The General Theory of Employment, Interest and Money Part 9

The a.s.sumption that n = x + y means, of course, that labour is always in a position to determine its own real wage. Thus, the a.s.sumption that labour is in a position to determine its own real wage, means that the demand for the output of the non-wage-goods industries obeys the above laws. In other words, it is a.s.sumed that the rate of interest always adjusts itself to the schedule of the marginal efficiency of capital in such a way as to preserve full employment. Without this a.s.sumption Professor Pigou's a.n.a.lysis breaks down and provides no means of determining what the volume of employment will be. It is, indeed, strange that Professor Pigou should have supposed that he could furnish a theory of unemployment which involves no reference at all to changes in the rate of investment (i.e. to changes in employment in the non-wage-goods industries) due, not to a change in the supply function of labour, but to changes in (e.g.) either the rate of interest or the state of confidence.

His t.i.tle the 'Theory of Unemployment' is, therefore, something of a misnomer. His book is not really concerned with this subject. It is a discussion of how much employment there will be, given the supply function of labour, when the conditions for full employment are satisfied. The purpose of the concept of the elasticity of the real demand for labour in the aggregate is to show by how much full employment will rise or fall corresponding to a given shift in the supply function of labour. Or?alternatively and perhaps better?we may regard his book as a non-causative investigation into the functional relationship which determines what level of real wages will correspond to any given level of employment. But it is not capable of telling us what determines the actual level of employment; and on the problem of involuntary unemployment it has no direct bearing.

If Professor Pigou were to deny the possibility of involuntary unemployment in the sense in which I have defined it above, as, perhaps, he would, it is still difficult to see how his a.n.a.lysis could be applied.

For his omission to discuss what determines the connection between x and y, i.e. between employment in the wage-goods and non-wage-goods industries respectively, still remains fatal.

Moreover, he agrees that within certain limits labour in fact often stipulates, not for a given real wage, but for a given money-wage. But in this case the supply function of labour is not a function of F'(x) alone but also of the money-price of wage-goods;?with the result that the previous a.n.a.lysis breaks down and an additional factor has to be introduced, without there being an additional equation to provide for this additional unknown. The pitfalls of a pseudo-mathematical method, which can make no progress except by making everything a function of a single variable and a.s.suming that all the partial differentials vanish, could not be better ill.u.s.trated. For it is no good to admit later on that there are in fact other variables, and yet to proceed without re-writing everything that has been written up to that point. Thus if (within limits) it is a money-wage for which labour stipulates, we still have insufficient data, even if we a.s.sume that n = x + y, unless we know what determines the money-price of wage- goods. For, the money-price of wage-goods will depend on the aggregate amount of employment.

Therefore we cannot say what aggregate employment will be, until we know the money-price of wage- goods; and we cannot know the money-price of wage-goods until we know the aggregate amount of employment. We are, as I have said, one equation short. Yet it might be a provisional a.s.sumption of a rigidity of money-wages, rather than of real wages, which would bring our theory nearest to the facts.

For example, money-wages in Great Britain during the turmoil and uncertainty and wide price fluctuations of the decade 1924?1934 were stable within a range of 6 per cent, whereas real wages fluctuated by more than 20 per cent. A theory cannot claim to be a general theory, unless it is applicable to the case where (or the range within which) money-wages are fixed, just as much as to any other case.

Politicians are ent.i.tled to complain that money-wages ought to be highly flexible; but a theorist must be prepared to deal indifferently with either state of affairs. A scientific theory cannot require the facts to conform to its own a.s.sumptions.

When Professor Pigou comes to deal expressly with the effect of a reduction of money-wages, he again, palpably (to my mind), introduces too few data to permit of any definite answer being obtainable. He begins by rejecting the argument (op. cit. p. 101) that, if marginal prime cost is equal to marginal wage- cost, non-wage-earners' incomes will be altered, when money-wages are reduced, in the same proportion as wage-earners', on the ground that this is only valid, if the quant.i.ty of employment remains unaltered?which is the very point under discussion. But he proceeds on the next page (op. cit. p. 102) to make the same mistake himself by taking as his a.s.sumption that 'at the outset nothing has happened to non-wage-earners money-income', which, as he has just shown, is only valid if the quant.i.ty of employment does not remain unaltered-which is the very point under discussion In fact, no answer is possible, unless other factors are included in our data.

