Keynes created the tools with which a monetary economy can be understood including the concepts of ‘effective demand’ (which showed that economies wouldn’t automatically gravitate to the full employment position and that lowering wages also wouldn’t provide full employment through manual intervention) and the ‘marginal propensity to consume’.(which formalised the proposition that the wealthier consumers became, the greater the hole in total spending that needed to be filled by investment and government deficit spending)
These tools created a propensity for modern governments to utilise deficit spending to a limited extent with the main factor limiting its use to eliminate unemployment completely being their own propensity to confuse their deficits with the debt found in the personal finances of their individual citizens and businesses.
Hopefully the lower section of the Overall Keynesian Diagram introduced in the video will redress that confusion.
The diagram on this page shows us the upper section of the Overall Keynesian Diagram referred to in that video, a diagram which hopefully provides another useful way of comprehending a monetary economy.
Its four columns have the following functions:
The 1st column sets out the previous year’s total profits figure.
The 2nd column sets out the total volume of wages paid out by all of the businesses in the economy as at the end of that year – this figure is based on the total profits figure for the previous year from column 1 and is generated according to the longer term ‘total profits to total wages’ ratio applicable to that economy, which for each diagram here I’ll assume to be exactly 3 to 7.
Essentially, and I’m basing this on commonly available statistics, each economy has a ‘total profits to total wages ratio’ that remains largely the same over long periods of time, in the sense that the total volume of wages paid out by all of the businesses in the economy by the end of any given year will generally relate to the previous year’s total profits figure in conformity with that ratio. This ratio varies from economy to economy but is roughly 3 to 7 in many economies.
Thus for year 1 shown here, because the figure in column 1 representing the previous year’s total profits is 3000 billion dollars, then in accordance with the exactly 3 to 7 ratio adopted for these diagrams, the total volume of wages paid out by all businesses by the end of year 1 in the second column is 7,000 billion.
The 3rd column sets out the total volume of spending in the domestic economy as at the end of that year, also known as the Gross Domestic Product, which is the main variable in the diagram, and which for year 1 is 10,400 billion.
That figure of 10,400 billion in spending comes from a variety of sources.
– some is from the spending by wage earners and profit earners of that portion of their wages and
profits that they haven’t saved.
– some comes from the government that has taxed it from wage earners and profit earners and
then spent it.
– some of that spending comes from borrowers spending the money they’ve borrowed.
– and some of that total spending, as we shall see later, may have come from government deficit spending.
The 4th and final column sets out that year’s total profits figure for all businesses in the economy,
and is obtained by deducting the figure in column 2, which is the figure for the total wages of paid out in that year, from the figure in column 3, which is the figure for total sales occurring that year.
For example, in relation to year 1 here, the figure of 3,400 billion is obtained by deducting the figure of 7,000 billion from the figure of 10,400 billion.
This gives a figure of 3400 billion in profits for year 1, as shown in column 4, and this figure also carries over to become the figure in column 1 for year 2.
Thus for year 2, the 3 to 7 ratio as applied to the 3,400 billion in column 1 representing the previous year’s total profits, means that all businesses combined in the economy will, by the end of year 2, pay out a total of 7933 billion in wages.
Then as total sales for year 2 happen to be 11,500 billion, then deducting the total wages of 7933 billion from that total sales figure of 11,500 billion, gives a total profit for year 2 of 3567 billion which will form the basis for the wages paid out the next year based again on the 3 to 7 ratio.
It works the other way as well.
If for year 1, total sales had only been, say, 9,950 billion instead of 10,400 billion, then the total profits figure for year 1 would have dropped to 2,950 billion instead of the 3,400 billion in this example, and the total wages paid out in year 2, in accordance with the same 3 to 7 ratio, would have been accordingly reduced to 6883 which is lower than the wages total for year 1 of 7,000, and accordingly would represent an increase in unemployment.