Wednesday, November 10, 2004

Interesting bits in the General Theory, part 4

The essence of the General Theory has to do with the fact that the marginal propensity to consume is less than one. This means that, for any increase in the employment of resources that will lead to an increase in aggregate income for the society, there is a part that will not be consumed (i.e. consumer demand does not rise one for one with aggregate income) and this part has to be made up by investment.

This leads to an interesting problem. If entrepreneurs decide to increase employment, they will lose money unless they decide to increase investment at the same time. Why is this? Because not all of the income that is paid to the new employees will be spent. Thus, if firms decide to hire additional workers so that their wage bill will rise by $100, their sales will not rise by the full $100 but by, say, $80. If firms hire new workers, then, it is not only because they expect consumption to rise, but because they expect that other entrepreneurs are going to be using the savings of the consumers to buy investment goods.

Now we see how it is perfectly plausible for the economy to find itself in a stable equilibrium where there is unemployment. That is, workers are willing to supply labor at the going wage, but employers are not willing to hire them because they are not confident that the resulting increase in demand will cover the costs of hiring them.

This will drive real wages down until they are just equal to the disutility of supplying additional labor. But the important point is that the marginal propensity to consume and the amount of investment that entrepreneurs are willing to undertake at any given moment determine the level of employment and then the real wage adjusts to that, and not vice-versa.


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