Recently there has been a
prolonged period of productivity increase without a corresponding increase in
labor income. The result is that the supply of goods and
services throughout the economy has increased, while the purchasing power of
labor has not. We analyze the consequences of this from a Keynesian point of view.
In Diagram 0 we show the classical Aggregate
Supply curve AS. It is just a vertical line at the size of the
economy, the size of the Gross National Product of the economy. The thinking behind the classical AS curve is that production is independent of price level. If money is added to the economy, or the
velocity of money increases, prices merely rise, or inflate, but production
does not increase. Similarly, if money
leaves the economy, or the velocity of money decreases, prices merely decrease,
or deflate. Production does not
decrease. The actual price level at e
is set by the intersection with the Aggregate Demand Curve AD, which is the relationship between the total demand for
goods and services and the price level. If the price level goes up, things are more
expensive, and people can buy, or choose to buy, a smaller quantity of goods. If the price level goes down, things are
cheaper, and people can buy, or choose to buy, a larger quantity of goods. So for a given quantity and velocity of
money, at a given supply of goods and services, there is feedback: An increase
in quantity demanded, above Q drives the price level
back up toward e, and a decrease in quantity demanded below Q drives the price level
back down toward e.
This is the same sort of feedback
that sets the equilibrium for the intersection of ordinary supply and demand
curves: If the price of a good goes up, manufacturers
want to make more, but people want less of it.
If the price goes down, manufacturers want to make less, but people want
to buy more. These two tendencies settle
where the supply and demand curves intersect.
Diagram 1 shows the Keynesian Aggregate Supply AS curve, as opposed to
the classical Aggregate Supply curve. The
rationale for the Keynesian AS curve bending back is the idea that, if the price level goes
below this level, production decreases dramatically because wages (and actually some
other prices, too, under oligopoly,) do not decrease rapidly. They are considered 'sticky,' for various
reasons, and so instead of wages going down, employment decreases. That is unemployment increases. Fewer workers implies, in the short run, production of goods and
services decreases. That is, Aggregate Supply
decreases. Meanwhile, the Aggregate Demand
curve shifts to the left, because fewer workers have money to purchase things. This is the
situation during a depression or recession. (Shown in red. The AD curve is
about in the position it was during the Great Depression, when first demand, and
then production, decreased by about a third.) The capacity
to produce is still there. It is still
at Q, but it isn't being utilized. Actual production is reduced to Q'. The GNP is smaller than it could, and should be.
The curved region of the AS curve represents the idea that, as the economy approaches
full capacity, resource bottlenecks appear, as some sectors reach full capacity
before others, driving up the price level. The closer to full capacity, the
greater the number of bottlenecks, and the more the price is driven up. We show the equilibrium point, where the
economy is actually performing, part way up the curve, at less than full
employment, and at less than full utilization of capital and resources. We
would expect this situation in a growing economy. An economy only rarely
operates at 'full' capacity.
In Diagram 2 we
see what happens when wages increase along with labor productivity. More is being produced, so the AS curves shifts to the right, and more is being demanded,
since wages have also increased. Both curves
shift a comparable amount , so employment remains high, as does the utilization of
capital. Other things being equal, the
price level stays the same, while the economy, the GDP, grows from Q to Q'. (We are
implicitly adjusting for any inflation.)
Next, in Diagram 3, we
consider when wages do not increase at a rate equal to the increase in labor
productivity, Since productivity
increases, more is being produced, so the AS curve shifts to the
right. The Aggregate Demand curve also shifts to the
right, but not as much. This is because income which would have gone to labor instead goes to the owners of
capital, who save a greater proportion of their income. Saving more, they spend proportionately less.
Since it moves
less, it is now further back along the backward bend of the Aggregate Supply
curve, into the recession region. Because labor borrows, in order to
maintain its living standards, this does not happen gradually. This borrowing temporarily shifts the AD curve along with the AS curve, as in Diagram 2. But this can only be temporary, because
eventually labor's credit runs out, and this happens suddenly. When it happens, the AD curve shifts back to
the left (the red AD" curve), and we
have a recession. (Diagram 4.)
Here the economy produces at quantity Q", less than the potential Q', which the real economy has grown capable of producing. With labor
productivity increased, but demand down, the economy becomes locked into a high
unemployment mode, with reduced demand. It also becomes
locked into a mode of low capacity utilization of capital and resources. This discourages investment.
There still
remain questions. One is why haven't prices declined significantly? Well, one of the things that has been
happening is that the economy has been running a trade deficit for a number of
years. So for a long time now, many sectors have already been running at below capacity.
Another, more ominous possibility is that the
consequences of Quantitative Easing are slowly being felt in the real
economy. People have wondered why, with
an apparent increase in the money supply, there hasn't been inflation. But if the money is trapped outside of the
real economy, then the quantity (M x V) hasn't changed much. This is because although M has increased, V, in
reality, counting all the QE money outside of the real economy which has zero
velocity, has become very low, and is only slowly increasing as more money slowly
enters the real economy. One of the
reasons this money is slow to enter the real economy is the dearth of
investment opportunities, a consequence of the fact that, although nominally
the economy is growing, from the point of view of employment, and labor income,
and thus consumer demand, it is still in recession.
