Ch. 9: Economic Instability:
A Critique of the SelfRegulating Economy
James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University
©2005 Thomson Business & Professional Publishing, A Division of Thomson Learning
1
Review of the Classical
Position
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Say’s Law holds, so insufficient demand
in the economy is unlikely.
Wages, prices, and interest rates are
flexible.
The economy is self-regulating.
Laissez-faire is the right and sensible
economic policy to implement.
2
Questioning the Classical
Position: Keynes

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According to Keynes, it was possible for
saving to increase and aggregate demand to
fall.
Individuals save and invest for a host of
reasons.
Saving is more responsive to changes in
income than to changes in the interest rate.
Investment is also responsive to technological
changes, business expectations, and
innovations in addition to the interest rate.
3
Keynes on Interest Rates


Saving and investment
depend on a number of
factors.
The interest rate is
important in
determining the level
of investment, but
other variables, such
as the expected rate of
profit, can be more
important.
4
Exhibit 1: Keynes’s View of Say’s Law
in a Money Economy
5
Keynes on Wage Rates
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Employees will resist an
employer’s efforts to cut
wages.
Wages may be inflexible
in the downward
direction.
The economy may not
automatically cure itself
of a recessionary gap.
The economy may not
be self-regulating.
6
Exhibit 2: The Economy Gets “Stuck”
in a Recessionary Gap
7
New Keynesians and
Wage Rates
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Keynes was criticized because he didn’t offer
an adequate explanation of inflexible wages.
Efficiency wage models provide a solid
microeconomic explanation for inflexible
wages.
Efficiency Wage Models: it is sometimes
in the best interest of business firms to pay
their employees higher-than-equilibrium
wage rates
8
Keynes on Prices
The internal structure
of an economy is
not always
competitive enough
to allow prices to
fall.
9
Is it a Question of the Time it
Takes for Wages to Adjust?


Classical (New Classical and
Monetarists) Economists : Wages
adjust quickly enough to consider the
economy self-regulating.
Keynesian (New Keynesian): Wages
adjust so slowly that one cannot say the
economy is self-regulating.
10
Exhibit 3: A Question of How Long It
Takes for Wage Rates and
Prices to Fall
11
Self-Test

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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?
12
The Simple Keynesian
Model
Three Simplifying Assumptions
1. The price level is constant
2. There is no foreign sector
3. The monetary side of the economy is
excluded.
13
The Keynesian
Framework Of Analysis
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Keynes was interested in total expenditures,
but 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.
14
The Consumption
Function
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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
15
The Consumption
Function
Consumption can
be increased in
three ways:
1. Raise autonomous
consumption
2. Raise disposable
income
3. Raise the MPC
16
The MPC and the MPS
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Marginal propensity to save
(MPS): the ratio 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
17
Exhibit 4: Consumption and
Saving at Different Levels of
Disposable Income (in billions)
18
The Multiplier

The Multiplier: the number that is
multiplied by the change in autonomous
spending to obtain the change in Real GDP.

 Real GDP = m x  Autonomous Spending

Multiplier(m) =

1
1- MPC
Change in Total Spending = Multiplier X
Change in autonomous spending
19
The Multiplier and Reality
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The multiplier takes time to have an
effect. This process can take months.
For the multiplier to increase Real GDP
(the way we have described), idle
resources must exist at each
expenditure round.
20
Self-Test
How is autonomous consumption
different from consumption?
 If the MPC is 0.70, what does the
multiplier equal?

21
The Simple Keynesian Model
in the AD-AS Framework
Shifts in the Aggregate Demand
Curve
 Changes in C, I, G (foreign sector
excluded by assumption) will shift
AD
 Change in total spending =
multiplier X change in autonomous
spending
22
Exhibit 5: The Multiplier and
Aggregate Demand
23
The Simple Keynesian Model
in the AD-AS Framework
The Keynesian Aggregate
Supply Curve
 Price level constant until fullemployment (natural real GDP).
 Aggregate supply curve has both
a horizontal and a vertical section.
24
Exhibit 6: The AS Curve in the
Simple Keynesian Model
25
The Theme of The Simple
Keynesian Model in AD-AS
Framework
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Price level constant until full-employment
(natural real GDP).
AD shifts if there are changes in C, I, or G.
Economy can be in equilibrium and a
recessionary gap.
Private sector may not be able to get the
economy out a a recessionary gap.
The government may have a management
role to play in the economy.
26
Exhibit 7: Can the Private Sector
Remove the Economy from a
Recessionary Gap?
27
Self-Test
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What was Keynes’s position with respect to
the self-regulating properties of an
economy?
What will happen to Real GDP if
autonomous spending rises and the
economy is operating in the horizontal
section of the Keynesian AS curve? Explain.
An economist who believes the economy is
self-regulating is more likely to advocate
laissez-faire than an economist who believes
the economy is inherently unstable. Agree
or disagree? Explain
28
Exhibit 8: The Derivation of
the Total Expenditures
(TE) Curve
29
Comparing Total Expenditures
and Total Production
There are three possible options:
1. Total Expenditures are less than Total
Production
2. Total Expenditures are greater than
Total Production
3. Total Expenditures equal Total
Production
30
Moving From Disequilibrium
to Equilibrium
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TE<TP: Growing inventories signal firms
they have overproduced. Firms cut back on
production to get to optimal inventory
levels, lowering Real GDP.
TE>TP: Shrinking inventories signal firms
they have under-produced. Firms increase
production to get to optimal inventory
levels, increasing Real GDP.
31
Exhibit 9: The Three States of
the Economy in the TE-TP
Framework
32
The Theme of The Simple
Keynesian Model In TE-TP
Framework
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Price level constant until full-employment
(natural real GDP).
TE shifts if there are changes in C, I, or G.
Economy can be in equilibrium and a
recessionary gap.
Private sector may not be able to get the
economy out a a recessionary gap.
The government may have a management
role to play in the economy.
33
Exhibit 10: The Economy: In
Equilibrium, and in a
Recessionary Gap Too
34
Self-Test
What happens in the economy if
total production (TP) is greater
than total expenditures (TE)?
 What happens in the economy if
total expenditures (TE) are greater
than total production (TP)?

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Coming Up (Ch. 10): The
Federal Budget and
Fiscal Policy
36