A response I got to the ABCT...

I was explaing the ABCT using Garrison's argument and I got this response:

Your model is not completely. First I'll assume that your increase in savings in due to economic growth (a change in MPS would irrelevant in the short run due to the Paradox of Thrift). This effects money demand, not money supply. Therefore, since money demand is downward sloping, a shift out will actually raise the interest rate, not lower it. Banks are more willing to lend, but people are also more willing to take out loans. Of course, money supply still does change due to the multiplier effect on the money supply, but this change in the quantity of money supplied is actually more of a counterbalance to the growth in demand. This causes a decrease in investment, which actually shifts aggregate demand inward, actually causing some stabilization. This is known as the "crowding effect", mainly since it is primarily seen as the result of an increase in government spending. There is, of course, an effect on money supply that does occur, but the primary effect is seen in money demand which drives interest rates upward. Furthermore, the inflationary pressures often build up during these boom periods which will lead to changes in the nominal interest rate, but this is not very important since there is usually no significant change in the real interest rate. It is certainly true that banks will hold more excess reserves during economic downturns since loans are not as safe then and people are less eager to take out a loan. This, of course, is part of the reason why we lower set lower interest rate targets.

Now with the gold standard issues change. Under the gold standard, the federal reserve cannot effect interest rates through targeting of the money supply since it is essentially fixed. Therefore, there is nothing offset this growth in the demand of money and interest rates swagger even more. Banks have the same amount of money to lend, but the desire to take on loans increases so banks can charge higher interest rates.

Furthermore, eclipsing all of this is the effect of the cycle of inflation and deflation. Under the gold standard, the price level is fixed in the long run so the short run consists of fluctuations between periods of inflation and periods of deflation. We don't want deflation. Deflation has a powerful effect on the propensity to save which causes aggregate demand to shift inward. Furthermore, this deflation also leads to downward pressure on real wages, reducing worker income. Really, though, all that aside, the inflexibility of the Federal Reserve to have an effect on monetary policy leaves the economy more vulnerable to exogenous changes in the various variables that compose it.

Obviously a Keynesian, and it's easy to dispose of arguments like the "paradox of thrift", but I can't help but thinking the response is a non sequitur of sorts. It appears as though he completely ignored my point about credit expansion (both through the Federal Reserve targetting the federal funds rate and through fractional reserve banking), and instead says that there is just an increase in money demand. Am I just being dense?

I'm no economist, but from my understanding of Austrian economics (I've done the Keynesian analogue up to first year university level courses) this is total hocus pocus. An increase in savings will lead to a fall in interest rates, not vice versa. It implies a decrease in the desire for money, not the opposite. Now, when the Federal Reserve or any other central bank artificially presses interest rates down, borrowing will become cheaper. Given, however, that this artificial fall in interest rates was based on an illusion, when the illusion is dispelled, there will not be enough real resources within the economy to satisfy all the projects undertaken. There will be no compensatory effects.

In addition, he merely stipulates that the gold standard will suffer from inflation and deflation without offering an account as to why this is so. He must think inflation is merely an increase in prices, which is to say he is confusing the symptom for the cause. His entire account is merely a veil to disguise utter ignorance of fundamental economics.

Try this: William Barnett and Walter Block, "On Hayekian Triangles," where they criticize their use.

The way I read it, he's discounting your point about credit expansion by claiming that such expansion is needed in order to maintain a stable price level in the face of rising money demand.  That is, since P=Ms/Md, then if Md goes up then Ms has to go up proportionately to keep P the same.  Apparantly this is a good thing since "we don't want deflation".

I wouldn't waste much time with this guy, besides whatever you have to do to get what you need out of him.

I think he fails to recognize that the problem is that investors are fooled into thinking real wealth within the economy has risen, when in reality all that has happened is that the government has waved its magic wand, albeit to no avail.

britainland:

Really, though, all that aside, the inflexibility of the Federal Reserve to have an effect on monetary policy leaves the economy more vulnerable to exogenous changes in the various variables that compose it

Keynesians really are the modern soothsayers.  With their spurious and gratuitous interjection of important sounding words and phrases, it is almost impossible to cut through the mumbo jumbo to understand what they are talking about. 

So, let's just take your correspondant's last line which I have quoted above.  Mises demonstrated that the flaw in Socialism is the ability to calculate.  Without the market to determine the prices, socialist planners can make no rational choices in the allocation of resources.  As all resources are scarce, this will result in inefficient production.  Long term then, Socialism cannot compete with free market capitalism. 

Jesus Huerta de Soto, in his book "Money, Bank Credit and Economic Cycles" has taken Mises calculation argument and applied it to the fully regulated financial institutions of western economies, the Central Bank being a main part.  The regulated and all emcompassing nature of these markets make them similar to socialist economies.  As a result, the Central Bank, just like the Central Planner, does not have the real information upon which to make informed decisions.  Contrary to your correspondant's claim, the Federal Reserve will always be incapable of regulating the economy, and because it cannot calculate, it is much more likely that any action it takes it will harm the economy. 

