Chapter 10: Self Adjustment or Instability

Keywords: Macroeconomic Equilibrium

A state of national economic
activity

wherein

aggregate

demand is met by aggregate

supply.
Short-run

macroeconomic

equilibrium occurs when the

quantity of GDP demanded

equals the quantity supplied,

which is where the AD and AS
curves intersect.

Keywords: Resource & Product Markets

Resource market is the market where factors of

production are traded, for example: labor, capital,

raw materials, machinery etc.
Product market - is the market where final products

which were produced by means of factors of

production are traded .

Introduction
Self-Adjustment or Instability focus on the adjustment
process how markets respond to an undesirable
equilibrium:
Why does anyone think the market might self-adjust
(returning to a desired equilibrium)?
Why might markets not self-adjust?
Could

market

outcomes?

responses

actually

worsen

macro

The Circular Flow of Income (CFI)

The circular flow is a handy model
of macroeconomic activity that
highlights the interaction between
households
and
businesses
through the product and resource
markets.
The household sector buys
production from the business
sector through the product
markets. Expenditures by the
household sector are consumption
expenditures. Revenue going to the
business sector is gross domestic
product (GDP).

The Circular Flow of Income (con)

The business sector hires factor
services from the household sector

through the resource markets.

Payments made by the business

sector are factor payments. Income

going to the household sector is

national income(NI).

Leakages
Leakage: Income not spent

directly

on

domestic

output in the national

product

market

but

instead diverted from the

circular flow of income;
for

example,

taxes

imports, and saving.

Injection
Injection: An addition of spending to
the circular flow of income. For
example,

exports

from

the

domestic markets (X), investments

(I) and government expenditures
(G).

Leakages & Injections

Three points of leakages and injections that are linked
together are:
1- Taxes
2- Imports
3- Savings

1- Taxes
In reference to taxes paid to the government:
a)Sales taxes are taken out of the circular flow in product
markets.
b)Payroll taxes and income taxes are taken out of
paychecks, so households dont spend that income.

Taxes are considered as a leakage from the CFI.

Ta x e s ( c o n )
however, this enables the government to provide public goods or quasi

public goods that would otherwise be unavailable to society. Along

with this, the money paid from taxes allows the government to

provide many benefits to society such as health care, infrastructure,

education, defense, etc. These provisions from the government allow

for the nation to prosper and are contribute to the national output of
the nation (GDP), hence these are considered injections into the CFI.

2- Imports
In reference to imports (income not spent directly on domestic output in the
national product market) , the domestic households buy imports from foreign

countries, which are considered to be leakages from the CFI because money is
being allocated towards the purchase of goods and services from foreign
product markets.

However, as domestic markets purchase imports from the foreign markets, it

allows the foreign markets to have availability to money that they can then use
to purchase the exports from the domestic markets. The spending on domestic
goods and services by foreign markets allows for money to be put into the CFI,
therefore it is considered to be an injection because this money contributes to
the

national

output.

3 - Saving
In reference to savings:
a) Households savings (disposable income household
consumption)
b) Firms savings (Depreciation allowances and retained
earnings)
They are considered as a leakage from the CFI because this
money is not used and is not put directly into the product
market.

Saving (con)
However, this capital that is saved is now available to the

firms and households to use as money for investments,

for lending, or for purchasing other goods and services.

Hence, as the firms and households put money into the

market for these various reasons, it is considered an

injection into the CFI because there is now more money

in the market and this money will then contribute to
the national output.

Leakages and Injections

INJECTIONS

Government spending
Exports

Investment
Product
market

Households
(disposable
income)

Business Firms

Factor
market

Saving

Imports

Household
taxes

LEAKAGES

Business
taxes

Business
saving

Macro Equilibrium
Injections

of

investment,

government

expenditures, and exports help offset leakages

from saving, imports, and taxes.

Macroeconomic equilibrium is possible only

if Leakages equal Injections.

Macro Equilibrium (con)

LEAKAGES

INJECTIONS

Consumer saving
Business saving
Taxes
Imports

Investment
Government spending
Exports

Macroeconomic equilibrium is possible only if leakages equal

injections.

Self-Adjustment?
Classical economists believed that (1) flexible interest
rates and (2) flexible prices equalize injections and
leakages. Consequently, this flexibility would lead to a
macroeconomic equilibrium.

1 - Flexible Interest Rates

Classical economists believed that If consumption

declines Savings picks up Interest rates will fall

Business investment (injections) will increase to

be equal to consumer saving (leakage)

Macroeconomic equilibrium will return.

Keynes felt that this ignores expectations:

Investment would fall in response to declining sales.

2- Flexible Prices
Classical economists believed that If demand for output falls
Prices will decline Consumers will buy more output
Macroeconomic equilibrium will return.

Again Keynes disagreed with the result:

If prices must be cut to move products, businesses are
likely to rethink present production and futur investment

plans.

The Multiplier Model

The multiplier model is an economic model that was first
proposed by John Keynes (the founders of modern
macroeconomics). The multiplier model is a model
of output determination -- it tells us what the level of

output (GDP) will be, based on the level of aggregate

demand when the price level is fixed The multiplier

model tells us how much the output (GDP) may change as

the aggregate demand

[C + Iplanned + G + (EX IM)]

shifts due to an initial change in its components .

The Multiplier Model (con)

The term multiplier refers to the way that an initial
increase in aggregate demand causes a wave effect
that leads to more and more spending and raises
the GDP by a multiple of that initial increase in
spending. The multiplier answers the question: if
autonomous expenditure rise for some exogenous
reason, how much does total real income (GDP) rise
in equilibrium? .

