Isn't a concept we talk about much in macro. Which is a bit weird, when you think about it. And it's always good to examine the way we think about things, and teach those things.
We talk about households' desired flow of saving, and firms' desired flow of investment, and we talk about the actual flow of saving and investment. We also say that firms have a desired stock of capital, and spend some time explaining how to get a desired flow of investment from that desired stock of capital. Why don't we talk about households' desired stock of savings, and compare it to firms' desired stock of capital, and compare both to the actual stocks of capital and other assets?
I don't know the answer to that question.
Think waaaay back, to the Keynesian Cross model of the traditional first-year textbook:
1. Desired expenditure Yd is an increasing function of income (aka production) Y. So Yd = a + bY where a > 0 and 0 < b < 1
2. In equilibrium, Yd = Y
What is the process that brings the economy to the equilibrium of this model? The traditional textbook story talks about undesired inventory investment. If Yd < Y, then firms will be accumulating inventories of unsold goods faster than they desire, so will eventually cut production.
Now suppose that all goods are services, like haircuts, and it is physically impossible to store unsold haircuts. That traditional story cannot work. We cannot even imagine a state of affairs in which Yd < Y. What are firms doing? Dragging people in off the street and forcing them to buy a haircut?
How are we supposed to teach this stuff in a modern service economy?
I am not an orthodox New Keynesian macroeconomist (ONKM), but I can pretend to be one.
Q: What determines the rate of interest?
ONKM: "The central bank sets the rate of interest."
Discussion: the above answer is a pure liquidity preference theory of the rate of interest. By having a perfectly elastic money supply curve, at some rate of interest chosen by the central bank, the stock of money adjusts to equal whatever quantity of money is demanded at that rate of interest. Like in all liquidity preference theories, the rate of interest is determined by the demand for money and the supply of money. The only difference here is that the money supply curve is perfectly interest-elastic.
Q: But what determines where the central bank chooses to set the rate of interest?
ONKM: "Loanable funds."
Suppose, just suppose, that you believed that printing money was irreversible, or just very hard to reverse. So central banks could increase the supply of base money by printing money, but could not (or could not easily) reduce the supply of base money again by burning money.
And suppose you knew that central banks had been printing very large amounts of money recently, because of special circumstances. Which they have. And suppose you thought that those special circumstances wouldn't last forever. Which they probably won't.
Would you be really scared of very high future inflation? I would be. Would you be saying that central banks should stop printing so much money, even if it did mean that aggregate demand is too low right now? I think I would be.
This is supposed to be a very simple post, mainly for non-economists.
"Printing money causes inflation" can mean three different things. What I will say here should be obvious to economists, but I'm not sure if it is obvious to non-economists. And it makes me wonder if sometimes things get lost in translation. Maybe, just maybe, some people are strongly opposed to central banks printing very large amounts of money because they misunderstand "printing money causes inflation". Who knows? Tell me what you think.
Those of us who teach Intro Economics know we have to spend some time carefully explaining the "other things equal" clause, and why it matters. Because the students won't get it unless we explain it. We tend to take it for granted that the silent "other things equal" clause is understood, but it might not be understood by all.
Paul Krugman is wasting his time trying to figure out why the rich and powerful don't like inflation. There's a simple answer, that also explains why the non-rich and non-powerful don't like inflation either.
And you don't need any fancy political economy to figure out the answer. If you want to know why non-economists don't like inflation: just ask a non-economist.
Inspired by Free Radical's post, I think I have figured out a simpler and clearer way to say what I want to say about Walras' Law.
Ask yourself the following question:
Q. Assume an economy where there are (say) 7 markets. Suppose 6 of those markets are in equilibrium (with quantity demanded equal to quantity supplied). Is it necessarily true that the 7th market must also be in equilibrium (with quantity demanded equal to quantity supplied)?
This is an open book exam, and you may Google if you wish.
This is a question for both macroeconomists and microeconomists. (And for non-economists too.)
...will an increase in the rate of interest paid for holding money be deflationary (because it increases the demand for money), or inflationary (because it increases the growth rate in the supply of money)?
This question crops up from time to time, in comments here and on other blogs, so I thought I would lay out a simple answer. Mostly as a "teaching" post, but also because it raises an interesting question about interest on reserves and central banks' communications strategy.
The answer is: an increase in the rate of interest paid for holding money will increase the equilibrium inflation rate; but it will not cause an additional one-time jump up or down in the equilibrium price level. (Yep, you gotta keep your head clear on the distinction between levels and rates of change over time.)
This is very very crude. It's something off the top of my head scribbled on a scrap of paper as an outline for a first draft. But I will never go beyond that outline, because I wouldn't be any good at doing it.
