Keynesian CircularFlow Analysis LaborBased Macroeconomics The Inherent Instability

Keynesian Circular-Flow Analysis (Labor-Based Macroeconomics) The Inherent Instability of a Wholly Private Economy (according to John Maynard Keynes) Roger W. Garrison 2010

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 FRAMEWORKERS FACTOR OWNERS CONSUMERS INCOME

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 SERRVICES WORKERS FACTOR OWNERS CONSUMERS INCOME

EXPENDITURES BUSINESS ORGANIZATIONS WORKERS FACTOR OWNERS CONSUMERS INCOME

What counts as income? What counts as Spending? SPENDING BY CONSUMERS SPENDING BY BUSINESSES SPENDING BY GOVERNMENT C+I+G BUSINESS ORGANIZATIONS RENTS WAGES In Keynesian equilibrium, INCOME equals EXPENDITURES. Y=E Y=C+I+G WORKERS FACTOR OWNERS CONSUMERS INTEREST PROFITS Y

EXPENDITURES BUSINESS ORGANIZATIONS In Keynesian equilibrium, INCOME equals EXPENDITURES. For a wholly private economy, Y=C+I WORKERS FACTOR OWNERS CONSUMERS INCOME

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 45 o 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 45 o Investment The As taught economy atdepends allislevels, in a INVESTMENT Keynesian the neither consumption on (current) equilibrium C = a + b. Y income somewhere function nor is an on along essential the rate o line—the 45 interest. component of Itofdepends line theitself b identifying Keynesian only on profit all framework. possible income-expenditure The expectations, presumedwhich stability CONSUMPTION equilibrium of themselves this function points. are not underlies Keynesian well-anchored in thinking. reality. economic 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 = a + b. Y CONSUMPTION C+I According to Keynes, it is only by “accident or design” that the economy is actually performing at its fullemployment potential. Yfe INCOME INVESTMENT We assume here that, Labor income Full (Yemployment = WN) implies that the In economy Keynesian is operating macroeconomics, on its initially, full employment is fully representative productionofpossibility frontier, thefull PPF employment itself beingimplies definedthat in the conditions prevail—if only total income, terms such of that sustainable output levelslabor of consumption market clears and at the going by accident. changes in labor investment goods. wage rate, the going wage W income stand in direct itself having emerged during a S proportion to changes in period in which the economy LABOR D INCOME total income. was experiencing no N macroeconomic problems.

EXPENDITURES C ΔI+ I EXCESS INVENTORIES C = a + b. Y INVESTMENT ΔC E= <Y ΔY CONSUMPTION Yfe INCOME According to Keynes, a collapse of investment activity (the collapse being attributed to a waning of “animal spirits”) is the W primary cause economic downturns. In response to reduced Note that the going opportunities, wage keeps “going” S investment and hence reduced employment the —even after the market conditions economy spirals downward into recession and possibly into that D gave rise to it are gone. deep depression. N

EXPENDITURES C+I C = a + b. Y Yfe 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 + b. Y DEFICIENCY OF INVENTORIES INVESTMENT CONSUMPTION 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 + b. Y 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 + b. Y INCOME From full-employment onward, there is upward Recovery may in continue as further investment activity drives The equilibrium points the pressure on both prices labor-demand level. . . there. And is since labor market traced outback to its full-employmentand wagebut 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 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 FACTOR OWNERS CONSUMERS INCOME

Keynesian Circular-Flow Analysis (Labor-Based Macroeconomics) The Inherent Instability of a Wholly Private Economy (according to John Maynard Keynes) Roger W. Garrison 2010