A.2 Macroeconomic Equilibrium and the Keynesian Cross

Learning Objective Find the macroeconomic equilibrium and analyze how it changes as economic conditions change.

Ask a business owner how much they plan on producing, and they’ll say that it depends on how much people plan on spending. Ask people how much they plan to spend, and they’ll say it depends on how much income they expect to earn. Ask them how much income they expect to earn, and they’ll tell you it depends on how much work they have, which depends on how much businesses produce.

If this all feels a bit circular, that’s because it is. As Figure 5 shows, spending depends on income, income depends on production, and production depends on spending. This is the interdependence principle at work, and it arises because one person’s spending creates a demand for others to produce more output, which boosts their income. When those folks spend that extra income, they’ll kick-start further cycles of interdependence as their spending stimulates greater production, more income, and yet more spending.

Figure 5 | Macroeconomic Interdependence

Introductory text reads, You’ll need to focus on the equilibrium in order to resolve the interdependence between income, spending, and production. The illustration shows a cycle diagram with the following data: Income leads to spending which in turn leads to Production and from production to Income.

Aggregate Expenditure in Macroeconomic Equilibrium

This interdependence makes macroeconomics seem harder than it really is. The secret to resolving this apparent circularity is to look for the equilibrium that results from the interaction of income, spending, and production.

Scientists describe an equilibrium as a stable situation with no tendency to change. In microeconomics, an individual market has a tendency to move to the equilibrium where the quantity of a product that’s supplied is equal to the quantity demanded. The idea of macroeconomic equilibrium is similar, but rather than analyzing an individual market, it involves thinking about the economy as a whole.

Macroeconomic equilibrium occurs when aggregate expenditure matches total production.

Macroeconomic equilibrium is the point at which the total quantity of output that buyers collectively want to purchase is equal to the total quantity of output that suppliers collectively produce. As such, it happens when aggregate expenditure (a measure of the total demand for stuff) equals GDP (a measure of total production, or the total supply of stuff):

Aggregate expenditure = GDP

macroeconomic equilibrium

Occurs when the quantity of output that buyers collectively want to purchase is equal to the quantity of output that suppliers collectively produce.

When total spending and total production are in balance, there’s no tendency for total output to change. That’s why you can forecast that an economy that’s in macroeconomic equilibrium is likely to stay there—at least until something else intervenes.

Macroeconomic equilibrium doesn’t mean that every single market for each individual product is in supply-equals-demand equilibrium. Supply might exceed demand in some markets (leading those suppliers to cut back on production), while in others, demand might exceed supply (leading those suppliers to expand production). In a macroeconomic equilibrium, these effects offset and, across the economy as a whole, businesses are producing as much stuff as people are willing to buy. As a result, there’s no reason for total production to either increase or decrease.

Macroeconomic equilibrium occurs on the 45-degree line.

Figure 6 illustrates a simple graphical trick to find all the points that are consistent with a potential macroeconomic equilibrium: When you graph aggregate expenditure against GDP, the set of points where the two are equal is simply the 45-degree line. That’s because a 45-degree line shows all the points where the value on the vertical axis (that is, aggregate expenditure) is equal to the value on the horizontal axis (which is GDP). Thus, the 45-degree line illustrates all the possible points of macroeconomic equilibrium.

Figure 6 | Macroeconomic Equilibrium Occurs on the 45-Degree Line

Introductory text reads Equilibrium occurs when: Aggregate expenditure equals G D P. The 45-degree line shows all possible points of macroeconomic equilibrium.

The graph plots Real G D P (Production) along the horizontal axis against Aggregate expenditure along the vertical axis. A positively sloping curve labeled 45-degree line: Aggregate expenditure equals G D P originates from the origin and terminates at the highest point on the graph. The slope of the curve, 45 degrees is marked on the graph.

The text above an arrow on the left, directed toward the curve reads, To the left of the 45-degree line: Aggregate expenditure exceeds production; Businesses meet current demand by selling inventories; Managers increase future production.

The text above an arrow on the right, directed toward the curve reads, To the right of the 45-degree line: Production exceeds aggregate expenditure; Businesses store excess product as inventories; Managers decrease future production.

Production will adjust toward the 45-degree line.

