Keynesian Approach to AD and Real GDP

Readers Question: What are the effects of a decrease in foreign incomes on UK exports, how will this effect the equilibrium level of income and the balance of trade?

Quite a few readers have asked this question. Unfortunately, A Level economics no longer uses the Keynesian 45 degree line approach to solving problems such as this. The last time I used this Keynesian model was quite a long time ago, so I am a bit reluctant to answer this kind of question. Nevertheless I will try offer some ideas.

Firstly, it is useful to understand what is happening from a simple perspective, then we can try to use the Keynesian model.

  • A decrease in foreign incomes will cause a fall in UK exports.
  • A fall in exports, ceteris paribus, will cause a fall in Aggregated Demand. (AD=C+I+G+X-M) A simple AD/AS diagram would suggest a fall in exports and AD, would lead to lower levels of equilibrium national output.
  • If the value of exports falls, and imports stay the same, we would expect a deterioration in the balance of trade (i.e. if imports are greater than exports we will get a bigger deficit or move from a trade surplus to a trade deficit.
  • Exports are an injection into the circular flow. i.e something that increase Aggregate Expenditure and Aggregate Demand. If exports falls, we will get a reduction in injections and AD.

The Keynesian 45 degree line.

In the Keynesian model we have a 45 degree line. This is the line that depicts where AE aggregate Expenditure = National Income Y.

We then add a consumption line onto the graph. Here consumption equals C+I+G+X-M. It is also known as the aggregate Expenditure. Therefore, if there is a fall in AE, it will lead to a fall in the equilibrium level of Real GDP. This level of real GDP, maybe less than potential.

Diagram of 45 Degree line.

In our example the AE will fall from (2) to (1)


More notes on Keynesian model at Cliff notes

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