Chapter 9: Economic Instability: Critique of SelfRegulating Economy

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Chapter 9 Economic Instability Critique of
Self-Regulating Economy

• Keynes View
• Wages/Prices dont automatically adjust down in
  recession
• Monopoly power, Unions, Price rigidity, ...
• SRAS unable to adjust to AD changes as readily as
  Classical view
• Economy doesnt automatically return to Full
  Employment

2

• New Keynesians View
• Competitive markets mean wages prices quickly
  adjust to demand/supply changes
• Then why dont markets adjust?
• New Keynesians use micro-based reasons for
  slowly adjusting prices and wages
• Wages adjust slowly due to long-term contracts
• Prices changes costly for firms in short-run
  response to demand changes
• Efficiency Wage Modelsabove market wages
  provide incentive for production and less
  shirking

3

• Summarizing (both) Keynesian Views
• Prices/Wages dont freely adjust in recession,
  even if surplus of goods/labor/inputs exist
• Breakdown or delay in market adjustments
• SRAS unable to adjust to Demand-Side changes in
  economy as quickly as Classical view assumes
• Fundamentally different view of market
  adjustments than Classical school

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How Long is Adjustment Process when in
Recessionary Gap?
Price Level
LRAS

• Classical View
• Wage/Ps decrease, returning economy to LRAS
• Relatively short time
• Keynesian View
• Short-run adjustment takes long time
• Economy not self-regulating in short-run
• Government intervention may be necessary

SRAS1
SRAS2

• 1

• 2

AD1

• Real GDP

Q1
QNatural
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Keynes on the Private Sector and Investment
Spending

• Investment spending not always responsive to
  lower interest rates
• Pessimistic business expectations
• Private sector unable to get economy our of
  recessionary gap

6
Classical View of Interest Rate Flexibility in
Credit Market
Interest Rate (i)

• Investment Demand (I1) slopes down
• Lower Interest Rate, lowers cost of borrowing ,
  raises Investment
• Savings (investment) Supply (S1) slopes up
• Higher Interest Rate, higher reward to saving,
  save more
• Equilibrium iE and E

S1
iE
I1

• s Save\Invested

E
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Classical View of Interest Rate Flexibility in
Credit Market (cont.)
Interest Rate (i)
S1

• Reduced C means Increased Supply of Saving lowers
  i, raising s Invested
• Flexibility of interest rates
• Lower i stimulates investment and AD

S2

• 1

i1
i2

• 2

I1
s Save\Invested
10
12
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Keyness Criticism of Interest Rate Flexibility
in Credit Market (cont.)

• Investment not always responsive to interest
  rates
• More responsive to income than interest rate
• Investment responds to expectations, innovations
• Even if interest rate adjusts, saving I may not
• Economy stuck in Recessionary Gap

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Keynesian View of Great Depression

• Market system not as stable as Classical View
• Keynes focused on determinants of AD
• Private-Sector spending decisions inherently
  unstable, especially I-spending
• Dont always respond to changes in Ps/interest
  rate
• Expectations important in dampening recession
  and promoting recovery
• Pessimistic expectations can magnify economic
  downturn
• Problem of market coordination