At points to the right of the 45-degree line, GDP exceeds aggregate expenditure, which is not an equilibrium. At these points—shown in purple—suppliers are producing more than people want to buy. Initially, they’ll store this excess supply as inventories. But producers don’t want to keep accumulating warehouses full of unsold inventories, and so eventually they’ll adjust by cutting production. This tendency to cut production when it exceeds aggregate expenditure will push the level of output back toward a macroeconomic equilibrium where aggregate expenditure and production are in balance—which occurs on the 45-degree line.

Alternatively, at points to the left of the 45-degree line, GDP is less than aggregate expenditure, which also is not an equilibrium. At these points—shown in green—suppliers are producing less than people want to buy. Initially, they’ll meet this excess demand by selling inventories, but that can’t continue forever. Rather than risk forgoing profitable sales if their inventories run out, they’ll ramp up production. This tendency to raise production when it’s less than aggregate expenditure will push the level of output back toward macroeconomic equilibrium, once again bringing them into balance along the 45-degree line.

Put the pieces together, and you’ll see that as managers adjust their production levels to better match aggregate expenditure, they’ll push GDP back toward macroeconomic equilibrium and the 45-degree line. It follows that any point along the 45-degree line can be a macroeconomic equilibrium.

Equilibrium occurs where aggregate expenditure crosses the 45-degree line.

Okay, so the 45-degree line tells you that there are many possible points of macroeconomic equilibrium where GDP could come into balance with aggregate expenditure. To figure out which of these possible outcomes will be next year’s actual outcome, you’ll need to figure out which one coincides with next year’s actual level of aggregate expenditure. And so it’s time to bring the aggregate expenditure line back into our analysis.

Macroeconomic equilibrium occurs at the point where the aggregate expenditure line meets the 45-degree line. As Figure 7 illustrates, at this point the level of aggregate expenditure is equal to GDP.

Figure 7 | Macroeconomic Equilibrium

Introductory text reads,

Equilibrium occurs where the aggregate expenditure line meets the 45-degree line.

A. The 45-degree line shows the set of possible equilibria where aggregate expenditure equals G D P.

B. The aggregate expenditure line shows how total spending varies with the level of G D P.

C. Macroeconomic equilibrium occurs where the aggregate expenditure line crosses the 45-degree line, ensuring that spending and production plans are consistent with each other.

The graph plots Real G D P along the horizontal axis against Aggregate expenditure along the vertical axis. A positively sloping curve labeled A. 45-degree line and the slope of the curve, 45 degrees is marked on the graph. A positive sloping curve labeled B. Aggregate expenditure line, originating at a point on the lower half of the graph intersects the 45-degree line at C. Macroeconomic equilibrium: Aggregate expenditure equals G D P, with the coordinates (Equilibrium G D P, Aggregate expenditure). Dashed lines from these points meet their respective coordinates on the horizontal and vertical axis.

That’s it! Now you know how to find the point of macroeconomic equilibrium: It occurs where the aggregate expenditure line crosses the 45-degree line. This framework is often called the Keynesian cross and you can probably see why. It’s a cross because it suggests that the economy will move to the level of output where the two lines cross. And it’s Keynesian because it illustrates the central insight of John Maynard Keynes, that spending plays a key role in determining macroeconomic outcomes.

Equilibrium GDP can fall short of potential GDP.

A macroeconomic equilibrium describes where we expect the economy to come to rest. But that doesn’t necessarily mean that it’s a good outcome—merely that it’s a stable one. Just as you can come to rest in a good place or a bad one, so too can the economy. A macroeconomic equilibrium can occur at a high level of GDP or at a low one—it really depends on the position of the aggregate expenditure curve. For instance, during the Great Depression, equilibrium GDP was far below potential GDP.

A low-GDP equilibrium.

Shifts in Aggregate Expenditure

So far we’ve focused mainly on the effects of changes in income, which lead to movement along the aggregate expenditure line. Let’s now expand our analysis to also include factors that might cause a change in aggregate expenditure at any given income level causing a shift in the aggregate expenditure line.

It’s important to distinguish between two forces that change spending: income and everything else. As you evaluate changes in spending, simply ask yourself: What caused this change? If it’s a change in income, the aggregate expenditure line won’t shift. But if it’s any other factor, then it shifts the aggregate expenditure line. As we’re about to see, any shift in the aggregate expenditure line leads to a new level of equilibrium GDP.

