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Economic stabilizer
Economic stabilizer, any of the institutions and practices in an economy that serve to
reduce uctuations in the business cycle through offsetting effects on the amounts of
income available for spending (disposable income). The most important automatic
stabilizers include unemployment compensation and other transfer payment programs,
farm price supports, and family and corporate savings.

The ultimate objective of research into the problems of economic instability (including
uctuations in output, employment, and prices) is to provide the foundation for
stabilization policy—that is, for the systematic use of scal and monetary policies to
improve an economy’s performance. The main tasks, therefore, are to explain how levels of
prices, output, and employment are determined and, on a more applied level, to furnish
predictions of changes in these variables—predictions on which stabilization policy can be
based.

Keynesian Analysis
The problems of economic stability and instability have, naturally, been of concern to
economists for a very long time. But, as a special eld of investigation, it emerged most
strongly from the con uence of two developments of the depression decade of the 1930s.
One was the development of national income statistics; the other was the reorientation of
theoretical thinking often referred to as the “Keynesian revolution.”

To understand why the theoretical contributions of John Maynard Keynes were regarded
as so important through much of the 20th century, one must examine the workings of a
modern economy. Such an economy comprises millions of people engaged in millions of
distinct activities; these activities include the production, distribution, and consumption of
all of the different goods and services that a modern economy provides. Some of the
economic units are large, with hierarchies of executives and other managerial specialists
who coordinate the productive activities of thousands or tens of thousands of people.
Aside from these relatively small islands of preplanned and coordinated activity, most of
the population pursues its myriad economic tasks without any overall supervised
direction. It resembles an immensely complicated, continuously changing puzzle that is
continually being solved and solved again through the market system. A breakdown in
the coordination of activities, such as occurred in the depression decade of the 1930s, is
very rare—in fact, it happened on that scale only once—or this system of organization
would not survive. The way in which the economic puzzle is solved without anyone
thinking about it has been the broad main theme of economic theory since the time of
the English economist Adam Smith (1723–90).

The problem of coordination

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If one singles out a particular household from the


millions of economic units and studies it over a period
of time, one can draw up a budget of that household’s
transactions. The budget will come out as a long list
of amounts sold and amounts bought. If at any time
this economic unit had tried to do something
different from what it actually did (cutting down, say,
on meat purchases to buy another pair of shoes), the
solution of the economic puzzle would have been
John Maynard Keynes, detail of a
watercolour by Gwen Raverat, about 1908;
correspondingly different. At the prevailing prices the
in the National Portrait Gallery, London. supply of meat would have exceeded the demand,
Courtesy of the National Portrait Gallery, and the demand for shoes would have exceeded the
London supply.

The point Keynes made, right or wrong, was that, if the economy were to function as a
coordinated system, the activities of each economic unit must be somehow controlled—
and controlled quite precisely. This is done through price incentives. By raising the price of
a good (relative to the prices of everything else), any economic unit can, generally
speaking, be made to demand less of it or to supply more of it; by lowering the price, it
can be made to demand more or to supply less. Through the con ux of prices, an
individual unit is thus led to t its activities into the overall puzzle of market demands and
supplies. If economic units could not be controlled in this fashion, the market-organized
system could not possibly function.

Keynesians therefore believe that in any given situation there exists, theoretically, one and
only one list of prices that will make the puzzle come out exactly right. But the amounts
that economic units choose to supply or demand of various goods at any given price list
depend on numerous factors, all of which change over time: the size of the population
and labour force; the stock of material resources, technology, and labour skills; “tastes” for
particular consumer goods; and attitudes toward consumption as against saving, toward
leisure as against work, and so on. Government policies—tax rates, expenditures, welfare
policies, money supply, the debt—also belong among the determinants of demand and
supply. A change in any of these determinants will mean that the list of prices that
previously would have equilibrated all of the different markets must be changed
accordingly. If prices are “rigid,” the system cannot adjust and coordination will break
down.

Price exibility
For coordination of activities to be preserved (or restored) when the economy is disturbed
by changes in these determinants, something still more is required: each separate price
must move in a direction that will restore equilibrium. This necessity for prices to adjust in
certain directions may be expressed as a communications requirement. To put it in
somewhat extreme form: for a given economic unit to plan its activities so that they will

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“mesh” with those of others, it must have information about the intentions of everyone
else in the system. When one of the determinants underlying market supplies and
demands changes so as to disequilibrate the system, ensuing price movements must
communicate the requisite information to everyone concerned.

One may suppose, for example, that in some period of political crisis the supply of crude
oil from the Middle East is cut off. The immediate result will be a worldwide excess
demand for oil and oil products of large proportions—that is, supply will fall far short of
demand at going prices. At the same time, those who derive their income from Middle
East oil production will have their incomes reduced, and excess supplies will emerge in
the markets for the goods on which those incomes previously were spent. For the system
to adjust, orders will have to go out to all demanders to cut down on their consumption of
oil and for all other suppliers of oil to increase their output so that the gap between
demand and supply can be closed. This is, in effect, what a rise in the world price of oil and
oil products will accomplish—millions of gasoline and heating oil users the world over will
respond to the pinch of higher prices, and the higher prices will also create a pro t
incentive for supply to be increased. (Falling prices will, in an analogous manner, close the
gaps in the markets in which the initial disturbance caused excess supplies to develop.)

Prices that are not rigid for some institutional reason will move in response to excess
demands and excess supplies. When demand exceeds supply, disappointed buyers will
bid up the price; when supply exceeds demand, unsuccessful suppliers will bid it down.
This mechanism solved the excess demand for the oil problem in the illustration above.
The question, however, is whether throughout the system as a whole it will always act so
as to move each of the prices toward its general equilibrium value.

