Lecture 11 Out of Sequence… Extending Endogenous Money Behavioural Finance Lecture 11 Out of Sequence… Extending Endogenous Money

Recap Last week we built model of pure credit economy: Type of Account Asset Liability Income Name Bank Reserve Firm Loan Firms Households Bank Symbol BR FL FD HD BD Compound Interest A Deposit Interest +B -B Pay Interest -C(=-A) -C +C Pay Wages -D +D HH Interest +E -E Consume F+G -F -G Repay Debt +H -H Relend Reserves -I +I Sum of flows H-I I-H B+F+G+I-(C+D+H) D+E-F C-(B+E+G) Pure credit economy can be self-sustaining Single initial loan causes sustained economic activity Positive bank balances, incomes

This week Extending model to include production Explaining values of parameters Expanding model to include growth Applying the model: Working out why lenders tend to lend too much money Modelling a “credit crunch”

Production Actual production involves Multiple commodities used to produce each other Factories (fixed capital); Machinery that Transforms inputs E.g, blast furnace Iron Ore + Coal in, Steel out Depreciates in use “Circulating” capital (Marx’s term) Goods used up entirely in producing output Raw materials, energy, intermediate goods (e.g., rivets become part of car) Many types of labour (skilled, unskilled, supervisors)

Modelling Production Economic models of production Basic Neoclassical: “factors of production” Labour & Capital In—Goods Out Numerous problems with this Shown to be invalid in “Cambridge Controversies” over the nature of capital Ignored (or not even known) by most neoclassical economists See History of Economic Thought lecture; Chapter 6 of Debunking Economics

Modelling Production Advanced Neoclassical General Equilibrium Multiple goods as inputs, multiple goods as outputs Better than “Factors of production” fallacy But problems with assumption that economy in continuous equilibrium See History of Economic Thought lecture; Chapter 8 of Debunking Economics Post-Keynesian Most are dynamic (good!) Use abstraction of single commodity output, & constant ratio between labour input & GDP output (not so good, but not as bad as neoclassical “factor of production” models)

Modelling Production “Sraffian” Based on work of Piero Sraffa Developer of critique of neoclassical “factor of production” model Model production as multiple goods as inputs producing multiple goods as output (very good) But work in equilibrium (very bad) Model of production used here Dynamic with abstraction of single commodity (Very good) Labour in—GDP out (Not so good) But later expanded to multiple goods in, multiple goods out…

Absolutely Basic Modelling of Production Start with: Single Output (Q or “GDP”) Labour input L Constant labour productivity (a) so that Q = a.L Constant money wage W Link between monetary model developed last lecture And physical output Is Price (P) Have to work out a dynamic equation for price…

Absolutely Basic Modelling of Production In equilibrium, price must just enable flow of demand to purchase flow of output Flow of output is Q = a.L L equals flow of wages divided by wage rate From last week’s lecture, flow of wages is Worker’s share of surplus generated in production Time lag between financing production and receiving sales revenue Balance in Firm sector’s deposit account

Absolutely Basic Modelling of Production So Labour employed L is this flow divided by the wage rate W: Physical output Q is then labour employed L multiplied by labour productivity a: Physical demand (D) is the monetary flow of demand divided by the price level P Monetary flow of demand is

Absolutely Basic Modelling of Production So demand in physical units per year is this divided by price level P: When economy is in equilibrium, flow of supply will equal flow of demand: We can now solve for what Price would be in equilibrium: Cancel Cancel Cancel Cancel

Absolutely Basic Modelling of Production So in equilibrium, price is a markup on the monetary cost of production: Money wage per worker divided by units of output per worker is the cost of production per unit produced Markup: 1/(1-s) is bigger than 1 Price as a markup on cost of production means that Prices convert the physical surplus into a monetary one Basic dynamic price equation consistent with this is: Relation in Equilibrium Time lag in price setting Rate of change of prices

