MECO 6303 – Business Economics

MECO 6303 – Business Economics Lesson 9 Saving, Investment and the Financial System Part B: Money and the Economy, National Income Accounting.

Schools of Economic Thought The Classical Economists(The Quantity Theory Tradition) Pre-Smith Adam Smith (1776); David Hume David RicardoJames Mill John Stuart Mill The Austrian School (1871) Carl Menger Böhm-Bawerk; Wieser Mises Hayek Modern Austrians Kirzner, Lachmann Boettke, Horwitz, Roger Garrison, Lewin The Neoclassical Revolution (1871) Karl Marx Alfred Marshall – Cambridge school Irving Fisher - America Keynes The Keynesian Revolution Samuelson, Solow, Tobin The Chicago School(approx. 1952 – 1990) Monetarism Milton Friedman Lesson 9

Explaining the Determination of the Quantity of Money in the Economy M is determined by (in decreasing order of importance) • The Federal Reserve System – by the level of Reserves and Currency in circulation (Base Money, High Powered Money) – using open market operations and setting interest rates • The Banks – by deciding how many reserves to hold (some are required) when making loans • The Public – by deciding how much currency and other money to hold. • It’s a very uncertain process! Lesson 9

Money and the Economy the equation of exchange Fed M  Economy. M  Y (some measure of economic activity, like GDP in monetary terms) Calculate P, a price index for Y, so that Q = Y/P then M  PQ or MV = PQ the equation of exchange. Alternative form: M=kPQ – the Cambridge cash balance equation. Lesson 9

Inflation and the equation of exchange • MV = PQ • V is the velocity of circulation • So gM + gV = gP + gQ; • If gV → 0; gM = gP + gQ. • The Business Cycle – Monetarist, Austrian and Keynesian. Lesson 9

Classical Economics and the Role of Money • The ascendancy of laissez faire ideas – Say’s Law and the monetary dichotomy • If V (and k) and Q are approximately constant we have the Quantity Theory of Money. • M  P or gM = gP Lesson 9

Crisis and Disillusionment: The Economics of Keynes and Keynesian Economics • The prosperous 1920’s in the U.S. and the struggles in the U.K. • Keynes, the man and his experiences • Keynesian economics – the market system needs help from the government. • The Keynesian Message - Consumption (savings), Investment and Money (interest rates). • C - A law of Consumption, the paradox of thrift and the danger of stagnation • I - Investment drives the economy, but its so unreliable because it depends so much on expectations • A “new’ theory of interest rates, its supply and demand for money, not loanable funds, its all about a preference for liquidity and expectations(again) of interest rates • It all adds up to a story of dangerous potential instability. • G - So you’ve gotta have the government pay for something, anything – dig some holes and fill them up again. • Q = C + I + G = GDP/P = Q Lesson 9

The Phillip’s Curve gP A Keynesian Tradeoff between Inflation and Unemployment Unemployment rate Lesson 9

The Monetarist Counterrevolution • Resistance at the University of Chicago • Milton Friedman - 1950’s - 1970’s many works. • Presidential address and the stagflation of the 1970’s – The Role of Monetary Policy – Nobel Prize • It should not attempt the impossible • It is impossible to control the real rate of interest • It is impossible to permanently reduce the rate of unemployment (NRH) • It should do only what is possible and desirable • It should control the supply of money to achieve predictable price stability (minimum inflation or deflation). • The only way this can be done is through a constant monetary growth rate – this is Monetarism. It’s like driving a boat with a faulty rudder across a lake • Monetarism in the spotlight Lesson 9

What’s left of the Phillips Curve? gP Unemployment rate Lesson 9

What’s Left? • The focus is on M and interest rates • Old style Keynesianism is dead, but so is simple Monetarism • What’s left is a mixture of different ideas • Maybe the Austrians are right Lesson 9

Saving And Investment in the National Income Accounts • GDP is both total income in an economy and total expenditure on the economy’s output of goods and services: Q = C + I + G + NX = GDP/P • Assume a closed economy – one that does not engage in international trade: Q = C + I + G • Now, subtract C and G from both sides of the equation: Q – C – G =I • The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S). • Substituting S for Q - C - G, the equation can be written as: S = I (For the economy as a whole, saving must be equal to investment) Lesson 9

The Meaning of Saving and Investment • National saving, or saving, is equal to: S = I S =Q – C – G S = (Q – T – C) + (T – G) • National saving is the total income in the economy that remains after paying for consumption and government purchases. • Private savingis the amount of income that households have left after paying their taxes and paying for their consumption. Private saving = (Q – T – C) • Public savingis the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G) Lesson 9

The Meaning of Government Surplus and Deficit • Surplus and Deficit • If T > G, the government runs a budget surplusbecause it receives more money than it spends. • The surplus of T - G represents public saving. • If G > T, the government runs a budget deficitbecause it spends more money than it receives in tax revenue. G comes at the expense of both C and I - crowding out. • G - T can be financed in three ways • Borrowing from the public • Borrowing from the foreign public or foreign governments • Borrowing from the Federal Reserve System (inflation - monetizing the debt). Lesson 9

MECO 6303 – Business Economics