Chapter 32: Keynesian Economics and IS-LM
Analysis
The Keynesian Cross
Full employment is defined as a point where those people who want to work at the going
market wage level are able to find a job. Any unemployment that did exist would be classed
as voluntary unemployment.
Planned and Actual Spending
Fundamental to Keynesian analysis is the distinction between planned and actual decisions
by households and firms. Planned spending, saving or investment refers to the desired or
intended actions of firms and households. Actual spending, saving or investment refers to
the realized, ex-post (after the event) outcome. Planned and actual outcome, therefore,
might be very different. Keynes suggested that there was no reason why equilibrium national
income would coincide with full employment output. Wages and prices might not adjust in
the short run because of sticky wages and prices, and so the economy could be at a position
where the level of demand in the economy was insufficient to bring about full employment.
The Equilibrium of the Economy
We have seen that a country’s GDP is divided into four components: consumption,
investment, government spending, and net exports. Imagine total expenditure in the
economy given by C+I+G+NX was exactly the same as national income. This would be
represented as a 45-degree line such as in figure 32.1. The 45-degree line connects all
points where consumption spending (actual expenditure) would be equal to national income
(planned expenditure). This line can be thought of as the equivalent of the capacity of the
economy - the aggregate supply (AS) curve. The C+I+G+NX line is a function of income - in
other words, spending depends on income. If income is higher, spending will also be higher
and so the C+I+G+NX line has a positive slope. The vertical intercept of the C+I+G+NX line
given as E0, is termed autonomous spending or autonomous expenditure. This is the
component of expenditure which does not depend on income/output - government spending
being a key element of this expenditure.
Where the actual spending is equal to planned spending is the short-run equilibrium of the
economy. Note that the use of the term ‘equilibrium’ does not mean ‘best’ or ‘desired’, it's
simply a point where actual spending is equal to planned spending. The economy is in
equilibrium where the C+I+G+NX line cuts the 45-degree line. This is referred to as the
Keynesian Cross. In panel (a) the economy is in equilibrium at a national income of Y1.
However, full employment national income is at Yf. Actual spending of C+I+G+NX gives an
equilibrium which is less than that required for full employment output. At the equilibrium Y1,
there is spare capacity in the economy. This is the equivalent to an economy being at a point
inside its production possibilities frontier. The difference between full employment output and
the expenditure required to meet it is termed the deflationary gap. Expenditure needs to rise
to C+I+G+NX1 in order to eliminate the deflationary gap which is the vertical distance
between actual spending and spending necessary to achieve full employment.
, In panel (b) the C+I+G+NX line cuts the 45-degree line at an output level of Y1 which is
higher than full employment output, Yf. In this situation, the economy does not have the
capacity to meet actual spending. This will trigger inflationary pressures. The difference
between full employment output and the expenditure line here is called the inflationary gap.
Actual spending needs to be reduced to eradicate the inflationary gap and the C+I+G+NX
line needs to be reduced to C+I+G+NX2 to bring the economy to an equilibrium where actual
spending equals full-employment output.
Demand Management
The deviations in the business cycle in the Keynesian analysis are primarily due to demand-
side factors. The principle behind Keynesian economics is simple, downturns in economic
activity occur because firms fail to sell all the goods and services they planned to sell. If
customers are not buying as many goods and services, firms will cut back production so they
won’t need as many workers. Workers will become redundant and laid off, thus
unemployment rises and the cause is due to demand deficiency. The cause of a fall in
consumption in the first place is often difficult to pinpoint. It could be due to confidence and
expectations, it could be how the public responds to news stories, or it could be due to a
change in patterns of consumption. Keynes argued that governments can use the tools of
Analysis
The Keynesian Cross
Full employment is defined as a point where those people who want to work at the going
market wage level are able to find a job. Any unemployment that did exist would be classed
as voluntary unemployment.
Planned and Actual Spending
Fundamental to Keynesian analysis is the distinction between planned and actual decisions
by households and firms. Planned spending, saving or investment refers to the desired or
intended actions of firms and households. Actual spending, saving or investment refers to
the realized, ex-post (after the event) outcome. Planned and actual outcome, therefore,
might be very different. Keynes suggested that there was no reason why equilibrium national
income would coincide with full employment output. Wages and prices might not adjust in
the short run because of sticky wages and prices, and so the economy could be at a position
where the level of demand in the economy was insufficient to bring about full employment.
The Equilibrium of the Economy
We have seen that a country’s GDP is divided into four components: consumption,
investment, government spending, and net exports. Imagine total expenditure in the
economy given by C+I+G+NX was exactly the same as national income. This would be
represented as a 45-degree line such as in figure 32.1. The 45-degree line connects all
points where consumption spending (actual expenditure) would be equal to national income
(planned expenditure). This line can be thought of as the equivalent of the capacity of the
economy - the aggregate supply (AS) curve. The C+I+G+NX line is a function of income - in
other words, spending depends on income. If income is higher, spending will also be higher
and so the C+I+G+NX line has a positive slope. The vertical intercept of the C+I+G+NX line
given as E0, is termed autonomous spending or autonomous expenditure. This is the
component of expenditure which does not depend on income/output - government spending
being a key element of this expenditure.
Where the actual spending is equal to planned spending is the short-run equilibrium of the
economy. Note that the use of the term ‘equilibrium’ does not mean ‘best’ or ‘desired’, it's
simply a point where actual spending is equal to planned spending. The economy is in
equilibrium where the C+I+G+NX line cuts the 45-degree line. This is referred to as the
Keynesian Cross. In panel (a) the economy is in equilibrium at a national income of Y1.
However, full employment national income is at Yf. Actual spending of C+I+G+NX gives an
equilibrium which is less than that required for full employment output. At the equilibrium Y1,
there is spare capacity in the economy. This is the equivalent to an economy being at a point
inside its production possibilities frontier. The difference between full employment output and
the expenditure required to meet it is termed the deflationary gap. Expenditure needs to rise
to C+I+G+NX1 in order to eliminate the deflationary gap which is the vertical distance
between actual spending and spending necessary to achieve full employment.
, In panel (b) the C+I+G+NX line cuts the 45-degree line at an output level of Y1 which is
higher than full employment output, Yf. In this situation, the economy does not have the
capacity to meet actual spending. This will trigger inflationary pressures. The difference
between full employment output and the expenditure line here is called the inflationary gap.
Actual spending needs to be reduced to eradicate the inflationary gap and the C+I+G+NX
line needs to be reduced to C+I+G+NX2 to bring the economy to an equilibrium where actual
spending equals full-employment output.
Demand Management
The deviations in the business cycle in the Keynesian analysis are primarily due to demand-
side factors. The principle behind Keynesian economics is simple, downturns in economic
activity occur because firms fail to sell all the goods and services they planned to sell. If
customers are not buying as many goods and services, firms will cut back production so they
won’t need as many workers. Workers will become redundant and laid off, thus
unemployment rises and the cause is due to demand deficiency. The cause of a fall in
consumption in the first place is often difficult to pinpoint. It could be due to confidence and
expectations, it could be how the public responds to news stories, or it could be due to a
change in patterns of consumption. Keynes argued that governments can use the tools of
