Presentation Transcript

1. Unit III

   ABCT

   Why do business cycles exist?
2. A Quick Review People will always chose the shorter and most productive processes first, because of the laws of time preference and maximizing utility. No one will choose the longer less productive processes of production when they can get an equal or greater quantity of goods from the shorter processes. People will only choose longer more productive processes if there are sufficient savings available to produce the necessary capital goods. Example: Growth in Robinson Crusoe’s Economy
3. The Time Market and the Capitalist The time market is the market on which present goods are exchanged for future goods. Two components of time market the loan market is the market where present money is exchanged for future money the structure of production is the market where wages (present money) is exchanged for labor services (future goods)
4. The Time Market and the Capitalist The capitalist supplies present money from savings in exchange for the future product of the laborers, which he intends to sell on the market for an expected future income. So the capitalist is actually trading present money for expected future money.
5. The Time Market and the Capitalist
6. The Function of the Capitalist The capitalist: Pays income to the workers in advance of the sale of their product on the market. Must sacrifice or give up present consumption in order to save money to invest in the structure of production. By saving he assumes the burden of waiting for income from the workers. He pays them before and during the production process and does not receive his until the process of production is completed before he receives his income.
7. The Function of the Capitalist The capitalist: Because present money is worth more than future money, the capitalist expects to receive more revenue from selling the product in the future than the costs (wages, rents) he pays in the present to produce the product. The excess of the selling price of the product over its costs of production is called the “rate of return on investment” or “the natural rate of interest.” It is determined by the supply of savings and demand for savings on the “time market,” which is also called the market for loanable funds.
8. The Determination of the Rate of Interest Interest Rate S S + ∆M i 5% 3% D Savings present $ in billions 300 200
9. Natural Economic Growth Consumer goods (C): ↓ DC → ↓PC → ↓πC→ ↓WC → ↓LC → ↓SC ↗ ↓ t.p. → ↓ C/S → ↑S → ↓i → ↑I ↙ WC→ ↓LC → ↓SC ↙ ← ← ← ↙ Capital goods (K): ↑ DK → ↑PK → ↑πK→ ↑WK → ↑LK → ↑SK Economic growth: ↑SK → ↑K → ↑K/L → ↑MPL → ↑ SC → ↓P → ↑W/P (real wages)
10. Natural Economic Growth Remember there is not one giant economy Just like there are time stages, there are two sectors Consumption (C) lower order goods Capital (K) higher order goods Keynes’ “paradox of thrift” is merely C∆K L shifts from C to K industries
11. Natural Economic Growth The increase in saving and (temporary) fall in consumption does not cause the economy to fall into recession. It is the means for shifting labor from producing iPods, jeans, and hamburgers to producing more factories, mining equipment and new research and development. The increase in saving allows more investment that lengthens the structure of production and increases the amount of capital and labor productivity. It raises real wages and improves everyone’s standard of living.
12. What a Good Business Cycle Theory Must Explain Why inflation is always followed by recession or depression and why the business cycle repeats itself Malinvestments need to correct themselves Waste or destruction of K
13. What a Good Business Cycle Theory Must Explain Why the business cycle has a much greater effect on capital goods industries than on consumer goods industries People still need to eat Keynes says K is volatile Too many animal spirits But investment is more sensitive to i than consumption
14. What a Good Business Cycle Theory Must Explain Why is there “a cluster of entrepreneurial errors,” that is, why do most entrepreneurs suddenly make mistakes and malinvestments at the same time Why do they all screw up, when they have been so successful before? Why now “too” greedy? Misled? What caused them all to fail?