Absolutely Basic Modelling of Production Minimum production system is therefore: Monetary-production model is This physical system Coupled with previous monetary flows table Type of Account Asset Liability Income Name Bank Reserve Firm Loan Firms Households Bank Symbol BR FL FD HD BD Compound Interest A Deposit Interest +B -B Pay Interest -C(=-A) -C +C Pay Wages -D +D HH Interest +E -E Consume F+G -F -G Repay Debt +H -H Relend Reserves -I +I Sum of flows H-I I-H B+F+G+I-(C+D+H) D+E-F C-(B+E+G)

A monetary model of production In equations: Financial sector as derived from table of flows Price system Labour-based production Simulation shows system describes viable pure credit economy:

A monetary model of production Monetary & physical systems consistent in equilibrium But convergence to equilibrium takes time: Original monetary flows only model Expanded monetary flows, physical flows and price model

A monetary model of production Monetary estimates of profits Rate of surplus (s) Times Firm Deposit Account (FD) Divided by turnover rate (tS) Converges over time to equal physical estimate Price times Quantity minus Costs (Wages only here) Ditto monetary estimate of wages One minus rate of surplus (1-s) Converges over time to Wage rate times Labour:

A monetary model of production Taking stock so far: Combining Circuit insights into nature of credit money; and Basic approach to dynamic modelling; Has yielded working model of “the circular flow” Not just a diagram… But working model of monetary and physical flows No hassles about assuming equilibrium, etc. Next stages Explain parameter values Allow for growth; and Beginnings of behaviour (rather than fixed parameters)

Parameter Values and Time Lags Values used for parameters may seem strange… w=26 for workers consumption; b=1 for bankers consumption Full list of values is: Interest rates based on long run averages Loan minus deposit rates normally 4% Rate of surplus & turnover arbitrary but generate income shares close to actual data Other 4 parameters (w, b, LR, RR) are inverse time lags: Time lag tells how long a process would take to reach its equilibrium if it continued linearly… It’s related to slope of a function at its initial point…

Parameter Values and Time Lags Consider just consumption Equation for outflow from account M is Solve this via integration: Graph for M0=100, w = 26: Notice that tangent to curve at t=0 crosses time axis at 2 weeks = 1/26th year = 1/w Slope of tangent is derivative… At t=0, slope of tangent is

Parameter Values and Time Lags Equation of tangent to curve at t=0 is Equals M0 at t=0 Slopes away at w.M0 Equals zero at t=1/w (in workers’ case, 1/26th of a year) Point where tangent to curve crosses zero gives convenient way to describe curve: Tangent hits zero at t=1/26 “Time lag for workers’ consumption is 1/26th of a year” tw=1/26 … Same idea used for all other parameters:

Parameter Values and Time Lags Click on graph to animate… Rule applies in general Time where tangent to curve crosses equilibrium value of function is the time lag of the function, expressed as fractions of the time unit (here, years)

Parameter Values and Time Lags Lets us interpret w as number of times a year workers “turnover” their accounts “Workers spend their wages 26 times a year” w = 26 And express consumption by workers as a time lag “Time lag for workers’ consumption is 2 weeks or 1/26th of a year” tW = 1/26 So consumption from household accounts can be shown as In practice, time lag version used, since it expresses behaviour in fractions of basic time unit of a year where w = 26 or where tw = 1/26

Parameter Values and Time Lags So the various “strange” parameter values mean: Parameter Value Time Lag Meaning tS ¼ tS = ¼ “Production takes ¼ year to go from outlaying M on inputs to getting M+ from sales” w 26 tW= 1/26 “Workers turnover their account balances every 2 weeks or 1/26th of a year” b 1 tB = 1 “Bankers turnover their accounts every year” LR 0.143 tLR = 7 “Loans are repaid every 7 years” RR 2 tRR = ½ “Banks relend reserves every 6 months or ½ year Time lags used from now on to better specify models

Growth Model so far shows that Keynes was right: sustained economic activity can be maintained with fixed stock of money as “revolving fund of finance” Capitalists can borrow money & make a profit Debt easily repaid… Circuit conclusions about viability of economy without rising injections of money based on errors in dynamics Next stage: how does money grow endogenously? Insight from Basil Moore: Firms finance operations by “lines of credit” Create new money if access line of credit AND debt grows by same amount

