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.

Savings versus Investments

Remember the scene in the Neverending Story where Atreyu must look into the Magic Mirror gate to reveal his true identity? Well savings and investment is basically the same, it is a true identity.

So when it is said that GDP equals consumption plus investment, government expenditures and net exports (NX, which will be ignored.) The right side must always equal the left side. Let's put it into equation form and figure out how we know savings equals investment.

Given:
Y= GDP
C= Consumption
G= Government Expenditures
I= Investment
NX= Net Exports, which we ignore because we are proposing a closed economy.
S= Savings
t= taxes

The equation from above is: Y=C+G+I
We can re write this to state: Y-C-G=I
So If we take GDP and subtract out consumption and government consumption we are left with Savings. Y-C-G=S and therefore S=I

We can then rework Y-C-G=S to include taxes, t. S= (Y-t-C) + (t-G). You can see that the t, taxes, cancel each other out. In this manner we can see that Private Savings equals (Y-t-C) and Public Savings equals (t-G). Or in ingles, private savings is equal to the remaining GDP after taxes and Consumption. The tax monies transfer to the government who then spend, G. If t is greater than G than there is a surplus and if not there is a deficit. When we net public and private savings, what is remaining is investment.

Thus, from earlier we can see that the financial system ensures that S=I by moving the money from people who can save it to people who can invest it.

It is important not to think of savings and investment as interchangeable words, they are not in economics. You do not invest when you buy a bond, you are saving. An entity invest when it purchases capital, such as, buildings or machinery.

Supply and Demand for Funds


The familiar supply and demand chart. This shows that as the real interest rate falls more funds are demanded. That is, business and consumers can undertake projects that will earn them more than the rate of interest charged for utilizing the funds. Conversely, less firms will loan at lower interest rates because they will not make enough return to compensate them for given their funds to risky clients. The balance is struck in this example at 1200 and a real interest rate of 5.5%. This is because the "invisible hand" will correct any meandering. Let's imagine that the real interest rate was higher than 5.5%, say 7%. What would happen? Well, more people would think that 7% was a good deal, thus they would increase the supply of savings to be invested. This would push down interest rates because of the additional supply. The market will work back to its equilibrium.

Let's examine the current situation. The financial crisis of 2007 and 2008 has now caused people to put more towards savings. The savings rate is up to 5.2% from 4% in the first quarter. This means that there has been an increase in funds that can be loaned.


In our example, we can see that the supply shifts parallel to the right. This means there is now a lower "real*" rate of interest than in the previous quarter, as the funds have moved from 1,200 to about 1,350. So the current financial crisis has encouraged households and businesses to save rather than consuming the money.

What could cause the demand curve to shift? Any encouragement of investment, say a tax credit for buying an automobile. This would cause the demand curve to parallel shift to the right as more entities used the tax credit plus a loan to purchase a new automobile.

*Real versus nominal: nominal is the quoted interest rate you see on Bloomberg, or the Wall Street Journal. The "real" rate of interest is adjusted for inflation.

How the financial system is the pipes to the economy, not the economy

Made the chart myself from my notes from various classes during my MBA. That is the financial system in a nutshell; not so difficult.

As the headline indicates the financial system is not the economy, it is the pipes that bring money from savers to entities who will invest the money. The investors will purchase capital and sell a product or service, portions of those earnings plus the initial investment will be returned, hopefully, to the savers. Now the genius of this system, at least before the financial crisis was its ability to securitize certain loans so that additional entities on the right side could purchase them. Thus more investment could be made and thus more capital added to the system and therefore productivity could be higher which increases the GDP of the country.

So before securitization, banks would loan money to a homeowner with the house as collateral. Unfortunately, there was a limit to the amount of loans the bank could make. This is because of its capital requirements imposed by the Federal Reserve and also because it was exposing itself to a concentrated risk in a particular market. Imagine, that the bank is in Detroit, given the well noted decline in the prospects of that city, the bank would have died just extending loans to commercial and residential real estate in the greater Detroit area.

So in the early 1980's a process was discovered to create a pool of loans and sell them to investors. Of course, Fannie Mae and Freddie Mac had been created to do this according to their charter. These entities tried to create a national mortgage market, thus money given to them through debt and equity offerings was used to purchase mortgages from all over the country. The thinking was that a property's value was tied to its local economy and by diversifying their risk by investing in all locales, plus the implicit government guarantee would allow investors to buy the bonds and equity that they offered. This market was a lucrative monopoly that investment banks broke into by the creation of sophisticated models.

