If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content
Current time:0:00Total duration:9:20

Video transcript

what I want to introduce you to in this video is the idea of a Keynesian Keynesian cross so 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 well 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 and what we'll see is we're going to build up our Keynesian cross analysis based on what we understand from the consumption function so 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 so right over here so this is very similar what we've done before we're actually thinking of it in terms of planning so let's say we have planned expenditures expenditures planned and we just we could just write the the components of aggregate expenditure here well you're going to have consumer spending you're going to have investment and I'm going to be careful here I'm going to call it planned investment this is exactly what firms are looking to produce and the reason why I differentiate this year 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 investment so those would be excess inventories above and beyond planned inventories if actual demand is higher than expected then it might eat into inventories and when inventories are eaten into it actually takes away from planned investment so there would actually be kind of a you'd be eating into the total investment in that situation so that's why I'm going to differentiate between planned investment and actual investment and then of course you have government spending and then finally you have net exports and for the sake of the analysis of the Keynesian cross and once again this is a super oversimplification we're going to assume that any 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 oversimplification so if we were to plot any of these vs. if we were to plot any of these versus aggregate income we'd say that they are really a flat line so maybe planned investment might look like something like something like that maybe government spending would look something like that in no ways at some level that's pre-planned it's it's kind of exogenous to our model it's not dependent in any way it's an external factor assuming it's fixed it's not dependent on aggregate income and so government spending it would look something like that and that exports maybe it looks something like that the one of these the factor that you can imagine because I said we're going to build on top of the consumption function that is that we're going to assume is driven by aggregate income is consumption right over here and so the way that this thing will look the way that this thing will look is you have so let me draw another 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 X spend ature so if we were to just plot if we were just to plot consumer spending we've seen that before especially if we assume a linear consumption function so what we studied in the last few videos these were 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 an upward slope that is less than one so consumption by itself would look something like this this would be consumer spending as a function of as a function of aggregate income and then if you add all of these constants to it then your then your then your your graph for aggregate planned expenditures would look something like this so if you added just net exports would get a little bit higher because these are constant at any point you would add this much if you add government a little higher than that and if you add all of them including plan 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 something that looks like this so I'm just starting off with consumer spending I'm fine 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 analyze and then if you add all of what we assume to be things and aggregate expenditures goes is going to be up here so this right over here is aggregate planned expenditures I should say now we know we know from the circular flow in the economy that we're not 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 so really an equilibrium these two things are going to be equal and 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 one where Y is always equal to expenditures so it might look it might look something something like this and 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 so when you look at aggregate planned expenditures or you could even view this as kind of aggregate demand as a function of aggregate income this is the actual point where the Inc where the actual economy is at equilibrium where expenditures are actually equal to where expenditures are actually equal to output and actually it's a little bit skewed the way I drew it but these actually should be this should be like a square actually let me see if I can draw it a little bit a little bit clearer than that just so it'll actually looks like a 45-degree line so maybe it looks it should really be a 45-degree line like that and so that seems a little bit better so that's the point at which we are at equilibrium and actually I don't like that because it makes it a little bit harder to analyze and hopefully you get the idea this should be a line that's where expenditures is equal to aggregate income so I'll do it like this just so it intersects at a point that's a little bit easier for me to analyze now this is where Keynes II the cranes Keynesian cross becomes a kind of interesting tool because we can start to think about what happens in situations so this is this is an equilibrium this is an equilibrium level of GDP what happens if for whatever reason that aggregate output aggregate income is then that equilibrium level so let's think about that scenario so 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 so 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 actual planned expenditures is right over here so all of this excess all of this excess above kind of 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 so in this case in this case this Delta this Delta is going to be added to your planned investment to get what the actual investment might be and when an when and when an economy is at that state then firm time to tell oh my god we're building inventory more than we expected we're not selling our products we're going to lower output so it there's kind of a natural feedback mechanism for the GDP to go back to equilibrium and 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 so this is y2 let me actually write as a subscript I don't know if there's a superscript there but we could call this we could call this y2 so over here over here aggregate demand at this level of output is more than what's actually being output people want more goods and services so right over here this is kind of a deficit of output and so this shows that people will be digging into inventory that the the existing inventories or the existing investment was not enough or I guess another way to think they'll they'll essentially inventories will be contracting if I let's say business was constant I had a lemonade stand I just keep an inventory of five cups of lemonade on hand and I sell a cup every hour if all of a sudden people start buying two cups an hour my inventory is going to start getting depleted and so this is what's reflected actual output actual output is below what's demanded and 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 and we're talking about inventories we're really talking about goods so let me produce more and so output will once again want to naturally go to that feedback point so hopefully that makes a little bit of sense in the next few videos we'll be using the Keynesian cross to think about how the kind of the Keynesian line of reasoning so how if you change one of these how that might affect the new equilibrium level of GDP