1st Introduction to the problem
2nd The main representatives and opponents
3rd Starting point: Say's law
4th Keynes' criticism on the Say's law
5th A simple C-I model
6th Criticism on the purchasing power parity theory
7th The alternative S-I model
8th Supply and demand for money
9th The Hick's IS-LM model
10th Integration of the employment function
11th Criticism on Keynes' assumptions
5th A simple C-I model
This initial criticism on Say's law soon developed into a complex system for explaining macroeconomic variables such as national income, employment, investment volume and consumption sum. We want to begin the analysis of Keynes' system with a very simple model. The problem variables here would be only the level of national income at which equilibrium dominates, i.e. at which the supply of and demand for consumer goods correspond, as well as the demand for consumer goods at equilibrium. If one wants, one can regard the level of income as an indication of realised employment. Data variables of the model are the consumer demand function and the autonomously determined investment demand.
At the centre of this simple model is the thesis that consumption demand was always smaller than income, so that a part of the income was always or mostly saved and therefore no longer flowed back into the cycle, i.e. it seeped away. Whereas Say proceeded from the assumption that the entire income would in turn lead to demand (either to consumption demand or to savings, but that these would be transferred into an investment demand), Keynes proceeds from the other extreme, i.e. that initially only those parts of income would lead to demand again which were consumed directly.
Of course, Keynesian theory also recognises investment demand, but in the initial models this is conceived as a creation of purchasing power which is completely independent of savings.
Let us examine the consumption function, which indicates how consumer demand changes with changes in income, in more detail. For this purpose, we draw a diagram. On the abscissa we plot the respective national income (E) and on the ordinate we plot the demand for consumer goods (C) and the demand for investment (I). Firstly, we draw the consumption function.
This purple consumption function intersects the ordinate in a positive sector. This is based on the fact that even if a household had no regular income at all, it would still have a consumption need that corresponds to the subsistence level and that would be supported by state aid (social assistance) if necessary.
Furthermore, we note that the consumption function has a gradient that is less than one and simply corresponds to the assumption that not the entire income is spent on consumption. We ask by how much consumption increases (dC) when income increases by one unit (strictly speaking by an infinitesimal unit) (dE). We call this quotient (dK/dE) the propensity to consume (c). For the sake of simplicity, we assume a linear consumption function. In this case, the propensity to consume is the same at every income level, i.e. constant. In reality, we can expect that the propensity to consume decreases as income increases, since more and more parts can be saved as income rises. However, the correlations that are to be illustrated in this first model are not distorted by this simplification.
The propensity to consume is distinguished from the consumption ratio (K/E), which indicates what percentage of income is spent on consumer goods (c‘). This consumption rate changes - given a linear course of the consumption function - with every change in income. We determine the consumption rate at a certain income level by drawing the radius vector from the coordinate origin to the consumption point that corresponds to the selected income level. Increasing income corresponds to an ever-decreasing consumption rate.
Let us now add to our graph our second determinant: investment demand. In this simplified Keynesian model, investment demand is treated as an autonomous variable, which means that investment demand does not depend directly on any economic variables, especially not on the level of national income or consumption demand. We can therefore include investment demand in our graphical model by forming a parallel with consumption demand, where the distance from the consumption function corresponds to the investment volume.
The line (curve) drawn in yellow in our diagram thus indicates how the total demand for goods, i.e. the sum of consumption and investment demand, changes when income varies. Since we assumed a constant investment volume, the total propensity to spend (dC+dI)/dE thus also corresponds to the propensity to consume, and therefore it is also less than one.
If in a next step we now must ask ourselves whether and, if so, at which level of national income an equilibrium exists, we still must think about the course of the supply curve. The value of the supply corresponds ex definitione to the national income since national income and the supply of goods represent merely two different sides of one and the same economic variable. Thus, in our diagram we can draw the supply as a 45° line from the origin of the coordinates.
