Circular Flow of Income theory

[JohnfrmClevelan]

Circular flow of income - Wikipedia

GDP = C (consumption) + I (investment) + G (government spending) + (X - M) (net exports, positive or negative)

Production = national income = potential demand.

If you have a $15 trillion economy, the national income is $15 trillion. If we spent 100% of our income buying our own production, then we would remain a $15 trillion economy.

But, as a whole, we never spend 100% of our income. How, then, does the economy grow, when aggregate demand needs to grow?

By additions to aggregate demand over and above the income from previous production. This can come from four places:

*net spending out of savings. (This never happens.)
*a trade surplus. (This never happens in the U.S.)
*federal deficit spending.
*increased private sector debt. (This normally happens in a good economy.)

Subtractions to aggregate demand include savings, trade deficits (which is just saving by foreign parties), a federal budget surplus, and decreased private sector debt.



Simply put, if additions to aggregate demand outweigh subtractions to aggregate demand, the economy grows. If subtractions outweigh additions, the economy shrinks. $1 billion in federal deficit spending or increased credit will result in more than $1 billion of income, because there will be some secondary spending effects. (This is all assuming that about 100% of deficit spending and increased credit goes to consumption and investment, but that's a pretty safe assumption.)

Also, banks do not lend out our savings.

Discuss.

 

[Kushinator]

Discuss.

You've neglected savings and international capital flow.

Total Savings = Private Savings + Public Savings (Taxes - Expenditures) + Foreign Savings (Imports - Exports)

If we assume the quantity of financial capital supply equals the quantity of financial demand (meaning supply is equal to demand at some rate of interest), we can derive Total Investment or (I).

S + (M - X) = I + (T - G)

Rearraning for I,

I = S + (T - G) + (M - X)

Meaning, when we run a trade surplus, total investment will be lower ceteris paribus. Which is just another way to show that you cannot fully grasp economic growth on the basis of accounting identities alone. This concept will be covered in greater detail in intermediate macroeconomics at most colleges and universities.

 

[JohnfrmClevelan]

You've neglected savings and international capital flow.

Total Savings = Private Savings + Public Savings (Taxes - Expenditures) + Foreign Savings (Imports - Exports)

If we assume the quantity of financial capital supply equals the quantity of financial demand (meaning supply is equal to demand at some rate of interest), we can derive Total Investment or (I).

S + (M - X) = I + (T - G)

Rearranging for I,

I = S + (T - G) + (M - X)

Meaning, when we run a trade surplus, total investment will be lower ceteris paribus. Which is just another way to show that you cannot fully grasp economic growth on the basis of accounting identities alone. This concept will be covered in greater detail in intermediate macroeconomics at most colleges and universities.

Be patient with me here, because I really want to understand your thinking.

Why would deficit spending decrease I? By my reasoning, there is more aggregate demand, and more money to earn.

By the same reasoning, net imports result in a loss of domestic demand. Why should that increase I?

And where does credit fit into your equations?

 

[Kushinator]

B
Why would deficit spending decrease I? By my reasoning, there is more aggregate demand, and more money to earn.

Governments become demanders of financial capital when they run deficits. If deficits grow, then there must be a decline in private investment, growth in private savings, or growth in the trade deficit.

By the same reasoning, net imports result in a loss of domestic demand.

This is not true. Imports grow with consumption, they are just balanced to zero in the NIPA identities. It's so imports are not counted twice in the GDP equation. Remember, imports are consumed... either for personal use or for business, as consumption of an imported good or service adds to aggregate consumption and therefore adds to total output.

And where does credit fit into your equations?

Are you asking how much of consumption, investment, government spending, importing, and exporting is driven by borrowing/lending?

 

[JohnfrmClevelan]

Governments become demanders of financial capital when they run deficits. If deficits grow, then there must be a decline in private investment, growth in private savings, or growth in the trade deficit.

When you consider that the government spends the proceeds from bond sales right back into the economy, I'm not seeing the loss of financial capital here, just a shift. As a whole, the private sector has everything they started with, plus the bonds.

This is not true. Imports grow with consumption, they are just balanced to zero in the NIPA identities. It's so imports are not counted twice in the GDP equation. Remember, imports are consumed... either for personal use or for business, as consumption of an imported good or service adds to aggregate consumption and therefore adds to total output.

If we have an income of $10 trillion, and we have a trade deficit of $2 trillion, how can we consume $10 trillion worth of domestic production? The trade deficit is just like saving $2 trillion of our income and not spending it.

Aren't imports a straight subtraction from GDP? (X - M)? If your exports are zero, imports are a negative.

Are you asking how much of consumption, investment, government spending, importing, and exporting is driven by borrowing/lending?

It's more a question of what S actually does. And I know your definition of savings differs from mine. In my definition, savings is income that we don't spend or invest in real production. It doesn't get loaned out, and there is always a net flow of dollars into savings. I don't see how investment is dependent on savings. To me, investment comes from a portion of earnings, plus increased credit.

