Endogenous Money Supply

This week’s macroeconomics class dealt with the question whether central banks set the interest rate or the money supply. According to the standard undergraduate macroeconomics textbook, the central bank sets the supply of money and can expand and contract it through open market operations (Blanchard, Amighini, Giavazzi, 2013). To be more exact, it is acknowledged that the central bank has full control only over the monetary base, which includes currency in circulation and bank reserves. But because the monetary base determines the money supply via the so-called money multiplier, it is generally said that the central bank increases the money supply if it increases the monetary base and decreases the money supply if it decreases the monetary base. The standard explanation is normally accompanied by a diagram of the ‘money market’ with a vertical Money Supply schedule, as shown below. Such a vertical line is equivalent to saying that the Money Supply is exogenously determined, because it does not depend on the interest rate.

money marke.png
The Money Market

However, when taking a closer at look what central banks actually do, one might be surprised that central banks rarely choose the supply of money deliberately. On the contrary, the money supply need not be fixed because central banks target the short-run interest rate instead. In the UK, for example, this is called the official Bank Rate, set by the Bank of England’s Monetary Policy Committee. The current Bank Rate is 0.25%. It was last cut in August from 0.5% and the next decision by the Monetary Policy Committee whether to revise or maintain the Bank Rate is going to be due on 3 November (BoE, 2016). A major implication of interest rate targeting, as practiced by the Bank of England, is that the money supply is endogenous, i.e. it is determined within the system rather than outside the system. Hence our Macro lecture revisited the theory and introduced the more realistic endogenous money story this week. It is broadly based on the undergraduate endogenous money teaching model by Fontana and Setterfield (2009). The following diagram summarises the exact mechanism of the endogenous money supply process.

endogenous-money-supply
Endogenous Money Supply Process (based on Fontana and Setterfield, 2009, p.134)

First, the central bank sets the short-run interest rate to a certain value, say i1= 0.25% as in the UK at the moment. At this rate it fully satisfies commercial banks’ demand for base money. Graphically this is shown through a perfectly elastic base money supply schedule in yellow. In words, one might say that the central bank is a price-maker and a quantity-taker.

In the second step, commercial banks pass this interest rate of the central bank on to households in the credit market. Thereby the interest rate charged by commercial banks is called the bank loans rate (rL1). It is set as a fixed mark-up over the short-run interest rate charged by the central bank in order to make a profit on their loans to households. Again, because commercial banks set a certain loans rate rather than the supply of credit, they are price-makers and quantity-takers with a perfectly elastic credit supply schedule in blue (CS). They fully satisfy the demand for credit by creditworthy households at the going loans rate. Next we need to look at the demand for credit (CD). It depends negatively on the commercial banks’ loans rate. When the loans rate is high, there is little demand for credit. Conversely, at a low loans rate demand for credit is going to be high. Ultimately, the equilibrium quantity of credit (C*) created in the credit market is at the point where the downward sloping credit demand schedule of households and the perfectly elastic credit supply schedule of commercial banks intersect; that is Point A.

In the third step, the credit market equilibrium feeds into the economy. This is because of the circular flow of the loans obtained by households. They are going to be receipts of someone else who, in turn, deposits the money in a bank account. This is why bank loans create bank deposits one-for-one in the diagram. This is captured by the Loans Deposit (LD) schedule in the panel on the bottom right.

In the fourth step, these bank deposits need to be supported by monetary reserves as a precautionary means for reducing the instability of fractional reserve banking and avoiding public panics etc. The exact Deposit Reserves schedule is going to depend on the reserve requirements mandated by the central bank. Yet because it is going to be a fraction of the overall bank deposits created, it will be a straight line proportional to the Loans Deposit (LD) schedule.

In the fifth and final step, we are back in the upper left corner of the diagram, which is the market for monetary reserves. Having determined the reserve requirements of the commercial banks, the central bank will supply this amount of money but at the price of the central bank (the short-run interest rate i1).

