Behavioural Finance

1
Behavioural Finance

• Lecture 11
• Out of Sequence
• Extending Endogenous Money

2
Recap

• Last week we built model of pure credit economy

• Pure credit economy can be self-sustaining
• Single initial loan causes sustained economic
  activity
• Positive bank balances, incomes

3
This week

• Extending model to include production
• Explaining values of parameters
• Expanding model to include growth
• Applying the model
• Working out why lenders tend to lend too much
  money
• Modelling a credit crunch

4
Production

• Actual production involves
• Multiple commodities used to produce each other
• Factories (fixed capital) Machinery that
• Transforms inputs
• E.g, blast furnace
• Iron Ore Coal in, Steel out
• Depreciates in use
• Circulating capital (Marxs term)
• Goods used up entirely in producing output
• Raw materials, energy, intermediate goods (e.g.,
  rivets become part of car)
• Many types of labour (skilled, unskilled,
  supervisors)

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Modelling Production

• Economic models of production
• Basic Neoclassical factors of production
• Labour Capital InGoods Out
• Numerous problems with this
• Shown to be invalid in Cambridge Controversies
  over the nature of capital
• Ignored (or not even known) by most neoclassical
  economists
• See History of Economic Thought lecture
• Chapter 6 of Debunking Economics

6
Modelling Production

• Advanced Neoclassical
• General Equilibrium
• Multiple goods as inputs, multiple goods as
  outputs
• Better than Factors of production fallacy
• But problems with assumption that economy in
  continuous equilibrium
• See History of Economic Thought lecture
• Chapter 8 of Debunking Economics
• Post-Keynesian
• Most are dynamic (good!)
• Use abstraction of single commodity output,
  constant ratio between labour input GDP output
  (not so good, but not as bad as neoclassical
  factor of production models)

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Modelling Production

• Sraffian
• Based on work of Piero Sraffa
• Developer of critique of neoclassical factor of
  production model
• Model production as multiple goods as inputs
  producing multiple goods as output (very good)
• But work in equilibrium (very bad)
• Model of production used here
• Dynamic with abstraction of single commodity
  (Very good)
• Labour inGDP out (Not so good)
• But later expanded to multiple goods in, multiple
  goods out

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Absolutely Basic Modelling of Production

• Start with
• Single Output (Q or GDP)
• Labour input L
• Constant labour productivity (a) so that
• Q a.L
• Constant money wage W
• Link between monetary model developed last
  lecture
• And physical output
• Is Price (P)
• Have to work out a dynamic equation for price

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Absolutely Basic Modelling of Production

• In equilibrium, price must just enable flow of
  demand to purchase flow of output
• Flow of output is
• Q a.L
• L equals flow of wages divided by wage rate
• From last weeks lecture, flow of wages is

Workers share of surplus generated in production
Balance in Firm sectors deposit account
Time lag between financing production and
receiving sales revenue
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Absolutely Basic Modelling of Production

• So Labour employed L is this flow divided by the
  wage rate W

• Physical output Q is then labour employed L
  multiplied by labour productivity a

• Physical demand (D) is the monetary flow of
  demand divided by the price level P
• Monetary flow of demand is

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Absolutely Basic Modelling of Production

• So demand in physical units per year is this
  divided by price level P

• When economy is in equilibrium, flow of supply
  will equal flow of demand

• We can now solve for what Price would be in
  equilibrium

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Absolutely Basic Modelling of Production

• So in equilibrium, price is a markup on the
  monetary cost of production

Money wage per worker divided by units of output
per worker is the cost of production per unit
produced
Markup 1/(1-s) is bigger than 1

• Price as a markup on cost of production means
  that
• Prices convert the physical surplus into a
  monetary one
• Basic dynamic price equation consistent with this
  is

Relation in Equilibrium
Time lag in price setting
Rate of change of prices
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Absolutely Basic Modelling of Production

• Minimum production system is therefore

• Monetary-production model is
• This physical system
• Coupled with previous monetary flows table

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A monetary model of production

• In equations

Financial sector as derived from table of flows
Price system
Labour-based production

• Simulation shows system describes viable pure
  credit economy

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A monetary model of production

• Monetary physical systems consistent in
  equilibrium
• But convergence to equilibrium takes time

• Original monetary flows only model

• Expanded monetary flows, physical flows and price
  model

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A monetary model of production

• Monetary estimates of profits
• Rate of surplus (s)
• Times Firm Deposit Account (FD)
• Divided by turnover rate (tS)
• Converges over time to equal physical estimate
• Price times Quantity minus Costs (Wages only
  here)
• Ditto monetary estimate of wages
• One minus rate of surplus (1-s)
• Times Firm Deposit Account (FD)
• Divided by turnover rate (tS)
• Converges over time to
• Wage rate times Labour

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A monetary model of production

• Taking stock so far Combining
• Circuit insights into nature of credit money and
• Basic approach to dynamic modelling
• Has yielded working model of the circular flow
• Not just a diagram

