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UNIVERSITY OF CAMBRIDGE Department of Land Economy LECTURE 1 EMERGENCE OF NCM Philip Arestis University of Cambridge and University of the Basque Country Department of Land Economy 1 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 Department of Land Economy 2 Circular Flow of Income Figure 1: Circular flow of income Department of Land Economy 3 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 Department of Land Economy 4 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 Department of Land Economy 5 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. Department of Land Economy 6 Circular Flow of Income Figure 2: Equilibrium level of income 45O E E’ E2 E1 0 B A Y1 Department of Land Economy C D E F Y2 Y 7 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. Department of Land Economy 8 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: Department of Land Economy 9 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: Department of Land Economy 10 Circular Flow of Income Figure 3: The IS relationship 45O E 0 Yo Y1 r2 r1 r0 Department of Land Economy Y2 E’ E E’’ Y IS 11 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. Department of Land Economy 12 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 Department of Land Economy 13 Real Sector Figure 4: Consumption function C C = c0 + c1Y 0 Department of Land Economy Y 14 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 Department of Land Economy 15 Real Sector Figure 5: Indifference curves Y1(1+r)+Y2 Y’2 C2 I2 I1 Y2 Y’1 Borrowing Department of Land Economy Y1 C1 Y1+Y2/(1+r) Saving 16 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. Department of Land Economy 17 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. Department of Land Economy 18 Real Sector CLR Figure 6 P C2 C1T C1P CSR Y1 Y2’ Department of Land Economy Y2 Y 19 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; Department of Land Economy 20 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. Department of Land Economy 21 Real Sector Figure 7 C Total Resources Saving C’ Dissaving Dissaving 0 Department of Land Economy Time 22 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. Department of Land Economy 23 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. Department of Land Economy 24 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. Department of Land Economy 25 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). Department of Land Economy 26 Real Sector Figure 8 r 0 Department of Land Economy I 27 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. Department of Land Economy 28 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 righthand 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. Department of Land Economy 29 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. Department of Land Economy 30 Real Sector Cycles 0<b<1 v=0 Department of Land Economy 0<b<1 v = large 31 Real Sector Cycles 0<b<1 v = relatively small Department of Land Economy 0<b<1 v = relatively large 32 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: Department of Land Economy 33 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. Department of Land Economy 34 Real Sector Figure 9 I 0 Department of Land Economy 1 q 35 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: Department of Land Economy 36 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. Department of Land Economy 37 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! Department of Land Economy 38 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. Department of Land Economy 39 Real Sector Government expenditure and taxes Recall Y = [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/(1c1)] = (1- c1)/(1- c1) = 1 i.e. balanced budget multiplier. Department of Land Economy 40 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; Department of Land Economy 41 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 nonRicardian consumers: fiscal policy still effective. Department of Land Economy 42 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) Department of Land Economy 43 Monetary Sector Figure 10 r Demand for Money (MD) = M(r, Y) 0 Department of Land Economy M 44 Monetary Sector Supply of money (MS): Figure 11 r 0 Department of Land Economy MS M 45 Monetary Sector Money multiplier: it is: (1) M = CP + D (2) H = CP + R (3) CP = cpD (4) R = sD So that: (1)’ M = cpD + D = (1+ cp)D (2)’ H = cpD + sD = (s+cp)D Department of Land Economy 46 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? Department of Land Economy 47 Monetary Sector Equilibrium in the money market: Figure12: r MS re 0 MD=MS Department of Land Economy M 48 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. Department of Land Economy 49 Monetary Sector The LM relationship: Figure 13 r r2 MS r1 M(r,Y2) r0 0 r2 r1 r0 0 M(r,Y1) M(r,Y0) M LM Y0 Y1 Department of Land Economy Y2 Y 50 Monetary Sector The IS-LM model: Figure 14 r LM re IS 0 Department of Land Economy Ye Y 51 Foreign Sector Open economy considerations: Figure 15 r LM BP re IS 0 Department of Land Economy Ye Y 52 Foreign Sector Economic policy: fixed exchange rate: LM r Figure 16 LM’ rre’e B C A BP B’ IS’ IS 0 Department of Land Economy Ye Ye’ Y 53 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; Department of Land Economy 54 Foreign Sector Economic policy: flexible exchange rate: LM r Figure 17 BP’ re A C B BP IS’ IS’’ IS 0 Department of Land Economy Ye Y 55 Foreign Sector Economic policy: flexible exchange rate: r LM LM’ Figure 18 BP BP’ re A B C IS 0 Department of Land Economy Ye Y 56 IS’ Inflation Inflation: Figure 19 LM r re IS 0 P 0 Department of Land Economy Ye Ye PC Y Y 57 Inflation Inflation: Figure 20 W/P NS W/P (W/P)e Ne ND N W (NS-ND)/NS U% Department of Land Economy 58 Inflation Inflation: Figure 21 W LRPC W2 W1 0 C D B A U1 U* U% SRPC1 Department of Land Economy SRPC2 59 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) Department of Land Economy 60 Inflation Figure 22 P M1 M2 P=(V/Y)M P2 P1 0 Department of Land Economy M1 M2 M 61 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. Department of Land Economy 62 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; Department of Land Economy 63 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; Department of Land Economy 64 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. Department of Land Economy 65