Imagine the following question on a PhD comprehensive exam:
"Using a macroeconomic model with monopolistically competitive firms, explain how an increase in the expected future price level will cause an increase in the current price level. Also explain whether there is an effect on real output.
Your answer must use words only, with no diagrams or equations. Be very precise about all the mechanisms that would be involved in this interdependent system of simultaneous causation. Your answer must assume no previous knowledge of economic theory or familiarity with economic concepts on the part of the reader. Try to make your answer as realistic as possible, using 10 real-world goods as examples. These should be goods that a homeowner with liquid domestic currency assets living in Sao Paulo Brazil in 1979 might want to buy in response to an increase in the expected future price level. Any transactions in your explanation must be shown to be consistent with double-entry bookkeeping. Please write clearly.
You have 2 hours to answer this question.
Your answer will be graded by a committee composed of: an accountant; a businessman; a Russian day-trader; an economics professor; and anyone else who happens to wander by. You must satisfy all these examiners in order to pass the exam, including follow-up questions in the oral.
Your answer, and the comments of your examiners, will be a permanent part of the public record."
I was foolish enough to try something like this (though I cheated a lot). (Sorry Winterspeak, but when I thought about what I was trying to do, it did seem rather funny, and I couldn't resist posting this, though the joke's really on me.)
Worthwhile Canadian Initiative 
RSJ,
“Under any accounting system, income statements will not aggregate if the entities are allowed to transact with each other.”
This is not correct.
Income for firms is revenue minus expenses.
Income for households is the same as “revenue”.
This difference in treatment is essential to logical micro/macro accounting structure.
It is what allows consistent aggregation, and it is what “allows” entities to transact with each other while keeping the overall logic of the accounting system coherent.
It is basic accounting 101. And it is essential.
(And this is a separate aggregation issue from “marked to market”, or including capital gains in income.)
Nick,
Your Friedman calculation is not intuitive to me, to the point where I’m lost. Sorry.
RSJ: Life is a lot easier if we use an accounting system where things do aggregate up.
Value added by a firm is not the same as the profits earned by the firm. It measures the incomes generated at that firm, including, for example, the income of the workers at the firm. Value added is the sales of a firm, minus its purchases from other firms. So when we add up the value added at every firm, we get final sales in the whole economy, and don’t double count by including sales of intermediate goods.
If we wanted to measure final sales in the economy as a whole, we could add up only the final sales at each firm, excluding sales it makes to other firms. But this is hard, because firms might not know whether a sale was to another firm. So instead we add up the value added by every firm.
anon: if you are studying economics (correct?) you really ought to learn about Milton Friedman’s Permanent Income Hypothesis. It’s important part of economics, quite apart from any accounting stuff. Google it. See what you find.
This thread is beginning to confirm my suspicion that economists actually spend too much time on accounting. I can only remember reading one economics paper where the results were wrong because there was a mistake in the accounting. Marty Weitzmann’s paper on Macro with Increasing Returns, about 20 years ago, left out profits from household income, and got some really weird results just because of that mistake.
“Income for firms is revenue minus expenses.”
No, that is savings, or net income for a firm.
Income is revenue. I don’t want to get into disputations about operating versus extraordinary items. That is specific to a certain systems, which isn’t important here.
In all accounting systems, the difference between income and consumption is savings, which is the change in net worth of the entity as recorded on the balance sheet statement. That is your “canonical” accounting system.
The issue is not household versus firm, it is the production unit. This applies to any production unit.
NIck,
re: value add — yes, sorry, I was thinking of economic value add, not gross value add. Too many words, in part because these topics are so important.
Life would be easier if A*B = A+B, but that’s only true when all your numbers are zero.
So do we pretend that incomes aggregate (so that our results only apply to autarky) or do we deal with the fact that economic actors do not spend out of their “value add” but out of their income?
There is no euler equation in which you optimize what portion of your “value add” you want to consume and what portion you want to spend. I don’t see how trying to re-define the investment/consumption decision in terms of value add is feasible.
This might be a helpful way to think about this — and it avoids entirely the use of any accounting term at all (except one):
When you consolidate balance sheets and income statements, this has the effect of removing all the financial transactions that occur between the units you are consolidating.
So a firm buys it’s iron supplier, and now it makes it’s own iron. It buys it’s power supplier, and now it makes it’s own power. The only financial transactions remaining are for the stuff that the firm needs but can’t make itself.
So the accounting boundary can be viewed as the “autarky” boundary.