Keynes said no. He maintained that there can be conditions under which excess demands
(or supplies) will not be “effectively” communicated so that, although certain prices are at
disequilibrium levels, no process of bidding them away from these inappropriate levels
will get started. This is the aw in the traditional conception of the operation of the price
system that prompted Keynes to introduce the concept of “effective demand.” To pre-
Keynesian economists the implied distinction between “effective” and (presumably)
“ineffective” demand would have had no analytical meaning. The logic of traditional
economic theory suggested two possibilities that might make the price system
inoperative: (1) that, in some markets, neither demanders nor suppliers respond to price
incentives, so that a “gap” between demand and supply cannot be closed by price
adjustments and (2) that, for various institutional reasons, prices in some markets are
“rigid” and will not budge in response to the competitive pressures of excess demands or
excess supplies. Keynes discovered a third possibility that, he argued, was responsible for
the depth and duration of severe depressions: under certain conditions, some prices may
show no tendency to change even though desires to buy and to sell do not coincide in the
respective markets and even though no institutional reasons exist for the prices to be
rigid.

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Say’s Law
Many writers before Keynes raised the question of whether a capitalist economic system,
relying as it did on the pro t incentive to keep production going and maintain
employment, was not in danger of running into depressed states from which the
automatic workings of the price mechanism could not extricate it. But they tended to
formulate the question in ways that allowed traditional economics to provide a
demonstrable, reassuring answer. The answer is known in the economic literature as Say’s
Law of Markets, after the early 19th-century French economist Jean-Baptiste Say.

For western Europe, the 19th century was a period of


rapid economic growth interrupted by several sharp
and deep depressions. The growth was made possible
in large measure by new modes of organizing
production and new technologies, such as the
spreading use of steam power. Was it possible that
output might grow so great that there would not be a
market for it all? Say’s Law denied the possibility.
“Supply creates its own demand,” ran the answer.
More precisely, the law asserted that the sum of all
excess supplies, evaluated at market prices, must be
identically equal to the sum of the market values of all
excess demands. It could be neither more nor less. In
J.-B. Say, lithograph by Gottfried Englemann the theoretical system of traditional economics, any
after a portrait by Achille-Jacques-Jean- inequality between these sums would quickly work
Marie Devéria.
itself out.
H. Roger-Viollet

An important special case should be noted. The good


in excess demand might, for instance, be money. One possibility, then, is excess supply for
all the other goods, matched by an excess demand for money. A situation with excess
demand for money matched by an excess supply of everything else is one in which the
level of all money prices is too high relative to the existing stock of money. If this is the
only trouble, however, Say’s Law suggests a relatively simple remedy: increase the money
supply to whatever extent required to eliminate the excess demand. The alternative is to
wait for the de ation to work itself out. As the general level of prices declines, the “real”
value of the money stock increases; this too, will, in the end, eliminate the excess demand
for money.

Model Of A Keynesian Depression


Involuntary unemployment
Another possible cause of a general depression was suggested by Keynes. It may be
approached in a highly simpli ed way by lumping all occupations together into one
labour market and all goods and services together into a single commodity market. The

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aggregative system would thus include simply three goods: labour, commodities, and
money. See

Table for a rough outline (a full treatment would be both technical and lengthy) of the
development of a “Keynesian” depression. One may begin by assuming (line 1) that the
system is in full employment equilibrium—that is, prices and wages are at their
equilibrium levels and there is no excess demand. Next the model may be put on the path
to disaster by postulating either (1) some disturbance causing a shift of demand away
from commodities and into money or (2) a reduction in the money supply. Either event
will result in the situation described in the Table as State 2, but the one assumed is a
reduction in the money supply by, say, 10 percent. The result is shown in the right-hand
column of the Table, where the quantity of commodities supplied minus the quantity
demanded multiplied by the price level (p) is equal in value to the excess demand for
money.

If money wages and money prices could immediately be reduced in the same proportion
(10 percent), output and employment could be maintained, and pro ts and wages would
be unchanged in “real” terms. If money wages are initially in exible, however, business
rms cannot be induced to lower prices by 10 percent and maintain output. In this
example they maintain prices in the neighbourhood of the initial price level—prices, then,
are also “in exible”—and deal with the excess supply by cutting back output and laying off
workers. Reducing supply eliminates the excess supply of commodities by throwing the
burden of excess supply back on the labour market. Thus, output and employment (which
are “quantities”) give way before prices do. This brings us to State 3 where, as in the Table,
the excess supply of labour times the money wage rate (w) equals the excess demand for
money in value.

If, with the system in this state, money wages do not give way and the money supply is
not increased, the economy will remain at this level of unemployment inde nitely. One
should recall that the only explanation for persistent unemployment that the pre-
Keynesian economics had to offer was that money wages were “too high” relative to the
money stock and tended to remain rigid at that level.

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Money wages might, nevertheless, give way so that, gradually, both wages and prices go
down by 10 percent—that is to say, a reduction of the size that would have solved the
entire problem had it occurred immediately (before unemployment could develop). This is
shown in the last line of the Table, which represents (albeit crudely) what Keynes
described as a state of “involuntary unemployment” and explained in terms of a failure of
“effective demand.”

In State 4, it is assumed, the excess demand for money is zero. Hence there is, at least
temporarily, no tendency for money income either to fall further or to rise. The prevailing
level of money income is too low to provide full employment. The excess supply of labour
and the corresponding excess demand for commodities (of the same market value) show
State 4 to be a disequilibrium state. The question is why the state tends to persist. Why is
there no tendency for income and output to increase and to absorb the unemployment?
Speci cally, why does not the excess demand for commodities induce this expansion of
output and absorption of unemployment?

