Dynamic Economics vs Static Economics
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Our Far-from-equilibrium Macro Economic Theory (FFEE) is a unique theory. Before you read our Sky Blue Monthly, we strongly advise you to read the basic ideas of FFEE presented in this paper. This will help you understand Sky Blue Monthly. The purpose of this paper is to clarify the logic behind each issue of Sky Blue Monthly.
We chose the name FFEE because of the inspiration by Ilya Prigogine and his contributions to far-from-equilibrium thermodynamics. For more information about Ilya Prigogine, go to: http://www.nobel.se/laureates/chemistry-1977-1-autobio.html Although our FFEE borrows a lot of concepts from Mathematics and Physics, FFEE is not originated from far-from-equilibrium thermodynamics.
The concepts of set, function, equivalence relation and the real number system are some of the most basic ideas in Mathematics. The one that we want to discuss is the concept of "equivalence relation" because it is essential to our FFEE.
A relation is an equivalence relation if and only if it is reflexive, symmetric and transitive. You may ask, "What are "reflexive", "symmetric" and "transitive"? What do they mean? "
A relation is reflexive if and only if x --> x for every x. The symbol "x" can be any event. However, only a few events are able to feedback on itself. Examples are "interest", "panic selling", "run on bank", "margin call", … etc. If a person is heavily in debt, he is unable to pay credit card bills on time and pile up interest charges. Unpaid interest will bring more interest charges. With compound interest, the interest is found by calculating the interest on all past interest as well as on the original principal. Hence, "interest" --> "interest". Panic selling is another good example. During a stock market crash, when the panic starts, it will soon become a one-way street because panic selling induces more panic selling, and then the market drops like a rock. Hence, "panic selling" --> "panic selling". A run on a bank is similar. Once the run occurs, it is almost impossible to stop without outside help mainly because "run on bank" is reflexive. "Margin call" is similar. If a large speculator has 600 short positions in coffee, suddenly, a frost wipes out a significant amount of Brazil's coffee crop, then coffee price rockets up. The speculator faces margin calls. He gets out 250 of his short positions to meet the margin calls and still intends to hold the rest because of "hope". The fact that he is covering causes coffee to go up even more. As a result, he faces margin calls again in the rest of his positions. He is forced to liquidate the remaining 350 short positions. Forced liquidation is reflexive. (We start to think about cash redemption in mutual fund industry. Oh, don't! We shall not think about this. It is a sin!)
A relation is symmetric if and only if x --> y implies y --> x. The symbols "x" and "y" are 2 different events. This is commonly known as "vicious cycle" or "benign cycle". For example, currency appreciation attracts capital inflow; and capital inflow causes further currency appreciation; and then further currency appreciation attracts even more capital inflow. Both of them are "cause"; and both of them are "effect". "Currency appreciation --> Capital inflow" implies "Capital inflow --> Currency appreciation". And "Capital inflow --> Currency appreciation" implies "Currency appreciation --> Capital inflow". Give you another example: Low inflation rate causes currency appreciation; then currency appreciation causes lower import price; lower import price means lower inflation rate; lower inflation rate will cause further currency appreciation; further currency appreciation will cause even lower inflation rate….
A relation is transitive if and only if x --> y and y --> z implies x --> z. Here, x, y, z are 3 different events. All relations in economics are transitive. If a government who cannot balance the book decides to increase public spending, then it will increase budget deficit, and larger budget deficit will add to the total national debt outstanding. In short, the decision to increase public spending will result in higher national debt. "Increase in public spending --> Larger budget deficit" and "Larger budget deficit --> Higher national debt" implies "Increase in public spending --> Higher national debt".
Any relation that is reflexive and/or symmetric is a dynamic relation (dynamic factor). Any non-reflexive and non-symmetric relation is a static relation (static factor). All relations in economics are transitive. Any economic theory that involves reflexive relation and/or symmetric relation is a Dynamic Economic Theory and is part of Dynamic Economics. Our FFEE is one of the theories in the world of Dynamic Economics. Any economic theory that contains neither reflexive relation nor symmetric relation is a Static Economic Theory and is part of Static Economics. Any Dynamic Economic Theory must contain at least one reflexive relation or symmetric relation. Any Static Economic Theory must contain no reflexive relation and no symmetric relation. All the economic theories that can be found in college textbooks are Static Economic Theories. We call these textbook theories Traditional Economic Theories (Academic Economic Theories).
US Dollar rose briskly from 1981 to 1984. During the same time period, US trade deficit increased enormously. From any university economic textbook, we find: trade deficit is bad for the currency. Thus, US Dollar should have depreciated. But, it did exactly the opposite! Why? Explanation: Currency value is decided by several factors: some are static factors (cause-effect), some are dynamic factors (reflexive and/or symmetric). Capital flow is dynamic while trade deficit is static. If dynamic factors are absent, we take static factors. If dynamic factors are present, forget about static factors.
From 1981 to 1984, there was a massive capital inflow into the US because of Reagan's policies. (Marginal tax rate was lowered, red tapes were cut, and the businesses were welcomed.) Since capital inflow (a dynamic factor) was present, we should ignore the trade deficit (a static factor). Capital inflow caused currency appreciation, so USD was rising even if trade deficit was horrible. Current situation (Dec. 1999) is similar. Capital inflow from foreign nations into the US stock market is present, so massive current account deficit can be ignored in the analysis of USD. If capital inflow (a dynamic factor) no longer floods the US, we must focus on current account deficit (a static factor). The dynamic factor (capital inflow) helps support USD; if it ceases to exist, USD will be under pressure.
Therefore, academic macro economic theory is not wrong, but it applies only under a special condition, i.e. without the presence of dynamic factors. We believe that the economic theories taught in college are special theories, not general theories. The motive to construct a general theory drove us into intense study and the result was our FFEE.
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