Lecture Twelve

1
Lecture Twelve

• Debate in Economics
• Theory of Capital/Income
• Theories of Money
• Neoclassical Exogenous
• Post Keynesian Endogenous

2
Theoretical Developments

• Behind policy fight, theoretical battles
• Perfection of Walrasian GE model (Arrow-Debreu)
• Classically-inspired critique of neoclassicism
  (Sraffa)
• Arrow-Debreu General Equilibrium
• proof of existence/uniqueness/stability/optimality
  of equilibrium (completing Walras work), but
• under assumptions of given resources, given
  tastes, given possible future states of world,
  contingent contracts, and no uncertainty, and
  peculiar definition of commodities
• The Keynesian Critique reality that factors of
  production are commodities, labour, land applied
  to show that neoclassical theory is internally
  inconsistent

3
Not cut and dried

• Though textbooks dont show it, economic theory
  often hotly debated by economists. Five instances
  shown here among many
• Sraffas 1926-30 critiques of diminishing
  marginal productivity
• Sraffas 1960 critique of general equilibrium and
  marginal productivity theory of distribution
• Shot in the foot Sonnenshein-Mantel-Debreu
  conditions on aggregation of individual demand
  curves
• Logical critique of Marshallian theory of the
  firm
• Is money exogenous or endogenous?

4
Sraffas argument

• Two key assumptions of short run theory of the
  firm
• Independent supply and demand curves
• Diminishing marginal productivity
• in practice are mutually inconsistent
• Independent supply and demand curves realistic
  when define industry narrowly (e.g., wheat)
• but then increased production will result from
  industry drawing marginal doses of allegedly
  fixed resource from other industries, inputs
  lying fallow
• Constant returns, constant costs

5
Sraffas argument

• If we next take an industry which employs only a
  small part of the 'constant factor' (which
  appears more appropriate for the study of the
  particular equilibrium of a single industry), we
  find that a (small) increase in its production is
  generally met much more by drawing 'marginal
  doses' of the constant factor from other
  industries than by intensifying its own
  utilisation of it thus the increase in cost will
  be practically negligible (Sraffa 1926)

6
Sraffas argument

• Diminishing marginal productivity realistic when
  industry defined widely (e.g., Agriculture)
• Input of fixed resource can be increased only
  with difficulty
• But then change in output of this industry will
  affect income distribution
• change in income distribution will affect demand
• impossible to ignore feedback effects between
  supply and demand

7
Sraffas argument

• If in the production of a particular commodity a
  considerable part of a factor is employed, the
  total amount of which is fixed or can be
  increased only at a more than proportional cost,
  a small increase in the production of the
  commodity will necessitate a more intense
  utilisation of that factor, and this will affect
  in the same manner the cost of the commodity in
  question and the cost of the other commodities
  into the production of which that factor enters
  and since commodities into the production of
  which a common special factor enters are
  frequently, to a certain extent, substitutes for
  one another ... the modification in their price
  will not be without appreciable effects upon
  demand in the industry concerned. (Sraffa 1926)

8
Sraffas argument

• Implication of Sraffas argument constant
  marginal costs in the short run
• In normal cases the cost of production of
  commodities produced competitively ... must be
  regarded as constant in respect of small
  variation in the quantity produced. And so, as a
  simple way of approaching the problem of
  competitive value, the old and now obsolete
  theory which makes it dependent on the cost of
  production alone appears to hold its ground as
  the best available. (Sraffa 1926)
• Sraffas argument largely ignored by profession
• replies focused on his critique of concept of
  diminishing returns in long run rather than short
  run

9
The Cambridge Controversies

• Critique of neoclassical economics initiated by
  Joan Robinson, Piero Sraffa (Cambridge UK) over
  nature of capital vis a vis land, labour
• Theory defended by Paul Samuelson, Robert Solow
  (Cambridge USA)
• Focus of attack validity of neoclassical theory
  of distribution based on supply and demand

10
The Cambridge Controversies

• Neoclassical theory argues that
• increasing supply of factor of production will
  reduce its price
• reducing its price will increase its use in
  production
• Factors price equals its marginal product
• Direct relationship between supply of factor and
  its price
• Models production as
• involving factors of production (Land, Labour,
  Capital) as inputs and goods as outputs
• versus classical position goods produced using
  goods and labour as inputs
• The neoclassical position of profit and capital
  is

11
The Cambridge Controversies
Increasing supply Decreasing price...
Diminishing marginal product
Increasing use of factor relative to others...
Marginal Product
Rate of profit is the marginal product of capital
Capital
12
The Cambridge Controversies

