MODEL 0. The Simple Circular Flow with CASH KEYNESIAN THEORY (KT) PrM CrM H&B C S I Y X Y = C + S. Must be true X = C + I. Must be true S = I. If and when the Credit Market is working well What if it isn’t working well?

MODEL 0. KEYNESIAN THEORY – adding CASH and ΔMD Keynesian Theory is named for John Maynard Keynes (“Canes”), who wrote during the Depression of the 1930s. Keynes’s principle point was that the government, by increasing its borrowing and spending, could help to end the Depression. More generally, he argued that the government was in a position to help the economy. Even more generally, he added to economics a description of the short-run workings of economies, essentially inventing macroeconomics as a field of study. We can describe much of Keynesian Theory (KT) by adding one element to the CF diagram. This element will be called “CASH.” It supposes that there is unspent money in the economy, including money held as reserves in banks. We will picture CASH as being attached to the Credit Market X PrM CrM H&B Y C S I CASH ΔMD ΔMD stands for “Change of Money Demand” The double headed arrow indicates that money can flow into and out of CASH. Money will flow in or out of CASH if I and S are not equal.

The CASH Model Y = C + S. Must be true X = C + I. Must be true ΔMD X PrM CrM H&B Y C S I Let us now suppose that the Credit Market does not always make S = I, that it is possible for Saving to be either greater than, or less than, Investment Of great importance is this pair of thoughts: -- S might not equal I in the “short run.” -- S will equal I in the “long run.” How long these “runs” are is not at all clear In the short run the difference between S and I can be made up for by people holding more or less Money (“Cash”). We will say that the demand for (holding) money has risen or fallen. Saving can wind up in one of two ways: It can be loaned and Invested It can be held by someone (including banks)

THIS SLIDE MODIFIED (9/12/17) This picture shows: the demand for money is rising money is going into Cash the public, including banks, holding more money Savings is greater than Investment CASH ΔMD X PrM CrM H&B Y C S I We will denote money going into Cash as a negative number – it is reducing the amount of money in the Credit Market -- and money coming out of Cash as a positive number, adding to money in the Credit Market. CASH -5 PrM CrM H&B +5 How can we interpret this picture? The situation shown here looks as if: -- People started to Save more -- Businesses were not inclined to borrow and Invest the extra Saving. -- The extra 5 sat as reserves in banks. The negative sign shows less money in the Credit Market This problem is not complete. It should also show a decrease of C and a decrease of X

The CASH Model -5 Y = C + S. Must be true X = C + I. Must be true PrM CrM H&B +0 How to interpret this? Businesses decided to borrow less; banks got stuck holding money they could not lend OR: Banks got scared, started to “hoard” money and Investment was reduced. Businesses that wanted loans could not get them -5 Total spending (X) fell as business borrowed and spent less

The CASH Model -- KT This picture shows: ΔMD PrM CrM H&B This picture shows: the demand for money is falling money is going out of Cash the public– including banks – are holding less money Savings is less than Investment PrM CrM H&B What happened? -5 The situation shown here looks as if people started to Save less, but banks had enough cash to be able to continue to lend for Business Investment from their reduced Money Demand. CASH +5

The CASH Model What happened? +5 PrM CrM H&B What happened? Businesses started to borrow more and banks had on hand enough money to meet that demand. Total spending rose

S ≠ I in the Short Run, when ΔMD ≠ 0 Y = C + S. Must be true The CASH Model X = C + I. Must be true S + ΔMD = I. Must be true. That is: $ into CrM = $ out of CrM CASH ΔMD X PrM CrM H&B Y C S I That is: S > I means ΔMD < 0; someone is holding on to money; the demand for money is rising; money is going out of the CrM S < I means ΔMD > 0; someone is reducing their money holding; the demand for money is falling; money is going into CrM Notice that all of the scenarios that involve MD changing seem unlikely to last very long. Banks cannot or will not indefinitely add to, or draw from, their reserves. Sooner or later Savings must equal Investment. S ≠ I in the Short Run, when ΔMD ≠ 0 S = I in the Long Run, when ΔMD = 0

Final – CRUCIAL -- Point Whenever S and I are unequal, X and Y will be unequal. We will interpret this as the economy having grown or shrunk. We have here what the first “Model 0” could not describe – the demand-driven rise and fall of GDP. CASH +5 PrM CrM H&B C In this case, there was a rise of Demand (x). Total Spending rose Since there was sufficient Cash to pay for the increased Investment, there was no off-setting reduction in someone else’s spending.

CASH -5 PrM CrM H&B In this case, there was a decrease of Demand (x). Total Spending fell. Investment fell and there was no off-setting increase of Consumption. So we now have an answer (not the only answer) as to why GDP can rise or fall. GDP rises when people hold less money; GDP falls when people hold more money.

Money is piling up in CASH I < S X < Y . Economic contraction -5 PrM CrM H&B MD is rising. Money is piling up in CASH I < S X < Y . Economic contraction CASH +5 PrM CrM H&B MD is falling Money is coming out of CASH. I > S X > Y Economic expansion Note what may appear backwards. A negative ΔMD, means the demand for money is rising. The negative sign means “less money in the CrM.” Likewise people holding less money is shown by a positive sign (more money into the CrM).

SUMMARY If MD (Cash) does NOT change: X does not change and changes of C and I will off-set each other If MD DOES change: X will change because C and I do not off-set each other In fact, X rises (falls) equal to ΔMD