While there is some real investment coming from (past) savings, there is still more money put into savings than taken out.

 

[Kushinator]

When you consider that the government spends the proceeds from bond sales right back into the economy, I'm not seeing the loss of financial capital here, just a shift.

Spending the proceeds of bond sales is not building capital. Capital comes from savings.

As a whole, the private sector has everything they started with, plus the bonds.

The deficit must be financed by personal savings, less private investment, or growth in the trade deficit.

If we have an income of $10 trillion, and we have a trade deficit of $2 trillion, how can we consume $10 trillion worth of domestic production? The trade deficit is just like saving $2 trillion of our income and not spending it.

I'm not understanding what you're trying to say.

Aren't imports a straight subtraction from GDP? (X - M)? If your exports are zero, imports are a negative.

Imports are subtracted from GDP because they are already counted in personal consumption. When i buy a new phone that was made overseas, and purchase a phone/data plan, i am consuming goods and services. So double counting doesn't occur, imports are subtracted from GDP. Exports are sales of domestic production.

It's more a question of what S actually does. And I know your definition of savings differs from mine. In my definition, savings is income that we don't spend or invest in real production.

If my business earns $100k/year after tax profit, and i save it for 2 years, i will have $200k + interest in the form of capital. You're operating from the false assumption that people don't ever spend their savings. Businesses do it every single day.

I don't see how investment is dependent on savings. To me, investment comes from a portion of earnings, plus increased credit.

Retained earnings is savings.

While there is some real investment coming from (past) savings, there is still more money put into savings than taken out.

Savings ebbs and flows based on economic conditions. Ironically enough, there are times when savings rates rise but total savings (and investment) declines. It happens during economic downturns, and is accompanied by lost wages. During these periods of economic uncertainty, we'll see inventory buildup which counts as a form of investment. Inventory buildup doesn't create jobs. Adding additional production capacity does create jobs.

 

[JohnfrmClevelan]

Spending the proceeds of bond sales is not building capital. Capital comes from savings.

The deficit must be financed by personal savings, less private investment, or growth in the trade deficit.

You're just repeating what you said before. I still don't see it.

The proceeds of those bond sales ends up in the private sector, the same place they were before. Nobody is depleting their savings, in an aggregate sense.

Does personal savings count bonds? Because bonds sure seem like savings vehicles to me.

Finally, since you don't need pre-existing money to create loans, I don't see where capital comes into play there. You can have investment without savings via bank loans.

I'm not understanding what you're trying to say.

Production = income = potential demand. If we spent 100% of our income, we could consume 100% of our production. If we save 10% of our income, we can only consume 90% of our production. And a trade deficit is just saving by foreign parties.

Imports are subtracted from GDP because they are already counted in personal consumption. When i buy a new phone that was made overseas, and purchase a phone/data plan, i am consuming goods and services. So double counting doesn't occur, imports are subtracted from GDP. Exports are sales of domestic production.

Yes, you consume the phone, and the retail markup, and all the other stuff that goes into buying anything. But some portion of our dollars go to China, who doesn't spend them on U.S. goods. That's where the loss comes in. I'm not saying that a trade deficit has to be bad for the economy, but the loss of income has to be made up somewhere.

If trade was equal, then great, their purchases of U.S. goods are just the same as if we had bought them ourselves - the income goes to us. But with a trade deficit, the income goes to China.

If my business earns $100k/year after tax profit, and i save it for 2 years, i will have $200k + interest in the form of capital. You're operating from the false assumption that people don't ever spend their savings. Businesses do it every single day.

But in the intervening two years, that savings wasn't spent on consumption or investment. That's a loss of GDP.

I understand that most people do spend their savings, eventually. But in the aggregate, the pile of savings just continues to grow. Government bonds are the best example.

Savings ebbs and flows based on economic conditions. Ironically enough, there are times when savings rates rise but total savings (and investment) declines. It happens during economic downturns, and is accompanied by lost wages. During these periods of economic uncertainty, we'll see inventory buildup which counts as a form of investment. Inventory buildup doesn't create jobs. Adding additional production capacity does create jobs.

Right, but there is almost always a net flow of income into savings (my definition of savings). And counting inventory buildup as part of I just drives me nuts. That was a big reason I started looking for alternative explanations, because it makes no sense. People don't spend their money, so I automatically increases? Makes no sense to me, other than as an equation-fixer.

 

[Kushinator]

I will finish the response later tonight or tomorrow. I lost my response in submission, and it was very disheartening.

One of the equations has an error. When solving for I, i needed to switch (T - G) to (G - T).

 

[Kushinator]

You're just repeating what you said before. I still don't see it.

The proceeds of those bond sales ends up in the private sector, the same place they were before. Nobody is depleting their savings, in an aggregate sense.

Nobody is depleting their savings because they are earning more income than they spend to earn it... on the aggregate. When this does happen, it's typically driven by an economic slowdown. We are not in any contention that deficits are an addition to GDP.

Does personal savings count bonds? Because bonds sure seem like savings vehicles to me.

