MMTed - Home Page of Public Education in Modern Monetary Theory

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OK, now we're going to extend the analysis into the real world a little bit more.

Here, we have a basic economy. We have households, business firms. Households save and consume. Business firms produce and invest. And we've also got a government sector and later we'll introduce some banks, the financial sector and the external sector.

So the basic motivation for firms in a capitalist monetary economy is they form expectations of what they can sell.

They assemble working capital by getting productive inputs from the household sector for which they pay incomes.

And those incomes allow the household sector to then consume. And as a result of the consumption-spending, the flow of spending, business firms provide output.

Now, at that simple state, that flow, that circular flow would persist forever because the households are consuming all of their income.

Business firms' expectations of what they can sell are being fully realised each period. And they're prepared to keep hiring and paying at incomes. Now, that's what we call equilibrium in macroeconomics. The problem is that that has no connotations of virtue in the sense that that economy will persist like that forever.

If nothing else changes but it could be at a state where households have very high levels of unemployment.

So let's make it more complicated.

Let's say the government now comes along and levies a tax.

And the households then have to pay a tax to the government out of their income. Now that means that they've got disposable incomes less than their income now. And as a result, their consumption is going to fall.

And business firms will react to that because they noticed the unsold inventories. They'll produce less, hire less workers, income will fall, consumption will fall and that the economy would quickly move into recession. And unemployment would be rising.

Now, to offset that, the government has to at least spend exactly the amount that's taking out in taxes for the lost consumption spending to be replaced by government spending.

So at the very least, governments have to run a balanced fiscal position in this simple world.

Now, think about what I said.

But there was high and might be high unemployment in that equilibrium state.

And so you can see quite clearly that if the government wanted to have less unemployment and move the economy to full employment, then it would have to spend more than its tax revenue. To inject more currency in spending into the economy, to promote further production, further sales, further income production and that would circle around the economy.

So the taxes are what we call a leakage. The government spending is an injection into the income expenditure system. It's complicated further. Households save and put money into their bank, the banking sector. And they also import from the external sector that we've got over here. Both of those actions are further leakages from the income expenditure system.

And if nothing else happened, then that economy would quickly go into recession because the income that was being produced is more of it's now getting lost and not being recycled back to the firms.

And so fortunately, we can identify some more offsetting injections in the form of business firms, borrowing from banks and investing in productive machinery, in technology, etc., and injecting investment spending into the economy.

And also, we receive export revenue from the rest of the world, buying production we've produced locally.

And so those injections then can be seen as offsetting those leakages from the system. And so we can maintain equilibrium if the some of the leakages, taxes, savings and imports are equal to the sum of the injections, government spending, business investment and export revenue.

Now, if we reach a situation where there's less than full employment at that equilibrium state and there's no likelihood of any change in business investment and exports, well then the only way you can restore the economy back to higher levels of employment is if the government increases its spending and moves into deficit.

So this now reinforces your understanding on why an economy can endure mass unemployment. Mass unemployment arises not through the fault of the unemployed, but because there's insufficient spending in the economy overall.

It's a macroeconomic problem, a systemic failure to create enough jobs. And it's because business firms are not anticipating sufficient sales for them to hire the workers that are in need of work and want to work.

So the only way an economy that's enduring mass unemployment can get out of that dilemma, given the non-government spending flows, the consumption, investment and export revenue, is for the government to increase its spending relative to its taxation. That's the only way an economy can move towards full employment under those conditions and those conditions are the typical conditions we encounter in the real world.

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Study Notes:

We are now starting to think like a macroeconomist.

In 1964, Cambridge economist, Joan Robinson quoted the French philosopher Henri Bergson: "Time is a device to keep everything from happening at once".

This helps us understand that mass unemployment arises because of the systemic failure to create enough jobs, which leaves individuals powerless to improve their own circumstances.

Why does the system fail in this way?

How can mass unemployment be considered an 'equilibrium' state?

Before the Great Depression, economists believed that if there was an excess supply of labour (unemployment) then the market would reduce the wage, and firms would demand more workers.

But Keynes showed that the wage is both a cost to firms and an income to workers, upon which spending depends. If we cut wages, we cut spending, which reduces output and employment.

The reference to time separating events is important.

The term 'equilibrium' in macroeconomics is used to refer to a situation where there are no forces present which would alter the current level of spending, output and national income. At that point, firms are selling all the output they produced based on their expectations of planned expenditure. Equilibrium is associated with a position of rest.

The basic macroeconomic rule then is that, subject to the existing productive capacity, total spending drives output and national income, which in turn, drives employment.

Firms will employ the number of workers they think will be required to produce the amount of output they expect to sell at a profit. They will hire more labour and produce more output if they think the sales revenue will be higher.

At this stage, they are guessing what the future might be, but in doing so, they have to make concrete decisions about the productive inputs they are to hire.

They convert money capital into working capital (labour, equipment, etc) in the hope that they will be able to realise profits upon sale - that is, end up with more money capital than they started with.

Their employment decisions thus depend on how optimistic they are about the future. Time separates these decisions from realisation.

The decision to produce determines how much income flows to the suppliers of the productive inputs. The firms have no way of knowing, in advance, how much of that income will flow back into sales though.

Habitual behaviour provides some clue. As income rises, a proportion will flow back into household consumption spending. Some will be lost to taxation, and some will flow out of the economy altogether to purchase imports.

These are the leakages from the expenditure-income stream.

On the other side, there are sources of spending which do not necessarily rely on the income flow - government spending, some components of business investment spending and the sales of production to foreigners as exports.

These sources of spending are called injections into the expenditure-income stream.

Equilibrium occurs when the sum of the leakages equals the sum of the injections.

Now, what if firms find that actual sales are less than the expected sales that they based their production decisions on?

This might occur because households decided to increase the proportion of their disposable income that they save or, perhaps, because export income was lower than expected. Behaviour can change.

Thus, firms were too optimistic and over supplied output. In this situation, an unplanned increase in the stock of inventories provides the signal to firms that they have been mistaken. Firms would react to this increase in inventories by decreasing output and national income and employment would fall and unemployment would rise.

The economy would adjust to this lower employment and output level and eventually firms would be selling all they produced, and equilibrium would be restored, albeit with much higher unemployment.

Unless there was an intervention, say through a government stimulus package, the economy would wallow in recession.

From an MMT perspective we can understand this situation in this way.

It is the introduction of State Money (defined as government taxing and spending) into a non-monetary economy that raises the spectre of involuntary unemployment.

As a matter of accounting, for aggregate output to be sold, total spending must equal the total income generated in production (whether actual income generated in production is fully spent or not in each period).

Involuntary unemployment is idle labour offered for sale with no buyers at current prices (wages). Unemployment occurs when the non-government sector, in aggregate, desires to earn the monetary unit of account through the offer of labour but doesn’t desire to spend all it earns, other things equal.

As a result, involuntary inventory accumulation among sellers of goods and services translates into decreased output and employment.

MMT then concludes that when all the non-government spending and saving decisions have been taken, if there is any mass unemployment then net government spending (spending less taxes) is too low.

2.11 Spending equals Income

Study Notes: