Chapter 10:Self-Adjustment or Instability?

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Debate• John Maynard Keynes challenged the

classical assertion that the economy would self-adjust to full employment.

• Keynes said that there would be no automatic self-adjustment; the economy could stagnate in persistent unemployment or have continuing inflation.

• This debate has continued since the 1930s and is ongoing.

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Learning Objectives

• 10-01. Know the sources of circular flow leakages and injections.

• 10-02. Know what the multiplier is and how it works.

• 10-03. Know how recessionary and inflationary GDP gaps arise.

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Leakages

• Leakage: income that is generated in production but is diverted out of the circular flow.– Saving (both household

and business).– Imports.– Taxes (both household

and business).

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Injections

• Injection: an addition of spending in the circular flow.– Investment spending.– Government spending.– Exports.

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Leakages and Injections

• For macro equilibrium, leakages must equal injections.

• When this occurs, output supplied equals output demanded.

• Ideally, this should occur at full-employment GDP.

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Self-Adjustment?• Classical economists assumed that leakages

always equaled injections.• For example, they use flexible interest rates as

the mechanism to ensure this.– If saving (leakage) exceeds investment (injection) …

• Available funds to borrow increase and interest rates fall, which spurs more investment borrowing.

– If investment (injection) exceeds saving (leakage) … • Available funds to borrow decrease and interest rates rise,

which inhibits investment borrowing.

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Self-Adjustment? Keynes’s Response

• Changing expectations: – As saving increases, consumption decreases and

GDP falls. Business outlook is gloomy.– Business investment spending would more

likely fall rather than rise.

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Self-Adjustment?

• Classical economists said that any rising inventory of goods would trigger falling prices.– This would lead to increased selling to reduce

the undesired inventory.– This increased selling would shift AD right

toward the GDP needed at the full-employment level.

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Self-Adjustment? Keynes’s Response

• Changing expectations: – More would be bought at lower prices, but…– As prices fall, profits diminish and businesses

will further reduce production and eliminate investment plans.

– They would produce no more until the undesired inventory is sold.

– This leads to yet more layoffs and to equilibrium at high unemployment.

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Self-Adjustment?

• Rather than adjusting back toward full employment, Keynes saw the economy becoming more unstable as businesses react to declining sales, falling prices, and lowered expectations of the future.

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The Effect on Household Income

• Reduced production means layoffs, and that means decreased household income.

• Reduced income means less spending, and AD shifts further to the left away from full employment.– A relatively small problem could snowball into a

much larger problem.

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The Multiplier Process• Steps in the multiplier process:– 1. Let investment decline.– 2. This leaves unsold output.– 3. Production is cut back.– 4. Income decreases.– 5. Consumer spending decreases.– 6. Go to step 2 above.

• The eventual decrease in spending will be much larger than the initial decline in spending.

• The eventual shift of AD to the left will be much larger than the initial shift to the left.

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The Multiplier Process• Multiplier: the multiple by which an initial

change in spending will alter the total expenditure after all spending cycles.

• Example: If MPC = 0.75, the multiplier is 1/(1-0.75) = 1/0.25 = 4.

• The impact of an initial spending change will be multiplied by a factor of 4.

1Multiplier = 1 - MPC

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The Multiplier Process

• The multiplier is governed by the size of the MPC. – If the MPC decreases, then the multiplier gets

smaller.– If the MPC increases, then the multiplier gets

larger.

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Keynesian Adjustment Process• Producers cut output and employment when

output exceeds AD at the current price level (leakages exceed injections).

• The resulting loss of income causes a consumer spending decline.

• This leads to further production cutbacks, more job loss, more lost income, and still less consumption.

• AD shifts further to the left as the multiplier process goes into effect.

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Recessionary GDP Gap• The recessionary GDP

gap equals the difference between equilibrium GDP (QE) and full-employment GDP (QF).

• It shows unused production capacity as the economy is underproducing.

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The Unemployment - Inflation Trade-Off

• The AS curve slopes upward.

• An AD increase causes both output and prices to rise, and unemployment to fall.

• Because of rising prices, the economy must move to point h, not point f, to close the recessionary GDP gap.

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Inflationary GDP Gap• The inflationary GDP

gap equals the difference between equilibrium GDP (QE) and full-employment GDP (QF).

• It shows the economy producing at a GDP level above full-employment GDP, with the economy subject to inflationary pressure.

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Demand-Pull Inflation• An excessive increase

in an injection or decrease in a leakage can cause the economy to overheat.– AD pushes too far to

the right, generating an inflationary GDP gap.

– Demand-pull inflation: prices rise due to excessive AD.

– Instability could cause an inflationary spiral.

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The Multiplier Process1. Let investment increase and shift AD right.2. Inventory depletes (a warning sign of inflation) and prices

rise.3. Production is increased.4. Income increases.5. Consumer spending increases.6. Go to step 2 above.

• The eventual increase in spending will be much larger than the initial increase in spending.

• The eventual shift of AD to the right will be much larger than the initial shift to the right.

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Booms and Busts• Keynesian analysis concluded that the

economy is vulnerable to abrupt changes in spending behavior and won’t self-adjust to a desired macro equilibrium.– Changing expectations for both consumers and

businesses adjust their market activities, which can lead to a worsening condition.

– Abrupt shifts of AD cause the recurring business cycles, resulting in a series of economic booms and busts.