Hahnel ABCs of Political Economy Modern Primer
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model insists that wage income and profit income are negatively related is that it assumes total income is fixed, because it implicitly assumes the economy is always producing at full capacity levels of output, which means it is always generating the highest level of total income possible. But if this assumption is not warranted – if an increase in the wage rate would change the level of capacity utilization and output – then the Sraffian conclusion that the rate of profit must fall need not follow. Even so, the simple Sraffa model we have explored does capture an important aspect of the relation between the wage rate and rate of profit: If production and therefore income is held constant (whether at full capacity levels, or below), the rate of profit and wage rate must be negatively related.
This same important conclusion applies in an extended version of the Sraffa model. If we include a number of other primary inputs to production besides labor, i.e. inputs like land, oil, and minerals that are not produced, if we allow for the fact that there are different kinds of labor, i.e. welders, carpenters, computer programmers, etc. with different wage rates, and if we allow for different rates of profits to capitalists in different industries, a general Sraffa model yields the conclusion that if the rate of pay to any group in the economy is increased, the rate of pay to all other groups as a whole must fall. Again, this more general conclusion only holds if production and therefore income is held constant – as is implicitly done in Sraffa models. But this conclusion can be easily misinterpreted for yet another reason. Even if production, and therefore income, is held constant, the above conclusion does not imply that if the wage rate for one group of workers goes up the wage rates for other workers must go down. It is possible that if mine workers, for example, get a wage increase, this will raise the cost of coal and all goods coal is used to produce, and thereby lower the real wage of all other workers who do not get a money wage increase. Certainly this is the possibility that capitalists, and mainstream economists and politicians who favor capitalists over workers, emphasize. But it is also possible for the mine workers to get a wage increase and for other workers to get wage increases as well – even if production and therefore income remains constant, provided the rate of profit of capitalists and/or the returns to owners of natural resources decline. In other words, the generalized Sraffa theorem that returns to factors are inversely related when production and income are held constant, does not deny the important possibility that when one group of workers gets a wage increase this helps others get wage increases as well by increasing their bargaining
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power. In essence this is the material basis for solidarity between different groups of workers in capitalist economies and one reason labor union confederations have found it in their interest to support one another when any one of them goes out on strike. When the united mine workers got a substantial wage increase in 1975 it did help the steel workers and automobile workers get wage increases as well over the next 12 months, even though the gross domestic product, and therefore gross domestic income, was essentially stagnant. This was possible because rates of profit and rents to resource owners declined – just as their supporters in the Ford Administration feared they would when President Ford tried unsuccessfully to block the mine workers’ new contract in 1975.
6Macro Economics: Aggregate Demand as Leading Lady
Before the Great Depression of the 1930s there was only “economic theory.” Thanks to the Great Depression and John Maynard Keynes we now have “micro economics” and “macro economics.” Economic theory bifurcated because some in the mainstream of the profession finally recognized that standard economic theory shed little light on either the cause of, or cure for the Great Depression. The old theory was relabeled “micro economics” and preserved as the centerpiece of the traditional paradigm, and a new theory called macro economics was created to explain the causes and remedies for unemployment and inflation.
The leading lady in Keynes’ new drama was aggregate demand, the demand for all final goods and services in general. By focusing on aggregated demand Keynes not only was able to explain why economic downturns can be self-reinforcing, he was able to explain demand pull inflation and how government fiscal and monetary policies could be used to combat unemployment and inflation. Short run macro economics can be understood using one new “law,” one “truism,” and simple theories of household consumption and business investment behavior.
THE MACRO “LAW” OF SUPPLY AND DEMAND
The new “law” is the macro law of supply and demand. It is the macro analogue of the micro law of supply and demand which is the key to understanding how markets for particular goods and services work. The macro law of supply and demand is the key to understanding how much goods and services in general the economy will produce, that is, whether we will employ our available resources fully and produce up to our potential, or we will have unemployed labor, resources, and factory capacity and consequently produce less than we are capable of. The macro law of supply and demand is also the key to understanding whether or not we will have
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inflation because the demand for goods and services in general exceeds the supply of goods and services the economy is capable of producing, resulting in excess demand which “pulls” up the prices of all goods and services.