Your model is not completely. First I'll assume that your increase in savings in due to economic growth (a change in MPS would irrelevant in the short run due to the Paradox of Thrift).

The paradox of thrift doesn't work, try again. Besides, I thought even Keynesians had given up on their stupid doctrine, even in my textbooks they talk of the importance of savings (in some cases anyway).

 This effects money demand, not money supply. Therefore, since money demand is downward sloping, a shift out will actually raise the interest rate, not lower it.

Is he saying an increase in savings is equal to an increase in the demand for money? Did he just confuse demand and supply? Does he not realise where demand for money comes from, nor the concept of time preference?

Banks are more willing to lend, but people are also more willing to take out loans.

How can people be simultaneously more willing to save, and also to borrow? You can have an increase in one or the other, not both at the same time, that's like saying people consume and save more at the same time, without their income changing. Higher savings can lead to lower interest rates and thus eventually to lower savings and more debt. It's called tending towards equilibrium.

 Of course, money supply still does change due to the multiplier effect on the money supply

The multiplier effect does not exist. He seems to be referring to the famous Economics of Magic espoused by Keynesians. What he's actually referring to, without realising it, is money working its way through the fractional reserve banking system and thus increasing the supply of money. The multiplier effect IS an increase in the supply of money, although most people don't understand how or why this happens.

but this change in the quantity of money supplied is actually more of a counterbalance to the growth in demand.

There is no counterbalance, as when savings are increased, demand for money decreases. Ultimately though, savings are channelled into investments so there can only be short term fluctuations in the demand for money as a result of a change in time preferences. In the long run, only an increase in the total goods and services produced can have a serious effect on the demand for money. Did I just say the dreaded L-word? Yes I'm afraid Keynesians and their governments aren't too happy of thinking about the long run.

This causes a decrease in investment, which actually shifts aggregate demand inward, actually causing some stabilization.

What? more savings cause a decrease in investment? Is he nuts? Does he not understand the simple supply and demand at work behind interest rates (without intervention that is).

Furthermore, the inflationary pressures often build up during these boom periods which will lead to changes in the nominal interest rate, but this is not very important since there is usually no significant change in the real interest rate.

Oh yes of course, when interest rates fluctuate from around 18% during the era of stagflation to around 1% in the aftermath of 9/11, the real interest rates stay the same. He's telling me real GDP growth fluctuated that much to account for such a huge change?

It is certainly true that banks will hold more excess reserves ....

Woah, slow down. Excess reserves? In excess of what? 3%? That's the current average reserve in the UK if I remember correctly. Excess reserves would be more than 100% of money held. He's got it all confused, again. All banks are inherently insolvent.

Furthermore, eclipsing all of this is the effect of the cycle of inflation and deflation. Under the gold standard, the price level is fixed in the long run so the short run consists of fluctuations between periods of inflation and periods of deflation.

Price level is fixed in the long run.....so now he's assuming a stagnation in the growth of goods and services. Obviously the purchasing power of a currency is affected not only by the supply of said currency, but also by the supply of everything that currency can buy, in other words all the goods and services produced within a country.

We don't want deflation.

Who's we? You and your gang of pseudo-economists? You seem to blatantly disregard the decades of deflation in America and the incredible rates of rising prosperity accompanied by them.

Deflation has a powerful effect on the propensity to save which causes aggregate demand to shift inward.

You could always have contracts for loans stipulating a return of principal + interest in REAL terms, rather than nominal terms. In fact, deflation is the only way to solve the age old P/(P+I) problem.

Furthermore, this deflation also leads to downward pressure on real wages, reducing worker income. Really, though, all that aside, the inflexibility of the Federal Reserve to have an effect on monetary policy leaves the economy more vulnerable to exogenous changes in the various variables that compose it.

Nope, it only affects nominal wages, since deflation would reduce both wages and prices, thus real wages would likely not change. And as someone else has pointed out, socialism can't calculate. To say that a government bureaucracy is more able to respond to exogenous shocks than a free market is a blatant contradiction of any common sense that one should have in economics.

Please feel free to correct me, maybe I’ve mis-interpreted him. If not, either he’s stupid, or I’m stupid.

Jon Irenicus:

I'm no economist, but from my understanding of Austrian economics (I've done the Keynesian analogue up to first year university level courses) this is total hocus pocus. An increase in savings will lead to a fall in interest rates, not vice versa. It implies a decrease in the desire for money, not the opposite.