Basically, the answer is that the unemployed do not have the cash (or the credit) to make
the excess demand for commodities effective. The traditional economic theory would
postulate that, when actual output is kept at a level below that of demand, competition
between unsuccessful potential buyers would tend to raise prices, thereby stimulating an
expansion. But this does not occur. The unemployed lack the means to engage in such
bidding for the limited volume of output. The excess demand for commodities is not
effective. It fails to produce the market signals that would induce adjustments of activities
in the right direction. Business rms, on their side of the market, remain unwilling to hire
from the pool of unemployed—even at low wages—because there is nothing to indicate
that the resulting increment of output can actually be sold at remunerative prices.

Keynes called this “involuntary unemployment.” It was not a happy choice of phrase since
the term is neither self-explanatory nor very descriptive. Some earlier analysts of the
unemployment problem had, however, tended to stress the kind of deadlock that might
develop if workers held out for wages exceeding the market value of the product
attributable to labour or if business rms insisted on trying to “exploit” labour by refusing
to pay a wage corresponding to the value of labour’s product. With the term “involuntary
unemployment,” Keynes wanted to emphasize that a thoroughly intractable
unemployment situation could develop for which neither party was to blame in this
sense. His theory envisaged a situation in which both parties were willing to cooperate,
yet failed to get together. An effective demand failure might be described as “a failure to
communicate.”

The failure of the market system to communicate the necessary information arises
because, in modern economies, money is the only means of payment. In offering their
labour services, the unemployed will not demand payment in the form of the products of
the individual rms. If they did, the excess demand for products would be effectively

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communicated to producers. The worker must have cash in order to exercise effective
demand for goods. But to obtain the cash he must rst succeed in selling his services.

Effects of business contraction


When business begins to contract, the rst manifestation is a decrease in investment that
causes unemployment in the capital goods industries; the unemployed are deprived of
the cash wage receipts required to make their consumption demands effective.
Unemployment then spreads to consumer goods industries. In expansion, the opposite
occurs: an increase in investment (or in government spending) leads to rehiring of
workers out of the pool of unemployed. Re-employed workers will have the cash with
which to exert effective demand. Hence business will pick up also in the consumer goods
industries. Thus, the theory suggests the use of scal policy (an increase in government
spending or a decrease in taxes) to bring the economy out of an unemployment state
that is due to a failure of effective demand.

Another observation may be made on Keynes’s doctrine of effective demand. The fact
that the persistence of unemployment will put pressure on wages also turns out to be a
problem. The assumption in the foregoing discussion was that money wages were at the
equilibrium level. Unemployment will tend to drive them down. Prices will tend to follow
wages down, since declining money earnings for the employed will mean a declining
volume of expenditures. In short, both wages and prices will tend to move away from,
rather than toward, their “correct” equilibrium values. Once the economy has fallen into
such a situation, Keynes pointed out, wage rigidity may actually be a blessing—a
paradoxical conclusion from the standpoint of traditional economics.

National Income Accounting


The circular ow of income and expenditure
A proper understanding of income and expenditure theory requires some acquaintance
with the concepts used in national income accounting. These accounts provide
quantitative data on national income and national product. Reliable information on these
was, for the most part, not available to economists working on problems of economic
instability before the 1930s. Modern economics differs from earlier work most markedly in
its quantitative, empirical orientation. The development of national income accounting
made this possible.

The de nitions of the major components of national income and product may,
accordingly, be introduced in the course of explaining income and employment theory.
The basic characteristic of the national income accounts is that they measure the level of
economic activity in terms of both product supplied and of income generated.
Correspondingly, national income analysis divides the economic system into distinct
sectors. The simplest approach uses two sectors: a business sector and a household
sector. All product is regarded as created by the business sector (thus, self-employed

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persons have to be treated as businesses in earning their income and as households in


disposing of it). Final goods output is divided into two components: consumer goods
produced for sale to households and investment goods for sale to rms. Similarly, all
income is generated in the business sector and none of it in the household sector
(nonmarket activities, such as the work of homemakers or home improvements, are not
counted in national product and income). The level of income generated equals the
market value of nal goods output.

Next is the household sector. All resources in the economy ultimately belong to
households. The households, therefore, have claim to all of the income generated through
the utilization of these resources by rms in creating the national product. Not all of the
income is, however, actually paid out to households, since corporations retain part of their
earnings. In building a simple model of the economy, one can disregard the “gross
business saving” item of the national income accounts and deal with income as if it were
all paid out (which means adopting the ction that retained earnings are rst paid out to
shareholders who then reinvest the same amount in the same rms). The households,
nally, dispose of their income in two ways: as expenditure on consumption goods and as
saving.

The foregoing discussion has made two accounting statements involving income. First,
s
income generated (Y) equals the value of consumption goods output (C ) plus the value
s d
of investment goods output (I): Y ≡ C + I. Second, consumption goods expenditures (C )
d
plus savings (S) equal income disposal: Y ≡ C + S. Both equalities hold simply because of
the way that the variables are de ned in the national income accounts. They hold true,
moreover, whatever the actual level of income happens to be. Such equalities, which are
true simply by de nition, are called identities (and are marked as such by using the sign ≡
instead of the usual equality sign). Another accounting convention may be noted here.
Investment (I) is de ned to include any discrepancy between consumer goods produced
and consumer goods sold. If production exceeds sales, the unsold goods are part of
inventory investment; if sales exceed output, inventory investment is negative, and I is
s d
reduced by the corresponding amount. It follows that C and C must be identically equal,
so that it becomes unnecessary to distinguish between them by superscript. Since
income generated is identically equal to income disposal, nally, it is clear that actual
investment must always equal actual saving: I ≡ S. Investment is the value of additions to
the system’s stock of capital. Saving is the increase in the value of the household sector’s
wealth. For the system as a whole, the two must be equal.

