0.4 The expenditure-output model

(This appendix should be consulted after first reading The Aggregate Demand/Aggregate Supply Model and The Keynesian Perspective .) The fundamental ideas of Keynesian economics were developed before the AD/AS model was popularized. From the 1930s until the 1970s, Keynesian economics was usually explained with a different model, known as the expenditure-output approach. This approach is strongly rooted in the fundamental assumptions of Keynesian economics: it focuses on the total amount of spending in the economy, with no explicit mention of aggregate supply or of the price level (although as you will see, it is possible to draw some inferences about aggregate supply and price levels based on the diagram).

The axes of the expenditure-output diagram

The expenditure-output model , sometimes also called the Keynesian cross diagram , determines the equilibrium level of real GDP by the point where the total or aggregate expenditures in the economy are equal to the amount of output produced. The axes of the Keynesian cross diagram presented in [link] show real GDP on the horizontal axis as a measure of output and aggregate expenditures on the vertical axis as a measure of spending.

The expenditure-output diagram

Remember that GDP can be thought of in several equivalent ways: it measures both the value of spending on final goods and also the value of the production of final goods. All sales of the final goods and services that make up GDP will eventually end up as income for workers, for managers, and for investors and owners of firms. The sum of all the income received for contributing resources to GDP is called national income (Y). At some points in the discussion that follows, it will be useful to refer to real GDP as “national income.” Both axes are measured in real (inflation-adjusted) terms.

The Potential GDP Line and the 45-degree Line

The Keynesian cross diagram contains two lines that serve as conceptual guideposts to orient the discussion. The first is a vertical line showing the level of potential GDP . Potential GDP means the same thing here that it means in the AD/AS diagrams: it refers to the quantity of output that the economy can produce with full employment of its labor and physical capital.

The second conceptual line on the Keynesian cross diagram is the 45-degree line, which starts at the origin and reaches up and to the right. A line that stretches up at a 45-degree angle represents the set of points (1, 1), (2, 2), (3, 3) and so on, where the measurement on the vertical axis is equal to the measurement on the horizontal axis. In this diagram, the 45-degree line shows the set of points where the level of aggregate expenditure in the economy, measured on the vertical axis, is equal to the level of output or national income in the economy, measured by GDP on the horizontal axis.