The Transfer Problem and Exchange Stability
Definition:
“Consider a unilateral payment from one country to the other. This involves two parts: a financial (monetary) transfer and a real transfer. The monetary transfer refers to the accumulation and liquidation of debt on the part of individuals or governments in each country, while the real transfer refers to the induced movement of goods.
...Assume that A is the transferring country. Whatever the type of transfer ... domestic expenditure in A is reduced, and in B (transferor) is increased, by the amount of the transfer. These changes in expenditure induce changes in demand that, at constant terms of trade, create disequilibrium in the balance of payments. The transfer problem may then be posed as the problem of determining the direction and extent of the change in the terms of trade required to eliminate”.
http://www.columbia.edu/~ram15/ie/ie-02.html
Examples:
U.S.A:-. In order to transfer resources in real (non-financial) terms from the rest of the world, the U.S. runs very large trade deficits in manufactures from surplus-saving industrial economies such as China, Japan etc. This “real” transfer of manufactures needed to cover the shortfall in American saving speeds the contraction in employment in U.S. manufacturing beyond the “natural” rate of decline experienced by other mature industrial economies.
Why is this a problem?
The upshot is a protectionist backlash in the United States, particularly by members of Congress with manufacturing constituencies. These people incorrectly blame “unfair” foreign trading practices—undervalued currencies, substandard labor practices,or “dumping” of subsidized exports in American markets—instead of America’s own deficient saving covered by foreign borrowing.
http://www.aeaweb.org/annual_mtg_papers/2007/0106_1015_0702.pdf
Thailand:- The reversal in the current account: the country was forced by the reversal of capital flows to go from a deficit of some 10 percent of GDP in 1996 to a surplus of 8 percent in 1998. The need to effect such a huge change in the current account represents what may be history's most spectacular example of the classic “transfer problem” debated by Keynes and Ohlin in the 1920s. In practice this swing has been achieved partly through massive real depreciation, partly though severe recession that produces a compression of imports.
http://web.mit.edu/krugman/www/FLOOD.pdf
Classical approach – equality between income and expenditure equating to full employment of resources.
Keynesian approach – economy has perfectly elastic supply of labour and demand for labour and commodities at fixed wage and price level.
Two Problems:
(a) Will method of transfer finance affect each countries demand for imports enough to create trade surplus/deficit needed to affect transfer?
· Finance will reduce As demand for goods and increase Bs. This improves As balance of trade and worsens Bs.
· This usually implies disequilibrium which must be adjusted. How?
Classical - price inflation/deflation to change terms of trade.
Keynesian – price inflation/deflation to change terms of trade or devaluation.
(b) Will adjustment mechanism restore equilibrium? Factors:
· Direction – will a small downgrade in A or Bs terms of trade improve or worsen its’ trade balance? Stability Problem!
· Magnitude of influence – if such a downgrade does improve terms of trade, can trade balance increase be enough to achieve surplus?
Classical approach – we assume full employment. So if a decrease in As expenditure = increase in Bs expenditure this means no multiplier effect. A’s balance of trade improves due to decrease in demand for imports & increase in demand for exports.
• Total improvement = ∑ As Import expenditure change + Bs Import expenditure change
• If ∑ As Import expenditure change + Bs Import expenditure change > unity => Transfer is undereffected so terms of trade will change against A – and vice versa also applies
Focusing on proportions of expenditure change, we assume expenditure proportions can be related to A and Bs marginal propensities to spend on imports/exports. We highlight 3 cases:
1. Free Trade: A receives all proceeds from exporting to B.
2. Tariffs but no transport costs: Under Classical approach, we assume tariffs are redistributed and spent by B. As such proportions of expenditure change on exports is greater than marginal propensity to spend on exports.
3. Transfer costs but no tariffs: Transfer costs are receipts for A. Hence transport costs are an indirect demand for goods. So proportion of expenditure change on exports is greater than marginal propensities to spend on exports.
What does classical approach mean for countries involved? Let’s assume transfer undereffected if – when both A and B have an increase in income - A has greater spending power.
In case 1, free Trade A and B pay same prices. For Classical theory to hold, if both countries have similar “tastes” for goods, the country with the higher income per head produces more “luxurious” goods for export i.e. goods differ in degree of necessity.
Where tariffs and transport costs exist, goods are cheaper in the exporting country. For classical approach to hold, a country must favour its’ exports over imports and country with lower income per head must produce necessary goods.
What about indirect consumption?
For the case of tariffs but no transport costs, we assume indirect consumption of tariffs is same as direct so classical approach holds.
Where we have both transport costs and free trade, if transport costs are added fully to imported goods, then consumers are more likely to purchase similar home produced goods. And vice versa.
Additional factors to consider?
1. Varying the home production of similar imported good? Not relevant as it’s the price ratio that’s the crucial factor here.
2. Non-traded goods? Is a factor as demand for such goods changes total demand for imports/exports.
More countries? Is a factor since balance of trade between A and B are no longer
eual or opposite
II. The Keynesian Transfer Problem
Assumptions:
- economy consists of a perfectly elastic supply of labour and commodities at a fixed wage and price level so that output, income and employment are determined by aggregate demand (AD)
- exchange rates & interest rates are fixed by monetary policy
- international capital movements are independent of national income.
Multiplier Equations: (for country A and B)
- these equations relate changes in national income and balance of payments to changes in demand
- all marginal propensities are positive to guarantee stability in the system
Notation:
· Ya,b total change in national income
· Ba total change in country A’s balance of payments
· Ia,b change in demand for country’s own output
· Ma,b change in demand for each other’s output
· T change in capital movements from A to B
· ca,b marginal propensity to spend on domestic output
· ma,b marginal propensity to spend on imports
· sa,b marginal propensity to save in each country
Equations:
Ya = Ia + caYa + Mb + mbYb
Yb = Ib + cbYb + Ma + maYa
Ba = Mb + mbYb - Ma - maYa - T
Keynesian Problem:
Unlike the classical (real) case we do not assume that aggregate expenditure of A and B will change equal to the amount expensed on financing and disposal of the transfer. Any such changes in expenditure will have multiplier effects on the balance of trade between A and B. The problem therefore is whether the transferor’s balance of payments worsens or improves as a direct result of the transfer.
Solution:
To solve this problem we simply substitute for the change in demand in the multiplier equations with the proportion of the transfer whereby demand for domestic and foreign goods is reduced in A and increased in B (or vice versa).
We will work with the change in demand for imports and the saving associated with the transfer since the transfer must alter demand for domestic goods and imports or the accumulation of assets through saving.
m` change in demand for imports (as a proportion of amount transferred)
s` change in saving (as a proportion of amount transferred)
quations:
Ya = 1 / sa (Ba + s`a T)
Yb = - 1 / sb (Ba + s`b T)
Ba = (m`a + m`b - ma / sa (s`a) - mb / sb (s`b) – 1) X (sasb / Δ) T
where Δ = sasb + samb + sbma
From these equations we concur that the transfer will be undereffected or overeffected where m`a + m`b (sum of proportions of transfer by which expenditure on imports is altered by financing and disposal of transfer) is less than or greater than
ma / sa (s`a) + mb / sb (s`b) + 1
This criterion allows the transfer to be either undereffected or overeffected according to the scales of various parameters. The behaviour of income therefore, is determined by whether the transfer is undereffected or overeffected.
Generally, there seems to be less reason in the Keynesian model than in the classical model to identify the direct effects of the transfer on demand with those of any other economic change.
