Transcript Department of Land Economy

UNIVERSITY OF
CAMBRIDGE
Department of Land Economy
LECTURE 1
EMERGENCE OF NCM
Philip Arestis
University of Cambridge and University of
the Basque Country
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LECTURE 1: INTRODUCTION
Circular Flow of Income
Real Sector
Monetary Sector
Foreign Sector
Inflation
Neoclassical Synthesis
New Classical Economics
New Keynesian Economics
New Consensus Macroeconomics
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Circular Flow of Income
Figure 1: Circular flow of income
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Circular Flow of Income
Y=C+S+T
E=C+I+G+X–Q
C+I+G+X–Q=C+S+T
(I - S) + (G – T) + (X – Q) = 0
or
I+G+X=S+T+Q
which implies injections equal to leakages
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Circular Flow of Income
Assuming closed economy:
Y=E=C+I+G
C = c0 + c1YD
with 0 < c1 < 1
Y = c0 + c1(Y – T) + I + G
YD = Y – T
Y = c0 + c1Y – c1T + I + G
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Circular Flow of Income
Y(1-c1) = c0 – c1T + I + G
Y = [1/(1-c1)].(c0 - c1T + I + G)
i.e. the equilibrium level of income
And with T and G given, but allowing I to
change:
ΔY = [1/(1-c1)]. ΔI or
(ΔY/ ΔI) = 1/(1-c1)
i.e. the multiplier.
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Circular Flow of Income
Figure 2: Equilibrium level of income
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E
E’
E2
E1
0
B
A
Y1
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D
E
F
Y2
Y
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Circular Flow of Income
Equivalently:
Y = C + S + T, or
S = Y – C – T, or
S = C + I + G – C – T, or
S = I + G – T, or
I = S + (T – G)
i.e. investment is equal to the total of savings.
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Circular Flow of Income
We may use the model:
Y=E=C+I+G
C = c0 + c1YD
YD = Y – T
I = i0 + i1r
where we treat G and T still as exogenous, but
I is treated now endogenous, with i1<0. We can
have:
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Circular Flow of Income
Y = c0 + c1(Y - T) + i0 + i1r + G
Y - c1Y = c0 - c1T + i0 + G + i1r
Y(1 - c1) = c0 - c1T + i0 + G + i1r
Y = [1/(1-c1)].(c0 + i0 - c1T + G)
+ [i1/(1-c1)].r
We explain this relationship in Figure 3:
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Circular Flow of Income
Figure 3: The IS relationship
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E
0
Yo
Y1
r2
r1
r0
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Y2
E’
E
E’’
Y
IS
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Real Sector
Continue with closed economy; so that we
examine consumption, investment, government
expenditure and taxation. Begin with
consumption.
Theories of consumption: absolute income
(Keynesian), permanent income and life cycle
hypotheses.
Absolute income views consumers as basing their
decisions on current income. The other two view
consumers as taking a longer-term view of income
when deciding on consumption.
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Real Sector
Absolute income hypothesis (Keynesian)
C = c0 + c1Y
where c0 is autonomous consumption, and c1 is
the marginal propensity to consume (equal to
ΔC/ΔY, i.e. the slope of the consumption
function).
See Figure 4
c1 = 1 – s where s is the marginal propensity to
save.
No smoothing over time
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Real Sector
Figure 4: Consumption function
C
C = c0 + c1Y
0
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Y
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Real Sector
Definitions
Intertemporal budget constraint: Y1 and Y2
representing income today and future income,
respectively; there is borrowing and lending at the
interest rate r;
See Figure 5;
Lifetime Utility Function: U = U(C1, C2);
Indifference curves;
See Figure 5 again.
Borrowing and saving in Figure 5
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Real Sector
Figure 5: Indifference curves
Y1(1+r)+Y2
Y’2
C2
I2
I1
Y2
Y’1
Borrowing
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Y1
C1
Y1+Y2/(1+r)
Saving
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Real Sector
Consumption smoothing shown in Figure 5 forms the
basis for permanent and life cycle theories of
consumption.
