Keynesian Circular-Flow Analysis

The Keynesian Vision

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 Income-Expenditure Framework

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.
 BUSINESS
ORGANIZATIONS

LABOR
AND OTHER

THE FACTOR SERVICES

CIRCULAR-FLOW
FRAMEWORK

WORKERS
INCOME
FACTOR
OWNERS

CONSUMERS
 BUSINESS
ORGANIZATIONS
EXPENDITURES

LABOR
AND OTHER
FACTOR SERVICES

Let the speed of rotation indicate the

strength (fast) or weakness (slow) of
the economy.
GOODS AND
SERVICES

WORKERS
INCOME
FACTOR
OWNERS

CONSUMERS
 BUSINESS
ORGANIZATIONS
EXPENDITURES

WORKERS
INCOME
FACTOR
OWNERS

CONSUMERS
OUTPUT

REAL
INCOME
F(K0,L)

C+I

LABOR
INPUT

REAL
WAGE
RATE S

LABOR
INPUT
 BUSINESS
ORGANIZATIONS
EXPENDITURES

In Keynesian equilibrium,
INCOME equals EXPENDITURES.

Y=E
Y=C+I+G

WORKERS
INCOME
FACTOR
OWNERS

CONSUMERS
EXPENDITURES
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 E=Y
represented on the horizontal axis.

45o
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
C+I
Investment
The
As taught
economy
atdepends
allislevels,
in a
INVESTMENT Keynesian
the
neither
consumption
on (current)
equilibrium
C = a + bY income
somewhere
function nor
is an
on
along
the the
rate
b
essential
of
45interest.
o line—component
It depends
the line itself
of
only
theonKeynesian
profit
identifying all possible
1 framework.
expectations, Thewhich
income-expenditure
CONSUMPTION presumed
themselves
equilibriumstability
are notof
points.
this function underlies
well-anchored in
a 45o Keynesianreality.
economic thinking.
INCOME

Keynes would say the

INCOME
investors are moved
Consumption and Investment (as well as Government Spending)
by the “animal spirits.”
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.
 EXPENDITURES
C+I

C = a + bY C = 120 + 0.60Y
b = 0.60

1
I = 240
In equilibrium, Y = E
a = 120
a So, Y = C + I
INCOME
Yeq = 900
Y = a + bY + I
Suppose that a = 120 and b = 0.60. Y = 120 + 0.60Y + 240
And suppose we know that investors Y – 0.60Y = 120 + 240
are spending 240 on investment goods.
0.40Y = 360
Can we calculate the equilibrium level
of income that corresponds to these Y = 900
parameters?
 EXPENDITURES
C+I

CONSUMPTION
C = a + bY

According to Keynes, it is
only by “accident or design”
that the economy is actually
performing at its full-
employment potential.
INCOME INVESTMENT
Yfe We assume here that,
Labor incomeThough
(YL = not emphasized by Keynes, In Keynesian
full employment
initially, full macroeconomics,
implies
employment
WL) is fully that the economy is operating onfull itsemployment
production
conditions possibility
implies
prevail that
—if only
representativefrontier,
of totalthe PPF itself being defined
thebylabor
inaccident.
terms
marketof sustainable
clears at the
income, suchoutput
that levels of consumption and going
investment
wage rate,goods.
the going
changes in labor
W
wage itself having emerged
S
income stand in direct during a period in which the
proportion to changes LABOR
INCOME D economy was experiencing no
in total income. macroeconomic problems.
L
EXPENDITURES
C+I

C = a + bY

INCOME
Yfe
OUTPUT

REAL
INCOME
F(K0,L)

C+I

LABOR
INPUT

REAL
WAGE
RATE S

LABOR
INPUT
EXPENDITURES
C+I

C = a + bY

INCOME
Yfe
EXPENDITURES
C
ΔI+ I
EXCESS INVENTORIES

C = a + bY
INVESTMENT
1
ΔY = (1 – b) ΔI
E=
<Y
ΔY CONSUMPTION The simple investment-
spending multiplier, 1/
(1-b), quantifies the
INCOME
extent of the downward
Yfe
900 spiraling.
INCOME
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
W and hence reduced employment opportunities, the
economy spirals downward
S into
Note recession
that and
the going possibly
wage keepsinto
deep depression. going—even after the market
D
conditions that gave rise to it are
N gone.
EXPENDITURES
ΔI = 100
C
ΔI+=I 100

