I recently posted two papers on SSRN that put forth a new framework for understanding the economy. The key finding is that the monetary base may prevent interest rates from converging with income-growth expectations, thereby giving rise to economic fluctuations, asset booms and busts as well as changes in the price level.
In Part I, I discuss the distinctive feature of a monetary economy, namely that bank-financed demand creates its own nominal supply (for the formal model, please refer to my paper Gain-Loss Utility, Interest Rates and Equilibrium). Part II looks at the micro-foundations of desired borrowings and savings and puts forth a new interest-rate model. The objective is to find the necessary and sufficient conditions under which aggregate desired borrowings and savings are in equilibrium. Part III discusses the implications for the business cycle.
First, a word of caution. My view of the economy is decidedly non-Walrasian (or non-classical)[1]. Practically, all mainstream macro models describe a Walrasian economy where supply creates its own demand with prices acting as the equilibrating mechanism. In other words, if you bring your goods to market, or labor-time, there is a price at which you will find a willing buyer. Output is determined by real factors such as labor supply, capital stock and productivity. The business cycle is caused by exogenous supply shocks, but the economy always self-corrects to full employment as prices change to equilibrate demand with supply. The New-Keynesian (NK) model, the workhorse of mainstream macro, does allow for involuntary unemployment in the short-term by introducing frictions, such as sticky prices and wage rigidities. In the long-term, though, even the NK model is Walrasian as prices have time to equilibrate demand with supply.
Another distinctive feature of a Walrasian economy is that the rate of interest represents the price of loanable funds at which the demand for investments in capital markets equals the supply of savings. Money is some exogenous object that exists ex-ante with no utility in and of itself — merely a veil that facilitates exchange. Banks are ignored as just another participant in the market for loanable funds. The NK model goes as far as to even ignore money. In the aftermath of the Volcker shock, money supply in advanced economies lost any relation to inflation and output. This was attributed to unstable money demand prompting NK economists to abstract away from money supply and demand altogether. Instead, interest rates in the NK model are given by a monetary policy rule such as the Taylor Rule, and inflation and output are modeled with some aggregate relationship such as the Phillips Curve.
The problem is that we do not live in a Walrasian world for the simple reason that money does not exist ex-ante. In a monetary economy, banks create money as they buy claims against borrowers’ future incomes in exchange for claims against themselves in the form of bank deposits[2]. Banks and money creation cannot be ignored for the purpose of studying the macro economy because banks are, in effect, market-makers. Banks don’t just intermediate between borrowers and savers — they stand ready to facilitate borrowers with new money creation even if there are no savers on the other side.
In a monetary economy, before any exchange of goods and services can occur, money must be created first. To illustrate, imagine an economy with agents and a single bank. Every agent uses a credit card, issued by the bank, to fund desired expenditures. Every time you swipe the credit card, you are borrowing from the bank and generating income for the seller. The bank finances this demand by creating money, posting a debit to the buyer’s account and a credit to the seller’s. Upon receipt of incomes, agents pay-off their credit card balances. This debt redemption results in the destruction of the corresponding money balances — effectively, credits in a given account cancel-out the debits.
The important take-away from this simple illustration is that we borrow and spend prior to receipt of incomes but in anticipation of such incomes. In the aggregate, it is this bank-financed demand that generates nominal incomes. This means that a monetary economy bootstraps, whereby incomes must be anticipated ex-ante in order to be generated ex-post. This is the defining feature of a monetary economy. Demand comes first.
In a monetary economy, bank-financed demand creates its own nominal supply with prices, output and employment being the unknown residuals. If you bring your goods to market, or labor-time, you may not find willing buyers, regardless of price, unless demand has been bootstrapped in the aggregate. This uncertainty is simply part of the profound uncertainty surrounding supply decisions. Unlike prices in a Walrasian economy, prices in a monetary economy do not equilibrate demand with supply because aggregate demand is determined ex-ante as a result of bootstrapping. Prices determine only relative demands and are simply the unknown residual resulting from the interaction between buyers and sellers. This is the reason why we can never tell the price level ex-ante, only ex-post. Also, the notion that prices are an unknown residual shares micro-foundations with Richard Thaler’s Endowment Effect (for more, please refer to this post: Bridging the Gap between Mainstream Macro and Behavioral Econ).
Chart 1 takes a closer look at bootstrapping. Aggregate demand is the sum of income expectations for the period plus desired borrowings less desired savings. Banks finance this demand by creating money. Buyer-agents spend the money, generating incomes for seller-agents. Seller-agents use the money to redeem their own borrowings incurred at the beginning of the period to finance the production of goods or their own expenditures. Upon such redemption, the money is destroyed. At the end of the period, actual borrowings equal, by identity, actual savings and the remaining money supply, also by identity, equals money demand. This is consistent with Keynes’ notion that actual incomes, not interest rates, equilibrate savings and investment. I take this idea a step further by showing that actual incomes also equilibrate money supply and demand.
I should note that not everyone in the economy bootstraps, meaning that some people prefer to spend after earning incomes, not prior to. Accordingly, agents in the economy can be divided into two groups — bootstrapping entrepreneurs and non-bootstrapping workers. Entrepreneurs borrow from banks to hire workers to produce goods and services in anticipation of future revenue. The newly-created money flows to workers in the form of wages. Workers now have the money to purchase the very same inventory they themselves produced. Effectively, entrepreneurs bootstrap the whole economy, which goes to show the importance and self-fulfilling nature of their “animal spirits”.
Bootstrapping is also the reason why the economy may suffer from unemployment. If some people do not bootstrap, say the unemployed, aggregate demand will be insufficient to provide them with jobs unless someone else bootstraps on their behalf. The problem is that actual incomes in prior periods strongly influence income expectations for the current period (aka, the “animal spirits” of entrepreneurs). Since prior-period incomes do not reflect the potential incomes that could have been earned by the unemployed, neither will income expectations for the current period. This means that the economy may find itself in a state of permanent unemployment. Expressed differently, any level of unemployment is possible and could be consistent with a steady state as long as aggregate demand has not been bootstrapped for the potential incomes of the unemployed.
With respect to the business cycle, the key driver is desired borrowings less desired savings, or the second box on the chart. If the box is positive (desired borrowings > desired saving), aggregate demand will come above income expectations for the current period. This boosts actual incomes, prices and employment above expectations (assuming firms raise both prices and employment in response to excess demand). On the flip side, if the box is negative (desired borrowings < desired savings), aggregate demand will come below income expectations for the current period. Such insufficient aggregate demand depresses actual incomes, prices and employment below expectations. In conclusion, to find the source of the business cycle, we need to find the cause of disequilibrium between desired borrowings and savings, which takes us to Part II of this post.
[1] Leon Walras was a French economist who formulated general equilibrium as a system of excess demand equations. The equilibrium condition is given by the price vector that zeros-out excess demands across all markets in space and time, including money and labor markets.
[2] Think of fiat money as a promise, issued by a bank or government, to redeem debt or tax obligations. The reason people accept such claims as money is because they are not without collateral. Fiat money is backed by the total amount of private debt in the economy plus our obligation as citizens to pay taxes.
