The Equilibrium of the Goods Market in the Four-Sector Model

The equilibrium condition in the goods market of the four-sector model is: Y=C(Y^DI) +I(i)+X – IM, i.e. national income is spent on household consumption (dependent on national income), desired investment (dependent on the interest rate), government expenditure (considered autonomous) and net exports, which is the difference of export and import (both of them autonomous). As was explained earlier, household consumption (and saving) depends on national income Y, so the question arises: what level of national income Y will provide the equilibrium of aggregate demand and supply at a given interest rate i defined by the market of loanable funds.

Any level of national income will determine the value of disposable income, and consumption, as a result. The part of national income left after consumption spending will have to finance government expenditure, and net export, and deducting these items, the remainder will have to cover the spending on planned investment: I=Y–C(Y^DI) – G – X + IM.

The goods market in the economy is in equilibrium, if the value of investment demand I(i) determined by the interest rate (and expectations on profitability) is equal to this value. With rising interest rates the level of planned investment decreases, therefore aggregate demand falls, implying lower national income in equilibrium. In the opposite case – i.e. with decreasing interest rates – the increased level of planned investment raises aggregate demand, and increased national income at equilibrium.

The relationship between the interest rates defined by the market of loanable funds and the associated incomes that maintain the equlibrium in the goods market is defined by the IS curve, that prescribes the condition of equality between investments (I), and savings (S) – that is, the part of income left after consumption (Hall-Taylor, 1997.) This relationship is illustrated in Figure 9.4.

An increase in autonomous factors – i.e. government expenditure and net export, as well as autonomous consumption and autonomous investment demand – will increase the equilibrium income at any constant interest rate, shifting the IS curve upward, while a decrease in these autonomous factors will shift it downward. The same downward shift will be the result of increasing autonomous taxes or tax rates, while the impact of increasing transfers is just the opposite.

The IS curve presented in Figure 9.4 defines the interest rates and the associated equilibrium incomes. When at the actual national income the prevailing interest rate is too high for equilibrium – the (Y,i) pairs lying above the IS curve represent such situations, – then the investment demand is too low for the actual income level, and the aggregate demand falls below aggregate supply, so producers find unsold finished goods accumulated in inventories. As a response, firms cut back production, and the value of aggregate supply (Y) starts to fall. Thus the decreasing income deccreases the levels of consumption and saving, and this process of adjustment goes on until savings fall back to the low level of planned investments. This automatic adjustment process eventually establishes the equilbrium of aggregate supply and aggregate demand. The opposite occurs when the actual national income

and interest rate represent a point below the IS curve. Then the interest is too low for the equilibrium income, the investment demand is too high, and aggregate demand is higher than aggregate supply. This encourages the firms to increase production, which leads to higher outputs, and higher incomes. The increase in income will increase consumption as well as savings, and the higher level of savings will finance the high investment demand.

Figure 9.4: Balance in the Goods Market, Deriving the IS Curve

Source: Author’s own construction

The position of IS is determined by C, I, G, X and IM, a change in any of them will change the IS itself. For example, if government expenditures increase, then the resulting increase in aggregate demand requires higher level of national income to maintain the equality of savings and planned investments at any constant interest rate, therefore the IS curve shifts upward. The impact of an increase in net export, marginal propensity to consume, or transfers will be similar.

9.3. Functions of Money, Commodity Money, Fiat Money

Money in the economy is often used as a medium of exchange of goods, with flows of money and goods going parallel to each other, but in the opposite directions. However, many economic activities occur, in which flows goods and flows of money are separated from each other, taking place at different moments of time. Examples of such situations are the paying of taxes for which individuals are provided with public services, or the purchase of goods on credit, or purchase of a service with pre-payment. Money flows in these examples seem to occur on their own, seemingly unrelated to flows of goods or services, and being controlled by their own rules, though with a strong feedback on the production processes. This explains why it is necessary to analyse monetary processes separately from production processes.

To do that, first we have to define the essential attributes of money. Any instrument may operate as ’money’ in the economy, if it is able to perform the functions required of money. The functions of money are (Farkasné Fekete- Molnár, 2007):

 A unit of account (a means of evaluation): Money allows the value of goods and services, or assets to be compared to each other (or to its own value, when the money is a valuable commodity in itself). It helps the consumer to compare the value of a kg of bread or a litre of fuel to his/her daily income, or helps the producer to compare the value of his/her product to the values of the productive resources used. Money can fulfill this function without being physically present, it is enough to understand the notion of value that it represents.

 Medium of exchange: in this function money is acceptable in exchange of goods or services, thus it is an intermediary in the exchange. An important condition for this function is the universal acceptance of money in exchange of goods, and people do that because they know that accepting money, later they can also use it to pay with for valuable goods.

