Tuesday, March 5, 2013

The Basic Identify of Macroeconomics

The Basic Identify of Macroeconomics is that income equals output.

While many consider identities empty, I think they are useful, especially in avoiding error and confusion.   In particular, the notion that it there can be a general glut of goods because people cannot afford to buy all that is being produced is inconsistent with this particular identity.  Now, that isn't an argument one hears much outside of vulgar Marxist circles, but I believe it is closely related to the popularity of the notion of a "balance sheet recession."

Failure to grasp the Basic Identity of Macroeconomics can lead to a notion that people need to borrow and go into debt to be able to afford to buy all that can be produced.     Once debt rises to a level that is "too high," then it is no longer possible to go further into debt, and so that part of output financed by debt cannot be sold and so will not be produced.   Worse, as all of the debt is repaid, then spending on output must necessary fall even more, because part of income that could have been used to afford output is instead being used to pay down debt. 

The reality is that there is always enough income to afford everything that is produced and credit involves some spending more is the earned while others are spending less than is earned.  A modest flow of borrowing and lending can result in a large build up in the stock of debt relative to the flow of income.    If debt gets "too high," then those who were lending can instead use their flow of receipts to directly fund spending.  If debts are paid down, then those receiving the debt repayments have an additional source of funds to purchase output.

Of course, it is always possible that firms and households may not want to purchase everything that can be produced, but there is always sufficient funds to pay for it if they want.

Let's explore the Basic Identity of Macroeconomics in the context of growing expenditures on output and growing nominal incomes.   Consider a monetary regime that targets a growth path for nominal GDP.   Further suppose that nominal GDP is growing 5%, and the trend growth rate for the productive capacity of the economy is 3%.   The trend inflation rate would be 2%.

How is it that people can afford to spend 5%  more next year than they earned this year?  Doesn't growing nominal income require that people borrow more  to keep on spending more each year than they spent the year before?  

The answer is that they will be able to spend 5% more next year out of the 5% extra that they will earn next year. 

Admittedly, I aways first earn income and then spend it.    However, my spending this year is not what I earned last year.   On the contrary, nearly everything I will spend this year is income I earn this year.  And next year, it will be the same.   Nearly everything I spend next year will be income that I earn next year.

But suppose the period is shortened.   Rather than "next year," focus on the next half month.  Most of my spending during the second half of March will be based upon what I earned in the first part of March.   If I lived paycheck to paycheck, then the only way I could spend more in the second half of March than I earned in the first half of March would be to borrow.   I could use my credit card to increase expenditures.

My expenditures do not directly rebound to an increase in my income to say the least.   I suppose that added earnings by the local grocery store might motivate someone to take classes at The Citadel, and then The Citadel might decide that the bonanza of tuition earnings should be used to fund a pay raise for the Faculty.    Not very likely.  

However, my added expenditures do increase the income of someone else.

Yet doesn't someone have to spend more than they earn to get spending higher in the second half of the month?  

But suppose that rather than pay me two times a month, The Citadel would to set up a program where funds continuously are shifted from its checking account to mine.   Further, suppose that instead of giving raises at the first of the year (if such materialize,) pay is increased continuously.  Is the intuition that money must first be earned and then spent nothing more than an artifact of the custom of paying income periodically and changing pay from time to time?

Perhaps more importantly, not everyone lives pay check to pay check.   While I would be hard pressed to substantially increase my expenditures a large amount all at once, I could easily manage a small increase over a short period of time.    For example, spending equal to 100% of my annual income payable right now would be difficult.   Spending 5% more in the first half of March than I was paid on March 1 would hardly be noticeable.  

Obviously, those who have substantially more liquid assets than I do could maintain a higher level of spending relative to income for longer than I can.   And there are others who come closer to living pay check to pay check who could never spend much more than they earn without  going into debt.

How is it possible for nominal GDP to rise without there being an increase in the quantity of money?  

The answer is simple.  The quantity of money is much larger than the amount of expenditures that are made in any particular second, any week, month or quarter.  .  There is surely an upper limit to the nominal flow of income and expenditure possible with a given nominal quantity of money, but this is far beyond a 5% increase in nominal income for economies not currently suffering hyperinflation.

The key determinant of next year's spending is expectations regarding next year's spending.   This determines how much firms are willing to pay their employees and how much interest they are willing to pay.  The incomes that people earn and expect to earn determine what they will spend.   

In the situation where people expect spending on output to rise 5%, and the productive capacity of the economy rises 3%, then the expectation that 3% more can be produced and sold, provides reason for firms to expect to earn at least 3% more and so be willing to pay 3% more to those supplying productive resources.  

Of course, they would like to pay less, but given their experience of modestly competitive labor and capital markets, they will know that they will have to pay more.    And it is that extra amount that everyone else going to be paying that will provide the means for their customers to purchase their product.

But in the assumed scenario, nominal expenditure is expected to grow more quickly than productive capacity.   There is inflation--trending at 2%.   However, the Basic Identity of Macroeconomics is true in both nominal and real terms.   Given the higher price level, those selling output with a higher nominal value will be generating higher nominal incomes for those supplying the resources to produce that output.  