III – Application of transfer theory
Transfer theory applied in the analysis of:
Reparation payments
International flows of long term capital.
Also more importantly in overcoming any Balance of Payment (BOP) disequilibrium through either automatic mechanisms of adjustment or planned government policies.
Both the floating and fixed rate regimes are "automatic" free-market mechanisms for international payments. With a "clean" floating rate, a monetary authority sets a monetary policy, but has no exchange-rate policy—the exchange rate you might say is on autopilot. In effect, the monetary base is determined domestically by a monetary authority. In other words, when a central bank purchases bonds or bills and increases its net domestic assets, the monetary base increases and vice versa. Whereas, with a fixed rate, a monetary authority sets the exchange rate, but has no monetary policy—monetary policy is on autopilot. In consequence, under a fixed-rate regime, the monetary base is determined by the balance of payments. In other words, when a country's official net foreign reserves increase, its monetary base increases and vice versa. With both of these free-market exchange-rate mechanisms, there cannot be conflicts between exchange-rate and monetary policies, and balance-of-payments crises cannot occur. Market forces automatically rebalance financial flows and avert balance-of-payments crises.
Government policies are important in overcoming the above mentioned imbalance. For example the UK government might intervenr to raise or lower the value of sterling. This can be done through short term interest rates: usually raising them attracts investors into buying sterling while lowering encourages selling. Another option is to utilize its foreign currency reserves to push up its value or at least hold it steady.
BOP imbalance occurs due to some form of transfer from the surplus to deficit country. This can be solved by creating a transfer of equal amount in opposite direction.
For example, with ‘full employment’ in deficit country, deterioration in terms of trade will be less (or improvement greater) the more deflation of expenditure in deficit country and inflation of expenditure in surplus country is spent on imports as opposed to on exportable goods. Terms of trade refers to the purchasing power of a country’s exports in terms of the imports it buys; it indicates how much of goods and services one country can buy from abroad with the goods and services it sells abroad. The terms of trade shift whenever a country’s exports will buy more or fewer imports. An improvement in the terms of trade occurs when export prices rise relative to import prices.
In the Keynesian transfer analysis:
With a positive Marginal prop to save (MPS) in both countries changes in income taxation adequate to yield change in budget surpluses or deficits equal to original BOP deficits will not solve the disequilibrium issue. However changes in government expenditure of this amount may do so. This example involves adjustments to aggregate income and expenditure.
A more important application looks at effects of changes in relative price levels on the BOP’s. Change by deflation or inflation of domestic currency prices of fixed exchange rates or by alteration of exchange rate.
Problem formulated in terms of
Effects of devaluation on trade balance
Stability of foreign exchange markets
The Central theoretical problem
Conditions under which a relative reduction in export prices would tend to improve a countries trade balance?
Volume of exports determined by demand from abroad which in turn depends on the state of importing country, price of exports which are dependant on inflation and exchange rate and finally the quality of products.
Look at the exchange stability problem in terms of transfer theory. We assume that trade is balanced and no barriers exist.
What happens in terms of country A if there is a reduction in the price of A’s exportables relative to B?
Transfer from A to B = in amount to the increase in the cost of A’s initial volume of exports.
And in terms of B to the reduction in the costs of B’s initial volume of imports.
With initial balance and small price change these two transfers are approximately equal.
Transfer is ‘financed’ and ‘disposed of’ through effects of the relative price change which will have income and substitution effects on the demands of the countries for their own and each others goods.
The income effect – real income falls as prices increase
The substitution effect – price change that causes the consumer to substitute away from the comparatively more expensive one.
Price change will affect two countries aggregate expenditure and expenditure on imports.
Exchange stability problem takes into account whether effects of price change on expenditure will be sufficient to effect the transfer implicit in the price change itself.
With regard to classical case All income is spent insuring that transfer is accompanied by equal change in the two countries expenditure.
Transfer will be over or under-effected or market stable or unstable according to whether sum of the proportion of the transfer by which two countries expenditure on imports change is greater or less than unity.
Unit elasticity describes a supply or demand curve which is perfectly responsive to change in price. That is quantity supplied or demanded changes according to the same percentage as the change in price.
These proportions, equal to the price of demand for imports of the countries so that the market is stable depend on whether the sum of these elasticities is greater or less than unity. Transfer analysis leads to stable or unstable dependant on whether elasticities greater of less than
1+ S’a (ma / Sa) + S’b (mb / Sb)
Sa - marginal propensity to save
m – marginal propensity to import
S’a – proportion of transfer by which saving from pre-transfer level of income is reduced in A by increase in price of A’s imports.
S’b – proportion of transfer by which saving from pre-transfer level of income is increased in B by decrease in the price of B’s imports.
S’s above represent the consequence of a fall in the price of imports on saving or increase in the price of imports on expenditure from initial income divided by initial value of imports.
When elasticity is less than unity (inelastic demand) higher prices bring larger outlays.
When elasticity is greater than unity (elastic demand) higher prices bring smaller outlays.
Laursen and Metzler – highlight that in the short run of the cycle, a rising proportion of real income is saved to the conclusion that an increase in price of imports would increase expenditure thus making critical sum of elasticities import demand greater than unity.
Harberger looks at effect of an increase in imports prices on savings. He assumed that saving is measured in exports goods and depends on real income only, and that changes in prices inducing no substitution between Savings and Consumption.
Therefore it can be deduced that the criteria of exchange stability becomes whether sum of elasticities of import demand is greater or less than 1 plus the sum of Marginal propensity to import.
Assumptions of this criticized for a number of reasons.
Day, Savings and Imports might be substitutes (as imports may be consumer durables yielding flow of satisfaction comparable to interest on saving)
Pearce, shows Day overlooks effects of change in price of Imports on real value of interest.
Spraos, shows MPS from a change in real income due to change in real income due to change in Import prices is likely to be substantially greater than MPS from change in output at constant prices.
Spraos and Pearce, show Harberger implies presence of money illusion since they ignore effects of an increase in price of Imports in reducing value of saving.
If substitution effects between imports and savings and Pigou’s effect of import prices on savings are ignored then Harberger analysis on assumption that real rather than money saving depends on real income to yield
S’ = (Average propensity to save / 1-APS) X ( €s -1)
$s is income elasticity of demand for real saving. I – APS is the equivalent of the average propensity to consume.
The above formula proposes that the effect of a fall in the price of imports on saving = (APS / APS) X (Income elasticity of demand for real saving – 1)
This alteration reconciles Harberger’s and Metzler and Laursen’s approach. It also confirms the workings below in deducing the effect of devaluation on expenditure from the relationship between the savings ratio (MPS) and income.
Average propensity to save = Savings / Volume of domestic Output.
(Savings here is equivalent to Volume of domestic output minus Consumption at home and abroad.)
However it assumes that imports are demanded for consumption only. If some imports are required for investment as would be reasonable and investment expenditure is fixed in real terms a fall in import prices affects money saving both by increasing consumers real income and by reducing the cost of investment imports.
The preceding result is than changed to
S’ = mc (APS / 1-APS)($s – 1) + mi
Mc and Mi are proportions of the original volume of imports devoted to consumption and investment, respectively. Even though the assumption that the critical value of the sum of the elasticities of import demand is greater than unity implies a slightly unrealistic assumption about the behavior of the savings ratio this last result can be supported by the introduction of investment imports.
