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CHAPTER 1 GENERAL MACROECONOMIC CONCEPTS |
"It is needful also not to charge the native commodities with too great customes, lest by indearing them to the strangers use, it hinder their vent. And especially forraign wares brought in to be transported again should be favoured, for otherwise that manner of trading ... cannot prosper nor subsist. But the Consumption of such forraign wares in the Realm may be the more charged, which will turn to the profit of the kingdom in the Ballance of the Trade, and ... enable the King to lay up the more Treasure...."Thomas Mun
- A Prologue to Methodology
- Methodologies - Schools of Thought
- The National Income Accounting Identity
- Expenditure Approach
- Income Approach
- Expenditure and Income Approach
- Types of Exchange Economies
- The Equation of Exchange
- Stock and Flow Variables and Analyses
- Time Dimension
- Uncertainty About the Future
- Consumption Functions
- Investment Functions
- What is Money?
- What is Money Supply?
- Money Demand Functions
- Money Supply Functions
- Money Illusion
- Competitive Markets and Price Flexibility
- Summary of Macroeconomic Concepts
- Summary of Keynesian and Monetarist Methodologies
Readings
I. A Prologue to Methodology
Thomas Mun was speaking as a true Mercantilist. Mercantilism is an economic doctrine that prevailed from, approximately, the end of the 15th century, commencing with the Age of Exploration, to the late 18th century, ending with the publication of Adam Smith's book, The Wealth of Nations. The goal of mercantilism was TREASURE! — To fill the king's coffers with as much gold and silver ("precious metals") as possible. The king needed "treasure" to hire soldiers to fight wars. Wars! Wars!
To achieve this goal, mercantilism favored international trade over domestic trade and manufacturing activities over raw materials activities. The mechanics for achieving the goal involved buying raw materials very cheaply from another country (a "colony"), processing the raw materials into high value-added manufactured articles, and selling the high value-added manufactured articles back to the raw materials country (the "colony"). The process would generate trade surpluses which would be settled in precious metals.
To achieve the goal, mercantilism advocated government involvement in economic affairs. The king was given great latitude to franchise monopoly corporations and trading companies in exchange for "kickbacks" and to levy duties on imports. The king made special treaties to obtain exclusive trading privileges, and the commerce of colonies was exploited for the benefit of the mother country. Production was carefully regulated with the object of producing goods of high quality and low cost, thus enabling a country to hold its place in foreign markets, earn a trade surplus, and bring in treasure.
A major problem with mercantilism is what to do with the inflow of "treasure." Without some mechanism for hoarding the treasure, mercantilist regimes would be plagued with an oversupply of money and serious inflation. Some mercantilists realized the danger of too much "treasure" flowing freely into the country and advised the king to melt it down and turn it into plates for his mantle until such time as he needed it to finance an army and he could take the plates down from the mantle and mint them into coin to pay for the soldiers. The idea sounds crazy, but it may actually have been the most rational and functional form of finance to sustain these economies and its success would have catapulted mercantilism as the mainstream paradigm into the present day.
However, functional finance did not prevail. Mercantilist economies were plagued with inflation. No countries were more plagued than Spain and Portugal. If treasure was truly the wealth of a nation, then Spain and Portugal should have won the mercantilist war. Why? They had ready-made access to all of the gold and silver in Latin America. Instead, they lost the war.
At the beginning of the mercantilist period, explorers from several European nations took off in cavalcades of ships to find Asia by sailing west. The Spanish and Portuguese explorers landed in what is now Central America, South America, and the Caribbean islands. To their surprise, they found gold! Wonderful, glorious gold! They didn't have to work for it. They had it solely for the mining.
The Spanish and Portuguese explorers brought home the gold in shiploads. They had it minted by the king and then went on a spending spree. Spanish and Portuguese merchants could not produce the products as fast as people demanded them. Prices rose.
Ordinarily, when prices rise, businesses increase output. However, in Spain and Portugal, another phenomenon was taking hold. The rate of return on exploration, namely, the amount of treasure one could bring back simply by sailing west, was greater than the return on production. Even as demand for domestic products increased, domestic businesses closed, output declined, and entrepreneurs went into the "exploration" business. Production in Spain and Portugal all but collapsed under the weight of their treasure.
Meanwhile, the British, French, and Dutch explorers landed in what is now North America. To their surprise, they found NO gold! They found only arable land. How disappointing! Or maybe not?
The British, French, and Dutch colonized North America. They produced cheap raw materials that were shipped back to the mother countries and manufactories in the mother countries transformed the raw materials into high value-added manufactured wares to sell back to the colonists. Throw in the taxes and the British, French, and Dutch monarchs reigned supreme.
England, France, and the Netherlands had a major advantage over Spain and Portugal. Spain and Portugal had discovered gold, but England, France, and the Netherlands had discovered productive resources. In the end, England, France, and the Netherlands could produce high valued-added manufactured products at prices well-below Spanish and Portuguese prices. Spain and Portugal ended up giving all of their gold to England, France, and the Netherlands just to buy the necessary items to feed, clothe, and shelter themselves.
The logic of mercantilism dictated the conclusion that the wealth of a nation lay in its stock of precious metals and had nothing to do with the productivity of the country. Productivity was merely a means to the end of acquiring the precious metals. Precious metals, on the other have could purchase anything. Demand created supply.
However, in 1776, Adam Smith disproved the logic of mercantilism and turned it on its head. After observing the economic histories of England, France, the Netherlands, Spain, and Portugal, he wrote the moral to the mercantilist story, namely, that the wealth of a nation lay not in its stock of precious metals, but in its stock of people, its resources, and its capital and that precious metals are merely a veil which allows us to acquire measure our wants and pay for them. The true wealth of a nation is its supply of resources, not the means to pay for them.
The paradigm derived from this body of economic literature, from Adam Smith (1776) down to John Stuart Mill (1850), held that "supply created demand" and that economies did not need governments to tell them what to do. Government should "laissez faire" — keep its hands out of economic affairs. Each individual acting in his or her own best interests would act in the best interests of society.
Was Adam Smith right and the Mercantilists wrong? No. Neither is right or wrong. Rather, what goes around, comes around.
In 1936, John Maynard Keynes debunked Smith's myth. He wrote that the postulates of the body of economic literature from Smith to Mill, which Keynes called the "the classical theory of economics," were "applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium." Living in a different time and a different place, Keynes proceeded to show that "the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience."
The time and place of Keynes writing was the early 1930s. Economies around the world were suffering from high rates of unemployment. Businesses were letting capital wither and die. Resources were plentiful. Why were they not being put to productive use?
Keynes concluded that demand was insufficient to purchase all of the product that businesses could produce. What we needed was more precious metals! We needed more money! We needed more spending! Keynes took economics both back to a mercantilist philosophy — demand creates supply and government involvement in the economy — and forward to a new set of fiscal tools for the government to use in solving the problems of the economy.
Well, which is it: "demand creates supply" or "supply creates demand"? Economist thought that they had fairly well sorted the chaff from the wheat when monetarists appeared on the scene in the 1970s. Monetarists were 20th century classical economists. Armed with more sophisticated tools and theoretical concepts, they upset the mainstream Keynesian paradigm with their own version of "supply-side" economics. Like the classical economists before them, they proceeded to demonstrate how excessive government involvement, especially in setting high tax rates and imposing excessive regulations on business, had hamstrung the U.S. economy and that lower taxes, less regulation, and smaller government were the keys to prosperity.
What we have observed throughout history — in the economic field as well as other social science areas (the "soft sciences") — are two predominant "methodologies," where the adherence to one denies the existence of the other. To illustrate, consider the following hypothetical situation:
You are driving home from work/school one day and are involved in a major automobile accident. You are thrown from your automobile and you lay bleeding on the side of the road. Two cars pull over and stop. Both cars are driven by doctors. The doctors get out of their cars and rush to your side.
Dr. Monetarist looks at you, holds his hands to the heavens, and yells, "Body heal thyself!"
Dr. Keynesian, kneeling beside your body, looks up at Dr. Monetarist and exclaims, "What? Are you crazy? If we don't stop this bleeding, call an ambulance, and get this person to the hospital immediately, s/he will die."
Dr. Monetarist looks down at Dr. Keynesian as if he is crazy. "My dear, Dr. Keynesian, from medical school, do you not remember our lectures on the natural laws of biology and the natural healing processes of the body?"
"Dr. Monetarist, you may well be right in the long run, but if we don't stop the bleeding now and get this person to the hospital, s/he will surely die. Here, give me your shirt so that I can make tourniquets to stop the bleeding while we wait for the ambulance."
A few minutes later the ambulance arrives. The patient is loaded onto a guerney and pushed into the ambulance. The ambulace speeds off to the hospital, but the patient is DOA on arrival. Why? It turns out that Dr. Keynesian tied the tourniquets too tight."
The hypothetical illustrates two different methodologies or approaches to practicing medicine. Neither is right, neither is wrong. They are just different. Adherence to one methodologiy assumes denial of the other. No one can be both kinds of doctors at the same time.
The same with economics. Since countries emerged from the dark ages and economic activity was legitimized, the study of economics has been governed by two different methodologies or approaches. These methodologies or approaches have competed for center stage. Sometimes one, sometimes the other holds the starring role. Like the medical methodologies, neither is right adn neither is wrong. They are just different. Adherence to one, denies the existence of the other. No one can be both at the same time. Keep this in mind as you continue through this book and the rest of the semester.
II. Methodologies
A methodology is a perspective or framework from which one approaches a problem. Two methodologies pervade the "soft sciences." A "soft science" (as opposed to a "pure science," like mathematics) is one which involves human beings --- human interaction with other human beings and with nature. Humans, unlike inanimate objects, learn from experience so that temporal responses are not easy to predict. The methodology presupposes certain characteristics about humans to simplify the process of explaining human behavior.
These methodologies may appropriately be identified as Left School and Right School. The Left School is oriented toward society as a whole, while the Right School is oriented toward the individual. As a result, affirmative policies tend to emerge from the Left school, while passive policies tend to flow from the Right School.
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Social sciences do not exhibit the same revolutionary breakthroughs as the pure sciences. Each methodology is omni-present and evolves over time. At any point in time, only one methodology dominates (the "mainstream" paradigm). When the conclusions of the "mainstream" paradigm fail to explain observed behaviors, the "latent" paradigm emerges and the replaces the "mainstream" paradigm. However, each time replacement occurs, the "latent" methodology emerges with an evolutionary, updated twist on its last assumptions about humans and human behavior. Monetarism is contemporary Classical economics and Keynesianism is contemporary Mercantilism; and, just as Classical economics replaced Mercantilism, Keynesianism replaced Classical economics, and Monetarism replaced Keynesianism.
Selection of a methodology creates a pre-scientific bias to one's approach to economic problems. Being an adherent to one methodology absolutely precludes use of the other methodology. This book attempts to explain the policies and policy theories of both methodologies.
III. The National Income Accounting Identity
Both the Left (Cambridge-Keynesian) and Right (Chicago-Monetarist) methodological approaches start with the National Income Accounting Identity. The identity sets the outer boundary for macroeconomic theory and policy analysis.
The National Income Accounting Identity states that all production for an economy is identical to the amount of income for the economy:
Y GNI
where GNP is Gross National Product, GNI is Gross National Income, and Y is a proxy variable for both GNP and GNI.
Gross National Product (GNP) is the total market value of all final goods and services produced for an economy over some time period, not for resale and not for resale in that time period:
Y PQ
where Q is the quantity of real output and P is the general level of prices.
Gross National Income (GNI) is the total value of all income earned by the factors of production:
Y wL + iK + rR + 
+ sp + ibt + cca
where w is the wage income earned by labor (L), i is the interest income earned by lenders to businesses to buy capital (K), r is the rental income received by landlords for the use of land and other natural resources (R),
is the profit income earned by entrepreneurs or shareholders, sp is the income earned by sole proprietors, ibt are the indirect business taxes collected by businesses and remitted to the government, and cca is capital consumption allowance or depreciation.
Gross Domestic Product (GDP) is total production within the country. It is GNP less net factor income from abroad:
Thus, GNP or GDP may be viewed either from the Expenditure Approach or the Income Approach and then from the Expenditure and Income Approach.
IV. Expenditure Approach
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n
GNP =
piqi = PQi=1
where Q is a measure of real output and P is the general level of prices. For purposes of analysis, the economy is divided into four spending groups:
PQ C + Ig + G + Xn
where C is consumption or spending by households on domestically produced consumer goods and services, Ig is investment or gross spending by businesses on domestically produced capital goods, G is government spending on domestically produced goods and services, and Xn is net exports or spending by foreigners on the home country's goods and services (exports) less spending by the home country on foreign goods and services (imports).
Personal Consumption (C) is the flow of spending by households on consumer goods and services that have been newly produced by domestic businesses. Since households buy goods and services for direct satisfaction, all consumption is on final goods and services.
Investment (Ig) is the flow of spending by businesses on capital goods that have been newly produced by domestic businesses. It includes both residential and nonresidential investment. It includes spending on fixed capital (If) and changes in inventories (Inv):
If + 
Inv If + Iv
Fixed capital is the buildings, equipment, and machines which are bought by firms for use in the production of other goods and services. It is destined to be consumed by the firm and not to be resold. Therefore, GNP includes the value of all newly produced fixed capital.
Inventories are the raw materials and semi-finished goods bought by firms to be processed and resold to other firms at higher stages of production. During the year, businesses buy raw materials and semi-finished goods and transform them into new products. The transformation process adds value to the raw materials and semi-finished goods. This change in the value added to the raw materials and semi-finished goods is called the net change in inventories. Only the net change in inventories during the year is included in GNP:
Inv Iv
Both fixed capital investment and inventory investment include spending on replacement capital as well as new capital. Replacement investment (Ir) is spending on capital to replace the portion of the fixed capital stock that has worn out during the year. It is some fraction of the existing stock of fixed capital:
dK
New investment or net investment (In) is spending that changes in the aggregate capital stock. It includes spending on newly produced fixed capital as well as changes in net inventories:
Kt - Kt-1
The importance of net investment is that it shows the direction of movement in an economy. A stationary economy (In = 0) is one in which business spending merely replaces that portion of capital stock which has worn out. The resource base is constant. An expanding economy (In > 0) is one in which business spending adds to the capital stock. The resource base is increasing. A contracting economy (In < 0) is one in which the capital stock is wearing out faster than it is being replaced. The resource base is decreasing.
Gross domestic business investment is the sum of replacement investment plus net investment:
Ir + In dK + (Kt - Kt-1)
Government expenditure (G) is the flow of spending by government on final goods and services as well as direct payments to labor for services rendered. (Transfer payments are considered as net tax collections (±T = Tn = - T + R) rather than as expenditures.)
Net exports (Xn) is the balance of trade (exports minus imports):
Exports (X) are sales of goods and services by the home country to foreigners, travel and tourism in the home country by foreigners, and transfers of income in the form of wages, interest, rent, and profits by foreigners to residents of the home country. Since exports generate employment and income for the home country, they get added into the GNP accounts.