• But working model of monetary and physical flows
• No hassles about assuming equilibrium, etc.
• Next stages
• Explain parameter values
• Allow for growth and
• Beginnings of behaviour (rather than fixed
  parameters)

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Parameter Values and Time Lags

• Values used for parameters may seem strange
• w26 for workers consumption
• b1 for bankers consumption
• Full list of values is

• Interest rates based on long run averages
• Loan minus deposit rates normally 4
• Rate of surplus turnover arbitrary but generate
  income shares close to actual data
• Other 4 parameters (w, b, LR, RR) are inverse
  time lags
• Time lag tells how long a process would take to
  reach its equilibrium if it continued linearly

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Parameter Values and Time Lags

• Consider just consumption by workers
• Equation for outflow from account is

• Solve this via integration

• Slope of tangent to this curve is

• At t0 this slope is

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Parameter Values and Time Lags

• Equation of tangent to curve at t0 is

• Equals M0 at t0

• Slopes away at w.M0

• Equals zero at t1/w (in workers case, 1/26th of
  a year)

• Time lag for workers consumption is 1/26th of a
  year
• Shown as tw1/26 in future

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Parameter Values and Time Lags

• Rule applies in general

• Time where tangent to curve crosses equilibrium
  value of function is the time lag of the
  function, expressed as fractions of the time unit
  (here, years)

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Parameter Values and Time Lags

• Lets us interpret w as number of times a year
  workers turnover their accounts
• Workers spend their wages 26 times a year
• w 26
• And express consumption by workers as a time lag
• Time lag for workers consumption is 1/26th of a
  year
• tW 1/26
• So consumption from household accounts can be
  shown as

• In practice, time lag version used, since it
  expresses behaviour in fractions of basic time
  unit of a year

or
where w 26
where tw 1/26
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Parameter Values and Time Lags

• So the various strange parameter values mean

• Time lags used from now on to better specify
  models

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Growth

• Model so far shows that
• Keynes was right sustained economic activity can
  be maintained with fixed stock of money as
  revolving fund of finance
• Capitalists can borrow money make a profit
• Debt easily repaid
• Circuit conclusions about viability of economy
  without rising injections of money based on
  errors in dynamics
• Next stage how does money grow endogenously?
• Insight from Basil Moore
• Firms finance operations by lines of credit
• Create new money if access line of credit
• AND debt grows by same amount

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Growth

• Easily incorporated by new row
• Both debt and firm deposits grow by same amount

• Both assets and liabilities of banking sector
  expand

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Growth

• Relate to level of Firm Deposits
• J FD/tNM
• Set tNM 20 Money doubles every 20 years
• Outcome is self-sustaining growth

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Growth

• Ditto for physical economy

• Circuitist insight that money and banking must be
  included in a model of capitalism
• Combined with dynamics
• Could be the Holy Grail that enables capitalism
  to be modelled accurately
• Next extensionvariable wages employment

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Variable wages

• Raises the vexed issue of the Phillips Curve
• Alleged statistical relationship between
• Level of unemployment and
• Rate of change of money wages
• Massively misinterpreted in literature
  textbooks
• Phillips was actually a systems engineer
• Using 1950s version of technology shown here
• Tried to introduce these methods to economics
• Misinterpreted and derided as Hydraulic
  Keynesianism
• Objective to introduce dynamics into economics!

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The Phillips Model

• RECOMMENDATIONS for stabilising aggregate
  production and employment have usually been
  derived from the analysis of multiplier models,
  using the method of comparative statics.
• This type of analysis does not provide a very
  firm basis for policy recommendations, for two
  reasons.
• First, the time path of income, production and
  employment during the process of adjustment is
  not revealed. It is quite possible that certain
  types of policy may give rise to undesired
  fluctuations, or even cause a previously stable
  system to become unstable, although the final
  equilibrium position as shown by a static
  analysis appears to be quite satisfactory.
• Second, the effects of variations in prices and
  interest rates cannot be dealt with adequately
  with the simple multiplier models which usually
  form the basis of the analysis. (Phillips 1954
  290)

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The Phillips Model

• Phillips built a dynamic model using flowchart
  showed one variable (e.g., unemployment)
  affecting rate of change of another (e.g., money
  wages)

• As part of model, postulated nonlinear
  relationship between output and wage/capital
  price inflation

Level of D
Rate of change of P
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The Phillips Model

• We may therefore postulate a relationship
  between the level of production and the rate of
  change of factor prices, which is probably of the
  form shown in Fig. 11 (308)

• Did research that led to Phillips curve to
  justify this part of his dynamic model, using
  19th century UK data

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The Phillips Curve

• Found a clear tendency for
• inverse relation between U and rate of change of
  money wages (Dwm)
• Dwm above curve when U falling, and vice-versa
• Fitted exponential curve to data

