Thinking in a Macro Way

To understand aggregate behavior, it is necessary to start at the aggregate or macro level of analysis rather than the individual or micro level. This is because there are certain relationships that must hold, by definition, at the aggregate level. These relationships are specified in macroeconomic accounting identities.

Reasoning at the individual and micro level is also necessary to understand many aspects of the economy, including the aggregate economy, but the micro reasoning must be consistent with the relationships holding at the macro level. In considering the aggregate economy, macro reasoning takes precedence over micro reasoning. If a micro argument is inconsistent with known macro relationships, it is the micro argument that must be rejected.

A major strength of modern monetary theory (MMT) is that it starts from relationships that must hold true at the aggregate level, and then ensures that any behavioral assumptions that go beyond what immediately follows from these aggregate relationships (and so are contestable) are fully consistent with the accounting identities. The same can be said of Keynes, Kalecki, Marx, and also to some extent the classical political economists (for instance, in their analysis of broad class behavior). MMT is the result of applying macro consistent reasoning in a way that takes account of institutional features of modern monetary systems.

But while macro consistency has guided MMT economists, and in varying degrees Keynes, Kalecki, Marx, and the classical political economists, it has not guided neoclassical macroeconomists, who have tried to start at the individual level and then simply add up (aggregate) individual results to obtain a picture of the aggregate economy. Starting from the micro and reasoning up to the macro, as the neoclassicals do, results in many fallacies of composition. Neoclassical general equilibrium theorists have themselves uncovered various aggregation problems. They run so deep that basically neoclassical macroeconomics cannot say anything of much interest about the aggregate economy without either assuming a ‘single commodity world’ or a ‘single consumer world’. Otherwise, there is no sound basis for aggregating the individual decisions of investors, producers, consumers, etc.

None of this is to suggest that there is only one valid theory of the aggregate economy. There is more than one way to conceive of economic behavior that is consistent with the macroeconomic accounting identities. However, if a theory is not macro consistent, it cannot be a valid theory of the aggregate economy.

Having said this, starting at the aggregate level is actually very revealing in terms of the types of behavioral assumptions we might want to make. In the remainder of this post, I want to provide an example of reasoning in a macro way. The approach begins with incontestable macroeconomic relationships and then employs contestable behavioral assumptions in an effort to go beyond what follows immediately from the macro identities. As a consequence, the arguments presented here are to a large degree contestable, but they are consistent with the macro relationships. In other words, I am giving one example of macro consistent reasoning.

One of my favorite examples of the insights possible with macro reasoning is due to Kalecki. For simplicity, we can begin by considering a pure closed private-sector economy. Government and external sectors will be included shortly.

Kalecki starts with two accounting identities that must hold for the period under consideration:

(1) Y = C + I

(2) Y = W + P

Here, Y is real output or income, C is private consumption, I is gross private investment, W is aggregate wages, and P is aggregate profits realized in the period.

In Marxian fashion, Kalecki then divides consumption into capitalist consumption out of profits, CP, and worker consumption out of wages, CW, and assumes that workers, in aggregate, consume all they earn: CW = W (this assumption can be relaxed without altering the basic insights). The first identity becomes:

(1′) Y = W + CP + I

Setting (1′) equal to (2) and rearranging gives:

P = CP + I

I find this expression very interesting. It may seem strange at first glance, but the expression tells us that capitalists’ own spending decisions as a class (CP + I) must equal their total profit (P). The reason for this is that workers’ wages return to the capitalists as a class when workers spend on consumption items, whereas capitalists’ expenditures go to other capitalists, and so to the capitalist class as a whole. Kalecki expresses this as “capitalists get what they spend and workers spend what they get”.

Now consider causation. Do profits determine the amount of capitalist expenditure, or do capitalist expenditures determine aggregate profit? Kalecki observes that capitalists can choose what they spend in the current period but not what they earn, implying that causation runs from capitalist expenditures to aggregate profit.