Tuesday, April 24, 2007
Tuesday, April 10, 2007
Chapter 4 – Government Money with Portfolio Choice
This posting is outside the 700 word boundary. It was decided that to reduce any further would mean losing clarity of summary, and the omittance of important facets of the theory.
Model portfolio choice (PC) adds T-Bills (US Treasury Bills) and interest payments into model SIM while also making the assumption that there is no production sector thus the household makes up the whole private sector. T-Bills are issued on a discount basis. At maturity you are offered the face value of the bill. The amount paid for the right to the face value at time T is lower i.e. at a discount, the difference being the interest rate.
The new balance sheet matrix shows that households can either hold cash or bills the sum of the two being the net worth. The total public debt is then equal to the bills held by the households and the bills held by the central bank. The central bank also takes deposits from the households.
The flow matrix in this chapter has two main changes to the previous chapter. Firstly the change in bills figures are added to the flow of funds accounts. Also there are now interest payments arising from government debt which must be accounted for. The central bank sector is now divided into current account and capital account. The current account deals with the inflows and outflows from the current operations of the central bank while the capital account describes any changes in the balance sheet of the central bank e.g. the purchase of new bills.
The Equations
The equations are built on the presumption that producers sell whatever is demanded and that householders have correct expectations regarding their incomes.
Y = C + G
Production is equal to consumption + government expenditure.
YD = Y – T + r-1 . Bh-1
Disposable income is enlarged by adding interest payments on government debt.
T = Ø . (Y + r-1 . Bh-1)
Taxable income is enlarged by adding interest payments on bills held by households.
The Portfolio Decision
Two decisions households face – How much they will save and how they will allocate wealth. The second decision is dependant on the first.
V = V-1 + (YD – C)
Difference between disposable income and consumption is equal to total change in wealth.
C = α1 . YD + α2. V-1, 0< α2 < α1 < 1
Money is replaced by wealth.
4.6A)
Households want to hold a certain amount (λ0) of wealth in bills and the rest (λ0-1) in money. The proportions are dependant on the level of interest on bills and the level of disposable income relative to wealth.
4.7)
Follows from equation 4.6A to show what has to be the share that people hold in the form of bills.
The endogeneity of the money supply
∆BS = Bs – Bs-1 = (G + r-1 . Bs-1) – (T + r-1 . Bcb-1)
The government deficit is financed by bills issued by the treasury department.
∆Hs = Hs - Hs-1 = ∆Bcb
Additions to the stock of high powered money are equal to the additional demand for bills by the central bank.
Bcb = Bs - Bh
r = r¯
The central bank is the residual purchaser of bills. It purchases all the bills offered by the government that the householders are not will to purchase at a given interest rate.
Hh = Hs
The amount of cash that households hold is equal to the amount of cash supplied by the central bank.
4.5 The Steady State Solutions Of The Model
4.5.1 The Puzzling Impact Of Interest Rates
By adding 100 Basis points to the interest rate the Banks set out in Model PC we can identify the difference between it and Model SIM. This results in an expected increase in Households holding more interest paying bills and an unexpected rise in disposable income and consumption. On this occasion when getting steady state solutions of the model government balances means that state revenues plus the profits of the central banks must be equal to pure government expenditures on goods and services plus the cost of servicing the government debt. We arrive at: (4.18)
Y* = G + r.B*h . (1 – θ) / θ = GnT/ θ
This is the steady-state value for national income. Likewise the steady-state solution for disposable income can be obtained by assuming consumption here equals disposable income and substituting Y* for its value in 4.18 we arrive at: (4.19)
C* = YD* = (G + r.N*h).[(1 – θ)/θ]
Both equations are, in full stationary state, an increasing function of the interest rate. This explains the earlier higher interest rates are associated with a higher steady-state national income. Ultimately higher interest rates mean larger absolute amount of bills and households are encouraged to hold a larger proportion of their wealth in the form of bills both leading to larger interest payments on debt.
4.5.2 Fully Developed Steady State Solutions
To formally demonstrate that an increase in the rate of interest will lead to an increase in the amount of bills held by households and an increase in the overall interest payments received by households we must find the value of B*h and substitute it into equations 4.18 amd 4.19. We first turn the consumption function (4.5) into a wealth accumulation function and combine equations 4.4 and 4.5 to get:
∆V = α2 . (α3 . YD – V – 1)
After identifying the value of ∆V = 0 and getting the ratio for wealth and disposable income we combine equations 4.21 and 4.7 we get a value for B*h. After much manipulation we arrive at:
Y* = (G/ θ) { 1 + α3. (1 – θ) . ѓ/[θ/(1- θ)] - α3 . ѓ }
4.6 Implications of changes in parameter values for temporary and steady-state income
4.6.1 Some Puzzling results
If there were an increase in the permanent level of government expenditures G or any permanent decrease in the overall tax rate θ would lead to an increase in the stationary level of income and disposable income: dY/dθ < 0 . Higher rates of interest leads to an increase in the flow of payments that arise from the government sector which leads to an increase of the steady-state level of disposable income and households holding more interest paying government debt. Also increases in the α3 parameter also eventually leads to an increase in stationary income or disposable income.
4.6.2 A Graphical Analysis
As discussed earlier, an increase in any of the propensities to consume means a decrease in the target wealth to disposable income ratio will result. Godley goes on to state that the effect of a higher propensity to consume out of expected disposable income is positive in the short-term, with GDP rising, but, on the other hand, GDP congregates to a new steady-state value in the long run, which is lower than the original steady-state.
Furthermore, National Income rises in the short-term, but then again this effect is only momentary. A lower propensity to save by individuals results in the stock of wealth decreasing, because consumption exceeds disposable income. However, the reduced consumption ultimately compensates for the higher consumption out of current income, so as the wealth continues to decrease, consumption and the interest income on government debt also continue to drop; until it reaches a “new stationary state”, which is lower than the previous steady-state.
Since this is a simplified model, both the household wealth and government debt decrease together, because households are consuming more and therefore, dissaving; while the government benefits from this boost in economic activity, through the generation of increased tax revenues.
In Model PC the relationship between disposable income (YD) and national income (Y) is more complicated than Model SIM, as it goes beyond taxes and takes into account interest payments on debt:
Y = r-1 * Bh-1 + YD /(1- θ)
This equation shows that any increase in the interest rate, or in the propensity to consume leads to a temporary increase in disposable income and national income.
Godley then goes on to state that when one is comparing steady-states, the aggregate income flow is still an increasing function of the interest rate, albeit the short-term impact of interest rates is to reduce consumption and hence income.
Finally, Godley explains that if government officials want to decrease the public debt-to-GDP ratio, they would need to increase tax rates or reduce interest rates, which would lead to a lower level of stationary income. Therefore, they should disregard the debt-to-income ratio if they want to maintain full-employment income.
Model portfolio choice (PC) adds T-Bills (US Treasury Bills) and interest payments into model SIM while also making the assumption that there is no production sector thus the household makes up the whole private sector. T-Bills are issued on a discount basis. At maturity you are offered the face value of the bill. The amount paid for the right to the face value at time T is lower i.e. at a discount, the difference being the interest rate.
The new balance sheet matrix shows that households can either hold cash or bills the sum of the two being the net worth. The total public debt is then equal to the bills held by the households and the bills held by the central bank. The central bank also takes deposits from the households.
The flow matrix in this chapter has two main changes to the previous chapter. Firstly the change in bills figures are added to the flow of funds accounts. Also there are now interest payments arising from government debt which must be accounted for. The central bank sector is now divided into current account and capital account. The current account deals with the inflows and outflows from the current operations of the central bank while the capital account describes any changes in the balance sheet of the central bank e.g. the purchase of new bills.
