Wage and employment in a finance-led economy

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Wage and employment in a finance-led economy

    Workshop on Effective Demand, Income Distribution and Growth th EAEPE Annual Conference, Bremen, November 10-12 17

    Wage and employment in a finance-led economy

    1Célia Firmin

    The object of this paper is to analyse the links between income distribution and growth in a finance-led economy. In fact, the increased share of financial activities creates a new macroeconomic and income distribution dynamic. Dividend distributed by firms, banks behaviour, financial profitability normsmodify investment and consumption dynamic. A

    growing part of income is collected by shareholders and affects the consumption function. Moreover, profitability norms fixed by shareholders in the short term may reduce investment. It results in a new macroeconomic dynamic which affects employment and wage determination.

    To study links between income distribution and growth, and thus employment, in finance-led economies, we will use a post Keynesian “stock-flow” macroeconomic model.

    This kind of model is developed by Godley and Lavoie (2001). These models are generally specified by a Kaleckian wages determination, by a mark-up rule in goods market. Here, we will introduce an endogenous wage determination lead by class struggle, as Goodwin (1967). We will still deal with a markup rule and take into account financial actors. The Goodwin model takes place in a classical framework, where saving affects investment and where there is no demand constraint. On the contrary in a Kaleckian or Keynesian framework, saving and investment don’t respond to the same determinants and the causal relation is reversed. So, the object of this paper is to introduce an endogenous wage determination in a Keynesian model, with a demand constraint but also with an investment financing constraint, in a finance-led economy. Moreover, there is no saving constraint in our model. But, money plays a central part and credit rationing can decrease investment. As Keynes (1937) said, a lack of liquidity can occur, but not of saving. Finance development affects banks behaviour and then credit access by modifying their liquidity preference.

     1 Université Paris I Panthéon-Sorbonne, MATISSE-CNRS (UMR 8595)

    106-112 Bld de l’Hôpital, 75013 Paris, Bureau 224


    To consider modern finance-led economies specifications, we will introduce financial and credit markets but also speculative assets market, as Taylor (1991). We will present the model by markets in a first time. Then, we will analyse wages and employment determination in a finance-led economy, in comparison to this of Goodwin (1967) model. We will also see the relationship between income distribution and cycles in a finance-led economy, always in comparison to Goodwin model. Finally, we will use simulations experiments to analyse model reactions to a change in key parameters, and mainly a change in financial parameters. More precisely, we will see what the relationships between wages determination and economic dynamic are in a finance-led economy.

1. Model presentation

    The model purpose is to introduce an endogenous wage determination, outside the goods market, as Goodwin (1967), in a post Keynesian model but also to consider finance development and credit rationing. For this, we will introduce financial profitability norms in the investment function and dividends distribution to shareholders. This last modify the consumption function. So, with dividends and interest payments, all profits are not invested. To achieve this, we will not consider the total profit share in the investment function, on contrary to Goodwin, but only anticipated profits linked to economic activity. Firms can finance their investments by issuing equities, borrowing from banks and by retained earnings.

    In this model, there are five agents: workers households, shareholders, firms, banks, and an external agent (foreign countries for example). It is composed by five markets: goods market, equities market, credit and money markets and speculative assets market. Accountable matrices are presented in annexes. Exponents in variables represent the demand (d) or the supply (s) and the indexes the agents (a for shareholders, w for workers, f for firms, b for banks and e for external agents).

    1.1. Goods market

    sddY?CI. It represents the The production level is determined by aggregate demand,

    total income which is divided between profits and wages. This income distribution influence next period consumption and investment.


    1.1.1. Consumption function

    We will consider two kinds of consumers:

    dCCC aw

    As Taylor (1991), we first consider wage-earning workers with a propensity to consume equal to one. The second part represents the shareholders. Their income is only constituted by dividends and interests on deposits. This is a simplification but it doesn’t really modify analysis results.

    Workers households consume wages of previous period:

    CW w(1)

    With . We will see in the next section how wages are set up. 1

    Shareholders hold interests on deposits and dividends. In counterpart they consume following their propensity to consume and they save:

    dd C(DrM)aa(1)ma(1)

    ddWith dividends received at the previous period, interest on deposits DrM(1)(1)ama

    and the propensity to consume.

    Dividends are determined following the stock of equities hold by shareholders

    dddddderhouseholds () and the equities rate of return (): and, Dreeeeae(1)(1)aeaaaa

    sDfsswith, dividends distributed by firms () on the stock of equities issued (). rDeeffsef

    The rate of return on deposits is exogenous, . rrmm

    1.1.2. Investment function

    On contrary to Goodwin (1967), we will not consider that profitability affects investment. The profitability level is an indicator of firms’ internal financial possibilities. Yet,

    firms distribute dividends and pay interest on loans. So, retained earnings represent a better indicator of firms’ income than the profits share. But, these variables don’t enter in firms’

    investment decision but in firms financing capacities. So, we will make a difference between


    firms’ investment decision according to economic activity and financial norms and investment financing conditions. Yet, these last can limit the investment, we will see this point with the credit market.

    The demand level influences the investment. Goodwin (1967) model doesn’t take into

    account the demand effect on investment, as N.Canry (2005) underlines. To analyse this effect, we will consider the rate of capacity utilisation, as most of post Keynesian models (Godley and Lavoie 2001, Taylor 1991).

    In a finance-led economy anticipated returns on investment, represented by the economic activity evolution, are compared with financial profitability norms and no more with interest rates as Keynes (1936). Because of uncertainty, past and present facts play an important part in firms’ decision and tend to replace anticipated events. Keynes (1936)

    developed this idea of past and present facts prevalence in investment decisions. Firms invest only if anticipated returns are equal to a certain norm. With financial activities development, this norm is now set up on financial markets. Boyer (2000) also introduces financial norms in the investment function. If the anticipated return is inferior to the financial profitability norm, firms will not invest. High financial profitability norms create increasing investment selectivity. We will see later firms behaviour in the speculative asset market when investment opportunities are weak.

    We can now present the investment function:

    dYI(1) ia(()bu0(1)KY(1)(2)

    Y(1)With economic activity fluctuations of previous period, financial (Y(2)

    Yuprofitability norms and the capacity utilisation ratio, with μ the productivity. We ?K

    ;;KK1?Iwill consider equally the capital depreciation:, with the depreciation ?tt1t


    Firms can finance their investment by retained earnings but also by issuing equities and contracting loans. We will see that the real investment can differ of the one established by the investment function.


    1.2. Equities market

    Equities are issued by firms. They finance by this mean a percentage x of their investment

    S), regardless to the price of equities. This which is not covered by retained earnings (f(1)

    formulation is inspired by Godley and Lavoie (2001) and Kaldor (1966). A lag of time is introduced because firms set up their financing structure on previous period because of uncertainty:

    sd ;,;;exISf(1)f(1)

    sRetained earnings are made up by total profits minus distributed dividends () and Df

    dinterest rate payments on loans (), plus return on speculative assets that firms can hold rL(1)l

    dsddFYW(), with . The rate of return on rZSFDrLrZT(1)(1)(1)zffTflzf

    rrspeculative assets (Z) is exogenous. zz

    rDistributed dividends are a percentage of previous period profits once interest () on l

    dloans () are paid: Lf

    sd ;;D~FrL(1)(1)fTlf

    Shareholders households, banks and external agents compose the demand for equities.

    ?Shareholders households wish to acquire a certain proportionof equities with their 1

    r)saving but this proportion is modulated by the relative rates of return on equities (and on e

    rbank deposits () : m

    d;,;;e??rrS a12ema

    dddddSWith their saving: and . SDrMCMMMaaama(1)a(1)aaa

    Banks use their unused funds with loans granted to acquire equities or speculative assets. They decide to purchase assets according to their liquidity preference and rates of

    sSMreturn. These funds are made up by their internal saving and deposits minus loans b

    granted. Yet, banks can be rationed by the amount of equities issued. We will see that in this case they use their funds on the speculative assets market:


    dsssd ;,;,emin??(rr)(SML);ee34bezbbfa

    sdbdddddWith , and . SrLDrZrMDreeeebl(1)bzd(1)ms(1)(1)(1)bebbbb

    With financial liberalization, if equities issued by firms can not be entirely got by banks and shareholders households, external agents complete the demand:

    dsdd eeeeefab

    Firms finance the rest of their investment with loans granted by banks.

    1.3. Credit and money markets

    Firms decide of their investment behaviour according to the function we have seen. But, they can experience credit rationing due to banks behaviour. In this case, firms’ external financing capacities are not sufficient to fulfil the anticipated investment.

    To simplify, we will consider that loans demand is made up by firms only, for investment financing. It represents the exact counterpart of equities issue:

    dd ;,L(1x)(IS)f(1)f(1)

    Banks grant loans according to their liquidity preference. In fact, they target a certain capital ratio which corresponds to their liquidity preference (Godley and Lavoie 2004). This

    ccLratio () is composed by the ratio of banks own funds on targeted loans (): Cb

    OFcb CcLb

    ssddsssWith and . We will OFOFSMLeZLLL(1)(1)bbbbbb

    consider here this ratio as exogenous. This ratio is a banks’ prudence behaviour indicator. It

    represents their confidence in the future (Lavoie 2004). Banks establish a kind of risk self-checking. So, there is an endogenous credit supply rationing (Plihon 1998).


    The firms’ financial situation influences loans granted by banks. Banks estimate this situation taking into account the firms’ debt ratio including interest payments. As present

    situation is unknown, we introduce a lag of one period.

    These two components set up the loans supply:

    ????1rsscl??SMLC(1)b??K(1)??sL bc1C

    sdSo, it could have a credit rationing: L)L

    sdMMBanks collect money deposits made by shareholders households: . Banks a

    deposits represent the difference between shareholders saving and equities

    ddpurchasing:. MSeaaa

    When banks resources are higher than loans granted and equities purchased, they can get speculative assets.

    1.4. Speculative assets market

    As Taylor (1991), we introduce a speculative assets market. These assets can be gold, real estates, or external assets for example. In our case, we will take the last one.

    Asset speculative supply follows the demand and is set up by external agents:

    sdZZ e

    Speculative assets demand is composed by firms and banks.

    Firms get speculative assets when their total resources are higher than investment opportunities:

    dsdd ;,ZSeLI(1)ffff

    So, their first activity is still investment but when opportunities on the goods market and so anticipated returns are too weak, they develop financial or speculative activities.

    With their unused resources, banks acquire speculative assets:


    dssdZSMLe bbb

2. Wages and employment

    2.1. Wages and employment in Goodwin model

    In his 1967 model, Goodwin analyses the links between income distribution and

    Lgrowth. Wages are endogenous and depend on employment rate v (v, with L the N

    employment and N the active population):

    ;w (uvw

    High employment rate increases wage share and so reduces profits, which decreases investment and growth. With profit share decreased, growth slows down because of a higher financing constraint for firms. Unemployment increases and a new cycle begins.

    In Goodwin model, distributive conflicts play an important role and income distribution is central to analyse cycles. But, this model takes place in a classical framework and financial actors are not considered.

    As Goodwin (1967), we will introduce an endogenous wage share determination, taking into account distributive conflicts but with financial actors. We will also use a kaleckian mark up rate principle to analyse wages in a finance-led economy.

    2.2. Wages and employment in a finance-led economy

    Aglietta and Rebérioux (2004) and Boyer (2000) analyse the central part of corporate governance in finance-led economies. This principle gives an important role to shareholders in firms’ management decisions. Financial profitability norms become central in income

    distribution. So, to introduce shareholders strength in distributive conflict, we have to take these norms into account.

