Economic Instability:A Critique of the Self-Regulating Economy

Del Mar College

John Daly©2002 South-Western Publishing, A Division of Thomson Learning

Questioning the Classical Position

• According to Keynes, it was possible for saving to increase and aggregate demand to fall.

• Individuals save and invest for a host of reasons, and that no single factor, like the interest rate, links these activities.

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

• Investment is more responsive to technological changes, business expectations, and innovations rather than the interest rate.

Keynes on Interest Rates

• Both saving and investment depend on a number of factors that may be far more influential than the interest rate.

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

Keynes on Wage Rates

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

• Wages may be inflexible in a downward direction.

• The economy is inherently unstable – it may not automatically cure itself of a recessionary gap.

• The economy may not be self-regulating.

New Keynesians and Wage Rates

• Many criticized Keynes because it didn’t offer a rigorous and complete explanation of inflexible wages.

• Long-Term labor contracts are often advantages for both employers and workers.

• These contracts have costs, but many believe the benefits clearly outweigh the costs.

• Workers and Employers use Long-Term contracts for mutually beneficial advantages.

New Keynesians and Wage Rates

• Efficiency wage models provide a solid microeconomic explanation for inflexible wages and thus are capable of explaining why continuing unemployment problems exist in some economies.

New Keynesians and Wage Rates

• Some believe there are solid microeconomic reasons for inflexible wages.

• “The most interesting and important line of work in current macroeconomic theory is the attempt to reconstruct plausible microeconomic underpinnings for a recognizably Keynesian macroeconomics.”

Keynes on Prices

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

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

• Wages and prices are not flexible (in a downward direction) and may not adjust downward in a recessionary gap.

• Many economists today take a position between Keynes and the classical economists. For them, the question is not whether wages and prices are flexible downward, but how long it takes for the wages and prices to adjust.

• The Keynesian position is the time is long enough to say that the economy is not self-regulating. Instead, the economy is inherently unstable: it can exist in a recessionary gap for a long time.

Keynesians and The Great Depression

• Keynes and the Keynesians thought that while their theory may not be right with respect to every detail, there was certainly enough evidence to say the classical view of the economy is wrong.

Q & A

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

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

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

The Keynesian Framework Of Analysis

Three Simple Assumptions

1. The price level is constant

2. There is no foreign sector

3. The monetary side of the economy is excluded.

The Keynesian Framework Of Analysis

• Keynes was interested in the level of total expenditures (TE) in general, but he was particularly concerned with Consumption.

• Consumption depends on disposable income.• Consumption and disposable income move in the

same direction.• When disposable income changes, consumption

changes by less.

The Consumption Function

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

• C=Co + MPC(Yd)

• MPC is equal to the change in consumption divided by the change in disposable income.

• MPC= C/ Yd

The Consumption Function

Consumption can be increased in three ways:

1. Raise autonomous consumption

2. Raise disposable income

3. Raise the MPC

The MPC and the MPS

• Marginal propensity to save (MPS) is the ration of change in saving to the change in disposable income

• MPS= S/ Yd

• It also follows that since C+S= Yd, then :

MPS+MPC=1

Deriving a Total Expenditures

Curve1. As disposable

income rises, so does consumption

2. Investment remains constant

3. Government Purchases remains constant

Comparing Total Expenditures and Total Production

There are three possible options:

1. Total Expenditures exceeds Total Production

2. Total Production exceeds Total Expenditures

3. Total Expenditures equals Total Production

Moving From Disequilibrium to Equilibrium

• TE<TP: Signals to firms they have overproduced. Firms cut back on goods they produce, lowering Real GDP closer to output levels where economy is willing to buy. Eventually, TE will equal TP.

• TE>TP: Signals to firms they have under produced. They increase the quantity of goods produced, causing Real GDP to rise. Eventually, TP will equal TE.

Graphical Framework of the Three States of the Economy in the Keynesian Framework

Q & A

• How is autonomous consumption different from consumption?

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

Can the Economy be in a Recessionary Gap and be in Equilibrium, too?

• The economy is in equilibrium, producing QE, but the Natural Real GDP is level is QN. Because the economy is producing at a Real GDP level less than the Natural Real GDP, it is in a recessionary gap.

The Multiplier

• Autonomous spending is any expenditure that is not related to a change in income or Real GDP.

• The multiplier is the number that is multiplied by the change in any autonomous spending component of total expenditures to give us the change in Real GDP.

• Multiplier(m) = 1 1- MPC

Real GDP = m x Autonomous Spending

The Multiplier and Reality

• First, the multiplier takes time to have an effect. This process can take months.

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

What Does the Keynesian Aggregate Supply Curve Look

Like?• If aggregate demand rises from AD1 to AD2, Real GDP rises, but there is no change in price level.

• If aggregate demand falls from AD1 to AD3, Real GDP falls and there still is no change in price level.

Keynes on the Private Sector

• Can the private sector increase its autonomous spending, shift the AD curve to the right, and thus remove the economy from recessionary gap?

• A change in interest rates, or business expectations , or both can cause a change in autonomous investment spending.

• Investment is not always responsive to lower interest rates. Business expectations with respect to future sales could be so negative that businesses wouldn’t invest more even if the interest rates fell.

• The private sector may not be able to get the economy out of a recession.

Q & A

• Suppose that prices are not fixed and there are no idle resources. Can a rise in autonomous spending raise Real GDP by some multiple of the amount of the rise? Explain your answer.

• If the MPS equals 0.23, then what does the multiplier equal?

• What is the relationship between a change in Real GDP (assuming a change in autonomous spending) and (the size of) the MPC?