Download Keynesian Circular Flow Analysis: Stabilizing an Inherently Unstable

Keynesian Circular-Flow Analysis
(Labor-Based Macroeconomics)
Stabilizing an Inherently Unstable
Economy with Government Spending
Roger W. Garrison
2008
EXPENDITURES
BUSINESS
ORGANIZATIONS
In Keynesian equilibrium,
INCOME
equals EXPENDITURES.
The
Keynesian
Circular Flow
in a Mixed Economy
Y=E
Y=C+I+G
But T = 0
WORKERS
INCOME
FACTOR
OWNERS
CONSUMERS
EXPENDITURES
C+I+G
C+I
GOVERNMENT
INVESTMENT
C
CONSUMPTION
45o
INCOME
INCOME
o line
too,
IfInvestment,
The
Government
no 45
taxes
are
(Y
spending
being
= is
E)the
stillis
same
as
inthe
a wholly
defines
collected
now the
allthird
(implying
component
possible
that the
private
economy,
implying
Keynesian
government
of total spending.
equilibria,
spending
While
but
is
either
that
government
now
facilitated
some
total
of
this
spending
by
borrowed
spending
(E) is
borrowing
doesn’t
impinge
includes
funds
considered
or by
government
newly
essential
printed
for
on
rates to
or that
spending
money),
theinterest
government
consumption
(G).
investment
spending
is in
behavior
function,isadditional
the
same as
interest-rate
ainsensitive
spending
wholly private
istomade
economy
with an
changes.
(C
eye
=a
to+itsbY).
overall effect on
the macroeconomy.
Consumption, Investment, and Government Spending are additive
components of total spending---the components themselves being
distinguished by their stability characteristics: stable (C ), unstable
(I), and stabilizing (G). The equilibrium income is now marked by
the intersection of the equilibrium condition (Y = E) and the
aggregate spending schedule (E = C + I + G).
EXPENDITURES
C+I+G
C+I
C
45o
INCOME
Yfe
We assume that, if only by “accident or design,” the economy is
initially functioning at its full-employment level and without inflation.
The demand for labor is strong enough to clear the labor market at
W
the going wage rate;
and the corresponding demand for output is
S
strong enough to clear all output
markets at their downwardly
sticky prices.
D
N
EXPENDITURES
C+I+G
C+I
ΔI
ΔY
1
ΔY = (1 – b) ΔI
45o
Yeq
Yfe
W
S
D
N
INCOME
C
Suppose now that a loss
of business confidence
causes investment
spending to fall by ΔI.
The economy responds,
not by adjustments in
prices, wages, and/or
interest rates but by
spiraling downward into
recession.
The magnitude of the change in income
(ΔY) is determined by applying the
spending multiplier. The economy is now
stuck in what Keynes called an
unemployment equilibrium.
EXPENDITURES
C+I+G
ΔG
ΔY
C+I+G
C
C+I
1
ΔY = (1 – b) ΔG
To restore full employment,
policymakers need to
compensate for the
decrease in investment
spending by increasing
government spending.
45o
Yeq
INCOME
Yeq = Yfe
By “design” (and despite the lack
of business confidence and the
stickiness of wages and prices),
the economy isWperforming at its
full-employment potentialSand
without inflation.
D
N
The economy responds to
this fiscal stimulant by
spiraling upwards,
retracing its steps to the
full-employment level of
income.
Once again, the spending
multiplier is in play.
EXPENDITURES
C+I+G
C+I
C
45o
Yfe
So, imagine an economy
with the interest rate out of
play, with downwardly
sticky prices and wage
rates, and with an
business community ruled
by psychological forces.
INCOME
Currently, the total spending in the economy happens to be just
enoughthis
but not
too much:
It’s just
enough,
means
there’s no
…and
is what
Keynes
calls
The which
General
Theory.
unemployment problem; it’s not too much, meaning that inflation
isn’t a problem, either.
And mercifully, fiscal agents stand at the ready, continuously
offsetting any changes in investment spending with equal-butopposite changes in government spending, thereby maintaining a
stability that the market economy itself could never achieve.
…and this is what Keynes calls The General Theory.
Keynesian Circular-Flow Analysis
(Labor-Based Macroeconomics)
Stabilizing an Inherently Unstable
Economy with Government Spending
Roger W. Garrison
2008