A solid understanding of economic theory is important when you operate a business. But at times, it can be difficult to apply theoretical concepts directly to the tangible operations of your company. Some theories, like those of the economist, John Maynard Keynes, present macroeconomic ideas regarding total spending in an economy and its impact on output and inflation. Keynesian theories, such as the 45-degree line of economics and the Keynesian cross, may be more relatable to your business than you think.
Who Was John Maynard Keynes?
John Maynard Keynes was a British economist whose work during the 1930s is largely known for helping to understand the Great Depression in economic terms. Keynes favored increased government spending and lower taxes in an effort to stimulate spending by the masses leading to economic recovery.
The demand-side theories of Keynes emphasize the importance of economic changes that occur over the short run. These differ from more traditional, classical economic theories, which held that cyclical swings in the economy, from employment to spending, should generally be modest and self-adjust in time. Historical events like the Great Depression put these traditional theories in a new light, and economists like Keynes began to reevaluate the ways in which the economy might be impacted in a variety of scenarios.
As a result, modern economic theories call for monetary policy changes by the Federal Reserve, as well as government incentive programs to lower unemployment and encourage the growth of business. In electing to make small tweaks here and there to its fiscal policy, the U. S. government is following some of the ideas proposed by Keynes.
Keynes was critical of the British government, which, at the time, employed a policy of cutting welfare spending and raising taxes. He felt that this would not do enough to spur the economy and could, in fact, make the state of the national economy worse. He argued that the economy needed to be stimulated so citizens would feel comfortable spending money.
What Is the 45-Degree Line of Economics?
The 45-degree line of economics is so named because it forms a 45-degree angle with both the x and y axes when charted. In Keynesian economics, this line illustrates all of the points at which aggregate expenditures, measured on the y, or vertical axis, are equal to aggregate production, which are measured on the x, or horizontal axis. The equation typically used for this line under this economic theory is y=ae. According to Keynesian economics, the aggregate expenditures line illustrates the equilibrium level of aggregate production.
The 45-degree line is also used in non-Keynesian economics to showcase the relationship between consumption and income. Graphically representing this helps to illustrate cost savings, the vertical difference between the consumption line and the 45-degree line.
What Is the Keynesian Cross?
The Keynesian cross model is used to illustrate the relationship between expenditure and output. It shows how the aggregate expenditure varies with the level of output. In this model, equilibrium occurs wherever the aggregate expenditure crosses the 45-degree line. The 45-degree line shows where aggregate expenditure is equal to output.
This model determines the equilibrium level of real gross domestic product at whichever point aggregate expenditures are equal to total output. In a Keynesian cross diagram, real GDP is shown on the horizontal axis. It is used to illustrate output. On the vertical axis, aggregate expenditure is used to illustrate spending.
When it comes to a Keynesian cross, GDP can be seen as both the value of what was spent on goods and the value of the production of goods. Since the money that will change hands as a result of the production involved in GDP will provide income to all workers, the GDP can sometimes be referred to as national income.
The Keynesian cross includes two lines that are conceptual and help you to make sense of the numbers on the model. The first of these is a vertical line extending from the x-axis, which shows the potential GDP. Potential GDP is defined as the total output an economy can achieve with full employment and all resources fully utilized.
The other conceptual line is the 45-degree line, which illustrates the points on the chart at which aggregate expenditure is equal to the aggregate output, also called the national economy.
The Keynesian cross model also includes a line called the aggregate expenditure schedule, which illustrates the economy’s total expenditures for each possible level of real GDP. It is at the intersection of this line and the 45-degree line where the economy can be thought of to be at equilibrium. In other words, this is the only point illustrated on the model that shows where aggregate demand equals the total level of production.
Models of this kind are helpful for determining government fiscal policy, a critical component of Keynesian economics. Since Keynes did not believe that an economy would necessarily just right itself, but rather it was up to the government to intervene, this model is useful on a macroeconomic scale to determine shortfalls or overages in the national economy.
Strategies for lowering unemployment, incentivizing businesses and making decisions at the Federal Reserve level related to monetary policy are all undertaken by the federal government at various points, depending in part on information provided by models like the Keynesian cross.
How the Keynesian Cross Relates to Your Business
Although the Keynesian cross is designed to illustrate macroeconomic theories, the information it showcases relates quite directly to businesses of all kinds. The choice of the public to spend or save their money, per economic theories like those of Keynes, are heavily rooted in the performance of the macroeconomy. Consumption expenditures tend to increase when the national income rises. This can mean good things for your profits.
