CuapTerR 27A Kaldor and Goodwin’s Models of Business Cycles Introduction We have explained in the previous chapter that J.R. Hicks! explained business cycles troy interaction of multiplier and accelerator subject tothe ceiling or upper limit fixed by full-emplome and the floor. In his analysis of business eycles he combined cycles with growth. Another sienicay Keynesian non-linear model of business cycles is that of Kaldor”, Two other important models trade cycles have been put forward by R-M. Goodwin and Milton Friedman. Like Hicks, Goodyy explains cycles around a growth trend and is a non-linear dynamic model of business cycles. Friedman uses his monetarist theory to analyze business cycles and is therefore known as Friedman’s monetary theory of trade cycles. We first explain Kaldor’s model of trade cycles. KALDOR’S MODEL OF BUSINESS CYCLES Kaldor in his model uses saving and investment functions which are of peculiar shape, The intersection of Kaldor’s investment and saving functions determines the level of economic activity (that is, the level of aggregate employment and output). The intersection of investment and saving functions, as shall be seen below, yields three equilibria, two stable and one unstable. We first explain investment and saving functions used by Kaldor in his model of trade cycles. Kaldor’s Investment Function, According to Kaldor’s investment function, investment isa function of income ¥ (i.e. level of economic activity) and the stock of capital (K). His investment function can be stated as follows: 1=f(Y,K) ar where 5,>° yi By Tepresents marginal propensity to invest. Note that Kaldor’s investment function is not the accelerator relationship. According to the conventional principle of accelerator, investment or demand for capital goods depends upon the rate of change of income (i.e. rate of change of the level of economic activt)) while, in Kaldor’s investment function, investment or demand for capital goods depends upon the level of income or economic activity. It should be noted that in Kaldor’s analysis the lev! 0 economic activity means the level of aggregate employment or aggregate output or income. Furthes in the Hicksian analysis accelerator or investment demand does not consider the effect of capital accumulation on the productive capacity and therefore on the new investment decisions by the entrepreneurs. In Kaldor's model of trade cycle, capital accumulation by raising the productive capacity affects the investment decisions of the entrepreneurs. The effect of the capital accumulation 1. LR. Hicks. A Contribution to the Theory of Trade Cycles, Oxford: Oxford University Press. 1950 2, _N, Kaldor, A Model of Trade Cycles, Economic Journal, Vol. 50, 1940, Pp. 78-92. 598 Scanned with CamScannerKaldor and Goodwin’ in’ Models of Business Cycles = a 2 "Yestment function and non-linear saving function i y Ty say for given K i > 0 Real Income ie Po) Real Income 5 fy 1A.1. Kaldor Non-Linear Investment Function 27A.2. Kaldor s Non-Linear Saving Function tat Kaldor explains trade cycles. Kaldor’s non-linear investment function is shown in Figure 11. According to this investment function, there is normal level of marginal investment propensity 1 @) in the middle range of real income or the level of economic activit That is, marginal opensity to invest is assumed to be small at both the high and low levels of economic activity. The declining slope (i.e. marginal investment propensity) of investment function at lower level of ral income (ie. economic activity) is due to decrease in profit opportunities for investment. At lighe level of economic activity, due to decrease in economies of scale and rise in financial costs ‘fproduction, marginal investment propensity a becomes small. Further, Kaldor assumes that there is inverse relation between investment and capital stock. Yorn evel of investment is high, there is large accumulation of capital stock which reduces the ‘age of available investment opportunities. This implies that asa result of large capital accumul: bye of investment falls for each level of income (i.e. economic activity). Thus, with accumulation ‘fore capital stock due to higher levels of investment in the upper portion, investment function ‘ane will shift downward. Kaldor’s Saving Function: Kaldor uses the following Keynesian saving function: dS S=f0 77° os : er $y Tepresents marginal propensity to save. AS in case of i 1 function Kaldor uses non-linear saving function which is also of a la hae and dranmFig, 274.2, In this saving function, used by Kaldor, at middle range "taionay income, there is a normal value of marginal