Imports (H) are the sales of goods and services by foreigners to the home country, travel and tourism abroad by residents of the home country, and transfers of income in the form of wages, interest, rent, and profits by residents of the home country to foreigners. Since imports generate employment and income abroad rather than for the home country, they get subtracted out of the GNP accounts.
Only net exports are included in GNP because imports are paid for out of current income and if decision-makers are buying foreign goods, which generate income for foreign factors of production, they cannot be paying for domestically produced goods, which generate income and employment at home.
V. Income Approach
Gross National Income (GNI) is the total income earned by the factors of production:
Y wL + iK + rR + + sp + ibt + cca,
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is the profit income earned by entrepreneurs or shareholders, sp is the income earned by sole proprietors, ibt are the indirect business taxes collected by businesses and remitted to the government, and cca is capital consumption allowance or depreciation for the portion of the capital stock that wears out each year.
Net National Product (NNP) is the income which could be made available to the factors of production in a two-sector economy (no government) after allowance is made for the wear and tear on capital during the production process:
Capital consumption allowance (cca) is the wear and tear on capital in the production process. It is a non-income charge since it is not an explicit payment. Capital consumption allowance is a form of forced saving by business (Sb) because it is part of current income that is unavailable for spending.
Depreciation is the real world accounting technique used to account for the wear and tear on capital on a per period basis. The depreciation of capital may or may not mirror the actual capital consumption, since several different accounting techniques are available to the firm for tax purposes.
National Income (NI) is the income which could be made available to the factors of production if governments collected only indirect business taxes (sales and excise taxes):
Indirect business taxes (ibt) is a tax (T) which is levied and paid at one point, but is designed to be passed along and born by someone else. Examples of indirect taxes are sales taxes, excise taxes, and tariffs.
Personal Income (PI) is the gross income of households after adjustment is made for corporate profit taxes, retained earnings by business, private transfers, and government transfers:
| PI | = | NI | - | corporate profit taxes, |
| - | retained business earnings, | |||
| ± | private transfers, and | |||
| ± | government transfers, including social welfare payments and benefits and interest on the national debt |
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Corporate profit taxes are levied by the government on corporate profits (T). These taxes are unavailable to the factors of production.
Retained business earnings are the portion of after-tax profits that are kept by the corporation and become part of its net worth. They are a form of voluntary saving by business (Sb) Retained earnings are unavailable to the factors of production. The portion of after-tax profits that not retained by businesses are available to the factors of production. They are paid to shareholders as dividends.
Private transfers are gifts from one individual or institution to another. When income is transferred, it is not spent. Therefore, it is saved. When the transferred income is received, it may be spent or saved. The result of private transfers is net saving (Sn).
Government transfers redistribute the national income by taxing some individuals or institutions and subsidizing others. Included in tax collections are Social Security payments into the fund. Included in tax transfers are Social Security payments from the fund and interest on the national debt. The result of government transfers is net tax collections (Tn = - T + R).
Disposable Personal Income (DPI) is the portion of GNI that households receive in monetary form. It may be either spent or saved.
Consumption (C) is what is spent on domestically produced goods and services. (Note: What is spent on foreign goods and services is included as imports in net exports.)
Saving (Sh) is what is not spent by households on domestically produced goods and services. Saving in no way implies how this portion of unused income is disposed. Ultimately, interest rates and liquidity preferences determine the destination of saving.
The National Income Accounting Identity can be rewritten in terms of the Expenditure and Income Approach.
VI. Expenditure and Income Approach
The National Income Accounting Identity as an Identity
An identity is a representation of a relationship where both sides are perfectly equal because they have been defined in such a way to be equal. Each side carries equal weight. Neither side is independent (cause) and neither side is dependent (effect). If either side changes, however, an identity states that the other side must change by the same magnitude and in the same direction. When one side changes, the other side changes, but nothing in an identity indicates which side will actively change and which side will passively respond.
As an identity, the National Income Accounting Identity states that the sum of all spending must equal the sum of all income or, more simply stated, the sum of all purchases must equal the sum of all sales.
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Equilibrium Condition Equilibrium is a state of rest, from which there is no tendency to change. GNP will remain the same, ex post, if injections equal withdrawals, ex ante. As long as spending plans are exactly equal to production plans, everything produced will be sold and there will be no incentive to change the existing pattern of income and production.
Disequilibrium Condition Disequilibrium is a state of unrest, from which there is a tendency to change. GNP will change, ex post, if injections are not equal to withdrawals, ex ante. If ex ante injections are less than ex ante withdrawals (an excess of saving), inventories will accumulate. With an excess of inventories, profits will fall. Firms will cut back on production, hire fewer workers (in the short-run), and pay out less income. GNP will fall, ex post. If ex ante injections are greater than ex ante withdrawals (an excess of spending), inventories will decumulate. With a decumulation of inventories, profits will rise. Firms will increase production, hire more workers (in the short-run), and pay out more income. GNP will rise, ex post.
The National Income Accounting Identity as a Functional Equation
A functional equation turns an identity into cause and effect. One side of the functional equation is independent (cause) and the other side is dependent (effect). The variables in the identity now have functional meaning, in that any change in the independent variable(s) (cause) brings about a change in the dependent variable (effect).
The National Income Accounting Identity can be turned into two functional equations. One equation shows that changes in expenditure cause changes in income
and the other equation shows that changes in income cause changes in expenditure.
The Keynesians Versus the Monetarists
Keynesians believe that "demand creates its own supply" or expenditure determines income. They write the National Income Accounting Identity so that income (Y) is a function of planned expenditure (Ep) on all newly produced final goods and services:
Y = Ep = C + Ig + G + Xn
Monetarists believe that "supply creates its own demand" or income determines expenditure. They write the National Income Accounting Identity so that planned expenditure (Ep) on all newly produced final goods and services is a function of income (Y):
Ep = Y = w + i + r +
+ sp + ibt + cca
Thus, from the very outset of any economic analysis, Keynesians and Monetarists look at the economy from very different viewpoints.
VII. Types of Exchange Economies
The Barter Production Economy
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The barter economy is a system of relative prices. All assets are valued in terms of all other assets. Buyers and sellers must know the relative prices of all real assets (Pa/Pb). As the number of real assets increases, the number of relative prices increases geometrically (n(n-1)/2). Prices continually vary in response to supply and demand.
The barter economy requires a double coincidence of wants. The buyer must have a real asset, which the seller wants, in exchange for what the seller has for the buyer. Otherwise, trade involves intermediate transactions until the buyer and seller have acquired what each other wants. Specialization and division of labor is very difficult. People do not always want to work for the real assets that the employer is giving as compensation. Even the government is reduced to collecting taxes as real assets and, then, it has only these real assets to spend.
A barter economy has a very low investment rate. Real investment (capital formation) must come directly from real saving. Any capital formation that does occur generally comes from the owner. For example, a farmer must set aside some of his crop from this year to get the seeds to plant next year. Tying up real saving in real investment is extremely risky. Fixed capital is difficult to accumulate, because firms that manufacture fixed capital do not necessarily manufacture the same equipment that they use in the manufacture of the new capital. If they did, they would have to take time away from the manufacture of the new capital to make their own equipment. Because saving must precede investment, the whole process is tedious and time-consuming.
The borrowing and lending process is extremely cumbersome. Future repayment requires a contract written in terms of real assets that are acceptable to both parties; but, the value of these real assets may change drastically by the time future payment is due. As a result, growth and development occur at an extremely slow rate.
The Monetary Production Economy
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The Equation of Exchange shows the relationship between money, its velocity, and the things that are being bought.