The manner in which the admission, that labour in fact stipulates for a given money-wage and not for a given real wage (provided that the real wage does not fall below a certain minimum), affects the a.n.a.lysis, can also be shown by pointing out that in this case the a.s.sumption that more labour is not available except at a greater real wage, which is fundamental to most of the argument, breaks down. For example, Professor Pigou rejects (op. cit. p. 75) the theory of the multiplier by a.s.suming that the rate of real wages is given, i.e. that, there being already full employment, no additional labour is forthcoming at a lower real wage. Subject to this a.s.sumption, the argument is, of course, correct. But in this pa.s.sage Professor Pigou is criticising a proposal relating to practical policy; and it is fantastically far removed from the facts to a.s.sume, at a time when statistical unemployment in Great Britain exceeded 2,000,000 (i.e. when there were 2,000,000 men willing to work at the existing money-wage), that any rise in the cost of living, however moderate, relatively to the money-wage would cause the withdrawal from the labour market of more than the equivalent of all these 2,000,000 men.

It is important to emphasise that the whole of Professor Pigou's book is written on the a.s.sumption that any rise in the cost of living, however moderate, relatively to the money-wage will cause the withdrawal from the labour market ofa number of workers greater than that of all the existing unemployed. Moreover, Professor Pigou does not notice in this pa.s.sage (op. cit. p. 75) that the argument, which he advances against 'secondary' employment as a result of public works, is, on the same a.s.sumptions, equally fatal to increased 'primary' employment from the same policy. For if the real rate of wages ruling in the wage-goods industries is given, no increased employment whatever is possible?except, indeed, as a result of non-wage-earners reducing their consumption of wage-goods. For those newly engaged in the primary employment will presumably increase their consumption of wage-goods which will reduce the real wage and hence (on his a.s.sumptions) lead to a withdrawal of labour previously employed elsewhere. Yet Professor Pigou accepts, apparently, the possibility of increased primary employment. The line between primary and secondary employment seems to be the critical psychological point at which his good common sense ceases to overbear his bad theory.

The difference in the conclusions to which the above differences in a.s.sumptions and in a.n.a.lysis lead can be shown by the following important pa.s.sage in which Professor Pigou sums up his point of view: 'With perfectly free compet.i.tion among workpeople and labour perfectly mobile, the nature of the relation (i.e.

between the real wage-rates for which people stipulate and the demand function for labour) will be very simple. There will always be at work a strong tendency for wage-rates to be so related to demand that everybody is employed. Hence, in stable conditions everyone will actually be employed. The implication is that such unemployment as exists at any time is due wholly to the fact that changes in demand conditions are continually taking place and that frictional resistances prevent the appropriate wage adjustments from being made instantaneously.'

He concludes (op. cit. p. 253) that unemployment is primarily due to a wage policy which fails to adjust itself sufficiently to changes in the real demand function for labour. Thus Professor Pigou believes that in the long run unemployment can be cured by wage adjustments; whereas I maintain that the real wage (subject only to a minimum set by the marginal disutility of employment) is not primarily determined by 'wage adjustments' (though these may have repercussions) but by the other forces of the system, some of which (in particular the relation between the schedule of the marginal efficiency of capital and the rate of interest) Professor Pigou has failed, if I am right, to include in his formal scheme.

Finally, when Professor Pigou comes to the 'Causation of Unemployment' he speaks, it is true, of fluctuations in the state of demand, much as I do. But he identifies the state of demand with the Real Demand Function for Labour, forgetful of how narrow a thing the latter is on his definition. For the Real Demand Function for Labour depends by definition (as we have seen above) on nothing but two factors, namely (1) the relationship in any given environment between the total number of men employed and the number who have to be employed in the wage-goods industries to provide them with what they consume, and (2) the state of marginal productivity in the wage-goods industries. Yet in Part V of his Theory of Unemployment fluctuations in the state of 'the real demand for labour' are given a position of importance. The 'real demand for labour' is regarded as a factor which is susceptible of wide short- period fluctuations (op. cit. Part V, chaps. vi.?xii.), and the suggestion seems to be that swings in 'the real demand for labour' are, in combination with the failure of wage policy to respond sensitively to such changes, largely responsible for the trade cycle. To the reader all this seems, at first, reasonable and familiar. For, unless he goes back to the definition, 'fluctuations in the real demand for labour' will convey to his mind the same sort of suggestion as I mean to convey by 'fluctuations in the state of aggregate demand'. But if we go back to the definition of the 'real demand for labour', all this loses its plausibility. For we shall find that there is nothing in the world less likely to be subject to sharp short- period swings than this factor.