15. What a Good Business Cycle Theory Must Explain Why all prices tend to fall during the recession, trough of a business cycle Hasn’t happened since WWII Due to heavy inflation Bankruptcies often prevented
16. Inflation and Artificial Growth Consumer goods (C): DC→ PC→ πC→ WC→ LC→ SC no ∆C↗ FED ↑R →↓i → ↑loans → M↑I ↙ no ∆S ↙ ← ← ← ↓ Capital goods (K): ↑ DK → ↑PK → ↑πK→ ↑WK → ↑LK → ↑SK Inflationary Boom: ↑M →↑W →↑C →∏↑→↑ DC →↑PC→↑WC Recessional/Economic growth: ↑i →↓loans →(I,DK,PK,πK,WK, LK)
17. Fed adds $ to bank vaults Labor shifts from C to K industries Some coming from Lc But also some unemployed pulled in Looks very prosperous (for a while) Then K to C Grasping for resources ↑P
18. The results: temporary unemployment in the K industries Only if allowed to readjust shift of L back to C industries more C goods and fewer K goods produced; production is readjusted to the to the true time preferences (C/S ratio) of consumers Remember S = Investment Only leakages is cash holding “folding money”
19. Monetary Expansion and Interest Rate Interest Rate S S + FED$ i 5% Fed gets scared 3% D Savings present $ in billions 300 200
20. Critiques of ABCT Why doesn’t the recession occur immediately after the Fed inflates the money supply? Inflation can go on for years and years. That is the essence of the theory People will eventually anticipate inflation Until hyper-inflation Germany 1920s Zimbabwe
21. Critiques of ABCT How come business men do not learn their lesson and refrain from borrowing and investing when the Fed inflates the money supply and drives interest rates down to artificially low levels? If they don’t “play” others will Cause them to fall behind Some play assuming they can get out before the recession Also, many businessmen can be assured that this system works
22. Critiques of ABCT Why does the shift of labor from the consumer goods to capital goods industries during the boom occur without higher unemployment but the shift back during the recession causes high unemployment Most L is pretty adaptable but the increase in K industries actually stresses employment, shortage of L for a while Consumer goods already fully employed Layoffs in K industries
23. Critiques of ABCT Why was their prolonged mass unemployment during the Great Depression? Not allowed to adjust Wages and prices not allowed to fall Increased G Public works Taxes kept high
24. Austrian Recipe for Curing Depressions: Dos The recession is a readjustment process. The recession is the good part of the cycle Production must be readjusted to the true (higher) time preferences of consumers. Do consumers want S or C
25. Austrian Recipe for Curing Depressions: Dos Therefore, there must be a reduction in the prices and production of capital goods (future consumption goods) and a relative increase in prices and production of consumer goods.
26. Austrian Recipe for Curing Depressions: Dos This means that some capital gods firms must go bankrupt and unemployment in the capital goods industries must temporarily increase until workers find jobs in the expanding consumer goods industries. Due to unlimited wants, there is never a “general glut” Never overproduction, just “mal-production”
27. Austrian Recipe for Curing Depressions: Dos Cut taxes-- ↓T → ↓C/S → ↑S → ↓i → ↑I → ↓U Cut government spending-- ↓G → ↓i → ↑I → ↓U Freeze Money Supply—ΔM = 0; this permits I to rise to its natural level to reflect people’s true time preferences and the actual amount of voluntary savings in the economy
28. Austrian Recipe for Curing Depressions: Dos Repeal laws (NLRA, minimum wage laws) that cause prices and wages to be rigid. Repeal business regulations, which raise costs of production and reduce the supply of goods. The increase in the supply of goods leads to higher real incomes and therefore causes a fall in t.p. and more voluntary saving, investment, and lower employment.
29. Austrian Recipe for Curing Depressions: Don’ts Interfere with the recession—“laissez faire” Re-inflate the money supply—allow prices and wages to fall to levels that clears the markets of excess supplies of goods and labor. Support prices and wages above equilibrium levels.
30. Austrian Recipe for Curing Depressions: Don’ts Raise taxes—this reduces voluntary saving and makes the recession longer and more painful because it increases C. People spend more to avoid 1099s Raise government spending—G is basically consumption spending which raises time preferences even further by diverting genuine saving away from investment by capitalists in the structure of production; this prolongs the recession and makes it more painful.
31. Keynes and Hayek: Head to Head An Application of Capital-Based Macroeconomics
32. Keynes and Hayek: Head to Head Friedrich A. Hayek 1899 — 1992 John Maynard Keynes 1883 — 1946
33. Visions and Frameworks Keynes’s vision of the economy suggests a circular-flow framework—in which earning and spending are brought into balance by changes in the level of employment. Hayek’s vision of the economy suggests a means-ends framework—in which the means of production are transformed over time into consumable output. Graphically, the circular flow appears as the Keynesian cross, the cross’s intersection identifying the particular state of the economy in which income and expenditures are in balance. Graphically, the means and ends appear as the Hayekian triangle, the triangle’s shape depicting the intertemporal pattern of investment. In equilibrium, the pattern of investment corresponds to the intertemporal preferences of consumers.
34. A BRIEF REVIEW of the KEYNESIAN CIRCULAR-FLOW FRAMEWORK
35. BUSINESS ORGANIZATIONS LABOR AND OTHER FACTOR SERVICES THE CIRCULAR-FLOW FRAMEWORK WORKERS CONSUMERS INVESTORS INCOME
36. BUSINESS ORGANIZATIONS EXPENDITURES consumption plus Investment LABOR AND OTHER FACTOR SERVICES GOODS AND SERVICES WORKERS CONSUMERS INVESTORS INCOME
37. BUSINESS ORGANIZATIONS EXPENDITURES consumption plus Investment Federal Reserve Policy SLOW 6 % FAST 2 % I N T E R E S T R A T E C O N T R O L WORKERS CONSUMERS INVESTORS INCOME
38. BUSINESS ORGANIZATIONS EXPENDITURES consumption plus Investment CONSUMPTION STAGES OF PRODUCTION WORKERS CONSUMERS INVESTORS INCOME
39. BUSINESS ORGANIZATIONS EXPENDITURES consumption plus Investment CONSUMPTION STAGES OF PRODUCTION WORKERS CONSUMERS INVESTORS INCOME
40. BUSINESS ORGANIZATIONS EXPENDITURES consumption plus Investment In Keynesian equilibrium, INCOME equals EXPENDITURES. Y = E For a wholly private economy: Y = C + I WORKERS CONSUMERS INVESTORS INCOME
41. C + I EXPENDITURES The economy is in a Keynesian equilibrium somewhere along the 45o line—the line itself identifying all possible income-expenditure equilibrium points. As taught at all levels, the consumption function is an essential component of the Keynesian framework. The presumed stability of this function underlies Keynesian thinking. Investment depends neither on (current) income nor on the rate of interest. It depends only on profit expectations, which themselves are not well-anchored in economic reality. INVESTMENT C = a + bY b 1 CONSUMPTION a 45o INCOME INCOME Consumption and Investment (as well as Government Spending) are portrayed as additive components of total spending. The three components are distinguished largely in terms of their stability characteristics: stable (C ), unstable (I), and stabilizing (G). A wholly private macroeconomy achieves an income-expenditure equilibrium when Y = C + I. Note that income itself (rather than prices, wages, or the interest rate) is the equilibrating variable.
42. C + I EXPENDITURES C = a + bY CONSUMPTION According to Keynes, it is only by “accident or design” that the economy is actually performing at its full-employment potential. We assume here that, initially, full employment conditions prevail—if only by accident. INCOME INVESTMENT Yfe Labor income (Y = WN) is fully representative of total income, such that changes in labor income stand in direct proportion to changes in total income. In capital-based macroeconomics, full employment implies that the economy is operating on its production possibility frontier, the PPF itself being defined in terms of sustainable output levels of consumption and investment goods. In Keynesian macroeconomics, full employment implies that the labor market clears at the going wage rate, the going wage itself having emerged during a period in which the economy was experiencing no macroeconomic problems. W S LABOR INCOME D N
43. C + I ΔI EXPENDITURES EXCESS INVENTORIES C = a + bY 1 (1 – b) ΔY = ΔI E < Y E = Y ΔY INCOME Yfe According to Keynes, a collapse of investment activity (the collapse being attributed to a waning of “animal spirits”) is the primary cause economic downturns. In response to reduced investment and hence reduced employment opportunities, the economy spirals downward into recession and possibly into deep depression. W Note that the going wage keeps going—even after the market conditions that gave rise to it are gone. S D The simple investment-spending multiplier, 1/(1-b), quantifies the extend of the downward spiraling. N
44. C + I ΔI EXPENDITURES EXCESS INVENTORIES C = a + bY 1 (1 – b) ΔY = ΔI E < Y E = Y ΔC ΔY INCOME Yfe According to Keynes, a collapse of investment activity (the collapse being attributed to a waning of “animal spirits”) is the primary cause economic downturns. In response to reduced investment and hence reduced employment opportunities, the economy spirals downward into recession and possibly into deep depression. W Note that the going wage keeps going—even after the market conditions that gave rise to it are gone. S D The simple investment-spending multiplier, 1/(1-b), quantifies the extend of the downward spiraling. N
