Open full sized image

Another possible cause of a general depression was suggested by Keynes. It may be approached in a highly simplified way by lumping all occupations together into one labour market and all goods and services together into a single commodity market. The aggregative system would thus include simply three goods: labour, commodities, and money. See Table for a rough outline (a full treatment would be both technical and lengthy) of the development of a “Keynesian” depression. One may begin by assuming (line 1) that the system is in full employment equilibrium—that is, prices and wages are at their equilibrium levels and there is no excess demand. Next the model may be put on the path to disaster by postulating either (1) some disturbance causing a shift of demand away from commodities and into money or (2) a reduction in the money supply. Either event will result in the situation described in the Table as State 2, but the one assumed is a reduction in the money supply by, say, 10 percent. The result is shown in the right-hand column of the Table, where the quantity of commodities supplied minus the quantity demanded multiplied by the price level (p) is equal in value to the excess demand for money.

If money wages and money prices could immediately be reduced in the same proportion (10 percent), output and employment could be maintained, and profits and wages would be unchanged in “real” terms. If money wages are initially inflexible, however, business firms cannot be induced to lower prices by 10 percent and maintain output. In this example they maintain prices in the neighbourhood of the initial price level—prices, then, are also “inflexible”—and deal with the excess supply by cutting back output and laying off workers. Reducing supply eliminates the excess supply of commodities by throwing the burden of excess supply back on the labour market. Thus, output and employment (which are “quantities”) give way before prices do. This brings us to State 3 where, as in the Table, the excess supply of labour times the money wage rate (w) equals the excess demand for money in value.

If, with the system in this state, money wages do not give way and the money supply is not increased, the economy will remain at this level of unemployment indefinitely. One should recall that the only explanation for persistent unemployment that the pre-Keynesian economics had to offer was that money wages were “too high” relative to the money stock and tended to remain rigid at that level.

Money wages might, nevertheless, give way so that, gradually, both wages and prices go down by 10 percent—that is to say, a reduction of the size that would have solved the entire problem had it occurred immediately (before unemployment could develop). This is shown in the last line of the Table, which represents (albeit crudely) what Keynes described as a state of “involuntary unemployment” and explained in terms of a failure of “effective demand.”

In State 4, it is assumed, the excess demand for money is zero. Hence there is, at least temporarily, no tendency for money income either to fall further or to rise. The prevailing level of money income is too low to provide full employment. The excess supply of labour and the corresponding excess demand for commodities (of the same market value) show State 4 to be a disequilibrium state. The question is why the state tends to persist. Why is there no tendency for income and output to increase and to absorb the unemployment? Specifically, why does not the excess demand for commodities induce this expansion of output and absorption of unemployment?

Basically, the answer is that the unemployed do not have the cash (or the credit) to make the excess demand for commodities effective. The traditional economic theory would postulate that, when actual output is kept at a level below that of demand, competition between unsuccessful potential buyers would tend to raise prices, thereby stimulating an expansion. But this does not occur. The unemployed lack the means to engage in such bidding for the limited volume of output. The excess demand for commodities is not effective. It fails to produce the market signals that would induce adjustments of activities in the right direction. Business firms, on their side of the market, remain unwilling to hire from the pool of unemployed—even at low wages—because there is nothing to indicate that the resulting increment of output can actually be sold at remunerative prices.

Keynes called this “involuntary unemployment.” It was not a happy choice of phrase since the term is neither self-explanatory nor very descriptive. Some earlier analysts of the unemployment problem had, however, tended to stress the kind of deadlock that might develop if workers held out for wages exceeding the market value of the product attributable to labour or if business firms insisted on trying to “exploit” labour by refusing to pay a wage corresponding to the value of labour’s product. With the term “involuntary unemployment,” Keynes wanted to emphasize that a thoroughly intractable unemployment situation could develop for which neither party was to blame in this sense. His theory envisaged a situation in which both parties were willing to cooperate, yet failed to get together. An effective demand failure might be described as “a failure to communicate.”

The failure of the market system to communicate the necessary information arises because, in modern economies, money is the only means of payment. In offering their labour services, the unemployed will not demand payment in the form of the products of the individual firms. If they did, the excess demand for products would be effectively communicated to producers. The worker must have cash in order to exercise effective demand for goods. But to obtain the cash he must first succeed in selling his services.

When business begins to contract, the first manifestation is a decrease in investment that causes unemployment in the capital goods industries; the unemployed are deprived of the cash wage receipts required to make their consumption demands effective. Unemployment then spreads to consumer goods industries. In expansion, the opposite occurs: an increase in investment (or in government spending) leads to rehiring of workers out of the pool of unemployed. Re-employed workers will have the cash with which to exert effective demand. Hence business will pick up also in the consumer goods industries. Thus, the theory suggests the use of fiscal policy (an increase in government spending or a decrease in taxes) to bring the economy out of an unemployment state that is due to a failure of effective demand.

