Keynesian Circular-Flow Analysis (Labor-Based Macroeconomics)

1. Keynesian Circular-Flow Analysis (Labor-Based Macroeconomics) The Inherent Instability of a Wholly Private Economy (according to John Maynard Keynes) Roger W. Garrison 2006

2. The Keynesian Vision Keynes’s vision of the economy suggests a circular-flow framework—in which earning and spending are brought into balance by changes in the level of employment. The Income-Expenditure Framework Graphically, the circular flow appears as the Keynesian cross, the cross’s intersection identifying the particular state of the economy in which income and expenditures are in balance.

3. BUSINESS ORGANIZATIONS LABOR AND OTHER FACTOR SERVICES THE CIRCULAR-FLOW FRAMEWORK WORKERS FACTOR OWNERS CONSUMERS INCOME

4. BUSINESS ORGANIZATIONS EXPENDITURES LABOR AND OTHER FACTOR SERVICES Let the speed of rotation indicate the strength (fast) or weakness (slow) of the economy. GOODS AND SERVICES WORKERS FACTOR OWNERS CONSUMERS INCOME

5. BUSINESS ORGANIZATIONS EXPENDITURES In Keynesian equilibrium, INCOME equals EXPENDITURES. Y = E For a wholly private economy, Y = C + I WORKERS FACTOR OWNERS CONSUMERS INCOME

6. EXPENDITURES, which constitute the left half of the circular flow, is represented on the vertical axis. EXPENDITURES INCOME, which constitutes the right half of the circular flow, is represented on the horizontal axis. E = Y 45o INCOME The circular character of the flow suggests an equality of left-half flow and right-half flow---as represented by a forty-five degree line passing through the origin.

7. C + I EXPENDITURES Investment depends neither on (current) income nor on the rate of interest. It depends only on profit expectations, which themselves are not well-anchored in economic reality. The economy is in a Keynesian equilibrium somewhere along the 45o line—the line itself identifying all possible income-expenditure equilibrium points. As taught at all levels, the consumption function is an essential component of the Keynesian framework. The presumed stability of this function underlies Keynesian thinking. INVESTMENT C = a + bY b 1 CONSUMPTION a 45o INCOME Keynes would say the investors are moved by the “animal spirits.” INCOME Consumption and Investment (as well as Government Spending) are portrayed as additive components of total spending. The three components are distinguished largely in terms of their stability characteristics: stable (C ), unstable (I), and stabilizing (G). A wholly private macroeconomy achieves an income-expenditure equilibrium when Y = C + I. Note that income itself (rather than prices, wages, or the interest rate) is the equilibrating variable.

8. C + I EXPENDITURES C = a + bY C = 120 + 0.60Y b b = 0.60 1 I = 240 In equilibrium, Y = E So, Y = C + I Y = a + bY + I Y = 120 + 0.60Y + 240 Y – 0.60Y = 120 + 240 0.40Y = 360 Y = 900 a = 120 a INCOME Yeq = 900 Suppose that a = 120 and b = 0.60. And suppose we know that investors are spending 240 on investment goods. Can we calculate the equilibrium level of income that corresponds to these parameters?

9. C + I EXPENDITURES C = a + bY CONSUMPTION According to Keynes, it is only by “accident or design” that the economy is actually preforming at its full-employment potential. We assume here that, initially, full employment conditions prevail—if only by accident. INCOME INVESTMENT Yfe Labor income (Y = WN) is fully representative of total income, such that changes in labor income stand in direct proportion to changes in total income. Though not emphasized by Keynes, full employment implies that the economy is operating on its production possibility frontier, the PPF itself being defined in terms of sustainable output levels of consumption and investment goods. In Keynesian macroeconomics, full employment implies that the labor market clears at the going wage rate, the going wage itself having emerged during a period in which the economy was experiencing no macroeconomic problems. W S LABOR INCOME D N

10. C + I EXPENDITURES C = a + bY INCOME Yfe

11. OUTPUT REAL INCOME C + I LABOR INPUT REAL WAGE RATE S D LABOR INPUT

12. C + I EXPENDITURES C = a + bY INCOME Yfe

13. C + I ΔI EXPENDITURES EXCESS INVENTORIES C = a + bY INVESTMENT 1 (1 – b) ΔY = ΔI E = Y E < Y The simple investment-spending multiplier, 1/(1-b), quantifies the extend of the downward spiraling. ΔY CONSUMPTION INCOME Yfe 900 INCOME According to Keynes, a collapse of investment activity (the collapse being attributed to a waning of “animal spirits”) is the primary cause economic downturns. In response to reduced investment and hence reduced employment opportunities, the economy spirals downward into recession and possibly into deep depression. W Note that the going wage keeps going—even after the market conditions that gave rise to it are gone. S D N

14. ΔI = 100 EXPENDITURES C + I ΔI = 100 C = a + bY 1 (1 – b) ΔY = ΔI 1 (1 – 0.6) (100) = 250 ΔY ΔY ΔY = 1 (1 – 0.6) (100) = 250 ΔY = INCOME 400 650 900 A further loss of confidence on the part of the business community will send the economy even further from its full-employment potential. In the Keynesian construction, prices and the wage rate are sticky downward. But note that they’re not stuck too high. They’re stuck just right. The going wage rate will clear the labor market once again—as soon as spending and hence labor demand recover to their full-employment levels. W S D N

15. EXPENDITURES C + I C = a + bY INCOME 900 Yfe Recovery may be self-initiating. Waning animal spirits may become waxing animal spirits. In due time, a pressing need to maintain or replace depreciating capital may account for the lower turning point of a bust-and-recovery sequence. (Keynes, of course, preferred not to wait it out. He advocated make-work projects, deficit spending, and monetary stimulation to get the economy turned around.) W S D N

16. EXPENDITURES C + I C = a + bY INCOME Yfe Recovery may continue as further investment activity drives labor-demand back to its full-employment level... W S D N

17. C + I EXPENDITURES C = a + bY INCOME From full-employment onward, there is upward pressure on both prices and wage rates. And since prices and wage rates are not sticky upwards, the economy experiences a spiraling inflation. Yfe Recovery may continue as further investment activity drives labor-demand back to its full-employment level... The equilibrium points in the labor market traced out during the recovery and inflationary spiral constitute the so-called L-shaped supply curve. but there is nothing about “animal spirits” that will bring the recovery process to an end at full employment. Over-optimism may push the economy beyond its full-employment level. W S D N

18. C + I EXPENDITURES C = a + bY INCOME Yfe Y = C + I C = C Even in Keynesian equilibrium, saving equals investment. But it’s not the interest rate that does the equilibrating. Rather, it’s income that adjusts (spirals up or spirals down) until the saving-investment equality is established. Y – C = I S = I

19. BUSINESS ORGANIZATIONS EXPENDITURES Dealing with the inherent instability of the economy, according to Keynes, requires policy activism. Well-gauged and well-timed fiscal policy (changes in government spending and the level of taxation) can counter the recessionary and inflationary forces that are deeply rooted in capitalism. WORKERS FACTOR OWNERS CONSUMERS INCOME

20. Keynesian Circular-Flow Analysis (Labor-Based Macroeconomics) The Inherent Instability of a Wholly Private Economy (according to John Maynard Keynes) Roger W. Garrison 2006