Chapter 10: Self Adjustment or Instability

Keywords: Macroeconomic Equilibrium• A state of national economic

activity wherein aggregate

demand is met by aggregate

supply.

• Short-run macroeconomic

equilibrium occurs when the

quantity of GDP demanded

equals the quantity supplied,

which is where the AD and AS

curves intersect.

Keywords: Resource & Product Markets

• Resource market is the market where factors of

production are traded, for example: labor, capital, raw

materials, machinery etc.

• Product market - is the market where final products

which were produced by means of factors of

production are traded .

Introduction

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?

The Circular Flow of Income (CFI)• The circular flow is a handy model

of macroeconomic activity that highlights the interaction between households and businesses through the product and resource markets.

• The household sector buys production from the business sector through the product markets. Expenditures by the household sector are consumption expenditures. Revenue going to the business sector is gross domestic product (GDP).

The Circular Flow of Income (con)• The business sector hires factor

services from the household sector

through the resource markets.

• Payments made by the business

sector are factor payments. Income

going to the household sector is

national income(NI).

Leakages

Leakage: Income not spent

directly on domestic

output in the national

product market but

instead diverted from the

circular flow of income;

for example, taxes ,

imports, and saving.

Injection

Injection: An addition of spending to

the circular flow of income. For

example, exports from the domestic

markets (X), investments (I) and

government expenditures (G).

L e a k a g e s & I n j e c ti o n s

Three points of leakages and injections that are linked

together are:

1- Taxes

2- Imports

3- Savings

1- Taxes

In reference to taxes paid to the government:

a)Sales taxes are taken out of the circular flow in product

markets.

b)Payroll taxes and income taxes are taken out of

paychecks, so households don’t spend that income.

Taxes are considered as a leakage from the CFI.

Ta x e s ( c o n )

however, this enables the government to provide public goods or quasi

public goods that would otherwise be unavailable to society. Along

with this, the money paid from taxes allows the government to

provide many benefits to society such as health care, infrastructure,

education, defense, etc. These provisions from the government allow

for the nation to prosper and are contribute to the national output of

the nation (GDP), hence these are considered injections into the CFI.

2- Imports

In reference to imports (income not spent directly on domestic output in the national

product market) , the domestic households buy imports from foreign countries,

which are considered to be leakages from the CFI because money is being allocated

towards the purchase of goods and services from foreign product markets.

However, as domestic markets purchase imports from the foreign markets, it allows

the foreign markets to have availability to money that they can then use to

purchase the exports from the domestic markets. The spending on domestic goods

and services by foreign markets allows for money to be put into the CFI, therefore it

is considered to be an injection because this money contributes to the national

output.

3 - Saving

In reference to savings:

a) Households savings (disposable income – household

consumption)

b) Firms savings (Depreciation allowances and retained

earnings)

They are considered as a leakage from the CFI because this

money is not used and is not put directly into the product

market.

Saving (con)

However, this capital that is saved is now available to the

firms and households to use as money for

investments, for lending, or for purchasing other goods

and services. Hence, as the firms and households put

money into the market for these various reasons, it is

considered an injection into the CFI because there is

now more money in the market and this money will

then contribute to the national output.

Leakages and Injections

Businesstaxes

Householdtaxes

ImportsSaving Businesssaving

INJECTIONS

ExportsGovernment spending

Investment

LEAKAGES

Productmarket

Factormarket

Business FirmsHouseholds(disposable

income)

M a c r o E q u i l i b r i u m

• Injections of investment, government

expenditures, and exports help offset leakages

from saving, imports, and taxes.

• Macroeconomic equilibrium is possible only

if ∑ Leakages equal ∑Injections.

M a c r o E q u i l i b r i u m ( c o n )

INJECTIONS

Investment Government spending

Exports

LEAKAGES

Consumer savingBusiness saving

Taxes Imports

•Macroeconomic equilibrium is possible only if leakages equal

injections.

Self-Adjustment?

Classical economists believed that (1) flexible interest

rates and (2) flexible prices equalize injections and

leakages. Consequently, this flexibility would lead to a

macroeconomic equilibrium.

1 - Flexible Interest Rates

Classical economists believed that If consumption

declines Savings picks up Interest rates will fall

Business investment (injections) will increase to

be equal to consumer saving (leakage)

Macroeconomic equilibrium will return.

• Keynes felt that this ignores expectations:

– Investment would fall in response to declining sales.

2- Flexible Prices

Classical economists believed that If demand for output falls

Prices will decline Consumers will buy more output

Macroeconomic equilibrium will return.

• Again Keynes disagreed with the result:

– If prices must be cut to move products, businesses are

likely to rethink present production and futur investment

plans.

T h e M u l ti p l i e r M o d e l

The multiplier model is an economic model that was first

proposed by John Keynes (the founders of modern

macroeconomics). The multiplier model is a model

of output determination -- it tells us what the level of

output (GDP) will be, based on the level of aggregate

demand when the price level is fixed The multiplier

model tells us how much the output (GDP) may change as

the aggregate demand [C + Iplanned + G + (EX – IM)]

shifts due to an initial change in its components .