C = a + bY
1
ΔY = (1 – b) ΔI

1
ΔY ΔY ΔY = (1 – 0.6) (100) = 250

1
ΔY = (1 – 0.6) (100) = 250

INCOME
400 650 900

A further loss of confidence

In theonKeynesian
the part of
construction,
the business prices and
community will send the theeconomy
wage rateeven
arefurther
sticky downward.
from its full-
employment potential.
But note that they’re not stuck too high.
W They’re stuck just right. The going wage rate
S will clear the labor market once again—as
D
soon as spending and hence labor demand
recover to their full-employment levels.
N
EXPENDITURES
C+I
C = a + bY

INCOME
Yfe
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.
W
S
(Keynes, of course, preferred not to wait it out. He advocated
make-work projects, deficit
D spending, and monetary stimulation
to get the economy turned
N
around.)
EXPENDITURES
C+I

C = a + bY

INCOME
Yfe

Recovery may continue as further investment activity drives

labor-demand back to its full-employment level...

W
S

N
EXPENDITURES
C+I

C = a + bY

INCOME
Yfe

Y=C+I Even in Keynesian equilibrium, saving

C=C equals investment. But it’s not the
interest rate that does the equilibrating.
Y–C=I Rather, it’s income that adjusts (spirals
S=I up or spirals down) until the saving-
investment equality is established.
 EXPENDITURES
C+I

C = a + bY

b The
In
Even
this
“Keynesian
in
wholly
a mixed
private
Cross”
economy,
economy,
marks spending
the
spending
spoton
where
consumption
on investment
incomegoods
equals
goodstypically
expenditures.
accounts counts
for the
for
1
about 70% remaining
of GDP.
expenditures.
In this wholly private
We assume
economy, herecount
it would that, for
initially, full
even more.
employment conditions prevail—though
a only by accident.
45o
INCOME
Yeq =Yfe
 EXPENDITURES
C+I

C = a + bY
Saving
Clearly,
Investment
issaving
represented
spending
equalsis by
investment
determined
the vertical
at
exclusively
distance
the samebetween
level
by business
of income
the consumption
psychology.
at which
Atequation
each
income
and equals
andevery
the level
45 O line.
expenditures.
of income,
Saving itisis
represented
negative for by lowthe vertical
levels separation
of income and
So now, let’s net
between
increasingly out consumption
C and
positive C+I. levels.
at higher
spending
(The 45Otolineshow that income
allows S = I is an
to be
a alternative equilibrium
45o
measured verticallycondition.
as well as
horizontally.)
INCOME Y=0 and C=Y give us two points
Yeq =Yfe
on the saving equation.
INVESTMENT
SAVING,

S = -a + (1-b)Y

1-b The
Investment
Just
Finally,
slope
by themselves,
the
of is
this
shading
represented
line isthese
on1-b,
theby
which
two
S=Ia
I graph
together
curves
matches
horizontal
(S
withandthe
perfectly
I) intercept
identify
line. withthe
(-a),
the
1
income-expenditure
allows
shadinguson to the
writeY=E the
equilibrium.
graph.
saving
INCOME equation.
-a
INVESTMENT
SAVING,

S = -a + (1-b)Y

INCOME
 RATE OF INTEREST
INVESTMENT
S
SAVING,

S
D
I

INCOME SAVIING (S)

INVESTMENT (D)

Market for
Loanable Funds
 RATE OF INTEREST
S
S
INVESTMENT
SAVING,

r1
I(r2)
r2 D
I(r1)

INCOME SAVIING (S)

INVESTMENT (D)

Market for
Loanable Funds
Keynes didn’t think I was a function
of r…but we now know it is.
EXPENDITURES
C + I(r)

C = a+ bY

INCOME
Y
 EXPENDITURES
C + I(r2)
C + I(r1)

C = a’ + bY

Market for
Loanable Funds
S

RATE OF INTEREST
S’
INCOME
Y Y’ S’
INVESTMENT
SAVING,

S r1
r2 D
I(r2)
I(r1)
SAVIING (S)
INVESTMENT (D)
INCOME

I(r1) I(r2)