ECONOMIA E POLITICA MONETARIA (Prof.

Elisabetta De Antoni) Aa 2011-2012

INTRODUCTORY LECTURE
PREMISE....................................................................................................................................................................................1

I) ENGLISH VERSION........................................................................................................ 3 B. SNOWDON, H. VANE, P. WYNARCZYK:.....................................................................3 A MODERN GUIDE TO MACROECONOMICS:.................................................................3 AN INTRODUCTION TO COMPETING SCHOOLS OF THOUGHT...................................3 EDWARD ELGAR, 1994....................................................................................................3 II) ITALIAN VERSION........................................................................................................3 ETAS, 1998 ....................................................................................................................... 3
1. THE OLD' CLASSICAL (PRE-KEYNESIAN) MODEL...............................................................................................4 The Existence of Full Employment Equilibrium.................................................................................................................35 2. The Keynesian revolution...................................................................................................................................................42 3. The demand for money.......................................................................................................................................................70 Krugmans description of the crisis.......................................................................................................................................88 Neoclassical Synthesis (1937-1965)........................................................................................................................................97 Monetarism.............................................................................................................................................................................138 the balance of payments........................................................................................................................................................161 new classical (macro) economics..........................................................................................................................................181

PREMISE
IN THE LAST THREE DECADES: the financial system has grown faster than the real economy (transactions, incomes distributed.) The leader industrialized country (US) has accumulated unprecedented levels of indebtedness (households, government, whole country).

 Thanks to liberalisation, financial techniques and innovations have become more and more unscrupulous and opaque. THE RESULT was an overall increase in financial fragility: the symptoms of a "disaster foretold" were before everybody's eyes. This instability clashed with the dogmas of the mainstream: The free market is stable. Financial markets are efficient. There was NO REASON TO WORRY!!!!!!! We had even entered a new era - the Great Moderationin which the trade cycle and inflation had been definitely bridled. THE CRISIS The world economy has been recently swept by one of the biggest financial crises within the memory of man with devastating effects on the real economy. This obliges us to rethink on the evolution of macroeconomic theory its future perspectives. THE COURSE The course will analyze the role of money and finance in the economy according to the main macroeconomic schools of thought. MAIN QUESTIONS: Why money (a simple piece of paper) is that important? Why finance (a simple way of transferring funds from savers to investors) is that important? Are money and finance a source of stability/instability? The recent financial turmoil confirms the importance of these questions. From the concrete point of view, the course will focus on both the sides of the money market, analyzing the theories of the demand for money and more generally of portfolio allocation the theories of the supply of money (the role of the central bank, of the financial system, of monetary policy). REQUIREMENTS English courses are usually choosen by foreign students.

In the past, many Erasmus students coming from other Faculties (Law, Political Sciences, Engineering.). To be accessible to everybody, the course requires: basic macroeconomics basic mathematics. TEXTBOOK (CHAPTERS 1-7) The textbook is available (also in the University Library) both in English and in Italian. I) ENGLISH VERSION B. SNOWDON, H. VANE, P. WYNARCZYK: A Modern Guide to Macroeconomics: An Introduction to Competing Schools of Thought Edward Elgar, 1994. II) ITALIAN VERSION B. SNOWDON, H. VANE, P. WYNARCZYK: Guida alla macroeconomia. Scuole di pensiero a confronto Etas, 1998 FURTHER MATERIAL Lectures notes/further references will be made available/specified on Comunit on line at the end of each week. EXAMS The course implies written exams. Questions will be in English. Answers can be either in English or in Italian. The student will be able to choose between two kinds of examination. THE SIMPLIFIED EXAMINATION will be mainly based on the textbook will carry a mark of up to a maximum of 25/30. THE EXTENDED EXAMINATION will be based on the textbook plus lecture notes will carry a mark of up to a maximum of 30/30 cum laude. NB Through ESSE3 (if not possible, by e-mail or during the lectures) students have to inform the teacher at least a week in advance if they intend to sit for the exam and for which kind of exam : the number of questionnaires that have to be prepared for the exam depends on the number of students involved. QUESTIONNAIRES will contain about ten questions concerning the different parts of the course/chapters of the book. questions will be of the following kind: What happens to the variable X if money supply increases according to this author/school of thought? Why? Explain and comment. .(5/10 rows for the answer)

What are the effects of a given fiscal/monetary measure according to this and that author/school of thought? Compare the two cases and comment. .(5/10 rows for the answer)
LECTURES

Monday 5-7 pm/Room 1A; Wednesday 3-4 pm/Room 2B

1. THE OLD' CLASSICAL (PRE-KEYNESIAN) MODEL

English not revised Keynes regarded as classical the economists who preceded him, i.e.: -the Classics (Smith, Ricardo)
-the Neoclassics (Marshall, Pigou). From a macroeconomic point of view, these pre-Keynesian economists generally placed complete faith in the market mechanism.

As we shall see, this faith has always dominated the field, up to nowadays. The recent financial turmoil, however, casts doubts on the effectiveness of market mechanisms. (Hopefully, textbook will be rewritten!!!) Main Presuppositions of the OC Model 1. Agents are rational; they: -have perfect knowledge; -are able to find their possibility frontier (the set of available options); -choose the optimal option, the one which maximizes their target 2. Markets are perfectly competitive; -there are many small agents with no market power -i. e. unable to affect market prices and quantities; -for competitive agents individually considered, prices are given.
3.Prices are perfectly flexible; they instantaneously clear all the markets.

Main Markets 1.Labor market 2.Goods market 3.Money market Every market implies 1. A demand curve D 2. A supply curve S 3. An adjustment mechanism towards equilibrium E

D E

OCs LABOUR MARKET We shall start with the OC demand for labour. THE OCS DEMAND CURVE FOR LABOUR This curve derives from the production function. The production function gives the maximum amount of output (Y) that can be produced out of any given amount of factor inputs (K,L). Y=A Y(K,L) where: Y is the output level. A is the total factor productivity: --it mirrors technology and input organization --by assumption, in the short run is given and equal to 1. K is the capital stock. --by assumption, in the short run is given. L is the employment level. As we have jus seen, in the short-run A e K are given (underlined) by assumption. The short-run production function thus becomes a relationship between output Y and employment L: if firms want to increase Y, they have to increase L. Thus, the short-run production function can then be represented as follows:

Y=Y(K,L)

Y1 Y0

L0

L1

The first derivative of the production function tells us by how much output Y rises if there is a unitary increase in L.

Y/L
It thus measures the productivity of the additional/marginal worker. It is consequently named marginal product of labour. Y/L=MPL Analogous considerations obviously hold for the marginal product of capital. Y/K=MPK Let us now analyze the properties of MPL and MPK. The basic assumptions underlying the production function are the following: -its first derivatives are positive Y/L=MPL>0 Y/K=MPK>0 -its second derivatives are negative MPL/L<0 MPK/K<0 Graphically, according to the production function, subsequent unitary increases in L (L=+1) cause positive but decreasing increases in Y (Y)

Y
Y1 +1 Y0 +1

Y=Y(K,L)

This means that marginal products MPL and MPK are:

-positive: any additional unit of L or K implies an increase in output Y -decreasing: the corresponding increases in Y are lower and lower.

The following figure represents the marginal product of labour (MPL): it is positive but decreasing. Every additional unit of labour is productive but than the previous ones.

MPL
MPL1 MPL2 MPL3

Why is the MPL decreasing? What is the theoretical justification for this phenomenon? The answer comes from the well known law of decreasing returns. In the short run, K is given. As L increases, the ratio K/L falls. On average, every subsequent unit of labour is thus associated with decreasing units of capital. As a consequence, labour becomes less and less productive. L K/L MPL Why is all of this important? As we shall see, under a regime of perfect competition, the downward sloped MPL curve coincides with the demand curve for labour Ld. We shall show this both graphically and algebraically.

Graphical demonstration In deciding how much labour to hire, profit maximizing firms will compare the returns and costs of labour: The return (the productivity) of each additional unit of labour coincides with its marginal product MPL= Y/L --The cost of each additional unit of labour is represented by the real wage, which for each individual competitive firms is given. W/P0

MPL

W/P
0

W/P0

Profit maximizing firms will hire all the units of labour that imply: --a return MPL --higher than the given labour cost (W/P0) --and thus guarantee a positive unitary profit (=MPL-W/P0). The units of labour -on the left of Ld0 are profitable: MPL>W/P0 >0 -on the right of Ld0 are not profitable: MPL<W/P0 <0 The optimal amount of labour will thus be Ld0 where MPL=W/P
MPL
>0

W/P0
<0

W/P0

Ld0

The quantity of labour Ld0 in the previous figure represents: --the profit maximizing amount of labour; --the demanded amount of labour. As a result, the MPL curve: -gives the optimal (and thus the demanded) amount of labour as a function of its price -coincides with the demand curve for labour MPL curve=L d curve Starting from point 0, if the real wage W/P increases to W/P1 below: -the profit maximizing amount of labour decreases to Ld1. -the demanded amount of labour falls to Ld1.

W/P1 W/P0

1 0

Ld1

Ld0

Conclusion 1. MPL curve=Ld curve 2. The MPL curve is negatively sloped. 3. The Ld curve is a negative function of the real wage: Ld=Ld(W/P) with Ld/W/P<0 Mathematical demonstration The profit of a competitive firm is defined as: =PY-WL According to the production function: Y=Y(K,L) By substituting =PY(K,L)-WL Given K,P,W, the competitive firm chooses the level of activity (L and thus Y) which maximizes its profit. Profit maximization requires that /L=0 i.e. that /L =P Y/L-W=0 By isolating the real wage W/P on the left hand side, we get W/P= Y/L=MPL Maximizing firms will expand employment L (and output Y) up to the point where the decreasing MPL equals the given real wage W/P.

W/P

MPL curve
0

W/P0

Ld0

At any given level of W/P, the MPL curve gives -the optimal quantity of labour, -the demanded quantity of labour. This confirms our previous result: the MPL curve coincides with the Ld curve. MPL curve= Ld curve A DIGRESSION Starting from the equality MPL=W/P and isolating the price level P, we get P = [1/MPL] W The left-hand term is the price of output P. The right-hand term is the marginal cost of output MgC. Specifically: -MPL is the marginal product of labour; -[1/MPL], the reciprocal of MPL, gives the labour requirement of each marginal unit of output; -[1/MPL] W, gives the marginal cost MgC of each additional unit of output. For a competitive firm, the price level P is given. What can we say about marginal costs? The figure below shows the MgC curve

MPL decreases as L (& Y) rise. MgC consequently rises with the level of L (&Y). L(&Y) MPL MgC(= 1 .W) MPL

MgC

The MgC curve slopes upwards: marginal costs are increasing. Since each additional unit of labour becomes less and less productive, each additional unit of output requires more labour: it consequently becomes more costly than the previous ones Profit maximizing firms will compare marginal costs with prices. For individual competitive firms, the price level is given at P*. It corresponds to an horizontal line in the figure below. Let us add the just derived upward sloping MgC curve. Firms will produce all the units of output which have a price higher than the marginal cost and thus guarantee a positive profit.

The units of output -on the left of Y* are profitable: P>MgC >0 -on the right of Y* are not profitable: P<MgC <0 -The optimal level of output will be Y*. where P= MgC

P,MgC

Mg

P* >0

Y*

This conclusion has the following implication. At the given price level P*, the MgC curve gives -firms optimal output level Y*, -firms supplied amount of output Y*. The upward sloping marginal cost curve thus coincides with individual firms supply curve of output MgC curve=Ys curve If the given price level P* increases: -more units of output will become profitable -the firm will increase its supply of output

MgC P*1 <0 P*0 >0

Y*0

Conclusion of the digression. Profit maximization can be expressed in two equivalent ways: the one implies the other!! 1.W/P=MPL

2. P=MgC The profit maximizing competitive firm simultaneously: -expands employment L up to the alignment of MPL to the given real wage W/P -expands output Y up to the alignment of the MgC to the given price P. The corresponding implications are the following: 1. MPL curve=individual firms negatively sloping Ld curve 2. MgC curve = individual firms positively sloping Ys curve We have thus learnt how profit maximizing competitive firms determine: 1. their demand for labour (a negative function of W/P) 2. their supply of output (a positive function of P) THE OC SUPPLY CURVE OF LABOUR Let us go back to microeconomic theory. Each worker has, say, 15 available hours a day. He can allocate them into two alternative uses: --leisure, which is a pleasure in itself. --work, which is onerous but allows her/him to get a real wage and thus to buy consumption goods. The worker/ consumer will choose the optimal combination of leisure/consumption, the one which maximizes his utility. Ceteris paribus, this combination will depend on the real wage. If the real wage W/P increases, each hour of work is better paid and thus allows to buy more consumption goods. Higher real wages represent a greater incentive to work. As the real wage W/P increases, workers will decrease their leisure and supply a greater amount of labour. W/P Ls The labour supply curve Ls will be upward sloping.
Ls curve W/P1 W/P0

Ls0

Ls1

L*

The maximum supplied amount of labour is given by the full utilization of the working age population L*. Conclusion: the supply of labour Ls is a positive function of the real wage W/P:

Ls=Ls(W/P) with Ls/W/P>0 THE EQUILIBRIUM OF THE LABOUR MARKET In the neoclassical world, the money wage W is perfectly flexible. At any given price level P, it clears the labour market.
Ld E Ls

W/Pfe

As a result: -the real wage goes to its equilibrium level W/Pfe. -employment goes to its equilibrium level Lfe. -in equilibrium, the supplied and demanded amounts of labour are both equal to Lfe. Lse=Lde=Lfe

Lfe

L*

This equilibrium of the labour market is a full employment (fe) one. i) There is no involuntary unemployment. At the equilibrium real wage rate, all those available to work can find a job. ii) There is only voluntary unemployment Ufe. part of (L*) remains unemployed. Ufe=L*-Lfe This unemployment, however, is voluntary. It includes workers that are not available to work at the equilibrium real wage rate W/Pfe. They would only work at a higher real wage.

Ld E

Ls

W/Pfe

Lfe

L*

OCs GOODS MARKET As we have seen, the labour market determines the equilibrium (full employment) level of employment Lfe. On that basis, the production function gives the equilibrium (full employment) level of output Yfe.

Yfe

Lfe

In the OC framework, the labour market: i) performs a crucial role: it determines the level of activity of the system L,Y ii) performs this role in the best possible way: the activity level is the full employment one. L=Lfe and Y=Yfe AGGREGATE SUPPLY Our previous analysis of the labour market provides us all the ingredients that are required in order to build the OCs aggregate supply of goods. Panel 1 in the figure below shows the labour market equilibrium: employment L goes to its full employment level Lfe. Panel 2 shows the production function: if L goes to Lfe, also real output Y goes to its full employment level Yfe. Panel 3 shows the 45line Ys=Ys: each of its points has equal abscissa and ordinate. With the aid of this line, we can transfer the equilibrium level of output Yfe in the upper panel. Panel 4 represents the goods market: the aggregate supply curve is a vertical line at Yfe.

Ysfe

(4)
Yfe Yfe

45

(2)
Ld
W/P

Lfe
Ls

(3)

Yfe

(1)

Lfe

The OC aggregate supply curve: --comes from the labour market. -- is a vertical line with equation Ys=Ysfe This conclusion holds whatever the variable in the vertical axis of panel 4 above is! AGGREGATE DEMAND The question is: will aggregate demand Yd be sufficiently high to absorb the full employment supply of output Yfe? Yes, according to the Says law. The Says law (1803) referred to a barter economy. Under that regime, if an agent supplies one good, it is in order to buy another good of the same value. Supply Yfe thus creates its own demand Yd. Demand is passive. If we consider a monetary economy, however, the Says law becomes questionable. This time, agents supply goods in exchange for money rather than in exchange for goods. The supply of goods does not necessarily create its own demand. This time, the alignment of aggregate demand Yd to aggregate supply Ys=Yfe is not automatic but requires an adjustment mechanism. Let us analyze the views of the Old Classics about this issue. By definition, in a closed economy, aggregate demand Yd is composed by: -C, households consumption -I, firms investment -G, government expenditure Yd=C+I+G As usual, G is exogenously given. According to the Old Classics, C and I are both negative functions of the rate of interest r; thus: Yd=C(r)+I(r)+G

with C/r<0 I/r<0 Ceteris paribus, aggregate demand is thus a negative function of the interest rate r. r C & I Yd The expression for aggregate demand is: Yd=Yd(r) with Yd/r<0 In the upper panel of the following figure, we can thus: -place the interest rate in the vertical axis; -draw a downward sloping aggregate demand curve Yd=Yd(r).
Yd(r)
Ysfe

re

Yfe Yfe Yfe

45 Lfe Ld L
s

Yfe

W/P

Lfe

GOODS MARKET EQUILIBRIUM The flexibility of the interest rate r leads to goods market equilibrium, aligning the level of aggregate demand Yd to the given full employment supply of output Ysfe. Ysfe=Yd(r) In a monetary economy, if supply creates its own demand, this is due to the interest rate. The interest rate r -is the variable that clears the goods market -is a real variable, determined in the real sector of the economy Three questions about the OC goods market -why is consumption C a negative function of the rate of interest r? -why is investment I a negative function of the rate of interest r? -above all, why does the interest rate r clear the goods market? 1 QUESTION: THE NEOCLASSICAL CONSUMPTION FUNCTION
ST

The worker/consumer works in exchange for an income that she/he can use for consumption C or for saving S.

In deciding how to use each euro of his income, the neoclassical consumer has the following alternatives: i) to consume the euro today ii) to save the euro today, to buy bonds and to consume (1+r) euro tomorrow. Saving implies future consumpti on! The consumers alternative is thus to consume -1 euro today -(1+r) euro tomorrow The rational consumer will choose the alternative which maximizes his utility. Ceteris paribus, the optimal solution will depend on r.
The interest rate is the incentive to save /to consume tomorrow. A higher interest rate increases the incentive to save: each euro saved today will give rise to a higher consumption tomorrow. As a consequence, an increase in r -will decrease current consumption -will increase current saving

r.C and S This means that i) consumption C is a negative function of the interest rate r C=C(r) with C/r<0 ii) saving S is a positive function of the interest rate r S=S(r) with S/r>0 This is precisely what we wanted to show.. 2 QUESTION. THE NEOCLASSICAL INVESTMENT FUNCTION
ND

We have seen that, according to the production function, the marginal products of K and L are both: --positive --decreasing Before we focused on the marginal product of labour MPL. Now, we shall instead consider the marginal product of capital MPK. By definition, the marginal product of capital is the increase in output Y due to a marginal (unitary) increase in the capital stock K. MPK=Y/K By definition, however, the increase in K represents an investment I. The positive and decreasing MPK can thus be associated with the investment level I.

MPK

MPK

As known, the behaviour of the MPK reflects the law of decreasing returns.1 In deciding their demand for investment goods, competitive maximizing firms will compare returns and costs. The return associated with each additional unit of K (with each new I) is represented by its MPK. The cost associated with each additional unit of K (with each new I)
is represented by the cost of the funds that firms have to borrow in order to invest. i.e. by the given interest rate r.

Firms will undertake all the investment projects which ensure a return MPK greater than the cost r and thus guarantee a positive profit >0.
MPK

MPK

r0

>0

<0

I0

In the previous figure, investments -on the left of I0 are profitable: MPK>r0 and thus >0 -on the right of I0 are not profitable: r0>MPK and thus <0 At the interest rate r0, --the profit maximizing amount of investments is I0. --the demanded amount of investment goods will be I0.

In equilibrium, employment is given at Lfe. Investment increases K and thus decreases the ratio Lfe/K. As K rises, every unit of capital K is associated with less units of labour L.
As a consequence, K becomes less and less productive.

Lfe/K

MPK

MPK

MPK

r0

I0

At any interest rate r, the MPK curve -gives the optimal (the demanded) amount of investment goods Id. -it thus coincides with the demand curve for investment goods Id. MPK curve=I d curve If the interest rate r increases -some investments (I0I1) will stop being profitable -the optimal amount of investment decreases -firms demand for investment goods falls.
1 0

r1 r0

I1

I0

The higher the interest rate r, the lower the demand for investment goods.
The demand function for investment goods is I=I(r)

with I/r<0 This is precisely what we wanted to justify. NB: The demand curves for labour Ld and for new capital goods Idcoincide with the respective marginal product curves. In the OCs environment, the demand for L and K derive from the production function (reflect technical factors). There is perfect coordination: firms are sure to be able to sell their whole output! 3 QUESTION. THE NEOCLASSICAL THEORY OF THE RATE OF INTEREST
RD

The goods market should be cleared by the price level P. By contrast, it is cleared by the interest rate r. Questions: What does the interest rate represent? What are the connections between the goods market and financial markets?

What is the role of financial markets? To answer, we have to reformulate the goods market equilibrium condition. Equilibrium implies the equality between aggregate supply and demand. Ys=Yd=Y Given the definition of aggregate demand Yd, we get Y=C+I+G By subtracting taxes T on both sides and moving consumption C to the left, we get Y-T-C = I + G-T
The left hand term is the definition of saving S. The equilibrium condition thus becomes

S = I + G-T This is an extremely important result: to say that Ys = Yd is the same as to say that S = I+G-T What is the intuitive explanation of this coincidence? Let us start from the goods market equilibrium condition Ys=Yd Usually we consider Ys as income produced. Goods market equilibrium requires the equality between income produced/supplied Ys and aggregate demand Yd. However, income produced is also income perceived. (Production turns into incomes for those who participate to the productive process. To simplify, we shall assume that income goes entirely to households; it is possible to show that this simplification does not change the results.) Goods market equilibrium thus also requires the equality between income received/perceived Ys and expenditure Yd. Income received is equal to expenditure in two cases: i) First case Everybody individually considered spends entirely her/his income. Aggregate income (white columns) is then equal to aggregate expenditure (grey columns).

Ys income expenditure

Yd

Households

Others sectors

Whole economy

ii) Second (more realistic) case below: The deficiencies and excesses of expenditure offset each other. Aggregate income is again equal to aggregate expenditure.
Ys income Yd

C
Other sectors

Households

Whole economy

THE SAVING-INVESTMENT APPROACH

Now we know the intuitive reason why Ys=Yd is equivalent to S = I+G-T This equivalence is crucial since it allows us to connect the goods market with financial markets (bonds, loans market) From the financial point of view: i) Saving S represents an equivalent demand for new bonds (supply of new loans). ii) The government deficit G-T is debt financed: it implies an equivalent supply of new government bonds (demand for new loans). iii) Investments I are too debt financed: they also imply an equivalent supply of new private bonds (demand for new loans). The financial system transfers funds against bonds (promises of payment) -from savers who have money in excess -to firms and to the government, who need money to finance their excess expenditures. Specifically, the goods market equilibrium condition

S= G-T +I implies the equality between i) S: a demand for new bonds Bd (a supply of new loanable funds LFs) S=Bd==LFs ii) G-T+I: a supply of new bonds Bs (a demand for new loanable funds LFd) G-T+I=Bs==LFd
Goods market and financial flows are two faces of a same coin!

The equilibrium of financial flows Bd=Bs=LFs=LFd ensures goods market equilibrium S=G-T + I Let us now introduce the interest rate. To this end we have to remember that: S=S(r) with S/r>>0 I=I(r) with I/r<0 G-T is exogenously given The demand for new bonds S is a positive function of the interest rate The supply of new bonds I+G-T is a negative function of the interest rate.
G-T + I(r)= Bs=LFd S=Bd=LFs

G-T

re Id=MPK function

Se=G-T+Ie

THE NATURE OF THE INTEREST RATE The interest rate is a real variable that aligns the forces of productivity (I) and thriftiness (S). It reflects the marginal product of capital as well as consumers time preferences.
It incentives households to contain consumption (to save) in order to finance the desired excess expenditure of firms and of the government.

THE ROLE OF THE RATE OF INTEREST The interest rate simultaneously clears the goods and financial markets. Let us analyze how this happens. An important premise In addition to the final reimbursement of the loan, bonds ensure a given yearly coupon CO as a compensation for the loan itself. The yearly percentage return of the bond is then equal to the ratio between the coupon CO and the bond price pb. r = CO/pb Given the coupon, the higher the bond price pb,the lower the interest rate r.

This inverse relationship between bond prices and interest rates is important for the adjustment process. pb r
THE ADJUSTMENT PROCESS

Let us start with a disequilibrium situation.

G-T + I= Bs=LFd r0 re

S=Bd=LFs

Se=G-T+Ie

At an interest rate level r0 higher than the equilibrium one re: S>G-T+I This excess of savings implies an excess demand for bonds EDB. S-[G-T+I]=EDB The bond price pb will increase and consequently the interest rate r will fall.
pb r By aligning the demand and the supply of financial flows, the interest rate clears: -the goods market, -financial markets The aforementioned coincidence between goods and financial markets equilibrium focuses exclusively on financial flows. The underlying assumption is that financial stocks are in equilibrium: people are perfectly happy about the stock of money and bonds inherited from the past. Stocks equilibrium does not interfere with flow equilibrium. This assumption, as we shall see, is all but granted. A DIGRESSION ABOUT FISCAL POLICY

What happens if the government increases government expenditure G (and government deficit G-T)?
The increase in G-T implies higher issues of government bonds.

The rise in the supply of new bonds G-T + I(r) causes fall in the bond price and an increase in the rate of interest. From equilibrium point 0 we move to equilibrium point 1 below.

G-T + I(r)=Bs

S(r)= Bd

r1

1 0

r0

S0=G0-T0+I0

S1=G1-T0+I1

The following figure shows the fiscal expansion (the same story) in terms of Ys=Yd. The increase in G raises aggregate demand, moving the Yd curve to the right. The issue of new government bonds raises the interest rate. This reduces private demand (C&I) along the new Yd curve.
In the end Yd goes back to its initial full employment level Ys=Yfe,

the only one compatible with the aggregate supply Yfe and thus with goods market equilibrium.
Ys r Yd1=C(r)+I(r)+G1 1 Y 0=C(r)+I(r)+G0 0
d

Yd= C(r) + I(r) G=Yd

Yfe

Let us compare the old (0) and the new (1) equilibrium. Equilibrium Ys comes from the labour market: it remains at its full employment level Yfe. Equilibrium Yd=C+I+G has thus to remain too at its full employment level Yfe. The new government expenditure G has to crowd out an equal amount of (C+I).

It does this trough the rise in the interest rate provoked by the issue of new government bonds.

Yfe = C(r)+I(r)+G
If output is at its full employment (its maximum) level government expenditure inevitably crowds out an equivalent amount of private expenditure. Crowding out is:

-real (the constraint is full employment output) -total or complete (each euro of public expenditure crowds out a euro of private expenditure)
MONEY MARKET

The fulcrum of the OCs money market is the famous Quantity Theory of Money. There are two versions of it. i) Fisher's version F ISHER ' S
IDENTITY OF EXCHANGES

In the real world, goods are exchanged against money.

---Money is a medium of exchange. ---Money is an input in transactions. However, we can say more on this issue! Individual goods are exchanged against an equivalent amount of money. The value of individual goods is equal to the amount of money paid for them.

cigarettes

P=4

Let us write this equivalence at the aggregate level. The value of the goods exchanged in the economic system is approximately equal to nominal income PY. The value of the money exchanged does NOT coincide with the existing quantity of money M. In any given period, every coin/banknote flows from hand to hand. In the example below, -I buy 4 euros of cigarettes -the tobacconist buys 4 euros of bread.

Tobacconist

Baker

If money does 2 rounds (finances 2 transactions) in a period, 4 euros of money finance 8 euros of transactions. M times 2 = value of transactions PY Generalizing, let us assume that money does V (rather then two) rounds
M times V=value of transactions PY We thus come to the Fisher's identity of exchange: MV=PY

V is the of circulation of money, equal to the value of transactions per unit of money (in our previous example=2) V=PY/M THE QUANTITY THEORY OF MONEY

If we introduce the following assumptions: i) M is exogenously determined by the central Bank ii) V is a given institutional constant iii) Y is given at its full employment level
we get the quantity theory of money When V and Y are given, an exogenous increase in M turns into an increase in P. MV=PY Let us divide both the terms by P, transforming the previous equation in real terms: M = (1) Y

The right hand side Y/V is given by the real sector. In equilibrium, also the left hand side has thus to be equal to Y/V. If this is true, increases in M cause equi-proportional increases in P, leaving the real quantity of money M/P unchanged at Y/V. If M doubles, the price level P too doubles. More generally: %M=%P Remember that labour market equilibrium gives W/Pfe. If money supply and the price level P doubles, the money wage W also doubles, leaving the real wage at its equilibrium level W/Pfe. %P=%W THE NEUTRALITY OF MONEY The important implications of the quantity theory of money are the following: i) any given percentage variation in money supply M implies an equi-proportional variation in nominal variables (P and W). %M=%P=%W ii) the real variables (W/P, Lfe, Yfe, C, I, r, M/P..) are all invariant to the quantity of money M. Money supply M does not affect them. iii) This means that money is -neutral, it only affects the nominal scale of the economy leaving real variables unchanged -a veil, that covers the real variables without affecting them. iv) Inflation is a monetary phenomenon. If prices rise too much, this means that money supply rises too much. The responsibility for inflation pertains to the central bank! v) The central bank controls M but not M/P, which in equilibrium is equal to Y/V!

ii) The Cambridge version (Marshall and Pigou)

Money is not an input in transactions Money is a particular good necessary to finance the purchases of all the other goods. As every other good, money will then have its own market, with

-a demand curve -a supply curve -an equilibrium condition

THE DEMAND CURVE FOR MONEY Let us start from Fisher's equation of exchange: MV=PY
By isolating M we get M=1 PY V If we put l/V=k the result is M=k PY This equation can be interpreted as a demand for money function:

Md=k PY Money is necessary to finance transactions. The transactions demand for money Md is then a multiple k of the value of transactions which take place in the economic system PY.
THE SUPPLY OF MONEY The assumption is that the supply of money is exogenously given Ms=M

MONEY MARKET EQUILIBRIUM

The equilibrium condition of the money market is: M=k PY

If we adopt the following usual assumptions: i) M is exogenously determined by the central Banck ii) K=1/V is a given institutional constant iii) Y is given at its full employment level
only P can clear the money market. MV=PY This leads to the Quantity Theory of Money. An increase in money supply M turns into an equi-proportional increase in nominal expenditure PY. Since real output Y is given, the result is an equi-proportional increase in P. M =k PY The same story can be told below in real terms The real demand for money (k Y) is given by the real sector. Equilibrium real supply M/P has also to be equal to k Y. Variations in the nominal quantity of money M only determine equi-proportional variations in the price level P. M =k Y P

Money is again -neutral, it only affects the nominal scale of the economy leaving real variables unchanged -a veil, that covers the real variables without affecting them. The Fisher's and the Cambridge versions of the quantity theory are perfectly equivalent. The difference is that money -in the first case is only an input in transactions; -in the second case is a good, with its own market.

Graphical representation of the money market

The equilibrium condition of the money market in real terms is: M/P=k Y where: --the left hand side is the supply of real money balances M/P. --the right hand side is the demand for real money balances kY which grows with real transactions and thus with real income Y. The money market equilibrium condition is shown by a straight line in the Y,M/P space.
M/P M/P=kY

As real income Y grows, the transactions real demand for money M/Pd=kY also grows. In equilibrium the real money supply M/Ps=M/P has to grow by the same amount. Y M/Pd=kY M/P As known, P is the variable that clears the money market. The increase in M/P is thus due to the fall in the price level P. If we want to buy more goods Y with a given money supply M, the price level P has to fall. Y M/Pd=kY M/PP Let us now connect the money market with the rest of the economic system.

According to the Old Classics, real income Y --comes from the labour market --is given at its full employment level Yfe The demand for real money balances is then kYfe. Given M, the price level will have to be such that (M/P)e = kYfe

M/P

M/P=kY

M/Pe

Yfe

MONETARY POLICY What happens if the central bank increases the nominal supply of money M? Given the full employment level of income Yfe, from initial equilibrium point 0 we move to disequilibrium point 1. At the full employment level of income, money supply now exceeds the demand. M > kYfe P

M/P M M/Pe

1 M/P=kY

Yfe

The excess supply of money ESM=M/P-kYfe will be used to purchase goods. Since the supply of goods Yfe is given at its full employment level, the higher demand for goods will only raise prices. The increase in P will decrease M/P, reabsorbing the excess supply of money. From point 1 we shall go back to point 0.

M/P M

1 P M/P=kY

M/Pe

Yfe

The equilibrium value of M/P -is equal to kYfe -is given by the real sector. Variations in the money supply M only determine equi-proportional variations in the nominal variables (P and W, given W/Pfe) %M=%P=%W According to the quantity theory of money: -money is neutral, -money is a veil. Inflation is a monetary phenomenon. The increase in the price level P reflects the increase in money supply M. The responsible for inflation is the central bank. The Central Bank controls M but not M/P It is unable to affect the real sector. It can only affect the price level.
OLD CLASSICAL MODEL: AN OVERALL SUMMARY

The following figure starts from the bottom and summarizes what we have said up to now. Make sure that you know what variable clears each market and why. Notice that the figure below only concerns real variables; by assumption they are independent of nominal variables M,P,W(this independence is defined OC dichotomy). The nominal scale of the economy (M,P,W) only depends on the level of money supply M. Fiscal and monetary policies are ineffective: remember why. M/P=kY
M/Pfe

Yd(r) rfe

Ysfe

Labour market Ld(W/P) =Ls(W/P) gives W/Pfe & Lfe Clearing variable W. Production function Ys=Ys(K,L) gives Yfe Clearing variable Ys. Goods market Ysfe=Yd(r) gives r Clearing variable r. Money market M/P=KY gives P&W Clearing variable P.

Yfe

Yfe

Money mkt Y
Yfe

Goods mkt Yfe

45

45

Yfe

Lfe

Yfe

product. fct Ld W/Pfe Ls

Lfe

labour Mkt

OLD CLASSICS AND UNEMPLOYMENT

According to historical evidence, labour market equilibrium is an exception. The real world is generally characterized by

the excess supply of labour (involuntary unemployment). Some people would like to work at the existing real wage. They, however, do not succeed in finding a job. In order to explain the existence of involuntary unemployment, Old Classics had to introduce imperfections. Specifically, they introduced money wage rigidities. Let us then assume that the nominal wage W -rather than being endogenously determined by labour demand and supply -is exogenously given (at a higher than equilibrium level) by the government/trade unions.
Ld curve =MPL curve Ls curve

The real wage rises from W/Pfe to W/P0. Only workers with MPL> W/P0.are profitable for firms. Firms demand for labour falls to L0.
Employment falls to L0.

