So I've noticed we have a few members who like talking about this and are interested in it.
So lets talk, today I'll be looking at a post on a hetrodox blog and pointing out the issues with it.
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While true to some extent, this is wrong empirically.
So, what's the issue with the argument here? I mean banks do create credit, right? If interest rates rise due to increased demand, the demand should result in more loans being made out, increasing the supply of money to offset this problem. The logic stands, but why doesn't it work?
Banks however, do have a theoretical cap on how much they can lend out. They need to hold fractional reserves and mixed in with that, there's also a level of required reserves by the central bank. So imagine a bank, the bank has 100 units in cash, the bank is required to hold 20% in reserves and the bank also holds an extra 5% based on habit as well, so this means 25% of the cash in the bank has to be covered by actual liquid assets. The central bank then gives the bank an extra 100 units, so it keeps 25% which is 25 and lends out 75 units. As this process repeats itself, we can calculate the total in the long run as . That being an approximation due to the fact taking the summation to infinity would require infinite time. To calculate however much reserves the banks would have kept over that period, we can in turn do . So the ratio between the two will be the following equation , in this case which is . So in this case 400 units will flow into the economy in the long run and 133 units will remain in various banks, which is the same as the original variables in the equation, overall the supply of loanable funds is going up and the bank is capped by this. M being the amount of money, RR being the reserve requirements and ER being excess reserves.
So why do we have a demand for loanable funds? Well it follows on that if there's a lot of demand and the bank in question hits the point where it's reserves are RR + ER or even near, it will start increasing it's interest rates in response to that, which is basic supply/demand microeconomics for a product, the product in questionbeing loanable funds. If taken on a much larger scale, it means that intrest rates will rise if there's large amount of excess demand in the market for loanable funds, like the original model itself suggests.
But...
The line of reasoning that the blog posts is ALSO true, increasing demand for money tends to result in the banks giving out credit, increase the supply of loanable funds and you counteract the increased demand. So to combine these two theories, we must assume that the PED for loanable funds is inelastic for a decent part of the way and then suddenly becomes very elastic once you start hitting the point in which I've highlighted,. This will be even more so seeing the economy will likely be running on steroids at this point, assuming that it's been boasted lots by gov spending. So the supply curve in the LF model is flatish, until it reaches a point and then it shoots up exponentially.
What does it mean for policy? Well it means that the "crowding out" effect is much lesser then what we imagined it was, meaning the option for fiscal stimulus should be on the table a lot more then it already is. BUT to go the way of the PKs here and think there's NO limit to this? That is mistaken, unless you remove reserve requirements entirely, which comes with other massive problems.
What.
I mean if it's arguing that we don't go into every little detail, well duh or we'd be here for ever. Interest rates typically flow together anyway, so seems a little nitpicky to go after that part. If we're saying that mainstream economics doesn't use empirical data, then that strikes me as being flat out false. The Austrians on the other hand...
and also
Hence
So y = 0.
Now that law has long been debunked, as the demand for money is also a thing that effects both supply and demand, meaning Walras and Say's Law fall apart once this aspect is included. The mainstream consensus doesn't believe in Say's Law nor do the PKs, the only people I think believe in it are the Austrians, but I'm unsure, so don't cite me here. Though the law doesn't matter as it doesn't really have anything to do with the quote here or what the central bank is doing, it just seems to be added on to make the writer seem "smart".
As for Endogenous Vs Exogenous money, they're basically both true, the Central Bank has control of the money supply via the tools available for it and can influence the economy by messing with the money multiplier, but it's also true that banks create money effectively when they hand out loans. What we're looking at is a composite function of both.
Not sure what the Taylor rule being unpopular these days really when modern Central Banks often do use expectations for their own advantage, one type of policy going out of use doesn't mean that economists have changed their views on Monetary Policy and don't now not see stable policy and modifying expectations as a good thing.
...the IS-LM model in undergraduate economics textbooks, which uses the loanable funds in the same textbook, literally stands for Investment/Saving - Liquidity/Money Supply
...
