Fractional-reserve banking

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https://en.wikipedia.org/wiki/Fractional-reserve_banking 

Banking
The old town hall where the Bank of Amsterdam (a full-reserve bank) operated.  Fractional-reserve banking is the system of banking operating in almost all countries worldwide, under which banks that take deposits from the public are required to hold a proportion of their deposit liabilities in liquid assets as a reserve, and are at liberty to lend the remainder to borrowers. Bank reserves are held as cash in the bank or as balances in the bank's account at the central bank. The country's central bank determines the minimum amount that banks must hold in liquid assets, called the "reserve requirement" or "reserve ratio". Most commercial banks hold more than this minimum amount as excess reserves.

Bank deposits are usually of a relatively short-term duration, and may be "at call", while loans made by banks tend to be longer-term, resulting in a risk that customers may at any time collectively wish to withdraw cash out of their accounts in excess of the bank reserves. The reserves only provide liquidity to cover withdrawals within the normal pattern. Banks and the central bank expect that in normal circumstances only a proportion of deposits will be withdrawn at the same time, and that reserves will be sufficient to meet the demand for cash. However, banks may find themselves in a shortfall situation when depositors wish to withdraw more funds than the reserves held by the bank. In that event, the bank experiencing the liquidity shortfall may borrow short-term funds in the interbank lending market from banks with a surplus. In exceptional situations, such as during an unexpected bank run, the central bank may provide funds to cover the short-term shortfall as lender of last resort.

Because banks hold in reserve less than the amount of their deposit liabilities, and because the deposit liabilities are considered money in their own right (see commercial bank money), fractional-reserve banking permits the money supply to grow beyond the amount of the underlying base money originally created by the central bank. In most countries, the central bank (or other monetary policy authority) regulates bank-credit creation, imposing reserve requirements and capital adequacy ratios. This helps ensure that banks remain solvent and have enough funds to meet demand for withdrawals, and can be used to limit the process of money creation in the banking system. However, rather than directly controlling the money supply, central banks usually pursue an interest-rate target to control bank issuance of credit and the rate of inflation.

History

Main article: History of banking

See also: Banknote

Fractional-reserve banking predates the existence of governmental monetary authorities and originated with bankers' realization that generally not all depositors demand payment at the same time. In the past, savers looking to keep their coins and valuables in safekeeping depositories deposited gold and silver at goldsmiths, receiving in exchange a note for their deposit (see Bank of Amsterdam). These notes gained acceptance as a medium of exchange for commercial transactions and thus became an early form of circulating paper money. As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional-reserve banking was born.

If creditors (note holders of gold originally deposited) lost faith in the ability of a bank to pay their notes, however, many would try to redeem their notes at the same time. If, in response, a bank could not raise enough funds by calling in loans or selling bills, the bank would either go into insolvency or default on its notes. Such a situation is called a bank run and caused the demise of many early banks.

These early financial crises led to the creation of central banks. The Swedish Riksbank was the world's first central bank, created in 1668. Many nations followed suit in the late 1600s to establish central banks which were given the legal power to set the reserve requirement, and to specify the form in which such assets (called the monetary base) are required to be held. In order to mitigate the impact of bank failures and financial crises, central banks were also granted the authority to centralize banks' storage of precious metal reserves, thereby facilitating transfer of gold in the event of bank runs, to regulate commercial banks, to impose reserve requirements, and to act as lender-of-last-resort if any bank faced a bank run. The emergence of central banks reduced the risk of bank runs which is inherent in fractional-reserve banking, and it allowed the practice to continue as it does today.

During the twentieth century, the role of the central bank grew to include influencing or managing various macroeconomic policy variables, including measures of inflation, unemployment, and the international balance of payments. In the course of enacting such policy, central banks have from time to time attempted to manage interest rates, reserve requirements, and various measures of the money supply and monetary base.

Regulatory framework

In most legal systems, a bank deposit is not a bailment. In other words, the funds deposited are no longer the property of the customer. The funds become the property of the bank, and the customer in turn receives an asset called a deposit account (a checking or savings account). That deposit account is a liability on the balance sheet of the bank.

Each bank is legally authorized to issue credit up to a specified multiple of its reserves, so reserves available to satisfy payment of deposit liabilities are less than the total amount which the bank is obligated to pay in satisfaction of demand deposits. Largely, fractional-reserve banking functions smoothly, as relatively few depositors demand payment at any given time, and banks maintain enough of a buffer of reserves to cover depositors' cash withdrawals and other demands for funds. However, during a bank run or a generalized financial crisis, demands for withdrawal can exceed the bank's funding buffer, and the bank will be forced to raise additional reserves to avoid defaulting on its obligations. A bank can raise funds from additional borrowings (e.g., by borrowing in the interbank lending market or from the central bank), by selling assets, or by calling in short-term loans. If creditors are afraid that the bank is running out of reserves or is insolvent, they have an incentive to redeem their deposits as soon as possible before other depositors access the remaining reserves. Thus the fear of a bank run can actually precipitate the crisis.

Many of the practices of contemporary bank regulation and central banking—including centralized clearing of payments, central bank lending to member banks, regulatory auditing, and government-administered deposit insurance—are designed to prevent the occurrence of such bank runs.

Economic function

Fractional-reserve banking allows banks to provide credit, which represent immediate liquidity to borrowers. The banks also provide longer-term loans, and act as financial intermediaries for those funds. Less liquid forms of deposit (such as time deposits) or riskier classes of financial assets (such as equities or long-term bonds) may lock up a depositor's wealth for a period of time, making it unavailable for use on demand. This "borrowing short, lending long" or maturity transformation function of fractional-reserve banking is a role that, according to many economists, can be considered to be an important function of the commercial banking system.

The process of fractional-reserve banking expands the money supply of the economy but also increases the risk that a bank cannot meet its depositor withdrawals. Modern central banking allows banks to practice fractional-reserve banking with inter-bank business transactions with a reduced risk of bankruptcy.