The Transactions Version explains how the supply of money balances, circulating through the economy, generates an equal and offsetting volume of nominal transactions:
PT,where Ms is the supply of money balances, V is the velocity or rate of circulation of these money balances, P is the general level of prices of all transactions, and T is the number of transactions.
The Income Version shows how the supply of money balances, circulating through the economy to buy newly produced final goods and services, generates an equal and offsetting volume of income for the factors of production:
PQ YM1V1
P1Q1 Y,
where Vy is the income velocity of money balances, P is the general level of prices for newly produced final goods and services, Q is the volume of real output of newly produced final goods and services, and Y is nominal income paid to the factors of production.
Money improves upon the barter production economy.
- Money establishes a uniform set of prices. Money becomes the standard for valuing all other assets (Pa/monetary unit = Pa/1). Prices are measured in absolute terms and people have only to compare the absolute prices to determine value.
- Money is a generalized claim with fungible properties. It separates the sale of an asset from the purchase of an asset and eliminates the double coincidence of wants. Anyone, including governments, can use anyone else's money balances to enter any market to buy any good or service.
- Money allows for increased specialization and division of labor. Any individual can go to work for any employer, receive an income in the form of money, and then spend that money in any market at any time.
- Money facilitates borrowing and lending. Contracts for principal and interest are written in money terms. Both parties know exactly what the future value of the contract is.
- Money simplifies the investment process. Nominal investment comes from nominal saving (the accumulation of money balances by surplus income units).
- The introduction of money gives government a uniform tax basis for levying and collecting taxes. governments can tax and spend money just like the private individuals and businesses.
P1Q1 Y
In a dysfunctional monetary production economy, some money circulates to buy capital sinks.
P2Q2
Capital sinks include land, objets d'art, sacred cows, relics, and underground activities like prostitution, drugs, and gambling. Capital sinks do not create income and employment. They are simply asset transfers. They drain money from its circulation in the production economy.
The Credit Production Economy
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In a credit production economy, money balances are borrowed and loaned in anticipation of spending. To induce hoarders to become lenders, borrowers must offer a return to compensate the lender for the opportunity cost of hoarding, either speculating or buying into capital sinks, and for the risks associated with lending. The higher these opportunity costs and risks, the higher the return which must be paid as compensation. But when high returns must be paid to lenders, even higher returns must be earned from the use of money balances. The higher the required return in use, especially in investment, the fewer the number of capital projects which will be undertaken and the slower the rate of both velocity and capital accumulation for growth and development. Velocity can be increased by reducing risk and increasing liquidity for the lender. Reduced risk and increased liquidity can be accomplished through intermediation in the form of either semi-direct (mutual funds) or indirect finance (financial intermediaries like banks and thrift institutions). In fact, the vital roles played by financial intermediaries are to make that which is more risky less risky and to make that which is less liquid more liquid.
In a functional credit economy, money circulates from the real sector through the financial sector and back to the real sector to create income and employment.
P1Q1 Y
In a dysfunctional credit economy, some money circulates in the real sector, but some money circulates only in the financial sector for speculation and never finds its way back to the real sector.
P3Q3
Like capital sinks, speculation does not create income and employment. It is simply an asset transfer and drains money from its circulation in the production economy.
VIII. The Equation of Exchange
The Equation of Exchange is a relationship between the money supply and the value of transactions created by its velocity or circulation. When people spend more, velocity goes up. When people spend less, velocity goes down.
The Equation of Exchange as an Identity
As an identity, the Equation of Exchange states that effective aggregate demand must equal aggregate supply, or, more simply stated, the sum of all purchases must equal the sum of all sales.
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PT,
where Ms is the supply of money balances, V is the velocity or rate of circulation of these money balances, P is the general level of prices of all transactions, and T is the number of transactions.
The Income Version shows how the supply of money balances, circulating through the economy to buy newly produced final goods and services, generates an equal and offsetting volume of income for the factors of production:
PQ Y,
where Vy is the income velocity of money balances, Q is the volume of real output of newly produced final goods and services, and Y is nominal income paid to the factors of production. Since GNI includes only transactions for newly produced final goods and services , the money supply so circulating yields GNP (= PQ), where Q is the quantity of newly produced final goods and services and P is a measure of their prices.
MsVy PQ GNIGNP
GNI
The Equation of Exchange as a Function
As a functional equation, the Equation of Exchange shows that a change in money supply, velocity, prices, or output causes a change in one or more of the other variables. The Equation of Exchange can be turned into many different functional equations. Each equation is used by a different methodological school. The only equation that both schools use in comon is the Marshallian money market equilibrium equation, which is really an identity.
Quantity Theory of Money (Classical economists, Monetarists)
| P = |
MsVy Q |
or | P = f(Ms)|Vy, Q |
Velocity (Vy) and real output (Q) are assumed to be constant, and a change in the money supply (Ms) causes prices (P) to change. The Classical Quantity Theorists concluded that a percentage change in the money supply leads directly to an equal and offsetting percentage change in prices, ceteris paribus. This version of the equation of exchange makes money a "veil" that determines only the absolute level of prices and has no affect on the level of real output or trade.
New Quantity Theory of Money (Monetarists, Supply-siders)
Velocity (Vy) is considered constant (or stable and predictable) and a change in the money supply (Ms) causes nominal income (PQ) to change. The Monetarists conclude that a percentage change in the money supply leads directly to an equal and offsetting percentage change in nominal income, ceteris paribus. This modified version of the equation of exchange allows for changes in the money supply to affect real output, depending on its relationship to natural output. If actual output is below natural output, then an increase in the money supply will increase real output. As actual output comes closer to natural output, the impact of an increase in the money supply is felt less in additions to output and more in rising prices.
Money Stimulates Trade Doctrine (Mercantilists, Keynesians)
| Q = |
MsVy P |
or | Q = f(Ms)|Vy, P |
Velocity (Vy) and prices (P) are considered constant and a change in the money supply (Ms) affects real output (Q). The Mercantilists and Keynes reasoned that a percentage change in the money supply leads directly to an equal and offsetting change in real output, ceteris paribus. This version removes money as a "veil," since the amount of money supply in circulation has a direct impact on the real sector of the economy.
Lockean Version (John Locke, Keynesians)
| Vy = |
PQ Ms |
or | Vy = f(1/Ms)|PQ |
Nominal output (PQ) is considered to be constant, because any change in the money supply (Ms) is offset by a change in velocity (Vy).
Money Market Equilibrium Condition (Alfred Marshall, Monetarists, Keynesians)
|
Ms (
|
1 Vy |
)PQ kPQ Md
|
The Marshallian "k" is the inverse of velocity. The money market equilibrium condition emphasizes money "sitting" rather than circulating. "k" may be constant or predictable, as in the Classical and Monetarist models, or variable, as in the Lockean and Keynesian models.
Liquidity Trap (Keynesians)
| k = Md = |
Ms PQ |
or | k = Md = f(Ms)|PQ |
Nominal output (PQ) is considered to be constant, because any change in the money supply (Ms) causes the demand for money Md to change by an equal and offsetting amount. The liquidity trap is a variation of the Lockean version, using the Marshallian k (the demand for money) rather than the velocity of money.
Theory of Reverse Causation (Keynesians)
| Ms = |
PQ Vy |
or | Ms = f(P,Q,Vy) |
A change in any of the variables --- prices (P), real output (Q), or velocity (Vy) --- causes the money supply (Ms) to change. The money supply is no longer an exogenous variable to be controlled by the central bank, but rather it is an endogenous variable, determined by the demand for money and the level of economic activity. This phenomenon occurs, especially, in a fractional banking system, where control of the money supply is shared by the central bank and the commercial banks, and in an open economy, where part of the original domestic money supply flows in and out of the country in response to current and capital flows.