A decrease in spending will shift the aggregate expenditure line down.

Let’s start by considering the effects of a decrease in aggregate expenditure. This would occur if consumers cut back on their spending, businesses reduce investment in new equipment, governments reduce their purchases, foreigners spend less on our exports, or Americans import more of their purchases from abroad. Any factor that leads to a decrease in aggregate expenditure at any given income level—whether due to a change in C, I, G, or NX—will shift the aggregate expenditure line downward, as shown by the purple line in Panel A on the left of Figure 8.

Figure 8 | Shifts in Aggregate Expenditure Can Cause Recessions and Expansions

The graphs plot Real G D P along the horizontal axis and Aggregate expenditure along the vertical axis.

The graph on the left is titled, Panel A: A Decrease in Spending.

Introductory text reads,

A. A decrease in aggregate expenditure at any given level of income causes the aggregate expenditure line to shift down.

B. This leads the economy to move to a new equilibrium, with a lower level of G D P, and hence lower income and employment.

C. Because G D P decreases, it follows that a decrease in aggregate expenditure causes a recession.

The graph plots a positive curve labeled 45-degree line originating at the origin and terminating at the highest point on the graph. Two other positive curves labeled Old aggregate expenditure and Decreased aggregate expenditure are plotted on the graph from top to bottom respectively. An arrow labeled A points from Old aggregate expenditure towards the Decreased aggregate expenditure curve.

The 45-degree line intersects the Old aggregate expenditure curve at value, Old G D P along the horizontal axis and Decreased aggregate expenditure curve at value, Lower G D P along the horizontal axis respectively. The intersection point with the Decreased aggregate expenditure curve is labeled B. New equilibrium. An arrow points from Old G D P to Lower G D P along the horizontal axis. Dashed lines from these points meet their respective coordinates on the horizontal axis.

The graph on the right is titled, Panel B: An Increase in Spending.

An introductory text reads,

A. An increase in aggregate expenditure at any given level of income causes the aggregate expenditure line to shift up.

B. This leads the economy to move to a new equilibrium, with a higher level of G D P, and hence higher income and employment.

C. Because G D P increases, it follows that an increase in aggregate expenditure causes an economic expansion.

The graph plots a positive curve labeled 45-degree line originating at the origin and terminating at the highest point on the graph. Two other curves labeled Increased aggregate expenditure and Old aggregate expenditure are plotted on the graph from top to bottom respectively. An arrow labeled A points from Old aggregate expenditure to Increased aggregate expenditure.

The 45-degree line intersects the old aggregate expenditure curve at Old G D P on the horizontal axis and Increased aggregate expenditure at Higher G D P. The point where the 45-degree line and the Increased aggregate expenditure curve intersect is labeled B New equilibrium. An arrow from Old G D P to Higher G D P on the horizontal axis is labeled C Expansion.

This lower level of aggregate expenditure yields a new macroeconomic equilibrium at a lower level of GDP. As the economy adjusts to this new equilibrium, GDP declines, causing a recession, or in a severe case, a depression. In this new equilibrium, output is much lower, and so businesses need fewer workers. As a result, this low-GDP equilibrium corresponds with widespread unemployment. Think of this as the equilibrium during the latest recession, or perhaps the Great Depression. Even worse: Because this economic slump is a macroeconomic equilibrium, it’s likely to persist until something changes.

A positive spending shock will shift the aggregate expenditure line up.

Following similar logic in the opposite direction suggests that an increase in aggregate expenditure can spark an economic boom. In this case, we’ll evaluate an increase in aggregate expenditure. Again, this increase in spending could reflect a rise in C, I, G, or NX. Whatever the cause, any factor that leads to an increase in aggregate expenditure at any given income level will shift the aggregate expenditure line upward, as shown by the green line in Panel B on the right of Figure 8.

This boost to spending yields a new macroeconomic equilibrium at a higher level of GDP. As the economy adjusts to this new equilibrium, GDP rises, causing an economic expansion. In this new equilibrium, output is much higher, and so businesses need more workers. As a result, this high-GDP equilibrium corresponds with low unemployment. Think of this as the equilibrium during an economic boom.

