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Keynesian Circular-Flow Analysis
(Labor-Based Macroeconomics)
The Inherent Instability
of a Wholly Private Economy
(according to John Maynard Keynes)
Roger W. Garrison
2006
The Keynesian Vision
Keynes’s vision of the economy suggests a circular-flow
framework—in which earning and spending are brought
into balance by changes in the level of employment.
The Income-Expenditure Framework
Graphically, the circular flow appears as the
Keynesian cross, the cross’s intersection identifying
the particular state of the economy in which income
and expenditures are in balance.
BUSINESS
ORGANIZATIONS
LABOR
AND OTHER
FACTOR SERVICES
THE
CIRCULAR-FLOW
FRAMEWORK
WORKERS
INCOME
FACTOR
OWNERS
CONSUMERS
BUSINESS
ORGANIZATIONS
EXPENDITURES
LABOR
AND OTHER
FACTOR SERVICES
Let the speed of rotation indicate the
strength (fast) or weakness (slow) of
the economy.
GOODS AND
SERVICES
WORKERS
INCOME
FACTOR
OWNERS
CONSUMERS
EXPENDITURES
BUSINESS
ORGANIZATIONS
In Keynesian equilibrium,
INCOME equals EXPENDITURES.
Y=E
For a wholly private economy,
Y=C+I
WORKERS
INCOME
FACTOR
OWNERS
CONSUMERS
EXPENDITURES
EXPENDITURES, which constitute
the left half of the circular flow, is
represented on the vertical axis.
INCOME, which constitutes the
right half of the circular flow, is
represented on the horizontal axis.
E=Y
45o
INCOME
The circular character of the flow suggests an equality of
left-half flow and right-half flow---as represented by a
forty-five degree line passing through the origin.
EXPENDITURES
C+I
1
a
45o
Investment
The
As
taught
economy
atdepends
allislevels,
in a
INVESTMENT
Keynesian
the
neither
consumption
on (current)
equilibrium
C = a + bY income
somewhere
function
nor
is an
on
along
the the
rate
o line—the
45interest.
essential
of
component
It depends
line itself
b
identifying
of
only
theonKeynesian
profit
all possible
income-expenditure
framework.
expectations,
The
which
CONSUMPTION
equilibriumstability
presumed
themselves
points.
are notof
this function underlies
well-anchored
in
Keynesianreality.
economic
thinking.
INCOME
Keynes would say the
investors are moved
Consumption and Investment (as well as Government
Spending)
by the “animal
spirits.”
are portrayed as additive components of total spending. The three
components are distinguished largely in terms of their stability
characteristics: stable (C ), unstable (I), and stabilizing (G).
INCOME
A wholly private macroeconomy achieves an income-expenditure
equilibrium when Y = C + I. Note that income itself (rather than
prices, wages, or the interest rate) is the equilibrating variable.
EXPENDITURES
C+I
C = a + bY
C = 120 + 0.60Y
b = 0.60
I = 240
1
In equilibrium, Y = E
a = 120
a
So, Y = C + I
Yeq = 900
INCOME
Y = a + bY + I
Suppose that a = 120 and b = 0.60.
Y = 120 + 0.60Y + 240
And suppose we know that investors
are spending 240 on investment goods.
Y – 0.60Y = 120 + 240
Can we calculate the equilibrium level
of income that corresponds to these
parameters?
0.40Y = 360
Y = 900
EXPENDITURES
C = a + bY
CONSUMPTION
C+I
According to Keynes, it is
only by “accident or design”
that the economy is actually
preforming at its fullemployment potential.
Yfe
INCOME
INVESTMENT
We assume here that,
Labor incomeThough
(Y = WN)
not emphasized by Keynes,
In Keynesian
full employment
macroeconomics,
implies
initially, full employment
is fully representative
that the economy
of
is operating onfull
itsemployment
production possibility
implies that
conditions prevail—if only
total income, frontier,
such that
the PPF itself being defined
the labor
in terms
market
of sustainable
clears at the
by accident.
changes in labor
output levels of consumption and
going
investment
wage rate,
goods.
the going
W
income stand in direct
wage itself having emerged
S
proportion to changes
during a period in which the
LABOR
D
INCOME
in total income.
economy was experiencing no
N
macroeconomic problems.
