Keynesian Circular Flow Analysis Stabilizing an Inherently Unstable

Keynesian Circular Flow Analysis Stabilizing an Inherently Unstable Economy with Government Spending 2006

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 FACTOR OWNERS CONSUMERS INCOME

EXPENDITURES C+I+G C+I GOVERNMENT INVESTMENT C CONSUMPTION 45 o INCOME o line too, If. Investment, 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 = to a +itsb. Y). overall effect on the macro-economy. 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 45 o 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 45 o 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. And 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. 45 o Yeq INCOME Yeq = Yfe By “design” (and despite the lack of business confidence and the stickiness of wages and prices), the economy is. Wperforming at its full-employment potential. Sand without inflation. D N The economy responds to this fiscal stimulant by spiraling upwards, retracing its steps to the fullemployment level of income. Once again, the spending multiplier is in play.

EXPENDITURES C+I+G C+I C 45 o 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 just happens to be just enough butwhat not too much: It’s just. The enough, which means …and this is Keynes calls General Theory. there’s no 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 Stabilizing an Inherently Unstable Economy with Government Spending 2006