Chapter 9 Economic Instability: A Critique of the Self-Regulating Economy What This Chapter Is About In the last chapter we discussed the self-regulating economy. Not all economists believe the economy is self regulating. Some economists believe that the economy can sometimes be given to instability. In other words, the economy may not remove itself from, say, a recessionary gap. We discuss this position in this chapter. Key Concepts in the Chapter a. efficiency wages b. consumption function c. autonomous spending d. multiplier e. Keynesian aggregate supply curve Efficiency wages refer to wage rates above equilibrium levels. For example, if the equilibrium wage rate is $30 an hour, an efficiency wage rate might be $35 an hour. Some economists believe there are solid microeconomic reasons for efficiency wages. The consumption function (in this chapter) relates consumption spending to disposable income. Autonomous spending is spending independent of income. For example, if investment spending rises from $40 million to $50 million even if income (in the economy) is constant, this $10 million change in investment spending is referred to as change in autonomous investment spending. The multiplier is the number that is multiplied by the change in autonomous spending to obtain the change in Real GDP. Review Questions 1. Does Keynes believe in Say’s law in a money economy? Explain your answer. 2. According to Keynesians, the economy can get stuck in a recessionary gap. According to them, why might the economy get stuck in a recessionary gap? 3. What is the Keynesian position on wages and prices? 78 Economic Instability: A Critique of the Self-Regulating Economy 79 4. What are the three simplifying assumptions in the simple Keynesian model? 5. Write the Keynesian consumption function. 6. Using the Keynesian consumption function, what will lead to a rise in consumption? 7. How is the marginal propensity to consume computed? 8. How is the marginal propensity to save computed? 9. Explain how the total expenditures (TE) curve is derived? 80 Chapter 9 10. What role does optimum inventory play in the Keynesian analysis of the economy? 11. What happens in the economy if TE > TP (TE = total expenditures; TP = total production). 12. According to Keynesians, can the economy be in equilibrium and in a recessionary gap, too? Explain your answer. 13. What does the multiplier equal? 14. What is the Keynesian position on the ability of the private sector to remove the economy from a recessionary gap? Economic Instability: A Critique of the Self-Regulating Economy 81 Problems 1. Fill in the blank spaces in the table. MPC (marginal Change in income Change in consumption propensity to consume) $2,000 $1,000 $1,000 $800 $10,000 $9,500 $3,456 $2,376 2. Fill in the blank spaces in the table. And disposable And the marginal Then autonomous If consumption is income is propensity to consume is consumption is $400 $1,000 0.20 $1,600 $1,900 0.80 $1,700 $2,000 0.75 3. Fill in the blank spaces in the table. Total expenditure Consumption Investment Net Exports curve shifts (up, down) falls by less than rises rises consumption rises rises by more than falls by more than falls consumption falls investment rises falls by more than investment rises, but rises rises falls by less than consumption rises 4. Fill in the blank spaces in the table. MPC Multiplier 0.75 0.80 0.60 5. Fill in the blank spaces in the table. The consumption function is C = Co + MPC (Yd), where Co = $200 and MPC = 0.80. Disposable Change in Consumption Change in Saving income disposable income consumption $10,000 $0 $8,200 $0 $12,000 $14,000 82 Chapter 9 6. Diagrammatically represent an economy stuck in a recessionary gap (within the AD-AS framework). Price Level Real GDP 7. Diagrammatically represent an economy stuck in a recessionary gap (within the TE-TP framework). TE Real GDP 8. What is the relationship between TE and TP at Q1? At Q2? At Q3? Economic Instability: A Critique of the Self-Regulating Economy 83 9. Explain what will happen in the economy if it is at Q1 in the exhibit in question 8. 10. Explain what will happen in the economy if it is at Q3 in the exhibit in question 8. What is the Question? Identify the question for each of the answers that follow. 1. Wages and prices may be inflexible. 2. Autonomous consumption. 3. 1 ÷ (1 – MPC) 4. Consumption divided by disposable income. 5. Inventories rise above optimum levels. 84 Chapter 9 What Is Wrong? In each of the statements that follow, there is something wrong. Identify what is wrong in the space provided. 1. If the economy is operating on the horizontal section of the Keynesian AS curve, then an increase in aggregate demand will raise Real GDP, but a decrease in aggregate demand will lower Real GDP and the price level, too. 2. According to Keynes, saving is more responsive to changes in interest rates than to changes in income. 3. Keynes’s major work was titled The General Theory of Employment, Income and Prices, and it was published in 1937. 4. When TE is greater than TP, inventories rise above the optimum inventory level. 5. When the economy is in disequilibrium, inventories are at their optimum levels. Economic Instability: A Critique of the Self-Regulating Economy 85 Multiple Choice Circle the correct answer. 