M.Sc.

in Comparative Law, Economics and Finance

May – June 2022

Lecturer: Jan Toporowski

Lecture 1: Macroeconomic Equilibrium and the Trade Cycle

Course Philosophy and Outline

Conventional approach to macroeconomics ad macroeconomic stability:

Banking and finance are vehicles for the saving choices of ‘rational’
individuals (‘agents’) who desire the best possible outcomes
(‘optimising’).
Confuses saving with finance.
Appeals to vanity of individuals (fear of appearing irrational);
& vanity of university professors (everyone should think like a ‘rational’
professor).
Vs:
Banking and finance as the products of history in which reasoning
individuals try to survive.
Effects of socialisation of individuals and rationality.
Problem of unintended consequences.
Need to understand how the system as a whole works, including
social/cultural/legal aspects.

Lecture methodology: combination of theory (explanation of how

economic and financial variables are related) with financial history to
show the evolution of theory, institutions and practice.

Student-led seminar discussions.

Lecture 1: Macroeconomic Equilibrium and the Business Cycle

Lecture 2: Money, Credit and Banking

Lecture 3: Interest Rates and Usury

Lecture 4: Corporate Finance

Lecture 5: The Emergence of the Credit Cycle & Central Banking

Lecture 6: The Great Crash

Lecture 7: Post-War Regulation

Lecture 8: Financial Liberalisation, Financial Innovation and Crisis

Lecture 1: Equilibrium and the Trade Cycle

1. Equilibrium
2. Profits and Money
3. Theories of Macroeconomic Instability

1. Equilibrium

Equilibrium as ‘method of thought experiment’ in JS Mill to reveal

full consequences of a given change (in prices, demand etc.).

From 1870s, Neo-classical General Equilibrium (Walras, Arrow-

Debreu)
Prices bring Supply = demand in all markets
Prices determined independently of money.
Money determines general price level.
No finance, ‘saving’ (income – consumption) = investment, brought to
‘equilibrium’ by rate of interest (the price of borrowed money).

No time: every day re-contracting so future never arrives.

But with no future, no finance and investment
(Finance and investment: making a present money commitment in face
of an uncertain future).

New Classical/Monetarist Equilibrium (Lucas) (1970s & 1980s)

Commodity (Ricardian) theory of money (money is unit of account).
Credit = saving.
Money determines price level.
Equilibrium is when expected price level = actual price level
No finance – everyone reasons in real terms (i.e., in terms of actual
commodities that we wish to consume now and in the future).

New Keynesian General Equilibrium (Stiglitz) (1990s)

Under-employment equilibrium because of asymmetric (imperfect)
information
& moral hazard (faced with uncertainty, banks may raise interest rates to
borrowers, attracting only desperate, most risky borrowers).
→ credit rationing (i.e., banking, but no finance) and ‘sticky’ prices.
(New Classical equilibrium with imperfect information)

2. Profits and Money

Where does money come from? Where do profits come

from (in a profit-driven society)?

Classical/neo-classical theory of profits:

Capital produces a surplus (in the form output in excess of

costs of production)

How does this happen?

How does capital create money income?

e.g.,

Economy consists with 100 firms each producing 100

loaves of bread in a given period.

Price of each loaf is £1. (Total output is 10,000 loaves, or

£10,000).

Each firm employs 10 workers, who are paid £5 for their

work in given period.

Total employment = 10 X 100 = 1,000.

Total wages (costs) = 1,000 X £5 = £5,000

Each firm needs to sell at least 50 loaves of bread in each

period to cover its costs.

Each firm has surplus of 50 loaves.

But capitalist firms do not want profits in form of surplus

production (or bread, cars etc.).

They want money profits.

How is surplus production monetised?

In this case, by sale of surplus loaves to capitalists (owners

of firms) who also consume; and to producers of baking

ovens (investment goods), whose workers and owners

cannot eat ovens.

Or, more generally:

Neo-classical political economy derived profit from

difference between sale value (price x volume of output)

and costs (ultimately wage rate x labour employed x

volume of output).

(Profits theory of Sir James Steuart [1712-1780]).

True for individual producer, but not for society as a whole.

Rosa Luxemburg question: capitalists do not want share

of surplus commodities produced, but money.

The solution (from Marx, Luxemburg Kalecki and

Keynes):

Three sectors:

X is value of total output of each sector;

W is wage income of those employed in each sector;

Π is profit income in each sector.

Wage goods: Xw = Ww + Πw

Investment goods: XI = WI + ΠI

Luxury (capitalists’ consumption): Xcc = Wcc + Πcc

If workers do not save, market equilibrium (S = D)

obtained when:

In market for wage goods: Xw = Ww + WI + Wcc

Profits are realised as money when:

Πw + ΠI + Πcc = XI + Xcc

i.e., Kalecki’s Profits equation:

Profits = Investment + Capitalists’ Consumption

More generally, in an open economy with government,

since Total Income = Total Expenditure

Y = C + I + (G – T) + (X – M), where

Y = Total Income;

C = Consumption;
I = Investment in Fixed Capital (not financial investment)

G = Government Expenditure; T = Taxation;

X = Exports; M = Imports.