Predicting the State of the Economy

Congratulations! You’ve now developed a framework that you can use to forecast how the economy will respond to changing economic conditions.

She’s looking into the future.

Follow the three-step recipe to forecast how the economy will respond.

All you need to do is answer the three questions:

• Step one: Have spending plans changed?

The question here is whether aggregate expenditure will change at any given income level. That means asking whether consumers will alter their spending, businesses will change how much they invest, policy makers will adjust government purchases, foreigners will shift their spending on exports from America, or Americans will change whether they make their purchases from abroad. (Make sure you remember to think about each of the components of aggregate expenditure—including C, I, G, and NX.)

• Step two: Shift the aggregate expenditure line

Is this an increase in spending at any given income level (shifting the aggregate expenditure line upward) or a decrease (shifting it down)?

• Step three: Analyze the new equilibrium

How does the equilibrium level of GDP change in the new equilibrium? And how does it compare to potential output, which is the level of GDP at which all resources are fully employed?

Let’s practice using this framework to forecast where the economy is going.

Example one: The government passes a fiscal stimulus bill that raises the level of government purchases by $1 trillion. How will this affect GDP?

Let’s follow our three-step recipe:

• Step one: This fiscal stimulus bill leads to an increase in government purchases—and hence aggregate expenditure—at any given income level.
• Step two: This increase in government purchases will increase aggregate expenditure, thereby shifting the aggregate expenditure line up by $1 trillion.
• Step three: As the figure in the margin illustrates, the new equilibrium level of GDP is higher than the previous level.

The graph plots G D P along the horizontal axis and Aggregate expenditure along the vertical axis.

Two positive curves labeled Old A E and New A E are plotted on the graph, from bottom to top respectively. Another positive curve, originating at the origin, intersects the curves New A E and Old A E. Dashed lines from these points meet their respective coordinates on the horizontal axis. An arrow labeled Increase in Y is directed from these points of Old A E to New A E on the horizontal axis. Another arrow labeled Increase in Delta G (1 T dollars) along the vertical axis is directed from the Old A E to New A E.

Example two: The Federal Reserve raises interest rates.

Let’s follow our three-step recipe:

• Step one: An increase in real interest rates leads households to consume less and businesses to invest less at any given income level.
• Step two: This decrease in consumption and investment will decrease aggregate expenditure, thereby shifting the aggregate expenditure line down.
• Step three: As the figure in the margin illustrates, this leads to a new equilibrium level of GDP that’s lower than the previous level.

The graph plots G D P along the horizontal axis and Aggregate expenditure along the vertical axis.

Two positive curves labeled Old A E and New A E are plotted on the graph, from top to bottom respectively. A 45-degree line, originating at the origin, intersects the New A E and Old A E. Dashed lines from these points meet their respective coordinates on the horizontal axis. An arrow labeled Decrease in Y is directed from these points of Old A E to New A E. Another arrow labeled Decrease in Delta C plus Delta I, along the vertical axis is directed from the Old A E to New A E.

Do the Economics

Think you’ve got this business of economic forecasting all figured out? Here are a half-dozen more examples for you to work through.

• The invention of new pharmaceuticals will increase American exports.

The graph plots G D P along the horizontal axis and Aggregate expenditure along the vertical axis.

Two positive curves labeled Old A E and New A E are plotted on the graph, from bottom to top respectively. Another positive curve labeled 45-degree line, originating at the origin, intersects the New A E and Old A E curves. Dashed lines from these points meet their respective coordinates along the horizontal axis. An arrow labeled Increase in Y is directed from these points of Old A E to New A E, along the horizontal axis. Another arrow labeled Increase in Delta N X, along the vertical axis is directed from the Old A E to New A E.

• An increase in net exports
• → Shift aggregate expenditure up
• Result: Higher GDP.

• A fall in stock market wealth makes consumers willing to spend less at each level of income.

The graph plots G D P along the horizontal axis and Aggregate expenditure along the vertical axis.

Two positive curves labeled Old A E and New A E are plotted on the graph, from top to bottom respectively. A 45-degree line originating at the origin, intersects the New A E and Old A E curves. Dashed lines from these points meet their respective coordinates along the horizontal axis. An arrow labeled Decrease in Y is directed from these points of Old A E to New A E, along the horizontal axis. Another arrow labeled Decrease in Delta C, along the vertical axis is directed from the Old A E to New A E.

