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Circuit theory extended: The role of speculation in crises

  • Lancastle, Neil
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    This paper asks why modern finance theory and the efficient market hypothesis have failed to explain long-term carry trades; persistent asset bubbles or zero lower bounds; and financial crises. It extends Godley and Lavoie (Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, 2007) and the Theory of the Monetary Circuit to give a mathematical representation of Minsky's Financial Instability Hypothesis. In the extended circuit, the central bank rate is not neutral and the path is non-ergodic. The extended circuit has survival constraints that include a living wage, a zero interest rate and an upper interest rate. Inflation is everywhere. The possibility of stable carry trades emerges. In high interest rate, hedge economies, powerful banks invest surplus loan interest. With speculation, banks lobby to enter investment markets and the system is precariously liquid/illiquid. In a Ponzi economy, where loans never get repaid, solvency is a balance between increasing reserves, reducing interest rates and rebuilding banks' balance sheets during systemic crises. Simulating bank bailouts, household bailouts and a Keynesian boost suggests that bank bailouts are the least effective intervention, exerting downward pressure on wages and household spending: austerity.

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    File URL: http://dx.doi.org/10.5018/economics-ejournal.ja.2012-34
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    File URL: http://econstor.eu/bitstream/10419/62591/1/72411291X.pdf
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    Article provided by Kiel Institute for the World Economy in its journal Economics: The Open-Access, Open-Assessment E-Journal.

    Volume (Year): 6 (2012)
    Issue (Month): ()
    Pages: =1-27

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    Handle: RePEc:zbw:ifweej:201234
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    1. Fama, Eugene F, 1991. " Efficient Capital Markets: II," Journal of Finance, American Finance Association, vol. 46(5), pages 1575-617, December.
    2. Bela Balassa, 1964. "The Purchasing-Power Parity Doctrine: A Reappraisal," Journal of Political Economy, University of Chicago Press, vol. 72, pages 584.
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    4. Marco Veronese Passarella & Malcolm Sawyer, 2014. "Financialisation in the circuit," Working papers wpaper18, Financialisation, Economy, Society & Sustainable Development (FESSUD) Project.
    5. Stephan Schulmeister, 2005. "The Interaction between Technical Currency Trading and Exchange Rate Fluctuations," Finance 0512033, EconWPA.
    6. Fischer, Christoph, 2002. "Real currency appreciation in accession countries: Balassa-Samuelson and investment demand," BOFIT Discussion Papers 8/2002, Bank of Finland, Institute for Economies in Transition.
    7. Philip Arestis, 2009. "New Consensus Macroeconomics: A Critical Appraisal," Economics Working Paper Archive wp_564, Levy Economics Institute.
    8. Miklos Koren & Peter Karadi, 2009. "A Spatial Explanation for the Balassa-Samuelson Effect," 2009 Meeting Papers 891, Society for Economic Dynamics.
    9. Hyman P. Minsky, 1992. "The Financial Instability Hypothesis," Economics Working Paper Archive wp_74, Levy Economics Institute.
    10. Keen, Steve, 2010. "Solving the paradox of monetary profits," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy, vol. 4, pages 1-32.
    11. Alvaro Angeriz & Philip Arestis, 2007. "Monetary policy in the UK," Cambridge Journal of Economics, Oxford University Press, vol. 31(6), pages 863-884, November.
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