 A standard of deferred payments (a means of establishing future claims and payments): In this function money is paid or accepted without any exchange of goods or services, that is, the transfer of money is separated from the transfer of goods. This happens when some goods are bought on credit, with payment occurring later in time, or when the consumer makes an advance payment well before the actual goods or services are delivered. The money transfers completely independent of transfers of goods also fall into this category (e.g. paying taxes, receiving grants, subsidies).

 Store of wealth (accumulating ‘treasures’): besides being a medium of exchange and a unit of account, money can be used to keep savings, and accumulate wealth.

Of all the forms of keeping wealth, money is the most liquid form²⁹, because the wealth kept in money can any time be easily spent on goods or properties, that is, used for exchange. Besides liquidity money must be able to hold its value for a long time, which, opposite to forms of money earlier in history (e.g. gold coins), is not obvious for our money of banknotes and metal coins, which loses its value during the times of inflation. Therefore to keep its value, the wealth stored in money form is usually deposited in banks, where the deposit interest protects the deposited value against inflation.

 World money (international currency): In this function money provides all the former four functions not only in national, but in international transactions and contexts. Not all national currencies satisfy the conditions for international money, but the currencies regularly used for international transactions - e.g. the USD, or EUR – do, of course.

The purchasing power of money depends on the actual price level. When the price level rises, the same amount of goods require higher amounts of money to pay for. Therefore economic agents need more money just to make the same purchases as before. When estimating how much money the economic agents need, the purchasing power of money will be the key aspect. With rising price levels the economic agents need increasing amounts of nominal money (to maintain the same purchasing power as before). For this reason the following terms will be defined:

• Nominal quantity of money (M, short for money): the amount of money, measured in units of the currency of actual purchasing power (e.g. 150000 HUF).

29 Liquid: it means, in this context, that it can be easily converted to cash, and then exchanged for goods any time, with no significant loss of value. This is usually not true for other forms of storing wealth – e.g. real estate, or other valuable property – because, if real estate is to sell urgently for money, the seller is often forced to accept a price well below its true value.

• Real money balances (L, short for liquidity preference): the purchasing power of the nominal quantity of money (measured in money of constant purchasing power), that is, in terms of quantity of goods and services it can buy. Real money balances are equal to the ratio of the nominal quantity of money to the price level, L=M/P. When price level rises the demand for nominal money increases proportionally, so that the demand for real money balances remains unchanged.

The history of development of modern money may be divided to four periods. In the first period the functions of money were performed by a commodity that also satisfied a consumer demand in itself (e.g. salt, animal skin, spices), so the same commodity was used either as a commodity on its own, or as money, so this money is called commodity money. The second period is the era of gold as money – the functions of money were performed at first by noble metals, as gold, silver and copper. Later the gold gained preference over silver, and became the unique media of exchange satisfying all money functions in itself, therefore this period is called the first stage of the gold standard. The third period is called the second stage of the gold standard, where besides money minted in gold, the representatives of gold - paper money, banknotes – were introduced into circulation to substitute gold in its function of medium of exchange, with the promise of redemption in gold. The fourth period is the stage of fiat money, or deposit money – in which money cannot be redeemed in gold, it has no intrinsic value, its physical form is a checking account in a bank, that is a promise from the bank to make payments for our transactions. This means, that our income arrives at a checking account in a bank, and at our request the bank will pay our debts (invoices, shopping bills, etc.) in the name of us. Besides checking accounts token coins and banknotes are also used as cash, but they are of secondary importance by now, as the non-cash payments have become increasingly general in contemporary economy. The modern deposit money, the fiat money of no intrinsic value is perfectly suitable to perform all the functions required of money, although the function of storing wealth is interpreted in a slightly modified form: fiat money is capable of storing wealth if deposited in a bank, or traded in the market of loanable funds, while cash stored outside the banking system is unable to preserve its value (Farkasné Fekete - Molnár, 2007).

The properties of fiat money are the following: a fiat money has no intrinsic value, its general form is a checking account, and it is created by the process of deposit creation, by way of making loans against deposits. The official currency of a country is the unique medium of exchange by law, and money supply is controlled by the central bank of the country (the National Bank of Hungary, the Federal Reserves of the United States of America, the Bank of England, etc.). The value of fiat money, not backed by a commodity, is determined – compared to the currencies of other countries – by the quantity and quality of output produced by the country, so that people holding the currency of this country can find goods and services that they are willing ande able to exchange for the money. So, in this sense, fiat money is backed somehow by commodities – and it can maintain its purchasing power if the increase in money supply is followed by a similar increase in the total output of the country. However, neither the producers, nor the consumers have any means to check whether the balance between the amount of fiat money supply and the amount of goods and services produced holds, therefore as long as the economic agents trust in money, believing that they are able to buy the valuable goods for their money, they will accept the face value of fiat money. Therefore we may say, that the value of fiat money is guaranteed by the confidence that economic agents feel about it, which fact is well supported by the workings of stock exchanges, where speculative behaviour may significantly devalue a currency.