45. EXPENDITURES C + I C = a + bY INCOME Yfe A further loss of confidence on the part of the business community will send the economy even further from its full-employment potential. In the Keynesian construction, prices and the wage rate are sticky downward. But note that they’re not stuck too high. They’re stuck just right. The going wage rate will clear the labor market once again—as soon as spending and hence labor demand recover to their full-employment levels. W S D N
46. EXPENDITURES C + I C = a + bY INCOME Yfe Recovery may be self-initiating. Waning animal spirits may become waxing animal spirits. In due time, a pressing need to maintain or replace depreciating capital may account for the lower turning point of a bust-and-recovery sequence. (Keynes, of course, preferred not to wait it out. He advocated make-work projects, deficit spending, and monetary stimulation to get the economy turned around.) W S D N
47. EXPENDITURES C + I C = a + bY INCOME Yfe Recovery may continue as further investment activity drives labor-demand back to its full-employment level... W S D N
48. C + I EXPENDITURES C = a + bY INCOME From full-employment onward, there is upward pressure on both prices and wage rates. And since prices and wage rates are not sticky upwards, the economy experiences a spiraling inflation. Yfe Recovery may continue as further investment activity drives labor-demand back to its full-employment level... The equilibrium points in the labor market traced out during the recovery and inflationary spiral constitute the so-called L-shaped supply curve. but there is nothing about “animal spirits” that will bring the recovery process to an end at full employment. Over-optimism may push the economy beyond its full-employment level. W S D N
49. MORPHING FROM CIRCULAR FLOW TO MEANS AND ENDS
50. C + I EXPENDITURES C = a + bY CONSUMPTION INCOME INVESTMENT Yfe The nature of the Keynesian-styled spiraling associated with recession, depression and inflation becomes more transparent with the production possibility frontier in play. Also, the PPF helps build a bridge from Keynes to Hayek. W S D N
51. C + I EXPENDITURES C = a + bY CONSUMPTION INCOME INVESTMENT Yfe A waning of animal spirits causes investment to decrease and with it income and consumption. The economy falls inside its PPF. W S D N
52. EXPENDITURES C + I C = a + bY CONSUMPTION INVESTMENT INCOME INVESTMENT Yfe Note that if investment were to fall to zero, the economy would settle into an income-expenditure equilibrium with Y = C. Thus, the vertical intercept of the Keynesian demand constraint is aligned with the intersection of the consumption function and the 45o line. A further waning sends the economy deeper into the PPF’s interior. Movements inside the frontier (and beyond it) trace out a linear relationship, showing how consumption varies with investment. W S D The straight line that passes through these points is the Keynesian demand constraint. N
53. C + I EXPENDITURES b (1 – b) a (1 – b) C = + I C = a + bY CONSUMPTION b 1 – b a (1 – b) INCOME INVESTMENT Yfe For simplicity, let a = 0 and b = 0.90. Then C = a + bY becomes C = 0.90Y. And C = a/(1-b) + b/(1-b) I becomes C = 9(I), which led Keynes to write: Equilibrium Condition: Y = C + I Consumption Equation: C = a + bY Solve for C = f(I): C = a + b(C + I) C = a + bC + bI C – bC = a + bI (1-b)C = a + bI C = a/(1-b) + [b/(1-b)]I “If, for example, the public are in the habit of spending nine-tenths of their income on consumption goods, it follows that if entrepreneurs were to produce consumption goods at a cost more than nine times the cost of the investment goods they are producing, some part of their output could not be sold at a price which covered its cost of production.” “The formula is not, of course, quite so simple as in this illustration…. But there is always a formula, more or less of this kind, relating the output of consumption goods which it pays to produce to the output of investment goods…. This conclusion appears to me to be quite beyond dispute. Yet the consequences which follow from it are at the same time unfamiliar and of the greatest possible importance.”
