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I reverse the right to be wrong. Yes I did spell it that way. Help me...

The national economy... the global economy. Hmmm. Economics is the study of production and exchange between people against the background of scarcity of resources and scarcity of time. But even so, does that really require that we personify the sum of all the economic actions taking place within a geographical area over a period of time?

Is the 'economy' we get out of this any more real than taking two random surveys of people to see who believes in fairies, then comparing the two and deciding whether belief in fairies is increasing or decreasing? Who's to say... well, besides Carl Menger, Ludwig von Mises, Friedrich Hayek, Murray Rothbard and so on.


Measuring an economy as an entity in its own right is a practice which found mainstream favour in the 20th Century, especially with the 1936 publication of John Maynard Keynes' General Theory of Employment, Interest and Money. We call this Macroeconomics.

And what would a Macroeconomist wanna measure? Why, gross domestic product of course!

GDP is the sum of all the new production and trade within a national economy, measured either as income or expenditure (I'm using the expenditure model), and in order to represent all the important stuff is actually expressed as an equation like so;

Y = C + I + G + (X - M)

or as the following diagram
The red arrows show where money flows.

In that there diagram we see Households paying Firms for goods and services on the outer left side, and wages, rents and profits flowing right back on the outer right side.

The inner arrows show investment of primary factors by Households in Firms and the material flow of further primary factors of production back to households. This is the production side of the economy, as opposed to the exchange or consumption side, which is the outer arrows.

NB: I'm not wasting my time or yours with the maths of GDP calculation partly because I can't remember it, and partly because it's so patently useless to anyone who doesn't want to work at the IMF, World Bank or World Trade Organisation.


Neoclassical economics, that is to say the mainstream in economics today, posits a particular theory about money under today's banking regime, that of five categories of money. And that pretty much means five different types of money, for those who monitor this type of thing to figure out what's available to whom. Oh and they all have codenames...

The Financial Times elucidates what they are far better than I can. I quoteth;

M0 and M1, also called narrow money, normally include coins and notes in circulation and other money equivalents that are easily convertible into cash. 
M2 includes M1 plus short-term time deposits in banks and 24-hour money market funds. 
M3 includes M2 plus longer-term time deposits and money market funds with more than 24-hour maturity. The exact definitions of the three measures depend on the country. 
M4 includes M3 plus other deposits. The term broad money is used to describe M2, M3 or M4, depending on the local practice.
Yeah, pretty elusive stuff.


So, on to the Old Lady of Threadneedle Street, and my, what a selection of skeletons we find in here! The system that allows the money supply to work as shown above is called fractional reserve banking. The central bank is the main regulator of the financial system and controls the money supply by adjusting the reserve requirement (see diagram below).

This shows what money supply expansions different reserve requirements lead to.

The United States currently has a reserve ratio in law of 10%, and the UK? Merely 3% here in Blighty. This means the UK money supply expansion is off the scale of the diagram above. Now it has to be said that the mechanism of money supply expansion is not usually well-explained.

The Bank of England released a paper demonstrating that fractional reserve banking creates money as it is lent on by private banks, thus invalidating the maths of the money multiplier theory above, but whatevs. I didn't go into the mathematical formulas of the theory anyway, precisely because it's bunk, like pretty much all algebra and calculus in economics.

On the next Ecomony Blogtime; fish-sticks and creme brulee abound as Matt inherits a solid gold house!


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