INCOME AND EMPLOYMENT THEORY

a body of economic analysis concerned primarily with understanding how the level of operation of the economy, i.e., the relative levels of output, employment, and prices, is determined. The practical aim of understanding the interrelation of these factors is to furnish predictions on which policies of economic stabilization can be based. Modern income and employment theory has developed since the publication of J.M. Keynes's General Theory of Employment, Interest and Money in 1936. Interest in the subject was triggered by the severity of the Great Depression in the United States and in Europe and the failure of the economic analyses of the time to explain the persistence of high levels of unemployment and the low levels at which business was operating. Classical economic thinking failed to explain the paradox and, indeed, aggravated the problem by recommending that taxes be raised steeply and the money supply be allowed to fall sharply. To understand fluctuations in the level of economic activity, one must examine the relationship between income, output, and expenditure. Since transactions are two-sided, in that one person's income is another person's expenditure, the relationship could be expressed in the form of a simple equation: Y = O = D, where Y is the national income, O is the value national output, and D is national expenditure. What this equation means is that effective demand is equal to income (i.e., purchasing power) as well as to output. Since consumers can either spend or save their income, Y = C + S, where C is consumption and S is savings. Similarly, on the output side, production is either sold to final customers or invested in inventory or new capital equipment and plant. So O = C + I, where C represents sales to final customers and I investment. Thus, C + S = C + I and, therefore, S = I. However, while savings and investment may thus be equated from an accounting standpoint, in fact actual planned savings and planned investment may differ. Within this discrepancy lie the seeds of economic instability. Suppose that in a given period savings rise above the previous level; the effect of this is a reduction in present demand with the prospect of increased future demand. If by coincidence additional capital formation (investment, such as in inventory) rises by the same amount, productive resources will continue to operate at capacity; there will be no change in the level of activity, and the economy will remain in equilibrium. However, if capital formation does not rise, then productive resources are wasted or idled; i.e., workers become unemployed and lose their current income. The fall in incomes further reduces consumer demand and also the rate of savings. Provided manufacturers do not alter their investment plans, equilibrium will eventually be achieved at a lower level of income. In reality it is not savings that are unstable but the level of investment, and a fall in investment will produce exactly the same kind of reaction as an increase in savings; conversely, a rise in investment or an increase in consumer spending will have the opposite effect. This simple income model explains the changes in national income in response to a change in planned savings or investment, but it does not show the extent of the change. The degree of change is determined by what Keynes called the consumption function, i.e., the marginal proportion of income spent. For illustration assume that, on average, consumers save 10 percent of their income. If the equilibrium is disturbed by an unplanned rise in investment, additional income and additional savings would be generated as described previously until a new equilibrium is reached at a higher level. At each stage the increase in savings will be 10 percent of the increase in income. The increase in income will eventually be 10 times the expansion of investment. This factor of 10 is called the multiplier, and it is the reciprocal of the ratio of savings to income (the marginal propensity to save). Keynes's primary aim in developing his theory was to show that, under certain conditions, the economy could become stuck in a disequilibrium, with productive resources in surplus (i.e., high level of unemployment) but income and output unable to rise sufficiently to reach an equilibrium. Put simply, his argument was that when business was unwilling or unable to increase investment because of ineffective (unfunded) demand, additional government spending would have the same effect of pulling the economy away from the point of disequilibrium. The use of fiscal policy (q.v.), such as an increase in government expenditure or a reduction in taxation, was the remedy prescribed to offset the lack of private demand. A competing theory of income and employment places the quantity of money in the controlling role. The analysis of the effects of increasing or decreasing the money supply is approximately parallel to that of the consumption-and-savings relation. The rules of thumb derived from the two theories may, in fact, be combined: an excess demand for goods or an excess supply of money (two phenomena that may be seen as aspects of but one) is associated with rising income; an excess supply of goods or an excess demand for money (similarly) is associated with falling income. Proponents of the money, or quantity, theory advocate monetary policy (q.v.) as the proper countercyclical tool of government. A third theory, far more complex even in its simplest form, relates the previous two through the nexus of the financial market and its principal characteristic, the market rate of interest.