    Firms set up their prices by a markup rule. The object here is to make this markup rule endogenous. In fact, in most postkeynsian models, the markup is an exogenous parameter and is set up only on goods market (Godley and Lavoie 2004, Kalecki 1990). Here, the markup


    rate depends on the difference between financial profitability norms and financial assets rate of return. This difference represents financial actor’s strength. As Goodwin (1967), we will take the employment level as an indicator of workers power. Here, we will use the unemployment rate, ur, instead of the employment rate. So, we can write the markup rate equation:

    ?p((r)ur? t1et

    When the unemployment rate increases, firms raise their markup rate up and wage share decreases. It is the same mechanism when financial norms go up. The unemployment is linked to economic growth, following Okun’s law. The present equation is inspired by Dos

    Santos and Zezza (2004). The unemployment rate depends on the difference between

    Yeconomic growth and the “normal” rate of growth (). This normal rate is set up by

    productivity and active population growth. Here, we will consider it as exogenous. So:

    ??Yt? ururYtt1t?Yt1?

    Income distribution affects consumption and investment, and by this way economic growth. This last determines employment and firms profits and so, income distribution. We will see by simulation method the links between income distribution and growth and if a decrease in wage share improves firms financing capacity and so investment and growth, as Goodwin (1967).

3. Results and experiments

    We have solved the model numerically and realised a series of simulation experiments. Two kinds of investment constraints appear. In fact, investment can be limited by effective demand level or by financing condition partly due to credit rationing.

    3.1. Cycles and income distribution

    With this model, we can find three economic trajectories, whatever the investment constraint form is. The regime can converge towards a steady-state situation, with under-employment stability. The growth rate is close to the natural one, firms can distribute dividends and set up a return rate equal to financial profitability norms and so the markup rate


    is stable. Wage share and consumption can be stabilized, as investment. In this condition, the unemployment rate is also stationary.

    The regime can also follow a cumulative recessive trajectory. It can happen for example when financial profitability norms are too high. In this case, the model is marked by instability. Firms increase the markup rate to raise distributed dividends and so financial assets rate of return. Consumption and utilization rate decrease, as investment, and provokes a fall in firms internal saving. So, investment financing constraint increases, as demand constraint, and the economy follows a recessive trend.

    Finally, we can analyse a last situation, with growth cycle. But the relationship between income distribution and growth is not the same as Goodwin (1967) one, even when there is a financing constraint. In fact, if the markup rate increases (when financial profitability norms are higher than financial assets rate of return) and so profit share, firms distribute more dividends and improve financial assets rate of return. In parallel, growth slows down because of the decrease in wage share. This last provokes a fall in consumption and by this way in investment. Consequently, unemployment rate increases. When assets rate of return is equal to financial profitability norms, or higher, firms are more sensitive to workers demands and markup rate can decrease, even if unemployment is higher.

    In this case, we can say that wages and employment loose their central role in income distribution dynamics. They seem to be adjustment variables, as growth and accumulation rates. Financial profitability norms, distributed dividends and so financial actors occupy a central part in this dynamic and explain cyclic fluctuations. They represent the first

    2. determinant of the markup rate

    At the opposite of Goodwin, a fall in wage share doesn’t create a recovery of the

    economy by the increase of investment. On contrary, it tends to depress the activity. We can explain this difference by the introduction of a demand constraint. Even if the economy is under a financing constraint, such a reduction creates a fall in profit due to economic activity deceleration. So, firms’ internal saving decreases and this constraint becomes higher. The causality between profits and investment is reverted referring to Goodwin classical model. Here, we follow Kalecki’s (1966) profit and investment causality. Investment determines

    profit and not the contrary. We can replace the Goodwin relation between wages, profits and

     2 We have made an other scenario without the unemployment rate in the markup equation and we find exactly the same results


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