• Exact apportioning of income to marginal
  productivity generates adding up problem
• Real wage equals MPL
• Rate of profit equals MPK
• So Total output equals

• Presume a standard neoclassical production
  function

• Differentiate w.r.t. L K to work out MPs

• Multiply by L K to work out incomes

13
The Cambridge Controversies

• Collect terms

• Then substitute in the definition of production

• What does ab1 mean?
• Neoclassical theory of distribution only
  consistent with constant returns to scale
• Double all inputs, output doubled
• But

14
The Cambridge Controversies

• Returns to scale highly unlikely to be simply
  constant
• Remember Smith on division of labour larger
  scale output enables greater specialisationincrea
  sing returns to scale
• Decreasing returns possible in some circumstances
• Double size and number of crew on supertankerit
  breaks in two and sinks
• Neoclassical theory of distribution thus valid
  only in extremely unlikely circumstance of
  constant returns to scale
• Problem arises from treating return to all
  factors as return for effort, versus (e.g.)
  treating return to capital as a surplus.

15
The Cambridge Controversies

• Bhaduri adds second critique
• Marginal approach to factor productivity
  perhaps valid at individual firm level
• But marginal approach to factor returns an
  aggregate phenomenononly possible if can ignore
  feedback effects of change on other industries
• But cant do this in aggregate

• Consider just profit

16
The Cambridge Controversies

• In general, dY/dK is

• This only equals the rate of profit if

• These assumptions perhaps valid at level of
  single firm or industry
• But at level of economy
• Changing amount of capital will change
  distribution of income, thus

• Given assumption of diminishing marginal
  productivity

• So profit cant equal marginal product of capital!

17
The Cambridge Controversies

• Sraffa, 1960
• Take economy in full general equilibrium
• All marginal changes complete
• What determines prices in full equilibrium if all
  marginal changes are over?
• Self-reproducing system of commodity production
• inputs commodities labour
• output commodities
• equilibrium prices of outputs must enable their
  purchase as inputs in next period
• System (1) Simple reproduction, commodity inputs
  only

18
The Cambridge Controversies

• 240 qr wheat 12 t iron 18 pigs --gt 450 qr
  wheat
• 90 qr wheat 6 t iron 12 pigs --gt 21 t
  iron
• 120 qr wheat 3 t iron 30 pigs --gt 60 pigs
• 450 qr wheat 21 t iron 60 pigs (sum of
  inputssum of outputs)
• Regardless of demand, prices must allow system to
  reproduce itself
• 450 qr wheat must buy 240 qr wheat, 12 t iron, 18
  pigs
• 21 t iron must buy 90 qr wheat, 6 t iron, 12 pigs
• 60 pigs must buy 120 qr wheat, 3 t iron, 30 pigs

19
The Cambridge Controversies
System of production
As a matrix equation
Has the solution
i.e., price system for simple reproduction
independent of demand, marginal utility, etc.
depends instead on system of production
20
The Cambridge Controversies

• System (2) Expanded reproduction
• surplus produced, must be split between
  capitalists and workers
• in equilibrium, a uniform rate of profit r,
  uniform wage w

21
The Cambridge Controversies

• r w values determine split of surplus between
  capitalists, workers. To determine prices, must
  therefore know either r or w beforehand
• Distribution therefore not determined by market
• Instead, different pattern of prices for every
  pattern of distribution marginal productivity
  theory of income distribution incorrect in
  general equilibrium
• But what about validity of production function,
  isoquants, when marginal changes still relevant?

22
The Cambridge Controversies

• Neoclassical position (by Samuelson)
• Concedes Classical position more factual
• output produced by heterogeneous commodities and
  labour, aggregate capital an abstraction
• But neoclassical position still defensible as an
  abstraction
• Samuelson (for neoclassicals) argues
• isoquants just a parable we use to teach students
• reality is different technologies, each with
  fixed ratio of capital to labour
• increase in price of capital will lead to less
  capital intensive technology being chosen

23
The Cambridge Controversies
Technology 1 low K/L ratio, used when K expensive
Envelope is isoquant
Technology 5 high K/L ratio, used when K cheap
Decreasing price of capital means more capital
intensive methods used, akin to simple parable
that decreased price means more capital used
24
The Cambridge Controversies

• As an aside, Samuelson ridicules classical
  theorys problems with labour theory of value,
  that capital-labour ratios must be the same in
  all industries.
• Problem Samuelson assumes each technology can be
  represented by a straight line relationship
  between capital and labour
• Garegnani shows that straight line relationship
  only applies if capital to labour ratio is the
  same in all industries
• If K/L ratios differ, each technology will be
  represented by a curve, not a straight line
• Curves can cut each other in more than one place

25
The Cambridge Controversies
Technology 1 low K/L ratio, used when K expensive
Envelope is isoquant
Technology 2 only used in intermediate K/L price
range
Technology 1 could also be used when K cheap
Problem known as reswitching simple
neoclassical parabledoes not work when multiple
industries considered.
26
The Cambridge Controversies

• Why a curved relationship?
• The definition of capital
• What is capital?
• Money?
• Machine?
• Both, obviously but how to add machines
  together?
• Money value only common feature
• but money value reflects expected profit
• rate of return and value of capital thus
  linked
• Sraffas solution reduce all machines to dated
  labour
• Machine today produced with
• labour last year, plus
• machinery inputs last year

27
The Cambridge Controversies

• If economy has been in long run equilibrium for
  indefinite past
• then all goods produced earned normal rate of
  profit r
• therefore value of machine now equals
• value of previous years inputs (labour and
  capital)
• multiplied by 1r
• Do it again replace last years machine inputs
  with
• labour and capital used to produce those machines
• multiplied by (1r)2
• Get a whole series of terms for the labor input
  each year multiplied by 1r, (1r)2, (1r)3
• Machine/commodity component reducible to almost
  (but not quite) zero.

28
The Cambridge Controversies

• Next the standard commodity
• Earlier, Sraffa shows how to devise a measure of
  value unaffected by the distribution of income
  the standard commodity
• When measured using this, there is a simple
  linear relationship between the real wage w, the
  rate of profit r, and the maximum possible rate
  of profit R

This can be reworked to give an expression for
the wage in terms of the rate of profit
29
The Cambridge Controversies

• Each years labor input to producing a machine
  today is thus broken down into
• the number of units of labor performed (say 1
  unit)
• times the wage rate w (now expressed in terms of
  r R)
• times 1r raised to the power of n, for how many
  years ago the labor was applied

Number of years ago that machine was made
Wage in terms of rate of profit
Rate of profit
Expression gives an unambiguous value for todays
capital input in terms of dated labor, but the
measured value of capital depends on the rate of
profit
30
The Cambridge Controversies

• So rather than the rate of profit depending on
  the amount of capital (marginal product theory of
  income distribution), the amount of capital
  depends on the rate of profit
• Second problem this relationship is very
  nonlinear
• First part falls uniformly as rate of profit
  rises
• Second part
• rises slowly as r rises
• rises rapidly as n (number of years ago rises)
• Two parts interact very unevenly
• For small change in r, second effect outweighs
  first as n rises
• For large change in r, first effect outweighs
  second for small n
• In between, cant pick whether increasing r will
  increase or decrease measured amount of capital

31
The Cambridge Controversies
Value of machine produced with one unit of labor
applied n years ago at a rate of profit r between
zero and 25 when R25
Made this year (n0)
Made 5 years ago (n5)
r0
r25
Measured value rises then falls as rate of
profit rises
Made 25 years ago (n25)
Made 10 years ago (n10)
32
The Cambridge Controversies

• Cant apply marginal productivity theory to
  capital
• return to capital cant reflect marginal product
  of capital
• measured amount of capital depends on rate of
  profit
• numerator/y-axis (r) and denominator/x-axis
  (amount of capital) are interdependent
• relationship is messy
• rises as r rises for a while
• then falls as r rises
• Rate of profit therefore cant be marginal
  productivity of capital

33
The Cambridge Controversies

• Numerous other facets to Cambridge Controversies
• Minority of neoclassicals who got involved in
  debate (Samuelson, Solow, Hahn, etc.) had 2
  eventual responses
• Grudgingly conceded critique had validity and
  started to develop alternative approaches to
  neoclassicism themselves (Samuelson, Solow)
• Abandoned attempt to make neoclassical economics
  relevant to real world and developed general
  equilibrium models as abstract thought
  experiments only (Hahn, etc.)
• Majority of neoclassicals assumed (wrongly) that
  debate won by neoclassicals and continued on as
  always.

