Lecturer : Javed Teelucksingh

Unit 2 Keynesian Aggregate Model

Keynesian Aggregate Model

To explain the determination of economic aggregates Keynes developed the Circular Flow of Income
model as an alternative to the supply and demand model of microeconomics. Recall the diagram below:

Consumers/Households

F.O.P

G& S

Exp 20m

Firms
Income 20m
Fig 1: Circular Flow
The diagram above represents a how income, expenditure and output flows throughout a closed economy
and more importantly how the economy is in equilibrium when income = expenditure = output. This can
be seen since in this diagram there are the consumers and there are the firms. Consumers have needs and
wants and thus firms try to satisfy them by producing goods and services to suit those needs and wants.
However in order to produce the goods and services firms need factors of production which are
essentially provided by the consumers/households. Now when household provide these factor services
they receive and equivalent income for it in our case 20 million at the same time firms are only able to
produce 20 million in goods and services since this is the total amount in factors that was provided to
them. On the other and when households receive this income they must consume and thus spend all there
income (20million expenditure) on the goods and services produced by the firms. Thus it can clearly be
seen that income = output = expenditure.
Nevertheless our purpose is to explain income determination using the Keynesian model, so that based on
our analysis so far we can say generally an economy is in equilibrium when total expenditure (E) is equal
to total income (Y) and since E = C + I + G + (X M) we get Y = C + I + G (X M).

Withdrawals and Injections

From the figure above Consumption (C) = Income (Y) in other words all of the income received in one
period is directly spent in the next. As a result it would appear that there would be no reason for the level
of Y to change and thus our economy would be in equilibrium. So that income in the first period is equal
to the consumption of the next period. If consumption is the only form of expenditure then expenditure in
this next period must be the same as this consumption. This expenditure, however is all received by firms
and all paid out again as income for factor services. So income and expenditure has a constant flow
throughout the circular flow of income. Thus we can write Ct = Et = Yt+1 = Ct+1 = Et+1 = Yt+2
Closed economy: is simply one that does not engage in international trade thus there is no imports and
exports in a closed economy
Open economy: is one that engages in international trade thus we would have imports and exports and
injections and withdrawals

Lecturer : Javed Teelucksingh

Unit 2 Keynesian Aggregate Model
where t is first time period and t+1 is the next time period. However there are various factors which cause
money to be withdrawn, or leak from the system and conversely there are also injections into it.
Withdrawals (W): is simply any part of income that is not passed on within the circular flow.
Withdrawals are also referred to as leakages of potential planned expenditures from the incomeexpenditure stream. Withdrawals are savings, purchases of goods from other countries (imports) and
taxes. Savings (S) can be undertaken by households since they do not spend all their income or by firms
who choose to retain some of their profits for future expansion. Taxes (T) by government may or may not
be re-spent and hence is a withdrawal. Finally imports (M) these are purchases by domestic consumers of
foreign goods and services and because part of domestic consumers income is going abroad to foreign
firms it is being withdrawn from the circular flow and thus is a withdrawal. Essentially the sum of
savings, taxes and imports would give us the total withdrawal for an economy. i.e. W = S + T + M
Injections (J): these are additions of potential planned expenditures to the income-expenditure stream.
Another way of saying it is injections is an expenditure which is not the consumption of domestic
households so that it comes from outside into the circular flow of income. The most obvious example of
an injection is exports (X) because the income of the firm selling them comes not from domestic
households but from overseas. Also another form of injection is investments (I) an example would
include a firm that produces investment or (capital) goods and sells them to another firm, this is an
injection because the flow of income and expenditure has been increased, even though this increase is not
a result of extra spending by households. Lastly we have government spending (G) which again may or
may not be financed by current taxation, past taxation, borrowing or by simply printing money thus
government expenditure is an injection. As with withdrawals the total injection in the economy is given
by the sum of total exports, government expenditure and investments i.e. J = I + G + X.
Referring back to the circular flow diagram above we illustrated a situation where there was equilibrium
in the economy where Aggregate Expenditure = Income and thus this was a closed economy. However if
we were to consider an open economy we would be face with withdrawals and injections and we would
observe with the inclusion of these concepts the economy would be subject to situations of disequilibrium
unless off course total withdrawals were equal to total injections. (W = J)

Models of income Determination

Keynesian
This model follows from the analysis of the circular flow of income and basically states that equilibrium
income is determined at the point where Aggregate Expenditure (E) is equal to Income (Y).
Diagrammatically we can illustrate this equilibrium however we have to utilize a tool Keynes developed
called the Keynesian cross or the 45 degree line. First of all we have met this tool before in our analysis of
the consumption function however Ill define it again. The Keynesian cross is a line constructed by
connecting all points where desired consumption (which is reflected as our expenditure on goods and
services) equals our disposable income. It is a handy tool as it allows us or assists in the location of the
breakeven level of income at which consumption spending equals disposable income. We will now
illustrate this model as follows:

