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Thread: Circular Flow of Income theory

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    Re: Circular Flow of Income theory

    Quote Originally Posted by Kushinator View Post
    Trade deficits are a positive component to investment growth. It's the trade-off for more consumption, as foreign savings are a component of aggregate investment.
    Before I respond - do you believe that money is neutral? Because that's what I'm getting from points like this one. It would explain a lot.
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    Re: Circular Flow of Income theory

    Quote Originally Posted by JohnfrmClevelan View Post
    Before I respond - do you believe that money is neutral? Because that's what I'm getting from points like this one. It would explain a lot.
    In the long run. In the short run, prices are sticky.
    It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.
    "Wealth of Nations," Book V, Chapter II, Part II, Article I, pg.911

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    Re: Circular Flow of Income theory

    Quote Originally Posted by Kushinator View Post
    In the long run. In the short run, prices are sticky.
    So this is where we differ.

    If I'm understanding your equations correctly, money, earned by the Chinese, is counted as investment when they buy Treasuries with it. But because I see Treasuries differently - as just another form of government liability, same as a dollar, I don't consider that to be investment. The government simply creates more liabilities when it wants to spend. And if the Chinese just decided to hold those dollars in dollar form, there would be no difference to the government's ability to create and spend money. Counting the sale of Treasuries as "investment" just seems like an equation-fixer, making it look like our trade imbalance is evened out by Chinese "investment" in our economy. But those dollars never enter our economy in reality. (The other stuff you mentioned - real investment in U.S. production, I agree. Purchase of stocks, though, is no more real investment than it is when we buy them.)

    Same problem with domestic savings. Income saved, whether saved in bank accounts or Treasuries, does not enter the economy unless and until it is spent, net. The pile of Treasuries only continues to grow, so there is no net spending from that, and account balances also continue to grow, so there is net saving there, too.

    Quote Originally Posted by Kushinator View Post
    Nobody is depleting their savings because they are earning more income than they spend to earn it... on the aggregate. When this does happen, it's typically driven by an economic slowdown. We are not in any contention that deficits are an addition to GDP.
    I'm not even counting interest here, I'm talking about the immediate effect of (bond purchases + govt. spending of the proceeds). Taken together, the private sector hasn't lost any dollars at all. The government has simply purchased stuff with new liabilities. If the Fed purchased those bonds, there would be a straight addition of dollars into the economy (after the spending) instead of an addition of bonds. It's the same as the direct issue of currency.

    Quote Originally Posted by Kushinator View Post
    Trade deficits are a positive component to investment growth. It's the trade-off for more consumption, as foreign savings are a component of aggregate investment.
    Using an extreme example, let's say we have a $10 trillion economy. We spend $1 trillion (net) of that on Chinese goods, and $9 trillion on domestic production. The Chinese buy nothing from us with their $1 trillion. Barring deficit spending and increased credit, how do we sell that last $1 trillion worth of U.S. goods that haven't been purchased?

    **************

    When I ask others, "how does an economy grow?," I usually get an answer that doesn't include money. The answer is "an increase in productivity," or "population growth," or "savings are invested." But my contention is that you cannot translate any of that into growth without money being part of the equation. Workers don't work harder/longer without being paid. You can't buy more materials for production without money, and the money has to come first. This is where I see a problem with classical models.
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    Re: Circular Flow of Income theory

    Quote Originally Posted by JohnfrmClevelan View Post
    If I'm understanding your equations correctly, money, earned by the Chinese, is counted as investment when they buy Treasuries with it.
    First off, these are identities, not equations, and they certainly are not mine. Secondly, no, it doesn't mean anything like that. Buying treasuries to finance deficit spending increases G, not I. What i've been trying to convey for this entire exchange is that in the event of a fiscal deficit, the only way for investment not to shrink is for the trade deficit (imports more than exports) and/or private savings to grow.

