1. Self-Adjustment or Instability? Chapter 10 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. 10-2 The Multiplier Process Keynes argued that things were likely to get worse once a spending shortfall emerged Suppose consumer spending falls due to a decline in wealth –Inventories of unsold goods start piling up –Businesses cut back on investment spending

3. 10-3 Undesired Inventory Economists distinguish desired (or planned) investment from actual investment Desired investment represents purchases of new plant and equipment plus any desired changes in business inventories Undesired investment Desired investment Actual investment 

4. 10-4 Falling Output and Prices Business firms are likely to react to undesired inventory buildups by cutting prices and reducing the rate of new output

5. 10-5 REAL OUTPUT PRICE LEVEL AD Shift Q F = $3,000 P1P1 Q1Q1 P0P0 $2,900 AD 0 F AD 1 b AS $100 billion decline in I d

6. 10-6 Household Incomes Firms usually cut wages and employment as they cut back production A reduction in investment spending leads to a reduction in household incomes

7. 10-7 Income-Dependent Consumption What starts off as a relatively small spending shortfall escalates into a much larger problem If disposable income falls, we expect consumer spending to drop as well This quickly translates into more unsold output and causes further cutbacks in production, employment, and disposable income

8. 10-8 The Multiplier Process 2. $100 billion in unsold goods appear 4. Income reduced by $100 billion5. Consumption reduced by $75 billion 6. Sales fall $75 billion 7. Further cutbacks in employment or wages 8. Income reduced by $75 billion more 9. Consumption reduced by $56.25 billion more Factor markets Product markets Business firms Households 10. And so on 3. Cutbacks in employment or wages 1. Investment drops by $100 billion

9. 10-9 The Multiplier The marginal propensity to consume (MPC) is the critical variable in this process Multiplier: The multiple by which an initial change in spending will alter total expenditure after an infinite number of spending cycles

10. 10-10 The Multiplier The total change in spending is equal to the initial change in spending multiplied by the multiplier

11. 10-11 The Multiplier An initial drop in spending of $100 billion would decrease total spending by

12. 10-12 The Multiplier Cycles

13. 10-13 Macro Equilibrium Revisited Key features of the adjustment process: –Producers cut output and employment when output exceeds aggregate demand at current price level –Resulting loss of income causes decline in consumer spending –Decline in consumer spending leads to further production cutbacks, more lost income, and even less consumption

14. 10-14 Sequential AD Shifts The decline in household income caused by investment cutbacks sets off the multiplier process, causing a secondary shift of the AD curve

15. 10-15 Multiplier Effects Real Output Price Level Q F = 3000 m a P0P0 26002900 AD 2 c  I = $100 billion  C = $300 billion b d AD 1 AS AD 0

16. 10-16 Price and Output Effects As long as the aggregate supply curve is upward-sloping, the shock of any AD shift will be spread across output and prices