Monetary Economics

During the 60-odd years since the death of Keynes there have existed two, fundamentally different, paradigms for macroeconomic research, each with its own fundamentally different interpretation of Keynes’s work.¹ On the one hand there is the mainstream, or neo-classical, paradigm, which is based on the premise that economic activity is exclusively motivated by the aspirations of individual agents. At its heart this paradigm requires a neo-classical production function, which postulates that output is the result of combining labour with capital in such a way that, provided all markets clear, there will be no involuntary unemployment while the national income is distributed optimally and automatically between wages and profits. If markets do not clear because wages or prices are ‘sticky’, the same structure will generate determinate, if sub-optimal, disequilibrium outcomes and, for many economists, it is the possibility of such stickiness that defines Keynesian economics. The key assumption that individual welfare maximization is the universal mainspring is not consistent with the view that firms have an independent existence with distinct motivations, because optimum prices, output and employment are all decided for them by the location of aggregate demand and supply schedules. And as production is instantaneous, while supply is brought into equivalence with demand through the market-clearing process, there is no systemic need and therefore no essential place for loans, credit money or banks. The concept of ‘money’ is indispensable, yet money is an asset to which there is not, in general, a counterpart liability and which often has no accounting relationship to other variables. Mainstream macroeconomic theory is a deductive system which needs no recourse to facts (though it may be ‘calibrated’ with numbers) and lends itself to analytic solutions.

Contemporary mainstream macroeconomics, as it can be ascertained from intermediate textbooks, is based on the system of national accounts that was put in place by the United Nations in 1953 — the so-called Stone accounts. At that time, some macroeconomists were already searching for some alternative accounting foundations for macroeconomics. In the United States, Morris A. Copeland (1949), an institutionalist in the quantitative Mitchell tradition of the NBER, designed the first version of what became the flowof-funds accounts now provided by the Federal Reserve since 1952 — the Z.1 accounts. Copeland wanted to have a framework that would allow him to answer simple but important questions such as: ‘When total purchases of our national product increase, where does the money come from to finance them? When purchases of our national product decline, what becomes of the money that is not spent?’ (Copeland 1949 (1996: 7)).

Money is created in two fundamentally different ways. On the one hand there is outside money, which is created whenever a government pays for something by making a draft on its central bank or by paying for something with banknotes, and which is extinguished when a payment is made by a member of the public to the government, typically in the form of taxes. This kind of money we may call government money, since it is issued by public institutions, namely the central bank or the Treasury department of central government. Government money is usually called central bank money or high-powered money in the literature. On the other hand there is inside money, which is created by commercial banks when they make loans, and which ceases to exist when loans are repaid. This second kind of money will be called private money, since it is issued by private institutions, namely private banks.

The present chapter combines the circular flow approach to money (featured in the last chapter) with the stock approach. In the circular flow approach, money is a device allowing transactions between agents to take place and illustrates Keynes’s famous ‘transactions’ motive for holding money. In the stock approach, money is seen as a financial asset which agents hold for investment purposes, or more precisely, as a placement as French scholars and Joan Robinson (1956: 8) say. The quantity of money held depends, in particular, on the rate of interest that can be obtained on other assets — an approach associated with Keynes’s ‘speculative’ and ‘precautionary’ motives. Agents make a portfolio choice between money and other possible financial assets. For this reason, the model developed in Chapter 4 is called Model PC, for portfolio choice.

The definition of wealth in Model PC in Chapter 4 comprised only two assets, money and bills. In this chapter a third asset, long-term government bonds, is introduced and this will provide an opportunity to discuss the notion of liquidity preference — hence the name Model LP — and also to introduce capital gains and losses into the system of accounts. An important feature of the new model will be that an increase in long-term interest rates will have a short-run negative effect on demand.