The point of intersection of the curve of total demand with the supply curve indicates at which income level supply and demand correspond. Since the demand curve starts above the origin of the coordinates and since its gradient is in any case lower than the gradient of the supply curve, it can be assumed that there is also an equilibrium point.
Let us now ask ourselves whether we can also expect that this equilibrium point is aimed for automatically from any state of disequilibrium, i.e. whether there is also a stable equilibrium.
In our graph above, the income EG corresponds to the equilibrium income. At the lower income E1, however, the total demand (yellow line) is greater than the supply (45° line). Thus, there is excess demand. The enterprises will try to satisfy this excess demand by expanding production. As a result, income rises and approximates the equilibrium income. Therefore, there is an automatic tendency towards equilibrium.
Now let us choose an income that is larger than the equilibrium income, the income E2. With this income, supply exceeds demand. Entrepreneurs will adjust supply to the reduced demand and reduce production. Again, supply adjusts itself to demand. So even from a supply surplus there are tendencies towards equilibrium.
In this way it is shown that an equilibrium tendency can be expected on the goods markets even under Keynesian conditions. However, this equilibrium mechanism differs in two respects from the equilibrium process described in the framework of neoclassical equilibrium theory. Firstly, while in a neoclassically functioning market it is price variations that trigger the equilibrium process, in the Keynesian model the equilibrium process takes place only via quantity changes. Secondly, neoclassical theory describes that equilibrium is normally aimed for from both the supply side and the demand side. In the Keynesian model, it is only adjustments in supply that help to eliminate the imbalance.
Now let us remember that Keynesian theory emerged during the Great Depression and claims to have developed a recipe for reducing unemployment. Unemployment and employment, however, have been mentioned only marginally at that time. We have asked about the determinants of national income and not about the causes of too little employment. Therefore, we still need to create the link between national income and employment in our diagram. We had already indicated that national income can be regarded as an indicator of employment. When real national income rises, employment normally rises as well. A more detailed analysis of these relationships follows in a later section of this chapter.
Now we had seen that in this simple C-I model, the propensity to consume alone, together with the autonomous volume of investment, determines the equilibrium point. Thus, there is no reason why this equilibrium on the goods markets should occur precisely at an income level at which there is also full employment. On the contrary, there is every indication that the equilibrium on the goods market generally corresponds to an imbalance on the labour market - but not necessarily to a supply surplus.
Let us now assume that the income that would guarantee full employment has just been reached at the income EVB . The actual income, on the other hand, was at EG, the equilibrium income, which does not guarantee full employment. Full employment can obviously be achieved here only if the yellow curve of the total demand can be shifted upwards by dI. This means that either the propensity to consume of private households and/or the investment demand must be increased by this amount.
Now, in both cases it is initially a matter of private demand, which cannot be influenced directly by the state. Nevertheless, it would be conceivable that the state itself would increase so-called infrastructure investments (such as investments in education or the traffic network) or that it would give enterprises an incentive to increase investment demand by means of subsidies.
However, when we presented this simple model, we pointed out that simplified assumptions were deliberately made in this model in order to make it easier to illustrate the basic problems of this model. Now that we have shown the basic problem, we can remove some of these unrealistic assumptions.
For this purpose, we take into account that those parts of the income that are not used for the purchase of domestically produced consumer goods can not only be saved, but that they can also be paid to the state as taxes or used as demand for consumer goods that are produced abroad. All three types of use (savings, income taxes, imports) have in common that income which has been generated domestically is used for purposes which no longer flow back into the immediate domestic cycle. We therefore want to refer to these three uses of income as immobilisation.
In a similar way, investment demand must be replaced by an extended concept. In this model we have assumed that investment demand is autonomous, i.e. not induced by other economic variables. Of course, investment demand is not the only demand that can be set autonomously. Besides investment demand, the state can increase its expenditures, whereby expenditures for goods and services, but also subsidies for enterprises or private households can be considered. These expenditures are also autonomous and do not simply result from the action of the other economic variables.