propensity to save {$). When due to w Scanned with CamScanner600 Macroeconomics : Theory and Policy level of national income is high, profits to the capitals, propensity to save of the rich capitalists is greater th ity in other words, the sk workers, Thus, marginal saving propensity |p } on in other » The slope of the Saving, funetion curve, S(1) will rise at higher levels of national income. On the other hand, at Tower iy, 7 of national income (i.e. economic activity) caused by lower investment, profit share jn nation income will fall leading to the decline in marginal propensity to save (ce. the slope of saving fincigg as Itis due to this particular behaviour of marginal propensity to save ($) ‘hal the saving fans curve, S(¥) takes the peculiar shape as shown in Fig, 27A.2. Determination of Level of Economic Activity: Stable and Unstable Equilibria S Will a higher levels of investment, | . yl a that of larger because the marginal Kaldor explains the occurrence of trade eycles through saving and investment functions whch by their interaction determine the level of activity, that is, the level of national output, employmay and income. Itis worth noting that Kaldor uses planned (i.e, ex-ante) saving and investment function and not the actual (i.e. ex-post) saving and investment functions. Planned or ex-ante invesiney ‘means intended addition to the stock of fixed capital and inventories of goods. This planned or ante investment differs from the realised or actual or ex-post investment by the amount of unintended increase or decrease in inventories of goods which arise due to the difference between planned and realised sales of goods. Similarly, planned ot ex-ante saving means the savings they intend to make for a period if they had accurately forecast their incomes. Therefore unexpected changes in te level of income will make the realised or ex-post savings different from the planned ot ex-ante savings. Kaldor uses the Keynesian equality of planned (ex-ante) investment and saving to explain the determination of equilibrium level of national income (economic activity). Given the peculiar non- linear investment and saving function curves three equilibria at points 4,B and C of national income are possible for any given level of capital stock, as shown in Figure 27A.3. Equilibrium at B is quite unstable both upward and downward. Above the equilibrium point B, planned investment exceeds planned saving and therefore when as a result of some disturbance or shock, planned investment exceeds saving, the national income (i.e. the level of activity) will go on moving upward until point Cis reached. On the other hand, with equilibrium position at point B, if as a result of some disturbance in the economy, the planned investment falls short of planned saving, the national income will go on moving downward until point A is reached. Thus, the equilibrium in the middle point B is 2 Real Income ‘srable ar quite unstable and, as explained Fig. 27A.3, Kaldor s Business Cyole Theory Unstable Equilibria Investment (J) and Saving (S) Scanned with CamScannerjc frees wi : gan bringing It back to the position p_ ' ““°MOMY away from the equilibrium position B Sea rants fe eequilibrium point C where both investmey ff) and investment function (I= /(Y) assume a jeane corresponding to a given level of activity, paitng inthe shifis in the investment and saving fun role cyoles found in free market economies. Suppose to start with in Fig, 27A.3 the economy is in cqilirium at point C where it is enjoying higher levels of income and employment as levels of toh investment and saving are high. The high level of investment at point C will cause capital sick (K) to be increasing and so the output of consumer goods. There are two consequences of fis. First, with the rapid increase in capital stock as a result of high level of investment, the portunities for further investment become temporarily restricted which will tend to make investment fil, Asa result of this, investment function curve will shift downward. On the other hand, with level of investment being high at point C (Fig. 27A.3), both the ‘orumption and saving increase for any given level of activity which will cause a shift in the sing function [S(¥)] curve upward. As a consequence of these shifts in investment function, 1(¥) ad saving function, S(Y), point C is gradually shifted leftward and point B rightward so as to come diser to one another (See Fig, 27A.4) and with this level of activity or real income will be reduced It is through changes in the stock of capital tions that Kaldor explains the self-generating sm) 1 a Y) cS £ iB B 