I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text by the end of this year. Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.
The material today continues the derivation and significance of Michel Kalecki’s theory of profits and then considers the issue of economic fluctuations. The consideration of economic dynamics brings together the concept of the expenditure multiplier which demonstrated how an injection of spending into the economy would, if there was excess capacity, multiply as the extra income generated was re-spent, and the accelerator model of investment spending, which was introduced earlier in this chapter.
Kalecki’s Generalised Model of Profits
Kalecki subsequently complicated his simplified two-sector model to include a foreign sector, a government sector and a recognition that workers do save. He considered this generalised theory to be applicable to the real world.
He sought to sought to examine the influence of the budget deficit, the external sector and workers’ savings on total profits.
In Chapter 8 we introduced the real expenditure model of national income determination and derived the aggregate demand equation as:
(12.9) Y = C + I + G + NX
where Y is national income (aggregate spending), G is government spending and NX is net exports (total exports minus total imports). In Kalecki’s model where workers and profit recipients were distinguished, C is taken now to be the aggregate of capitalists’ consumption (Cp) and workers’ consumption. Workers’ consumption is equal to total worker income post tax (Vn) minus workers’ saving (Sw).
To recognise the different sources of total consumption, Equation (12.9) could thus be written as:
(12.10) Y = Cp + (Vn – Sw) + I + G + NX
Total income claimants on national income (Y) are:
(12.11) Y = Pn + Vn + T
where P and V are as before (profits and total wages and salaries) but the subscript n denotes these flows are net of taxes paid, and T is total taxes.
Thus (setting the expenditure components of total income equal to the claims on total income) we get:
(12.12) Cp + (Vn – Sw) + I + G + NX = Pn + Vn + T
We can solve this for Gross Profits after tax (Pn) to get:
(12.13) Pn = I + (G – T) + NX + Cp + Vn – Sw – Vn
(12.14) Pn = I + (G – T) + NX + Cp – Sw
which says that gross profits after tax (Pn) equals gross investment (I), plus the budget deficit (G – T), plus the export surplus (NX), plus capitalists’ consumption (Cp) minus workers’ saving (Sw).
This is the model shown in Figure 12.6 as Table 2.
Gross profits after tax will be higher, the higher is gross investment (I), the larger the budget deficit (G – T), the higher is capitalists’ consumption (Cp) and the lower is workers’ saving (Sw).[NOTE: A SECTION ON THE BEHAVIOURAL FACTORS THAT INFLUENCE Cp and Sw TO BE INSERTED HERE]
Kalecki identified some interesting features of this model.
For example, when there are positive net exports and/or budget deficits, then gross net profits (Pn) will rise higher than the level that would be generated by gross investment and capitalist consumption (as in the simplified model).
So an individual domestic capitalist who is able to increase their net exports will be able to glean extra profits “at the expense of their foreign rivals” [NOTE: GET EXACT QUOTE FROM Kalecki, 1964:51).
Kalecki said (in his 1965 book noted above, page 51):
[NOTE – A FURTHER ELABORATION OF THE FOREIGN SECTOR WILL APPEAR IN CHAPTER 15 THE OPEN ECONOMY]
It is from this point of view that the fight for foreign markets may be viewed.
Anticipating the discussion of fiscal policy in Chapter 13, Kalecki’s generalised model of the determination of aggregate profits considered budget deficits added to capitalist profits through their positive effect on national income. The budget deficit leads to the private sector receiving more dollar flows from government spending than it is returning to the government via taxes. Budget deficits thus provide an increased capacity for capitalists to realise their production plans and sell output because they expand the total aggregate demand in the economy.
Kalecki said that budget deficits allow the capitalists to make profits (net exports constant) over and above what their own spending will generate.
Government spending not only directly stimulates aggregate demand but through the multiplier effect it also increases the incomes of household, who, in turn, purchase goods and services from firms.