    Same problem with domestic savings. Income saved, whether saved in bank accounts or Treasuries, does not enter the economy unless and until it is spent, net. The pile of Treasuries only continues to grow, so there is no net spending from that, and account balances also continue to grow, so there is net saving there, too.
    Under the basis of the NIPA identity construct, savings equals investment, and investment = private savings + public savings + foreign savings

    I'm not even counting interest here, I'm talking about the immediate effect of (bond purchases + govt. spending of the proceeds). Taken together, the private sector hasn't lost any dollars at all. The government has simply purchased stuff with new liabilities. If the Fed purchased those bonds, there would be a straight addition of dollars into the economy (after the spending) instead of an addition of bonds. It's the same as the direct issue of currency.
    That's not how it works though. Money used to purchase bonds doesn't get to flow into private investment, it becomes G instead of I. Do you understand why this is so?

    Using an extreme example, let's say we have a $10 trillion economy. We spend $1 trillion (net) of that on Chinese goods, and $9 trillion on domestic production. The Chinese buy nothing from us with their $1 trillion. Barring deficit spending and increased credit, how do we sell that last $1 trillion worth of U.S. goods that haven't been purchased?
    GDP in that instance isn't $10 trillion, it's $9 trillion. GDP is about domestic production.

    When I ask others, "how does an economy grow?," I usually get an answer that doesn't include money. The answer is "an increase in productivity," or "population growth," or "savings are invested." But my contention is that you cannot translate any of that into growth without money being part of the equation. Workers don't work harder/longer without being paid. You can't buy more materials for production without money, and the money has to come first. This is where I see a problem with classical models.
    I'm not talking advocating classical models, as i'm really drawing from Post-Keynesian economics. Once again, you cannot understand economic growth through the lens of accounting identities... all they were created to do was, well, count. C, I, and G all possess a co-variances that are impossible to determine using your methodology. If you're interested in understanding economic growth, i'd start with reading about the Cobb-Douglass production function as a good primer. From there, you can be better prepared to learn more advanced growth theories, e.g. exogenous/endogenous.
    It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.
    "Wealth of Nations," Book V, Chapter II, Part II, Article I, pg.911

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    Re: Circular Flow of Income theory

    Quote Originally Posted by Kushinator View Post
    First off, these are identities, not equations, and they certainly are not mine. Secondly, no, it doesn't mean anything like that. Buying treasuries to finance deficit spending increases G, not I. What i've been trying to convey for this entire exchange is that in the event of a fiscal deficit, the only way for investment not to shrink is for the trade deficit (imports more than exports) and/or private savings to grow.
    I grows with private savings only because that leads to a buildup of unsold inventory. I would think that a buildup of unsold inventory would cause a business to scale back production.

    How an increased trade deficit leads to increased domestic investment is still a mystery to me.

    Quote Originally Posted by Kushinator View Post
    That's not how it works though. Money used to purchase bonds doesn't get to flow into private investment, it becomes G instead of I. Do you understand why this is so?
    The money used to purchase bonds probably wasn't going to flow into private investment anyway. It could just as easily have remained in bank account balances, had the Fed purchased those bonds instead, or if we simply issued currency directly. Treasury purchasers are looking for small, risk-free returns, with the emphasis on risk-free. If they wanted to invest in real production, they were free to do so. And businesses are still free to get bank loans if they wish to invest.

    The money used to purchase bonds went to government spending, then into consumption (mostly) when the earners of that government spending spent their income. So it not only became G, it also became C. Basically, that money went from savings to consumption; the savers, though, now hold bonds.

    Quote Originally Posted by Kushinator View Post
    GDP in that instance isn't $10 trillion, it's $9 trillion. GDP is about domestic production.
    GDP changes over time, though. It was $10 trillion in Year X. Now, in year (X+1), there is only $9 trillion of income because of the trade deficit.

    Quote Originally Posted by Kushinator View Post
    I'm not talking advocating classical models, as i'm really drawing from Post-Keynesian economics. Once again, you cannot understand economic growth through the lens of accounting identities... all they were created to do was, well, count. C, I, and G all possess a co-variances that are impossible to determine using your methodology. If you're interested in understanding economic growth, i'd start with reading about the Cobb-Douglass production function as a good primer. From there, you can be better prepared to learn more advanced growth theories, e.g. exogenous/endogenous.
    The circular flow model covers growth. You get growth from an increase in aggregate demand, which requires an increase in income over and above what you get from past production. And you get that increased income from increased private sector credit, deficit spending, and/or a trade surplus. It's more than accounting identities.
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    Re: Circular Flow of Income theory

    Quote Originally Posted by JohnfrmClevelan View Post
    I grows with private savings only because that leads to a buildup of unsold inventory. I would think that a buildup of unsold inventory would cause a business to scale back production.
    That's part of it, but not all of it. If the economy is strong and inventories are depleting, we're still going to see stronger private domestic investment absent inventory growth.

