1. McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Self-Adjustment or Instability Chapter 10

2. 2 Leakages and Injections Total spending doesn’t always match total output at the desired full- employment–price-stability level. LO1

3. 3 The Circular Flow The focus of macro concern is whether desired injections will offset desired leakage at full employment. Full employment GDP is the value of total output (real GDP) produced at full employment. LO1

4. 4 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) LO1

5. 5 Consumer Saving A leakage is income not spent directly on domestic output, but instead is diverted from the circular flow. LO1

6. 6 Consumer Saving Saving is a primary leakage from the circular flow. Saving represents income not directly returned to the product markets. LO1

7. 7 Consumer Saving If full-employment income is $3 trillion, then consumption would equal $2350 billion. C F = $100 billion + 0.75($3000 billion) = $2350 billion LO1

8. 8 Real GDP 50 100 Price Level Leakage and AD CFCF 2,350 3,000 Q F Real consumer demand at Q F AS Output not demanded by consumers LO1

9. 9 Imports and Taxes Imports and taxes represent leakage from the circular flow. LO1

10. 10 Business Savings Business saving is also a leakage from the circular flow of income. Gross business saving is depreciation allowances and retained earnings. LO1

11. 11 Injections into the Circular Flow An injection is an addition of spending to the circular flow of income. Injections of investment, government expenditures, and exports help offset leakages from saving, imports, and taxes. LO1

12. 12 Leakages and Injections LO1

13. 13 Self-Adjustment? Classical economists believed that flexible interest rates and flexible prices equalize injections and leakages. This flexibility would lead to full employment.

14. 14 Flexible Interest Rates According to classical economists, if interest rates fell far enough, business investment (injections) would equal consumer saving (leakage).

15. 15 Changing Expectations Keynes disagreed with classical economists concerning the role of flexible interest rates in reaching full employment. Keynes argued that investment would fall in response to declining sales.

16. 16 Flexible Prices Classical economists believed that a falling price level would prompt consumers to buy more output.

17. 17 Expectations (Again) Keynes disagreed with classical economists concerning the role of flexible prices in reaching full employment. Keynes argued that declining retail prices would prompt investment cutbacks.

18. 18 REAL OUTPUT (in billions of dollars per year) PRICE LEVEL (average price) AD Shift Q F = $3,000 P1P1 Q1Q1 P0P0 $2,900 AD 0 F b AS $100 billion decline in I d

19. 19 The Multiplier Process Keynes argued that things were likely to get worse once a spending shortfall emerged. LO2

20. 20 A Decline in Investment Suppose expectations fall. Businesses cut back on investment spending. Unsold capital goods start to pile up. LO2

21. 21 Undesired Inventory Economists distinguish desired (or planned) investment from actual investment. Actual investment = Desired investment + Undesired investment LO2

22. 22 Falling Output and Prices Business firms are likely to react to undesired inventory buildups by cutting prices and reducing the rate of new output. LO2

23. 23 Household Incomes Firms usually cut wages and employment as they cut back production. A reduction in investment spending implies a reduction in household incomes. LO2

24. 24 Income-Dependent Consumption What starts off as a relatively small spending shortfall quickly snowballs into a much larger problem. If disposable income falls, we expect consumer spending to drop as well. LO2

25. 25 Income-Dependent Consumption The marginal propensity to consume is a critical variable. The marginal propensity to consume (MPC) is the fraction of each additional (marginal) dollar of disposable income spent on consumption. It is the change in consumption divided by the change in disposable income. LO2

26. 26 The Multiplier The multiplier is the multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles. LO2

27. 27 The Multiplier The change in total spending equals the multiplier times the initial change in aggregate spending. Initial change in aggregate spending multiplier Total change in spending  LO2

28. 28 The Multiplier The cumulative decease in total spending is equal to the AD shortfall multiplied by the multiplier. A recessionary gap of $100 billion per year would decrease total spending by $400 billion per year (MPC = 0.75). LO2

29. 29 The Multiplier LO2

30. 30 The Multiplier Process 1. $100 billion in unsold goods appear 3. Income reduced by $100 billion4. Consumption reduced by $75 billion 5. Sales fall $75 billion 6. Further cutbacks in employment or wages 7. Income reduced by $75 billion more 8. Consumption reduced by $56.25 billion more Factor markets Product markets Business firms Households 9. And so on 2. Cutbacks in employment or wages LO2

