42838 (Endogenous Cycle Models)

Contents

Introduction

1. Endogenous Cycle Models: Kaldor's Non-Linear Cycle

Conclusion

Literature

Introduction

The multiplier-accelerator structures reviewed above have linear dynamic structures. As a result, cycles are generated and maintained only by structurally unstable parameter values (Samuelson) or dampened dynamics with continuous exogenous shocks (Frisch-Slutsky) or exogenously-constrained explosive dynamics (Hicks). As a result, early Keynesian linear multiplier-accelerator fall dangerously close to an "untheoretical" explanation of the cycle - precisely what the original Oxbridge research programme was designed to avoid.

However, linear structures are often adopted because they are simple and the results they yield are simple. But simplicity is sometimes more a vice than a virtue - particularly in the case of macrodynamics and economic fluctuations. It is not only unrealistic to assume linearity, but the very phenomena that we are out to uncover, the formation of cycles and fluctuations, becomes relegated to the "untheory" of exogenous shocks, ceilings, floors, etc. The contention of Lowe (1926) and many Keynesian writers is that theories of fluctuations ought really to explain how fluctuations arise endogenously from a working system otherwise (paraphrasing Lowe's title), how is business cycle theory possible at all?

As a result, many economists have insisted that non-linear structures should be employed instead. Why interest ourselves with non-linear dynamics? As one famous scientist answered, for the same reason we are interested in "non-elephant animals". In short, non-linear dynamical structures are clearly the more general and common case and restricting attention to linear structures not only unrealistically limits the scope of analysis, it also limits the type of dynamics that are possible.

1. Endogenous Cycle Models: Kaldor's Non-Linear Cycle

One of the most interesting theories of business cycles in the Keynesian vein is that expounded in a pioneering article by Nicholas Kaldor (1940). It is distinguishable from most other contemporary treatments since it utilizes non-linear functions, which produce endogenous cycles, rather than the linear multiplier-accelerator kind which rely largely on exogenous factors to maintain regular cycles. We shall follow Kaldor's simple argument and then proceed to analyze Kaldor in the light of the rigorous treatment given to it by Chang and Smyth (1971) and Varian (1979).

What prompted Kaldor's innovation? Besides the influence of Keynes (1936) and Kalecki (1937), in his extremely readable article, Kaldor proposed that the treatment of savings and investment as linear curves simply does not correspond to empirical reality. In (Harrodian version of) Keynesian theory, investment and savings are both positive functions of output (income). The savings relationship is cemented by the income-expenditure theory of Keynes:

S = (1-c) Y

whereas investment is positively related to income via an accelerator-like relationship, (which, in Kaldor, is related to the level rather than the change in income):

I = vY

where v, the Harrod-Kaldor accelerator coefficient, is merely the capital-output ratio. Over these two relationships, Kaldor superimposed Keynes's multiplier theory: namely, that output changes to clear the goods market. Thus, if there is excess goods demand (which translates to saying that investment exceeds savings, I > S), then output rises (dY/dt > 0), whereas if there is excess goods supply (which translates to savings exceeding investment, I < S), then output falls.

The implications of linearity can be visualized in Figure 1, where we draw two positively-sloped linear I and S curves. To economize on space, we place two separate sets of curves in the same diagram. In the left part of Figure 1, the slope of the savings function is larger than that of the investment function. Where they intersect (I = S) is the equilibrium Y*. As we can note, left of Y*, investment is greater than savings (I > S), hence output will increase by the multiplier dynamic. Right of point Y*, savings is greater than investment (I < S), hence output will fall. Thus, the equilibrium point Y* is stable.

In the right side of Figure 1, we see linear S and I functions again, but this time, the slope of the investment curve is greater than that of the savings curve. Where they intersect, Y*, investment equals savings (I = S) and we have equilibrium. However, note that left of the equilibrium Y*, savings are greater than investment (I S), so output will increase and move further to the right of Y*. Thus, equilibrium Y* is unstable.

Fig.1 - Savings, Investment and Output Adjustment

Both exclusive cases, complete stability and complete instability, are implied by linear I and S curves in figure 1, are incompatible with the empirical reality of cycles and fluctuations. Hence, Kaldor concluded, it might be sensible to assume that the S and I curves are non-linear. In general, he assumed I = I (Y, K) and S = S (Y, K), where investment and savings are non-linear functions of income and capital as in the Figure 2 below.

We shall focus the relationship with income first. The logic Kaldor (1940) gave for this is quite simple.

The non-linear investment curve, shown in Figure 2 can be explained by simply recognizing that the rate of investment will be quite low at extreme output levels. Why? Well, at low output levels (e. g. at Y_A), there is so much excess capacity that any increase in aggregate demand will induce very little extra investment.

The extra demand can be accomodated by existing capacity, so the rate of investment is low. In contrast, at high rates of output, such as Y_C, Wicksellian problems set in. In other words, with such high levels of output and demand, the cost of expanding capacity is also increasing, capital goods industries are supply-constrained and thus demand a higher price from entrepreneurs for producing an extra unit of capital. In addition, the best investment projects have probably all already been undertaken at this point, so that the only projects left are low-yielding and simply might not be worth the effort for the entrepreneur.

