Question

Use a ${45}^{\circ }$ -line diagram to illustrate macroeconomic equilibrium. Make sure your diagram shows the aggregate expenditure function and the level of equilibrium real GDP and that your axes are properly labeled.

Short answer

The solution is a diagram with labeled Axes as 'Aggregate Expenditure' for Y-Axis and 'Real GDP' for X-Axis. A ${45}^{\circ }$ line runs from the origin representing points where Aggregate Expenditure equals GDP. The aggregate expenditure function is drawn as a curve, intersecting the 45-degree line. This intersecting point is the equilibrium real GDP.

Step-by-step solution

Draw the Axes

Begin by drawing the axes for the diagram. Label the vertical axis as 'Aggregate Expenditure' (AE) and the horizontal axis as 'Real GDP'

Draw the 45 Degree Line

Draw a line that rises at a ${45}^{\circ }$ angle from the origin. This line represents all the points where Aggregate Expenditure equals Real GDP.

Draw the Aggregate Expenditure Curve

Draw the aggregate expenditure curve in your diagram. This curve illustrates the total spending in the economy at a given level of real GDP.

Mark the Equilibrium

Find the point where the aggregate expenditure curve intersects the 45-degree line. This point represents the level of equilibrium real GDP. Label this point clearly.

Key concepts

45-Degree Line Diagram

The 45-degree line diagram is a fundamental tool in macroeconomics, primarily used to demonstrate the concept of macroeconomic equilibrium. On a graph, the 45-degree line is drawn from the origin at a perfect angle of 45 degrees, symbolizing points where aggregate expenditure equals real GDP. This line acts as a benchmark, illustrating balance in the economy.

To construct the diagram, start by setting up your axes: the vertical axis represents aggregate expenditure, and the horizontal axis denotes real GDP. The 45-degree line crosses these axes in a manner such that every point on the line shows an identity of expenditure and income, marking spots where what is being produced is completely bought. This visual ensures easy comparison between actual aggregate expenditure in the economy and proposed spending levels.

Aggregate Expenditure

Aggregate expenditure (AE) is the total spending in an economy on goods and services at a given level of real GDP. It is a combination of consumption, investment, government spending, and net exports:

• Consumption is the purchasing of goods and services by households.
• Investment represents spending on capital goods by businesses.
• Government spending includes all government consumption and investment.
• Net exports are the exports minus imports of an economy.

The aggregate expenditure curve in the 45-degree line diagram shows how this total spending changes with different levels of real GDP. It is typically upward sloping, indicating that as real GDP increases, spending generally rises due to higher incomes leading to more consumption. This curve's intersection with the 45-degree line is particularly important, as it marks the equilibrium real GDP in the economy.

Real GDP

Real GDP, or real Gross Domestic Product, measures the value of all goods and services produced in an economy adjusted for inflation. It provides a more accurate depiction of a nation's economic output over time as it removes the distortive effect of price increases.

In the context of the 45-degree line diagram, real GDP is plotted on the horizontal axis. As an indicator of economic health, real GDP helps assess whether an economy is growing, stagnating, or contracting. By looking at the levels of real GDP at various points on the diagram, we can infer the economy's performance and the adequacy of aggregate expenditure. High real GDP indicates a thriving economy, while low values suggest underperformance, often triggering policy changes to stimulate growth.

Equilibrium Real GDP

Equilibrium real GDP is where the aggregate expenditure equals total output, indicated by the intersection of the aggregate expenditure curve and the 45-degree line in our diagram. This point illustrates a state of balance where the quantity produced exactly meets the quantity purchased.

At this intersection, there is no unintended inventory accumulation or depletion, meaning businesses have sold exactly what they have created. This level of real GDP marks economic stability, as there are no pressures for the economy to increase or decrease output. Understanding where equilibrium real GDP lies can assist policymakers in developing fiscal or monetary strategies to address imbalances, whether it is a surplus or a shortage in the economy.