The Role of credit in a Keynesian monetary economy

Abstract

This paper describes the features of a monetary economy on the basis of Keynes's distinction between a real exchange economy and a monetary economy. In The General Theory, Keynes identifies the reasons for the non-neutrality of money by highlighting the store of wealth function of money; this approach has been adopted by most Keynesian economists. The aim of this paper is to show that such an approach only partially explains the reasons for money non-neutrality and that important elements which demonstrate the relevance of monetary variables emerge when the means of payment function of money is considered. Investigating the role of this function requires that we deal explicitly with how spending decisions are financed. The paper argues that the market for credit must be considered separately from the market for money, and that a viable credit theory can be built from Keynes's post-General Theory writings.

Acknowledgments

I am grateful to Geoffrey Harcourt, Marc Lavoie and two anonymous referees for their helpful comments on an earlier draft of this paper. Thanks are due to the Fondazione Cariplo for financial support.

Notes

¹Davidson (1994, p. 95), for example, writes: ‘suppose because the future suddenly appears more uncertain, people decide to buy fewer space vehicles (automobiles) to transport themselves geographically and instead demand more time vehicles to convey their purchasing power to an unspecified future time to meet possible liquidity needs. The decreased demand for space vehicles causes unemployment in the economy's auto factories. The increased demand for liquidity does not induce an offsetting increase in employment in the production of money or any good producible in the private sector. Of course, if peanuts were money … then unemployment in the auto industry would be offset by increased employment in the peanut farms…. Uncertainty and unwillingness to commit earned income to current purchases of producibles (a process that the layperson terms savings) will cause unemployment, if, and only if, the object of the savers' desire is a resting place for their savings that is non producible and not readily substitutable for producibles—even if prices are flexible.’ Likewise, Kregel (1980, p. 43) states that: ‘in a monetary production economy … when incomes are paid in terms of money, income will represent demand for either current output or stores of value. The use of income to demand “money” as a store of value, however, is not an effective demand (for labor), because it does not lead to the expectation of future sales of producibles goods, and this does not create the expectation of income.’

²Romer (2000) proposes to rewrite the IS–LM model, eliminating the LM curve. For a description of the strategies of the contemporary monetary authorities see Leiderman & Svensson (1995), Mishkin (1999), Meltzer (2001).

³This view can be traced back to Smith (1776) and Ricardo (1821). The modern version of this thesis was elaborated by Menger (1892), and it has been taken up more recently by Brunner & Meltzer (1971), Jones (1976), Kyotaki & Wright (1989) and Gravelle (1996).

⁴Keynes (1933b, p. 81) borrows a device from Marx to describe the differences between the two economies: ‘The distinction between a co-operative economy and an entrepreneur economy bears some relation to a pregnant observation made by Karl Marx…. He pointed out that the nature of production in the actual world is not, as economists seem often to suppose, a case of C–M–C’, i.e. of exchanging commodity (or effort) for money in order to obtain another commodity (or effort). That may be the standpoint of the private consumer. But it is not the attitude of business, which is a case of M–C–M', i.e. of parting with money for commodity (or effort) in order to obtain more money.’

⁵‘In actual fact under a gold standard gold can be produced, and in a slump there will be some diversion of employment towards gold mining. If, indeed, it were easily practicable to divert output towards gold on a sufficient scale for the value of the increased current output of gold to make good the deficiency in expenditure in other forms of current output, unemployment could not occur; except in the transitional period before the turn-over to increased gold-production could be completed’ (Keynes, 1933b, pp. 85–86).

⁶Keynes (1933b, p. 86) maintains that the characteristics of a fiat money make income fluctuations caused by a lack of effective demand more frequent.

⁷See for example, Graziani (1996); Parguez & Seccareccia (2000); Fontana (2000); Rochon (1999, 2003).

⁸And, as Minsky (1980) points out, all of these models posit an important difference between how the demand for consumer goods and the demand for investment goods are financed: they assume that investment decisions are financed by bank credit while consumption decisions are financed through current income. This is not a completely realistic hypothesis since household debt for the purchase of durable consumption goods can be, and in some countries is, substantial (Arestis & Howells, 1999). A complete model should take account of both corporate and household demand for credit; here we only consider investment financing because the analysis of this phenomenon is sufficient to highlight the fundamental features of a monetary economy.

⁹‘… [E]x-ante investment is an important, genuine phenomenon, inasmuch as decisions have to be taken and credit or “finance” provided well in advance of the actual process of investment…’ (Keynes, 1937c, p. 216).

