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.