21.1 Aggregate Output and Keynesian Cross Diagrams #Notebook

21.1 Aggregate Output and Keynesian Cross Diagrams #Notebook

Developed in 1937 by economist and Keynes disciple John Hicks, the IS-LM model is still used today to model aggregate output (GDP, or GNP) and interest rates in the short run. It begins with John Maynard Keynes’s recognition that

AoS = AD = Cs + Inv + Gs + NExpo

Aggregate output (Supply) = Aggregate demand = Consumer expenditure + Investment + Governemnt spending + Net exports

Keynes further explained that Consumer expenditure can be calculated by:

Consumer expenditure = Autonomous consumer expenditure (food, clothing, shelter, and necessaries) + ( Marginal propensity to consume X Disposable income )

For example, during the Great Depression, the investment fell from $232 billion to $38 billion (in 2000 USD), so the aggregate output fell by more than $232 billion − $38 billion = $194 billion. 

We know that because investment fell and the marginal propensity to consume was > 0, so, the fall was more than $194 billion.

An increase in exports over imports will increase aggregate output by the increase in NExpo times the expenditure multiplier. Likewise, a decrease in NExpo will decrease aggregate output by the decrease in NExpo times the multiplier.

Government spending (Gs) also increases aggregate output. However, some government spending comes from taxes, which consumers view as a reduction in income. With taxation, the consumption must to minus the taxations.

Many governments, including that of the United States, responded to the Great Depression by increasing tariffs. Today we know that such policies beggared everyone. What were policymakers thinking?

They were thinking that tariffs would decrease imports and thereby increase NExpo and aggregate output. That would make their trading partner’s NExpo decrease, thus beggaring them by decreasing their aggregate output.

But, in reality, it was dead wrong. Other countries retaliated with tariffs of their own. Even if they did not do it, it was a losing strategy because by making trading partners poorer.

In short, the policy limited their own ability to import and led to no long-term change in NExpo.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.