Stabilizing an Inherently Unstable Economy with Government Spending

Roger W. Garrison 2008

Keynesian Circular-Flow Analysis(Labor-Based Macroeconomics)

BUSINESSORGANIZATIONS

WORKERS

FACTOROWNERS

CONSUMERS

INCOME

EXPENDITURES

In Keynesian equilibrium,INCOME equals EXPENDITURES.

Y = EY = C + I + G But T = 0

The Keynesian Circular Flow in a Mixed Economy

The 45o line (Y = E) still defines all the possible Keynesian equilibria, but now total spending (E) includes government spending (G).

Investment, too, is the same as in a wholly private economy, implying either that government borrowing doesn’t impinge on interest rates or that investment spending is insensitive to interest-rate changes.

Government spending is now the third component of total spending. While some of this spending is considered essential for the government to function, additional spending is made with an eye to its overall effect on the macroeconomy.

If no taxes are being collected (implying that the government spending is facilitated by borrowed funds or by newly printed money), consumption behavior is the same as in a wholly private economy (C = a + bY).

EX

PE

ND

ITU

RE

S

INCOME

CONSUMPTION

INVESTMENT

INCOME

45o

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).

GOVERNMENT

C

C + I C + I + G

EX

PE

ND

ITU

RE

S

INCOME

45o

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 the going wage rate; and the corresponding demand for output is strong enough to clear all output markets at their downwardly sticky prices.

C

C + I C + I + G

Yfe

N

S

D

W

Yeq

ΔI

ΔY

The magnitude of the change in income (ΔY) is determined by applying the spending multiplier.

The economy responds, not by adjustments in prices, wages, and/or interest rates but by spiraling downward into recession.

EX

PE

ND

ITU

RE

S

INCOME

C

C + I

45o

Suppose now that a loss of business confidence causes investment spending to fall by ΔI.

N

W

S

D

C + I + G

Yfe

ΔIΔY = 1(1 – b)

The economy is now stuck in what Keynes called an unemployment equilibrium.

By “design” (and despite the lack of business confidence and the stickiness of wages and prices), the economy is performing at its full-employment potential and without inflation.

ΔG

ΔY

To restore full employment, policymakers need to compensate for the decrease in investment spending by increasing government spending.

The economy responds to this fiscal stimulant by spiraling upwards, retracing its steps to the full-employment level of income.

EX

PE

ND

ITU

RE

S

INCOME

C

45o

Once again, the spending multiplier is in play.

C + I + G

ΔGΔY = 1(1 – b)

C + I C + I + G

Yeq = Yfe

N

S

D

W

Yeq

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.

EX

PE

ND

ITU

RE

S

INCOME

45o

Currently, the total spending in the economy happens to be just enough but not too much: It’s just enough, which means there’s no unemployment problem; it’s not too much, meaning that inflation isn’t a problem, either.

C

C + I C + I + G

Yfe

And mercifully, fiscal agents stand at the ready, continuously offsetting any changes in investment spending with equal-but-opposite 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.

…and this is what Keynes calls The General Theory.

Stabilizing an Inherently Unstable Economy with Government Spending

Roger W. Garrison 2008

Keynesian Circular-Flow Analysis(Labor-Based Macroeconomics)