Monetary Economics An Integrated Approach to Credit, Money, Income, Production and Wealth Wynne Godley and Marc Lavoie Monetary Economics From the same authors: Wynne Godley Industrial Pricing in the United Kingdom (with Ken Coutts and William D. Nordhaus) (Cambridge: Cambridge University Press) 1978. Macroeconomics (with Francis Cripps) (Oxford: Oxford University Press) 1983. Marc Lavoie Macroéconomie: Théories et controverses postkeynésiennes (Paris: Dunod) 1987. Foundations of Post-Keynesian Economic Analysis (Aldershot: Edward Elgar) 1992. Milton Friedman et son œuvre, (co-edited with Mario Seccareccia) (Montréal: Presses de l’Université de Montréal) 1993. Avantage numérique, l’argent et la Ligue nationale de hockey (Hull: Vents d’Ouest) 1997. Désavantage numérique, les francophones dans la LNH (Hull: Vents d’Ouest) 1998. Central Banking in the Modern World: Alternative Perspectives (co-edited with Mario Seccareccia) (Cheltenham: Edward Elgar) 2004. Introduction to Post-Keynesian Economics (London: Palgrave/Macmillan) 2006. Monetar y Economics An Integrated Approach to Credit, Money, Income, Production and Wealth Wynne Godley and Marc Lavoie © Wynne Godley and Marc Lavoie 2007 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published in 2007 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world. PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan ® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN-13: 978–0–230–50055–6 hardback ISBN-10: 0–230–50055–2 hardback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Godley, Wynne. Monetary economics : an integrated approach to credit, money, income, production and wealth / by Wynne Godley and Marc Lavoie. p. cm. Includes bibliographical references and index. ISBN-13: 978–0–230–50055–6 ISBN-10: 0–230–50055–2 1. Money. 2. Economics – Mathematical models. I. Lavoie, M. (Marc). II. Title. HG221.G57 2007 332.4—dc22 2006049315 10987654321 16 15 14 13 12 11 10 09 08 07 Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne Contents Notations Used in the Book ix List of Tables xviii List of Figures xx Preface xxxiv 1 Introduction 1 1.1 Two paradigms 1 1.2 Aspiration 4 1.3 Endeavour 9 1.4 Provenance 11 1.5 Some links with the ‘old’ Yale school 13 1.6 Links with the post-Keynesian school 16 1.7 A sketch of the book 18 A1.1 Compelling empirical failings of the neo-classical production function 20 A1.2 Stock-flow relations and the post-Keynesians 21 2 Balance Sheets, Transaction Matrices and the Monetary Circuit 23 2.1 Coherent stock-flow accounting 23 2.2 Balance sheets or stock matrices 25 2.3 The conventional income and expenditure matrix 33 2.4 The transactions flow matrix 37 2.5 Full integration of the balance sheet and the transactions flow matrices 43 2.6 Applications of the transactions flow matrix: the monetary circuit 47 3 The Simplest Model with Government Money 57 3.1 Government money versus private money 57 3.2 The service economy with government money and no portfolio choice 58 3.3 Formalizing Model SIM 61 3.4 A numerical example and the standard Keynesian multiplier 68 3.5 Steady-state solutions 71 3.6 The consumption function as a stock-flow norm 74 3.7 Expectations mistakes in a simple stock-flow model 78 3.8 Out of the steady state 83 3.9 A graphical illustration of Model SIM 88 v vi Contents 3.10 Preliminary conclusion 91 A3.1 Equation list of Model SIM 91 A3.2 Equation list of Model SIM with expectations (SIMEX )92 A3.3 The mean lag theorem 92 A3.4 Government deficits in a growing economy 95 4 Government Money with Portfolio Choice 99 4.1 Introduction 99 4.2 The matrices of Model PC 99 4.3 The equations of Model PC 102 4.4 Expectations in Model PC 107 4.5 The steady-state solutions of the model 111 4.6 Implications of changes in parameter values on temporary and steady-state income 116 4.7 A government target for the debt to income ratio 124 A4.1 Equation list of Model PC 126 A4.2 Equation list of Model PC with expectations (PCEX) 126 A4.3 Endogenous money 127 A4.4 Alternative mainstream closures 129 5 Long-term Bonds, Capital Gains and Liquidity Preference 131 5.1 New features of Model LP 131 5.2 The value of a perpetuity 131 5.3 The expected rate of return on long-term bonds 132 5.4 Assessing capital gains algebraically and geometrically 134 5.5 Matrices with long-term bonds 136 5.6 Equations of Model LP 137 5.7 The short-run and long-run impact of higher interest rates on real demand 150 5.8 The effect of household liquidity preference on long rates 153 5.9 Making government expenditures endogenous 160 A5.1 Equations of Model LP 165 A5.2 The liquidity trap 167 A5.3 An alternative, more