Saturday, August 29, 2009

Supply and Demand for Funds Redux

In my last post I wrote about the market for loanable funds and one way to shift the supply of funds and one way to shift the demand of funds. I wanted to talk about another way to move the supply of funds, through government expenditures.

In the textbook I am reading, it shows the standard economic rhetoric. First, imagine the government spends more money than it receives in taxes. This is a deficit. How does this affect savings? Well, we showed that Savings=(Y-t-C) + (t-G). So if the government runs a deficit in this equation it decreases savings (increase a negative.) Thus, because savings is equal to investment, it is decreasing the supply of loanable funds.

In the previous example, where households are delaying consumption and instead saving their excess earnings we moved from the intersection of the blue and red lines down to the the intersection of green and red. In this example of the government running a deficit the supply curve instead shifts left and real interest rates rise. This has not occurred in the current crisis. Why not?

As TARP money flowed into the financial system in 2008 and record bailouts occurred it was "common" wisdom on the street that the increased supply of Treasury securities would choke the market and the bond vigilantes would drive down the price of Treasury securities and the yields would increase. These vigilantes keep the government honest.

Here is Brad Delong. "It is astonishing. Between last summer and the end of this year the U.S. Treasury will expand its marketable debt liabilities by $2.5 trillion--an amount equal to more than 20% of all equities in America, an amount equal to 8% of all traded dollar-denominated securities. And yet the market has swallowed it all without a burp..."

He points us to JR Hicks and his essay "Mr Keynes and the Classics."

Figure one is the IS-LM or Investment Savings-Liquidity preference Money Supply. Point P is where goods and services equal the money supply. In figure 2 it shows the LM curve only. Basically, what Keynes proposed, at least through Hick's interpretation is that if the LM curve is shaped as it is in figure 2 than the government can run a deficit which shifts the IS curve to the right but which will not allow interest rates to rise. So basically if Point P is anywhere between zero and the beginning of the dashed LM line no amount of change in IS will raise interest rates. Secondly, the dashed LM curve shows that even by adding to the money supply and shifting LM outwards, the horizontal segment will still stay the same and will not allow interest rates to rise.

How can the LM curve be shaped like this, what theory underpins this formulation?

Basically, firms and households desire more savings, remember savings in economics is the purchase of securities like bonds, and when bond prices are bid up, the yields which are inversely related to price fall. The next step should be the equilibrium where firms now see that they can meet their investment hurdle rates and households no longer want to save at such low rates of return. However, because both are so scarred they do not act in this manner and instead wish only to hold cash until a more stable economic environment emerges. Because firms are not putting out investments, especially firms such as banks whose investments are loans, the monetary velocity falls and reach that horizontal asymptote shown in figure 2.

Milton Friedman, Alan Greenspan and Ben Bernanke would advocate the monetary vision that by adjusting the money supply will increase prices. However, as shown in figure 2 and discussed above the expansion of the LM curve does not alleviate the flat part of the curve, just pushes it out further (the dashed version) and thus the IS curve is unaffected. So what can be done?

As Hicks explains Keynesian responses are made for this situation. Hicks stated "So the General Theory of Employment is the Economics of Depression."

As it has been shown above the monetary supply increases will not increase the interest rates of an economy in a depression. Thus, the Federal Reserve is basically powerless except to provide liquidity, but to bring the rise in prices, to move from the horizontal segment to the normal economic environment, shown in the first example, is through fiscal expenditures by the government. This is why some economists such as Paul Krugman, the aforementioned Brad DeLong and countless others offered that a stimulus package should be instated. The hope was that by having the government invest in infrastructure or transferring money directly to the states so that they would be able to maintain their current spending, (states must run balanced budgets thus when recessions come and their tax revenues decrease they must decrease their spending, this is a bad thing when they all do it at the same time; not so bad when it is just a single state like Michigan.) It is hoped/proposed that by having the government invest money that firms and households are not willing to, the money multiplier can be brought to a positive relationship.

With the unfolding crisis over the past 2+ years here is the 10 year Treasury yields, remember yields falling is because prices are rising. I think Hicks is vindicated in his understanding of Keynes and Depression Economics.

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