Chapter 5 The theoretical foundations

of employment policy part I





01st The Say's law as a starting point

02nd The neo-classical criticism of Say's law

03rd The meaning of the inflexibility

04th Policy conclusions from the classical position

05th The criticism from Keynes’ school

06th The employment theory of Keynes

07th Employment policy conclusions

08th The determinants of effective demand

09th The criticism of the Keynesian theory of employment

10th Stagflation and hysteresis phenomena

11th Too low supply of employment?



01st The Say's law as a starting point


In the following three chapters of this lecture, we like to deal with the theoretical foundations of business cycle policy. Let us begin with the employment policy. According to the theorem formulated by Jean Baptiste Say applies: every supply creates its own demand.


Because the proceeds of the enterprises always turn into income. Initially, the production factors used for production are paid by the entrepreneur from the sales proceeds. He pays a wage to the employees, he pays the respective price for the raw materials and semi-finished products purchased from other enterprises. If he leases floors, he also must pay a rent, and lastly, interest will be paid on the loans taken out. The entire remaining amount of the sales proceeds goes to the entrepreneur as profit. Thus, the sum of all expenses and the profit must ex definitione correspond to the sum of the sales proceeds. On the expenditure side of this consolidated balance sheet, therefore, only incomes are listed.


These values for expenditures and revenues are compared in a consolidated balance sheet. Consolidated means that in reality there are many enterprises which are linked by division of labour; but that in the balance sheet created here, on the one hand, the revenues and, on the other hand, the expenditures of all enterprises are summarised. In this case, the expenses that entrepreneurs pay to others can be offset against each other.


It is assumed that the economic connections are so complex that they can only be recognised if one proceeds stepwise in the analysis. In a first step, one assumes a model without external and state relations, in order to subsequently, only in a second step, lead the model step by step to reality and to take into account both foreign trade and the financial interrelationships with the state.


Thus, in this first model, there are neither import expenditures nor export revenues. Furthermore, the tax payments of citizens to the state and the free services provided by the state to private households and enterprises (subsidies and transfer incomes) are neglected.


How are the different incomes used now? Income can either be consumed or saved. Savings are invested. The sum of the demand (consumption and investment) therefore always corresponds to the supply value.




One more word on the statement that the savings turn completely to investment. In reality, we must assume that, on the one hand, there are private households that hoard their savings, so that this part of the savings is not used for investments. At the same time, however, it should also be considered that private banks in reality have the possibility, within certain limits, to provide enterprises with a larger loan amount than they themselves have received due to savings deposits. One speaks in this connection of the creation of deposit money by the private banks.


If Say ignored these possibilities and assumed that all savings would be invested, it was because savings could be deposited almost exclusively by entrepreneurs in Say's time, the mass of employees had such a low income that it only sufficed for the existential consumption requirements and thus there was no possibility to save larger parts of the income.


This means that saver and investor coincided in one person at Say's time. If an entrepreneur wanted to invest, he had to raise the necessary funds by his own savings, and conversely applied that the entrepreneur could only have an interest in saving some of his income if he had the intention to invest it. In other words: since savers and investors were one and the same person, one could also assume that savings and investment were the same size, thus every saving was invested also.



02nd The neo-classical criticism of Say's law


This assumption, however, corresponds no longer to today's reality. In the aftermath of Say arose corporations whose capital requirements exceeded the own capital namely. At the same time, the income of many workers had risen so much that they could save income portions. Thus, one could no longer assume that savers and investors represent the same person. Consequently, one identity of saving and investing could no longer be assumed.


Nevertheless, on normal capital markets there is - according to the neo-classical view - a trend to equilibrium of saving and investment. Interest rate variations ensure equilibrium namely. If the savings supply is larger than the investment demand, the interest rate decreases. But if the investment demand exceeds the savings supply, the interest rate rises. An interest rate cut will then lead by way of a reduction of the savings and an increase in investment to a reduction in excess supply on the capital market, while an increase in interest rates by way of an increase in savings and a decline in the investment demand will reduce the excess demand. 





