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THE GENERAL ECONOMIC MODEL
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Chapter 1
General Economic Concepts
Chapter 2
What is Policy?
Chapter 3
History of Macroeconomic Policies in the United States
Chapter 4
Policy Goals: Maximum Employment
Chapter 5
Policy Goals: Maximum Production
Chapter 6
Policy Goals: Price Stability
Chapter 7
Policy Goals: External Balance
Chapter 8
Subsidiary Policy Goals
Chapter 9
Conflicting Policy Goals
Chapter 10
The Policy Makers
Chapter 11
The Policy Instruments
Chapter 12
The Decision-Making Processes
Chapter 13
The Policy Indicators
Chapter 14
The General Economic Model
Chapter 15
Monetarist Monetary and Fiscal Policies
Chapter 16
Keynesian Monetary and Fiscal Policies
Chapter 17
Debt Management Policies
Chapter 18
Incomes Policies
Chapter 19
Supply Management Policies
Chapter 20
The Long Wave
Chapter 21
Contemporary Issues
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  1. Topological and Centrix Configurations of the Economy
  2. The Monetary Production Economy
  3. The Credit Production Economy
  4. Normal and Abnormal Economies
  5. By Development of the Economy
  6. Temporal Economies
  7. Developing Countries
  8. Inner Cities, Ghettos, and Other Depressed Areas Within Developed Countries
  9. Policy Implications
  10. Summary
    Readings
    Websites
top    I. Topological and Centrix Configurations of the Economy

The Basic Model

The economy is like a fungible gelatin mold. Its topology is an inverted parabolic solid that reshapes itself as money flows back and forth among the several sectors.

normalt


On the vertical axis (z-axis) is the money supply (Ms). In the plane, the x-axis represents the flow of money (V) in and out of the financial and real sectors for the production of income and new output (Y = PQ). The y-axis represents the flow of money in and out of hoarding (H) and financial speculation (S).

In two-dimensional space, layers of the parabolic solid are projected as motile ellipses in centrix configuration.

normalc

Variations on a Theme

Once the basic model has been exposited, a number of different topological and centrix configurations for a variety of economic scenarios can be advanced. Based on these configurations, different policy alternatives are suggested.

top    II. The Monetary Production Economy

With No Hoarding

In a monetary production economy, with no hoarding, the money supply flows into the production of income and new output only. The production of income and new output depends only on the amount of money in circulation and its velocity.

Centrix Analysis

On a two-dimensional plane, income and output are represented by arrows, moving out to the right from the origin. When the money supply is M0 and its velocity is low, only income Y0 is generated. When velocity is higher, a higher income Y1 is generated. Alternatively, if velocity is constant, then increasing the money supply will raise income to Y1.

monetarynohoardingc

Topological Analysis

In three-dimensional space, there is only one plane intersecting the x- and z-axes, with an inverted half-parabola representing the flow of money into the production of income and new output. When the money supply is M0, the amount of income and new output depends upon its velocity of circulation (Vy). When velocity is low, only income Y0 is generated. When velocity is higher, a higher income Y1 is generated. Alternatively, if velocity is constant, then increasing the money supply to M1 will raise income to Y1.

monetarynohoardingt

With Hoarding

In a monetary production economy, with hoarding, the money supply flows into either the production of income and new output or hoarding in capital sinks and black markets. The production of income and new output depends not only on the amount of money in circulation and its income velocity, but also on the money supply that is drained and circulates in the capital sinks and black markets sector.