31. 31 The Multiplier Cycles LO2

32. 32 Macro Equilibrium Revisited Key features of the Keynesian adjustment process: Producers cut output and employment when output exceeds aggregate demand at the current price level (leakages exceed injections). LO2

33. 33 Macro Equilibrium Revisited Key features of the Keynesian adjustment process: The resulting loss of income causes a decline in consumer spending. Declines in consumer spending lead to further production cutbacks, more lost income, and still less consumption. LO2

34. 34 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. LO2

35. 35 Multiplier Effects Real Output (in billions of dollars per year) Price Level (average price) Q F = 3000 m a P0P0 26002900 AD 2 c  I = $100 billion  C = $300 billion b d AD 1 AS AD 0 LO2

36. 36 Price and Output Effects The impact of a shift in aggregate demand is reflected in both output and price changes. LO3

37. 37 Recessionary GDP Gap As long as the aggregate supply curve is upward-sloping, the shock of any AD shift will be spread across output and prices. LO3

38. 38 Recessionary GDP Gap The recessionary GDP gap is the amount by which equilibrium GDP falls short of full-employment GDP. The recessionary GDP gap equals the difference between equilibrium real GDP (Q E ) and full-employment real GDP (Q F ). LO3

39. 39 Recessionary GDP Gap The recessionary GDP gap is the classic case of cyclical unemployment. Cyclical employment is the unemployment attributable to a lack of job vacancies, that is, to an inadequate level of aggregate demand. LO3

40. 40 Recessionary GDP Gap REAL OUTPUT(in billions of dollars per year) PRICE LEVEL (average price) QEQE QFQF P0P0 PEPE AD 0 AD 2 AS c m a Recessionary GDP gap LO3

41. 41 Short-Run Inflation-Unemployment Trade-Offs The shape of the aggregate supply curve adds to the difficulty of restoring full employment.

42. 42 Upward-Sloping AS When AD increases both output and prices go up. So long as the short-run AS is upward sloping, there is a trade-off between unemployment and inflation.

43. 43 The Unemployment-Inflation Trade-Off REAL OUTPUT (in billions of dollars per year) PRICE LEVEL (average price) Q E = $2800Q F = $3000 AS PEPE P3P3 P4P4 AD 2 c h f AD 3 AD 4 g Recessionary GDP gap

44. 44 “Full” vs. “Natural” Unemployment Full employment is the lowest rate of unemployment compatible with price stability. The closer the economy gets to capacity output, the greater the risk of inflation.

45. 45 “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.

46. 46 Adjustment to an Inflationary GDP Gap Operating through the multiplier process, an increase in investment might initiate an inflationary spiral. LO3

47. 47 Increased Investment An increase in investment spending shifts the aggregate demand curve to the right. LO3

48. 48 Inventory Depletion When AD increases due to increased investment available inventories shrink. Inventory depletion is a warning sign of impending inflation. LO3

49. 49 Household Incomes As investment increases, household incomes get a boost as producers increase their output to rebuild inventories and supply more investment goods. LO3

50. 50 Induced Consumption Consumers purchase more goods and services as their incomes increase. Eventually consumer spending increases by a multiple of the income change. LO3

51. 51 A New Equilibrium The increase in AD causes both output and prices to increase. This increase in the average price level is known as demand-pull inflation. Demand-pull inflation is an increase in the price level initiated by excessive aggregate demand. LO3

52. 52 Demand-Pull Inflation Real Output (in billions of dollars per year) Price Level (average price) a w r AD 0 AS QFQF QEQE P0P0 P6P6 AD 5 AD 6  C = $300 billion  I = $100 billion Inflationary GDP gap LO3

53. 53 Boom and Busts The basic conclusion of the Keynesian analysis is that: The economy is vulnerable to abrupt changes in spending behavior, and The economy won’t self-adjust to a desired macro equilibrium.

54. 54 Boom and Busts The responses of market participants to an abrupt AD shifts are likely to worsen rather than improve market outcomes.

55. 55 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.

56. 56 Consumer Confidence Consumer spending consists of two components: Autonomous – represented by the letter (a) in the consumption function, and Induced – represented by the letters (bY) in the consumption function. C = a + bY

57. 57 Consumer Confidence When consumer confidence changes, the value of (a) changes and the consumption function shifts.

58. 58 Consumer Confidence 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.

59. 59 Consumer Confidence

60. 60 The Official View: Always a Rosy Outlook Governments often paint a picture of the economy which is better than what actually exists.

61. McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Self-Adjustment or Instability End of Chapter 10