The Value of Money
The value of money is its purchasing power:
| Ms = | 1 P |
When prices go up, the value of money goes down. When prices go down, the value of money goes up.
IX. Stock versus Flow Variables and Analyses
Differentiating Stock and Flow Variables
A stock variable is something that exists at a point in time. If one stops and holds time still, one can observe the world as it is. What one sees at that point is the current stock. For example, at any one point in time, one observes only one set of prices. Anything that can be valued at a point in time by the set of prices at that time is a "stock" variable. Stock variables are found on balance sheets:
At any one point in time, one can locate and value one's assets: homes, cars, stereos, stocks, bonds, and money balances. Businesses list their stocks of cash, accounts receivable, inventory, and fixed capital in their balance sheet statements. The sum of all assets is total wealth.
At that point in time, one may also have liabilities or debts owed to others: mortgages, loans, notes, bonds issued, etc. Net worth or net wealth is total assets (total wealth) minus total liabilities.
Stock variables are money supply, food, clothing, bonds, and savings accounts. As money is exchanged for other assets, and vice versa, income and expenditure adapt passively. Changes in the money supply lead to passive changes in income and output based upon its velocity or rate of "flow" through the economy:
A flow is something that occurs over time. One cannot observe a flow at a point in time, but rather only as time passes. Over time, one earns income and one makes expenditures. What one does not spend, one saves. Saving is loaned to households, who borrow to buy real estate and consumer goods, to businesses, who borrow to buy capital goods, to governments, who borrow to buy social overhead capital and pay military and civilian personnel, and to foreigners, who borrow for the same reasons. One cannot see income, spending, saving, investment, borrowing, or lending, except as time passes. Flow variables are found on income statements.
Flow variables are income, spending, and saving. As income is spent, the stock of assets adapt passively. Changes in velocity lead to passive changes in the "stock" of assets:
Relationship of "Stock Variables" to "Flow Variables"
While the two terms have separate and distinct time interpretations, they are linked in the following sense. The difference between two stocks, one at time t0 and the other at time t1, is the net of all flows between t0 and t1.
Suppose a person takes an inventory of everything one has and owes at 12:00 midnight December 31. At that point, he has a house, a car, three cans of beans, a dozen hot-dogs and rolls, and $100 in the bank. The next day is a holiday. He does not work, he earns no income. However, to survive, the person consumes a can of beans and four hot-dogs on rolls. His net wealth has shrunk by the amount of consumption during the holiday. The second day the person works. After work he goes to the bank for $50. With that $50 he takes his girlfriend out for dinner. The third day he works, and after work, he goes home and consumes another can of beans and four hot-dogs on rolls. The fourth day the person works, and after world he goes to the bank to draw out another $50 to spend on dinner. The fifth day the person works, but now he gets paid for all five days --- $1,000. The $1,000 is his income. After work, he goes to the bank and deposits $900, talking $100 in cash. He goes to the supermarket and buys food. When he returns home, he once again stops, holds time still, and takes stock of his assets. What he has at this point --- a house, a car, one can of beans, four hot-dogs, four rolls, an additional $100 in food, and $900 in the bank --- is the net difference in the flow that took place over the last six days.
The Keynesians Versus the Monetarists
Keynesians analyze economic behavior and activity in terms of flow variables. They look at the economy "over time." Keynesian economic participants respond to flow disturbances and changes in "flow" variables. Stocks adjust passively in the Keynesian framework. Keynesian macroeconomics policies are designed to control velocity (flow).
Monetarists analyze economic behavior and activity in terms of stock variables. They look at the economy "at a point in time." Monetarist economic participants respond to stock disturbances and changes in relative prices. Flows adjust passively in the Monetarist framework. Monetarist macroeconomic policies are designed to control the supply of money (stock).
X. Time Dimension
Differentiating the Short Run from the Long Run Periods
The short-run time period is a period of imperfect adjustment to a situation perceived as temporary. The short-run is the period in which a demand disturbance alters the capacity utilization rates of existing plant and equipment or a supply disturbance temporarily alters the consumption/saving ratio of households.
The long-run time period is the period in which all economic participants have had the opportunity to evaluate existing economic events and to realize any and all possible adjustments permanently.
While the two time periods have different effects, they are inextricably linked in the sense that the long-run is nothing more than the sum of its short-run periods and short-run disturbances may ultimately alter long-run behavior. In the long-run, short-run demand and/or supply disturbances permanently alter the buy level and composition of demand as well as the quantity of all resources available for production and the pattern of resource usage.
Short Run and Long Run Adjustment Processes
Short-run adjustments In the short-run, the resource base remains relatively fixed and firms produce more or less in response to perceived temporary shifts in the consumption/saving ratio. The consumption/saving ratio changes aggregate demand. Changes in the consumption/saving ratio may be caused by either a change in money balances or a change in income velocity.
When the consumption/saving ratio increases, economic participants spend relatively more than they save. Inventories are involuntarily decumulated. To replace lost inventory, businesses increase production. They hire more workers. Employment increases and unemployment decreases. Capacity utilization increases and excess capacity decreases. As capacity utilization increases, marginal and average costs begin to rise, necessitating price increases.
When the consumption/saving ratio decreases, economic participants save relatively more than they spend. Inventories are involuntarily accumulated. To run off inventories, businesses decrease production. They lay off workers. Employment decreases and unemployment increases. Capacity utilization decreases and excess capacity increases. When costs are cut sufficiently, prices respond in kind.
A supply-side shock will also alter the consumption/saving ratio in the short-run. In the short-run, households will continue to spend more or less of their income to maintain a certain level of comfort. When a supply-shock forces up prices, the higher cost consumption is paid for by sacrificing saving. The consumption/saving ratio increases. When a supply-side shock reduces prices, economic participants respond in the short-run by consuming the same amount and adding the surplus income to saving. The consumption/saving ratio decreases.
Long-run adjustments In the long-run, firms respond to changes in the consumption/saving ratio by altering the size of their production facilities. Firms either add to capacity in response to an increased consumption/saving ratio or eliminate excess capacity in response to a decreased consumption/saving ratio. As capacity utilization rates increase, firms seek to expand. Aggregate demand increases as firms seek to spend down money balances to acquire new capital goods. Eventually, capital costs and interest rates increase. As the new capacity is added and brought on-line, capacity utilization rates decrease. This new capacity reduces cost pressures. Price and interest rate increases top out, stabilize, and eventually fall. The more new capacity is added, the less additional capacity is needed. This slow down in investment reduces pressures on capital prices and interest rates. As capacity utilization decreases, firms seek to become "leaner and meaner." Aggregate demand falls as firms close older, less productive facilities and divest and sell off excess capital. Capital costs and interest rates decrease. Price decreases bottom out, stabilize, and eventually rise as aggregate demand returns to its long-run equilibrium level.
In the long-run, households respond by restoring the velocity of their money balances and their consumption/saving ratio to a more "normal" level. If a short-run supply shock permanently raises prices, households are forced to cut consumption to restore velocity and the consumption/saving ratio to its more "normal" lower level. Households cannot live on credit and consume in excess of their income indefinitely. Eventually, this consumption must be paid for through increased saving. On the other hand, if a short-run supply shock permanently reduces prices, households adjust upward their consumption levels to improve their comfort. This increased spending raises velocity and the consumption/saving ratio to its more "normal" higher level, as the additional consumption is financed from saving.
As expansion and contraction of the economy proceed, the composition of demand and the pattern of resource allocation is changed to reflect the new economic circumstances. During an expansion, not all industries experience the same demand growth. In fact, the demand for some output may actually contract as economic participants substitute newer, better models as well as new products. During a contraction, not all industries experience the same contraction in demand. In fact, the demand for some output may actually be growing as economic participants readjust their buying patterns in response to changes economic circumstances.
