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The Debate on Self-Adjustment or Instability

John Maynard Keynes challenged the classical assertion of self-adjustment to full

employment.

Keynes argued that the economy could stagnate in persistent unemployment or have
continuing inflation.

The debate started in the 1930s and is ongoing.

This chapter focuses on how markets respond to an undesirable equilibrium.

Core questions include why markets might self-adjust, why they might not, and whether
market outcomes can worsen macro outcomes.

Leakages in the circular flow include saving, imports, and taxes.

Injections in the circular flow include investment spending, government spending, and
exports.

For macro equilibrium, leakages must equal injections.

Classical economics claims that leakages always equal injections, with flexible interest
rates as a mechanism.

Keynes argued that changing expectations would lead to decreased consumption and
GDP.

Classical economics suggests that rising inventory triggers falling prices, resulting in
increased selling and shifting of AD.

Keynes argued that as prices fall, businesses reduce production and eliminate investment
plans, leading to high unemployment.

Keynes saw the economy becoming more unstable as businesses react to declining sales
and lowered expectations.

Reduced production leads to decreased household income and less spending, shifting AD
further away from full employment.

The multiplier process involves steps such as investment decline, unsold output,
production cutbacks, and decreased consumer spending.

The eventual decrease in spending and shift of AD to the left will be much larger than the
initial decline and shift.

The Multiplier Process in Economics

The multiplier process operates in reverse.

Steps of the multiplier process:

 Investment increases and shifts AD (aggregate demand) right.

Inventory depletes, causing prices to rise.

Production is increased.

Income increases.

Consumer spending increases.

Go back to step 2.

The eventual increase in spending is larger than the initial increase.

The eventual shift of AD to the right is larger than the initial shift.

The multiplier is the factor by which an initial change in spending alters total expenditure.

The multiplier equation: 1/(1 - MPC)

MPC (Marginal Propensity to Consume) determines the size of the multiplier.

If MPC decreases, the multiplier gets smaller; if MPC increases, the multiplier gets larger.

Examples of calculating the multiplier for different MPC values.

An exercise in calculating the multiplier for specific MPC values.

Example exercise of calculating total change in spending using the multiplier.

Keynesian Adjustment Process: producers cut output and employment when output
exceeds AD, leading to a decline in consumer spending, further production cutbacks, job
loss, and decreased consumption.

Notes on AD shifts and GDP gaps

The recessionary GDP gap is the difference between equilibrium GDP (QE) and full-
employment GDP (QF), indicating unused production capacity in an under-producing
economy.

The AS curve slopes upward, and an increase in AD causes output, prices, and
unemployment to rise. To close the recessionary GDP gap, the economy must move to
point h, not point f.

The inflationary GDP gap is the difference between equilibrium GDP (QE) and full-
employment GDP (QF), showing the economy producing above full-employment GDP with
inflationary pressure.

Demand-pull inflation occurs when AD pushes too far to the right, generating an
inflationary GDP gap. Excessive AD causes prices to rise.

Keynes concluded that changes in spending behavior can lead to booms and busts in the
 economy, as the economy won't self-adjust to a desired macro equilibrium.

Consumer confidence plays a vital role in the economy. Changes in spending, such as
saving instead of spending or paying back debt rather than borrowing, can affect the
multiplier process and shift AD left.

Maintaining consumer confidence is crucial, as an increase or decrease in confidence can

impact AD. A decline in consumer confidence may require a positive official view of the
economy.

The circular flow has leakages (consumer saving and taxes, business saving and taxes,
and imports) and injections (investment spending, government spending, and exports).

The multiplier is a sequential process that occurs when an abrupt change in spending
(injections) shifts the AD curve. The size of the multiplier is determined by the size of MPC
and is equal to 1/(1-MPC).

Recessionary GDP gaps occur when the macro equilibrium GDP is smaller than full-
employment GDP, while inflationary GDP gaps occur when the macro equilibrium GDP
exceeds full-employment GDP.

Chapter 11 will cover fiscal policy, the difference between the real GDP gap and the AD
shortfall, and their significance.

Tools and Scope of Fiscal Stimulus and Restraint

Fiscal stimulus tools and their desired scope are discussed.

The excess measures of aggregate demand (AD) are mentioned in relation to fiscal
stimulus.

The tools of fiscal restraint and their desired scope are explained.

The impact of the multiplier on fiscal policy is discussed.