Sorry for jumping on this thread so late, but it took me a while to work this out.  An increase in savings, by definition, is an increase, not decrease, in the desire for money.  The desire for money implies the desire for future goods over present goods.  One who desires money, and therefore future goods, over present goods, saves his money.

Borrowing, on the other hand, demonstrates a desire for present goods over money, even future money. One does not borrow money to save it for some future good; one borrows money to spend it on present goods.  He values present goods over money so much so that he is willing to spend money he does not yet have, and in fact, more money than the asking price, for present goods.

You are correct, however, that an increase in savings will then lead to a lowering of interest rates.  The interest rate is nothing but the price of a loan.  As the demand for present goods decreases (saving), the demand for loans also decreases, leading to the fall in price of loans.

Right. I guess what I meant to say was money for present use.

-Jon

JackCuyler:

An increase in savings, by definition, is an increase, not decrease, in the desire for money. 

That's not how I've always thought of it. To me, when interest rates fall as a result of higher savings, this is because the supply of money has increased. People, rather than spend their money now, are saving it for later, in other words, the supply of loanable funds increases, not its demand. On the other hand, when people borrow money, the money borrowed is the demand.

Thus, if you draw a supply/demand diagram, and you show an increase in supply (more people saving), interest rates will fall. Likewise, ceteris paribus if you show an increase in demand for loanable funds, interest rates rise.

However, the way you've explained it, if an increase in savings is an increase in the "desire" (demand) for money, then shifting out the demand curve on the diagram would increase the interest rate, rather than lower it. So more savings increases interest rates? This frankly doesn't make sense.

Maybe I've mis-understood you?

Fred Furash:

JackCuyler:

An increase in savings, by definition, is an increase, not decrease, in the desire for money. 

That's not how I've always thought of it. To me, when interest rates fall as a result of higher savings, this is because the supply of money has increased. People, rather than spend their money now, are saving it for later, in other words, the supply of loanable funds increases, not its demand. On the other hand, when people borrow money, the money borrowed is the demand.

Thus, if you draw a supply/demand diagram, and you show an increase in supply (more people saving), interest rates will fall. Likewise, ceteris paribus if you show an increase in demand for loanable funds, interest rates rise.

However, the way you've explained it, if an increase in savings is an increase in the "desire" (demand) for money, then shifting out the demand curve on the diagram would increase the interest rate, rather than lower it. So more savings increases interest rates? This frankly doesn't make sense.

Maybe I've mis-understood you?

I'm working with the premise that one borrows not to have more money simply for the sake of having more money, but for the sake of spending it immediately on a good or goods.  This implies a desire for goods over money.  When ones saves, on the other hand, one desires money over the goods said money could puchase at the moment.  Hence, increased borrowing is neither an increase in saving nor an increase in the demand for money, but rather an increase in demand for goods.

There are three things one can do with money  - save it, spend it or loan it.  If the market is experiencing a high rate of saving, there will be a decrease in spending, and therefore a decrease in borrowing.  Those who wish to increase their cash holdings through interest on loans will necessarily set the price of such loans low.  On the other hand, with a decrease in saving, there will be an increase in spending, and therefore an increase in borrowing.  This increased demand will lead to an increase the price of such loans.

Saving does not increase the supply of money, it just slows the exchange of money for goods.  However, an actual increase in the supply of money, through fractional reserve banking or fiat printing presses, will have the same effect on interest rates as an increase in saving, which will lead to massive and widespread calculation errors.  Businesses are fooled into thinking there is more saving going on than there really is.

JackCuyler:

I'm working with the premise that one borrows not to have more money simply for the sake of having more money, but for the sake of spending it immediately on a good or goods.  This implies a desire for goods over money.  When ones saves, on the other hand, one desires money over the goods said money could puchase at the moment.  Hence, increased borrowing is neither an increase in saving nor an increase in the demand for money, but rather an increase in demand for goods.

There are three things one can do with money  - save it, spend it or loan it.  If the market is experiencing a high rate of saving, there will be a decrease in spending, and therefore a decrease in borrowing.  Those who wish to increase their cash holdings through interest on loans will necessarily set the price of such loans low.  On the other hand, with a decrease in saving, there will be an increase in spending, and therefore an increase in borrowing.  This increased demand will lead to an increase the price of such loans.

Saving does not increase the supply of money, it just slows the exchange of money for goods.  However, an actual increase in the supply of money, through fractional reserve banking or fiat printing presses, will have the same effect on interest rates as an increase in saving, which will lead to massive and widespread calculation errors.  Businesses are fooled into thinking there is more saving going on than there really is.

I think I understand what you're saying now about the supply of money. If I change the words "supply of money" in my previous post to "supply of loanable funds" will that make more sense? I think I was muddling up fractional reserve banking with full reserve banking. If the supply of money stays constant, when more people borrow, less must save, and vice versa.