Professor Pigou's 'real demand for labour' depends, by definition, on nothing but F(x), which represents the physical conditions of production in the wage-goods industries, and (x), which represents the functional relationship between employment in the wage-goods industries and total employment corresponding to any given level of the latter. It is difficult to see a reason why either of these functions should change, except gradually over a long period. Certainly there seems no reason to suppose that they are likely to fluctuate during a trade cycle. For F(x) can only change slowly, and, in a technically progressive community, only in the forward direction; whilst (x) will remain stable, unless we suppose a sudden outbreak of thrift in the working cla.s.ses, or, more generally, a sudden shift in the propensity to consume. I should expect, therefore, that the real demand for labour would remain virtually constant throughout a trade cycle. I repeat that Professor Pigou has altogether omitted from his a.n.a.lysis the unstable factor, namely fluctuations in the scale of investment, which is most often at the bottom of the phenomenon of fluctuations in employment.

I have criticised at length Professor Pigou's theory of unemployment not because he seems to me to be more open to criticism than other economists of the cla.s.sical school; but because his is the only attempt with which I am acquainted to write down the cla.s.sical theory of unemployment precisely. Thus it has been inc.u.mbent on me to raise my objections to this theory in the most formidable presentment in which it has been advanced.

Chapter 20.

THE EMPLOYMENT FUNCTION.

I.

In chapter 3 (Chapter 3 ) we have defined the aggregate supply function Z = ?(N), which relates the employment N with the aggregate supply price of the corresponding output. The employment function only differs from the aggregate supply function in that it is, in effect, its inverse function and is defined in terms of the wage-unit; the object of the employment function being to relate the amount of the effective demand, measured in terms of the wage-unit, directed to a given firm or industry or to industry as a whole with the amount of employment, the supply price of the output of which will compare to that amount of effective demand. Thus if an amount of effective demand Dwr, measured in wage-units, directed to a firm or industry calls forth an amount of employment Nr in that firm or industry, the employment function is given by Nr = Fr(Dwr). Or, more generally, if we are ent.i.tled to a.s.sume that Dwr is a unique function of the total effective demand Dw, the employment function is given by Nr = Fr(Dw) That is to say, Nr men will be employed in industry r when effective demand is Dw.

We shall develop in this chapter certain properties of the employment function. But apart from any interest which these may have, there are two reasons why the subst.i.tution of the employment function for the ordinary supply curve is consonant with the methods and objects of this book. In the first place, it expresses the relevant facts in terms of the units to which we have decided to restrict ourselves, without introducing any of the units which have a dubious quant.i.tative character. In the second place, it lends itself to the problems of industry and output as a whole, as distinct from the problems of a single industry or firm in a given environment, more easily than does the ordinary supply curve?for the following reasons.

The ordinary demand curve for a particular commodity is drawn on some a.s.sumption as to the incomes of members of the public, and has to be re-drawn if the incomes change. In the same way the ordinary supply curve for a particular commodity is drawn on some a.s.sumption as to the output of industry as a whole and is liable to change if the aggregate output of industry is changed. When, therefore, we are examining the response of individual industries to changes in aggregate employment, we are necessarily concerned, not with a single demand curve for each industry, in conjunction with a single supply curve, but with two families of such curves corresponding to different a.s.sumptions as to the aggregate employment. In the case of the employment function, however, the task of arriving at a function for industry as a whole which will reflect changes in employment as a whole is more practicable.

For let us a.s.sume (to begin with) that the propensity to consume is given as well as the other factors which we have taken as given in above, and that we are considering changes in employment in response to changes in the rate of investment. Subject to this a.s.sumption, for every level of effective demand in terms of wage-units there will be a corresponding aggregate employment and this effective demand will be divided in determinate proportions between consumption and investment. Moreover, each level of effective demand will correspond to a given distribution of income. It is reasonable, therefore, further to a.s.sume that corresponding to a given level of aggregate effective demand there is a unique distribution of it between different industries.

