MODEL 0. The Simple Circular Flow with CASH
KEYNESIAN THEORY (KT)
H&B
Y
S
C
PrM
X
Y = C + S. Must be true
X = C + I. Must be true
CrM
I
S = I. If and when
the Credit Market is working well
What if it isn’t working well?
MODEL 0. KEYNESIAN THEORY – adding CASH
Keynesian Theory is named for John Maynard Keynes (“Canes”), who wrote during the
Depression of the 1930s.
Keynes’s principle point was that the government, by increasing its borrowing and spending,
could help to end the Depression. More generally, he argued that the government was in a
position to help the economy.
We can describe much of Keynesian Theory (KT) by adding one element to the CF diagram.
This element will be called “CASH.” It supposes that there is unspent money in the economy,
including money held as reserves in banks. We will picture CASH as being attached to the
Credit Market
ΔMD stands for “Change of Money
Demand”
Y
H&B
The double headed arrow indicates that
money can flow into and out of CASH.
S
CrM
ΔMD
CASH
PrM
X
I
C
Money will flow in or out of CASH if I and S
are not equal.
Y = C + S. Must be true
The CASH Model
X = C + I. Must be true
Y
H&B
S
ΔMD
CASH
X
PrM
I
C
CrM
Let us now suppose that the Credit Market
does not always make S = I, that it is possible
for Saving to be either greater than, or less
than, Investment
Of great importance is this pair of thoughts:
-- S might not equal I in the “short run.”
-- S will equal I in the “long run.”
How long these “runs” are is not at all clear
In the short run the difference between S and I can be made up for by people holding
more or less Money (“Cash”). We will say that the demand for (holding) money has
risen or fallen.
Saving can wind up in one of two ways:
1. It can be loaned and Invested
2. It can be held by someone (including banks)
Y = C + S. Must be true
The CASH Model
X = C + I. Must be true
Y
H&B
S
C
ΔMD
CrM
CASH
I
X
PrM
This picture shows:
1.the demand for money is rising
2.money is going into Cash
3.the public – including banks – are holding
more money
4.Savings is greater than Investment
We will denote money going into Cash as
a negative number, money coming out of
Cash as a positive number
How can we interpret this picture?
H&B
+5
-5
CASH
PrM
CrM
The situation shown here looks as if:
-- People started to Save more
-- Businesses were not inclined to borrow
and Invest the extra Saving.
-- The extra 5 sat as reserves in banks.
-5
The negative sign shows less money in the
Credit Market
Y = C + S. Must be true
The CASH Model
X = C + I. Must be true
H&B
+0
-5
CASH
PrM
-5
CrM
-5
How to interpret this?
Businesses decided to borrow less; banks got
stuck holding money they could not lend
OR:
Banks got scared, started to “hoard” money
and Investment was reduced. Businesses that
wanted loans could not get them
Total spending (X) fell as business borrowed
and spent less
The CASH Model -- KT
H&B
CrM
ΔMD
CASH
This picture shows:
1.the demand for money is falling
2.money is going out of Cash
3.the public– including banks – are holding
less money
4.Savings is less than Investment
PrM
H&B
-5
CrM
+5
CASH
PrM
What happened?
The situation shown here looks as if people
started to Save less, but banks had enough
cash to be able to continue to lend for
Business Investment from their reduced
Money Demand.
The CASH Model
H&B
What happened?
CrM
+5
CASH
PrM
+5
+5
Businesses started to borrow more and
banks had on hand enough money to meet
that demand.
Total spending rose
Y = C + S. Must be true
The CASH Model
X = C + I. Must be true
S + ΔMD = I. Must be true.
That is: $ into CrM = $ out of CrM
Y
H&B
S
ΔMD
CASH
X
PrM
Notice that all of the scenarios
that involve MD changing seem
unlikely to last very long. Banks
cannot or will not indefinitely
add to, or draw from, their
reserves. Sooner or later Savings
must equal Investment.
I
C
CrM
That is:
S > I means ΔMD < 0; someone is holding on
to money; the demand for money is rising;
money is going out of the CrM
S < I means ΔMD > 0; someone is reducing
their money holding; the demand for money
is falling; money is going into CrM
S ≠ I in the Short Run,
when ΔMD ≠ 0
S = I in the Long Run,
when ΔMD = 0
Final – CRUCIAL -- Point
Whenever S and I are unequal, X and Y will be unequal.
We will interpret this as the economy having grown or
shrunk.
We have here what the first “Model 0” could not describe
– the demand-driven rise and fall of GDP.
H&B
In this case, there was a rise of
Demand (x). Total Spending rose
C
+5
CASH
+5
PrM
CrM
+5
Since there was sufficient Cash to
pay for the increased Investment,
there was no off-setting reduction
in someone else’s spending.
H&B
-5
CASH
-5
CrM
-5
In this case, there was a decrease
of Demand (x). Total Spending
fell. Investment fell and there was
no off-setting increase of
Consumption.
PrM
So we now have an answer (not the only answer) as to why
GDP can rise or fall. GDP rises when people hold less money;
GDP falls when people hold more money.
H&B
-5
CASH
PrM
CrM
-5
-5
H&B
+5
CASH
PrM
MD is rising.
Money is piling up in CASH
I<S
X < Y . Economic contraction
+5
CrM
+5
MD is falling
Money is coming out of CASH.
I>S
X>Y
Economic expansion
Note what may appear backwards.
A negative ΔMD, means the demand for money is rising. The negative
sign means “less money in the CrM.”
Likewise people holding less money is shown by a positive sign (more
money into the CrM).
SUMMARY
If MD (Cash) does NOT change:
X does not change and changes of C and I will off-set each other
If MD DOES change:
X will change because C and I do not off-set each other
In fact, X rises (falls) equal to dMD