Figure 1 shows the circular ow of income and expenditures connecting the two sectors.
Investment and consumption expenditures add up to the aggregate demand for nal
goods output. The value of nal goods output is paid out by the business sector as
income to the household sector. The major part of income goes back to the business
sector as expenditures on consumption goods; the remainder is allocated by households
to saving. Corresponding to the counterclockwise money ow (but not shown) is the

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clockwise ow of the things that the money is paid for: labour and other resource services
from households to rms in exchange for money income; consumer goods and services in
exchange for consumption expenditures from rms to households; and equities, bonds,
and other debt instruments issued by rms in return for the funds saved by households.

Figure 1 shows a break in the ow of saving as it


passes into investment. From the accounting
standpoint—where investment necessarily equals
saving—there is no rationale for this. It has been done
here to focus attention on the point in the circular
Figure 1: The circular flow of income
ow that, in the income–expenditure theory,
expenditures (see text).
represents the causal nexus in the income-
Encyclopædia Britannica, Inc.
determining process. This theory, in its simplest form,
is the next topic.

A simple income–expenditure model


Because accounting identities—between gross national product and gross national
income, between saving and investment, and so on—express relationships that must hold
whatever the level of income, they cannot be used to explain what determines the
particular level of income in a given period or what causes the level of income to change
from one period to the next. The explanation of what happens must be based on
statements about the behaviour of the participants in the economic system; in the
present context, this means the behaviour of rms and households.

The following oversimpli ed model of an economy assumes that the business sector will
be satis ed to maintain any given level of output as long as aggregate demand (that is,
expenditures on nal goods) exactly equals the volume of income generated at that level
of output. If, in a given period, aggregate demand exceeds the income payments made by
rms in producing that period’s output, rms will be expanding in the next period; if
aggregate demand falls short of the income payments made, rms will contract in the
next period. The naïveté of this supply hypothesis is evident from the fact that the
behaviour of rms is described without any reference to the costs of their inputs or to the
price of their outputs; the business sector passively adapts output and income generated
to the level of aggregate demand. In this model, the level of income is entirely determined
by aggregate demand. Firms will act so as to maintain that income ow if, and only if, the
exact same amount that they pay out as incomes “comes back to them” in the form of
spending on nal goods output. If aggregate demand shrinks, production and
employment will decline and there will be downward pressure on the price level; if
aggregate demand swells, there will be an in ationary problem.

In the system of Figure 1, all of the income generated accrues to households. Households
allocate their income to consumption and saving. With consumption there is no problem
—it constitutes spending on nal goods. Saving, however, does not constitute spending

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on nal goods output. This part of the income generated by the business sector does not
automatically come back to it in the form of revenue from sales. Saving, therefore, may be
treated as a leakage from the circular ow.

Investment, which consists of spending of capital by the business sector on new plant and
equipment and on desired additions to inventories, is, in the same terminology, an
injection into the circular ow. If, for example, investment and saving each amount to $20
million per year, the leakage and the injection will balance. But if saving is $20 million per
year and the injection of investment expenditures is only $10 million per year, there will be
a disequilibrium. Unsold goods will accumulate at an annual rate of $10 million. The
business sector, however, will not rest content with this state of affairs but will act to
reduce output, employment, and (perhaps) prices. Households will be forced to reduce
their consumption spending. The reduction of income will go on until the planned (or
desired) rates of saving and investment become equal. A similar argument will show that,
if the leakage of planned saving were to fall short of the injection of planned investment,
the level of income would rise.

When income is at a level such that there is no ongoing tendency for it to change in
either direction, the system is in “income equilibrium.” The simple system depicted in
Figure 1 is in income equilibrium when the condition shown by this equation is ful lled: I =
S. This is not, however, the accounting identity discussed earlier. The symbols I and S now
refer to planned, or desired, magnitudes, which may very well be unequal. When planned
investment exceeds planned saving, income will be rising. When planned saving exceeds
planned investment, income will be falling. An equivalent way of stating the above
“equilibrium condition” is to write Y = C + I. In this equation the left-hand side is actual
income and the right-hand side is planned aggregate demand.

This is the simplest class of income-determination model. It makes no allowance for


international trade or government economic activity. Those may be treated in the same
way that saving and investment were treated—as leakages or injections. Thus, exports
constitute spending by foreign nationals on domestic goods—an injection. Imports
constitute spending out of domestic income on foreign goods—a leakage. Taxes are taken
out of the circular ow—a leakage—whereas government expenditures are an injection.
The effects of these leakages and injections on the level of income are analogous to those
of saving and investment. If income is initially at an equilibrium level, an increase in a
leakage (if not at the same time offset by a decrease in another leakage or an increase in
an injection) will cause income to fall. An increase in an injection (not offset by a decrease
in another injection or an increase in a leakage) will cause income to rise. An income
equilibrium is reached when the sum of all leakages is balanced by the sum of all
injections.

The Multiplier

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The simple income–expenditure model of the economy is not a complete model. It


suf ces to show only the direction of the change in income that would result from, say, a
decline in planned investment (or a rise in taxes or a decline of exports). It does not show
the extent of the income change.

To do this the model must be expanded to include a description of how consumers spend
their incomes. For the sake of the exposition, one may assume that the spending of
households varies according to the size of their incomes. A simple way of putting this is
the following equation: C = a + by. In this equation the coef cient a is a constant
indicating the amount that households will spend on consumption independently of the
level of income received in the current period, and the coef cient b gives the fraction of
each dollar of income that will be spent on consumption goods.

If one were able to obtain reliable quantitative information on the volume of investment
spending being planned and on the coef cients a and b of the “consumption function”
above, one could then calculate the value of aggregate demand (C + I) for every possible
level of income Y. Only one of these alternative levels of income is an equilibrium one; that
is, one for which aggregate demand will ensure that all of the income paid out by rms
“comes back” to the business sector as spending on nal goods. The equilibrium
condition is: Y = C + I.