Centrix Analysis

On a two-dimensional plane, income, output, and hoarding are represented by quarter-ellipses, remolding themselves from narrow and horizontal to narrow and vertical as money flows out of new production and into "capital sinless" and black markets. When the money supply is M0 and hoarding is H0, income Y0 is generated. When hoarding increases to H2, only income Y2 is generated, as the ellipse becomes longer (along the y axis) and narrower (along the x axis).

monetaryhoardingc

Topological Analysis

In three-dimensional space, there is now a three-dimensional quadrant, with an inverted parabolic quarter-sphere representing the topological flow of money into the production of income and new output, on the one hand, and into hoarding in capital sinks and black markets, on the other. When the money supply is M0 the amount of income and new output depends upon its velocity of circulation (Vy) as well as the money supply and velocity which are lost to hoarding. When there is little hoarding at H0, a higher income of Y0 is generated. As hoarding increases to H2, income falls to Y2.

monetaryhoardingt

top    III. The Credit Production Economy

With No Speculation

The role of the financial sector is to make less risky that which is more risky and to make more liquid that which is less liquid. The introduction of a financial sector into an economy increases velocity for the production of income and new output by drawing money balances out of hoarding. In a credit production economy, with no speculation, the money supply flows through the financial sector into the production of income and new output. As idle balances are drawn out of hoarding and into the financial sector, the increased velocity of money for newly produced goods increases income and new output.

Centrix Analysis

On a two-dimensional plane, the economy's centrix configuration shifts from a vertical quarter-ellipse to a horizontal half-ellipse. When the money supply is M0 and a financial sector (F0) is introduced, hoarding falls from H2 to H0 while income and output rise from Y2 to Y0.

creditnospeculationc

Topological Analysis

In three-dimensional space, the economy's topological configuration is now an inverted parabolic half-sphere. When the money supply is M0 and a financial sector (F0) is introduced, hoarding falls from H2 to H0 while income and output rise from Y2 to Y0.

creditnospeculationt

With Speculation

The introduction of a financial sector is not without its flaws. If returns in the financial sector are higher than on new production, a portion of money balances will be drained to circulate solely for speculative purposes. Financial speculation includes options and futures, arbitrage, and takeover trading. In a credit production economy, with speculation, the money supply can flow into any of the four sectors. As speculation increases, the flow of money through the financial sector for productive purposes decreases, income velocity falls, and income and new output decline.

Centrix Analysis

On a two-dimensional plane, income and output, productive finance, hoarding, and speculation are represented by ellipses, remolding themselves from narrow and horizontal to narrow and vertical as money flows out of new production and into hoarding and speculation. When the money supply is M0 and hoarding and speculation are H0 and S0, respectively, productive finance and income are F0 and Y0, respectively. When hoarding and speculation increase to H2 and S2, respectively, productive finance and income are only F2 and Y2, respectively. The ellipse becomes longer (along the y-axis) and narrower (along the x-axis).


Topological Analysis

In three-dimensional space, there is now a three-dimensional inverted parabolic sphere representing the topological flow of money into each of the sectors. When the money supply is M0, the amount of income and new output depends upon its velocity of circulation (Vy) as well as the money supply and velocity which are lost to hoarding and speculation. When there is little hoarding (H0) or speculation (S0), a higher income of Y0 is generated. As hoarding and speculation increase to H2 and S0, respectively, then finance for productive purposes and income fall to F2 and Y2, respectively.


top    IV. Normal and Abnormal Economies

The Normal Economy

The normal economy is one in which the bulk of the money supply is circulated for productive purposes. A maximum amount of productive finance and income and new output are produced with a minimum amount of hoarding and speculation. The normal economy is characterized by "a bubble of speculation on a sea of enterprise".

Centrix Analysis

On two-dimensional plane, the centrix configuration for a normal economy is a narrow horizontal ellipse. When the money supply is M0, the normal economy will have income, productive finance, hoarding, and speculation of Y0, F0, H0, and S0, respectively. If the money supply is increased to M1, the normal economy will have income, productive finance, hoarding, and speculation of Y1, F1, H1, and S1, respectively. Velocity in the normal economy is fairly stable, so that all monetary activities increase in proportion.

normalc

Topological Analysis

In three-dimensional space, the topological configuration for a normal economy is an horizontal inverted parabolic ellipsoid, elongated along the x-axis and narrow along the y-axis. When the money supply is M0, the normal economy will have income, productive finance, hoarding, and speculation of Y0, F0, H0, and S0, respectively. If the money supply is increased to M1, the normal economy will have income, productive finance, hoarding, and speculation of Y1, F1, H1, and S1, respectively. Velocity in the normal economy is fairly stable, so that all monetary activities increase in proportion.

normalt

The Abnormal Economy

The abnormal economy is one in which the bulk of the money supply is circulated for non-productive purposes. A minimum amount of productive finance and income and new output are produced with a maximum amount of hoarding and speculation. The abnormal economy is characterized by "a bubble of enterprise on a sea of speculation".

