# Chapter 8. Purchasing Power Theory

Outline:

1st Introduction to the problem

2nd The classical depression policy

3rd The core statements of the simple purchasing power theory

4th Criticism of the simple purchasing power theory

5th The modified purchasing power theory: Abba P. Lerner

6th The results in the framework of the Kaldorian distribution theory

7th Consideration of supply factors

8th Side effects

9th Concluding remarks

1st Introduction to the problem

According to the purchasing power theory, an expansionary wage policy can contribute to an increase in employment and thus to a reduction in unemployment. Expansionary wage policy is understood here as the attempt to raise wage rates more than the increase in labour productivity. The purchasing power theory is based on the theory of John Maynard Keynes.

In this contribution we want to present the core statements of the purchasing power theory and show that these theses wrongly refer to the Keynesian theory. Although it is possible to reformulate this theory with Abba P. Lerner in such a way that it correctly reflects the Keynesian correlations, the inclusion of Kaldor's distribution theory, which is also Keynesian, shows that even in this case the conclusions of the purchasing power theory are wrong.

2nd The classical depression policy

Contrary to this, during the Great Depression, the Brüning government attempted to overcome the depression through deflationary policies, including pressure on wages. The government based this on neoclassical theory, according to which unemployment must be attributed to the fact that wages are above the equilibrium level. According to this theory, it should be possible to reduce unemployment by lowering wages. Let us look at the following diagram, namely the quadrant on the top right. On the ordinate we have the wage rate, on the abscissa the amount of labour measured in hours of work. Real variables (e.g. real wage rate) are assumed. The red curve indicates the demand for labour, the blue curve the supply of labour. Equilibrium was reached at a real wage rate (l/p)*; the actual real wage, however, would be ( l/p) 0. Unemployment (the labour supply surplus) would therefore be A0 – A*. A reduction in the real wage rate could - as the diagram shows - reduce unemployment.

# J. M. Keynes doubted now whether wage reductions during times of depression actually help to increase employment. In times of depression, entrepreneurs would be in strong competition with each other on the goods markets, and therefore they would be forced to pass on every cost reduction, including wage reductions, entirely in the form of price reductions. The real wage could not be reduced in this way and thereby the reason for an increase in employment would also drops away.

Somewhat more complicated is the analysis within the framework of neoclassical theory. Politicians or wage bargaining partners can only ever influence the nominal wage, although only a reduction in the real wage results in an increase in employment. At constant monetary value, however, the price level of goods would have to decline if the quantity of goods would increase as a result of the wage reductions. But in this way, the initial real wage reduction is partially reversed.

We assume that the nominal wage rate and thus the real wage rate were initially lowered to (l/p)*. This leads in a first step to full employment (A*). The increase in employment also causes production to rise to the quantity (X*) according to the production function (see the quadrant on the bottom right).

If we now assume that the sum of monetary value (the product of the quantity of money in circulation and the velocity of money in circulation) remains constant, i.e. is not adjusted despite the expansion of the volume of goods, the price level of goods must fall from P0 to P* in accordance with the quantity equation (see the quadrant on the bottom left). This, however, causes the real wage rate (l/p) to rise again and the increase in employment and production is partly reversed. However, this negative effect could be prevented if the central bank would adjust the money supply in circulation to the changes in the real quantity of goods.

3rd The core statements of the simple purchasing power theory

The purchasing power theory, by contrast, assumes that it is not wage reductions but wage rate increases that lead to an increase in employment. Unemployment is due to a deficit in the demand for goods; with wage increases, an increase in the demand for consumer goods can be expected, so that the production of goods would increase and thus also employment.

This theory is wrong, since wage rate increases only lead to an increase in the induced demand for goods and since, according to Keynesian theory, an increase in employment can only be expected if the autonomous demand for goods increases. Therefore, let us look at the following graph. Let the production quantity (the domestic product) be plotted on the abscissa and the demand on the ordinate.

# The starting point is the consumption function: C(Y), according to which consumption would increase with growing national income, although - and this is a core statement of the Keynesian system - consumption demand would increase less than national income, however. It is therefore assumed that the propensity to consume is less than one.

(By the way: for the sake of simplicity, we have drawn the consumption function as a straight line in our graph. This means that the propensity to consume remains constant even with a rising income. The Keynesian school, however, assumed that the propensity to consume decreased with increasing income. This results in a curved consumption curve. Since the results discussed here remain unaffected by the change in the propensity to consume, we can assume a linear consumption function without distorting the results).

Furthermore, it is assumed that investment expenditures are given autonomously, i.e. they do not depend on the level of the domestic product. We can therefore consider the investment expenditures by shifting the consumption line parallel upwards by the amount of the constant investment expenditure; in this way we obtain the course of total private and domestic demand for goods.  Taking the government into account, the deficit-financed government expenditures must then be added to the curve of total demand. The curve of total demand then shifts upwards again by the amount of government spending.

