Transcript Self-Adjustment or Instability?

13e
Chapter 10:
Self-Adjustment or Instability?
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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.
10-2
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.
10-3
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).
10-4
Injections
• Injection: an addition of
spending in the circular
flow.
– Investment spending.
– Government spending.
– Exports.
10-5
Leakages and Injections
• For macro equilibrium,
leakages must equal
injections.
• When this occurs,
output supplied equals
output demanded.
• Ideally, this should
occur at fullemployment GDP.
10-6
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.
10-7
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.
10-8
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.
10-9
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.
10-10
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.
10-11
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.
10-12
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.
10-13
The Multiplier Process
• Multiplier: the multiple by which an initial
change in spending will alter the total
expenditure after all spending cycles.
Multiplier =
1
1 - MPC
• Example: If MPC = 0.75, the multiplier is 1/(10.75) = 1/0.25 = 4.
• The impact of an initial spending change will
be multiplied by a factor of 4.
10-14
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.
10-15
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.
10-16
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.
10-17
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.
10-18
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 fullemployment GDP, with
the economy subject to
inflationary pressure.
10-19
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.
10-20
The Multiplier Process
1. 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.
10-21
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.
10-22