Thus, the rate of investment will also be relatively low. At output levels between Y_A and Y_C (e. g. at Y_B), the rate of investment is higher. Thus, the non-linearity of the I curve is reasonably justified.

What about the non-linear savings curve, S? As shown in Figure 2, it is assumed by Kaldor that savings rates are high at extreme levels of output. At low levels of output (Y_A), income is so low that savings are the first to be cut by individuals in their household decisions.

Therefore, at this point, the rate of saving (or rather, in this context, the rate of dissaving) is extremely high. Slight improvements in income, however, are not all consumed (perhaps by custom or precaution), but rather much of it is saved.

In contrast, at high levels of output, Y_C, income is so high that the consumer is effectively saturated. Consequently, he will save a far greater portion of his income - thus, at points like Y_C, the savings rate is quite high.

Fig.2 - Non-Linear Investment and Savings

With the non-linearity of I and S justified, Kaldor (1940) proceeded to analyze cyclical behavior by superimposing the I and S curves (as in Figure 2). As we can see, there are three points of intersection (A, B and C) where savings equals investment (I = S). Let us consider each individually. Left of point A, investment is greater than savings hence, by the multiplier, Y increases to Y_A; to the right of point A, savings is greater than investment (hence Y decreases to Y_A). Consequently, it is easy to note that A (and Y_A) is a stable point. The same analysis applies to the points to the right and left of Y_C, hence C (and Y_C) is also a stable point.

Intersection point B (at Y_B) in Figure 2 is the odd one. Left of B, savings exceeds investment (so Y falls left of Y_B) and right of B, investment exceeds savings (so Y increases right of Y_B). Thus, B is an unstable point. Consequently, then, we are faced with two stable equilibria (A and C) and an unstable equilibrium (B). How can this explain cyclical phenomenon? If we are at A, we stay at A. If we are at C, we stay at C. If we are at B, we will move either to A or C with a slight displacement. However, no cycles are apparent.

The clincher in Kaldor's system is the phenomenon of capital accumulation at a given point in time. After all, as Kaldor reminds us, investment and savings functions are short term. At a high stable level of output, such as that at point Y_C in the figure above, if investment is happening, the stock of capital is increasing. As capital stock increases, there are some substantial changes in the I and S curves. In the first instance, as capital stock increases, the return or marginal productivity of capital declines. Thus, it is not unreasonable to assume that investment will fall over time. Thus, it is acceptable that dI/dK < 0, i. e. the I curve falls.

However, as capital goods become more available, a greater proportion of production can be dedicated to the production of consumer goods. As consumer goods themselves increase in number, the prices of consumer goods decline. For the individual consumer, this phenomenon is significant since it implies that less income is required to purchase the same amount of goods as before. Consequently, there will be more income left over to be saved. Thus, it is also not unreasonable to suspect that the savings curve, S, will gradually move upwards, i. e. dS/dK > 0. This is illustrated in Figure 3.

Fig.3 - Capital Accumulation and Gravitation of Investment and Savings Curves

So, we can see the story by visualizing the move from Figure 2 to Figure 3. Starting from our (old) Y_C, as I (Y, K) moves down and S (Y, K) moves down, point B will gradually move from its original position in the middle towards C (i. e. Y_B will move right) while point C moves towards B (Y_C moves left). As shown in Figure 3, as time progresses, and the investment and savings curves continue on their migration induced by capital accumulation, and B and C approximate each other, we will reach a situation where B and C meet at Y_B = Y_B and the S and I curves are tangential to each other. Notice that at this point in time, C is no longer stable - left and right of point C, savings exceeds investment, thus output must fall - and indeed will fall catastrophically from Y_B = Y_C to the only stable point in the system: namely, point A at Y_A.

At Y_A, we are again at a stable, short-run equilibrium. However, as in the earlier case, the S and I curves are not going to remain unchanged. In fact, they will move in the opposite direction. As investment is reigned back, there might not even be enough to cover replacement.

Thus, previous investment projects which were running on existing capital will disappear with depreciation. The usefulness (i. e. productivity) of the projects, however, remains. Thus, the projects reemerge as "new" opportunities. In simplest terms, with capital decumulation, the return to capital increases and hence investment becomes more attractive, so that the I curve will shift upwards (see Figure 4).

Similarly, as capital is decumulated, consumer industries will disappear, prices rise and hence real income (purchasing power) per head declines so that, to keep a given level of real consumption, savings must decline. So, the S curve falls. Ultimately, as time progresses and the curves keep shifting, as shown in Figure 4, until we will reach another tangency between S and I analogous to the one before. Here, points B and A merge at Y_A = Y_B and the system becomes unstable so that the only stable point left is C. Hence, there will be a catastrophic rise in production from Y_A to Y_C.