Home > Aggregate Demand, Macro > The Keynesian Cross in the Open Economy

The Keynesian Cross in the Open Economy

January 25, 2012

The Keynesian Cross showed the relationship between planned expenditure and actual expenditure.

Keynesian Cross

It was based on the Keynesian model of aggregate demand:

In the Keynesian model, demand is made up of consumption, investment, government spending, and net exports:

Y=C(Y-T)+I(Y,r)+G+(X(Y*,\epsilon )-M(Y, \epsilon).

This is a fuller version of the Y=C+I+G+(X-M) that you will have seen at A-level, it just expresses what the components of AD are functions of:

In the context of the open economy we can expand our understanding of the Keynesian Cross by considering specifically the effect of exports and imports. Increasing exports adds to aggregate demand, whilst increasing imports decreases aggregate demand. So aggregate demand can be best thought of as the demand for domestic goods rather than the domestic demand for goods. That is, aggregate demand in an economy depends on the demand (both at home and abroad) for domestic produced goods, rather than the domestic demand for goods, some of which will be spent on buying imports that counts towards another economy’s aggregate demand.

We can therefore define three forms of demand:
DD – Domestic demand for goods (C + I + G + M)
AA – Domestic demand for domestic goods (C + I + G)
ZZ – Demand for domestic goods (C + I + G + Z)

Here we start with purple line DD, the domestic demand for goods, and subtract imports to get AA, the domestic demand for goods. Then we add exports, the equivalent of a vertical shift upwards because the demand for exports is exogenous and does not depend on domestic income like the other components of AD that increase with domestic income do. This gives us our ZZ line, the demand for domestic goods.

Now we can consider the implications of the DD and ZZ line, and whether it means we have a trade deficit or trade surplus. The ‘planned expenditure’ line in the Keynesian Cross corresponds to the ZZ line, really it is the ‘planned expenditure on domestic goods’.

Trade deficit

The equilibrium comes at Y1, where the ZZ line intersects the 45 degree line. This is where demand for goods, Z, equals income, Y. But at this point, the DD curve is above the ZZ curve. This means the domestic demand for goods is higher than the demand for domestic goods, ie our economy’s citizens are demanding more goods than the demand for goods they produce. This means they must be importing more than they are exporting, and we have a trade deficit.

Trade surplus

Again the equilibrium comes at Y1, where the ZZ line intersects the 45 degree line. This is where demand for goods, Z, equals income, Y. But at this point, the DD curve is below the ZZ curve. This means the domestic demand for goods is lower than the demand for domestic goods, ie our economy’s citizens are demanding fewer goods than the demand for goods they produce. This means they must be exporting more than they are exporting, and we have a trade surplus.

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Categories: Aggregate Demand, Macro
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