EXPENDITURES
C+I
C = a + bY
Yfe
INCOME
OUTPUT
REAL
INCOME
C+I
LABOR
INPUT
REAL
WAGE
RATE
S
D
LABOR
INPUT
EXPENDITURES
C+I
C = a + bY
Yfe
INCOME
EXPENDITURES
C
ΔI+ I
EXCESS INVENTORIES
C = a + bY
INVESTMENT
1
ΔY = (1 – b) ΔI
ΔY
900
Yfe
E=
<Y
The simple investmentspending multiplier,
1/(1-b), quantifies the
extend of the downward
spiraling.
CONSUMPTION
INCOME
INCOME
According to Keynes, a collapse of investment activity (the
collapse being attributed to a waning of “animal spirits”) is the
primary cause economic downturns. In response to reduced
W and hence reduced employment opportunities, the
investment
Note
the going
wage
keeps
S
economy spirals downward
intothat
recession
and
possibly
into
going—even after the market
deep depression. D
conditions that gave rise to it are
N
gone.
EXPENDITURES
ΔI = 100
C
ΔI+=I 100
C = a + bY
1
ΔY = (1 – b) ΔI
ΔY
ΔY
1
ΔY = (1 – 0.6) (100) = 250
1
ΔY = (1 – 0.6) (100) = 250
400
650
900
INCOME
A further loss of confidence
In theon
Keynesian
the part of
construction,
the business
prices and the
community will send the
wage
economy
rate are
even
sticky
further
downward.
from its fullemployment potential.
But note that they’re not stuck too high.
W
They’re stuck just right. The going wage rate
S
will clear the labor market once again—as
D
soon as spending and hence labor demand
recover to their full-employment levels.
N
EXPENDITURES
C+I
C = a + bY
900
Yfe
INCOME
Recovery may be self-initiating. Waning animal spirits may
become waxing animal spirits. In due time, a pressing need to
maintain or replace depreciating capital may account for the
lower turning
W point of a bust-and-recovery sequence.
S
(Keynes, of course, preferred not to wait it out. He advocated
D
make-work projects, deficit spending, and monetary stimulation
N
to get the economy turned
around.)
EXPENDITURES
C+I
C = a + bY
INCOME
Yfe
Recovery may continue as further investment activity drives
labor-demand back to its full-employment level...
W
S
D
N
EXPENDITURES
C+I
C = a + bY
INCOME
From full-employment
onward, there is upward
Recovery
may in
continue as further investment
activity
drives
The equilibrium
points
pressure
on both
prices
level...
but
thereAnd
is since
the laborlabor-demand
market tracedback
out to its full-employmentand
wage
rates.
nothing
about
the and
recovery
during the
recovery
and“animal spirits” that will bring
prices
wage rates are
process
an end at full
W employment.
inflationary
spiraltoconstitute
not sticky upwards, the
S
the so-called L-shaped
economy experiences a
Over-optimism may push the economy beyond
its inflation.
fullsupply curve.
spiraling
D
employment level.
Yfe
N
EXPENDITURES
C+I
C = a + bY
Yfe
Y=C+I
C=C
Y–C=I
S=I
INCOME
Even in Keynesian equilibrium, saving
equals investment. But it’s not the interest
rate that does the equilibrating.
Rather, it’s income that adjusts (spirals up
or spirals down) until the savinginvestment equality is established.
EXPENDITURES
BUSINESS
ORGANIZATIONS
Dealing with the inherent instability
of the economy, according to Keynes,
requires policy activism. Well-gauged
and well-timed fiscal policy (changes
in government spending and the level
of taxation) can counter the
recessionary and inflationary forces
that are deeply rooted in capitalism.
WORKERS
INCOME
FACTOR
OWNERS
CONSUMERS
Keynesian Circular-Flow Analysis
(Labor-Based Macroeconomics)
The Inherent Instability
of a Wholly Private Economy
(according to John Maynard Keynes)
Roger W. Garrison
2006