They are not savings. Money is spent on bonds, as such this money is not consumed or invested. In other words, a portion of savings is used to purchase Treasury securities as opposed to private debt.

Can we both agree that it's the private sector that drives wealth creation, innovation, productivity, etc...?

Finally, since you don't need pre-existing money to create loans, I don't see where capital comes into play there. You can have investment without savings via bank loans.

Banks just aren't going to make collateral-free loans to people. Number one, it's way more expensive. The more you have to borrow against, the cheaper the cost of obtaining additional capital. Number two, it increases potential losses, which must be offset by obtaining capital to meet their risk requirements.

Production = income = potential demand. If we spent 100% of our income, we could consume 100% of our production. If we save 10% of our income, we can only consume 90% of our production. And a trade deficit is just saving by foreign parties.

Trade deficits are a positive component to investment growth. It's the trade-off for more consumption, as foreign savings are a component of aggregate investment.

But some portion of our dollars go to China, who doesn't spend them on U.S. goods

We've been through this before i believe. No, dollars don't go to China. Instead, Chinese companies (sometimes under the direction of their government) invest the proceeds of their profitable sales in dollar denominated assets. They might buy U.S. Treasury Bonds, Corporate Bonds, stocks, real estate, hold cash balances, etc....

I'm not saying that a trade deficit has to be bad for the economy, but the loss of income has to be made up somewhere.

You can't call it lost income, because you are incorrectly assuming consumption of foreign goods and services will always be equally supplied by domestic producers. While i'm sure we could build low wage tech manufacturing campuses throughout the U.S., but it would still be more expensive and less profitable than purchasing them from cheaper suppliers. Imports are negated from the identity because we are trying to consider domestic production. Even though imports are consumed or invested (which increases both C and I), they are not representitive of domestic production.

The result is a net zero, not loss of income. Furthermore, foreign savings (represented as (I - X) > 0) is a component of investment.

But with a trade deficit, the income goes to China.

It goes into U.S. accounts owned by Chinese corporations. You're misrepresenting the constructs of the identity you've chosen to build your theory from. Imports become a net zero, because Chinese goods are consumed or become part of domestic investment.

But in the intervening two years, that savings wasn't spent on consumption or investment. That's a loss of GDP.

If you want to bind your analysis to the NIPA identities, you have to follow the rules of this identity, which is savings = investment… or that supply = demand… or financial supply = financial demand.

I understand that most people do spend their savings, eventually. But in the aggregate, the pile of savings just continues to grow. Government bonds are the best example.

Savings grows because people and businesses continue to earn profit.

Right, but there is almost always a net flow of income into savings (my definition of savings). And counting inventory buildup as part of I just drives me nuts. That was a big reason I started looking for alternative explanations, because it makes no sense. People don't spend their money, so I automatically increases? Makes no sense to me, other than as an equation-fixer.

It is a form of business investment… and when we go back to the identities, savings = investment. Remember, these are accounting identities, and therefore they have severe limitations when trying to understand economic growth.

 

[Kushinator]

In post no.2, it should read:

S + (M - X) = I + (T - G)

Rearraning for I,

I = S + (G - T) + (M - X)

 

[JohnfrmClevelan]

Trade deficits are a positive component to investment growth. It's the trade-off for more consumption, as foreign savings are a component of aggregate investment.

Before I respond - do you believe that money is neutral? Because that's what I'm getting from points like this one. It would explain a lot.

 

[Kushinator]

Before I respond - do you believe that money is neutral? Because that's what I'm getting from points like this one. It would explain a lot.

In the long run. In the short run, prices are sticky.

 

[JohnfrmClevelan]

In the long run. In the short run, prices are sticky.

So this is where we differ.

If I'm understanding your equations correctly, money, earned by the Chinese, is counted as investment when they buy Treasuries with it. But because I see Treasuries differently - as just another form of government liability, same as a dollar, I don't consider that to be investment. The government simply creates more liabilities when it wants to spend. And if the Chinese just decided to hold those dollars in dollar form, there would be no difference to the government's ability to create and spend money. Counting the sale of Treasuries as "investment" just seems like an equation-fixer, making it look like our trade imbalance is evened out by Chinese "investment" in our economy. But those dollars never enter our economy in reality. (The other stuff you mentioned - real investment in U.S. production, I agree. Purchase of stocks, though, is no more real investment than it is when we buy them.)

Same problem with domestic savings. Income saved, whether saved in bank accounts or Treasuries, does not enter the economy unless and until it is spent, net. The pile of Treasuries only continues to grow, so there is no net spending from that, and account balances also continue to grow, so there is net saving there, too.

Nobody is depleting their savings because they are earning more income than they spend to earn it... on the aggregate. When this does happen, it's typically driven by an economic slowdown. We are not in any contention that deficits are an addition to GDP.

