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Ch. 9: Economic Ch. 9: Economic Instability:Instability:A Critique of the Self-A Critique of the Self-Regulating EconomyRegulating Economy

James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts UniversityUniversity©2005 Thomson Business & Professional Publishing, A Division of Thomson ©2005 Thomson Business & Professional Publishing, A Division of Thomson LearningLearning

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Review of the Classical Review of the Classical PositionPosition

Say’s Law holds, so insufficient Say’s Law holds, so insufficient demand in the economy is unlikely.demand in the economy is unlikely.

Wages, prices, and interest rates are Wages, prices, and interest rates are flexible.flexible.

The economy is self-regulating.The economy is self-regulating. Laissez-faire is the right and sensible Laissez-faire is the right and sensible

economic policy to implement.economic policy to implement.

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Questioning the Questioning the Classical Position: Classical Position: KeynesKeynes According to Keynes, it was possible for According to Keynes, it was possible for

saving to increase and aggregate demand saving to increase and aggregate demand to fall.to fall.

Individuals save and invest for a host of Individuals save and invest for a host of reasons.reasons.

Saving is more responsive to changes in Saving is more responsive to changes in income than to changes in the interest rate.income than to changes in the interest rate.

Investment is also responsive to Investment is also responsive to technological changes, business technological changes, business expectations, and innovations in addition to expectations, and innovations in addition to the interest rate.the interest rate.

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Keynes on Interest Keynes on Interest RatesRates Saving and Saving and

investment depend investment depend on a number of on a number of factors.factors.

The interest rate is The interest rate is important in important in determining the level determining the level of investment, but of investment, but other variables, such other variables, such as the expected rate as the expected rate of profit, can be more of profit, can be more important.important.

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Exhibit 1: Keynes’s View of Say’s Law in a Money Economy

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Keynes on Wage RatesKeynes on Wage Rates

Employees will resist Employees will resist an employer’s efforts an employer’s efforts to cut wages.to cut wages.

Wages may be Wages may be inflexible in the inflexible in the downward direction.downward direction.

The economy may The economy may not automatically not automatically cure itself of a cure itself of a recessionary gap.recessionary gap.

The economy may The economy may not be self-regulating.not be self-regulating.

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Exhibit 2: The Economy Gets “Stuck” in a Recessionary Gap

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New Keynesians and New Keynesians and Wage RatesWage Rates

Keynes was criticized because he Keynes was criticized because he didn’t offer an adequate explanation of didn’t offer an adequate explanation of inflexible wages.inflexible wages.

Efficiency wage models provide a solid Efficiency wage models provide a solid microeconomic explanation for microeconomic explanation for inflexible wages.inflexible wages.

Efficiency Wage ModelsEfficiency Wage Models: it is : it is sometimes in the best interest of sometimes in the best interest of business firms to pay their employees business firms to pay their employees higher-than-equilibrium wage rateshigher-than-equilibrium wage rates

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Keynes on PricesKeynes on Prices

The internal The internal structure of an structure of an economy is not economy is not always always competitive competitive enough to allow enough to allow prices to fall.prices to fall.

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Is it a Question of the Time Is it a Question of the Time it Takes for Wages to it Takes for Wages to Adjust?Adjust?

Classical (New Classical and Classical (New Classical and Monetarists) EconomistsMonetarists) Economists : Wages : Wages adjust quickly enough to consider the adjust quickly enough to consider the economy self-regulating.economy self-regulating.

Keynesian (New Keynesian)Keynesian (New Keynesian):: Wages adjust so slowly that one Wages adjust so slowly that one cannot say the economy is self-cannot say the economy is self-regulating. regulating.

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Exhibit 3: A Question of How Long It Takes for Wage Rates and Prices to Fall

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Self-TestSelf-Test

What do Keynesians mean when they What do Keynesians mean when they say the economy is inherently say the economy is inherently unstable?unstable?

““What matters is not whether the What matters is not whether the economy is self-regulating or not, but economy is self-regulating or not, but whether prices and wages are flexible whether prices and wages are flexible and adjust quickly.” Comment on this and adjust quickly.” Comment on this statement.statement.

