KEYNESIAN CROSS

In the Keynesian Cross model show in figure x above, the Z Line represents the equal relationship between an increase in total output and income being matched by an equal increase in total spending.

However, in reality, a certain increase in total output and income will lead to a less than equal rise in total spending, due to some of this income being subject to taxation, and also since some of this spending may be transferred abroad through the purchase of foreign imports. This gives rise to the D Line, which represents the actual relationship between total income and spending in the economy. Therefore, equilibrium will be achieved at Point E, where aggregate demand represented by total spending is equal to aggregate supply represented by total output.

The stability of this equilibrium is ensured by changes in inventory levels. For example, if total spending exceeds total output, levels of unsold stock will fall, leading to higher prices for a smaller supply of goods and services. This will depress demand and spending, thus ensuring the reacquisition of Point E again. Conversely, if total spending is below total output, levels of unsold inventory will fall, leading to reduced production until the economy operates at Point E again.

Lastly, with Aggregate Demand being defined as the total sum of consumption, investment, government spending and net exports within the economy, we can use the Keynesian Cross model to show that increases in any one of these components will lead to the D Line shifting up in figure x, leading to increased spending and output. Conversely, any decreases in the components of Aggregate Demand will lead to the D Line shifting down, resulting in decreased spending and output.