¹⁰‘Increased investment will always be accompanied by increased saving, but it can never be preceded by it. Dishoarding and credit expansion provides not an alternative to increased saving, but a necessary preparation for it. It is the parent, not the twin, of increased saving (Keynes, 1939, p. 281).

¹¹See Graziani (1984), Lavoie (1986), Bibow (1995) and Chick (1997). This point was also made by Keynes himself (1937c, p. 223).

¹²This point is stressed by Graziani (1996, p. 147).

¹³The analysis of this second phase can be developed using Tobin's results on the role of financial intermediaries in satisfying the portfolio preferences of wealth owners and debtors; see Tobin (1963); Tobin & Brainard (1963). The difference between the model developed in this paper and Tobin's is that Tobin ignores the role of banks in the process of investment decision financing and he only considers the action of the banks and other financial intermediaries in reconciling the portfolio preferences of debtors and creditors.

¹⁴It is possible to define the demand for CDs starting from the households' balance sheet:

where: M = money stock and B _H  = the value of bonds held by households. In terms of flows, we have:

Once W, and Y have been fixed, the money stock and the flow of deposits ΔD demanded by the households are determined by equations (5) and (7). The equation for S(Y) determines the sum of ΔCD and ΔB demanded by wealth owners. In the model, CDs are perfect substitutes for government bonds, so we can assume that the wealth owners will buy all the government bonds not purchased by the central bank:

The flow of bonds purchased by the central bank (ΔB _CB ) coincides with the flow of monetary base which is used by the banks in order to establish the reserve fund:

From these relations it is possible to obtain the demand for CDs:

If we observe that:

we obtain:

Substituting from above, we have finally:

This last equation coincides with equation (10). This model does not specify the interest flows and envisages a small number of assets and liabilities; for a more detailed model see Godley (1999).

¹⁵The structure of this model is consistent with Howells (1995), Arestis & Howells (1996, 1999), Lavoie (1999).

¹⁶This distinction is analogous to the distinction between ‘money demand’ and ‘liquidity preference’ made by Wray (1992).

¹⁷The model is in this respect compatible with Kaldor's (1982) hypothesis of money supply endogeneity, which is based on a clear conceptual separation of the money and credit markets (see Bertocco, 2001).

¹⁸Cottrell (1994, p. 599) maintains, for example, that the money supply endogeneity hypothesis is in conflict with Keynes's thought: ‘Keynes saw the banks as playing a key role; by acceding to or denying such demand for advance finance, they determine whether or not ex ante investment plans will be realised. They are able in effect, to place a limit on the pace of investment that is quite distinct from the ultimate limit posed by full employment. On the Kaldor/Moore view on the other hand, the banks are mere ciphers in this process, passively accommodating whatever demands they happen to experience.’

¹⁹In the model presented in this work we assume that investments are financed only with the creation of new money. It is possible to extend the model and to assume that firms issue bonds sold to the public; in this case firms finance their investment by using existing money which has been accumulated by wealth owners. This hypothesis leads us to specify a link between investment decisions and savings decisions, given that the stock of wealth owned by wealth holders corresponds to the sum of saving flows realised in previous periods. It would be incorrect, however, to conclude that investment decisions depend on savings, for two reasons. Firstly, there is not an unequivocal relationship between wealth and firms' investment decisions: investment decisions do not coincide with the stock of wealth because, given the existing stock of wealth and the new money created by banks, the level of investment will be conditioned by the amount of money the public decides to give firms in return for bonds. Secondly, the two ways of financing investments, i.e. creation of new money by banks or a bond issue, have equivalent effects on the level of income; in both cases the flow of investment projects implemented by firms will lead to an expansion of income capable of inducing a saving flow equal to that of investment. If the issuing of bonds were equivalent to the financing of investment through savings, there should be no increase in income since the increased demand for investment goods would be offset by a decrease in demand for consumer goods by savers. Within a Keynesian perspective, however, in both cases we will have the same increase of income and savings with a corresponding wealth variation; the only difference concerns the composition of wealth: where investment is financed through bonds, wealth owners will hold a lower share of money. This point is clearly present in Kaldor (1982); see Bertocco (2001).

²⁰‘The idea that it is comparatively easy to adapt the hypothetical conclusions of a real wage economics to the real world of monetary economics is a mistake. It is extraordinarily difficult to make the adaptation, and perhaps impossible without the aid of a developed theory of monetary economics’ (Keynes, 1933a, p. 410).