    How an increased trade deficit leads to increased domestic investment is still a mystery to me.
    A trade deficit is foreign savings, and we already know that savings equals investment within the constructs of the NIPA identity.

    The money used to purchase bonds probably wasn't going to flow into private investment anyway. It could just as easily have remained in bank account balances
    That's speculation. We do know there is opportunity cost, and every dollar that flows into government cannot count towards consumption or investment.

    The money used to purchase bonds went to government spending, then into consumption (mostly) when the earners of that government spending spent their income. So it not only became G, it also became C. Basically, that money went from savings to consumption; the savers, though, now hold bonds.
    Again, the NIPA identities are distinct for a reason. If something is counted in C, it is not counted in I, G, or NX. This works for government spending as well. What you're claiming violates the NIPA identity.

    GDP changes over time, though. It was $10 trillion in Year X. Now, in year (X+1), there is only $9 trillion of income because of the trade deficit.
    So you've constructed a scenario where GDP was $10 trillion in year 1, and in year 2 it was $9 trillion? Basically, consumption, investment, and government all declined in your example. That's not how import growth transpires in reality. Imports grow as the economy grows and decline as the economy declines.

    The circular flow model covers growth. You get growth from an increase in aggregate demand, which requires an increase in income over and above what you get from past production. And you get that increased income from increased private sector credit, deficit spending, and/or a trade surplus. It's more than accounting identities.
    It has several holes, particularly when you call imports a reduction in GDP (which i've demonstrated is false) and try to redefine savings and investment.
    It is not very unreasonable that the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.
    "Wealth of Nations," Book V, Chapter II, Part II, Article I, pg.911

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    Re: Circular Flow of Income theory

    Quote Originally Posted by JohnfrmClevelan View Post
    When I ask others, "how does an economy grow?," I usually get an answer that doesn't include money. The answer is "an increase in productivity," or "population growth," or "savings are invested." But my contention is that you cannot translate any of that into growth without money being part of the equation. Workers don't work harder/longer without being paid. You can't buy more materials for production without money, and the money has to come first. This is where I see a problem with classical models.
    Let's be very specific about how money and prices enter actual economic models.

    I'll use the simplest model of consumer choice possible: we have two goods c(1) and c(2), priced at p(1)>0 and p(2)>0, respectively. Our consumer has a budget of m. His preferences are given by U(c(1), c(2)) := u(c(1)) + b*u(c(2)), where u(.) is a monotonically increasingly and concave scalar function over positive real scalars and b is a positive fraction. You can think of c(1) and c(2) as consumptions in two periods. Our consumer maximizes utility by choice of c(1) and c(2).

    max { u(c(1)) + b*u(c(2)) } subject to p(1)c(1) + p(2)c(2) = m

    Under the conditions, I imposed on the function u(.), it is optimal to spend all the money, hence the equality above. Now, we typically also say that the slope of u(.) around c=0 tends toward infinity to make sure it is also optimal to consume at least a little all the time and we usually assume u(.) is twice differentiable in the first quadrant. If we do, the problem has a very simple solution defined by a system of 3 equations:

    u'(c(1)) = lambda * p(1)
    u'(c(2)) = lambda * p(2)
    p(1)c(1) + p(2)c(2) = m

    with lambda being the Lagrange multiplier. The Envelop Theorem shows lambda is also the marginal utility of money (i.e., the partial derivative of U(c(1), c(2)) with respect to m evaluated at the optimal consumption path), or the value the consumers get out of relaxing a bit his budget constraint.

