Keynesian Equilibrium

## National Output

Typical relationships among income, employment, and output are summarized in Table 1. Column 1 shows the employment needed to produce the levels of National Output (column 2) firms are willing to offer at current prices if they are confident it will be sold. You might think of the National Output schedule as reflecting a Keynesian Aggregate Supply curve because firms willingly produce whatever is demanded. For example, firms will employ 120 million workers and produce \$7,000 billion (or \$7 trillion) in output and income only if they expect sale of this output for \$7 trillion. Remember, "demand creates its own supply" in Keynesian analysis.

Table 1 here

 Table 1     Levels of Income, Employment, and Output  (billions of dollars) (1) Employment (millions of workers) (2) National Output & Income (3)   Planned Consumption (4)   Planned Saving (5)   Planned Investment (6) Unplanned Inventory Changes (7) AE =Aggregate Expenditures (columns 3 + 5) 100.00 \$5,000 \$   5,100 \$-100 \$ 300 \$ -400 \$ 5,400 105.00 5500 5500 0.00 300.00 -300.00 5800 110.00 6000 5900 100.00 300.00 -200.00 6200 115.00 6500 6300 200.00 300.00 -100.00 6600 120.00 7,000 6700 300.00 300.00 - 0 - 7000 equilibrium 125.00 7500 7100 400.00 300.00 100.00 7400 130.00 8000 7500 500.00 300.00 200.00 7800 135.00 8500 7900 600.00 300.00 300.00 8,200

Aggregate Expenditures

Aggregate Expenditure is the sum of all plans for consumer spending, investment, government purchases, and net foreign spending. However, basic Keynesian models of closed, private economies simplify analysis by ignoring government and the foreign sector, so column 7 in Table 1 reflects Aggregate Expenditures (AE) as the sum only of planned consumption (column 3) and planned investment (column 5); AE = C + I summarizes the levels of planned Aggregate Spending for each level of output and income.

Equilibrium

National Output is graphed as a 45o ray from the origin in Figure 1 because, in Keynesian theory, Aggregate Supply (output) adjusts passively to Aggregate Demand (expenditures).[1]

Keynesian equilibrium is achieved when Aggregate Output and Income (on the horizontal axis) precisely equals planned Aggregate Expenditures (on the vertical axis).

Keynesian macroeconomic equilibrium occurs when this Aggregate Expenditures curve intersects the 45o line. Following convention, Y (on the horizontal axis) denotes real National Income and is measured against planned Aggregate Expenditures (on the vertical axis).

FIGURE 1   Keynesian Equilibrium

Equilibrium income (point e) is found where National Output just equals Aggregate Expenditures. Any disequilibrium would entail pressure to move the economy back to the \$7,000 billion income level. If income were below \$7,000 billion, Aggregate Expenditures would exceed National Output, so shrinking inventories would create expansionary pressure, boosting employment and output–the economy would move upward to point e. If output exceeds AE, inventories swell because sales are less than firms forecast. Production cutbacks and layoffs will then restore the economy to equilibrium at point e.

Classical theory concludes that deviations from full employment represent disequilibria that are, at most, short-run phenomena quickly remedied by Say's Law and flexible interest rates, wages, and prices. Keynesian perceptions of a short-run disequilibrium have a different focus.

Disequilibrium occurs whenever plans for Aggregate Expenditures differ from Aggregate Output and Income.

How is equilibrium restored? Classical reasoning suggests that supply creates its own demand—price adjustments automatically adapt real Aggregate Spending to accommodate full employment levels of output. Keynesians respond that demand creates its own supply—that supply passively adjusts to demand. In this context, spending and demand are synonymous.

Let's put Keynesian adjustment processes under the microscope: In a disequilibrium, Aggregate Expenditures determine output and employment. Table 1 lists eight levels of National Output and planned Aggregate Expenditures. At what level will equilibrium be achieved? Consider employment of 105 million with National Output equal to \$5,500 billion. Planned Aggregate Expenditure equals \$5,800 billion and so exceeds the \$5,500 billion in National Output. What adjustments will rebalance National Output and Aggregate Spending?

In this situation, most firms will not maintain inventories adequate for their customers' demands. As inventories evaporate (the vertical distance between AE and the 45o reference line), firms will respond by expanding employment and output. This stimulates income. Suppose employment grows from 105 to 110 million. Even employment of 110 million workers poses a problem: Aggregate Expenditures—now \$6,200 billion—still exceed National Output—now \$6,000 billion. Employment, output, and income will continue to climb until 120 million people are working. Aggregate Expenditures and National Output both equal \$7,000 billion at this employment level. Any further pressures to expand output are offset by pressures to contract output—firms steadily maintain inventories that meet customers' demands.

Pressures to restore equilibrium are summarized in Figure 1. Unplanned inventory changes equal the vertical distances between the Aggregate Expenditures curve (C + I) and the 45o National Output line (C + S). For example, at output of only \$5,500 billion (point a), planned Aggregate Expenditure is \$5,800 billion (point b). Excess Aggregate Spending (b - a = \$300 billion) shrinks inventories, generating expansionary pressure that pushes the economy rightward from both a and b up the 45o National Output line to equilibrium at point e (\$7 trillion).

What happens if National Output exceeds planned AE? Suppose most firms were overly optimistic in forecasting consumer and investor demands and produced \$7,500 billion worth of goods and services. Inventories of unsold goods would become bloated. Businesses cannot precisely regulate inventories because customers may buy either more or less than firms expect. In this case, firms would reduce inventories and output by cutting back production, necessitating employee layoffs. As output fell to point e in Figure 1, business inventories would shrink to the planned levels. This economy settles at an equilibrium income of

\$7,000 billion.

Both Table 1 and Figure 1 indicate that National Income will expand when output is less than \$7,000 billion because spending exceeds production. When income or output exceeds \$7,000 billion, income falls because production exceeds spending. Only when National Output is exactly \$7,000 billion are all decision makers content to continue operating at existing levels of production, consumption, and investment. All forces are balanced and, given the Keynesian assumptions that wages and prices are "sticky" (or downwardly rigid), net pressures for the economy to shrink or grow from this short-run equilibrium are weak or even nonexistent.

Price vs. Quantity Adjustments

In individual markets, price adjustments are part of the cure for disparities between the quantities of specific goods demanded and supplied. Price rises in individual markets if quantity demanded exceeds quantity supplied; if quantity supplied exceeds quantity demanded, price falls. Keynesians assume that quantity adjustments predominate in situations of excess capacity and high unemployment—the Aggregate Supply curve is treated as horizontal.

The price level is constant in a simple depression model because capacity is assumed not to be a crucial constraint—expanding output when many workers are idle does not require higher wage or price incentives. Classical analysis presumes severe capacity constraints because market economies are thought to hover close to full employment. Thus, the classical Aggregate Supply curve is vertical, and the classical model relies on price-level adjustments to buffer against shocks to Aggregate Demand.

[1] Recall that any variable plotted against an equal variable is on a 45o line.

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