34
The traditional view

• Money a veil over barter
• No impact on real transactions
• Common to some classicals (Smith, Ricardo, Mill)
  and neoclassicals
• Strongest proponent Say

Every producer asks for money in exchange for
his products, only for the purpose of employing
that money again immediately in the purchase of
another product for we do not consume money, and
it is not sought after in ordinary cases to
conceal it ... producers, though they have all of
them the air of demanding money for their goods,
do in reality demand merchandise for their
merchandise. OREF I 118
35
Micro version

• Theory of consumer demand
• Indifference curves show preferences between goods

Budget line shows income, absolute prices
Double all prices, income, no change in preferred
bundle
Chips
Beer
Money prices irrelevant, only relative prices
matter
36
Macro version

• Quantity theory of money

No. of transactions (level of output)
Stock of money
Price level
No. of times stock turns over in a year

• Stock of money (controlled by government) sets
  absolute price level
• Inflation caused by money supply growth exceeding
  output growth
• Solution increase M by rate of growth of T
  (Monetarism)

37
Macro version

• Quantity theory explanation for inflation

No change in T (set by real factors)
P must rise
V assumed constant
Increase M
Causation runs from M to P
38
Rival approach Endogenous money

• Origins in Banking School, Tooke, Marx
• Modern-day Keynes, Post Keynesians
• Money not neutral in short or long run
• Money supply endogenous
• Critical of neoclassical micro macro

39
Endogenous money Micro

• Neoclassical budget line argues 100 of income
  spent
• Money allocated to saving seen as just another
  form of spending
• No utility from holding money itself
• Keyness criticism
• Money held for liquidity, given uncertain future
• our desire to hold Money ... is a barometer of
  the degree of our distrust of our own
  calculations and conventions concerning the
  future OREF II 18
• So Money gives utility, but highly
  unstable--shifts as expectations change
• Indifference curve analysis inappropriate for
  consumer behaviour under uncertainty

40
Endogenous money Micro

• The Money just a veil fallacy
• Neoclassical micro
• Double prices incomes, no change in welfare
• Real world
• Double prices incomes
• better off if in debt
• worse off if net lender
• Inflation can reduce real debt burden. An
  example
• Borrower Income 40K, Mortgage 120K, Interest
  rate 9 repayments 12K Disposable income 28K
• Double prices incomes Income 80K, repayments
  still 12K Disposable income 68K

41
Endogenous money Micro

• Borrower
• 2.4 times disposable income from doubling
  income/prices
• Definitely better off 6K increase in spending
  in old prices
• Lender
• Inflation reduces value of assets
• Thus inflation has income distribution effects
• Workers normally borrowers
• Benefit from inflation
• Some rich (rentiers) normally lenders
• Lose from inflation

42
Endogenous money Micro

• Economy not barter based but credit
• Major companies have lines of credit
• Can borrow between zero and some maximum at will
• Used to buffer input price changes, wage
  payment/changes, new ventures, etc.
• Instant increase in loan means instant increase
  in credit money supply
• Direction of causation runs from price changes
  (including wages) to money supply
• reverse of Monetarist view (increase in money
  supply causes increase in prices)
• Basil Moore other US monetary Post Keynesians
  main proponents of this view

43
Endogenous money Macro

• Quantity Equation a truism

But...
These 3 are givens
Price level
Output
This is just a ratio
Stock of money

• Exogenous money (Friedman) argues V stable
• Endogenous money argues V variable
• Statistics support Endogenous money
• V rises during booms/deregulation
• V falls during slumps/reregulation

44
Endogenous money Macro

• Quantity Equation
• is flexible
• works backwards

Changes in P T (e.g., increase in wages) force
changes in money supply
Causation runs from PT to M
If M inflexible during a boom, V can rise
via financial innovations
where
money multiplier
Base money
Bank loans (M3)
45
Endogenous money Macro

• Reserve Bank controls B but
• Primary role lender of last resort guarantees
  depositors funds
• If bank gets into trouble, Reserve will
• Relax (increase) m
• Expand B to suit
• The need for an elastic currency to offset
  weekly, monthly and seasonal shocks, and avert
  the resulting chaotic interest rate fluctuations
  and financial crises, was the major determining
  factor in the formation of the Federal Reserve
  System (Moore 2 540)

So causation runs backwards in the money
multiplier too
46
Endogenous money Macro

• Significance of endogenous money argument
• Money matters finance sector has significant
  effects on real output, employment, etc.
• Government policy severely constrained
• Cannot control money supply (or cant control
  easily)
• Interest rate affects not just propensity to
  invest, but ability to repay debt
• Mechanics of endogenous money first spelt out by
  Basil Moore
• Argues money supply in LM model is not vertical
  (Reserve Bank controlling quantity) but
  horizontal (Reserve sets short interest rate,
  credit system determines supply of money)

47
Endogenous money the main mechanisms

• Moore argues
• Primary short term role of banks is to provide
  firms with working capital
• Primary need for additional working capital is
  new wage demands or material costs
• Also role in investment
• Debt seems to be the residual variable in
  financing decisions. Investment increases debt,
  and higher earnings tend to reduce debt. (Fama
  and French 1997)
• The source of financing most correlated with
  investment is long-term debt These correlations
  confirm the impression that debt plays a key role
  in accommodating year-by-year variation in
  investment. (Fama and French 1998)
• Credit expands contracts w.r.t. needs of firms

