The Simple Keynesian Model, which is also known as the Keynesian Cross, emphasizes

one basic point. That point is that a decrease in aggregate demand can lead to a stable
equilibrium with substantial unemployment.

The Simple Keynesian Model application first explains the roles of consumption and
investment and then explains the accounting identity Y = C + I + G. Together, these
elements determine the equilibrium level of output.

The policy analysis experiments study the effects of animal spirits and fiscal policy. The
numerical results illustrate the calculation of a fiscal policy multiplier.

A concluding experiment extends the model to make investment a function of the interest
rate. Graphing the shifts in investment caused by changes in interest rates then reveals a
simple version of the IS curve found in an IS/LM analysis.

Model Link: The Simple Keynesian Model

<activate the model links>
Printable PDF Exercises

The Simple Keynesian Model is important not so much for its ability to capture the
details of recessions, but for its ability to demonstrate the possibility of a stable
equilibrium at less than full employment. While the real wage rate adjusts in the
Classical Model to move the economy to full employment, the real wage rate does not
appear in the Simple Keynesian Model and equilibrium is achieved by adjustments in
aggregate demand, which equals aggregate income. The equilibrium aggregate income
need not imply full employment.

Animal Spirits?

The 2001 U.S. recession could fit the Simple Keynesian Model. The dot-com meltdown
and the 9/11 shock had psychological as well as economic impacts. Could 2001 be the
recession that is due to a failure of animal spirits?
"...most, probably, of our decisions to do something positive, the full consequences
of which will be drawn out over many days to come, can only be taken as a result of
animal spirits--of a spontaneous urge to action rather than inaction, and not as the
outcome of a weighted average of quantitative benefits multiplied by quantitative
probabilities...if the animal spirits are dimmed and the spontaneous optimism
falters... enterprise will fade and die," - J.M Keynes: The General Theory of
Employment, Interest, and Money
The Simple Keynesian Model
Introduction
The Simple Keynesian Model is simple. There is no intent to put forward a
realistic
depiction of a complete macroeconomy. The idea is to illustrate a select set of
important points.
Most important among those points is that the economy can be in equilibrium
without
being at full employment. The Classical Model, which is the major predecessor to
the
Keynesian models, is anchored around an equilibrium in the labor market where
the
wage rate adjusts to clear the market, leaving no unemployment. In the Simple
Keynesian Model, there is no wage rate and the level of aggregate output adjusts
to
reach an equilibrium. Simple equations not necessarily involving interest rates,
wage
rates, or prices determine consumption, investment, and government spending.
The Model
The accounting identity
Y=C+I+G
establishes one relation between consumption C, investment I, government
spending
G, and total income Y. G is treated as exogenous, but economic behavior
determines
C and I:
C = 125 + 0.75 Y - 10 R
I = 120 -10 R + Animal Spirits
Consumption depends on the interest rate R because C = Y - S and savings S
depends
on the interest rate. R is held constant through most of these exercises.
Exercises Holding R Constant
1. Suppose Animal Spirits equal the baseline value of zero and I = 60. Determine
the equilibrium value for income Y. If full employment is Y = 500, is this
equilibrium full employment?
2. Suppose animal spirits are unfavorable (negative). What happens to Y?
3. If government spending increases, show that Y increases by a multiple of the
EconModel Exercises www.econmodel.com/classic/
change in government spending.
Changing R to Construct an IS Curve
4. Set R to several different values. Graph Y vs. R to produce an IS Curve.
 The Simple Multiplier Model
Suppose a factory with a payroll of $500,000 locates in a
Lemmingville, a typical suburban community. Suppose further
that the $500,000 is the only money that the factory spends in
the community, that all employees live in Lemmingville, and
that each person who lives there spends exactly one half of his
income locally. By how much will the income of Lemmingville
rise as a result of the new factory?

The $500,000 will be an addition to Lemmingville income. But

the story does not end here because, by assumption, the
people who earn the payroll will spend one half of the payroll,
or $250,000, in the community. This $250,000 will become
income for the shopkeepers, plumbers, lawyers, teachers, etc.
Thus Lemmingville income will rise by at least $750,000. But
the story does not end here either. The shopkeepers,
plumbers, etc. who received the $250,000 will in turn spend
one half of their new income locally, and this $125,000 will
become income for other people in the community. Total
Lemmingville income is now $875,000. The process will
continue on and on, and as it does, total income will approach
$1,000,000.

Notice that the initial half million in income expands to one

million once in the system. There is a multiplier effect that is
similar to the multiplier effect in the model of contingent
behavior. The size of the multiplier in our suburb depends on
the percentage of income people spend within the community.
The smaller the percentage, the more quickly the extra income
leaks out of the economy and the smaller the multiplier.

The Keynesian multiplier model applies to the national

economy the logic by which a new factory can increase a
town's income by a multiple of its payroll. Central in this model
is an assumption about how people spend, the consumption
function. The consumption function says that the amount
people spend depends on their income, and that as income
increases, so does consumption.

The table below illustrates a consumption function. It says that

if people expect incomes of $10,000, they will spend $12,500.
This amount of spending is possible if people plan to borrow or
to dissave. (To dissave means to sell assets.) The table says
that when expected income is $30,000, people will spend
$27,500, which means that they plan to save $2,500.