According to Keynes, why might According to Keynes, why might aggregate demand be too low?aggregate demand be too low?

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The Simple Keynesian The Simple Keynesian ModelModel

Three Simplifying AssumptionsThree Simplifying Assumptions

1.1. The price level is constantThe price level is constant

2.2. There is no foreign sectorThere is no foreign sector

3.3. The monetary side of the The monetary side of the economy is excluded.economy is excluded.

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The Keynesian The Keynesian Framework Of AnalysisFramework Of Analysis Keynes was interested in total Keynes was interested in total

expenditures, but was particularly expenditures, but was particularly concerned with consumption.concerned with consumption.

Consumption depends on disposable Consumption depends on disposable income.income.

Consumption and disposable income Consumption and disposable income move in the same direction.move in the same direction.

When disposable income changes, When disposable income changes, consumption changes by less.consumption changes by less.

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The Consumption The Consumption FunctionFunction ConsumptionConsumption=Autonomous =Autonomous

Consumption + marginal propensity Consumption + marginal propensity to consume (MPC) multiplied by to consume (MPC) multiplied by disposable income.disposable income.

C=CC=Coo + MPC(Y + MPC(Ydd)) MPC is equal to the change in MPC is equal to the change in

consumption divided by the change consumption divided by the change in disposable income.in disposable income.

MPC= MPC= C/ C/ Y Ydd

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The Consumption The Consumption FunctionFunction

Consumption Consumption can be increased can be increased in three ways:in three ways:

1.1. Raise Raise autonomous autonomous consumptionconsumption

2.2. Raise disposable Raise disposable incomeincome

3.3. Raise the MPCRaise the MPC

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The MPC and the MPSThe MPC and the MPS

Marginal propensity to save Marginal propensity to save (MPS)(MPS): the ratio of change in : the ratio of change in saving to the change in disposable saving to the change in disposable incomeincome

MPSMPS= = S/ S/ Y Yd d

It also follows that since C+S= YIt also follows that since C+S= Ydd

then :then :

MPS+MPC=1MPS+MPC=1

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Exhibit 4: Consumption and Exhibit 4: Consumption and Saving at Different Levels of Saving at Different Levels of Disposable Income (in Disposable Income (in billions)billions)

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The MultiplierThe Multiplier

The MultiplierThe Multiplier: the number that is : the number that is multiplied by the change in autonomous multiplied by the change in autonomous spending to obtain the change in Real spending to obtain the change in Real GDP.GDP.

Real GDP = Real GDP = mm x x Autonomous Autonomous SpendingSpending

Multiplier(Multiplier(mm)) = 1 = 1 1- MPC1- MPC

Change in Total SpendingChange in Total Spending = Multiplier = Multiplier X Change in autonomous spendingX Change in autonomous spending

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The Multiplier and The Multiplier and RealityReality

The multiplier takes time to have The multiplier takes time to have an effect. This process can take an effect. This process can take months.months.

For the multiplier to increase Real For the multiplier to increase Real GDP (the way we have GDP (the way we have described), idle resources must described), idle resources must exist at each expenditure round.exist at each expenditure round.

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Self-TestSelf-Test

How is autonomous consumption How is autonomous consumption different from consumption?different from consumption?

If the MPC is 0.70, what does the If the MPC is 0.70, what does the multiplier equal?multiplier equal?

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The Simple Keynesian The Simple Keynesian Model in the AD-AS Model in the AD-AS FrameworkFramework

Shifts in the Aggregate Shifts in the Aggregate Demand CurveDemand Curve

Changes in C, I, G (foreign Changes in C, I, G (foreign sector excluded by sector excluded by assumption) will shift ADassumption) will shift AD

Change in total spending = Change in total spending = multiplier X change in multiplier X change in autonomous spendingautonomous spending

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Exhibit 5: The Multiplier and Exhibit 5: The Multiplier and Aggregate DemandAggregate Demand

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The Simple Keynesian The Simple Keynesian Model in the AD-AS Model in the AD-AS FrameworkFramework

The Keynesian Aggregate The Keynesian Aggregate Supply CurveSupply Curve

Price level constant until full-Price level constant until full-employment (natural real employment (natural real GDP).GDP).