This enables us to determine what amount of employment in each industry will correspond to a given level of aggregate employment. That is to say, it gives us the amount of employment in each particular industry corresponding to each level of aggregate effective demand measured in terms of wage-units, so that the conditions are satisfied for the second form of the employment function for the industry, defined above, namely Nr = Fr(Dw) Thus we have the advantage that, in these conditions, the individual employment functions are additive in the sense that the employment function for industry as a whole, corresponding to a given level of effective demand, is equal to the sum of the employment functions for each separate industry; i.e.

Fr(Dw) = N = ?Nr = ?Fr(Dw).

Next, let us define the elasticity of employment. The elasticity of employment for a given industry is dNr Dwr eer = ???? ??? , dDwr Nr since it measures the response of the number of labour-units employed in the industry to changes in the number of wage-units which are expected to be spent on purchasing its output. The elasticity of employment for industry as a whole we shall write dN Dw ee = ???? ??? , dDw NrProvided that we can find some sufficiently satisfactory method of measuring output, it is also useful to define what may be called the elasticity of output or production, which measures the rate at which output in any industry increases when more effective demand in terms of wage-units is directed towards it, namely dOr Dwr eor = ???? ??? , dDwr Or Provided we can a.s.sume that the price is equal to the marginal prime cost, we then have

1.

?Dwr = ?????Pr 1 ? eor where Pr is the expected profit. It follows from this that if eor = 0, i.e. if the output of the industry is perfectly inelastic, the whole of the increased effective demand (in terms of wage-units) is expected to accrue to the entrepreneur as profit, i.e. ?Dwr = ?Pr; whilst if eor = 1, i.e. if the elasticity of output is unity, no part of the increased effective demand is expected to accrue as profit, the whole of it being absorbed by the elements entering into marginal prime cost.

Moreover, if the output of an industry is a function ?(Nr) of the labour employed in it, we have 1 ? eor Nr ?"(Nr) ???? = ? ??????? ,.

eer pwr{?'(Nr)}2 where pwr is the expected price of a unit of output in terms of the wage-unit. Thus the condition eor = 1 means that ?"(Nr) = 0, i.e. that there are constant returns in response to increased employment.

Now, in so far as the cla.s.sical theory a.s.sumes that real wages are always equal to the marginal disutility of labour and that the latter increases when employment increases, so that the labour supply will fall off; cet. par., if real wages are reduced, it is a.s.suming that in practice it is impossible to increase expenditure in terms of wage-units. If this were true, the concept of elasticity of employment would have no field of application. Moreover, it would, in this event, be impossible to increase employment by increasing expenditure in terms of money; for money-wages would rise proportionately to the increased money expenditure so that there would be no increase of expenditure in terms of wage-units and consequently no increase in employment. But if the cla.s.sical a.s.sumption does not hold good, it will be possible to increase employment by increasing expenditure in terms of money until real wages have fallen to equality with the marginal disutility of labour, at which point there will, by definition, be full employment.

Ordinarily, of course, eor will have a value intermediate between zero and unity. The extent to which prices (in terms of wage-units) will rise, i.e. the extent to which real wages will fall, when money expenditure is increased, depends, therefore, on the elasticity of output in response to expenditure in terms of wage-units.

Let the elasticity of the expected price pwr in response to changes in effective demand Dwr, namely (dpwr/dDwr) (Dwr /pwr), be written e'

pr.

Since Or pwr = Dwr, we have dOr Dwr dpwr Dwr ???? ??? + ???? ??? = 1.

dDwr Or dDwr pwr or e'

pr + eor = 1.

That is to say, the sum of the elasticities of price and of output in response to changes in effective demand (measured in terms of wage-units) is equal to unity. Effective demand spends itsell, partly in affecting output and partly in affecting price, according to this law.

If we are dealing with industry as a whole and are prepared to a.s.sume that we have a unit in which output as a whole can be measured, the same line of argument applies, so that e'

p + eo = 1, where the elasticities without a suffix r apply to industry as a whole.

Let us now measure values in money instead of wage-units and extend to this case our conclusions in respect of industry as a whole.

If W stands for the money-wages of a unit of labour and p for the expected price of a unit of output as a whole in terms of money, we can write ep (= (Ddp) / (pdD)) for the elasticity of money-prices in response to changes in effective demand measured in terms of money, and ew (= (DdW) / (WdD)) for the elasticity of money-wages in response to changes in effective demand in terms of money. It is then easily shown that ep = 1 = eo(1 ?ew).

This equation is, as we shall see in the next chapter, first step to a generalised quant.i.ty theory of money. If eo = 0 or if ew = 1, output will be unaltered and prices will rise in the same proportion as effective demand in terms of money. Otherwise they will rise in a smaller proportion.

