MODEL 0. The Simple Circular Flow.

PrMPrM

CrMCrM

H&BH&B

X

Y

C

I

S

Y = C + S. Must be true

X = C + I. Must be true

S = I. If and when the Credit Market is working well

What if it isn’t working well?

The CASH Model

PrMPrM

CrMCrM

H&BH&B

X

Y

C

I

S

Y = C + S. Must be true

X = C + I. Must be true

Let us now suppose that the Credit Market does not always make S = I, that it is possible for Saving to be either greater than, or less than, Investment

Of great importance is this pair of thoughts:-- S might not equal I in the “short run.”-- S will equal I in the “long run.” How long these “runs” are is not at all clear

In the short run the difference between S and I can be made up for by people holding more or less Money (“Cash”). We will say that the demand for (holding) money has risen or fallen.

CASHCASH

ΔMD

Saving can wind up in one of two ways:1.It can be loaned and Invested2.It can be held by someone (including banks)

The CASH Model

PrMPrM

CrMCrM

H&BH&B

X

Y

C

I

S

Y = C + S. Must be true

X = C + I. Must be true

This picture shows:1.the demand for money is rising2.money is going into Cash3.the public– including banks – are holding more money4.Savings greater than Investment CASHCASH

ΔMD

+0

+5

+5

PrMPrM

CrMCrM

H&BH&B

CASHCASH

The situation shown here looks as if people started to Save more, but Businesses were not inclined to borrow and Invest the extra Saving. The extra 5 sat as reserves in banks.

How can we interpret this picture?

The CASH Model Y = C + S. Must be true

X = C + I. Must be true

OR:Banks got scared, started to “hoard” money and Investment was reduced. Businesses that wanted loans could not get them

PrMPrM

CrMCrM

H&BH&B

-5

0CASHCASH

+5

How to interpret this?

Businesses decided to borrow less; banks got stuck holding money they could not lend

The CASH Model

PrMPrM

CrMCrM

H&BH&B

X

Y

C

I

S

Y = C + S. Must be true

X = C + I. Must be true

This picture shows:1.the demand for money is falling2.money is going out of Cash3.the public– including banks – are holding less money4.Savings is less than Investment CASHCASH

ΔMD

PrMPrM

CrMCrM

H&BH&B

+0

-5

What happened?

CASHCASH

-5 The situation shown here looks as if people started to Save less, but banks had enough cash to be able to continue to lend for Business Investment.

The CASH Model Y = C + S. Must be true

X = C + I. Must be true

What happened?PrMPrM

CrMCrM

H&BH&B

+5

0CASHCASH

-5 Businesses started to borrow more and banks had on hand enough money to meet that demand.

The CASH Model

PrMPrM

CrMCrM

H&BH&B

X

Y

C

I

S

Y = C + S. Must be true

X = C + I. Must be true

That is:S > I means ΔMD > 0; someone is accumulating money; the demand for money is risingS < I means ΔMD < 0; someone is reducing their money holding; the demand for money is falling

CASHCASH

ΔMD

S = I+ ΔMD . Must be true. That is: $ into CrM = $ out of CrM

Notice that all of the scenarios that involve MD changing seem unlikely to last very long. Banks cannot or will not indefinitely add to, or draw from, their reserves. Sooner or later Savings must equal Investment.

S ≠ I in the Short Run, when ΔMD ≠ 0

S = I in the Long Run, when ΔMD = 0

S < I means ΔMD < 0; someone is reducing their money holding; the demand for money is falling

Final – CRUCIAL -- Point

Whenever S and I are unequal, X and Y will be unequal.We will interpret this as the economy grew or shrunk.We have here what the first “Model 0” could not describe – the demand-driven rise and fall of GDP.

PrMPrM

CrMCrM

H&BH&B

+5

+5

0CASHCASH

-5

In this case, there was a rise of Demand (x). Total Spending rose

PrMPrM

CrMCrM

H&BH&B

-5

-5

0CASHCASH

+5

In this case, there was a decrease of Demand (x). Total Spending fell

IF … AND MD … THEN I … AND X …

C rises/S fallsdoes not change falls does not change

falls does not change falls

C falls/S rises does not change rises does not change

rises does not change falls

IF … AND MD … THEN S and C … AND X …

I risesdoes not change S rises, C falls does not change

falls do not change rises

I fallsdoes not change S falls, C rises does not change

rises do not change falls

A SUMMARY

If MD does NOT change: X does not change; C and I off-set each other

If MD DOES change: X will change; C and I do not off-set each other

IF … THEN AND X …

MD does not change

C rises/S falls I falls

does not changeC falls/S rises I rises

I rises S rises, C falls

I falls S falls, C rises

IF … And MD changes THEN … AND X …C rises/S falls MD falls I does not change rises

C falls/S rises MD rises I does not change falls

I rises MD falls C and S do not change rises

I falls MD rises C and S do not change falls

SAME SUMMARY