In sum, the exogenous money supply approach taught in introductory macroeconomics at undergraduate level states that the central bank sets the base money and, via the money multiplier, the money supply. This then determines the interest rate. In contrast, the endogenous money supply approach, we are now learning in intermediary macroeconomics moves closer towards reality and what central banks, like the Bank of England, actually do. With the endogenous money supply approach, we acknowledge that most central banks target the interest rate. This, in turn, determines the volume of loans in the economy and ultimately the money supply and the base money. As Carlin and Soskice (2006) point out, the chain of causality in the endogenous money supply approach is reversed and approximates the actual behaviour of central banks better than the exogenous money supply story. In fact, Fontana and Setterfield use their endogenous money model together with a model for pricing, production and the labour market to explain the mechanisms underlying the global financial crisis. They show that their model based on endogenous money supply captures the credit crunch together with its adverse impacts on output and unemployment.

Thanks for reading!

Jasse


References

Blanchard, O., Amighini, A., & Giavazzi, F. (2013). Macroeconomics: A European perspective. Harlow: Pearson.

BoE (2016). Monetary Policy Committee Decisions, Minutes and Forecasts. Available at: http://www.bankofengland.co.uk/monetarypolicy/Pages/decisions.aspx [Accessed 28 September 2016].

Carlin, W., & Soskice, D. (2006). Macroeconomics: Imperfections, institutions, and policies. Oxford: Oxford University Press.

Fontana, G. and Setterfield, M. (2009). Macroeconomics, endogenous money and the contemporary financial crisis: a teaching model. Int. J. Pluralism and Economics Education, 1(1/2), pp.130–147.

 

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Social Science Bites: Behavioural Economics

Today I stumbled across the podcast series Social Science Bites. Led by David Edmonds and Nigel Warburton, it is a series of interviews with leading social scientists about their perspectives on society and the contribution of social sciences to enhance our understanding of it. In August 2012, Edmonds and Warburton interviewed Robert Shiller on Behavioural Economics. The interview is only a quarter of an hour long, yet it is a real jewel for getting the bigger picture why the movement has revolutionised the field of Economics over the last twenty years and why it is going to become even more important in the future.

Nigel Warburton starts the interview by asking Shiller for a rough definition of behavioural economics. Shiller explains that behavioural economics is a merger of economics with other social sciences. A major benefit of this is that by introducing psychology, sociology, and political science into economics, the field has moved closer toward reality. In contrast, standard economics relies on rational optimisation which describes actual human behaviour rather poorly. Hence it is not surprising that conventional economics cannot seem to explain coherently why we ended up in a global financial crisis in the late 2000s.

Shiller describes bluntly that in the economics profession of twenty years ago speculative bubbles could not exist because economists treated markets as collectively rational and ‘smart’. Yet this rationality continued at individual level. In consumer theory economists assumed that humans always maximise their consumption. Shiller points out that the elegance and simplicity of economists’ models were also their shortfalls. Recognising that human behaviour is far more complex has led to the behavioural economics movement. It is in some sense interdisciplinary because it makes use of many discoveries of psychologists. Shiller illustrates this with the example of fairness. While economists assume that people act in pure self-interest, human behaviour is governed by a sense of fairness and equity. In his research Shiller has shown that fairness even enters the area of labour contracts. Nevertheless, standard economics does not consider it to be part of the contract between employees and employers.

I must say that I especially like the second half of the interview in which Robert Shiller debunks the assertion that economics is a science and economists are ‘hard-scientists’. In doing so, Shiller refers to the renowned British economist Alfred Marshall who already said that “economics cannot be compared with the exact physical sciences: for it deals with the ever changing and subtle forces of human nature” (Marshall, 1920, p.12). Likewise, Shiller advocates that the study of how humans are thinking cannot be hard science but requires intuition, human judgement and a broader perspective on human behaviour guided by psychology and sociology. Yet he points out that the economics profession is currently suffering from “physics-envy”, but the Einstein model is not going to fit with real world thinking. What adds to this problem is the shortage of data, especially in Macroeconomics, which makes any scientific method inappropriate for predicting major macroeconomic fluctuations like the last global financial crisis.