So what we have here, is a guy that's found flaws in mainstream economics, COMPLETELY thrown out the insights in modern economics, even though the logic still works and is true and then gone back to older theory and used that, pretending the newer advances don't exist. The reverse is true with mainstream economics, ie ignore older stuff for new. It seems to me that he's seen part of the truth, but not the whole truth and that's a thing, as he does bring up some decent points.
You've got two sides, one is saying we should stick with Friedman's opinion that it doesn't matter if the model has issues, but if it's backed by stats it's true and the other side is putting forward alternative models with also work, but not giving decent stats. Both have issues and I think the profession needs to do what I've done and worked out how they BOTH work.
...
So yeh guys. Post away!
So lets talk, today I'll be looking at a post on a hetrodox blog and pointing out the issues with it.
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The loanable funds hoax
from Lars Syll The loanable funds theory is in many regards nothing but an approach where the ruling rate of interest in society is — pure and simple — conceived as nothing else than the price of l…
rwer.wordpress.com
The loanable funds theory is in many regards nothing but an approach where the ruling rate of interest in society is — pure and simple — conceived as nothing else than the price of loans or credits set by banks and determined by supply and demand — as Bertil Ohlin put it — "in the same way as the price of eggs and strawberries on a village market."
It's a beautiful fairy tale, but the problem is that banks are not barter institutions that transfer pre-existing loanable funds from depositors to borrowers. Why? Because, in the real world, there simply are no pre-existing loanable funds. Banks create new funds — credit — only if someone has previously got into debt! Banks are monetary institutions, not barter vehicles.
While true to some extent, this is wrong empirically.
So, what's the issue with the argument here? I mean banks do create credit, right? If interest rates rise due to increased demand, the demand should result in more loans being made out, increasing the supply of money to offset this problem. The logic stands, but why doesn't it work?
Banks however, do have a theoretical cap on how much they can lend out. They need to hold fractional reserves and mixed in with that, there's also a level of required reserves by the central bank. So imagine a bank, the bank has 100 units in cash, the bank is required to hold 20% in reserves and the bank also holds an extra 5% based on habit as well, so this means 25% of the cash in the bank has to be covered by actual liquid assets. The central bank then gives the bank an extra 100 units, so it keeps 25% which is 25 and lends out 75 units. As this process repeats itself, we can calculate the total in the long run as . That being an approximation due to the fact taking the summation to infinity would require infinite time. To calculate however much reserves the banks would have kept over that period, we can in turn do . So the ratio between the two will be the following equation , in this case which is . So in this case 400 units will flow into the economy in the long run and 133 units will remain in various banks, which is the same as the original variables in the equation, overall the supply of loanable funds is going up and the bank is capped by this. M being the amount of money, RR being the reserve requirements and ER being excess reserves.
So why do we have a demand for loanable funds? Well it follows on that if there's a lot of demand and the bank in question hits the point where it's reserves are RR + ER or even near, it will start increasing it's interest rates in response to that, which is basic supply/demand microeconomics for a product, the product in questionbeing loanable funds. If taken on a much larger scale, it means that intrest rates will rise if there's large amount of excess demand in the market for loanable funds, like the original model itself suggests.
But...
The line of reasoning that the blog posts is ALSO true, increasing demand for money tends to result in the banks giving out credit, increase the supply of loanable funds and you counteract the increased demand. So to combine these two theories, we must assume that the PED for loanable funds is inelastic for a decent part of the way and then suddenly becomes very elastic once you start hitting the point in which I've highlighted,. This will be even more so seeing the economy will likely be running on steroids at this point, assuming that it's been boasted lots by gov spending. So the supply curve in the LF model is flatish, until it reaches a point and then it shoots up exponentially.
What does it mean for policy? Well it means that the "crowding out" effect is much lesser then what we imagined it was, meaning the option for fiscal stimulus should be on the table a lot more then it already is. BUT to go the way of the PKs here and think there's NO limit to this? That is mistaken, unless you remove reserve requirements entirely, which comes with other massive problems.
