Chapter 5:

Economic Instability
:
A Critique of the Self-Regulating Economy
:
Keynesian
Questioning the Classical Position

• According to Keynes, it was possible for saving to increase

and aggregate demand to fall.

• Individuals save and invest for a host of reasons, and that no

single factor, like the interest rate, links these activities.

• Saving is more responsive to changes in income than to

changes in the interest rate.

• Investment is more responsive to technological changes,

business expectations, and innovations rather than the
interest rate.
Keynes on Interest Rates

• Both saving and investment depend on a number of factors

that may be far more influential than the interest rate.

• The interest rate is important in determining the level of

investment, but other variables are more important such as
the expected rate of profit.
Keynes on Wage Rates

• Employees will naturally resist an employer’s efforts

to cut wages.

• Wages may be inflexible in a downward direction.

• The economy is inherently unstable – it may not

automatically cure itself of a recessionary gap.

• The economy may not be self-regulating.

New Keynesians and Wage Rates

• Many criticized Keynes because it didn’t offer a

rigorous and complete explanation of inflexible wages.

• Long-Term labor contracts are often advantages for

both employers and workers.

• These contracts have costs, but many believe the

benefits clearly outweigh the costs.

• Workers and Employers use Long-Term contracts for

mutually beneficial advantages.
New Keynesians and Wage Rates (Contd.)

• Efficiency wage models provide a solid

microeconomic explanation for inflexible wages and
thus are capable of explaining why continuing
unemployment problems exist in some economies.

• Some believe there are solid microeconomic reasons

for inflexible wages.
Efficiency Wage
Keynes on Prices

• The internal structure of an economy is not always

competitive enough to allow prices to fall.

• Keynes suggested that anticompetitive or monopolistic

elements in the economy sometimes prevent price
from falling.
Differences:
Is It a Question of the Time It Takes for Wages
and Prices to Adjust?

• Wages and prices are not flexible (in a downward direction) and
may not adjust downward in a recessionary gap.

• Many economists today take a position between Keynes and the

classical economists.

• For them, the question is not whether wages and prices are
flexible downward, but how long it takes for the wages and
prices to adjust.

• The Keynesian position is the time is long enough to say that the
economy is not self-regulating.

• Instead, the economy is inherently unstable: it can exist in a

recessionary gap for a long time.
SELF-TEST

1. What do Keynesians mean when they say the economy is

inherently unstable?

2. “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.

3. According to Keynes, why might aggregate demand be too

low?
The Keynesian Framework Of Analysis

3 Simple Assumptions:

1. The price level is constant

2. There is no foreign sector

3. The monetary side of the economy is excluded.

The Keynesian Framework Of Analysis (Contd.)

• Keynes was interested in the level of total expenditures (TE) in

general, but he was particularly concerned with Consumption.

• Total Expenditures (TE) = C + I +G

• Consumption depends on disposable income.

• Consumption and disposable income move in the same direction.

• Yd = C + S → C = Yd – S

• When disposable income changes, consumption changes by less.

The Consumption Function

• Consumption = Autonomous Consumption (C0)

+
marginal propensity to consume (MPC) X disposable income (Yd)

→ C = Co + MPC(Yd)
→ C = Co + bYd

• MPC is equal to the change in consumption divided by the change in

disposable income.

→ MPC=  C/  Yd
The Consumption Function (Contd.)

• Consumption can be increased/decreased in 3 ways:

C = Co + MPC(Yd)
1. Raise/reduce in autonomous consumption
2. Raise/reduce in disposable income
3. Raise/reduce the MPC
The Saving Function
C + S = Yd → S = Yd - C

→C = Co + MPC(Yd)

S = Yd - C
= Yd - [Co + MPC(Yd)]
= Yd - Co - MPC(Yd)
= - Co + Yd - MPC(Yd)
= - Co + (1 – MPC)Yd
= - Co + (MPS)Yd

