes, was inadequate spending.
The Keynesian cross is an attempt to model this insight.
Planned Expenditure We begin our derivation of the Keynesian cross by
drawing a distinction between actual and planned expenditure. Actual expenditure
is the amount households, firms, and the government spend on goods and ser-
vices, and as we first saw in Chapter 2, it equals the economy’s gross domestic
product (GDP). Planned expenditure is the amount households, firms, and the
government would like to spend on goods and services.
Why would actual expenditure ever differ from planned expenditure? The an-
swer is that firms might engage in unplanned inventory investment because their
sales do not meet their expectations. When firms sell less of their product than
they planned, their stock of inventories automatically rises; conversely, when
firms sell more than planned, their stock of inventories falls. Because these un-
planned changes in inventory are counted as investment spending by firms, ac-
tual expenditure can be either above or below planned expenditure.
Now consider the determinants of planned expenditure. Assuming that the
economy is closed, so that net exports are zero, we write planned expenditure E as
the sum of consumption C, planned investment I, and government purchases G:
E = C + I + G.

1
The IS–LM model was introduced in a classic article by the Nobel-Prize-winning economist
John R. Hicks, “Mr. Keynes and the Classics: A Suggested Interpretation,’’ Econometrica 5 (1937):
147–159.

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 260 | P A R T I V Business Cycle Theory: The Economy in the Short Run

To this equation, we add the consumption function

C = C(Y − T ).
This equation states that consumption depends on disposable income (Y − T ),
which is total income Y minus taxes T.To keep things simple, for now we take
planned investment as exogenously fixed:

I = I−.
And as in Chapter 3, we assume that fiscal policy—the levels of government pur-
chases and taxes—is fixed:
−,
G=G
−.
T=T
Combining these five equations, we obtain
− ) + I− + G
−.
E = C(Y − T
This equation shows that planned expenditure is a function of income Y, the
level of planned investment I−, and the fiscal policy variables G
− and T
−.
Figure 10-2 graphs planned expenditure as a function of the level of income.
This line slopes upward because higher income leads to higher consumption and
thus higher planned expenditure.The slope of this line is the marginal propensity
to consume, the MPC: it shows how much planned expenditure increases when
income rises by $1. This planned-expenditure function is the first piece of the
model called the Keynesian cross.
The Economy in Equilibrium The next piece of the Keynesian cross is the as-
sumption that the economy is in equilibrium when actual expenditure equals
planned expenditure. This assumption is based on the idea that when people’s
plans have been realized, they have no reason to change what they are doing.

figure 10-2

Planned Planned Expenditure as a

expenditure, E Planned expenditure, E ⫽ C(Y ⫺ T ) ⫹ I ⫹ G Function of Income Planned
expenditure depends on
income because higher income
leads to higher consumption,
which is part of planned
MPC expenditure. The slope of this
$1 planned-expenditure function
is the marginal propensity to
consume, MPC.

Income, output, Y

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 C H A P T E R 1 0 Aggregate Demand I | 261

Recalling that Y as GDP equals not only total income but also total actual ex-
penditure on goods and services, we can write this equilibrium condition as

Actual Expenditure = Planned Expenditure

Y = E.

The 45-degree line in Figure 10-3 plots the points where this condition holds.
With the addition of the planned-expenditure function, this diagram becomes
the Keynesian cross. The equilibrium of this economy is at point A, where the
planned-expenditure function crosses the 45-degree line.
How does the economy get to the equilibrium? In this model, inventories
play an important role in the adjustment process.Whenever the economy is not
in equilibrium, firms experience unplanned changes in inventories, and this in-
duces them to change production levels. Changes in production in turn influ-
ence total income and expenditure, moving the economy toward equilibrium.

figure 10-3

Planned The Keynesian Cross The equi-

expenditure, E Actual expenditure,
Y⫽E
librium in the Keynesian cross
is at point A, where income
(actual expenditure) equals
Planned expenditure, planned expenditure.
A E⫽C⫹I⫹G