Additionally, according to macroeconomic theory, a well-regulated fractional-reserve bank system also benefits the economy by providing regulators with powerful tools for influencing the money supply and interest rates. Many economists believe that these should be adjusted by the government to promote macroeconomic stability.

Money creation process

Main article: Money creation

When a loan is made by the commercial bank, the bank is keeping only a fraction of central bank money as reserves and the money supply expands by the size of the loan. This process is called "deposit multiplication".

The proceeds of most bank loans are not in the form of currency. Banks typically make loans by accepting promissory notes in exchange for credits they make to the borrowers' deposit accounts. Deposits created in this way are sometimes called derivative deposits and are part of the process of creation of money by commercial banks. Issuing loan proceeds in the form of paper currency and current coins is considered to be a weakness in internal control.

The money creation process is also affected by the currency drain ratio (the propensity of the public to hold banknotes rather than deposit them with a commercial bank), and the safety reserve ratio (excess reserves beyond the legal requirement that commercial banks voluntarily hold). Data for "excess" reserves and vault cash are published regularly by the Federal Reserve in the United States.

Just as taking out a new loan expands the money supply, the repayment of bank loans reduces the money supply.

Types of money

There are two types of money created in a fractional-reserve banking system operating with a central bank:

1. Central bank money: money created or adopted by the central bank regardless of its form – precious metals, commodity certificates, banknotes, coins, electronic money loaned to commercial banks, or anything else the central bank chooses as its form of money.
2. Commercial bank money: demand deposits in the commercial banking system; also referred to as "chequebook money", "sight deposits" or simply "credit".

When a deposit of central bank money is made at a commercial bank, the central bank money is removed from circulation and added to the commercial banks' reserves (it is no longer counted as part of M1 money supply). Simultaneously, an equal amount of new commercial bank money is created in the form of bank deposits.

Money multiplier

Main article: Money multiplier

The money multiplier is a heuristic used to demonstrate the maximum amount of broad money that could be created by commercial banks for a given fixed amount of base money and reserve ratio. This theoretical maximum is never reached, because some eligible reserves are held as cash outside of banks. Rather than holding the quantity of base money fixed, central banks have recently pursued an interest rate target to control bank issuance of credit indirectly so the ceiling implied by the money multiplier does not impose a limit on money creation in practice.

Formula

The money multiplier, m, is the inverse of the reserve requirement, R:

${\displaystyle m=\frac{1}{R}}$

Money supply

Components of US money supply (currency, M1, M2, and M3) since 1959. In January 2007, the amount of "central bank money" was $750.5 billion while the amount of "commercial bank money" (in the M2 supply) was $6.33 trillion. M1 is currency plus demand deposits; M2 is M1 plus time deposits, savings deposits, and some money-market funds; and M3 is M2 plus large time deposits and other forms of money. The M3 data ends in 2006 because the federal reserve ceased reporting it.

 

Components of the euro money supply 1998–2007

 

See also: Money supply

In countries with fractional-reserve banking, commercial bank money usually forms the majority of the money supply. The acceptance and value of commercial bank money is based on the fact that it can be exchanged freely at a commercial bank for central bank money.

The actual increase in the money supply through this process may be lower, as (at each step) banks may choose to hold reserves in excess of the statutory minimum, borrowers may let some funds sit idle, and some members of the public may choose to hold cash, and there also may be delays or frictions in the lending process. Government regulations may also limit the money creation process by preventing banks from giving out loans even when the reserve requirements have been fulfilled.

Regulation

Because the nature of fractional-reserve banking involves the possibility of bank runs, central banks have been created throughout the world to address these problems.

Central banks

Main article: Central bank

Government controls and bank regulations related to fractional-reserve banking have generally been used to impose restrictive requirements on note issue and deposit taking on the one hand, and to provide relief from bankruptcy and creditor claims, and/or protect creditors with government funds, when banks defaulted on the other hand. Such measures have included:

1. Minimum required reserve ratios (RRRs)
2. Minimum capital ratios
3. Government bond deposit requirements for note issue
4. 100% Marginal Reserve requirements for note issue, such as the Bank Charter Act 1844 (UK)
5. Sanction on bank defaults and protection from creditors for many months or even years, and
6. Central bank support for distressed banks, and government guarantee funds for notes and deposits, both to counteract bank runs and to protect bank creditors.

Reserve requirements

The currently prevailing view of reserve requirements is that they are intended to prevent banks from:

1. generating too much money by making too many loans against a narrow money deposit base;
2. having a shortage of cash when large deposits are withdrawn (although a legal minimum reserve amount is often established as a regulatory requirement, reserves may be made available on a temporary basis in the event of a crisis or bank run).

In some jurisdictions (such as the European Union), the central bank does not require reserves to be held during the day. Reserve requirements are intended to ensure that the banks have sufficient supplies of highly liquid assets, so that the system operates in an orderly fashion and maintains public confidence.

In other jurisdictions (such as the United States), the central bank does not require reserves to be held at any time – that is, it does not impose reserve requirements.

In addition to reserve requirements, there are other required financial ratios that affect the amount of loans that a bank can fund. The capital requirement ratio is perhaps the most important of these other required ratios. When there are no mandatory reserve requirements, which are considered by some economists to restrict lending, the capital requirement ratio acts to prevent an infinite amount of bank lending.

Liquidity and capital management for a bank

Main articles: Capital requirement and Market liquidity

To avoid defaulting on its obligations, the bank must maintain a minimal reserve ratio that it fixes in accordance with regulations and its liabilities. In practice this means that the bank sets a reserve ratio target and responds when the actual ratio falls below the target. Such response can be, for instance:

1. Selling or redeeming other assets, or securitization of illiquid assets,
2. Restricting investment in new loans,
3. Borrowing funds (whether repayable on demand or at a fixed maturity),
4. Issuing additional capital instruments, or
5. Reducing dividends.

