FLASH SALE! - "FINANCIAL MODELING COURSE BUNDLE AT 60% OFF" Enroll Now

Keynesian Cross

Updated on January 29, 2024
Article byPriya Choubey
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Keynesian Cross Model?

The Keynesian cross, also known as the expenditure-output model identifies the equilibrium point in a nation’s real gross domestic product (GDP), representing the point where aggregate expenditure equals economic output. It is a fundamental concept in macroeconomics developed by the British economist John Maynard Keynes.

Keynesian Cross

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Keynesian Cross (wallstreetmojo.com)

This model provides a simplified framework for understanding income and spending dynamics in an economy. Additionally, it sheds light on the multiplier effect, which illustrates how an initial change in spending can lead to a more significant change in income. Furthermore, it underscores the importance of government spending and fiscal policy in influencing economic stability and growth.

Key Takeaways

  • The Keynesian cross refers to a macroeconomic model that identifies the equilibrium point of the real GDP where the economy’s aggregate expenditures become equal to the economic output.
  • John Maynard Keynes suggested it as the expenditure-output approach (as it was known between the 1930s and 1970s).
  • It is mathematically denoted as Y = AE.
  • When Y = AE, the economy is in a stable state, furthermore, If AE exceeds Y, there is an inflationary gap, but an expenditure gap exists if Y is more than AE.

Keynesian Cross Model Explained

The Keynesian Cross model, originally known as the expenditure-output approach, predates the introduction of aggregate demand and aggregate supply concepts and serves as a foundational tool for analyzing the relationship between aggregate income and spending within an economy. It was developed by John Maynard Keynes between the 1930s and 1970s.

Keynesian economics is a widely studied macroeconomic theory emphasizing government intervention to address economic downturns and promote stability. Keynesian policies, such as increasing government spending during recessions or cutting taxes to stimulate consumer spending, can effectively boost demand and reduce unemployment during economic contraction.

Economists often use the Keynesian cross to predict the impact of government spending on economic output. It relies on two key components:

  1. Aggregate Expenditure (AE): AE represents the total spending within the economy and includes consumption expenditure (C), investment expenditure (I), government spending (G), and net exports (exports – imports).
  2. Income (Y): This denotes the total income earned by individuals and businesses within the economy.

However, Keynesian economics has faced criticism over time. Some argue that excessive government intervention can lead to inflation and distortions in the market. Additionally, the effectiveness of Keynesian policies can be influenced by factors like public confidence and expectations. In practice, many countries adopt a mix of economic theories, including Keynesian principles, to shape their economic policies.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Equation

The Keynesian Cross model is expressed through an equation that illustrates the equilibrium condition where aggregate income (Y) equals aggregate expenditure (AE):

Y = AE

= C + I + G + (X – M)

= C + I + G + NX

Here’s the breakdown:

When total spending (AE) equals total income (Y), the economy is in equilibrium or stable. If AE surpasses Y, it results in an unintended reduction in inventory, prompting firms to increase production, thus boosting income. Conversely, if AE falls short of Y, an unplanned inventory surplus occurs, reducing production and income.

Diagram

The Keynesian cross diagram is a graphical representation of the interrelationship between aggregate expenditure (AE) and real GDP in an economy, offering valuable insights rooted in Keynesian economics. It is an indispensable tool for economists and policymakers to analyze the impacts of fluctuations in spending, investment, or other economic factors on an economy’s equilibrium GDP. The Keynesian cross diagram is as follows:

Keynesian Cross Graph

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Keynesian Cross (wallstreetmojo.com)

To understand the above graph, let us first go through its various components:

  • 45-Degree Line: A 45-degree line originates from the point (0,0) and extends towards the upper right. This line symbolizes the Keynesian cross equilibrium between real GDP and aggregate expenditure. Any point along this line signifies that the total spending in the economy equals the total income.
  • Aggregate Expenditure Line: Contrasting with the 45-degree line, this line slopes downward. It showcases the relationship between aggregate expenditure (AE) and real GDP. Commencing above the 45-degree line, this curve signifies that at lower income levels, spending exceeds income (even when income is low), and as income increases, it gradually slopes downwards.
  • Equilibrium Point: The point at which the aggregate expenditure line intersects the 45-degree line denotes the Keynesian cross-equilibrium point of the economy. Here, total spending equals total income, signifying a balanced economy. 
  • Economic Gaps: Depending on the relative position of the aggregate expenditure line to the 45-degree line, one can identify whether there exists an expenditure gap (when below the 45-degree line, indicating lower spending than income) or an inflationary gap (when above the 45-degree line, implying higher spending than income).

Examples

The following examples represent the relationship between income and spending in an economy:

Example #1

Imagine an economy with only two sectors: households and businesses. Households earn income by working and spend most of it on goods and services (consumption). Businesses produce those goods and services and invest in new equipment and factories.

Now, let’s assume that in this economy:

  • Households earn $1,000 in income.
  • They decide to spend $800 on buying goods and services.
  • Businesses invest $200 to expand their production capacity.

In this scenario, the total spending in the economy (Aggregate Expenditure, AE) is $800 (from households’ consumption) + $200 (from business investment) = $1,000.

The total income earned in the economy (Y) is also $1,000.

The economy is in equilibrium since AE ($1,000) equals Y ($1,000). In other words, the total spending matches the total income, indicating a stable economic state.

Example #2

Suppose in an economy, the consumption function is expressed as C = 200 + 0.6Y, investment is $2000, government spending amounts to $1200, and net exports equal $400. Determine the economic output at which the equilibrium level can be attained.

Solution:

AE = C + I + G + (X – M) = 200 + 0.6Y + 2000 + 1200 + 400 = 3800 + 0.6Y

To identify equilibrium, let us assume that AE is equal to Y:

AE = Y

Y = 3800 + 0.6Y

0.4Y = 3800

Y = $9500

Therefore, the equilibrium income in such an economy can be achieved at $9500. However, if the aggregate expenditure increases beyond $9500, there will be an inflationary gap. But if it is lower than $9500, then an expenditure gap occurs.

Frequently Asked Questions (FAQs)

1. What is the key difference between the Keynesian cross model and the IS-LM model?

The Keynesian Cross Model and the IS-LM Model are two distinct frameworks within macroeconomics. These models provide valuable perspectives on how economic variables impact overall economic activity.
 The former primarily focuses on short-term output and expenditure determination. However, the latter studies the relation and interaction among interest rates, money supply, and income in the short and medium term.

2. Is MPC constant in the Keynesian cross model?

In the Keynesian cross model, it is commonly assumed that the Marginal Propensity to Consume (MPC) remains constant in the short run. This assumption implies that households consistently spend a fixed portion of any additional income they receive.

3. What is the four-sector Keynesian cross model?

The Four-Sector Keynesian Cross Model expands upon the standard Keynesian Cross Model by incorporating the external sector, which includes exports (X) and imports (M). In addition to households, businesses, and the government, it considers the foreign sector’s economic impact. This model helps analyze the effects of international trade and capital flows on a nation’s equilibrium income and expenditure.

This article has been a guide to what is Keynesian Cross. Here, we explain the topic in detail, including its diagram, equation, and examples. You may also find some useful articles here –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *