McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Self-Adjustment or Instability Chapter 10
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McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies, All Rights Reserved
Self-Adjustment or Instability
Self-Adjustment or InstabilityChapter 10Chapter 10
2
Leakages and Injections
Total spending doesn’t always match total output at the desired full-employment–price-stability level.
LO1
3
The Circular Flow
The focus of macro concern is whether desired injections will offset desired leakage at full employment.
Full employment GDP is the value of total output (real GDP) produced at full employment.
LO1
4
Leakages and Injections
Businesstaxes
Householdtaxes
ImportsSaving Businesssaving
INJECTIONS
ExportsGovernment spending
Investment
LEAKAGES
Productmarket
Factormarket
Business Firms
Households(disposable
income)
LO1
5
Consumer Saving
A leakage is income not spent directly on domestic output, but instead is diverted from the circular flow.
LO1
6
Consumer Saving
Saving is a primary leakage from the circular flow.
Saving represents income not directly returned to the product markets.
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7
Consumer Saving
If full-employment income is $3 trillion, then consumption would equal $2350 billion.
CF = $100 billion + 0.75($3000 billion)
= $2350 billion
LO1
8
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
LO1
9
Imports and Taxes
Imports and taxes represent leakage from the circular flow.
LO1
10
Business Savings
Business saving is also a leakage from the circular flow of income.
Gross business saving is depreciation allowances and retained earnings.
LO1
11
Injections into the Circular Flow
An injection is an addition of spending to the circular flow of income.
Injections of investment, government expenditures, and exports help offset leakages from saving, imports, and taxes.
LO1
12
Leakages and Injections
INJECTIONS
Investment Government spending
Exports
LEAKAGES
Consumer savingBusiness saving
Taxes Imports
LO1
13
Self-Adjustment?
Classical economists believed that flexible interest rates and flexible prices equalize injections and leakages.
This flexibility would lead to full employment.
14
Flexible Interest Rates
According to classical economists, if interest rates fell far enough, business investment (injections) would equal consumer saving (leakage).
15
Changing Expectations
Keynes disagreed with classical economists concerning the role of flexible interest rates in reaching full employment.
Keynes argued that investment would fall in response to declining sales.
16
Flexible Prices
Classical economists believed that a falling price level would prompt consumers to buy more output.
17
Expectations (Again)
Keynes disagreed with classical economists concerning the role of flexible prices in reaching full employment.
Keynes argued that declining retail prices would prompt investment cutbacks.
18
REAL OUTPUT (in billions of dollars per year)
PR
ICE
LE
VE
L (
aver
age
pric
e)AD Shift
QF = $3,000
P1
Q1
P0
$2,900
AD0
F
AD0
b
AS
$100 billion decline in I
d
19
The Multiplier Process
Keynes argued that things were likely to get worse once a spending shortfall emerged.
LO2
20
A Decline in Investment
Suppose expectations fall.
Businesses cut back on investment spending.
Unsold capital goods start to pile up.
LO2
21
Undesired Inventory
Economists distinguish desired (or planned) investment from actual investment.
Actual investment =
Desired investment + Undesired investment
LO2
22
Falling Output and Prices
Business firms are likely to react to undesired inventory buildups by cutting prices and reducing the rate of new output.
LO2
23
Household Incomes
Firms usually cut wages and employment as they cut back production.
A reduction in investment spending implies a reduction in household incomes.
LO2
24
Income-Dependent Consumption
What starts off as a relatively small spending shortfall quickly snowballs into a much larger problem.
If disposable income falls, we expect consumer spending to drop as well.
LO2
25
Income-Dependent Consumption
The marginal propensity to consume is a critical variable.
The marginal propensity to consume (MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption.
It is the change in consumption divided by the change in disposable income.
LO2
26
The Multiplier
The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles.
LO2
27
The Multiplier
The change in total spending equals the multiplier times the initial change in aggregate spending.
Initial change in aggregate
spending multiplier
Total change in spending
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28
The Multiplier
The cumulative decease in total spending is equal to the AD shortfall multiplied by the multiplier.
A recessionary gap of $100 billion per year would decrease total spending by $400 billion per year (MPC = 0.75).
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29
The Multiplier
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30
The Multiplier Process
1. $100 billion in unsold goods appear
3. Income reduced by $100 billion 4. Consumption reduced by $75 billion
5. Sales fall $75 billion6. Further cutbacks in employment or wages
7. Income reduced by $75 billion more
8. Consumption reduced by $56.25 billion more
Factor markets
Product markets
Business firms
Households
9. And so on
2. Cutbacks in employment or wages
LO2
31
The Multiplier Cycles
LO2
32
Macro Equilibrium Revisited
Key features of the Keynesian adjustment process:
Producers cut output and employment when output exceeds aggregate demand at the current price level (leakages exceed injections).