II.

Let us return to the employment function. We have a.s.sumed in the foregoing that to every level or aggregate effective demand there corresponds a unique distribution of effective demand between the products of each individual industry. Now, as aggregate expenditure changes, the corresponding expenditure on the products of an individual industry will not, in general, change in the same proportion;?partly because individuals will not, as their incomes rise, increase the amount of the products of each separate industry, which they purchase, in the same proportion, and partly because the prices of different commodities will respond in different degrees to increases in expenditure upon them.

It follows from this that the a.s.sumption upon which we have worked hitherto, that changes in employment depend solely on changes in aggregate effective demand (in terms of wage-units), is no better than a first approximation, if we admit that there is more than one way in which an increase of income can be spent. For the way in which we suppose the increase in aggregate demand to be distributed between different commodities may considerably influence the volume of employment. If, for example, the increased demand is largely directed towards products which have a high elasticity of employment, the aggregate increase in employment will be greater than if it is largely directed towards products which have a low elasticity of employment.

In the same way employment may fall off without there having been any change in aggregate demand, if the direction of demand is changed in favour of products having a relatively low elasticity of employment.

These considerations are particularly important if we are concerned with short-period phenomena in the sense of changes in the amount or direction of demand which are not foreseen some time ahead. Some products take time to produce, so that it is practically impossible to increase the supply of them quickly.

Thus, if additional demand is directed to them without notice, they will show a low elasticity of employment; although it may be that, given sufficient notice, their elasticity of employment approaches unity.

It is in this connection that I find the princ.i.p.al significance of the conception of a period of production.

A product, I should prefer to say, has a period of production n if n time-units of notice of changes in the demand for it have to be given if it is to offer its maximum elasticity of employment. Obviously consumption-goods, taken as a whole, have in this sense the longest period of production, since of every productive process they const.i.tute the last stage. Thus if the first impulse towards the increase in effective demand comes from an increase in consumption, the initial elasticity of employment will be further below its eventual equilibrium-level than if the impulse comes from an increase in investment. Moreover, if the increased demand is directed to products with a relatively low elasticity of employment, a larger proportion of it will go to swell the incomes of entrepreneurs and a smaller proportion to swell the incomes of wage-earners and other prime-cost factors; with the possible result that the repercussions may be somewhat less favourable to expenditure, owing to the likelihood of entrepreneurs saving more of their increment of income than wage-earners would. Nevertheless the distinction between the two cases must not be over-stated, since a large part of the reactions will be much the same in both.

However long the notice given to entrepreneurs of a prospective change in demand, it is not possible for the initial elasticity of employment, in response to a given increase of investment, to be as great as its eventual equilibrium value, unless there are surplus stocks and surplus capacity at every stage of production. On the other hand, the depletion of the surplus stocks will have an offsetting effect on the amount by which investment increases. If we suppose that there are initially some surpluses at every point, the initial elasticity of employment may approximate to unity; then after the stocks have been absorbed, but before an increased supply is coming forward at an adequate rate from the earlier stages of production, the elasticity will fall away; rising again towards unity as the new position of equilibrium is approached. This is subject, however, to some qualification in so far as there are rent factors which absorb more expenditure as employment increases, or if the rate of interest increases. For these reasons perfect stability of prices is impossible in an economy subject to change?unless, indeed, there is some peculiar mechanism which ensures temporary fluctuations of just the right degree in the propensity to consume. But price-instability arising in this way does not lead to the kind of profit stimulus which is liable to bring into existence excess capacity. For the windfall gain will wholly accrue to those entrepreneurs who happen to possess products at a relatively advanced stage of production, and there is nothing which the entrepreneur, who does not possess specialised resources of the right kind, can do to attract this gain to himself. Thus the inevitable price-instability due to change cannot affect the actions of entrepreneurs, but merely directs a de facto windfall of wealth into the laps of the lucky ones (mutatis mutandis when the supposed change is in the other direction). This fact has, I think, been overlooked in some contemporary discussions of a practical policy aimed at stabilising prices.

It is true that in a society liable to change such a policy cannot be perfectly successful. But it does not follow that every small temporary departure from price stability necessarily sets up a c.u.mulative disequilibrium.

III.

We have shown that when effective demand is deficient there is under-employment of labour in the sense that there are men unemployed who would be willing to work at less than the existing real wage.