1. If total production is less than total expenditures, then business firms a. have underproduced. b. will increase production. c. have overproduced. d. b and c e. a and b 2. Consumption is ___________ related to disposable income, according to the consumption function discussed in the text. a. inversely b. directly c. inversely at times, directly at other times d. not e. There is not enough information to answer the question. 3. Less is produced than households want to buy. This holds when a. TE = TP. b. TP > TE. c. TE > TP. d. the multiplier is greater than 1. e. none of the above 4. The efficiency wage model is an explanation of wage ___________ and therefore provides support for ___________ economics. a. rigidity; classical b. flexibility; Keynesian c. rigidity; Keynesian d. flexibility; classical e. flexibility; monetarist 5. Which of the following statements is true? a. Keynes believed that monopolistic elements in the economy will prevent immediate price declines. b. Keynes believed that during periods of high unemployment, labor unions will prevent wages from falling fast enough to restore full employment. c. Keynes believed in Say’s law in a barter economy. d. all of the above e. none of the above 6. Keynes did not believe that interest rate flexibility would ensure that ___________ equals saving. a. consumption b. investment c. the multiplier d. marginal propensity to consume e. net exports 7. Which of the following is an aspect of Keynesian economics? a. Wages and prices are flexible. b. The economy can exhibit instability. c. The private sector can always remove the economy from a recessionary gap. d. The economy cannot get stuck in a recessionary gap. e. c and d 86 Chapter 9 8. If income rises from $600 to $700 and consumption rises from $300 to $380, the marginal propensity to consume is ________. a. 0.54 b. 0.80 c. 1.00 d. 0.65 e. none of the above 9. If autonomous consumption rises by $600 and as a result real national income rises by $3,000, then the marginal propensity to consume is _______. a. 0.90 b. 0.80 c. 0.70 d. 0.60 e. 0.40 10. According to efficiency wage models, a. labor productivity depends on the wage rate the firm pays employees. b. labor productivity depends on environmental conditions. c. labor specificity is a function of the wage rate. d. efficiency is a result of seven production factors. e. none of the above 11. In the real world, we should expect the multiplier process to work itself out a. almost instantly. b. within a few days. c. only if the SRAS curve is upward sloping. d. only over many months. e. c and d 12. In the TE-TP (Keynesian) model, the price level is assumed to be ___________, so any changes in TE will bring about a multiplier effect in ___________. a. rising; consumption b. constant; Real GDP c. rising; Real GDP d. falling; investment e. rising; government purchases 13. If investment and government purchases are independent of income, and consumption rises as income rises, then the TE curve will intersect the vertical axis at some point above the origin. The distance between the origin and the point of intersection is equal to a. autonomous investment. b. autonomous consumption. c. autonomous government spending. d. net exports. e. the multiplier. 14. The ratio of consumption to income is called the a. marginal propensity to save. b. average propensity to save. c. average propensity to consume. d. marginal propensity to consume. e. There is not enough information to answer the question. Economic Instability: A Critique of the Self-Regulating Economy 87 15. If Keynesians believe that the economy can get stuck in a recessionary gap, then they probably don’t always hold that ____________ is the best policy. a. raising consumption b. laissez faire c. increasing the money supply d. a and b e. none of the above True-False Write a “T” or “F” after each statement. 16. Keynes believed that an increase in saving would not necessarily stimulate an equal amount of added investment spending. ____ 17. According to the Keynesian consumption function, consumption spending can be some positive amount even when disposable income is zero. ____ 18. When TE > TP, the inventories of firms are rising above their optimum levels. ____ 19. According to Keynesians, the economy can be in a recessionary gap and in equilibrium, too. ____ 20. According to Keynes, the private sector could not always remove the economy from a recessionary gap. ____ Fill in the Blank Write the correct word in the blank. 21. _______________ _______________ models hold that it is sometimes in the best interest of business firms to pay their employees higher-than-equilibrium wage rates. 22. If wages are _______________ in the downward direction, it is possible for an economy to get stuck in a recessionary gap. 23. If the economy is operating in the horizontal part of the ______________ ______________, then any change in aggregate demand will change Real GDP, but not the price level. 24. If the marginal propensity to consume is _________, then the multiplier is 2.5. 25. If people save for a certain dollar goal ($50,000), then it is possible for saving to ____________ as interest rates rise.