I'm not even counting interest here, I'm talking about the immediate effect of (bond purchases + govt. spending of the proceeds). Taken together, the private sector hasn't lost any dollars at all. The government has simply purchased stuff with new liabilities. If the Fed purchased those bonds, there would be a straight addition of dollars into the economy (after the spending) instead of an addition of bonds. It's the same as the direct issue of currency.

Trade deficits are a positive component to investment growth. It's the trade-off for more consumption, as foreign savings are a component of aggregate investment.

Using an extreme example, let's say we have a $10 trillion economy. We spend $1 trillion (net) of that on Chinese goods, and $9 trillion on domestic production. The Chinese buy nothing from us with their $1 trillion. Barring deficit spending and increased credit, how do we sell that last $1 trillion worth of U.S. goods that haven't been purchased?

**************

When I ask others, "how does an economy grow?," I usually get an answer that doesn't include money. The answer is "an increase in productivity," or "population growth," or "savings are invested." But my contention is that you cannot translate any of that into growth without money being part of the equation. Workers don't work harder/longer without being paid. You can't buy more materials for production without money, and the money has to come first. This is where I see a problem with classical models.

 

[Kushinator]

If I'm understanding your equations correctly, money, earned by the Chinese, is counted as investment when they buy Treasuries with it.

First off, these are identities, not equations, and they certainly are not mine. Secondly, no, it doesn't mean anything like that. Buying treasuries to finance deficit spending increases G, not I. What i've been trying to convey for this entire exchange is that in the event of a fiscal deficit, the only way for investment not to shrink is for the trade deficit (imports more than exports) and/or private savings to grow.

Same problem with domestic savings. Income saved, whether saved in bank accounts or Treasuries, does not enter the economy unless and until it is spent, net. The pile of Treasuries only continues to grow, so there is no net spending from that, and account balances also continue to grow, so there is net saving there, too.

Under the basis of the NIPA identity construct, savings equals investment, and investment = private savings + public savings + foreign savings

I'm not even counting interest here, I'm talking about the immediate effect of (bond purchases + govt. spending of the proceeds). Taken together, the private sector hasn't lost any dollars at all. The government has simply purchased stuff with new liabilities. If the Fed purchased those bonds, there would be a straight addition of dollars into the economy (after the spending) instead of an addition of bonds. It's the same as the direct issue of currency.

That's not how it works though. Money used to purchase bonds doesn't get to flow into private investment, it becomes G instead of I. Do you understand why this is so?

Using an extreme example, let's say we have a $10 trillion economy. We spend $1 trillion (net) of that on Chinese goods, and $9 trillion on domestic production. The Chinese buy nothing from us with their $1 trillion. Barring deficit spending and increased credit, how do we sell that last $1 trillion worth of U.S. goods that haven't been purchased?

GDP in that instance isn't $10 trillion, it's $9 trillion. GDP is about domestic production.

When I ask others, "how does an economy grow?," I usually get an answer that doesn't include money. The answer is "an increase in productivity," or "population growth," or "savings are invested." But my contention is that you cannot translate any of that into growth without money being part of the equation. Workers don't work harder/longer without being paid. You can't buy more materials for production without money, and the money has to come first. This is where I see a problem with classical models.

I'm not talking advocating classical models, as i'm really drawing from Post-Keynesian economics. Once again, you cannot understand economic growth through the lens of accounting identities... all they were created to do was, well, count. C, I, and G all possess a co-variances that are impossible to determine using your methodology. If you're interested in understanding economic growth, i'd start with reading about the Cobb-Douglass production function as a good primer. From there, you can be better prepared to learn more advanced growth theories, e.g. exogenous/endogenous.

 

[JohnfrmClevelan]

First off, these are identities, not equations, and they certainly are not mine. Secondly, no, it doesn't mean anything like that. Buying treasuries to finance deficit spending increases G, not I. What i've been trying to convey for this entire exchange is that in the event of a fiscal deficit, the only way for investment not to shrink is for the trade deficit (imports more than exports) and/or private savings to grow.

I grows with private savings only because that leads to a buildup of unsold inventory. I would think that a buildup of unsold inventory would cause a business to scale back production.

How an increased trade deficit leads to increased domestic investment is still a mystery to me.

That's not how it works though. Money used to purchase bonds doesn't get to flow into private investment, it becomes G instead of I. Do you understand why this is so?

The money used to purchase bonds probably wasn't going to flow into private investment anyway. It could just as easily have remained in bank account balances, had the Fed purchased those bonds instead, or if we simply issued currency directly. Treasury purchasers are looking for small, risk-free returns, with the emphasis on risk-free. If they wanted to invest in real production, they were free to do so. And businesses are still free to get bank loans if they wish to invest.

The money used to purchase bonds went to government spending, then into consumption (mostly) when the earners of that government spending spent their income. So it not only became G, it also became C. Basically, that money went from savings to consumption; the savers, though, now hold bonds.

GDP in that instance isn't $10 trillion, it's $9 trillion. GDP is about domestic production.

GDP changes over time, though. It was $10 trillion in Year X. Now, in year (X+1), there is only $9 trillion of income because of the trade deficit.

