MECO 6303 Business Economics

1
MECO 6303 Business Economics
Lesson 7 Saving, Investment and the Financial
System Part B Money and the Economy, National
Income Accounting.
2
Schools of Economic Thought
The Classical Economists (The Quantity Theory
Tradition) Pre-Smith Adam Smith (1776) David
Hume David RicardoJames Mill John Stuart Mill
The Austrian School (1871) Carl
Menger Böhm-Bawerk Wieser Mises Hayek Modern
Austrians Kirzner, Lachmann Boettke, Horwitz,
Roger Garrison, Lewin
The Neoclassical Revolution (1871)
Karl Marx
Alfred Marshall Cambridge school Irving Fisher
- America Keynes
The Keynesian Revolution Samuelson, Solow, Tobin
The Chicago School (approx. 1952 1990)
Monetarism Milton Friedman
3
Explaining the Determination of the Quantity of
Money in the Economy

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

4
Money and the Economy the equation of exchange

• Fed ?M ? Economy.
• M ? Y (some measure of economic activity, like
  GDP in monetary terms)
• Calculate P, a price index for Y, so that
• Q Y/P then
• M ? PQ or MV PQ the equation of exchange.
• Alternative form MkPQ the Cambridge cash
  balance equation.

5
Inflation and the equation of exchange

• MV PQ
• V is the velocity of circulation
• So gM gV gP gQ
• If gV ? 0 gM gP gQ.
• The Business Cycle Monetarist, Austrian and
  Keynesian.

6
Classical Economics and the Role of Money

• The ascendancy of laissez faire ideas Says
  Law and the monetary dichotomy
• If V (and k) and Q are approximately constant we
  have the Quantity Theory of Money.
• M ? P or gM gP

7
Crisis and Disillusionment The Economics of
Keynes and Keynesian Economics

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

8
The Phillips Curve
gP
A Keynesian Tradeoff between Inflation and
Unemployment
Unemployment rate
9
The Monetarist Counterrevolution

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

10
Whats left of the Phillips Curve?
gP
Unemployment rate
11
Whats Left?

• The focus is on M and interest rates
• Old style Keynesianism is dead, but so is simple
  Monetarism
• Whats left is a mixture of different ideas
• Maybe the Austrians are right

12
Saving and Investment in the National Income
Accounts

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

13
The Meaning of Saving and Investment

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

14
The Meaning of Government Surplus and Deficit

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

End of Part B