Centrix Analysis

On two-dimensional plane, the centrix configuration for an abnormal economy is a narrow vertical ellipse. When the money supply is M0, the abnormal economy will have income, productive finance, hoarding, and speculation of Y0, F0, H0, and S0, respectively. If the money supply is increased to M1 the abnormal economy will have income, productive finance, hoarding, and speculation of Y1, F1, H1, and S1, respectively. Velocity is much less stable in the abnormal economy, so that not all monetary activities increase in proportion.

abnormalc

Topological Analysis

In three-dimensional space, the topological configuration for an abnormal economy is a vertical inverted parabolic ellipsoid, narrow along the x-axis (productive finance and income and new output) and elongated along the y-axis (hoarding and speculation). When the money supply is M0, the abnormal economy will have income, productive finance, hoarding, and speculation of Y0, F0, H0, and S0, respectively. If the money supply is increased to M1, the abnormal economy will have income, productive finance, hoarding, and speculation of Y1, F1, H1, and S1, respectively. Velocity is much less stable in the abnormal economy, so that not all monetary activities increase in proportion.

abnormalt

top    V. By Development of the Economy

The Undeveloped Country

The typical undeveloped country has no financial sector and only limited monetization of domestic transactions. As such, there can be no financial speculation and little taxation, but much hoarding. Income velocity of the money supply is low as are its income and new output.

Centrix Analysis

The centrix configuration of the undeveloped country is Y0H0O.

developmentc

Topological Analysis

The topological configuration of the undeveloped country is M0Y0H0O.

developmentt

The Less Developed Country

The typical less developed country has a primitive financial sector with a few financial intermediaries, perhaps, owned and operated by the government, through which some prior hoarding is funneled for productive uses. Internal transactions are somewhat more monetized than in an undeveloped economy so that the government now has some small leeway to levy taxes, especially on hoarding activities (e.g. capital gains taxes on land speculation), and to respend these money balances to increase the income velocity of the money supply. As a result, its income and new output are enlarged over those of the undeveloped country.

Centrix Analysis

The centrix configuration of the less developed country is Y1H1F1S1.

developmentc

Topological Analysis

The topological configuration of the less developed country is M0Y1H1F1S1.

developmentt

The Developing Country

The typical developing country has a variety of financial intermediaries, several of which are owned and operated by private individuals, and rudimentary financial markets through which much prior hoarding is funneled for productive uses. Internal transactions are almost fully monetized so that the government can levy a variety of taxes to respend money balances and raise velocity. As a result, the income and new output of a developing country are larger than those of the less developed country.

Centrix Analysis

The centrix configuration of the developing country is Y2H2F2S2.

developmentc

Topological Analysis

The topological configuration of the developing country is M0Y2H2F2S2.

developmentt

The Developed Country

The typical developed country has a mature financial sector, replete with a full complement of financial intermediaries and markets, that minimizes risks and maximizes liquidity to keep money balances flowing into productive uses. Internal transactions are fully monetized so that the government has complete flexibility in levying taxes on any and all transactions. This maximizes the government's ability to control velocity through its taxing and spending policies. As a result, income velocity in the developed country is higher than in any other country and its income and new output are the largest.

