Self-Adjustment or Instability? Chapter 10 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

10-2 Self-Adjustment or Instability Focus on the adjustment process – how markets respond to an undesirable equilibrium –Why does anyone think the market might self- adjust (returning to a desired equilibrium)? –Why might markets not self-adjust? –Could market responses actually worsen macro outcomes?

10-3 Leakages and Injections Total spending doesn’t always match total output at the desired full-employment–price- stability level The focus of macro concern is whether desired injections will offset desired leakages at full employment

10-4 Leakages and Injections Injection: An addition of spending to the circular flow of income Leakage: Income not spent directly on domestic output but instead diverted from the circular flow; for example, saving, imports, taxes

10-5 Leakages and Injections Business taxes Household taxes Imports Saving Business saving INJECTIONS Exports Government spending Investment LEAKAGES Product market Factor market Business Firms Households (disposable income)

10-6 Consumer Saving Saving represents income not directly returned to the product markets Say the consumption function is: With full employment output of $3 trillion, consumption at full employment is

10-7 Real GDP Price Level Leakage and AD CFCF 2,350 3,000 Q F Real consumer demand at Q F AS Output not demanded by consumers

10-8 Imports and Taxes Imports and taxes also represent leakages –Income spent on imports is not part of aggregate demand for domestic output –Sales taxes are taken out of the circular flow in product markets –Payroll taxes and income taxes are taken out of paychecks, so households don’t spend that income

10-9 Business Savings The business sector also keeps part of the income generated in product markets Gross business saving: Depreciation allowances and retained earnings

10-10 Injections into the Circular Flow Injections of investment, government expenditures, and exports help offset leakages from saving, imports, and taxes Injections must equal leakages if all the output supplied is to equal the output demanded (macro equilibrium)

10-11 Leakages and Injections Macro equilibrium is possible only if leakages equal injections. Of these, consumer saving and business investment are the primary sources of (im)balance.

10-12 Self-Adjustment? Classical economists believed that flexible interest rates and flexible prices equalize injections and leakages –If spending declines, savings picks up and interest rates fall –If demand for output falls, prices decline This flexibility would lead to full employment

10-13 Flexible Interest Rates If interest rates fell far enough, business investment (injections) would equal consumer saving (leakage) and full employment would return Keynes felt that this ignores expectations –Investment would fall in response to declining sales

10-14 Flexible Prices Classical economists believed that a falling price level would prompt consumers to buy more output, leading to full employment Again Keynes disagreed with the result –If prices must be cut to move merchandise, businesses are likely to rethink production and investment plans

10-15 The Multiplier Process Keynes argued that things were likely to get worse once a spending shortfall emerged Suppose consumer spending falls due to a decline in wealth –Inventories of unsold goods start piling up –Businesses cut back on investment spending

10-16 Undesired Inventory Economists distinguish desired (or planned) investment from actual investment Desired investment represents purchases of new plant and equipment plus any desired changes in business inventories Undesired investment Desired investment Actual investment 

10-17 Falling Output and Prices Business firms are likely to react to undesired inventory buildups by cutting prices and reducing the rate of new output

10-18 REAL OUTPUT PRICE LEVEL AD Shift Q F = $3,000 P1P1 Q1Q1 P0P0 $2,900 AD 0 F AD 1 b AS $100 billion decline in I d

10-19 Household Incomes Firms usually cut wages and employment as they cut back production A reduction in investment spending leads to a reduction in household incomes

10-20 Income-Dependent Consumption What starts off as a relatively small spending shortfall escalates into a much larger problem If disposable income falls, we expect consumer spending to drop as well This quickly translates into more unsold output and causes further cutbacks in production, employment, and disposable income

10-21 The Multiplier Process 2. $100 billion in unsold goods appear 4. Income reduced by $100 billion5. Consumption reduced by $75 billion 6. Sales fall $75 billion 7. Further cutbacks in employment or wages 8. Income reduced by $75 billion more 9. Consumption reduced by $56.25 billion more Factor markets Product markets Business firms Households 10. And so on 3. Cutbacks in employment or wages 1. Investment drops by $100 billion