One key way to estimate profits or business growth is to study the economic behavior of consumers in times when aggregate expenditures, aggregate outputs and real GDP have been similar to the present time. Consumer behaviors, according to Keynesian theory, will likely be similar when circumstances are parallel.
Marginal Propensity to Consume
In economics, there is a concept known as the marginal propensity to consume, or MPC. This is closely linked to another concept, called the marginal propensity to save, or MPS. These two ideas account for the portion of each dollar that a consumer will either spend or hold on to when provided the opportunity. Since the idea is predicated on portions of dollars, the sum of MPC and MPS must always equal 1.
The ideas of MPC and MPS can be averaged on a national basis, and models exist that illustrate how these behaviors change at different levels of real GDP. These figures can be very useful for businesses in estimating how profits might increase or decrease over time. Say, for instance, the MPC is 0.9, and the MPS is 0.1. Numbers of this nature would be a very good indicator that general consumer behavior is trending towards a propensity to consume. This could be an excellent time for your business to invest in a new advertising campaign or launch a new product line.
The Multiplier Effect
One of the most important aspects of Keynesian economic theory is known as the multiplier effect. This idea is directly correlated to the marginal propensity to consume. For instance, the government has injected some funding into the economy in an effort to create a stimulus. In theory, this would lead to increased spending and overall economic activity. According to Keynes, spending boosts aggregate output and ultimately leads to even more income and a higher GDP. In order for this to be the case, however, workers must be willing to part with their income. This is where the idea of MPC comes into play.
The multiplier effect is directly related to the marginal propensity to consume. This is because the money that one person spends and therefore puts back into the economy becomes income for another worker. That worker can then spend some of his income, and so on. Over time, this leads to an overall increase in the MPC, which spurs economic growth on the whole.
This notion is called the multiplier effect because, in essence, each dollar that is spent creates multiple dollars in economic growth as the cycle continues and the economy is spurred. Some economists argue that the multiplier effect has less impact than Keynes’ theories suggested, but it is still accepted to have an effect at some level.
How to Use the 45-Degree Line of Economics
When you are managing a business and focused on issues of strategic planning, it is essential to understand the basics of macroeconomics and how large, sweeping changes in the national economy might impact your company. The Keynesian cross and the 45-degree line of economics can provide important insights into the country’s overall health and consumers’ financial behaviors.
The 45-degree line can be used to show the ways in which aggregate expenditures and real GDP impact business inventories. Over time, this can affect future levels of real GDP. By examining this information, a business can decide whether to plan on increasing or decreasing their inventory. For instance, if the 45-degree line and Keynesian cross indicate that aggregate expenditures are too high, businesses likely will have to sell off inventory. In turn, this would necessitate additional investment by the company, as they would need to produce more inventory in the future to catch up. Real GDP would then increase.
On the flip side, if aggregate expenditures are too low, your business will likely need to build up its inventory. Since you will be investing resources and building inventory, you will have less money available to invest. This can lead to a general slowdown. In a situation like this one, real GDP will usually decrease across the board.
Applying macroeconomic theories like those of John Maynard Keynes to your business can be complicated, but keeping good economic principles in mind and watching the market over time helps to ensure accuracy. Prior to making any major business decisions, it’s a good idea to consult a financial planner or economist with knowledge of the market, the national economy and its trends.
Generally speaking, economic theories like those of Keynes are sound, and models like his cross and 45-degree line have been proven many times over to be accurate. They can provide a solid background for determining the right time to increase or decrease inventory for your company. Scaling up or down based upon large macroeconomic movements can place your business in an excellent position when the economy next offers plenty of marginal propensity to consume, as this will significantly drive profits. Planning in accord with economic theory and maintaining a solid backup plan in case the national economy does not behave as predicted is a safe, smart strategy for employing the information of macroeconomics.
- Investopedia: Keynesian Economics
- AmosWeb Encyclonomic: 45-Degree Line
- Khan Academy: The Expenditure-Output, Or Keynesian Cross, Model
- University of Albany: Intermediate Macroeconomics
- Texas Gateway: The Expenditure-Output or Keynesian Cross Model
- FreeEconHelp: Aggregate expenditure and the 45 degree line (Keynesian Cross)
Danielle Smyth is a writer and content marketer from upstate New York. She has been writing on business-related topics for nearly 10 years. She owns her own content marketing agency, Wordsmyth Creative Content Marketing (www.wordsmythcontent.com) and she works with a number of small businesses to develop B2B content for their websites, social media accounts, and marketing materials. In addition to this content, she has written business-related articles for sites like Sweet Frivolity, Alliance Worldwide Investigative Group, Bloom Co and Spent.