3 2 Ss 5 & g > = ° K 1, 0: Real Income y Real Income Fig. 27A.5. ‘Shifting of Investment and Saving Curves resulting in B & C coming closer. resulling in B and C joining together. tothe culfe situation, The critical point isteeched when asa result of gradual shifting two curves, the two points coincide and combined point BC is reached (See Fig. 27A.5). TIAA, Shifting of Investment Saving Curves Scanned with CamScannerMacroeconomics : Theory and Policy However, the combined equilibrium point BC in Figs 216 He sonable it Cov direction and stable in the upward direction. Therefore, after some CATE he oseving greater than investment (S> J) the level of activity (that is, ip SSeaiitalow ae IY until a ney, stable equilibrium point dis reached. But stable equilibrium A represtnr ® i ly equilirign where levels of income and employment are very small. In othe at equilibrium poi ssi sssion in the economy. er i oe riovevethe eeeie will not remain at the low-activity ene at meet for ever, This is because forces will again accumulate which will cause shift in ex-ante ivesiment and curves. When low-level activity continues at point 4 for some time, investment ecomesinsicieg to cover even depreciation of fixed capital, negative net induced invest will occur. With iis the investment opportunities again become available which would cause upward shift in thy investment curve. Kaldor points out this upward tendency in the level of activity may be reinfo by the new innovations which require further investments. This will give further boost tothe ley of activity. 602 Savi y Si y y vy in) 50) jc HY) o s & 2 y & a é é os 5 g AB 5 5 z 5 z I ‘A o > ot Real Income o Real Income Fig. 27A.6. Shifting of! & Scurves resulting Fig. 27A.7. Stable Equilibrium at AB in the Downward in A & B coming closer. Direction and Unstable upwards. ___ Furthermore, with the gradual decrease in capital stock at low activity point A will reduce income per person employed. This will cause saving function curve S(Y), to shift downward over time. Thus after a while upward shift of investment function curve and downward shift inthe saving curve will cause A to shift rightward and B leftward so that points A and B come closer 0 each other (see Fig. 27A.6 and this process will continue until a tangency point AB is reached (Set Fig. 27A.7). This new equilibrium point AB in Fig. 27A.7 is stable in the downward direction but is unstable in the upward direction because planned investment (J) exceeds planned saving ( above the tangency point AB. Thus, following a shock, capital will go on accumulating and rel income wil goon sing until point C is onee again reached (See Fig. 274.7). Ar point Cit ‘iences a strong yom. it i cant chen e om the circle is complete. After some time the cycle starts Evaluation. Kaldor’s model of business ¢ itasit l : ° yele has a great merit as it brings out self-generatiné nature of business cycles. The business cycle will occur even if one of the we eurves is lineat. FO" example, cyclical nature of economic activity does not change significantly if saving function cu" is linear. Itmay be noted that due to the great * it en reformulated by Chang and Smyth and Schiee of Kaldor’s model ofbusines cele thas id Scanned with CamScannerKaldor and Goodwi Models of Business Cycles o GOODWIn’s MODEL OF BUSINE: : CYCLES out oodwin's model of business cycles sera seve We ti har Hiciah Bee he thinks there is need to combine growth and : | | uction of i exponent growing autonome sora growth in his model of trade cycles by pin labour force and improvements in techniques oth, These 10 FACTO, in his view, cause pers wearily equal to growth in demand, Accor through occasional bursts of innovatioy WW are crucial factors in determining economic Persistent growth in productive capacity but not é ‘ding to Goodwin, adequate growth in demand is sieved U na mal investment, Rie ihe Glace of a cycle means that aggregate demand is not always uate ye Cabacities of capitalism and at first we might be tempted to that they are ever realized. In 7 i 7 I P wonder s general, new techniques require heavy investment outlays sien swell demand so that both increased output per labourer and the increased number of labourers aeatsorbed. When the economy has achieved its new higher levels of output and capital, it cannot jolthem because the great bursts of investment (both innovational and accelerational) is necessary ineeatete effective demand, and when it ceases, demand and output drop, thus creating unemployed cil and unemployed labour”3, Goodwin assumes that structural coefficients of the economy such as propensity to consume