The Equations
The equations are built on the presumption that producers sell whatever is demanded and that householders have correct expectations regarding their incomes.
Y = C + G
Production is equal to consumption + government expenditure.
YD = Y – T + r-1 . Bh-1
Disposable income is enlarged by adding interest payments on government debt.
T = Ø . (Y + r-1 . Bh-1)
Taxable income is enlarged by adding interest payments on bills held by households.
The Portfolio Decision
Two decisions households face – How much they will save and how they will allocate wealth. The second decision is dependant on the first.
V = V-1 + (YD – C)
Difference between disposable income and consumption is equal to total change in wealth.
C = α1 . YD + α2. V-1, 0< α2 < α1 < 1
Money is replaced by wealth.
4.6A)
Households want to hold a certain amount (λ0) of wealth in bills and the rest (λ0-1) in money. The proportions are dependant on the level of interest on bills and the level of disposable income relative to wealth.
4.7)
Follows from equation 4.6A to show what has to be the share that people hold in the form of bills.
The endogeneity of the money supply
∆BS = Bs – Bs-1 = (G + r-1 . Bs-1) – (T + r-1 . Bcb-1)
The government deficit is financed by bills issued by the treasury department.
∆Hs = Hs - Hs-1 = ∆Bcb
Additions to the stock of high powered money are equal to the additional demand for bills by the central bank.
Bcb = Bs - Bh
r = r¯
The central bank is the residual purchaser of bills. It purchases all the bills offered by the government that the householders are not will to purchase at a given interest rate.
Hh = Hs
The amount of cash that households hold is equal to the amount of cash supplied by the central bank.
4.5 The Steady State Solutions Of The Model
4.5.1 The Puzzling Impact Of Interest Rates
By adding 100 Basis points to the interest rate the Banks set out in Model PC we can identify the difference between it and Model SIM. This results in an expected increase in Households holding more interest paying bills and an unexpected rise in disposable income and consumption. On this occasion when getting steady state solutions of the model government balances means that state revenues plus the profits of the central banks must be equal to pure government expenditures on goods and services plus the cost of servicing the government debt. We arrive at: (4.18)
Y* = G + r.B*h . (1 – θ) / θ = GnT/ θ
This is the steady-state value for national income. Likewise the steady-state solution for disposable income can be obtained by assuming consumption here equals disposable income and substituting Y* for its value in 4.18 we arrive at: (4.19)
C* = YD* = (G + r.N*h).[(1 – θ)/θ]
Both equations are, in full stationary state, an increasing function of the interest rate. This explains the earlier higher interest rates are associated with a higher steady-state national income. Ultimately higher interest rates mean larger absolute amount of bills and households are encouraged to hold a larger proportion of their wealth in the form of bills both leading to larger interest payments on debt.
4.5.2 Fully Developed Steady State Solutions
To formally demonstrate that an increase in the rate of interest will lead to an increase in the amount of bills held by households and an increase in the overall interest payments received by households we must find the value of B*h and substitute it into equations 4.18 amd 4.19. We first turn the consumption function (4.5) into a wealth accumulation function and combine equations 4.4 and 4.5 to get:
∆V = α2 . (α3 . YD – V – 1)
After identifying the value of ∆V = 0 and getting the ratio for wealth and disposable income we combine equations 4.21 and 4.7 we get a value for B*h. After much manipulation we arrive at:
Y* = (G/ θ) { 1 + α3. (1 – θ) . ѓ/[θ/(1- θ)] - α3 . ѓ }
4.6 Implications of changes in parameter values for temporary and steady-state income
4.6.1 Some Puzzling results
If there were an increase in the permanent level of government expenditures G or any permanent decrease in the overall tax rate θ would lead to an increase in the stationary level of income and disposable income: dY/dθ < 0 . Higher rates of interest leads to an increase in the flow of payments that arise from the government sector which leads to an increase of the steady-state level of disposable income and households holding more interest paying government debt. Also increases in the α3 parameter also eventually leads to an increase in stationary income or disposable income.
4.6.2 A Graphical Analysis
As discussed earlier, an increase in any of the propensities to consume means a decrease in the target wealth to disposable income ratio will result. Godley goes on to state that the effect of a higher propensity to consume out of expected disposable income is positive in the short-term, with GDP rising, but, on the other hand, GDP congregates to a new steady-state value in the long run, which is lower than the original steady-state.
Furthermore, National Income rises in the short-term, but then again this effect is only momentary. A lower propensity to save by individuals results in the stock of wealth decreasing, because consumption exceeds disposable income. However, the reduced consumption ultimately compensates for the higher consumption out of current income, so as the wealth continues to decrease, consumption and the interest income on government debt also continue to drop; until it reaches a “new stationary state”, which is lower than the previous steady-state.
Since this is a simplified model, both the household wealth and government debt decrease together, because households are consuming more and therefore, dissaving; while the government benefits from this boost in economic activity, through the generation of increased tax revenues.
In Model PC the relationship between disposable income (YD) and national income (Y) is more complicated than Model SIM, as it goes beyond taxes and takes into account interest payments on debt:
Y = r-1 * Bh-1 + YD /(1- θ)
This equation shows that any increase in the interest rate, or in the propensity to consume leads to a temporary increase in disposable income and national income.
Godley then goes on to state that when one is comparing steady-states, the aggregate income flow is still an increasing function of the interest rate, albeit the short-term impact of interest rates is to reduce consumption and hence income.
Finally, Godley explains that if government officials want to decrease the public debt-to-GDP ratio, they would need to increase tax rates or reduce interest rates, which would lead to a lower level of stationary income. Therefore, they should disregard the debt-to-income ratio if they want to maintain full-employment income.
Monday, March 26, 2007
Wk 7 26/03/07 - PBL posting
Wk 7 26/03/07
Team members: Sinead, Martina,Mark, Shane and Jason
PBL to:
(a) work out figures in Table 3.4 Godley
(b) calc for period 2 if theta is now 30%
(c) calc for period 3 if theta is now 30%
note a = alpha, t = theta, d = delta
theta = t = .2 for (a) & .3 for (b); G = 20
(a)
Y = G/(a1-a1*t) = 38.5
T = t*Y = 38.5*0.2 = 7.7
YD = Y - T = 38.5 - 7.7 = 30.8
C = a1*YD + a2*H-1 = 30.8*0.6 + 0.4*0 = 18.5
dHh = YD - C = 30.8 - 18.5 = 12.3
dHs = G - T = 20 - 7.7 = 12.3
H = dHh + H-1 = 12.3 + 0 = 12.3 - {note dHh and not dH as in notes}
(b) formulae as before...
Y = 34.48
T = 0.3*34.48 = 10.34
YD = Y - T = 34.48 - 10.34 = 24.14
C = 0.6*24.14 + 0.4*0 = 14.48
dHs = 20 - 10.34 = 9.65
dHh = 24.14 - 14.5 = 9.65
H = 9.64 + 0 = 9.65
(c)
Y = 34.48 (as per period 2) + a2*H-1
Note - we need to calc as such as system is recursive!
a2*H-1 is MPC out of past wealth, H-1 for previous period.