Nigel Warburton ends the interview asking about the value of behavioural economics. Clearly, for Shiller the value lies in being able to model human behaviour more realistically. He takes the medical school as example. Incorporating what is going on inside the brain allows behavioural economists to move away from “revealed preferences”. This is why behavioural economics, including neuro-economics, is going to become more and more important in the future. With the help of other social sciences, the profession can move away from restricting assumptions like rational optimisation or revealed preferences. Shiller stresses that the insights from the field of behavioural economics are likely to benefit our society at large. At the forefront this includes better public policy-making and reducing the occurrence of crashes. With the use of behavioural economics, Shiller envisions the future role of economists to be one of “prevention”, a bit like the street planners which nobody observes but without whom traffic wouldn’t run smoothly or not at all.

If you have 15 spare minutes, the full interview ant transcript can be found here. It is more than worth it!

Jasse


References

Marshall, A. (1920). Principles of Economics. An introductory volume. 8th ed. Macmillan & Co, London.

Shiller, A. (2012). Robert Shiller on Behavioral Economics. Interview by Nigel Warburton, Social Sciences Bites, 1 August 2012 [Online]. Available at: http://www.socialsciencespace.com/2012/08/robert-shiller-on-behavioral-economics/ [Accessed 25 September 2016]

Thought Experiment – A Macro-Game of Bankers and Households

Today is going to be a creative post, that is a thought experiment, and anyone who is familiar with Game Theory will recognise the Prisoner’s Dilemma underlying my game. I was inspired by Schelling’s Micromotives and Macrobehavior to think a little bit more about the group dynamics and interactions within the economy. Especially in Macroeconomics we tend to assume that economic actors have certain preferences and, given these preferences, make optimal decisions to maximise their utility. Yet this might hold for “free market activities” which do not have a social dimension, but normally we would expect to see contingent behaviour; that is behaviour “that depends on what others are doing” (Schelling, 1978, p.17).

Let’s assume that our fictitious economy consists of only banks and households. We also have an impartial government as regulator on the side. Both banks and households have two choices; they can either play it safe or play it risky. In particular, banks can decide to sell safe products or risky products. Likewise, households can play it safe by not taking on excessive debt, or they can play it risky and invest in risky assets or take out large mortgages for their dream house. In sum, we have two players and two choices in our economy. To maximise their payoffs (think profit, income or wealth) both households and banks want to play it risky. In particular, the bar underneath the payoff “3” indicates that “play risky” is the dominant strategy for each player.

banks and consumers.png

Having set up our game, let’s start with an economy just after a recession. Government tightened financial regulation over the downturn which prevents banks from selling risky products and provides households with proper incentives to pay down their debt and not take out risky loans. So we are in the upper left corner of our game matrix. Banks and households must play it safe, because “play risky” is not a feasible option. This is indicated by the dotted red line. One might call this “social organisation” as legitimate government intervention or, if favouring a free market without any government action, dictatorship. However, in our game the government with its role as regulator stabilizes the unstable equilibrium.

For a while our economy works pretty well. Consumers pay down their debts and are happy to play it safe. Banks are happy to provide their customers with safe products. But over time vivid memories of the past recession fade and government regulation feels too tight, given that our economy is doing well. Having paid down their debt, consumers feel prepared to build their dream house. Their aspirations for wealth and status rise. Banks return to business as usual and seek to maximise their profits. They start lobbying government to deregulate financial markets and they will eventually succeed. Likewise, consumers will start to advocate a removal of the strait jacket and government will have to listen. As the barriers for households and banks fall, so does the “social organisation”. Our equilibrium in the upper left corner becomes unstable. Both consumers and banks now have the incentive to play it risky. They will end up in the bottom right corner of our game matrix eventually.