W/P0 W/Pfe

0
E

The system moves from point E to point 0.

Ld0=L0
Lfe Ls0
L*

Involuntarily unemployment (the excess supply of labour) now is Ls0-L0>0

Firms have no convenience to hire those who are involuntary unemployed. The real wage is too high: in their case W/P0>MPL THE OLD CLASSICAL MODEL WITH GIVEN WAGES If employment L falls in the labour market below, according to the production function aggregate supply Ys too falls. This leads to an increase in the interest rate in the goods market (Yd has to fall) and to the increase in the price level in the money market (kY and M/P fall).
Yd(r) M/P=kY
M/Pfe=kYfe

Ys0
0

Ysfe

r0 0 rfe

Labour market W W/P Ld L Production function L Ys

M/P0=kY0

Y0

Yfe

Y0

Yfe

Money market

Goods market

Goods market Ys r Yd Money market Y kY =M/P P

Yfe Y0
45

Yfe Y0

Yfe Y0
45

Y0

Yfe

L0

Lfe

production function Ld WP0 W/Pfe

Y0

Yfe

Ls

To sum up, we have stagflation, i.e. stagnation (L, Y, C I) plus inflation (P) involuntary unemployment L0Lfe

labour market L 0=L0 Lfe

d

REMEDIES AGAINST INVOLUNTARY UNEMPLOYMENT

FISCAL POLICY Let us assume a fiscal expansion (00): G=G-T=Bs In financial markets: pb & r In the goods markets, aggregate demand falls: r C(r) &I(r) Yd(r) Equilibrium income Y returns to its initial level Y0: output levels beyond Y0 are not profitable. At the end, government expenditure only crowds out private expenditure. Y0=C(r)+I(r)+G There are no benefits in terms of employment and income! Activity levels beyond L0&Y0 are not profitable according to the labour market.

Yd1(r)
r1 1 Yd0(r)

Ys C&I 0 0 G

r0

Ys=Y0

MONETARY POLICY Let us assume a monetary expansion (00): M & M/P Disequilibrium point 0 implies: ESM=EDG Output Y is given from the labour market: the EDG turns into a higher price level: P The real money supply falls to the initial level M/P Money is neutral. The central bank can affect M but not M/P. Again, no benefits in terms of employment and output! Activity levels beyond L0&Y0 are not profitable according to the labour market.

M/P1

M/P= k Y

M/P0=kY0

Y0

Ld

W/P0 W/Pfe

WAGE FLEXIBILITY Involuntary unemployment Ls0-L0 implies L ESL The money wage W becomes flexible. The real wage falls from W/P0 to W/Pfe, W/P Firms demand for labour increases. Employment and output rise. Ld L&Y We reach the full employment equilibrium.
s

Ld0=L0

Lfe

Ls0

L*

Involuntary unemployment is due to an excessive cost of labour. Firms do not hire (and do not produce) more workers since labour is too expensive. Wage flexibility is the only weapon against involuntary unemployment!

THE PRE-KEYNESIAN CONCEPTION OF THE ECONOMY

The pillars of the pre-Keynesian approach are the following: Perfect rationality: Perfect competition: Perfect price flexibility: Markets are simultaneously in equilibrium. Everybody buys (sells) the optimal quantity. There is no individual incentive to change. In this idealistic Olympus the real sector spontaneously goes to its general (full employment) equilibrium. there is no need for economic policy.

economic policies may even be dangerous, better not to intervene government expenditure only crowds out private expenditure money supply only affects the price level Rigidities/imperfections The real world is not that perfect. If the system does not reach its general (fe) equilibrium, it is precisely because of these imperfections (wage rigidity). The main task of economic policy authorities is to remove them.
Theoretical developments Modern versions of general equilibrium theory are much more complex: inter-temporal, dynamic, stochastic The underlying vision, however, remains the one presented above. Concrete developments This is precisely the vision that inspired the European Monetary Union: the European Central Bank is responsible for inflation (link money/prices) National Government Budgets have to be balanced (no crowding out) The labour market flexibility and the increase in the skill/productivity of labour are the only remedies against unemployment.

MACROECONOMIC EQUILIBRIUM: ITS EXISTENCE, UNIQUENESS, STABILITY

ITS

Let us reconsider the under-employment equilibrium situation represented by points 0 in the goods market (right upper panel) and in the labour market (lowest panel). The goods market is in equilibrium (Ys0=Yd), the labour market is not. The excess supply of labour can be defined involuntary unemployment.

M/P=kY

Yd(r) r0

Ys0
0

M/P0=kY0

Y0

Yfe

Y0 Goods market

At the ongoing W/P0, some workers would like to work, but cannot find a firm available to hire them.

Money market

Y0

Y0

Y0
45

Y0

L0 production function

Y0

WP0

Ld 0
Efe

Ls

According to the OCs, this situation presupposes constraints on market mechanisms: minimum money wages W imposed by trade unions or governments.

labour market Ld0=L0

Let us then remove the obstacles! Let us liberalise the labour market!
M/P=kY M/Pfe=kYfe M/P0=kY0
Efe

Yd(r) r0 rfe

Ys0
0

Ysfe

Efe

Y0

Yfe

Y0

Yfe

Money market

Goods market

Yfe Y0
45

Yfe Y0

Yfe Y0
45

If money wages W become flexible: -the excess supply of labour will push W downwards -the system will reach its f.e. equilibrium.

Y0

Yfe

L0

Lfe

production function

Y0

Yfe

WP0 W/Pfe

Ld 0
Efe

Ls

labour market L =L0

d 0

Lfe

Old Classics (the standard) macroeconomic theory assumes that full employment equilibrium: exists is unique is stable. As we shall see, these three assumptions are not necessarily true.

The Existence of Full Employment Equilibrium

According to the OCs, goods market equilibrium can be specified in the following alternative ways. First formulation: Y=C+I+G
Aggregate supply Ysfe is equal to aggregate demand Yd.

Second formulation: S=I+G-T

The deficiencies of expenditure (S) are equal to the excesses of expenditure I+G-T.

Yd

Ysfe
rfe

G-T + I

S (Yfe)

rfe

Yfe

Sfe=G-T+I

Both the formulations assume that full employment equilibrium exists. Paul Krugman, 2008 Nobel Prize, questions this assumption.2 In his view, we can frequently face the following situation. First formulation: Y=C+I+G
r

Second formulation: S=I+G-T

r

Yd

Ysfe

I+G-T

S(Yfe)

Yfe

S, I+G-T

For positive interest rates r>0, there is no interception between the relevant curves. This means that full employment equilibrium does not exist. Specifically, according to Krugman, at any interest rate r0: the corresponding level of aggregate demand Yd0 will determine output Y0<Yfe (left-hand panel); the insufficiency of aggregate demand will constrain the system to an under-employment equilibrium. the low level of income will reduce saving, moving the corresponding function leftwards (right-hand panel). First formulation: Y=C+I+G Second formulation: S=I+G-T

P. Krugman (2011), Mr Keynes and the Moderns, paper presented at a Conference organized by the University of Cambridge in order to celebrate the 75th anniversary of the publication of Keyness The General Theory.

Yd
r0

Ysfe

I+G-T

S(Y0)

S(Yfe)

r0

Yd0=Ys0

Yfe

S0= I0+G-T

In the aforementioned situation, monetary policy is totally impotent. Even at a zero interest rate, only fiscal policy can stimulate the economy leading aggregate demand and output to their full-employment levels, moving the I+G-T function to the intersection with the full employment saving function. First formulation: Y=C+I+G Second formulation: S=I+G-T
I+G-T

Ysfe

S(Yfe)

r0 Yd0=Ys0 Yfe
Y

r0

S0= I0+G0-T0

Krugman associates the aforementioned situation with the liquidity trap envisaged by Keynes.3 In his view, the liquidity trap itself is not only a myth or a historical curiosity. It describes the past experience of Japan: a long-lasting recession despite what looked like very loose monetary policy. It can also describe the current situation in the United States, in the UK, and in the eurozone. As it happened to Japan, these economies may be facing lost decades due to a persistently inadequate demand.

THE UNIQUENESS OF EQUILIBRIUM

If we take into account the possibility of non linear functions, macroeconomic equilibrium is not necessarily unique. Kaldor (a follower of Keynes in Cambridge) for instance considers a non linear short-run relationship between investment I and income Y. In his view, investment is a positive function of income.

Krugmans analysis, however, does not seem totally correct on this issue. As we shall see, Keyness liquidity trap does not necessarily imply low or zero interest rates. It only implies the expectation of percentage increases in interest rates greater than interest rates themselves.

The propensity to invest out of income I/ Y is low at low levels of Y, when excess capacity is high. is low again at high levels of Y, i.e. when the bottlenecks due to the over-utilization of the given capital stock make it difficult for firm to get new investment goods.

According to Kaldor, saving too is a positive function of income. Let us then assume a linear relationship between saving S and income Y. In the absence of public sector (G=T=0), goods market equilibrium requires the equality S=I.
I C1 A1 B1
I1

We then have three (not one) equilibrium points: A, B, C. Let us assume that: Y/t= (I-S). Thus Y rises when I>S (i.e when Yd=C+I>Ys=C+S) Y falls when S>I (i.e. when Yd=C+I<Ys=C+S) This means that: A, B are locally stable equilibriums: the system tends to them C is a locally unstable equilibrium: the system tends to move away from it.

We shall analyze the details of Kaldors analysis in the future. For now, let us see the conclusion! S S,I B the system cyclically fluctuates from A to B and vice versa. income fluctuates from Ya to Yb and vice versa. A Y equilibrium is only a temporary situation
Yb

Ya

THE STABILITY OF EQUILIBRIUM

The basic presupposition of orthodox theory is the dogma of stability: if we are in disequilibrium, the price mechanism quickly leads us to general equilibrium. The underlying philosophy is the following:

An egg cannot persistently stay on its lower tip. Disequilibrium situations: are not persistent can be ignored. However, the gravity force cannot be automatically extended from physics to economics. To show this, let us analyse the cobweb approach. This approach starts with the following assumptions: time is composed by periods (days, months, years..) the current period is 0, future periods are 1, 2, 3 the initial situation implies a given disequilibrium quantity Q=Q0 demand and supply curves D and S perform different roles the D curve determines P and does this instantaneously the S curve determines Q and does this with a one-period lag. Let us then see what happens in the first two periods.
S

P0

Period 0 Quantity is given at Q0 The D curve instantaneously gives P0 We are in point 0. Period 1 At P0, the S curve associates the quantity Q1. The D curve instantaneously gives the new price P1 We are in point 1.

P1 Q0

1
D Q1
Q

Let us now consider the subsequent periods. Period 2 At P1, the S curve associates Q2 The D curve gives the new price P2 We are in point 2. Period 3 At P2 the S curve associates the new quantity Q3 The D curve gives the new price P3 We are in point 3.
Q

P0 P2 P3 P1

0 2

3 1

D
Q0 Q2 Q3 Q1

The figure looks like a cobweb!

The system oscillates along the D curve (0-1-2-3..) converging towards equilibrium. This, however, is only one of possible outcomes.

If the D and S curves have the slope shown below: the system unendingly oscillates from 0 to 1 and vice versa. Q and P experience constant fluctuations around their equilibrium levels without converging at them. equilibrium is unstable!!
D
P0 Pe
P1

1
Q0 Qe Q1

The third case below is even worse: the system is again unstable but now: oscillations get bigger and bigger leading us away from equilibrium
P D 4 2 0 S

3 Q

Q0

SUMMARY: THE BEHAVIOUR OF Q IN THE THREE CASES

Damped oscillations

Qe Q0 Time t

Constant oscillations

Qe Q0 Time t

Explosive oscillations

Qe Q0
0 Time t

CONCLUSION the adjustment mechanism is not as simple as we usually assume: the stability of equilibrium is far from being granted: the economy may exhibit a cyclical behaviour with constant or even with explosive oscillations. KEYNES AND MACROECONOMIC EQUILIBRIUM The aforementioned doubts about the existence, uniqueness, stability of equilibrium belong to the Keynesian tradition. However, Keyness main purpose was to question the stability of full employment equilibrium. In Keyness view, the price mechanism does not work. During the Great Depression of the 1930s, W and P fell but employment did not rise. Even when it has no constraints, the price mechanism is unable to clear simultaneously all the markets leading to full employment equilibrium. The system stops at an under-employment equilibrium. Keynes gives us various theoretical reasons for this. If the fall in money wages W turns into an equi-proportional fall in prices P, the real wage (the real cost of labour) W/P does not change and thus employment does not rise. When money wages W and prices P fall, the expectation of future falls may cause a postponement of expenditure (a fall in aggregate demand) which further raises unemployment instead of reabsorbing it. The fall in money wages W and prices P may alter the income distribution to the detriment of poor household (who have a higher propensity to spend out of income) with depressive effects on aggregate demand, output and employment. In Keyness view, the main cause of unemployment has to be found in the goods (not in the labour) market. After all, when the prospects of sale are low, firms have no incentive to produce/to hire. Even if the labour cost W falls, output and unemployment will not rise. If the price mechanism does not work, the State has to intervene.

Trough expansionary monetary and fiscal measures, it has to stimulate aggregate demand AD. The higher prospects of sale will induce firms to expand output and employment
P AD E0 AS

Pe0

Goods Market (upper panel) The rightward shift of the AD curve will raise output to its full employment level Yfe.. Labour market (lower panel) In order to increase output, firms will have to hire more workers. Employment too will rise to Nfe. Money wages are not an obstacle to the expansion. Through the increase in P allowed by the higher AD, firms will reduce the real wage W/P keeping it in line with the decreasing labour productivity.

Ye0

Yfe

Y Ns s

Nd
W/Pe0

E0

Nde0=Ne0

Nfe

Nse0

According to what we have just said, the main contribution of Keyness 1936 book (The General Theory of Employment, Interest and Money) consists in abandoning the assumption of the stability of equilibrium denouncing the tendency of the system to under-employment equilibriums, Unemployment represents a chronic pathology of capitalism!! To explain this market failure or coordination failure, however, Keynes had to revolutionize the whole theory of the working of the system. This will be the subject of the next lecture.

2. The Keynesian revolution

(English not revised) There are many interpretations of Keynes. Every economist has his own view about Keyness messages in his famous 1936 book: THE GENERAL THEORY OF EMPLOYMENT, INTEREST AND MONEY This revolutionary book proposes an entirely different perspective. We shall present a conventional, inevitably simplified, account. INTRODUCTION Keyness presuppositions are the following. i)Perfect competition Keynes keeps the Old Classics assumption of perfect competition. For him this is not a key issue, better to leave it.

Keynes differs from the Old Classics in the following fundamental aspects. ii) Collective rationality is bounded. The price mechanism is not necessarily able to clear instantaneously all the markets, leading the system to its general (full-employment) equilibrium. Market mechanisms are not perfect, the invisible hand is not omnipotent. We generally face market failures. iii) Individual rationality is bounded. Agents ignore the future (prices, incomes, returns..). They do not know probabilities, expected values and so on. As a consequence, they cannot maximize. Agents behaviours are dominated: not by a rational process of optimization but by their imperfect expectations and by the degree of confidence placed on them. Not by chance, the three pillars of Keyness architecture have all a psychological component (rather then a rational/maximizing one). We refer to: the propensity to consume out of income the marginal efficiency of capital (the propensity to invest at any given r) the liquidity-preference (the propensity to hold money rather then other assets). THE GENERAL THEORY AND BOUNDED COLLECTIVE AND INDIVIDUAL RATIONALITY: the system in which we live...seems capable of remaining in a chronic condition of sub-normal activity for a considerable period without any market tendency either towards recovery or towards complete collapse. Moreover, the evidence indicates that the full, or even approximately full, employment is of rare and short-lived occurrence.(249) Our knowledge of the factors which will govern the yield of an investment some years hence is very slight and often negligible,....it amounts to little and sometimes to nothing. (149) human decisions affecting the futurecannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; and it is our innate urge to activity which makes the wheels go round, our rational selves choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.(162-3) Starting from the aforementioned presuppositions, Keynes focuses on the following markets. 1. Goods market 2. Money market 3. Labor market These markets coincide with the ones considered by the Old Classics: This time, however, the hierarchy is different. The labour market draws back from the first to the last position. For the OC, the labour market was the cause of what happens elsewhere. For Keynes, it is the consequence of what happens elsewhere.

At the first place, Keynes places the goods market. As we shall see, this leads us to one of his main messages!!
THE SUPREMACY OF THE GOODS MARKET

The supremacy of the goods market is based on the rejection of the Says law. In Keyness view, the Says law can be only referred to a barter economy, where goods are exchanged against goods. The corn produced in such an economy is not thrown away: it is either consumed by households or invested (sowed) by firms. In either case, the supply of goods inevitably creates its own demand. Aggregate demand is passive: it aligns itself to aggregate supply. In the monetary economy where we live, by contrast, goods are exchanged against money. The supply of goods then implies an equivalent demand for money. People have the option of holding money instead of consuming/investing. The supply of goods does not necessarily create its own demand. Aggregate demand performs an autonomous role. Keynes adds that firms produce in order to sell, they do not like to accumulate unsold inventories. It is thus aggregate demand Yd that determines firms supply of output Ys firms demand for labour Ld. the activity level of the system. Thus, Keynes places aggregate demand at the centre of his architecture. If uncertainty about the future is high/if future prospects are bad, people prefer to hold money rather than to spend. The demand for money, however, does not stimulates output and employment! The low demand for goods in its turn determines a low supply of output/a low demand for labour by firms. We thus face Keyness under-employment equilibrium. The goods market clears, the labour market does not: the supplied amount of labour exceeds the demanded one. THE GENERAL THEORY: Unemployment develops, that is to say, because people want the moon; men cannot be employed when the object of desire (i.e. money) is something that cannot be produced and the demand for which cannot be readily choked off. (235) Aggregate demand only exceptionally reaches its full employment level. Unemployment is an endemic pathology of capitalism. All the other pathologies (inflation, financial instability) lead to unemployment. Unemployment can take place autonomously and persistently.

On this basis, Keynes firmly rejects neoclassical theory and its blind faith in the omnipotence of the invisible hand. OCs general equilibrium theory analyzes the simultaneous equilibrium of all agents and markets. In doing this, however, it ends with focusing on the very particular (and unrealistic) case of full employment equilibrium. As a consequence of this, it is neither general nor realistic. THE GENERAL THEORY I shall argue that the postulates of the classical theory are applicable to a special case only and not to the general case, the situation it assumes being a limiting point of the possible equilibrium positions. Moreover, the characteristic of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience. (3) Keynes wrote his book in the middle of the Great Depression, a Depression so deep, widespread, persistent to deserve capital letters. One over four Americans was unemployed; the system took more than 10 year to recover. Keynes could not believe in the omnipotence of the invisible hand, i.e. in the spontaneous tendency of the system towards its general equilibrium. Market mechanisms may be unable to stimulate aggregate demand to its full employment level. Keyness book was deliberately entitled THE General Theory: it envisages underemployment equilibriums (in addition to the limit case of general equilibrium), and thus represents the truly general as well as a realistic - theory. Keyness belief that the invisible hand is not omnipotent is confirmed by our recent experience. The mainstreams blind faith in market mechanisms fuelled the big wave of financial liberalization that led to the recent sub-prime crisis. Theories are not irrelevant: ideas are destined to affect the world. Before we have quoted a sentence at the beginning of Keyness book, below we quote a very illuminating sentence at the end of it. THE GENERAL THEORY: The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. (383) GOODS MARKET As we have seen, according to Keynes this is the main market. In it, aggregate demand has a key role. AGGREGATE DEMAND

By definition, aggregate demand is: Yd = I + C + G G is exogenously given. C and I, by contrast, are endogenously determined. Let us see how. THE ELEMENTARY KEYNESIAN CONSUMPTION FUNCTION Keyness consumers live in an uncertain world. They do not know the future (incomes, prices...) As a consequence, the are not able to behave rationally, calculating the optimal/maximizing amount of leisure/labour, of current/future consumption... Given the impossibility of rational evaluations, psychological elements come into play! Specifically, the decision to consume reflects the following psychological law. Consumption C is a positive function of disposable income Y-T. C=c [Y-T] which means that saving S (defined as Y-T-C) can be specified as: S=(1-c) [Y-T] where 0<c<1 is the marginal propensity to consume 0<1-c<1 is the marginal propensity to save As her/his disposable income Y grows, the consumer increases at the same time: her/his living standard (C) her/his saving (S) Y C S In Keyness uncertain world, saving has a different nature. It represents a demand for financial assets conceived as safety margins against uncertain events (loss of the job, health problems, car accidents..). As a consequence, it is not an inevitable future demand for consumption goods. It is a command on future consumption, i.e. a possibility of spending in case of need. Notice that 1. Consumers behaviour now is different. In the Old Classics, C and S were both functions of the rate of interest r: the choice between the two reflected a profitability criterion; In Keynes, C and S are functions of income Y; the choice reflects a budget constraint criterion.

Old Classics
C(r) S(r)

Keynes
C,S C(Y) S(Y)

C,S

2. The Says law is only partially true: supply creates demand, but only partially! Every additional euro stimulates consumption by c<1 only. THE ELEMENTARY KEYNESIAN INVESTMENT FUNCTION According to the Old Classics, the demand curve for investments goods Id reflects the marginal product of capital MPK, i.e. the maximum amount of output that can be technically produced by every new capital good. MPK= Y(K,L)/K Keynes rejects this mechanistic-technical approach. If the invisible hand is not omnipotent, resources are not necessarily fully utilized. The additional output produced by a new capital good might then remain unsold. From the technical point of view, the new capital good might also have a high MPK. From the economic point of view, however, it may yield a zero or even a negative return. Thus,the number of passengers that a new plane can technically contain (the number of seats) is not crucially important for its profitability. What is important is the number of people who will presumably use the plane, the tickets that they will be presumably available to pay, the presumable cost of the flights Expectations concerning these issues take the place of technical factors (the production function)! In Keyness view, an investment good can be associated with a series of expected annuities Qe1, Qe2,..Qen, (revenue less cost of the corresponding additional output) referred to one, two, n years ahead into the future. This set of expected Q is the prospective yield of the investment itself. Let us then divide the present value of the prospective yield PVQ by the supply price or replacement cost of the investment good PsI, (the price at which the good itself would be newly produced). The ratio gives the expected percentage yield of the investment good, i.e. its marginal efficiency of capital MEK. MEK= PVQ/PsI Firms rank available investment projects on the basis of their MEK. They start considering the investment with the highest MEK and subsequently take into account investments with lower and lower MEK.

By ordering all possible investment projects on the basis of their MEK, they get the curve of the MEK: a negatively sloping function of the investment level I.
MEK
Curve of the MEK

Investment is debt financed. Profitable investment projects are thus the ones which imply an expected percentage return (a MEK) higher than the cost of borrowing (the interest rate r) and consequently ensure a positive expected profit >0.
MEK >0 r0

0 <0 Ia I0 Ib

At the interest rate r0 in the figure: investment goods on the left of I0 are profitable investment goods on the right of I0 are not profitable the profitable amount of investments is thus I0 the demanded amount of investment goods will be I0. At any interest rate r, the MEK curve gives the amount of investment goods demanded for, it thus coincides with the demand curve for investments goods Id. MEK curve=I d curve
MEK = Id r1 1 0

r0
I1

I0

If the interest rate r increases the profitable amount of investment goods decreases the demanded amount of investments goods falls. Thus, the Keynesian investment function can be written as

I=I(r) with I/r<0 Apparently, the OCs investment function was the same. There are, however, deep differences!! The demand curve for investment goods Id: in the Old Classics coincided with the curve of the MPK, i.e. with the first derivative of the production function. It tended to be objective (based on shared technical factors) and stable. in Keynes coincides with the curve of the MEK. It mirrors expectations and confidence about an unknown future. As a consequence, it is subjective (based on firms optimism/pessimism) and volatile. THE GENERAL THEORY: Most, probably, of our decisions to do something positive, the full consequences of which will be drawn over many days to come, can only be taken as a result of animal spirits -of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. (161) Given the psychological nature and the volatility of expectations, the MEK- and thus the Id function - are highly unstable. Investment is the most unstable/volatile component of aggregate demand. the market will be subject to waves of optimistic and pessimistic sentiment, which arein a sense legitimatewhere no solid basis exists for a reasonable calculation. (154) In existing conditions or, at least, in the conditions that existed until lately where the volume of investment is unplanned and uncontrolled, subject to the vagaries of the marginal efficiency of capital as determined by the private judgment of individuals ignorant or speculative (3245). In addition, in the situation of uncertainty in which we live, the MEK - and consequently the investment level- tends to be wrong: i.e. too low to ensure the full-employment level of aggregate demand. According to Keyness paradox of poverty in the midst of plenty, for instance, a rich economy is characterized by a high level of consumption and investment and consequently implies a low propensity to consume and to invest. THE GENERAL THEORY: Not only is the marginal propensity to consume weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive..
THE AGGREGATE DEMAND FUNCTION

By substituting the elementary consumption and investment functions

C=c(Y-T) I=I(r) into the definition of aggregate demand Yd=C+I+G we get Keyness aggregate demand function Yd= c(Y-T) + I(r) + G As in the OC, ceteris paribus Yd is a negative function of the interest rate. The underlying assumptions, however, were very different. GOODS MARKET EQUILIBRIUM In Keyness view, firms produce in order to sell. Aggregate supply Ys thus aligns itself to aggregate demand Yd. It follows that goods market equilibrium requires: Ys=Yd= c(Y-T) + I(r) + G By eliminating the apexes Ys=Yd=Y the equilibrium condition of the goods market becomes Y = c(Y-T) + I(r) + G With simple transformations,4 it can also be written as S=I(r) + G-T The coincidence between the last two expressions should sound familiar!! We shall consider both the formulations of goods market equilibrium. FIRST FORMULATION OF THE GOODS MARKET EQUILIBRIUM CONDITION As we have seen, goods market equilibrium implies the equality between aggregate supply and aggregate demand, which is a negative function of the interest rate Y = c(Y-T) + I(r) + G Ceteris paribus, equilibrium income Y is thus related to the interest rate r. Old Classics too had a similar relationship. This time, however, the causality direction is opposite. Old Classical model Labour market equilibrium leads aggregate supply to its full employment level Ysfe Aggregate demand Yd has to align itself. This alignment is due to the interest rate. Causality runs from Y to r. Ysfe Yd r On the basis of his rejection of the Says law, Keynes claims that firms produce in order to sell. It is thus aggregate demand Yd that determines aggregate supply Ys
4

Subtracting T from both sides, we get Y-T = I(r) + c(Y-T) + G-T. By collecting Y-T on the left hand side, we get (1-c) (Y-T)= I(r) + G-T According to the saving function S=(1-c) (Y-T), the result is that S=I(r) + G-T.

With this, Keynes reverts the Old Classics approach. Money market equilibrium gives the rate of interest r Ceteris paribus, the interest rate gives the level of aggregate demand Yd Aggregate supply Ys aligns itself with aggregate demand. Causality runs from r to Y. r Yd Ys Old Classics
Yd Yfes

Keynes
Yd

Yfes=Yd

Yd=Ys

The reversal of the causality direction in the relationship between r and Y brings to light many other crucial novelties. 1. The variable which clears the goods market changes. In the OC this variable was the interest rate, which aligned Yd with the given Ysfe. In Keynes this variable is real output Y which aligns itself to the demand level Yd corresponding to the given interest rate coming from the money market. 2. The role of aggregate demand radically changes. According to the OC, Yd was passive: it ended with aligning itself to Ysfe. In Keynes, Yd has an active and central role: it determines the level of output. 3. The overall performance of the system is different According to the OC, the system spontaneously tends to its full employment equilibrium According to Keynes, general equilibrium is only the limit and rare case in which aggregate demand Yd is at its full employment level. We generally face underemployment equilibriums. Admitting unemployment too, Keyness theory represents THE General Theory. 4. The adjustment mechanisms are radically different. According to the OC, the goods market was cleared by the interest rate (a price). OC thus had price adjustments with a deviation-counteracting nature: they role consisted in re-absorbing deviations from equilibrium According to Keynes, the goods market is cleared by real income (a quantity) Keynes thus has quantity adjustments with a deviation-amplifying nature: To understand this nature, let us consider Keyness income and expenditure multiplier. Solving the goods market equilibrium condition for Y, we get: Y= 1 [I(r) cT + G] (1-c) where -[I(r) + G cT] is autonomous expenditure (independent of Y, underlined for this) -1/(1-c) is the Keynesian multiplier.

The point is that being c>1 - the multiplier is greater than one. As an example, if c=0.8, then 1/(1-c)=5. 1/(1-c)>1 This means that any change in autonomous expenditure [I(r) +GcT] has a multiplied/amplified impact on equilibrium income Y. Autonomous impulses are amplified: any increase in Y raises induced demand (cY) and vice versa. Keyness quantity adjustments have a deviation-amplifying nature. 5. The role of the State in the economy is radically different. If we face an underemployment situation, can fiscal policy help? According to the Old Classics, fiscal policy was ineffective. Given Yfe, G could only crowd out private expenditure C&I. This happened thanks to the endogenous increase in the interest rate. Yfe = C(r)+I(r)+G According to Keynes, fiscal policy is very effective. Through the multiplier, it also stimulates induced consumption. The result is an amplified increase in equilibrium income. Y = C(Y-T)+I(r)+G Old Classics
Yd1 1 r1 r0 Yd0 Ys
fe

Keynes
Yd1 0 1

Y0 r0

Yfe

Y0

Y1

SECOND FORMULATION OF THE GOODS MARKET EQUILIBRIUM CONDITION The goods market equilibrium condition can also be written as S(Y) = I(r) + G-T In Keyness view: I(r) is given by the interest rate r coming from money market equilibrium; G-T is exogenously given; I(r)+G-T is consequently given; S is a function of real income Y Y is the clearing variable that aligns S to the given I(r)+G-T!! The causality direction is the following. I(r)+G-T Y S

Keyness saving-investment approach is thus very different from the OCs one. According to the OC, the interest rate (in the vertical axis) is the variable which clears the goods market aligning S(r) and I(r)+G-T (in the horizontal axis). According to the Keynes, real income (in the horizontal axis) is the variable which clears the goods market aligning S(Y,T) to the given I(r)+G-T (in the vertical axis). Old Classics Keynes
I(r)+G-T S(r) S,I,G,T S(Y,T) re I(r)+G-T

Se=G-T+Ie

Ye

If we assume G=T=0, goods market equilibrium implies S(Y) = I(r). According to Keynes, an increase in the demand for investment goods corresponding to the given interest rate r0 stimulates income Y thus creating an equal amount of additional saving S.
S(Y,T ) 1 0

I1(r0) I0(r0)

Y0

Y1

THE GENERAL THEORY When investment changes, income must change in just that degree which is necessary to make the change in saving equal to the change in investment. (184) Analogous considerations hold for an increase in government expenditure G. According to the OC, given the full-employment income level, a higher G crowds out an equal amount of private expenditure - C(r) and I(r) and does this through the increase in the interest rate. According to Keynes, a higher G stimulates income Y creating an equal amount of additional saving S.
Old Classics

Keynes

I(r)+G-T 1 re 0

S(r)

S,I,G,T 1 0

S(Y,T)

I(r0)+G0-T0

Se0=Ie0

Se1=Ie1

Y0

Y1

To sum up, we cannot claim that households saving represents a source of financing for firms investment and for the government deficit. Causality runs into the opposite direction. [I(r)- G-T] Y S Lending represents a stock (not a flow) operation: it implies the substitution of bonds (promises of payment) for money in wealth holders portfolios. The just mentioned passive/adaptive role of saving S leads to the well know paradox of thrift. Households can individually decide how much to consume and to save. In other words, they can autonomously decide their individual saving. In equilibrium, however, aggregate saving S depends on the expenditure decisions of firms (I) and of the government (G-T). Let us assume that individual households decide to save more at any Y,T. As a consequence of the increase in the marginal propensity to save, the saving function moves from S0 to S1 in the figure. The system consequently moves from the initial equilibrium point 0 to the disequilibrium point 0. What kind of disequilibrium is it? The increase in the propensity to save 1-c implies a decrease in the propensity to consume c. At Y0, the increase in saving implies an equivalent fall in consumption. Point 0 thus implies an excess supply of goods which will depress equilibrium income Y and saving S.
S, I, G

S1 0 S0 1 0 [I(r)+G-T]

Y1

Y0

In the new equilibrium point 1, the increase in the propensity to save 1-c is fully offset by the consequent fall in equilibrium income Y.