Figure 2 shows how the level of income in the system is determined, on the assumption
that investment is $20 million, that the coef cient a is $20 million, and that the coef cient
b (the fraction of each dollar of income that consumers will spend) is 0.6. The horizontal
axis measures income, the vertical, aggregate demand (C + I). The line drawn at a 45°
angle (from 0) contains all of the points at which suppliers might be in equilibrium; i.e.,
the points in the space at which aggregate demand would have the same value as
income. The investment schedule (marked I = Ī ) is drawn parallel to the income axis at
0
height 20, showing that investment spending does not depend on income. The
consumption function (marked C = a + by) starts at 20 on the vertical axis (the value of a)
and rises 60 cents for each dollar of income (the value of b) to the right. The aggregate
demand schedule (marked C + Ī ) is obtained by the vertical summation of the C and Ī
0 0
schedules. It contains all of the points at which demanders would be in equilibrium,
showing, for each level of income, the volume of spending on nal goods that they would
be satis ed to maintain.

The only position that demanders and suppliers will both be satis ed to maintain is given
by the intersection of the aggregate demand schedule with the 45° line. In Figure 2 this
point (Ŷ ) is found at an income level of $100 million. For this simple system, which has but
0
one leakage and one injection, the equilibrium level of income may equally well be
regarded as determined by the condition that planned saving equals planned investment.
Since saving is de ned as household income not spent on consumption (i.e., Y - C ≡ S), one
obtains (by substituting a + by for c) the saving schedules S = -a + (1 - b) Y, which in Figure
2 is shown to intersect the investment schedule at Y = $100 million.
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Figure 2 shows what will happen if this equilibrium is


disturbed. Consider a (temporary) situation in which
income is running at more than $100 million per year.
At all levels of income to the right of Ŷ aggregate
0
demand (C + Ī ) is seen to fall below supply as given
0
by the 45° line. (Also, saving exceeds investment.) The
business sector will not be willing to maintain this
state of affairs but will contract. An excess supply of
nal goods is associated with falling income.
Figure 2: Relation between income and
aggregate demand (see text). Similarly, at income levels to the left of Ŷ , where
0
Encyclopædia Britannica, Inc. investment exceeds saving, aggregate demand will
exceed supply. An excess demand for nal goods is
associated with rising income.

Finally, Figure 2 shows how much income would fall as a result of a decline in investment
by $10 million per year (cf. the dotted lines). The decline in investment is shown by the
shift of the investment schedule from Ī to Ī , which results in a downward shift of the
0 1
aggregate demand schedule from C + Ī to C + Ī . The new income equilibrium (Ŷ ) is
0 1 1
found at Y = $75 million.

Thus, a change in investment spending (ΔI) of $10 million is found to lead to a change in
income (ΔY) of a larger amount, here $25 million, which is to say, by a multiple of 2.5. The
reason is that, when the $10 million is transmitted to households as income, households
will increase their consumption spending by $6 million (b × $10 million). This rise in
consumption spending again raises income, and of this additional income 60 percent is
also spent on consumption—and so on. Each time, 40 percent of the increment to income
“leaks” into saving. The relationship between the initial change in “autonomous spending”
(ΔI) and the change in the level of income (ΔY), which will have taken place once this
process has run its course, is given by:

where, following Keynes, the expression ( ) is called the “Multiplier.”


1
1-b

The model of income determination presented above is exceedingly simple; it captures


little of the complexity of a modern industrialized economy. It does, however, suggest one
approach to the problem of stabilizing the economy at a high level of income and
employment. Assuming that the consumption function is fairly stable (i.e., that the level of
consumption spending associated with any level of income can, with a fair degree of
accuracy, be predicted on the basis of past experience), uctuations in income may be
attributed to changes in the other variables. Historical statistics show investment
spending by private business to have been the most volatile of the major components of

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national income; changes in investment, therefore, tend (as in the example above) to be
the focus of concern for one school of economists. The implication is that the government
can manipulate “injections” and “leakages” so as to offset changes in private investment.
Thus, a drop in investment might be offset by a corresponding increase in government
expenditures (increasing an injection) or a decrease in taxes (decreasing a leakage). These
measures belong to scal policy.

Monetary Policy
Another point of view holds that the scal approach presented above is misleading
because it ignores the part played by monetary factors in determining the level of
economic activity. The following discussion presents an alternative model, which, though
equally simplistic, suggests that primary reliance be put on monetary policy.

“Money” in what follows may be taken to refer to currency (coins and notes) plus the
checking deposit liabilities of commercial banks. For the sake of brevity, the model
developed in the preceding section will be referred to as the income model. The naive
quantity theory model that will be explained here may be labelled the money model.

The income model dealt with changes in money income in terms of the demand for and
supply of output. The money model focusses on the supply of and demand for money.
The income model explained the determination of the level of income in terms of
relationships between its component ows. The money model emphasizes the
relationship between money supply and income. The structure of the income model was
based on the distinction between household and business (and government) sectors. In
the money model, the distinction is between the banking sector (supplying the money)
and the nonbanking sectors (the demanders). The concept of income is the same in both
models.

In the money model, the supply of money is treated with the same simplicity that was
accorded investment in the income model—as “autonomously” determined, which is to
s
say that it is not affected by other factors: M = M̄. This assumes that the central bank is
able completely to control the stock of money, which is held at whatever level the bank
desires.

The dynamic relationship in the income model was the consumption function. Here it is
the money demand function. The amount of money demanded is assumed to vary with
income (and, in this naive version of quantity theory, with nothing else). The simplest
d
relationship between income and the demand for money would be: M = kY. Here, k is a
d
constant. Since Y is a ow (measured per year) and M a stock (the average stock of
1
money over the year), k has the dimension of a “storage period.” If k = / , for example, the
4
equation states that the nonbanking public desires on the average to hold a cash balance
that is equal to the total of three months’ income.

