Rebuilding the Theoretical Model of Inflation on Credit with Loanable Funds

Abstract

In this chapter, the core concepts of inflation, disinflation and deflation with expectations that underpin the credit cycle in Chapter 7 are modelled to provide a theoretical link that relates to the growth of loans and, consequently, to the endogenous flow of the money supply. The idea is to add to Friedman’s notion that ‘Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than output’. Now put this into reverse, disinflation and deflation are forever and ubiquitously a monetary occurrence in that it can only happen because of an abrupt decrease in the growth of the money supply, which is less than the expected change in production, leading to real, destabilising effects, triggered by endogenous changes to the desires of commercial banks to create money in the economy.

Appendix

Keynes incorporates the keyword of ‘money ’ in his title of the General Theory (1936) to highlight its importance in the creation of Gross Domestic Income (GDP) in nominal terms. In contrast, the Classical belief assumes that money is merely a ‘curtain’ hiding the real economy. Money ’s only undertaking for Classical economists was the determination of the absolute price level, but it had no function as far as relative prices or the formation of the national output and employment were concerned, behind the curtain. Indeed, for Keynes , money had major rȏle in the determination of the rate of interest , which is a determining factor of investment within national income, although the analysis here extends it to consumption as well. It is an irony that many expositions of Keynesian theory concerning fiscal policy neglect the crucial function of the monetary system (Peacock and Shaw 1976).

Moreover, the introduction of the monetary system into the following income identity, $Y$, by means of consumption , $C$, and investment , $I$, partly dependent on the real of interest, $ri$, which is equal to $i_{t}^{\text{B}} - (E_{t} \Delta_{t + 1} + C_{\text{R}}$, where $i_{t}^{\text{B}}$ denotes the borrowing rate of interest minus the expectations of inflation , $E_{t} \Delta P_{t + 1}$, and the credit premium , $C_{\text{R}}$, which is somewhat determined by the demand and supply of loanable funds from the banking sector:

$$Y_{t}^{\text{D}} = C + I + G + X - M,$$

(9.23)

where consumption , therefore, is equal to the expression of

$$C = \overline{C} + c Y^{\text{d}} - \lambda {\text{ri}},$$

(9.24)

$\overline{C}$ is autonomous consumption , $c$, the marginal propensity to consume (MPC) and $Y^{\text{d}}$, denoting disposable income in the form of

$$Y^{\text{d}} = Y - t \cdot Y + T,$$

(9.25)

the average tax rate, $t$, and $T$ denotes transfer incomes , which is determined by

$$T = \overline{T} - \eta {\text{Y}},$$

(9.26)

where $\overline{T}$ denotes autonomous transfer payments along with a negative $\upeta$, representing the average rate of credit transfer. The value on ${\text{ri}}$ measures the negative relationship between the real rate of interest and the borrowing of loanable funds to finance, in the main, consumption of durable goods, in part, determined by the interest-elasticity coefficient , $\lambda$. Investment expenditure is as follows:

$$I = \overline{I} - \beta {\text{ri}} + \Omega Y,$$

(9.27)

$\overline{I}$ measures fixed capital formation expenditure along with investment demand relating to the negative, $\beta$, on the real rate of interest , but with a positive $\Omega$, the accelerator coefficient on income because of the magnifying process of the Keynesian multiplier with the indirect effects of expectations on consumer demand. In the case of government expenditure and exports, the assumption they are exogenous to the model that is

$$G = \overline{G} \,{\text{in}}\,{\text{addition}}\,{\text{to}}\,X = \overline{X}$$

(9.28)

Finally, with regard to the negative rȏle of imports, the function, which includes income, $Y$ is as follows:

$$M = \overline{M} + mY,$$

(9.29)

where $\overline{M}$ is autonomous expenditure on imports with $m$, the marginal propensity to import out of income, $Y$.

Substituting (9.24)–(9.29) into (9.23) and simplifying derive the expression of

$$Y_{t}^{\text{D}} = \alpha \left( {\overline{A} - {\text{bri}}} \right),$$

(9.30)

where $\alpha = 1/1 - c\left( {1 - \left( {t + b} \right)} \right) - \Omega + m$, is the multiplier , $\overline{A} = \left( {\overline{C} + c\overline{T} + \overline{I} + \overline{G} + \overline{X} - \overline{M} } \right)$, which denotes the autonomous components, and finally, $b = \left( {\beta + \lambda } \right)$, captures the sensitivity coefficients that relate to the real rate of interest with respect to investment and consumption that allows for the entrance of the loanable funds market into the analysis and to provide its crucial input into decision-making process within the circular of income, output and employment .