Aggregate saving S thus returns to be equal to the given [I(r)+G-T], as required by the goods market equilibrium condition. S= (1-c) (Y-T) =I(r)-G-T Household can thus decide their individual saving, but not their aggregate saving. The paradox of thrift is a typical example of Keyness fallacies of composition!! Aggregate results are not the simple sum of individual behaviours. Coordination is important ingredient for the behaviour of the system. MONEY MARKET In Keyness view, households take two separate kinds of decisions. Firstly, they have to decide how to allocate their income between consumption and saving, i.e. between the purchase of goods on the one hand and the purchase of new financial assets on the other hand. Secondly, they have to allocate their stock of wealth (current plus previous savings) between the two alternatives represented by money and bonds. The demand for bonds (promises of payment) is a supply of funds. This approach implies a revolution in the concepts of saving S, of money M, of the interest rate r Saving According to the OC, saving was finalized to future consumption. In Keyness view, saving is a safety margin against an unknown and uncertain future; it represents a demand for new financial assets, a only potential demand for future consumption goods. Money According to the OC, money was a medium of exchange. The relevant option was to hold money/to buy goods The excess supply of money thus implied an excess demand for goods. Given Ysfe, money supply M only determined the price level P. According to Keynes, money is mainly a financial asset/a store of value. This time, the relevant option is to hold money or bonds. The excess supply of money implies an excess demand for bonds. Money supply M consequently determines the bond price and interest rate. Interest rate According to the OC, the interest rate was the incentive to postpone consumption. Each unit of todays consumption turns into (1+r) units of tomorrows consumption. The higher r is, the higher the incentive to save is. In Keyness view, by holding money we lose the interest rate on bonds. The interest rate is the (opportunity) cost of holding money. THE GENERAL THEORY: Interest has been usually regarded as the reward of not-spending,

whereas in fact it is the reward of not-hoarding. (174) DEMAND FOR MONEY In Keyness view, the demand for money M/Pd=L is not (or not only) a positive function of income Y it is mainly a negative function of the interest rate r (the opportunity cost of holding money). M/Pd=L(r) with L/r<0 The OC would object that: money ensures a zero pecuniary return, bonds a positive return r>0 the demand for money as a store of value should be zero. wealth/saving should be entirely held in the form of bonds. money is entirely used for transactions purposes Keyness answer is that there is a preference for money as such: a liquidity-preference. This is the reason why L(..) is the notation for the demand for money adopted by Keynes himself. The reasons for this liquidity preference are the following ones. Money is a safe asset: the price of a euro is always a euro. Bonds are unsafe assets: the price of a bond depends on supply and demand; in the future it might also fall to zero. Specifically, bonds imply: -expected capital losses (if bond prices are expected to fall) -the risk of unexpected capital losses (unexpected falls in bond prices) At any given interest rate, portfolio choices thus reflect the state of expectations and confidence. As the investment demand function, also the demand for money function L(r) tends to be highly volatile. As confidence falls, liquidity-preference rises. The demand for money (as a safe asset) increases. The demand for bonds (the supply of credit) falls. As we shall see, this is precisely what happened in the regime of uncertainty that followed the sub-prime crisis. Money became a safe refuge. The credit market experienced an unprecedented credit crunch. SUPPLY OF MONEY We may assume that the supply of money is exogenously given: M/Ps=M/P0 MONEY MARKET EQUILIBRIUM

Money market equilibrium requires the equality between the supply and the demand for money. Since money supply is given, equilibrium requires the alignment of the demand for money. This alignment is due to the interest rate, which then represents the clearing variable. M/P0=L(r) In the M/P,r space, the money market is represented by: a negatively sloping demand curve L(r) a vertical supply curve M/P The interest rate r clears the money market aligning L(r) to the given M/P.
L(r)
re E M/P0

M/P

To see the adjustment process, let us start with a disequilibrium interest rate r0. At r0, there is excess supply of money. ESM People demand for bonds, the alternative to money. ESM=EDB As a result, bond prices pb rise and the interest rate r falls. pb r The market goes to its equilibrium E.
r0

M/P
ESM

r0
E

re

L(r)
Ld0 M/P

M/P

Now, the role and the nature of the interest rate radically changes. Old Classics: r cleared the goods market aligning Yd(r) to the given Ysfe it was a real variable
Yd0 Ys L(r)
r

Keynes: r clears the money market aligning M/Pd=L(r) to the given M/Ps it is a monetary variable
M/P

Yfe

M/P

The same story can be told in terms of the saving-investment approach.

In the OCs, the interest rate r: represented at the same time -the incentive to save (to consume tomorrow rather than today) -the incentive to invest (given the MEK). as such, it cleared the goods market aligning S and I+G-T In Keynes, the interest rate r: is the incentive to hold bonds rather than money. clears the money market, aligning L(r) to the given supply M/P. THE GENERAL THEORY The rate of interest is not the price which brings into equilibrium the demand for resources to invest with the readiness to abstain from consumption. It is the price which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash.(167) THE ROLE OF MONEY IN THE ECONOMY The monetary and the real sector can be related as follows. The interest coming from money market equilibrium determines investment and consequently aggregate demand and income in the goods market.
L(r) M/P0 Yd=Yd(r)

r0

r0

M/P0

Yd0=Ys0

Starting from an initial equilibrium, let us then assume an exogenous increase in money supply M/P. In the money market (left hand panel), the money supply curve M/P moves to the right. At the initial interest rater0, the increase in M/P creates an excess supply of money an excess demand for bonds The bond price falls, the rate of interest rises: We reach the new equilibrium point 1, at a lower interest rate r1 Let us now consider the goods market (right hand panel). As the interest rate falls from r0 to r1, investment rise. This leads to an amplified increase in demand and income (from Y0 to Y1).

L(r)

M/P0 M/P1 0 1

Yd=Yd(r)

r0 r1

r0 r1

0 1

M/P0

M/P1

Yd0=Ys0 Yd =Ys 1 1

All of this implies a radical change in the role of money and monetary policy i) there is no more dichotomy (separation) between the monetary and the real sectors. The rate of interest connects the two sectors. MrIYdY ii) there is no more neutrality. Money is not neutral, is not a veil: it affects the real variables I,Y. MrIYdY iii) Monetary policy becomes effective. Money does not limit itself to affect prices (the nominal scale of the economy); it stimulates economic activity. iv) The transmission mechanism of monetary policy is indirect. Money turns into a demand for bonds, not for goods. At first it implies an increase in the price of bonds and a fall in the interest rate. Through the intermediation of the interest rate, it then affects aggregate demand and income. v) The effectiveness of monetary policy is not automatic/mechanic. Being indirect, the money/income link may also break. Specifically, monetary policy becomes ineffective when: -money supply does not affect the interest rate (liquidity trap) -the interest rate does not affect investments (no propensity to invest) THE GENERAL THEORY: there might be several slips between the cup and the lip. vi)The control of the interest rate by the central bank can be jeopardized by the instability of expectations and by the consequent volatility of the demand for money. In order to control the interest rate, the central bank should know the demand for money function. The latter should be stable whilst it is not. THE GENERAL THEORY

 It is evident, then, that the rate of interest is a highly psychological phenomenon. (202) The demand for money is strongly affected by expectations and confidence about the future. As an example, a wave of pessimism implies an increase in the demand for money (the safest asset). As a result, the interest rate rises even if money supply has remained unchanged. Pessimism can thus frustrate the Central Banks efforts to reduce the interest rate and to stimulate the economy. This is what is actually going on after the sub-prime crisis. The Italian spread problem reflects this kind of situation.
L(r) M/P0 1 0 r1 r0 Yd=Yd(r) 1 0

r1 r0

M/P0

Yd1=Ys1

Yd0=Ys0

vii)The control of the money supply by the central bank is not granted. To simplify, we have previously assumed an exogenous supply of money, entirely under the control of monetary authorities. As we shall see, however, money supply has also an endogenous component which is not easy to forecast and to offset. Labor market The connection between goods and labour markets is represented by the production function. This is true both for the Old Classics and for Keynes: both of them admit the relationship between income and employment. The causality direction, however, is opposite.

In the Old Classics causality ran from the labour to the goods market. The production function gave the output level corresponding to full employment. It was full employment that determines output. LfeYsfe In Keynes, causality runs from the goods to the labour market. The production function gives the level of employment L0 required to produce the equilibrium output level Y0 =Yd(r0). It is output which then determines employment. Yd=Y0L0

Y0

L0

THE INDIRECT DEMAND CURVE FOR LABOUR Keyness approach is the following. Labour is necessary to produce goods: The demand for goods Yd thus represents an indirect demand for labor ILd. Yd=Y ILd=L0

Yd0=Y0

ILd0=L0

ILd W/P Ld Ls

The indirect demand curve for labour ILd is represented by a vertical line at L0 in the labour market

ILd0=L0

If the level of employment L0 is given by the indirect demand curve for labour ILd, what is the role of the traditional Ld and Ls curves? THE ROLE OF THE TRADITIONAL L
D

CURVE

To simplify, Keynes keeps the assumption of perfect competition. Let us then remember the two profit maximizing rules of competitive firms. 1. Prices are equal to marginal costs,: an increasing function of Y. P=MgC=(1/MPL)W 2. Real wages W/P are equal to the MPL, a decreasing function of L W/P=MPL These maximizing rules are two faces of the same coin. At the exogenously given nominal wage W0 competitive firms lower prices to the marginal cost MgC. By so doing, they raise the real wage W0/P to the marginal product of labour MPL0 corresponding to (L0). As known, under perfect competition the traditional Ld curve coincides with the MPL curve. Ld = MPL At the employment level L0 given by ILd, the traditional Ld curve gives us: the marginal product of labour MPL0 the equilibrium real wage W0/P0= MPL0 the equilibrium price level P0 associated with the given money wage W0 P0=MgC=(1/MPL0)W0
W/P ILd Ls 0 Ld=MPL curve

W0/P=MPL0

ILd0=L0

To sum up, both the Old Classics and Keynes adopted the traditional MPL=Ld curve. Since perfect competition implies that MPL=W/P, both of them envisaged a negative relationship between W/P and Ld. The causality direction, however is totally different. According to the OC, it was the real wage W/P which determined the demanded amount of labour Ld. Competitive firms hired all the workers whose marginal product was higher than the real wage. According to Keynes, by contrast, it is the indirect demand for labour ILd= L0 which determines the real wage W0/P. Aggregate demand Yd(r0) gives the equilibrium level of output Y0, of employment L0 and of the marginal product of labour MPL0. By lowering prices to the marginal cost, competitive firms raise the real wage W/P to the given marginal product of labour MPL0 The reversion of the causality direction leads to many important novelties.

The money and the real wage become less important. It is the money wage W (not the quantity of money M) that determines the nominal scale of the economy. Labour is needed to produce almost any kind of goods. The cost of labour inevitably affects the marginal cost and thus the price level. Inflation is a cost-push phenomenon, not a monetary phenomenon. WP Money wages are not responsible for unemployment. We cannot claim that unemployment is due to an excessive cost of labour. True, workers determine the money wage W0. What matters for firms too, however, is the real cost of labour W0/P. The latter in turn depends on the price level P determined by firms. At any activity level (L0,Y0), firms determine the price level P0=MgC0=(1/MPL0)W0 and thus the real wage (the real cost of labour). W0/P0= MPL0 The fall in money wage is not a therapy against unemployment. Competitive firms align prices to marginal costs. If the nominal cost of labor W falls by half, the price level P too falls by half. This means that the real cost of labour W/P does not change: W=MPL0 P Money wages are not an obstacle to economic expansion. What matters in the labour market is the endogenous real wage W/P, not the exogenous money wage W. As income Y and employment L rise, the MPL falls. With this, both the marginal cost MgC and the price level P rise. The rise in prices aligns the real wage W0/P to the lower MPL. Y&L MPL MgC=(1/MPL0)W0 P W0/P (=MPL) The obstacle to full employment may be represented by the interest rate (not by the money wage). Full employment equilibrium in the goods market (right hand panel) might require a negative interest rate. According to the money market (left hand panel), however, the interest rate cannot fall below zero. According to Krugman, this is precisely what is happening nowadays. Even at a zero interest rate, aggregate demand and output are lower than the full employment ones.

L(r)

M/P

Yd=Yd(r)

M/P

Yfe

THE GENERAL THEORY: The rate of interest may fluctuate for decades about a level which is chronically too high for full employment (204) THE ROLE OF THE TRADITIONAL L CURVE The traditional labour supply curve has no influence on economic activity. Nevertheless, it has a very important role.
S

Given L0 and W0/P0=MPL0, the traditional Ls curve gives us: the quantity of labour supplied Ls0 the excess supply of labour (Keyness involuntary unemployment). U0= Ls0-L0

W/P W0/P0=MPL0

ILd Ld 0 U0 Ls

ILd0=L0

Lfe

Ls0

L*

For the Old Classics, the excess supply of labour ESL=U represented a voluntary unemployment. It was due to the excessive cost of labour imposed by trade unions/left political parties. Wage rigidity jeopardized the price mechanism: the result was unemployment. The latter: was involuntary for individual workers, but voluntary for workers as a group (trade unions, left parties). For Keynes, the excess supply of labour ESL=U represents an involuntary unemployment. Unemployed are workers: -who would like to work at the current wage W/P0 -but do not succeed in finding a job. The reason why firms do not hire them -is not the excessive cost of labour -is the low aggregate demand for output and consequently the low indirect demand for labour. THE GENERAL THEORY:

For, admittedly, more labour would, as a rule, be forthcoming at the existing money-wage if it were demanded. (7) Keyness equilibrium -is not a general (full employment) equilibrium -is an underemployment equilibrium. Full employment is only a special case. The normal situation is one in which there is involuntary unemployment. The only therapy against unemployment is the concomitant increase: in the demand for goods in the indirect demand for labour. This will imply: the increase in MgC=P the fall in MPL=W/P
ILd0=L0 Lfe Ls0 W/P W/P0=MPL0 ILd 0 Efe

Ls

A SUMMARY

Keyness model can be summarized as follows.

money market L(r) r0 M/P0 0 r0 goods market Yd(r) 0

The model starts from the top (the demand side of the economy) Money market M/P=L(r) gives r0 Goods market Ys=Yd(r) gives Ys0=Yd(r0)=Y0 Production function Ys=Ys(K,L) gives ILd0=L0 Labour market Ld=Ld(W/P) gives MPL0=W0/P0; P0 Ls=Ls(W/P) gives U0=ESL=Ls0-L0

M/P0 Y=Y(K,L) Y0 0 Y0

Yd0=Y0 0

Y=Y

ILd0=L0 W0/P0=MPL0 0
U0

Y0 L
s

labour market Ld ILd0=L0 Ls0

Full employment equilibrium is only a very special case. Left to itself, the system generally experiences under-employment equilibriums. All the markets clear with the exception of the labour market, which is characterized by an excess supply of labour.

Responsible for involuntary unemployment is the insufficient level of aggregate demand. Out of a low confidence and a high uncertainty about the future, consumers and investors prefer to hold money rather then to spend. THE GENERAL THEORY The only radical cure for the crises of confidence which afflict the economic life of the modern world would be to allow the individual no choice between consuming his income and ordering the production of the specific capital-asset which, even thought it be on precarious evidence, impresses him as the most promising investment available to him. It might be that, at times when he was more than usually assailed by doubts concerning the future, he would turn in his perplexities towards more consumption and less new investment. But that would avoid the disastrous, cumulative and far reaching repercussions of its being open to him, when thus assailed by doubts, to spend his income neither on the one nor on the other. Those who have emphasised the social dangers of the hoarding of money have, of course, had something similar to the above in mind. (161) The market mechanism (the invisible hand) is not able to lead the system to its general (full employment) equilibrium. Its impotence is not a question of money wage/price rigidity. As shown by the dramatic experience of the Great Depression, even when money wages and prices are perfectly flexible, the system may not tend to its full employment equilibrium. Let us remove the assumption of a given money wage. Following the standard theory, let us also assume that the excess supply of labour turns into a fall in money wages and prices. There are reasons to believe that this fall will stimulate aggregate demand. As prices P fall, the real supply of money M/P will rise, the interest rate r will fall and aggregate demand and output Y will rise. Thanks to wage and price flexibility, the system will actually tend towards its general equilibrium.
M/P0 L(r) M/P1 Yd=Yd(r)

r0 r1 M/P0

0 1

r0 r1 Yd0=Ys0

0 1

M/P1

Yd1=Ys1=Yfe

There are, however, also reasons to believe that aggregate demand will fall. If the fall in the price level fuels expectations of further future falls, for instance, people will have the incentive to postpone expenditure. Aggregate demand and output will then fall, accentuating unemployment.

L(r)

M/P0 M/P1

Yd=Yd(r)

r0

r0

M/P0

Yd1=Ys1=Y1

Yd0=Ys0=Y0

If the invisible hand is impotent, monetary and fiscal authorities have to intervene. They have two possibilities: monetary expansion and fiscal expansion. MONETARY POLICY A monetary expansion decreases the interest rate in the money market, with expansionary effects on investment, aggregate demand and income in the goods market. M/P r I Yd Y
M/P0 L(r) M/P1 Yd=Yd(r)

r0 r1 M/P0

0 1

r0 r1 Yd0=Ys0

0 1

M/P1

Yd1=Ys1=Yfe

FISCAL POLICY An increase in government expenditure G has amplified expansionary effects on aggregate demand and income in the goods market. Y = C(Y)+I(r)+G
L(r) M/P0 M/P1 Yd=Yd(r)

r0

r0

M/P0

Yd0=Ys0=Y0

Yd0=Ys0=Yfe

Keynes, however, is more confident in fiscal than in monetary policy. His problem is the volatility of expectations and investment. During a recession, for instance, the low confidence in the future and the high uncertainty depress firms investment; stimulate the demand for money.

This tends to jeopardize the Central Banks attempts to stimulate the economy. Keyness suggestion is to stimulate the economy through the government expenditure in investment goods. THE GENERAL THEORY For my own part, I am now somewhat sceptical of the success of a merely monetary policy directed to influence the rate of interest. [] since it seems likely that the fluctuations in the market estimation of the marginal efficiency of different types of capital [] will be too great to be offset by any practicable change in the rate of interest. (164) I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an even greater responsibility for directly organizing investment.. (164) EXPECTATIONS AND CONFIDENCE IN KEYNES Our exposition focused on the skeleton of The General Theory. Its purpose was to highlight its revolutionary contribution in terms of: adjustment mechanisms and their effectiveness role of aggregate demand and supply nature and role of the interest rate nature and role of money role of wages nature of unemployment role of macroeconomic policies and so on As we have said in the beginning, however, this is only a conventional, inevitably simplified, presentation of The General Theory. As an example, it generally presuppose an important simplification: the assumption that the state of expectations and the degree of confidence in the future are given. Obviously, in the real world this is not necessarily true. Changes in expectations and confidence affect: the marginal efficiency of capital (the investment function) the liquidity-preference (the demand for money function). the propensity to consume out of income (the consumption function) Investment implies irrevocable long-term decisions that concern the far future. It consequently represents the variable which is most vulnerable to the changes in expectations and confidence. Not by chance, Keynes considers investment as the main source of the business cycle (of economic fluctuations). THE GENERAL THEORY:

The Trade Cycle is best regarded, I think, as being occasioned by a cyclical change in the marginal efficiency of capital, though complicated and often aggravated by associated changes in the other significant short-period variables of the economic system. (313) In Keyness view, the business cycle is thus mainly caused by the fluctuations in the MEK. With regard to this, Keynes assumes that full employment investment would have a yield of 2 per cent. Firms, however, do not know it. They optimistically start (lets say) with the unrealistic assumption of a much higher yield (6%). Out of this, investment, income, profits increase leading to an economic expansion that confirming firms optimism. As soon as firms realize to be excessively optimistic, however, they fall in a contrary error of pessimism. The expected return on investment falls to zero. This time, investment, income, profits decrease confirming firms pessimism. The latter, however, is again excessive. This discovery will give rise to a new wave of optimism and to a new expansionary phase. These waves of optimism and pessimism will generate upswings and downswings in economic activity. THE GENERAL THEORY: But over and above this it is an essential characteristic of the boom that investments which will in fact yield, say, 2 per cent in conditions of full employment are made in the expectation of a yield of, say, 6 per cent, and are valued accordingly. When the disillusion comes, this expectation is replaced by a contrary error of pessimism, with the result that investments, which would in fact yield 2 per cent in conditions of full employment, are expected to yield less than nothing; and the resulting collapse of new investment then leads to a state of unemployment in which the investments, which would have yielded 2 per cent in conditions of full employment, in fact yield less than nothing. (32122) Fluctuations in investment will be strengthened by the liquidity preference. Pessimism implies the increase in the demand for money and thus in the interest rate. This has a depressive effect on the economy which confirms the lack of confidence. Financial markets thus contribute to economic fluctuations. The General Theory: Moreover, the dismay and uncertainty as to the future that accompanies a collapse in the marginal efficiency of capital naturally precipitates a sharp increase in liquidity-preferenceand hence a rise in the rate of interest. Thus the fact that a collapse in the marginal efficiency of capital tends to be associated with a rise in the interest rate may seriously aggravate the decline in investment.. (316) To leave expectations out of the scene means to ignore many of the important issues raised by Keynes. The General Theory is much richer than any textbook presentation!!

3. The demand for money

(English not revised) Among other things, Old Classics and Keynes had a quite different conception of money. OLD CLASSICS Money is a medium of exchange, necessary to finance the purchase goods. Two analogous theories: 1. The Fishers identity of exchanges. MV = PY where V(=PY/M) is the velocity of circulation of money. 2. The Cambridge version M=k PY where k=1/V In both cases, the result was the Quantity Theory of Money. i) Given Y=Yfe and given V(k=1/V), money supply M only determines P (and W). Money is a veil, money is neutral. M V = P Y There is a stable relationship between money M and nominal income PY. KEYNES Money is mainly a store of value, a way to transfer purchasing power from the present to an uncertain future. The alternative is represented by bonds B. By holding money, we loose the interest rate on bonds. The demand for money is thus a negative function of the interest rate. L=L(r) Money supply determines the interest rate. It only indirectly affects investment I(r), aggregate demand and income. M/P=L(r) Keynes, however, (i) did not deny the transactions demand for money, money desired in order to finance foreseen transactions (the newspaper we buy every day) (ii) introduced the precautionary demand for money; money desired in order to finance unforeseen transactions (the taxi after an unexpected thunderstorm). iii) assumed that the transactions and precautionary demands for money are both positive functions of nominal income. Keyness money market equilibrium condition thus becomes: M=L(r) PY If money supply M increases, now everything (not only PY and P) may change.

M = L(r) P Y There is not necessarily a stable relationship between money M and nominal income PY. The increase in money supply may simply imply a fall in the interest rate. Given its crucial role, what follows will be precisely devoted to Keyness relationship L(r) between the demand for money and the interest rate. DEVELOMPMENTS ON KEYNESS SPECULATIVE DEMAND FOR MONEY Keyness liquidity preference (the relationship between the demand for money and the interest rate) stimulated further theoretical work. We refer to Tobin (1958), Liquidity preference as behavior towards risk. Tobin got the Nobel Prize in 1981. Let us consider the speculative demand for money Money M is an alternative to bonds B. The opportunity cost of holding money is the interest rate on bonds. The higher the interest rate r on bonds is, the lower the demand for money L will be. L=L(r)

L(r) r1

r0

Ld 1

Ld0

M/P

If we look better, however, matters are not that simple. bonds yield a positive interest rate r, money yields a zero interest rate. Why should people demand for money? If we consider only the interest rate, the demand for money should be zero
r Md=0 for any r>0

Theoretical question: how can we justify Keyness speculative demand for money? Empirical question: how can we justify the fact that in the real world wealth holders actually hold money?

TOBINS FIRST INSIGHT: THE CAPITAL LOSSES ON BONDS While the price of a euro is always a euro, the price of a bond varies according to supply and demand. Differently from money, in the future bonds might loose their value and imply capital losses. If I sell at 50 euros a bond that I bought at 100, I experience a negative capital gain (a capital loss) of (50-100)/100=-50% In Tobins view, the return on bonds has thus two components: i) the interest rate r, that is equal to the coupon C=1 that the bond promises to pay at the end of each year of its life divided by the price of the bond Pb. There is an inverse relationship between the interest rate r and the bond price Pb r = 1/Pb ii) the expected capital gain (loss) on bonds, given by the expected percentage variation of the bond price Pb. ge = Pbe-Pb Pb Since r = 1/Pb Pb = 1/r Pbe = 1/re By substituting in ge we get ge= (1/re) (1/r) = (r/re) -1 1/r The total return on bonds thus is: e= r + ge = r + (r/re - 1) It consequently is i) a positive function of the current interest rate (r). Ceteris paribus, an increase in r implies a higher percentage interest payment a lower current bond price (a higher capital gain) ii) a negative function of the expected interest rate (re). Ceteris paribus, a higher expected interest rate implies a lower expected bond price (a lower capital gain/a higher capital loss) The equivalence between money and bonds requires e=0. The interest rate has to be perfectly offset by equal expected capital losses. e= r + r/re 1=0 THE INDIVIDUAL DEMAND FOR MONEY

Every individual agent has his own re, based on his view of past history. Given re, from the expression above we can derive the particular level of the interest rate r=rc at which e=0, i.e. bonds (as money) yield a zero total return. e= r + r/re 1=0 This particular level of r is defined as the critical rate of interest rc rc= re/(1+re) The critical interest rate rc is a positive function of re. It varies from individual to individual. rc/re>0 The higher re: the lower the expected bond price Pbe, the higher the expected capital loss ge, the higher the critical interest rate rc needed to offset it. If we compare the current interest rate r with the critical interest rate rc, we can then conceive 3 alternatives: i) r>rc e>0 Money yields 0, bonds yield e>0. Wealth is entirely held in bonds: Md=0, Bd=W ii) r=rc e=0 Money yields 0, bonds yield e=0. M and B are totally indifferent. iii) r<rc e<0 Money yields 0, bonds yield e<0. Wealth is entirely held in money Md=W, Bd=0 According to Tobins analysis, the individual demand for money is thus the following.
r

r>rc; e>0; Md=0, only bonds

rc

r=rc; e=0; M&B indiff.

W

r<rc; e<0 Md=W, no bonds

M

By introducing capital gains/losses on bonds, Tobin consequently derives an all or nothing individual demand for money function. Let us put together the individual Md functions, ordering them on the basis of rc= re/(1+re)

Most pessimist about bonds, higher expected capital losses (highest rc, highest re, lowest peb)
c1

c2

c3

Most optimist about bonds, lowest exp. capital losses (lowest rc, lowest re, highest peb)
r
c4

c5

c6

As known, rc is a positive function of re. To order on the basis of rc means to order on the basis of re. The first individual is the most pessimist about bonds, the most inclined to hold money. He has: the highest rc the highest re. the lowest expected bond price Pbe the maximum expected capital loss on bonds ge. The last individual is the most optimist about bonds, the less inclined to hold money. -the lowest rc -the lowest re. -the highest expected bond price Pbe -the lowest expected capital loss on bonds ge. Let us now introduce the (given) current interest rate r, the horizontal broken lines in the figure. Remember that the demand for money requires e<0, i.e that r<rc At r=r1: nobody wants money At r=r2, agent 1 starts holding in money At r=r3: agents 1,2,3,4 hold their wealth in money At r=r4: everybody wants to hold only money.
r rc1 rc2 r2 rc3 rc4 rc5 rc6 r3 r1

r4

The particular case (r<rc6) in which everybody wants to hold only money is Keyness extreme case named liquidity trap. For everybody: expected capital losses on bonds would require a higher interest rate. the expected total return on bonds is negative. bonds become hot potatoes that nobody wants to hold. Under liquidity trap, the bond market stops working. Nobody wants to buy bonds (hot potatoes),

as a consequence nobody can sell bonds. Remember that the liquidity trap does not necessarily require a low current interest rate; it may simply imply a even higher expected interest rate. Under liquidity trap: the demand for money function becomes perfectly elastic. changes in money supply do not affect the interest rate. If money supply increases, people simply hold it. They do not buy bonds (hot potatoes, sources of losses). The bond price does not rise, the interest rate does not fall. Money supply loses any influence on the interest rate.
r
Ms

Md

To sum up, at this stage Tobins conclusion is that, in order to justify Keyness speculative demand for money L=L(r), we cannot consider the interest rate only: we have also to take into account the expected capital losses on bonds. Starting from this presupposition, Tobin obtains: an all or nothing individual demand for money function a downward sloping aggregate demand for money function la Keynes a theoretical justification for the particular case of the liquidity trap. PROBLEMS Tobins analysis is not yet fully satisfying. i) In the short-run, it does not explain portfolio differentiation. Tobins agent holds either money or bonds. In the real world, by contrast, agents hold both money and bonds. ii) It does not explain the long-run demand for money. By definition, in the long-run expectations are correct. This means that r=re, Pb=Pbe and ge=0. The total return on bonds e=r+ge thus becomes e=r>0 Individuals should hold only bonds and no money. There is still something missing in Tobins theory. TOBINS SECOND INSIGHT: THE RISKINESS OF BONDS

Our expectations are not necessarily correct. There is always the risk that they are wrong. As a consequence, we have to consider: not only the expected total return on bonds e=r+ge but also the risk that our expectations are wrong. From this point of view: money is a safe asset: the future value of 1 euro will certainly be 1 euro, as expected. bonds are a risky asset: the future value of B will not necessarily be the expected one pbe Let us see how Tobin proceeds. The agent: has a whole set of expected capital gains/losses on bonds ge associates a probability P(ge) to each of them. Let us assume that the distribution of these probabilities is normal. A normal distribution gives us: i) the mean value ge, which has the highest probability; ii) the standard deviation g.

ge-g

ge

ge+g

The interval ge+g is associated with a probability of 68%. If g were almost zero, our mean value ge would have an almost 68% probability of being correct. The higher g, the higher the riskiness associated with our ge. The standard deviation g thus becomes a measure of the bond riskiness. Individuals portfolio allocation To sum up, the alternative is between: money, with zero return and zero risk bonds, with positive expected return e=r+ge and risk g On each single bond, the agents expects: a total return e a risk g Given the amount of his bonds B, he can then calculate: the total expected return of his portfolio Rt the total risk of his portfolio t

His portfolios total return Rt is equal to the amount of bonds B times the expected total return on each bond (e=r+ge). 1. Rt = B (r+ge) His portfolios total risk t is equal to the amount of bonds B times the expected risk on each bond g.. 2. t= B g From the 2nd equation, we get a straight line in the lower panel below: 3. B = (1/g) t There is a positive relationship between B and t . Ceteris paribus, a higher total risk t implies a higher amount of bonds B. The maximum amount of B is given by individual wealth W.
0 B W

B=(1/g)t

By substituting equation 3 in equation 1, we get the individuals possibilities frontier between portfolios total return Rt and total risk t. 4. Rt= (r+ge) t g The frontier is shown by the straight line in the upper panel according to which Rt is an increasing function of t.
Rt RT=[(r+ge)/g] t

In order to increase his portfolios total return Rt, the agent has to buy bonds B. This, however, also raises his portfolios total risk t.

B=(1/g) t

The two straight lines B= (1/g) t and Rt= (r+ge) t g show the positive relationship between B, t, Rt 0<B<W t & Rt Let us now add the agents indifference curves between total return Rt, and total risk t. In the presence of risk aversion: These curves are upward sloping: more t has to be offset by more Rt Higher curves imply a higher utility: they associate higher returns Rt with any given level of risk t.

Rt

RT=[(r+ge)/g] t

0 B W

t
B=(1/g) t

RT=[(r+ge)/g] t Rt

Rt *

t*

B* W B=[1/g] t

The tangency between the indifference curves and the possibilities frontier gives the utility maximizing solution. According to the figure, our agent: will have a total return Rt* and a total risk t* in the upper quadrant. will hold 0B* bonds and B*W money in the lower quadrant Now the agent differentiates her/his portfolio: she/he holds both money and bonds!! WHAT HAPPENS IF THE INTEREST RATE ON BONDS INCREASES? The interest rate affects the slope of the possibilities frontier. This frontier rotates upwards in the upper panel. The new optimal solution is point 2.

Upper panel: we reach a higher indiff. curve i.e. a higher utility level. Lower panel: B rises M=W-B falls Conclusion: The demand for money is a negative function of the interest rate on bonds r.

Rt

Rt=[(r+ge)/g] t

Rt*

0 t* B*

B=(1/g) t

WHAT HAPPENS IF EXPECTED CAPITAL GAIN ON BONDS INCREASES? An increase of ge has exactly the same effect as an increase in the interest rate r. The possibility frontier rotates upwards in the upper panel. The new optimal solution is point 2. Upper panel: we reach a higher indiff. curve i.e. a higher utility level. Lower panel: B rises M=W-B falls Conclusion: The demand for money is a negative function of expected capital gains on bonds.
Rt=[(r+ge)/g] t

Rt

1
Rt*

0 t* B*

B=(1/g) t

WHAT HAPPENS IF THE RISKINESS OF BONDS FALLS? The possibility frontier Rt rotates upwards again in the upper panel. The new optimal solution is again point 2. This time, however, the B curve rotates downwards in the lower panel. If the risk on each bond g falls, any given total risk T in the horizontal axis implies more bonds B in the vertical axis.

Upper panel: we reach a higher indiff. curve i.e. a higher utility level. Lower panel: B rises M=W-B falls Conclusion: If the bonds riskiness falls, the demand for money falls
Rt=[(r+ge)/g] t
2

Rt

1 Rt*

0 t* B*
1 2

B=(1/g) t

OVERALL

CONCLUSION

Tobins demand for money is represented by the following equation Md=L(r, ge, g) These is a plausible result! Insofar as bonds become more attractive, offering: a higher interest rate, a higher expected capital gain a lower risk then, the demand for money falls. Specifically, Tobins analysis justifies the negative relationship between Md and r. However, the advantage is that this time: i) in the short run, the individual agent holds both money and bonds. Put otherwise, now we understand why in the real world people differentiate their portfolios, holding both money and bonds. ii) in the long run there is still a demand for money, even if ge=0 and e >0. In terms of returns bonds are more profitable, but money decreases the risk of the whole portfolio. For Tobin, as for Keynes, the alternative is then between: money, with zero expected return e=0 and zero risk bonds, with positive expected return e=r+ge and positive risk g Tobins work aims at justifying Keyness liquidity preference. Keynes, however, would have not shared Tobins analysis. In his view, agents ignore the future. They do not know the probability distribution. Tobin takes the expected return and risk on bonds as given. Nowadays experience, however, tells us that they are not given. As an example, the fluctuations in the Italian spread reflect the waves of optimism and pessimism about Italian bonds. Ceteris paribus, whenever bonds become less desirable, the demand for money and thus the interest rate raise.

Tobin (1969) A general equilibrium approach to monetary theory In this new article, Tobin introduces a new/successful way of organizing financial accounting. Assets/Sectors M/P B/P K W/P Private S. M/Pd B/Pd Kd Pr. wealth Public S. -M/Pd -B/Pd Pub. wealth -Kd Nat. Wealth Exogenous S.

The previous table is a picture of the whole financial system. The columns show the sectors (private, public, exogenous) The rows show the assets (M, B, K) Each element is a demand (supply) if positive (negative). Specifically --M is demanded for by the private sector and supplied by the public one. --B are demanded for by the private sector and supplied by the public one. --K is demanded for by the private sector and exogenously supplied (pas history). The sum by column gives the sectors wealth. The sum by row gives the equilibrium of the markets: excess demand/supply has to be zero Notice that, when one element in the accounting matrix changes, other elements too have to change. Moving to theory, Tobin adopts a general equilibrium framework specifying the following model of the financial system. 1. W/P=(M+B)/P+q K 2. fm(rb, rk, Y/W) W/P = M/P 3. fb (rb, rk, Y/W) W/P = B/P 4. fk(rb, rk, Y/W) W/P = q K 5. rk q =R Let us consider Tobins equations one by one. 1. W/P=(M+B)/P+q K This is the definition of the private sectors real wealth W/P. It is composed by money, bonds and capital in real terms. The q variable is the price of capital goods Pk divided by the general price level P. In other words, q=Pk/P is the relative price of capital goods. 2. fm(rb, rk, Y/W) W/P = M/P 3. fb (rb, rk, Y/W) W/P = B/P 4. fk(rb, rk, Y/W) W/P = q K These three equations are the assets markets equilibrium conditions. The real supply of each asset (right-hand term) is taken as exogenously given.