03rd The meaning of the inflexibility


Despite Say's law, mass unemployment occurred during the Great Depression of the late 1920s.


But it is not the imbalances in the capital market that are blamed by neo-classics for unemployment. According to this theory, it is rather the shortcomings of the labour market that cause unemployment.


Price rigidity and immobility are, according to the neo-classics, the main causes of unemployment. With full wage flexibility, wage cuts could reduce unemployment. But if wages are not lowered to equilibrium level, unemployment remains.




04th Policy conclusions from the classical position


The neoclassical line of thought allows two different strategies for overcoming unemployment:


The optimal strategy is to reduce inflexibility by competition policy in all markets, including labour markets!


A second-best strategy would consist in a compulsory reduction in prices and wages!


The path of the first alternative was chosen by Hoover's policy in the USA, while the second alternative path was chosen by Brüning's policy in Germany.



05th The criticism from Keynes’ school


John Maynard Keynes criticised Say's law. For Keynes applies firstly the thesis of hoarding of savings: savings are not all deposited interest-bearing.


Secondly, Keynes assumes the thesis that investments are not interest-elastic, i.e. they do not respond sufficiently to interest rate reductions.


The result is a general unemployment: as a consequence of the increase in savings, less consumer goods are demanded, production is restricted and eventually workers are made redundant.


To explain the thesis of hoarding Keynes developed the thesis of the liquidity trap: Savings are no longer deposited interest-bearing from a certain low interest rate on. At very low interest rates, the expectation is namely that interest rates will rise again in the near future. However, a rise in interest rates - at least for fixed-income securities - will entail a price decrease since future profits are discounted.


Thus, the capital investment at extremely low interest rates is associated with a price loss that may be greater than the already low interest income in these times. Therefore, at the low point in the economy it is no longer worthwhile to invest the savings interest-bearing. The savings are hoarded and are invested interest-bearing only after the beginning of the upswing. It is thus by no means irrational actions that lead according to Keynes believes thereto that parts of the savings are hoarded.





Now, how does Keynes explain his thesis of the low interest elasticity of investments? In times of decline in sales, it was not worthwhile to increase the already excessive production capacity by way of net investments. Furthermore, interest rate reductions do not bring added profit, as the strong competition in times of economic downturn forces entrepreneurs to pass on interest rate reductions immediately by way of price reductions. Finally, the share of interest costs in the total costs is so low that interest rate reductions are insufficient to expand investment demand. Therefore the overall costs decrease - according to Keynes - only slightly at interest rate reductions.



06th The employment theory of Keynes


General price reductions are not sales increasing, in the opinion of Keynes, since they lead to income declines. Price cuts would only lead to increased demand if the total income remained constant. But this could not be expected just in case of economic downturns. The price reductions would lead to a reduction of the wage income by way of a reduction of the supply, so that the demand for goods would not rise despite of the price reduction, but would even decline further.


Price reductions would only lead to increases in demand if the price of a good decreased in comparison to the price of other goods and if, moreover, the price of goods decreased in comparison to the price of the factors of production. Due to cumulative processes, an increase in the contraction would take place finally. On balance, this would result in an increase in sales difficulties.


In a diagram we draw the domestic product and the employment on the abscissa, and the consumption and the investment we draw on the ordinate. The supply curve coincides with the 45 ° line passing through the coordinate origin. The demand curve has a rising course, caused thereby that the consumer demand increases with rising income and the investment demand is considered to be constant (autonomous).


It is assumed that regardless of the income, a certain minimum consumption is exercised so that the consumption curve does not start at the origin. According to Keynesian theory, consumer demand is always rising less than income.





Price reductions do not trigger an equilibrium trend since neither the supply curve nor the demand curve respond to price reductions.