Table 1: A Consumption Function

Expected Income Consumption Expected Savings
$10,000 $12,500 -$2,500
12,000 14,000 -2,000
20,000 20,000 0
30,000 27,500 2,500

The table shows that if expected income rises by

$2,000, from $10,000 to $12,000, people will increase
their spending by $1,500, or that they will only spend
three-fourths of additional income that they expect to
receive. This fraction of additional income that people
spend has a special name, the marginal propensity to
consume (or mpc for short). In the table above the mpc
is always three-fourths. Thus if income increases by
$8000, from $12,000 to $20,000, people increase
spending by $6,000, from $14,000 to $20,000.

The marginal propensity to consume can be computed

with the formula:

(1) MPC = (change in consumption) divided by (change

in income)

In addition, economists often talk of the marginal

propensity to save, which is the fraction of additional
income that people save. Since people either save or
consume additional income, the sum of the marginal
propensity to save and the marginal propensity to
consume should equal one.

The value of the marginal propensity to consume should

be greater than zero and less than one. A value of zero
would indicate that none of additional income would be
spent; all would be saved. A value greater than one
would mean that if income increased by $1.00,
consumption would go up by more than a dollar, which
would be unusual behavior. For some people a mpc of 1
is reasonable, meaning that they spend every
additional dollar they get, but this is not true for all
people, so if we want a consumption function that tells
us what people on the average do, a value less than one
is reasonable.

The consumption function can also be illustrated with

an equation or a graph. The equation that gives the
consumption function in the table above is:

(2) Consumption = $5000 + (3/4)(Expected Income).

If people expect an income of $10,000, this equation

says consumption will be:

(3) Consumption = $5000 + (3/4)($10000) = $5000 +

$7500 = $12500

which is the same result that the table contains. Notice

that one can see the marginal propensity to consume in
this equation. It is the fraction 3/4.

Graphing the consumption function presented above in

the table and equation yields a straight line with a
slope of 3/4 shown below. If the slope of the
consumption function, which is the mpc, never changes,
the consumption function is linear. If the mpc changes
as income changes, then the consumption function will
be a curved line, or a nonlinear consumption function.
The $5,000 term in equation 2 is shown on the graph as
the intercept, which indicates the amount of
consumption if expected income is zero.
When will this model be in equilibrium? To answer this,
recall that spending by one person is income for
another. Because so far we have assumed that
consumption is the only form of spending, the amount
of consumption spending will equal actual income. If
people expect income of $10,000 and spend $12,500,
actual income will exceed expected income. It is
reasonable to suppose that as a result people will
change their expectations, and thus their behavior. The
logical equilibrium condition in this model is that
expected income should equal actual income.

In the table we see that $20,000 will be equilibrium

income. When people expect income to be $20,000,
they act in a way to make their expectations come true.
We can show the solution on a graph by adding a line
that shows all the points for which actual income equals
expected income. These points will form a straight line
that will bisect the graph, shown below as a 45-degree
line. Equilibrium income occurs in the model when the
spending line intersects the 45-degree line.
It is relatively simple to add business and government spending to
this model.

The Simple Keynesian Model

The Simple Keynesian Model, also known as the Keynesian cross, is too simple for many
purposes, but it does have a couple of advantages. First, it illustrates an important point:
the economy can be in equilibrium at less than full employment. Second, the structure is
simple enough to facilitate a first attempt at analysis by students.

EconModel

The EconModel presentation allows you to study this model graphically and
numerically. You can trace out the effects of changes in investment and government
spending.
Autonomous Investment

Government Spending

Interest Rates

The General Model

An Accounting Identity

The demand for output can be decomposed as Y = C + I + G.

National Income and Product Accounts.

Consumption and Saving

Economic behavior. Consumption is a function of income. C = f(Y).

Investment

I is autonomous for now. Could go either way.

Government Spending and Taxes

G is exogenous.

A Simple Linear Consumption Function

Suppose C = a + b (Y - T ), where T is an exogenous lump sum tax and a and b are

parameters. (b is known as the marginal propensity to consume.)

Equilibrium

We can solve for Y both graphically (see below) and algebraically.

The solution for equilibrium output is

Y = (1-b) ( a + I + G - bT ).
-1

The Multiplier

The change in Y for a given change in G is known as the multiplier. For lump-sum taxes,
the multiplier for G is (1-b) . That is, G is multiplied by (1-b) to determine Y.
-1 -1
An Advanced Model: Percentage Taxes

Suppose C = a + b (Y - T ), where T = t Y is a percentage income tax and a, b, and t are

parameters. The solution for equilibrium output is

Y = (1-b+t) ( a + I + G ).
-1

Increasing the tax rate t decreases Y.

and (1-b+t) percentage taxes. lower in the second case.

-1

An Example: Inventory Cycles

[do math here because it is not below]

inventory cycles

Another Advanced Model: An IS Curve

An advanced element of the EconModel presentation constructs an IS Curve. If

investment is a function of the interest rate I = I(R), then changing R traces out an IS
curve.

While this analysis does construct an IS Curve, the IS/LM derivation has the advantage
that putting the interest rate on an axis focuses attention on the role of the interest rate in
determining investment. In that presentation, the latter effect is depicted as the slope of a
curve rather than as the shift in a curve.

How does this fit with a complete Keynesian model?

For the sake of completeness, the Simple Keynesian Model in an IS/MP World page
shows how the Simple Keynesian Model can be seen as a special case of a full-blown
Keynesian model.