The real demand for each assets (left-hand term) is assumed to be a share/a fraction f(..) of real wealth W/P. The demand for assets as a whole (M, B, K) is constrained by existing wealth. fm()W/P + fb()W/P + fk()W/P=W/P This means that the sum of the f() functions is equal to one: fm()+ fb()+fk()=1 The f() functions in turn depend: on the interest rates on bonds (rb) on the interest rate on capital (rk) on the ratio between income Y and wealth W. The role of interest rates The demand for each assets is: a positive function of the return on the asset itself a negative function of the return on alternative assets. This means that: the demand for money fm() is negatively related both to rs and to rk. the demand for bonds fb() is positively related to rb and negatively related to rk. the demand for capital fk() is positively related to rk and negatively related to rb. The role of Y/W The rise in Y/W increases the transactions demand for money fm() as a share of wealth and consequently decreases the demand for bonds fb() and capital fk(). Equation 5 below deserves particular attention. 5. rk q =R Specifically, Tobins q has a crucial role in the model. It is often referred to in the literature: its meaning has to be well understood! Let us consider Tobins capital goods market. In it we find:
a short-run capital supply curve SRKs, which is a vertical line. In the short-run, the capital stock is given: it takes time to increase it. a long-run capital supply curve LRKs, which is an upward sloping line. Under perfect competition, prices equal marginal costs. As K grows, marginal costs and the general price level P also grow. a demand curve for capital goods Kd which has the usual decreasing slope.
SRKs Pk K
d 1

LRKs

0 Pks=P=Pkd

Starting with the initial long-run equilibrium point 0, if the demand for capital increases

from Kd0 to Kd1: at first, we move from 0 to the new shortrun equilibrium 0 in 0 Pkd>Pks; this gap is an incentive to produce new K goods. as K increases, we move to the new longrun equilibrium point 1.

Pk Pk d

Kd1 Kd0

SRKs 0 0 1

LRKs

Pks=P

Tobins q is the ratio between: the demand price for capital Pkd (how much people are available to pay for new capital goods) the supply price of capital Pks=P (how much producers require to produce new capital goods) q=Pkd/P In the short-run, q can be different from 1. q>1 presupposes an expansion of the economy; Pkd> P, there is an incentive to increase K q<1 presupposes a contraction of the economy Pkd< P, there is an incentive to decrease K q=1 we have long-run equilibrium, the K stock is the optimal one. Given expected profits from capital goods PRF the two prices of capital goods Pkd and Pks=P generate two rates of return. R=PRF/P rk=PRF/Pkd The ratio between the two rates of return is R/rk=Pkd/P=q We thus come to the 5th equation of Tobins model: if we have two prices, we also have two returns. R =rk q With this, we have cleared the meaning of each single equation. Moving to the model as a whole, we have to remember that one of the three equilibrium conditions is redundant. According to the Walras low, the equilibrium of n-1 markets inevitably ensures the equilibrium of the nth market. With this, our description of Tobins model is complete. The implications of Tobins model. Starting from a general equilibrium situation, Tobin then calculates what happens: i) in the case of an exogenous increase in money supply M ii) in the case of an exogenous increase in bond supply B. Tobins results are the following

M q rb rk + -

B ? + ?

Money raises q, with unquestionable expansionary effects on income Bonds, by contrast, have uncertain effects on q and thus on income. Why money is inevitably expansionary whilst bonds are not? Let us consider the two cases. 1st case: M The price of (and the interest rate on) money is given: the value of one euro is always one euro. banknotes imply a zero return. The substitution effect does not work. In the presence of an increase in money supply M, the price of money does not fall and the interest rate on money does not rise. There is no incentive to demand for more money, substituting it to the other assets. By contrast, the wealth effect does work! As M rises, the higher W will stimulate the demand for all assets. Since fm(.) is less that 1, there will be an excess supply of money which will turn into a demand for alternative assets. The result is that: pkd rises q=Pkd/P becomes >1 investments and income grow. 2nd case: B The price of (and the interest rate) on bonds varies accordingly to supply and demand. The excess supply of bonds will turn into: a fall in the bond price pb a rise in the bond interest rate rb. Bonds become more profitable than before. The substitution effect will thus imply: a higher demand for bonds B a lower demand for alternative assets M and K. The wealth effect will imply: a higher demand for bonds B a higher demand for alternative assets M and K. What happens to the demand for B? the substitution effect (rb) is positive the wealth effect (B=W) is positive the demand for bond will align itself to the higher supply.

What happens to the demand for M&K? the substitution effect (rb) is negative. the wealth effect (B=W) is positive the overall results depends on which of the two effects prevails. To our purposes, the result is that: pkd may rise, remain constant or fall q=Pkd/P may become >1,=1 or <1 investment and income may grow, remain constant, or fall. TOBINS CONCLUSION: Money is a simple piece of paper without any intrinsic value. However, it has unquestionable expansionary effects on economic activity. What is the secret of money? The reason why money has expansionary effects on economic activity while bonds have uncertain effects, is that money has a fixed price and return: has no restrictive substitution effects has only expansionary wealth effects. To sum up, the constancy of the price of money: at an individual level explains why people hold money even if it has no return. at an aggregate level, explains why money is expansionary while bonds are not necessarily so. Tobins q is well known in the literature. Its main messages are the following. i) There are two kind of prices: the price of assets, depending on profit expectations and thus volatile the price of goods, depending on production costs and thus more stable and easier to forecast. ii) the excess of asset prices over the price level is an incentive to increase investments and output. THE TRANSACTIONS DEMAND FOR MONEY We refer to Baumol (1952), The transactions demand for cash: an inventory approach. STANDARD VIEW ON THE TRANSACTIONS DEMAND FOR MONEY The individual agent: perceives a monthly monetary income PY spends it entirely, at a constant rate, during the month holds an amount of money PY at the beginning and 0 at the end.

On average, he holds M= (1/2) PY By generalizing, we get the known OCs transactions demand for money function: M=k PY

PY

+
PY/ 2

1 month

BAUMOLS OBJECTION TO THE STANDARD VIEW Agents can behave in a more intelligent and profitable way! Rather than holding money from the beginning to the end, they can buy bonds at the beginning of the month and sell them gradually in order to finance their transactions. Contrarily to money, bonds yield an interest rate. The purchase/sale of bonds, however, implies a transaction cost. Let us consider February, composed by 4 weeks. The individual spends C=PY/4 each week. He thus needs only C amount of cash at the beginning of each week. The rest of his income PY can be held in bonds.
1st week The individual needs C= PY in money. The remaining PY can be used to buy bonds. His bond holdings will be 3/4 PY. 2nd week The individual needs again C= PY in money. He will sell an equivalent amount of bonds. His bond holdings will fall to 2/4 PY. 3d week The individual needs the usual C= PY in money. He will sell an equivalent amount of bonds. His bond holdings will fall to 1/4 PY. 4th week The individual needs the usual C= PY in money. He will sell an equivalent amount of bonds. His bond holdings will fall to zero.

PY

M M

M B

3/4 PY 2/4 PY

M M

1/2 PY

1st w

2nd w

3rd w

4th w time

This strategy has a cost in terms of money Z1 in terms of bonds Z2.

I)

THE COST IN TERMS OF MONEY Z1 Money implies the loss of the interest rate on bonds. Let us calculate this cost.

i) In our case of 4 weeks, the amount of money held at the

beginning of each week is: C=PY/4 The amount of money held on average is C/2

Md C C/2

ii) In the more general case of n periods, the amount of money held at the beginning of each period is: C=PY/n The amount of money held on average is: C/2 The cost of the strategy in terms of money Z1 is given by the loss of the interest rate r on average money balances C/2. Z1=r C/2 where C=PY/n
II)

THE COST IN TERMS OF BOND Z2

Every purchase/sale of bonds implies a transaction cost. We have to lose time in order to go to the bank, to pay the bank fee and so on. Let us calculate these transactions costs.
Transactions are shown by the arrows in the figure. Bonds are bought at the beginning of the month sold at the beginning of each of the following 3 weeks. The number of transactions is equal to the number of the periods (n). Since C=PY/n we get n=PY/C

By assumption, the cost of each transaction is given by a constant t. Thus, the cost of the strategy in terms of bonds Z2 is given by the number of transactions n=PY/C times the given unitary transaction cost t. Z2=t n= t PY/C THE TOTAL COST OF THE STRATEGY The total cost, in terms both of money and of bonds, is: Z = Z1 + Z2 = (r C/2) + (t PY/C) Let us now find the value of C that minimizes the total cost Z. The first derivative has to be zero. Z/C = ( r/2 ) - ( t PY/C2 ) = 0 By solving, we get

C2/4 = t PY/2r From C we get the demand for money Md=C/2

Md

C Md =C/2

This means that Md=C/2= (t PY/2r)1/2 BAUMOLS CONCLUSION Transactions requirements can be fulfilled not only by money but also by bonds. Money has no return and no cost, bonds imply a return r and a transaction cost t. The transactions demand for money will be: a positive function of nominal income PY a positive function of transactions costs on bonds t a negative function of the interest rate on bonds r + - + d d M = M (PY, r, t) To justify Keyness relationship between Md and r, we do not need the speculative demand for money. Also the transactions demand for money is a negative function of the interest rate. THE SUBPRIME CRISIS: AN EXAMPLE OF THE LIQUIDITY TRAP? Keynes presented the liquidity trap as a limit and unrealistic case. However, the liquidity trap has been used to interpret the recent financial turmoil. In what follows, we shall refer to a recent book by P. Krugman, 2008 Nobel Prize. The book is entitled: The Return of Depression Economics and the Crisis of 2008. It is easy and pleasant to read and has also been translated into Italian.

Krugmans description of the crisis

The main phenomena at its origin are: monetary expansion financial deregulation financial innovation. Let us analyze each of them! i) US Monetary Policy The first relevant aspect is the expansionary stance adopted by the Fed in the 2000s. According to the dominant approach, the task of a Central Bank

consists in manoeuvring the interest rate in such a way as to keep inflation and the exchange rate under control. In the period under examination, inflation was contained by the competition from Chinese imports the dollar was sustained by capital inflows (again, from China). This led the Fed to believe that the interest rate was the right one; it consequently felt authorized to sustain the economy and assets prices. As a consequence, the Fed: increased the liquidity of the system reassured private agents about its availability to support asset prices. In both the cases, this sustained the level of credit/indebtedness. ii) Financial Deregulation In the last three decades of the 20th century, the dominant economic theory had being placing increasing faith in market mechanisms. Markets are efficient: they know their business!! This led to a widespread process of deregulation. One example is the 1999 repeal of the Glass-Steagle Act, i.e. the removal of the financial compartmentalization inherited from the 1930s. To quote Leijonhufvud (2009): All financial institutions were allowed to engage in all kinds of transactions. The regulatory structure was not reworked. The old matching of regulators to industry segments was entirely lost, leaving a confused division of labour between agencies with many overlaps and many lacunae which the industry quickly learned to exploit. iii) Financial Innovation Deregulation fuelled an intense process of financial innovation. Its two main manifestations consisted in: the loan securitization the shadow banking system. Securitization Financial deregulation allowed originators banks to sell their loans to special/suitable intermediaries (Conduit, Special Purpose Vehicles) which had less legal constraints/obligations/controls . These intermediaries packaged the loans and sold them to investors in the shape of collateralized debt obligations CDO.
Expansionary Monetary Policy

Confidence

Credit=Indebtedness

By buying these CDO, investors became the owners of the loans. Specifically, they acquired the right to perceive the interest payments the final repayment of the loan They, however, also took over the credit risks. The possibility of transferring loans (with the corresponding loan risk) allowed banks to undertake more and riskier operations. In both the cases, this sustained the level of credit/indebtedness. The Shadow Banking System Thanks to financial liberalization, non-bank financial intermediaries started issuing new kinds of short-run liabilities (auction-rate securities, asset-backed commercial paper), in order to finance their long-term assets. While bank deposits were subject to constraints (supervision, reserve and patrimonial requirements..), these new short-run financial instruments implied no restriction. Non bank financial intermediaries thus transformed themselves into a shadow banking system: they performed the same role as banks but without any restriction whatsoever. Their funds could be freely invested to a greater extent into risky assets offering higher returns. The overall results of financial innovation (of securitization and of the development of the shadow banking system) were: a massive increase in the lenders propensity to risk (in confidence Conf) a massive increase in credit availability (in credit/indebtedness) The overall result was a further increase in credit/indebtedness. Real Effects To benefit from credit expansion was mainly the US households sector (HLD).
The consumption spiral A first consequence was the increase in HLDS demand for durable consumption goods C. This triggered the consumption
Expansionary Monetary Policy

Conf

Credit/Indebtedness

Financial Deregulation

Financial Innovation

spiral: more C, more Y, more C In the period, it was HLDs consumption to sustain the growth gap between the USA and Europe.

Expansionary Monetary Policy Cd

+
+

Conf

IndHLD

Financial Deregulation

Financial Innovation

To grow with HLDS indebtedness, however, it was also their demand for houses. This triggered the housing spiral: higher demand for houses Hd; higher home prices PH; expectations of capital gains on houses; higher demand for houses Hd.
Expansionary Monetary Policy C
+
+
d

Conf

IndHLD
+

Financial Deregulation

Hd
+

PH

Financial Innovation

As known, it is precisely here that the subprime problem arose. In the euphoria of the housing boom, buyers were given sub-prime (low quality) loans: requiring little or no down payment with monthly bills that were beyond their ability to afford. From the lenders point of view, it did not matter whether the borrower could actually make the mortgage payments. Troubled borrowers could always either refinance or pay off the mortgage by selling the house. With the housing boom, house prices rose to the point where purchasing a home became out of reach for many Americans. By the fall of 2005, sales began to fall. Some months later, house prices began dropping, slowly at first, then with growing speed. As soon as house prices fall below the worth of the mortgage, subprime borrowers became insolvent. This triggered a wave of failures. Subprime insolvencies led to a crisis of confidence in: i) Collateralized Debt Obligations, backed (as we have seen) by subprime loans. These obligations became hot potatoes that nobody wanted to hold any more, as in the case of Keyness liquidity trap. ii) traditional and shadow banking system: having purchased these obligations, it had experienced heavy capital losses. It was no more reliable.

iii) insurance compianies; having ensured collateralized obligations through new financial instruments named Credit Default Swaps (CDS), they now had problems in fulfilling their debt commitments. They too were no more reliable. The result of this wave of pessimism was: a bank run, depositors now wanted cash a general deleveraging: being afraid about he future, everybody wanted to reduce indebtedness a credit crunch, everybody wanted to hold money instead of lending it. The fall in asset prices and the credit crunch drove the economy to the worst world recession since the 1930s. Under these circumstances, monetary policy became relatively ineffective: a new analogy with the liquidity trap according to Krugman. The Central Bank can act as a lender of last resource. This, however, is not much helpful in a situation in which everybody wants to reduce indebtedness.. The lending of last resource: can solve liquidity problems, (a temporary lack of liquidity). cannot solve the solvency problems associated with bad loans and toxic assets. Fiscal policy has turned out to be more effective. It had not only the traditional income effect: the support of income and employment. It also had a financial effect: Let us think for instance about the public recapitalization of troubled financial intermediaries Fiscal expansion, however, had also the usual contraindications: an unprecedented increase in US government deficit. an unprecedented increase in US government debt. THE FETISH OF LIQUIDITY: KEYNES AND SPECULATION Chapter 12 of The General Theory introduces the Stock Exchange. The stock market: is not conceived as a source of funds for investors. but as a secondary market in which capital goods can be bought and sold. Specifically, Keynes critically analyzes two functions of the stock market: the evaluation of assets the revocability of investment decisions.
THE EVALUATION OF ASSETS

According to Keynes, the desired investment level corresponds to the equality between the interest rate r and the marginal efficiency of capital MEK=Q/MgC, where Q is the (this time by assumption perpetual) expected profit from investment and MgC is the marginal cost of investment itself (of output in general). r= MEK=Q/MgC

The comparison la Keynes between the two rates of return can be easily transformed into the comparison la Tobin between two prices. With simple passages, from the previous equation we can get: MgC=Q/r This equation in turn can be then interpreted as the equality between: the supply price of investment goods PsI, equal to the marginal cost MgC. the demand price of investment goods PdI, equal to the given present value of expected profits PVQ=Q/r5 PsI = PdI The intersection between the demand and supply prices of investment goods gives the profitable investment level Ip in the figure below. For I=Ip, the present value of expected profit is higher than the production cost.

PsI =MgC

PdI=PVQ=Q/r

Ip

Following Keynes, let us now add the evaluations of the Stock Exchange, the prices at which existing capital goods can be exchanged in the stock market PSE is the current price of shares PSEex is the expected price of shares As we shall see, if these two prices fall outside the area included between the MC and the PV curves above, the actual investment level will not coincide with the profitable one Ip. We shall then experience situations of underinvestment/of overinvestment. 1st Case: PSE<MgC
5

It is easy to show that PVQ= Q + Q + (1+r) (1+r)2 tends to PVQ=Q/r

Q + (1+r)3

Q (1+r)4

PsI =MgC
P

PdI=PVQ=Q/r

PSE
Ip I

Since the current price of shares (PSE) is lower than the marginal cost MgC, the entrepreneur will prefer to buy the cheaper existing capital assets rather than to order the more expensive new capital goods. The demand for investment goods will fall to zero. Investments projects Ip that would have been profitable from a productive point of view will not be undertaken.6 The economy will experience an underinvestment situation. 2nd Case: PSEex>PV

PsI =MgC
P

PSEex PdI=PVQ=Q/r

Ip

Iov

Since the expected price of shares PSEex is higher than the present value PVQ, the demand for new capital goods will rise from Ip to Iov. Investments projects that are not profitable from a productive point of view (IpIov in Figure 1) will be undertaken. The point is that these projects are profitable from a speculative point of view. The entrepreneur buys them not for keeps but with the prospect of selling them at a higher price in the Stock Exchange.
6

Analogous considerations hold if the expected price of shares is lower than the marginal cost. In this case, the purchase of existing capital assets is simply postponed. To quote Keynes: For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify s value of 30, if you also believe that the market will value it at 20 three months hence (1936: 155).

The economy will experience an overinvestment situation. THE GENERAL THEORY Stock market evaluations inevitably exert a decisive influence on the rate of current investment. For there is no sense in building up a new enterprise at a cost greater than that at which a similar enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum if it can be floated off on the Stock Exchange at an immediate profit (Keynes 151). This situation brings us to Keyness casino capitalism. Expected share prices (PSEex) replace the present value of prospective yields PVQ. The mass psychology of the market prevails over the dark forces of time and ignorance which envelop our future (155). In short, speculation replaces entrepreneurship. Keyness well known conclusion is that when this happens, the process of capital accumulation is jeopardized. [W]hen the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done (159). When PSE and PSEex coexist, Keyness casino capitalism reaches its climax.

PsI =MgC
P

PSEex PdI=PV=Q/r

PSE Ip
I

Entrepreneurs will stop investing, transforming themselves into speculators. All their energies will be devoted to buying and selling shares. The revocability of investment decisions Let us now come to the second function of the stock market. Thanks to it, entrepreneurs: can sell investment goods to others instead of holding them for all their lives. The individual investment decision becomes revocable!

This revocability, however, is only a mirage. Keynes defines it as THE FETISH OF LIQUIDITY, i.e. as a false myth.7 For the individual investor, investment becomes more liquid and less risky. For the economy as a whole, however, investment is the same as before. At the aggregate level, the investment decision is not revocable. This perception error/this mirage: stimulates the accumulation process but leads to less liquid and more risky investments. THE GENERAL THEORY Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity [] It forgets that there is not such thing as liquidity of investment for the community as a whole (1936: 155). Keyness fetish of liquidity may be re-read in the light of a sort of fallacy of decomposition in decision making. The decomposition refers to the distinction between the decision to buy and the decision to hold investment goods (between managers and owners of capital assets). In the presence of the stock market, the two kinds of decisions do not necessarily coincide any more. The fallacy consists in the fact that investments which are fixed for the community are [] made liquid for the individual (153). The financial evolution of capitalism subtends an increasing specialization, which in turn implies an increasing decomposition in decision making. Firms recourse to direct external financing introduces the distinction between the purchase of investment goods and their financing, i.e. between firms and savers. Financial intermediation introduces the further distinction between the lenders/creditors the ultimate financiers i.e. between financial intermediaries and savers. All of this, however, does not necessarily imply any fallacy. After all, the success of the financier depends on the success of the borrower. Savers and/or financial intermediaries may even contribute to the assessment of investment profitability, thus improving the process of capital accumulation. The fallacy of decomposition reappears, however, with the increasing recourse to secondary financial markets.
7

Notice that, as a concept, the fetish of liquidity is quite different from the liquidity preference.

Modern financial intermediaries buy financial assets mainly with the purpose of selling them at a higher price in secondary markets. Expected capital gains replace prospective yields up to maturity. Securities turn out to be more liquid and safer for their individual owners, with the result of becoming more illiquid and riskier for the economy as a whole. The same holds for the recent securitization processes in the credit market. Securitization introduces the distinction between: the lender, the originator of the loan and the ultimate creditor, to whom debt commitments are due to. If the financial institution that originates the loan can transform it into securities and sell it to others, credit looks more liquid and safer for individual lenders, thus becoming less liquid and riskier for the economy as a whole. To conclude, Keynes perplexities about secondary markets can help us to understand the spreading of junk assets and loans which led to the ongoing crisis. What is to be done? What suggestions can we draw from The General Theory? THE GENERAL THEORY To make the purchase of an investment permanent and indissoluble, like marriage, [] might be a useful remedy for our contemporary evils. Unfortunately, however, secondary markets cannot be closed. if individual purchases were rendered illiquid, this might seriously impede new investment (160). However, secondary markets should at least be made inaccessible and expensive.8 The introduction of a substantial Government [] transfer tax on all transactions might prove the most serviceable reform available, with a view to mitigating the predominance of speculation over enterprise in the US. (160) Current proposals concerning the tax on financial transactions (the so called Tobin Tax) are thus rooted in Keyness The General Theory.

Neoclassical Synthesis (1937-1965)

(English not revised) The Keynesian revolution opened a DEEP SPLIT inside macro theory: OC: the invisible hand leads to general (full employment) equilibrium
8

To quote Keynes: it is usually agreed that casinos should, in the public interest, be inaccessible and expensive (1936: 159).

Keynes: market failures generate under-employment equilibriums. The whole working of the system was conceived in a different way. The two views were unable to communicate. In order to dialogue, we need a common language. Immediately after the publication of Keyness (1936) book, the profession started with rebuilding a common framework in order to reopen the debate. We thus have the Neoclassical Synthesis! ? It tried to find a synthesis, able to include as special cases: General Equilibrium Theory (GET) Keyness General Theory (GT).
WHY SYNTHESIS

?9 It started with supporting Keynes. Involuntarily, however, it ended with supporting the (Neo) Classics.
WHY NEOCLASSICAL MAIN PROTAGONISTS

1. Hicks, Nobel Prize in 1972. 2. Modigliani, Nobel Prize in 1985 3. Patinkin The first step of the Synthesis was to find out the core differences between the opposite views. With regard to this, it focused on two issues: the nature of aggregate demand the role of aggregate demand The second step was to build a unitary framework able to include the opposite views as extreme cases. HICKS One year after the publication of the GT, in 1937, Hicks wrote a famous article: Mr Keynes and the Classics: A Suggested Interpretation. This article introduced the known IS-LM model. This model is sometimes still used in elementary textbooks: more than 70 years, a really long life in Economics! Hicks Presuppositions In Hicks opinion, the basic split between OC and Keynes did not concern the supply side of the economy.
9

In actual fact, it was Samuelson to introduce the definition Neoclassical Synthesis in his famous book. The reason why he did so is that Keynesian theories were considered too extreme under McCarthyism.

Both Old Classics and Keynes referred to a regime of perfect competition, in which prices equal marginal costs. Given the decreasing marginal product of labour, marginal costs are increasing. At any given money wage W, prices P are a positive function of income Y. Both OC and Keynes thus envisaged an upward sloping aggregate supply curve whose position depends on money wages W. P=P(Y,W)

P=P(Y,W)

Hicks admitted that there was a difference: Old Classics assumed flexible money wages W Keynes took the money wage as exogenously given. In Hicks view, however, this difference was not crucial. After all, Keynes himself claimed that his results did not depend on this specific assumption: the money wage W only affected the nominal scale of the economy (P). Hicks then assumed W given both for the OC and for Keynes, If the aggregate supply curve P=P(Y,W) coincides with the upward sloping marginal cost curve, it is aggregate demand which determines the level of output. We have to focus on it!!

Yd

P=P(Y,W)

Hickss questions were: Is Yd determined by the money market? Is it a monetary phenomenon? Is Yd determined by the goods market? Is it a real phenomenon?

What are the relevant demand shocks? Are they monetary? Are they real? What is the best macro policy to control aggregate demand? Is it monetary policy? Is it fiscal policy? Hicks answered these questions: from the Classical point of view from Keyness point of view. As far as Keynes is concerned, however, Hicks distinguished between Keyness Special Theory, his most innovative contribution Keyness General Theory, his book considered as a whole. Hicks needed to clarify the differences in order to build the unitary framework he was looking for. Hickss Case 1. Old Classical Theory with W given
MONEY MARKET

Money is a medium of payment/of exchange, used to buy goods. The demand for money is K PY, where K is an institutional constant. The supply of money M is exogenously given. The money market equilibrium condition is: M=k PY Money supply M determines nominal expenditure PY. Specifically, M determines: the price level P if money wages W are flexible as in the Quantity Theory; With flexible money wages, the activity level Ys=Yd=Y is the full-employment one. The money market M=K PY is then cleared by P. MP the income level Y if money wages W are exogenously given as in our case. The aggregate supply function is P=P(Y,W). Money market M = k P(Y,W) Y is then cleared by real income Y. MY The money market equilibrium condition requires the equality between the demand for money (L=kPY) and the supply of money (M). Let us then name it LM curve. With W given, money market equilibrium gives real income Y. The LM curve thus becomes a vertical line in the panel Y, r.
LM

Real income Y is a monetary variable.

GOODS MARKET

OC goods market equilibrium implies the equality between S(r) and I (r)+G-T. It gives the equilibrium interest rate. S(r)=I (r)+G-T r The goods market equilibrium condition requires the equality between private S(r) plus public (T-G) saving and investment (I). Let us then call it IS curve Goods market equilibrium gives r. The IS curve is an horizontal line in the panel Y, r. The rate of interest is a real variable.
LM

IS

AGGREGATE DEMAND Aggregate demand Yd=Y is given by the IS-LM intersection. According to the OCs, Yd: is a monetary phenomenon, depends on money supply M. Money is a medium of payment: it is used to buy goods it determines the level of Yd
r
LM

IS

To sum up: The interest rate is a real phenomenon. Aggregate demand is a monetary phenomenon. Demand shocks are monetary. To control aggregate demand, better to use monetary policy. Hickss Case 2. Keyness Special Theory This theory represents Keyness most innovative contribution. MONEY MARKET Keyness innovation is liquidity-preference. Money is a store of value, the safest/most liquid way in which wealth can be held. As a store of value, money is alternative to bonds. The demand for money is then a negative function L(r) of the interest rate on bonds. The equilibrium condition of the money market is M=L(r) r

Money market equilibrium now gives the interest rate r. The LM curve is an horizontal line in the panel Y, r. The rate of interest becomes a monetary variable.

LM

GOODS MARKET Keyness innovation is the multiplier: the link between C and Y accentuates the effects on real income Y of exogenous expenditure (I(r),G). The goods market equilibrium condition is the following one. Y=C(Y) +I(r)+G Y At any r coming from the money market, goods market equilibrium gives Y. r I Y C Y The IS curve is downward sloping in the panel Y, r. It gives income, a real variable.
IS

LM r

AGGREGATE DEMAND Aggregate demand and income Yd=Y is given by the IS-LM intersection. It is a real phenomenon. At any r, an increase in autonomous expenditure triggers the multiplier, giving rise to an amplified increase in Y (to an amplified shift of the IS curve).
IS

LM r

To sum up The interest rate is a monetary phenomenon. Aggregate demand is a real phenomenon. Demand shocks are real. To control aggregate demand, better to use fiscal policy. Hicks comment Keyness special theory introduced two innovations: i) the liquidity preference in the money market (L(r)). ii) the multiplier in the goods market. However, Keyness most important innovation is the first one!

Without the liquidity preference: the LM curve would be vertical aggregate demand would be monetary the multiplier (the position of the IS curve) would not affect income. the interest rate would be real.

r IS0

LM0

Hickss Case 3. Keyness General Theory According to Hicks, the General Theory is more general than Keyness special theory. Keynes: introduced the speculative demand for money/the liquidity preference (link Md/r) but did not deny the transactions demand for money (link Md/PY) and added the precautionary demand for money (new link Md/PY) Let us then reconsider Keyness General Theory GT as a whole. MONEY MARKET Keyness demand curve for money becomes L=L(r) PY The equilibrium condition of the money market is the following one. At any given Y, the money market is cleared by r. M=L(r) P(Y,W) Yr
L(r, Y0)
M

Specifically, increases in Y and consequently in the demand for money imply increases in equilibrium r.
L(r, Y1)
M

L(r, Y0)

r0

Money market equilibrium is thus represented by an upward sloping LM curve in the panel Y, r. Y L r The result is the traditional IS-LM model.

IS

LM

Aggregate demand is simultaneously determined by the two sectors!!! This, however, is not the end of the story! In Hicks re-reading, The General Theory also considered

the extreme cases a and b in the figure below.

Case a: the liquidity trap. Bonds are hot potatoes, with negative expected return (e<0). At the given interest rate, L=Md= independently of Y. The LM curve becomes horizontal Y does not L(=) and thus does not r Case b; only transactions demand for money At very high interest rates, wealth is held entirely in bonds. M is only used as a medium of payment. The LM curve becomes vertical.

r
b

LM

ISb

a
ISc
ISa
Y

HICKSS CONCLUSION Keynes was right: his GT is actually more general than (superior to) GET. The reason is that Keynes did not only introduce the liquidity preference. He also envisaged the following possibilities: case b, in which Yd is monetary (as in the OCs). case a, in which Yd is real (as in Ks special case) case c, in which Y is simultaneously determined by monetary and real forces.
d

LM
b
c

ISb

a
ISa

ISc

MODIGLIANI In 1944, Modigliani writes an important article: Liquidity preference and the theory of interest and money. Modigliani agrees on what Hicks said. If we focus on the nature of aggregate demand, the GT is described by the IS-LM model is definitely more general/superior. According to Modigliani, however, the main problem might not be the determination of aggregate demand but the role of aggregate demand. The effects on Y of shifts in aggregate demand depend on aggregate supply P=P(Y,W) To what extent Keyness results depend on the assumption of money wage rigidity? What happens in Keyness model if money wages become flexible? Can we still have involuntary unemployment? To answer these questions, the following figure:

starts with the assumption of given money wages represents the demand side of the economy (the IS-LM model) adds the supply side.
IS0 r0 0 LM0

Goods Market. The IS0-LM0 interception gives Yd0. Aggregate supply Y0 aligns itself to Yd0. Production function It gives the corresponding level of employment L0. Labour market The Ld curve gives the real wage W/P0. At W/P0, the given nominal wage W0 gives the price level P0. The Ls curve gives involuntary unempl. U0=Ls0-L0 The result is Keyness underemployment equilibrium

Yd0=Y0 Y=Y(K,L) 0 Y0
45

Y0

L0 Ld W/P0 0 Ls
Y0

U0

L0

Ls0

Below, let us see what happens if money wages become flexible.

The solid lines show the initial under-employment equilibrium corresponding to the given W0. The dotted line show what happens if money wages become flexible.
Ysfe IS0 r0 0 1 LM0

Yd0=Y0 Y=Y(K,L) Yfe Y0 1 0 Yfe Y0

45

Ysfe

Labour market (below) the excess supply of labour implies a fall in W. real wages fall too employment goes to Lfe. Production function: Y goes to Ysfe. Goods market (above) Full employment aggregate supply Ysfe becomes greater than aggregate demand Yd0 There is an excess supply of goods!

1 0

L0 Lfe Y0 Yfe

Ld
W/P
0

Ls
0 1

L0

Lfe

Ls0

What happens in the goods market?

Ysfe IS0 r0 0 1

LM0

LM1

Y0

Ysfe

The excess supply of goods Ysfe-Yd0 implies a fall in prices P. As the price level P falls: M/P increases the LM curve moves downwards. P M/P Bd pb r (at any Y) Yd (the IS-LM intersection) increases to Ysfe the system reaches its full employment equilibrium. At that point: the labour market is in equilibrium wages and prices stop falling.

If wages and prices are flexible, the system goes to its general equilibrium The adjustment mechanism is based on the so-called Keynes effect (LM)10 W P M/P r I Yd Can we conclude: that Keyness contribution simply consists in introducing wage rigidity into GET? that the GT is the particular case of GET where W are rigid? Modiglianis answer to these questions is negative! Keyness innovative contribution is the liquidity trap. Below, the excess supply Ysfe-Yd0 in the goods market keeps implying: a fall in prices P an increase in M/P
r IS0 Ysfe LM0

Under the liquidity trap, however, the increase in M/P does not affect the LM curve.11

W P M/P without r I Yd
The result is that Aggregate demand remains Y0 i The activity level remains Y0. The system remains in point 0. There is no tendency to full employment.

Yd0

Yfe

Under liquidity trap, bonds become hot potatoes that nobody wants. The increase in money supply turns into an equivalent increase in the demand for money. It does not stimulate the demand for bonds. The bonds price does not rise and that the interest rate does not fall. W P M/P without r I Yd Modiglianis conclusion
10

Indeed, Keynes took this effect into account. However, he also thought that it was not necessarily important. Under price deflation, aggregate demand may fall instead of rising. The expectation of further price falls might cause a postponement of private expenditure, depressing Yd. Fisher (1933) adds that price deflation increases the real value of debts, with depressive effects on Yd. 11 Consider the money market in the panel M/P, r. If the demand curve for money is horizontal, the interest rate does not depend on money supply.