Because different funding options have different costs, and differ in reliability, banks maintain a stock of low cost and reliable sources of liquidity such as:

1. Demand deposits with other banks
2. High quality marketable debt securities
3. Committed lines of credit with other banks

As with reserves, other sources of liquidity are managed with targets.

The ability of the bank to borrow money reliably and economically is crucial, which is why confidence in the bank's creditworthiness is important to its liquidity. This means that the bank needs to maintain adequate capitalisation and to effectively control its exposures to risk in order to continue its operations. If creditors doubt the bank's assets are worth more than its liabilities, all demand creditors have an incentive to demand payment immediately, causing a bank run to occur.

Contemporary bank management methods for liquidity are based on maturity analysis of all the bank's assets and liabilities (off balance sheet exposures may also be included). Assets and liabilities are put into residual contractual maturity buckets such as 'on demand', 'less than 1 month', '2–3 months' etc. These residual contractual maturities may be adjusted to account for expected counterparty behaviour such as early loan repayments due to borrowers refinancing and expected renewals of term deposits to give forecast cash flows. This analysis highlights any large future net outflows of cash and enables the bank to respond before they occur. Scenario analysis may also be conducted, depicting scenarios including stress scenarios such as a bank-specific crisis.

Hypothetical example of a bank balance sheet and financial ratios

An example of fractional-reserve banking, and the calculation of the "reserve ratio" is shown in the balance sheet below:

Example 2: ANZ National Bank Limited Balance Sheet as of 30 September 2017
Assets	NZ$m	Liabilities	NZ$m
Cash	201	Demand deposits	25,482
Balance with Central Bank	2,809	Term deposits and other borrowings	35,231
Other liquid assets	1,797	Due to other financial institutions	3,170
Due from other financial institutions	3,563	Derivative financial instruments	4,924
Trading securities	1,887	Payables and other liabilities	1,351
Derivative financial instruments	4,771	Provisions	165
Available for sale assets	48	Bonds and notes	14,607
Net loans and advances	87,878	Related party funding	2,775
Shares in controlled entities	206	[Subordinated] Loan capital	2,062
Current tax assets	112	Total Liabilities	99,084
Other assets	1,045	Share capital	5,943
Deferred tax assets	11	[Revaluation] Reserves	83
Premises and equipment	232	Retained profits	2,667
Goodwill and other intangibles	3,297	Total Equity	8,703
Total Assets	107,787	Total Liabilities plus Net Worth	107,787

In this example the cash reserves held by the bank is NZ$3,010m (NZ$201m cash + NZ$2,809m balance at Central Bank) and the demand deposits (liabilities) of the bank are NZ$25,482m, for a cash reserve ratio of 11.81%.

Other financial ratios

The key financial ratio used to analyze fractional-reserve banks is the cash reserve ratio, which is the ratio of cash reserves to demand deposits. However, other important financial ratios are also used to analyze the bank's liquidity, financial strength, profitability etc.

For example, the ANZ National Bank Limited balance sheet above gives the following financial ratios:

1. cash reserve ratio is $3,010m/$25,482m, i.e. 11.81%.
2. liquid assets reserve ratio is ($201m + $2,809m + $1,797m)/$25,482m, i.e. 18.86%.
3. equity capital ratio is $8,703m/107,787m, i.e. 8.07%.
4. tangible equity ratio is ($8,703m − $3,297m)/107,787m, i.e. 5.02%
5. total capital ratio is ($8,703m + $2,062m)/$107,787m, i.e. 9.99%.

It is important how the term "reserves" is defined for calculating the reserve ratio, as different definitions give different results. Other important financial ratios may require analysis of disclosures in other parts of the bank's financial statements. In particular, for liquidity risk, disclosures are incorporated into a note to the financial statements that provides maturity analysis of the bank's assets and liabilities and an explanation of how the bank manages its liquidity.

Commentary

Main article: Monetary reform

See also: Full-reserve banking

Instability

In 1935, economist Irving Fisher proposed a system of full-reserve banking, where banks would not lend on demand deposits but would only lend from time deposits. It was proposed as a method of reversing the deflation of the Great Depression, as it would give the central bank (the Federal Reserve in the US) more direct control of the money supply.

Legitimacy

Austrian School economists such as Jesús Huerta de Soto and Murray Rothbard have strongly criticized fractional-reserve banking, calling for it to be outlawed and criminalized. According to them, not only does money creation cause macroeconomic instability (based on the Austrian Business Cycle Theory), but it is a form of embezzlement or financial fraud, legalized only due to the influence of powerful rich bankers on corrupt governments around the world. US Politician Ron Paul has also criticized fractional-reserve banking based on Austrian School arguments.

Descriptions

Adair Turner, former chief financial regulator of the United Kingdom, stated that banks "create credit and money ex nihilo – extending a loan to the borrower and simultaneously crediting the borrower's money account".

Post-Keynesian economics

From Wikipedia, the free encyclopedia

https://en.wikipedia.org/wiki/Post-Keynesian_economics 

Post-Keynesian economics is a school of economic thought with its origins in The General Theory of John Maynard Keynes, with subsequent development influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor, Sidney Weintraub, Paul Davidson, Piero Sraffa and Jan Kregel. Historian Robert Skidelsky argues that the post-Keynesian school has remained closest to the spirit of Keynes' original work. It is a heterodox approach to economics.

Introduction

The term "post-Keynesian" was first used to refer to a distinct school of economic thought by Eichner and Kregel (1975) and by the establishment of the Journal of Post Keynesian Economics in 1978. Prior to 1975, and occasionally in more recent work, post-Keynesian could simply mean economics carried out after 1936, the date of Keynes's General Theory.

