Steady State Macroeconomics : The Fundamentals of Keynessian Theories

Key features of the theory

• the amount of factors depend on the interplay between the aggregate demand and aggregate supply
• the long run is only the outcome of business cycles
• in keynessian theories the level of investments explains the amount of savings
• investments here are funded by loans via money creation. The monetary sector play a crucial role in economic growth.
• ratios of substitution between factors is fixed and limited in the short run by technology

State of research

• Increases is labor productivity enforces economic growth to avoid unemployment, which is a societal goal
• The secular stagnation is explained as the combination of the lower return on capital and the lower consumption rate when high incomes are achieved
• Zero growth can be achieve via low investments, equal to the depreciation rate
• Most of the research confirm that zero growth is compatible with positive interest rates and suffciently high taxes
• Authors agree that capital accumulation must be stopped
• Some authors call out that money creation is behind the mandate for growth, and companies will not be able to pay the loans without growth

Fundamentals of the General Theory

• Effective Demand

Keynes rejects an equal increase of demand following an increase in supply. It is actually the other way around, effective demand determines the size of production.

On the supply side, increases in employment [m1] increases production by a predetermined proportion. On the demand side, it leads to wage [m2] increase, which should be smaller than the economic value [m4] increase. The increase in wages increase consumption [m3], but lower than the increase in income. There the increase in aggregate supply is bigger than in aggregate demand [m5]. Investment will depend on the perspective of a bigger value than cost of expanding production.

As long as the economy is below the level of effective demand, the positive feedback of investment and additional demand continues, at a certain point, the costs of extra production exceed the effect on aggregate demand and investment does not expand further.

Aggregate demand entails investments [m6] and consumption [m4]. Once crucial determinant of consumption is the level of employment, wages and the consumption the income generates.  This is determine by the propensity to consumer [m7] which depends on the ditribution of income [m8].

Aggregate demand also depends on investments, which depends on the efficiency of capital [m9]. the returns on capital depends on the difference between producing the goods [m10] and the revenues from selling them [m11].

On the supply side, the question is the relantionship between production size and employment [m1]. The technology determines the % of labor and capital required for a given level of production [m12]. 

The level of capital equipment utimately determines the production capacity [m13]. In combination with the technology that determines the returns of capital [m14].  Those operate in a circular basis.

Deep dive into the determines of aggregate demand

• Consumption

Mainly depend on wages. The level of wages depend on the technological state and ultimately on the demand of work. The propensity to consume depend on the income distribution [m5].  The lower the income and wealth [m16], the higher the proportion employed in consumption.

• Investments

They are mainly determined by the efficiency of capital and the interest rates. The expected future revenues comming from those investments [m17] determines the efficiency of capital. Technologies could make future investments more or less profitable and hence increase uncertainty.

Given a supply of money [m19], the money demand is determined by the liquidity preference [m20], which among multiple factors depends on the the income and wealth of individuals, as well as the return provided by such investments.

•  Technology

The level of technology stablish a fix relationship between the inputs and output, and depends on the amount of investments used to improve the state of technology.

If the technology is labor augmenting, to keep employment constant aggregate demand should increase.The problem with that is that lower employment reduces aggregate demand, which makes the returns on increasing labor augmenting technology less favorable.

Goverment spending is sometimes used to compensate for the reduction in employment as technology develops.

Formal theory

The following equation states from left to right: future consumption coming from investment returns, change in consumption from wages and investments should be equal to the expected profits in the future, the current expenses of firms and the savings coming from wage income. It does stablish what needs to change in order to have growth or no growth. 

Conditions for a zero growth economy

If we are in a current growing economy, all variables from the equation will have positive values. In the absence of technological progress, it will be harder to keep the returns on capital and the incentives to expand production further. In a non growing economy without technological change, investments should be sufficient to back up depreciation to avoid further expansion.

Whether we are in a growing or non growing economy, the technological progress that reduces the human factors needs some sort of work redistribution to keep employment and wage level constant. In the negative case, the lower income due to lower wages will reduce future expectations of effective demand and lead to unemployment and economic stagnation. Only with goverment spending employment could be mantained.

Another possible policy for achieving zero growth economy is to increase taxation of factors such as resources to prevent further expansion of the production. That would stop the economic growth but not necessary prevent unemployment, as the substitution of factors is not possible at least in the short run.

In a zero growth economy with constant positive investments, the required conditions are that all income from investments and work is consumed, and the consumption out of profits C1p should be equal to the profits and expenses out of investments, to finance the entire activity.

Preliminary results

Without technological change, there is a long term tendency for zero growth, as the efficiency fo capital declines.

With technological change applied on labor, work distribution and sufficiently large wage increase per hour needs to take place to keep employment and consumption constant. If this is not applied, goverment spending will be required to avoid a crisis of employment and overproduction.

To avoid the expanstion of production as technological progress evolves, there have to be mesures to ensure labor input is reduced sufficiently, plus income and its distribution to remain constant.

Harrod: warranted, actual and natural growth

According to Harrod, there is an optimal amount of savings that avoid unemployment. In a steady state economy, that could lead to zero or small saving rate depending on the level of depreciation and individual preferences. His theory aims to ensure that all savings are used for investments.

Domar: Capacity and demand effects

According to Domar, an stable growth rate is achieved when the supply and demand are equal to prevent overproduction or inflation. For that to happen, there have to be sufficient investments to cover the savings, and this balance depend on the growth of the input factors and technology.

A steady state economy without technologica change, the productivity of new investments should be zero or equal to its depreciation costs. In order words, the investments does not create new capacity to be absorbed by demand.

Neoclassical synthesis IS-LM and AS-AD

The demand depends on the demand on the goods market and the money market IS-LM, while the supply depends on the labor market AS-AD. 