Keyness original contribution: is not money wage rigidity is a sort of interest rate rigidity (the liquidity trap) generated by expectations. Modigliani versus Hicks Hicks: the GT is more general than (superior to) GET because it introduces the liquidity preference L(r). Modigliani the GT is more general than (superior to) GET because it introduces the liquidity trap. However: according to Keynes himself, the liquidity trap is a very special and uncommon case. Result Modigliani involuntarily marginalizes Keyness contribution. PATINKIN We refer to Patinkin (1956), Money interest and prices. The book is well known in monetary theory. According to Patinkin, there is a logical mistake in classical theory. This mistake concerns the classical dichotomy, i.e. the separation between the real and monetary sectors. What does this dichotomy imply? i) According to the money market, M=K PY nominal expenditure PY is a monetary phenomenon MPY ii) According to the goods market, Yd=C(r) +I(r)+ G real demand Yd is a real phenomenon rYd Patinkins critique i) How is it possible to separate real demand Yd from nominal expenditure (PY)? ii) How can money supply M affect nominal demand (P Yd) without affecting real demand Yd? iii) This is a logical mistake of classical theory! Patinkins solution To remove this mistake, let us introduce a direct link from real money balances M/P to real expenditure.

Consumption, for instance, depends -not only on the rate of interest -but also on wealth (M/P). C= C(r, M/P) Aggregate demand thus becomes: Yd = C(r, M/P) + I(r) + G The real stock of money M/P now affects also the goods market (the IS curve) With this novelty, let us reconsider what happens when money wages become flexible.
r IS0 Y fe
s

LM0

Yd0

Yfe

As we have seen, under liquidity trap the Keynes effect does not work: the LM curve does not move downwards. W P M/P (without r I Y) HOWEVER the Patinkins real balance effect (or the Pigou effect) works. The IS curve shifts rightwards W P M/P C Yd=Y (at any r) With wage flexibility, the system thus goes to its full employment equilibrium! Outside the special case of the liquidity trap, if money wages are flexible, unemployment (excess labour supply) implies: W P M/P The increase in M/P in turn triggers: i) the Keynes effect only (LM) M/P r I Yd ii) the real balance or Pigou effect only (IS) M/P C Yd iii) a combination of the two effects. Wage and price flexibility leads to full employment equilibrium.

IS0

LM0

Y0

Y*

Patinkins conclusion Modigliani is wrong: the interest rate rigidity is not a problem. If money wages are flexible, the system goes to its full employment (general) equilibrium even under liquidity trap. Only wage rigidity can justify Keyness under-employment equilibrium. The GT is the particular case of GET in which money wage rigidity stops the adjustments mechanisms. Keynes only introduced imperfections. GET is more general than /superior to Keyness General Theory Comment This is the anti-Keynesian (neoclassical) conclusion of the whole Synthesis.

After Patinkin, Hicks himself rejected the IS-LM model! Patinkins contribution affected the debate in two crucial ways: the adoption of general equilibrium as a benchmark: in the absence of imperfections, GET would describe the real world the adoption of the rigidity based interpretation of Keynes. PATINKIN AND THE QUANTITY THEORY As we have seen, Patinkin rejected the classical dichotomy: the monetary and the real sectors are interconnected. What about the neutrality of money? What about the quantity theory of money? Let us consider the full-employment version of the IS-LM model money wages and prices are fully flexible income is at its full employment level Y*. the endogenous variables now become r and M/P. M/P= L(r) Y* Y*=C(Y*, r , M/P) + I(r) + G If we represent the full employment IS-LM model in the new M/P, r space (rather than in the usual Y, r space) the slopes of the two curves change: the LM curve slopes downwards the IS curve slopes upwards
r

LM
0

IS

The LM curve is downward sloping: (r M/Pd=Yd P M/P) The IS curve is upward sloping: r Yd P M/P The IS-LM intersection gives the equilibrium values for r* and M/P*.

r*

M/P*

M/P

Equilibrium real money balances M/P* are endogenously given by the system. If the central bank increases M by x%, the equilibrium price level P raises by x%. The conclusion is that Patinkin: rejects the classical dichotomy by introducing the real balance effect but reaffirms the neutrality of money: the supply of money M only determines the price level P. Patinkin, however, also claims that neutrality requires very specific/restrictive conditions. Let us extend the definition of wealth. Wealth is composed not only by money M, but also by other assets O (bonds, capital..). W=M+O

Our full employment IS-LM model then becomes: M/P= L(r) Y* Y*=C(Y*, (M/P + O/P) + I(r) + G Let us assume the following relationship, where gives the composition of wealth: O/P= M/P By substituting, we get: M/P= L(r) Y* Y*=C(Y*, (1+) M/P) + I(r) + G The model is similar to the previous one. The difference is that now we also have . This new coefficient affects -goods market equilibrium (the position of IS) -the solution of the model M/P*=M/P*() Under these circumstances, money is neutral only if it does not affect the composition of wealth (). If nominal money supply M affects , it also affects equilibrium M/P* (a real variable). If this happens, money is not neutral! (A comment: it is difficult to imagine a monetary policy that does not affect the composition of wealth. The neutrality of money does not seem very realistic.) A COMMENT ON THE NEOCLASSICAL SYNTHESIS After Patinkin: GET became the right theory: it described a world without imperfections. The rigidity-based interpretation of the GT became (and generally is still now) the dominant one. However, Keynes would not have agreed!!!!!! he lived during the Great Depression of the 1930s. at that time, there was an unprecedented fall in money wages and prices despite this, employment and income kept falling. According to Keynes, the fall in money wages and prices may increase (rather than decrease) unemployment. In a deflationary regime: uncertainty increases, with depressive effects on Yd expectation of further price falls might determine a postponement of private expenditure, with further depressive effects on Yd Keyness main message was precisely that the price mechanism does not work. Possible objections to the Synthesis i) Expenditure might become independent on P

When expectations are depressed, the fall in W and P (and the consequent increase in M/P) might not stimulate Yd and Y. Given the pessimistic expectations about the future, firms might not invest more and consumers might not spend more. This objection is not at all unrealistic! In Japan, the interest rate fell almost to zero without stimulating economic activity. During the Great Depression, the fall in W and P did not succeed in stimulating aggregate demand and income.
r

IS LM

Yfe

Y0=Yd0

Ysfe

ii) money supply is endogenous (Post Keynesian School) One of the crucial assumptions of the Synthesis is that money supply M is fully under the control of the central bank. Let us assume that money is endogenous. Now, money supply M aligns itself to the demand for money. If P falls by x%, the demanded and supplied quantities of money both fall by x%. %P =%Md=%Ms The result is that, as W and P fall, this time M/P remains constant. The Keynes/Patinkin-Pigou effects do not come into play. Despite falling money wages and prices, the system remains in an under-employment equilibrium. iii) The burden of debt and of debt commitments Under a regime of falling prices: the real value of the debts inherited from the past rises (Fisher) the real value of the debt commitments12 inherited from the past rises (Minsky). Under these circumstances, as money wages and prices fall: debtors might become insolvent; we might experience waves of bankruptcies; consumption and investment would fall; unemployment would rise instead of falling. 5. ORTHODOX KEYNESIAN SCHOOL (English not revised) The Neoclassical Synthesis dominated the debate in the 1950s and 1960s. A long time interval in economics. The Orthodox Keynesian School (OKS) 13 represents the Keynesian component of the Synthesis itself.
12 13

Debt commitments are represented by interest payments and by the repayment of the principal.

Orthodox Keynesians were also called i) Hydraulic Keynesians, out of their mechanical view of the working of the system and ii) Bastard Keynesians, since they took expectations as given, thus ignoring the important role that the GT assigned to them.

Its main exponent is Tobin, 1981 Nobel Prize. Our presentation of the OKS will focus on the two issues raised by the Synthesis: the role of aggregate demand and the nature of aggregate demand.
AGGREGATE DEMAND

We shall adopt the following steps: we shall start with the IS-LM model and with its policy implications; we shall derive the aggregate demand curve AD and discuss its nature; we shall add the aggregate supply curve AS; we shall analyze the role of AD according to the OKS. THE IS-LM MODEL The Synthesis used Hicks IS-LM model for theoretical reasons; its purpose was to compare Mr. Keynes and the Classics. The OKS uses the IS-LM model for applied purposes; its purpose is to understand the real world and the role of macro policies. Let us then start with Hicks IS-LM model with given P. The expression for the LM curve (the money market equilibrium condition) is: - + M =L(r) Y P The slope of the LM curve is positive Given the real supply of money M/P, the positive effect on the demand for money L of an increase in income Y has to be offset by the negative effect of an increase in the interest rate r. M = L(r) Y P Put otherwise: Y L r (at any M/P) The position of the LM curve depends on the given M and P. If M/P rises, the interest rate r falls at any Y: the LM curve moves downwards. M =L(r)Y P Put otherwise: M/P r (at any Y) The following representation of the money market confirms that: at any M/P, the rate of interest rises as income grows (positive slope of the LM) at any Y, the interest rate falls when M/P increases (downward shift of the LM)

L(r)Y1 r L(r)Y0

M/P0

M/P1 r LM(M0/P0)

A(Y)

A(Y)
r0

0
B(M/P)
M/P

B(M/P)
Y0 Y1

The expression for the IS curve (the goods market equilibrium condition) Equilibrium income Y is equal to the multiplier 1/(1-c) (where c is the marginal propensity to consume) times autonomous expenditure [....] i.e. the expenditure which does not depend on income. The latter in turn includes a given component A and a term (d r) describing the depressive effect on investments of the interest rate level. The given component A is autonomous with respect to (independent of) Y and r and includes government expenditure, autonomous consumption and autonomous investment. Y= 1 [ A d r] (1-c) The slope of the IS curve is negative An increase in r is associated with a fall in investment I and income Y (amplified by traditional multiplier processes) at any A. LM(M /P ) IS(A ) r Y= 1 [ A d r] (1-c)
0 0 0

r0

Put otherwise: r I Y C Y (at any A)

Y0 Y

The position of the IS curve depends on autonomous expenditure A As A rises, income Y rises (by a multiplied amount) at any r: the IS curve shifts rightwards. IS(A ) IS(A ) r Y= 1 [ A d r] (1-c)
0 1

r0

Put otherwise: A Y C

Y (at any r)
Y0 Y

The solution of the IS-LM model (in terms of Y and r) The IS-LM intersection gives the solutions for Y and r corresponding to the given values of the exogenous variables A0 and M0/P0. At point 0, both the money and the goods markets are in equilibrium.

IS(A0)

LM(M0/P0)

r0

Y0

Monetary Policy in the IS-LM model An increase in money supply M implies a decrease in r at any Y. M/P=L(r)Y The LM curve shifts downwards. Equilibrium moves from 0 to 1: the interest rate falls (from r0 to r1) investment and income rise (from Y0 to Y1) To sum up: M/P r (LM) I&Y (on the given IS)

IS(G0)

LM(M0/P0)

r0 r1

0 1

LM(M1/P0)

Y0

Y1

Fiscal policy in the IS-LM model An increase in government expenditure G stimulates A and consequently Y at any r. Y= 1 [A-d r] (1-c) The IS curve shifts rightwards. Equilibrium moves from 0 to 1 equilibrium income Y rises the demand for money L rises the equilibrium interest rate rises this implies a partial crowding out of I To sum up: G A Y (IS) L r (LM) I&Y (new IS)
AGGREGATE DEMAND

IS(G0) r1

IS(G1)

LM(M0/P0) 1

0 r0

Y0

Y1

The IS-LM model assumes a given price level P. If we change the P level, we get the aggregate demand curve AD. Starting from the initial equilibrium point 0, let us then assume a fall in P.

IS(G0)

LM (M0/P0)
0 1

LM (M0/P1)

Upper panel If P falls, M/P rises (a monetary expansion) the LM curve moves downwards Yd=Y increases To sum up: P M/P r I Y C Y Lower panel Connecting point 0 (Y0,P0) and point 1 (Y1,P1), we get the AD curve.

AD
P0 P1

Y0

Y1

0
1

Y0

Y1

The AD curve summarizes the IS-LM model. It gives the Y,P combinations which simultaneously ensure the equilibrium of the money and of the goods markets. The slope of the AD curve is negative The increase in P generates a monetary restriction which depresses investment and thus equilibrium income. P M/P r I Yd=Y The position of the AD curve depends on economic policies!!
IS(G1)
r

IS(G0) 0

LM (M0/P0) 1F

1M

LM (M1/P0)

Upper panel Starting from point 0: a monetary expansion M&M/P brings us to 1M a fiscal expansion G brings us to 1F. In both the cases, income Y rises at any P. Lower panel If Y increases at any P, the AD curve shifts rightwards.

Y0

Y1

P0

1 AD0 AD1

Y0

Y1

THE NATURE OF AGGREGATE DEMAND

With regard to the nature of the AD curve, we can envisage two alternatives: the demand level Yd mainly depends on monetary factors (rigid LM curve) and consequently monetary policy is more important. the demand level Yd mainly depends on real factors (rigid IS curve) and consequently fiscal policy is more important. Orthodox Keynesians were definitely in favour of the second alternative. According to them: the IS curve tends to be relatively rigid; it mainly affects the demand level Yd.

the LM curve tends to be relatively flat it mainly affects the interest rate r. To sum up: AD is mainly determined by real factors fiscal policy is the best control weapon monetary policy affects r, but r has a negligible influence on Y. AGGREGATE SUPPLY

IS

LM

The OKS envisaged two AS curves: one for the short-run and one for the long-run. Short-run aggregate supply curve (SRAS) At any given money wage W, the marginal cost rises with Y prices rise with the marginal cost P=P(Y,W) The slope of the SRAS curve is positive: Y MgC=P (at any W) The position of the SRAS curve depends on the given W. W MgC=P (at any Y) The SRAS curve moves upwards.

SRAS(W0)

Long-run aggregate supply curve (LRAS) Money wages become fully flexible Unemployment (ESL) leads to a fall in W The labour market goes to its full-empl. equil. Output goes to its full-employment level The LRAS is a vertical line at Y=Yfe
P LRAS

Yfe

Given the two AS curves, we obviously have: a short-run equilibrium (the AD-SRAS intersection) a long-run equilibrium (the AD-LRAS intersection)

Short-run equilibrium AD-SRAS Let us start with short-run equilibrium point 0. Money wages are given at W0. Equilibrium income is Y0<Yfe. There is involuntary unemployment (excess supply of labour ESL).

P AD

LRAS

SRAS(W0)

Y0

Yfe

Transition to the long-run The excess supply of labour causes a fall in money wages W which implies a fall in marginal costs and prices W MgC=P (at any Y) The SRAS curve shifts downwards. Long run equilibrium AD-LRAS We move to the intersection ASLR-AD (point 1) Output goes to its full employment level Yfe. The labour market reaches its equilibrium. Money wages and prices stop falling.
P LRAS SRAS(W0)

AD

1
Y0
Yfe

THE ROLE OF AGGREGATE DEMAND As we have seen: short-run equilibrium is given by the AD-SRAS interception; long-run equilibrium is given by the AD-LRAS interception. Starting from a short-run under-employment equilibrium (point 0) there are two ways of reaching full employment income. Market mechanisms (0-1) Given the initial excess supply of labour: money wages and prices fall at any Y; the SRAS curve moves downwards; the system moves to its long-run equilibrium (1); income Y goes to its full employment level Yfe. Expansionary macroeconomic policies (0-2) With expansionary macroeconomic policies: aggregate demand Yd rises at any P; the AD curve moves rightwards; the system moves to long-run equilibrium (2).
P LRAS SRAS(W0)

AD

2 1

Y0

Yfe

The Orthodox Keynesian School claimed that economic policies are better since:

i) market mechanisms may take a long time Time matters for mortal human beings: in the long-run, we all might be dead. ii) short-run negative shocks are always possible Leftward shifts in the AD or SRAS curves may counteract the tendency to full employment and further increase short-run unemployment.

LRAS
P

AD0 2 0 1

SRAS1

SRAS0

AD1
Y1 Y0 Yfe

CONCLUSION ABOUT THE OKS Orthodox Keynesians belong to the Neoclassical Synthesis. Their starting point is consequently that market mechanisms are effective: in the absence of money wage and price rigidities, the system tends to its general (full employment) equilibrium. According to the OKS, in the short run (in which we live): money wages and prices tend to be rigid; we generally experience an under-employment equilibrium; Keyness theory (interpreted here as rigidity based) is right. In the long run, however, money wages become fully flexible; the system tends to its full-employment equilibrium; GET is right. As Keynes, OKs rejected the Says law. In their view: AD performs an active and crucial role; it determines output in the short-run; it determines the price level in the long run. As Keynes, OKs believed in active demand policies. In their view: market mechanisms take time; in the short-run, the State has to stimulate AD and income. As Keynes, OKs rejected the quantity theory of money, questioning the monetary nature of expenditure. M/P = L(r) Y (LM curve) can be written as M . 1 . = PY L(r) which becomes M V(r) = PY The velocity of circulation V is a positive function of the rate of interest r L(r) V(r) There may be no connection between M and PY M V(r)=PY As Keynes, OKs claimed that AD is a mainly real phenomenon.

The relevant equation for Y is the Keynesian multiplier (the IS curve) expression: Y= 1 [ A d r] (1-c) As Keynes, OKs believed that fiscal policy is more effective than monetary policy All of this explains why Orthodox Keynesians represented the Keynesian side of the Neoclassical Synthesis. Their expressly claimed to be followers of Keynes. Out of this, Orthodox Keynesians were strongly criticized by: Monetarists, who questioned the assumption of wage rigidity re-proposing the dogma of stability and the quantity theory of money. Heterodox economists, who objected that the rigidity-based interpretation of the GT adopted by the OKS neglects Keyness most innovative contribution: the crucial role of expectations and uncertainty, the failures of the price mechanism, the systems instabilityActually, in Keyness view, wage flexibility represented a source of additional problems, not a solution. The main problems for this school of thought came, however, from the real world. As known, the OKS assumed the downward rigidity of money wages and given expectations. In the 1950s and 1960s, these assumptions were somehow acceptable: price stability made them reasonably relevant and plausible. With the two oil shocks of the 1070s, however, the situation radically changed. In the inflationary context of the 1970s, the downward rigidity in money wages became irrelevant whilst the assumption of given expectations became totally unrealistic. OKS: EXTENSIONS In what follows, we shall consider some extensions of the OKSs framework. 1 EXTENSION: THE PHILLIPS CURVE This first extension concerns aggregate supply AS.
ST

In 1958 Phillips analyzed the data concerning the British economy over the period 1861-1957. With this, he found a strong econometric relationship between: the growth rate of money wages and prices (gw, gp) and the rate of unemployment (u). This relationship became a great success. It turned out to be true not only for United Kingdom but also for the other industrialized countries. The Phillips curve is shown in the following figure: a fall in the rate of unemployment (u) implies a rise in the growth rate (g) of nominal wages (W) and prices (P).

gw=gp

Phillips curve gw=gp=f(u)

u*

The message of the Phillips curve is that policy makers face a trade off: if they want to decrease unemployment, they have to accept a higher inflation rate. The fall in unemployment implies the increase in income. The Phillips curve thus corresponds to an upward sloping aggregate supply curve. The novelty is that this time aggregate supply is defined in terms of the inflation rate gp, rather than in terms of the price level P. u (Y) gw&gp The OKS added the Phillips curve to the IS-LM model. The upper panel below shows the IS-LM model. The lower panel below shows the upward sloping AS curve (in gp) corresponding to the Phillips curve. Remember that the position of the LM curve depends on M/P.
r

LM1 1 0 LM0

Initial point 0 The IS-LM model gives output Y0 The AS curve gives the inflation rate gp0 If the Central Bank keeps M constant: inflation decreases M/P; the LM curve shifts upwards; the system moves to point 1; Y goes to its not-inflationary level Y*; there is monetary stability gm0=gp0=0. If the Central Bank keeps M/P constant the LM curve remains where it is; the system remains in point 0; income remains Y0; M grows at the same rate as P (gm0=gp0)

gP

Y*

Y0

AS

gP0
Y* Y*

0 1 Y0

CONCLUSION Policy makers can keep income at Y0 (above its not-inflationary level Y*) In this case, however, they have to accept and to finance the corresponding inflation rate gp0. gm=gp

There is a trade-off between employment and inflation. To reach higher levels of employment, it is necessary to accept and to finance higher inflation rates. Inflation is not a monetary phenomenon: money simply accommodates it. In the 1960s, inflation was low. Policy makers were much more worried about unemployment. Central Banks tended to accommodate inflation. Theoretical justifications of the Phillips curve The Phillips curve was an empirical relationship. Given the relevance of its implications, it was very important to find a theoretical justifications for it. We shall examine two theoretical explanations inside the OKS: the one offered by Lipsey the one offered by Modigliani and Padoa Schioppa. LIPSEY The justification proposed in 1960 by Lipsey refers to the standard analysis of the labor market. According to the laws of supply and demand: if there is excess demand for labour (EDL>0), W and P rise (gw&gp>0) if the labour market is in equilibrium (EDL=0), W and P are stable (gw &gp=0) if there is excess supply of labour (EDL<0), W and P fall (gw &gp<0) Following Lipsey, let us assume: that the goods market (the IS-LM model) determines the level of output Y; that output in turn determines employment; that firms Ld curve determines the corresponding real wage W/P;
By aligning prices to marginal costs, competition between firms also aligns the real wage to the marginal product of labour on the Ld curve. In case of W/P>W/P* and EDL>0, overtime pay induces reluctant workers to overtime work.

the excess demand for labour EDL determines the growth rate (g) of money wages W and prices P. Starting from these assumptions, we can figure out three possible situations in the figure below. The upper panel shows the labour market; the lower panel shows the Phillips curve (PhC). Point B low L, high u L >L ; g <0 Employment Lb is below L*, unempl. ub>u*; Ld Ls There is excess supply of labour ESL (Ls>Ld). B Money wages W consequently fall. The Ph.C associates the high unempl. rate (ub>u*) L=L*; u=u* E L =L ; g =0 W/P* with falling money wages (gw<0). Point A A high L, low u Employment La is above L*(overtime pay & work) L >L ; g >0 There is excess demand for labour EDL (Ld>Ls). La Lb L* Money wages W consequently rise. The Ph.C associates the low unempl. rate (ua<u*) A gw>0 with rising money wages (gw>0). E gw=0 Point E ua ub u* There is labour market equilibrium (Ld=Ls). PhC gw<0 B Money wages W are stable.
s d w s d w d s w

The Ph.C associates the equil. unempl. rate u* with stable money wages (gw=0). Implications: the not-inflationary income level Y* coincides with full employment income. full employment implies a positive (in the subsequent debate, a natural) unemployment rate u*.
The aggregate equality Ls=Ld implies a number of unemployed (in some sectors, regions) equal to the number of vacancies (in other sectors, regions). In equilibrium, people searching for new jobs are temporarily unemployed

Doubts on Lipseys analysis: Lipseys explanation of the Phillips curve presupposes a generally unbalanced labour market. In equilibrium, Lipseys PhC becomes the equilibrium point corresponding to u=u*, gw=gp=0 Modigliani and Padoa Schioppa (1977) Modigliani is the one who contributed to the Synthesis. Padoa Schioppa died recently; he was an internationally known Italian economist. In the middle of the inflationary phase of the Italian economy, the two authors proposed a different explanation of the Phillips curve. They move to: a non-competitive regime the context of social conflict prevailing in the 1970s. Under these circumstances: the Ld curve gives the real wage which firms are available to pay at any L; the Ls curve gives the real wage which workers require at any L. As the activity level (Y&L) increases, confidence and social claims increase. Workers (less worried about loosing their job) require higher real wages: this is the reason why their Ls curve is upward sloping. Firms (less worried about loosing their market shares) require higher profits and consequently offer lower wages: this is the reason why their Ld curve is downward sloping. Let us now add the usual assumptions: the IS-LM equilibrium gives the income level Y0. according to the production function, the corresponding employment level is L0 in the following figure. Ld
W/Pw

Ls
B
A L* L0

W/Pf

At the employment level L0 below: the real wage required by workers is W/Pw; the real wage offered by firms is W/Pf; workers want more than what firms offer. Social conflict is thus shown by the vertical distance between the Ls and Ld curves AB= W/Pw- W/Pf

To analyze the consequences of social conflict, let us assume that:

firms determine the price level P workers (trade unions) determine the money wage W.
Ld W/Pw
B

Ls
Workers are happy Firms are not They P &W/P

W/Pf
L*

A L0

Firms are happy Workers are not They W & W/P

Point A. Firms are happy, workers are not. Trade unions ask for higher W. The real wage W/P rises. We move to point B. Point B. Workers are happy, firms are not. Firms raise the price level P. The real wage W/P falls. We go back to point A. Point A. Firms are happy, workers are not. Trade unions ask again for higher W. We return to point B and so on.

The result is the so called price-wage spiral that characterized the Italian economy in the 1970s. Inflation reflects the degree of social conflict: gw=gP=f( Ww - Wf) P P Higher Y and L levels imply: W/P a higher social conflict Ld higher inflation rates. This is an alternative way of justifying the Phillips curve the corresponding AS curve
0

Ls

L*

L0 0

The rest of the story is the same as before. On the basis of the underlying IS-LM model: If nominal money supply M is kept constant: -inflation will decrease M/P; -the LM curve will shift upwards; -Yd=Y and L will fall at their not-inflationary levels. If real money supply M/P is kept constant (i.e. if money supply grows at the same rate as W and P) -M/P will be constant -the LM curve will not move -Yd=Y and L will not change -employment will remain at the existing level L0 -the wage-price spiral will keep going. As before, the persistence of inflation needs an accommodating monetary stance. This time, however, the not-inflationary levels of employment L* and income Y*

are not related to full-employment (workers preferences/productivity): they simply imply the absence of social conflict! Social consensus/agreement makes it possible to expand income and employment without increasing the inflation rate. A decrease in social conflict implies: an upward shift in the Ld curve: firms reduce profits and offer higher wages a downward shift in the Ls curve: workers require lower wages The not-inflationary levels of employment L* and income Y* increase.
L*0 L*1 Ls0
W/P

Ld0

The Modigliani and Padoa Schioppa model can be applied to the past Italian experience. In the 1970s - the period of high social conflict (red brigades) and of the two oil crises - the Bank of Italy accommodated inflation. The wage-price spiral led to a two-digits inflation. In the 1980s, the Italian central bank adopted a restrictive anti-inflationary stance. Social conflict was reabsorbed by the fall in income and by the rise in unemployment. THE WEALTH EFFECTS OF FISCAL POLICY This second extension concerns the demand side of the economy and, specifically, the effectiveness of fiscal policy. Let us start with the traditional approach to fiscal policy of the Synthesis and of the Orthodox Keynesian School. Point 0 below represents an initial IS-LM equilibrium implying a balanced government budget G=T. A bond-financed increase in government expenditure G implies a rightward shift of the IS curve, leading us to point 1F. The increase in aggregate demand and income raises the demand for money and the interest rate. As a result, the new government expenditure implies a partial crowding out of private investment. To avoid this crowding out, the Central Bank has to increase money supply thus financing part of the deficit (point 1M) The increase in G is more expansionary when financed by money rather when financed by government bonds.
LM(M0/P0) 1F 0
1M

IS(G1)

IS(G0) r1 r0

LM(M1/P0)

Y0

Y1

The objection raised inside the Synthesis to the traditional IS-LM approach was that it ignores the wealth effects of fiscal policy (Silber 1967). To simplify, let us assume P=1. Let us then introduce the definition of financial wealth W*, composed by money M and bonds B. W*=M+B Subsequently, let us add the government budget constraint (Christ 1967). The financing of the government deficit implies an equivalent issue of money and bonds. As a consequence, the deficit gives rise to an equivalent increase in financial wealth W*. This in every period!! DF=G-tY=B+M=W* The creation of financial wealth W* in turn generates wealth effects both in the money market and in the goods market. Wealth effects in the money market (LM curve) Wealth stimulates the demand for money. The money market equilibrium condition (LM) thus becomes: M = L( r, Y, W*) An increase in financial wealth W*: raises the demand for money L raises the equilibrium interest rate r at any Y As a consequence: the LM curve moves upwards equilibrium income Y falls. W* L r (LM up) I Y (on the given IS)
r 1 0 LM0

IS0 Y

The restrictive wealth effects in the money market due to the financing of the government deficit repeat themselves in every period, leading to subsequent falls in equilibrium income.

3 2 1 0

LM0

IS0 Y

Wealth effects in the goods market (IS curve) Wealth stimulates autonomous

consumption and thus autonomous expenditure A. The goods market equilibrium condition (IS) then becomes: Y= 1 [ A(G, W*) d r] (1-c)

The increase in financial wealth due to the financing of the government deficit raises autonomous consumption and expenditure A. Income Y consequently increases at any r. The IS curve consequently moves rightwards. Equilibrium income Y rises. W* A Y

LM0 1 0

IS0 Y

The expansionary wealth effects on the goods market of the financing of the government deficit repeat themselves in every period, leading to subsequent increases in equilibrium income.

r 2 1 0

LM0

IS0 Y

To conclude, in each period the financing of government deficit gives rise to: restrictive wealth effects in the money market expansionary wealth effects in the goods market. The 1950s and 1960s were years of not-inflationary growth and of economic progress. It was then legitimate to believe that the economy were basically stable. Orthodox Keynesians thus assumed the systems stability. This led them to conclude that the expansionary wealth effects of government deficit prevail over the restrictive ones. Through the consequent expansion of income and of fiscal revenues, government deficit would end with balancing itself. In the medium-run, its wealth effects would then stop and income would reach a stable equilibrium level. DF= G - t Y=W*=0 In the figure below, government expenditure is exogenously given at G0. Tax revenues are a positive function T=tY of income, where the parameter t is the given tax rate. Initially, income is Y0 with G0>tY0. Let us assume that the financing of the initial government deficit DF 0=G0-tY0=W* considered as a whole has expansionary wealth effects. The consequent increase in income Y and in tax revenues tY will end with reabsorbing the initial government deficit. The system will thus reach the stable medium-run equilibrium point 1, with no government deficit, with no creation of wealth and wealth effects and with a stable equilibrium income level Y1.

G,T G0

T=tY 1 G0

T0=

Y0

Y1

As we have just seen, the stability of the system requires a balanced government budget: DF=G-tY=W*=0 In the medium-run, income Y has to generate a fiscal revenue tY equal to the given government expenditure G. The expression for medium-run equilibrium income thus becomes: Y=G/t The medium-run effect of government expenditure on equilibrium income consequently is Y/G = 1/t>0 The conclusion is that: government expenditure G has an expansionary effect on equilibrium income; this expansionary effect depends on the tax rate t: with a higher t, the income level needed in order to reabsorb the government deficit is lower; this expansionary effect does not depend on the way (M or B) in which it is financed: the effectiveness of fiscal policy does not require the support of monetary authorities.14 Orthodox Keynesians went even further. In the expression for the government deficit, let us introduce interest payments (iB), where i is the nominal interest rate and B is the stock of pre-existing government bonds. DF=G + iB - tY=W* G-tY is the primary deficit iB are interest payments on previously issued government bonds. The medium run equilibrium condition becomes: DF=G + iB - tY=W*=0 The expression for medium-run equilibrium income consequently becomes: Y=(G + iB)/t The medium-run effect on income of government expenditure thus becomes: Y/G= (1+ i B/G)/t>0 The conclusion is the following.
14

In order to focus on wealth effects, the exposition deliberately ignores the supply side of the money market. Let us now extend the analysis. Financial wealth generally stimulates the demand both for money and for bonds. In the case of monetary financing, the increase in money supply thus implies an equal increase in financial wealth that only partially turns into an increase in the demand for money. This means that the increase in money supply prevails over the increase in the demand considered in the text. The overall result is a downward shift of the LM curve that strengthens the expansionary effects of government expenditure. Medium run equilibrium income remains the one considered in the text. The novelty is that, in case of monetary financing, stability is granted and does not need ad hoc assumptions.