Closed economy: is simply one that does not engage in international trade thus there is no imports and
exports in a closed economy
Open economy: is one that engages in international trade thus we would have imports and exports and
injections and withdrawals

Lecturer : Javed Teelucksingh

Unit 2 Keynesian Aggregate Model
Expenditure

E=Y

AE
A
E1

Ye

Income/output

The diagram above illustrate the keynesian model of income determination, we have already established
from our analysis of the circular flow that an economy is in equilibrium when E = Y we have also
introduced the Keynesian cross which would be used to determine equilibrium. The line labeled E = Y is
the Keynesian cross and each point on this curve shows a situation where total expenditure is equal to
income and is also known as the planned expenditure for the economy.
In other words it shows how all firms in an economy plan to allocate their income in the production of
goods and services so this curve essentially represents the supply of output. Now the reason I say this is
remember the 45 degree line shows a situation where expenditure is equal to income and the total income
generated within an economy is called GDP and thus GDP is sometimes referred to as the aggregate
supply.
On the other hand we have our actual expenditure which is labeled AE above this is also called the
aggregate expenditure of the economy and is given by the formula C + I + G + (X-M) and this formula
also defines the aggregate demand. So that in short equilibrium income would be determined where our
planned expenditure is equal to our actual expenditure. This is labeled as point A in the diagram above
with an associated income/output level of Ye and expenditure of E1.
Nevertheless now that we understand where equilibrium income is we need to understand how an
economy reaches equilibrium. Consider any point to the left of point A on the diagram; any point below
A show a situation where our actual expenditure is greater than our planned expenditure question is
how does the economy reaches equilibrium. Well lets consider whats happening if our actual
expenditure also called the aggregate demand is greater and our planned expenditure which is really a
reflection of supply then this is a type of disequilibrium known as a shortage. A shortage is said to occur
when the demand is greater than supply. So if what consumers are demanding is greater than the amount
Closed economy: is simply one that does not engage in international trade thus there is no imports and
exports in a closed economy
Open economy: is one that engages in international trade thus we would have imports and exports and
injections and withdrawals

Lecturer : Javed Teelucksingh

Unit 2 Keynesian Aggregate Model
firms had planned to produce then firms would react by stepping up on production. To do this they would
have to employ additional labor as well as more of the other factors and thus their expenditure would
increase but at the same time output would increase and this action continues until output and expenditure
is equal thereby re- establishing equilibrium.
Now consider the other side of the picture that is, any point to the right of A which shows a situation
where Planned Expenditure is greater than Actual Expenditure and this the other form of
disequilibrium known as a surplus. A surplus is said to exist when the supply is greater and the demand in
our case we have the total planned expenditure by firms in the economy is greater than the actual
expenditure so that firms would be faced with rising levels of stocks and thus would react by cutting back
on production. In the process of cutting back on production firms would lay off workers and thus overall
expenditure would fall and at the same time output would fall until it reaches equilibrium level again.

Injection and Withdrawal Approach

We have already introduced these two concepts and have thus established that W = S + M + T and J = I +
X + G and once the total withdrawals are equal to total injections (W = J) the economy would be in
equilibrium or equivalently we could also write where E = Y. Consider the diagram below:
Expenditure
Withdrawals

Injection

Ye

Income

So the diagram above illustrates equilibrium income using the withdrawal and injection approach. What
we observe is that the injection line is perfectly elastic (that is it is flat and thus it means it has a fixed
value) this because in this model we assume that injections in autonomous that is not influenced by
income. However we observe that withdrawal line is upward sloping meaning in our model withdrawal
are induced, that is it varies with the level of income and since it has a positive slope withdrawals
increases as income rises. So the point labeled F is where equilibrium occurs and thus any point to the
right of F would mean there would be an unplanned rise in stock levels in the firm and so they would
Closed economy: is simply one that does not engage in international trade thus there is no imports and
exports in a closed economy
Open economy: is one that engages in international trade thus we would have imports and exports and
injections and withdrawals

Lecturer : Javed Teelucksingh

Unit 2 Keynesian Aggregate Model
have to cut back on production to re-establish equilibrium. While any point to the left of F means that
households and firms are purchasing more of the real national output than firms had planned thus this
would cause a run down of stock levels encouraging firms to increase its output until equilibrium is
established again.