I'm not talking advocating classical models, as i'm really drawing from Post-Keynesian economics. Once again, you cannot understand economic growth through the lens of accounting identities... all they were created to do was, well, count. C, I, and G all possess a co-variances that are impossible to determine using your methodology. If you're interested in understanding economic growth, i'd start with reading about the Cobb-Douglass production function as a good primer. From there, you can be better prepared to learn more advanced growth theories, e.g. exogenous/endogenous.

The circular flow model covers growth. You get growth from an increase in aggregate demand, which requires an increase in income over and above what you get from past production. And you get that increased income from increased private sector credit, deficit spending, and/or a trade surplus. It's more than accounting identities.

 

[Kushinator]

I grows with private savings only because that leads to a buildup of unsold inventory. I would think that a buildup of unsold inventory would cause a business to scale back production.

That's part of it, but not all of it. If the economy is strong and inventories are depleting, we're still going to see stronger private domestic investment absent inventory growth.

How an increased trade deficit leads to increased domestic investment is still a mystery to me.

A trade deficit is foreign savings, and we already know that savings equals investment within the constructs of the NIPA identity.

The money used to purchase bonds probably wasn't going to flow into private investment anyway. It could just as easily have remained in bank account balances

That's speculation. We do know there is opportunity cost, and every dollar that flows into government cannot count towards consumption or investment.

The money used to purchase bonds went to government spending, then into consumption (mostly) when the earners of that government spending spent their income. So it not only became G, it also became C. Basically, that money went from savings to consumption; the savers, though, now hold bonds.

Again, the NIPA identities are distinct for a reason. If something is counted in C, it is not counted in I, G, or NX. This works for government spending as well. What you're claiming violates the NIPA identity.

GDP changes over time, though. It was $10 trillion in Year X. Now, in year (X+1), there is only $9 trillion of income because of the trade deficit.

So you've constructed a scenario where GDP was $10 trillion in year 1, and in year 2 it was $9 trillion? Basically, consumption, investment, and government all declined in your example. That's not how import growth transpires in reality. Imports grow as the economy grows and decline as the economy declines.

The circular flow model covers growth. You get growth from an increase in aggregate demand, which requires an increase in income over and above what you get from past production. And you get that increased income from increased private sector credit, deficit spending, and/or a trade surplus. It's more than accounting identities.

It has several holes, particularly when you call imports a reduction in GDP (which i've demonstrated is false) and try to redefine savings and investment.

 

[TheEconomist]

When I ask others, "how does an economy grow?," I usually get an answer that doesn't include money. The answer is "an increase in productivity," or "population growth," or "savings are invested." But my contention is that you cannot translate any of that into growth without money being part of the equation. Workers don't work harder/longer without being paid. You can't buy more materials for production without money, and the money has to come first. This is where I see a problem with classical models.

Let's be very specific about how money and prices enter actual economic models.

I'll use the simplest model of consumer choice possible: we have two goods c(1) and c(2), priced at p(1)>0 and p(2)>0, respectively. Our consumer has a budget of m. His preferences are given by U(c(1), c(2)) := u(c(1)) + b*u(c(2)), where u(.) is a monotonically increasingly and concave scalar function over positive real scalars and b is a positive fraction. You can think of c(1) and c(2) as consumptions in two periods. Our consumer maximizes utility by choice of c(1) and c(2).

max { u(c(1)) + b*u(c(2)) } subject to p(1)c(1) + p(2)c(2) = m

Under the conditions, I imposed on the function u(.), it is optimal to spend all the money, hence the equality above. Now, we typically also say that the slope of u(.) around c=0 tends toward infinity to make sure it is also optimal to consume at least a little all the time and we usually assume u(.) is twice differentiable in the first quadrant. If we do, the problem has a very simple solution defined by a system of 3 equations:

u'(c(1)) = lambda * p(1)
u'(c(2)) = lambda * p(2)
p(1)c(1) + p(2)c(2) = m

with lambda being the Lagrange multiplier. The Envelop Theorem shows lambda is also the marginal utility of money (i.e., the partial derivative of U(c(1), c(2)) with respect to m evaluated at the optimal consumption path), or the value the consumers get out of relaxing a bit his budget constraint.

Now, what's the point about prices? Well, it turns out that the ratio of prices is what determines the optimal basket c* = (c*(1),c*(2)). You can divide the first equation by the second and you will notice:

u'(c(1))/u'(c(2)) = p(1)/p(2)
p(1)c(1) + p(2)c(2) = m

that if you divided everything by p(2), it wouldn't change a damn thing. In other words, instead of talking about dollars, you would be talking about quantities of the second good. Your budget would be M := m/p(2), which is the maximal amount of c(2) you can buy with m dollars at the price p(2) dollars. Hence, the demand functions you get out of this have a very special property: Marshallian demands are homogeneous of degree 0 with respect to the price/budget vector (p(1),p(2),m). If c(p(1),p(2),m) := c*, then you get the following:

For any g>0,

c(g*p(1), g*p(2), g*m) = (g^0) * c(p(1),p(2),m) = c(p(1),p(2),m).