The Keynesians Versus the Monetarists
Keynesians use a short-run time frame to explain the levels of income and employment over the course of a typical business cycle. Their primary concern is over temporary changes in the velocity of money supply circulation which changes as the consumption/saving ratio changes. Velocity increases when the consumption/saving ratio increases and velocity decreases when the consumption/saving ratio decreases.
Monetarists use a long-run time frame to explain the levels and patterns of demand and resource allocation that emerge after all possible adjustments have been realized. In the long-run, velocity is assumed to be stable (or at least, predictable). Their primary concern is over temporary changes in the money supply which alter the long-run equilibrium consumption/saving ratio.
XI. Uncertainty About the Future
The future plays an important role in most human activities. In economics it is no different, for the economic actions of today are the basis for the economic fortunes or disasters of tomorrow. Yet, most economic actions are taken based on a perception of the future that is not known ahead of time. Therefore, decisions are made and actions are taken in anticipation of an uncertain future.
Two Kinds of Uncertainty
True uncertainty or non-measurable uncertainty Neither of these uncertainties is measurable. True uncertainty is incapable of quantification and insurability. Thus, it cannot be included in a model easily, without making subjective valuations of how economic participants respond to disappointing expectations about the future. In a world with true uncertainty, economic participants must remain more liquid in anticipation of disappointments down the road. Not all assets are perfect substitutes for one another; but rather, they are only imperfect substitutes. Segmentation is based on the assets' liquidity properties.
Probabilistic uncertainty or predictable uncertainty or risk Each of these can be measured. All events are known and can be assigned weights or probabilities that sum to 1.0, such that a definitive and calculable outcome is possible. Such definitive and calculable outcomes are certain in the sense that they can be predicted with some measure of confidence. This type of uncertainty or risk is very often insurable against disappointment, e.g. life insurance, fire and theft insurance, etc. Predictability and insurability take the guess world out of decision-making. Economic participants are never subject to disappointment, because they know what the future holds. Therefore, they can buy and sell all assets (both real and financial) without fear of becoming illiquid in the future. Assets are perfect substitutes for one another (Axiom of Gross Substitution).
Probabilistic uncertainty also provides a manageable methodology for models that draw conclusions about the real world. These models are often justified on the grounds that
- they eliminate subjective factors,
- they ease the mathematical and verbal exposition, and
- a world of disappointed expectations results in a level of turbulence beyond the skill of model builders to analyze.
Keynesians believe that the future is not measurable or known in any probabilistic sense. For Keynesians, time moves in only one direction --- forward. But while the past may be known for certain, the future is not. Since money is always needed to enter the [real and financial] markets, not all assets are perfect substitutes for one another. Economic participants will always hold some idle money balances for precautionary purposes. How much economic participants hold in this capacity is a "measure of their uncertainty about the future." To Keynesians, a monetary production economy operating with complete certainty (or probabilistic uncertainty) is a contradiction in terms. Keynesian theory emphasizes the reasons for holding money balances, otherwise known as "money sitting."
Monetarists believe that the future is certain or at least calculable or known in the probabilistic sense. Therefore, in the Monetarist framework economic participants have no need to hold precautionary balances. All assets are perfect substitutes for one another (Axiom of Gross Substitution). Monetarists sympathize with Adam Smith, who said, "A man must be perfectly crazy who, where there is tolerable security, does not employ all the stock which he commands, whether it be his own or borrowed of other people, in some one or other of [these] three ways: for his own present consumption, for future profit from production, or future profit from lending." Monetarists believe money is to be spent. Accordingly, if people have a little more, they will spend a little more if they have a little less, they will spend a little less. Monetarist theory emphasizes the reasons for spending money balances, otherwise known as "money on the wing."
XII. Consumption Functions
Consumption (C) is household spending on newly produced domestic goods and services. By definition, all consumer goods and services are final goods and services.
Consumer Expenditure Versus Consumption Expenditure
Consumer expenditure is the amount spent annually by households on final goods and services. It considers only the actual dollar amount spent during the year and not the economic life of purchases, which, depending on the durability of the good, may last several years. Because of the durability of these goods, their replacement can be timed. Replacement can take place on a regular basis (i.e., trading-in and upgrading an auto every three years) or it can be postponed indefinitely (i.e., until the auto literally dies). Because the durable goods component of annual consumer expenditure is very erratic, this spending can vary widely each year. The actual amount of consumer spending in any time period depends upon the income and borrowing constraints of households during the period.
Consumption expenditure is the annualized flow of household spending. It differs from consumer expenditure in that it is the amount of consumer expenditure "amortized" by households. For example, if total consumer expenditure was $2.7 billion in 1986, and $1.7 billion was spent on non-durable goods, while $1.0 billion was spend on durable goods, then total consumption expenditure depends on the average life of the consumer durable. If the average life of consumer durables is ten (10) years, then the $1.0 billion is amortized at a rate of $100 million per year and total consumption expenditure for 1986 was $1.8 billion. Thus, consumption expenditure measures the "use" or "using up" of consumer goods or wealth over time rather than the per period consumer expenditure.
The Keynesians Versus the Monetarists
Keynesians rely on total spending in a fixed time period to determine income, employment, and prices for that period. They use consumer expenditures as the measure of household spending. In the Keynesian model, consumption (annual consumer expenditure) is primarily a function of current disposable income:
According to Keynes, in the short-run, households prefer comfort to security:
"This is especially the case...of the so-called cyclical fluctuations of employment during which habits, as distinct from more permanent psychological propensities, are not given time enough to adapt themselves to changed objective circumstances. For a man's habitual standard of life usually has the first claim on his income, and he is apt to save the difference...between his actual income and the expense of his habitual standard; or, if he does adjust his expenditure to changes in his income, he will over short periods do so imperfectly. Thus a rising income will often be accompanied by increased saving, and a falling income by decreased saving, on a greater scale at first than subsequently.When households receive income, they immediately allocate it between consumption and saving according to the marginal propensity to consume out of income (b):
"For the satisfaction of the immediate primary needs of a man and his family is usually a stronger motive than the motives toward accumulation, which only acquire effective sway when a margin of comfort has been attained."
Therefore, if income rises, households may spend a little bit more, but they will probably continue to spend about what they did before the increase in income. What is left over is saved and is added to their pool of savings (accumulated wealth). If income falls, households may spend a little bit less, but they will probably continue to spend about what they did before the decline in income. Spending in excess of income is financed out of past savings (accumulated wealth) or by borrowing from the savings (accumulated wealth) of others. What real goods they buy or how they deploy their saving in terms of other assets is irrelevant. The stock of real and financial assets adjusts passively to the marginal propensity to consume."The fundamental psychological law...is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, cut not by as much as the increase in their income."
The Consumption Function C
Ca - bTaC = Y
C = (Ca - bTa) + b(1-t)YdYlow Yb Yhigh Yd D = Dissaving = (Y - C) < 0 S = Saving = (Y - C) > 0
The Keynesian approach is also known as the income effect. As disposable income changes, households spend more or less, depending on whether current disposable income is rising or falling. In the diagram to the right, the income effect moves households along the consumption function from Ylow to Yhigh, and back again, as income changes.