Households and banks can play it risky for some time, meaning that the negative payoffs compared to the coordination on “play safe” in the upper left corner might not be obvious right away. This is because risky choices do spur economic growth, entrepreneurial activity and innovation. Yet they probably also trigger a speculative bubble, including excessive debt and risk-taking, in our economy.

Left to their own devices, households and banks continue to play it risky. But at some point the bubble bursts due to rising financial instability and euphoria turns into fear. Households and banks call for the government to step in. On the one hand, banks probably need financial support. On the other hand, consumers want more protection and might need financial support as well. The government agrees to step in conditional on tightening financial regulation. In sum, we are back in the upper left corner of our game matrix with a renewed “social organisation” enforced by government and a stable play-it-safe equilibrium.

The goal of my hypothetical game is not to model a real-world economy but to illustrate the social dynamics underlying macroeconomic outcomes. While the game might not be perfect, it is intended as a nudge to get the bigger picture of contingent behaviour. The game exemplifies the coordination failure together of the two groups without an impartial third party with whom they can contract for social organisation. Both banks and households would be better off playing it safe all the time. Yet, in my game we are going to see cyclical behavior. The drive to maximise profits and increasing aspirations for wealth and status will always induce banks and consumers to advocate for less regulation over time.

Many thanks for staying with me until the end of my thought experiment!

Jasmin


References

Schelling, T.C. (1978). Micromotives and Macrobehavior. New York: W.W. Norton & Company.

Boom Bust Boom

Today our Alternative Economics Society at Strathclyde had their Welcome Meeting for the academic year. They screened the documentary Boom Bust Boom largely motivated by the global financial crisis of 2008 and the corresponding failure of standard economic theory. It is an attempt to explain the economics underlying booms and busts to a wider audience. In doing so, it features an impressive line-up of contributors from Macroeconomist Paul Krugman to Behavioral Economist Dan Ariely. It also features psychologist Daniel Kahneman and economists Steve Keen, Perry Mehrling and Robert J Shiller among others.

This documentary is by any means not the standard documentary I would have mind. It makes extensive use of animation, puppetry and songs coupled with expert insights and a good amount of sarcasm to explain why crashes keep happening and why our economic system is inherently unstable. The documentary starts off with a history of financial crashes. It revisits the Tulip Mania, South Sea and Railway Bubble, and the 1929 Crash. All four examples illustrate the common features of bubbles. A bubble has something magical or new inducing people to think that “this time it is different”. It is argued that people always find a reason to abandon their rational behaviour. In doing so there is a general tendency for periods of euphoria and pessimism with bubbles being of the self-fulfilling type.

The documentary also revisits the Great Depression after the Wall Street crash on the 29th of October 1929. It argues that the bubble preceding the Great Depression was different from other bubbles because it combined euphoria with excessive borrowing which is said to be the “most toxic combination in capitalism”. When the practice of buying on the margin, i.e. borrowing money to buy stocks, shot back, fear spread and the bubble eventually had to burst.

At some point after the 1929 Crash and the Great Depression, however, people’s memories started to fade. As the older generations died the younger generations made the same mistakes all over again. Similar to the reasons for the 1929 crash, the starting point was the creation of too much debt in the private sector. Exactly this is where the documentary introduces the work of Hyman Minsky which I referred to in earlier posts. Minsky essentially argued that stability leads to instability. In his today well-known financial instability hypothesis, he recognised that after an economic downturn government would pass stricter financial regulation. However, this would be followed by a prolonged period of stability which would make people overconfident and optimistic. The recovery from the last recession would subsequently turn into euphoria, followed by deregulation and the next bubble. Despite Minsky’s prediction of a major financial crisis 25 years before it actually happened he was largely disregarded in the Economics profession. Yet our society would have benefited greatly from Minsky’s insights; the documentary stresses that “anyone who read Minsky could have seen it coming”.