Post-Keynesian economists are united in maintaining that Keynes' theory is seriously misrepresented by the two other principal Keynesian schools: neo-Keynesian economics, which was orthodox in the 1950s and 60s, and new Keynesian economics, which together with various strands of neoclassical economics has been dominant in mainstream macroeconomics since the 1980s. Post-Keynesian economics can be seen as an attempt to rebuild economic theory in the light of Keynes' ideas and insights. However, even in the early years, post-Keynesians such as Joan Robinson sought to distance themselves from Keynes, and much current post-Keynesian thought cannot be found in Keynes. Some post-Keynesians took a more progressive view than Keynes himself, with greater emphases on worker-friendly policies and redistribution. Robinson, Paul Davidson and Hyman Minsky emphasized the effects on the economy of practical differences between different types of investments, in contrast to Keynes' more abstract treatment.

The theoretical foundation of post-Keynesian economics is the principle of effective demand, that demand matters in the long as well as the short run, so that a competitive market economy has no natural or automatic tendency towards full employment. Contrary to the views of new Keynesian economists working in the neoclassical tradition, post-Keynesians do not accept that the theoretical basis of the market's failure to provide full employment is rigid or sticky prices or wages. Post-Keynesians typically reject the IS–LM model of John Hicks, which is very influential in neo-Keynesian economics, because they argue endogenous bank lending to be more significant than central banks' money supply for the interest rate.

The contribution of post-Keynesian economics has extended beyond the theory of aggregate employment to theories of income distribution, growth, trade and development in which money demand plays a key role, whereas in neoclassical economics these are determined by the forces of technology, preferences and endowment. In the field of monetary theory, post-Keynesian economists were among the first to emphasise that money supply responds to the demand for bank credit, so that a central bank cannot control the quantity of money, but only manage the interest rate by managing the quantity of monetary reserves.

This view has largely been incorporated into mainstream economics and monetary policy, which now targets the interest rate as an instrument, rather than attempting to accurately control the quantity of money. In the field of finance, Hyman Minsky put forward a theory of financial crisis based on financial fragility, which has received renewed attention.

Main features

In 2009 Marc Lavoie listed the main features of post-Keyenesian economcs:

• Effective demand
• Historical and dynamic time

He also lists 5 auxiliary features:

• The possible negative impact of flexible prices
• The monetary production of the economy
• Fundamental uncertainty
• Relevant and contemporary microeconomics
• Pluralism of theories and methods

Strands

There are a number of strands to post-Keynesian theory with different emphases. Joan Robinson regarded Michał Kalecki's theory of effective demand to be superior to Keynes' theories. Kalecki's theory is based on a class division between workers and capitalists and imperfect competition. Robinson also led the critique of the use of aggregate production functions based on homogeneous capital – the Cambridge capital controversy – winning the argument but not the battle. The writings of Piero Sraffa were a significant influence on the post-Keynesian position in this debate, though Sraffa and his neo-Ricardian followers drew more inspiration from David Ricardo than Keynes. Much of Nicholas Kaldor's work was based on the ideas of increasing returns to scale, path dependence, and the key differences between the primary and industrial sectors.

Paul Davidson follows Keynes closely in placing time and uncertainty at the centre of theory, from which flow the nature of money and of a monetary economy. Monetary circuit theory, originally developed in continental Europe, places particular emphasis on the distinctive role of money as means of payment. Each of these strands continues to see further development by later generations of economists.

Modern Monetary Theory is a relatively recent offshoot influenced by the macroeconomic modelling of Wynne Godley and Hyman Minsky's ideas on the labour market, as well as chartalism and functional finance.

Recent work in post-Keynesian economics has attempted to provide micro-foundations for capacity underutilization as a coordination failure (economics), justifying government intervention in the form of aggregate demand stimulus.

Current work

Journals

Much post-Keynesian research is published in the Review of Keynesian Economics (ROKE), the Journal of Post Keynesian Economics (founded by Sidney Weintraub and Paul Davidson), the Cambridge Journal of Economics, the Review of Political Economy, and the Journal of Economic Issues (JEI).

United Kingdom

There is also a United Kingdom academic association, the Post Keynesian Economics Society (PKES). This was previously called the Post Keynesian Economics Study Group (PKSG) but changed its name in 2018. In the UK, post-Keynesian economists can be found in:

• SOAS University of London
• University of Greenwich
• University of Leeds
• Kingston University
• King's College London, International Political Economy
• Goldsmiths, University of London
• University of the West of England, Bristol
• University of Hertfordshire
• Cambridge University, Land Economy
• Birmingham City University
• University College London, Institute for Innovation and Public Purpose
• Open University
• University of Winchester

United States

In the United States, there are several universities with a post-Keynesian bent:

• The New School, New York City
• The University of Massachusetts Amherst
• The University of Utah, Salt Lake City
• Bucknell University, Lewisburg, Pennsylvania
• Denison University, Granville, Ohio
• Levy Economics Institute at Bard College, Annandale-on-Hudson, New York
• University of Missouri–Kansas City
• University of Denver
• Colorado State University, Fort Collins
• The University of Massachusetts Boston
• John Jay College of Criminal Justice at City University of New York, New York City

Netherlands

• Erasmus University, Rotterdam
• International Institute of Social Studies, The Hague
• University of Groningen, Groningen

France

• Sorbonne Paris North University

Canada

In Canada, post-Keynesians can be found at the University of Ottawa and Laurentian University.

Germany

In Germany, post-Keynesianism is very strong at the Berlin School of Economics and Law and its master's degree course: International Economics [M.A.]. Many German Post-Keynesians are organized in the Forum Macroeconomics and Macroeconomic Policies.

Australia

University of Newcastle

The University of Newcastle in New South Wales, Australia, houses the post-Keynesian think-tank the Centre of Full Employment and Equity (CofFEE).