=> 34.48 + 0.4*9.65 = 38.36
T = 0.3*38.36 = 11.5
YD = 38.36 - 11.5 = 26.86
C = 0.6*26.86 + 0.4*9.65 = 16.11 + 3.86 = 19.98
dHs = 20 - 11.5 = 8.5
dHh = 26.86 - 18.35 = 8.5
H = 8.5 + 9.65 = 18.15
Team members: Sinead, Martina,Mark, Shane and Jason
PBL to:
(a) work out figures in Table 3.4 Godley
(b) calc for period 2 if theta is now 30%
(c) calc for period 3 if theta is now 30%
note a = alpha, t = theta, d = delta
theta = t = .2 for (a) & .3 for (b); G = 20
(a)
Y = G/(a1-a1*t) = 38.5
T = t*Y = 38.5*0.2 = 7.7
YD = Y - T = 38.5 - 7.7 = 30.8
C = a1*YD + a2*H-1 = 30.8*0.6 + 0.4*0 = 18.5
dHh = YD - C = 30.8 - 18.5 = 12.3
dHs = G - T = 20 - 7.7 = 12.3
H = dHh + H-1 = 12.3 + 0 = 12.3 - {note dHh and not dH as in notes}
(b) formulae as before...
Y = 34.48
T = 0.3*34.48 = 10.34
YD = Y - T = 34.48 - 10.34 = 24.14
C = 0.6*24.14 + 0.4*0 = 14.48
dHs = 20 - 10.34 = 9.65
dHh = 24.14 - 14.5 = 9.65
H = 9.64 + 0 = 9.65
(c)
Y = 34.48 (as per period 2) + a2*H-1
Note - we need to calc as such as system is recursive!
a2*H-1 is MPC out of past wealth, H-1 for previous period.
=> 34.48 + 0.4*9.65 = 38.36
T = 0.3*38.36 = 11.5
YD = 38.36 - 11.5 = 26.86
C = 0.6*26.86 + 0.4*9.65 = 16.11 + 3.86 = 19.98
dHs = 20 - 11.5 = 8.5
dHh = 26.86 - 18.35 = 8.5
H = 8.5 + 9.65 = 18.15
Friday, March 16, 2007
EC6012 – Monday Week 5 – Chapter 3 "The Simplest Model with Government Money" Summary
Firstly, we define two methods of money creation: “Outside” (i.e. Government) and “Inside” (i.e. Private) money. The former is created when a government makes payments and the opposite is when the said government receives taxes. The latter is created by banks via loans and its’ opposite is the repayment of said loans. We initially postulate a simple model, SIM, and build from there. SIM assumes:
1. A closed economy.
2. All transactions occur in government money, i.e. no private banks.
3. Demand-led, i.e. unlimited labour force.
SIM has 6 items, e.g. Money (H) which is a source for households, therefore, positive and negative for government (as it’s debt, therefore a use). From this, for Households, Production and Government we build a behavioural matrix describing inter-transactional relations (except Output, which only appears once) between these sectors such that all columns and rows in this matrix sum to zero. It’s entities are:
1. Households 2. Production 3. Govt
1. Consumption -Cd +Cs
2. Govt. Expenditure +Gs -Gd
3. Output [Y]
4. Wages +W.Ns -W.Nd
5. Taxes -Ts +Td
6. Change in money stock -Hh +Hh
(Where s, d, h, w and N equate to supply, demand, household, cash, wages and employment respectively)
From this we start to build our equations:
3.1. Cs = Cd
3.2. Gs = Gd
3.3. Ts = Td
3.4. Ns = Nd
…where state demand equals supply.
How can we ensure equality between sales and purchases, given production might differ from supply, and supply from demand?
We employ the Keynesian/Kaleckian quantity adjustment mechanism. By this, producers produce exactly what is demanded, i.e. no inventories. Also firms sell whatever is demanded, i.e. no rationing.
We add to SIM by defining Disposable income (i.e. household wages minus tax) as:
3.5. YD = W*Ns - Ts
Further we define Tax rate on taxable income (q) as:
3.6. Td = q*W*Ns and Consumption (being dependent on YD and past wealth accumulated H-1) as:
3.7. Cd = a*YD+a2*Hh-1
Government spending, not covered by taxes is met via issuing of debt (i.e. cash money), so
3.8. Hs = DHs - Hs-1 = Gd - Td
Household wealth is the excess of income over expenditure. We say Hh represents household cash, so:
3.9. DHh = Hh - Hh -1 = YD – Cd
Finally, we define national income identity thusly:
3.10. Y = Cs + Gs
…from income perspective is:
3.10. Nd = Y/W
…this completes SIM. Wages are assumed fully exogenous.
The Walrasian principle dictates the removal of one redundant equation to avoid over-determination. Said equation is:
3.12. DHh = DHs
…because savings must equal investment.
Previous equations yield Y* (equilibrium) as:
3.13. Y* = G/ 1 - a1*(1 - q)
..but this is only short-run/temporary equilibrium, i.e. not steady-state. We use 3.7. to solve for long-term. It says that consumers spend current income PLUS savings, hence income level rises despite fixed government expenditure.
We define steady-state as state whereby stock and flows (i.e. key variables) remain in constant relationship to each other. If variable levels are constant, as per SIM, the steady-state is stationary i.e. no government surplus or deficit. Hence:
3.14. Y* = G/q
…G/q is called fiscal stance. Stationary dictates consumption must equal disposable income. Previous equations yield:
3.15. YD* = C* = G*(1 - q)/ q
Finally we define stationary value of household wealth as:
3.16. H* = [(1 - a1)/a2] * YD* = a3*YD* = a3*G*[(1 - q) /q] where a3= (1 - a1)/ a2
The a3 coefficient is the stock-flow norm of households. Combined with Modigliani’s consumption function, it means when households earn more than expected, more is saved. This assumes consumption depends on lagged wealth besides current disposable income.
Uncertainty is brought into SIM by making consumption depend on expected (e), not actual, income. Ergo, households can only guess expected disposable income: Hd. So
3.17. DHd = Hd - Hh-1 = YDe - Cd
Since end of period money stock must differ from that initially demanded we say:
3.18. Hh - Hd = YD - Yde
Thus money acts as a buffer in that it allows people to transact without knowing exactly what their income and expenditure levels will be.
SIM is now more recursive in that expected, not realized, income is used. If we assume expected income equals that realized previously:
3.19. Yde = YD - 1
..which builds SIMEX. People here amend consumption based on wealth and future income changes.
We solve Y for intermediate situations thusly:
3.20. Y = (G + a2)*(H-1)/(1 - a1)*(1 - q)
…so proving Keynes claim that money links each period with the next. The intermediate stock of money is:
3.21. Hh = (1 - a1)*(1 - q)*Y + (1 - a2)*H-1
…the last two intermediate equations are out-of-equilibrium, but temporary since they’re the values that would be achieved in each period.
1. A closed economy.
2. All transactions occur in government money, i.e. no private banks.
3. Demand-led, i.e. unlimited labour force.
SIM has 6 items, e.g. Money (H) which is a source for households, therefore, positive and negative for government (as it’s debt, therefore a use). From this, for Households, Production and Government we build a behavioural matrix describing inter-transactional relations (except Output, which only appears once) between these sectors such that all columns and rows in this matrix sum to zero. It’s entities are:
1. Households 2. Production 3. Govt
1. Consumption -Cd +Cs
2. Govt. Expenditure +Gs -Gd
3. Output [Y]
4. Wages +W.Ns -W.Nd
5. Taxes -Ts +Td
6. Change in money stock -Hh +Hh
(Where s, d, h, w and N equate to supply, demand, household, cash, wages and employment respectively)
From this we start to build our equations:
3.1. Cs = Cd
3.2. Gs = Gd
3.3. Ts = Td
3.4. Ns = Nd
…where state demand equals supply.
