Economic Instability: A Critique Of The Self Regulating Economy

Questioning The Classical Position  Keynes and Keynesian thought the classical view of the economy was wrong.

Questioning The Classical Position (continued)  The classical: 1. Say’s law holds 1. Say’s law holds insufficient demand in the economy is insufficient demand in the economy is unlikely. unlikely. 2. Wages, prices, and interest rates are flexible. 2. Wages, prices, and interest rates are flexible. 3. The economy is self regulating. 3. The economy is self regulating.

Keynes’s Criticism Of Say’s Law In A Money Economy  Classical economists: - If consumption spending fell because - If consumption spending fell because saving increased, then saving increased, then total spending would not fall because the total spending would not fall because the added saving brings more investment added saving brings more investment spending, spending, (Keynes disagreed) (Keynes disagreed)

Keynes’s Criticism Of Say’s Law In A Money Economy (continued)  Keynes’s view of Say’s law in a money economy: a decrease in “consumption” and subsequent increase in “saving” may not be matched by an equal increase in “investment.” Thus a decrease in “total expenditures” may occur. a decrease in “consumption” and subsequent increase in “saving” may not be matched by an equal increase in “investment.” Thus a decrease in “total expenditures” may occur. Exhibit 1 Page 197. Exhibit 1 Page 197.

Keynes’s Criticism Of Say’s Law In A Money Economy (continued)  Classical: “saving” and “investment” depend on the interest rate. “saving” and “investment” depend on the interest rate. Keynes: Keynes: “saving” and “investment” depend on a number of factors that may be far more influential than the interest rate. “saving” and “investment” depend on a number of factors that may be far more influential than the interest rate.

Keynes On Wage Rates  Classical: if unemployment rate is greater than the natural unemployment rate, a surplus exists in the labor market (Table Page 184), thus wage rate fall. if unemployment rate is greater than the natural unemployment rate, a surplus exists in the labor market (Table Page 184), thus wage rate fall. Keynes: Keynes: did not believe above statement adjusted so simple. Wage rates may be inflexible in a downward direction. did not believe above statement adjusted so simple. Wage rates may be inflexible in a downward direction. Exhibit 2 Page 199 Exhibit 2 Page 199

New Keynesians And Wage Rates  Efficiency wage models: sometimes in the best interest of business firms to pay their employee higher than equilibrium wage rates. sometimes in the best interest of business firms to pay their employee higher than equilibrium wage rates.

Keynes On Prices  Classical: prices in the economy are flexible, move up and down in response to market forces. prices in the economy are flexible, move up and down in response to market forces. Keynes: Keynes: not always competitive enough to allow prices to fall. not always competitive enough to allow prices to fall.

 Exhibit 3 Page 200 How long it takes for wage rates and prices to fall. How long it takes for wage rates and prices to fall.

The Simple Keynesian Model  Assumptions: 1. The price level is constant until economy 1. The price level is constant until economy reaches its full employment (Natural Real reaches its full employment (Natural Real GDP). GDP). 2. No foreign sector (closed economy) 2. No foreign sector (closed economy) TE = C + I + G TE = C + I + G 3. Monetary side of the economy is 3. Monetary side of the economy is excluded. excluded.

The Simple Keynesian Model (continued)  The consumption function: 1. “Consumption” depends on “disposable income”. 1. “Consumption” depends on “disposable income”. “Disposable income” = income – taxes “Disposable income” = income – taxes 2. Consumption and disposable income move in the same direction. 2. Consumption and disposable income move in the same direction. 3. When disposable income changes, consumption changes by less. 3. When disposable income changes, consumption changes by less. C = Co + (MPC)(Yd) C = Co + (MPC)(Yd) MPC = marginal propensity to consume MPC = marginal propensity to consume MPC = delta C / delta Yd MPC = delta C / delta Yd Co = autonomous consumption, independent of disposable income. Co = autonomous consumption, independent of disposable income.

The Simple Keynesian Model (continued)  Consumption and saving: S = Yd – [Co + (MPC)(Yd)] S = Yd – [Co + (MPC)(Yd)] MPS = delta S / delta Yd MPS = delta S / delta Yd MPC + MPS = 1 MPC + MPS = 1

The Simple Keynesian Model (continued)  Multiplier: - to obtain the overall change in total - to obtain the overall change in total spending. spending. m = 1 / ( 1 – MPC ) m = 1 / ( 1 – MPC ) Change in total spending = multiplier x Change in total spending = multiplier x change in autonomous spending change in autonomous spending

The Simple Keynesian Model In The AD-AS Framework  Shifts in the Aggregate Demand Curve: - There are C, I, G that can shift the AD - There are C, I, G that can shift the AD curve. curve. - Co increases…..C increases…………… - Co increases…..C increases…………… AD increases AD increases Exhibit 5 Page 207. Exhibit 5 Page 207.

The Simple Keynesian Model In The AD-AS Framework (continued)  The Keynesian Aggregate Supply Curve: - has both a horizontal section and a vertical - has both a horizontal section and a vertical section. section. Exhibit 6 Page 207. Exhibit 6 Page 207.

The Simple Keynesian Model In The AD-AS Framework (continued)  The economy in a recessionary gap: - Keynes believed the economy could get - Keynes believed the economy could get stuck in a recessionary gap. stuck in a recessionary gap. Exhibit 7 Page 209. Exhibit 7 Page 209.

The Simple Keynesian Model In The TE (Total Expenditure) – TP (Total Product)  Deriving a Total Expenditure (TE) curve: TE = C + I + G TE = C + I + G Exhibit 8 Page 211. Exhibit 8 Page 211. TE curve is upward sloping. TE curve is upward sloping.

The Simple Keynesian Model In The TE (Total Expenditure) – TP (Total Product) (continued)  What will shift the TE curve?: - TE curve shifts if there is change in C, I, or - TE curve shifts if there is change in C, I, or G. G. - a rise in C will shift the TE curve upward. - a rise in C will shift the TE curve upward. - a decline in I will shift the TE. - a decline in I will shift the TE.

The Simple Keynesian Model In The TE (Total Expenditure) – TP (Total Product) (continued)  Comparing Total Expenditure (TE) and Total Production (TP): 1. TE < TP, disequilibrium 1. TE < TP, disequilibrium 2. TE > TP, disequilibrium 2. TE > TP, disequilibrium 3. TE = TP, equilibrium 3. TE = TP, equilibrium