The opposite is the case. If the government runs a budget surplus – where spending is less than taxation revenue – then aggregate profits are reduced. There are two ways in which this occurs. Aggregate spending falls which reduces the revenue that firms receive. Further, if the surplus is achieved with increased business tax rates, then the firms have less after tax profit.
The only time that a rising budget deficit will not add to real profits is if there is full capacity and the rising deficits push nominal aggregate demand beyond the real capacity of the economy to increase output and real income.
A recurrent theme in the public debate which we will consider in Chapter 18 Policy Debates is the issue of crowding out. We also consider the concept of crowding out in Chapter 13 Fiscal Policy.
Basically, many economists think that government spending and private investment compete for a finite pool of saving and this competition has to be resolved by higher interest rates, which damages private investment.
Accordingly, budget deficits are said to “crowd out” private spending. The same economists typically add a further argument to justify their claim that budget deficits are damaging. They allege that public spending is generally wasteful in comparison to private spending because the latter is allegedly “disciplined” by the market. This is in reference to their belief that the self-regulating market results in the most efficient allocation of resources because inefficient uses of resources are priced out of use by demand and supply forces.
As a preliminary insight into why the crowding out argument is without substance, we can reflect on Kalecki’s profit determination model.
The crowding out argument relies on the claim that savings are finite and borrowers have to compete with each other to gain access to that finite pool.
Consider the conclusion that rising private saving (lower propensity to consume) and/or falling deficits impact negatively on profits. The impact is via declines in national income overall. It is probable that when firms are experiencing a reduction in profits as the conditions in the goods and services market deteriorate that they will reduce their rate of investment.
Equally, private investment adds to private profits and brings forth its own saving via the expansion of national income. In the same way, budget deficits add to private profits and, if accompanied by debt issuance, merely borrow back the funds they spend and stimulate growth in saving via the expansion of national income.
These are fundamental insights of a modern monetary economy that were well understood by Kalecki in his work on the determination of profits and the dynamics of a capitalist economy.
The key articles/books that outline Kalecki’s approach to profits are:
- Essai d’une theorie du mouvement cyclique des affaires, Revue d’economie politique, 1935.
- A Macrodynamic Theory of Business Cycles, Econometrica, 1935.
- Essays in the Theory of Economic Fluctuations, 1939.
- A Theory of Profits, Economic Journal , 1942.
- Studies in Economic Dynamics, 1943.
Business cycles – Fluctuations in Economic Activity
In the last section, we considered Michel Kalecki’s theory of aggregate profit determination. We gained an understanding of the way in which profits vary as national income fluctuates in response to variations in capitalist consumption and investment, workers’ saving, the budget balance and the external balance.
The fluctuations in economic activity and the resulting changes in national income are refered to as the business cycle. When economists refer to the business cycle they are considering fluctuations in economic activity that arise from variations in overall spending.
As a matter of terminology, economists often reference an economic variable in terms of the business cycle. There are three broad relationships:
- Counter-cyclical – which occur when a variable rises (falls) when the level of economic activity falls (rises). That is, we would observe a negative correlation between the variable and economic activity.
- Pro-cyclical – which occur when a variable rises (falls) when the level of economic activity rises (falls). That is, we would observe a positive correlation between the variable and economic activity.
- Acyclical – there is no relationship between the variable and economic activity. That is, there would be a zero correlation between the two variables.
Typical pro-cyclical variables are household consumption, business investment, imports and employment. Typical counter-cyclical variables are unemployment and underemployment, and the budget balance (we will explain this in more detail in Chapter 13 when we consider fiscal policy).
Economists also consider macroeconomic variables in terms of the timing of the business cycle. The points in time when the cycle moves expansion to contraction (the peak) or contraction to expansion (the trough) are referred to as turning points.
A variable that demonstrates cyclical behaviour before real GDP has “turned” is referred to as a leading indicator because its movement pre-dates the change in direction of the cycle.
Well-known leading indicators include new housing starts; new spending (orders) on plant and equipment by firms; purchase of consumer durables by households; and new job creation by firms.