Aggregate supply curve has Aggregate supply curve has both a horizontal and a vertical both a horizontal and a vertical section.section.

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Exhibit 6: The AS Curve in Exhibit 6: The AS Curve in the Simple Keynesian Modelthe Simple Keynesian Model

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The Theme of The Simple The Theme of The Simple Keynesian Model in AD-AS Keynesian Model in AD-AS FrameworkFramework

Price level constant until full-employment Price level constant until full-employment (natural real GDP).(natural real GDP).

AD shifts if there are changes in C, I, or G.AD shifts if there are changes in C, I, or G. Economy can be in equilibrium and a Economy can be in equilibrium and a

recessionary gap.recessionary gap. Private sector may not be able to get the Private sector may not be able to get the

economy out a a recessionary gap.economy out a a recessionary gap. The government may have a management The government may have a management

role to play in the economy.role to play in the economy.

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Exhibit 7: Can the Private Exhibit 7: Can the Private Sector Remove the Economy Sector Remove the Economy from a Recessionary Gap?from a Recessionary Gap?

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Self-TestSelf-Test

What was Keynes’s position with respect What was Keynes’s position with respect to the self-regulating properties of an to the self-regulating properties of an economy?economy?

What will happen to Real GDP if What will happen to Real GDP if autonomous spending rises and the autonomous spending rises and the economy is operating in the horizontal economy is operating in the horizontal section of the Keynesian AS curve? section of the Keynesian AS curve? Explain.Explain.

An economist who believes the economy An economist who believes the economy is self-regulating is more likely to is self-regulating is more likely to advocate laissez-faire than an economist advocate laissez-faire than an economist who believes the economy is inherently who believes the economy is inherently unstable. Agree or disagree? Explainunstable. Agree or disagree? Explain

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Exhibit 8: The Derivation of the Total Expenditures (TE) Curve

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Comparing Total Comparing Total Expenditures and Total Expenditures and Total ProductionProduction

There are three possible options:There are three possible options:

1.1. Total Expenditures are less than Total Expenditures are less than Total Production Total Production

2.2. Total Expenditures are greater Total Expenditures are greater than Total Productionthan Total Production

3.3. Total Expenditures equal Total Total Expenditures equal Total ProductionProduction

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Moving From Moving From Disequilibrium to Disequilibrium to EquilibriumEquilibrium

TE<TPTE<TP: Growing inventories signal : Growing inventories signal firms they have overproduced. Firms firms they have overproduced. Firms cut back on production to get to optimal cut back on production to get to optimal inventory levels, lowering Real GDP.inventory levels, lowering Real GDP.

TE>TPTE>TP: Shrinking inventories signal : Shrinking inventories signal firms they have under-produced. Firms firms they have under-produced. Firms increase production to get to optimal increase production to get to optimal inventory levels, increasing Real GDP.inventory levels, increasing Real GDP.

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Exhibit 9: The Three States of the Economy in the TE-TP Framework

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The Theme of The Simple The Theme of The Simple Keynesian Model In TE-TP Keynesian Model In TE-TP FrameworkFramework

Price level constant until full-employment Price level constant until full-employment (natural real GDP).(natural real GDP).

TE shifts if there are changes in C, I, or G.TE shifts if there are changes in C, I, or G. Economy can be in equilibrium and a Economy can be in equilibrium and a

recessionary gap.recessionary gap. Private sector may not be able to get the Private sector may not be able to get the

economy out a a recessionary gap.economy out a a recessionary gap. The government may have a management The government may have a management

role to play in the economy.role to play in the economy.

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Exhibit 10: The Economy: In Equilibrium, and in a Recessionary Gap Too

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Self-TestSelf-Test

What happens in the economy if What happens in the economy if total production (TP) is greater total production (TP) is greater than total expenditures (TE)?than total expenditures (TE)?

What happens in the economy if What happens in the economy if total expenditures (TE) are total expenditures (TE) are greater than total production greater than total production (TP)?(TP)?

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Coming Up (Ch. 10): The Coming Up (Ch. 10): The Federal Budget and Federal Budget and Fiscal PolicyFiscal Policy