Keynesian Macroeconomics and Economic Instability: A Critique of the Self-Regulating Economy

Based of Ch. 10, Macroeconomics by Roger A. Arnold

Critique of the self-regulating economyLast lecture we learned that an economy can remove itself from a recessionary gap and according to Say’s Law there should not be an inadequate demand in the economy

J.M. Keynes challenged all four of the following classical position beliefs: (1) Say’s Law holds, so that insufficient demand in the economy is unlikely (2) Wages, prices, interest rates are flexible (3) The economy is self-regulating (4) Laissez-faire is the right and sensible economic policyEvidence: The Great Depression

Keynes’s Criticism of Say’s Law in a Money Economy:If saving increases by Tk. 1000 then investment might not increase by Tk. 1000 (it increases less)Total Expenditure would fall, hence, if saving increases then AD might fall…(in class discussion based on 10-1a of Textbook, p. 218-19)

Keynes believed saving and investment wasn’t ONLY dependent on interest rate but other factors as well. And hence flexibility of interest rate in the credit market cannot ensure: saving = investment.

In addition Keynes proposed that the relationship between saving and investment might not always be direct rather they could be inversely related! (Example in class, borrowed from book)

Keynes’s Criticism of Say’s Law in a Money EconomyIf saving increases by Tk. 1000 then investment might not increase by Tk. 1000 (it increases less)Total Expenditure would fall, hence, if saving increases then AD might fall…(in class discussion based on 10-1a of Textbook, p. 218-19)

Keynes believed saving and investment wasn’t ONLY dependent on interest rate but other factors as well. And hence flexibility of interest rate in the credit market cannot ensure: saving = investment.

In addition Keynes proposed that the relationship between saving and investment might not always be direct rather they could be inversely related! (Example in class, based on example from book)

Keynes on Wage Rates

The economy can self-regulate if we assume wage is flexible.

But Keynes argued wages may be inflexible in the downward direction.Since workers and labour unions would resist wage cuts. In addition, firms may not lower wages since it might lead to lower worker productivity and disgruntled workers (dissatisfied workers)

If wage doesn’t fall then economy can’t get our recessionary gap.

Keynes on Prices

In the self-regulatory economy we also assumed that the price level was flexible. When the SRAS curve shifted due to changes in wage rate, the price level changed as well. BUT Keynes argued price level in the economy is not always flexible because of anticompetitive or monopolistic elements in the economy.

Remember from ch. 3: Price moves due to market forces. If there is excess demand. Consumers compete with each other and bid the price up. If there is excess supply, the firms/suppliers compete to each other to sell their excess goods and hence lower the price. But if there are anticompetitive elements in the economy this adjustment won’t happen easily.

Classical Macroeconomists VS KeynesiansKeynesians argue even if these the wages and price levels adjust, it takes to long, and hence the economy can’t be called self regulatory.

If it takes a short (reasonable) amount of time for the economy to get out of the recessionary gap, then we may call it self-regulatory. Classical Macroeconomists believed this was the case. Keynesians disagreed.

Table in p.224 sums up the differences in opinions nicely. Have a look.

The Simple Keynesian Model

Assumptions:1) Price level fixed until the economy reaches its full employment or

Natural Real GDP level2) No foreign sector (Hence no NX, net export)3) Monetary side of the economy is excluded (the credit market)

The Elements of the Keynesian ModelThe Consumption Function: Composed of two parts: 1) is the autonomous consumption which is independent of the disposable income 2) Induced consumption- - depends on disposable income

MPC, marginal propensity to consume =

Example, change in taxes (class discussion)When does C change? When, changes (class discussion)

Consumption and Saving:Saving = Disposable Income – ConsumptionS =

Marginal Propensity to Save (MPS) =

MPC + MPS = 1

Multiplier: If the autonomous consumption of a household increases by 1000 taka then total expenditure in the economy increases by greater than 1000 taka. Sounds strange? …Remember someone’s expense = someone’s income. Hence, the income of another household increases by 1000 taka and that household spends (MPC x 1000) which again ends up as the income of another household…who again spends (MPC x MPC x 1000) = MPC2 x 1000. As you can see there is a domino effect in the economy. This is the multiplier process.