Consequently, as effective demand increases, employment increases, though at a real wage equal to or less than the existing one, until a point comes at which there is no surplus of labour available at the then existing real wage; i.e. no more men (or hours of labour) available unless money-wages rise (from this point onwards) faster than prices. The next problem is to consider what will happen If, when this point has been reached, expenditure still continues to increase. Up to this point the decreasing return from applying more labour to a given capital equipment has been offset by the acquiescence of labour in a diminishing real wage. But after this point a unit of labour would require the inducement of the equivalent of an increased quant.i.ty of product, whereas the yield from applying a further unit would be a diminished quant.i.ty of product. The conditions of strict equilibrium require, therefore, that wages and prices, and consequently profits also, should all rise in the same proportion as expenditure, the 'real' position, including the volume of output and employment, being left unchanged in all respects. We have reached, that is to say, a situation in which the crude quant.i.ty theory of money (interpreting 'velocity' to mean 'income-velocity') is fully satisfied; for output does not alter and prices rise in exact proportion to MV.

Nevertheless there are certain practical qualifications to this conclusion which must be borne in mind in applying it to an actual case: (1) For a time at least, rising prices may delude entrepreneurs into increasing employment beyond the level which maximises their individual profits measured in terms of the product. For they are so accustomed to regard rising sale-proceeds in terms of money as a signal for expanding production, that they may continue to do so when this policy has in fact ceased to be to their best advantage; i.e. they may underestimate their marginal user cost in the new price environment.

(2) Since that part of his profit which the entrepreneur has to hand on to the rentier is fixed in terms of money, rising prices, even though unaccompanied by any change in output, will redistribute incomes to the advantage of the entrepreneur and to the disadvantage of the rentier, which may have a reaction on the propensity to consume. This, however, is not a process which will have only begun when full employment has been attained;?it will have been making steady progress all the time that the expenditure was increasing. If the rentier is less p.r.o.ne to spend than the entrepreneur, the gradual withdrawal of real income from the ormer will mean that full employment will be reached with a smaller increase in the quant.i.ty of money and a smaller reduction in the rate of interest than will be the case if the opposite hypothesis holds. After full employment has been reached, a further rise of prices will, if the first hypothesis continues to hold, mean that the rate of interest will have to rise somewhat to prevent prices from rising indefinitely, and that the increase in the quant.i.ty of money will be less than in proportion to the increase in expenditure; whilst if the second hypothesis holds, the opposite will be the case. It may be that, as the real income of the rentier is diminished, a point will come when, as a result of his growing relative impoverishment, there will be a change-over from the first hypothesis to the second, which point may be reached either before or after full employment has been attained.

IV.

There is, perhaps, something a little perplexing in the apparent asymmetry between inflation and deflation. For whilst a deflation of effective demand below the level required for full employment will diminish employment as well as prices, an inflation of it above this level will merely affect prices. This asymmetry is, however, merely a reflection of the fact that, whilst labour is always in a position to refuse to work on a scale involving a real wage which is less than the marginal disutility of that amount of employment, it is not in a position to insist on being offered work on a scale involving a real wage which is not greater than the marginal disutility of that amount of employment.

Chapter 21.

THE THEORY OF PRICES.

I.

So long as economists are concerned with what is called the theory of value, they have been accustomed to teach that prices are governed by the conditions of supply and demand; and, in particular, changes in marginal cost and the elasticity of short-period supply have played a prominent part. But when they pa.s.s in volume II, or more often in a separate treatise, to the theory of money and prices, we hear no more of these homely but intelligible concepts and move into a world where prices are governed by the quant.i.ty of money, by its income-velocity, by the velocity of circulation relatively to the volume of transactions, by h.o.a.rding, by forced saving, by inflation and deflation et hoc genus omne; and little or no attempt is made to relate these vaguer phrases to our former notions of the elasticities of supply and demand. If we reflect on what we are being taught and try to rationalise it, in the simpler discussions it seems that the elasticity of supply must have become zero and demand proportional to the quant.i.ty of money; whilst in the more sophisticated we are lost in a haze where nothing is clear and everything is possible. We have all of us become used to finding ourselves sometimes on the one side of the moon and sometimes on the other, without knowing what route or journey connects them, related, apparently, after the fashion of our waking and our dreaming lives.