But does the further thesis of the inflexibility of prices apply at Keynes, too? Although Keynes assumes inflexibility of prices primarily downwards, this assumption does in no way represent the actual Keynesian contribution. Inflexibility of prices and wages leads to unemployment according to the classical thesis as well.


Again, we examine a diagram on whose abscissa we draw labour and on whose ordinate we draw the wage rate. We assume a normal supply curve for labour (rising trend) and a normal demand curve (decreasing trend) for labour.


We assume now that the actual wage rate (l1) is situated above the equilibrium wage (l0). At this wage rate, labour supply exceeds labour demand (unemployment). On a functioning competitive market, the wage rate would fall to the equilibrium wage and thus reduce unemployment.




Let us ask now for Keynes' criticism of a deflationist policy according to which unemployment shall be reduced by politically induced price reductions, as primarily Bruning's government tried to do. Keynes' answer is in contrast, that price variations do not enter in the determinants of demand, since price reductions also lead to income reductions. Although equilibrium processes take place on the goods markets, it is not price movements but quantity movements that lead to equilibrium!



07th Employment policy conclusions


If we assume Keynesian theory, the following conclusions result regarding the desired employment policy: only an increase in effective demand can trigger an increase in employment! The effective demand here consists of:


· consumption expenditures (C),

· investment expenditures (I),


and if we now consider also the economic activity of the state as well as the external relations in addition:


· the deficit of the state budget (A-T) and the

· surpluses of the current account (X-M).


For the employment effect, the kind of demand is irrelevant; employment increases can be triggered by an increase in investment, consumption, export earnings as well as government spending.


There occurs a multiplicative effect: an increase in effective demand leads to an increase in income, which constitutes a multiple of the increase in the effective demand of the state.


The starting point would be a simple graphic model of Keynes' theory with an abscissa on which we draw the domestic product and employment, and with an ordinate on which we draw the effective demand.


In this diagram we draw the investment line parallel to the abscissa, since we assume an autonomous investment volume.


Furthermore, we plot the savings function, which has a positive course, since the savings rise with increasing income.


Contrary to the Keynesian theory, which assumes a rising savings rate as income increases, a consistent consumption rate is assumed here for the sake of simplicity. The results are not distorted thereby.


We now assume that the investment volume would rise, for example, by the value of one (e.g. 1 billion euros). In our diagram, this leads to a shift of the investment line upwards by the amount one. Our diagram shows that the new intersection lies at an income that has risen stronger in relation to the starting point than the inducing increase in investment. According to Pythagorean theorem, the incline of the savings line (= savings rate s) determines the extent of the income increase dY. The formula applies:





Induced increases in demand are not enough to reduce unemployment. It requires an autonomous increase in demand, thus an increase in demand at a consistent income.


Take the example of wage increases: wage increases induce a growth in demand by way of income increases, the demand rises only with increasing income. However, since at an increased production the increase in demand is always lower than the supply growth - the consumption rate at Keynes is always lower than one - demand is necessarily rising lower than supply, and the excess supply is even increasing, thus enterprises will once again reduce production to the original level.






Assuming the Keynesian employment theory, how could a reduction in unemployment be brought about now? The increase of the transfer income leads to an increase in employment. In contrast to the wage increase, an increase in demand is generated here at a consistent national income namely.





We have already indicated earlier that in the scope of the Keynesian theory it does not matter actually what kind of demand is increased. Only the fact that the demand for goods is increased was important.


A more detailed analysis shows, however, that this conclusion needs to be modified. How large the multiplicative effects of a demand growth are in the individual case and how such a policy is to be assessed depends very much on the question of whether consumption expenditures or capital expenditures will rise, respectively whether government spending will be increased, or tax rates will be reduced.


The decision in favour of a certain kind of demand influences namely:


· the size of the multiplier; a budget deficit due to a government spending increase has a higher multiplier than due to a tax reduction!


· the political feasibility of these measures; a deficit in the state budget can e.g. fail on the constitution!


· and the secondary effects on other aims; investment increases have a stronger growth effect than increases in consumption!


To be continued!