Economic Instability:

A Critique of the Self-Regulating Economy

Del Mar College, John Daly
2002 South-Western Publishing, A Division of Thomson Learning

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 employers
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 didnt 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

Some believe there are solid
microeconomic reasons for inflexible
wages.
The most interesting and important line of
work in current macroeconomic theory is
the attempt to reconstruct plausible
microeconomic underpinnings for a
recognizably Keynesian macroeconomics.

New Keynesians and Wage Rates

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.

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

Is it a Question of the Time it

Takes for Wages 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.

Keynesians and The Great

Depression
Keynes and the
Keynesians thought
that while their theory
may not be right with
respect to every detail,
there was certainly
enough evidence to
say the classical view
of the economy is
wrong.

Q&A
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?

The Keynesian Framework Of

Analysis

1.
2.
3.

Three Simple Assumptions

The price level is constant
There is no foreign sector
The monetary side of the economy is
excluded.

The Keynesian Framework Of

Analysis
Keynes was interested in the level of total
expenditures (TE) in general, but he 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.

The Consumption Function

Consumption=Autonomous Consumption +
marginal propensity to consume 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

The Consumption Function

Consumption can be
increased in three
ways:
1. Raise autonomous
consumption
2. Raise disposable
income
3. Raise the MPC

The MPC and the MPS

Marginal propensity to save is the ration 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

Deriving a Total
Expenditures
Curve
As disposable
income rises, so
does
consumption
Investment
remains constant
Government
Purchases
remains constant

Comparing Total Expenditures

and Total Production
There are three possible options:
1. Total Expenditures exceeds Total
Production
2. Total Production exceeds Total
Expenditures
3. Total Expenditures equals Total
Production

Moving From Disequilibrium to

Equilibrium
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.
TE>TP: Signals to firms they have under
produced. They increase the quantity of goods
produced, causing Real GDP to rise. Eventually,
TP will equal TE.

Graphical Framework of the Three States of the

Economy in the Keynesian Framework

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
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

The Multiplier and Reality

First, the multiplier takes time to have an
effect. This process can take months.
Second, for the multiplier to increase Real
GDP (the way we have described), idle
resources must exist at each expenditure
round.

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
wouldnt invest more even if the interest rates fell.
The private sector may not be able to get the
economy out of a recession.

Q&A
How is autonomous consumption different
from consumption?
What happens in the economy if total
production (TP) is greater than total
expenditures (TE)?
If the MPS equals 0.23, then what does the
multiplier equal?