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Keynesian Cross

gdp1.jpg1. Let's consider closed private economy without government spending and international trade. Hence, according to Keynesian theory, the aggregate demand is the sum of consumption and investment AD = C + I.

Keynes supposed that consumption is the function of disposable income Y: C(Y) = C0 + cY, where c is marginal propensity to consume, 0 < c < 1, C0 is autonomous consumption - the consumption expenditures that are unrelated to income and would occur even if household disposable income was zero. Next we assume that investment is a constant I = I0. Hence

AD(Y) = C0 + I0 + cY.

Let us denote C0 + I0 = A0.

2. Let equilibrium level of income Y* is the income at which the economy creates just enough spending to purchase the output produced. In other words, equilibrium occurs when aggregate demand (aggregate expenditures) AD(Y) is equal aggregate supply (aggregate domestic output) AS=Y:
Y* = AD (Y*), hence
Y* = A0/(1-c)

We can see this equilibrium on the upper graph called Keynesian cross.

3. Marginal propensity to consume is c - the proportion of each additional dollar of income that is used for consumption expenditures. The rest of income goes on savings S = Y - C. Hence,
S(Y) = -C0 + (1 - c)Y , and for equilibrium level of income:
S(Y*) = -C0 + (1 - c)A0/(1-c) = I0,
i. e. equilibrium occurs in the point where aggregate savings equal aggregate investment.

We can see this conclusion on the lower graph.

We'll consider the multiplier effect in the next post.

P.S.
GDP (gross domestic product) is the total market value of all goods and services produced within the political boundaries of an economy during a given period of time, usually one year. The aggregate expenditures approach to measurement of GDP reflects in the Basic Keynesian Equation GDP = C + I + G + NE, where C- consumption, I - gross investment, NE - net exports and G - government spending. I. e. we can consider the GDP in the conclusions above and the Y* is the equilibrium GDP that equalize aggregate supply (AS) and aggregate demand (AD).

Posted by mazoo at February 27, 2005 5:11 PM

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The Multiplier Effect Feb 27, 2005

Comments

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good luck

Posted by: Nicolas Martin at July 18, 2005 6:12 AM

Thank you very much, Nicolas!

Posted by: Mazoo at July 25, 2005 9:06 PM

thanks very much.this is very helpful to me. i am studying for Caribbean Advanced Proficiency Exams, Economics. this is a blessing!

Posted by: swatie at February 5, 2006 6:05 PM

Thanks Mazoo.
Im an external student at LSE. Life is hard but people like you simplify it enough to be tolerable.

Posted by: Ken at March 21, 2006 11:13 AM