Disequilibrium macroeconomics

From Wikipedia, the free encyclopedia
https://en.wikipedia.org/wiki/Disequilibrium_macroeconomics

Disequilibrium macroeconomics is a tradition of research centered on the role of disequilibrium in economics. This approach is also known as non-Walrasian theory, equilibrium with rationing, the non-market clearing approach, and non-tâtonnement theory. Early work in the area was done by Don Patinkin, Robert W. Clower, and Axel Leijonhufvud. Their work was formalized into general disequilibrium models, which were very influential in the 1970s. American economists had mostly abandoned these models by the late 1970s, but French economists continued work in the tradition and developed fixprice models.

Macroeconomic disequilibria

In the neoclassical synthesis, equilibrium models were the rule. In these models, rigid wages modeled unemployment at equilibria. These models were challenged by Don Patinkin and later disequilibrium theorists. Patinkin argued that unemployment resulted from disequilibrium. Patinkin, Robert W. Clower, and Axel Leijonhufvud focused on the role of disequilibrium. Clower and Leijonhufvud argued that disequilibrium formed a fundamental part of Keynes's theory and deserved greater attention.

Robert Barro and Herschel Grossman formulated general disequilibrium models, in which individual markets were locked into prices before there was a general equilibrium. These markets produced "false prices" resulting in disequilibrium. Soon after the work of Barro and Grossman, disequilibrium models fell out of favor in the United States and Barro abandoned Keynesianism and adopted new classical, market-clearing hypotheses. However, leading American economists continued work with disequilibrium models, for example Franklin M. Fisher at MIT, Richard E. Quandt at Princeton University, and John Roberts at Stanford University.

Disequilibrium and unemployment

Diagram based on Malinvaud's typology of unemployment shows curves for equilibrium in the goods and labor markets given wage and price levels. Walrasian equilibrium is achieved when both markets are at equilibrium. According to Malinvaud the economy is usually in a state of either Keynesian unemployment, with excess supply of goods and labor, or classical unemployment, with excess supply of labor and excess demand for goods.

While disequilibrium economics had only a supporting role in the US, it had major role in European economics, and indeed a leading role in French-speaking Europe. In France, Jean-Pascal Bénassy (1975) and Yves Younès (1975) studied macroeconomic models with fixed prices. Disequilibrium economics received greater research as mass unemployment returned to Western Europe in the 1970s. Disequilibrium economics also influenced European policy discussions, particularly in France and Belgium. European economists such as Edmond Malinvaud and Jacques Drèze expanded on the disequilibrium tradition and worked to explain price rigidity instead of simply assuming it.

Malinvaud used disequilibrium analysis to develop a theory of unemployment. He argued that disequilibrium in the labor and goods markets could lead to rationing of goods and labor, leading to unemployment. Malinvaud adopted a fixprice framework and argued that pricing would be rigid in modern, industrial prices compared to the relatively flexible pricing systems of raw goods that dominate agricultural economies. In Malinvaud's framework, prices are fixed and only quantities adjust. Malinvaud considers an equilibrium state in classical and Keynesian unemployment as most likely. He pays less attention to the case of repressed inflation and considers underconsumption/unemployment a theoretical curiosity. Work in the neoclassical tradition is confined as a special case of Malinvaud's typology, the Walrasian equilibrium. In Malinvaud's theory, reaching the Walrasian equilibrium case is almost impossible to achieve given the nature of industrial pricing. Malinvaud's work provided different policy prescriptions depending on the state of the economy. Given Keynesian unemployment, fiscal policy could shift both the labor and goods curves upwards leading to higher wages and prices. With this shift, the Walrasian equilibrium would be closer to the actual economic equilibrium. On the other hand, fiscal policy with an economy in the classical unemployment would only make matters worse. A policy leading to higher prices and lower wages would be recommended instead.

"Disequilibrium macroeconometrics" was developed by Drèze's, Henri Sneessens (1981) and Jean-Paul Lambert (1988). A joint paper by Drèze and Sneessens inspired Drèze and Richard Layard to lead the European Unemployment Program, which estimated a common disequilibrium model in ten countries. The results of that successful effort were to inspire policy recommendations in Europe for several years.

Disequilibrium extensions of Arrow–Debreu general equilibrium theory

In Belgium, Jacques Drèze defined equilibria with price rigidities and quantity constraints and studied their properties, extending the Arrow–Debreu model of general equilibrium theory in mathematical economics. Introduced in his 1975 paper, a "Drèze equilibrium" occurs when supply (demand) is constrained only when prices are downward (upward) rigid, whereas a preselected commodity (e.g. money) is never rationed. Existence is proved for arbitrary bounds on prices. A joint paper with Pierre Dehez established the existence of Drèze equilibria with no rationing of the demand side. Stanford's John Roberts studied supply-constrained equilibria at competitive prices; similar results were obtained by Jean-Jacques Herings at Tilburg (1987, 1996). Roberts and Hering proved the existence of a continuum of Drèze equilibria. Then Drèze (113) proved existence of equilibria with arbitrarily severe rationing of supply. Next, in a joint paper with Herings and others (132), the generic existence of a continuum of Pareto-ranked supply-constrained equilibria was established for a standard economy with some fixed prices. The multiplicity of equilibria thus formalises a trade-off between inflation and unemployment, comparable to a Phillips curve. Drèze viewed his approach to macroeconomics as examining the macroeconomic consequences of Arrow–Debreu general equilibrium theory with rationing, an approach complementing the often-announced program of providing microfoundations for macroeconomics.

Specific economic sectors

Credit markets

Main article: Credit rationing

Disequilibrium credit rationing can occur for one of two reasons. In the presence of usury laws, if the equilibrium interest rate on loans is above the legally allowable rate, the market cannot clear and at the maximum allowable rate the quantity of credit demanded will exceed the quantity of credit supplied.

A more subtle source of credit rationing is that higher interest rates can increase the risk of default by the borrower, making the potential lender reluctant to lend at otherwise attractively high interest rates.