How can we ensure equality between sales and purchases, given production might differ from supply, and supply from demand?
We employ the Keynesian/Kaleckian quantity adjustment mechanism. By this, producers produce exactly what is demanded, i.e. no inventories. Also firms sell whatever is demanded, i.e. no rationing.
We add to SIM by defining Disposable income (i.e. household wages minus tax) as:
3.5. YD = W*Ns - Ts
Further we define Tax rate on taxable income (q) as:
3.6. Td = q*W*Ns and Consumption (being dependent on YD and past wealth accumulated H-1) as:
3.7. Cd = a*YD+a2*Hh-1
Government spending, not covered by taxes is met via issuing of debt (i.e. cash money), so
3.8. Hs = DHs - Hs-1 = Gd - Td
Household wealth is the excess of income over expenditure. We say Hh represents household cash, so:
3.9. DHh = Hh - Hh -1 = YD – Cd
Finally, we define national income identity thusly:
3.10. Y = Cs + Gs
…from income perspective is:
3.10. Nd = Y/W
…this completes SIM. Wages are assumed fully exogenous.
The Walrasian principle dictates the removal of one redundant equation to avoid over-determination. Said equation is:
3.12. DHh = DHs
…because savings must equal investment.
Previous equations yield Y* (equilibrium) as:
3.13. Y* = G/ 1 - a1*(1 - q)
..but this is only short-run/temporary equilibrium, i.e. not steady-state. We use 3.7. to solve for long-term. It says that consumers spend current income PLUS savings, hence income level rises despite fixed government expenditure.
We define steady-state as state whereby stock and flows (i.e. key variables) remain in constant relationship to each other. If variable levels are constant, as per SIM, the steady-state is stationary i.e. no government surplus or deficit. Hence:
3.14. Y* = G/q
…G/q is called fiscal stance. Stationary dictates consumption must equal disposable income. Previous equations yield:
3.15. YD* = C* = G*(1 - q)/ q
Finally we define stationary value of household wealth as:
3.16. H* = [(1 - a1)/a2] * YD* = a3*YD* = a3*G*[(1 - q) /q] where a3= (1 - a1)/ a2
The a3 coefficient is the stock-flow norm of households. Combined with Modigliani’s consumption function, it means when households earn more than expected, more is saved. This assumes consumption depends on lagged wealth besides current disposable income.
Uncertainty is brought into SIM by making consumption depend on expected (e), not actual, income. Ergo, households can only guess expected disposable income: Hd. So
3.17. DHd = Hd - Hh-1 = YDe - Cd
Since end of period money stock must differ from that initially demanded we say:
3.18. Hh - Hd = YD - Yde
Thus money acts as a buffer in that it allows people to transact without knowing exactly what their income and expenditure levels will be.
SIM is now more recursive in that expected, not realized, income is used. If we assume expected income equals that realized previously:
3.19. Yde = YD - 1
..which builds SIMEX. People here amend consumption based on wealth and future income changes.
We solve Y for intermediate situations thusly:
3.20. Y = (G + a2)*(H-1)/(1 - a1)*(1 - q)
…so proving Keynes claim that money links each period with the next. The intermediate stock of money is:
3.21. Hh = (1 - a1)*(1 - q)*Y + (1 - a2)*H-1
…the last two intermediate equations are out-of-equilibrium, but temporary since they’re the values that would be achieved in each period.
EC6012 – Monday Week 5 – 12/03/07.
Group members present:
* Alex, Martina, Mark,Sinead and Jason.
* PBL - exercise & presentation was done on the Multiplier effect
First post, answers to Problem 4:
EC6012 – Problem 4
Q.1.1 Why must the Vertical Columns sum to zero?
They describe the sums of money that actually change hands and therefore represent a system of accounting identities. The change in the amount of money held in one sector must always equal the difference between receipts and payments in the other sectors.
Q.1.2 Why must the Horizontal Rows sum to zero?
The rows represent the Circular Flow of Income. Flows move in a zero sum space – i.e. ‘everything comes from somewhere and everything goes somewhere’ (Godley & Lavoie, pg. 6). Every component in the matrix must have an equivalent component elsewhere. Therefore flows must always equal zero e.g. consumption is a receipt of money by business but a payment by households.
Q.2 Write out an explanation for each row.
§ Consumption – In each period, the households consume either their disposable income or the wealth they have accumulated in previous periods or both. Consumption therefore must be some proportion alpha of the flow of disposable income and the opening stock of money.
§ Government Expenditure – The government buys services and pays for them with money (-Gd). Production companies/business sector receive this money in return for services rendered (+Gd). Thus this row will always sum to zero.
§ Output – In this case output is a positive flow (though not of cash) for the business sector as goods and services are produced within this sector thus creating a profit. For the households, Output is a negative flow as they are ultimately the ones producing the output.
§ Factor Income – The wage bill is denoted as a wage rate (W) times employment (N). The production sector supplies services to the household sector and the government and also demands a volume of employment at a wage rate which is exogenously determined. The s and d denote ‘supply’ and ‘demand’. Households earn income (+W.Ns) while the production sector pays employees (-W.Nd), thus the row also sums to zero.
§ Taxes – Households who earn income are subject to tax on their wages (-Td) while the government earns taxes as receipts from each employee (+Td). Again this row will sum to zero.
§ Change in money stock – Money (H) is a liability for the government, i.e. it is public debt or the debt of the government. On the other hand, money (H) is an asset for the household as it represents their accumulated wealth at a particular point in time. +change Hs in the Government sector is given by the difference between government receipts and expenditures in that period. Because there are no tangible assets in this matrix, additions to cash holdings constitute the saving of the households.
* Alex, Martina, Mark,Sinead and Jason.
* PBL - exercise & presentation was done on the Multiplier effect
First post, answers to Problem 4:
EC6012 – Problem 4
Q.1.1 Why must the Vertical Columns sum to zero?
They describe the sums of money that actually change hands and therefore represent a system of accounting identities. The change in the amount of money held in one sector must always equal the difference between receipts and payments in the other sectors.
Q.1.2 Why must the Horizontal Rows sum to zero?
The rows represent the Circular Flow of Income. Flows move in a zero sum space – i.e. ‘everything comes from somewhere and everything goes somewhere’ (Godley & Lavoie, pg. 6). Every component in the matrix must have an equivalent component elsewhere. Therefore flows must always equal zero e.g. consumption is a receipt of money by business but a payment by households.
Q.2 Write out an explanation for each row.
§ Consumption – In each period, the households consume either their disposable income or the wealth they have accumulated in previous periods or both. Consumption therefore must be some proportion alpha of the flow of disposable income and the opening stock of money.
§ Government Expenditure – The government buys services and pays for them with money (-Gd). Production companies/business sector receive this money in return for services rendered (+Gd). Thus this row will always sum to zero.
§ Output – In this case output is a positive flow (though not of cash) for the business sector as goods and services are produced within this sector thus creating a profit. For the households, Output is a negative flow as they are ultimately the ones producing the output.
§ Factor Income – The wage bill is denoted as a wage rate (W) times employment (N). The production sector supplies services to the household sector and the government and also demands a volume of employment at a wage rate which is exogenously determined. The s and d denote ‘supply’ and ‘demand’. Households earn income (+W.Ns) while the production sector pays employees (-W.Nd), thus the row also sums to zero.
