The circular flow is a model used to show how money and products move in the economy. I am going to use a simplified version to show the effect of changes in labor share of income. Many people think that labor income is not quantitatively different than capital income. I will show that GDP is affected by labor share of income.
Let's start out with a basic model. It will only involve owners of 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 and exports.
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 (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)
GDP = consumption + investment
GDI = labor income + capital income
GDP = GDI
Money increases in the economy when banks make loans using a fractional reserve system. The banks can lend out more money than they have in reserves. This is how money is created in the economy. Banks can just create money when they make loans. So now we can change the graph above to show an increased level of investment by banks.
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 as income yet.
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.
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 from the increased level of investment and the new increased consumption is now $1.336 million.
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.
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 with the increased investment until equilibrium is reached. Here is what the economy will look like once it reaches equilibrium, where (Savings = investment) and (In-coming = out-going).
The important thing to see in this moment is that GDI (gross domestic income) has increased to $1.625 million from the original increased investment of $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.
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 quantitative easing... 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...
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%.
- After the crisis, labor's share of income fell 5%. The result is that the ability of investment to increase GDI or GDP output is muted. Investment has had less power to boost GDP.
- Investment returns to firms in smaller amounts. Firms receive less in-coming money.
- Labor's consumption and labor's savings have decreased. This would be obvious from lower labor share and lower GDI.
- Look closely at the capital income in graphs #5 and #6. In graph #6, capital's income has actually risen, in spite of GDI falling. This model shows how capital income and corporate profits can reach record heights while Main street struggles.
- A lower labor share affects the efficacy of loose monetary policy. How can you expect loose monetary policy to put money in the hands of people when the falling labor share is taking money out of their hands? And any increased investment results in more upside for capital income with more downside for labor's income.
- Loose monetary policy is heading toward a lower equilibrium level of GDP due to the lower labor share. Why has the economy responded so poorly to loose monetary policy? We can clearly see above that a lower labor share mutes the potential of investment to raise GDP.
Note: There is more that can be done with this model.
- Effective demand limits can be incorporated.
- The adjustments of monetary policy to these dynamics can be incorporated.
- We would also find that unemployment's natural rate would be higher if we associate the rise in real GDP with utilization of labor and capital. Once GDP is limited to a lower 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.)