The Keynesian

Cross Model, The

Money Market, and
IS/LM
Planned expenditure and actual
expenditure.
 Constructing the Keynesian Cross

• Actual expenditure is Y and

planned expenditure is
E = C + I + G.
• I, G, and T are assumed E
exogenous and fixed. Y=E

• Our consumption function is E=C+I+G

C = c(Y–T), where c is the
marginal propensity to E* mpc
consume (mpc).
£1
• Mapping out
E = c(Y–T) + I + G gives us… Y
Y*
• The slope of E is the mpc.
• In equilibrium planned
expenditure equals total
expenditure or Y=E.
 Constructing the Keynesian Cross

• Equilibrium is at the point where Y

= C + I + G. Inventory
accumulates.
drops.
• If firms were producing at Y1
then Y > E E
• Because actual expenditure Y=E
exceeds planned expenditure,
inventory accumulates, E=C+I+G
stimulating a reduction in E* mpc
production.
• Similarly at Y2, Y < E £1
• Because planned expenditure
exceeds actual expenditure, Y2 Y* Y1
Y
inventory drops, stimulating
an increase in production.
 Government expenditure and tax multipliers

• An increase of G by ΔG causes an
upward shift of planned expenditure
by ΔG.
• Notice that ΔY > ΔG. This is because
although ΔG causes an initial change
in Y of ΔG, the increased Y leads to E
an increase in consumption and Y=E
triggers a multiplier effect.
• Now suppose a decrease of T by ΔT ΔG
that causes an upward shift of E2 mpc*ΔT
planned expenditure by mpc*ΔT. E3

• Notice again that ΔY > ΔT but that ΔY E1

is less than in the case with ΔG. This
is because ΔT causes no initial
change in Y as ΔG did, the decrease Y
in T simply leads to an increase in Y1 Y 3 Y2
consumption and triggers the
multiplier effect.
 Building the IS curve
E
E=Y
• The IS curve maps the
relationship between r and Y for E=C+I(r1)+G
the goods market.
Let the interest rate E=C+I(r2)+G
This decrease in
So Y decreases
increase from r1 to from
r2
investment
The IS curve causes
mapsthe out this ΔI
reduce Y
planned to Y .
1 investment
planned
relationship
expenditure
between
2
the
from I(rto
function
interest 1) to
rate, I(r
shift ). output
r, 2down.
and
(or income) Y. Y
Y2 Y1

r r

r2 r2

r1 r1
I(r) IS
I Y
I(r2) I(r1) Y2 Y1
 Shifting the IS curve
E
E=Y
• While changing r allows us to map
out the IS curve, changes in G, T, or
mpc cause Y to change for any E=C+I+G2
level of r. This causes a shift in the E=C+I+G1
IS curve.
ΔG
Suppose an increase in G
causes planned
expenditure to shift up by Y
Y1 Y2
ΔG.
r
For any r the increase in G
causes an increase in Y of
ΔG times the government
expenditure multiplier.
r1
Therefore, the IS curve IS´
shifts to the right by this IS
amount. Y
Y1 Y2
 A loanable funds market interpretation

• The IS curve maps the relationship

between r and Y for the loanable
funds market in equilibrium.

• Suppose Y increases from Y1 to Y2. This • The IS curve maps out this
raises savings from S(Y1) to S(Y2) relationship between the lower
resulting in a lower equilibrium interest interest rate and increased
rate. income.

r r
S(Y1) S(Y2)

r1 r1

r2 r2 IS
I(r)
I Y
Y1 Y2
A loanable funds market interpretation of fiscal policy

• While changing r allows us to map

out the IS curve, changes in G, T,
or mpc cause Y to change for any
level of r. This causes a shift in
the IS curve.
• Suppose again an increase in G. In • Therefore, for a given Y there is a
the loanable funds market this higher level of r. So, the IS curve
results in a decrease in S and an shifts up by this amount.
increase in the interest rate.

r r
S(G2) S(G1)

r2 r2
IS´
r1 r1
I(r) IS
I Y
Y1
 Building the LM curve

• The LM curve maps the

relationship between r and Y for
the money market.

Given money supply The LM curve maps

and money demand out this relationship
suppose an increase in between
income raises money r and Y.
demand.
r r
(M/P)s
LM

r2 r2

r1 r1
L(r,Y1) L(r,Y2)
Real
Y
Money Y1 Y2
Balances
 Shifting the LM curve

• While changing money demand

allows usGiven
to mapmoney
out thesupply and
LM curve,
Now
changesmoney there is
in M ordemand a higher
P causesuppose
r to reala
interest
changedecrease rate
for any level for the
of money
in the current
Y. Thisstock The LM curve shifts
causes a shiftlevel
in the
of LM curve.
output. up so that at the same
shifts real money supply to
the left resulting in a higher level of output the
equilibrium interest rate. interest rate is higher.

r (M2/P)s (M1/P)
s r
LM´ LM

r2 r2

r1 r1
L(r,Y)
Real
Money Y
Y
Balances
 IS=LM: The Short Run Equilibrium

• Given our IS and LM equation we can

now determine the short run
equilibrium interest rate and output

• By mapping out the relationship

between Y and r when the goods
market (or loanable funds market)
is in equilibrium we get the IS
curve.
• By mapping out the relationship
between Y and r when the money
market is in equilibrium we get the LM r
curve. LM
• When we set IS=LM we can solve
for the equilibrium levels of r and
Y. This represents simultaneous
equilibrium in the goods market
(or loanable funds market) and the r*
money market. IS
Y
Y*
 Conclusion

• We constructed the IS curve from the goods

market and from the loanable funds market.
We discussed shifting factors for IS.
• We constructed the LM curve from the
money market and discussed shifting
factors for LM.
• Finally, we set IS=LM to achieve equilibrium
in all markets giving us short run
equilibrium r and Y.