54. C + I EXPENDITURES C = a + bY CONSUMPTION INCOME INVESTMENT Yfe To keep track of possible interest-rate movements, the loanable-funds market can be brought into view. S RATE OF INTEREST Though Keynes argued that neither saving nor investment depend to any significant extent on the interest rate, he also argued that both curves (as conventionally drawn) shift together, leaving the interest rate unchanged. D SAVIING (S) INVESTMENT (D)
55. C + I EXPENDITURES C = a + bY CONSUMPTION INCOME INVESTMENT INVESTMENT Yfe With the loanable-funds market in play, we see that decreased investment is accompanied by a leftward shift in the demand for loanable funds, putting downward pressure on the interest rate. S RATE OF INTEREST Appearing in Keynes’s General Theory is this specific application of the loanable-funds framework. The implications, according to Keynes, is that the loanable-funds reckoning is, at best, superfluous. W S But the spiraling downward of income implies that the supply of loanable funds (a.k.a. saving) also shifts leftward, relieving the downward pressure on the interest rate. D D N SAVIING (S) INVESTMENT (D)
56. As shown on page 180 of his General Theory, Keynes presented the loanable funds market with the interest rate [ r ] on the horizontal axis. Although he failed to label the vertical axis, the accompanying text indicates that “saving” and “investment” are measured vertically. i Keynes’s diagram can be flipped over and rotated 90 degrees to make it conform to modern renditions of the market for loanable funds. S, I S, I Some of the saving curves are intended only to demonstrate that income is a shift parameter and are not otherwise relevant to Keynes’s argument. So, let’s omit them
57. i ieq S’ = I’ S = I S, I Keynes believed that a shift in investment demand would be accompanied by a matching shift in the saving schedule. Some of the saving curves are intended to demonstrate that income is a shift parameter and are not otherwise relevant to Keynes’s argument. So, let’s omit them.
58. EXPENDITURES C + I C CONSUMPTION INCOME INVESTMENT INVESTMENT Yfe S RATE OF INTEREST Appearing in Keynes’s General Theory is this specific application of the loanable-funds framework. The implications, according to Keynes, is that the loanable-funds reckoning is, at best, superfluous. D SAVIING (S) INVESTMENT (D)
59. C + I EXPENDITURES C CONSUMPTION INCOME INVESTMENT INVESTMENT Yfe Hence the Paradox: Try to save more and you’ll instead earn less! The rightward shift in supply of loanable funds puts downward pressure on the interest rate. But before there is any movement along the demand for loanable funds, the pressure is relieved as reduced consumption causes income and hence saving to fall. To resolve Keynes’s “Paradox of Thrift” requires only that we replace the Keynesian cross, which reflects the economy’s circular flow, with the Hayekian triangle, which depicts means and ends in their temporal sequence. Keynes also denied that an increase in saving would have the effect imagined by the loanable-funds theorists. Keynes’s “Paradox of Thrift,” as articulated in his General Theory is to the point: “Every ... attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself.” S RATE OF INTEREST S W S D D N SAVIING (S) INVESTMENT (D)
60. C + I EXPENDITURES C CONSUMPTION CONSUMPTION INCOME INVESTMENT Yfe The level of consumption that appears as a part of the Keynesian circular flow also appears in the capital-based framework as the consumable output of a temporal sequence of production activities. S RATE OF INTEREST D SAVIING (S) INVESTMENT (D)
61. CONSUMPTION CONSUMPTION CONSUMPTION STAGES OF PRODUCTION INVESTMENT INVESTMENT Note that the sole effect on the structure of production comes from the initial reduction in consumption. The derived-demand effect works undiminished on all the earlier stages. The interest rate is effectively out of play. The leftward shift of saving took the downward pressure off of interest rates. And, in any case, the capital structure is assumed to be fixed. The market mechanisms in play here are still those envisioned by Keynes. In accordance with the paradox, an increase in saving causes the economy to spiral down to a less-than-full-employment level. Keynes, however, assumed a “fixed structure of industry,” which in the current context implies a a Hayekian triangle of fixed shape, the only live issue being the triangle’s size, which represents the level of employment and the extent of capital utilization. We begin, as before, with the economy functioning at its full employment level. The labor market is representative of each of the stages of production that make up the economy’s capital structure. The level of consumption that appears as a part of the Keynesian circular flow also appears in the capital-based framework as the consumable output of a temporal sequence of production activities. S RATE OF INTEREST S W W S S D D D N N SAVIING (S) INVESTMENT (D)
