Keynesian cross

In the Keynesian cross diagram, a "desired total spending" (or "aggregate expenditure", or "aggregate demand") curve (shown in blue) is drawn as a rising line since consumers will have a larger demand with a rise disposable income, which increases with total national output. This increase is due to the positive relationship between consumption and consumers' disposable income in the consumption function. Aggregate demand may also rise due to increases in investment (due to the accelerator effect), while this rise is reduced if imports and tax revenues rise with income. Equilibrium in this diagram occurs where total demand, AD, equals the total amount of national output, Y, (which corresponds to total national income or production). Here, total demand equals total supply.

In the diagram, the equilibrium level of output and demand is determined where this desired spending curve intersects a line that represents the equality of total income and output (AD=Y). The intersection gives the equilibrium output, Y'.

The movement toward equilibrium is mostly via changes in inventories inducing changes in production and income. If current output exceeds the equilibrium, inventories accumulate, encouraging businesses to cut back on production, moving the economy toward equilibrium. Similarly, if the level of production is below the equilibrium, then inventories run down, encouraging an increase in production and thus a move toward equilibrium. This equilibration process occurs when the equilibrium is stable, i.e., when the AD line is steeper than the AD=Y line.

The equilibrium level of output determines the equilibrium level of employment in the model. (In a dynamic view, these are connected by Okun's Law.) There is no reason within the model why the equilibrium level of employment should correspond to full employment. Bringing in other considerations may imply this correspondence, though.

If any of the components of aggregate demand (C + I_p + G + NX) rises at each level of income, for example because business becomes more optimistic about future profitability, that shifts the entire AD line "upward". This raises equilibrium income and output. Similarly, if the elements of AD fall, that shifts the line downward and lowers equilibrium output. (The AD=Y line does not shift under the definition used here).

Assumptions

The Keynesian cross produces an equilibrium under several assumptions. First, the AD (blue) curve is positive. The AD curve is assume to be positive because an increase in national output should lead to an increase in disposable income and, thus, an increase in consumer consumption, which makes up a portion of aggregate demand. [Suranovic, Steven M. "Chapter 50-7: The Keynesian Cross Diagram." "International Finance Theory and Policy". Last Updated on 1/20/05 http://internationalecon.com/Finance/Fch50/F50-7.php] Second, the AD curve is assumed to have a positive, vertical intercept. The AD curve must have a positive, vertical intercept to cross the AD=Y curve. If the curves do not cross, there is no equilibrium and no equilibrium output can be determined. The AD curve will have a positive, vertical intercept as long as there is some aggregated demand--from consumer spending, investment, net exports, or government spending--even if there is no national output. [Suranovic, Steven M. "Chapter 50-7: The Keynesian Cross Diagram." "International Finance Theory and Policy". Last Updated on 1/20/05 http://internationalecon.com/Finance/Fch50/F50-7.php] Finally, the AD curve must have a slope less than 1. This holds true as long as an increase in output does not lead to an equal or greater increase in aggregate demand. As long as some of the additional output is either spent on exports or saved, this assumption holds true. [Suranovic, Steven M. "Chapter 50-7: The Keynesian Cross Diagram." "International Finance Theory and Policy". Last Updated on 1/20/05 http://internationalecon.com/Finance/Fch50/F50-7.php]

Notes

External links

* Suranovic, Steven M. " [http://internationalecon.com/Finance/Fch50/F50-7.php Chapter 50-7: The Keynesian Cross Diagram.] " "International Finance Theory and Policy".
* [http://www.fgn.unisg.ch/eurmacro/tutor/c02.html The Keynesian Cross] includes an applet that demonstrates the Keynesian cross and how it responds to changes in underlying parameters
* [http://demonstrations.wolfram.com/KeynesianCrossDiagram/ Keynesian Cross Diagram] by Fiona Maclachlan, The Wolfram Demonstrations Project.