CHAPTER 10 – SELF-ADJUSTMENT OR INSTABILITY?

I. Introduction
A. Keynesian view of macroeconomics emphasizes that:

1. Macro failure is likely to occur in a market-driven economy.

2. Macro failure is likely to persist.

B. Classical economists agreed with the first point but believed the economy would quickly self-adjust.

C. This chapter focuses on the adjustment process that changes macro outcomes, especially:

1. Why does anyone think the market might self-adjust (returning to a desired equilibrium)?

2. Why might the market not self-adjust?

3. Could market responses actually worsen macro outcomes?

II. Leakages and injections
A. Consumer Saving

1. Full-employment GDP – The total market value of final goods and services that could be produced in a given time period at full employment: potential GDP

2. Leakage – Income not spent directly on domestic output, but instead diverted from the circular flow, for example, saving, imports, taxes.

3. The Circular Flow (Figure 10.1, Page 199)

• The income generated in production doesn’t return completely to product markets in the form of consumer spending.

• Business investment, government purchase of goods and services, and exports inject spending into the circular flow.

• The focus of macro concern is whether desired injections will offset desired leakage at full employment.

4. Leakage and AD (Figure 10.2, Page 200)
   Disposable income is only about 70 percent of total income and consumers save some of their disposable income.

B. Imports and taxes

1. Saving is not the only source of leakage

2. Imports also represent leakage from the circular flow.

3. Taxes are a form of leakage as well.

C. Business Savings

1. Gross Business Saving – Depreciation allowances and retained earnings.

2. Business saving is also a leakage from the circular flow of income.

D. Injections into the Circular Flow
Injection – An addition of spending to the circular flow of income.

E. Self-Adjustment?

1. Flexible Interest Rates

• If consumer spending exceeds business investment, unspent income must be piling up somewhere.

• In the classical view, the interest rates fall far enough so that business investment equals consumer saving.

2. Changing Expectations

• Keynes argued that classical economists ignored expectations.

• He thought investment spending would not increase in response to declining sales.

3. Flexible Prices

• If prices fall when less output than is produced, then prices could fall to produce full employment.

4. Expectations (again)

• Keynes argued that declining prices likely would prompt investment cutbacks, not full employment.

III. The Multiplier Process
A. The emergence of a recessionary gap is a critical turning point in the economy’s performance.

Undesired Inventory

1. When a recessionary gap emerges, producers are unable to sell all the goods that they had hoped to.

2. The unsold goods pile up as inventory.

3. To keep track of these unwanted changes in investment, we distinguish desired (or planned) investment from actual investment.

4. Formula:

Actual Investment = Desired Investment + Undesired Investment

F. Falling Output and Prices (Figure 10.4, Page 202)

1. Business firms are most likely to react to undesired inventory buildups by cutting prices and reducing the rate of new output.

B. This reduction in inventory investment and output will multiply throughout the economy over time.

C. Household Incomes

1. As firms cut back production in a recession they usually cut wages, employment, or both.

2. A reduction in investment spending implies a reduction in household incomes.

3. In The News: “Small Business Hold Off on Big Purchases”
   The article describes cutbacks by small firms in their capital spending based on a 2001 survey by the National Federation of Independent Businesses.

D. Income-Dependent Consumption (Figure 10.5, Page 206)

1. If disposable income falls, we expect consumer spending to drop as well.

2. The consumption function tells how much spending will drop.

3. The marginal propensity to consumer (MPC) is the critical variable in this process.

4. Marginal Propensity to Consumer (MPC) – The fraction of each additional (marginal) dollar of disposable income spent on consumption; the change in consumption divided by the change in disposable income.

5. The Multiplier (Table 10.1, Page 206)

• The decline in spending will be much larger than the initial (autonomous) spending decrease.

• Multiplier – The multiple by which an initial change in aggregate spending will alter total expenditure after an infinite number of spending cycles; (1/(1-MPC).

• Formula:

Multiplier =	1
	1 - MPC

• The cumulative decease in total spending resulting from the appearance of a recessionary gap at full employment is equal to the gap multiplied by the multiplier.

• In The News: “Companies Begin Another Round of Job Cuts”
  In 2001, companies that already laid off workers are doing so again.

• World View: “U.S. Slowdown Helps Derail Asia”
  The US high-tech slump is affecting Asia. The article lists cutbacks in Japan, Taiwan, and China

IV. Macro Equilibrium Revisited
A. The key feature of the Keynesian adjustment process are:

• Producers cut output and employment when output exceeds desired spending.

• 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.

B. 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. (Figure 10.6, Page 209)

C. Price and Output Effects (Figure 10.7, Page 210)

1. The impact of a shift in aggregate demand is reflected in both output and price changes.

2. The Real 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.

• The Real GDP gap equals the difference between the equilibrium real output (QE) and full-employment real output (QF)

3. GDP gap (real) – The difference between full-employment GDP and equilibrium GDP.

4. The real GDP gap represents the amount by which the economy is underproducing during a recession, the classic case of cyclical unemployment.

