Fiscal Policy and Business Cycles

By Alvin H. Hansen | Go to book overview

Chapter XIV
THE DYNAMIC VERSUS THE CIRCULAR FLOW ECONOMY

THE central stream of economic thought, comprising the early classical and neoclassical writers, has often been described as a system of static economics. It consisted essentially of an analysis of how the pricing process determines the allocation of productive resources. It explained how commodities and productive agents are priced in a "circular flow" economy and how, in a society so constituted, the productive process generates a demand for the products which it creates, so that the economy could continue to function at full employment. The rigorous Ricardian analysis explained how the pricing process ensures the reproduction of both the capital and the labor supply without either growth or contraction. It explained how the productive process is able to create consumer demand sufficient to absorb the whole product. In a "circular flow" economy, consumption equals net output. Saving takes the form of allocating a sufficient amount of the gross product to capital replacement. In such a society the whole of the net real income is consumed and aggregate saving is directed exclusively to capital replacement. In such a society the level of consumers' demand determines the volume of investment.

Such was the character of the equilibrium state of early classical theory. Profits tend to fall to that irreducible minimum which will just ensure a maintenance of the accumulated capital stock. Wages tend to fall to the so-called "subsistence" level, varying from country to country according

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