One of the objects of the foregoing chapters has been to escape from this double life and to bring the theory of prices as a whole back to close contact with the theory of value. The division of economics between the theory of value and distribution on the one hand and the theory of money on the other hand is, I think, a false division. The right dichotomy is, I suggest, between the theory of the individual industry or firm and of the rewards and the distribution between different uses of a given quant.i.ty of resources on the one hand, and the theory of output and employment as a whole on the other hand. So long as we limit ourselves to the study of the individual industry or firm on the a.s.sumption that the aggregate quant.i.ty of employed resources is constant, and, provisionally, that the conditions of other industries or firms are unchanged, it is true that we are not concerned with the significant characteristics of money. But as soon as we pa.s.s to the problem of what determines output and employment as a whole, we require the complete theory of a monetary economy. Or, perhaps, we might make our line of division between the theory of stationary equilibrium and the theory of shifting equilibrium?meaning by the latter the theory of a system in which changing views about the future are capable of influencing the present situation. For the importance of money essentially flows from its being a link between the present and the future. We can consider what distribution of resources between different uses will be consistent with equilibrium under the influence of normal economic motives in a world in which our views concerning the future are fixed and reliable in all respects;?with a further division, perhaps, between an economy which is unchanging and one subject to change, but where all things are foreseen from the beginning. Or we can pa.s.s from this simplified propaedeutic to the problems of the real world in which our previous expectations are liable to disappointment and expectations concerning the future affect what we do to-day. It is when we have made this transition that the peculiar properties of money as a link between the present and the future must enter into our calculations. But, although the theory of shifting equilibrium must necessarily be pursued in terms of a monetary economy, it remains a theory of value and distribution and not a separate 'theory of money'. Money in its significant attributes is, above all, a subtle device for linking the present to the future; and we cannot even begin to discuss the effect of changing expectations on current activities except in monetary terms. We cannot get rid of money even by abolishing gold and silver and legal tender instruments. So long as there exists any durable a.s.set, it is capable of possessing monetary attributes and, therefore, of giving rise to the characteristic problems of a monetary economy.

II.

In a single industry its particular price-level depends partly on the rate of remuneration of the factors of production which enter into its marginal cost, and partly on the scale of output. There is no reason to modify this conclusion when we pa.s.s to industry as a whole. The general price-level depends partly on the rate of remuneration of the factors of production which enter into marginal cost and partly on the scale of output as a whole, i.e. (taking equipment and technique as given) on the volume of employment. It is true that, when we pa.s.s to output as a whole, the costs of production in any industry partly depend on the output of other industries. But the more significant change, of which we have to take account, is the effect of changes in demand both on costs and on volume. It is on the side of demand that we have to introduce quite new ideas when we are dealing with demand as a whole and no longer with the demand for a single product taken in isolation, with demand as a whole a.s.sumed to be unchanged.

III.

If we allow ourselves the simplification of a.s.suming that the rates of remuneration of the different factors of production which enter into marginal cost all change in the same proportion, i.e. in the same proportion as the wage-unit, it follows that the general price-level (taking equipment and technique as given) depends partly on the wage-unit and partly on the volume of employment. Hence the effect of changes in the quant.i.ty of money on the price-level can be considered as being compounded of the effect on the wage-unit and the effect on employment.

To elucidate the ideas involved, let us simplify our a.s.sumptions still further, and a.s.sume (1) that all unemployed resources are h.o.m.ogeneous and interchangeable in their efficiency to produce what is wanted, and (2) that the factors of production entering into marginal cost are content with the same money-wage so long as there is a surplus of them unemployed. In this case we have constant returns and a rigid wage-unit, so long as there is any unemployment. It follows that an increase in the quant.i.ty of money will have no effect whatever on prices, so long as there is any unemployment, and that employment will increase in exact proportion to any increase in effective demand brought about by the increase in the quant.i.ty of money; whilst as soon as full employment is reached, it will thenceforward be the wage-unit and prices which will increase in exact proportion to the increase in effective demand.

Thus if there is perfectly elastic supply so long as there is unemployment, and perfectly inelastic supply so soon as full employment is reached, and if effective demand changes in the same proportion as the quant.i.ty of money, the quant.i.ty theory of money can be enunciated as follows: 'So long as there is unemployment, employment will change in the same proportion as the quant.i.ty of money; and when there is full employment, prices will change in the same proportion as the quant.i.ty of money'.