Labour markets

Main article: Labour shortage

Main article: Unemployment

Labour markets are prone to particular sources of price rigidity because the item being transacted is people, and laws or social constraints designed to protect those people may hinder market adjustments. Such constraints include restrictions on who or how many people can be laid off and when (which can affect both the number of layoffs and the number of people hired by firms that are concerned by the restrictions), restrictions on the lowering of wages when a firm experiences a decline in the demand for its product, and long-term labor contracts that pre-specify wages.

Spillovers between markets

Main article: Effective demand

Disequilibrium in one market can affect demand or supply in other markets. Specifically, if an economic agent is constrained in one market, his supply or demand in another market may be changed from its unconstrained form, termed the notional demand, into a modified form known as effective demand. If this occurs systematically for a large number of market participants, market outcomes in the latter market for prices and quantities transacted (themselves either equilibrium or disequilibrium outcomes) will be affected.

Examples include:

• If the supply of mortgage credit to potential homebuyers is rationed, this will decrease the demand for newly built houses.
• If labourers cannot supply all the labor they wish to, they will have constrained income and their demand in the goods market will be lower.
• If employers cannot hire all the labor they wish to, they cannot produce as much output as they wish to, and supply in the market for their good will be diminished.

Evolutionary economics

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https://en.wikipedia.org/wiki/Evolutionary_economics 

Evolutionary economics is part of mainstream economics as well as a heterodox school of economic thought that is inspired by evolutionary biology. Much like mainstream economics, it stresses complex interdependencies, competition, growth, structural change, and resource constraints but differs in the approaches which are used to analyze these phenomena.

Evolutionary economics deals with the study of processes that transform economy for firms, institutions, industries, employment, production, trade and growth within, through the actions of diverse agents from experience and interactions, using evolutionary methodology. Evolutionary economics analyzes the unleashing of a process of technological and institutional innovation by generating and testing a diversity of ideas which discover and accumulate more survival value for the costs incurred than competing alternatives. The evidence suggests that it could be adaptive efficiency that defines economic efficiency. Mainstream economic reasoning begins with the postulates of scarcity and rational agents (that is, agents modeled as maximizing their individual welfare), with the "rational choice" for any agent being a straightforward exercise in mathematical optimization. There has been renewed interest in treating economic systems as evolutionary systems in the developing field of Complexity economics.

Evolutionary economics does not take the characteristics of either the objects of choice or of the decision-maker as fixed. Rather, its focus is on the non-equilibrium processes that transform the economy from within and their implications. The processes in turn emerge from actions of diverse agents with bounded rationality who may learn from experience and interactions and whose differences contribute to the change. The subject draws more recently on evolutionary game theory and on the evolutionary methodology of Charles Darwin and the non-equilibrium economics principle of circular and cumulative causation. It is naturalistic in purging earlier notions of economic change as teleological or necessarily improving the human condition.

A different approach is to apply evolutionary psychology principles to economics which is argued to explain problems such as inconsistencies and biases in rational choice theory. Basic economic concepts such as utility may be better viewed as due to preferences that maximized evolutionary fitness in the ancestral environment but not necessarily in the current one.

Predecessors

In the mid-19th century, Karl Marx presented a schema of stages of historical development, by introducing the notion that human nature was not constant and was not determinative of the nature of the social system; on the contrary, he made it a principle that human behavior was a function of the social and economic system in which it occurred.

Marx based his theory of economic development on the premise of developing economic systems; specifically, over the course of history superior economic systems would replace inferior ones. Inferior systems were beset by internal contradictions and inefficiencies that make them impossible to survive over the long term. In Marx's scheme, feudalism was replaced by capitalism, which would eventually be superseded by socialism.

At approximately the same time, Charles Darwin developed a general framework for comprehending any process whereby small, random variations could accumulate and predominate over time into large-scale changes that resulted in the emergence of wholly novel forms ("speciation").

This was followed shortly after by the work of the American pragmatic philosophers (Peirce, James, Dewey) and the founding of two new disciplines, psychology and anthropology, both of which were oriented toward cataloging and developing explanatory frameworks for the variety of behavior patterns (both individual and collective) that were becoming increasingly obvious to all systematic observers. The state of the world converged with the state of the evidence to make almost inevitable the development of a more "modern" framework for the analysis of substantive economic issues.

Veblen (1898)

Thorstein Veblen (1898) coined the term "evolutionary economics" in English. He began his career in the midst of this period of intellectual ferment, and as a young scholar came into direct contact with some of the leading figures of the various movements that were to shape the style and substance of social sciences into the next century and beyond. Veblen saw the need for taking account of cultural variation in his approach; no universal "human nature" could possibly be invoked to explain the variety of norms and behaviors that the new science of anthropology showed to be the rule, rather than the exception. He emphasis zed the conflict between "industrial" and "pecuniary" or ceremonial values and this Veblenian dichotomy was interpreted in the hands of later writers as the "ceremonial/instrumental dichotomy" (Hodgson 2004);

Veblen saw that every culture is materially based and dependent on tools and skills to support the "life process", while at the same time, every culture appeared to have a stratified structure of status ("invidious distinctions") that ran entirely contrary to the imperatives of the "instrumental" (read: "technological") aspects of group life. The "ceremonial" was related to the past, and conformed to and supported the tribal legends; "instrumental" was oriented toward the technological imperative to judge value by the ability to control future consequences. The "Veblenian dichotomy" was a specialized variant of the "instrumental theory of value" due to John Dewey, with whom Veblen was to make contact briefly at the University of Chicago.

Arguably the most important works by Veblen include, but are not restricted to, his most famous works (The Theory of the Leisure Class; The Theory of Business Enterprise), but his monograph Imperial Germany and the Industrial Revolution and the 1898 essay entitled Why is Economics not an Evolutionary Science have both been influential in shaping the research agenda for following generations of social scientists. TOLC and TOBE together constitute an alternative construction on the neoclassical marginalist theories of consumption and production, respectively.