§ Taxes – Households who earn income are subject to tax on their wages (-Td) while the government earns taxes as receipts from each employee (+Td). Again this row will sum to zero.
§ Change in money stock – Money (H) is a liability for the government, i.e. it is public debt or the debt of the government. On the other hand, money (H) is an asset for the household as it represents their accumulated wealth at a particular point in time. +change Hs in the Government sector is given by the difference between government receipts and expenditures in that period. Because there are no tangible assets in this matrix, additions to cash holdings constitute the saving of the households.
Monday, March 5, 2007
Keynes Summary of Chapter 7 - The Meaning of Saving and Investment
The purpose of The General Theory is to address the question as to what determines the employment of the available resources in the monetary-entrepreneur economy. It is the firm, as the entrepreneurs’ entity, which employs resources that is the key to addressing this issue. Keynes highlights profit as the motivating factor in this economy. He had to see demand from the sellers and buyers point of view and to go from the individual seller and the individual buyer to the economy as a whole. This involved Keynes establishing the exact relationship between an income (and hence savings and investment) and an output in any period.
The theory of the supply of output as a whole expressed in terms of the employment of the resources required to produce the output as a whole makes up the supply side of Keynes theory of employment. Based on the idea that firms undertake production to sell output at a profit to consumers and investors.
In order to formulate the demand for output as a whole Keynes separated the demand for goods and services into those purchased for consumption and those purchased for investment purposes.
Keynes placed expectations at the center of his analysis both of production and of investment. Time usually passes between the seller forming expectations and the buyer deciding to buy the output. For this reason the two aspects of demand may be different.
Income as a stream over time cannot be continuously used for immediate consumption purposes unless people are to live on a day to day basis. Part of current income is therefore set aside for immediate consumption and part for future production and consumption. To form his theory of the demand for output in terms of employment he measures consumption and income in terms of wage-units. Expenditure for consumption purposes comes directly out of income while expenditure for investment comes from past and present savings. The entrepreneur must incur certain costs in order to acquire capital for investment. It is necessary to pay a price for the commodity if it is being purchased from another entrepreneur or incur the costs of directly employed factors and of other inputs if the entrepreneur produces the capital himself. Taking this into consideration the entrepreneur must have access to the necessary financial means to pay for these outlays and must insure the expected yield is higher than outlay.
Income proper is equal to the value of output but when you take costs such as user costs into consideration it is based on net income that the entrepreneur decides what to spend on consumption. A persons ability to consume depends on his income and a decision to not consume now is seen as a decision to save. Saving allows the individual to have provisions in the future, the amount of this provision depends on the individuals time preferences.
Keynes only takes expenditure on newly produced output for investment purposes into account and proposes that the “exchange of old investments” and “creation and discharge of debts” cancels out when looking at the investment for the economy as a whole. Keynes proposes that investment has to be induced while he says that consumption is a “habitual propensity” limited by income. The inducement for investment is the expectations of a profitable return on the output rather than a desire to have output available for future consumption.
The point of effective demand for the firm is the point at which a particular level of production and employment offer the maximum attainable profit levels. Keynes and Robertson both take an increase of savings over investment to mean that income is falling even though they phrase it differently while an increase of investment over savings is said to induce entrepreneurs to increase both employment and output.
Obviously with a change in output and employment there will be a change in wage-units i.e. money wage of a labour unit and therefore distribution of this asset amongst borrowers and lenders. “Forced saving” needs to be compared against a standard rate of saving and Bentham when dealing with this concept was looking at an increase in the quantity of money and a full employment scenario.
Keynes believes the principle that saving always involves investment or there cannot be investment without saving to be a sounder view than there can be investment without saving. To show this he states no one can save unless they first own an asset or no one can acquire an asset unless someone parts with their asset or produces an asset of that value.
Saving and spending are two sided affairs. What one individual spends becomes another persons’ income and therefore allows that individual to save a part of his income. If one person consumes less to save more this affects the savings levels of another so the economy as a whole does not benefit from such actions. In regards to the monetary economy money is seen to affect motives and decisions. Keynes notes that the amount of money people hold is dependant on their incomes and prices of securities primarily which is seen as the natural alternative to money. Income, prices and the amount of money the bank creates are all interlinked and this is the main proposition of the monetary theory. Basic economic theory highlights the fact that there cannot be a buyer without a seller or vice versa. The individual looks at his demand as a one sided transactions where as in the case of formulating economic theory this is not the case for the aggregate.
The theory of the supply of output as a whole expressed in terms of the employment of the resources required to produce the output as a whole makes up the supply side of Keynes theory of employment. Based on the idea that firms undertake production to sell output at a profit to consumers and investors.
In order to formulate the demand for output as a whole Keynes separated the demand for goods and services into those purchased for consumption and those purchased for investment purposes.
Keynes placed expectations at the center of his analysis both of production and of investment. Time usually passes between the seller forming expectations and the buyer deciding to buy the output. For this reason the two aspects of demand may be different.
Income as a stream over time cannot be continuously used for immediate consumption purposes unless people are to live on a day to day basis. Part of current income is therefore set aside for immediate consumption and part for future production and consumption. To form his theory of the demand for output in terms of employment he measures consumption and income in terms of wage-units. Expenditure for consumption purposes comes directly out of income while expenditure for investment comes from past and present savings. The entrepreneur must incur certain costs in order to acquire capital for investment. It is necessary to pay a price for the commodity if it is being purchased from another entrepreneur or incur the costs of directly employed factors and of other inputs if the entrepreneur produces the capital himself. Taking this into consideration the entrepreneur must have access to the necessary financial means to pay for these outlays and must insure the expected yield is higher than outlay.
Income proper is equal to the value of output but when you take costs such as user costs into consideration it is based on net income that the entrepreneur decides what to spend on consumption. A persons ability to consume depends on his income and a decision to not consume now is seen as a decision to save. Saving allows the individual to have provisions in the future, the amount of this provision depends on the individuals time preferences.
Keynes only takes expenditure on newly produced output for investment purposes into account and proposes that the “exchange of old investments” and “creation and discharge of debts” cancels out when looking at the investment for the economy as a whole. Keynes proposes that investment has to be induced while he says that consumption is a “habitual propensity” limited by income. The inducement for investment is the expectations of a profitable return on the output rather than a desire to have output available for future consumption.
The point of effective demand for the firm is the point at which a particular level of production and employment offer the maximum attainable profit levels. Keynes and Robertson both take an increase of savings over investment to mean that income is falling even though they phrase it differently while an increase of investment over savings is said to induce entrepreneurs to increase both employment and output.
Obviously with a change in output and employment there will be a change in wage-units i.e. money wage of a labour unit and therefore distribution of this asset amongst borrowers and lenders. “Forced saving” needs to be compared against a standard rate of saving and Bentham when dealing with this concept was looking at an increase in the quantity of money and a full employment scenario.
Keynes believes the principle that saving always involves investment or there cannot be investment without saving to be a sounder view than there can be investment without saving. To show this he states no one can save unless they first own an asset or no one can acquire an asset unless someone parts with their asset or produces an asset of that value.