62. Three modifications are needed to transform the Keynesian vision into the Hayekian vision: And now, the “Paradox of Thrift” becomes a “Gateway to Growth.” With wage rates and the interest rate both adjusting to changing market conditions, the economy can move along its PPF and the structure of production can adjust to an increase in saving. 1. Divide the structure of production into stages. 3. Get rid of the Keynesian Demand Constraint. 2. Allow for stage-specific labor markets---in which wage rates adjust to changed market conditions. CONSUMPTION CONSUMPTION STAGES OF PRODUCTION STAGES OF PRODUCTION STAGES OF PRODUCTION INVESTMENT INVESTMENT RATE OF INTEREST S W W W S S S D D D D D N N N SAVIING (S) INVESTMENT (D)
63. BUSINESS ORGANIZATIONS EXPENDITURES “Mr. Keynes’s aggregates conceal the most fundamental mechanisms of change.” ---F. A. Hayek CONSUMPTION STAGES OF PRODUCTION WORKERS FACTOR OWNERS CONSUMERS INCOME
64. Keynes and Hayek: Head to Head Friedrich A. Hayek 1899 — 1992 John Maynard Keynes 1883 — 1946
65. Austrians vs. Keynesians on Policy T-G = 0 is G austerity, not people cutting spending T-G < 0 is deficit spending
66. Austrians vs. Keynesians on Policy Summary: Austrians want to “save” our way out of depression Keynesians want to “spend” our way out of depression RBCT Not a ∆$ Technology shocks cause business cycles
67. Preventing Depressions Do not start an inflationary boom by expanding M and artificially lowering i. Abolish the Federal Reserve System. Restore the Gold Standard. Abolish fractional reserve banking.
68. Adam and the BRICKYARD
69. Adam and the Brickyard The old Soviet-style brickyard knows no markets and knows no prices. It serves only as a keeper of the bricks. The housing czar asks the brick czar how many houses can be built. The brick czar sends Adam to the brickyard to count the bricks. Adam’s count is overly optimistic: “Enough bricks to build six houses.” (Five may be a more realistic number.) The housing czar informs the master-builder, who then sets his workers to the task: two rows of three houses each.
70. Adam and the Brickyard The situation is summed up by Ludwig von Mises: “[Consider] the position of a master-builder whose task it is to erect a building out of a limited supply of building materials.” “If this man overestimates the quantity of the available supply, he drafts a plan [that cannot be carried to completion because] the means at his disposal are not sufficient.”
71. Adam and the Brickyard “He over sizes the groundwork and the foundation and only discovers later in the progress of the construction that he lacks the materials needed for the completion of the structure.” “It is obvious that our master-builder’s fault was not overinvestment [malinvestment], but an inappropriate employment of the means at his disposal.” LUDWIG VON MISES, HUMAN ACTION, 3rd ed., 1966 p. 560
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87. Adam and the Brickyard Query: Wouldn’t it help to print more money?
88. Adam and the Brickyard Query: Would it help to print more money?
89. Adam and the Brickyard Five houses could have been built had the master-builder set out to build just five. But in trying to build six, he was forced into liquidating (dismantling houses) owing to the lack of sufficient bricks. Given the losses (broken bricks) that always accompany liquidation, the master-builder, in the end, could only complete four houses. And so we have it: Boom, bust, liquidation, and (partial) recovery.
90. Adam and the Brickyard
91. Adam and the Brickyard The supply of bricks is given. It is represented by a vertical supply curve. If the bricks were sold rather than allocated by the housing czar, the demand for bricks would determine the market price.
92. Adam and the Brickyard If we allow for incentives to govern both sides of the brick market, then the supply of bricks is upward-sloping. With supply and demand fully in play, the market coordinates buying and selling and gives us and equilibrium price and quantity.