Rearranging the expression gives:

P – CP = I

Since workers have been assumed to spend all they earn in aggregate, the left-hand side of this expression represents private saving, S. It is that part of aggregate profits not consumed by capitalists. So:

S = I

Since Kalecki has already observed that capitalists choose what they spend, not what they earn, this implies that causation runs from investment to saving. That is, capitalist investment determines private saving. Keynes, of course, in a similar analysis argued that income is determined by investment, and that saving is a function of income.

Kalecki’s analysis can be extended to gain insight into some of the factors influencing the average (economy-wide) realized rate of profit, r, which roughly speaking can be represented as aggregate profit divided by the amount of fixed capital, K, tied up in production. That is, r = P/K. (For Marx, the denominator should also include outlays on raw materials and wages, but if the turnover period for these items is short relative to the accounting period under consideration – e.g. a year – the impact on the economy-wide rate of profit is small, and doesn’t alter the basic issues under discussion.)

Drawing on Kalecki’s analysis, we have:

r = (CP + I) / K

In this expression, gross private investment, I, will add not only to profit in the numerator, but also to the amount of fixed capital, K, in the denominator to the extent that gross investment exceeds depreciation of fixed capital. Here, ΔK = I – δ, where δ is depreciation. So investment adds to aggregate profit and aggregate fixed capital.

To see the significance of this, consider an extreme example in which CP = 0, I = 100 each year and there is zero depreciation. If K = 1000 initially, the rate of profit in successive years will be 100/1000, 100/1100, 100/1200, … . That is, there will be a tendency for the rate of profit to decline as capital intensity increases. (The tendency will be mitigated to the extent that depreciation occurs.) This is similar to Marx’s tendency for the rate of profit to fall, except expressed in price rather than value terms and applied to realized profit rather than produced surplus value. In the case where all surplus value produced is realized, the two measures — produced surplus value and realized profit — coincide. For Marx, this tendency for the rate of profit to decline will continue until a crisis causes the value of K to collapse. Once prices of the components of fixed capital fall, the value of K in the denominator will be reduced, and the rate of profit revived.

It is interesting to note that, technically, there is something of an “out” which could help capitalists avoid a fall in the realized rate of profit, at least up to a point. The “out” is capitalist consumption, Cp. Provided there is excess capacity, which is the normal condition in a capitalist economy, capitalists could increase their consumption relative to their investment. To the extent that they did this, profit (the numerator) would increase without causing the capital stock (the denominator) to expand. The decline in the rate of profit would be attenuated to some extent. The limit to this avenue is full capacity utilization. At that point, no additional boost could be given to the rate of profit in this manner. Instead, something would need to be done either about distribution (a redistribution of income to capitalists props up the rate of profit) or K needs to devalue.

From Marx’s (contestable) perspective, there is another obstacle to this method of attenuating the tendency for the rate of profit to fall. Competition compels capitalists to reinvest some of the previous period’s profit in the current period in an effort to improve productivity (compete on cost) and increase productive capacity (maintain market share). This makes it unlikely that they will lift their consumption, relative to investment, to a degree sufficient to maintain the rate of profit. A similar obstacle could be identified from a Kaleckian or Keynesian (contestable) perspective. Since capitalists typically have a lower propensity to consume than workers, and in any case are a tiny cohort of society, the rate of profit is unlikely to be maintained on the strength of capitalist consumption.

Once the government sector is included, Kalecki’s analysis suggests that, up to full capacity utilization, fiscal policy could be used to moderate any tendency for the realized rate of profit to fall. In a commodity-backed monetary system or common currency arrangement, this would be difficult. But in modern monetary systems — those involving flexible exchange-rate fiat currencies — governments have such a capacity if they choose to use it.

To see this, we can introduce the government and external sectors into Kalecki’s analysis. The basic identities become:

(1”) Y = C + I + G + NX

(2′) Y = W + P + T

where Y is income, G is government expenditure, T is tax revenue, and NX is net exports.

Following the same procedure as we did in the case of a pure private-sector economy but allowing now for worker saving and the additional sectors gives:

P = CP + I + BD + NX – SW

where BD = budget deficit = G – T and SW is worker saving.