Monetarists rely on Say's Law: "Supply creates its own demand" and stock adjustments. They use consumption expenditure as the measure of household spending. Because consumption expenditure is consumer expenditure "smoothed out" over time, it depends more on wealth than on current disposable income in each period. Income is allocated to consumption and saving based on the marginal propensity to consume out of wealth (g):
When households receive income, it immediately becomes part of their money balances (one type of wealth). The portfolio balance approach assumes that households will hold (or acquire) alternative types of assets such that their total utility or satisfaction is maximized and the marginal utility (or return) from the last dollar spent on each asset is the same:
As long as goods have economic life, only a fraction of the consumer expenditure has been "consumed." What's left over (in the above case $900 million) is added to net wealth. Because the remaining economic life of goods represents unused consumption or net wealth, production is also smoothed out over time in the Monetarist model. There is no need to produce more to replace what has not been used up. If saving is not consuming, then both saving and wealth are greater and more stable over time in the Monetarist framework, and the Monetarists are correct in stating that consumption is a function of wealth.
As long as prices remain the same, households will spread those money balances over the acquisition of all types of assets (real and financial), according to their utility schedules for real goods and services and their desired returns from financial assets to maximize their total satisfaction. If they have too many real assets, they will buy more financial assets. If they have too many financial assets, they will buy more real assets. Once their portfolios of all assets is satisfactory, they will stop spending. Thus, the flow is passive and incidental to the adjustment of their stock positions. If relative prices change, households will once again evaluate the marginal utility or return from alternative assets and adjust their portfolios accordingly. Again, the flow is passive or incidental to the stock adjustment.
The Monetarist approach is also known as the wealth effect. As wealth changes, households spend more or less, depending on whether wealth is rising or falling. Wealth is a non-income variable, included in autonomous consumption (Ca). In the diagram above, the wealth effect shifts the consumption function up and down as wealth increases and decreases.
XIII. Investment Functions
Investment (I) is spending by business on newly produced capital goods. By definition, all fixed capital is a final good. Investment spending also includes changes in inventories.
Determinants of Investment
The amount of investment depends upon demand growth, profitability expectations, and interest rates.
, e, i)
The investment demand function is positively related to demand growth and profitability expectations, but negatively related to interest rates. If interest rates rise or fall, investment decreases or increases, as businesses move up and down along the investment demand function in response to the interest rate change. However, if demand growth and profitability expectations change, the investment demand function shifts. If demand grows faster and businesses have expectations of greater profits, the function shifts out. If demand grows slower or contracts and businesses have expectations of lower profits or losses, the function shifts in.
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The sensitivity of the investment demand function determines how effectively a change in interests rates stimulates investment. Sensitivity is measured by elasticity. The elasticity of the investment demand function is the absolute value of the percentage change in investment given a percentage change in the interest rate:
| |eI| = | % change I % change i |
When the investment demand function is elastic (IM), investment is more responsive to small changes in the interest rate. When the investment demand function is inelastic (IK), investment is less responsive to small changes in the interest rate .
The Keynesians Versus the Monetarists
Keynesian economics has often been referred to as "depression" economics. In a depression, demand growth is slow or contracting. Businesses have a lot of excess capacity and their actual stock of capital is generally larger than their desired stock of capital. Businesses' expectations about the future are pessimistic and businesses are highly uncertain about the future of their markets and their profits. They tend to be highly unresponsive to changes in interest rates (0 < eI < 1), because they are simply not interested in accumulating more capital at this stage of the business cycle. In the diagram to the right, the Keynesian investment demand function (IK) is highly insensitive to changes in interest rates.
Monetarist economics is a contemporary version of Classical "full employment" economics. When an economy is at full employment, demand is generally growing very fast. Businesses are operating at their capacity limitations and their actual stock of capital is generally smaller than their desired stock of capital. Businesses' expectations about the future are optimistic and they feel extremely certain about the future of their markets and their profits. They tend to be highly responsive to even small changes in interest rates (1 < eI < oo), because they are definitely interested in accumulating more capital at this stage of the business cycle. In the diagram to the right, the Monetarist investment demand function (IM) is highly sensitive to changes in interest rates.
XIV. What is Money?
Money (M) is a generalized claim on all other assets, both now and in the future. Money is a concept and does not change.
The Functions of Money
As a unit of account, money measures value.
As a medium of exchange, money serves as generalized purchasing power or value in exchange for all other assets.
As a store of value, money stores purchasing power over time.
As a standard of deferred payment, money is the medium in which contracts are written for payment or repayment in the future.
The Keynesians Versus the Monetarists
Keynesians emphasize the medium of exchange function of money. They view money as liquidity par excellence. Liquidity is the ease of marketability, exchangeability, or resalability of one asset for another. Keynesians emphasize the immediacy of money as a medium of exchange and its ability to get a buyer into the market here and now.
Monetarists emphasize the store of value function of money. They view money as a temporary abode of purchasing power. A temporary abode of purchasing power stores purchasing power until such time as the buyer wants to enter the market. Monetarists emphasize the spending power of money and its need to store value over time until the buyer is ready to enter the market.
XV. What is Money Supply?
Money supply (Ms) is the asset or group of assets that society sets aside for buyers' claims. While the concept of money is universal, the supply of money is not. At one time or another, grains, cattle, salt, wool, arrowheads, beads, shells, fishhooks, and metals have been used as money. Whale teeth served as money in the Fiji Islands, tobacco functioned as money in colonial America, and cigarettes performed the function of money in POW camps during WW II and the Korean and Vietnam wars. In today's economic setting, token coins, paper notes, and demand deposits are acceptable monies. Some would go so far as to include savings accounts, money market mutual fund, and T-bills. What is included in the money supply depends upon various social and technical conventions and upon which part of the definition of money is emphasized.
Types of Money Supplies
Full-bodied money is commodity money. Its exchange value is the intrinsic value of the commodity. It has value in use as well as exchange.
Representative full-bodied money is paper money. Its intrinsic value is 0. Its exchange value is the intrinsic value of the underlying commodity. It has little or no value in use. It has value only in exchange.
Fiat money is full-bodied, representative full-bodied, or paper money authorized by decree of the government. Legal tender is fiat money. Its exchange value is greater than its intrinsic value. It has little or no value in use. It has value only in exchange.
Credit money is a debt; an IOU. Its exchange value is greater than its intrinsic value. It has little or no value in use. It has value only in exchange.
Which asset or group of assets best serve(s) the functions of money?
Medium of Exchange That asset or group of assets which is most liquid. As a medium of exchange, these assets have an instantaneous command over all other assets and allow individuals to go directly into the market without any intermediary transaction. However, they contain little or no protection against loss of purchasing power between receipt and expenditure.
Store of Value That asset or group of assets which best protects purchasing power between receipt and expenditure. As a store of value, these assets will have either a rate of return or price appreciation. However, they may also depreciate in value between receipt and expenditure and/or require an intermediate transaction for entry into the market.
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The Keynesians Versus the Monetarists
Keynesians include only the most liquid assets in money supply. The liquidity of assets is determined by analyzing the properties of all assets:
Portability means that the asset is easy to carry around. The asset must be light in weight and small in bulk relative to its value.
Recognizability means that the asset is easy to identify and its value is easily recognized. The asset must be capable of standardization at a point in time. All units must be identical or homogeneous.
Durability means that the asset is durable and does not deteriorate or depreciate over time. The asset must be capable of standardization over time.
Divisibility means that the asset is capable of being divided into smaller units without losing value. The value of the asset must equal the sum of its parts.
Non-reproducibility means that the asset is not capable of being reproduced on demand or counterfeited.
Predictability of value means that the asset has a fixed price.
The most liquid assets have the most of these properties. They require no intermediate transaction and can be used on the spot to obtain other assets. The Keynesian money supply currently includes only cash and checkable deposits, or what the Federal Reserve narrowly defines as M1.