45°
Income, output, Y
Equilibrium
income

For example, suppose the economy were ever to find itself with GDP at a level
greater than the equilibrium level, such as the level Y1 in Figure 10-4. In this case,
planned expenditure E1 is less than production Y1, so firms are selling less than they
are producing. Firms add the unsold goods to their stock of inventories. This un-
planned rise in inventories induces firms to lay off workers and reduce production,
and these actions in turn reduce GDP.This process of unintended inventory accu-
mulation and falling income continues until income Y falls to the equilibrium level.
Similarly, suppose GDP were at a level lower than the equilibrium level, such as
the level Y2 in Figure 10-4. In this case, planned expenditure E2 is greater than pro-
duction Y2. Firms meet the high level of sales by drawing down their inventories.

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 262 | P A R T I V Business Cycle Theory: The Economy in the Short Run

figure 10-4

Expenditure, E Actual expenditure The Adjustment to Equilibrium in

the Keynesian Cross If firms were
producing at level Y1, then planned
expenditure E1 would fall short of
Unplanned
Y1 drop in production, and firms would
inventory accumulate inventories. This
E1 causes Planned expenditure inventory accumulation would
income to rise. induce firms to reduce production.
E2 Similarly, if firms were producing at
Unplanned level Y2, then planned expenditure
Y2 inventory E2 would exceed production, and
accumulation firms would run down their
causes inventories. This fall in inventories
income to fall. would induce firms to raise
45° production. In both cases, the
Y2 Y1 Income, output, Y firms’ decisions drive the economy
Equilibrium toward equilibrium.
income

But when firms see their stock of inventories dwindle, they hire more workers and
increase production. GDP rises, and the economy approaches the equilibrium.
In summary, the Keynesian cross shows how income Y is determined for given
levels of planned investment I and fiscal policy G and T. We can use this model to
show how income changes when one of these exogenous variables changes.
Fiscal Policy and the Multiplier: Government Purchases Consider how
changes in government purchases affect the economy. Because government pur-
chases are one component of expenditure, higher government purchases result in
higher planned expenditure for any given level of income. If government pur-
chases rise by G, then the planned-expenditure schedule shifts upward by G, as
D
in Figure 10-5.The equilibrium of the economy moves from point A to point B.
D
This graph shows that an in-
crease in government purchases
leads to an even greater increase
in income. That is, Y is larger
D
© The New Yorker Collection. 1992 Dana Fradon

than G. The ratio Y/ G

D D D
from cartoonbank.com. All Rights Reserved.

is called the government-

purchases multiplier; it tells
us how much income rises in
response to a $1 increase in gov-
ernment purchases. An implica-
tion of the Keynesian cross is
that the government-purchases
multiplier is larger than 1.
“Your Majesty, my voyage will not only forge a new route to the spices of Why does fiscal policy have a
the East but also create over three thousand new jobs.” multiplied effect on income?

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 C H A P T E R 1 0 Aggregate Demand I | 263

figure 10-5

Expenditure, E An Increase in Government

Actual expenditure Purchases in the Keynesian Cross
Planned An increase in government
B expenditure purchases of G raises planned
E2 ⫽ Y2 ⌬G D
expenditure by that amount for any
⌬Y given level of income. The
1. An increase equilibrium moves from point A to
E1 ⫽ Y1 in government point B, and income rises from Y1
A
purchases shifts to Y2. Note that the increase in
planned expenditure income Y exceeds the increase in
upward, . . . D
government purchases G. Thus,
D
fiscal policy has a multiplied effect
on income.
45°
Income, output, Y
⌬Y

E1 ⫽ Y1 2. . . . which increases E2 ⫽ Y2
equilibrium income.