The supply of goods is represented in this graph by the 45° line; indeed, ex definitione, every level of domestic product corresponds to a supply of goods of exactly this level. The point of intersection of the total demand curve with the 45° line then indicates at which domestic product and thus ultimately also at which level of employment persists equilibrium on the goods markets.

4th Criticism of the simple purchasing power theory

Within the framework of the purchasing power theory, there occurs a confusion between induced and autonomous demand. According to Keynes, only an increase in autonomous demand leads to an employment increase in equilibrium. An increase in the wage rate, however, at best only leads to an increase in induced demand.

An increase in autonomous demand manifests itself in an upward shift of the demand curve. The increase in induced demand caused by wage rate increases, on the other hand, manifests itself in a movement along a constant demand curve. They are induced by a rise in disposable income and therewith consumer demand rises as well. However, a new equilibrium at higher domestic product and thus also higher employment would only be expected with an upward shift of the demand curve.

This means that an expansive wage policy only triggers a movement to the right along the constant consumption function via the assumed increase in income and that in this way no shift of the equilibrium can be achieved. In the long run, the market remains in an equilibrium with underemployment, the wage rate increases fizzle out in price increases without any real increases in goods production and thus no increase in employment can be expected.

# Furthermore, there is a confusion between absolute and relative demand growth. Keynesian theory attributes unemployment to a demand deficit. This means that the demand for goods is lower than the potential supply. Therefore, an increase in employment can only be expected if demand increases more than supply, in other words, if demand increases in relation to supply.

Under Keynesian conditions, however, an increase in the wage rate leads to a smaller increase in demand than in supply, since the cost value of supply increases by the total increase in the wage total, while due to the assumed propensity to consume always smaller than one, the induced consumption demand always increases less than the increase in the wage total.

The simple purchasing power theory presupposes what it is trying to prove, i.e. a 'petitio principii' takes place. This theory aims to prove that wage rate increases lead to employment increases. It assumes that wage rate increases lead in a first step to equally large wage income increases.

However, this is only the case if the demand for labour hours does not decrease to the same extent due to the wage rate increase. This, however, is the point at issue. According to neoclassical theory, wage rate increases always lead to a decline in the demand for labour. However, a refutation of the traditional theory would only be achieved if changes in the demand for employment were not simultaneously regarded as already proven facts.

Now, one could argue that it is sufficient to prove a positive employment effect if the demand for labour decreases to a lesser extent than the wage rate increases. Then too, wage income increases and thus eventually increases in the demand for goods would already be expected. The relationship between an increase in the wage rate and a reduction in employment demand is measured here by the demand elasticity of employment.

If we assume a Cobb-Douglas production function, then the elasticity of demand for labour is necessarily greater than one, though.

# This means that the decline in employment is greater than the increase in wage rates, so that wage income initially declines and does not - as assumed - increase.

5th The modified purchasing power theory: Abba P. Lerner

The modified purchasing power theory developed by A. P. Lerner avoids the weaknesses of the original purchasing power theory. Lerner assumes that wage rate increases lead to an increase in the wage ratio and that in this way the aggregate consumption ratio increases, since employees have a higher propensity to consume than the self-employed. This, however, results in an upward shift of the demand curve - as required for an increase in employment.

# It is true that under Keynesian conditions an increase in the consumption ratio triggers an increase in employment. It is also true that an increase in the wage ratio triggers an increase in the consumption ratio (c), since the propensity to consume of wage earners (cl) is empirically proven to be higher than that of profit earners (cg).

Ex definitione is valid:

# In this case, however, the demand curve for goods shifts upwards, which leads to an increase in equilibrium employment. In this chain of evidence, only the thesis that wage rate increases lead to wage ratio increases requires to be proved.

6th The results in the framework of the Kaldorian distribution theory

The question is actually whether an increase in the wage rate under Keynesian conditions leads to an increase in the wage ratio at all. The distribution theory of N. Kaldor applies here. However, the Keynesian distribution theory developed by N. Kaldor states that mere wage rate increases do not lead to an increase in the wage ratio; that only if employees additionally increase their propensity to save an increase in the wage ratio can be expected. If, however, the savings rate of employees increases, the demand curve in the modified Kaldor model shifts downwards, with the consequence that the wage ratio increase is bought by a decline in real domestic product and thus also in employment.

# However, Kaldor developed his distribution theory for times of overemployment. But since we must assume an underemployment situation when analysing the theory of purchasing power, a modification of Kaldor's distribution theory is required.

In the case of underemployment, Kaldor's distribution theory contains a degree of freedom that can only be eliminated by considering supply relations in addition to demand. The level of saving depends not only on the level of domestic product, but additionally on the distribution of income. The higher the profit share, the higher the total savings, ceteris paribus. In this way, we obtain a set of saving functions depending on the profit share. Thus, the equilibrium domestic product however also depends on the level of the profit share. As the following graph shows, equilibrium income decreases to the extent that the profit share increases.