T h e M u l ti p l i e r M o d e l ( c o n )

The term multiplier refers to the way that an initial

increase in aggregate demand causes a wave effect

that leads to more and more spending and raises

the GDP by a multiple of that initial increase in

spending. The multiplier answers the question: “if

autonomous expenditure rise for some exogenous

reason, how much does total real income (GDP) rise

in equilibrium? ”.

The Multipl ier Process

The main reason why this happens is because when you

spend money, the person who receives that money from

you as payment will turn around and spend some of it. And

the same thing will happen when that person spends his

money -- the person he paid the money to will turn around

and spend some it, too. The chain of spending continues

until there's nothing left to spend.

The Multipl ier Process ( c o n )

This multiplier process works both ways, (1) A drop in consumer

spending (2) An increase in unsold inventories firms will react

by (3) Reducing prices and (4) Cutting back the production

(investment spending) which will leads to (5) A reduction in

wages (household incomes) and (6) An increase in unemployment

rate (7) More lost income (8) Even less consumption.

Accordingly, what started off as a relatively small spending shortfall

escalated quickly into a much larger problem.

The Marginal Propensity to Consume (MPC)

The key concept in the multiplier model is the marginal propensity to

consume (MPC) The fraction of an extra dollar of a person's disposable

income that the person will spend on consumer goods.

Multiplier: The multiple by which an initial change in spending will alter total

expenditure after an infinite number of spending cycles.

11-

MultiplierMPC

The Total Change in Spending

The total change in spending is equal to the initial

change in spending multiplied by the multiplier:

1 1-

Total change initial changein spending in spendingMPC

H y p o t h e ti c a l E x a m p l e # 1 First off, suppose everyone has the same MPC = (0.75) - I withdraw $100 from my savings account and spend it all on a leather jacket.- Biff, the leather jacket salesman, since he has MPC = 0.75, spends (0.75)* $100

= $75 (on a hat).- Cheryl, the hat salesperson, spends (0.75)*$75 = $56 (on a puppy).- Ralph, the dog breeder, spends (0.75)*$56 = $42 (on a haircut) - Olga, the hairstylist, spends (0.75)*$42 = $32 (on food). - and so on.

• Note that each subsequent amount spent is 75% of the previous amount. • After many more iterations the amount spent will be so tiny (75% of a

fractional cent) that we can forget about it. But by then the total increase in spending will have been quite large (∑ spending = [1 /(1-MPC)] * 100 = $400).

Hypothetical Example # 2

2. $100 billion in unsold goods appear

4. Income reduced by $100 billion 5. Consumption reduced by $75 billion

6. Sales fall $75 billion7. 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

10-31

Hypothetical Example (con)Spending Cycles Change in

Spending During Cycle

Cumulative decrease in Spending

First cycle $100.00 $100.00 Second cycle 75.00 175.00 Third cycle 56.25 231.25 Fourth cycle 42.19 273.44 Fifth cycle 31.64 305.08 Sixth cycle 23.73 328.81

Nth cycle 400.00

Hypothetical Example (con)

• An initial drop in spending of $100 billion would decrease total spending by:

1 1-

1 $100 1- 0.75

4 $100

$400

Total change initial changein spending in spendingMPC

billion

billion

billion

Shifts in Aggregate Demand

• The primary cause of shifts in the economy is

aggregate demand. In fact, unlike the aggregate

demand curve, the aggregate supply curve does not

usually shift independently. This is because the

equation for the aggregate supply curve contains no

terms that are indirectly related to either the price

level or output.

AD Shifts & Multiplier Effects

The decline (or increase) in

household income caused by

investment cutbacks (or increase)

will cause an initial shift of the AD

curve (AD0 AD1) to the left (or

right) which in its turn trigger the

multiplier process, causing an

induced shift (multiplier effects)

of the AD curve (AD1 AD2).

Consequently, we have a new AD

curve and a new equilibrium.

Conclusions of Keynes• 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.

The Consumption Function

The consumption function is a mathematical formula laid out by Keynes. The formula was designed to show the relationship between real disposable income and consumer spending.

Where:C = Consumer spendinga = Autonomous consumption, or the level of consumption that would still exist even if income was $0.b = Marginal propensity to consume (MPC), which is the ratio of consumption changes to income changes.YD = Real disposable income.

DC a bY

The Consumption Function (con)

• A sudden change in government spending or exports

could get the multiplier ball rolling.

• The multiplier process could also originate with a

change in consumer spending due to changes in the

consumption function. Because consumer spending (C)

outweighs other components of aggregate demand

(AD), the threat of unexpected changes in consumer

behavior is serious.

Changes in The Consumption Function

• When consumer confidence changes, the value of

a changes and the consumption function shifts.

• A change in consumer confidence also change the

value of b, altering the consumer’s willingness to

spend out of each additional dollar in income.

Consumer Confidence

Consumer confidence is affected by various financial, political, and international events.

Source: University of Michigan

The Official View: Always a Rosy Outlook –> Maintaining Consumer Confidence

Governments often paint a picture of the economy which

is better than what actually exists to avoid declines in

consumer confidence hence changing the level of

consumer spending (C) Trigger a multiplier process.