    Now, what's the point about prices? Well, it turns out that the ratio of prices is what determines the optimal basket c* = (c*(1),c*(2)). You can divide the first equation by the second and you will notice:

    u'(c(1))/u'(c(2)) = p(1)/p(2)
    p(1)c(1) + p(2)c(2) = m

    that if you divided everything by p(2), it wouldn't change a damn thing. In other words, instead of talking about dollars, you would be talking about quantities of the second good. Your budget would be M := m/p(2), which is the maximal amount of c(2) you can buy with m dollars at the price p(2) dollars. Hence, the demand functions you get out of this have a very special property: Marshallian demands are homogeneous of degree 0 with respect to the price/budget vector (p(1),p(2),m). If c(p(1),p(2),m) := c*, then you get the following:

    For any g>0,

    c(g*p(1), g*p(2), g*m) = (g^0) * c(p(1),p(2),m) = c(p(1),p(2),m).

    The fundamental point here is that if people care about real stuff (time, food, cars, shelter, etc.), the comparison operates on their ability to substitute between them: in other words, it depends on the ratios of prices and not the prices, per se.


    It's important to understand that point because it helps make sense of how people introduce money as a potent force in macroeconomics today.

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    Re: Circular Flow of Income theory

    The aforementioned problem is part of the contemporary modeling apparatus, except that we rely on more sophisticated versions of that same basic problem to characterize choices made by households. So, how do we introduce a meaningful role for prices in those models?

    In a typical New Keynesian DSGE model, two important elements are introduced in the production sector of the economy. The first one is the use of monopolistic competition. We assume there is a continuum of infinitely many goods that are not perfect substitutes. Each of them is produced by one firm in each period and this grants firms the possibility to not all ask for the same price. Obviously, all firms decide on a pricing strategy subject to the demand for their specific good. The second one is imposing restrictions on the ability of firms to change prices. There are many ways to do this, but one of the most popular devices is what we call Calvo Pricing. The idea is that firms can adjust their prices each period with a certain probability, call it q, so that they have to anticipate the possibility of using a suboptimal price for a few quarters when they pick it. It's very abstract, but it has a very convenient property with regards to the average duration of a pricing episode.

    You are at time 0 and moving to time 1. There is an average number of periods that you expect to spend with prices p(0) at time 0. Call E(D) this expected duration. With probability q, you will change your price for p(1) at time 1. In this case, your episode lasted one period. With probability 1-q, however, you would be essentially back to square one: from time 1, you can expect to wait a further E(D) period on average, so that conditional on reaching that node from time 0, you can expect your pricing episode to last E(D) + 1. You thus get the following equation:

    E(D) = q*1 + (1-q)*(E(D) + 1)

    which implies E(D) = 1/q. This is the primary reason why people like the Calvo pricing scheme: it's a very quick and dirty way of looking at microeconomic data on how long firms keep their prices on average to pin down the value of q. The same logic can apply and very often applies to the supply of labor: you assume there are infinitely many types of labor, not all of which are perfect substitutes and you can use the same Calvo pricing mechanism there too.

    The interesting point is that we do these tricks because we know as a matter of fact that prices do not change every quarter. They tend to stick around 3 quarters or so, on average. The rationale usually is the idea of "menu costs": it is costly to change prices. Traditionally, the idea involves printing new menus, but you can also think about the whole problem of using resources to determine what would be a good price.

    Now, how are prices potent forces here? Because not all prices move at the same time, there is a delay between real changes and price movements. The tight link you would get between prices and real production costs*** in simpler models break down since some prices lag behind and, hence, some price ratios are not reflecting the real ability of the economy to substitute between them. THAT is how contemporary macroeconomics introduce a role for nominal variables.

    ___________________________
    PS: The tight link comes from the maximization problem of the firm. Under monopolistic competition without pricing rigidities (whether Calvo style or others), the optimal price is a multiple of marginal costs every period. In that environment, price ratios reflect the real cost of bringing stuff to the market in terms of how much of the other stuff needs to be sacrificed. In NK DSGE, this breaks down: some prices lag and firms have to think about pricing rigidities when they choose prices so it conveys distorted information to consumers.
    PS II: If you also want monetary aggregates in the model, you have to make holding money valuable -- i.e., people need to want to hold on to money. But, again, money plays a role through their impact on prices and prices matter insofar as people respond to price ratios to make choices.
    Last edited by TheEconomist; 08-24-19 at 03:54 PM.

