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Department of Land Economy

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### Department of Land Economy

LECTURE 1

EMERGENCE OF NCM

Philip Arestis

University of Cambridge and University of the Basque Country

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

Circular Flow of Income

Figure 1: Circular flow of income

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

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

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.

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.

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:

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:

45O

E

E’

E

0

Y1

Y2

Circular Flow of Income- Figure 3: The IS relationship

E’’

Yo

Y

r2

r1

r0

IS

Y0

Y1

Y2

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.

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

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

Saving

Real Sector- Figure 5: Indifference curves

Y1(1+r)+Y2

Y’2

C2

I2

I1

Y2

Y’1

Y1

Y1+

Y2/(1+r)

C1

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.

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.

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;

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.

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.

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.

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.

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).

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.

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 right-hand 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.

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.

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:

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.

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:

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.

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!

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.

Real Sector

- Government expenditure and taxes
- RecallY = [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/(1-
c1)] = (1- c1)/(1- c1) = 1

- i.e. balanced budget multiplier.

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;

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 non-
Ricardian consumers: fiscal policy still effective.

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)

Monetary Sector

- Money multiplier: it is:
- M = CP + D
- H = CP + R
- CP = cpD
- R = sD
So that:

(1)’ M = cpD + D = (1+ cp)D

(2)’ H = cpD + sD = (s+cp)D

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?

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.

Monetary Sector

- The LM relationship: Figure 13

r

MS

r2

r1

M(r,Y2)

r0

M(r,Y1)

M(r,Y0)

0

M

r2

LM

r1

r0

0

Y0

Y1

Y2

Y

Foreign Sector

- Economic policy: fixed exchange rate: Figure 16

LM

r

LM’

BP

B

C

re’

A

re

B’

IS’

IS

0

Y

Ye

Ye’

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;

Foreign Sector

- Economic policy: flexible exchange rate: Figure 17

LM

r

BP’

BP

B

C

A

re

IS’

IS’’

IS

0

Y

Ye

Foreign Sector

- Economic policy: flexible exchange rate: Figure 18

r

LM

LM’

BP

BP’

A

re

C

B

IS’

IS

0

Ye

Y

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)

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.

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;

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;

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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