The following points highlight the two main approaches to the income theory. The approaches are: 1. Income-Expenditure Approach 2. Saving-Investment Approach.
1. Income-Expenditure Approach:
The income theory of prices involves on the one side an analysis of income and aggregate demand, and on the other, an analysis of costs and aggregate supply. Prices are determined by money income and real income.
The total money income (Y) is the value of goods and services produced in any period of time and expressed in terms of money. It is determined by the remuneration paid in terms of money to the factors of production. Thus it also refers to the sum of total expenditure (E) incurred on goods and services during a period.
On the other hand, the ‘real’ income is the total value of real goods and services produced in any period. It is determined by the total money value of goods and services expressed in terms of a general price level of a particular year taken as the base.
Thus the money value of real income is the money income which is determined by the prices of goods and services or output. Symbolically, Y = P.O where, Y is money income or money expenditure which produces a flow of income; P is the general level of prices, and O is the physical volume of goods and services produced. It follows that P= Y/O.
It means that prices are determined by the ratio of money income to total output. When money income (Y) rises more rapidly than output (O) prices (P) will tend to increase. If, on the other hand, output (O) increases more rapidly than money income (Y), prices (P) will tend to fall. It is clear from the above that total money income equals total expenditure which, in turn, is equal to consumption expenditure (C) plus investment expenditure (I). Therefore, symbolically, Y=E=C+I.
According to Keynes, it is the total money income which determines the total expenditure of the community. An increase in the money income means increase in investment expenditure, the propensity to consume being stable in the short run.
The increased investment will raise effective demand which will, in turn, raise output and employment. But what about prices? So long as there is unemployment, prices do not rise with increase in output. This is because the supply of factors is perfectly elastic.
Therefore, output will change in the same proportion as the quantity of money, and there will be no change in prices. When the supply of factors becomes somewhat inelastic (or factors are in short supply), this may lead to increase in marginal costs and prices. As full employment is reached, the elasticity of supply of output falls to zero (perfectly inelastic), and prices rise in proportion to increase in the quantity of money.
Thus the income theory states that the increase in the quantity of money depends upon increase in money income and aggregate expenditure, and prices start rising when the full employment level is being reached. Once the full employment level is reached, prices rise in the same proportion as the increase in money income and aggregate expenditure.
2. Saving-Investment Approach:
An alternative to the Keynesian income-expenditure theory is the saving-investment approach to income theory. In fact the income-expenditure approach (Y=C+I) is the same thing as the saving-investment approach. Both saving (S) and investment (I) are defined as the excess of income over consumption (Y-C) so that they are necessarily equal. Symbolically
S = Y-C
I = Y-C
Keynes also established this equality in another way. He defined income as equal to consumption plus investment (Y=C+f), and saving as the excess of income over consumption (S-Y-C). Thus
Y = C+l or I = Y-C
S = Y-C
We have seen above that the equality between saving and investment is brought about by the mechanism of income. On the other hand, income depends upon relation between saving and investment. So long as saving and investment are equal, there will be the equilibrium level of income and the price level will be stable. If saving and investment are disturbed, the price-level also changes via the change in expenditure.
If saving exceeds investment, it means that people reduce their expenditure on goods and services. They are hoarding more money and spending less. This reduces the velocity of circulation of money. This leads to a reduction in the income of the producers of goods and services.
Reduced expenditure and income lead to a fall in the price level. As prices fall, investment also declines due to a fall in the marginal efficiency of capital which leads to further fall in income, output, employment, and prices. This process will continue till prices reach the bottom of the depression.
If investment exceeds saving people increase their expenditure on goods and services. They are spending more and saving less. This causes the velocity of circulation to increase. This increases the income of the producers of goods and services. Increase in expenditure and income lead to a rise in the price level.
This will increase the profit expectations or marginal efficiency of capital. As a result, investment will increase further which will, in turn, raise employment, income, expenditure, output and prices to still higher levels. But the increase in investment leading to an increase in aggregate expenditure, demand, and income do not lead to rise in the price level immediately.
So long as the output of goods and services rises proportionately with the increase in the demand for goods and services, there would not be a general rise in the price level.
If output does not increase proportionately, increase in investment will increase income and the price level. But increase in output is possible only if there are unemployed resources in the economy. When the economy reaches the full employment level, further increase in income will not raise output to the level of increase in aggregate expenditure.
