Outline:
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!