National income is defined as the investments and savings in a country’s economy. Keynesian cross model shows the formula for equilibrium national income as; Y= C +I+ G+ (X-M); where Y is the national income, C is aggregate consumption, I is aggregate investment, G is government spending, X is exports and M is imports. The aggregate demand is an upward curve since it is assumed consumers demand more when their disposable income is high. There is a positive relationship between disposable income and consumption and therefore it is true to argue that demand will always increase with increase in disposable income. Aggregate demand also increases as investment increases but is negatively affected if it happens that imports and taxes increase due to rise in investment since they negatively affect the investment level.
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The equilibrium level is at the point where AD, total demand, is equal to Y, national output. At this point, total supply equals total demand. The major factor leading to a movement towards the equilibrium points is inventory changes as a result of changes in income and production- if it happens that the current output is more than the equilibrium level, inventories will accumulate leading to a cut down in production and thus a downward move towards the equilibrium. On the other hand, with a production level below the equilibrium, there is short of inventories and thus businesses will produce more leading to an upward move towards the equilibrium.
If there is a rise in any of the aggregate demand components, C, Ip, G or NX, the demand curve shifts upward. The rises in these components can be as a result of increases in production because of increased optimism about the profitability in the future. This increase will lead to an increase in the equilibrium levels. Similarly, with a decrease in any of the demand components, the demand curve shifts downwards and leads to a decrease in the equilibrium levels.
Keynes effect assumes that quantity demanded increases with decrease in price and vice versa. With constant nominal money supply, decreasing price implies lower interest rates and thus higher spending. The major emphasis in this model is “that a decrease in aggregate demand can lead to a stable equilibrium with substantial unemployment”. Full employment is argued to be arrived at when there are adjustments in the aggregate demand.
The equilibrium national income (Y”) is as shown in the figure below. At Y”, the desired spending curve intersects the total income curve; AD=Y.
Keynesian cross model has a number of limitations. The first one is the fact that “not all of gross private domestic investment counts as part of aggregate demand” (Dolan & Lindsey, 1994, p.139). This means that the aggregate demand is undervalued since some investments, which need increase aggregate demand is left out. It is assumed that most of the investment is as a result of general over-production or unplanned inventory accumulation and thus there is always a decrease in national income whenever there is unplanned inventory accumulation. This implies that only the planned investment is included in the aggregate demand.
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Another limitation is that unlike all other demand curves, which are downward sloping, the aggregate demand curve in this case is upward sloping since it is assumed that an increase in national income or output will lead to increased disposable income and thus increased demand. The last limitation is the fact that the national output curve needs to be steeper than the aggregate demand curve for the two to intersect. This implies that it is assumed that the aggregate demand curve has a positive vertical intercept so as to cross Y curve.
In Keynesian cross theory, it is assumed that an economy does not necessary need to have full employment for it to be stable. As it is advocated in classical theories that there should be full employment in the economy to prevent recessions and inflation, Keynes argues that an economy can be stable only when there is adjustment in the aggregate demand. This way, equilibrium aggregate income does not necessary mean full employment. J. M. Keynes supports this argument by stating that,
“Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits–of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities…if the animal spirits are dimmed and the spontaneous optimism falters… enterprise will fade and die” (Heijdra, 2009, p.25).
It should be noted that although Keynesian cross model is simple and easy to understand, its limitations make it unreliable. Its demand curve contradicts with all the other theories.