Saving and spending are two sided affairs. What one individual spends becomes another persons’ income and therefore allows that individual to save a part of his income. If one person consumes less to save more this affects the savings levels of another so the economy as a whole does not benefit from such actions. In regards to the monetary economy money is seen to affect motives and decisions. Keynes notes that the amount of money people hold is dependant on their incomes and prices of securities primarily which is seen as the natural alternative to money. Income, prices and the amount of money the bank creates are all interlinked and this is the main proposition of the monetary theory. Basic economic theory highlights the fact that there cannot be a buyer without a seller or vice versa. The individual looks at his demand as a one sided transactions where as in the case of formulating economic theory this is not the case for the aggregate.
Keynes Summary of Chapter 6 - Income,Income, Saving and Investment
Income
To comprehensively define income we first state:
A – Sales, A1 – cost of sales, G – Capital Equipment. Some part of A+G-A1 will pertain to Capital Equipment before current period. To define income of current period, we deduct from A+G-A1 an amount that refers to value given by equipment from previous period. Calculating said sum enables us to define income. There exists two methods for attaining such: one (i) pertains to production; the other (ii) to consumption.
(i) We define G as net result of maintenance and depreciation for capital equipment during production of output. B’ is that spent on maintenance even if not used in production. Having spent B’, G’ is the worth of it at period end i.e G’ – B’ is, assuming its’ not used to produce A, maximum net value conserved from previous period. Further G-A1 is that used to produce A. So (G’-B’)-(G-A1) is U, user cost of A. A’s factor cost, F, is amount paid out to other factors of production. And prime cost of output A is F + U.
Income then is excess of output value over prime cost, and is causally significant for employment. We assume user cost is positive, since it’s negative only when an entrepreneur has increased capital equipment by his own labour. We note aggregate Consumption (C) as ∑A-A1 and aggregate investment (I) as ∑A1-U. And –U is an entrepreneurs investment (with U his disinvestment) relating to his own equipment. Hence consumption = A and investment = -U where A1=0. Also, effective demand is I an entrepreneur expects to get. An aggregate demand function relates various hypothetical employment quantities to expected output yields; and effective demand is the point on it which becomes effective as, related to supply, it equates to employment level which maximises entrepreneur’s profits.
(ii) Involuntary losses can affect capital equipment values, so-called “Acts of God”. These are “insurable risks”. We define supplementary cost (V) as excess depreciation over user cost. Subtracting income and gross profit from V yields net income and net profit. So, aggregate net income is equal to A – U – V. Windfall loss pertains to changing equipment value, due to unforeseen factors. Net income is crucial when an entrepreneur decides his spending limits. Another is the windfall gain/loss on capital account. His consumption is determined by excess of current account proceeds over sum of prime and supplementary costs – a windfall loss has lesser impact than equivalent supplementary.
Supplementary costs estimation depends on accounting method used, thou its’ expected value is known. The allowance for supplementary costs can be calculated on the basis of current values and expectations at the end of an accounting period. It is more accurate when doubt exists to assign an item to the capital account and to only include what supplementary costs are definitely belong there. Supplementary costs are important because they effect consumption.
Savings and Investment
Any reservations regarding the meaning of savings stems from doubts regarding it’s components, which are simplistically income and expenditure. As income is defined earlier expenditure remains indistinct. Furthermore as expenditure refers to the value of goods sold to consumers during that period it is the definition of a consumer-purchaser which we seek. A distinction between consumer-purchaser and investor-purchaser serves as an inevitable distinction between consumer and entrepreneur thus defining A1 as the value of what one entrepreneur buys from another. Consumption then equals the total sales made during the period less the total sales made by one entrepreneur to another or ∑ (A – A1). With this definition for consumption and with income equalling A –U it follows that saving equals A1 – U with net saving equal to A1 – U – V.
The part of the income which has not passed into consumption being current investment allows us to derive A1 – U as the investment for the period while A1 – U – V allows for impairment in value giving the net investment. Traditional usage of the great majority of economics implies:
Income = value of output,
current investment = the part of current output not consumed
saving = income-consumption
Therefore saving = investment.
In addition to this relationship saving can be defined as a mere residual and the act of investment causes saving to increase by a corresponding amount. This is due to psychological habits which offer the market the opportunity to settle allowing readiness to buy to equal readiness to sell.
To comprehensively define income we first state:
A – Sales, A1 – cost of sales, G – Capital Equipment. Some part of A+G-A1 will pertain to Capital Equipment before current period. To define income of current period, we deduct from A+G-A1 an amount that refers to value given by equipment from previous period. Calculating said sum enables us to define income. There exists two methods for attaining such: one (i) pertains to production; the other (ii) to consumption.
(i) We define G as net result of maintenance and depreciation for capital equipment during production of output. B’ is that spent on maintenance even if not used in production. Having spent B’, G’ is the worth of it at period end i.e G’ – B’ is, assuming its’ not used to produce A, maximum net value conserved from previous period. Further G-A1 is that used to produce A. So (G’-B’)-(G-A1) is U, user cost of A. A’s factor cost, F, is amount paid out to other factors of production. And prime cost of output A is F + U.
Income then is excess of output value over prime cost, and is causally significant for employment. We assume user cost is positive, since it’s negative only when an entrepreneur has increased capital equipment by his own labour. We note aggregate Consumption (C) as ∑A-A1 and aggregate investment (I) as ∑A1-U. And –U is an entrepreneurs investment (with U his disinvestment) relating to his own equipment. Hence consumption = A and investment = -U where A1=0. Also, effective demand is I an entrepreneur expects to get. An aggregate demand function relates various hypothetical employment quantities to expected output yields; and effective demand is the point on it which becomes effective as, related to supply, it equates to employment level which maximises entrepreneur’s profits.
(ii) Involuntary losses can affect capital equipment values, so-called “Acts of God”. These are “insurable risks”. We define supplementary cost (V) as excess depreciation over user cost. Subtracting income and gross profit from V yields net income and net profit. So, aggregate net income is equal to A – U – V. Windfall loss pertains to changing equipment value, due to unforeseen factors. Net income is crucial when an entrepreneur decides his spending limits. Another is the windfall gain/loss on capital account. His consumption is determined by excess of current account proceeds over sum of prime and supplementary costs – a windfall loss has lesser impact than equivalent supplementary.
Supplementary costs estimation depends on accounting method used, thou its’ expected value is known. The allowance for supplementary costs can be calculated on the basis of current values and expectations at the end of an accounting period. It is more accurate when doubt exists to assign an item to the capital account and to only include what supplementary costs are definitely belong there. Supplementary costs are important because they effect consumption.
Savings and Investment
Any reservations regarding the meaning of savings stems from doubts regarding it’s components, which are simplistically income and expenditure. As income is defined earlier expenditure remains indistinct. Furthermore as expenditure refers to the value of goods sold to consumers during that period it is the definition of a consumer-purchaser which we seek. A distinction between consumer-purchaser and investor-purchaser serves as an inevitable distinction between consumer and entrepreneur thus defining A1 as the value of what one entrepreneur buys from another. Consumption then equals the total sales made during the period less the total sales made by one entrepreneur to another or ∑ (A – A1). With this definition for consumption and with income equalling A –U it follows that saving equals A1 – U with net saving equal to A1 – U – V.
The part of the income which has not passed into consumption being current investment allows us to derive A1 – U as the investment for the period while A1 – U – V allows for impairment in value giving the net investment. Traditional usage of the great majority of economics implies:
Income = value of output,
current investment = the part of current output not consumed
saving = income-consumption
Therefore saving = investment.
In addition to this relationship saving can be defined as a mere residual and the act of investment causes saving to increase by a corresponding amount. This is due to psychological habits which offer the market the opportunity to settle allowing readiness to buy to equal readiness to sell.
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