But it will lead to an upward rise in the price level in the same proportion as the increase in income. To conclude, it is the inequality in saving and investment that brings about changes in the price level, and changes in the price level are due to changes in income rather than in the quantity of money.
Superiority of Income-Expenditure (or Saving-Investment) Theory over the Quantity Theory:
The income-expenditure theory of money is considered superior to the quantity theory of money on the following grounds:
1. Explains Business Cycles:
The quantity theory cannot explain changes in prices during the upswing and downswing of a business cycle. It does not explain why an abundance of money during a depression fails to bring about a revival, and shortage of money stops a boom. The income theory is superior to the quantity theory because it explains them. According to the saving-investment theory, when investment exceeds saving revival starts from a depression.’ Mere increase in the supply of money is not enough to bring about a revival.
It is the’ rise in business expectations of profit (or the marginal efficiency of capital) that encourage investment and the revival starts. On the other hand, a boom does not stop due to decrease in the money supply alone. Rather it stops because saving exceeds investment due to the fall in the expectations of profit.
Thus it is changes in investment due to changes in business expectations of profit that lead to cyclical upswing and downswing. Crowther has aptly said, “The Quantity Theory of Money explains, as it were, the average level of the sea; the Saving and Investment Theory explains the violence of the tides.”
2. Explains Changes in Velocity of Circulation of Money:
The quantity theory of money does not explain the causes of changes in the velocity of circulation of money. The saving-investment theory is superior in that it gives an adequate explanation of such changes. When saving exceeds investment, it means that people are hoarding more money and spending less.
This reduces the velocity of circulation of money. On the contrary, when investment exceeds saving people are spending more which causes the velocity of circulation of money to increase. Thus changes in the velocity of circulation of money are caused by the relationship between saving and investment.
3. Explains Causal Relationship between Quantity of Money-and Price Level:
The Quantity Theory of Money fails to explain the causal relationship between the quantity of money and the price level. It simply explains that the relationship between the two is direct and proportional. The saving-investment theory is superior in that it shows that the actual relationship between the money supply and price level is neither direct nor proportional.
It is disequilibrium between saving and investment that leads to changes in the price level. An increase in the quantity of money is partly saved and partly spent. If investment exceeds saving, income will increase which will raise aggregate expenditure, output, employment and prices.
The inverse will be the case when saving exceeds investment. Thus there is no direct relationship between the quantity of money and price level. As pointed out by Crowther, “The effect of a given change in M (quantity of money) on the price level is not a simple cause-and-effect relationship as the Quantity Theory supposed, but a most complex chain reaction.”
Moreover, when the quantity of money increases, the price level does not rise proportionately. So long as there are unemployed resources in the economy, an increase in money income will not lead to a rise in the price-level if output increases proportionately to the increase in aggregate demand. It is only when .the resources are fully employed that the price level will increase proportionately to the increase in the quantity of money.
4. Applicable in the Full Employment and Unemployment:
The quantity theory of money is based on the assumption of full employment that is why it establishes a direct and proportional relationship between the quantity of money and price level. The saving-investment theory is superior to it because it analyses the effect of money on the price level when there is unemployment in the economy.
5. Explains Short Run Changes:
The saving-investment theory is more realistic than the quantity theory of money because it explains short run changes in the value of money (or price level), whereas the quantity theory of money explains the long run changes. This is unrealistic because in the long run we are all dead.
6. Considers both Monetary and Real Factors:
Again, the saving-investment theory is superior to the quantity theory of money in that it takes into consideration both the monetary and real factors in determining the value of money. Such factors as saving, investment, aggregate output are taken along with the quantity of money and aggregate expenditure. This makes the income theory better than the quantity theory of money.
7. Policy Implications:
The policy implications of the saving-investment theory are more realistic than the quantity theory of money. The quantity theory of money concentrates exclusively on monetary policy. On the other hand, the saving-investment theory lays more emphasis on expenditure and income that affect economic activity more than the quantity of money. This fact has been proved by the dominance of income (fiscal) policy over the monetary policy since 1950s.
We may conclude with Crowther that the saving-investment theory “goes considerably nearer to the reality of things than the quantity theory. It reveals the fundamental tendencies of which the behaviour of money and prices is merely the surface of the symptom.”