Self-Adjustment or Instability

• Focus on the adjustment process – how markets respond to an undesirable equilibrium– Why does anyone think the market might self-

adjust (returning to a desired equilibrium)?– Why might markets not self-adjust?– Could market responses actually worsen

macro outcomes?

Leakages and Injections

• Total spending doesn’t always match total output at the desired full-employment–price-stability level

• The focus of macro concern is whether desired injections will offset desired leakages at full employment

Leakages and Injections

• Injection: An addition of spending to the circular flow of income

• Leakage: Income not spent directly on domestic output but instead diverted from the circular flow; for example, saving, imports, taxes

Leakages and Injections

Businesstaxes

Householdtaxes

ImportsSaving Businesssaving

INJECTIONS

Exports

Government spending

Investment

LEAKAGES

Productmarket

Factormarket

Business Firms

Households(disposable

income)

Consumer Saving

• Saving represents income not directly returned to the product markets

• Say the consumption function is:

• With full employment output of $3 trillion, consumption at full employment is

$100 0.75D DC a bY Y

$100 0.75 $3,000 $2,350 FC billion billion

Real GDP

50

100

Pri

ce L

evel

Leakage and AD

CF

2,350 3,000QF

Real consumer demand at QF

ASOutput not demanded by consumers

Imports and Taxes

• Imports and taxes also represent leakages– Income spent on imports is not part of

aggregate demand for domestic output– Sales taxes are taken out of the circular flow

in product markets– Payroll taxes and income taxes are taken out

of paychecks, so households don’t spend that income

Business Savings

• The business sector also keeps part of the income generated in product markets

• Gross business saving: Depreciation allowances and retained earnings

Injections into the Circular Flow

• Injections of investment, government expenditures, and exports help offset leakages from saving, imports, and taxes

• Injections must equal leakages if all the output supplied is to equal the output demanded (macro equilibrium)

Leakages and Injections

INJECTIONS

Investment

Government spendingExports

LEAKAGES

Consumer savingBusiness saving

Taxes Imports

Macro equilibrium is possible only if leakages equal injections. Of these, consumer saving and business investment are the primary sources of (im)balance.

Maintaining Consumer Confidence

• A sudden change in government spending or exports could get the multiplier ball rolling.

• The whole process could also originate with a change in consumer spending.

Consumer Confidence

• Consumer spending consists of two components:– Autonomous – represented by the letter (a)

in the consumption function, and– Induced – represented by the letters (bY) in

the consumption function.

C = a + bY

Consumer Confidence

• When consumer confidence changes, the value of (a) changes and the consumption function shifts.

Consumer Confidence

• A change in consumer confidence can also change the value of (b) altering the consumer’s willingness to spend out of each additional dollar in income.

Consumer Confidence

Self-Adjustment?

• Classical economists believed that flexible interest rates and flexible prices equalize injections and leakages– If spending declines, savings picks up and

interest rates fall– If demand for output falls, prices decline

• This flexibility would lead to full employment

Flexible Interest Rates

• If interest rates fell far enough, business investment (injections) would equal consumer saving (leakage) and full employment would return

• Keynes felt that this ignores expectations – Investment would fall in response to declining

sales

Flexible Prices

• Classical economists believed that a falling price level would prompt consumers to buy more output, leading to full employment

• Again Keynes disagreed with the result– If prices must be cut to move merchandise,

businesses are likely to rethink production and investment plans

The Multiplier Process

• Keynes argued that things were likely to get worse once a spending shortfall emerged

• Suppose consumer spending falls due to a decline in wealth– Inventories of unsold goods start piling up– Businesses cut back on investment spending

Undesired Inventory

• Economists distinguish desired (or planned) investment from actual investment

• Desired investment represents purchases of new plant and equipment plus any desired changes in business inventories

Undesired investment

Desired investment

Actual investment

Falling Output and Prices

• Business firms are likely to react to undesired inventory buildups by cutting prices and reducing the rate of new output

Household Incomes

• Firms usually cut wages and employment as they cut back production

• A reduction in investment spending leads to a reduction in household incomes

Income-Dependent Consumption

• What starts off as a relatively small spending shortfall escalates into a much larger problem

• If disposable income falls, we expect consumer spending to drop as well

• This quickly translates into more unsold output and causes further cutbacks in production, employment, and disposable income

The Multiplier

• The marginal propensity to consume (MPC) is the critical variable in this process

• Multiplier: The multiple by which an initial change in spending will alter total expenditure after an infinite number of spending cycles

1

1-Multiplier

MPC

The Multiplier

• The total change in spending is equal to the initial change in spending multiplied by the multiplier

1

1-

Total change initial changein spending in spendingMPC

The Multiplier

• An initial drop in spending of $100 billion would decrease total spending by

1

1-

1$100

1- 0.75

4 $100

$400

Total change initial changein spending in spendingMPC

billion

billion

billion

The Multiplier Process

2. $100 billion in unsold goods appear

4. Income reduced by $100 billion 5. Consumption reduced by $75 billion

6. Sales fall $75 billion7. Further cutbacks in employment or wages

8. Income reduced by $75 billion more

9. Consumption reduced by $56.25 billion more

Factor markets

Product markets

Business firms

Households

10. And so on

3. Cutbacks in employment or wages

1. Investment drops by $100 billion

Why $75B, because MPC = .75$100B X .75 = $75B.