Permanent Income Hypothesis
Y = Yp + YT
where Yp is permanent income, long-run or average
income; and YT is transitory income. So that:
C = cpYp with 0 < cp <1. So, consumption is geared to
permanent income, not current income. See Figure 6.
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Real Sector
In figure 6, consider income Y1, which gives
permanent consumption C1P. If income is Y2, then
we have consumption at C1T, so that Y2’Y2 is then
transitory income. What permanent consumption
would then be depends crucially whether the
transitory component Y2’Y2 is treated as
permanent or not. If it is treated as permanent
consumption is thereby C2P.
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Real Sector
CLR
Figure
6
P
C2
C1T
C1P
CSR
Y1 Y2’
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Y2
Y
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Real Sector
Life cycle hypothesis
Consumers maintain a stable pattern of
consumption throughout their lifetime;
Consumption is related to total resources;
Consumption smoothing is beneficial;
Borrowing and saving benefit welfare;
Borrowing when young and saving for retirement
allows consumption smoothing over the life cycle;
See Figure 7;
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Real Sector
We may, thus, have:
Ct = wVt
where Vt is the present value of total resources;
and
Vt = Wt-1 + Yt + [YtE/(1+r)n]
where the summation is over the remainder of the
lifetime, Wt-1 is accumulated net wealth carried
over from last period, Yt is current income and the
third term is the present value of expected future
income over the remainder of lifetime.
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Real Sector
Figure 7
C
Total Resources
Saving
C’
Dissaving
Dissaving
0
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Real Sector
Investment: defined as additions to capital stock,
i.e. to the nation’s productive assets;
I = ΔK
Investment comprises of three parts:
Fixed business investment: additions to capital
stock;
Inventory business investment: stocks of inputs,
semi-completed and finished goods that firms hold
in stocks;
Residential investment: investment on improving
or building residential property.
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Real Sector
In what follows we discuss investment
without referring to its parts. We begin with
the possibility that I=I(r).
V = R1/(1+r) + R2/(1+r)2 + ….. + Rn/(1+r)n
where V=present net value of future yields
(R), and r is the rate of interest.
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Real Sector
Compare V to the cost of undertaking
investment (V’), so that if V>V’ new
investment is undertaken; otherwise not.
As r changes, investment is affected. If r
increases, V decreases and given V’ a lower
volume of investment is undertaken. If r
decreases then investment increases.
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Real Sector
So that I = I(r): see Figure 8.
If future yields change, the investment
relationship shifts; a change in r means a
movement along the I-relationship.
Relationship can be shifted: expectations;
technological change; stock of capital, etc.
But if state of expectations is important, it
can imply: I#I(r).
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Real Sector
Figure 8
r
0
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I
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Real Sector
An alternative way of approaching investment
decisions is to ask what the discount rate (i) might
be that equates V and V’, where V’ now is:
V’ = R1/(1+i) + R2/(1+i)2 + ….. + Rn/(1+i)n
and i is now called the marginal efficiency of
capital; we then compare i with r, so that if i>r
investment is undertaken; otherwise it is not.
We may now explain how to derive Figure 8,
where the I-relationship is depicted.
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Real Sector
As r increases, the right-hand side of the equation
decreases and the present value is now smaller
than V’; also i tends towards r as investment
decreases.
As r decreases, the opposite happens; the righthand side of the equation increases and the present
value is now bigger than V’; also i tends towards r
as investment increases.
The two ways are alternatives and may not always
give the same result since a change in r does not
affect i systematically.
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Real Sector
Accelerator hypothesis
Y=C+I
C = a + bYt-1
I = vΔYt-1 = v(Yt-1 - Yt-2)
so that:
Y = a + bYt-1 + v Yt-1 - vYt-2
ΔYt = (b+v) ΔYt-1 - v ΔYt-2
Cyclical behaviour depending on the values of v
and b, but mainly v.
