1. Lecture 10 Part 1 Extending Endogenous Money
Behavioural Finance
Lecture 10 Part 1
Extending Endogenous Money

2. Recap Last week we built model of pure credit economy
Model of a pure credit, paper money economy in QED:
Right-click on zip file to download QED
Expand to QED subdirectory on your computer to run

3. Recap
Terms in model:

4. Recap
Flow diagram and graphs

5. Recap & This Lecture Pure credit economy can be self-sustaining
Single initial loan causes sustained economic activity
Positive bank balances, incomes
This lecture:
Extending model to include production
Explaining values of parameters
Expanding model to include growth
Applying the model:
Why lenders tend to create too much debt
Modelling a “credit crunch”

6. 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 (wears out over time) 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)

7. 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
Weaknesses in model ignored (or not even known) by most neoclassical economists
See History of Economic Thought lecture;
Chapter 6 of Debunking Economics

8. 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)

9. 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 (Very good)
With abstraction of single commodity (Not so good)
Labour in—GDP out (Not so good)
But later expanded to multiple goods in, multiple goods out…

10. 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…

11. 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

12. 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

13. 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:
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14. 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

15. 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)

16. 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:

17. 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

18. 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:

19. 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)

20. 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…

21. 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

22. 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:

23. 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)

24. 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

25. Parameter Values and Time Lags
So the various “strange” parameter values mean:
Parameter
Value
Time Lag
Meaning tS
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

26. 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

27. 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…

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

29. 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

30. 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!

31. 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)

32. 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

33. 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…

34. 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

35. 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

36. 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

37. 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
In 2nd half of lecture…