The Keynesian Cross Equilibrium
The economy is in equilibrium when actual expenditure equals planned expenditure. This is based on the idea that when people's plans have been realized, they have no reason to change what they are doing. Since actual expenditure is also total income , we can write this equilibrium condition as:
The 45° line plots the points where the condition holds. The equilibrium is point A, where the planned expenditure function crosses the 45° line.
Inventories play an important role in the adjustment process toward the equilibrium. Whenever the economy is not in equilibrium, firms experience unplanned changes in inventories which induces them to change production levels. Changes in production move the economy toward equilibrium income.
We can explore how the adjustment works by selecting a level of income which is not the equilibrium:
If income is below the equilibrium level , then planned expenditure falls short of production and so firms are selling less than they are producing. Firms add the unsold goods to their stock of inventories. This unplanned increase in inventories leads firms to reduce production, which decreases income. This process of unplanned inventory investment and falling income continues until income falls to the equilibrium level .
Similarly, if income is lower than the equilibrium level , then planned expenditure is greater than production and so firms are selling more than they are producing. Firms meet the high level of sales by using up their inventories. This unplanned decrease in inventories leads firms to increase production, which increases income. This process of increasing income continues until income reaches the equilibrium level . Hence in both cases, the firms' decisions drive the economy toward equilibrium.