• A decrease in consumption
• → Shift aggregate expenditure down
• Result: Lower GDP.

• An investment tax credit leads businesses to spend an extra $2 trillion on machinery.

The graph plots G D P along the horizontal axis and Aggregate expenditure along the vertical axis.

Two positive curves labeled Old A E and New A E are plotted on the graph, from bottom to top respectively. A 45-degree line originating at the origin intersects the New A E and Old A E curves. Dashed lines from these points meet their respective coordinates along the horizontal axis. An arrow labeled Increase in Y is directed from these points of Old A E to New A E, along the horizontal axis. Another arrow labeled Increase in Delta I (2 T dollars), along the vertical axis is directed from the Old A E to New A E.

• An increase in investment
• → Shift aggregate expenditure up
• Result: Higher GDP.

• As uncertainty rose, many managers decided to postpone major investment projects.

The graph plots G D P along the horizontal axis and Aggregate expenditure along the vertical axis.

Two positive curves labeled Old A E and New A E are plotted on the graph, from top to bottom respectively. A 45-degree line originating at the origin intersects the New A E and Old A E curves. Dashed lines from these points meet their respective coordinates along the horizontal axis. An arrow labeled Decrease in Y is directed from these points of New A E to Old A E, along the horizontal axis. Another arrow labeled Increase in Delta I, along the vertical axis is directed from the Old A E to New A E curves.

• A decrease in investment
• → Shift aggregate expenditure down
• Result: Lower GDP.

• A decrease in the value of the U.S. dollar makes American exports more attractive to foreigners.

The graph plots G D P along the horizontal axis and Aggregate expenditure along the vertical axis.

Two positive curves labeled Old A E and New A E are plotted on the graph, from bottom to top respectively. A 45-degree line originating at the origin intersects the New A E and Old A E curves. Dashed lines from these points meet their respective coordinates along the horizontal axis. An arrow labeled Increase in Y is directed from these points of New A E to Old A E, along the horizontal axis. Another arrow labeled Increase in Delta N X, along the vertical axis is directed from the Old A E to New A E.

• An increase in net exports
• → Shift aggregate expenditure up
• Result: Higher GDP.

• The government invested $2 trillion modernizing American military equipment.

The graph plots G D P along the horizontal axis and Aggregate expenditure along the vertical axis.

Two positive curves labeled Old A E and New A E are plotted on the graph, from bottom to top respectively. A 45-degree line originating at the origin intersects the New A E and Old A E curves. Dashed lines from these points meet their respective coordinates along the horizontal axis. An arrow labeled Increase in Y is directed from these points of Old A E to New A E along the horizontal axis. Another arrow labeled Increase in Delta G (2 T dollars), along the vertical axis is directed from the Old A E to New A E curves.

• An increase in government purchases
• → Shift aggregate expenditure up
• Result: Higher GDP.

Moderate changes in spending can have large effects on output.

The graph plots G D P along the horizontal axis and Aggregate expenditure along the vertical axis.

Two positive curves labeled Old A E and New A E are plotted on the graph, from bottom to top respectively. A 45-degree line originating at the origin intersects the New A E and Old A E curves. Dashed lines from these points meet their respective coordinates along the horizontal axis. An arrow labeled, Larger change in output is directed from these points of Old A E to New A E along the horizontal axis. Another arrow labeled Increase Small change in spending, along the vertical axis is directed from the Old A E to New A E.

There’s one final point to notice, and it’s evident in each of the examples you’ve just worked through: The shift in the aggregate expenditure line (the change in spending noted along the vertical axis) is small relative to the resulting change in real GDP (the shift along the horizontal axis). This suggests that even small or moderate changes in aggregate expenditure can have quite large effects—effectively multiplied effects—on GDP. These multiplied effects further reinforce the idea that moderate shifts in aggregate expenditure can drive the large changes in output that occur over the business cycle. This insight also suggests that government policy can have a sizable effect on GDP, as moderate changes in government purchases might have a multiplied effect on output. Let’s dig deeper into understanding how these multiplier effects work.