Centrix Analysis

The developed country has a normal centrix configuration: an ellipsoid, elongated along the x-axis and narrow along the y-axis. The centrix configuration of the developed country is Y3H3F3S3.

developmentc

Topological Analysis

The developed country has a normal topological configuration: an horizontal inverted parabolic ellipsoid, elongated along the x-axis and narrow along the y-axis. The topological configuration of the developed country is M0Y3H3F3S3.

developmentt

The Overdeveloped Country

The typical overdeveloped country has an overly sophisticated financial sector that makes speculation too easy and overtly visible tax bases that make levying taxes too easy. The net result is that money supply circulates on the one hand solely for speculative purposes and on the other flows underground into non-taxable transactions to avoid exactive taxes. As a result, income velocity is lower than in a developed country and income and new output are smaller.

Centrix Analysis

The overdeveloped country has an abnormal centrix configuration: a vertical ellipsoid, narrow along the x-axis and elongated along the y-axis. The centrix configuration of the overdeveloped country is Y4H4F4S4.

developmentc

Topological Analysis

The overdeveloped country has an abnormal topological configuration: a vertical inverted parabolic ellipsoid, narrow along the x-axis and elongated along the y-axis. The topological configuration of the overdeveloped country is M0Y4H4F4S4.

developmentt

top    VI. Temporal Economies

The Economy in the Short-run Period

In the short run, velocity is not so stable. If the money supply is increased, income velocity may fall as the additional balances are drawn into hoarding and speculation, leaving productive finance and income and new output at the same level.

Centrix Analysis

The initial centrix configuration is Y0H0F0S0. When the money supply is increased to M1, the short-run centrix configuration is Y0H2F0S2.

timeperiodc

Topological Analysis

The initial topological configuration is M0Y0H0F0S0. When the money supply is increased to M1, the short-run topological configuration is M1Y0H2F0S2.

timeperiodt

The Economy in the Long-run Period

In the long-run, velocity is more stable. Relative price distortions between hoarding and speculation, on the one hand, and productive finance and new production, on the other, will increase the income velocity for the latter. Money supply will flow out of hoarding and speculation into productive finance and income and new output.

Centrix Analysis

The long-run centrix configuration response to the increased money supply is Y1H1F1S1.

timeperiodc

Topological Analysis

The long-run topological configuration response to the increased money supply M1Y1H1F1S1.

timeperiodt

top    VII. Developing Countries

In the developing countries, especially where the financial sector is rudimentary and incomplete, an increase in the money supply from may be offset by a decrease in income velocity as the new balances are drained into capital sinks and black markets, leaving productive finance (F0) and income and new output (Y0) at the same or even a lower level. Because of the limited number of profitable production alternatives, a primitive financial sector, and the profitability and popularity of hoarding activities, new monies entering the system have only one shot at raising income and new output. Foreign economic aid and loans from banks and international lending agencies have only a one-shot effect, namely spending on the initial project. Thereafter, the new monies find their way out of the flow for income and new output. As the demand for and prices of capital sinks and black market goods and services increase, their higher returns make additional production less attractive. In the limit, income velocity slows further as productive money supply is drawn into hoarding activities and income and output fall below their initial level. Unless and until the government addresses the issue of financial sector development, each attempt at further development is self-defeating and requires ever larger doses of monetary help.

For example, assume that the government of a less developed country wants to embark on a development program by increasing its capital stock. Since monetized tax bases are immature, the government can finance its capital program by printing money, borrowing from foreign banks and international lending agencies, or accepting foreign economic aid.

Centrix Analysis

The economy starts with a centrix configuration of Y0H0F0S0. An increase in the money supply initially reconfigures the economy as Y1H0F0S0, with all new monies going into production. However, after these new monies have been circulated once, they end up in the hands of private individuals, who circulate them not through the financial sector and back into new production, but rather into hoarding activities where returns and rewards are much higher. Income and new output fall back to their original levels. The second round effect of an increase in the money supply is to reconfigure the economy as Y0H1F0S0. As returns and rewards from hoarding increase, so does the volume of money balances drawn to hoarding activities. Income and new output fall below their original levels. The final centrix configuration is Y2H2F0S0.