arsave and capital-output ratio are such as to give ‘explosive oscillations’.? According to him, investment once begun carries the free market economy to full employment and this upper limit {isesrapidly with accumulation of capital which allows the realisation of the technological progress. Tus, the expansion of the economy is constrained by the full-employment ceiling. However, after remaining at the peak, certain forces push it downward again, Thus, in the absence of lags, Goodwin's roéel visualizes a two-phase cycle, full employment and deep depression. Formal Framework of Goodwin’s Model Goodwin takes capital stock rather than income as the central explanatory variable. He rejects tte simple proportionality of capital and output (i.e. constant capital-output ratio) and explains investment on the basis of comparison of desired capital stock with the actual capital stock. He 1s fetible accelerator’ as the explanatory principle for investment. According to this principle, ‘etinvestment will be undertaken as long as desired capital stock is greater than existing capital and disinvestment will occur if desired capital stock is less than the existing capital stock. Thus the cnial equation of his model of cyclical growth is that of factors which. determine desired capital (() stock and is stated as under: K*=VY+BO a Where V’is the acceleration coefficient (i.e. capital-output ratio), Y is the output, and (By) is a Draneter representing a change in technique or technology. According to equation (1), innovation ‘technological advance implies that more capital is desired with a given output and the accelerator ©) implies that more capital is desired with increased output. Thus equation (1) describes the Miciple of flexible accelerator”. eee 3. RM. Goodwin, “A Model of Cyclical Growth” Norid (London: Macmillan, 1955) ; : How the interaction of multiplier whose value is determined by propensity to consume and acceleration Coefficient whose value depends on capital-output ratio gives rise 10 explosive oscillations. See the Previous chapter 27) in E, Lumberg (Ed.), The Business Cycle in the Post-War Scanned with CamScanner60s Macroeconomics : Theory and Policy | Goodwin argues that even if B(A) in equation (1) is ignored, it ie describe the Convent, accelerator principle which assumes a perfect adjustment of capital 40 oxdpt A all tings 0," contrary, in Goodwin's model it is assumed that “with a given stock of capital we can Produce (by overtime, etc.) than it was designed to produce, and obviously also less. Furthermore, ing capacity there is usually some stand-by or-peak-load capacity which ean d this high-level operation involves higher variable costs, s rain oh staff and equipment all of which create a pressure to expand capital and capacity Therefore, the short-run is charg by “failure to exemplify the acceleration principle” " ‘The pressure to expand capital stock through investment is proportional to the difg,, between desired capital stock (K*) and the actual capital stock (K) subject to two On-line, constraints, The upper limit is set by maximum output of new capital goods obtainable With give, capital stock and labour and therefore corresponds to the full-employment ceiling visualize, JR. Hicks. The lower limit is set by the rate at which capital can be scrapped at zero gross investmen, (Note : Zero gross investment implies that depreciation allowances are not spent on replacement capital.) It follows from above that, according to Goodwin, 1=4(K*=K) +0) where A is proportion of the gap between the desired capital stock (K*) and the actual capil stock (K) which determines investment. Since investment leads to the expansion in productive capacity, the equation (2) represents the supply side of the model. Demand in Goodwin's modelis given by the Keynesian multiplier and can be stated as under: vLQ). a The relation between income or output (¥) and investment (/) depends on the size of multiplier which is governed by marginal propensity to consume or save. Goodwin notes that propensity i save is rather small which ensures higher value of multiplier in the downswing of a business cycle because expenditure is difficult to be reduced when incomes decline. ‘We now proceed to derive the complete version of Goodwin's model. To do so, we substiue the value of K* of equation (1) in equation (2) and get I= Av ¥+ BQ) -K] Since Y=/(1) 7= f(D + (BO) -K] 1= dof (D+ ABO) 2K AK = dof (2) + 2BW) —1 Dividing both sides by 2 we have Kevan prt vo From the above equation (4) it follows that capi arid technological change (i.e. innovations). ‘apital stock (K) depends on investmen