48
Endogenous money the main mechanisms

• Firms face new wage/material cost/investment
  demand
• Firms extend lines of credit with banks for
  working capital/investment finance shortfalls
• Increased loans lead to increased deposits by
  recipients of expenditure
• New deposits are created after the loans, but
  balance the new indebtedness
• Central bank need to underwrite liquidity ensures
  changes to base/money multiplier (itself no
  longer monitored) accommodate additional loans
• Causation thus works
• From P and T to M (with volatile V)
• From M to m and B

49
Endogenous money initial consequences

• The money supply is determined by the demands of
  the commercial sector, not by the government
• It can therefore expand and contract regardless
  of government policy
• Credit money carries with it debt obligations
  (whereas fiat or commodity money does not),
  therefore debt dynamics are an important part of
  the monetary system
• Financial behaviour of commercial sector is thus
  a crucial part of the economic system.
• What does the data tell us about
  exogenous/endogenous debate?

50
Data on Endogeneity vs Exogeneity

• M1 and monetary base would need to lead M2, M3,
  inflation and/or trade cycle for exogenous view
  of money supply to be corect
• Kydland Prescott 1990
• Statistical analysis of leads lags in US
  Economy
• There is no evidence that either the monetary
  base or M1 leads the cycle, although some
  economists still believe this monetary myth. Both
  the monetary base and M1 series are generally
  procyclical and, if anything, the monetary base
  lags the cycle slightly.
• US Flow of Funds data shows
• ratio between broader money and M1 appears
  procyclical and very unstable
• Debt to Money ratio has grown and cycled as
  Minsky predicted

51
Kydland and Prescotts conclusions re money

• "This finding that the real wage behaves in a
  reasonably strong procyclical manner is counter
  to a widely held belief in the literature."
  (13-14)
• Supports Moore on main role of working capital
• The chart 4 shows that the bulk of the
  volatility in aggregate output is due to
  investment expenditures. (14)
• A Keynesian perspective, despite neoclassical
  leanings of authors
• "There is no evidence that either the monetary
  base or M1 leads the cycle, although some
  economists still believe this monetary myth. Both
  the monetary base and M1 series are generally
  procyclical, and, if anything, the monetary base
  lags the cycle slightly." (14)
• So M1 lags the cycle

52
Kydland and Prescotts conclusions re money

• "The difference in the behaviour of M1 and M2
  suggests that the difference of these aggregates
  (M2 minus M1) should be considered. This
  component mainly consists of interest-bearing
  time deposits, including certificates of deposit
  under 100,000. It is approximately one-half of
  annual GDP, whereas M1 is about one-sixth. The
  difference of M2-M1 leads the cycle by even more
  than M2 with the lead being about three
  quarters.
• From Table 4 it is also apparent that money
  velocities are procyclical and quite volatile."
  (17)
• M2 leads the cycle, while M1 lags it
• Then how can M1 cause M2, which is the
  presumption of exogenous money theory?
• Again, despite neoclassical leanings of authors,
  results and conclusions support non-neoclassical
  perspectives

53
Ratios of US Key Monetary Variables 1959-2000
Blowout in M3M1 ratio coincides with US Stock
Market Bubble
The new economy or a credit bubble?
54
USA Money Supply 1959-2001

• Same data, now in terms note growing role of
  credit money

• M1 from 50 to lt20 of supply growth of M1
  during post-1989 downturn growth of M2/3 during
  new economy

55
Debt Secular trend and cycles a la Minsky
Its a new economy, Jim, but not as wed like to
believe it
56
Role of Endogenous Money

• Endogenous money gives fundamentally different
  picture of economy to exogenous money
• Money crucial vs money neutral
• No natural rate for output, employment vs
  natural rates set by real forces, independent of
  money credit
• Government unable to control money supply, but
• government counter-cyclical policy vital vs no
  government intervention is best exogenous money
  case
• Endogenous money integrates finance with macro,
  vs micro focus of EMH and macro/finance divorce

57
Endogenous money consequences

• The money supply is determined by the demands of
  the commercial sector, not by the government
• It can therefore expand and contract regardless
  of government policy
• Credit money carries with it debt obligations
  (whereas fiat or commodity money does not),
  therefore debt dynamics are an important part of
  the monetary system
• Financial behaviour of commercial sector is thus
  a crucial part of the economic system.