LO2
33
Macro Equilibrium Revisited
Key features of the Keynesian adjustment process:
The resulting loss of income causes a decline in consumer spending.
Declines in consumer spending lead to further production cutbacks, more lost income, and still less consumption.
LO2
34
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.
LO2
35
Multiplier Effects
Real Output (in billions of dollars per year)
Pri
ce L
eve
l (av
era
ge p
rice
)
QF = 3000
maP0
2600 2900
AD2
c
I = $100 billionC = $300 billion
b
d
AD1
AS
AD0
LO2
36
Price and Output Effects
The impact of a shift in aggregate demand is reflected in both output and price changes.
LO3
37
Recessionary GDP Gap
As long as the aggregate supply curve is upward-sloping, the shock of any AD shift will be spread across output and prices.
LO3
38
Recessionary GDP Gap
The recessionary GDP gap is the amount by which equilibrium GDP falls short of full-employment GDP.
The recessionary GDP gap equals the difference between equilibrium real GDP (QE) and full-employment real GDP (QF).
LO3
39
Recessionary GDP Gap
The recessionary GDP gap is the classic case of cyclical unemployment.Cyclical employment is the unemployment attributable to a lack of job vacancies, that is, to an inadequate level of aggregate demand.
LO3
40
Recessionary GDP Gap
REAL OUTPUT (in billions of dollars per year)
PR
ICE
LE
VE
L (a
vera
ge p
rice)
QE QF
P0
PE
AD0
AD2
AS
c
m a
Recessionary GDP gap
LO3
41
Short-Run Inflation-Unemployment Trade-Offs
The shape of the aggregate supply curve adds to the difficulty of restoring full employment.
42
Upward-Sloping AS
When AD increases both output and prices go up.
So long as the short-run AS is upward sloping, there is a trade-off between unemployment and inflation.
43
The Unemployment-Inflation Trade-Off
REAL OUTPUT (in billions of dollars per year)
PR
ICE
LE
VE
L (
ave
rag
e p
rice
)
QE = $2800 QF = $3000
AS
PE
P3
P4
AD2
ch
f
AD3
AD4
g
Recessionary GDP gap
44
“Full” vs. “Natural” Unemployment
Full employment is the lowest rate of unemployment compatible with price stability.
The closer the economy gets to capacity output, the greater the risk of inflation.
45
“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.
46
Adjustment to an Inflationary GDP Gap
Operating through the multiplier process, an increase in investment might initiate an inflationary spiral.
LO3
47
Increased Investment
An increase in investment spending shifts the aggregate demand curve to the right.
LO3
48
Inventory Depletion
When AD increases due to increased investment available inventories shrink.
Inventory depletion is a warning sign of impending inflation.
LO3
49
Household Incomes
As investment increases, household incomes get a boost as producers increase their output to rebuild inventories and supply more investment goods.
LO3
50
Induced Consumption
Consumers purchase more goods and services as their incomes increase.
Eventually consumer spending increases by a multiple of the income change.
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51
A New Equilibrium
The increase in AD causes both output and prices to increase.
This increase in the average price level is known as demand-pull inflation.
Demand-pull inflation is an increase in the price level initiated by excessive aggregate demand.
LO3
52
Demand-Pull Inflation
Real Output (in billions of dollars per year)
Pri
ce L
eve
l (av
era
ge p
rice
)
a
w
r
AD0
AS
QF QE
P0
P6
AD5
AD6
C = $300 billion
I = $100 billion
Inflationary GDP gap
LO3
53
Boom and Busts
The basic conclusion of the Keynesian analysis is that:
The economy is vulnerable to abrupt changes in spending behavior, and
The economy won’t self-adjust to a desired macro equilibrium.
54
Boom and Busts
The responses of market participants to an abrupt AD shifts are likely to worsen rather than improve market outcomes.
55
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.
56
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
57
Consumer Confidence
When consumer confidence changes, the value of (a) changes and the consumption function shifts.
58
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.
59
Consumer Confidence
60
The Official View: Always a Rosy Outlook
Governments often paint a picture of the economy which is better than what actually exists.
McGraw-Hill/Irwin
©2008 The McGraw-Hill Companies, All Rights Reserved
Self-Adjustment or Instability
Self-Adjustment or Instability
End of Chapter 10End of Chapter 10
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