Output, Inflation and Growth

The social result of economic activity is the satisfaction of human wants. In any period of time, say a year, an immense variety of goods (cars, clothes, books and beer) and services (such as those of doctors, dentists, politicians and pop singers) becomes available in varying quantities. These goods and services satisfy the wants of those who purchase them. Obviously not all wants are satisfied by this economic activity, for wants are virtually insatiable and resources are scarce. But if we think of the ‘economic system’ of a country in this way we can, subject to some obvious safeguards, regard it as a ‘machine’ for organising the production of goods and services which ultimately satisfy human wants.

In Chapter 1 we defined the four main problems with which this book deals as being to explain:

In this chapter we define some of the concepts which we shall need to employ in describing how the economy operates and developing a theory to explain why the economy operates as it does.

In the last chapter we erected a consistent set of definitions which provided us with a conceptual scheme in terms of which we can (and shall) describe economic behaviour. How do we measure the concepts we have defined? The easiest way of answering this question is to construct, and work through, a simple example.

We have now defined a set of accounting concepts in terms of which we can describe, in a systematic and unambiguous way, the behaviour of the UK economy. To do this we had to spend some time and effort in looking at purely accounting problems. There is therefore a risk that in concentrating on the development of a conceptual framework we have lost sight of our main objective. Accordingly this is a good point at which, before looking at the behaviour of the UK economy in Chapter 6, to take stock of what we have learned.

In the last chapter we made use of the concept of a ‘production possibility curve’ to distinguish two macroeconomic problems.

Many students of economics find the analytical and expository devices used by economists forbidding or even frightening. This is particularly the case where the devices employ—or look as if they employ—mathematical modes of expression and mathematical methods of reasoning.

In this chapter we begin our main job of constructing an economic theory which can be used to explain why the economic system behaves as we saw that it did in Chapter 6. We approach this task by developing a model of the economic system. Since the economic system is complicated, the model, to be useful, must necessarily also be complicated. We shall begin, however, by constructing a model of extreme simplicity and introduce complexities later only when the properties of the simple model have been thoroughly understood. Accordingly we start with a system in which (i) there is no government (i.e. no public-sector) economic activity, and (ii) there is no international trade. We also make one additional assumption, namely that the price of a unit of output is constant. This enables us to identify changes in the money values of variables with changes in their ‘real’ values and postpone discussion of the determination of prices. Each of these assumptions is removed later.

In the last chapter we argued that enterprises would adjust their output per period until planned sales and actual sales were equal. At this level of output enterprises would be in equilibrium: that is, they would have no reason to adjust their output plans in any way.

In Chapter 9 we showed that if we knew: we could determine the equilibrium level of output and hence, via the production function, the equilibrium level of employment. We also demonstrated that the equilibrium level of output (= income) was stable.¹

In Chapter 10 we developed a theory of investment and found that, given (i) the marginal efficiency of capital schedule adjusted for borrower’s risk, and (ii) the cost of borrowing, we could determine the equilibrium rate of real planned investment. Given the rate of real planned investment (determined in this way) we could then, from the schedule of the propensity to consume (itself derived from the consumption function) determine the equilibrium level of output and employment from the condition that, in equilibrium, planned saving must be equal to planned investment.

As a result of our work in Chapter 11 we now have a theory of the determination of the equilibrium rate of interest. Our elementary model is thus complete. It is therefore convenient at this point to summarise our argument: that is, to display in full the characteristics of the model at this stage. Once this is done we can proceed (i) to see where the model needs further extensions, and (ii) to see what predictions it yields.

Thus far our analysis has proceeded on the convenient, but highly unrealistic, assumptions that the economy does not engage in international trade and does not contain a public sector. In this chapter we relax the second of these assumptions: that is, we seek to introduce a public sector. In the chapter which follows we shall take account of international trade: that is, we shall introduce the international sector.