Government expenditure has again an expansionary effect on equilibrium income. This expansionary effect keeps depending on the tax rate t: in the presence of a higher t, the income level needed to reabsorb the government deficit is lower. This time, however, the way in which the deficit is financed is no more irrelevant. Bond financing (B/G>0) now becomes more expansionary than money financing (B/G=0). In the case of bond financing, the rise in equilibrium income and in tax revenues has to offset not only the initial increase in G but also the increase in interest payments iB. Comments The debate on the wealth effects of government deficit seems to represent an example of bounded rationality in economic theory: a myopic over-evaluation of the present. The conclusions on wealth effects derive from the assumption that the economic system is stable. In the 1950s and 1960s, this assumption was relatively plausible. Industrialized economies performed well; government deficits and debts were contained. According to nowadays experience, however, stability is not that granted. Industrialized countries are currently experiencing the worst crisis after the Great Depression. At the beginning, instability was endogenously generated by the financial sphere of the private sector. Subsequently, however, it has also affected public finances. In order to offset the dramatic consequences of the crisis, many countries have reached unprecedented levels of government deficit and debt. In the case of the weakest countries like Greek, Spain and Italy, the financial systems availability to buy government bonds has decreased. The bond-financing of their government deficits and the refinancing of their government debts are getting more and more expensive. This is the origin of the ongoing spread problem. An analogous example of bounded rationality in economic theory is offered by the recent pre-crisis experience. The nineties were goods years for the US economy. The industrial application of the ICT fuelled a period of sustained not-inflationary growth. The profession (the Chairman of the FED, Ben Bernanke, included) claimed that we had inaugurated a new era - the Great Moderation in which economic fluctuation would have been contained and under control. In a 2000 article, Blanchard (chief economist of the IMF) proudly wondered: What do we know about macroeconomics that Fisher and Wicksell did not? Slogans are often dangerous. Some years later, we face the opposite question: What did Fisher and Wicksell know about macroeconomics that we have forgotten? Bonds are promises to pay concerning interest payments as well as the repayment of the principal. Bonds will be considered as assets (as component of wealth) only insofar as these promises are credible. If the government has to represent a reliable debtor, its deficit and debt have not to be perceived as excessive and uncontrollable. This leads us to the problem of the sustainability of government debt. The sustainability of government debt As we have seen, in a static economy the medium-run stability of the system requires: a constant stock of bonds a zero government deficit. G + rB - tY= B=0

Let us now move to a growing economy. If income Y grows, the stock of bonds B too may grow. The problem is that the ratio B/Y has not to rise. Such a rise might undermine the confidence on government bonds of financial markets. Let us consider the government budget in nominal terms and in discrete time. By assumption, T=G. DFt = (G-T) + i Bt-1= i Bt-1=Bt = Bt - Bt-1 where: G=T are given nominal variables i is the given nominal interest rate Bt-1 is the stock of government debt at the end of the previous period Bt is the stock of government debt at the end of the current period According to the previous expression, government debt self-feeds itself (si autoalimenta). The existing stock of government bonds (Bt-1) generates interest payments (iBt-1) which imply new bond issues, thus increasing the stock of government debt (Bt). Every euro of todays debt implies (1+i) euros of tomorrows debt. The growth rate (g) of government debt (B) is thus equal to the interest rate (i). Government debt self-feeds itself, growing at a rate equal to the interest rate. gb=i15 The growth rate of nominal income gPY is given by the inflation rate gP plus the growth rate of real income gY. gpy=gp +gy The government debt sustainability condition requires that the growth rate of government bonds is not greater than the growth rate of income. Such a condition can be thus formulated in two alternative ways: in nominal terms, the nominal interest rate i has to be lower than, or equal to, the growth rate of nominal income. i < gp +gy in real terms, the real interest rate r=i-gp has to be lower than, or equal to, the growth rate of real income gy. r (= i - gp) < gy This means that government debt sustainability also depends: on the availability of financial markets to buy government bonds (via interest rate) on monetary policy (again, via interest rate) on the growth rate of the economy (via real income) Specifically, the sustainability problem can be accentuated:
15

If government deficit is not balanced, government debt grows more rapidly at the beginning but at the end its growth rate tends to be equal to the interest rate. Dividing the expression for the deficit by Bt-1, we get gb = Bt - Bt-1= ( G-T ) + i Bt-1 Bt-1 In the presence of a bond financed government deficit, B automatically grows with the passing of time and consequently the ratio G-T/ Bt-1 tends to zero. The growth rate of government debt consequently tends to g b=i; independently of the given level of the initial deficit.

by a crisis of confidence in government bonds by a restrictive monetary stance by a low growth rate of the economy The afore-mentioned sustainability condition: is often mentioned in the economic policy debate (newspapers, television and so on). is particularly relevant for Italy, given its high government debt/GDP ratio The condition, however, is only a rule of thumb. It is based on crucial simplifying assumptions, for instance: that the interest rate is given, independently of G-T that the real growth rate gy is given, independently of G-T. that the inflation rate gp is given, independently of G-T. To analyze the problem properly, we should develop a model. The results, however, would then depend on the specification of the model itself. The historical experience of the last decades shows that government debt sustainability can represent a problem. Public finance is not as stable as Orthodox Keynesians thought.
NEOCLASSICAL OBJECTION TO THE EFFECTIVENESS OF FISCAL POLICY

We shall refer to Barro 1974: Are government bond net wealth? Barros different perspective Orthodox Keynesians considered bonds as financial assets of the private sector. However, government bonds also represent debts of the state! In the future, these debts will have to be repaid by new taxes. The anticipation of these future taxes has depressive effects on consumption As a result, government expenditure may become totally ineffective: it may end with crowding out private consumption. Barros basic assumptions: there is perfect coordination, prices clear all the markets; income is always at its full employment level; there is perfect knowledge, agents know the future. (In such a perfect world, however, any policy seems destined to be ineffective!) The consumer plans her/his consumption for the whole life. Life is composed by two periods: the present (period 0) and the future (period 1). Todays and tomorrows decisions are strictly interconnected. If the consumer saves sacrificing todays consumption (C<Yd), it is in order to consume more tomorrow. If the consumers dissaves today (C>Yd), she/he will inevitably have to consume less tomorrow in order to repay her/his debt. Present and future are connected by the consumer inter-temporal budget constraint, which requires the equality between: the present value of consumption PVC the present value of disposable income PVYd PVC=PVYd

Specifically C0 + C1 = Y0 + Y1 - T0 - T1 (1+r) (1+r) (1+r)

1 today Analogously, 1 today (1+r) This means that: 1 today (1+r) is equivalent to (1+r) tomorrow is equivalent to 1 tomorrow is the present (actual) value of 1 tomorrow

By isolating C1 on the right hand side, the inter-temporal budget constraint becomes a sort of consumption frontier. Given the capitalized (the future) value of disposable income [], a higher C0 today implies a lower C1 tomorrow. C1 = [Y0 (1+r)+Y1-T0 (1+r)-T1] - (1+r) C0 The intertemporal budget constraint is shown by the downward sloping line in the figure. The optimal solution is point O, where the budget constraint is tangent to the highest indifference curve. In the figure, the utility function is such that the consumer prefers a stable consumption path. The solution thus is: C0=C1=C

C1

O C1

45

C0M

*= LM
0

C0

Point A below shows the given income levels in the two periods (Y0,Y1). Without financial system, our consumer would have had to choose point A, on a lower indifference curve (corresponding to a lower utility level). Specifically, she/he would have been forced to choose: a higher current consumption C0=Y0 in period 0 a lower future consumption C1=Y1 in period 1

C1

O C1 S0(1+r) Y1 S0 C0 Y0 C0 A

In the presence of the financial system, by contrast, our consumer can reach the optimal solution (point O) (corresponding to a higher utility level) and stabilize her/his consumption (C0=C1=C) as desired. Specifically, in period 0 she/he can consume only C0=C and save Y0-C0=S0 in period 1 she/he can rise her/his consumption from Y1 to C0=C=Y1+(1+r) S0. What about fiscal policy? As known, the consumers inter-temporal budget constraint is: PVC=PVYd i.e. C0 + C1 = Y0 + Y1 - T0 - T1 (1+r) (1+r) (1+r) Analogously, the governments inter-temporal budget constraint requires that the present value of government expenditure (PVG) is equal to the present value of taxes (PVT). PVG=PVT i.e. G0 + G1 = T0 + T1 (1+r) (1+r) Today, the government may run a bond financed deficit G0-T0=B0. Tomorrow, however, it will have to repay its debt (1+r)B0=(1+r) (G0-T0) by running a corresponding surplus T1-G1. T1-G1=(1+r)B0=(1+r) (G0-T0) By substituting the governments into the consumers budget constraint, we get C0 + C1 = Y0 + Y1 - G0 - G1 (1+r) (1+r) (1+r) First implication; the tax and bond financing of G are perfectly equivalent

-a tax financed government expenditure G0 implies T0=G0 taxes today. -a bond financed government expenditure G0 implies T1=G0(1+r) taxes tomorrow, -the present value of taxation is the same in both the cases (PVT=G0). This leads us to the famous Ricardian equivalence theorem: bonds are not wealth, they are future taxes. Tax financing and bond financing are perfectly equivalent. Second implication: government expenditure crowds out private consumption We have seen that a new government expenditure G0, however financed, raises the present value of taxation by G0. From the consumers point of view, it thus implies an equivalent fall in the present value of her/his disposable income an equivalent fall in the present value of her/his consumption. Government expenditure crowds out an equal amount of private consumption. Third implication: a bond financed government expenditure stimulates current saving In the case of a new government expenditure G0 financed by bonds, the new taxes T1=G0(1+r) will be collected tomorrow, when government bonds will have to be repaid. The consumer has to save more in order to be able to pay these new future taxes. Comments: Barros results obviously depend on his initial assumptions; first of all, the assumption of a full-employment income Y which by itself implies the ineffectiveness of government expenditure. 3rd extension: the long-run IS-LM model According to the OKS, in the long-run money wages and prices become perfectly flexible. The labour market reaches its equilibrium; outputs Y goes to its full employment level Yfe. The long-run aggregate supply curve LRAS is a vertical line at Yfe. Let us analyze the long-run working of the IS-LM model.
LRAS IS E

LMe(M/Pfe)

rfe, rfe

Yfe

The long-run equilibrium of the real sector is given by the intersection IS/LRAS Yfe, rfe The LM curve is passive: its position (i.e. M/P) has to adapt itself to the intersection IS/LRAS. M/Pfe=L(Yfe, rfe) This adaptation is based on the price level P, at the given level of M M Pfe (& Wfe)

There is dichotomy. Real equilibrium does not depend on the nominal scale of the economy

r
IS

LRAS

The labour mkt gives the LRAS curve and output Yfe.
LMe(M/Pe)

The goods mkt (IS curve) gives rfe, the interest rate at which Yd(r)=Ysfe. (a real variable). The money mkt gives M/Pfe. Given Yfe&rfe, M/Pfed and consequently M/Pfes are given. Point E represents a real equilibrium (Yfe, rfe, M/Pfe) independent of the nominal scale of the economy (M, P, W).

Yfe

Monetary policy is ineffective: money is neutral. Money supply M does not affect M/P; it only determines the price level P (and money wages W). The figure below shows the case of a monetary expansion. LRAS From 0 to 0: monetary expansion r LM0 IS M M/P r (LM) I&Yd (on the IS curve) Point 0: excess demand for goods Yd0>Yfe 0 Adjustment mechanism: P M/P LM1 Point 0: we go back to the initial position.
0 -The LM is passive: its position has to adapt itself to the ISASLR intersection. -Equilibrium real money balances M/Pfe (the LM position) is consequenly given by the real sector. -An increase in M creates an equi-proportional increase in P.

Yfe

Yd0

Fiscal policy too is ineffective Let us assume a bond financed increase in government expenditure.
r IS0 IS1 LRAS 1 LM(M0/P1) LM(M0/P0) 0 Point 0: initial equilibrium. Point 0: G Yd (IS): excess demand for goods Yd0>Yfe Adjustment mechanism: P M/P r (LM) Point 1; new equilibrium at Yfe again. Equilibrium income does not change The crowding out of I is -total -real (the constraint is Y=Yfe)

Yfe

INFLATIONARY EXPECTATIONS Before we have considered a non inflationary regime, with once and for all changes in M and P. Let us now move to an inflationary regime with: rising money and prices gM=gP>0 an expected inflation rate equal to the effective one gPe=gP >0 Expected inflation introduces the distinction between the nominal (i) and the real (r) interest rate: i=r+gPe According to the IS-LM model, the wealth holder has the choice between money and bonds. Inflation decreases the real value of both of them (M/P&B/P).

The cost of money holdings (i=r+gPe) is given by the real interest rate on bonds (r) plus the expected loss in purchasing power due to inflation. The traditional LM curve will thus be defined in terms of the nominal interest rate i. The new LM* curve in the figure (in r= i- gPe) gives the real interest rate r. The vertical distance between the two curves is obviously equal to expected inflation gPe.
i,r LM (in i) LM* (in r=i-gPe) gPe

For investors, what matters is the real interest rate r. Inflation reduces the real value of loans. It thus represents a gain for firms who borrow in order to invest. The real cost of borrowing is thus r= i- gPe For the IS curve, what matters is the LM* curve (in r). The equilibrium real interest rate (rfe) is given by the interception LRAS/IS. The relevant LM curve (the LM*) has to intersect that point (via fluctuations in P). Point R thus represents the equilibrium of the real sector (Yfe, rfe). Point N represents the equilibrium of the monetary sector (ife=rfe+gPe).
LRAS ife r
fe

LM gPe

(in i= r+ gPe) LM* (in r)

IS Yfe

The figure below analyzes the full employment effects of inflation. In the initial situation of monetary stability where gP=gPe=0 the nominal interest rate coincides with the real one (i0=r0) the LM0 (in i) curve coincides with the LM0* (in r) the real and the nominal equilibrium of the system coincide with point R0 Let us move to an inflationary regime where gM=gP=gPe>0 real equilibrium remains at R0 the real interest rate remains at r0 the LM0* curve (in r) coincides with the initial one. the LM curve (in i) moves upwards to LM1 the nominal equilibrium of the system moves to N1 the nominal interest rate i raises by an amount equal to expected inflation (i1=r0+ gPe)

LRAS N1

LM1 gPe

(in i)

i1 i0=r0 =

R0=N0

IS0 Yfe

Adjustment mechanism Inflationary expectations initially imply a corresponding fall in the real interest rate (r) at any given nominal interest rate (i). The LM* curve (in r) falls below the unchanged LM curve (in i). This has expansionary effects on investment and aggregate demand (on the unchanged IS curve). Since output is already at full-employment, however, the higher demand will only increase the price level P. The consequent fall in M/P will raise the nominal and the real interest rates. The LM* curve (in r) and the LM curve (in i) will both shift upwards, At the end, the real interest rate (r) will go back to its initial level. The only effect of inflation will be an equivalent increase in the nominal interest rate (i) in the figure.16.
LRAS N1 R0=N0 0 IS0 Yfe LM1 LM0= LM*0=LM0=LM*1 LM*0

i1 i0=r0 =

Who cares about the increase in the nominal interest rate? To answer, let un focus on the money market. Inflation decreases the purchasing power of money. Expected inflation gPe consequently raises the cost of holding money (i). The demand for money L thus falls in favour of the demand for goods. The excess demand for goods raises the price level P. The real supply of money M/P consequently falls, aligning itself to the lower demand. Money market equilibrium moves from point 0 to point 1. M = L(i, Yfe) P

16

Looking at the LM1, however, this reflects a rise in the price level P and a fall in M/P. We shall come back to this below.

M/Ps1 i1 r1=r0=i0 1 gPe 0

M/Ps0

Inflation tax

M/Pd

M/P1

M/P0

The conclusion is that inflation implies an inflation tax, with tax rate gPe and tax base M/P1. As a consequence of this tax, real money balances M/P fall from M/P0 to M/P1. Since money is wealth, this is the welfare loss due to inflation. Conclusion In a regime of flexible money wages and prices: Money is neutral Changes in the level of money supply M imply equi-proportional changes in the level of P, leaving M/P and all the other real variables unchanged. The level of M does not really matter. Money is not super-neutral Changes in the growth rate of money supply M imply an inflation tax on money holdings that in turn decreases M/P. Real money balances M/P are real wealth, this is thus a real welfare cost. The growth rate of M really matters. LEIJONHUFVUDS HETERODOX VIEWS ABOUT INFLATION The empirical value of the inflation tax is negligible. Thus, according to neoclassical theory, anticipated inflation has no relevant real costs. Nominal variables grow at the same rate as M, real variables remain (essentially) the same. The real world however, is radically different. In a 1995 book, Leijonhufvud and Heymann analyze the experience of high inflation in Argentina. Inflation implied a great contraction in economic activity (not only a negligible inflation tax). How to explain this?? Leijonhufvuds and Heymanns answer is the following. Under an inflationary regime, uncertainty increases. The result is that: agents and economic policy authorities loose the ability to forecast the future. They have no idea about future costs, future price levels, future profits, future interest rates, and so on. Between the phone call and her/his arrival, the taxi driver has already increased the price. When uncertainty is so high, economic decisions become more difficult to take. medium and long-term contracts disappear. -in financial markets, the segments beyond twelve months disappear; only very short-term assets are exchanged. -in the real sector, investments drastically fall. All of this entails heavy depressive repercussions on the real economy.

Monetarism
(English to be revised) The Monetarist School flourished from mid-1950s to mid-1960s. This school represented the neoclassical component of the Synthesis. Its aim was to restate the pre-Keynesian Quantity Theory of Money. Milton Friedman was the leader of the Monetarist School; he got the 1976 Nobel Prize. The following presentation of his contribution will focus on the two issues raised by the Synthesis: the nature of aggregate demand the role of aggregate demand.
THE NATURE OF AGGREGATE DEMAND

Basic Questions Is aggregate demand mainly a real or a monetary phenomenon? Do shocks mainly come from the real or from the monetary sector? To be more effective is fiscal or monetary policy? Orthodox Keynesians answered that: aggregate demand is a real phenomenon; the basic equation for Y is the expression below of the Keynesian multiplier; income fluctuations are mainly due to real disturbances: expectations, and thus the investment component of autonomous expenditure A, are highly volatile. fiscal policy is the most efficient weapon for the control of A and consequently of economic activity. Y = [A - d i] Monetarists objected that aggregate demand is a monetary phenomenon; the basic equation for Y is the one at the basis of the Quantity Theory; monetary shocks are the main source of fluctuations in nominal income; monetary policy is the most efficient weapon for the control of economic activity. (M) V = (PY) The crucial role assigned to money explains the label Monetarism In order to present the monetarist view about the nature of aggregate demand, we shall start with: Friedman (1956), The Quantity Theory of Money: a Restatement. This article was published in the same year as the 1st edition of Patinkins book, which completed the Synthesis. As the title claims, its aim was to restate the Quantity Theory of Money. The IS-LM model adopted by Orthodox Keynesians focused on the allocation of financial wealth between money and bonds. Friedman extends the concept of wealth; in his view, wealth W* includes all what yields

future income streams either in monetary or in non monetary terms. The main components of wealth - and the corresponding income streams - are shown in the following table. Assets
Money M Bonds B Equities E Durable goods G Human capital H

Pecuniary or not pecuniary income streams

Transactions, precautionary and speculative non-pecuniary services, whose amount depends on the purchasing power of the stock of money (ceteris paribus, on P) Nominal interest payments, in percentage equal to the nominal interest rate on bonds rb Dividends d (a share of firms real profits which in percentage ensure a real return re ) plus expected inflation gep (an expected capital gain on real assets) Non pecuniary services (car, washing machine, flat). Their value is expected to rise with expected inflation gep Labor incomes, corresponding to a percentage return h on human capital H.

Returns
P rb re+gep gep h

On this basis, Friedman deduces that the nominal demand for money Md is: a demand for real money balances M/P, i.e. a positive function of P; a negative function of the rates of return on non-monetary assets; a positive function of nominal wealth W*. Md=f(P, rb, re+gep, gep, h, W*) As we have seen, wealth has the property of yielding future incomes streams (pecuniary or not) If we multiply nominal wealth W* by the average interest rate r, we get the average future nominal income stream. Friedman defines it as permanent nominal income Ynp. Ynp=r W* Without explanations, Friedman then assumes that current income is equal to permanent income. The superscript p thus disappears. Yn=r W* This means that W*= Yn /r The equation for the nominal demand for money then becomes: Md=f(P, rb, re+gep, gep, h, Yn/r) This function can be further simplified: the twofold negative effect of gep can be unified. the average interest rate in Yn/r can be removed; its role is captured by individual rates of return. Md=f(P, rb, re, gep, h, Yn) Finally, we have to consider that what is relevant is the amount of money in real terms M/P. If nominal variables (P and PY) double, the nominal demand for money Md too doubles. 2Md=f(2P, rb, re, gep, h, 2Yn) More generally, if P and PY grow by , Md too has to grow by . Md=f(P, rb, re, gep, h, Yn) Given nominal income Yn =PY, by setting

=1/Yn =1/PY we get (1/PY) Md= f(1/Y, rb, re, gep, h, 1) This means that Md= f(1/Y, rb, re, gep, h, 1) PY In equilibrium, Md is equal to the exogenously given money supply M. The money market equilibrium condition consequently becomes: M= f(1/Y, rb, re, gep, h, 1) PY Friedman highlights that everybody (even Keynes himself) would agree on this result. What is then the distinguishing feature of Monetarism? According to Friedman, Monetarism is characterized by the following assumptions: the supply of money M is exogenous the f() function behaves like a constant. This can be due to many reasons: -the variables inside f() come from the real sector and are consequently given for the monetary sector; -the variables on which f(..) depends do not vary with time by a significant amount; -the variables on which f(..) depends vary with time, but their effects on f(...) offset each other. -f(..) has a very low sensitivity to its determinants: more generally, f(..) is a stable and predictable function of a limited number of variables. Under these assumptions: nominal income PY becomes a stable and predictable function of the given money supply M; put otherwise, nominal income is a monetary phenomenon; economic fluctuations reflect nominal shocks; money supply is the best control weapon. PY = f(1/Y, rb, re, gep, h, 1)-1 M When money supply M increases, the excess supply of money will turn into a demand for alternative assets. Partly through the fall in interest rates and partly (as we shall see, above all) through wealth effects, this will stimulate the value of expenditure on goods and services. M PY To sum up, Monetarism (the modern Quantity Theory proposed by Friedman) is essentially a monetary theory of nominal income. It is the equation above (not the expression for the Keynesian multiplier) that we have to estimate in order to explain and to forecast the time behaviour of nominal income. With regard to the debate animating the Synthesis, Friedman (1956) proudly adds that Monetarism represents THE general theory: Old Classics took real income Y as given at its full employment level;. Keynes (according to the mainstream interpretation) took money wages W and thus P as given; Monetarism focuses on nominal income PY, without introducing ad hoc assumptions in order to distinguish between real income Y and prices P. In his (1958) article, The supply of money and changes in prices and output, Friedman claims

that the relationships between M and PY is strongly confirmed by econometric evidence. Money and nominal income have a very similar cyclical behavior. The peaks (troughs) in the money cycle, however, anticipate the peaks (troughs) in the nominal income cycle. This confirms that causality runs from money M to nominal income PY: nominal income is a monetary phenomenon. M PY
M, PY

M PY

peaks troughs

time

The debate between Friedman and Tobin In a 1970 article entitled Money and income: post hoc ergo propter hoc, James Tobin - leader of the Orthodox Keynesian School - objected that: post hoc does not mean propter hoc put otherwise, afterwards does not mean as a consequence of. Firms have generally to get bank credit before investing, and bank credit in turn stimulates money supply. The expansion in bank credit and in money supply thus anticipates the expansion of expenditure and income. Nevertheless, it is a consequence of the higher propensity to spend. More generally - according to Tobin - money supply M is endogenous.17 The existing amount of money depends on the behavior of the economy. As a consequence, it is outside the control of the central bank. Let us see why. As mediums of payment, we use: currency CU (coins and banknotes in our pockets) bank deposits D. Money supply can be consequently defined as: M = CU + D According to the budget constraint of the banking system, bank deposits D are equal to bank reserves RE plus bank credit CR. D = RE + CR By substituting above, we get that: M=CU+RE+CR By definition, the coins and banknotes issued by the central bank
17

According to Tobins (1963) article entitled Commercial banks as creators of money, however, the distinction between banks and the other financial intermediaries in not sharp. For a recent debate on this issue, see the web site uneasy money.

represent the monetary base or the high powered money (H), which in its turn is held partly by the non bank public (as currency CU) and partly by banks (as bank reserves RE). H=CU+RE The result is that M=H+CR Money supply has thus two components: the high powered money - or monetary base H, which is issued by the central bank bank credit CR, created by the banking system by buying bonds (promises of payment) or by granting loans. To conclude, the banking system too creates money. When you get a credit from a bank, you exchange a promise of payment (a non monetary asset) against banknotes or deposits (a monetary asset). Thanks to bank credit, the quantity of money available to the non-bank public rises. In Friedmans view, the most important component of money supply is the high powered money or monetary base H issued by the Central Bank. Bank credit (and thus the whole money supply) can be considered as a multiple of H. 18 The control of H by the central bank consequently ensures the control of the whole M. The supply of money is exogenously determined by monetary authorities. In the relationship between money and nominal income, causality thus runs from the former to the latter. M PY According to Tobin, by contrast, the main component of money supply is represented by bank credit. This variable is determined by banks and by their customers, not by the monetary authorities.19 This means that bank credit and money supply are endogenously determined by the economic system. In the relationship between money and nominal income, causality runs from the latter to the former. PY CRd CRs M=H+CR To conclude, Tobins objection to Friedman is that: the quantity theory equation explains money supply M, not income Y. income is determined by the Keynesian multiplier (1/1-c) and by autonomous expenditure A.
18

Let us assume that the desired amount of CU and RE is a given fraction of bank deposits D, i.e. that CU=cu D, RE=re D, CR=(1-re) D. From H=CU+RE we have that: D=[1/(cu+re)] H Since M=CU+D=(1+cu) D, we can conclude that: M=[(1+cu)/(cu+re)] H The Keynesian multiplier [1/(1-c)] focuses on the interdependence between expenditure and income, coming to the conclusion that in the goods market income Y is a multiple of autonomous expenditure A. The money multiplier [(1+cu)/(cu+re)] focuses on the interdependence between bank deposits and bank credit according to which the monetary based deposited into the banking system comes back to the non-bank public through bank credit and is deposited again. The result is that the stock of money M is a multiple [(1+cu)/(cu+re)] of the monetary base H created by the central bank. In Friedmans view, the parameters cu and re (and consequently the whole money multiplier) can be considered as given. The control of the monetary base H by the central bank consequently ensures the control of the whole supply of money M. According to Tobin, by contrast, cu and re are not given. They reflect the choices of banks and of their customers and consequently depend on the behavior of the economy. 19 The endogenous nature of money is one of the tenets of the Post Keynesian School. This issue is crucial. As we have seen, if money is endogenous, the fall in money wages and prices is unable to lead the system to its full employment equilibrium.

Extending Tobins approach, we may notice that money supply can be endogenous also in the absence (and thus independently) of the banking system, i.e. when M=H. This can happen as a consequence of the strategy adopted by the central bank. Given the demand for money function (L), the monetary authority has two options: it can control the amount of money (M); in this case, money supply is exogenous whilst the rate of interest (i) is endogenously determined by the demand for money. it can control the interest rate (i); in this case, the latter becomes endogenous whilst money supply is endogenously determined by the demand for money.
i Md=L(i)PY Ms

Ms

The choice between the two intermediate targets (the quantity of money M and the interest rate i) will depend: on their controllability by the central bank; on their ability to affect the final targets (output, prices..) of the central bank.
Strategy of the Central Bank Instruments
(open market operations)

Intermediate Targets
(money supply, interest rates)

Final Targets
(expenditure, output, prices.)

Until the 1990s, the strategy of monetary authorities was generally based on the control of money supply. In line with the Quantitative Theory, this was meant to ensure the control of expenditure and prices. With time, however, this strategy proved increasingly impracticable and ineffective. The stock of money proved increasingly difficult to control. The link between money and expenditure (the velocity of circulation) became increasingly unstable and unpredictable. Given the impracticability and the ineffectiveness of the control of money supply, monetary authorities moved to the control of the interest rate. Currently, central banks set the interest rate and offer all the amount of money that the system requires. Put otherwise, the interest rate is exogenous whilst money supply is endogenous. Tthe conduct of modern central banks is usually described by the Taylor rule: it = (rt* + gpt*) + a (gpt - gpt*)+ay (Yt-Yt*) where the asterisked variables represent desired/target values; the non-asterisked variables represent observed/expected values; the coefficients a and ay represent given parameters with positive values.

In the previous equation: the first term on the right-hand side (rt*+gpt*) represents the nominal interest rate desired by the central bank i*, given by the sum of the desired real interest rate rt* plus the desired inflation rate gpt*. the last two terms on the right hand side (gpt - gpt*) and (Yt-Yt*) tell us that, whenever inflation gpt or output Y are higher than desired, the central bank restricts the economy by raising the interest rate i above its target level i*. The following graph compares the actual Fed funds rate with the value generated by the Taylors rule. The Taylor rule seems to be a reasonably good representation of the U.S. monetary policy!! The same holds for many Central Banks of other industrialized countries (EMU, UK..).

Thus, if we consider the experience of nowadays, Tobin was right in highlighting the endogenous nature of money supply.
THE DANGEROUS LIAISON BETWEEN MONEY AND INCOME

As we have seen, the demand for money function is the starting point of Monetarism. This function is analyzed in more detail in two famous articles: Friedman 1970, A theoretical framework for monetary analysis Friedman 1971, A monetary theory of nominal income. Following Fisher, Friedman starts with the distinction between the nominal interest rate (i) and the real interest rate (r). As known, the relationship between the two is: i = r + gep By holding money, we have two kinds of costs: the real interest rate on alternative assets (r); the expected fall in moneys purchasing power due to expected inflation (gep) It is thus the nominal interest rate (i = r + gep) which is relevant for the demand for money (L). In a not-inflationary environment in which gep=0, nominal and real interest rates coincide. The money market equilibrium condition can thus be written in the usual way, where r=i is the average interest rate. M=L(i=r) PY In an inflationary environment in which gep>0, however, nominal and real interest rates diverge. Since the demand for money depends on the nominal interest rate,

the money market equilibrium condition becomes: M = L(i=r + gep) PY As an example, let us start with an initial equilibrium where: -money supply M grows at a rate of 6% -nominal income PY grows at a rate of 6% -prices P grow (for instance) at a rate of 3% -real income Y grows at a rate of 3% -expected inflation gep is 3% (in equilibrium expectations are correct) 6% 3% 3% 3% M = L( r + gep) P Y Let us now assume that -the growth rate of money supply raises to 12%. -the real interest rate r does not change We shall reach a new equilibrium where: -money M grows at a rate of 12% -nominal income PY grows at a rate of 12% -prices P grow (for instance) at a rate of 6% -real income Y grows at a rate of 6% -expected inflation (as current inflation) gep is 6% (in equilibrium expectations are correct) 12% 6% 6% 6% M = L( r + gep) P Y In each of the two equilibrium situations, money M and nominal income PY grow at the same rate: first by 6% and then by 12%. In the transition phase, however: -expected inflation gep rises from 3% to 6%. -the nominal interest rate i=r+gep rises -the speculative component of the demand for money L(..) falls -nominal income grows at a rate higher than 12% M = L(r + geP) P Y Friedmans analysis can be represented in the following figure. At time T , the growth rate of money supply exogenously rises from 6% to 12%. In the old and in the new equilibrium, money M and nominal income PY grow at the same rate (firstly 6% and then 12%). The two series, however, do not coincide. In the transition period, as inflationary expectations rise, PY grows faster than M.
0

logM, logPY

logPY

Transition geP i L PY

log M
12%

6%
Old equilibrium

T0 Transition

New equilibrium

Time t

The example considered above implies a regular transition to the new equilibrium. In Friedmans view, however, the monetary sector may also be unstable. The change in the growth rate of M may then imply an explosive reaction in PY.

Log PY Log M, LogPY

Log M

Time t

The cumulative process which leads to the explosive reaction of income is due to the interdependence between gep and L(..). On the one hand, the rise in expected inflation (gep) implies an increase in the nominal interest rate i=r+ gep which reduces the demand for money L. gep i L On the other hand, the decrease in L implies an increase in the demand for goods which fuels actual and thus expected inflation. L gp gep Starting with the monetary nature of aggregate demand, Friedman consequently comes to the conclusion that money: is a powerful weapon for the control of nominal expenditure; but is also so powerful that it can be destabilizing. Friedmans belief is consequently that central banks: should not pursue a short-term perspective, using money as a countercyclical tool for the fine-tuning of economic activity; should instead adopt a long-run perspective, using money to accommodate the growth of real income (gy) without leaving any room to inflation (gp).

Friedmans monetary policy rule consequently is: gm=gy Comments on Friedmans analysis about the nature of AD i) The real interest rate r To simplify, let us consider a not inflationary environment. In terms of the IS-LM model with P given that was used by the Synthesis, the Monetarists framework is the opposite of the Orthodox Keynesians one: -the interest rate (i=r) is given by the real sector (a flat IS curve) -real income is given by the monetary sector (a rigid LM curve)
LM

r=i

IS

By assuming that the real interest rate r is given, however, Friedman too introduces an ad hoc assumption. With this, he can no longer present Monetarism as THE general theory. Downsizing its ambitions, he is forced to recognizes that: -Old Classics took real income as given at its full-employment level -Keynes (orthodox interpretation) and Orthodox Keynesians took nominal wages and prices as given -Monetarists take the real interest rate as given. At this stage, Friedman also comes to admit that his ad hoc hypothesis of a given interest rate lacks a convincing theoretical justification. To quote his own words, in the absence of this justification his monetary theory of nominal income resembles the Shakespearean play of Hamlet without its Prince. If Friedman subscribes to the Quantity Theory of Money, however, it is because he firmly believes that (contrary to the money sector) the real sector is stable. -Thanks to the price mechanism, the labour market tends to its equilibrium. -Aggregate supply consequently tends to its full employment level Yfe. -The goods market (the IS curve) gives the interest rate (a real variable) which aligns Yd to Yfe. -The LM curve is passive: it adapts itself to the ASfe-IS intersection through the fluctuations in P. -Equilibrium money balances M/P are given by the ASfe-IS intersection (by the real sector). -Money is neutral: money supply can only affect the price level.

ASfe

LM(M/P)

r=i

IS
Yfe

ii) The nominal interest rate According to Orthodox Keynesians, a monetary expansion implies a fall in the nominal interest rate. M i According to Friedman, the opposite happens. A monetary expansion raises actual and thus expected inflation. Given the real interest rate, it consequently raises the nominal interest rate. M i = r+ geP iii) The velocity of circulation V According to the Old Classics, the velocity of circulation was an institutional constant. Real income was at its full employment level. The result was the neutrality of money.. MV=PY According to Keynes, the equilibrium condition of the money market is M=L(i) PY The velocity of circulation is the reciprocal of L(i). 1/L(i)=V(i) This means that V is a positive function of the interest rate i (instead of being a constant). i L(i) V=1/L(i) In the presence of a monetary expansion which lowers the interest rates, the velocity of circulation falls and this mitigates the impact of M over PY To conclude, in Keyness view, V performs an anti-cyclical role. M V(i) = P Y According to Friedman, the equilibrium condition of the money market is M = L(r+gep) YP. On this basis, a monetary expansion: -increases actual and expected inflation; -raises the nominal interest rate i=r+gpe; -implies the fall in L(..) and the increase in V=1/L(..). M gp gpe i L V=1/L The velocity of circulation V accentuates the impact of M over PY Friedmans conclusion is that the role of V is pro-cyclical.

MV=PY iv) The role of monetary policy The high confidence placed in the link from M to PY might suggest that Friedman is favorable to monetary policy. As we have seen, this is absolutely false!!! Money may have explosive effects on nominal income: we have to use it the least possible. Money supply should simply accommodate the real growth of the economy, without giving any room to inflation. Friedmans rule for monetary policy consequently is: gm=gy v) Expectations As we have seen, in the transition period inflationary expectations gradually adapt themselves to their new equilibrium values. With regard to this, Friedman assumed adaptive expectations. Todays expectations gpet are equal to yesterdays expectations gpet-1 adjusted by a fraction <1 of the error made yesterday (gp t-1-gpet-1). People make errors, but gradually correct them. gpet = gpet-1+ (gp t-1- gpet-1) The adjustment of expected to effective values is ruled by an asymptotic process. In order to learn to predict correctly, we need an infinite amount of time. Adaptive expectation are generally wrong. People make systematic errors.
gP1

gPe
g
e P 0= P0

t1

Time t

FRIEDMAN AND THE ROLE OF AGGREGATE DEMAND In Friedmans view, money supply M determines nominal income Yn. Put otherwise, the central bank can control nominal expenditure. The crucial question then becomes: how does nominal income Yn split into prices P and quantities Y? Yn = (P?) (Y?) The Orthodox Keynesians answer was based on the original version of the Phillips curve: inflation is a negative (positive) function of unemployment (real income)

the rise in nominal income usually reflects the increase both in real output and in inflation. + gp = gw = f(u) = F(Y) Friedman rejects the original version of the Phillips curve. Lipseys justification of this curve presupposes a labour market in disequilibrium. Friedman instead believes that the price mechanism clears all the markets. Starting from these presuppositions, he has to solve two questions: How to explain unemployment? How to explain income fluctuations? UNEMPLOYMENT If the labour market is generally in equilibrium, why in reality so many people are unemployed? Friedmans answer is that labour market equilibrium implies: a positive amount of unemployment, i.e. a natural level of unemployment. The reason is that: people often leave their jobs in order to search for better jobs; they consequently become temporarily unemployed. unemployment in some regions/sectors is offset by vacancies in other regions/sectors. At the aggregate level, however, the labour market is in equilibrium. Friedmans conclusions are the following. Demand side macroeconomic policies can do nothing against natural unemployment. Supply side policies, by contrast, can help: by creating employment agencies by stimulating workers mobility by improving workers training. ECONOMIC FLUCTUATIONS This time, Friedmans problems are the following. If the system tends to be in its general (full employment) equilibrium, why in reality expansions and recessions alternate relentlessly? General equilibrium implies the dichotomy between nominal and real variables: how to explain the relationship between gp=gw and u represented by the Phillips curve? To answer these questions, Friedman returns to the labour market. LONG-RUN LABOUR MARKET EQUILIBRIUM In the long-run, the system is in its general equilibrium with perfect foresight. Real variables are at their full-employment levels. Money supply determines the behaviour of nominal variables. Current and expected variables coincide.