However, government spending obviously only has a demand-increasing effect if it is financed on a deficit basis. If the state were to finance these expenditures with additional tax revenues, it would reduce private consumption demand to the same extent; on balance, autonomous demand would not have increased or - as we will show later - not significantly.
Besides government spending, autonomous demand can also be exercised by foreign buyers, namely when exports rise more strongly than imports. We want to combine all three autonomous types of demand (investment, deficit financed government spending as well as export surpluses) as purchasing power creation. In our graph, this means that instead of investment demand, the entire purchasing power creation must be added to consumption demand.
Therefore, the state can now also ensure in quite different ways that income is raised to the level necessary for full employment by way of the creation of purchasing power. In its own sector, it can invest in infrastructure and hire more civil servants, but it can also offer subsidies to enterprises if they expand investment demand, it can reduce tax rates and thus increase the propensity to consume in relation to national income, or finally it can pay out transfer income to households, e.g. in the form of increased pensions.
Before we can address the question of which government measures are necessary to increase employment, we want to convert the IC model into an SI model, since the correlations between government measures and employment can be shown more easily in this model.
We get from the C-I model to the S-I model if we recall that between consumer demand (C) and savings (S) - in a closed economy without economic activity of the state - the following relationship exists ex definitione:
We thus obtain the respective value for savings by subtracting from the alternative values for national income respectively not the consumption demand, but the difference between national income and consumption demand. In the simplified model, we can use S to draw the savings, or in the extended model, in which we take into account foreign trade relations and the economic activity of the state, we can use S to draw the entire decommissioning of purchasing power. In this case, the value of I corresponds not only to investment, but to the total creation of purchasing power.
In our new diagram, the intersection of the blue-drawn saving function with the red-drawn investment function shows the national income E1 at which savings and investment are in equilibrium on the capital market. Due to the correlations depending on the definition, there is equilibrium on the capital markets exactly when there is also equilibrium on the goods markets.
We now want to assume that underemployment exists at this income and that full employment is only reached at a national income in the amount of E2. The angle s that results at the intersection of the two curves measures the propensity to save and the propensity to decommission. As is known, the sine of this angle corresponds to the opposite cathode dI divided by the hypotenuse dE. Therefore, the equation of the income multiplier applies:
Thus, if the government wants to increase income by dE, it must increase purchasing power creation dI in such a way that government spending is a fraction of the desired increase in income, whereby this fraction corresponds to the reciprocal of the savings rate (in the generalised model, the decommissioning rate).
In principle, three strategies can be distinguished here when the state attempts to increase employment by means of fiscal policy measures in application of Keynesian teachings: it can decide on deficit spending, deficit without spending or spending without deficit.
We always speak of deficit spending when the state increases government expenditure for employment policy reasons, but finances it with loans or government bonds, i.e. on a deficit basis. A deficit without spending, on the other hand, is when tax revenues are reduced while the level of government spending remains constant. Finally, the concept of spending without deficit provides for government spending to be increased but financed by additional regular tax revenues.
The first concept of deficit spending yields the highest efficiency. According to the income multiplier developed above, which in a closed economy without economic activity just corresponds to the reciprocal of the propensity to save, results, for example, at a propensity to save of 20% (1/5) and an increase in expenditure of € 1 billion in an increase in income of € 5 billion.
The second concept of deficit without spending has a multiplier reduced by one and thus has a somewhat lower efficiency:
In this case, dT denotes the reduction in tax revenues. The deduction of dT in the formula can be understood if we consider that in the first period in which the tax rates are reduced, only the private disposable income is increased, while the national income remains unchanged. In the following periods, consumer demand rises due to the increased private disposable income of the previous period and this causes an increase in national income.
Consequently, from the second period onwards, the same multiplicative process takes place as in the case of deficit spending. However, since the increase in income in the first period is omitted in the case of deficit without spending and in the case of deficit spending it corresponds to just the extent of the increase in government expenditure, this means that in the case of deficit without spending the overall increase in income is just lower by the amount of the tax reduction than in the case of deficit spending. In our example, a tax cut of €1 billion would lead to an increase in income of €4 billion.