The reason is that, according to the consumption function C = C(Y − T ), higher

income causes higher consumption.When an increase in government purchases
raises income, it also raises consumption, which further raises income, which fur-
ther raises consumption, and so on.Therefore, in this model, an increase in gov-
ernment purchases causes a greater increase in income.
How big is the multiplier? To answer this question, we trace through each step
of the change in income. The process begins when expenditure rises by G,
which implies that income rises by G as well.This increase in income in turn
D
D
raises consumption by MPC × G, where MPC is the marginal propensity to
D
consume. This increase in consumption raises expenditure and income once
again.This second increase in income of MPC × G again raises consumption,
D
this time by MPC × (MPC × G), which again raises expenditure and income,
D
and so on.This feedback from consumption to income to consumption contin-
ues indefinitely.The total effect on income is

Initial Change in Government Purchases =

DG
First Change in Consumption = MPC ×
DG
Second Change in Consumption = MPC2 ×
DG
Third Change in Consumption = MPC3 ×
. . DG
. .
. .

DY = (1 + MPC + MPC + MPC 3 + . . .) G.

2
D
The government-purchases multiplier is

DY/DG = 1 + MPC + MPC + MPC 3 + . . .

2

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 264 | P A R T I V Business Cycle Theory: The Economy in the Short Run

This expression for the multiplier is an example of an infinite geometric series.A re-
sult from algebra allows us to write the multiplier as2

DY/DG = 1/(1 − MPC).

For example, if the marginal propensity to consume is 0.6, the multiplier is

DY/DG = 1 + 0.6 + 0.6 + 0.63 + . . .

2

= 1/(1 − 0.6)
= 2.5.

In this case, a $1.00 increase in government purchases raises equilibrium income

by $2.50.3

Fiscal Policy and the Multiplier: Taxes Consider now how changes in taxes
affect equilibrium income. A decrease in taxes of T immediately raises dispos-
D
able income Y − T by T and, therefore, increases consumption by MPC × T.
D D
For any given level of income Y, planned expenditure is now higher. As Figure
10-6 shows, the planned-expenditure schedule shifts upward by MPC × T. The
equilibrium of the economy moves from point A to point B.
D

2
Mathematical note: We prove this algebraic result as follows. Let
z = 1 + x + x 2 + . . ..
Multiply both sides of this equation by x:
xz = x + x 2 + x3 + . . ..
Subtract the second equation from the first:
z − xz = 1.
Rearrange this last equation to obtain
z(1 − x) = 1,
which implies
z = 1/(1 − x).
This completes the proof.
3
Mathematical note: The government-purchases multiplier is most easily derived using a little calcu-
lus. Begin with the equation
Y = C(Y − T ) + I + G.
Holding T and I fixed, differentiate to obtain
dY = C ′dY + dG,
and then rearrange to find
dY/dG = 1/(1 − C ′ ).
This is the same as the equation in the text.

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 C H A P T E R 1 0 Aggregate Demand I | 265

figure 10-6

Expenditure, E A Decrease in Taxes in the

Actual expenditure
B Planned Keynesian Cross A decrease in taxes
E2 ⫽ Y2 expenditure of T raises planned expenditure by
MPC ⫻ ⌬T
D
MPC × T for any given level of
D
income. The equilibrium moves
⌬Y
from point A to point B, and
1. A tax cut income rises from Y1 to Y2. Again,
E1 ⫽ Y1 shifts planned fiscal policy has a multiplied effect
A
expenditure on income.
upward, . . .

45°
Income,
⌬Y
output, Y

E1 ⫽ Y1 2. . . . which increases E2 ⫽ Y 2
equilibrium income.

Just as an increase in government purchases has a multiplied effect on income,

so does a decrease in taxes. As before, the initial change in expenditure, now
MPC × T, is multiplied by 1/(1 − MPC).The overall effect on income of the
D
change in taxes is

DY/DT = −MPC/(1 − MPC).

This expression is the tax multiplier, the amount income changes in response
to a $1 change in taxes. For example, if the marginal propensity to consume is
0.6, then the tax multiplier is

DY/DT = −0.6/(1 − 0.6) = −1.5.

