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Keynesian Circular-Flow Analysis

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Title: Keynesian Circular-Flow Analysis


1
Keynesian Circular-Flow Analysis (Labor-Based
Macroeconomics)
The Inherent Instability of a Wholly Private
Economy (according to John Maynard Keynes)
Roger W. Garrison 2006
2
The Keynesian Vision
Keyness vision of the economy suggests a
circular-flow frameworkin 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 crosss intersection
identifying the particular state of the economy
in which income and expenditures are in balance.
3
BUSINESS ORGANIZATIONS
LABOR AND OTHER FACTOR SERVICES
THE CIRCULAR-FLOW FRAMEWORK
WORKERS FACTOR OWNERS CONSUMERS
INCOME
4
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 SERVICES
WORKERS FACTOR OWNERS CONSUMERS
INCOME
5
BUSINESS ORGANIZATIONS
EXPENDITURES
WORKERS FACTOR OWNERS CONSUMERS
INCOME
6
BUSINESS ORGANIZATIONS
EXPENDITURES
In Keynesian equilibrium, INCOME equals
EXPENDITURES. Y E Y C I G
WORKERS FACTOR OWNERS CONSUMERS
INCOME
7
BUSINESS ORGANIZATIONS
EXPENDITURES
In Keynesian equilibrium, INCOME equals
EXPENDITURES. Y E For a wholly private
economy, Y C I
WORKERS FACTOR OWNERS CONSUMERS
INCOME
8
EXPENDITURES, which constitute the left half of
the circular flow, is represented on the vertical
axis.
EXPENDITURES
INCOME, which constitutes the right half of the
circular flow, is represented on the horizontal
axis.
E Y
45o
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.
9
C I
EXPENDITURES
The economy is in a Keynesian equilibrium
somewhere along the 45o linethe line itself
identifying all possible income-expenditure
equilibrium points.
As taught at all levels, the consumption function
is an essential component of the Keynesian
framework. The presumed stability of this
function underlies Keynesian thinking.
Investment depends neither on (current) income
nor on the rate of interest. It depends only on
profit expectations, which themselves are not
well-anchored in economic reality.

INVESTMENT
C a bY
b
1
CONSUMPTION
a
45o
INCOME
Keynes would say the investors are moved by the
animal spirits.
INCOME
Consumption and Investment (as well as Government
Spending) 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).
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.
10
C I
EXPENDITURES
C a bY
C 120 0.60Y
b
b 0.60
1
I 240
In equilibrium, Y E So, Y C I Y a bY
I Y 120 0.60Y 240 Y 0.60Y 120
240 0.40Y 360 Y 900
a 120
a
INCOME
Yeq 900
Suppose that a 120 and b 0.60.
And suppose we know that investors are spending
240 on investment goods.
Can we calculate the equilibrium level of income
that corresponds to these parameters?
11
C I
EXPENDITURES
C a bY
CONSUMPTION
According to Keynes, it is only by accident or
design that the economy is actually preforming
at its full-employment potential. We assume here
that, initially, full employment conditions
prevailif only by accident.
INCOME
INVESTMENT
Yfe
Though not emphasized by Keynes, full employment
implies that the economy is operating on its
production possibility frontier, the PPF itself
being defined in terms of sustainable output
levels of consumption and investment goods.
In Keynesian macroeconomics, full employment
implies that the labor market clears at the going
wage rate, the going wage itself having emerged
during a period in which the economy was
experiencing no macroeconomic problems.
Labor income (Y WN) is fully representative of
total income, such that changes in labor income
stand in direct proportion to changes in total
income.
W
S
LABOR INCOME
D
N
12
C I
EXPENDITURES
C a bY
INCOME
Yfe
13
OUTPUT REAL INCOME
C I
LABOR INPUT
REAL WAGE RATE
S
D
LABOR INPUT
14
C I
EXPENDITURES
C a bY
INCOME
Yfe
15
C I
?I
EXPENDITURES
EXCESS INVENTORIES
C a bY
INVESTMENT
1 (1 b)
E lt Y
?I
?Y
E Y
The simple investment-spending multiplier,
1/(1-b), quantifies the extend of the downward
spiraling.
?Y
CONSUMPTION
INCOME
Yfe
900
INCOME
According to Keynes, a collapse of investment
activity (the collapse being attributed to a
waning of animal spirits) is the primary cause
economic downturns. In response to reduced
investment and hence reduced employment
opportunities, the economy spirals downward into
recession and possibly into deep depression.
W
Note that the going wage keeps goingeven after
the market conditions that gave rise to it are
gone.
S
D
N
16
?I 100
EXPENDITURES
C I
?I 100
C a bY
1 (1 b)
?I
?Y
1 (1 0.6)

(100) 250
?Y
?Y
?Y
1 (1 0.6)

(100) 250
?Y
INCOME
900
650
400
In the Keynesian construction, prices and the
wage rate are sticky downward. But note that
theyre not stuck too high. Theyre stuck just
right. The going wage rate will clear the labor
market once againas soon as spending and hence
labor demand recover to their full-employment
levels.
A further loss of confidence on the part of the
business community will send the economy even
further from its full-employment potential.
W
S
D
N
17
EXPENDITURES
C I
C a bY
INCOME
900
Yfe
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 point of a bust-and-recovery
sequence. (Keynes, of course, preferred not to
wait it out. He advocated make-work projects,
deficit spending, and monetary stimulation to get
the economy turned around.)
W
S
D
N
18
EXPENDITURES
C I
C a bY
INCOME
Yfe
Recovery may continue as further investment
activity drives labor-demand back to its
full-employment level...
W
S
D
N
19
C I
EXPENDITURES
C a bY
INCOME
From full-employment onward, there is upward
pressure on both prices and wage rates. And since
prices and wage rates are not sticky upwards, the
economy experiences a spiraling inflation.
Yfe
Recovery may continue as further investment
activity drives labor-demand back to its
full-employment level...
The equilibrium points in the labor market traced
out during the recovery and inflationary spiral
constitute the so-called L-shaped supply curve.

but there is nothing
about animal spirits that will bring the
recovery process to an end at full employment.
Over-optimism may push the economy beyond its
full-employment level.
W
S
D
N
20
C I
EXPENDITURES
C a bY
INCOME
Yfe
Y C I C C
Even in Keynesian equilibrium, saving equals
investment. But its not the interest rate that
does the equilibrating. Rather, its income that
adjusts (spirals up or spirals down) until the
saving-investment equality is established.
Y C I S I
21
BUSINESS ORGANIZATIONS
EXPENDITURES
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
22
Keynesian Circular-Flow Analysis (Labor-Based
Macroeconomics)
The Inherent Instability of a Wholly Private
Economy (according to John Maynard Keynes)
Roger W. Garrison 2006
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