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Since there is a determined amount of money in the system, it can be in equilibrium only
when the nonbanking sector is satis ed to hold exactly the amount of money that exists,
d s
no more and no less: M = M . The system represented by these three equations is shown
s
in Figure 3. The determination of income in the system is shown by assuming M = $25
1
million and k = / . The amount of money demanded is equal to supply when income is
4
$100 million. A reduction of the money supply to $20 million will cause income to decline
to a level of $80 million per year.

Figure 3 shows what will happen if income


temporarily exceeds the gure of $100 million per
year. To the right of Ŷ , the amount of money
0
demanded exceeds the existing stock of it. The way
for an individual to build up his cash balance is to
reduce his disbursements below his receipts. But his
spending (to the extent that it is spending on nal
goods at least) is somebody else’s income. A general
Figure 3: Relation between money demand
and income (see text). attempt to build up cash balances cannot succeed—it
Encyclopædia Britannica, Inc. does not induce an increase in the money supply in
this model—because it will result in a decline of
income throughout the system. This decline will continue to whatever level is required to
make the nonbanking sector bring the amount of money it demands into line with the
amount in existence. An excess demand for money is associated with falling income.
Similarly, if the amount of money demanded falls short of the amount supplied, an
individual may decide to reduce his cash balance by increasing his disbursements—but
the money stays in the system; incomes will rise all around. An excess supply of money is
associated with rising income.

The stabilization policy that this model suggests is obvious: if the relationship between
income and the demand for money is stable, the system can be maintained in
equilibrium by keeping the money supply constant or, in a growing economy, by allowing
the money stock to grow at roughly the same rate as real output. If the relationship
between income and the demand for money is found to shift about over time, the money
stock should be made to grow more rapidly in periods of increasing demand for money
and more slowly in periods of decreasing demand.

Comparisons Of The Income And Money Models


Although the two models seem to have nothing in common—the crucial variables of one
do not even appear in the other—their descriptions of what happens during income level
movements are not contradictory. Falling income is associated with an excess supply of
goods and services in the income model, with an excess demand for money in the money
model. Rising income is associated with an excess demand for goods in the rst model,
with an excess supply of money in the other. Evidently the two models give only partial

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descriptions of what is going on: one model looks at the process from the “real” side only
and the other from the “monetary” side. But an excess demand for goods on one side will
be associated with an excess supply of money on the other, and vice versa, so in this
respect the two are consistent.

The controversy between the two schools of thought represented by the models has
mainly to do with two issues. One issue is which set of policy instruments— scal or
monetary—provides the best means of stabilizing the economy. The other, more
fundamental, issue concerns the causes of income movements. As seen above, changes
in investment were the main cause of income movements in the income model; changes
in the money stock were the main cause in the money model. Simplistic as the two
models are, they embody the con icting hypotheses of the two contending schools.
Income–expenditure theorists attribute the instability of income primarily to events that
in uence the business sector’s expectations with regard to the pro tability of new
investment, thus in uencing investment. The modern quantity theorists see the irregular
time path of the money stock as the most important factor.

The gross features of economic history do not contradict either hypothesis. Private
investment has indeed been the most volatile component of Gross National Product.
Similarly, the movements of the money stock have conformed to those of money income:
rapid in ation has been associated with a rapid growth of the money supply; severe
recessions, with a decline in the money supply; and mild recessions, with a slowdown in
the growth of the money supply. (“Mild” recessions may be thought of as recessions
during which total employment stagnates, and the growth in unemployment, therefore,
is largely due to the growth of the labour force.) The controversy has in large measure
come to concern the direction of causation: one side maintains that shifts in investment
cause income changes and infers that these in turn induce changes in the money stock
which go in the same direction; the other side maintains that changes in the size or rate
of growth of the money stock cause income changes that in turn will tend to fall most
heavily on the investment component of income.

The problem of resolving this controversy is twofold. First, the theoretical issue is less
clear-cut than implied above. Each side acknowledges that neither investment nor the
money supply is autonomous and that each affects the other. The question has become,
therefore, which model is “most nearly true” and which model, consequently, should be
regarded as a “ rst approximation” in guiding stabilization policy.

Second, the empirical methods at the disposal of economists are not yet adequate for
settling such issues. Attempts have been made to compare the performance of the two
models by testing whether the best predictions of income are obtained by using actual
data for “autonomous expenditures” and assuming that consumption will obey the
consumption–income relation that has generally obtained in the past or by using actual
money stock gures and assuming that money demand will obey the relation to income
that has generally obtained in the past. These attempts have bogged down in
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disagreements on various statistical matters and must be judged inconclusive. They have
shown, however, that even with consumption functions and money demand functions
that are a good deal more “reasonable” than the naive relationships above, the predictions
of both models are too inaccurate for the purposes of stabilization policy.

Each model emphasizes one set of disturbances (“real” or “monetary”, respectively) that
will cause income to change. Each gives a partial view of the process of income-level
movements. What is needed, therefore, is a third model explaining the linkages between
“real” and “monetary” forces that these two simple models leave out.

Interest-Rate Policy
The third model brings a crucially important—but hitherto generally neglected—element
into the picture of the economic system; namely, nancial markets. For simplicity, the
model has only one nancial market; there is only one class of nancial instruments
(referred to as “securities”) and only one yield (a single interest rate). The standard security
may be thought of as a bond promising to pay annually a xed number of dollars. The
interest rate is the value of the coupon expressed as a percentage of the market price of
the bond. Consequently, if excess demand for bonds brings their price up, the interest rate
falls; if excess supply sends the bond price down, the interest rate rises.