# The demand conditions alone now no longer determine the income distribution; the demand factors now only exert an influence on the distribution insofar as the equilibrium solution must be located on the negatively inclined demand curve of the distribution. Which point of this curve is realised now depends additionally on supply factors.

# 7th Consideration of supply factors

We derive the supply curve of the distribution from the macroeconomic cost function developed by Barone. On the abscissa we plot the aggregate production quantity, on the ordinate the price level as well as the aggregate average costs. The cost curve is created by plotting the average costs of the individual enterprises (or industries), starting with the enterprises with the lowest average costs, followed by the enterprises with respectively higher average costs. In this way, a staircase-shaped total cost curve is created.

# It now depends on the realised price how many goods are produced. Initially, only the most cost-effective enterprises will start production. However, if demand rises and with it the price of goods, it is also worthwhile for less cost-efficient enterprises to start production. The producer with the least favourable average costs is called a marginal entrepreneur; the price just covers his average costs.

The price thus rises to the level of the average costs of the marginal entrepreneur whose production is only just needed to satisfy demand. Since the intramarginal enterprises (the enterprises with the lower average costs) also achieve the price oriented to the cost level of the marginal enterprise, they make profits, so-called differential profits, which are higher the greater the difference is to the cost level of the marginal enterprise.

We can now draw the Barone curve as supply curve of the distribution in our distribution diagram. The point of intersection of the supply curve with the demand curve then indicates at which domestic product and at which distribution (at which profit share) the economy achieves equilibrium.

# If we now assume that due to an expansive wage policy the aggregate consumption ratio increases, which is equivalent to the aggregate saving ratio decreasing, then in our diagram the demand curve of the distribution shifts downwards. Equilibrium on the capital market in fact only occurs if the aggregate saving ratio corresponds to the investment ratio, which is assumed to be constant. If the saving ratio of employees rises, then the aggregate saving ratio which corresponds to the investment ratio is already realised at a lower profit share.

However, this means at the same time that the domestic product has also declined and therewith employment. Thus, an expansive wage policy does not lead at all to the desired increase in employment.

# 8th Side effects

In a Keynesian world, wage rate increases can trigger further negative side effects. The cost increases and price increases associated with the wage increase trigger an increase in the demand for money due to the transaction motive. According to Keynesian liquidity theory, the demand for cash increases with rising income. This additional demand for money leads to interest rate increases, which in turn reduce the demand for investment and thereby employment (= liquidity effect). However, this negative effect could be compensated by an expansionary monetary policy.

# According to A. C. Pigou, wage rate increases furthermore lead to price increases due to cost increases. Households are forced to increase their savings rate, otherwise they will no longer achieve their savings goals. At the point in time (t + x), one needs a certain savings sum, which now increases due to the price increases. The increase in the savings rate in turn has an employment-reducing effect. This is referred to as the Pigou effect.

# Furthermore, wage rate increases lead to a substitution of labour by capital via a deterioration in the wage-interest ratio and thus to a "rationalisation" of workplaces. With a given technology, this is referred to as the substitution effect; with labour-saving technical progress, it is referred to as the rationalisation effect. The substitution effect is illustrated in the following diagram:

# The effects on employment are shown in the graph below:

# These negative employment effects are even exacerbated if the central bank pursues a policy of cheap money, thereby causing the wage-interest ratio to rise by yet another.

Our previous considerations have always assumed a Keynesian world and have seen the cause of unemployment primarily in a deficit in the demand for goods. De facto, however, we have to assume that today's mass unemployment is mainly caused by too high unit costs (classical unemployment).

In this case, the attempt to eliminate unemployment primarily by increasing demand is unsuitable as such, even if increases in wage rates - as hoped for within the framework of the purchasing power theory - could be expected to lead to increases in the demand for goods. Even if the demand for goods increases and thereby also production, it is not guaranteed in every case that unemployment will decrease. One must reckon with the possibility that the expansion of production will have a different effect on the various labour qualities.

If, for example, the increased production is due to an intensification of capital, this change in technology has a negative effect on the unskilled labour force. If the existing unemployment occurs mainly among unskilled workers, unemployment does not decrease despite increased production. Only the employment opportunities of skilled workers improve, but they are already fully employed.

There is even the danger that production cannot be expanded due to a lack of skilled workers, and that parts of production are therefore relocated abroad, with the result that the situation of unskilled workers deteriorates even further.

9th Concluding remarks

Our considerations have shown that wage rate changes have very different effects on the level of employment. It is not possible to say with certainty what effect a wage rate increase actually has on the level of employment, since the ramifications are too varied. But even wage rate reductions cannot be regarded as employment increasing in every case. One must conclude from these findings that wage rate variations are rather an unsuitable means of combating unemployment.