The lowest effect is shown by the concept of spending without deficit. It amounts to only 1, so that an increase in expenditure of 1 billion only leads to an increase in income of 1 billion. At first it may seem incomprehensible that expansionary effects on income can be expected at all if the additional government spending is financed with tax revenues. One could assume that the expansionary effects of government spending are compensated by the contractionary effects of the equally high tax revenues. The reason why a small expansionary effect can still be expected here is that the share of the state, which has a propensity to spend of one in the case of a balanced budget, increases here and that the average propensity to spend of the entire economy therefore increases, since private households show a propensity to spend of less than one.
But these three concepts are not only to be judged according to their efficiency. Decisions for or against one of these concepts also depend on which side effects on other goals are expected and how differently the individual methods can be implemented politically.
During the Great Depression, the question was discussed whether permanent state intervention was needed or whether a one-time stimulus would be sufficient to get the economic system out of the crisis.
In the early years of the crisis, the prevailing view was that the state merely had to stimulate the economy and that the economic system - once again set in motion - was itself capable of maintaining a high level of employment.
If we confine ourselves to the multiplier theory, we can clearly state: A one-time increase in government spending will raise national income and with it the level of employment only temporarily. If one wants to raise the income level in the long run, a permanent use of fiscal policy resources is also required.
However, if besides the multiplier theory we also take into account the acceleration principle, then the conclusions are no longer so clear-cut. As P. A. Samuelson has shown, one-off changes in effective demand (i.e. also one-off increases in government spending) can certainly trigger cumulative effects and raise national income to the full employment level for several periods.
In the context of the discussion on economic policy, the question was also discussed whether the state should make use of certain automatically operating mechanisms (built-in flexibility) or whether the state should prefer a set of instruments that allowed autonomous decisions at any time.
Automatic mechanisms are present in, for example, unemployment insurance or in tax progression. Within unemployment insurance, expenditure automatically increases in times of recession and depression (unemployment benefits are granted), while contribution income decreases due to the decline in employee income. The increase in expenditure increases the level of consumption expenditure without this expansionary effect being compensated by contractionary effects on the part of contribution income.
Also, the tax progression has a stabilising effect on the economy. If income rises for cyclical reasons, tax revenues increase overproportionately due to the progression.
Automatically operating mechanisms have the advantage that they are not affected by any inside lag (time lag), i.e. they take effect more quickly, and that they also take effect when the measures necessary for economic policy are unpopular and when politicians are not willing to adopt these measures for electoral reasons.
The disadvantage of a built-in stabiliser is, however, that here the state has no possibility to adapt the employment policy measures to the concrete situation. For example, it might be desirable to aim for a different employment programme depending on the level of unemployment and the severity of the structural deficits. Such differences must be abandoned if cyclical policy is approached solely by way of built-in stabilisers.
Finally, as part of the fiscal policy discussion, the question of the way in which the state's deficit should be financed was debated. The following types of financing can be distinguished:
- Financing from a previously accumulated surplus,
- Financing through capital market funds,
- Financing by taking out a loan at simultaneous money creation.
According to the Basic Law, however, extraordinary government expenditures may at best be temporarily covered by loans from the central bank.
The decision in favour of one or the other type of financing depends in turn on the answer to the question in what way these instruments can be regarded as efficient, how these individual types of financing can be politically achieved (e.g. whether financing through central bank loans is excluded by the constitution) and what side effects may perhaps emanate from the individual instruments.
A reduction in efficiency occurs in the case of financing from capital market funds since the fact that the state acts as a buyer on the capital market has an interest-increasing effect and since interest rate increases lead to a reduction in the effective demand (investment). As long as the liquidity preference is high and the interest elasticity of demand is low in times of recession and depression these efficiency reductions are, however, only of minor importance.
