Keynesian Circular Flow Analysis Stabilizing an Inherently Unstable Economy with Government Spending 2006

The Keynesian Circular Flow in a Mixed Economy BUSINESS ORGANIZATIONS EXPENDITURES In Keynesian equilibrium, INCOME equals EXPENDITURES. Y = E The Keynesian Circular Flow in a Mixed Economy Y = C + I + G But T = 0 WORKERS FACTOR OWNERS CONSUMERS INCOME

C + I + G C + I EXPENDITURES GOVERNMENT Investment, too, is the same as in a wholly private economy, implying either that government borrowing doesn’t impinge on interest rates or that investment spending is insensitive to interest-rate changes. INVESTMENT C If no taxes are being collected (implying that the government spending is facilitated by borrowed funds or by newly printed money), consumption behavior is the same as in a wholly private economy (C = a + bY). The 45o line (Y = E) still defines all the possible Keynesian equilibria, but now total spending (E) includes government spending (G). Government spending is now the third component of total spending. While some of this spending is considered essential for the government to function, additional spending is made with an eye to its overall effect on the macro-economy. CONSUMPTION 45o INCOME INCOME Consumption, Investment, and Government Spending are additive components of total spending---the components themselves being distinguished by their stability characteristics: stable (C ), unstable (I), and stabilizing (G). The equilibrium income is now marked by the intersection of the equilibrium condition (Y = E) and the aggregate spending schedule (E = C + I + G).

C + I + G C + I EXPENDITURES C 45o INCOME Yfe We assume that, if only by “accident or design,” the economy is initially functioning at its full-employment level and without inflation. The demand for labor is strong enough to clear the labor market at the going wage rate; and the corresponding demand for output is strong enough to clear all output markets at their downwardly sticky prices. W S D N

C + I + G C + I EXPENDITURES ΔI C Suppose now that a loss of business confidence causes investment spending to fall by ΔI. ΔY 1 (1 – b) The economy responds, not by adjustments in prices, wages, and/or interest rates but by spiraling downward into recession. ΔY = ΔI 45o INCOME Yeq Yfe The magnitude of the change in income (ΔY) is determined by applying the spending multiplier. W And the economy is now stuck in what Keynes called an unemployment equilibrium. S D N

Once again, the spending multiplier is in play. C + I + G EXPENDITURES ΔG C + I + G C + I C To restore full employment, policymakers need to compensate for the decrease in investment spending by increasing government spending. ΔY 1 (1 – b) ΔY = ΔG 45o The economy responds to this fiscal stimulant by spiraling upwards, retracing its steps to the full-employment level of income. INCOME Yeq Yeq = Yfe By “design” (and despite the lack of business confidence and the stickiness of wages and prices), the economy is performing at its full-employment potential and without inflation. W S Once again, the spending multiplier is in play. D N

…and this is what Keynes calls The General Theory. C + I + G C + I EXPENDITURES C So, imagine an economy with the interest rate out of play, with downwardly sticky prices and wage rates, and with an business community ruled by psychological forces. 45o INCOME Yfe Currently, the total spending in the economy just happens to be just enough but not too much: It’s just enough, which means there’s no unemployment problem; it’s not too much, meaning that inflation isn’t a problem, either. …and this is what Keynes calls The General Theory. And mercifully, fiscal agents stand at the ready, continuously offsetting any changes in investment spending with equal-but-opposite changes in government spending, thereby maintaining a stability that the market economy itself could never achieve.

…and this is what Keynes calls The General Theory.

Keynesian Circular Flow Analysis Stabilizing an Inherently Unstable Economy with Government Spending 2006