10-22 The Multiplier The marginal propensity to consume (MPC) is the critical variable in this process Multiplier: The multiple by which an initial change in spending will alter total expenditure after an infinite number of spending cycles

10-23 The Multiplier The total change in spending is equal to the initial change in spending multiplied by the multiplier

10-24 The Multiplier An initial drop in spending of $100 billion would decrease total spending by

10-25 The Multiplier Cycles

10-26 Macro Equilibrium Revisited Key features of the adjustment process: –Producers cut output and employment when output exceeds aggregate demand at current price level –Resulting loss of income causes decline in consumer spending –Decline in consumer spending leads to further production cutbacks, more lost income, and even less consumption

10-27 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

10-28 Multiplier Effects Real Output Price Level Q F = 3000 m a P0P AD 2 c  I = $100 billion  C = $300 billion b d AD 1 AS AD 0

10-29 Price and Output Effects As long as the aggregate supply curve is upward-sloping, the shock of any AD shift will be spread across output and prices

10-30 Recessionary GDP Gap Recessionary GDP gap: The amount by which equilibrium GDP falls short of full- employment GDP –Represents the amount by which the economy is under-producing during a recession –Classic case of cyclical unemployment

10-31 Recessionary GDP Gap REAL OUTPUT PRICE LEVEL QEQE QFQF P0P0 PEPE AD 0 AD 2 AS c m a Recessionary GDP gap

10-32 Short-Run Inflation-Unemployment Trade-Offs The shape of the aggregate supply curve adds to the difficulty of restoring full employment When AD increases both output and prices go up With upward sloping short-run AS there is a trade-off between unemployment and inflation

10-33 The Unemployment-Inflation Trade-Off REAL OUTPUT PRICE LEVEL Q E = $2800Q F = $3000 AS PEPE P3P3 P4P4 AD 2 c h f AD 3 AD 4 g Recessionary GDP gap

10-34 “Full” vs. “Natural” Unemployment Full employment: The lowest rate of unemployment compatible with price stability; variously estimated at between 4 and 6 percent unemployment The closer the economy gets to capacity output, the greater the risk of inflation

10-35 “Full” vs. “Natural” Unemployment Neoclassical and monetarist economists do not accept this notion of full employment In their view, the long-run AS curve is vertical so that there is no unemployment-inflation trade-off

10-36 Adjustment to an Inflationary GDP Gap A sudden shift in aggregate demand can have a cumulative effect on macro outcomes This multiplier process works both ways An increase in investment might initiate an inflationary spiral

10-37 Inventory Depletion When AD increases, available inventories shrink –Inventory depletion is a warning sign of impending inflation As producers increase output to rebuild inventories and supply more investment goods, household incomes get a boost

10-38 Induced Consumption Consumers purchase more goods and services as their incomes increase Eventually consumer spending increases by a multiple of the income change

10-39 A New Equilibrium The increase in AD causes both output and prices to increase Inflationary GDP gap: The amount by which equilibrium GDP exceeds full-employment GDP

10-40 Demand-Pull Inflation Real Output Price Level a w r AD 0 AS QFQF QEQE P0P0 P6P6 AD 5 AD 6  C = $300 billion  I = $100 billion Inflationary GDP gap

10-41 Boom and Busts The basic conclusion of Keynesian analysis is that the economy is vulnerable to changes in spending behavior and won’t self-adjust to a desired macro equilibrium The responses of market participants are likely to worsen rather than improve market outcomes

10-42 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 due to changes in the consumption function

10-43 Consumer Confidence When consumer confidence changes, the value of a changes and the consumption function shifts 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

10-44 Consumer Confidence Consumer confidence is affected by various financial, political, and international events. Source: University of Michigan

10-45 The Official View: Always a Rosy Outlook Because consumer spending outweighs other components of aggregate demand, the threat of abrupt changes in consumer behavior is serious Governments often paint a picture of the economy which is better than what actually exists to avoid declines in confidence

Self-Adjustment or Instability? End of Chapter 10 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin