Labor share affects the potential of investment to raise GDP

The circular flow is a model used to show how money and products move through an economy. I am going to use a simplified version to show the effect of labor share of income on GDP. Many people think that labor income is not quantitatively different than capital income. I will show that the equilibrium level of GDP is affected by a change in labor share of income. This would have important implications for monetary policy and expectations of GDP potential.

Basic Equilibrium

Let’s start out with a basic model. It will only involve labor, owners of capital, firms and a financial sector. The only injection into the circular flow will be investment. The only leakage from the circular flow will be savings. The model does not include the government sector nor imports/exports.

Circular flow 1

Graph #1

Start at the out-going income from firms. Firms are paying out $1 million in income. 80% will go to labor (labor share of income of 80%). 20% will go to capital (capital share of 20%). The GDI (gross domestic income) of the economy is $1 million. Capital takes all of their income and saves it for investment. Labor takes 85% of their income and consumes production of finished goods and services (marginal propensity to consume of 85%). Labor takes the remaining 15% of their income and puts it into savings.

Capital savings and labor savings then add together for the total of savings in the economy. Then those savings are invested in firms to maintain and increase the means of production. Consumption is directed at the finished goods and services produced from the capital used in the means of production. The in-coming money to firms is the sum of investment and labor’s consumption.

In the graph above, the economy is in equilibrium. (Savings = investment) (In-coming = out-going)

In equilibrium…

GDP = consumption + investment

GDI = labor income + capital income

GDP = GDI

Investment rises

Money increases in the economy when banks make loans. This is how money is created in the economy. Banks can just create money when they make loans. So let’s change the graph above to show an increased level of investment by banks.

Circular flow 2Graph #2

Look in the green boxes. Investment has risen to $520 thousand from $320 thousand. Investment is injecting an extra $200 thousand into the economy. Maybe QE is finally providing liquidity. The result is that there is now $1.2 million in-coming to the firms. Consumption has not changed because the extra investment has not been paid out yet as income.

The economy is going into a disequilibrium. (Savings ≠ investment) (In-coming ≠ out-going)

Firms now pay out that “in-coming” $1.2 million as income maintaining the same labor share of 80% and capital share of 20%. We allow that money to flow through the economy. Let’s see what we end up with.

Circular flow 3Graph #3

We see the out-going $1.2 million go through the circular flow and leads to a total savings of $384 thousand, which is still less than the investment level. Consumption has risen to $816 thousand. Total in-coming into firms has now risen to $1.336 million from the increased level of investment and the new increased consumption.

The economy is still not in equilibrium. (Savings ≠ investment) (In-coming ≠ out-going)

Firms now pay out the increased in-coming money of $1.336 million in another round as income to labor and capital.

Circular flow 4
Graph #4

We see that total savings continues to increase and that consumption continues to increase. The in-coming money to firms continues to increase. And so the economy goes through numerous rounds like this until an equilibrium is reached. All this is due to the original disequilibrium created from increased investment by banks. Here is what the economy will look like once it reaches equilibrium, where (Savings = investment) and (In-coming = out-going).

Circular flow 5
Graph #5

The important thing to see here is that the equilibrium level of GDI (gross domestic income) has increased by $625 thousand as a result of increasing the investment level by $200 thousand.

But now let me ask you… What equilibrium level of GDI would this model have reached if labor share of income had fallen to 75%? If you think there is no quantitative difference between labor and capital income, then the resulting GDI should be the same, right?

Lowering labor’s share of income

I will now lower labor’s share of income in the model. Why? Because labor’s share of income has fallen 5% since the crisis. This fall is unprecedented. And I present a simplified simulation of how that fall in labor share affects investment… and how it affects the efficacy of monetary policy… cough cough.

I will simply change labor’s share to 75% using the increased level of investment of $520 thousand. Then I will solve for the equilibrium level of GDI. Here it is…

Circular flow 6Graph #6

GDI has fallen from $1.625 million to a lower equilibrium of $1.434 million. We can see that the economy is in equilibrium (Savings = investment) and (In-coming = out-going). The only difference was lowering labor’s share to 75%.

Conclusions

  1. After the crisis, labor’s share of income fell 5%. The result is that the ability of investment to increase GDP output is muted. Investment has had less power to boost GDP. The truth is that the economy needs even more investment to get the same result it would have had with a higher labor share.
  2. Investment returns to firms in smaller amounts. Firms receive less in-coming money. Demand would appear low, but it’s just a labor share constraint on demand.
  3. Labor’s consumption and labor’s savings have decreased. This is obvious from lower labor share and lower GDI. Yet, look closely at the capital income in graphs #5 and #6. In graph #6, capital’s income at equilibrium with a lower labor share has actually risen to $358 thousand, in spite of GDI falling too. This model shows how corporate profits can reach record heights and Main Street struggles when labor share falls.
  4. A lower labor share affects the efficacy of accommodative monetary policy. How can you expect monetary policy to put money in the hands of people when the falling labor share is taking money out of their hands?  Again, demand would appear low.
  5. Why has the economy responded so poorly to loose monetary policy? Monetary policy is heading toward a lower equilibrium level of GDP due to the lower labor share. We can clearly see above that a lower labor share mutes the potential of investment to raise GDP.
  6. We would also find that the natural rate of unemployment would be higher if we were to associate the rise in real GDP with utilization of labor and capital. Once GDP is limited to a lower equilibrium level by a lower labor share, employment also gets limited. (My view is that the natural rate of unemployment has risen to around 7% due to the fall in labor share.) Keynes sought to show that employment gets limited by effective demand. This model supports that view.

Bottom line: Just raise labor share of income and monetary policy will work better.

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