Both are founded on his dichotomy, which is at its core a valuational principle. The ceremonial patterns of activity are not bound to any past, but to one that generated a specific set of advantages and prejudices that underlie the current institutions. "Instrumental" judgments create benefits according to a new criterion, and therefore are inherently subversive. This line of analysis was more fully and explicitly developed by Clarence E. Ayres of the University of Texas at Austin from the 1920s.

Schumpeter

Joseph A. Schumpeter , who lived in the first half of the 20th century, was the author of the book The Theory of Economic Development (1911, transl. 1934). It is important to note that for the word development he used in his native language, the German word "Entwicklung", which can be translated as development or evolution. The translators of the day used the word "development" from the French "développement", as opposed to "evolution" as this was used by Darwin. (Schumpeter, in his later writings in English as a professor at Harvard, used the word "evolution".) The current term in common use is economic development.

In Schumpeter's book, he proposed an idea radical for its time: the evolutionary perspective. He based his theory on the assumption of usual macroeconomic equilibrium, which is something like "the normal mode of economic affairs". This equilibrium is being perpetually destroyed by entrepreneurs who try to introduce innovations. A successful introduction of an innovation (i.e. a disruptive technology) disturbs the normal flow of economic life, because it forces some of the already existing technologies and means of production to lose their positions within the economy. His vision and economics inspired many economists who wanted to study how the economy develops and lead to a now powerful International Joseph A. Schumpeter Society.

Later development

A seminal article by Armen Alchian (1950) argued for adaptive success of firms faced with uncertainty and incomplete information replacing profit maximization as an appropriate modeling assumption. Milton Friedman proposed that markets act as major selection vehicles. As firms compete, unsuccessful rivals fail to capture an appropriate market shar e, go bankrupt and have to exit. The variety of competing firms is both in their products and practices, that are matched against markets. Both products and practices are determined by routines that firms use: standardized patterns of actions implemented constantly. By imitating these routines, firms propagate them and thus establish inheritance of successful practices. Kenneth Boulding was one of the advocates of the evolutionary methods in social science, as is evident from Kenneth Boulding's Evolutionary Perspective. Kenneth Arrow, Ronald Coase and Douglass North are some of the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel winners who are known for their sympathy to the field.

More narrowly the works Jack Downie and Edith Penrose offer many insights for those thinking about evolution at the level of the firm in an industry.

Nelson and Winter (1982) and after

Richard R. Nelson and Sidney G. Winter's book An Evolutionary Theory of Economic Change (1982, Paperback 1985) was a real seminal work that marked a renaissance of evolutionary economics. It lead to the dissemination of the evolutionary ideas among wide strands of economists and was followed by foundations of International Joseph A. Schumpeter Society, European Association for Evolutionary Political Economy, Japan Association for Evolutionary Economics, and Korean Society for Innovation Management and Economics.

Nelson and Winter have focused mostly on the issue of changes in technology and routines, suggesting a framework for their analysis. Evolution and change must be distinguished. Prices and quantities constantly change but it is not an evolution. For an evolution takes place, there must be something that evolves. Their approach can be compared and contrasted with the population ecology or organizational ecology approach in sociology: see Douma & Schreuder (2013, chapter 11). More recently, Nelson, Dosi, Pyka, Malerba, Winter and other scholars have been proposing an update of the state-of-art in evolutionary economics.

Evolution and change must be distinguished. Prices, quantities and GDPs constantly change through time but they are not evolution. Pier P. Saviotti pointed out as key concepts of evolution three ideas: variation, selection, and reproduction. The concept of reproduction is often replaced by replication or retention. Retention is preferred in evolutionary organization theory. Other related concepts are fitness, adaptation, population, interactions, and environment. Each item is related to selection, learning, population dynamics, economic transactions, and boundary conditions. Nelson and Winter raised two major examples of evolving entities: technologies and organizational routines. Yoshinori Shiozawa listed four entities that evolve: economic behaviors, commodities, technologies, and institutions. Then, mechanisms that provide selection, generate variation and establish self-replication, must be identified. A general theory of this evolutionary process has been proposed by Kurt Dopfer, John Foster and Jason Potts as the micro meso macro framework.

If the change occurs constantly in the economy, then some kind of evolutionary process must be in action, and there has been a proposal that this process is Darwinian in nature. Other economists claimed that evolution of human behaviors can be Lamarckian.

Evolutionary economics had developed and ramified into various fields or topics. They include technology and economic growth, institutional economics, organization studies, innovation study, management, and policy, and criticism of mainstream economics.

Economic processes, as part of life processes, are intrinsically evolutionary. From the evolutionary equation that describe life processes, an analytical formula on the main factors of economic processes, such as fixed cost and variable cost, can be derived. The economic return, or competitiveness, of economic entities of different characteristics under different kinds of environment can be calculated. The change of environment causes the change of competitiveness of different economic entities and systems. This is the process of evolution of economic systems.

In recent years, evolutionary models have been used to assist decision making in applied settings and find solutions to problems such as optimal product design and service portfolio diversification.

Why does evolution matter in economics

Evolutionary economics emerged from dissatisfaction of mainstream (neoclassical) economics. Mainstream economics mainly assumes agents that optimize their objective functions, such as utility function for consumers and profit for firms. Optimization under budget constraint has a solution if the function is continuous and the prices are positive. However, when the number of goods is large, it is often difficult to obtain the bundles of goods that maximize the utility. This is the question of bounded rationality. Herbert A. Simon once stated in Administrative Behavior that whole contents of management science can be reduced to two lines. The same contentions apply to the economics. Most of economics behaviors except deliberated plans are routines which follows satisficing principle. Evolutionary economics is conceived as an economics of large complex system.

