EMERGENCE OF NCM

1
Department of Land Economy

• LECTURE 1
• EMERGENCE OF NCM
• Philip Arestis
• University of Cambridge and University of the
  Basque Country

2
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

3
Circular Flow of Income

• Figure 1 Circular flow of income

4
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

5
Circular Flow of Income

• Assuming closed economy
• Y E C I G
• C c0 c1YD
• with 0 lt c1 lt 1
• Y c0 c1(Y T) I G
• YD Y T
• Y c0 c1Y c1T I G

6
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
• ?Y 1/(1-c1). ?I or
• (?Y/ ?I) 1/(1-c1)
• i.e. the multiplier.

7
Circular Flow of Income

• Figure 2 Equilibrium level of income

45O
E
E
C
B
D
E
A
F
0
Y
8
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.
  

9
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 i1lt0. We can
• have

10
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

11
Circular Flow of Income

• Figure 3 The IS relationship

E
Y
Yo
r2
r1
r0
IS
Y0
Y1
Y2
12
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.

13
Real Sector

• Absolute income hypothesis (Keynesian)
• C c0 c1Y
• where c0 is autonomous consumption, and c1 is
  the marginal propensity to consume (equal to
• ?C/?Y, 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

14
Real Sector

• Figure 4 Consumption function

C
C c0 c1Y
Y
0
15
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

16
Real Sector

• Figure 5 Indifference curves

Y1(1r)Y2
Y2
C2
I2
I1
Y2
Y1
Y2/(1r)
Y1
C1
Y1
17
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 lt cp lt1. So, consumption is
  geared to permanent income, not current income.
  See Figure 6.

18
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 Y2Y2 is then
  transitory income. What permanent consumption
  would then be depends crucially whether the
  transitory component Y2Y2 is treated as
  permanent or not. If it is treated as permanent
  consumption is thereby C2P.

19
Real Sector
CLR

• Figure 6

C2P
CSR
C1T
C1P
Y
Y1
Y2
Y2
20
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

21
Real Sector

• We may, thus, have
• Ct wVt
• where Vt is the present value of total resources
• and
• Vt Wt-1 Yt ?YtE/(1r)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.

22
Real Sector

• Figure 7

C
Total Resources
Saving
C
Dissaving
Dissaving
0
Time
23
Real Sector

• Investment defined as additions to capital
  stock, i.e. to the nations productive assets
• I ?K
• 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.

24
Real Sector

• In what follows we discuss investment without
  referring to its parts. We begin with the
  possibility that II(r).
• V R1/(1r) R2/(1r)2 .. Rn/(1r)n
• where Vpresent net value of future yields
  (R), and r is the rate of interest.

25
Real Sector

• Compare V to the cost of undertaking investment
  (V), so that if VgtV 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.

26
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 II(r).

27
Real Sector

• Figure 8

r
0
I
28
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/(1i) R2/(1i)2 .. Rn/(1i)n
• and i is now called the marginal efficiency
  of capital we then compare i with r, so that if
  igtr investment is undertaken otherwise it is
  not.
• We may now explain how to derive Figure 8, where
  the I-relationship is depicted.

29
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.

30
Real Sector

• Accelerator hypothesis
• Y C I
• C a bYt-1
• I v?Yt-1 v(Yt-1 - Yt-2)
• so that
• Y a bYt-1 v Yt-1 - vYt-2
• ?Yt (bv) ?Yt-1 - v ?Yt-2
• Cyclical behaviour depending on the values of v
  and b, but mainly v.

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Real Sector
Cycles
0 lt b lt 1 v 0
0 lt b lt 1 v large
32
Real Sector

• Cycles

0 lt b lt 1 v relatively small
0 lt b lt 1 v relatively large
33
Real Sector

• Tobins 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
  firms
• capital stock (K0).
• Changes in q affects investment

34
Real Sector

• If qgt1, then investment increases installed
  capital produces higher market value for the
  firm. Thus investment increases if qlt1 the
  opposite happens. Thus investment decreases if
  q1 then nothing happens.
• See Figure 9.

35
Real Sector

• Figure 9

I
0
q
1
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Real Sector

• Residential investment
• Tobins 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

37
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.

38
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!

39
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.

40
Real Sector

• Government expenditure and taxes
• Recall Y 1/(1-c1).(c0 - c1T I G)
• (?Y/ ?G) 1/(1- c1)
• (?Y/ ?T) - c1/(1- c1)
• (?Y/ ?G) (?Y/ ?T) 1/(1- c1) - c1/(1-
• c1) (1- c1)/(1- c1) 1
• i.e. balanced budget multiplier.

41
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

42
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.

43
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)

44
Monetary Sector

• Figure 10

r
Demand for Money (MD) M(r, Y)
0
M
45
Monetary Sector

• Supply of money (MS) Figure 11

r
0
M
46
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 (scp)D

47
Monetary Sector

• So that
• M (1cp)/(scp).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?

48
Monetary Sector

• Equilibrium in the money market Figure12

r
re
0
M
MDMS
49
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 (1r).1
  but inflation in the next period is important
  thus (1r) (1R).(1pt1), where pt1 is the
  inflation rate in period t1 this is
  approximated to
• r R pt1 or
• R r - pt1
• But r is normally assumed.

50
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
Y
Y2
51
Monetary Sector

• The IS-LM model Figure 14

r
LM
re
IS
0
Y
Ye
52
Foreign Sector

• Open economy considerations Figure 15

r
LM
BP
re
IS
0
Ye
Y
53
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
54
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

55
Foreign Sector

• Economic policy flexible exchange rate Figure 17

LM
r
BP
BP
B
C
A
re
IS
IS
IS
0
Y
Ye
56
Foreign Sector

• Economic policy flexible exchange rate Figure 18

LM
r
LM
BP
BP
A
re
C
B
IS
IS
0
Ye
Y
57
Inflation

• Inflation Figure 19

LM
r
re
IS
0
Y
Ye
PC
P
0
Y
Ye
58
Inflation

• Inflation Figure 20

W/P
W/P
NS
(W/P)e
ND
(
Ne
N
NS-ND)/NS
W
U
59
Inflation

• Inflation Figure 21

W
LRPC
C
D
W2
B
W1
A
0
U
U1
U
SRPC1
SRPC2
60
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)

61
Inflation

• Figure 22

P
M1
M2
P(V/Y)M
P2
P1
0
M1
M
M2
62
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.

63
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

64
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

65
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.