More on saving, investment and income

The following builds on the preceding blog about chapter 6 of Keynes’s General Theory. It seeks to clarify the Keynesian framework for measuring national income and to give further clarity to the meaning of income, saving, and investment. Keynes’s closed-economy analysis, as set out in chapter 6 of his General Theory, will be extended to include the foreign and government sectors. A distinction between the creation of value added and its distribution will also be drawn. This is because commentators, politicians, and lobbyists often (deliberately or otherwise) conflate value creation with value distribution. Incorporating the government and foreign sectors, it will be shown, preserves the equality of saving and investment. Aggregate saving can be determined either from the expenditure approach to national income determination or from the income approach; both approaches yield the same figure for saving and this further confirms the power of Keynes’s framework.

Incorporating the government and foreign sectors

In the following table, the productive sector of an economy has been split into the B2B sector whose businesses buy and sell between themselves, the B2C sector whose businesses sell to households, the B2G sector whose businesses sell goods and services to the government, and to the B2F sector whose businesses sells goods and services to foreigners. Sales and purchases between businesses in the B2B sector have been cancelled against each other so that only transactions between the B2B and the other sectors remain. These remaining transactions cancel on consolidation. The residual purchases figure of 500 that remains after consolidation represents imports since all other purchases, totalling 1,000, were made from the B2B sector. In a closed economy without a government sector, as assumed in chapter 6 of Keynes’s General Theory, consolidated A1 would be zero.

CodeDescription B2B B2C B2G B2F AdjustmentConsolid
ARevenue1,00040,00010,0005,000(1,000)55,000
A1Purchases500500300200(1,000)500
IInventory
adjustment
400(500)(600)400(300)
ICapital
adjustment
4,000(3,000)6,0007,000
U = A1 – IUser cost100(3,000)3,900(6,200)(1,000)(6,200)
Y = A – UValue added90043,0006,10011,20061,200

User Cost

The items in red relate to User Cost, denoted as U, and is obtained from A1 – I. Subtracting user cost (U) from Revenue (A) yields business income (Y) known as Value Added. Value Added is a measure of the additional market value added by the factors of production to purchased materials, goods, and services (denoted by A1). The factors of production, namely land, labour, capital, and government, will subsequently receive a share of the value added as a reward for their respective contributions. This is covered later.

In cases where no capital expenditure has taken place, the user cost will consist of just revenue costs (purchases of materials or finished goods plus an inventory adjustment) and a charge for depreciation. When capital equipment has been purchased, A1 will include the cost of new capital equipment. In these cases, user cost U must be decreased by the cost of the purchased capital equipment so that only revenue expenditure is set against revenue (A). This is achieved via a capital adjustment. Examples of capital adjustments are supplied in the above illustration. If capital expenditure has taken place then the capital adjustment will be positive. If the capital adjustment is negative then this will be because of depreciation of capital equipment. If a positive capital adjustment is higher than A1 then capital equipment is being made “in-house” rather than being purchased in a finsished state from an outside supplier. In the above example, the B2C and B2F sectors are making their own capital equipment.

Factor Costs

In addition to user cost, Keynes also identifies a second set of costs which he calls factor costs. Whereas user costs are concerned with payments to other entrepreneurs, factor costs are those payments a business makes in exchange for services other than those provided by entrepreneurs. These services facilitate, or are necessary for, production and exclude raw materials, finished goods, and capital equipment. The classical factors of production are land, labour, and capital, but in modern advanced societies government should be included. Hence factor costs include wages, rental payments, interest charges, business rates and corporation tax, and dividend payments. Factor costs are a distribution of value added and represent factor income in the hands of the factors of production.

The table shown below lists the aggregate factor costs of an economy. The total is 61,200, which is equal to the aggregate value added calculated above.

Factor costConsolidatedHouseholdsGovernmentRentiers
Wages (W )50,000
Interest (i)1,000
Taxation (T)4,000
Dividends (d)5,000
Profit (Pi)1,200
Value added61,200

In the following table each factor cost in the above list has been assigned to the sector for which the factor cost is income. So wages paid to labour is household income, interest and dividends paid to financiers are rentier incomes, and taxation is income received by government. The aggregate retained profits (Pi) of 1,200 is assigned to the rentier sector since retained profits form part of shareholders’ equity. Rental payments made by businesses would be assigned to rentiers.

Factor costConsolidatedHouseholdsGovernmentRentiers
Wages (W )50,00050,000
Interest (i)1,0001,000
Taxation (T)4,0004,000
Dividends (d)5,0005,000
Profit (Pi)1,2001,200
Value added61,20050,0004,0007,200

Saving

Saving is given by aggregate A1 minus aggregate U. Referring to the value added statement above we get 500 – (- 6,200) = 6,700 which, reassuringly, is equal to business investment shown in the same statement.

The saving figure of 6,700 is further confimed by aggregating the saving of each sector, assuming that the expenditure by the government and by foreigners is consumption expenditure. The following table sets this out:

Saving by sectorHouseholdsGovernmentForeignersRentiersTotal
Income (W ) 50,000(T) 4,000(M) 5007,20061,700
Expenditure(C) 40,000 (G) 10,000(X) 5,00055,000
Saving (S)10,000(6,000)(4,500)7,2006,700

The government deficit of 6,000 falls short of total saving of 6,700, and falls short of household saving of 10,000, and of private sector saving of 17,200. This seems to refute the claim made by the MMT school that government deficits are necessary, otherwise the private sector can not save.

Consumption expenditure versus revenue expenditure

A source of confusion sometimes arises between these two terms. Consumption expenditure is spending by households on goods and services provided by business. Whether a householder perceives the items purchased as capital or revenue in nature is irrelevant – sales by firms to households are consumption expenditure. From a business point of view, items sold to households are stock-in-trade, which are revenue in nature. Capital expenditure is undertaken by businesses, not by households.

Summary and conclusions

Keynes’s framework set out in chapter 6 of his General Theory defines income, saving, and investment in a closed economy without a government sector. An attempt has been made here to extend his methodology and ideas, using his notation, to an open economy with a government sector.

Keynes’s concept of business income is value added. This has enabled his ideas to be illustrated by a value added statement.

It is business that creates value added. Other sectors of the economy, although they may facilitate the creation of value added, and/or be necessary for creation of value added, do not create value added. Instead, they absorb it. These value absorbing sectors correspond to the factors of production, namely land, labour, capital, and government.

For the purpose of national income accounting, household purchases of goods and services from firms are consumption expenditure, whether or not householders perceive the purchases as capital expenditure or as revenue expenditure. For national income accounting purposes, the distinction between capital and revenue expenditure is relevant only to the spending activities of firms.

MMT’s claim that government deficits are necessary for private saving to take place is not plausible (leaving aside the desirability of saving).


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