Keynesian Circular-Flow Analysis

Keynes’s vision of the economy suggests a circular-flow framework—in which earning and spending are brought into balance by changes in the level of employment.

The Keynesian Vision

Graphically, the circular flow appears as the Keynesian cross, the cross’s intersection identifying the particular state of the economy in which income and expenditures are in balance.

The Income-Expenditure Framework

BUSINESSORGANIZATIONS

WORKERS

FACTOROWNERS

CONSUMERS

LABOR AND OTHERFACTOR SERVICES

INCOME

THECIRCULAR-FLOW

FRAMEWORK

BUSINESSORGANIZATIONS

WORKERS

FACTOROWNERS

CONSUMERS

LABOR AND OTHERFACTOR SERVICES

INCOME

GOODS ANDSERVICES

EXPENDITURES

Let the speed of rotation indicate the strength (fast) or weakness (slow) of

the economy.

LABORINPUT

REALWAGERATE S

D

LABORINPUT

OUTPUT

REALINCOME

C + I

F(K0,L)

BUSINESSORGANIZATIONS

WORKERS

FACTOROWNERS

CONSUMERS

INCOME

EXPENDITURES

In Keynesian equilibrium,INCOME equals EXPENDITURES.

Y = EY = C + I + G

45o

E = Y

EX

PE

ND

ITU

RE

S

INCOME

The circular character of the flow suggests an equality of left-half flow and right-half flow---as represented by a forty-five degree line passing through the origin.

EXPENDITURES, which constitute the left half of the circular flow, is represented on the vertical axis.

INCOME, which constitutes the right half of the circular flow, is represented on the horizontal axis.

The economy is in a Keynesian equilibrium somewhere along the 45o line—the line itself identifying all possible income-expenditure equilibrium points.

As taught at all levels, the consumption function is an essential component of the Keynesian framework. The presumed stability of this function underlies Keynesian thinking.

EX

PE

ND

ITU

RE

S

INCOME

CONSUMPTION

INVESTMENT

INCOME

C = a + bY

C + I

45oa

b

1

Consumption and Investment (as well as Government Spending) are portrayed as additive components of total spending. The three components are distinguished largely in terms of their stability characteristics: stable (C ), unstable (I), and stabilizing (G).

A wholly private macroeconomy achieves an income-expenditure equilibrium when Y = C + I. Note that income itself (rather than prices, wages, or the interest rate) is the equilibrating variable.

Investment depends neither on (current) income nor on the rate of interest. It depends only on profit expectations, which themselves are not well-anchored in economic reality.

Keynes would say the investors are moved by the “animal spirits.”

EX

PE

ND

ITU

RE

S

INCOME

C = a + bY

C + I

Suppose that a = 120 and b = 0.60.

In equilibrium, Y = E

So, Y = C + I

Y = a + bY + I

Y = 120 + 0.60Y + 240

Y – 0.60Y = 120 + 240

0.40Y = 360

Y = 900

b

a

C = 120 + 0.60Y

And suppose we know that investors are spending 240 on investment goods.

I = 240

Can we calculate the equilibrium level of income that corresponds to these parameters?

1

Yeq = 900

a = 120

b = 0.60

Though not emphasized by Keynes, full employment implies that the economy is operating on its production possibility frontier, the PPF itself being defined in terms of sustainable output levels of consumption and investment goods.

Yfe

According to Keynes, it is only by “accident or design” that the economy is actually performing at its full-employment potential.

We assume here that, initially, full employment conditions prevail—if only by accident.

EX

PE

ND

ITU

RE

S

INCOME

C = a + bY

L

W

S

D

C + I

INVESTMENT

CO

NS

UM

PT

ION

In Keynesian macroeconomics, full employment implies that the labor market clears at the going wage rate, the going wage itself having emerged during a period in which the economy was experiencing no macroeconomic problems.

LABOR INCOME

Labor income (YL = WL) is fully representative of total income, such that changes in labor income stand in direct proportion to changes in total income.

EX

PE

ND

ITU

RE

S

C = a + bY

C + I

INCOMEYfe

LABORINPUT

REALWAGERATE S

D

LABORINPUT

OUTPUT

REALINCOME

C + I

F(K0,L)

EX

PE

ND

ITU

RE

S

C = a + bY

C + I

INCOMEYfe

E < Y

EX

PE

ND

ITU

RE

S

INCOME

N

W

S

D

ΔY

EXCESS INVENTORIES

ΔI

C + I

C = a + bY

ΔI

ΔY = 1(1 – b)

According to Keynes, a collapse of investment activity (the collapse being attributed to a waning of “animal spirits”) is the primary cause of economic downturns. In response to reduced investment and hence reduced employment opportunities, the economy spirals downward into recession and possibly into deep depression.