The lesson from Minsky is that capitalism is inherently unstable. Yet neoclassical economic models with the assumptions of rationality and a general equilibrium do not allow for instability and bubbles in the first place. The documentary rightly points out that models are at the core of economics and they do serve their purpose if their features resemble the real world in some meaningful way. Yet Steve Keen points toward the problem that neoclassical economists ignore banks, debt and money. Omitting these features from the economic model is what made it depart from the real-world economic system.

Another pillar in the documentary is free market ideology. In seeing the market as collectively rational with optimal allocation and distribution of wealth, deregulation followed and markets were left to their own devices. Yet free market ideology misses the importance of human behaviour in economics. The documentary goes back to the work of both Daniel Kahneman and Laurie Santos highlighting human tendency for irrationality. A major implication is to admit people’s biases in Economics and the documentary advocates for better policy-making around human biases. It uses the banking system as a major example for designing a banking system for humans instead of a system of fragility and systemic instability.

Lastly, the documentary addresses the need for a new Economics education. The experience of the financial crisis has led students to enquire about the mechanisms and reasons behind it. Yet standard Economics has little to offer to explain deviations from the general equilibrium model. The documentary calls for a more active debate in economics which is currently dominated by the mainstream. Its solution is to adopt a different approach in economics: (1) make it a piece of history and social thought and (2) make it something done together.

The documentary concludes with the lesson that people have learnt nothing from history. They tend to forget because it is in our human nature. Yet this sets us up for the emergence of future booms and busts and it is the Economics profession’s turn now to act and embrace its duty.

Overall, the documentary is great for getting the bigger picture of the global financial crisis and the importance of human behavior in macroeconomics. It revisits booms and busts from both a Keynesian and Behavioral Economics perspective. Sometimes I miss more diversity in explanations and solutions. Yet I think it does balance clarity through the use of animations and puppetry with rigor and economic theory. Being intended for a wider audience it serves its purpose in my opinion. Hopefully it is a wake-up call that Economics matters and that it matters to everyone in society. So if you want to hear more on the financial crisis of 2008 in a non-technical fashion and you like the ‘Muppets’, then this is clearly the right documentary for you.

Many thanks for reading,

Jasse


Boom Bust Boom (2015). Documentary, Brainstorm Media, London. Directed by Terry Jones, Bill Jones, and Ben Timlett.

Schelling’s Masterpiece Micromotives and Macrobehavior

Being back in Glasgow for my fourth and final year at university I got myself a copy of Thomas C. Schelling’s Micromotives and Macrobehavior (1978) from the Andersonian library. I picked the book first and foremost as an introduction to behavioural approaches in Macroeconomics. However, one may regard it also as a critique of New Classical Economics.

Today I want to talk about the first chapter which is named after the book. Schelling opens the chapter with an example that should be familiar to most university students. He explains that he once gave a lecture to an audience of eight hundred people. The large amount of people is not surprising given his prominence. Yet what was striking was the distribution of the audience within the lecture hall:

schelling-micromotives-and-macrobehavior

All people were crowding in the back while the twelve rows in the front remained empty. Schelling first assumed that the seats had been allocated like this but he was soon to find out that the seating distribution in the hall was, in fact, voluntary.