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The Phillips Curve
Deviations from trend because of
Fitted through average wage change U for
0-2,2-3,3-4, 4-5,5-7,7-11 unemployment
Wage-price spiral due to wars falling U
Rising unemployment
34
The Phillips Curve fitted to 1913-1948 data
Rapid rise in U 13 fall in M prices cost of
living agreements
War-induced rise in M prices
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The Phillips Curve

• Economists didnt comprehend Phillips on dynamics
• Instead, latched onto trade-off, static
  interpretation of unemployment-wage rise
  relationship
• Proposition that policy makers could choose an
  unemployment-inflation pair became part of
  orthodox Keynesianism
• Unfortunately, static relation didnt seem to
  hold
• Keynesian economics discredited by this
• But employment-wage change relation common to all
  schools of economics
• Still used in neoclassical static models
• Here introduced as Phillips intendedas part of
  dynamic model

36
Variable wages

• Basic Phillips curve introduced here
• Advanced Phillips curve should include all 3
  influences Phillips noted
• Level of unemployment (highly nonlinear)
• Rate of change of unemployment
• Rate of change of retail prices operating
  through cost of living adjustments in wage rates
  when retail prices are forced up by a very rapid
  rise in import prices or agricultural
  products. Economica 1958 p. 283-4
• Function fitted to employment rate rather than
  unemployment
• A generalised exponential function

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Variable wages

• Exponential function is y(x) ex (where e
  2.718)

• Generalised version which
• can place an exponential curve anywhere on the
  x-y axis
• control the slope

Slope at that point
(x,y) pair curve goes through
Minimum value

• Dont worry about the details
• Fitted to Phillipss UK data the values for this
  are

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Variable wages

• Employmentmoney wage change function is

• Other elements of reality introduced now
• Rising population
• Rising labour productivity
• Still a very basic model, but first truly
  monetary circular flow model ever

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Variable wages
Looks complicated, but if you understood the
table of financial flows, you understand this

• Model in detail

• Financial system as before

• Prices a lagged adjustment to markup on cost of
  production

• Employment Flow of money wages divided by money
  wage

Prices
Employment

• Output Employment times productivity

Output
Exponential growth in productivity and population

• Change in money wage a nonlinear reaction to
  employment rate

Employment Rate
Money Wage
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Basic Circular Flow Model

• Model still skeletal
• Basic entities in economy
• Financial accounts
• Firms
• Workers
• Relationships between them
• Interest Debt payments
• Wages and consumption
• But only one muscle
• Worker response to level of employment
• Much more needed for adequate model

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Basic Circular Flow Model

• Firm response to rate of profit
• Speculation rather than investment
• Variations in consumption due to economic
  conditions, etc.
• But interesting results even from skeleton
• Non-neutrality of money
• Higher money creationlower unemployment
• Persistent inflation possible
• Deflation if rate of money creation drops
• Can also ask the model policy questions (shown
  later)

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Basic Circular Flow Model

• Some sample outputs

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Policy (1) Should lenders be controlled?

• What happens to bank income if
• Rate of new money creation speeds up
• Rate of relending existing reserves accelerates
• Rate of repayment of existing loans drops?

• Changing lending parameters by factor of 2
  triples bank income
• Banks have inherent bias to providing as much
  debt as possible
• As endogenous money theorists assert

44
Policy (2) Can a credit crunch cause a recession?

• 3 key financial parameters altered by factor of 2

• Crunch causes temporary rise in unemployment AND
  sustained higher level
• Inflation turns to deflation and then lower
  sustained rate of inflation

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Policy (3) Best way to fight a credit crunch?

• Standard multiplier model policy
• Obama explaining his economic policy, April 2009
• there are a lot of Americans who understandably
  think that government money would be better spent
  going directly to families and businesses instead
  of banks wheres our bailout?, they ask.
• the truth is that a dollar of capital in a bank
  can actually result in eight or ten dollars of
  loans to families and businesses, a multiplier
  effect that can ultimately lead to a faster pace
  of economic growth. (page 3 of speech)
• Simulation 100 billion injection 1 year after
  crunch
• (a) Boost banks reserves
• (b) Boost firms (debtors) deposits

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Policy (3) Best way to fight a credit crunch?

• New flows table

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Policy (3) Best way to fight a credit crunch?

• Stimulus inflow of 100 billion for one year
  after crunch
• Modelled as a pulse
• Takes value of 100 (billion) for a year after
  crunch till two years after
• No consideration yet of how government money
  created

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Policy (3) Best way to fight a credit crunch?

• Stimulus inflow of 100 billion for one year
  after crunch

• Outcome opposite of money multiplier prediction
• Better to give stimulus to debtors than banks
• Reason higher rate of turnover
• Funds injected into BR flow out slowly
• Funds injected into FD flow out quickly
• Higher rate of turnovergreater impact from
  stimulus

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Conclusion

• Circuit model still skeletal
• But already reaches different economic policy
  results to standard models
• Next week
• The Financial Instability Hypothesis