→ MPS + MPC = 1 → MPS = 1 - MPC

→ C = Co + MPC(Yd) → S = - Co + (1 – MPC)Yd
The MPC and the MPS

• Marginal propensity to save (MPS) is the ration of change in saving

to the change in disposable income

• MPS =  S/  Yd
→ C = Co + MPC(Yd) → S = - Co + (1 – MPC)Yd

• YD = C + S

→ C = Co + MPC(Yd) → C = 100 + O.8Yd

→ S = - Co + Yd (MPS) or - Co + Yd (1 – MPC)

→ S = - 100 + 0.2Yd
Deriving a Total Expenditures Curve:
1. As disposable income
rises, so does
consumption

2. Investment remains
constant.

3. Government
Purchases remains
constant.

4. TE = C + I +G
Comparing Total Expenditures (TE) and Total Production (TP)

There are 3 possible options:

1. Total Expenditures exceeds Total Production (TE > TP)

2. Total Production exceeds Total Expenditures (TP > TE)

3. Total Expenditures equals Total Production (TE = TP)

Graphical Framework of the Three States of the Economy in the
Keynesian Framework
 Moving From Disequilibrium to Equilibrium

1. TE < TP

• Signals to firms they have overproduced.

• Firms cut back on goods they produce, lowering

Real GDP closer to output levels where economy is
willing to buy.

• Eventually, TE will equal TP.

Moving From Disequilibrium to Equilibrium (Contd.)

2. TE > TP:

• Signals to firms they have underproduced.

• They increase the quantity of goods produced,

causing Real GDP to rise.

• Eventually, TP will equal TE.

SELF-TEST

1. How is autonomous consumption different from

consumption?

2. What happens in the economy if total production (TP) is

greater than total expenditures (TE)?
 Can the Economy be in a Recessionary Gap and be in
Equilibrium, too?

• The economy is in
equilibrium, producing
QE, but the Natural
Real GDP is level is QN.

• Because the economy

is producing at a Real
GDP level less than the
Natural Real GDP, it is
in a recessionary gap.
The Multiplier (m)
• Autonomous spending is any expenditure that is not related to a
change in income or Real GDP.

• The multiplier is the number that is multiplied by the change in any

autonomous spending component of total expenditures to give us the
change in Real GDP.

• Multiplier (m) =1 / (1- MPC)

•  Real GDP = m x  Autonomous Spending

What Does the Keynesian Aggregate Supply Curve
Look Like?

• If aggregate demand rises from AD1 to AD2, Real GDP rises, but there is
no change in price level.

• If aggregate demand falls from AD1 to AD3, Real GDP falls and there still
is no change in price level.
 Keynes on the Private Sector

• Can the private sector increase its autonomous spending, shift the
AD curve to the right, and thus remove the economy from
recessionary gap?

• A change in interest rates, or business expectations , or both can

cause a change in autonomous investment spending.

• Investment is not always responsive to lower interest rates.

• Business expectations with respect to future sales could be so

negative that businesses wouldn’t invest more even if the interest
rates fell.

• The private sector may not be able to get the economy out of a
recession.
The Theme of the Simple Keynesian Model
• In terms of AD and AS, the essence of the simple Keynesian model can
be summarized in five statements:

1. The price level remains constant until Natural Real GDP is reached.
2. The AD curve shifts if there is a change in C, I, or G.
3. According to Keynes, the economy could be in equilibrium and in a
recessionary gap too.
4. The private sector may not be able to get the economy out of a
recessionary gap. In other words, the private sector (households and
businesses) may not be able to increase C or I enough to get the AD
curve to intersect the AS curve.
5. The government may have a management role to play in the
economy. According to Keynes, government may have to raise
aggregate demand enough to stimulate the economy to move it out
of the recessionary gap and to its Natural Real GDP level.
SELF-TEST

1. Suppose that prices are not fixed and there are no idle
resources. Can a rise in autonomous spending raise Real
GDP by some multiple of the amount of the rise? Explain
your answer.

2. If the MPS equals 0.23, then what does the multiplier

equal?

3. What is the relationship between a change in Real GDP

(assuming a change in autonomous spending) and (the size
of) the MPC?