developingc

Topological Analysis

The economy starts with a topological configuration of M0Y0H0F0S0. An increase in the money supply initially reconfigures the economy as M1Y1H0F0S0, with all new monies going into production. However, after these new monies have been circulated once, they end up in the hands of private individuals, who circulate them not through the financial sector and back into new production, but rather into hoarding activities where returns and rewards are much higher. Income and new output fall back to their original levels. The second round effect of an increase in the money supply is to reconfigure the economy as M1Y0H1F0S0. As returns and rewards from hoarding increase, so does the volume of money balances drawn to hoarding activities. Income and new output fall below their original levels. The final topological configuration is M1Y2H2F0S0.

developingt

Sometimes, the initial money endowment has a first round velocity less than one. This occurs because of inefficiencies in public production and corruption among public officials.

Public production In developing countries, the government often owns and operates many businesses, especially those requiring heavy capital expenditures for growth and development. But public production has its own problems, because there is no incentive to economize on costs. Therefore, the initial money endowment gets lost in cost overruns and income and new output grow by less than the initial money endowment.

Foreign aid and borrowing In developing countries, foreign economic aid and borrowing are funneled through the government. Corrupt public officials, who are privy to this "insider information", can establish corporations to take advantage of government contracts and drain the initial money endowment from its productive flow into hoarding activities, especially into foreign accounts.

Each attempt to develop the country is met not only with defeat but with successively lower levels of income and output. With each new attempt to develop, the amount of monetary stimulus must be increased just to sustain the original income and output levels. This explains the frustration of individuals, public officials, economists, and others, who claim that countries like the United States, which provide economic aid to developing countries, and international lending agencies like the IMF and World Bank, which make loans for to developing countries, are "throwing good money after bad". Some of the aforementioned arguments also explain why developing countries have a difficult time adopting the austerity measures imposed by lenders as a requirement for refinancing and new loans.

top    VIII. Inner Cities, Ghettos, and Other Depressed Areas Within Developed Countries

Inner cities, ghettos, and other depressed areas within developed countries (e.g. Appalachia) pose the same problem as developing countries. They have low levels of income and new output, virtually no financial sector (except for a few loan sharks, pawn shops, and check cashing establishments), and much hoarding. Each attempt to raise the standard of living for people within the depressed area is met not only with defeat, but with the need to increase the amount of financial support just to maintain the status quo. For example, assume that the government seeks to develop and raise income in a depressed area by transferring income from its productive sector to the depressed sector. The transfer payment is an infusion of new money supply into the area. In theory, as these new money balances are spent and recirculated, they provide an inducement to produce more new goods and services, thus raising income and output. In reality, the theoretical conclusion fails to materialize for several reasons.

Sellers generally live outside the depressed area. Therefore, the new money balances are repatriated after initial circulation to the high income sector. New money balances circulate only once. There is no second round effect. The injection is not self-sustaining. Therefore, the experiment must be repeated to maintain the same standard of living.

Sellers are generally in a unique monopoly position. Economic participants in depressed areas generally lack information concerning where to get the "best buys for their money", and even with sufficient information, they lack transportation to comparison shop. This immobility means that sellers can raise prices rather than output and landlords can raise rents rather than supply new housing.

Normally, rising prices would induce new sellers into the area. However, in many of these depressed areas, risks and costs are high, thus discouraging the entry of new competition. Many of these areas have high crime rates that raise both insurance premiums and the hurdle rate of return required for new production. Most of these areas lack a labor force with qualified skills. Therefore, additional costs must be incurred in training and retraining labor. Most new businesses are small (too small to sell equity shares) and their owners lack track records. Therefore, the cost of capital and interest rates on loans are much higher.

With rising prices, real income falls and the government must increase the amount of the transfer just to maintain the original standard of living.