The working of the nancial market is depicted in the model as follows. Investment by the
business sector is assumed to be nanced through the issue of securities. The higher the
interest rate that rms must pay on their securities, the smaller will be the investment
program that they see as promising to be pro table. Thus, investment will be discouraged
by a rise and encouraged by a fall in the interest rate. Households, in deciding how to
divide their income between consumption and saving, will consider the amount of future
consumption that can be gained by abstaining from consumption now (i.e., by saving).
The higher the rate of interest, the larger the amount that can be spent on future
consumption per dollar not spent in the present. Thus, saving is encouraged by a rise and
discouraged by a fall in the interest rate. Coins, notes, and some checking deposits are
assets on which interest is not paid. An individual who holds them has the alternative of
converting some part of his money holdings into interest-bearing form. Thus, the amount
of money demanded will tend to diminish when the interest rate rises and to increase
when it falls. The banking system creates money by buying assets from the public, paying
for the assets through the issuance of additional monetary liabilities (e.g., checking
deposits). Banks must decide whether turning part of their cash reserves to an income-
earning use is worth the risks of decreased “liquidity” entailed by lower bank reserves.
Hence there is a tendency for the money supply to increase when the interest rate rises
and to decrease when it falls.

In this model, then, the interest rate acts as a price in controlling the behaviour of the
individual agents whose activities are to be coordinated. The interest rate itself is
determined by the demand for and supply of money and securities. An increase in

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planned investment will be associated with the issuance of a large volume of securities. It
will tend, therefore, to create an excess supply of securities, to lower securities prices, and
to raise the rate of interest. Similarly, an increase in planned saving will tend to create an
excess demand for securities, to raise their prices, and to lower the rate of interest. An
increased demand for money will, in part, reduce the demand for and increase the supply
of securities; it tends to create an excess supply of securities and to raise the interest rate.
An increase in the supply of money will tend to reduce the rate of interest.

These qualitative propositions are the framework of the new model, integrating the two
d d
previous models as follows: (1) I = I(r); (2) C = C(Y,r); (3) S = Y - C; (4) S = I; (5) M = M (Y,r); (6)
s s d s
M = M (r); and (7) M = M . Here, Equations 1 through 4 restate the income model with the
modi cation that investment is no longer simply “autonomous” but depends on the
current level of the interest rate (r). Equations 5 through 7 restate the money model with
the modi cation that the demand for money and the supply of money also depend on
the interest rate. Two conditions now have to be simultaneously ful lled for the system to
be in equilibrium: desired saving must equal desired investment (Equation 4), and the
amount of money that individuals and rms desire to hold must equal the amount that
the banking sector desires to supply (Equation 7).

Only a partial account of the ways in which this model works can be given here. The
following illustrative examples begin with the system in equilibrium at full employment.
The rst illustration adopts the view of someone who has learned the income model and
hence is thoroughly imbued with the idea that rising income results from an excess of
planned investment over planned saving. Faced with the proposition, drawn from the
money model, that an increase in the money supply will also cause income to rise, he will
ask how such a change in the money supply can cause a discrepancy between saving and
s
investment when there was none to begin with. The answer is that an increase in M will
mean that there is an excess supply of money and a corresponding excess demand for
commodities and securities, but the immediate impact of excess demand will be felt
almost exclusively in the securities market. The excess demand for securities drives the
rate of interest down—and this encourages investment and discourages saving. At that
point, consequently, a “gap” opens up between desired saving and investment.

For the second illustration, consider instead someone who has learned the money model
and who, consequently, knows that income falls when the amount of money demanded
exceeds the supply. In Keynes’s work the “disturbance” given the most play is some
unspeci ed event that makes business rms take a darker view of the returns to be
expected from new investment. Hence, the amount of investment that they will want to
undertake at the prevailing interest rate declines. The question is how such a change in
planned investment can cause a discrepancy between money demand and money
supply when there was none to begin with. The simplest answer is that a decline in
planned investment will be associated with a reduction in the amount of securities
oated on the market and thus with the emergence of an excess demand for securities.

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This drives securities prices up, which is to say that the interest rate falls. At a lower rate of
interest, individuals will desire larger money balances than before; in addition, the banks
will tend to reduce the money stock somewhat. At that point, consequently, a gap will
open between the amount of money demanded and the amount supplied.

The analysis of the consequences of government scal action is somewhat more


complicated. If the government tries to stimulate the economy through increased
expenditures, the effects will be felt in at least two ways. First, the increased spending is
an “injection” added to commodity demand and may be treated, therefore, from the
Model A standpoint in the same way as an increase in private investment. Second,
however, this spending may be nanced through increased taxes, through government
borrowing, through creation of new money, or through some combination of the three.
The strongest effects are gained by following the third alternative, the creation of new
money. The excess demand for goods and services created by the increase in spending
will then be matched by an excess supply of money, which, as seen above, will drive down
the interest rate and cause increased investment, etc. To the direct stimulus of the
spending program, this method of paying for it adds the indirectly achieved stimulus of
increased private investment. (Needless to say, the double effect on money income is not
always desirable. The fact that this method of nancing government spending has almost
always been heavily resorted to in wartime accounts for the historical association of large
in ations with wars.) The method of the second alternative, government borrowing,
consists of nancing the increase in spending through the issue of government bonds.
This creates an excess supply of securities, driving up the interest rate. At the higher
interest rate, money demand is lessened and money supply somewhat increased, but the
consequent excess supply of money will be of smaller magnitude than that entailed by
creating new money. The higher interest rate will also discourage private investment.
Thus, the indirect effects of government borrowing are seen to involve a decrease in
private investment partially offsetting the initial increase in government spending. The
size of this offset has become one of the major issues between “monetarist” and “income–
expenditure” economists. The monetarists argue that the offset is so nearly complete that
scal action will be largely ineffectual unless it is accompanied by an increase in the
money supply, but an increase in the money supply will have almost as powerful effects
without any simultaneous scal action. The other side concedes that scal action will be
more powerful when nanced through changes in the money supply but maintains that
countercyclical variations in government spending nanced through borrowing must still
be regarded as an important stabilization method.

