Foreign Capital Budget Deficit Exports PrM H/B Consumption TRSY FxMCrM THE COMPLETE “MONEY” MODEL The FED Cash Change of Money Demand Rest of the World.

Foreign Capital

Budget Deficit

Exports

PrM

H/B

Consumption

TRSYFxM CrM

THE COMPLETE “MONEY” MODEL

The FEDCash

Change of Money Demand

Rest of the World

Banks & Credit

Fiscal Policy

Money

The Inner Loop

Investment GovernmentPurchases

Imports Saving(net) Taxes

Income

Spending

LaM

wagesProfit,

interest, rent

Change of Money Supply

ABBREVIATIONS

E I

PrM

H/B

X

C

Y

TRSY

T

G

FxM CrM

F S

K BB/Def

The FEDCash

ΔMDΔMS

We will often omit the Labor Market

THE COMPLETE CIRCULAR FLOW

The BASIC MODELY = IncomeCd = Domestic ConsumptionS = SavingI = InvestmentX = Spending

The TREASURYG = Gov’t PurchasesT = Net TaxesBB = the budget balance = T – GDef = the Deficit = G – TTP = Transfer Payments

The FOREIGN SECTORF = ImportsE = ExportsK = Foreign Capital Flows

MONEYΔMD = changes of Money Demand

to/from CASHΔMS = changes of Money Supply

to/from the FED

Y = Cd + F + S + TX = Cd + E + I + GS + K + ΔMS = I + Def + ΔMDT + Def = G (T = Tgross – TP)F = E + K

The “PLACES”H/B = Households and BusinessesPrM = The Product MarketLaM = the Labor MarketCrM = the Credit MarketFxM = the Foreign Exchange MarketTRSY = the government TreasuryCASH = the public demand for moneyFED = the Federal Reserve

E I

PrM

H/B

X

C

Y

TRSY

T

G

FxM CrM

F S

THE CLOSED MODEL ignores the money variables

K BB/Def

Sometimes we will

ignore ΔMD and/or ΔMS

I

PrM

H/B

X

C

Y

TRSY

T

G

CrM

S

THE TREASURY MODEL

BB/Def

Often we will ignore the rest of the world

The FED

ΔMS

Cash

ΔMD

E I

PrM

H/B

X

C

Y

FxM CrM

F S

THE FOREIGN MODEL

K

Sometimes we will ignore

Fiscal Policy to concentrate on foreign trade

The FED

ΔMS

Cash

ΔMD

I

PrM

H/B

X

C

Y

CrM

S

THE BASIC MODEL

No Treasury or Foreign Sector

The FED

ΔMS

Cash

ΔMD

THE CLOSED MODEL – an important conclusion, Part I

E IPrM

H/B

X

C

Y

TRSY

T

G

FxM CrM

F S

K BB/Def

If we start with a given amount of income (Y), we can picture that money flowing through the economy to where it ends up as spending (X).

The rule for this model is: “All the money going into any box will equal the money going out of that box.”

Question: “Is it possible that X is ever different from Y?”

Answer: “X must always be the same as Y in the CLOSED MODEL”

This should sound curious. We have a model that says that total spending (that is, GDP) never changes, when it obviously does in fact change. The model is, nevertheless surprisingly useful particularly as the LONG RUN MODEL.

THE CLOSED MODEL – an important conclusion, Part I

E IPrM

H/B

X

C

Y

TRSY

T

G

FxM CrM

F S

K BB/Def

“X must always be the same as Y in the CLOSED MODEL”

This is so because the money that leaves Households and Businesses as Income must all go “somewhere.” That money must eventually wind up being spent, since there is nowhere else for it to go.

THE CLOSED MODEL – an important conclusion, Part II

E IPrM

H/B

X

C

Y

TRSY

T

G

FxM CrM

F S

K BB/Def

When we add either of two items to the diagram we get a new conclusion.

FED

ΔMS

Cash

ΔMD With either ΔMD or ΔMS in the model it is now possible for X and Y to be different

BIG CONCLUSION: In order for GDP (spending) to rise or fall there must be a change in either the money supply or money demand.

This is because money going to and from Cash or the Fed is going and coming from “nowhere.” The money more or less appears and disappears from the economy.

PrM

H/B

X

Cd

Y

The OPEN Model – the Short Run picture

Once we see that X and Y can be different we can build a simpler model. This is particularly useful for the Keynesian, short-run view of the economy. We will divide the economic flows into three parts.

1. Domestic Consumption: this is the part of income that immediately becomes spending.

2. Leakages: these are the parts of income that are not immediately returned to the product market as spending.

Leakages = Imports, Saving and Taxes

3. Injections: these are the parts of total spending other than domestic consumption: the parts of spending that do not immediately arise out of current income.

Injections = Exports, Investment and Government Purchases

The OPEN Model – the Short Run picture

In the Open Model the Leakages seem to go “nowhere.”The Injections seem to come from “nowhere.”

It can be useful to think of it that way. It is also good to remember that the complete model does contain two “nowheres.” They are …

1. Cash – changes of money demand and2. the Fed – changes of the money supply

The Three Models

PrM

H/B

X

Cd

Y

The OPEN Model the Short Run

The MONEY Modelthe versatile one. This one can do what either of the others can

E I

PrM

H/B

X

C

Y

TRSY

T

G

FxM CrM

F S

K BB

FED

ΔMS

Cash

ΔMD

E IPrM

H/B

X

C

Y

TRSY

T

G

FxM CrM

F S

K BB

The CLOSED Modelthe Long Run

Injections = E + I + G

Leakages = F + S + T