The macro law of supply and demand says: aggregate supply will follow aggregate demand if it can. Aggregate supply is simply the supply of all final goods and services produced as a whole, or in the aggregate. It includes all the shirts and shoes produced, all the drill presses and conveyor belts produced, and all the MX missiles and swing sets for parks produced. Aggregate demand is the demand for all final goods and services as a whole. It includes the demand from all the households for shirts and shoes, the demand from all businesses for drill presses and conveyor belts, and the demand from every level of government for missiles and swings sets for parks. The rationale behind the macro law of supply and demand is as follows: The business sector is not clairvoyant and cannot know in advance what demand will be for its products. Of course individual businesses spend considerable time, energy, and money trying to estimate what the demand for their particular good or service will be, but in the end they produce what amounts to their best guess of what they will be able to sell. The business sector as a whole produces as much as it thinks it will be able to sell at prices it finds acceptable. Businesses don’t produce more because they wouldn’t want to produce goods and services they don’t expect to be able to sell. And they don’t produce less because this would mean foregoing profitable opportunities.
What if the business community is overly optimistic. That is, what will happen if the business sector produces more than it turns out it is able to sell? This does not mean that every business, or every industry, is producing more than it can sell. No doubt some businesses, and maybe even entire industries, will have underestimated the demand for their product. But what if, on average, or as a whole, businesses overestimate what they will be able to sell? Most businesses will find they are selling less from their warehouse inventories than they are producing and adding to those inventories each month. While a business may decide this is a temporary aberration and continue at current levels of production for a time, if inventories continue to pile up in warehouses businesses will eventually cut back on production rates. When that occurs the supply of goods and services in the aggregate will fall to meet the lower level of aggregate demand – aggregate supply will follow aggregate demand down.
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What if businesses are overly pessimistic? That is, what will happen if the business sector produces less than it turns out it is able to sell? Businesses will discover their error soon enough because sales rates will be higher than production rates, and inventories in warehouses will be depleted. So even if they initially underestimate the demand for their products, businesses will increase production when they discover their error, and therefore production, or aggregate supply, will rise to meet aggregate demand – aggregate supply will follow aggregate demand up.
But there might be circumstances under which the business sector won’t be able to increase production. What if all the productive resources in the economy are already fully and efficiently employed? In this case the increased labor and resources necessary for one business to increase its production would have to come from some other business where they were already employed, so the increased production of one business would be matched by a decrease in the production of some other business, and production as a whole, or aggregate supply, could not increase. This is why the macro law of supply and demand says that aggregate supply will follow aggregate demand if it can. If the economy is already producing the most it can, if it is already producing what we call potential, or full employment gross domestic product, aggregate supply will not be able to follow aggregate demand should the aggregate demand for goods and services exceed potential GDP.
Like the micro “law” of supply and demand, the macro “law” of supply and demand should be interpreted as the usual results of sensible choices people make in particular circumstances, rather than like the law of gravity that applies exactly to every mass in the presence of every gravitational force. The macro law of supply and demand derives from the common-sense observation that, on average, when businesses find their inventories being depleted because sales are outstripping production they will increase production rates if they can; while if they find their inventories increasing because sales rates are less than production rates, they will decrease production.
Notice how this simple, common-sense law provides powerful insights about what level of production an economy will settle on, and whether or not the labor, resources, and productive capacities of the economy will or will not be fully utilized. And notice how the answer to the question: “How much will we produce?” is not necessarily: “As much as we can.” If the demand for goods and
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services in the aggregate is equal to potential GDP, then when aggregate supply follows aggregate demand we will indeed produce up to our capability. But if aggregate demand is less than potential GDP, then when aggregate supply follows aggregate demand, production will be less than the amount we are capable of producing, and consequently, there will be unemployed labor and resources, and idle productive capacity. This does not happen because the business community wants to produce less than it can. It is because it is not in its interest to produce more than it can sell. And while it is true that the owners of the businesses in a capitalist economy are the ones who decide how much we will produce, there is no point in blaming them for lack of economic patriotism when they decide to produce less than we are capable of, because any “patriotic” business that persisted in producing more than it could sell would be rewarded by being competed out of business by less “gung-ho” competitors.
