The income theory of money seeks to trace the effects of the use of money upon economic activity in a capitalist economy. It examines how the economic system functions and income is determined, in a macro- sense, and how the prices are affected and thereby traces the aggregate relationship between money, prices and income.
The following are the main postulates of the income theory of the prices or the income-expenditure approach to the value of money:
1. The concept of income is viewed as “money income” and “real income.”
Money income refers to the total income received by the community in terms of money as the sum of factors’ reward during a period. It represents the money value of aggregate real output during that period. In other words, money income is the national income expressed in terms of money.
Real income refers to the total volume of real goods and services produced by the community in the given period. Real income depends on the availability of real resources and its employment in the economy.
In a way, money income and real income are the two sides of the same coin. The money value of real income is the money income. It is determined by the prices of output. It may be stated thus:
Y = PO
Y = money income;
P = price level; and
O = total output or real income.
This equation suggests that money income is equal to the value of total production, i.e., price level multiplied by total output.
The abovementioned equation may be regarded as the fundamental equation of the income theory. It shows that prices are interlinked between money income and real income. Since:
Apparently, when money income (Y) rises more rapidly than output or real income prices P will tend to rise. If, on the other hand, O increases more rapidly than Y (i.e., real income increases faster than money income), P, price level, may be expected to fall.
2. The level of income in an economy depends on the productivity and the level of employment. The level of employment is determined by the level of effective demand which depends on the aggregate demand function.
The aggregate demand function or the level of effective demand, in turn, determined by the aggregate of consumption and investment expenditure.
Consumption expenditure refers to the money expenditure on consumption goods. It is the function of income and the propensity to consume.
Investment expenditure refers to the money spent by the entrepreneur in the creation of new capital goods. Thus:
Total Expenditure = Consumption Expenditure + Investment Expenditure.
3. The flow of total expenditure determines the flow of money income in the economy, since one person’s expenditure becomes another person’s income. In fact, there is a circular flow between the two.
In the economy, A’s expenditure becomes B’s income and B’s expenditure in turn may become C’s income and so on. Thus, expenditure generates income and income generates further expenditure.
Thus, income theorists believed that the level of income depends upon the behaviour of the circular flow of expenditure or spending (consumers’ and investors’ spending, for new consumption and investment, and the enterpriser’s spending on the factors of production).
An expansion of this circular flow of spending means an expansion of money income and a contraction of these spending means a contraction of money income. Obviously, a constant flow of expenditure will generate a constant flow of money income in the community.
Money income determines the spending capacity of the community and the aggregate expenditure of the community constituting effective demand, in turn, determines the real income, or the level of output and employment.
Thus, according to income theorists, particularly Keynes, the strategic factor determining output or real income is the level of expenditure in the community.
Whereas classical theory treats expenditure as a passive factor that is dependent on the level of transactions or output and the supply of money, the Keynesian income theory treats expenditure as the active, determining factor and output as the passive, dependent one.
It is aggregate expenditure constituting effective demand which determines how much of the community’s production capacity will actually be employed. The volume of the total expenditure may, however, affect employment and output, no less than prices.
According to the income- expenditure approach, thus, expenditure affects physical output as well as the general price level of output. In the case of a contraction of aggregate expenditure, both price level and physical output (or real income) as well as money income fall; economic activity as a whole will contract, and vice versa.
The abovementioned postulates relate to income-expenditure approach to the income theory of money.
Keynes systematically and analytically exposes these ideas through saving-investment equilibrium analysis in his General Theory. Therefore, the income theory of money is also described as the saving and investment approach.