Lecture 10 Part 2 Extending Endogenous Money Behavioural Finance Lecture 10 Part 2 Extending Endogenous Money

Variable wages Basic Phillips curve introduced here Advanced Phillips curve includes 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] Done in final model in last lecture 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 has been extended to multiple commodities fixed capital Financial Instability Hypothesis and government policy Next week The Financial Instability Hypothesis