The fundamental point here is that if people care about real stuff (time, food, cars, shelter, etc.), the comparison operates on their ability to substitute between them: in other words, it depends on the ratios of prices and not the prices, per se.


It's important to understand that point because it helps make sense of how people introduce money as a potent force in macroeconomics today.

 

[TheEconomist]

The aforementioned problem is part of the contemporary modeling apparatus, except that we rely on more sophisticated versions of that same basic problem to characterize choices made by households. So, how do we introduce a meaningful role for prices in those models?

In a typical New Keynesian DSGE model, two important elements are introduced in the production sector of the economy. The first one is the use of monopolistic competition. We assume there is a continuum of infinitely many goods that are not perfect substitutes. Each of them is produced by one firm in each period and this grants firms the possibility to not all ask for the same price. Obviously, all firms decide on a pricing strategy subject to the demand for their specific good. The second one is imposing restrictions on the ability of firms to change prices. There are many ways to do this, but one of the most popular devices is what we call Calvo Pricing. The idea is that firms can adjust their prices each period with a certain probability, call it q, so that they have to anticipate the possibility of using a suboptimal price for a few quarters when they pick it. It's very abstract, but it has a very convenient property with regards to the average duration of a pricing episode.

You are at time 0 and moving to time 1. There is an average number of periods that you expect to spend with prices p(0) at time 0. Call E(D) this expected duration. With probability q, you will change your price for p(1) at time 1. In this case, your episode lasted one period. With probability 1-q, however, you would be essentially back to square one: from time 1, you can expect to wait a further E(D) period on average, so that conditional on reaching that node from time 0, you can expect your pricing episode to last E(D) + 1. You thus get the following equation:

E(D) = q*1 + (1-q)*(E(D) + 1)

which implies E(D) = 1/q. This is the primary reason why people like the Calvo pricing scheme: it's a very quick and dirty way of looking at microeconomic data on how long firms keep their prices on average to pin down the value of q. The same logic can apply and very often applies to the supply of labor: you assume there are infinitely many types of labor, not all of which are perfect substitutes and you can use the same Calvo pricing mechanism there too.

The interesting point is that we do these tricks because we know as a matter of fact that prices do not change every quarter. They tend to stick around 3 quarters or so, on average. The rationale usually is the idea of "menu costs": it is costly to change prices. Traditionally, the idea involves printing new menus, but you can also think about the whole problem of using resources to determine what would be a good price.

Now, how are prices potent forces here? Because not all prices move at the same time, there is a delay between real changes and price movements. The tight link you would get between prices and real production costs*** in simpler models break down since some prices lag behind and, hence, some price ratios are not reflecting the real ability of the economy to substitute between them. THAT is how contemporary macroeconomics introduce a role for nominal variables.

___________________________
PS: The tight link comes from the maximization problem of the firm. Under monopolistic competition without pricing rigidities (whether Calvo style or others), the optimal price is a multiple of marginal costs every period. In that environment, price ratios reflect the real cost of bringing stuff to the market in terms of how much of the other stuff needs to be sacrificed. In NK DSGE, this breaks down: some prices lag and firms have to think about pricing rigidities when they choose prices so it conveys distorted information to consumers.
PS II: If you also want monetary aggregates in the model, you have to make holding money valuable -- i.e., people need to want to hold on to money. But, again, money plays a role through their impact on prices and prices matter insofar as people respond to price ratios to make choices.

 

[JohnfrmClevelan]

It has several holes, particularly when you call imports a reduction in GDP (which i've demonstrated is false) and try to redefine savings and investment.

The domestic consumption that comes with imports (retail sales, etc.) should already be covered by C. (X - M) then denotes the net dollars that flowed out of the U.S. to buy Chinese goods and stayed there.

If we were net exporters, we would be selling more production in exchange for dollars, and GDP (and our income) would logically increase. Why is it wrong to say that net imports would have a negative effect on GDP?

Just repeating the NIPA identities doesn't help me understand them. I want to understand the logic behind the claims. GDP seems logical to me; your definition of I does not. Nor does S.

 

[JohnfrmClevelan]

Let's be very specific about how money and prices enter actual economic models.

I'll use the simplest model of consumer choice possible: we have two goods c(1) and c(2), priced at p(1)>0 and p(2)>0, respectively. Our consumer has a budget of m. His preferences are given by U(c(1), c(2)) := u(c(1)) + b*u(c(2)), where u(.) is a monotonically increasingly and concave scalar function over positive real scalars and b is a positive fraction. You can think of c(1) and c(2) as consumptions in two periods. Our consumer maximizes utility by choice of c(1) and c(2).

max { u(c(1)) + b*u(c(2)) } subject to p(1)c(1) + p(2)c(2) = m

Under the conditions, I imposed on the function u(.), it is optimal to spend all the money, hence the equality above. Now, we typically also say that the slope of u(.) around c=0 tends toward infinity to make sure it is also optimal to consume at least a little all the time and we usually assume u(.) is twice differentiable in the first quadrant. If we do, the problem has a very simple solution defined by a system of 3 equations:

u'(c(1)) = lambda * p(1)
u'(c(2)) = lambda * p(2)
p(1)c(1) + p(2)c(2) = m

with lambda being the Lagrange multiplier. The Envelop Theorem shows lambda is also the marginal utility of money (i.e., the partial derivative of U(c(1), c(2)) with respect to m evaluated at the optimal consumption path), or the value the consumers get out of relaxing a bit his budget constraint.