The size and skill level of the labor force, the amount of resources and productive capacity we have, and the level of productive knowledge we have achieved, determine what we can produce. We call this level of output potential, or full employment GDP. But whether or not we will produce up to our capacities depends on whether there is sufficient aggregate demand for goods and services to induce businesses to employ all the productive resources available. If they have good reason to think they wouldn’t be able to sell all they could produce, they won’t produce it, and actual GDP will fall short of potential GDP. Any changes in the size or skill of the labor force, quantity or quality of productive resources, size or quality of the capital stock, or state of productive knowledge will change the amount of goods and services we can produce, i.e. the level of potential GDP. But what will determine the amount we will produce is the level of aggregate demand, and only changes in aggregate demand will lead to changes in what we do produce.
In sum: If aggregate demand is equal to potential GDP, actual GDP will be equal to potential GDP. But if aggregate demand is less than potential GDP, actual GDP will be equal to the level of aggregate demand and less than potential GDP. If aggregate demand is greater than potential GDP businesses will try to increase production levels to take advantage of favorable sales opportunities. But once the economy has reached potential GDP, as much as businesses might want to increase production further they won’t be able to. Instead, frustrated employers will try to outbid one another for fewer
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employees and resources than there is demand for – pulling up wages and resource prices. And frustrated consumers will try to outbid one another for fewer final goods and services than there is demand for, pulling up prices in what we call “demand pull inflation” – a rise in the general level of prices caused by demand for goods and services in excess of the maximum level of production we are capable of.
AGGREGATE DEMAND
Aggregate demand, AD, is composed of the consumption demand of all the households in the economy, or what we call aggregate, or private consumption, C; the demand for investment, or capital goods by all businesses in the economy, or what we call investment demand, I; and the demand for public goods and services by local, state, and federal governments, or what we loosely call government spending, G.
One of Keynes’ greatest insights was that the forces determining the level of consumer, business, and government demand are substantially independent from the forces determining the level of potential production or output. He also pointed out that even though businesses would try to adjust to discrepancies between aggregate demand and supply when they arose, that in addition to the equilibrating forces described in the micro law of supply and demand, disequilibrating forces could operate in the macro economy as well. In particular, Keynes pointed out that weak demand for goods and services leading to downward pressure on wages and layoffs was likely to further weaken aggregate demand by reducing the buying power of the majority of consumers. He pointed out that this would in turn lead to more downward pressure on wages and more layoffs, which would reduce the demand for goods even further. The logical result was a downward spiral in which aggregate demand, and therefore production, moved farther and farther away from potential GDP. Keynes ridiculed his contemporaries’ faith that excess supply of labor during the depression would prove self-eliminating as wages fell. He quipped that no matter how cheap employees became, employers were not likely to hire workers when they had no reason to believe they could sell the goods those workers would make. Keynes pointed out that the demand reducing effect of falling wages on employment could outweigh the cost reducing effect of lower labor costs on employment – particularly during a recession when finding buyers, not lowering production costs, was the chief concern of businesses. As a result Keynes rejected the complacency of his
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colleagues in face of high and rising levels of unemployment based on what he considered to be unwarranted faith that (1) demand should be sufficient to buy full employment levels of output, and (2) unemployment should be eliminated by falling wages.
Consumption demand
Keynes reasoned that the largest component of aggregate demand, household consumption, was determined for the most part by the size of the household sector’s disposable, or after tax income. He postulated that household consumption: (1) depended positively on disposable income, (2) that only part of any new or additional disposable income would be consumed because part of additional income would be saved, (3) that even should disposable income sink to zero consumption would be positive as people dipped into savings or borrowed against future income prospects to finance necessary consumption. No economic relationship has been more empirically tested and validated than the consumption–income relationship. Countless “cross section studies” using data from samples of households with different levels of income and consumption in the same year, as well as “time series studies” using data for national income and aggregate consumption over a number of years in hundreds of different countries, all invariably confirm Keynes’ bold hypothesis and intuition. The “consumption function” is far and away the most accurate indicator of economic behavior in the macro economist’s arsenal. In its simplest (linear) form: C = a + MPC(Y–T) where C stands for aggregate consumption, Y stands for gross domestic income, GDI, T stands for taxes which are the part of income households can neither consume nor save since they are obligated to taxes, “a” is a positive number called “autonomous consumption” representing the amount the household sector would consume even if disposable income were zero, and MPC stands for the “marginal propensity to consume out of disposable income,” that is, the fraction of each additional dollar in disposable income that will go into consumption rather than saving.