Conversely, a variable that demonstrates cyclical behaviour after real GDP has “turned” is referred to as a lagging indicator because its movement post-dates the change in direction of the cycle.
Well-known lagging indicators include the rate of inflation; the change in persons employed; and the rate of wage inflation.[NOTE A TABLE HERE SHOWING THE KEY MACROECONOMIC VARIABLES IN TERMS OF THEIR LAG/LEAD STATUS AND THEIR CYCLICALITY]
Figure 12.7 depicts a stylised business cycle detailing the essential elements that economists identify. These elements include the recovery or growth phase where real GDP is increasing period after period until it reaches the peak – the point at which real GDP reaches its localised maximum.
The economy then goes into a downturn of some severity – sometimes moderate and other times severe – where the real GDP declines overall. If this phase lasts for two or more successive quarters then the economy is said to be in recession. At some point the economy reaches the trough, which is the lowest point real GDP reaches of that particular cycle.
The trend real GDP growth rate depicts the underlying direction of real GDP by ignoring the cyclical fluctuations.
Note also that the real GDP growth can accelerate or decelerate while still remaining positive. For a recession to occur the level of real GDP has to decline (that is, negative growth must occur).
Figure 12.8 shows the evolution of annual percentage growth in real GDP for Australia from 1960 to the first-quarter 2012. The data is derived from the Australian National Accounts available from the Australian Bureau of Statistics and is quarterly in frequency. The formula used to calculate the annualised growth rate from quarterly data is as follows:
(12.15) Annual Growth = 100*(Real GDPt – Real GDPt-4)/Real GDPt-4
where the t subscript refers to the quarter in question. So if t was March 2012, then t-4 would be March 2011 and so on.
The graph depicts several business cycles over this period of different intensities. While each nation experiences different intensities of growth and contraction between peaks, the Australian experience is representative of the general pattern of economic development.
Source: Australian Bureau of Statistics, National Accounts data.
Economic fluctuations are not regular occurrences by which we mean the time span between peaks and troughs and the depth (amplitude) of the cycle are variable over time. While Figure 12.7 depicted peaks that increased over time it is possible to envisage a peak that falls below the previous peak.
The point to understand is that economic activity moves over time in these wave like patterns oscillating between peaks and trough as aggregate demand fluctuates.
We refer to a single business cycle as the time between two peaks because that period contains a completed upswing and downswing.
Other terminology has been used in relation to the business cycle. For example, economists sometimes differentiate between an recovery (upswing) and a boom in terms of the relationship to real GDP to its trend. So a recovery (from a trough) becomes a boom, once real GDP exceeds its current trend value.
Further, a downturn might describe the fall in real GDP between the peak and the trend line, whereas the economy might be considered to be in recession once real GDP moves below its current trend level.
A very deep and drawn out recession is sometimes referred to as a depression and, fortunately, governments have a good understanding of the policy tools at their disposable (fiscal and monetary policy) to ensure we rarely encounters recessions so harsh that we consider them to be depressions.
The Interaction of the Expenditure Multiplier and the Investment Accelerator
In Chapter 8, we introduced the concept of the expenditure multiplier which demonstrated how an injection of spending into the economy would, if there was excess capacity, multiply as the extra income generated was re-spent.
In this Chapter, we introduced the accelerator model of investment spending, whereby a firm would augment its capital stock through investment spending in order to have enough capital available to produce the expected demand for its output.
In this section we bring the two concepts together to show how a business cycle might evolve.
The material that follows is considered advanced and is based on the work by Roy Harrod [NOTE REFERENCE HERE]. The essential idea can be described in a relatively straightforward way.
The accelerator theory of investment spending is based on the notion that net investment is driven by expected changes in output demand. Firms thus seek to put in place capital stock which will be sufficient to produce the expected demand for their output at current technology and practice.
The multiplier concept indicates that when there is an exogenous boost in aggregate spending (for example, from government, investment and/or exports) the initial spending increase is multiplied through the expenditure system as consumers are induced by the rising income to increase their consumption.