The Multiplier Process

The main reason why this happens is because when you
spend money, the person who receives that money from
you as payment will turn around and spend some of it. And

the same thing will happen when that person spends his
money -- the person he paid the money to will turn around
and spend some it, too. The chain of spending continues
until there's nothing left to spend.

T h e M u l t i p l i e r P ro c e s s ( c o n )
This multiplier process works both ways, (1) A drop in consumer
spending (2) An increase in unsold inventories firms will react
by (3) Reducing prices and (4) Cutting back the production
(investment spending) which will leads to (5) A reduction in wages
(household incomes) and (6) An increase in unemployment rate
(7) More lost income (8) Even less consumption.
Accordingly, what started off as a relatively small spending shortfall
escalated quickly into a much larger problem.

The Marginal Propensity to Consume (MPC)

The key concept in the multiplier model is the marginal propensity to
consume (MPC) The fraction of an extra dollar of a person's

disposable income that the person will spend on consumer goods.

Multiplier: The multiple by which an initial change in spending will alter

total expenditure after an infinite number of spending cycles.

1
Multiplier
1- MPC

The Total Change in Spending

The total change in spending is equal to the initial
change in spending multiplied by the multiplier:

1
Total change
initial change

in spending
in spending
1- MPC

Hypothetical Example# 1
First off, suppose everyone has the same MPC = (0.75)
- I withdraw $100 from my savings account and spend it all on a leather
jacket.
- Biff, the leather jacket salesman, since he has MPC = 0.75, spends (0.75)*
$100 = $75 (on a hat).
- Cheryl, the hat salesperson, spends (0.75)*$75 = $56 (on a puppy).
- Ralph, the dog breeder, spends (0.75)*$56 = $42 (on a haircut)
- Olga, the hairstylist, spends (0.75)*$42 = $32 (on food).
- and so on.

Note that each subsequent amount spent is 75% of the previous amount.
After many more iterations the amount spent will be so tiny (75% of a
fractional cent) that we can forget about it. But by then the total increase in
spending will have been quite large ( spending = [1 /(1-MPC)] * 100 =
$400).

Hypothetical Example # 2
4. Income reduced by $100 billion

5. Consumption reduced by $75 billion

Households

8. Income reduced by
$75 billion more

9. Consumption reduced
by $56.25 billion more
1. Investment drops
by $100 billion

Factor
markets

10. And so on
7. Further cutbacks in
employment or wages

6. Sales fall $75 billion

Business
firms
3. Cutbacks in employment
or wages

2. $100 billion in unsold

goods appear

Product
markets

Hypothetical Example (con)

Spending Cycles

First cycle
Second cycle
Third cycle
Fourth cycle
Fifth cycle
Sixth cycle
Nth cycle

Change in
Spending During
Cycle

Cumulative
decrease in
Spending

$100.00
75.00
56.25
42.19
31.64
23.73

$100.00
175.00
231.25
273.44
305.08
328.81
400.00
10-31

Hypothetical Example (con)

An initial drop in spending of $100 billion
would decrease total spending by:
1
Total change
initial change

in spending
in spending
1- MPC
1

$100 billion
1- 0.75
4 $100 billion
$400 billion

Shifts in Aggregate Demand

The primary cause of shifts in the economy is
aggregate demand. In fact, unlike the aggregate

demand curve, the aggregate supply curve does not

usually shift independently. This is because the

equation for the aggregate supply curve contains no

terms that are indirectly related to either the price

level or output.

AD Shifts & Multiplier Effects

The

decline

(or

increase)

in

household income caused by

investment cutbacks (or increase)
will cause an initial shift of the AD
curve (AD0 AD1) to the left (or

right) which in its turn trigger the

multiplier process, causing an
induced shift (multiplier effects)

of the AD curve (AD1 AD2).

Consequently, we have a new AD
curve and a new equilibrium.

Conclusions of Keynes
The basic conclusion of Keynesian analysis is
that the economy is vulnerable to changes in
spending behavior and wont self-adjust to a
desired macro equilibrium.
The responses of market participants are
likely to worsen rather than improve market

outcomes.

The Consumption Function

The consumption function is a mathematical formula laid out
by Keynes. The formula was designed to show the
relationship between real disposable income and consumer
spending.

C a bYD
Where:
C = Consumer spending
a = Autonomous consumption, or the level of consumption
that would still exist even if income was $0.
b = Marginal propensity to consume (MPC), which is the
ratio of consumption changes to income changes.
YD = Real disposable income.

The Consumption Function (con)

A sudden change in government spending or
exports could get the multiplier ball rolling.

The multiplier process could also originate with a

change in consumer spending due to changes in the
consumption function. Because consumer spending
(C) outweighs other components of aggregate
demand (AD), the threat of unexpected changes in

consumer behavior is serious.

Changes in The Consumption Function

When consumer confidence changes, the value of a
changes and the consumption function shifts.

A change in consumer confidence also change the

value of b, altering the consumers willingness to
spend out of each additional dollar in income.

Consumer Confidence

Source: University of Michigan

Consumer confidence is affected by various financial, political, and

international events.

The Official View:

Always a Rosy Outlook > Maintaining Consumer Confidence
Governments often paint a picture of the economy which
is better than what actually exists to avoid declines in
consumer confidence hence changing the level of
consumer spending (C) Trigger a multiplier process.