Investment demand
The most volatile and difficult part of aggregate demand to predict is business investment demand. First, note that in short run macro models investment is treated as part of the aggregate demand for goods and services because what happens when businesses decide to undertake an investment project is they first must buy the machinery
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and equipment necessary to carry it out. That is, the first effect of investment is to increase the demand for what we call capital or investment goods. This is not to deny that the purpose of investment is to increase the ability of businesses to produce more goods and services. But while investment eventually increases potential GDP, and may lead to an increase in the actual supply of goods and services in the future, its immediate effect is to increase the demand for investment goods. Second, Keynes himself had a very eclectic theory of investment behavior emphasizing the importance of psychological factors on business expectations and the rate of change of output as an indicator of future demand conditions. Moreover, political economists emphasize the importance of the rate of profit and capacity utilization in determining the level of investment as we see in a long run political economy macro model studied in chapter 9. But a simple relationship between investment demand and the rate of interest in the economy is sufficient to understand the logic of monetary policy, and all we need for the present.
Businesses divide their after tax profits between dividends, paid to stockholders and retained earnings, income available for the corporation to use as it sees fit. If a business wants to finance an investment project the first thing it usually does is pay for it out of retained earnings. But often retained earnings are not sufficient to finance a major investment project, and therefore a business must borrow money to add to its retained earnings to purchase all the investment goods a major project requires. A company can borrow from a bank or can borrow from the public by selling corporate bonds, but no matter how it decides to borrow it will have to pay interest. If interest rates in the economy are high, the cost of borrowing will be high. When the cost of borrowing is high the rate of return on an investment project will have to be high to warrant undertaking it given the high cost of borrowing required to carry it out. Presumably fewer investment projects will have this high rate of return, and therefore businesses will want to undertake fewer investment projects when interest rates in the economy are high.1
1.Even if a company can finance the entire investment project out of its retained earnings, the opportunity cost of the project is high when interest rates are high because if the retained earnings were not used to finance the project they could be deposited in a savings account paying a high rate of interest. So whether or not a company borrows or finances an investment project entirely out of retained earnings, it is less likely to invest when interest rates are high, and more likely to invest when interest rates are low.
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Another way to see why there should be a negative relationship between interest rates and investment demand is to ask when a business is most likely to want to engage in investment. When interest rates are low it is cheaper to finance investment projects. When they are high it is more expensive. As much as possible it makes sense for businesses to refrain from investing when interest rates are high, and wait until interest rates are low to do their investing. We can express this negative relation between the rate of interest and investment demand most simply in a linear investment function such as: I = b – 1000r, where I is investment demand measured in billions of dollars, b is the amount of investment the business sector would undertake if the real rate of interest in the economy were zero, and r is the real rate of interest in the economy, expressed as a decimal. While primitive, this investment function is sufficient to illustrate the logic of monetary policy we explore in chapter 7. It says that whenever interest rates rise by 1% investment demand will fall by 10 billion dollars, and whenever interest rates fall by 1% investment demand will increase by 10 billion dollars.
Government spending
If we ignore the foreign sector for the moment, the only other source of demand for final goods and services besides the household and business sectors is the government sector. We call the final goods and services demanded by national, state, and local governments G. While some state and local governments face restrictions on whether or not they can run a deficit, it is possible for the federal government to spend either more or less than it collects in taxes.2 If the government spends less than it collects in taxes we say the government is running a budget surplus. If it spends more we say it is running a budget deficit. And if it spends exactly as much as it collects in taxes during a year we say the budget is balanced. Any individual or business can spend more than its income in a year if it can convince someone to lend it additional money, and the government can spend more than it collects in taxes by borrowing
2.There are two easy ways to remind yourself that the federal government can spend more than it collects in taxes: First, it did so, in fact, every year from 1970 until 1998. Second, were it not possible for the government to spend more than it collects, politicians and economists would not bother debating the wisdom of passing a “balanced budget amendment” to the Constitution outlawing such behavior!