What I want to introduce you to in this video
is the idea of a Keynesian Cross.
This is one of the tools of analysis of Keynesian thinking
which is really the idea that maybe every now and then
the GDP, when it's at equilibrium,
isn't at an optimal state.
It's operating well below potential
and the way that we might be able to get.
If you are a follower of Keynesian thinking,
the way that we can get it closer to,
potential closer to full employment
is by somehow affecting aggregate demand in some way.
What we'll see is,
we're going to build up our Keynesian Cross analysis
based on what we understand from the consumption function.
We're going to first start thinking about
planned expenditures.
We're going to think about what happens
when planned expenditures deviates from actual output,
from actual expenditures, right over here.
This is very similar to what we're done before
but we're actually thinking of it in terms of planning.
Let's say we have planned expenditures,
expenditures planned
and we could just write the components
of aggregate expenditure here.
Well, you're going to have consumer spending,
you're going to have investment.
I'm going to be careful here,
I'm going to call it planned investment.
This is exactly what firms are looking to produce.
The reason why I differentiate this here
is because, if for whatever reason,
aggregate expenditure is less than they expect
then they might build up inventories
and those inventories get counted as investments.
Those would be excess inventories above and beyond
the planned inventories.
If actual demand is higher than expended
then it might eat in to inventories
and when inventories are eaten into
it actually takes away from planned investments
there would actually be kind of a,
you would be eating into the total investment
in that situation.
That's why I'm going to differentiate
between planned investment and actual investment.
Then of course, you have government spending
and then finally you have net exports.
For the sake of the analysis of the Keynesian Cross,
once again, this is a super over simplification,
we're going to assume that at any given level of GDP
or aggregate output that these are all constant.
That these are not really dependent
on aggregate output or GDP
which is of course a huge over simplification.
If we were to plot any of these
versus aggregate income
we'd say that they are really a flat line.
Maybe planned investment might look something like that.
Maybe government spending would look something like that.
No ways at some level that's preplanned,
it's exogenous to our model.
It's not dependant in any way.
It's an external factor.
Assuming it's fixed,
it's not dependent on aggregate income.
So government spending looks something like that
and net exports, maybe it looks something like that.
The one factor that you can imagine
because I said we're going to build
on top of the consumption function
that we're going to assume is driven by aggregate income
is consumption right over here.
The way that this thing will look,
the way that this thing will look
is you have ...
So let me draw another plot right over here,
draw another plot.
We have aggregate income,
that is going to be our independent variable
and then over here we can just view this as expenditure.
If we were just to plot consumer spending,
we've seen that before
especially if we assume a linear consumption function.
What we've studied in the last few videos
is all linear consumption functions
and depending on how you write it,
but they all look something like this.
They have a positive vertical axis intercept
and they have upward slope that is less than 1.
Consumption by itself would look something like this,
this would be consumer spending
as a function of aggregate income.
Then if you all all of these constants to it
then your graph for aggregate planned expenditures
would look something like this.
if you added just in net exports
it would get a little bit higher
because these are constant.
Any point you would add this much,
if you add government a little higher than that
and if you add all of them including planned investments
you might get something that looks,
and I'll do it in this color right over here,
you might get something that looks like this.
I'm just starting off with consumer spending.
I'm using a linear consumption function,
you don't have to,
but it makes the Keynesian Cross analysis
a lot more cross like and easier to analyse.
If you add all what we assumed to be constant things
and aggregate expenditures is going to be up here.
This right over here
is aggregate planned expenditures I should say.
Now, we know from the circular flow in the economy
that when an economy is at equilibrium,
your aggregate output is equal to your aggregate expenditures
or your aggregate expenditures
is equal to your aggregate income.
Really, at an equilibrium,
these two things are going to be equal.
We can actually plot a line that shows all the points
that those are equal.
That would be a line that has essentially a slope of 1
where Y is always equal to expenditures.
It might look something like this.
This is where the name Keynesian cross comes from
because essentially you have planned expenditures
and then right over here you have the equilibrium line
or what I call the equilibrium line
because these are all points where income
is equal to expenditure.
Right over here, income is equal to expenditure.
Income is equal to expenditure.
When you look at aggregate planned expenditures
or you can even view this as aggregate demand
as a function of aggregate income.
This is actual point
where the actual economy is at equilibrium
where expenditures are actually equal to,
where expenditures are actually equal to output.
Actually, it's a little bit skewed the way I drew it
but these actually should be like a square.
Actually, let me see if I can draw a little bit
clearer than that.
Just so it will actually looks like a 45 degree line.
It should really be a 45 degree line like that.
That seems a little bit better.
That's the point at which we are at equilibrium.
Actually, I don't like that
because it makes it a little bit harder to analyse.
But hopefully you get the idea.
This should be a line that's where expenditures
is equal to aggregate income.
Like this so it intersects at a point
that's a little bit easier for me to analyse.
Now, this is where the Keynesian Cross
becomes a kind of interesting tool
because we could start to think about
what happens in situations.
This is an equilibrium level of GDP.
What happens if for whatever reason
that aggregate income
is higher than that equilibrium level?
Let's think about scenario.
Let's say we're over here.
Let me do that in magenta.
Let's say we're over here.
Let's call that Y1.
What is going on?
What is going on right over here at Y1?
Over here, the aggregate output
which is the same thing as aggregate income
is right over here.
Well, this is the actually planned expenditures,
is right over here.
All of these excess. All of these excess
above the planned demand,
these are essentially going to be inventories building up.
The economy is producing more than it actually needs,
inventories are going to build up.
Firms are not selling all of their products
and that excess built up inventory
is going to be reflected in investment.
In this case, this delta.
This delta is going to be added to your planned investment
to get what the actual investment might be.
When an economy is at that state
then firms would say, "Oh my god!
"We're building inventory more than we expected.
"We're not selling our products.
"We're going to lower output
"so there's a natural feedback mechanism for the GDP
"to go back to equilibrium."
Let's think about what happens
if it's below that equilibrium point.
Let's say that GDP is,
let's call that right over here.
This is Y2.
Actually, I could write it as a subscript.
I don't know, I wrote a superscript there.
We could call this Y2.
Over here, aggregate demand at this level of output
is more than what's actually being output.
People want more goods and services.
Right over here,
this is a deficit of output
and so this shows that people
will be digging into inventory.
That the existing inventories
or the existing investment was not enough.
Or, I guess another way to think it,
essentially, inventories will be contracting.
Let's say business was constant.
I had a lemonade stand, I just keep an inventory
of 5 cups of lemonade on hand
and I sell a cup every hour.
If all of a sudden people start buying 2 cups an hour
my inventory is going to start getting depleted
and so this is what's reflected.
Actual output is below what's demanded.
When firms start seeing
that their inventories get depleted, they say,
"Oh my god!
"I don't want to run out of my goods and services.
"Let me start producing more."
Then when we're talking about inventories
we're really talking about goods.
So let me produce more.
So output will once again
want to naturally go to that feedback point.
Hopefully that makes a little bit of sense.
In the next few videos we'll be using the Keynesian Cross
to think about the Keynesian line of reasoning.
If you change one of these,
how that might affect the new equilibrium level of GDP.