Now, what's the point about prices? Well, it turns out that the ratio of prices is what determines the optimal basket c* = (c*(1),c*(2)). You can divide the first equation by the second and you will notice:

u'(c(1))/u'(c(2)) = p(1)/p(2)
p(1)c(1) + p(2)c(2) = m

that if you divided everything by p(2), it wouldn't change a damn thing. In other words, instead of talking about dollars, you would be talking about quantities of the second good. Your budget would be M := m/p(2), which is the maximal amount of c(2) you can buy with m dollars at the price p(2) dollars. Hence, the demand functions you get out of this have a very special property: Marshallian demands are homogeneous of degree 0 with respect to the price/budget vector (p(1),p(2),m). If c(p(1),p(2),m) := c*, then you get the following:

For any g>0,

c(g*p(1), g*p(2), g*m) = (g^0) * c(p(1),p(2),m) = c(p(1),p(2),m).

The fundamental point here is that if people care about real stuff (time, food, cars, shelter, etc.), the comparison operates on their ability to substitute between them: in other words, it depends on the ratios of prices and not the prices, per se.


It's important to understand that point because it helps make sense of how people introduce money as a potent force in macroeconomics today.

Thanks for joining the thread, first of all.

That said, your explanations might as well be written in German for all the help they are to a layman. You need to dumb it way down on this forum.

I'm obviously in a camp that doesn't think standard economic theory is completely correct. And before you dismiss that, my camp includes plenty of Ph.D.s that studied standard economics and then came to the MMT camp, plus those Ph.D.s that started out there. So it has some validity.

I'm also seeing years of incorrect assumptions and incorrect predictions coming from the orthodox economics crowd. So I don't think it's off base to question the validity of the thinking that still dominates the field. Right now in Jackson Hole, Krugman and Summers are coming to some very MMT-like conclusions, but without acknowledging MMT itself or any of the MMT academics that have been saying the same things, and publishing papers, for years. They are bending into pretzels trying to validate Krugman's IS/LM ideas, instead of simply questioning whether it's valid at all. Mostly, I believe, because they have too much to lose by admitting that they have been wrong for years.

 

[Kushinator]

(X - M) then denotes the net dollars that flowed out of the U.S. to buy Chinese goods and stayed there.

Incorrect.

Imports are a net zero because their consumption and investment properties will be subtracted at the end. It has nothing to do with net dollars flowing out, as this isn't even occurring within the NIPA identities. They are measurements of domestic production. If you buy an iphone, there are other aspects of the phone that are not produced in China, such as the applications, insurance, shipping, retail, etc....

If we were net exporters, we would be selling more production in exchange for dollars, and GDP (and our income) would logically increase.

GDP increases with exports... not net exports. This is the common misconception that keeps appearing throughout our exchanges. Exports increase domestic output. Imports are a net zero.

Why is it wrong to say that net imports would have a negative effect on GDP?

For the same reasons i've stated throughout this exchange and many others. Imports are not a reduction in domestic output. You're trying to make the claim that by importing something we are foregoing the production of the imported good. That's simply not true.

Just repeating the NIPA identities doesn't help me understand them. I want to understand the logic behind the claims. GDP seems logical to me; your definition of I does not. Nor does S.

That's because you're operating under the construct of your own theories. If you cannot understand why imports do not reduce domestic production (and in almost all cases increase both consumption and investment), then we've come to an impasse. I've laid it out as best i could. If there is anything that you're not understanding, please let me know.

 

[JohnfrmClevelan]

For the same reasons i've stated throughout this exchange and many others. Imports are not a reduction in domestic output. You're trying to make the claim that by importing something we are foregoing the production of the imported good. That's simply not true.

No, I'm saying that we are spending some of our (limited) income on imports. Income that won't be used to buy domestic goods. The result of that income leaving the U.S. economy is less future income for the U.S. economy.

I can choose to buy some gadget, direct from China (just to eliminate other variables), which increases China's income, or I can choose to buy some American good, which increases U.S. income. I can't do both.

 

[Kushinator]

No, I'm saying that we are spending some of our (limited) income on imports. Income that won't be used to buy domestic goods. The result of that income leaving the U.S. economy is less future income for the U.S. economy.

That's not what the NIPA identities tell us. They tell us that we didn't produce enough to satisfy consumption preferences, and therefore we are consuming beyond domestic production.