orthodox, depiction of the bond market 168 6 Introducing the Open Economy 170 6.1 A coherent framework 170 6.2 The matrices of a two-region economy 171 6.3 The equations of a two-region economy 173 6.4 The steady-state solutions of Model REG 176 6.5 Experiments with Model REG 180 6.6 The matrices of a two-country economy 187 6.7 The equations of a two-country economy 191 6.8 Rejecting the Mundell–Fleming approach and adopting the compensation approach 194 Contents vii 6.9 Adjustment mechanisms 201 6.10 Concluding thoughts 207 A6.1 Equations of Model REG 209 A6.2 Equations of Model OPEN 211 A6.3 Historical and empirical evidence concerning the compensation principle 213 A6.4 Other institutional frameworks: the currency board 214 A6.5 How to easily build an open model 215 7 A Simple Model with Private Bank Money 217 7.1 Private money and bank loans 217 7.2 The matrices of the simplest model with private money 218 7.3 The equations of Model BMW 222 7.4 The steady state 227 7.5 Out-of-equilibrium values and stability analysis 233 7.6 The role of the rate of interest 240 7.7 A look for ward 247 A7.1 The equations of Model BMW 247 8 Time, Inventories, Profits and Pricing 250 8.1 The role of time 250 8.2 The measure of profits 252 8.3 Pricing 263 8.4 Numerical examples of fluctuating inventories 276 A8.1 A Numerical example of inventory accounting 278 9 A Model with Private Bank Money, Inventories and Inflation 284 9.1 Introduction 284 9.2 The equations of Model DIS 285 9.3 Additional properties of the model 293 9.4 Steady-state values of Model DIS 295 9.5 Dealing with inflation in (a slightly modified) Model DIS 300 A9.1 Equation list of Model DIS 308 A9.2 The peculiar role of given expectations 310 A9.3 Equation list of Model DISINF 312 10 A Model with both Inside and Outside Money 314 10.1 A model with active commercial banks 314 10.2 Balance sheet and transaction matrices 315 10.3 Producing firms 318 10.4 Households 322 10.5 The government sector and the central bank 331 10.6 The commercial banking system 333 10.7 Making it all sing with simulations 342 10.8 Conclusion 374 viii Contents A10.1 Overdraft banking systems 374 A10.2 Arithmetical example of a change in portfolio preference 376 11 A Growth Model Prototype 378 11.1 Prolegomena 378 11.2 Balance sheet, revaluation and transactions-flow matrices 379 11.3 Decisions taken by firms 383 11.4 Decisions taken by households 392 11.5 The public sector 397 11.6 The banking sector 399 11.7 Fiscal and monetary policies 404 11.8 Households in the model as a whole 422 11.9 Financial decisions in the model as a whole 435 11.10 A concluding recap 441 12 A More Advanced Open Economy Model 445 12.1 Introduction 445 12.2 The two matrices 446 12.3 Equations of the generic model 450 12.4 Alternative closures 462 12.5 Experiments with the main fixed exchange rate closure 466 12.6 Experiments with alternative fixed exchange rate closures 472 12.7 Experiments with the flexible exchange rate closure 478 12.8 Lessons to be drawn 487 A12.1 A fundamental and useful open-economy flow-of-funds identity 490 A12.2 An alternative flexible exchange rate closure 492 13 General Conclusion 493 13.1 Unique features of the models presented here 493 13.2 A summary 499 References 501 Index 514 Notations Used in the Book A d Advances demanded by private banks A, A s Central bank advances made to private banks add Random change in liquidity preference add bL Spread of bond rate over the bill rate add l Spread of bill rate over the deposit rate add 2 Random change in government expenditures AF Amortization funds B $ £ Bills held by £ households but issued by the $ country B £ $ Bills held by $ households but issued by the £ country B $ cb£ Bills held by the £ central bank but issued by the $ country (foreign reserves of country £) B $ cb$ Bills held by $ central bank and issued by the $ country B £ cb£ Bills held by the £ central bank and issued by the £ country B d , B hd Bills demanded by households (ex ante) B b , B bd Bills actually demanded by banks B bdN Bills notionally demanded by banks B cb Bills held by the central bank B h , B hh Bills held by households B s Treasury bills supplied by government bandB, bandT Lower and upper range of the flat Phillips curve BL d Long-term bonds demanded by households BL h Long-term bonds held by households BL s Long-term bonds issued by government BLR Bank liquidity ratio, actual or gross value BLR N Bank liquidity ratio, net of advances BLPR Banks liquidity pressure ratio bot Bottom of an acceptable range botpm Bottom of the acceptable range of the profitability margin of banks ix [...]