This created a nefariously named "shadow banking system." That is mutual funds, hedge funds, pension funds and insurance companies now owned mortgages and other loans that had been pooled, which had previously been the domain of banks only. Banks I might add that were under the regulation and protection of the Federal Reserve and the FDIC.

The problem that was run into in this crisis is one as old as banking itself. Basically, a ___ [bank, mutual fund, hedge fund, insurance co] will use money [CD, savings account, mutual fund share, claim, policy] that is of a short maturity to buy an investment that is of a longer duration or maturity. [commercial real estate loan, residential real estate loan, private equity loan] This is done to take advantage of a normal interest rate environment where longer maturity investments earn an increasing rate of return the further out in maturity that one moves out. This spread between short-duration, low interest rate and long-duration, higher interest rate is how _____ [bank, mutual fund, hedge fund, insurance co] make money to return to their investors. So when I leave 10,000 dollars at Bank of America, it turns around and offers a loan of 90,000 dollars to a couple buying a home in Omaha. (This is the money multiplier that is a an effect of the reserve requirement affected by the Federal Reserve, I am assuming a 10% requirement.)

Here is the visualization:

The green is the money the entity makes by "playing" the spread.

The problem comes about when savers panic. Maybe the have been lied to by rating agencies charged with deciding how "safe" a security is, maybe regulators are asleep at the wheel, or the regulators have been "captured" by the industry in which they patrol or the investors have been lied to by the firm selling the security. Thus the right side calls in its claims and invest directly into the government securities, the so called return of principal instead of caring about return on principal. Or they could just hold cash under the mattress or spread their money about in various accounts at different banks making sure not to breach the protection offered by the FDIC. Of course consumers are not the only ones, companies will also do not with the FDIC but instead by moving their funds into the Treasury market.

This leads to no one purchasing the previous securities and the securities value falls precipitously and possibly more than the actual underlying value of the investment. As always "Res tantum valet quantum vendi potest," or an item is only worth what some one else will pay for it.

The allocation of capital, a scarce resource, is vital to the economy. However, the value it creates versus the losses it makes in bad times may net out or even be negative. Moving forward, elected officials must discern a more virtuous manner in which to allocate monies; the system cannot be seem to be based upon an expectation of bailouts.

Later, I plan on writing about National Income Accounts and the market for funds.

A study of Economics

I started up a post about the difference in thinking between economists who advocate a Keynesian or modified Keynesian response to a recession and those who propose to do little to interfere with an economy as a government response would be inefficient and lead to loss of freedom. However, it wasn't too far into the post that I realized my thinking was not as clear as it should be. Thus, over the past few days I have been reviewing my macroeconomics textbook and will place my notes and examples up here. It is a fairly lengthy section of the book almost 300 pages, so this may take more than a few posts.

In the beginning... there was Jin. He resides on an island in the South Pacific; and for this example is completely alone. Thus, he is the sole source of GDP, he makes all the income and consumes all the goods and services. Adam Smith would hope that Jin could recruit people to join him, dividing up labor and creating more than one person could do alone, but this is not to be the case.

So how much can he consume, what is the nation of Jin's GDP? It all depends on his productvity. You can see that he is only one person and thus labor will be held constant in this economy. So whether, he gets to eat like a king or pick through barnacles all depends on how well Jin can hunt, fish, gather or grow. If Jin fishes with a wooden spear he carved, he may catch a fish a day and subsist. However, if he can tie tree vines together to create a cast net he might be able to catch 3 fish a day. Then he could either eat a more kingly meal or only fish every third day; hopefully the latter so that he might be able to create a distress signal for his rescue.

There are 4 basics determinants of productivity in Jin's case, there is his capital, his labor, his natural resources and his knowledge or technology. So capital would be his spear or his net. His labor includes any skills or knowledge he has acquired up to this point; if he had participated in Outward Bound he would be more productivity than if he had not. Natural resources are the fish stock, the tree limbs and vines, and the beach or cove that he fishes from. Finally there is the technology or knowledge. This is very closely related to labor, but with one slight difference. Knowledge would be akin to the quality of the instruction, the books, the programs that Jin learned. Whereas his labor knowledge is putting that experience to work.

Finally, there has to be a diminishing return to the inputs put into the economy and there is. This graph is complex but we need only focus on a few points for this next idea.



So if we look where Y1 is relative to Y0 you can see a very large leap in the Y value by adding one unit of K or capital. However, if you look at Y2 versus Y0 you can see that adding an additional amount of capital does not garner the same amount of productivity, that is the difference between Y2 and Y0 is far less than Y0 and Y1.

In Jin's case giving him another net to cast does not help his productivity because he can only throw one cast net at a time.

Till next time, Cheers!