Well yes, other factors do effect investment, but so does the cost of borrowing. If it didn't, then Volcker hiking interest rates should've had little to no effect on investment. Wouldn't mind seeing the empirical research here, as I just went and looked and there are papers showing otherwise.As already noticed by James Meade decades ago, the causal story told to explicate the accounting identities used gives the picture of "a dog called saving wagged its tail labelled investment." In Keynes's view — and later over and over again confirmed by empirical research — it's not so much the interest rate at which firms can borrow that causally determines the amount of investment undertaken, but rather their internal funds, profit expectations and capacity utilization.
As is typical of most mainstream macroeconomic formalizations and models, there is pretty little mention of real world phenomena, like e. g. real money, credit rationing and the existence of multiple interest rates,
What.
I mean if it's arguing that we don't go into every little detail, well duh or we'd be here for ever. Interest rates typically flow together anyway, so seems a little nitpicky to go after that part. If we're saying that mainstream economics doesn't use empirical data, then that strikes me as being flat out false. The Austrians on the other hand...
Ok, Walras' law in the original approach was a way of assuming that if we have a system of partial equilibriums, like , with the 0 implying that there's no excess demand in the function and assuming that supply = demand, due to the fact that people creating a supply of something are creating a demand in the product, then it follows that changing the function to must mean y is 0, due to the following:The loanable funds theory in the 'New Keynesian' approach means that the interest rate is endogenized by assuming that Central Banks can (try to) adjust it in response to an eventual output gap. This, of course, is essentially nothing but an assumption of Walras' law being valid and applicable, and that a fortiori the attainment of equilibrium is secured by the Central Banks' interest rate adjustments. From a realist Keynes-Minsky point of view this can't be considered anything else than a belief resting on nothing but sheer hope. [Not to mention that more and more Central Banks actually choose not to follow Taylor-like policy rules.] The age-old belief that Central Banks control the money supply has more an more come to be questioned and replaced by an 'endogenous' money view, and I think the same will happen to the view that Central Banks determine "the" rate of interest.
and also
Hence
So y = 0.
Now that law has long been debunked, as the demand for money is also a thing that effects both supply and demand, meaning Walras and Say's Law fall apart once this aspect is included. The mainstream consensus doesn't believe in Say's Law nor do the PKs, the only people I think believe in it are the Austrians, but I'm unsure, so don't cite me here. Though the law doesn't matter as it doesn't really have anything to do with the quote here or what the central bank is doing, it just seems to be added on to make the writer seem "smart".
As for Endogenous Vs Exogenous money, they're basically both true, the Central Bank has control of the money supply via the tools available for it and can influence the economy by messing with the money multiplier, but it's also true that banks create money effectively when they hand out loans. What we're looking at is a composite function of both.
Not sure what the Taylor rule being unpopular these days really when modern Central Banks often do use expectations for their own advantage, one type of policy going out of use doesn't mean that economists have changed their views on Monetary Policy and don't now not see stable policy and modifying expectations as a good thing.
A further problem in the traditional loanable funds theory is that it assumes that saving and investment can be treated as independent entities.
...the IS-LM model in undergraduate economics textbooks, which uses the loanable funds in the same textbook, literally stands for Investment/Saving - Liquidity/Money Supply
That I can agree with, finance is an important aspect of an economy. I suppose that line of reasoning though can be applied to ALL models, don't use them in isolation and watch out for feedback loops. It doesn't "debunk" it, as the article tries to put forward, as much as the fact money supply effects prices doesn't mean we should chuck out supply-demand.Contrary to the loanable funds theory, finance in the world of Keynes and Minsky precedes investment and saving. Highlighting the loanable funds fallacy, Keynes wrote in "The Process of Capital Formation" (1939):
...
So what we have here, is a guy that's found flaws in mainstream economics, COMPLETELY thrown out the insights in modern economics, even though the logic still works and is true and then gone back to older theory and used that, pretending the newer advances don't exist. The reverse is true with mainstream economics, ie ignore older stuff for new. It seems to me that he's seen part of the truth, but not the whole truth and that's a thing, as he does bring up some decent points.
You've got two sides, one is saying we should stick with Friedman's opinion that it doesn't matter if the model has issues, but if it's backed by stats it's true and the other side is putting forward alternative models with also work, but not giving decent stats. Both have issues and I think the profession needs to do what I've done and worked out how they BOTH work.
...
So yeh guys. Post away!