Growth Easily incorporated by new row Both debt and firm deposits grow by same amount: Type of Account Asset Liability Income Name Bank Reserve Firm Loan Firms Households Bank Symbol BR FL FD HD BD Compound Interest A Deposit Interest +B -B Pay Interest -C(=-A) -C +C Pay Wages -D +D HH Interest +E -E Consume F+G -F -G Repay Debt +H -H Relend Reserves -I +I New Money +J Sum of flows H-I I-H+J B+F+G+I+J-(C+D+H) D+E-F C-(B+E+G) Both assets and liabilities of banking sector expand…

Growth Relate to level of Firm Deposits: J = FD/tNM Set tNM = 20; “Money doubles every 20 years” Outcome is self-sustaining growth:

Growth Ditto for physical economy: Circuitist insight that money and banking must be included in a model of capitalism Combined with dynamics Could be the “Holy Grail” that enables capitalism to be modelled accurately… Next extension—variable wages & employment

Variable wages Raises the vexed issue of the “Phillips Curve”… Alleged statistical relationship between Level of unemployment and Rate of change of money wages Massively misinterpreted in literature & textbooks Phillips was actually a systems engineer Using 1950s version of technology shown here Tried to introduce these methods to economics Misinterpreted and derided as “Hydraulic Keynesianism” Objective: to introduce dynamics into economics!

The Phillips Model… “RECOMMENDATIONS for stabilising aggregate production and employment have usually been derived from the analysis of multiplier models, using the method of comparative statics. This type of analysis does not provide a very firm basis for policy recommendations, for two reasons. First, the time path of income, production and employment during the process of adjustment is not revealed. It is quite possible that certain types of policy may give rise to undesired fluctuations, or even cause a previously stable system to become unstable, although the final equilibrium position as shown by a static analysis appears to be quite satisfactory. Second, the effects of variations in prices and interest rates cannot be dealt with adequately with the simple multiplier models which usually form the basis of the analysis.” (Phillips 1954: 290)

The Phillips Model… Phillips built a dynamic model using flowchart: showed one variable (e.g., unemployment) affecting rate of change of another (e.g., money wages…) As part of model, postulated nonlinear relationship between output and wage/capital price inflation: Level of D Rate of change of P

The Phillips Model… “We may therefore postulate a relationship between the level of production and the rate of change of factor prices, which is probably of the form shown in Fig. 11…” (308) Did research that led to Phillips curve to justify this part of his dynamic model, using 19th century UK data…

The Phillips Curve Found a “clear tendency” for inverse relation between U and rate of change of money wages (Dwm) Dwm above curve when U falling, and vice-versa Fitted exponential curve to data: Unemployment Dwm

The Phillips Curve Deviations from trend because of: Fitted through average wage change & U for 0-2,2-3,3-4, 4-5,5-7,7-11% unemployment Wage-price spiral due to wars; falling U Rising unemployment

The Phillips Curve fitted to 1913-1948 data Rapid rise in U; 13% fall in M prices; “cost of living” agreements War-induced rise in M prices

The Phillips Curve Economists didn’t comprehend Phillips on dynamics Instead, latched onto “trade-off”, static interpretation of unemployment-wage rise relationship Proposition that policy makers could choose an unemployment-inflation pair became part of orthodox Keynesianism… Unfortunately, static relation didn’t seem to hold Keynesian economics discredited by this But employment-wage change relation common to all schools of economics Still used in neoclassical static models Here introduced as Phillips intended—as part of dynamic model

Variable wages Basic Phillips curve introduced here Advanced Phillips curve should include all 3 influences Phillips noted: Level of unemployment (highly nonlinear) Rate of change of unemployment Rate of change of retail prices “operating through cost of living adjustments in wage rates… when retail prices are forced up by a very rapid rise in import prices … or … agricultural products.” [Economica 1958 p. 283-4] Function fitted to employment rate rather than unemployment A generalised exponential function