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    Re: Circular Flow of Income theory

    Quote Originally Posted by Kushinator View Post

    It has several holes, particularly when you call imports a reduction in GDP (which i've demonstrated is false) and try to redefine savings and investment.
    The domestic consumption that comes with imports (retail sales, etc.) should already be covered by C. (X - M) then denotes the net dollars that flowed out of the U.S. to buy Chinese goods and stayed there.

    If we were net exporters, we would be selling more production in exchange for dollars, and GDP (and our income) would logically increase. Why is it wrong to say that net imports would have a negative effect on GDP?

    Just repeating the NIPA identities doesn't help me understand them. I want to understand the logic behind the claims. GDP seems logical to me; your definition of I does not. Nor does S.
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    Re: Circular Flow of Income theory

    Quote Originally Posted by TheEconomist View Post
    Let's be very specific about how money and prices enter actual economic models.

    I'll use the simplest model of consumer choice possible: we have two goods c(1) and c(2), priced at p(1)>0 and p(2)>0, respectively. Our consumer has a budget of m. His preferences are given by U(c(1), c(2)) := u(c(1)) + b*u(c(2)), where u(.) is a monotonically increasingly and concave scalar function over positive real scalars and b is a positive fraction. You can think of c(1) and c(2) as consumptions in two periods. Our consumer maximizes utility by choice of c(1) and c(2).

    max { u(c(1)) + b*u(c(2)) } subject to p(1)c(1) + p(2)c(2) = m

    Under the conditions, I imposed on the function u(.), it is optimal to spend all the money, hence the equality above. Now, we typically also say that the slope of u(.) around c=0 tends toward infinity to make sure it is also optimal to consume at least a little all the time and we usually assume u(.) is twice differentiable in the first quadrant. If we do, the problem has a very simple solution defined by a system of 3 equations:

    u'(c(1)) = lambda * p(1)
    u'(c(2)) = lambda * p(2)
    p(1)c(1) + p(2)c(2) = m

    with lambda being the Lagrange multiplier. The Envelop Theorem shows lambda is also the marginal utility of money (i.e., the partial derivative of U(c(1), c(2)) with respect to m evaluated at the optimal consumption path), or the value the consumers get out of relaxing a bit his budget constraint.

    Now, what's the point about prices? Well, it turns out that the ratio of prices is what determines the optimal basket c* = (c*(1),c*(2)). You can divide the first equation by the second and you will notice:

    u'(c(1))/u'(c(2)) = p(1)/p(2)
    p(1)c(1) + p(2)c(2) = m

    that if you divided everything by p(2), it wouldn't change a damn thing. In other words, instead of talking about dollars, you would be talking about quantities of the second good. Your budget would be M := m/p(2), which is the maximal amount of c(2) you can buy with m dollars at the price p(2) dollars. Hence, the demand functions you get out of this have a very special property: Marshallian demands are homogeneous of degree 0 with respect to the price/budget vector (p(1),p(2),m). If c(p(1),p(2),m) := c*, then you get the following:

    For any g>0,

    c(g*p(1), g*p(2), g*m) = (g^0) * c(p(1),p(2),m) = c(p(1),p(2),m).

    The fundamental point here is that if people care about real stuff (time, food, cars, shelter, etc.), the comparison operates on their ability to substitute between them: in other words, it depends on the ratios of prices and not the prices, per se.


    It's important to understand that point because it helps make sense of how people introduce money as a potent force in macroeconomics today.
    Thanks for joining the thread, first of all.

    That said, your explanations might as well be written in German for all the help they are to a layman. You need to dumb it way down on this forum.

    I'm obviously in a camp that doesn't think standard economic theory is completely correct. And before you dismiss that, my camp includes plenty of Ph.D.s that studied standard economics and then came to the MMT camp, plus those Ph.D.s that started out there. So it has some validity.

    I'm also seeing years of incorrect assumptions and incorrect predictions coming from the orthodox economics crowd. So I don't think it's off base to question the validity of the thinking that still dominates the field. Right now in Jackson Hole, Krugman and Summers are coming to some very MMT-like conclusions, but without acknowledging MMT itself or any of the MMT academics that have been saying the same things, and publishing papers, for years. They are bending into pretzels trying to validate Krugman's IS/LM ideas, instead of simply questioning whether it's valid at all. Mostly, I believe, because they have too much to lose by admitting that they have been wrong for years.
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