Aggregate Demand

The IS function describes the relationship between the interest rate and the aggregate demand in the goods market.  The aggregate demand depends on the level of consumption, investments, interest rate and goverment expenditure. The interest rates conditions the level of investment and ultimately the level of demand. In the LM function the interest rate is define at the equilibrium between the supply and demand of money, which depends on the level of economic activity.

The interdependency between the IS and LM creates the aggregate demand function AD.

Aggregate Supply

The Labor market determines the real wage levels, which utimate is determined by the market power of firms. Depending of the bargaining power of firms and employees, the level of wages and unemployment will be one or another.  The price level is determined by the nominal wages and desired markup. Production will be determined by the amount of labor the company ultimately hired and its productivity.

Steady State Economic conditions

In order to achieve a steady state is that consumption levels, investment and goverment spending remain constant. There is no stability concern in such a model, even if unemployment is possible in such a steady state.

Kalecki: Investments and the Business Cycle

Theory

"capitalists earn what they spend, workers spend what they earn"

According to the author the price setting does not depend only on the costs of production but also on the market power. The complex multisector model of the author is able to represent the business cycle, but the long term conditions for steady state economy are also derived. 

One of the conditions is that average investments equal depreciation rate. The other condition is that the entire profits saved should be invested. What is very interesting is that any income distribution is compatible with a steady state economy.

With technological change, if that effect capital effectivity the investment should be below the depreciation rate, and if it affects resources or labor, they have to be used less, the latter being distributed as wages remain stable to not change demand.

Kaldor: Technical Progress function

In his theory investments lead to capital accumulation and the introduction of new technologies. Together, these two effects lead to increases in per capita income. The central question is how this mechanism needs to change in order to facilitat a steady state economy. 

If technical progress depends on investments, investments lead to per capita growth in the absence of depreciation. Net investments need to be zero in order to stop capital accumulation and productivity increase via innovations. No investment means no technological progress.

With depreciation, the investments required to keep capital stock constant lead to innovation that reduces the demand for labor, and redistribution of working hours is required to keep employment constant.If the technological change is resource and no labor augmenting, labor demand is constant and resource use decays over time. 

If investments are zero or very small, savings have to be small too.  Savings have to be equal to the amount of capital required to be replaced by depreciation to lead to zero profits. If savings and investments are not equal and the latter is bigger, that leads to positive profits. In any case, they will need to be low to avoid further investments.

Robinson: Biased Technical Change

Robinson's model of the economy entails one sector in which consumption goods and capital goods are produced. In each sector, workers earn wages and entrepeneurs receive profits. The wage and profit share in each sectors are determined by the levels of wages and prices. Wages determines costs and depends on worker's power, while prices are determined by the willingness of the firms to make larger profits. This profit can be expand also by increasing the market share, which requires lower prices.

All wages are consume and all profits are invested. Investment increase the capital goods sector and profits. Wages rise in the same sector,which increases demand in the goods sector which lead to higher profits for the goods sector.  This intercausal relationship between investments and profits defines whether the economy grow. The size of investment and economic growth depends on the size of the profits. Growth allows for profit and consumption increases.

According to Robinson's, technological change affect labor productivity in both sectors, depending on the syncrony of the productivity increase, we can talk about different types of technological progress (capital saving, capital using).

Enterpreneurs can reach increasing investments or keeping them constant as technological progress develops. That will have different outcomes in terms of the amount of labor required, as increasing investment could keep employment constant, while constant investments lead to unemployment.

Steady state economy

Without technological change, the profit share is decisive. That is determined by the capacity of workers to claim a large share of profits so it equals depreciation rates of capital.There are two confronting forces though. as low profit shares means large wages shares. The latter implies high demand and additional incentives for investment. One can make depreciation and taxes sufficiently large so both shares become relatively low and further growth does not happen.

With technological change that increases labor productivity in the consumption goods sector that would lead to investments as firms will try to compete for market share. Expected demand should be flattened to avoid incentives for further expansion, via working hours reduction and limits to input use in general.

With technological change that increase labor productivity more in the capital goods sector, investment will increase as long as taxes does not avoid that. Working hour reduction will happen if investments are stopped, which could lead to a transfer for workers or unemployment. 

With neutral technological change, a reduction in investment and hence labor used will be required in both sectors.

Summary of the results and section

Keynessian theories provide a more realistic representation of the economy, as there could be excesses and shortages in capacity, demand and employment. The degree of substitutability between factors is fixed in the short term, and there is not infinite susbtitution between resources and capital/labor as with neoclassical theories. 

In the next section we will deep dive in the monetary aspects of the theory which is also a great addition to the neoclassical models. We will need a separate section to reflect the important role of energy as a non substitutable source of useful work, and what according to many ecological economists is behind the growth in productivity of the last century.

Now we will briefly summary the conditions for a steady state economy within the keynessian theories:

1. Effective demand must be constant, and that ultimately means stable supply, wage income and consumption.
2. Investments have to be smaller and in line with depreciation rates. For that to happen, expected net profits have to be low or zero. That will require goverment policy as technological progress increases the expected revenue stream and hence could push for further investments.
3. Technological progress, when labor augmenting, lower labor demand in the steady state and then unemployment. To avoid a economic crisis, the additional profits should be place to ensure constant labor income and distribution of hours should be enabled to keep consumption constant. Goverment spending could also keep demand constant while unemployment grows.

The social stability of such economy, and the amound of income inequality, heavily depends on the technological progress type (resource/labor/capital augmenting) and the public interventions applied to it (taxes on profits, unemployment transfers, unions...). The right combination of resource augmenting technological investments, social benefits and capital tax schemes could provide a stable economy with moderate inequality, lower environmental impacts and runnable businesses. 

In the next section we will explore the monetary policies that could stop the growth mandate in detail.