This chapter extends the closed economy framework developed in previous chapters to describe two economies which trade merchandise with one another. Our methodology differs from the usual textbook approach, according to which models of individual closed economies are eventually ‘opened’, but which give no consideration to what other countries must be held to be doing and how a full set of interactions between all countries might be characterized. The excuse is that the open economy under study is presumed to be small compared to the rest of the world, so that the feedback effects can be assumed to negligible. But then not much can be said about the US economy, the size of which surely guarantees large feedback effects on the rest of the world, nor about the European community or the block of Asian countries including Japan. This partial equilibrium approach is the more surprising because international trade theory is usually treated within a relatively sophisticated two-country and two-good framework. We shall discuss open economy macro-economics using models of an economic system which, taken as a whole, is closed, with all flows and all stocks fully accounted for wherever they arise.¹

As pointed out earlier, money is created in two fundamentally different ways. In Chapters 3–6, we only dealt with government money — indifferently called high-powered money, central bank money, cash money or outside money. This kind of money had a peculiar characteristic: it carried no interest yield. It is now time to introduce private money, that is, the money created by private banks. Although private, or commercial, banks could also print cash money or banknotes, as they indeed were allowed to do in the past before central banks were awarded the monopoly, we shall assume that all private money takes the form of money deposits. We shall further assume that these bank deposits carry an interest yield.

The present chapter applies the accounting lessons and the pricing behaviour that we discussed in Chapter 8. A preliminary model describing a closed economy with no government is deployed, based on ‘inside’ money created by banks. After having explored its main features, we will be able to move on to two more realistic models of a whole modern industrial monetary economy, those of Chapters 10 and 11, that deal simultaneously with privately issued money and government-issued money.

The following chapter combines Model PC, which described an economy in which there was portfolio choice but only with government (or ‘outside’) money, with Model DIS in which there were inventories but only credit (or ‘inside’) money. We shall call the model to be developed the INSOUT Model, since it combines inside and outside money. In the process we shall describe the main ways in which the central bank exercises control over commercial banks. In addition, the description of commercial banks will go beyond the simple equality between loans and deposits, with which we were content in the previous chapters. In the present chapter, commercial banks will actually need to take decisions of their own.

This is by far the most ambitious chapter of the book. It sets out a rigorous basis for the integration of Keynesian-Kaleckian macroeconomics (with constant or increasing returns to labour, growth, mark-up pricing, etc.) with a model of the financial system comprising banks, loans, credit money and equities, together with a model of inflation. Central contentions of the chapter are that, with trivial exceptions, there are no equilibria outside financial markets and that the role of prices is to distribute the national income, with inflation sometimes playing a key role determining the outcome.

The open economy model deployed in Chapter 6 was very much simplified, with fixed exchange rates and no private transactions in foreign assets, while central banks held all their foreign exchange reserves in the form of gold. In this chapter we add a number of realistic features.¹ Private agents trade foreign assets. Official account imbalances are settled normally by transactions in dollar-denominated assets, with gold only playing a small role. International trade depends both on national output and relative prices, implying a distinction between nominal and real values.² A minimum of five prices are considered: export prices, import prices, the price of sales, a domestic sales price and a GDP deflator. Fixed and flexible exchange rate regimes will both be explored. But many simplifying assumptions remain. There are only two countries, there is no domestic or foreign investment in fixed or working capital,³ firms do not hold financial assets, there is no endogenous wage inflation, there are no commercial banks or credit money, and the treatment of expectations is rudimentary. Yet we already need nearly one hundred equations to close the model and for inclusion of further realistic features we would require several more.

We now wish to recapitulate the main features of our method and of our models. Since it was argued in Chapter 1 that our method shared many features with Tobin’s New Haven approach, we shall emphasize here how and why our models are still distinct from those of Tobin. Indeed, we strongly believe that the closure of our models, as well as their spirit, make them indeed quite distinct. The reader having now gone through the various chapters and experiments that were conducted there should be able to appreciate the distinctions that we are about to claim. It should be understood that in several instances it is the features of the more sophisticated and realistic models, those presented in the later chapters, that are under consideration. We shall refer to the models enclosed in the present book as the G&L models.