Home > Macro/Monetary Theory > A Really Simple Model

A Really Simple Model

I have been trying to discover and explain the real effects of our monetary system for a while now and I have recently discovered that in sort of “lefty” circles they are already somewhat aware of what I’ve been talking about.  And what’s more, they have a much simpler way of explaining it.  (A few notes on this video: First, I know nothing about the political ideology of whoever made this.  I say “lefties” because the basic idea was originally pointed out to me in the movie “Zeitgeist: Addendum” which is mostly nonsense but this part of it I think is correct.  Second, I linked to part three of a five-part video.  The first three are all pretty good in my opinion and add some context if you want to watch all of them.  Toward the end of the third one it starts to go off the rails a little.  For instance I am very uncomfortable with concepts like usury, and their reasons why real money wouldn’t work make no sense.)So I want to present a much simpler monetary model which should give you something to think about even if you aren’t very familiar with the Hotelling rule or the Fisher equation.  There are many imporant issues raised by this which I will deal with in the coming days. 

Consider a 2 period economy where all investment and consumption is financed by borrowing from the central bank at interest rate r.  And let the total amount of money borrowed (the money supply) in period 1 be M. 

Question: In period 2 how much money will flow out of the economy?

Answer: All of it (M).  In fact the total amount owed will be M(1+r) but this will be greater than the total amount of money in the economy.  So in other words the central bank will soak up all the money it created in the previous period and everyone will still be in debt for even more.  This is because the money “created” was loaned and when the loan comes due that money has to be paid back to the central bank taking it out of circulation.  

 This means two things.  First, some people are going to go bankrupt and get foreclosed upon.  This is impossible to avoid because there just simply isn’t enough money to pay all the debts in the economy.  This fact is true regardless of how much real wealth is created between periods 1 and 2.  Second, because of this, people will have to scramble to not be one of those who go bankrupt.  This means they will all be clamoring to get their hands on some of those dollars (a little more than what they borrowed).  The only way to get the money will be to trade real goods.  In other words everyone will be trying to trade real goods for money, and (I reiterate) no matter how many real goods were created in the economy from period 1 investment, there will not be enough money in circulation for everyone to trade them for enough of it to pay off their debts.  In an attempt to pay these debts they will bid the prices of these good down and there is no natural floor on the prices of real goods!  In a simple frictionless model where everyone is identical this will mean that no matter how much real wealth is created, the nominal value of it will be less than what is owed and the central bank will repossess it all.

In a model with more than two periods, it gets more complicated but the basic idea still holds.  Every time the central bank lends out money, they increase the money supply by some amount  but they also create a debt even larger than that to be paid at some future date.  In other words, the net effect of this (in the long run) is to decrease the money supply.   So in order to keep the economy from collapsing (as described above) the money supply will have to be increased in some way to offset the money being sucked back up by the central bank.  The easiest way to do this will be to lend out more money.  In order to do this, all they will have to do is lower the interest rate.  Problem solved, everyone lives happily ever after.

Wait a minute, wouldn’t this mean the interest rate would have to keep decreasing forever?  And isn’t it the case that you can’t decrease the interest rate below zero?  So wouldn’t that mean that when interest rates go to (or near) zero, you will lose the ability to keep pumping money into the economy, and then as money keeps getting sucked back out, prices will fall and foreclosures will mount and the economy will start to break down?  And then what happens?

Well don’t worry, if people refuse (or are unable) to keep borrowing individually to prop up the monetary system, we still have another tool in our Keynesian toolbox.  We can just use the government to accumulate debt in the name of the people collectively.  This is the logic underlying the Keynesian position that you must use fiscal policy to stimulate an economy when it is in a liquidity trap and monetary policy is not effective.  Problem solved, everyone lives happily ever after.

But doesn’t this mean that we will just keep getting more and more collectively in debt to private institutions giving them the power to cut us off and repossess all of our wealth at any time they choose?  That’s just hate mongering….

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  1. February 4, 2013 at 3:25 am

    There is no reason to not paerrpe for a career change while still working at your current job. Look into your interests and find out what you are passionate about. You may find out that it is much easier to get up every day and do what you love rather than be in it just for the $$$$. I should know, I did the whole college thing and got a degree in business worked in suit and tie environment for many years and then went back and got a more creative skill, I ended up still working in a corporate environment but have a much more creative role. A new skill can always be combined with existing, plus a future employer may love the fact that you think outside of the box .

  2. February 4, 2013 at 3:43 am

    Look at the word fear as; FALSE, EVIDENCE, APPEARING, REAL. The word isn’t as scary when you break it down.Ask yourself if you will have any reregts if you don’t go after your passion. If the answer is yes try to work on your passion slowly. Start on the week ends until you have the nerve to take a leap. In my experience, you have to believe in you. When you believe a special feeling of peace comes over you. NOW WHAT?

  3. February 6, 2013 at 12:14 pm

    Julie,You can still have your job for now and at the same time maybe become a big ssiter or tutor children or find out about a mission trip during your vacation time. also can use now what to ask others what ways have they given back and you might be able tofind out answers to your situation ..let me know if you would like bernadette marie

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