The two concepts can thus interact. A multiplied spending increase and growth in output will, in turn, increase investment via the accelerator principle.
Given investment is a component of aggregate spending, the rise in net investment will, in turn, have a multiplied impact on total spending and output and so the economy moves into an upward phase in the business cycle.
But once the economy reaches a peak in real GDP, the accelerator becomes a negative influence on net investment which then via the multiplier generates a decline in total spending.
So there is an interaction between investment as an exogenous driver of the multiplier and investment as an induced spending reaction as a result of the accelerator principle.
This was the basic insight that underpinned the Harrod-Domar model of economic cycles (and growth) and supports the notion developed by Keynes that we considered in Chapters 10 and 11 on the labour market, that the economy has no natural full employment level that it gravitates towards.
In those chapters, we learned that because the capitalist economy is prone to under-full employment equilibrium positions which have to be disturbed by government policy stimulus.
The Flexible Accelerator was defined as:
(12.5) It = d[vYt – K*t-1] + IR
If we only consider net investment we can ignore replacement investment (IR) because it is likely to change slowly and not be a significant determinant of the business cycle.
We also ignored inventory investment to keep the model simple. More elaborate accelerator models would consider firms adjust their inventories to ensure they can meet unexpected demand changes subject to carrying costs.
To add an element of reality to the model we would hypothesises that when making their net investment decisions, firms respond to changes in output last period rather than the current period. Further, in the real world, households adjust their consumption with a lag and so in the following model we use last period’s disposable income as the decision-making variable for households.
Combining the acceleration theory of investment with these assumptions, we can write the aggregate expenditure model as:
(12.15) Yt = cYt-1 + It = d[vYt-1 – K*t-1] + G + NX
where cYt-1 is household consumption and It = d[vYt – K*t-1] is net private investment. For simplicity we assume that the tax rate is zero so we can ignore it and that the propensity to import is zero so NX is just exports. These assumptions allow us to simplify the calculation of the multiplier.
We defined K* earlier in the Chapter as being equal to vYt-1. It follows then that K*t-1 = vYt-2.
Accordingly, Equation (12.15) can be re-written as:
(12.16) Yt = cYt-1 + It = dv[Yt-1 – Yt-2] + G + NX
If we had equilibrium, then real GDP is constant which means that Yt = Yt-1 = Yt-2 = Y*. So we can solve Equation (12.16) for its equilibrium or steady-state properties as:
(12.16) Y* = cY* + G + NX
Note that the Accelerator term drops out when real GDP is constant.
We re-arrange Equation (12.16) as follows (calling G + NX = A)
(12.16) Y* = 1/(1-c)A
Equation (12.16) says that total real income will be a multiple [1/(1-c)] of autonomous spending A. We could have expressed this in terms of the full expenditure multiplier that we derived in Chapter 8, but we lose no explanatory power here by using a simplified expression.
As an example, assume the marginal propensity to consume was 0.8 and A was 100. From Equation (12.16) we would solve the equilibrium level of real income to be Y* = 5 x 100 = 500.
If, for example, the government increased its autonomous spending and A rose to 120, then the new higher equilibrium national income would be 600.
The understanding you gain from these results is that:
So what role does the investment accelerator play? The answer is that once we consider the dynamics of the macroeconomy – the way in which it moves over time – the interaction between the expenditure multiplier and the accelerator becomes relevant.
The previous example merely considered two snapshots where the economy was (temporarily) at rest. How it traversed between those two steady-states is the domain of economic dynamics and business cycle analysis.[NOTE – A TABLE IS COMING HERE TO SHOW THE DYNAMICS OF THE SYSTEM]
That is all I have time for today.
The next section shows the interaction between the multiplier and the accelerator using a numerical and graphical example.
Alternative Olympic Games Medal Tally
My Alternative Olympic Games Medal Tally is now active.
I update it early in the day and again around lunchtime when all the sports are concluded for the day.
That is enough for today!
(c) Copyright 2012 Bill Mitchell. All Rights Reserved.