1. Ch. 9: Economic Instability: A Critique of the Self-Regulating Economy
James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University
©2005 Thomson Business & Professional Publishing, A Division of Thomson Learning

2. Review of the Classical Position
Say’s Law holds, so insufficient demand in the economy is unlikely.
Wages, prices, and interest rates are flexible.
The economy is self-regulating.
Laissez-faire is the right and sensible economic policy to implement.

3. Questioning the Classical Position: Keynes
According to Keynes, it was possible for saving to increase and aggregate demand to fall.
Individuals save and invest for a host of reasons.
Saving is more responsive to changes in income than to changes in the interest rate.
Investment is also responsive to technological changes, business expectations, and innovations in addition to the interest rate.

4. Keynes on Interest Rates
Saving and investment depend on a number of factors.
The interest rate is important in determining the level of investment, but other variables, such as the expected rate of profit, can be more important.

5. Exhibit 1: Keynes’s View of Say’s Law in a Money Economy

6. Keynes on Wage Rates
Employees will resist an employer’s efforts to cut wages.
Wages may be inflexible in the downward direction.
The economy may not automatically cure itself of a recessionary gap.
The economy may not be self-regulating.

7. Exhibit 2: The Economy Gets “Stuck” in a Recessionary Gap

8. New Keynesians and Wage Rates
Keynes was criticized because he didn’t offer an adequate explanation of inflexible wages.
Efficiency wage models provide a solid microeconomic explanation for inflexible wages.
Efficiency Wage Models: it is sometimes in the best interest of business firms to pay their employees higher-than-equilibrium wage rates

9. Keynes on Prices
The internal structure of an economy is not always competitive enough to allow prices to fall.

10. Is it a Question of the Time it Takes for Wages to Adjust?
Classical (New Classical and Monetarists) Economists : Wages adjust quickly enough to consider the economy self-regulating.
Keynesian (New Keynesian): Wages adjust so slowly that one cannot say the economy is self-regulating.

11. Exhibit 3: A Question of How Long It Takes for Wage Rates and Prices to Fall

12. Self-Test
What do Keynesians mean when they say the economy is inherently unstable?
“What matters is not whether the economy is self-regulating or not, but whether prices and wages are flexible and adjust quickly.” Comment on this statement.
According to Keynes, why might aggregate demand be too low?

13. The Simple Keynesian Model
Three Simplifying Assumptions
The price level is constant
There is no foreign sector
The monetary side of the economy is excluded.

14. The Keynesian Framework Of Analysis
Keynes was interested in total expenditures, but was particularly concerned with consumption.
Consumption depends on disposable income.
Consumption and disposable income move in the same direction.
When disposable income changes, consumption changes by less.

15. The Consumption Function
Consumption=Autonomous Consumption + marginal propensity to consume (MPC) multiplied by disposable income.
C=Co + MPC(Yd)
MPC is equal to the change in consumption divided by the change in disposable income.
MPC=  C/  Yd

16. The Consumption Function
Consumption can be increased in three ways:
Raise autonomous consumption
Raise disposable income
Raise the MPC

17. The MPC and the MPS
Marginal propensity to save (MPS): the ratio of change in saving to the change in disposable income
MPS=  S/  Yd
It also follows that since C+S= Yd
then :
MPS+MPC=1

18. Exhibit 4: Consumption and Saving at Different Levels of Disposable Income (in billions)

19. The Multiplier
The Multiplier: the number that is multiplied by the change in autonomous spending to obtain the change in Real GDP.
 Real GDP = m x  Autonomous Spending
Multiplier(m) = 1
1- MPC
Change in Total Spending = Multiplier X Change in autonomous spending

20. The Multiplier and Reality
The multiplier takes time to have an effect. This process can take months.
For the multiplier to increase Real GDP (the way we have described), idle resources must exist at each expenditure round.

21. Self-Test How is autonomous consumption different from consumption?
If the MPC is 0.70, what does the multiplier equal?

22. The Simple Keynesian Model in the AD-AS Framework
Shifts in the Aggregate Demand Curve
Changes in C, I, G (foreign sector excluded by assumption) will shift AD
Change in total spending = multiplier X change in autonomous spending

23. Exhibit 5: The Multiplier and Aggregate Demand

24. The Simple Keynesian Model in the AD-AS Framework
The Keynesian Aggregate Supply Curve
Price level constant until full-employment (natural real GDP).
Aggregate supply curve has both a horizontal and a vertical section.

25. Exhibit 6: The AS Curve in the Simple Keynesian Model

26. The Theme of The Simple Keynesian Model in AD-AS Framework
Price level constant until full-employment (natural real GDP).
AD shifts if there are changes in C, I, or G.
Economy can be in equilibrium and a recessionary gap.
Private sector may not be able to get the economy out a a recessionary gap.
The government may have a management role to play in the economy.

27. Exhibit 7: Can the Private Sector Remove the Economy from a Recessionary Gap?

28. Self-Test
What was Keynes’s position with respect to the self-regulating properties of an economy?
What will happen to Real GDP if autonomous spending rises and the economy is operating in the horizontal section of the Keynesian AS curve? Explain.
An economist who believes the economy is self-regulating is more likely to advocate laissez-faire than an economist who believes the economy is inherently unstable. Agree or disagree? Explain

29. Exhibit 8: The Derivation of the Total Expenditures (TE) Curve

30. Comparing Total Expenditures and Total Production
There are three possible options:
Total Expenditures are less than Total Production
Total Expenditures are greater than Total Production
Total Expenditures equal Total Production

31. Moving From Disequilibrium to Equilibrium
TE<TP: Growing inventories signal firms they have overproduced. Firms cut back on production to get to optimal inventory levels, lowering Real GDP.
TE>TP: Shrinking inventories signal firms they have under-produced. Firms increase production to get to optimal inventory levels, increasing Real GDP.

32. Exhibit 9: The Three States of the Economy in the TE-TP Framework

33. The Theme of The Simple Keynesian Model In TE-TP Framework
Price level constant until full-employment (natural real GDP).
TE shifts if there are changes in C, I, or G.
Economy can be in equilibrium and a recessionary gap.
Private sector may not be able to get the economy out a a recessionary gap.
The government may have a management role to play in the economy.

34. Exhibit 10: The Economy: In Equilibrium, and in a Recessionary Gap Too

35. Self-Test
What happens in the economy if total production (TP) is greater than total expenditures (TE)?
What happens in the economy if total expenditures (TE) are greater than total production (TP)?

36. Coming Up (Ch. 10): The Federal Budget and Fiscal Policy