In the previous chapter we looked at the consequences of introducing international trade into our model in the framework of a regime of ‘pegged’ exchange rates. However, since 1972, the UK exchange rate has not been pegged, but has been determined by a ‘managed float’: that is, by a foreign exchange market in which the authorities intervene, from time to time, as an additional buyer or seller of foreign exchange. At this stage we do not wish to discuss why the UK authorities chose to act in this way. We therefore consider only the limiting case of a ‘perfectly clean’ float even though, since the collapse of the Bretton Woods system (the ‘occasionally jumping peg’) most countries’ floats have been more or less ‘dirty’.

So far the whole of our analysis has proceeded on the simplifying assumption that the price level is given and invariant. This does not mean that the level of prices exerts no influence in our model. Indeed if we look back at Chapter 11 we see that the price level is a determinant, of the demand for active (M₁ balances and thus of the rate of interest. Since the rate of interest, given the MEI schedule, determines (as explained in Chapter 10) the rate of real planned investment, which, in its turn, determines, via the multiplier, the equilibrium level of real income and, via the production function, the level of employment, it is clear that the level of prices exerts a considerable influence in our system. It is plain, therefore, that to complete our theory we need to consider how the price level itself gets determined. To explain this is the job of this chapter.

In the last chapter, we constructed the aggregate supply schedule on the assumptions that:

In Chapter 15 we completed our account of the static ‘neo-Keynesian’ model by examining the relationship such a model predicts between an assumed exogenous change in the nominal money stock and the endogenous response of the price level.

The job of this chapter is to give an account of ‘monetarist macroeconomics’: that is, the macroeconomic theory typically held by those economists who are identified (or identify themselves) as ‘monetarists’. This is not an easy thing to do for at least two reasons.

In the last chapter we attempted to give an outline of ‘monetarist’ macroeconomics and to contrast this with the ‘Keynesian’ model we developed in earlier chapters. In developing any model — whether ‘Keynesian’, ‘monetarist’, or what you will — there is always a risk of losing sight of its overall structure in the necessarily rather detailed examination of its component parts. This chapter is designed to guard against this risk by:

In Chapter 19 we developed an account of the process whereby, over the long run, the capacity of the economy to produce output grows. In this chapter we consider why, as a matter of observation, the growth path followed by the economy involves fluctuations in the extent to which, in any given year, the available capacity is utilised. The problem of economic fluctuations is often discussed under the heading of the theory of economic cycles. What then is a cycle?

Thus far our discussion of the problem of prices in our macroeconomic model has had two principal characteristics. It has been:

In our outline of the liquidity preference theory of interest we have already put forward a definition of the money supply. This definition, however, was stated dogmatically and the principles underlying it were never discussed. At the same time we made reference to the concept of liquidity. Our task in this chapter is to examine the concepts of money and liquidity in more detail and thus explain and justify the brief references made in the course of our earlier analysis.

In the previous chapter we saw that modern money consists of two components: (i) demand deposits with the commercial banks; (ii) notes. Of these the first, and most important component, consists of liabilities of the commercial banks, the second of liabilities of the central bank. Since we have defined the money supply as:

the nominal value of demand deposits and notes held by the non-bank public

it follows that, to explain its determination, we must examine the behaviour of the commercial banks and the central bank, for, just as an individual controls the nominal value of the IOUs he or she issues, so do banks and, in doing so, the latter control the money supply.

In the previous chapter we found that there were three determinants of the money supply:

The analysis of the previous chapter leads to the conclusion that it is useful to decompose the money supply into two elements:

In the earlier chapters of this book we have tried to do two things.

The purpose of this chapter is to use three of the major macroeconomic models of the UK economy to obtain estimates of its dynamic response to defined policy actions.

The aim of this chapter is to give an account of ‘neo-Keynesian’ and ‘monetarist’ approaches to the conduct of macroeconomic policy with special reference to the UK. This is done, not with the intention of demonstrating that one approach is superior to the other, but in order to show, as clearly as possible, in what ways the two approaches differ and what issues in positive economics stand behind these differences.