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Department of Land Economy 1
UNIVERSITY OF
CAMBRIDGE
Department of Land Economy
LECTURE 1
EMERGENCE OF NCM
Philip ArestisUniversity of Cambridge and University of
the Basque Country
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Department of Land Economy 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
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Department of Land Economy 3
Circular Flow of Income
Figure 1: Circular flow of income
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Department of Land Economy 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
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Department of Land Economy 5
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
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Department of Land Economy 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:
ΔY = [1/(1-c1)]. ΔI or
(ΔY/ ΔI) = 1/(1-c1)i.e. the multiplier.
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Department of Land Economy 7
Circular Flow of Income
Figure 2: Equilibrium level of income
Y0 Y1 Y2
E
E2
E1A
BC
D
F
E
E’45O
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Department of Land Economy 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.
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Department of Land Economy 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 i1<0. We can
have:
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Department of Land Economy 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:
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Department of Land Economy 11
Circular Flow of Income
Figure 3: The IS relationship
Y0 Y1 Y2
E
E
E’45O
IS
Yo
Y0 Y1 Y2
E’’
r2
r1
r0
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Department of Land Economy 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.
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Department of Land Economy 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
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
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Department of Land Economy 14
Real Sector
Figure 4: Consumption functionC
Y
C = c0 + c1Y
0
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Department of Land Economy 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
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Department of Land Economy 16
Real Sector
Figure 5: Indifference curves
Y1(1+r)+Y2
Y1+Y2/(1+r)
Y’2
C2
Y2
Y’1 C1 Y1
Borrowing Saving
I1
I2
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Department of Land Economy 17
Real Sector
Consumption smoothing shown in Figure 5 forms the basis for permanent and life cycle theories of consumption. Permanent Income HypothesisY = 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.
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Department of Land Economy 18
Real Sector
In figure 6, consider income Y1, which gives permanent consumption C1
P. If income is Y2, then we have consumption at C1
T, 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 C2
P.
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Department of Land Economy 19
Real Sector
Figure 6CLR
CSR
YY1
C1P
C2P
C1T
Y2’ Y2
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Department of Land Economy 20
Real Sector
Life cycle hypothesisConsumers 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;
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Department of Land Economy 21
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.
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Department of Land Economy 22
Real Sector
Figure 7
C
Time0
DissavingDissaving
Saving
Total Resources
C’
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Department of Land Economy 23
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.
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Department of Land Economy 24
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.
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Department of Land Economy 25
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.
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Department of Land Economy 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: I#I(r).
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Department of Land Economy 27
Real Sector
Figure 8
r
I0
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Department of Land Economy 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/(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.
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Department of Land Economy 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.
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Department of Land Economy 30
Real Sector
Accelerator hypothesisY = 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.
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Department of Land Economy 31
Real Sector
0 < b < 1v = 0
0 < b < 1v = large
Cycles
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Department of Land Economy 32
Real Sector
Cycles
0 < b < 1v = relatively small
0 < b < 1v = relatively large
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Department of Land Economy 33
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:
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Department of Land Economy 34
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.
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Department of Land Economy 35
Real Sector
Figure 9
0 q
I
1
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Department of Land Economy 36
Real Sector
Residential investment
Tobin’s q theory fits nicely this type of
investment;
Clearly, qH = V0H /PH, where V0
H 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:
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Department of Land Economy 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.
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Department of Land Economy 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!
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Department of Land Economy 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.
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Department of Land Economy 40
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/(1-
c1)] = (1- c1)/(1- c1) = 1
i.e. balanced budget multiplier.
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Department of Land Economy 41
Real Sector
Crowding-outChanges in G, or T, has no impact on
Income; private expenditure is reduced at thesame time and by the same amount;
Crowding-In?Ricardian ModelRicardian consumers are rational, utility
maximisers, forward-looking and smoothconsumption over time;
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Department of Land Economy 42
Real Sector
Permanent income is more relevant thancurrent income;
Consequently, G and T policies wouldinfluence future spending and tax policies,which Ricardian consumers are able topredict; an increase in G means T increases infuture, so no impact on Y;
But real world a mixture of Ricardian and non-Ricardian consumers: fiscal policy still effective.
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Department of Land Economy 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)
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Department of Land Economy 44
Monetary Sector
Figure 10
r
M0
Demand for Money (MD) = M(r, Y)
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Department of Land Economy 45
Monetary Sector
Supply of money (MS): Figure 11r
M0
SM
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Department of Land Economy 46
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
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Department of Land Economy 47
Monetary Sector
So that:
M = [(1+cp)/(s+cp)].HM = mHWhere m is the money multiplierIf 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?
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Department of Land Economy 48
Monetary Sector
Equilibrium in the money market: Figure12:r
M0
re
MD=MS
SM
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Department of Land Economy 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: (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.
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Department of Land Economy 50
Monetary Sector
The LM relationship: Figure 13
M(r,Y0) M(r,Y1)
M(r,Y2)
r
M
r0
r1
r2
LM
r0
Y0 Y1
r1
0 YY2
r2
MS
0
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Department of Land Economy 51
Monetary Sector
The IS-LM model: Figure 14r
Y
LM
IS
re
Ye0
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Department of Land Economy 52
Foreign Sector
Open economy considerations: Figure 15 r
Y0
LM
IS
BP
re
Ye
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Department of Land Economy 53
Foreign Sector
Economic policy: fixed exchange rate: Figure 16r
Y0
re
Ye
IS
LM
BP
IS’
LM’
Ye’
re’ AB
C
B’
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Department of Land Economy 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;
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Department of Land Economy 55
Foreign Sector
Economic policy: flexible exchange rate: Figure 17r
Y
re
Ye0
IS
BP
LM
IS’
AB
BP’
C
IS’’
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Department of Land Economy 56
Foreign Sector
Economic policy: flexible exchange rate: Figure 18
IS
LMr
0 Y
re
Ye
BP
A
LM’
B
IS’
BP’
C
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Department of Land Economy 57
Inflation
Inflation: Figure 19r
Y
Y
0
0
Ye PC
LM
IS
P
Ye
re
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Department of Land Economy 58
Inflation
Inflation: Figure 20W/P
N
ND
NSW/P
NS-ND)/NS(W
U%
(W/P)e
Ne
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Department of Land Economy 59
Inflation
Inflation: Figure 21
SRPC1
LRPC
0
W
U%
SRPC2
U*U1
W1
W2
AB
C D
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Department of Land Economy 60
Inflation
InflationMV = PYMD = kPYMS = MS
MD = MS = MkPY = M, orP = (1/kY)M = (V/Y)Mi.e. the monetary theory of inflation (see Figure 22)
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Department of Land Economy 61
Inflation
Figure 22P
M0
P=(V/Y)M
P1
M1
P2
M2
M1 M2
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Department of Land Economy 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.
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Department of Land Economy 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;
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Department of Land Economy 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;
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Department of Land Economy 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.