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Real Sector
Cycles
0<b<1
v=0
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0<b<1
v = large
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Real Sector
Cycles
0<b<1
v = relatively small
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0<b<1
v = relatively large
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Real Sector
Tobin’s q
q = V0 / pkK0
where V0 is the market value of firm, which is
the expected discount future cash flows of
firm; and pkK0 is the replacement cost of installed
capital, where pk is the price of purchasing the firm’s
capital stock (K0).
Changes in q affects investment:
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Real Sector
If q>1, then investment increases: installed capital
produces higher market value for the firm. Thus
investment increases; if q<1 the opposite happens.
Thus investment decreases; if q=1 then nothing
happens.
See Figure 9.
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Real Sector
Figure 9
I
0
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q
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Real Sector
Residential investment
Tobin’s q theory fits nicely this type of
investment;
Clearly, qH = V0H /PH, where V0H is the
discounted value of future rents; the cost of
building a house is given by the construction
price (PH).
It follows that: qH = R/rPH, from which:
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Real Sector
If rPH is given, then as R increases, more
residential investment is undertaken. What
may determine rental value of housing is
economic activity, i.e. income or
unemployment.
Also for given R as the rate of interest
increases and/or PH increases, then less
investment is undertaken.
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Real Sector
UK experience
R has been increasing; r has been low and PH has
not been high; consequently q for investment
should be very high.
The evidence shows that housing construction is
low! Why?
High planning costs;
Strategic action by planning developers, who may
prefer gradual development for otherwise they
might flood the market pushing R down!
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Real Sector
Asymmetric information leading to credit
rationing; this could come about in view of
adverse selection and moral hazard;
Adverse selection: lenders do not have full
information about borrowers, who may not be able
to repay in view of their high risk undertakings;
this discourages ‘sensible’ borrowers;
Moral hazard: borrowers act immorally; for
example, depositors do not know banks, which
may undertake high risks.
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Real Sector
Government expenditure and taxes
Recall Y = [1/(1-c1)].(c0 - c1T + I + G)
(ΔY/ ΔG) = 1/(1- c1)
(ΔY/ ΔT) = [- c1/(1- c1)]
(ΔY/ ΔG) + (ΔY/ ΔT) = 1/(1- c1) + [- c1/(1c1)] = (1- c1)/(1- c1) = 1
i.e. balanced budget multiplier.
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Real Sector
Crowding-out
Changes in G, or T, has no impact on
Income; private expenditure is reduced at the
same time and by the same amount;
Crowding-In?
Ricardian Model
Ricardian consumers are rational, utility
maximisers, forward-looking and smooth
consumption over time;
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Real Sector
Permanent income is more relevant than
current income;
Consequently, G and T policies would
influence future spending and tax policies,
which Ricardian consumers are able to
predict; an increase in G means T increases in
future, so no impact on Y;
But real world a mixture of Ricardian and nonRicardian consumers: fiscal policy still effective.
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Monetary Sector
Money is anything that performs four functions:
medium of exchange; unit of account; store of
value; and standard of deferred payments;
Different definitions: M0, M1, M2, M3 etc;
Demand for Money: transactions motive,
speculative motive and precautionary motive;
See Figure 10;
Demand for Money: MD = M(r, Y)
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Monetary Sector
Figure 10
r
Demand for Money (MD) = M(r, Y)
0
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M
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Monetary Sector
Supply of money (MS): Figure 11
r
0
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M
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Monetary Sector
Money multiplier: it is:
(1) M = CP + D
(2) H = CP + R
(3) CP = cpD
(4) R = sD
So that:
(1)’ M = cpD + D = (1+ cp)D
(2)’ H = cpD + sD = (s+cp)D
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Monetary Sector
So that:
M = [(1+cp)/(s+cp)].H
M = mH
Where m is the money multiplier
If the elements on the right-hand side do not
change endogenously, then M is exogenous;
otherwise endogenous;
Can it ever be exogenous in view of the central
bank control of the rate of interest?