In the limit when all production units are consolidated, you have complete autarky.
But if you want a monetary model, then you can’t assume autarky. Incomes do not aggregate — not even for the “representative” actor. To assume that they do is to disallow monetary transactions.
And I think this failure of aggregation is the difference between a monetary economy and autarky.
RSJ: “And I think this failure of aggregation is the difference between a monetary economy and autarky.”
Now, that is a useful point. Or nearly so. It just needs re-stating a little.
We want a definition of “income” that won’t be affected by how the accountant/economist measuring income does the aggregation. “Value added” meets that criterion.
But if we are talking about things like the (flow) volume of monetary transactions, and the (stock) demand for money, in a monetary exchange economy, (which are quite different from income), then we do not want our measures to be unaffected by aggregation. If the economy really were just one big firm, it probably wouldn’t use money at all (and even if it did, it would use a lot less).
There’s income. And there’s monetary transactions. Totally different things.
RSJ: from your wikipedia link: “For firms, income generally refers to net-profit: what remains of revenue after expenses have been subtracted.” Net income means after taxes.
RSJ/Anon:
I don’t see why you keep inventing your own definitions of income (e.g. income == revenue).
I gave a typical example of income statement breakdown earlier.
Any accountant knows that there is no abstract “income”, What they operate with is “net income” == revenue – expenses -depreciation -taxes. Revenue includes sales/services/interest income/investment income. There is just no generic income in the accounting world.
Anon: Income for households is the same as “revenue”.
That cannot be true, accounting 101 notwithstanding.
Net income for households is determined in the same way as for firms. Why should it be otherwise ? With your definition delta net-worth is no longer equal to net income (minus possible dividends in the case of the firm). Such redefinition (household income == household revenue) goes against the centuries of established accounting practices.
Now, I understand why economists may want to define their own notion of income, but, then, they should not be appealing to the established accounting practices authority.
RSJ,
LOL!
The Wiki reference you gave agrees 100 per cent with my view:
“However, for households and individuals, income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings received… in a given period of time. For firms, income generally refers to net-profit: what remains of revenue after expenses have been subtracted.”
Oh the humanity! Oh the erudition!
vjk,
As per above, income for households is “top-line” income, before any household expenses. It is analogous to the firm revenue line.
Income for firms is “bottom-line”, after deducting expenses from revenue.
I used the term “revenue” in relation to households only as the analogous accounting line to the revenue line of the firm. The term “revenue” is not used for households in normal usage, as it represents the self-same accounting line that is defined as household income.
Nick,
The economics profession has been a complete failure in its efforts to understand the financial crisis.
It continues to search for a description of reality that fits its theories, rather than a theory that fits the reality.
If somebody comes up with some sensible intuition about Friedman’s theory, I’ll be interested. Until then, there’s no great urgency to discover something that is likely useless in any sense of its application to real world problems.
Nick,
“There’s income. And there’s monetary transactions. Totally different things.”
Income can be — depending on the accounting system used — a non-cash item because there are imputations that may not be reflected in cash transactions.
But those imputations aren’t central, and we can construct accounting systems in which they aren’t made. It’s really a question of bad aggregation.
In NIA, “savings” is the increase in the capital stock.
But from the point of view of the decision maker, savings is the time shifting of consumption.
It is the ability to consume without producing. Buying a factory, in an of itself, doesn’t achieve this.
The amount of consumption that the household successfully time shifts is dependent on the resale value of the good. And here, any long lived good will do. A factory, a coin, land that produces nothing, etc.
So there is a fundamental difference between what savings means to the individual decision maker and the economy-wide accounting of savings as investment. Trying to redefine the accounting system can’t work. You will never get equality between individual savings and economy-wide savings.
To equate the two at all times requires a set of rational asset valuation assumptions, which are implausible.
There is no fundamental law that the decision maker’s savings — successful deferral of consumption — is the same as the economy-wide accounting of savings — investment.
Equality between the two is a happy accident.
You can argue, over the long run, that they average out. But you have 20 year bull and bear cycles, so maybe you have equality over 40 year time periods. Maybe. But you don’t have equality in each period.
It is not true, in each period that the sum of household savings is equal to national savings. Therefore it is not true that just because the bond markets clear, that household savings demands are being met.
If expectations of the future resale value are falling, then you can have excess savings demands that are not being met independent of any demand to hold money balances. This has little to do with a desire to hold a stock money. That’s only relevant in that households care about future resale value — C/P, so obviously they care about M/P. But they care about any asset/P just as much as they care about M/P.