Another observation may be made on Keynes’s doctrine of effective demand. The fact that the persistence of unemployment will put pressure on wages also turns out to be a problem. The assumption in the foregoing discussion was that money wages were at the equilibrium level. Unemployment will tend to drive them down. Prices will tend to follow wages down, since declining money earnings for the employed will mean a declining volume of expenditures. In short, both wages and prices will tend to move away from, rather than toward, their “correct” equilibrium values. Once the economy has fallen into such a situation, Keynes pointed out, wage rigidity may actually be a blessing—a paradoxical conclusion from the standpoint of traditional economics.

A proper understanding of income and expenditure theory requires some acquaintance with the concepts used in national income accounting. These accounts provide quantitative data on national income and national product. Reliable information on these was, for the most part, not available to economists working on problems of economic instability before the 1930s. Modern economics differs from earlier work most markedly in its quantitative, empirical orientation. The development of national income accounting made this possible.

The definitions of the major components of national income and product may, accordingly, be introduced in the course of explaining income and employment theory. The basic characteristic of the national income accounts is that they measure the level of economic activity in terms of both product supplied and of income generated. Correspondingly, national income analysis divides the economic system into distinct sectors. The simplest approach uses two sectors: a business sector and a household sector. All product is regarded as created by the business sector (thus, self-employed persons have to be treated as businesses in earning their income and as households in disposing of it). Final goods output is divided into two components: consumer goods produced for sale to households and investment goods for sale to firms. Similarly, all income is generated in the business sector and none of it in the household sector (nonmarket activities, such as the work of homemakers or home improvements, are not counted in national product and income). The level of income generated equals the market value of final goods output.

Next is the household sector. All resources in the economy ultimately belong to households. The households, therefore, have claim to all of the income generated through the utilization of these resources by firms in creating the national product. Not all of the income is, however, actually paid out to households, since corporations retain part of their earnings. In building a simple model of the economy, one can disregard the “gross business saving” item of the national income accounts and deal with income as if it were all paid out (which means adopting the fiction that retained earnings are first paid out to shareholders who then reinvest the same amount in the same firms). The households, finally, dispose of their income in two ways: as expenditure on consumption goods and as saving.

The foregoing discussion has made two accounting statements involving income. First, income generated (Y) equals the value of consumption goods output (C^s) plus the value of investment goods output (I): Y ≡ C^s + I. Second, consumption goods expenditures (C^d) plus savings (S) equal income disposal: Y ≡ C^d + S. Both equalities hold simply because of the way that the variables are defined in the national income accounts. They hold true, moreover, whatever the actual level of income happens to be. Such equalities, which are true simply by definition, are called identities (and are marked as such by using the sign ≡ instead of the usual equality sign). Another accounting convention may be noted here. Investment (I) is defined to include any discrepancy between consumer goods produced and consumer goods sold. If production exceeds sales, the unsold goods are part of inventory investment; if sales exceed output, inventory investment is negative, and I is reduced by the corresponding amount. It follows that C^s and C^d must be identically equal, so that it becomes unnecessary to distinguish between them by superscript. Since income generated is identically equal to income disposal, finally, it is clear that actual investment must always equal actual saving: I ≡ S. Investment is the value of additions to the system’s stock of capital. Saving is the increase in the value of the household sector’s wealth. For the system as a whole, the two must be equal.

Open full sized image

Figure 1: The circular flow of income expenditures (see text).

Encyclopædia Britannica, Inc.

Figure 1 shows the circular flow of income and expenditures connecting the two sectors. Investment and consumption expenditures add up to the aggregate demand for final goods output. The value of final goods output is paid out by the business sector as income to the household sector. The major part of income goes back to the business sector as expenditures on consumption goods; the remainder is allocated by households to saving. Corresponding to the counterclockwise money flow (but not shown) is the clockwise flow of the things that the money is paid for: labour and other resource services from households to firms in exchange for money income; consumer goods and services in exchange for consumption expenditures from firms to households; and equities, bonds, and other debt instruments issued by firms in return for the funds saved by households.

Figure 1 shows a break in the flow of saving as it passes into investment. From the accounting standpoint—where investment necessarily equals saving—there is no rationale for this. It has been done here to focus attention on the point in the circular flow that, in the income–expenditure theory, represents the causal nexus in the income-determining process. This theory, in its simplest form, is the next topic.