Self-Adjustment or Instability

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Self-Adjustment or Instability?
Chapter 10
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Self-Adjustment or Instability
• Focus on the adjustment process – how
markets respond to an undesirable equilibrium
– Why does anyone think the market might selfadjust (returning to a desired equilibrium)?
– Why might markets not self-adjust?
– Could market responses actually worsen macro
outcomes?
10-2
Leakages and Injections
• Total spending doesn’t always match total
output at the desired full-employment–pricestability level
• The focus of macro concern is whether desired
injections will offset desired leakages at full
employment
10-3
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
10-4
Leakages and Injections
INJECTIONS
Government spending
Exports
Investment
Product
market
Households
(disposable
income)
Business
Firms
Factor
market
Saving Imports Household
taxes
LEAKAGES
Business
taxes
Business
saving
10-5
Consumer Saving
• Saving represents income not directly returned
to the product markets
• Say the consumption function is:
C  a  bYD  $100  0.75YD
• With full employment output of $3 trillion,
consumption at full employment is
CF  $100  0.75 $3,000 billion  $2,350 billion
10-6
Leakage and AD
Price Level
Output not demanded
by consumers
CF
AS
100
50
Real consumer
demand at QF
2,350
3,000
QF
Real GDP
10-7
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
10-8
Business Savings
• The business sector also keeps part of the
income generated in product markets
• Gross business saving: Depreciation
allowances and retained earnings
10-9
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)
10-10
Leakages and Injections
LEAKAGES
INJECTIONS
Consumer saving
Business saving
Taxes
Imports
Investment
Government spending
Exports
Macro equilibrium is possible only if leakages equal injections. Of these, consumer
saving and business investment are the primary sources of (im)balance.
10-11
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
10-12
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
10-13
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
10-14
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
10-15
Undesired Inventory
• Economists distinguish desired (or planned)
investment from actual investment
Actual
investment

Desired
investment

Undesired
investment
• Desired investment represents purchases of
new plant and equipment plus any desired
changes in business inventories
10-16
Falling Output and Prices
• Business firms are likely to react to undesired
inventory buildups by cutting prices and
reducing the rate of new output
10-17
AD Shift
PRICE LEVEL
AS
$100 billion
decline in I
P0
P1
F
d
b
AD0
AD1
$2,900
Q1
QF = $3,000
REAL OUTPUT
10-18
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
10-19
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
10-20
The Multiplier Process
4. Income reduced by $100 billion
5. Consumption reduced by $75 billion
Households
8. Income reduced by
$75 billion more
9. Consumption reduced
by $56.25 billion more
1. Investment drops
by $100 billion
Factor
markets
Product
markets
10. And so on
7. Further cutbacks in
employment or wages
6. Sales fall $75 billion
Business
firms
3. Cutbacks in employment
or wages
2. $100 billion in unsold
goods appear
10-21
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
Multiplier 
1- MPC
10-22
The Multiplier
• The total change in spending is equal to the
initial change in spending multiplied by the
multiplier
1
Total change
initial change


in spending
in spending
1- MPC
10-23
The Multiplier
• An initial drop in spending of $100 billion
would decrease total spending by
1
Total change
initial change


in spending
in spending
1- MPC
1

 $100 billion
1- 0.75
 4  $100 billion
 $400 billion
10-24
The Multiplier Cycles
Spending Cycles
First cycle
Second cycle
Third cycle
Fourth cycle
Fifth cycle
Sixth cycle
Nth cycle
Change in
Spending During
Cycle
Cumulative
decrease in
Spending
$100.00
75.00
56.25
42.19
31.64
23.73
$100.00
175.00
231.25
273.44
305.08
328.81
400.00
10-25
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
10-26
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
10-27
Multiplier Effects
AS
C = $300 billion
Price Level
I = $100 billion
m
d
a
P0
b
AD0
c
AD1
AD2
2600
2900
QF = 3000
Real Output
10-28
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
10-29
Recessionary GDP Gap
• Recessionary GDP gap: The amount by
which equilibrium GDP falls short of fullemployment GDP
– Represents the amount by which the economy is
under-producing during a recession
– Classic case of cyclical unemployment
10-30
Recessionary GDP Gap
PRICE LEVEL
AS
AD2
P0
m
a
c
PE
AD0
Recessionary
GDP gap
QE
QF
REAL OUTPUT
10-31
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
10-32
The Unemployment-Inflation Trade-Off
PRICE LEVEL
AS
AD3
AD4
AD2
P4
P3
c
g
PE
h
f
Recessionary GDP gap
QE = $2800 QF = $3000
REAL OUTPUT
10-33
“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
10-34
“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
10-35
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
10-36
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
10-37
Induced Consumption
• Consumers purchase more goods and services
as their incomes increase
• Eventually consumer spending increases by a
multiple of the income change
10-38
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
10-39
Demand-Pull Inflation
C
Price Level
I
AS
= $300 billion
= $100 billion
w
P6
r
P0
a
AD6
AD5
Inflationary GDP gap
AD0
QF
Real Output
QE
10-40
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
10-41
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
C  a  bYD
10-42
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
10-43
Consumer Confidence
Source: University of Michigan
Consumer confidence is affected by various financial, political, and
international events.
10-44
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
10-45
Self-Adjustment or Instability?
End of Chapter 10
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
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