Let us assume that the growth rate of money supply (gm) rises from an initial 0% to a subsequent 10% There is dichotomy: real and monetary variables are independent from each other. In real terms , the new and the old long-run equilibrium (points 0 and 1) coincide. In monetary terms, the growth rate of nominal variable rises from 0% to 10%.
Ld0

Ls0

W/Pfe

0-1

0 Initial long-run equilibrium gm = gp = gep = gw= 0% and L=Lfe 1 Subsequent long-run equilibrium gm = gp = gep = gw= 10% and L=Lfe

Lfe

Long-run equilibrium consequently implies: no fluctuations in employment L and income Y a natural rate of unemployment (ufe) a vertical Phillips curve at ufe no relationship between nominal and real variables no trade off between inflation and unemployment. SHORT-RUN LABOUR MARKET EQUILIBRIUM In the short-run, expectations are not necessarily correct. Let us see the implications of imperfect foresight. Keynes took the money wage as given. The Synthesis and Orthodox Keynesian gave much importance to the rigidity of money wages. According to Friedman, this is a nonsense. What matters in the labour market is the real wage W/P (not the money wage W). Firms look at the incidence of labour costs on prices W/P. Workers look at the purchasing power of their wages W/P Bargainings in the labour market inevitably concern the real wage W/P. At any employment level L, the real wage desired (W/P)* by firms and by workers is given respectively by the traditional Ld and Ls curve.
Ld (W/P)w* Ls

(W/P)f*

At any given desired real wage (W/P)*, the desired money wage W* is: W* = (W)* P P However, money wages are negotiated in advance.

The relevant price in wage bargaining is not the current (P) but the expected one (Pe). W*=(W)* Pe P The corresponding real wage W*/P is W*=(W)* Pe P P P In the long-run, expected and actual prices coincide. The negotiated real wage W*/P thus coincides with the desired one (W/P)*. The latter, common to firms and workers, is given by the intersection between the traditional Ld and Ls curves. W*=(W)* P P In the short-run, however, expectations are not necessarily correct. In the presence of forecasting errors (Pe P), the negotiated real wage W*/P will no more coincide with the desired one (W/P)*. Firms and workers will move away respectively- from their traditional Ld and Ls curves. W* = (W)* Pe (W)* P P P P An overestimation of the price level (Pe > P) will imply a negotiated real wage W*/P which is higher then the desired one (W/P)*. Firms (workers) will offer (require) a real wage above their traditional Ld (Ls) curve. W*>(W)* P P An underestimation of the price level (Pe < P), will imply a negotiated real wage W*/P which is lower then the desired one (W/P)*. Firms (workers) will offer (require) a real wage below their traditional Ld (Ls) curve. W*<(W)*e P P According to Friedman, information is asymmetric. firms -who set prices- have all the information necessary to anticipate them correctly (their Pe = P). Firms behaviour is consequently described by the traditional Ld curve. workers, by contrast, do not know the future price level in advance. Their expectations are based on the recent past. In the light of these premises, let us reconsider the previous case of a growth rate of money supply (and consequently of nominal variables) which rises from the initial 0% to a subsequent 10%. Looking at the past, workers expect that nominal variables remain constant (gep=0%). They consequently will require the same money wage as before (gw*=0). By so doing, for mistake they will accept a 10% fall in the real wage. Their labor supply curve Ls will shift below the traditional one (from Ls0 to Ls0). Given the lower labour cost, employment will increase (a supply side phenomenon). The system will move to the short-run equilibrium point 0.

Ld0

Ls0
0-1

inflationary surprise: gp =10% > gep=gw* =0%

Ls0

W/P0 W/P0

W/P falls below W/Pfe L rises above Lfe. Y rises above Yfe u falls below ufe.

Lfe

L0

However, Friedmans short-run is really short-lived: price data are published relatively frequently. With time, workers will then realize their forecasting errors. As a result, they will gradually correct them (adaptive expectations). Specifically, they will ask for higher money (and real) wages W* (W*/P). Their labor supply curve will go back from the Ls0 to the traditional Ls0 curve. The system will move back from short-run equilibrium 0 to long-run equilibrium 1. Employment (unemployment) will go back to its natural level Lfe (ufe). Current and expected nominal variables will now grow at a 10% rate.
IMPLICATIONS FOR THE

PHILLIPS CURVE

Following Friedman, we shall distinguish between: the short-run the long-run. FRIEDMANS SHORT-RUN PHILLIPS CURVE As we have seen: what matters in the labour market are real wages W/P; ceteris paribus, desired money wages W*=(W/P)* Pe depend on expected prices Pe; ceteris paribus, the growth rate of money wages (gw) will then reflect expected inflation (gep) On the basis of these premises, Friedman claims that the short-run Phillips curve has to be inflation augmented. Behind the lines, it subtends a given expected rate of inflation gep. gw=f(u) +gep The negative slope of Friedmans short-run Phillips Curve At the given expected rate of inflation gep: the short-run Phillips curve will be downward sloping. there will be a negative relationship between the growth rate of money wages gep and the rate of unemployment u. This result derives from Friedmans analysis of the labour market. As we have seen, when the growth rate of money and prices rises from 0 to 10%: workers do not realize the change (their gep=0) they ask for the same money wage as before (gW=0) they involuntarily ask for lower real wages (gp=10%)

their Ls curve moves rightwards employment and output rise unemployment falls. The relevant short-run Phillips curve implies a 0% expected inflation (gep=0). When actual inflation rises to 10%, there is an inflationary surprise (gp - gep) which stimulates the economy. The higher rate of inflation thus implies a fall in the rate of unemployment u. We move from point 0 to point 1 (the new short-run equilibrium).

gP

SRPC(gep=0) 1 0 ufe
u

10%

Notice that in Friedman: causality runs from inflation gp to unemployment u. For Keynes and for the OKS, the direction of causality was the opposite: the activity level determined marginal costs and prices. fluctuations in employment and output are supply led. If unemployment is high, it is because labour supply is low. For Keynes and for the OKS, unemployment was due to a low demand for labour. The position of Friedmans short-run Phillips Curve depends on the given expected rate of inflation gep. When u=ufe, we are in general equilibrium. This means that foresight is perfect. At u=u*, expected and current inflation consequently coincide (gp=gep). The inflation rate gp corresponding to ufe along the curve thus gives us the given expected rate of inflation gep. underlying the whole curve.

gp

SRPC(gep=10%)

gp=10%
0

ufe

Instead of the traditional unique Phillips curve, we shall have a whole set of short-run Phillips curves; each of them implies a given expected rate of inflation gep higher Phillips curves imply higher expected rates of inflation gep

SRPC(gep=30%) SRPC(gep=15%) SRPC(gep=0%) gp=30% gp=15% gp=0%

ufe

LONG-RUN

PHILLIPS CURVE

As we have seen, according to Friedman, in the long-run: the labour market reaches its full employment equilibrium; unemployment is at its natural/equilibrium rate ufe; the long-run Phillips curve is a vertical line at u=ufe. ; there is perfect foresight: current and expected variables coincide. actual and expected nominal variables grow at the same rate as money supply;

 the growth rate of nominal variables does not affect the real sector of the economy.
gp LRPC

Initial long-run equilibrium 0 (with gm=0) u=ufe and gm=gp=gep=gw=0 Subsequent long-run equilibrium 1 (with gm=10%) u= ufe and gm=gp=gep=gw=10% Long-run Phillips curve u=ufe

gm=gp=10% gm=gP=0%

ufe

In the long-run, there is no trade-off between unemployment and inflation!

FRIEDMANS

PHILLIPS CURVE AND MONETARY POLICY

MONETARY EXPANSION Let us start from an initial not-inflationary long-run general equilibrium point 0. unemployment is at its natural rate u* nominal variables are stable (gm=gp=gw=0) expectations are correct (gep=0) we are both on the LRPC and on the SRPC corresponding to gep=0

gp

LRPC

SRPC (gep=0%)

0%

0
ufe

Let us now assume an expansionary monetary policy. Money supply and prices start rising at 10%. gm = gp=10% New short-run equilibrium. Workers do not realize the change; they keep expecting a stable price level (gep=0%). We shall move leftwards on the corresponding SRPC (gep=0%)

gp

When actual inflation rises to 10%, there is an inflationary surprise (gp - gep) which stimulates the economy.
SRPC (gep=0%)

The higher rate of inflation thus implies a fall in the rate of unemployment u. We move from point 0 to point 0(a short-run equil.). Unexpected inflation stimulates economic activity.

10%

0%

0
ufe

In the short-run, the monetary expansion is effective However, it acts through an inflationary surprise which damages workers inducing them to accept lower wages. Transition to the new long-run equilibrium short-run equilibrium 0 is inevitably temporary: expected inflation is 0% whilst actual inflation is 10%; gradually, workers realize and correct their errors; they consequently ask for a higher money (and real) wage; the short-run Phillips curve moves upwards. New long-run equilibrium We end up at point 1, at the same time: on the LRPC on the new SRPC corresponding to gep=10%. In the new long-run equilibrium 1, actual and expected nominal variables grow by 10%: u= ufe and gm=gp=gep=ga =10%

gp

SRPC(gep=10%)

LRPC

SRPC(gep=0%)

10%

0%

0 ufe

In the long-run, money is neutral and monetary policy has no real effect. In the short-run, a higher rate of growth in money supply stimulates economic activity. In the long-run, however, the only effect is a higher growth rate in current and expected nominal variables. This is undesirable, since inflation implies the inflation tax. The negative effects of a monetary expansion are accentuated by Friedmans accelerationist hypothesis.

If monetary authorities want to keep u<ufe, they have to surprise workers again and again with ever new injections of inflation.
gp
LRPC

To keep u<u*, the rate of inflation has to accelerate from 0%, to 10%, to 20% and so on.
SRPC(gep=20%) SRPC(gep=10%)

20% 10% 0%

3 1

4 2 0

ufe

SRPC(gep=0%)

According to Friedmans accelerationist hypothesis, any u<ufe implies an inflation rate: which is not constant but grows with the passing of time. The natural rate of unemployment ufe represents the not-accelerating-inflation rate of unemployment (NAIRU). Friedmans trade-off: is not between unemployment and a given rate of inflation. is between unemployment and an accelerating rate of inflation. If monetary authorities insist in keeping u<ufe, they will have to surprise workers again and again inflation will rise again and again. the short-run Phillips curve will move upwards again and again Monetary policy tends to have: no permanent effect on real variables. persistent and increasing effects on nominal variables. Better to use monetary policy against inflation! MONETARY CONTRACTIONS Let us start with a long-run equilibrium with a 10% inflation rate. u=ufe and gm = gp= gep= gw= 10% Let us assume that the central bank decides to reduce inflation from 10% to 5%. The growth rate in money supply gm (and in prices gp) falls from 10% to 5%. Fridmans labour market

Looking at the past, workers do not perceive the fall in the rate of inflation; they keep asking for the same growth rate in money wages as before (gW=10%); by so doing, however, they involuntarily ask for higher real wages (gp=5%); their Ls curve moves leftwards; employment and output fall; unemployment rises. The new short-run equilibrium is represented by point 0 below. Not realizing the restrictive turn in monetary policy, workers keep expecting a 10% rate of inflations. We shall consequently move rightwards on the SRPC(gep=10%) As actual inflation falls to 5%, there is a deflationary surprise (gp < gep) which depresses the economy.
gp SRPC(gep=10%) SRPC(gep=5%)
10%

The lower rate of inflation thus implies a rise in the rate of unemployment u. We move from point 0 to point 0 Unexpected deflation depresses economic activity.

0 1

5% 0 %

ufe

Transition to the new long-run equilibrium short-run equilibrium 0 is inevitably temporary: expected inflation is 10% whilst actual inflation is 5%; gradually, workers realize and correct their errors; they consequently ask for a lower money (and real) wage; the short-run Phillips curve moves downwards. The new long-run equilibrium point 1: belongs to the LRPC belongs to the new SRPC corresponding to gep=5%. the activity level is the full employment one (u= ufe ) current and expected nominal variables grow by 5% (gm=gp=gep=gw=5%) Friedmans conclusion is that monetary contractions imply: temporary costs in terms of employment and output permanent benefits in terms of inflation.
ANTI-INFLATIONARY STRATEGIES

Let us start with an initial long-run equilibrium point A where: u=u* and gm = gp= gep= gw= 30% Let us assume that monetary authorities want to reduce the inflation rate from 30% to 10%.

The target of the Central Banks is point B where: u=u* and gm = gp= gep= gw= 10% As shown by the figure below, the central bank can chose between two alternative strategies: The cold turkey option: gm drastically falls from 30% to 10% a big once and for all deflationary surprise the behaviour of the system is: ABC The gradualist option: gm gradually falls from 30% to 20% to 10% many small deflationary surprises the behaviour of the system is: A234C

In order to understand the figure below, we have to keep in mind that: an unexpected fall in gm=gp and the associated deflationary surprise gp<gep imply a rightward movement along the SRPC corresponding to the given expected rate of inflation gep the downward revision of inflationary expectations gep implies a leftward shift in the SRPC, which brings us on the LRPC

gp

LRPC

SRPC(gep=30%)
SRPC(gep=20%)
30%

1st strategy A gp =30%, gep=30% B gp =10%, gep=30% C gp =10%, gep=10% 2nd strategy A gp =30%, gep=30% 2 gp =20%, gep=30% 3 gp =20%, gep=20% 4 gp =10%, gep=20% C gp =10%, gep=10%

SRPC(g =10%)

e p

A
3 2 4

20% 10%

ufe

u2

ub

Friedmans conclusion is that gradualism is better: it takes more time but implies lower short-run costs in terms of unemployment. Friedman assumes imperfect foresight by workers. If they had a magicians crystal ball, however, theyworkers would succeed in forecasting perfectly. With perfect foresight, the Phillips curve would be vertical also in the short run. The decrease in money supply from 30% to 10% would bring us directly from point A to point C. Deflation would imply no real cost in terms of unemployment. There would be no reason to adopt a gradualist strategy. Better to choose the cold turkey option.
THE INGREDIENTS OF

FRIEDMANS SUCCESS

In his works, Friedman succeeded in anticipating what would have happened in the following decade.

The 1970s (with their two oil shocks) were a period of high inflation. Nominal interest rates increased, as Friedman had foreseen. The Phillips curve started to move upwards, as Friedman had foreseen. Unemployment and inflation started to rise at the same time: as Friedman had foreseen. In the early 1980s, Reagan in the US and Mrs. Thatcher in the UK adopted the gradual antiinflationary strategy suggested by Friedman. However, Friedman was an anticipator at a theoretical level too. By giving a central role to expectations, he paved the way to the rational expectations revolution in economic theory. All of this explain Friedmans extraordinary success.

the balance of payments

(English to be revised) This lecture is addressed to those of you that have not followed the course of international economics: I have been given the task to fill the gap. My target is to present: the essential concepts and the basic notions; in the simplest way. In an open the economy, we have to introduce a new agent: the rest of the world. To symplify, we shall assume that there are only two countries: the domestic country is Italy the foreign country is the US. Italy exchanges goods, sevices, assets with the US. These exchanges obviously imply corresponding payments between the two countries. The Italian Balance of Payments is the account that records the transactions and the related payments between Italy and the rest of the world. Italian sales enter with a positive sign since they give rise to cash receipts from abroad. Italian purchases enter with a negative sign since they give rise to cash paymentst . Italian net sales, the difference between sales and purchases corresponding to the Italian net cash receipts, is the Italia Balance of Payments. BP=Sal-Pur The Balance of Payments BP can be: positive: -Italy is a net seller/receives net payments from the rest of the world; -its Balance of Payments is positive or in surplus. negative: -Italy is a net buyer/makes net payments to the rest of the world; -its Balance of Payments is negative or in deficit. nihil: -Italian sales to and purchases from the rest of the world offset each other; -the Balance of Payments is balanced. The Italian Balance of Payments is obviously connected with the foreign Balance of Payments (the US one). The surplus of Italy implies an equal deficit of the US and viceversa.

THE FOREIGN EXCHANGE MARKET Goods, services and assets are exchanged against money. At the national level, i.e. in domestic transactions, every country uses its own currency (euro in Italy, dollars in the US). At the international level, i.e. in transactions between different countries, to be used is the strongest currency (historically, the dollar). International transactions of goods, services, assets thus also imply transactions between currencies. The Italian seller gives goods/services/assets against dollars; living in Italy, she/he needs euros to finance domestic payments. She/he will thus supply dollars against euros. The Italian buyer has to pay in dollars her/his purchases from the rest of the world. She/he will thus demand for dollars against euros. Transactions between currencies take place in the foreign exchange market shown by the following figure, where: the symbol $ in the horizontal axis is the amount of dollars the symbol E in the vertical axis is the price of the dollar in euros (the nominal exchange rate) the $d curve is the demand curve for dollars the $s curve is the supply curve of dollars
E

$d

$s

The dollar market, looks like the other markets but is actually more complex. As we shall see, it is deeply connected: with the euro market with foreign transactions of goods, services, assets. CONNECTION WITH THE EURO MARKET In our two countries case, the dollar is exchanged against euros. The dollar market is thus connected with the euro market.

$d=s

$s=d

The demand for dollars is a supply of euros; the demand curve for dollars $d thus coincides with the supply curve of euros s. The supply of dollars is a demand for euros; the supply curve of dollars $s thus coincides with the demand curve for euros d. The price of the dollar in euros (E) is the reciprocal of the price of the euro in dollars (1/E). If we need 2 euros to buy 1 dollar, we need 1/2 dollars to buy 1 euro. The E variable is the nominal exchange rate. An increase in E implies that we need more euros to buy 1 dollar: the dollar rises in value and the euro decreases in value. A decrease in E implies that we need less euros to buy 1 dollar: the euro rises in value and the dollar decreases in value. On Friday, for instance: 1 $ = 0.67 (E) and 1 = 1.49 $ (1/E) The recent performance of 1/E (the price of the in $): the euro has gained value, the dollar has lost value.

CONNECTION WITH FOREIGN TRANSACTIONS The foreign exchange market is also connected with international transactions.

$d=s=Pur

$s=d=Sal

If Italy demands for dollars against euros $d=s, it is in order to pay its purchases from abroad. The curve $d=s thus becomes the $d=s=Pur curve. If Italy supplies dollars against euros $s=d, it is because it has sold goods/services/assets to the rest of the world. The curve $s=d thus becomes the $s=d=Sal curve. The Balance of Payments BP, our net sales Sal-Pur, is thus given by the horizontal distance between the two curves. It is deeply connected with foreign exchange transactions.
E

$d=s=Pur

$s=d=Sal

BP+ =ES$=ED
0

BP- =ED$=ES
$

A Balance of Payment surplus (BP+ in the figure) implies -an excess supply of dollars ES$ -and an excess demand for euros ED. A Balance of Payment deficit (BP- in the figure) implies -an excess demand for dollars ED$ -and an excess supply of euros ES. We can thus write: BP= Sal-Pu =ES$=ED Foreign exchange market equilibrium requires a balanced Balance of Payments. BP=0 To understand precisely why, however, we have to distinguish between the flexible exchange rate regime the fixed exchange rate regime. FLEXIBLE EXCHANGE RATES The nominal exchange rate E is determined by market laws: it rises (falls) if there is excess demand for (supply of) dollars thus clearing the market.

$d=s=Pur

$s=d=Sal

BP+=ES$=ED
E1 E0 0

E2

BP-=ED$=ES
$

Let us start, from the wrong exchange rate E1. The country is a net seller, its BP=Sal-Pur>0 is in surplus. As a consequence of its net sales, it gets net receipts in dollars from abroad. Italian citizens live in Italy and use euros. This will originate a sale of dollars (ES$) against euros (ED). The price of the dollar (E) will fall. The price of the euro (1/E) will rise. The foreign exchange market will reach its equilibrium (point 0). The decrease in the nominal exchange rate E implies: a nominal depretiation of the dollar: the dollar decreases in value. a nominal appretiation of the euro: the euro rises in value. To sum up, at the exchange rate E1 Italy has a balance of payments surplus: its currency (the euro) appretiates. USA have a balance of Payments deficit: their currence (the dollar) depreciates. Let us now start from the wrong exchange rate E2. The country is a net buyer, its BP is in deficit. Its net purchases form abroad have to be paid in dollars. This will originate a net sale of euros (ES) by Italian importes against dollars (ED$). The price of the dollar (E) will rise. The price of the euro (1/E) will fall. The foreign exchange market will reach its equilibrium (point 0). The increase in the nominal exchange rate E implies: a nominal appreciation of the dollar: the dollar rises in value. a nominal depretiation of the euro: the euro decreases in value. To sum up, at the exchange rate E2: Italy has a balance of payments deficit: its currency (the euro) depretiates. USA have a balance of Payments surplus: their currence (the dollar) apprectiates. Conclusions about the flexible exchange rate regime: If a country has a Balance of Payments surplus (deficit), its currency experiences an appreciation (a depretiation). The stability of exchanges rates (and thus of international transactions) requires a balanced Balance of Payments. FIXED EXCHANGES RATES This time, the exchange rate E is extablished by an agreement between the Central Banks; its established value is called parity.

The parity E can be modified if needed. Central Banks can decide for instance to increase E (to decrease 1/E), i.e. to revaluate (devaluate) the dollar (the euro) to decrease E (to increase 1/E), i.e. to devaluate (revaluate) the dollar (the euro) Parity revisions, however, have to be exceptional: under normal conditions, the parity has to remain fixed. According to what has been said before, the exchange rate remains spontaneously stable only if the Balance of Payments is balanced. If this is not the case, the Central Bank has to intervene in order to stabilize the exchange rate.
E

$d=s=Pur

BP+=ES$=ED
1

$s=d=Sal

E1 E0 0 2 E2

Central Bank $d = s OR Ms

BP-=ED$=ES

Central Bank $s = d OR Ms
$

Let us assume that the parity is E1. The Balance of Payments surplus (BP+) implies: an excess supply of dollars an excess demand for euros. The price of the dollar E would tend to fall. To avoid this, the Central Bank has to intervene: by demanding for dollars by supplying euros. The $d=s moves to the right, thus ensuring the stability of the exchange rate at the parity E1. The Balance of Payments surplus thus implies: an increase in official reserves (dollars) OR held by the central bank an increase in the money supply (euro into circulation) Under fixed exchange rates, we thus find the following relationship: BP=OR=M A Balance of Payments surplus (BP>0) implies (in every period) an equivalent increase: in foreign or official reserves OR in money supply M A Balance of Payments deficit (BP<0) implies (in every period) an equivalent decrease: in foreign reserves RU in money supply M Under fixed exchange rates, to stabilize the level of OR and M we need a balanced Balance of Payments. BP=0

Overall conclusion: the Balance of Payments equilibrium condition ensures: the stability of the exchange rate E under flexible exchange rates the stability of foreing/official reserves OR and of M under fixed exchange rates.
DIGRESSION:EXCHANGE RATES IN THE REAL WORLD

After World War II, 44 countries signed the Bretton Woods Agreement which established a regime of fixed exchange rates. The aim was to favour international stability, international trade and international growth. The Bretton Woods Regime was anchored to the dollar, unanimously recognized as the sovereign currency. Participating countries committed themselves to stabilize their currencies with respect to the dollar and the dollar in turn was convertible into gold. The Bretton Wood Regime lasted up to the 1970s. At the end of the 1960s, the increase in US military expenditure connected with the Vietnam War required the Fed financing. The increase in the supply of dollars obviously tended to weaken the dollar. The other countries were consequently obliged to issue domestic currency and to buy dollars. The generalized increase in money supply stimulated worldwide inflation. The generalized increase in the official reserves in dollars increased the requests to convert dollars into gold. The US gold reserves dangerously fell. In 1971, Nixon announced the end of the convertibility into gold. Not much later, the whole Bretton Wood agreement was repudiated. The dollar underwent a heavy depreciation and we entered the flexible exchange rates regime that persists today. Central banks keep intervening into the foreign exchange market, but exchange rates are now determined by the market. The current situation is characterized by global imbalances. The US experience a huge current account deficit that by itself would lead to the depreciation of the dollar. The other countries (mainly China) buy dollars in order to avoid the appreciation of their currencies and defend their competitiveness. In Europe, the aim to contain exchange rate instability and speculation led to the European Monetary System in 1979 and to the European Monetary Union in 1999. With a single currency, the exchange rate is not only fixed: it is irrevocably equal to one. THE BALANCE OF PAYMENTS EQUILIBRIUM CONDITION To understand what the equilibrium condition BP=0 implies we have to understand which are the variables which BP depends on. Foreign transactions include issues that are very different and thus depend on different variables. We shall distinguish between: goods and serices assets. The Balance of Payments can thus be divided into two accounts. The current account CA gives the net sales of goods and services The capital account KA gives the net sales of assets. BP =CA+ KA THE CURRENT ACCOUNT We shall focus on international exchanges of goods and services. The other components of CA are less important. Let un introduce the following definitions:

Exports X are the sales of goods and services to the rest of the world Imports Q are the purchases of goods and services from abroad. Net Exports NX=X-Q are the difference between exports and imports. Current Account CA coincides with net exports NX. CA=NX=X-Q What are the determinants of X,Q and thus of NX? NX=X(....?....) -Q (....?....)=NX(....?....) The theory of demand helps us to answer these questions. According to it, demand is a function: of income of relative prices. Lets us then start from income: our exports X are a foreign demand for our goods and services, they thus depend on foreign income Yf. our imports Q are a domestic demand for foreign goods and services; they are thus a positive function of domestic income Y. net exports NX will thus depend on Yf and Y. + + + NX=X(... , Yf) -Q (... , Y) =NX(...., Yf, Y) As fars as the signs are concerned: an increase in foreign income Yf increases our exports X and thus stimulates the Current Account NX. an increase in domestic income Y increases our imports Q and thus depresses the Current Account NX. Let us now consider relative prices. Specifically, let us define by R the relative price of foreign goods,relative to (divided by) the price of domestic goods. As R rises, foreigh (domestic) goods become relatively more (less) expensive. The consequence is that: foreign residents will increase their purchases of domestic products (our exports), now relatively cheaper domestic residents will decrease their purchases of foreign products (our imports), now relatively more expensive. The result is an increase in our net exports NX. R has a positive effect on NX. + + - + + + NX=X(R , Yf) -Q (R , Y)=NX( R, Yf, Y) Let us reconsider the R variable, defined as the price of foreign goods Pf relative to (divided by) the price of domestic goods P. R=?Pf P The foreign price level Pf is in dollars. We have to convert it in euros in order to be able to divide it by the domestic price level P. This can be easily done by multiplying Pf by the nominal exchange rate E. R=EPf P

R is the real exchange rate. It gives the price of foreign relatively to domestic goods. The higher R is, the higher Italian competitiveness is. By definition: a real exchange rate depretiation implies a rise in R; Italian goods loose value (depretiate), Italy becomes more competitive. a real exchange rate appretiation implies a fall in R; Italian goods rise in value (appretiate), Italy becomes less competitive. To sum up, the Current Account function is the following: + + NX=NX(EPf , Yf, Y) P
DIGRESSION: THE EQUILIBRATING ROLE OF EXCHANGE RATES

We know that a BP deficit implies a depreciation of the domestic currency. If we are net purchasers, we need to buy dollars against euros in order to pay for our imports. The dollar will appreciate, the euro will depreciate. BP- =ED$=EO E & 1/E We also know that the depreciation implies an increase in competitiveness which tends to reabsorb the deficit, thus clearing the Balance of Payments. The exchange rate has the role of clearing BP. BP= NX=NX(EPf , Yf, Y)=0 P However, our analyis is not yet complete: we have not taken into account the fact that exports are valuated in euros and imports in dollars. To remedy, let us take the BP in euros. P NX =P X(....) - EPf Q(...) In real terms: NX =X(....) - EPf Q(...) P This means that: NX = X(....) - R Q(...) On the basis of this reformulation, a devaluation has two opposite effects: the aforementioned quantity effect due to the fact that our competitiveness increases stimulating exports and discouraging imports NX =X(..R..) - R Q(..R..) a new price effect due to the fact that -after the devaluation- our imports become more expensive. NX = X(....) - R Q(...) According to the Marshall Lerner condition, however, under normal conditions (with usual

parameters) the positive effect prevails. According to the J effect, this happens only at the end. Initially we face the negative price effect of a deprecitaion. Subsequently the quantity effect comes into play and prevails. In the Italian case, the price effect has been very important. Italy cannot substitute imported oil with domestic products. Above all, oil is an important component of domestic production costs. The increase in the oil cost turns into an increase in domestic prices P. Competitiveness does not improve, the BP deficit persists. The result is a devaluation-inflation spiral that erodes any gain in productivity. The exchange rate looses its re-equilibrating role. EPf P
DIGRESSION: THE PURCHASING POWER PARITY

If countries produce exactly the same good, we have to apply the unique price low: the same good tends to have the same price everywhere. In equilibrium, foreign (EPf) and domestic prices (P) have to be perfectly aligned: EPf=P Under flexible exchange rates, equilibrium E aligns domestic and foreign prices. The expression for the equilibrium exchange rate thus becomes: E=P/Pf In percentage variations: %E=%P-%Pf According to the theory of the purchasing power parity, the growth rate of the nominal exchange rate (%E) reflects the gap between internal (%P ) and external (%Pf ) inflation. A country with a higher inflation rate will experience a curent accout deficit and a depreciation of the domestic currency. At the end, the disadvantage in terms of higher inflation (P ) will be perfectly offset by the depreciation of the domestic currency (E). (E) Pf=(P) THE CAPITAL ACCOUNT The capital account KA registers the net sales of assets, i.e. the difference between the sales and purchases of assets. To simplify, we shall consider financial assets only. KA=Asal-Apur This time, the problem is how international wealth is allocated between domestic and foreign assets. In the short-run, the level of wealth can be taken as given. The wealth allocation between domestic and foreign assets will then depend on domestic (i) and foreign (if) interest rates. An increase in domestic interest rates (i) will make domestc assets relatively more profitable thus stimulating (reducing) our sales (purchases). Our capital account will improve. KA=Asal-Apur An increase in foreign interest rates (if) will make foreign assets relatively more profitable thus reducing (stimulating) our sales (purchases). Our capital account will worsen. KA=Asal-Apur

The conclusion is that: +, KA=KA(i , if )

DIGRESSION: THE THEORY OF THE INTEREST RATE PARITY

Let us assume that: international transactions concern only financial assets. assets are precisely the same in the two countries. In equilibrium, domestic and foreign assets have to yield equal rates of return. These rates of return, however, are also affected by the exchange rate. The expected percentage appreciation (depreciation) of the $ (of the ) increases (decreases) the profitability of foreing (domestic) assets. The equilibrium of the BP thus requires that: i=if + (Ee-E)/E Under a regime of flexible exchange rates, E clears the BP. The equilibrium value of the nominal exchange rate then becomes: E= . Ee. (1+ i -if) According to the theory of the interest rate parity, E depends on i, if, Ee. The nominal exchange rate E is a negative function of the domestic interest rate i. By increasing the domestic interest rate, the central bank can sustain its currency. i CK BP+=EO$=ED E (appreciation) The nominal exchange rate E is a positive function of the foreign interest rate if. By increasing the foreign interest rate, the foreign central bank can sustain its currency. if CK BP-=ED$=EO E (depreciation) The nominal exchange rate E is a positive function of the expected exchange rate E Ee (if + (Ee-E)/E) CK BP-=ED$=EO E (depreciation) Expected depreciation turns into an effective one!!! This important phenomenon is typical of the currency crises (1976, 1992). A week country is prone to speculative attacks. Its currency is expected to depreciate, domestic assets are not appealing, capital outflows will prevail, its currency will depreciate. To simplify, hereafter we shall assume E=Ee focusing on the comparison between domestic and foreign interest rates. However, we have to remember the aforementioned crucial role of expectations. BP Let us consider three cases. International transactions concern goods and services only. This assumption was reasonable before the 1980s, when capital flows were constrained. In this case, the external constraint becomes: + + EQUILIBRIUM

BP=NX=NX(EPf , Yf, Y) =0 P Ceteris paribus, external equilibrium: requires a given level of domestic income Yex , the one corresponding to BP=0. can be represented by a vertical BP line in the figure below. Remember that imports are a positive function of domestic income. On the left of Yex: income Y is too low imports Q are too low NX are too high BP is in surplus On the right of Yex: income Y is too high imports Q are too high NX are too low BP is in deficit
CA=BP=0 i
BP+ BP-

Yex

If the other variables (specifically, E) are given, foreign equilibrium represents a constraint for domestic economic activity International transactions concern financial assets only. This assumption is reasonable after the 1980s, when capital flows were liberalized. The external constraint now becomes: BP= KA=KA( i , if )=0 Ceteris paribus, external equilibrium: implies a given level of the domestic interest rate i, the one corresponding to BP=0. can be represented by a horizontal BP line BP in the figure below. Above iex: the domestic i is too high capital inflows are too high BP is in surplus Below iex: the domestic i is too low capital inflows are too low BP is in deficit
i
BP+

iex
BP-

KA=BP=0

If the other variables (specifically, E) are given, foreign equilibrium represents a constraint for the domestic interest rate. International transactions concern both goods and services and assets. Putting the current and capital accounts together, we get: + + +,BP=NX(EPf , Yf, Y) +KA(i, if)=0 P

Point 0 represents the situation in which every account is balanced: CA=KA=BP=0 If domestic income and imports increase, the current account experiences a deficit. If the domestic interest rate raises, the capital account experiences a surplus. If the current account deficit is perfectly offset by the capital account surplus, BP remains balanced. Ceteris paribus, the BP=0 condition can be represented by an upward sloping BP line in the figure below. External equilibrium is not a constraint for the domestic activity level! Insofar as the rise in income Y is associated with the necessary rise in the rate of interest i, BP keeps being balanced. Point 0 CA=0 KA=0 Point 1 CA>0 KA<0 Point 2 CA<0 KA>0 BP=0 BP=0
i
1 CA=0 i 2 0 KA=0

BP=CA=KA=0

BP=0
Y

Point 1 represents the Chinese situation: the current account surplus is offset by the capital account deficit the sale of goods and services finances the purchase of financial assets Point 2 represents the American situation: the current account deficit is offset by the capital account surplus the purchase of goods and services is offset by the sale of financial assets Questions: Why is this situation not satisfying? Why do economists currently speak of global imbalances? Answer: US financial assets are promises of payment. US capital inflows imply an increase in the US indebtedness towards China, this in every period. Indebtedness cannot grow for ever Sooner or later, debt has to be repaid. Implications The BP line describes a short-run equilibrium: it takes stocks as given. But stock are not given!! In the long run, only point 0 is sustainable. THE MUNDELL-FLEMING MODEL Mundell (Nobel Prize) and Fleming extended the IS-LM model to an open economy. This ment: to extend the IS curve to an open economy to extend the LM curve to an open economy to add the BP curve, i.e. the condition according to which BP=0 The IS curve in an open economy

What changes is the definition of aggregate demand. To the domestic component: C+I+G we have to add the foreign component: NX=X-Q. The reason is that: exports X are a foreign injection of demand for domestic goods; imports Q are the part of domestic demands directed towards foreign goods. We thus get: AD=C+I+G+NX We know that: NX=NX(EPf/P;Yf,Y) Starting from this expression, we shall distinguish between: the autonomous component of net exports NX(...), i.e. the component that does not depend on domestic income Y; the induced component of net exports; i.e. the component that depends on domestic income Y. To simplify, we shall specify it as q times Y, where q=Q/Y is the marginal propensity to import. NX=NX(EPf, Yf) - q Y P Taking into account: this NX function the traditional consumption function C = C0 + c1 (Y-T) the traditional investment function I = I d i the goods market equilibrium condition Y=AD, we get the following expression for goods market equilibrium income (the IS curve) in an open economy. Y= 1 [{C0 -c1T + I + G + NX(EPf/P, Yf)} - d i] 1 - c1 + q Two are the novelties in it: The fall of the multiplier due to the marginal propensity to import q. When income grows, induced demand grows stimulating a new increase in income. In an open economy, however, part of the induced demand is addressed towards foreign (rather than domestic) products. It thus stimulates foreign (rather than domestic) output. As a consequence of this leakage, the multiplier falls. The term NX (EPf/P, Yf) inside autonomous expenditure. Autonomous expenditure now also depends on EPf/P and Yf. Domestic equilibrium is now connected with the performance of the world economy. Let us consider this connection. an increase in the real exchange rate R (in Italian competitiveness) stimulates our NX, thus increasing aggregate demand and domestic income. an increase in foreign income Yf stimulates our NX, increasing aggregate demand and domestic income. Domestic and foreign activity levels are interconnected. The LM curve in an open economy

What changes is the supply side of the money market.The supply of money now includes: the traditional domestic/internal component Mint controlled bu the Central Bank; a foreign component given by the Balance of Payments BP. M=M int +BP Under fixed exchange rates, the Balance of Payments surplus (deficit) implies an equivalent increase (fall) in the money supply in every period. Under flexible exchange rates, the nominal exchange rate clears the Balance of Payments and the foreign component of money supply is zero. The expression for the LM curve in an open economy thus becomes: Mi+BP=f1Y-f2i P The BP curve To simplify, let us assume that: capital flows are so big that CA becomes irrelevant: CA is important as a component of AD, not as a component of BP. there is perfect capital mobility: any small difference between foreign and domestic interest rates gives rise to huge capital flows. Equilibrium implies i=if our country is a small one, unable to affect the international interest rate. In equilibrium, it is thus the domestic interest rate i that aligns itself to the foreign one if. Under these assumptions, the equilibrium condition of the Balance of Payments becomes i=if The BP curve is a horizontal line corresponding to i=if. The Balance of Payment is in equilibrium only when the domestic interest rate is equal to the foreign one. THE IS-LM-BP MODEL The IS-LM-BP model is shown in the following figure.
IS LM

if

BP

Domestic equilibrium, the equilibrium of domestic goods and financial markets, is given by the intersection between the IS and LM curves Foreing equilibrium, the Balance of Payments equilibrium, is given by the horizontal BP curve. Overall equilibrium requires that the IS-LM intersection belongs to the BP curve.