I can choose to buy some gadget, direct from China (just to eliminate other variables), which increases China's income, or I can choose to buy some American good, which increases U.S. income. I can't do both.

You're operating from a zero-sum parameter. You can't make the case, given the variables present, that imports reduce domestic production. To do so would require an entirely different analysis.

Here is an article from FRED:

The typical textbook treatment of GDP is the expenditure approach, where spending is categorized into the following buckets: personal consumption expenditures (C); gross private investment (I); government purchases (G); and net exports (X – M), composed of exports (X) and imports (M). Textbooks often capture this in one relatively simple equation:

GDP = C + I + G + (X – M).

Notice that, here, imports (M) are subtracted. On the surface, this implies that an extra dollar of spending on imports (M) will decrease GDP by one dollar. For example, let’s assume you spend $30,000 on an imported car; because imports are subtracted (e.g., “– M”), the equation seems to imply that $30,000 should be subtracted from GDP. However, this cannot be correct because GDP measures domestic production, so imports (foreign production) should have no impact on GDP.

When the Bureau of Economic Analysis (BEA; see its primer on this topic) measures economic output, it categorizes spending with the National Income and Product Accounts (NIPA). Some of this spending (which is counted as C, I, and G) is spent on imported goods. As such, the value of imports must be subtracted to ensure that only spending on domestic goods is measured in GDP. For example, $30,000 spent on an imported car is counted as a personal consumption expenditure (C), but then the $30,000 is subtracted as an import (M) to ensure that only the value of domestic production is counted. As such, the imports variable (M) functions as an accounting variable rather than an expenditure variable. To be clear, the purchase of domestic goods and services increases GDP because it increases domestic production, but the purchase of imported goods and services has no direct impact on GDP.

The misconception that imports reduce GDP also seems to be implied when the GDP components are stacked using the FRED release view. Notice that the green “net exports” area is negative. This occurs because the dollar value of imported goods and services exceeds the value of exported goods and services. While this aspect of net exports (X – M) is useful for evaluating how international trade affects economic activity, it can be misleading. Like the misleading aspects of the expenditure equation, it suggests (visually) that imports reduce overall GDP. While the graph is not incorrect, it is important to keep in mind that, when calculating GDP, the value of imports is actually subtracted from the other components of GDP (personal consumption expenditures, gross private domestic investment, government consumption expenditures, and gross investment), not exports. Again, it’s important to emphasize that the imports variable (M) is an accounting variable rather than an expenditure variable.

 

[JohnfrmClevelan]

That's not what the NIPA identities tell us. They tell us that we didn't produce enough to satisfy consumption preferences, and therefore we are consuming beyond domestic production.

...and domestic production = income. We are consuming with what we earned in the past. It's the future income that I'm concerned with.

We can consume beyond domestic production only because of increased credit and/or deficit spending. Eliminate those, and we can only spend what we earn. Minus what we choose to save.

You're operating from a zero-sum parameter. You can't make the case, given the variables present, that imports reduce domestic production. To do so would require an entirely different analysis.

Well, in the moment, it is a zero-sum parameter. I have a limited income, and I can only spend it once. If our combined income is $15 trillion in 2018, that is limited (absent credit). And if we don't consume $15 trillion of domestic production in 2019, then production will fall to meet whatever we do spend.

Here is an article from FRED:

Yes, GDP is properly measured at the time. I have no problem with that. Consumption is consumption, no matter what you buy. But those variables change year-over-year, and the flow of dollars, as well as the creation of new dollars, makes a difference to those variables.

 

[Kushinator]

...and domestic production = income. We are consuming with what we earned in the past. It's the future income that I'm concerned with.

We can consume beyond domestic production only because of increased credit and/or deficit spending. Eliminate those, and we can only spend what we earn. Minus what we choose to save.

This is not true either. These are accounting identities, not expenditures as the FRED article notes. Furthermore, there is a stock of savings that can (and is) drawn upon to make purchases. Economic growth is more than deficit spending, which is what you're trying to make the case for throughout these exchanges... i.e. that the Treasury should forego issuing bonds and just print their expenditures on demand. I for one oppose this type of system, because it incorrectly assumes that government is the driver of innovation and growth.

Well, in the moment, it is a zero-sum parameter. I have a limited income, and I can only spend it once. If our combined income is $15 trillion in 2018, that is limited (absent credit). And if we don't consume $15 trillion of domestic production in 2019, then production will fall to meet whatever we do spend.

Again, you're improperly understanding what the NIPA identities are telling you. Output is consumed on the basis of production, not income. People can go into debt, pull from savings, substitute, etc... in order to meet their consumption and investment goals in the absence of the necessary income. Same applies with government.

Yes, GDP is properly measured at the time. I have no problem with that. Consumption is consumption, no matter what you buy. But those variables change year-over-year, and the flow of dollars, as well as the creation of new dollars, makes a difference to those variables.

No it does not! I cannot understand why you're refusing to acknowledge this simple point: imports do not reduce GDP.

Repeat after me... imports do not reduce GDP.