The Multiplier
The multiplier concept focuses on how responsive income is to changes in the level of aggregate demand.
For example, as economic activity starts to increase economics agents may become more optimistic about
economic prospects and hence this influences firms to increase investment and consumers to spend more.
So that what started off as just a small increase or decrease in aggregate demand is magnified by how
people interpret the situation and their belief of how it would affect their standard of living. To help
understand this better consider a decrease in government spending on domestically produced weapons,
this would cause an initial fall in output and thus income from weapons production. However the laid off
workers will in turn cut back on their expenditure on consumer goods, thus in the local areas around the
weapons factories, shops, cinemas, licensed drinking places etc will be faced with reduced demand and
perhaps may lay off workers or reduce their payments. This further reduces demand and so on, thus the
initial effect on aggregate demand is multiplied by a reduction in the income of consumers and demand
for consumer goods. Consider the diagrams below:
Expenditure

E=Y
B

AE = 5% increase

AE2

AE1

Y=15%

J2
J1

Y1

Y2

income

Closed economy: is simply one that does not engage in international trade thus there is no imports and
exports in a closed economy
Open economy: is one that engages in international trade thus we would have imports and exports and
injections and withdrawals

Lecturer : Javed Teelucksingh

Unit 2 Keynesian Aggregate Model
Above we show how the multiplier works using both the Keynesian aggregate model as well as the
injection withdrawal model. From the Keynesian model we observe as the aggregate expenditure
increases by 5% it resulted in a rightward shift of the Aggregate expenditure line from AE1 to AE2
establishing a new equilibrium point at B causing income/output to increase by 15% from Y1 to Y2. On
the other hand we also observe that if injections were to increase it would shift to a higher curve in our
case from J1 to J2 causing and increase in income also from Y1 to Y2.this is a diagrammatic example of
the multiplier principle. The numerical value of the change is known as the multiplier, the strength of the
multiplier or its coefficient is given by the symbol K.
Multiplier: this principle is that a change in the level of injection (or withdrawals) brings about a
relatively larger change in the level of national income.
Simple example of multiplier at work

1st recipients

Increase in income
Y
1000

increase in consumption
C
666.67

increase in savings
S
333.33

2nd recipients

666.67

444.44

222.23

3rd recipients

444.44

296.30

148.14

4th recipients

296.30

197.53

98.77

5th recipients

197.53

131.69

65.84

Total

Y = $3000

C = $2000

S = 1000

Assume that investment and savings are the only injection and withdrawal respectively. If a firm decides
to construct a new building costing $1000, then the income of builders and the suppliers of the raw
materials will rise (or change) by $1000. In addition let us assume that the recipients of the $1000 have an
MPC = 2/3 or 0.667 thus they would spend/consume 666.67 and save the rest which was from the table
$333.33. Nevertheless this $666.67 consumed by the builders and suppliers creates income for another
group of people and assuming their MPC is also 2/3 then they would consume 444.44 out of the 666.67
and save the rest. This process continues with each new round of spending being two thirds of the
previous round and thus a long chain of extra income, extra consumption and extra saving is set up. The
whole process comes to an end when the addition to savings total $1000 this is because only then will the
Closed economy: is simply one that does not engage in international trade thus there is no imports and
exports in a closed economy
Open economy: is one that engages in international trade thus we would have imports and exports and
injections and withdrawals

Lecturer : Javed Teelucksingh

Unit 2 Keynesian Aggregate Model
extra savings in equal to extra investment so S = I and economy is in equilibrium. At this point additions
to income are $3000 so that $1000 extra investment created $3000 rise in income, therefore the multiplier
in this case is 3 well see this in next section.

The Multiplier Formula

Based on our example above we have seen that the amount of income that goes back into the circular flow
is really governed by the MPC so we can thus say that the multiplier is governed by the MPC. We also
observed that the additions to income followed the following pattern or series: Y = $1000 + $666.67 +
$444.44 + 296.30 + ., and this was because the MPC was 2/3. Lucky for us such a series is well known
in maths as a geometric progression series and its value is given by the formula: 1/1-r where r is the value
of the common ratio. In the case of the multiplier the common ratio is the MPC so we get:
K= 1

and if MPC = 2/3 then we get K =

1 - MPC

=3

1- 2/3

So now we see how we got the multiplier as 3 from last section. It is important to note that the larger
the MPC the larger the Multiplier will be.
Equilibrium and the Multiplier
In our example all extra income was either consumed or withdrawn we can write: MPC + MPW = 1
where the MPW is the marginal propensity to withdraw. Thus it follows that 1 MPC = MPW, and we
could also write the formula for the multiplier as: K =
1
MPW
So that if we know the value of MPW we can predict the effect of a change in injections upon national
income. The effect will be the change in injections multiplied by K, which we write as:
Y = K J or as Y = 1

MPW
To determine the overall MPW we must total all the other propensities to withdraw. That is:
K=

MPS + MPT + MPM

Where MPW = MPS + MPT + MPM and MPS is the marginal propensity to save, MPT is the marginal
propensity of taxation and MPM is the marginal propensity to import.

Closed economy: is simply one that does not engage in international trade thus there is no imports and
exports in a closed economy
Open economy: is one that engages in international trade thus we would have imports and exports and
injections and withdrawals