By how much will total expenditure rise? Depends on multiplierMultiplier (m) = Change in total spending = m x change in autonomous spendingJust as consumption has an autonomous consumption component so do government purchases and investment…

The Multiplier and Reality

Summary: A change in autonomous spending (either consumption, investment or government purchases) leads to a greater change in total spending. And assuming price level is fixed (economy operating below Natural Real GDP) then the change in total expenditure is equal to the change in Real GDP.

In reality, the increase in Real GDP takes time and idle resources must exist (which is likely if Real GDP < Natural Real GDP => surplus in the labour market and resources for other market.

If idle resources are not available then GDP increases and not real GDP which implies that only price level increases…

The Simple Keynesian Model In the AD-AS FrameworkShifts in the AD Curve: Exhibit 7 (in class discussion)AD curve shifts twice. First shift is equal to the increase in autonomous expenditure ( and second shifts occur due the multiplier process

The Keynesian AS Curve: Exhibit 8 (in class discussion)Horizontal until Natural Real GDP and vertical at Natural Real GDP.

The Economy In a Recessionary Gap

Exhibit 9 (In class discussion)Here, there is no SRAS and hence no shift of SRAS which caused the economy to return to the LRAS. The only way that the economy can return to Long Run Equilibrium is by an increase in AD. But Keynes argued that consumption and investment could never rise enough to bring the economy back to the LR equilibrium. In a recessionary gap, businesses are pessimistic about future sales and hence a fall in interest rate does not result in a rise in investment spending.

Laissez-Faire no longer feasible…Government has role to play – topic of next chapter.

The Simple Keynesian Model In The TE-TP FrameworkTotal Expenditures (TE) = C + I + GRemember: We are assuming there are no foreign economies. So no NX

The TE curve is upward sloping – Exhibit 11 (d), p. 236

Changes in C, I or G will shift the TE curve. If any one goes up then the TE curve shifts up. Opposite is true as well.

Comparing Total Expenditures (TE) and Total Production (TP)Businesses produce goods and services which are bought in the three sectors of the economy (household, business and government).

The total production of these goods and services can be greater than what the three sectors buy, TP > TE (1)

It could be less than what the three sectors buy, TP < TE (2)

And it could be equal to what the three sectors buy, TP = TE (3)

(1) & (2) Disequilibirum (3) Equilibrium

Moving from Disequilibrium to EquilibriumBusiness firms hold inventory to guard against unexpected changes in demand. In reality, they maintain an optimum inventory – just the right of amount of inventory.

If, TP > TE, then the excess goods and services are added to the inventory. Inventory levels rise above optimum inventory level. This is a signal for firms that they have overproduced so they cut back on production. TP until, TP=TE (equilibrium is reached)

If, TP < TE, Inventory levels below the optimum inventory level which signals to firms they have under-produced and hence they increase their production, TP until TP = TE (equilibrium is reached)

The Graphical Representation of The Three States In The TE-TP FrameworkExhibit 12. Important.

As you can see TE curve is upward sloping. As Real GDP (total quantity of G & S) increases total expenditure in the economy increases. Makes sense.

TP curve is simply a since, Total Production ($) = Real GDP. Remember: Real GDP is the market value of all final G & S produced annually inside the economy, adjusted for price changes.

Equilibrium occurs where the two curves intersect . On the right side of the intersecting point, TP > TE unexpected rise in inventory signals overproduction. Firms cut back on production. Real GDP until (refer to Exhibit 12. Important).

The Economy in a Recessionary Gap and the Role of GovernmentExhibit 13, p. 240. Important. The Economy: In Equilibrium, and in a Recessionary Gap Too(In the TE-TP framework)

At Equilibrium A, Real GDP < Natural Real GDP, hence economy is in a recessionary gap. As evident in the graph, the only way the economy can move towards the LR equilibrium is when the TE curve shifts upwards. Which occurs only if C, I or G rises. Keynes believed the private sector (C and I) cannot do this, hence the government (G) should increase its purchases.