The history of the Old Keynesian model is very quick. You have Keynes' 1936 General Theory, and Hicks' 1937 ISLM model. Done. All else is commentary.
The history of the New Keynesian model is very slow. It took about three decades. We need to divide it into stages.
(Or is my perspective biased by the fact that I wasn't alive in the 1930's and 1940's, and only started paying attention to economics in the 1970's?)
In a couple of hours the Bank of Canada will do what it does eight times a year. It will set a temporary target for the overnight rate of interest. Will it raise it, lower it, or leave it the same? What will its decision depend on? How will its decision affect the Canadian economy?
If I were teaching intro macroeconomics to a bunch of students who were only interested in the here and now, like journalists who would be covering today's decision by the Bank of Canada, this is what I would teach: I would teach the Phillips Curve; some sort of IS curve; and discuss how the Bank of Canada would interpret the data using the Phillips Curve and IS curve and respond to the data to try to keep inflation at its 2% target.
I would teach something very similar to what Simon Wren-Lewis wants to teach.
But university teaching is not just about the here and now.
The answer we normally give, when teaching intro macro, is: "It depends on price stickiness; if prices are very flexible it will be short, and if prices are very sticky it will be long."
A better answer would be: "It depends on monetary policy; if monetary policy is very good it will be short, and if monetary policy is very bad it will last forever."
I think I am on the same page here as Simon Wren-Lewis. And I agree with Simon that this point matters not just for students of intro macro.
That's the equilibrium condition for the real rate of interest in a competitive economy. I will explain what it means a little later.
This is intended as a simple "teaching" post, and because I have a strange feeling that the theory of interest and capital is becoming topical again in the blogosphere, and that a post like this might be helpful.
This is primarily for teachers of intro macro. Maybe for teachers of intermediate macro too, as a way to interpret ISLM.
We have two quite different theories of what determines the rate of interest:
Loanable Funds says that the rate of interest is determined by desired saving and desired investment.
Liquidity Preference says that the rate of interest is determined by the supply of money and the demand for money.
What happens if those two theories give different answers? Like in this pair of diagrams, where the blue interest rate that equalises desired saving and desired investment is above the red interest rate that equalises the supply of money with the demand for money? So both theories can't be right at the same time?
This is how we can reconcile these two apparently contradictory theories of the rate of interest:
Alone again or, just me and the money multiplier, against the world of trendy sophisticates who have put aside such childish things. It brings out the reactionary contrarian in me. And the world needs more reactionary contrarians, to help provide negative feedback against the faddish bubble multiplier of popular theory.
There are two multipliers we teach in first year: the money multiplier; and the "keynesian" (Hawtreyan?) multiplier. Both are set aside as embarrassing reminders of childhood. Let me defend them both. They have a lot in common.
Keynes' "aggregate supply function" in chapter 3 of the General Theory is just the "classical" labour demand function plus the "classical" production function. Except for the weird presentation, there is nothing new there. It is old and boring. It is Keynes' "aggregate demand function" that is new and exciting.
[Update: See Roger Farmer's response.]
(I'm disagreeing with Roger Farmer on the interpretation of the 45 degree line. I say the 45 degree line is not a supply curve. This post explains what I think it is.)
Here's the Keynesian Cross diagram:
How should we interpret the green 45 degree line?
Update: I sketch my own answer in the comments below.
This is a question for all students of New Keynesian macroeconomics. I mean "students" in the sense of "those who study", so that includes the profs too. It is a very basic question. There is no fancy math to fool you. If you cannot answer this question, then you do not understand the New Keynesian model. You have let the math fool you into thinking you understand it, just because you can solve the equations.
Assume the simplest NK model, with no investment, government, or foreigners. There is only consumption. But there are two sorts of consumption: there is consumption of produced goods (let's call it "fruit", with lots of different varieties of fruit); and there is consumption of leisure. Standard model.
Start in equilibrium. Now suppose the central bank makes a mistake, and sets the interest rate too high for one period. Intertemporal substitution of consumption kicks in. The representative agent wants to consume less this period, and so actual consumption drops.
Question: But why is it consumption of fruit that drops? Why isn't it consumption of leisure that drops? Why don't too high interest rates cause a boom in output and employment?
I'm staying out of this argument. But I can't resist a challenge to show the New Keynesian model in pictures, with indifference curves, production functions, and budget lines.
I can't do it in one picture. I need two.
I thought Noah Smith's post on why we should teach intro micro before intro macro was very good. I agree with Noah: even though macro is much more glamorous, micro is just as useful and important, and we are more confident that micro works. (Read his post for the full story.)
I want to add a couple of points in support of Noah, then talk about what I think is a bigger issue: the splitting of micro and macro into two separate half courses. I'm against splittism, but it's getting harder and harder to fight off the separatist forces.