Monetarists include any and all assets that maintain and secure purchasing power. Thus, the Monetarist money supply includes the Keynesian money supply plus a host of other assets that act as temporary stores of purchasing power, e.g. savings accounts, CDs, etc. or what the Federal Reserve more broadly defines as M2. In the limit, all other assets can serve as stores of purchasing power so that the Monetarist economy reduces to the Classical (barter) system, where money is simply a "veil" that determines the absolute level of prices (Axiom of Gross Substitution).
XVI. Money Demand Functions
The money demand function (Md) relates the quantity of money individuals wish to hold to other variables on which that quantity depends. These variables depend upon people's motives for holding money.
Motives for Holding Money
Transactions Motive The most obvious reason for holding money balances is to spend them. Thus, every time money income is received, a portion will be held in money balances to make ordinary disbursements. Since spending increases as income increases, transactions balances are an increasing function of income:
Precautionary Motive People also hold money as a precautionary measure in case of an emergency. Precautionary money balances are generally held in some ratio to income to provide for a given standard of living in an emergency. This is akin to saying that the average family of four living in an urban area should have on hand six months income in liquid assets as a contingency. Additional precautionary balances will be held depending on the state of expectations about the future and the degree of uncertainty. Thus, precautionary balances are positively related to income and uncertainty:
Speculative Motive People often hold money just for speculating on asset prices. Asset prices vary inversely to their fixed returns. For example, when interest rates are low, bond prices are high. Since no additional capital gains can be made from holding bonds, individuals will sell bonds and accumulate money balances. As interest rates rise, bond prices fall and the opportunity cost of holding idle money balances increases. When individuals believe interest rates have peaked (bond prices are lowest), they will economize on cash balances and buy bonds. Holding bonds affords individuals both high interest income and future capital gains (when interest rates fall). In the Keynesian system, where individuals have a choice only between cash and bonds, they hold either all cash or all bonds and the demand for money is perfectly elastic at imin.
In the real world, not all individuals think alike or hold identical expectations. As interest rates rise, various individuals will begin to think rates have peaked and that bond prices have reached bottom. Different individuals with different interest rate expectations will gradually decumulate money balances and buy bonds. As interest rates fall (bond prices rise), various individuals will begin to think interest rates have fallen to their lowest levels and will begin to sell bonds, take capital gains, and accumulate cash balances for the next interest rate cycle.
In the real world, individuals are not limited to just two alternatives: cash and bonds. They have a variety of financial assets with varying degrees of risk from which to choose. Varying risk-return preferences draw individuals through the spectrum of interest-bearing assets. This variety smooths out the demand for money function and makes it more interest-inelastic. To the extent that switching involves transaction costs --- transportation to and from the bank, brokers commissions, etc.--- and some element of risk, nominal interest rates will have to be higher; but the same principles for the speculative motive hold. The higher the return from other financial assets, the smaller money balances will be. The lower the return from other financial assets, the larger money balances will be. Thus, speculative balances are negatively related to interest rates:
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The Keynesians Versus the Monetarists
Keynesians believe that money is wanted for all four reasons: Md = f(Y, i, µ). The Keynesian money demand function is MdK. It is very sensitive to small changes in the interest rate.
Monetarists believe that money is wanted only for the transactions motive: Md = f(Y). The Keynesian money demand function is MdM. It is not very sensitive to changes in the interest rate.
XVII. Money Supply Functions
The money supply function (Ms) relates the quantity of money supply to interest rates. The supply of money is determined partly exogenously or autonomously by the central monetary authority and partly endogenously or induced by economic activity and economic participants.
Exogenous Determination of the Supply of Money
Exogenous determination of the money supply is when the amount of money supply in circulation can be determined independent of economic activity. The central monetary authority (the Federal Reserve) has the ability through use of its policy tools to determine the exact amount of money supply in circulation. Federal reserve credit --- open market operations (OMO) and lending at the discount window (d) --- determines the monetary base (high powered money) and reserve requirements (r) determine the amount of loans banks can make to expand the money supply from the monetary base.
Given the manipulation of these policy tools, the money supply is perfectly inelastic at some maximum amount (Ms0) from base B0.
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Reserve Requirements (r) When the Fed lowers reserve requirements, base B0 can be expanded all the way to Ms1 (the dotted line --- shifts right). When the Fed raises reserve requirements, base B0 can be expanded only to Ms2 (the dotted line --- shifts left).
Endogenous Determination of the Supply of Money
Traditional theory assumes that the money demand function and the money supply function are independent of one another, so that a change in the money supply will change the interest rate and the quantity demanded of money by predictable amounts. Interdependence of the money demand function and the money supply function refers to the ability of changes in the money demand function to cause changes in the quantity supplied of money. The supply of money is partially a function of the demand for money.
The effect of economic activity and the actions of economic participants on the money supply is called endogenous determination or reverse causation. Endogenous determination or reverse causation occurs when a change in the demand for money changes the supply of money, such that the two sides of the money market are interdependent rather than independent. It is especially prevalent in a fractional banking system, where commercial banks can expand the money supply from any given base (B0) in response to an increase in loan demand and contract the money supply with the same base (B0) when loan demand falls.
Endogenous determination or reverse causation also occurs because the Treasury can change the base (from B0 to B1 or B2) and the amount of money (from Ms0 to Ms1 or Ms2) by circulating its own coin and currency. In addition, commercial banks can expand the base (from B0 to B1 or B2) and the money supply (from Ms0 to Ms1 or Ms2) by borrowing domestically at the discount window and abroad in the Eurodollar market. Commercial banks can also alter the multiplier and the money supply with their excess reserve holdings and lending policies. Individuals can change the multiplier by altering the composition of the money supply --- shifting from cash to demand deposits to time deposits and back again. In both of the latter cases, any base (B0) can be expanded to either Ms1 or Ms2.
The Keynesians Versus the Monetarists
Keynesians believe that the demand for money and the supply of money are interdependent. They assume that the money supply is determined partly exogenously by the central monetary authority and partly endogenously by the demand for money. As economic activity rises and falls, changes in the demand for money cause changes in the supply of money (reverse causation).
Monetarists believe that the supply of money is independent of the demand for money. They assume that that the supply of money is determined exogenously by the central monetary authority and that the demand for money is driven by individuals tastes and preferences as reflected in their utility schedules and the system of relative prices of other assets. They also assume that, although private economic activity and economic participants may influence the money supply, the central monetary authority has the ability, through use of its policy tools, to offset private sector fluctuations to control the amount of money in circulation.
XVIII. Money Illusion
Money illusion is the valuation of income and assets in money terms, without adjusting for price changes. People who have money illusion ignore changes in purchasing power, even as prices are changing. They focus on money income and nominal money balances, not real income or real money balances. They can be duped into working more hours for less real income.
People who have no money illusion know exactly what the purchasing power of their income and assets is. They focus on real income and real money balances. They cannot be duped into working more hours for less real income.
Example 1 Assume that you are currently earning $40,000 per year in salary. Your boss tells you that she is giving you a 50% raise and that your new salary will be $60,000. If you have money illusion, you walk away elated. If you have no money illusion, you ask youself, "How much are prices expected to increase over the next year?" If prices are expected to increase at their current rate of 2.5%, you walk away elated. Today, you are earning $40,000 to buy $40,000 worth of goods and services. Next year, you will be earning $60,000 to buy $41,000 worth of goods and services. Your boss has just given you a 46.3% increase in purchasing power. If, however, prices are expected to increase by 100%, you walk away sad and dejected. Today, you are earning $40,000 to buy $40,000 worth of goods and services. Next year, you will be earning $60,000 to buy $80,000 worth of goods and services. Your real income will be only $30,000 and you will have lost 25% in purchasing power.
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