Note that the going wage keeps going—even after the market conditions that gave rise to it are gone.

The simple investment-spending multiplier, 1/(1-b), quantifies the extent of the downward spiraling. Yfe

E = Y

INCOME

CONSUMPTION

INVESTMENT

900

ΔY ΔY = 1(1 – 0.6)ΔY

EX

PE

ND

ITU

RE

S

INCOME

N

S

D

W

C = a + bY

C + I

In the Keynesian construction, prices and the wage rate are sticky downward.

But note that they’re not stuck too high. They’re stuck just right. The going wage rate will clear the labor market once again—as soon as spending and hence labor demand recover to their full-employment levels.

A further loss of confidence on the part of the business community will send the economy even further from its full-employment potential.

ΔIΔY = 1(1 – b)

ΔI = 100

(100) = 250

900 650

ΔY = 1(1 – 0.6)

(100) = 250

ΔI = 100

400

900

Recovery may be self-initiating. Waning animal spirits may become waxing animal spirits. In due time, a pressing need to maintain or replace depreciating capital may account for the lower turning point of a bust-and-recovery sequence.

(Keynes, of course, preferred not to wait it out. He advocated make-work projects, deficit spending, and monetary stimulation to get the economy turned around.)

EX

PE

ND

ITU

RE

S

INCOME

C = a + bYC + I

N

S

D

W

Yfe

Yfe

Recovery may continue as further investment activity drives labor-demand back to its full-employment level...

EX

PE

ND

ITU

RE

S

INCOME

C + I

C = a + bY

N

S

D

W

EX

PE

ND

ITU

RE

S

C = a + bY

C + I

INCOMEYfe

Y = C + IC = C

Y – C = IS = I

Even in Keynesian equilibrium, saving equals investment. But it’s not the interest rate that does the equilibrating. Rather, it’s income that adjusts (spirals up or spirals down) until the saving-investment equality is established.

Even in a mixed economy, spending on consumption goods typically counts for about 70% of GDP. In this wholly private

economy, it would count for even more.

EX

PE

ND

ITU

RE

S

INCOME

C = a + bY

C + I

45o

a

b

1

In this wholly private economy, spending on investment goods accounts for the

remaining expenditures.

The “Keynesian Cross” marks the spot where income equals expenditures.

Yeq=Yfe

We assume here that, initially, full employment conditions prevail—though

only by accident.45o

Saving is represented by the vertical distance between the consumption equation and the 45O line. Saving is

negative for low levels of income and increasingly positive at higher levels.

(The 45O line allows income to be measured vertically as well as

horizontally.)

EX

PE

ND

ITU

RE

S

INCOME

C + I

C = a + bY

SA

VIN

G,

INV

ES

TM

EN

T

INCOME

a

-a

1

1-b

S = -a + (1-b)Y

I

Yeq=Yfe

Investment spending is determined exclusively by business psychology.

At each and every level of income, it is represented by the vertical separation

between C and C+I.

Clearly, saving equals investment at the same level of income at which

income equals expenditures.

So now, let’s net out consumption spending to show that S = I is an alternative equilibrium condition.

Y=0 and C=Y give us two points on the saving equation.

The slope of this line is 1-b, which together with the intercept (-a),

allows us to write the saving equation.

Investment is represented by a horizontal line.

Just by themselves, these two curves (S and I) identify the

income-expenditure equilibrium.

Finally, the shading on the S=I graph matches perfectly with the

shading on the Y=E graph.

45o

SA

VIN

G,

INV

ES

TM

EN

T

INCOME

S = -a + (1-b)Y

I

D

SS

AV

ING

,IN

VE

ST

ME

NT

S

I

SAVIING (S) INVESTMENT (D)

INCOME

RA

TE

OF

IN

TE

RE

ST

Market for Loanable Funds

D

SS

AV

ING

,IN

VE

ST

ME

NT S

I(r1)

I(r2) r2

r1

SAVIING (S) INVESTMENT (D)

INCOME

Keynes didn’t think I was a function of r…but we now know it is.

RA

TE

OF

IN

TE

RE

ST

Market for Loanable Funds

EX

PE

ND

ITU

RE

SC + I(r)

INCOMEY

C = a+ bY

EX

PE

ND

ITU

RE

S

C = a’ + bY

C + I(r1)

INCOMEY’Y

C + I(r2)

D

S

r2

r1

SAVIING (S) INVESTMENT (D)

RA

TE

OF

IN

TE

RE

ST

Market for Loanable Funds

I(r1) I(r2)

SA

VIN

G,

INV

ES

TM

EN

T

I(r1) I(r2)

INCOME

S

S’

S’