Transcript Economic Instability: A Critique of the Self

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
Curve
1. 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?