Evolutionary psychology

See also: Behavioral economics and Neuroeconomics

A different approach is to apply evolutionary psychology principles to economics which is argued to explain problems such as inconsistencies and biases in rational choice theory. A basic economic concept such as utility may be better explained in terms of a set of biological preferences that maximized evolutionary fitness in the ancestral environment but not necessarily in the current one. In other words, the preferences for actions/decisions that promise "utility" (e.g. reaching for a piece of cake) were formed in the ancestral environment because of the adaptive advantages of such decisions (e.g. maximizing calorie intake). Loss aversion may be explained as being rational when living at subsistence level where a reduction of resources may have meant death and it thus may have been rational to place a greater value on losses than on gains.

People are sometimes more cooperative and altruistic than predicted by economic theory which may be explained by mechanisms such as reciprocal altruism and group selection for cooperative behavior. An evolutionary approach may also explain differences between groups such as males being less risk-averse than females since males have more variable reproductive success than females. While unsuccessful risk-seeking may limit reproductive success for both sexes, males may potentially increase their reproductive success much more than females from successful risk-seeking. Frequency-dependent selection may explain why people differ in characteristics such as cooperative behavior with cheating becoming an increasingly less successful strategy as the numbers of cheaters increase.

Economic theory is at present characterized by strong disagreements on which is the correct theory of value, distribution and growth. This also influences the attempts to find evolutionary explanations for modern tastes and preferences. For example an acceptance of the neoclassical theory of value and distribution lies behind the argument that humans have a poor intuitive grasp of the economics of the current environment which is very different from the ancestral environment. The argument is that ancestral environment likely had relatively little trade, division of labor, and capital goods. Technological change was very slow, wealth differences were much smaller, and possession of many available resources were likely zero-sum games where large inequalities were caused by various forms of exploitation. Humans, therefore, may have poor intuitive understanding of the benefits of free trade (causing calls for protectionism), the value of capital goods (making the labor theory of value appealing), and may intuitively undervalue the benefits of technological development. The same acceptance of the neoclassical thesis that demand for labour is a decreasing function of the real wage and that income differences reflect different marginal productivities of individual contributions (in labour or savings) lies behind the argument that persistence of pre-capitalist model of thinking may explain a tendency to see the number of available jobs as a zero-sum game with the total number of jobs being fixed which causes people to not realize that minimum wage laws reduce the number of jobs or to believe that an increased number of jobs in other nations necessarily decreases the number of jobs in their own nation, as well as a tendency to view large income inequality as due to exploitation rather than as due to individual differences in productivity. This, it is accordingly argued, may easily cause poor economic policies, especially since individual voters have few incentives to make the effort of studying societal economics instead of relying on their intuitions since an individual's vote counts for so little and since politicians may be reluctant to take a stand against intuitive views that are incorrect but widely held. Most non-neoclassical schools of thought would not judge calls for protectionism necessarily mistaken nor would agree that minimum wage laws reduce the number of jobs nor would reject the basic intuition imperfectly expressed by the labour theory of value and now more rigorously argued by modern Marxian-Sraffian theory (namely, that exploitation is present under capitalism too), and therefore would judge this specific evolutionary argument strictly to depend on a questionable theory of the working of market economies.

Evolution after Unified Growth Theory

Main article: Unified growth theory

The role of evolutionary forces in the process of economic development over the course of human history has been explored in the past few decades. Oded Galor and Omer Moav advanced the hypothesis that evolutionary forces had a significant role in the transition of the world economy from stagnation to growth, highlighting the persistent effects that historical and prehistorical conditions have had on the evolution of the composition of human characteristics during the development process.

Galor and Moav argued that the Malthusian pressure determined the size and the composition of the human population. Lineages whose traits were complementary to the economic environment had higher income, and therefore higher reproductive success, and the inevitable propagation of these traits fostered the growth process and ultimately contributed to the take-off from an epoch of stagnation to the modern era of sustained growth.

Evolution of predisposition towards child quality

Galor and Moav hypothesize that during the Malthusian epoch, natural selection has amplified the prevalence of traits associated with predispositions towards the child quality in the human population, triggering human capital formation, technological progress, the onset of the demographic transition, and the emergence of  sustained economic growth.

The testable predictions of this evolutionary theory and its underlying mechanisms have been confirmed empirically and quantitatively. Specifically, the genealogical record of half a million people in Quebec during the period 1608-1800, suggests that moderate fecundity, and hence tendency towards investment in child quality, was beneficial for long-run reproductive success. This finding reflect the adverse effect of higher fecundity on marital age of children, their level of education, and the likelihood that they will survive to a reproductive age.

Evolution of time preference

Oded Galor and Omer Ozak examine the evolution of time preference in the course of human history. They hypothesize and establish empirically that agricultural characteristics that were favorable to higher return to agricultural investment in the Malthusian era triggered a process of selection, adaptation, and learning that increase the prevalence of long-term orientation among individuals in society. They further establish the variations in these agricultural characteristics across the globe are associated with contemporary differences in economic and human behavior such as technological adoption, education, saving, and smoking.

Evolution of loss aversion

Oded Galor and Viacheslav Savitskiy explore the evolutionary foundation of the phenomenon of loss aversion. They theorize and confirm empirically that the evolution of loss aversion reflects an evolutionary process in which humans have gradually adapted the climatic shocks and their asymmetric effects on reproductive success in a period in which the available resource was very close to the subsistence consumption. In particular, they establish that individuals and ethnic groups that descended from regions that are characterized by greater climatic volatility tend to be loss-neutral, whereas those originated in regions in which climatic conditions are more spatially correlated, tend to be more loss averse.

Evolution of risk aversion

Oded Galor and Stelios Michalopoulos examine the coevolution of entrepreneurial spirit and the process of long-run economic development. Specifically, they argue that in the early stages of development, risk-tolerant entrepreneurial traits generated an evolutionary advantage, and the rise in the prevalence of this trait amplified the pace of the growth process. However, in advanced stages of development, risk-aversion gained an evolutionary advantage, and contributed to convergence across countries.