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The real incomes component of the Real Money Theory
A note

Hector McNeill1

In the note entitled: "A Real Money Theory", the specific determinants of real income in the form of total quantities of products and services consumed were not elaborated. However, this was an oversight because understanding the role of average prices in the context of policy and accepting that money volumes do not influence prices, it is apparent that another basis for policy is required to help moderate prices and support real incomes.

This is further support for the Real Incomes Approach to Economics.

Real income determinants

At the end of the note "A Real Money Theory" a model (RMT) to substitute the QTM and the Cambridge model, was set out as follows:
M = (P.Y) + (a + k) . (i)


M (a + k) = P. Y .... (ii)


M is the quantity of money;
P is the price level;
Y real income (substituting T in the Irving equation);
a is assets;
k is savings.

Under the subheading "Inflation" it was explained that the conventional QTM, the Cambridge model and the proposed RMT do not possess any functional relationship to price movements or quantities of goods. This is because these depend upon separate functions where the determinants are the microeconomic factors that determine input resources allocation and price setting by economic units. These decisions determine the resulting revenues that are dependent on the price elasticities of consumption. The range of operational price elasticities of consumption are a function of consumer purchasing power which is determined by wage levels paid by these same units to their workforce (endogenous).

Inflation therefore has no direct connection to the volume of M (exogenous) or the price of M in the form of interest rates (exogenous)2. Therefore Y, the aggregate quantities and qualities of real consumption of physical goods and services under the RMT equality, should rise if average unit prices fall. Therefore the focus of any policy aiming to maintain or raise real incomes, for any particular level of M, asset and savings, needs to provide incentives for unit price moderation or reduction. Price reduction increases real income levels because more consumption is possible linked to price elasticities of consumption.

Physical and price performance

The only means the real production and services economy can raise real incomes growth is therefore through microeconomic decisions to raise physical production and price performance (see: "Price Performance Ratio"). This requires improvements in productivity to improve the necessary unit price flexibility by reducing unit costs of production and enable marginal unit prices of output reductions. This can be achieved while stabilizing or even increasing unit profits or total corporate income as a function of price elasticity of consumption and resulting rates of market penetration.

Microeconomic foundations are important

As can be appreciated from this exploration, attempting to manage the economy with such top down models such as the QTM or even more realistic RMT provides little orientation as to which policy instruments should be applied to augment growth in real incomes. The Real Incomes Approach to Economics focuses improving the price performance of companies through enhanced productivity and, as such, is one of the only macroeconomic theory (based on the PAC model) that is fully supply side because it is founded on microeconomic principles and it operates on the basis of policy instruments that can be managed by decision makers at economic unit level to create real aggregate macroeconomic growth.

1 Hector McNeill is the Director of SEEL-Systems Engineering Economics Lab.

2 Input costs rise to the extent that loans are used either as credit for consumption or loans for investment.

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