... banks, of households Targeted capital stock Capital account balance, inclusive of the official settlements account Capital account balance, excluding official transactions Ld , Lfd L, Ls , Lfs , Lf Lg Lhd Lhs , Lh Loans demanded by firms from banks Loans supplied by banks to firms Loans to government sector Loans demanded by households from banks Loans supplied by banks to households M, Mh , Mhh M1, M1h Money... propensity to consume out of current income (MPC), for a given target wealth to disposable income ratio The transition from a stationary to a growing economy: impact on the government debt to GDP ratio (continuous curve) and on the government deficit to GDP ratio (dotted curve) Discrepancy between the target wealth to income ratio and the realized wealth to income ratio with economic growth Money demand and. .. inventories (and hence bank loans), following an increase in the target inventories to sales ratio Evolution of real output and real consumption, relative to their initial steady state values, following an increase in the target inventories to sales ratio Evolution of household wealth and of its various components, relative to their initial steady state values, during the first periods that follow an. .. sector implies an equivalent transaction by another sector (every purchase implies a sale), while every financial balance (the difference between a sector’s income and its outlays) must give rise to an equivalent change in the sum of its balance-sheet (or stock) variables, with every financial asset owned by one sector having a counterpart liability owed by some other Provided all the sectoral transactions... HUCe HWC Reserves demanded by banks Reserves supplied to banks by the central bank Cash money demanded by households Cash money held by households Cash money held by government Cash money supplied to households by the central bank High-powered money, or cash money, supplied by the central bank Historic costs Expected historic costs Historic unit cost Expected historic unit cost Historic wage cost xi... balance sheet of the Bank of England (the UK central bank): change in foreign reserves, stock of money, holdings of domestic Treasury bills Effect of an increase in the US propensity to import on the US debt to GDP ratio and on the UK debt to income ratio, within a fixed exchange rate regime with endogenous foreign reserves Effect of an increase in the UK propensity to import, within a fixed exchange... accounts and government balances of both countries, following an increase in the South propensity to import, with monetary rules based on changes in gold reserves Evolution of interest rates, following an increase in the South propensity to import, with interest rates acting on propensities to consume and reacting to changes in gold reserves Evolution of trade accounts and government balances, following an. .. comes from somewhere and everything goes somewhere’ such an arrangement of concepts will describe the activities and evolution of the whole economic system, with all financial transactions (including changes in the money supply) fully integrated, at the level of accounting, into the processes which generate factor income, expenditure and production As any model which includes the whole range of economic... income ratio and of the burden of personal debt, following an increase in the gross new loans to personal income ratio Evolution of real output and real consumption, relative to the base line solution, following an increase in the gross new loans to personal income ratio Evolution of the bank capital adequacy ratio and of the bank liquidity ratio, relative to the base line solution, following an increase... new loans to personal income ratio Evolution of the lending rate set by banks, following an increase in the gross new loans to personal income ratio Evolution of the government deficit to GDP ratio and of the government debt to GDP ratio, relative to the base line solution, following an increase in the gross new loans to personal income ratio Evolution of Tobin’s q ratio, the price-earnings ratio and . 2004. Introduction to Post-Keynesian Economics (London: Palgrave/Macmillan) 2006. Monetar y Economics An Integrated Approach to Credit, Money, Income, Production and Wealth Wynne Godley and Marc Lavoie ©. Congress Cataloging-in-Publication Data Godley, Wynne. Monetary economics : an integrated approach to credit, money, income, production and wealth / by Wynne Godley and Marc Lavoie. p. cm. Includes. Monetary Economics An Integrated Approach to Credit, Money, Income, Production and Wealth Wynne Godley and Marc Lavoie Monetary Economics From the same authors: Wynne Godley Industrial