93. Adam and the Brickyard We can generalize from bricks to all investable resources and let our supply and demand depict the financial markets that mobilize those resources. The quantity axis shows saving (supply) and investment (demand). The “i” on the vertical axis stands for “Adam”--a.k.a. the interest rate.
94. Adam and the Brickyard At the equilibrium rate of interest, saving equals investment. Loanable funds supplied equals loanable funds demanded. The amount of investable resources supplied equals the amount demanded.
95. Adam and the Brickyard The supply of loanable funds reflects people’s inclination to save. This inclination--i.e., their savings preferences--can change. People may decide to save more--possibly for retirement or to finance their children’s education.
96. Adam and the Brickyard Saving more is depicted by a rightward shift in the supply of loanable funds. With more funds available at 5% than are demanded by the investment community, the interest rate is bid down--to 2.3% where, once again, saving equals investment. The economy grows more rapidly than before.
97. Adam and the Brickyard Without an increase in the supply of loanable funds, the economy’s growth rate is set by the equilibrium values of saving and investment: S = I = 800. If monetary expansion pushs the economy to grow faster, the increased growth rate is not sustainable.
98. Adam and the Brickyard Without an increase in the supply of loanable funds, the economy’s growth rate is set by the equilibrium values of saving and investment: S = I = 800. If monetary expansion pushes the economy to grow faster, the increased growth rate is not sustainable.
99. Adam and the Brickyard Pumping new money through credit markets has some effects that, initially, are similar to the effects of increased saving. The interest rate decreases. Investment increases. But the increased investment is accompanied by increased consumption. It is not funded by genuine saving.
100. Adam and the Brickyard Genuine saving actually decreases. Which is to say, consumption increases. In the story of Adam and the Brickyard, it is as if we were dealing not with bricks, but with gingerbread: At the same time builders are trying to build more gingerbread houses, the would-be future occupants are eating more gingerbread.
101. Adam and the Brickyard The conflict between (high levels of) investment and (low levels of) saving is, for a time, masked by credit creation. The change in the money supply is precisely I - S. Eventually, the boom is revealed to be artificial and the economy, short on bricks and shorter on gingerbread, experiences a bust.
102. The recession is the recovery period; the “hangover” following the binge of the artificial boom Bailouts Stimulus Packages Nationalizations More Regulations Low Interest Rates Lower Taxes Less Regulation Eliminate Price Controls Stop Inflating! The inevitable recession is the market process of adjusting the structure of production back to satisfying consumers’ real time-preferences. Bankruptcies, defaults and unemployment increase as the malinvestments are liquidated. This frees up the land, labor and capital to be put to use satisfying real consumer demand. The recession-recovery can only be slowed down and made more severe by government interference, since the market process requires free market prices.
103. Money creation cannot go on forever; a “permanent boom” is impossible Further money creation – attempting to keep interest rates low – may delay the bust, but it will only create even more malinvestments, which will cause a bigger bust in the future. Hyperinflation is when the money supply is increased so much (in an attempt to delay a bust) that the value of the money rapidly decreases, until it is almost worthless.
104. Government actions following the bust of 1929 caused the Great Depression The Forgotten Depression, 1920-21 From 1913 to 1920, the newly-founded central bank of the United States increased the money supply by 100%. This created a large artificial boom, resulting in an inevitable bust in 1920. Government Interventions to “Help The Economy”: Almost none The recession was severe, but short. Within 18 months, the economy had recovered. The Great Depression, 1929-1946 From 1921 to 1929, the central bank increased the money supply by 63%. This created a large artificial boom, resulting in an inevitable bust in 1929. Government Interventions to “Help The Economy”: Bailouts Stimulus packages Deposit “insurance” Bank nationalisations High government taxation/spending Public works High deficits/debts Price controls Further money creation Mass confiscation of gold The end of the classical “gold-standard” dollar The result was very severe, and long; the Great Depression; the economy did not recover for 17 years.
105. Remember Adam: Don’t bite off more than you can chew! “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”
106. Next Chapter Preview… Lesson XVII! Monetarists