(x,y) pair curve goes through Variable wages Exponential function is y(x) = ex (where e = 2.718) Generalised version which can place an exponential curve anywhere on the x-y axis & control the slope: Slope at that point (x,y) pair curve goes through Minimum value Don’t worry about the details Fitted to Phillips’s UK data the values for this are:

Variable wages Employment—money wage change function is: Other elements of reality introduced now: Rising population Rising labour productivity Still a very basic model, but first truly monetary “circular flow” model ever

Exponential growth in productivity and population Variable wages Model in detail: Looks complicated, but if you understood the table of financial flows, you understand this Financial system as before Prices a lagged adjustment to markup on cost of production Employment = Flow of money wages divided by money wage Prices Employment Output = Employment times productivity Output Exponential growth in productivity and population Change in money wage a nonlinear reaction to employment rate Employment Rate Money Wage

Basic Circular Flow Model Model still “skeletal” Basic entities in economy Financial accounts Firms Workers Relationships between them Interest & Debt payments Wages and consumption But only one “muscle” Worker response to level of employment Much more needed for adequate model…

Basic Circular Flow Model Firm response to rate of profit Speculation rather than investment Variations in consumption due to economic conditions, etc. But interesting results even from skeleton: Non-neutrality of money Higher money creation—lower unemployment Persistent inflation possible Deflation if rate of money creation drops Can also ask the model “policy questions” (shown later)…

Basic Circular Flow Model Some sample outputs…

Policy (1) Should lenders be controlled? What happens to bank income if Rate of new money creation speeds up Rate of relending existing reserves accelerates Rate of repayment of existing loans drops? Changing lending parameters by factor of 2 triples bank income Banks have inherent bias to providing as much debt as possible… As endogenous money theorists assert

Policy (2) Can a credit crunch cause a recession? 3 key financial parameters altered by factor of 2: Crunch causes temporary rise in unemployment AND sustained higher level Inflation turns to deflation and then lower sustained rate of inflation…

Policy (3) Best way to fight a credit crunch? Standard “multiplier model” policy: Obama explaining his economic policy, April 2009: “there are a lot of Americans who understandably think that government money would be better spent going directly to families and businesses instead of banks – ‘where’s our bailout?,’ they ask”. “the truth is that a dollar of capital in a bank can actually result in eight or ten dollars of loans to families and businesses, a multiplier effect that can ultimately lead to a faster pace of economic growth.” (page 3 of speech) Simulation: $100 billion injection 1 year after crunch: (a) Boost banks’ reserves; OR (b) Boost firms’ (debtors’) deposits

Policy (3) Best way to fight a credit crunch? New flows table: Type of Account Asset Liability Income Name Bank Reserve Firm Loan Firms Households Bank Symbol BR FL FD HD BD Compound Interest A Deposit Interest +B -B Pay Interest -C(=-A) -C +C Pay Wages -D +D HH Interest +E -E Consume F+G -F -G Repay Debt +H -H Relend Reserves -I +I New Money +J Bank Stimulus; OR +K Firm Stimulus +L Sum of flows H-I+K I+J-H B+F+G+I+J+L-(C+D+H) D+E-F C-(B+E+G)

Policy (3) Best way to fight a credit crunch? Stimulus inflow of $100 billion for one year after crunch Modelled as a “pulse” Takes value of $100 (billion) for a year after crunch till two years after No consideration yet of how government money created…

Policy (3) Best way to fight a credit crunch? Stimulus inflow of $100 billion for one year after crunch Outcome opposite of “money multiplier” prediction Better to give stimulus to debtors than banks Reason: higher rate of turnover Funds injected into BR flow out slowly Funds injected into FD flow out quickly Higher rate of turnover—greater impact from stimulus

Policy (3) Best way to fight a credit crunch? Showing same model as flowchart: A “circular flow” But in fact like two “coupled electric fields” Don’t mix, but… Rotation of money in financial system Causes opposite rotation of goods in production system

Conclusion Circuit model still skeletal But already reaches different economic policy results to standard models Model extended to multiple commodities Will be extended to include fixed capital, government, and Financial Instability Hypothesis Next week The Financial Instability Hypothesis