Why $56.25B, because MPC = .75

$75B X .75 = $56.25B.

The Multiplier Cycles

Macro Equilibrium Revisited

• Key features of the adjustment process:– Producers cut output and employment when

output exceeds aggregate demand at current price level

– Resulting loss of income causes decline in consumer spending

– Decline in consumer spending leads to further production cutbacks, more lost income, and even less consumption

Sequential AD Shifts

• The decline in household income caused by investment cutbacks sets off the multiplier process, causing a secondary shift of the AD curve

Multiplier Effects

Real Output

Pri

ce

Lev

el

QF = 3000

maP0

2600 2900

AD2

c

I = $100 billion

C = $300 billion

b

d

AD1

AS

AD0

Change of $100B causes AD shiftFrom AD0 to AD1

Change of $300B causes AD shiftFrom AD1 to AD2

Subsequent Shift

Price and Output Effects

• As long as the aggregate supply curve is upward-sloping, the shock of any AD shift will be spread across output and prices

Recessionary GDP Gap

• Recessionary GDP gap: The amount by which equilibrium GDP falls short of full-employment GDP– Represents the amount by which the

economy is under-producing during a recession

– Classic case of cyclical unemployment

Recessionary GDP Gap

REAL OUTPUT

PR

ICE

LE

VE

L

QE QF

P0

PE

AD0

AD2

AS

c

m a

Recessionary GDP gap

Inadequate Demand

Short-Run Inflation-Unemployment Trade-Offs

• The shape of the aggregate supply curve adds to the difficulty of restoring full employment

• When AD increases both output and prices go up

• With upward sloping short-run AS there is a trade-off between unemployment and inflation

The Unemployment-Inflation Trade-Off

REAL OUTPUT

PR

ICE

LE

VE

L

QE = $2800 QF = $3000

AS

PE

P3

P4

AD2

ch

f

AD3

AD4

g

Recessionary GDP gap

“Full” vs. “Natural” Unemployment

• Full employment: The lowest rate of unemployment compatible with price stability; variously estimated at between 4 and 6 percent unemployment

• The closer the economy gets to capacity output, the greater the risk of inflation

“Full” vs. “Natural” Unemployment

• Neoclassical and monetarist economists do not accept this notion of full employment

• In their view, the long-run AS curve is vertical so that there is no unemployment-inflation trade-off

Adjustment to an Inflationary GDP Gap

• A sudden shift in aggregate demand can have a cumulative effect on macro outcomes

• This multiplier process works both ways

• An increase in investment might initiate an inflationary spiral

Inventory Depletion

• When AD increases, available inventories shrink– Inventory depletion is a warning sign of

impending inflation

• As producers increase output to rebuild inventories and supply more investment goods, household incomes get a boost

Induced Consumption

• Consumers purchase more goods and services as their incomes increase

• Eventually consumer spending increases by a multiple of the income change

A New Equilibrium

• The increase in AD causes both output and prices to increase

• Inflationary GDP gap: The amount by which equilibrium GDP exceeds full-employment GDP

Demand-Pull Inflation

Real Output

Pri

ce L

evel

a

w

r

AD0

AS

QF QE

P0

P6

AD5

AD6

C = $300 billion

I = $100 billion

Inflationary GDP gap

“Full” vs. “Natural” Unemployment

• Full employment: The lowest rate of unemployment compatible with price stability; variously estimated at between 4 and 6 percent unemployment

• The closer the economy gets to capacity output, the greater the risk of inflation

“Full” vs. “Natural” Unemployment

• Neoclassical and monetarist economists do not accept this notion of full employment

• In their view, the long-run AS curve is vertical so that there is no unemployment-inflation trade-off

Adjustment to an Inflationary GDP Gap

• A sudden shift in aggregate demand can have a cumulative effect on macro outcomes

• This multiplier process works both ways

• An increase in investment might initiate an inflationary spiral

Inventory Depletion

• When AD increases, available inventories shrink– Inventory depletion is a warning sign of

impending inflation

• As producers increase output to rebuild inventories and supply more investment goods, household incomes get a boost

Induced Consumption

• Consumers purchase more goods and services as their incomes increase

• Eventually consumer spending increases by a multiple of the income change

A New Equilibrium

• The increase in AD causes both output and prices to increase

• Inflationary GDP gap: The amount by which equilibrium GDP exceeds full-employment GDP

Demand-Pull Inflation

Real Output

Pri

ce L

evel

a

w

r

AD0

AS

QF QE

P0

P6

AD5

AD6

C = $300 billion

I = $100 billion

Inflationary GDP gap

Boom and Busts

• The basic conclusion of Keynesian analysis is that the economy is vulnerable to changes in spending behavior and won’t self-adjust to a desired macro equilibrium

• The responses of market participants are likely to worsen rather than improve market outcomes

Maintaining Consumer Confidence

• A sudden change in government spending or exports could get the multiplier ball rolling

• The whole process could also originate with a change in consumer spending due to changes in the consumption function

DC a bY

Consumer Confidence

• When consumer confidence changes, the value of a changes and the consumption function shifts

• A change in consumer confidence can also change the value of b, altering the consumer’s willingness to spend out of each additional dollar in income

The Official View: Always a Rosy Outlook

• Because consumer spending outweighs other components of aggregate demand, the threat of abrupt changes in consumer behavior is serious

• Governments often paint a picture of the economy which is better than what actually exists to avoid declines in confidence