5. Cyclical Employment – Unemployment attributable to a lack of job vacancies, i.e., to an inadequate level of aggregate demand.

D. Short-Run Inflation- Unemployment Trade-Offs (Figure 10.8, Page 210)

1. 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.

2. “Full” vs. “Natural” Unemployment

• Full Employment – The lowest rate of unemployment compatible with price stability; variously estimated at between 4 and 6 percent unemployment.

3. The closer the economy gets to capacity output, the greater the risk of inflation.

4. Not everyone accepts this notion of full employment

5. Neoclassical and monetarist economists prefer to focus on long-run outcomes. In their view, the long-run AS curve is vertical and there is no unemployment-inflation trade-off.

V. ADJUSTMENT TO AN INFLATIONARY GAP
A. Increased Investment (Figure 10.9, Page 211)

1. An increase in investment spending shifts the aggregate demand curve to the right.

2. Inventory Depletion

• When AD increases due to increased investment available inventories shrink.

• Investors can increase spending quicker than firms can increase their production.

• Desired investment falls below actual investment.

• Decline in inventory investment alerts producers that it might be a good time to raise prices.

• Inventory depletion is a warning sign of impending inflation.

B. Household Incomes – when investment increases, household incomes get a boost as producers increase their output to rebuild inventories and supply more investment goods. To do so producers must hire more workers or extend working hours.

C. Induced consumption – (Table 10.1 and Figure 10.9, Page 211)

• As household income increases, consumers purchase more goods and services.

• The amount of this induced consumption is suggested by the marginal propensity to consume.

• Eventually consumer spending increases by a multiple of the income change.

• The induced consumption combined with the multiplier effect shifts AD to right a second time

D. A New Equilibrium

1. The increase in AD causes both output and prices to increase. This increase in the average price level is known as demand-pull inflation.

2. Demand-pull inflation – An increase in the price level initiated by excessive aggregate demand.

E. Booms and Busts

1. The Keynesian analysis concludes that the economy is vulnerable to abrupt changes in spending that won’t self adjust.

2. The result is recurring business cycles consisting of alternating AD shifts and multiplier effects.

VI. THE ECONOMY TOMORROW
A. Maintaining Consumer Confidence

1. The basic conclusion of the Keynesian analysis is that the economy does not self-adjust.

2. Instead, the economy may end up stabilizing at price or output levels that are far removed from our macro goals of full-employment and price stability.

B. Consumer Confidence

1. Consumer spending consists of two components:

• Autonomous (represented by the letter ‘a’ in the consumption function)

• Induced (represented by the letters ‘bY’ in the consumption function)

2. Autonomous consumption is influenced by non-income factors, including consumer confidence.

3. When consumer confidence changes, the value of ‘a’ changes and the consumption function shifts.

4. 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.

5. In the News: “Harris Poll: Wiser but Unbowed”
   An August 2001 poll found US adults believing that good times will return despite the slowing economy.

6. World View: “Thrift Shift – The More the Japanese Save for a Rainy Day, The Gloomier it Gets”
   This Wall Street Journal article discusses how the high savings rate in Japan is depressing their economy. When Japanese consumers became more pessimistic about their economy, the started saving more and spending less. This shifted AD leftward and deepened the recession

C. The Official View: Always A Rosy Outlook

1. Because consumer spending vastly outweighs any other component of aggregate demand, the threat of abrupt changes in consumer behavior is serious.

2. Recognizing this, public officials strive to maintain consumer confidence in the economy tomorrow, even when such confidence might not be warranted.

3. With consumers in mind, governments often paint a picture of the economy that is better than what actually exists.

COMMON STUDENT ERRORS

Students often believe the following statements are true. The correct answer is explained after the incorrect statement is presented.

1. Since saving and investment must be the same by definition, a closed economy must be at expenditure equilibrium because investment equals saving. If there are excess inventories or if people are forced to save because they cannot spend on desired goods and services, then the income level may be different from equilibrium income. Do not confuse actual investment and actual saving with intended investment and intended saving.
    

2. If consumers save more, interest rates will fall and investment will rise. Interest rates may fall because increased saving. However, Keynes showed that businesses might invest less when they expect to sell less. The lower consumption that results from increased saving may actually cause businesses to reduce investment.
    

3. Expenditure equilibrium and full-employment GDP are always the same. Expenditure equilibrium and full-employment GDP are determined in different ways. The full-employment GDP occurs at the GDP level there is no significant inflationary pressure. This may or may not be the output level where the economy reaches an expenditure equilibrium (where AS intersects AD).