Having, however, satisfied tradition by introducing a sufficient number of simplifying a.s.sumptions to enable us to enunciate a quant.i.ty theory of money, let us now consider the possible complications which will in fact influence events: (1) Effective demand will not change in exact proportion to the quant.i.ty of money.

(2) Since resources are not h.o.m.ogeneous, there will be diminishing, and not constant, returns as employment gradually increases.

(3) Since resources are not interchangeable, some commodities will reach a condition of inelastic supply whilst there are still unemployed resources available for the production of other commodities.

(4) The wage-unit will tend to rise, before full employment has been reached.

(5) The remunerations of the factors entering into marginal cost will not all change in the same proportion.

Thus we must first consider the effect of changes in the quant.i.ty of money on the quant.i.ty of effective demand; and the increase in effective demand will, generally speaking, spend itself partly in increasing the quant.i.ty of employment and partly in raising the level of prices. Thus instead of constant prices in conditions of unemployment, and of prices rising in proportion to the quant.i.ty of money in conditions of full employment, we have in fact a condition of prices rising gradually as employment increases. The theory of prices, that is to say, the a.n.a.lysis of the relation between changes in the quant.i.ty of money and changes in the price-level with a view to determining the elasticity of prices in response to changes in the quant.i.ty of money, must, therefore, direct itself to the five complicating factors set forth above.

We will consider each of them in turn. But this procedure must not be allowed to lead us into supposing that they are, strictly speaking, independent. For example, the proportion, in which an increase in effective demand is divided in its effect between increasing output and raising prices, may affect the way in which the quant.i.ty of money is related to the quant.i.ty of effective demand. Or, again, the differences in the proportions, in which the remunerations of different factors change, may influence the relation between the quant.i.ty of money and the quant.i.ty of effective demand. The object of our a.n.a.lysis is, not to provide a machine, or method of blind manipulation, which will furnish an infallible answer, but to provide ourselves with an organised and orderly method of thinking out particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interactions of the factors amongst themselves. This is the nature of economic thinking. Any other way of applying our formal principles of thought (without which, however, we shall be lost in the wood) will lead us into error. It is a great fault of symbolic pseudo-mathematical methods of formalising a system of economic a.n.a.lysis, such as we shall set down in section vi of this chapter, that they expressly a.s.sume strict independence between the factors involved and lose all their cogency and authority if this hypothesis is disallowed; whereas, in ordinary discourse, where we are not blindly manipulating but know all the time what we are doing and what the words mean, we can keep 'at the back of our heads' the necessary reserves and qualifications and the adjustments which we shall have to make later on, in a way in which we cannot keep complicated partial differentials 'at the back' of several pages of algebra which a.s.sume that they all vanish. Too large a proportion of recent 'mathematical' economics are merely concoctions, as imprecise as the initial a.s.sumptions they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.

IV.

(1) The primary effect of a change in the quant.i.ty of money on the quant.i.ty of effective demand is through its influence on the rate of interest. If this were the only reaction, the quant.i.tative effect could be derived from the three elements?(a) the schedule of liquidity-preference which tells us by how much the rate of interest will have to fall in order that the new money may be absorbed by willing holders, (b) the schedule of marginal efficiencies which tells us by how much a given fall in the rate of interest will increase investment, and (c) the investment multiplier which tells us by how much a given increase in investment will increase effective demand as a whole.

But this a.n.a.lysis, though it is valuable in introducing order and method into our enquiry, presents a deceptive simplicity, if we forget that the three elements (a), (b) and (c) are themselves partly dependent on the complicating factors (2), (3), (4) and (5) which we have not yet considered. For the schedule of liquidity-preference itself depends on how much of the new money is absorbed into the income and industrial circulations, which depends in turn on how much effective demand increases and how the increase is divided between the rise of prices, the rise of wages, and the volume of output and employment. Furthermore, the schedule of marginal efficiencies will partly depend on the effect which the circ.u.mstances attendant on the increase in the quant.i.ty of money have on expectations of the future monetary prospects. And finally the multiplier will be influenced by the way in which the new income resulting from the increased effective demand is distributed between different cla.s.ses of consumers.

Nor, of course, is this list of possible interactions complete. Nevertheless, if we have all the facts before us, we shall have enough simultaneous equations to give us a determinate result. There will be a determinate amount of increase in the quant.i.ty of effective demand which, after taking everything into account, will correspond to, and be in equilibrium with, the increase in the quant.i.ty of money.