As a summary we can say, that the purchasing power – or the real value – of fiat money with no intrinsic value will be stable, if the growth of money supply is in balance with

the growth of total output (goods and services). When the total output, and real income of an economy increase, then the real money supply should be increased at the same rate, so that the extra output can be exchanged for money in the market. To achieve this, the supply of nominal money will be increased, resulting in higher real money supply if the price level remains the same.

9.4. Money Supply, Creation of Money in Contemporary Economy After summarising the main properties of money we can describe the quantity of money in circulation by the notion of money supply. Money supply is the quantity of money in circulation in the economy, in the forms of cash (banknotes or coins), and as currency deposited on checking accounts (current accounts) in banks. Money supply is interpreted as a nominal amount of money (M^S) and its real value, that is, purchasing power is determined by the actual price level (P), and is equal to M^S/P. Money supply is determined by the banking system – that is, the central bank, and the commercial banks regulated by the central bank.

The banking system of a central bank and several commercial banks is called two-tier banking system. The role of the central bank is to provide banking services for the government and act as the bank of the state, to provide the money supply, to implement monetary policy by controlling the amount of money in circulation, and to regulate and supervise the operations of commercial banks. The central bank is independent of the government, although some cooperation is necessary about monetary policy. The commercial banks are profit-oriented monetary institutions, they provide banking services for the private sector (households and firms).

A central bank has four instruments to regulate the operations of commercial banks.

The refinancing interest rate (the base rate, or prime loan rate of the central bank) defines the interest rate at which the central bank makes a loan for a commercial bank, when a commercial bank wishes to do transactions (offer loans) above its own financial resources.

The reserve ratio defines the ratio of checking deposits that commercial banks are required to hold on reserve at the central bank- so this ratio of deposits cannot be offered for borrowing.

The rediscount rate defines the interest rate that the central bank charges when it buys bonds or other securities from commercial banks. The open market operations mean that the central bank buys or sells securities (mainly government bonds). When the cental bank purchases securities from commercial banks, the money it pays to the commercial bank is new money injected in circulation, and the process is called creation of central bank money. When the central bank sells securities, the commercial banks buying them will hand over part of their money to the central bank, therefore the money supply available at commercial banks will decrease. The above four instruments are the basis of monetary policy.

The quantity of money in circulation is controlled by the deposit money in banks, on checking accounts. The various deposits held in banks are, however, very different considering their liquidity. The most liquid form of bank deposits is the current account (checking account, or sight deposit), because the owner of this deposit can access the money any time. The savings deposits, and other time-deposits are somewhat less mobile for transactions, because the owner, accessing them before their maturity date may lose the deposit interest. Long-term securities, and deposits made in foreign currency are still less liquid, and accessing them is more complicated. The purpose of holding money in a checking account is to spend it on immediate tansactions, regular expenditures, while the other forms of deposits serve the purposes of saving. For this reason the money in circulation is classified, and the following monetary aggregates are defined:

 M0 money: cash (banknotes and coins) produced by the central bank, and the reserves of commercial banks deposited in the central bank.

 M1 (money in narrow sense, narrow money): includes the cash currency in M0 and the deposits in checking accounts, sight deposits, which are perfectly liquid, suitable for immediate everyday payments.

 M2: includes M1, plus deposits in savings accounts, small denomination time-deposits, short-term deposits, which are less liquid than M1, although relatively easily transferred to liquid forms at a small cost.

 M3: adds less liquid assets to M2, namely the long-term securities of large denominations, international currency deposits, mutual funds shares.

Money in the narrow sense is the M1–type money, as it is readily available for transactions, while the monetary aggregates M2, and M3 are often called ‘quasi-money’, or

’near money’. Money supply and money demand refer to supply and demand of M1 money, indicating the quantity of readily available money that can be spent immediately. The money supply function defines the supplied quantity of nominal money as: M^S = M1, while the real value, i.e. the purchasing power of this money is real money supply = M^S/P = M1/P, also called real money balances. The purchasing power of nominal money supply depends on the price level. The central bank controls nominal money supply, while the real money supply will be defined by the market, as a function of the actual price level.

The central bank has five main instruments to control the nominal money supply.

These are: the quantity of cash currency (banknotes and coins in M0) and the central bank money introduced into circulation through the banking system; the reserve ratio; the base rate of interest determined by the central bank; the rediscount rate, and the open market operations of the central bank. These are the instruments of monetary policy (Farkasné Fekete - Molnár, 2009). Summing up the above, the money supply is determined by the banking system, and it is not directly related to the real processes in the economy, so it is considered an exogeneous attribute for the economy.

9.5. Factors Determining the Demand for Money, The Money Demand

9.5. Factors Determining the Demand for Money, The Money Demand