Explaining Business Cycles 5. Goodwin, on. cit Scanned with CamScannerif K*>K, then /=]-D if K* =K, then /”=0 if K*< K, then ”=—D Now suppose technological advan innovati eerie aad ae a " (Ze. innovations) or BQ) is absent and the economy is fe ee esired capital stock exceeds capital stock, then net investment (f)will oc . Fale Period over time until actual capital stock (K) becomes equal to the desired cil stock (K*). During the period net investment or capital accumulation is taking place, it will ‘wing about expansion in output, income and employment through interaction of multiplier and accelerator and the economy will move up till the upper limit. When the desired capital stock is reached investment will slacken. This will cause the economy tomove downward through the interaction of multiplier and accelerator which will now cause rapid fall in output and employment. This downward movement continues until gross investment (/® ) falls to zero, that is, even depreciation allowances are not spent. The depreciation continues to cccut until the capital stock falls below the low level required in the depression. In this way we see tha, according to Goodwin, sharp booms are periodically accompanied by prolonged depression. ‘There is a lower limit or floor to the downswing set by the minimum investment required to replace capital that is scrapped in each period. It is worth noting that the floor of economic activity in Goodwin's model also rises with each successive cycle because of greater expenditure and sociated fixed outlay during the previous boom period. Hence there is imit to which the desired tpt stock falls, Thus the economy surges forward and plunges down but does not go back 10 the old level. Growth and Cycles i ic growth which, according to Goodwin, ‘The above analysis ignores the tw« sources of economic grow! * play crucial role in cae ing the cyclical growth. As mentioned above, two sources of economic trowth are: (1) the increase in size of labour force and (2) nereck® Xe productivity oflabour due to srnare: (1) the incr progress. Asaresult of the operation of hese (wo OFS there is ise in ikemployment ceiling Own assumes that al growth inthe fllemployment cling : ough growth of capital stock resulting in boom, full- pi At te ec is accumulated to equip the increased ‘mployment output may rise rapi P d i bove the previous peak and carries the bay ees, But his output rises above th a sary ie cae ae secular multiplier. Along with accelerator his causes lage ised to ein fllemplose! OUP say percent oO Py aceeerating capital stock “ gowth of wed enpital Pg this in combination with the slowly iB ; of desired capital at Stermines the length of boom” wool, + Lunberg (Ed) The Business Cycles inthe Post-War & RM, i tical Growth in E Lu Goodwin, A Model of Cycl Period, Macmillan, London Scanned with CamScanner606 Finally, when itis | rising labour productivit s recognized that innovation (i.e. technological advance) an, de : ire additional investment, we gop . “Me ty will generally requir 1 n Be a ey hort depression period in Goodwin's © 5 et * ‘olonged boom period and sI n 'SMode| gp,“ realy, namely Pony comments "stead rise Bt) wil further prolong hepa sagt ih cepession whe aration in Bf) may acconn fo diferences Betvees cee ang a ‘ and between countries”.” me Evaluation fies Goodwin, like J.R. Hicks, assumes an economy whose behaviour i characterized y , . . towards ‘explosive oscillations’. Therefore, these oscillations must be constrained by ‘eit Sy ‘floors’ if business eycles of reasonably regular amplitude are to be explained. ‘This 2% “ghtly done so by Goodwin in his model business eycle. But if economy’s inherent en bee, towards ‘damped cycles’, then persistent cycles cannot be accounted for by Goodwins Ragnar Frisch, the Nobel prize winner in economics, has given a correct answer in terms fy random shocks to the system”.8 Random shocks means erratic changes in any orall of the ce whether exogenous or endogenous. Thus accelerator-multiplier interaction models as ofan and Hick alongwith random shocks fo the economy, as pointed out by Surrey, provide aewm explanation of trade eycles with fairly regular amplitude. M.J.C. Suey i right when the wou “Informally random shocks keep the systems in motion and prevent its settling down to 4 stable equilibrium, but the frequency of the cycles which the system follows is governed by muti, accelerator interaction. There is some tentative empirical evidence that this is indeed a plausible view to take of the generation of business cycles” 9 iness Cycles, AER, 9. M.J.C. Surrey, op. cit. p. 255 i Scanned with CamScanner