In this example, a $1.00 cut in taxes raises equilibrium income by $1.50.4

4
Mathematical note: As before, the multiplier is most easily derived using a little calculus. Begin with
the equation
Y = C(Y − T ) + I + G.
Holding I and G fixed, differentiate to obtain
dY = C ′(dY − dT ),
and then rearrange to find
dY/dT = −C ′/(1 − C ′ ).
This is the same as the equation in the text.

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 CHAPTER 5 The Keynesian System (I): The Role of Aggregate Demand 101

FIGURE 5-7 Effect of an Increase in Taxes on Equilibrium Income

a. Aggregate Expenditures 45°
C, I, G (C + I + G)0

A b (C + I + G)1

b
B
–b⌬T
a – bT0 + I0 + G0
a – bT1 + I0 + G0

Y1 Y0 Y
Income (Output)

b. Investment, Government Spending, Saving, and Taxes

S + T1
I, G, S, T
S + T0

(1 – b)
B A
I0 + G0 I0 + G0

Y1 Y0 Y
Income (Output)
An increase in taxes from T0 to T1 shifts the aggregate expenditure schedule downward in part a, from
(C + I + G)0 to (C + I + G)1 to equilibrium point B, because taxes are in the intercept. Equilib-
rium income falls from , Y0 to Y1. In part b, starting at equilibrium point A, the saving plus taxes
schedule shifts up, from S + T0 to S + T1. Equilibrium moves from A to B.

The tax multiplier is one less in absolute value than the government expenditure multi-
plier. This fact has an important implication for the effects of an increase in govern-
ment spending accompanied by an equal increase in taxes, a balanced-budget increase.
To find the effects of such a combination of policy changes, we add the two policy mul-
tipliers to get the following expression:
⌬Y ⌬Y 1 -b 1 - b
+ = + = = 1
⌬G ⌬T 1 - b 1 - b 1 - b
balanced-budget A 1-dollar increase in government spending financed by a 1-dollar increase in taxes
multiplier
increases equilibrium income by 1 dollar. This result, termed the balanced-budget
gives the change in
equilibrium output
multiplier, reflects the fact that tax changes have a smaller per-dollar impact on equi-
that results from a librium income than do spending changes. The value of 1 for the multiplier results
1-unit increase or because the tax multiplier is one less in absolute value than the spending multiplier.
decrease in both The latter result does not carry through in many more complex models, but the result
taxes and govern- that tax changes affect aggregate demand by less per dollar than changes in govern-
ment spending ment spending is quite general.
104 PART II CLASSICAL ECONOMICS AND THE KEYNESIAN REVOLUTION

5.7 Exports and Imports in the Simple Keynesian Model

Both imports and exports have been growing as shares of GDP over recent decades.
In 1960, U.S. imports of goods and services totaled 4.4 percent of GDP. By 2010, this
figure was 16.3 percent of GDP. Exports rose from 4.9 percent of GDP in 1960 to
12.7 percent in 2010. Overall, the U.S. economy has become much more closely
linked to those of other nations over the past 50 years. This section focuses on the
roles of imports and exports in determining equilibrium income in the simple Keyne-
sian model. Recall from Chapter 2 that GDP (Y ) consists of consumption, invest-
ment, and government spending plus net exports. Net exports are exports minus
imports. The condition for equilibrium output in the open economy (including
exports and imports) is
Y = E = C + I + G + X - Z (5.23)
Compared with equation (5.2), the condition for equilibrium in the closed economy,
we have added exports (X) to aggregate demand and subtracted imports (Z). Exports
are the foreign demand for domestic output and therefore part of aggregate demand.
Also, because imports are included in C, I, and G but are not demands for domestic
goods, we must subtract them from aggregate demand.
To find an expression for equilibrium GDP in the open-economy model, we follow
the same procedure as for the closed-economy case; we take investment and govern-
ment spending as exogenous—that is, as autonomous expenditure components. Con-
sumption is given by the consumption function
C = a + bY (5.24)
where, because they play no essential role in our discussion here, we have left out
taxes, and therefore do not need to distinguish between GDP (Y) and disposable
income (YD = Y - T). To compute equilibrium output for the open-economy case,
we need to specify the determinants of imports and exports.
To simplify our analysis, we assume that imports consist solely of consumption
goods. The demand for imports is assumed to depend on income and to have an auton-
omous component.
Z = u + vY u 7 0, 0 6 v 6 1 (5.25)
The parameter u represents the autonomous component of imports. The parameter v
is the marginal propensity to import, the increase in import demand per unit increase
in GDP, a concept analogous to the MPC (b) in (5.24).16
The demand for U.S. exports is a part of the foreign demand for imports. The for-
eign demand for imports depends on the level of foreign income, being determined by
an import demand function analogous to equation (5.25). From the U.S. point of view,
foreign income and, hence, the demand for our exports are exogenous.
Additional variables that we would expect to influence both U.S. demand for
imports and foreign demand for U.S. exports are the relative price levels in the two
countries and the level of the exchange rate. These variables determine the relative
costs of the two countries’ products to residents of either country. Note that we are
assuming that price levels and the exchange rate are fixed. The effects on imports and
exports of changes in the price level or exchange rate are examined in Part IV.

