self-adjustment or instability

1. Self-Adjustment or Instability Chapter 10

2. Leakages and Injections Total spending doesn�t always match total output at the desired full-employment�price-stability level. The circular flow of income illustrates how this undesirable outcome comes about and how it might be resolved.

3. Circular Flow The focus of macro concern is whether desired injections will offset desired leakage at full employment. A leakage is income not spent directly on domestic output, but instead is diverted from the circular flow.

4. Leakages and Injections

5. Consumer Saving Saving is a primary leakage from the circular flow. It represents income not directly returned to the product markets.

6. Consumer Saving If full-employment income is $3 trillion, then consumption would equal $2350 billion.

7. Leakage and AD

8. Imports and Taxes Imports and taxes represent leakage from the circular flow.

9. Business Savings Business saving is also a leakage from the circular flow of income. Gross business saving is depreciation allowances and retained earnings.

10. Injections into the Circular Flow Injections of investment, government expenditures, and exports help offset leakages from saving, imports, and taxes. An injection is an addition of spending to the circular flow of income.

11. Leakages and Injections

12. Self-Adjustment? Classical economists believed that flexible interest rates and flexible prices equalize injections and leakages. This flexibility would lead to full employment.

13. Flexible Interest Rates According to classical economists, if interest rates fell far enough, business investment (injections) would equal consumer saving (leakage).

14. 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.

15. Flexible Prices Classical economists believed that a falling price level would prompt consumers to buy more output.

16. Expectations (Again) Keynes disagreed with classical economists concerning the role of flexible prices in reaching full employment. Keynes argued that declining retail prices were likely to prompt investment cutbacks.

17. AD Shift

18. The Multiplier Process Keynes argued that things were likely to get worse once a spending shortfall emerged.

19. A Decline in Investment Suppose expectations fall so that businesses cut back on investment spending. Accumulated inventories of unsold capital goods will result.

20. Undesired Inventory Economists distinguish desired (or planned) investment from actual investment. Actual investment = Desired investment + Undesired investment

21. Falling Output and Prices Business firms are likely to react to undesired inventory buildups by cutting prices and reducing the rate of new output.

22. Household Incomes A reduction in investment spending implies a reduction in household incomes. Firms usually cut wages and employment as they cut back production.

23. Income-Dependent Consumption If disposable income falls, we expect consumer spending to drop as well. 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.

24. 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.

25. The Multiplier The change in total spending equals the multiplier times the initial change in aggregate spending.

26. The Multiplier The cumulative decease in total spending is equal to the gap multiplied by the multiplier.

27. The Multiplier

28. The Multiplier Process

29. The Multiplier Cycles

30. 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).

31. Macro Equilibrium Revisited Key features of the Keynesian adjustment process: The resulting loss of income causes a decline in consumer spending.

32. 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.

33. Multiplier Effects

34. Price and Output Effects The impact of a shift in aggregate demand is reflected in both output and price changes.

35. 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. The recessionary GDP gap is the amount by which equilibrium GDP falls short of full-employment GDP.

36. Recessionary GDP Gap The recessionary GDP gap equals the difference between equilibrium real GDP (QE) and full-employment real GDP (QF).

37. Recessionary GDP Gap The recessionary GDP gap is the classic case of cyclical unemployment.

38. Recessionary GDP Gap

39. Short-Run Inflation-Unemployment Trade-Offs The shape of the aggregate supply curve adds to the difficulty of restoring full employment.

40. 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.

41. The Unemployment-Inflation Trade-Off

42. �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.

43. �Full� vs. �Natural� Unemployment Neoclassical and monetarist economists do not accept this notion of full employment.

44. Adjustment to an Inflationary GDP Gap Operating through the multiplier process, an increase in investment might initiate an inflationary spiral.

45. Increased Investment An increase in investment spending shifts the aggregate demand curve to the right.

46. Inventory Depletion When AD increases due to increased investment available inventories shrink. Inventory depletion is a warning sign of impending inflation.

47. Household Incomes As investment increases, household incomes get a boost as producers increase their output to rebuild inventories and supply more investment goods.

48. Induced Consumption Consumers purchase more goods and services as their incomes increase. Eventually consumer spending increases by a multiple of the income change.

49. 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.

50. Demand-Pull Inflation

51. 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.

52. 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.

53. 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

54. Consumer Confidence When consumer confidence changes, the value of (a) changes and the consumption function shifts.

55. 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.

56. Consumer Confidence

57. The Official View: Always a Rosy Outlook Governments often paint a picture of the economy which is better than what actually exists.

58. Self-Adjustment or Instability End of Chapter 10