Economic participants may not spend all of the newly acquired money supply on new output. Often the new money balances find their way directly into hoarding: gambling, in the hope of malting a "quick buck", drugs to relieve their misery now, and the church and religious relics to relieve their misery in the future.

top    IX. Policy Implications

Once the topological and centrix configurations for a variety of economic scenarios are identified, policy mailers can compare the actual with the desired configuration. Different policy alternatives can then be suggested to remedy basic economic problems to move the economy from its actual configuration to its desired configuration.

Which policy measures are most effective depends upon the level of development of both the real and financial sectors. At low levels of development and in depressed areas within developed countries, pectoral imbalances need to be addressed. The most efficient means for achieving balance are income/output management policies that affect the real sector directly. Capital can be more easily accumulated through the direct efforts of government than through the indirect efforts of private individuals, who must obtain hurdle rates of profit to induce private money balances out of hoarding and into production. As the economy develops, however, the government's efforts must be redirected. It must look first and foremost, at developing a financial sector to keep money balances flowing into production at a fairly stable rate. This can be accomplished with the creation of financial intermediaries, which provide interest-bearing liquid depositories for money balances and loans to small businesses. As backup support to these financial intermediaries, the government must establish a central bank. Concurrently, the government must plan for financial markets, which provide for liquid ownership and large scale financing for larger firms. Financial markets can gain depth and breadth as the government successively privatizes its own enterprises.

At higher levels of development, income/output management policies become unwieldy and some form of demand management is more efficient. If the problem is erratic money supply growth, especially in a trade-dependent country, then neutralization of the money supply is key to obtaining non-inflationary growth. But successful money supply management can only be achieved if the monetary authority has the ability to react and respond quickly to adverse movements in the money supply. Reserve requirements, capital requirements, and liquidity ratios are bulky instruments of control. Discount rates and lender of last resort facilities are necessary, but not sufficient, since borrowing is at the discretion of the financial institutions. Open market operations are the most efficient means, but require a mature financial sector for successful control of the money supply. Foreign exchange operations may be required when the disturbances are external.

If the problem is erratic velocity, then neutralization of velocity is required. This can be achieved either through fiscal policy or interest rate policy. However, which instruments are ultimately chosen depends upon the source of this instability. The Keynesian-Monetarist debates have centered on private versus public sector sources of instability, e.g. erratic spending by government versus erratic spending by private sector economic participants on capital and consumer goods. This analysis goes further to seek out exactly the specific "drain" into which money balances are going. For example, throughout the 1980s, much of the new money supply was drained into financial speculation (options and futures trading, program trading, junk bonds, etc.) and takeover activity rather than new capital. Hence, low productivity and slow growth. An appropriate velocity management policy might have been to tax capital gains on speculative finance and use the proceeds to finance new ventures. This has the effect of transferring money balances from speculation back into the productive flow. If the problem is land speculation, the government can levy a land tax and redirect the proceeds to increase velocity on new production. If the problem is black markets, the government can legalize them, tax the transactions, and redirect the proceeds to increase velocity on new production. If the problem is inflation, the government can slow velocity by taxing more and/or spending less. If the problem is recession and unemployment, the government can increase velocity by reducing taxes and/or spending more. Alternatively, the monetary authority can raise interest rates to slow velocity or lower interest rates to increase velocity.

The above list of policy alternatives could be extended indefinitely; but, rather than making generalizations in this section, the next seven chapters are devoted to the theoretical links between policies and goals.

top     Summary



top    Readings

The Role of Expectations in the FRB/US Macroeconomic Model, Flint Brayton, Eileen Mauskopf, David Reifschneider, Peter Tinsley, and John Williams, Federal Reserve Bulletin, Apr 1997

Measuring and Analyzing Aggregate Fluctuations: The Importance of Building From Microeconomic Evidence, John C. Haltiwanger, Review (FRBStL), 79(3) May/Jun 1997, with Commentary, by Alan Heston and Commentary, by Jeffrey Campbell

Evaluating International Economic Policy with the Federal Reserve's Global Model, Andrew Levin, John Rogers, and Ralph Tryon, Federal Reserve Bulletin, Oct 1997

top    Websites



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