Adjustment process Since the BP position is given by if, the IS-LM intersection has to align itself to the BP curve. Questions To solve a system of 3 equations, we need 3 endogenous variables. Two of them are the usual ones: i and Y. What is the 3rd endogenous variable? To have an interseption between 3 curves, one of them has to align itself to the other two. What is this passive curve? The answer depends on the exchange rate regime. As we shall see: under flexible exchange rates, the 3rd endogenous variable is the exchange rate E. As a consequence, in equilibrium the IS curve ends up with aligning itseflt to the intersection between the BP-LM curves. The IS curve is passive, fiscal policy is ineffective. under fixed exchange rates, the 3rd endogenous variable is money supply M. As a consequence, the LM curve ends up with aligning itseflt to the intersection between the BP-IS curves. The LM curve is passive, monetary policy is ineffective.
FLEXIBLE: thanks to E IS
LM IS

FIXED: thanks to M

LM

if

BP

if

BP

FLEXIBLE EXCHANGE RATES What happens if domestic equilibrium (the IS-LM interception) does not imply the Balance of Payments equilibrium (i=if)? Are there authomatic adjustment mechanisms which lead the system to a both internal and external equilibrium? ADJUSTMENTS MECHANISMS Point 0 in the figure below shows an initial domestic equilibrium given by the IS0-LM0 intersection. This domestic equilibrium lies above the BP curve. At point 0, the domestic interest rate i is higher than the foreign one if.We are net sellers of assets; our Balance of Payments is in surplus. This surplus implies: an excess supply of dollars an excess demand for euros. As a result: the dollar depreciates in nominal terms (E)

the euro appreciates in nominal terms(1/E). Ceteris paribus, the real exchange rate appreciates too. R=EPf/P As a consequence of the appreciation, Italian goods become less competitive. Autonomous net exports NX(EPf/P, Yf) fall. This does not affect BP, which is dominated by capital flows. It however depresses aggregate demand AD=C+I+G+NX and equilibrium income. The IS curve moves to the left. We move to the internal and external equilibrium represented by point 1. The Balance of Payments is now balanced; the exchange rate becomes stable. IS0 0 if 1 BP LM0
Point 0: i>if BP+=ES$ = ED E (1/E) Appreciation Competitiv. NX Y IS leftwards Point 1

Conclusion: A surplus (deficit) of the Balance of Payments implies an appreciation (a depretiation) of nominal and real exchange rates. The IS curve adapts itself through the exchange rate fluctuations. To underline its passive role, the IS curve is shown as a broken line in the figure. The passive role of the IS curve suggests that under flexible exchange rates: fiscal policy is ineffective (does not affect income). monetary policy is effective (does affect income). Let us verify these insights. FISCAL POLICY Let us start from the internal and external equilibrium represented by point 0. Let us assume an increase in government expenditure. The IS curve moves to the right, domestic equilibrium moves to point 1. As income grows, the demand for money grows. The domestic interest rate i thus rises above the foreign one if. Point 1 thus implies a surplus of the Balance of Payments which triggers the authomatic adjustment mechanisms. The Balance of Payments surplus implies an excess supply of (demand for) dollars (euros). The nominal (E) and then the real (R=EPf/P) exchange rates appreciate. As a consequence of the appreciation, Italian goods become less competitive; autonomous net exports NX(EPf/P, Yf) fall. Aggregate demand AD=C+I+G+NX and income fall; the IS curve moves to the left. We move to the internal and external equilibrium point 2, which coincides with point 0.

IS0

LM0

0-2
if BP

1: new domestic eq. G Y L i i>if BP+=ES$ = ED E (1/E) Appreciation Competitiv. NX Y IS downwards Point 2

Conclusion on fiscal policy under flexible exchange rates: Fiscal policy is ineffective, i.e. unable to affect equilibrium income. Point 0 and point 2 imply the same income level. Under flexible exchange rates, the IS curve is passive: it has to adapt itself to the LM-BP interception. Fiscal policy cannot permanently affect it. Fiscal policy, however, modifies the composition of demand and income. Let us compare point 0 with point 2. Since income and the interest rate are the same, consumption and investments too are the same. The new government expenditure, however, implies an exchange rate appretiation that depresses net exports. Every euro of government expenditure crowds out a euro of net exports: a government deficit implies a current account deficit (twin deficit approach) and vice versa. Y = C + I + G + NX MONETARY POLICY Let us start again with the internal and external equilibrium represented by point 0, the interception between IS0 and LM0. Let us now assume an increase in money supply. The LM curve moves to the right; domestic equilibrium moves to point 1. The domestic interest rate i falls below the foreign one if. Point 1 implies a deficit of the Balance of Payments which triggers the authomatic adjustment mechanisms. The Balance of Payments deficit implies an excess demand for (supply of) dollars (euros). The nominal and real exchange rates depreciate (E, 1/E,R=EPf/P): Italian goods become more competitive. As a consequence of the higher competitiveness, autonomous net exports NX(EPf/P, Yf) rise. Aggregate demand AD=C+I+G+NX and domestic income consequently rise. The IS curve moves to the right. We go to the new internal and external equilibrium represented by point 2.
LM0
1: new domestic eq. M i i<if BP-=ED$ = ES E (1/E) Depreciation Competitiv. NX Y IS rightwards Point 2

IS0 0
if

2 BP 1

Conclusion about monetary policy under flexible exchange rates: Monetary policy is not only effective, as you can see by comparing income levels corresponding to point 0 and 2; it is also more effective than in a closed economy (point 1). A shift in the LM curve turns into an equivalent shift of the LM-BP interception. The IS curve is passive and adapts itself, strengthening the effectiveness of monetary policy. The transmission mechanism changes. Monetary policy does not affect the equilibrium interest rate and investment, as in a closed economy. It affects the exchange rate and thus net exports. As a consequence of the depreciation and of the associated increase in NX, income and consumption grow. Y = C + I + G + NX FIXED EXCHANGE RATES ADJUSTMENTS MECHANISMS Point 0 in the figure shows an initial domestic equilibrium given by the IS0-LM0 intersection. This domestic equilibrium lies below the BP curve. The domestic interest rate i0 is lower than the foreign one if. We are net buyers of assets; the Balance of Payments is in deficit. The Balance of Payments deficit implies: an excess demand for dollars an excess supply euros. To stabilize the exchange rate, the Central Bank has to: sell dollars buy euros. Thus, the Balance of Payments deficit turns into a fall in official reserves and in money supply. As a consequence of the fall in money supply, the LM curve moves upwards. The system goes to the internal and external equilibrium represented by point 1. The Balance of Payments is now balanced; money supply becomes stable.
IS0
LM0

1
if

Point 0 i<if BP-=ED$ = ES OR=Ms LM upwards Point 1

BP

Conclusion A Balance of Payments deficit (surplus) implies a decrease (an increase) in money supply in every period which depresses (stimulates) aggregate demand and equilibrium income.

 The internal and external equilibrium (point 1) is given by the IS-BP interception. The LM curve adapts itself through money supply fluctuations. To underline its passive role, the LM curve is shown as a broken line in the figure. The passive role of the LM curve suggests that under fixed exchange rates -monetary policy is ineffective (does not affect income). -fiscal policy is effective (does affect income). Let us now verify these insights. MONETARY POLICY Let us start again with the internal and external equilibrium represented by point 0. Let us assume that the Central Bank increases the domestic component of money supply. The LM curve moves to the right; domestic equilibrium moves to point 1. The domestic interest rate falls below the foreign one. Point 1 implies a deficit of the Balance of Payments which triggers the authomatic adjustment mechanisms. The Balance of Payments deficit implies an excess demand for dollars an excess supply euros. To stabilize the exchange rate, the Central Bank has to sell dollars buy euros. The BP deficit thus turns into a fall in official reserves and in money supply. As a consequence of the fall in the external component of money supply, the LM curve moves upwards. The system moves to the internal and external equilibrium represented by point 2, coinciding with point 0. The Balance of Payments is now balanced. Money supply thus becomes stable.
IS0 0-2
if

LM0

Point 1 Ms i i<if BP-= ED$ = ES

BP

OR=Ms LM upwards Point 2

Conclusions about monetary policy under fixed exchange rates Monetary policy is ineffective, it is unable to affect equilibrium money supply and thus equilibrium income. Under fixed exchange rates, the LM curve goes back to the interception between the IS and BP curves. Any increase in the domestic component of M is perfectly offset by the decrease in the foreign component. M=Mint+BP The Balance of Payments deficit (surplus) can be interpreted as a consequence of a too high (low) money creation by the Central Bank (monetary approach to the Balance of Payments). In equilibrium, since i and Y are given, the demand for money is given. As a

consequence, equilibrium money supply is also given. The central bank cannot modify it: any excess supply of money is reabsorbed by a BP deficit and vice versa. FISCAL POLICY Let us start again with the internal and external equilibrium represented by point 0. Let us assume an increase in government expenditure. The IS curve moves to the right; domestic equilibrium moves to point 1. The domestic interest rate rises above the foreign one. Point 1 thus implies a surplus of the Balance of Payments which triggers the authomatic adjustment mechanisms. The Balance of Payments surplus implies: an excess supply of dollars an excess demand for euros. To stabilize the exchange rate, the Central Bank has to: buy dollars sell euros. The result is an increase in official reserves and in the money supply. As a consequence of the increase in money supply the LM curve moves downwards. The system goes to the internal and external equilibrium represented by point 2. The Balance of Payments is now balanced. The money supply thus becomes stable.
IS0 1 0
if

LM0

2 BP

Point 1 G Y L i i>if BP+= ES$ = ED OR=Ms LM downwards Point 2

Conclusions about fiscal policy under fixed exchange rates Fiscal policy is not only effective: it is also more effective than in a closed economy. The reason is that a fiscal expansion is now associated with a monetary expansion. Under fixed exchange rates, the shift in the IS curve turns into a shift of the IS-BP interseption. The LM curve adapts itself strengthening the effectiveness of fiscal expansion.. Since equilibrium interest rate is equal to the given if, there is no crowding out of investments. Government expenditure can have its full multiplier effects on induced consumption and income. Y=C+I+G

new classical (macro) economics

(English to be revised)

The New Classical School dominated the debate in the 1970s. Main protagonists: Lucas, Sargent, Wallace, Barro, Prescott. Lucas, Prescott and Sargent got, respectively, the 1995, 2004, 2011 Nobel Prize. The NCS has been also defined as Monetarism Mark II (Tobin 1980). From Friedmans Monetarism Mark 1, it takes the idea that AD is determined by the money market. shocks are monetary. As we shall see, however, there are differences! New Classics are more rigorous and more formalized. In their view, each relationship has to be micro-founded i.e. derived from agents inter-temporal maximizing behaviour. This is the reason why, in the definition new classical (macro) economics, the word macro is in brackets: according to this school, macroeconomics is undistinguishable from microeconomics.
KEYSTONES

1. Market clearing hypothesis 2. Rational expectations hypothesis 3.Surprise supply curve. 1

ST

KEYSTONE: THE MARKET CLEARING HYPOTHESIS

As we have seen, Friedman adopted: a partial equilibrium approach at the beginning, i.e. when he derived AD as a monetary phenomenon. a general equilibrium approach at the end, when he analyzed the Phillips curve. New Classics adopt from the beginning a micro-founded inter-temporal general equilibrium approach. Their assumptions are the usual ones: the system is perfectly competitive;it is composed by atomistic agents (described by representative agents) without market power. Specifically, these agents take prices as given and choose the quantities which maximize their profit/utility competitive agents are perfectly rational; they avoid systematic forecasting errors in their expectations prices are perfectly flexible; they instantaneously and simultaneously clear every market, thus perfectly coordinating agents optimal plans equilibrium exists, is unique and stable. Contrarily to the world where we live, everything is perfect here! These are strong (and unrealistic) assumptions.

The basic framework is thus a general equilibrium one: New Classics, however, start with the usual deterministic component; add the stochastic component, represented by random shocks. Random shocks cannot be anticipated. Thus, in the absence of shocks, we would have full-information. in the presence of shocks, we have incomplete information. With this, New Classics paved the way to the economics of information. One of the pioneers in this field was Phelps, who got the 2006 Nobel Prize. 2
ND

KEYSTONE: THE RATIONAL EXPECTATIONS HYPOTHESIS

Which theories of expectations have we met up to now? KEYNES There is no tendency to general equilibrium. General equilibrium does not reflect the real world. We cannot base our expectations on it. The future is totally uncertain/obscure, we simply ignore it. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten year hence of a railway, a copper mine, a textile factoryamounts to little and sometimes to nothing; or even five years hence. (TGT 150) Always in Keyness views, our forecasts cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist.. Actually, we do not know: the set of possible future events; their numerical probabilities. What we can do, what we usually do, is: to take the existing situation and to project it into the future, modified only to the extent that we have more or less definite reasons for expecting a change. In addition, our decisions will depend: not only on these forecasts; but also on the confidence attached to them, i.e on how highly we rate the likelihood of our best forecast turning out quite wrong. If we expect large changes, but are very uncertain as to what precise form these changes will take, then our confidence will be week. Expectations and the state of confidence determine the propensity to invest (the MEK). Given the extreme precariousness of our basis of knowledge: the state of confidence tends to be week;

people tend to hold money as a safe asset; investment tends to be low; the system tends to get trapped into under-employment equilibriums. ORTHODOX KEYNESIANS They took expectations as given: an assumption which is theoretically unsatisfactory and unrealistic! This implies that exogenous expected values do not necessarily coincide with equilibrium values. If so, how can this equilibrium persist? How can it be an equilibrium? This is a logical inconsistency. FRIEDMAN Friedman assumes adaptive expectations. Let us consider the growth rate of prices gp. Todays inflationary expectations gpet are equal to yesterdays inflationary expectations gpet-1 adjusted by a fraction <1 of the forecasting error made yesterday (gp t-1-gpet-1). gpet = gpet-1+(gp t-1- gpet-1) People make forecasting errors, but gradually correct them. In equilibrium, forecasting errors disappear and expectations become stable. gp t-1= gpet-1= gpet However, adaptive expectations have big inconveniences: They are backward-looking, they only look at the past. They do not take into account what we know about the present or what we can guess about the future. If the OPEC countries announce an increase in oil prices, adaptive expectations are not affected. This is not rational: information is too precious to be neglected. They are generally wrong. If in time t0 the equilibrium price level rises from P0 to P1, As we have seen, adaptive expectations take a long time to adapt. They tend to be true only asymptotically. Generally, they imply forecasting errors. They imply systematic errors People keep behaving in the same wrong way. They do not learn from the past. This behavior is not rational
NEW CLASSICS

Given the aforementioned inconveniencies, New Classics: rejected the adaptive expectations hypothesis; adopted the rational expectations hypothesis.

Muth introduced the concept in 1961. Lucas made it popular since the beginning of the 1970s. Rational agents maximize their utility also in forming their expectations. They use all available information and do it in the best way. Let us start with available information. According to Lucas, agents know: economic theory; the true (the general equilibrium) model; the parameters of the model. Put otherwise, new classical agents know the deterministic component of reality. but ignore the random component. Let us then consider the price level Pt; it has a deterministic component Pt (the general equilibrium solution) a stochastic component (the random error et). Pt =Pt + et Expectations are given by expected values: Pet = E(Pt) = E(Pt) + E(et) Rational agents use available information in the best possible way. To this end, they avoid systematic errors. Specifically, they: have learnt from past experience have recognized their systematic errors; are able to avoid them. If errors are not systematic: E(et)=0 Specifically, random errors have: zero mean E(et)=0 zero serial correlation E(et, et-i)=0 Under these assumptions, rational agents foresee the deterministic component of prices Pt. Pet = E(Pt) = Pt If they make forecasting errors, this is due to the random component et. Pt -Pet = Pt-Pt = et Rational expectations do not imply perfect foresight. On average, however, foresight is perfect. Rational expectations are based: not on the past behaviour of the variable,

but on the equilibrium solution for it; expected values are thus consistent with the equilibrium ones. You might object that poor human beings: face many theories do not know which theory is the right one do not know the model do not know the parameters do not have enough intellectual capability to solve the model and so on.. The answer of the New Classics is that, by avoiding systematic errors, rational agents end up with behaving as if they knew the deterministic component of the system. The philosophy is that people learn. More exactly, rational agents have already learnt what was possible to learn. 3
RD

KEYSTONE: LUCASS SURPRISE AGGRETAE SUPPLY FUNCTION

In Lucss view, current income Yt is given by: the natural (the general equilibrium) income Yn a cyclical component due to the inflationary surprise Pt-Pet =et a random component ut. We thus have: Yt=Yn + (Pt-Pet) +ut or Yt=Yn + (et) +ut Let us see it graphically! Point A below represents an initial general equilibrium situation: income Y is at its natural level Yn. expected (Pe) and equilibrium prices (Pe) coincide. Let us now assume a monetary expansion and a consequent increase in aggregate demand AD. The new general equilibrium is represented by point A. The higher demand leads to an increase in the equilibrium price level. At this point, Lucas distinguishes two cases. The increase in AD& P is anticipated: expected and equilibrium prices keep coinciding; Y remains at Yn; we move from A to A on the vertical aggregate supply curve AS*; the textbook associates this vertical AS* curve with the long-run equilibrium; I would prefer to associate it with full information general equilibrium.

The increase in AD& P is unanticipated: in the presence of an inflationary surprise Pt-Pte=et, income Y rises above Yn; we move from A to B on the upward sloping aggregate supply curve AS; the textbook associates this AS curve with the short-run SR; I would prefer to associate it with the incomplete information characterizing the short-run.
AS* A AD0 Pe0=Pe0 A B e AS

The AS* curve: reflects the case of full information The SRAS curve: reflects the case of incomplete information

Yn
THEORETICAL JUSTIFICATION FOR

LUCASS APPROACH

Lucass theory reminds us Friedmans theory of the Phillips/AS curve. The underlying assumptions, however, are different in the two cases. Friedman had asymmetric information: firms have full information, workers do not. Lucas has incomplete (but symmetric) information. Agents learn from each other: they thus inevitably end up with the same information. However, workers and firms may be equally wrong. In the presence of an increase in the price level, both of them face a signal extraction problem: are they facing an increase in the general price level (that notoriously does not affect real variables)? are they facing an increase in the relative price of (in the relative demand for) their products/services? 1st Case: workers are wrong (Lucas and Rapping 1969) Workers misinterpret the general increase in absolute prices and wages. They mistakenly believe that their current real wage (their current productivity) has increased above its natural level. They consequently decide to work more today and to postpone leisure in the future. 2nd Case: firms are wrong (Lucas 1972-3) Firms only know what happens in their markets (in their islands). They consequently interpret the increase in the absolute price level as an increase in the relative price of their product. Put otherwise, they mistakenly think to be in the presence of a shift in real demand towards their products. As a consequence, they increase their output levels.

THE EFFECTIVENESS OF MONETARY POLICY

We refer to Sargent and Wallace 1975. Their model is composed by three equations: an aggregate demand function; a monetary rule; the surprise supply function; AGGREGATE DEMAND FUNCTION The Quantity Theory equation MtV=PtYt can be interpreted as an aggregate demand function AD. Yt = MtV Pt The slope of the AD curve is downward: Yt = MtV Pt The position of the AD curve depends on M. The increase in M causes the increase in Y at any price level P. The AD curve moves rightwards. Yt = MtV Pt The AD function can be also expressed as follows: Pt=(MtV/Yt) To simplify, we shall assume that the transactions demand for money depends on permanent (natural) income. The price level then becomes a constant. The AD consequently becomes a horizontal line. Pt=(MtV/Yn) If we add a random component ut, we get the following expression for AD: Pt=(MtV/Yn) + ut
MONETARY RULE

By assumption, money supply M has: a given exogenous component a; an anti-cyclical component b(Yn-Yt-1); (when output falls below its natural level, the central bank raises M in order to stimulate the economy and vice versa) a random component wt. Mt = a + b (Yn-Yt-1) + wt SURPRISE AGGREGATE SUPPLY FUNCTION

As known, the expression for the AS curve is: Yt=Yn + (Pt-Pet) + t

SOLUTION OF THE MODEL

Let us substitute the monetary rule into the AD function. Pt = V [ a + b (Yn-Yt-1) + wt] + ut Yn Let us then calculate the expected value of prices: the random components now disappear. Pet = E(Pt) = V [ a + b (Yn-Yt-1) ] Yn We can now calculate the surprise effect; it only includes the random components. P - Pet= V wt + ut Yn By substituting the surprise effect into the aggregate supply function Yt = Yn + (Pt-Pet) + t we finally get the following expression for equilibrium income: Yt = Yn + V wt + ut + t Yn Income fluctuations around the natural level are exclusively due to random shocks.
IMPLICATIONS FOR MONETARY POLICY

According to the monetary rule: Mt = a + b (Yn-Yt-1) + wt monetary policy has: a systematic component a + b (Yn-Yt-1) a random component wt. The expression for equilibrium income Yt includes only the random component wt. Yt = Yn + V wt + ut + t Yn This has the following implications. The systematic component of monetary policy: is fully anticipated by agents; does not imply any surprise; does not affect equilibrium income.

AS* P P1 C AS

P0

In the case of an anticipated M&AD: P and W grow at the same rate; AD and AS move upwards by the same %; we move from A to C on the AS* curve; the nominal scale of the economy grows; real variables do not change; we have no real effect, even in the short-run.

AD0
Yn

The random component of monetary policy: implies a surprise which pushes Y above its natural level Yn. Agents do non realize that only the nominal scale of the economy has changed. Firms/workers mistakenly believe to face an increase in the relative price of their products/services. They consequently supply more output/labor, leading to an increase in output Y. We move from A to B on the AS curve.
AS*
P

P1

C B

AS

P0

A AD1 AD0
Yn

The monetary surprise,, however, is only temporary. Data on prices become available very quickly. As surprise disappears, income goes back to its natural level Yn. The system moves from B to point C on the AS* curve. The only permanent effect is the increase in the absolute price level.
AS*
P

AS1 AS0 B

P1

P0

A AD1 AD0
Yn

From this analysis, Sargent and Wallace 1975/6 derived the following proposition. Sargent got the 2011 Nobel Prize. POLICY INEFFECTIVENESS PROPOSITION OR IRRELEVANCE HYPOTHESIS This famous proposition maintains that:

a fully anticipated monetary policy does not have real effects; only an unanticipated monetary policy has (short-run) real effects. To be (temporarily) effective, the central bank has to behave like a drunk! The effects of a random behaviour, however, are not necessarily the desired ones. What sense would such a conduct make? The policy ineffectiveness proposition represented a true novelty! Friedman reached the conclusion that monetary policy: in the short-run has real effects; in the long-run affects only nominal variables. New Classics questioned even the short-run real effects. In their view, only an unanticipated monetary policy, a monetary surprise, can have short-run real effects. Anyhow, the real effects of a monetary surprise: are only temporary; are socially costly, implying a resource misallocation. Monetary policy (either anticipated or unanticipated) permanently affects only the price level. Better not to control income, better to focus on prices. A fully anticipated (based on a fixed monetary rule/announced and credible) monetary contraction has no real costs. In this case, the best monetary strategy is the cold turkey one (from A to C below).

gp

LRPC

SRPC

C ufe u

THE SACRIFICE RATIO

The sacrifice ratio is the amount of output lost in order to reduce inflation. ORTHODOX KEYNESIANS the short-run maladjustment concerns wage rigidity; wage maladjustments require a long time to disappear; in this long-lasting short-run, money has real effects; the sacrifice ratio might be relevant and long-lasting. MONETARISTS the short-run maladjustment concerns inflationary expectations;

data on prices are ready available: the short-run is of short duration; the real effects of monetary policy are not long-lasting; NEW CLASSICS a fully anticipated monetary contraction has no real costs even in the short-run; it implies a zero sacrifice ratio; this means that an announced and credible cold turkey strategy does not imply any sacrifice in terms of output and employment. Is it easy for a central bank to be credible? Let us see. TIME INCONSISTENCY AND CREDIBILITY We refer to Kydland and Prescott 1977. Prescott got the Nobel Prize in 2004. In the view of the two authors, economic policy: has not to do with the planetary system; is a dynamic game between policy makers and rational agents. Policy makers: face a constraint represented by the Phillips curves; on that basis, choose the combination of unemployment and inflation which maximizes social utility. Below, we shall analyze the constraint and the utility function of policy makers. THE CONSTRAINT As known, in any given circumstance we face two kinds of Phillips curves: a short-run one and a long-run one. Vertical long-run Phillips curve LRPC In the long-run: inflation is fully anticipated; there are no inflationary surprises; unemployment is at its natural rate un; there is no trade-off between the rate of inflation gp and the rate of unemployment u.
gP
LRPC

un

Downward sloping short-run Phillips curve SRPC Each short-run Phillips curve implies a given expected rate of inflation gep. This given gep is represented by the ordinate corresponding to un: unemployment is the natural one only when current and expected inflation coincide and there are no surprises.

gp

SRPC(gep=10%)

gp=10%
0

un

each short-run Phillips curve is downward sloping: Whenever current inflation gp rises above (falls below) the expected one gep, we have a positive (negative) surprise e= gp - gep>0 (<0) which stimulates (depresses) output and employment.

gp 10%

SRPC(gep=10%)

un

higher short-run Phillips curves imply higher expected rates of inflation.

SRPC(gep=30%) SRPC(gep=15%) SRPC(g =0%) gp=30% gp=15% gp=0%

un
e p

At u=ufe

gep=gp

SOCIAL UTILITY

Social utility is a negative function of inflation/deflation and unemployment: all of them are undesirable. The social utility function generates a set of indifference curves. Each indifference curve reflects a given social utility level. Slope of the indifference curve The indifference curves are downward (upward) sloping. At any given social utility level U*, a higher unemployment rate has to be offset by a lower inflation (deflation) rate. Position of the indifferent curve Indifference curves to the left imply a lower unemployment rate at any gp. They thus imply higher social utility levels.
gP

SU3>

SU2>

SU1

SOCIAL UTILITY MAXIMIZATION The central bank maximizes social utility.

gp

LRPC

The optimal long-run solution: is point A on the LRPC Point A implies: the natural unemployment rate un; a zero actual and expected inflation rate.

un

A
u

Let us assume that this policy is announced (gm= gp=0) and that the announcement is credible. We instantaneously go to A: actual and expected inflation are zero. As soon as this policy is implemented, however, point A stops being the optimal solution. Put otherwise, it is not time-consistent: it is optimal ex ante but not ex post (NB). Let us see why.
gp 10% SRPC(gep =0) B LRPC

In A, actual and expected inflation are zero gep=gp=0

A u

un

When expected inflation is 0, however: the constraint the SRPC (gep =0). the short-run optimal solution is point B.

As we have seen, the short-run optimal point is B. Monetary authorities have then the incentive to cheat (to belie their announcement): announced and expected inflation is 0%; current inflation becomes (a totally unexpected) 10%; there is a surprise effect unemployment falls below its natural level un. With the passing of time, people realize that actual inflation has risen to 10%.

gp

SRPC(10%) SRPC(0)

LRPC

The short-run Phillips curve then moves from SRPC(0) to SRPC(10%) We move to point C, which: is time-consistent: authorities have no incentive to cheat. but is sub-optimal: point A would imply a higher social utility level. u

10%

A un

Thus, the central bank announces again a zero inflation strategy. gm= gp=0 Now, however, the central bank has lost its credibility. People know that in point A it would have the incentive to cheat. If monetary authorities announce a zero growth rate in money and prices, people do not trust them and keep expecting a 10% inflation rate.
gp 10% SRPC(0) SRPC(10%) LRPC

The growth rate of M and P falls from 10% to 0. Instead of going directly from C to A, the system first goes to D and only afterwards goes to A.
D

A un

The shift from the sub-optimal point C u to the optimal point A now implies a high sacrifice ratio.

Conclusion about time inconsistency Discretionary policies are time inconsistent: monetary authorities have the incentive to cheat. As a consequence, monetary policy looses its credibility. implies a high sacrifice ratio. THE LUCAS CRITIQUE Lucas had another important insight that has to be mentioned. Monetary policy affects expectations and thus the behaviors of private agents. This means that it: affects the parameters of the system; influences the model. Econometric regressions:

are estimated on the basis of historical time series; reflect the old model, not the new one. Econometric models cannot be used to predict the effects of economic policy. MAIN WEAKNESSES OF NEW CLASSICAL ECONOMICS Its presuppositions are extreme! Continuous market clearing. Prices are not perfectly flexible; they leave room to coordination failures. The system is not constantly in general equilibrium. Demand policies have real effects. Perfect rationality Individual rationality is bounded. We do not have all the necessary information: the future for instance is unknown. The processing of information is costly anddifficult. Many problems are mathematically unsolvable, even by the best available computer. Surprise effects. Data on price and money supply are readily available. The surprise effect cannot explain the intensity and persistence of actual business cycles. Money Supply is not exogenous. Not by chance, the subsequent school of thought, the Real Business Cycle Theory, substituted monetary with real shocks, focusing on technical progress and innovation. A PERSONAL VIEW After the Keynesian revolution, the Neoclassical Synthesis re-introduced general equilibrium as a benchmark. The economic system in itself would be perfect, but there are maldjustments which disturb its functioning. In the perfect general equilibrium world, however, maladjustments are difficult to justify. They consequently tend to be questioned and lastly rejected. If we look at the evolution of macroeconomic thought, this happened: to wage rigidity (Modigliani, Patinkin, Orthodox Keynesians) to the rigidities in price expectations (Friedman) to monetary surprises (Lucas) This led the mainstream to the conclusion that: the system in itself is perfectly stable; fluctuations are general equilibrium ones, caused by external random shocks. The recent financial turmoil, however was not caused by an exogenous shock;

(see the 2008 Lectio Magistralis delivered by Driffill on the Cifrem web page) Under this perspective: present mainstream theory is not very useful the economists of the past may help more (Obama and Bernanke follow Keyness prescription). the history of economic thought is not a waste of time.