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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