6th Criticism on the purchasing power parity theory
In public, it is often attempted to use Keynesian theory as proof that also an expansionary wage policy, in which wage rates are raised above the productivity of labour, would contribute to an increase in employment. If wage income rises due to higher wage rates, then consumer demand also increased, and this would lead - as Keynes' theory postulates - to an increase in national income and thus also in employment.
This conclusion is based on misunderstandings. Let us look at the C-I model again. If wage incomes are increased, there is a movement along the consumption function. Here we assume an income E1 at which unemployment was given. As a result of the wage increase, the income rose to E2, where there would be full employment.
As the graph shows, there is a supply surplus on the goods markets with this new national income, which also corresponds to an increased employment. This supply surplus now triggers a reduction in production by enterprises and thus again also a reduction in employment. A lasting solution could have been achieved only if the equilibrium point between supply and demand on the goods markets had moved in the direction of full employment income E2.
The flaw in this theory of purchasing power is that it does not distinguish between an induced and an autonomous increase in consumer demand. According to Keynesian theory, only an increase in autonomous (effective) demand leads to an increase in income and thus also to an increase in employment. However, an increase in wage incomes through increased wage rates does not trigger an autonomous, but only an induced increase in demand.
In our model, an expansionary wage policy manifests itself as a movement along the given and unchanged consumption function. But only an upward shift of the consumption function would also have caused an increase in equilibrium income. However, an upward shift of the consumption function would only have occurred if the propensity to consume had increased while income has remained the same.
The actual error of this approach lies in the fact that what one wants to prove is already assumed as proven. This is called a petitio principii. One wants to prove that an expansive wage policy increases income and thus also employment. In order to prove this, it is assumed that incomes rise due to the expansionary wage policy. But just this is the problem.
It is controversial whether wage rate increases lead to a sustained increase in income and employment. Therefore, the assumption that income has increased must not be made either. Rather, this statement must firstly be derived from the evidence. Of course, there is a temporary increase in income. However, a lasting solution to the employment problem could only be expected if the equilibrium income, the point of intersection between the supply curve and the demand curve, had also shifted to the right.
Now, Abba P. Lerner has shown a way to bring the purchasing power theory into line with Keynesian teaching by making some changes in the assumptions. Lerner assumes here that the increase in wage rates (beyond the increase in productivity) leads to a redistribution in favour of the employees. If one assumes - and this is in line with empirical studies - that employees have a higher propensity to consume than profit recipients, then the wage increase does indeed lead to an increased propensity to consume by way of redistribution. However, this in turn is tantamount to shifting the consumption function upwards and thus also realising equilibrium on the goods markets with a higher income and thus also with higher employment.
In this case, the autonomous consumption demand does in fact increase and this is sufficient within the framework of a Keynesian model to bring about the desired increase in income. Thus, it would appear that this modified purchasing power theory is consistent with Keynesian doctrine.
However, this demonstration is based on the assumption that wage increases lead to a redistribution of national income in favour of the employees. Precisely this assumption does not correspond to the other results of Keynes' doctrine. Keynes himself had excluded the question of what factors determine the distribution of income from his consideration. In his models, the distribution of income is considered as a data variable that is not to be examined further.
However, the continuation of the Keynesian doctrine by Nicholas Kaldor had led to the question of the determinants of income distribution between wage earners and the self-employed.
One of the most important results of this macroeconomic and also Keynesian distribution theory is Nicholas Kaldor's statement that mere wage rate increases would have no long-term influence on income distribution, that the wage share could only be increased sustainably if employees saved a larger part of their income. If employees would not save, then enterprises could fully pass on the wage increases to the price, since the purchase sum would also have increased by this amount due to the wage increase.
We will deal with Keynesian distribution theory in more detail in the second part of this lecture. Here we want to conclude these considerations with the statement that an expansive wage policy alone is an unsuitable means to sustainably increase employment.
To be continued!