MODEL 0. The Simple Circular Flow. PrM CrM H&B X Y C I S Y = C + S. Must be true X = C + I. Must be true S = I. If and when the Credit Market is working well What if it isn’t working well?

The CASH Model PrM CrM H&B X Y C I S Y = C + S. Must be true X = C + I. Must be true Let us now suppose that the Credit Market does not always make S = I, that it is possible for Saving to be either greater than, or less than, Investment Of great importance is this pair of thoughts: -- S might not equal I in the “short run.” -- S will equal I in the “long run.” How long these “runs” are is not at all clear In the short run the difference between S and I can be made up for by people holding more or less Money (“Cash”). We will say that the demand for (holding) money has risen or fallen. CASH ΔMD Saving can wind up in one of two ways: 1.It can be loaned and Invested 2.It can be held by someone (including banks)

The CASH Model PrM CrM H&B X Y C I S Y = C + S. Must be true X = C + I. Must be true This picture shows: 1.the demand for money is rising 2.money is going into Cash 3.the public– including banks – are holding more money 4.Savings greater than Investment CASH ΔMD PrM CrM H&B CASH The situation shown here looks as if people started to Save more, but Businesses were not inclined to borrow and Invest the extra Saving. The extra 5 sat as reserves in banks. How can we interpret this picture?

The CASH Model Y = C + S. Must be true X = C + I. Must be true OR: Banks got scared, started to “hoard” money and Investment was reduced. Businesses that wanted loans could not get them PrM CrM H&B -5 0 CASH +5 How to interpret this? Businesses decided to borrow less; banks got stuck holding money they could not lend

The CASH Model PrM CrM H&B X Y C I S Y = C + S. Must be true X = C + I. Must be true This picture shows: 1.the demand for money is falling 2.money is going out of Cash 3.the public– including banks – are holding less money 4.Savings is less than Investment CASH ΔMD PrM CrM H&B What happened? CASH -5 The situation shown here looks as if people started to Save less, but banks had enough cash to be able to continue to lend for Business Investment.

The CASH Model Y = C + S. Must be true X = C + I. Must be true What happened? PrM CrM H&B +5 0 CASH -5 Businesses started to borrow more and banks had on hand enough money to meet that demand.

The CASH Model PrM CrM H&B X Y C I S Y = C + S. Must be true X = C + I. Must be true That is: S > I means Δ MD > 0; someone is accumulating money; the demand for money is rising S < I means Δ MD < 0; someone is reducing their money holding; the demand for money is falling CASH ΔMD S = I+ Δ MD. Must be true. That is: $ into CrM = $ out of CrM Notice that all of the scenarios that involve MD changing seem unlikely to last very long. Banks cannot or will not indefinitely add to, or draw from, their reserves. Sooner or later Savings must equal Investment. S ≠ I in the Short Run, when Δ MD ≠ 0 S = I in the Long Run, when Δ MD = 0 S < I means Δ MD < 0; someone is reducing their money holding; the demand for money is falling

Final – CRUCIAL -- Point Whenever S and I are unequal, X and Y will be unequal. We will interpret this as the economy grew or shrunk. We have here what the first “Model 0” could not describe – the demand-driven rise and fall of GDP. PrM CrM H&B +5 0 CASH -5 In this case, there was a rise of Demand (x). Total Spending rose

PrM CrM H&B -5 0 CASH +5 In this case, there was a decrease of Demand (x). Total Spending fell

IF …AND MD …THEN I …AND X … C rises/S falls does not changefallsdoes not change fallsdoes not changefalls C falls/S rises does not changerisesdoes not change risesdoes not changefalls IF …AND MD …THEN S and C …AND X … I rises does not changeS rises, C fallsdoes not change fallsdo not changerises I falls does not changeS falls, C risesdoes not change risesdo not changefalls A SUMMARY If MD does NOT change: X does not change; C and I off-set each other If MD DOES change: X will change; C and I do not off-set each other

IF …THENAND X … MD does not change C rises/S fallsI falls does not change C falls/S risesI rises S rises, C falls I fallsS falls, C rises IF …And MD changesTHEN …AND X … C rises/S fallsMD fallsI does not changerises C falls/S risesMD risesI does not changefalls I risesMD fallsC and S do not changerises I fallsMD risesC and S do not changefalls SAME SUMMARY