16
Note that, because consumption includes imports, b is the MPC for both domestic and imported goods.
Because v is the marginal propensity to import (consumption goods), b - v is the MPC for domestic goods.
 CHAPTER 5 The Keynesian System (I): The Role of Aggregate Demand 105

With imports given by equation (5.25) and exports assumed to be exogenous, we

can compute equilibrium income from equation (5.23) as follows:
Y = C + I + G + X - Z (5.23)
C ⫺Z

v
v
= a + bY + I + G + X - u - vY

Y - bY + vY = a + I + G + X - u
11 - b + v2Y = a + I + G + X - u (5.26)

1a + I + G + X - u2
1
Y =
1 - b + v
To examine the effects of foreign trade in the model, we compare equation (5.26)
with the equivalent expression for equilibrium income from the closed-economy model,
equation (5.14). This expression, omitting the tax variable (T), can be written as

1a + I + G2
1
Y = (5.27)
1 - b
In both equations (5.26) and (5.27), equilibrium income is expressed as the product of
two terms: the autonomous expenditure multiplier and the level of autonomous
expenditures. Consider how each of these is changed by adding imports and exports
to the model.
Take first the autonomous expenditure multiplier, 1>(1 - b + v) in equation
(5.26) as opposed to 1>(1 - b) in equation (5.27) for the closed-economy model.
Because v, the marginal propensity to import, is greater than zero, the multiplier in
(5.26), 1>(1 - b + v), will be smaller than the multiplier in (5.27), 1>(1 - b). For
example, if b = 0.8 and v = 0.3, we would then have
1 1 1
= = = 5
1 - b 1 - .08 0.2
and
1 1 1
= = = 2
1 - b + v 1 - 0.8 + 0.3 0.5
From these expressions, it can be seen that the more open an economy is to foreign
trade (the higher v is), the lower will be the autonomous expenditure multiplier.
The autonomous expenditure multiplier gives the change in equilibrium income
per unit change in autonomous expenditures. It follows, therefore, that the more open
an economy is (the higher v is), the smaller will be the response of income to aggregate
demand shocks, such as changes in government spending or autonomous changes in
investment demand. The decline in the value of the autonomous expenditure multi-
plier with a rise in v can be explained with reference to the multiplier process (Section
5.5). A change in autonomous expenditures—a change in government spending, for
example—will have a direct effect on income and an induced effect on consumption
with a further effect on income. The higher the value of v, the larger the proportion of
this induced effect that will be a change in demand for foreign, not domestic, consumer
goods. Consequently, the induced effect on demand for domestic goods and, hence, on
domestic income will be smaller.17 The increase in imports per unit of income

17
Recall from footnote 16 that b - v is the MPC for domestic goods. A higher v (given b) therefore means
a lower MPC for domestic goods and a lower value for the multiplier.