Y – C = Saving (S) = I + (G – T) + (X – M)

Simplify by assuming no government and no foreign trade;

S=I

Assume 2 classes in society: capitalists and workers who

consume (Cc , Cw) and save (Sc , Sw).

S = I = Sc + Sw

Capitalists income = Profits = Cc + Sc

Since Sc = S – Sw = I – Sw

Profits = I + Cc – Sw (Kalecki Profits equation).

Do profits determine I, Cc etc., or I, Cc etc. determine

profits?
 ‘Capitalists may decide how much to spend, but they

cannot decide how much to earn’ (Kalecki)

Kaldor’s summary of Kalecki: Workers spend what they

earn, capitalists earn what they spend.

3. Theories of Macroeconomic Instability

Equilibrium (Real) Business cycle

Rational individuals adapt their labour supply according to consumption
and saving preferences.
Real (i.e., inflation-adjusted) rate of interest is rate of discount of future
consumption for current consumption,
i.e., how much people will work to save for future consumption:
at higher interest less needs to be saved for a given future
consumption.
Cycle is created by people changing how much they work, in response to
changes in interest rates, wages, technology, prices.
Commodity money, no finance.
Do people really decide how much they work?
Financial accelerator (Bernanke-Gertler)
Business cycle caused by ‘fluctuations in net worth’ (assets minus
liabilities) of ‘agents’:
Asset prices rise and fall with business cycle, but liabilities are
usually fixed in money terms.
→ vulnerability to financial risk & higher interest rates.
Credit money & finance.
But vague on why net worth & liquidity fluctuates.

Monetary Business Cycle

Wicksell, Hawtrey & Austrians (Rothbard)
Money rate of interest, vs. ‘real’ rate of interest (rate of profit or
marginal productivity of capital):
A money rate of interest higher than the profit on new investment
causes firms to stop investing:
A money rate lower than the profit on new investment causes
firms to start investing.
→ fluctuations in investment, relative to saving → business cycles.
Credit view of money & finance.
Financial crises are due to ‘over-investment’ caused by interest rates
being too low
(circular reasoning: How do we know they were too low? Because the
financial crisis happened …; or we can only know retrospectively)

Investment Business Cycle

Wicksell, Kalecki, Keynes, Schumpeter.
Investment cycles dependent upon profits (internal liquidity of firms)
Importance of corporate finance and liquidity.

Ricardian Marxist Business Cycle

Marx, Goodwin.
Inverse relationship between profits and wages → business cycles: in
boom rising wages depress profits → low investment, recession. In
recession, falling wages raise profits → increased investment.
Commodity money, limited finance.

Financial Business cycle

Kalecki, Steindl, Minsky
Credit and finance change nature of capitalism.
Financial obligation (debt) replaces income/consumption/love of money
as motivator of economic activity.
Complex credit view of money & finance.
Cycles driven by credit inflation and deflation.
Rest of course:
How credit money emerged.
How credit money works.
How credit money changed macroeconomic structure and stability.

Allocation of Seminar questions:

Class 1 (31 May a.m.): Organisation of discussions. Allocation of

topics. Questions about readings.

Class 2 (31 May p.m.):

Discuss: The difference between History and Equilibrium.

1) What do economists mean by equilibrium?

2) What is meant by ‘general equilibrium’?
3) Why should an economy exhibit ‘cyclical’ variations?

Class 3 (6 June):
Discuss:
'Gladstone, speaking in a parliamentary debate on Sir Robert Peel's Bank
Act of 1844 and 1845, observed that even love has not turned more men
into fools than has meditation upon the meaning of money. He spoke of
Britons to Britons. The Dutch, on the other hand, who in spite of Petty's
doubts possessed a divine sense for money speculation from time
immemorial, have never lost their senses in speculation about money.'
K. Marx, A Contribution to the Critique of Political Economy, New
York: International Publishers 1970, p.64

1. Explain what is meant by commodity money, paper money, and

credit. What are the differences between them?
2. What are the practical reasons behind monetary innovation that is
the move from commodity money, to paper money, to credit?
3. What role does ‘confidence’ play in credit markets?

Class 4 (7 June):
1. Explain the difference between long-term and short term rates of
interest. Who sets these rates of interest?
2. Why do different securities yield different rates of interest?
3. Explain the difference between the rate of interest on a security,
and its market yield?

Class 5 (16 June a.m.):

1. What is the difference between stocks and shares?
2. What advantage is there in having a stock market (as opposed to
just having banks)?
3. What are ‘bulls’ and ‘bears’ in stock markets?

Class 6 (16 June p.m.):

1. What do central banks do?
2. Explain the ‘lender of last resort’.
3. Why is government debt a problem?

Class 7 (23 June a.m.):

1. What was the ’Treasury’ or deflationist view?
2. What was the Schumpeter or ‘liquidationist’ view?
3. What was the solution urged by Keynes?
 4. What are the main arguments for and against financial regulation?

Class 8 (23 June p.m.): Revision