If Assets/P are plunging, then this means that households are failing to defer consumption and have unmet savings demands regardless of what is happening in the bond markets.
You cannot assume that bond market clearing is the same as Assets/P being at their desired level. Everyone can want the asset prices to go up, but if they don’t believe that asset prices will go up, then they wont go up. And that means that borrowing will decrease, even though everyone in the economy wants someone else to borrow, and drive their own asset prices back up.
Anon,
“I used the term “revenue” in relation to households only as the analogous accounting line to the revenue line of the firm. ”
Yes, and I was primarily discussing the euler equation of households here. So there are different accounting conventions used for both, and you can pick which term you want to apply to both. Why is your choice “correct” and mine not? Seriously, are you ever interested in engaging in a discussion or is it always about being cantankerous and scoring points. What is your problem?
Anon:
“The term “revenue” is not used for households in normal usage”
That’s because there is, typically, no “normal usage” for household accounting. With few exceptions, one is concerned with household accounting only during the tax period. Hence, confusing and inconsistent terminology.
Now, assuming one wanted to do some household accounting, why would one invent and use a confusingly close but yet different vocabulary ? Why would one not use established financial accounting terminology ? How can one profess respect for accounting rules and immediately abandon some very basic accounting terms ?
For example, as I wrote earlier, if you abandon the notion of “net income” for households, you lose the name for household net worth growth expressed as a difference between the last fiscal period net worth and the current period net worth. Also, intentionally or unintentionally, you ignore, or at least de-emphasize, various kinds of household expenses by concentrating on some generic “income”.
This kind of terminological confusion surely cannot be helpful in conducting a meaningful discussion. At least, the terms have to be clearly defined if they differ from the accepted financial accounting usage.
RSJ,
“For example, as I wrote earlier, if you abandon the notion of “net income” for households, you lose the name for household net worth growth expressed as a difference between the last fiscal period net worth and the current period net worth.”
Not at all.
Household income is allocated to consumption and saving (and taxes).
The name for the addition to net worth is saving.
Prior period net worth plus saving, marked to market at the end of the period, becomes end of period net worth. It’s fairly simple.
RSJ, you seem prone to tantrums. You should take it easy. That comment you responded to at 6:54 wasn’t even addressed to you. BTW, I estimate I disagree totally with about 75 per cent of everything you write, but I don’t make a huge tantrum deal about it. That’s just the way it is. It’s internet democracy. And if you believe your role and destiny are to instruct everybody else that your view must be right, you are truly delusional. You have to approach the art of persuasion with a little less hubris and a little more humility.
sorry, the first part of 7:47 should have been addressed to vjk
VJK,
The issue is that an economy contains households, firms, government, and the foreign sector. Not to mention banks.
And you need one consistent accounting system to describe all of the above. Tax accounting, reserve accounting, BoP accounting and GAAP all have different conventions.
One approach is to just use different terms based on which pairwise transactions you are describing when the point of view is clear.
But that’s not very useful, particularly when you need to talk about transactions between different groups.
I have no problem with just using revenues and expenditures (firm based), and household savings are called “earnings” instead of savings, or perhaps “net income”. You can’t help but offend someone.
But in macro the central actor is the household, as the household is the ultimate owner of all assets and in most nations (e.g. not china), all savings are realized by households, rather than retained by firms or governments. So the trifecta of income-consumption = savings is the one I generally use, and I think this is a reasonable choice.
And I’m sure in the last statement, I will have offended someone working with government finances when I said that running surpluses is equivalent to “retaining” savings 🙂 Or someone else will launch some diatribe saying that households cannot earn profits. Etc.
Seriously, in just a simple accounting system, you have 3 variables for the statement of incomes and 3 variables for your balance sheet.
That’s 6 different words. No reason to have 40 words.
My preferred set of words are assets, liabilities, net worth/income, consumption, and savings.
There is no reason to make this more complicated than it is, even if you have to be talk about a firm “consuming” intermediate inputs or “consuming” capital in the course of production in order to obtain savings that add to the income of the firm’s owners.
I’d rather have a simple system with 6 words, particularly when looking at a model.
Anon,
Right. You don’t like my tone, and the you think I am a less effective communicator. And you think it’s your place to give unasked for advice about these meta issues to strangers by insulting them.
How does that explain your own tone? Why are you here, if not to make economic arguments? Even one would be nice, and if you make enough, then you wouldn’t be just a discord generator; you would be adding value to the discussion instead of subtracting it.