Each firm will perceive a need to charge higher prices to keep up with rising costs.   And each firm will perceive a need to pay more for resources because competitors receiving those higher prices for their products will be willing to pay more.    And those receiving the higher incomes from those resources will be able to afford the higher prices.

But what about the quantity of money?   Isn't inflation caused by an excessive growth in the quantity of money?  

Yes, of course.

If it is true that expectations of higher spending on output can generate higher incomes which make it possible to purchase all of that output, then a fixed quantity of money implies higher velocity (nominal GDP divided by the quantity of money.)  Again, outside of the final stages of a hyperinflation, where every effort to economize on money balances has already been attempted, an increase in velocity is easily possible.  

However, that doesn't mean that money cannot anchor nominal GDP.   It isn't that higher nominal income requires a higher quantity of money in some physical sense, it is rather than when nominal income rises, the typical person prefers to hold more money.   If the quantity of money fails to rise with this increased demand, then each individual can correct the deficiency by spending less than they earn.   And this will cause nominal GDP to grow less.   The failure of the quantity of money to keep up with nominal GDP will interfere with the expected growth in nominal GDP.   

Now, breaking these expectations may be difficult.   A short disruption in spending that is expected to be reversed can and is likely to result in a modest temporary change in the demand for money.    Those left short on money will simply hold less, because that is why they hold money--to smooth temporary shortfalls in receipts relative to expenditures.   The demand for money will grow less than usual, which is simply the other side of the coin of velocity rising enough to accommodate the expected growth in nominal GDP.  

But if the monetary regime is inconsistent with creating sufficient money to meet the demand generated by the expected trend in nominal GDP, those temporary deviations will generate new expectations--a new expected path of nominal GDP, with spending on output falling with these new expectations.

The opposite problem is not much different.   If the quantity of money rises above the amount demanded, each individual can correct the problem by spending more.   This will tend to raise spending beyond the expected path.   As long as this is expected to be temporary, then any such deviation will be small, largely to a temporary increase in the demand for money.   However, if the monetary regime no longer generates a quantity of money consistent with the expected path of nominal expenditures, then these small temporary deviations will grow and a new expected path of both spending on output and nominal incomes will develop.

It is a mistake to assume that someone must receive additional new money either as a gift or as a loan in order to provide funding to push spending on output and nominal incomes above the current level.   What is needed is a monetary regime that is expected to create a sufficient quantity of money to meet the future demand to hold money.   If that condition is met, then the increased expenditures can be funded from the increased incomes generated by the increased expenditures.

If we start with the assumption of constant nominal expenditure and income, and suppose that expectations of spending, output, and pricing are all consistent with that nominal anchor, then shifting to growing nominal expenditures and income would almost certainly require some impetus.   While it is possible that an announcement of the new regime could cause the shift, such a strong version of rational expectations is implausible.  But that doesn't mean that people will never learn, and that today's new level of nominal GDP is expected to persist forever.

Consider an economy that when through a Great Inflation, and then with a good bit of pain and suffering, a disinflationary policy has lead to more modest growth in spending on output and nominal incomes.    Is it really reasonable to assume that such an economy requires a continued push to force expenditures and nominal incomes higher because everyone expects that nominal income will remain fixed?  

So what about credit?   The "problem" with credit has nothing to do with what people can afford to spend but rather with what they want to spend.   As explained above, credit involves some people spending less than earned and others spending more than earned.    If those wanting to spend less than they earn right now create a greater credit supply than the demand for credit by those who want to spend more than they earn, then this amounts to a desire to spend less than earned in aggregate.   These suppliers of credit can afford to spend more, but they would rather not.   

Now, it is possible that a surplus of credit would result in the frustrated suppliers of credit (savers) being compelled to spend more out of their income.   They have no other choice because they can find no borrowers.   However, in a monetary economy there is always the alternative of simply holding money.   This is an increase in the demand for money, and there is no doubt that a monetary regime unable to supply the quantity of money demanded, especially one that is expected to be unable to do so, will push spending below what were the anticipated levels and generate reduced expectations of expenditures.

To say that growing spending on output and growing nominal incomes requires that borrowers choose to borrow more takes the desires of those supplying credit as some kind of unalterable reality.    But it is a choice they make.   Lend, hold money, or spend.  (In my view, the best framing of the current monetary regime is that the choice is to lend by purchasing debt instruments, lend by holding money, or spend.)    If those supply credit were to instead spend what they earn, then aggregate spending could grow without there being any increase in borrowing.

Of course, in an economy with rising real incomes and rising prices, it is likely that the nominal amount that people would like to borrow will be growing along with the nominal amount that lenders would like to lend.     It would be quite remarkable if nominal incomes increased with there being no increase in nominal borrowing, lending and debt.    With rising real incomes, the most likely scenario is going to be increases in real borrowing, lending, and debt as well.  

But no increase in nominal or real borrowing is needed to fund growing nominal expenditures.   The Basic Identity of Macroeconomics implies that it is always possible to fund growing nominal expenditures out of the growing nominal incomes that are generated by those growing nominal expenditures.

P.S.  I favor a nominal GDP level target with a 3 percent growth rate.   I favor a trend growth rate of nominal GDP equal to the trend growth rate of potential output.   I favor a trend inflation rate of zero.

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