Finally, the average rate of profit becomes:

r = (CP + I + BD + NX – SW) / K

With the extra sectors included, there are now other possible “outs” that give support to the rate of profit up to the point of full capacity utilization. The most important “out” is the government’s capacity to run budget deficits. In fact, for the world economy as a whole, NX = 0, and the most reliable “out” at the global level would appear to be the government’s capacity to run budget deficits.

Again, the limit to this, so far as the rate of profit is concerned, is full capacity utilization. Beyond that, attempts to maintain the rate of profit would have to resort to policies that added to productive capacity without increasing K (the value of the privately accumulated capital stock) or that even reduced the value of K. Public investment in science and technology enables improvements in productivity, and hence reductions in prices of the elements of privately owned fixed capital. Public investment in infrastructure expands productive capacity without adding to the value invested in K by capitalists. Nationalizations reduce the size of the private sector, which can shrink K relative to P.

Needless to say, there are better policy aims than propping up the rate of profit. An economy geared towards not-for-profit activity would have no need for such class-interested policies. A currency-issuing government could facilitate such a reconfiguration of the socioeconomic landscape. It would, of course, entail a transcending of capitalism.


9 thoughts on “Thinking in a Macro Way

  1. A third Peter here – and agree, this is a very good post. For novices like myself it really puts things in perspective. Will be exploring more of your posts, thanks a lot!

  2. Peter C,

    I agree with Peter D: this post is dynamite. The whole site, not only the history of economic thought posts, is terrific.

    I’ll recommend it to my friends (who are also MMTers, but without much knowledge about economics in general).

  3. In your later analysis you appear to have made up your own definition of GDP (it should be “Y = C + I + G + NX”). Taxes are not subtracted from this.

    I also note that your falling rate of profit (and subsequent conclusions) only work in an ideal world of a fixed rate of investment and capital which never wears out. In the real world, capital (plant and equipment) needs to be replaced, so K doesn’t increase monotonically, and investment increases as capital increases (presuming the economy grows as the capital stock increases). So your conclusions appear to apply to this idealized economy, not to the real world.

  4. ThomasW: Welcome. Thanks for taking the time to comment.

    Yes, that was a confusing treatment of income, which has now been amended. In the original post, I referred to income net of tax, which meant that GDP = Y + T = C + I + G + NX and Y = C + I + G – T + NX. I should have included tax in income. I have now corrected the two identities to Y = C + I + G + NX and Y = W + P + T. The resulting expression for profit is, of course, unaltered.

    The link on Kalecki provided in the post presents the following equivalent expression for profit:

    P = Cp + I + Dg + Ee – Sw

    Here, Dg is government debt for the period (equal to the budget deficit, G – T), Ee is the net external surplus (i.e. NX), Sw is worker saving (assumed zero in Kalecki’s simpler models).

    Regarding your point about depreciation, that is addressed in the post. The numerical example sets the rate of depreciation to zero to illustrate the effect, but it is simple enough to show the rate of profit falling with depreciation occurring. Modifying the example, let gross investment be 100 each year, depreciation 50 (or whatever, provided net investment is positive). The rate of profit in successive periods will be 100/1000, 100/1050, 100/1100. Clearly, the rate of profit falls, but at a slower rate than when depreciation is ignored. This was mentioned in the post as follows:

    [T]here will be a tendency for the rate of profit to decline as capital intensity increases. (The tendency will be mitigated to the extent that depreciation occurs.)

    True, you can increase I from period to period as well, but any increase in I beyond what is already included in the numerical example above will equally add to K. Repeating the modified version of the example, but allowing I to increase by 50 each period, gives rates of profit 100/1000, 150/1100, 200/1250, …, which clearly doesn’t help the situation.

    In the absence of deficit expenditure sufficient to maintain profitability (by either maintaining a high rate of capacity utilization or using public investment to limit the growth of K relative to P), the revival of profitability requires crisis and a collapse in the prices of the components of K.

  5. Marxist tricky stuff. But this seems like a pretty important post, even if I don’t know why yet.


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