But what does it have to do with Economics? Despite being a rather harmless example, it does illustrate the importance of micromotives in macrobehavior. Simultaneously, it stands in stark contrast with the interpretation of the situation from the viewpoint of Economics. When people make decisions economists tend to assume that they maximise their utility; that is, choose the best alternative available to them given their preferences. In Schelling’s example all seats were available to all the members in the audience. As a result, one would be inclined to conclude that the people preferred to occupy the seats in the back. Their preferences induced them to make this choice voluntarily because they maximised their utility by sitting in the back neither being able to understand much of the lecture nor having enough space to sit comfortably. Yet this would disregard the complexity of the situation at hand. What is more, the example anticipates a major lesson of the book:

“These situations, in which people’s behaviour or people’s choices depend on the behaviour or the choices of other people, are the ones that usually don’t permit any simple summation or extrapolation to the aggregates. To make that connection we usually have to look at the system of interaction between individuals and their environment.” (Schelling, 1978, p.14)

Schelling’s insights prove valuable for Economics because he offers a starting point to re-think our economy as a system in which everyone who reacts to the environment is also part of it. In doing so, his work is probably mostly in unison with Keynes’ idea of animal spirits. Both take a more behavioural perspective in macroeconomics. Both stress that people show contingent behaviour; that is, their behaviour is correlated with other people’s behaviour in the economy. For example, individuals’ goals, aspirations and views are going to be influenced by others’ goals, aspirations and views. One might also note that with the spread of social media and global interconnectedness the concept of contingent behaviour is more important than ever before. Yet the more general moral of Schelling’s story is that social interactions matter and they do matter for Economics. While we may carry on to assume that economic agents have certain preferences it is important to recognise that these are influenced by their environment and other people’s behaviour.

Besides, the moral for university lecturers might be to use Schelling’s insights to nudge their students to choose front seats over seats in the back. This might not only make lecturers happier but also students, helping them reach their true preferences of hearing well and having a comfortable seat. Yet one would need to know more about the emergence of the patterns of aggregate behaviour in the seating distribution to tweak it for the greater good.

Despite not being finished with Schelling’s book, I can clearly say that it is one of the most inspiring books in the sphere of Social Sciences and Economics I have come across so far. In my opinion it joins the ranks of Kahneman’s Thinking, Fast and Slow and Animal Spirits by Akerlof and Shiller and I hope that my post today inspired you to pick up a copy from your library as well!

Thanks for reading,

Jasse

 


References

Schelling, T.C. (1978). Micromotives and Macrobehavior. New York: W.W. Norton & Company.

Behavioural Macro

The summer went by quickly and in preparation for my Honours year at university I have read a lot. My reading list contained mostly books on Behavioural Economics. Thereby one of the jewels is Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George Akerlof and Robert Shiller. I came across this book in the first place because I intend to apply prospect theory and reference dependence to risk attitudes in my dissertation in order to explain dynamic risk taking behaviour of economic actors over time. This includes a discussion of why my hypothesis matters for the macro-economy. I see important links between individuals’ risk attitudes at micro-economic level and market outcomes in aggregate. For this Akerlof and Shiller’s book has proven to be a gold mine. Inspired by pure Keynesian Macroeconomics it is packed with behavioural theories and real world economics.

In Behavioral Macroeconomics and Macroeconomic Behavior Akerlof makes his behavioral approach even more explicit in calling the field Behavioral Macroeconomics. In discussing six macroeconomic phenomena inconsistent with New Classical Economics he sets the scene for a return to behavioral microfoundations in Macroeconomics. Rather than boring undergrads to death with efficient market hypotheses, rational agent models, the natural rate theory or universal optimising behaviour in all aspects of economic life, our standard Macroeconomics education should take a leaf out of Akerlof’s book and start becoming real- world economics, that is Behavioural Macro… In adopting such a perspective I would expect positive externalities, such as reduced student absenteeism. Hence a more behavioural perspective on Macroeconomics would actually become a positive-sum game; for lecturers as well as students.

I encourage you to check out Akerlof’s paper and his book co-authored with Robert Shiller if Behavioural Macro sounds like your thing!

Jasse


References

Akerlof, G.A. (2002). Behavioral Macroeconomics and Macroeconomic Behavior. The American Economic Review, 92(3), 411-433.

Akerlof, G.A., and Shiller, R.J. (2009). Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Princeton, NJ: Princeton University Press.