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Monetary Sector
Equilibrium in the money market: Figure12:
r
MS
re
0
MD=MS
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Monetary Sector
But, which interest rate?
r is the nominal interest rate; R is the real rate of
interest: what is the difference?
Then value of £1 in the next period is: (1+r).1; but
inflation in the next period is important: thus:
(1+r) = (1+R).(1+πt+1), where πt+1 is the inflation
rate in period t+1; this is approximated to:
r = R + πt+1 or:
R = r - πt+1
But r is normally assumed.
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Monetary Sector
The LM relationship: Figure 13
r
r2
MS
r1
M(r,Y2)
r0
0
r2
r1
r0
0
M(r,Y1)
M(r,Y0)
M
LM
Y0
Y1
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Y2
Y
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Monetary Sector
The IS-LM model: Figure 14
r
LM
re
IS
0
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Y
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Foreign Sector
Open economy considerations: Figure 15
r
LM
BP
re
IS
0
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Y
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Foreign Sector
Economic policy: fixed exchange rate:
LM
r
Figure 16
LM’
rre’e
B
C
A
BP
B’
IS’
IS
0
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Ye’
Y
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Foreign Sector
In Figure 16 (slide 53) we demonstrate the
impact of fiscal and monetary policy in the
case of the open economy with a fixed
exchange rate;
In Figures 17 (slide 55) and 18 (slide 56) we
demonstrate the impact of fiscal and
monetary policy in the case of the open
economy respectively, assuming a flexible
exchange rate;
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Foreign Sector
Economic policy: flexible exchange rate:
LM
r
Figure
17
BP’
re
A
C
B
BP
IS’
IS’’
IS
0
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Y
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Foreign Sector
Economic policy: flexible exchange rate:
r
LM LM’
Figure 18
BP BP’
re
A
B
C
IS
0
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Ye
Y
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IS’
Inflation
Inflation: Figure 19
LM
r
re
IS
0
P
0
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Ye
PC
Y
Y
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Inflation
Inflation: Figure 20
W/P
NS
W/P
(W/P)e
Ne
ND
N W
(NS-ND)/NS
U%
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Inflation
Inflation: Figure 21
W
LRPC
W2
W1
0
C
D
B
A
U1
U*
U%
SRPC1
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Inflation
Inflation
MV = PY
MD = kPY
MS = MS
MD = MS = M
kPY = M, or
P = (1/kY)M = (V/Y)M
i.e. the monetary theory of inflation (see
Figure 22)
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Inflation
Figure 22
P
M1
M2
P=(V/Y)M
P2
P1
0
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M2
M
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Inflation
Figure 22 highlights the importance of
controlling the money supply; also the
importance of a stable demand for money;
If problems, i.e. monetary authorities not
able to control the money supply or unstable
demand for money, then controlling the
money supply cannot control inflation;
Direct inflation targeting is the alternative.
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Neoclassical Model
We may put together all markets;
Result is Neoclassical Model as in Figure
1.1;
Explain Rational Expectations; this enables
proper understanding of New Classical
Economics;
Derive Figure 1.2 that enables to explain the
New Classical Economics;
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Further Developments
Still further developments resulted in the
New Keynesian Economics as in Figure 1.3;
Discuss policy attempts of the time at
money supply control; but the point about
money supply exogeneity should be made
as a prelude to New Consensus
Macroeconomics and Taylor Rule in
particular;
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New Consensus Macroeconomics
Eventually, and emanating from the New
Keynesian Economics, the New Consensus
Macroeconomics emerged;
Policy implications rather different from
those of New Keynesian Macroeconomics:
inflation targeting;
See subsequent slides in the rest of the
lectures.
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