Keynesian Circular-Flow Analysis (As Applied to a Wholly Private Economy) Saving and Investment—and their Equilibration according to John Maynard Keynes and according to Dennis Robertson. Roger W. Garrison 2009

Income is used mainly for consumption, but some of it is saved. E = Y EXPENDITURES 45o INCOME The INCOME and the EXPENDITURES that make up the circular flow contain a large common element, namely CONSUMPTION. Income is used mainly for consumption, but some of it is saved. Expenditures are mostly for consumption, but some is for investment. In an income-expenditure equilibrium, C + S must equal C + I. Income is used mainly for consumption, but some of it is saved. Expenditures are mostly for consumption, but some is for investment.

The “Keynesian Cross” marks the spot where income equals expenditures. C + I EXPENDITURES C = a + bY b Even in a mixed economy, spending on consumption goods typically counts for about 70% of GDP. In this wholly private economy, it would count for even more. In this wholly private economy, spending on investment goods accounts for the remaining expenditures. The “Keynesian Cross” marks the spot where income equals expenditures. 1 We assume here that, initially, full employment conditions prevail—though only by accident. a 45o 45o INCOME Yeq=Yfe

Investment spending is determined exclusively by business psychology. C + I EXPENDITURES C = a + bY Clearly, saving equals investment at the same level of income at which income equals expenditures. Saving is represented by the vertical distance between the consumption equation and the 45O line. Saving is negative for low levels of income and increasingly positive at higher levels. (The 45O line allows income to be measured vertically as well as horizontally.) Investment spending is determined exclusively by business psychology. At each and every level of income, it is represented by the vertical separation between C and C+I. So now, let’s net out consumption spending to show that S = I is an alternative equilibrium condition. a 45o Y=0 and C=Y give us two points on the saving equation. INCOME Yeq=Yfe INVESTMENT SAVING, S = -a + (1-b)Y 1-b Just by themselves, these two curves (S and I) identify the income-expenditure equilibrium. Finally, the shading on the S=I graph matches perfectly with the shading on the Y=E graph. Investment is represented by a horizontal line. The slope of this line is 1-b, which together with the intercept (-a), allows us to write the saving equation. I 1 INCOME -a

INVESTMENT SAVING, S = -a + (1-b)Y I INCOME

INVESTMENT SAVING, S I INCOME With this saving-investment equilibrium, it just so happens that the demand for labor is just strong enough to clear the labor market at the going wage. W S D N

SAVIING (S) INVESTMENT (D) RATE OF INTEREST INVESTMENT SAVING, S D I INCOME SAVIING (S) INVESTMENT (D) The pre-Keynesian understanding of the relationship between saving and investment took the form of the supply and demand for loanable funds. As the appropriate movement in the interest rate clears the market for loanable funds, the appropriate movement in the wage rate clears the market for labor. With this saving-investment equilibrium, it just so happens that the demand for labor is just strong enough to clear the labor market at the going wage. W W S S D D N N

SAVIING (S) INVESTMENT (D) RATE OF INTEREST INVESTMENT SAVING, S D I INCOME SAVIING (S) INVESTMENT (D) In summary terms: both interest rates and wage rates respond in conventional ways to changes in market conditions, allowing investment to correspond to saving preferences and allowing the labor market to find its equilibrium. With market conditions now changed, the wage rate adjusts so that, once again, the supply and demand for labor are brought into balance. Suppose, now, that people decide to save more. In the pre-Keynesian world, this increased thriftiness would be depicted as a rightward shift in the supply of loanable funds. Investment spending does not increase. And with increased saving (i.e., decreased spending), excess inventories develop and the economy spirals downward. Incomes are reduced until saving is, once again, equal to investment. However, if people do become more thrifty, the consequences are not good. The increased thriftiness is depicted by an upward shift in the saving equation. Keynes didn’t believe that people would simply “decide to save more.” He argued that current spending (and hence saving) depends exclusively upon current income, i.e., S = -a + (1-b)Y. With lower incomes and hence decreased demands for output, the demand for labor falls. However, wage rates are “sticky downward” and do not adjust to the new market conditions. So, unemployment persists until suitable fiscal and monetary policies are implemented. In summary terms: the interest rate is no part of the coordinating mechanism that brings saving and investment into balance, and the wage rate is too downwardly sticky to allow for labor-market adjustments. W W S S D D N N

Keynesian Circular-Flow Analysis (Labor-Based Macroeconomics) Saving and Investment—and their Equilibration according to John Maynard Keynes and according to Dennis Robertson. Roger W. Garrison 2009