2. The Debate
John Maynard Keynes challenged the classical assertion that the economy would self-adjust to full employment.
Keynes said that there would be no automatic self-adjustment; the economy could stagnate in persistent unemployment or have continuing inflation.
This debate has continued since the 1930s and is ongoing.
In this chapter we introduce leakages and injections and the Keynesian arguments against self-adjustment.

3. Learning Objectives
Know the sources of circular flow leakages and injections.
Know what the multiplier is and how it works.
Know how recessionary and inflationary GDP gaps arise.
We will use these objectives to review the chapter.

4. Leakages
Leakage: income that is generated in production but is diverted out of the circular flow.
Saving (both household and business).
Imports.
Taxes (both household and business).
Recall the circular flow. Leakages drop out of the flow, thereby reducing the flow of income and expenditure.

5. Injections Injection: an addition of spending in the circular flow.
Investment spending.
Government spending.
Exports.
Recall the circular flow. Injections enter the flow, thereby increasing the flow of income and expenditure.

6. Leakages and Injections
For macro equilibrium, leakages must equal injections.
When this occurs, output supplied equals output demanded.
Ideally, this should occur at full-employment GDP.
If injections equal leakages, the flow stays steady.

7. Self-Adjustment?
Classical economists assumed that leakages always equaled injections.
For example, they use flexible interest rates as the mechanism to ensure this.
If saving (leakage) exceeds investment (injection) …
Available funds to borrow increase and interest rates fall, which spurs more investment borrowing.
If investment (injection) exceeds saving (leakage) …
Available funds to borrow decrease and interest rates rise, which inhibits investment borrowing.
A surplus in a market (here the credit market) leads to a lower price (interest rate falls).
A shortage in a market (here the credit market) leads to a higher price (interest rate rises).
Note the strong emphasis on microeconomic concepts in the classical argument.

8. Self-Adjustment? Keynes’s Response
Changing expectations:
As saving increases, consumption decreases and GDP falls. Business outlook is gloomy.
Business investment spending would more likely fall rather than rise.
Keynes looked beyond microeconomics. He stated that with declining sales and unused production capacity, businesses would not take advantage of lower interest rates and borrow for investment. Rather, they would put off investments until the future looked brighter.

9. Self-Adjustment?
Classical economists said that any rising inventory of goods would trigger falling prices.
This would lead to increased selling to reduce the undesired inventory.
This increased selling would shift AD right toward the GDP needed at the full-employment level.
Again, here is the microeconomic mind-set.

10. Self-Adjustment? Keynes’s Response
Changing expectations:
More would be bought at lower prices, but…
As prices fall, profits diminish and businesses will further reduce production and eliminate investment plans.
They would produce no more until the undesired inventory is sold.
This leads to yet more layoffs and to equilibrium at high unemployment.
Keynes countered by saying that some firms will go out of business and others will cut back production.
They would sell off existing overstocked inventory before making more. Only big businesses could do this.
By the 1930s corporations had grown sufficiently large to act this way.

11. Self-Adjustment?
Rather than adjusting back toward full employment, Keynes saw the economy becoming more unstable as businesses react to declining sales, falling prices, and lowered expectations of the future.
Keynes concluded that waiting for business to pick up production, for firms to increase investment, and for consumers to increase spending in this gloomy outlook was not going to work in any time frame that society could stand.

12. The Effect on Household Income
Reduced production means layoffs, and that means decreased household income.
Reduced income means less spending, and AD shifts further to the left away from full employment.
A relatively small problem could snowball into a much larger problem.
Note the cascading effect: Layoffs mean smaller incomes. So sales fall, production must also fall, and more layoffs occurs, further reducing incomes. Then another round occurs.

13. The Multiplier Process
Steps in the multiplier process:
1. Let investment decline.
2. This leaves unsold output.
3. Production is cut back.
4. Income decreases.
5. Consumer spending decreases.
6. Go to step 2 above.
The eventual decrease in spending will be much larger than the initial decline in spending.
The eventual shift of AD to the left will be much larger than the initial shift to the left.
Here we use investment decline as the trigger. Go step by step down the list. When you get to step 6, recycle to step 2 and do it again … and again …

14. The Multiplier Process
Multiplier: the multiple by which an initial change in spending will alter the total expenditure after all spending cycles.
Example: If MPC = 0.75, the multiplier is 1/(1-0.75) = 1/0.25 = 4.
The impact of an initial spending change will be multiplied by a factor of 4. 1
Multiplier =
1 - MPC
Every cycle multiplies the problem. This is the multiplier process.

15. The Multiplier Process
The multiplier is governed by the size of the MPC.
If the MPC decreases, then the multiplier gets smaller.
If the MPC increases, then the multiplier gets larger.
The term 1 – MPC appears in the denominator. Recall that 1 – MPC = MPS.
If MPC increases in size, MPS decreases in size and the multiplier gets smaller and vice versa.
If MPS increases in size, MPC decreases in size and the multiplier gets bigger and vice versa.

16. Keynesian Adjustment Process
Producers cut output and employment when output exceeds AD at the current price level (leakages exceed injections).
The resulting loss of income causes a consumer spending decline.
This leads to further production cutbacks, more job loss, more lost income, and still less consumption.
AD shifts further to the left as the multiplier process goes into effect.
Here we show how a recession begins and deepens.

17. Recessionary GDP Gap
The recessionary GDP gap equals the difference between equilibrium GDP (QE) and full-employment GDP (QF).
It shows unused production capacity as the economy is underproducing.
The economy has declined as AD shifted from AD0 to AD2.

18. The Unemployment - Inflation Trade-Off
The AS curve slopes upward.
An AD increase causes both output and prices to rise, and unemployment to fall.
Because of rising prices, the economy must move to point h, not point f, to close the recessionary GDP gap.
If the AS curve were horizontal, we would need to go only to point f.
But some of the energy of the stimulus will go toward inflation, so we end up at point h.

19. Inflationary GDP Gap
The inflationary GDP gap equals the difference between equilibrium GDP (QE) and full-employment GDP (QF).
It shows the economy producing at a GDP level above full-employment GDP, with the economy subject to inflationary pressure.
The economy has shifted from AD0 to AD6.

20. Demand-Pull Inflation
An excessive increase in an injection or decrease in a leakage can cause the economy to overheat.
AD pushes too far to the right, generating an inflationary GDP gap.
Demand-pull inflation: prices rise due to excessive AD.
Instability could cause an inflationary spiral.

21. The Multiplier Process
Let investment increase and shift AD right.
Inventory depletes (a warning sign of inflation) and prices rise.
Production is increased.
Income increases.
Consumer spending increases.
Go to step 2 above.
The eventual increase in spending will be much larger than the initial increase in spending.
The eventual shift of AD to the right will be much larger than the initial shift to the right.
This step-by-step process can be used just as the one for going into recession.

22. Booms and Busts
Keynesian analysis concluded that the economy is vulnerable to abrupt changes in spending behavior and won’t self-adjust to a desired macro equilibrium.
Changing expectations for both consumers and businesses adjust their market activities, which can lead to a worsening condition.
Abrupt shifts of AD cause the recurring business cycles, resulting in a series of economic booms and busts.
This summarizes the position of Keynes and the Keynesians.