The “Natural” Rate Of Interest And Effective Demand


The thought of Knut Wicksell
Around the turn of the century, the Swedish economist Knut Wicksell contributed greatly
to the understanding of the function of the rate of interest in the mechanism determining
income and price-level movements. Assuming an economy initially in full-employment

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equilibrium, Wicksell analyzed the various ways in which the system might depart from
that position because of discrepancies between the prevailing market rate of interest and
what he termed the “natural rate.” The latter rate, hypothetical rather than directly
observable, may be thought of as the interest rate level that would have to prevail for the
system to remain at full employment with stable prices. In illustrating the use made of
this concept, one should distinguish between processes initiated by “real” disturbances
(the rst two examples below) and those initiated by “monetary” disturbances (the third
example).

The rst example is one in which business rms see increased opportunities for pro table
investment. The system is already at full employment, and hence an increase in spending
on investment without a corresponding decrease in spending for consumption would
spell in ation. What kind of adjustment will maintain stable prices? A rise in the interest
rate will (1) moderate the increase in investment spending and (2) cause households to
divert some of their income from consumption into increased saving. The hypothetical
level of the interest rate that will exactly match the net increase in investment with the
decrease in consumption (increase in saving) is the new value of Wicksell’s “natural rate.”
But the adjustment of the market rate may, for several reasons, come to a halt after going
only part of the way to the new natural rate level. At some level of the market rate below
natural rate, where planned investment still exceeds the savings that households provide
for its nancing, the banks may step in and nance the difference through expansion of
the money supply. Thus, in ation results. In Wicksell’s theory there is in ationary pressure
on the system associated with a market rate below the natural level and, in the version of
it given here, with an increase in the money supply.

The second example involves a change in public behaviour in that households desire to
save more and consume less, out of any given level of income. The decreased demand for
consumption goods threatens to cause de ation (or unemployment). To prevent this it is
necessary to switch resources over to investment goods production, which requires a
lowering of the interest rate. Thus, an increase in saving means that the natural rate of
interest declines. The adjustment of the market rate of interest may again be incomplete
if falling rates induce banks, say, to reduce their new lending below scheduled loan
repayments, thus reducing the money supply. Part of the saving done by households then
goes, directly or indirectly, into reducing the private sector’s indebtedness to banks rather
than into nancing investment. Thus, de ationary pressure on the system is, in Wicksell’s
theory, associated with a market rate of interest above the natural rate and, in this
example, with a decreased supply of money.

The third example is one in which banks desire to expand their loans and, thereby, their
monetary liabilities—creating a “monetary” disturbance. Since “real” incentives to save
and to invest have not changed, the natural rate of interest has not changed. The
increased supply of bank credit will, however, drive the market rate down. It goes below
the natural rate, the money supply is increased in the process, and in ation is the result.

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Keynes and Wicksell


Keynes rst took up Wicksell’s idea in his Treatise on Money (1930). In Wicksell’s writings,
discrepancies between the natural and market rates had invariably been associated with
expansion or contraction of bank credit. Keynes emphasized that such discrepancies may
develop and continue without expansion or contraction of the money supply, because of
speculation in the securities markets. For example, if the natural rate has decreased and
the market rate starts to edge down in response to an excess of the household savings
offered in demand for securities over the supply of new securities marketed to nance
investment, securities prices will rise. This, Keynes suggested, will cause some speculators
in “old” securities to enter the market and supply savers with securities from their
holdings. The excess demand pressure on the market is thus relieved and the rise in prices
(fall of the market rate) halted. The motive for these transactions is the speculators’ hope
that they can buy back their securities at lower prices later. In the meantime, the
speculators hold their funds in the form of ready money; there has been an increase in the
amount of money demanded rather than, as Wicksell assumed, a decrease in the money
supply.

The Wicksell–Keynes theory was an important contribution to the theory of the income-
determination process. Yet there is nothing in its main elements that should have startled
a pre-Wicksellian traditional economist. The natural rate is essentially the interest rate
that would prevail in general equilibrium, and a market rate different from the natural
rate is a disequilibrium interest rate. Traditional economics was clear enough as to the
consequences that will follow if one or more of the prices in the system “gets stuck” at a
disequilibrium level. The Wicksell–Keynes theory, therefore, may be regarded as a
particular application of previously familiar principles.

Keynes returned to the Wicksellian theme in The General Theory of Employment, Interest
and Money (1936), but in that revolutionary work he gave the theory a genuinely novel
twist: he argued that the system might be seriously out of equilibrium even though the
prevailing interest rate was exactly at the Wicksellian natural level. This might happen
because the interest rate mechanism cannot ensure that the plans of households and
business rms with regard to future consumption and production will mesh with each
other. There might, for example, be an increase in household saving—that is, a decrease in
the demand for current consumption goods and an increase in the planned demand for
future goods. Coordination of household and business activities requires that business
rms respond by shifting resources out of the production of present consumption goods
and into investment activities that lay the groundwork for increased output in the future.
Households, in carrying out their saving decisions, do not place contractual orders with
producers for future deliveries of particular goods and services. Thus, the future demands
implicit in current saving decisions may not be effectively communicated to producers, as
ef cient coordination would require. If producers draw up their investment plans on the
basis of forecasts of future demand that do not correspond to the spending that

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households are prepared to undertake in the future, there will be an excess demand (or
excess supply) for future output.

Such effective demand failure is not the result of changes in interest rates or in the supply
of money. The logical way of dealing with it—when it occurs—is through scal policy
measures. The effective demand doctrine is the signal contribution of Keynesian
economics to income and employment theory. It is thus no coincidence that Keynesian
economics has become associated with an emphasis on the use of scal, rather than
monetary, stabilization policies.

The Editors of Encyclopaedia Britannica

"Economic stabilizer". Encyclopædia Britannica. Encyclopædia Britannica Online.


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