Download The Application of Circuit- consistent Money to Macroeconomic

The Application of Circuitconsistent Money to
Macroeconomic Modelling
Diarmid J G Weir
University of Stirling
Email: [email protected]
19th October 2005
With thanks to my PhD supervisors Professor Sheila Dow and Dr Alberto
Montagnoli for help and support.
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1. Introduction
The premise of this paper is that describing the macroeconomy for the purposes
of illustrative and predictive modelling will be enhanced by the inclusion of money in a
way that is consistent with plausible explanations for the origin, valuation and current
nature of money. The inclusion of money in standard neoclassical models generally
relies on one of three techniques: the insertion of government-liability money in the
utility function eg: Buiter (2005); money as an additional good that lowers transaction
and/or production costs; eg: King and Plosser (1984); or the addition of a ‘Cash-inAdvance’ constraint to the usual household budget constraint; eg: Cooley and Hansen
(1995). None of these techniques are satisfactory because they suffer from one or both
of the following deficiencies: they do not acknowledge the origin and destruction of
money in the private sector and how this affects private sector budget constraints; they
do not explain why money should be held across periods. In contrast to these
techniques, I believe that the insights provided by the Theory of the Monetary Circuit
(TMC), can lead us to a much more realistic way of integrating money into
macroeconomic models.
We shall start this paper by briefly describing what we believe to be the critical
features of money in a modern economy. We then go on to outline the monetary circuit
and the features that make it a desirable explanation of the nature of modern money.
In the following section we will discuss how the monetary circuit imposes a
constraint on firms, how monetary circuit theorists have envisaged the effect of this
constraint on the behaviour of firms, with particular focus on the issues of investment
and profits and what the consequences of this constraint might be. We will suggest that
the consequences suggested by monetary circuit theorists such as Graziani and Parguez
may not be strictly correct.
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To focus on the issues involved in the interpretation of the TMC in relation to
the macroeconomy we formalise some of the critical relationships between the aims of
firms and those of households from a circuit perspective while leaving open the source
of firms’ profits but assuming utility maximisation of households. The role of central
bank money and the effect of exogenous changes in the interest rate at which this
money is lent to the commercial banks is included in the model.
Finally we draw some conclusions from the preceding discussion and modelling
exercise.
2. The Essential Features of Modern Money
2.1 Money Creation and Economic Activity
There are two critical features of modern money:
1) Money facilitates economic activity because it is a guarantee of receiving a reward
for assisting that activity (providing labour) when that activity is neither its own
reward (that is it has at least relative disutility), nor does it earn an immediate
reward because either:
a) Production takes time
b) Output of the productive activity does not itself match completely the desires of
those who assist in its production.
2) Money represents a guaranteed claim on the output of some production process.
This gives it a reason to be accepted and held by individuals. It is not enough that
there is a positive externality to society as a whole, since every individual
transaction, whether a purely barter transaction or one involving money, is purely
bilateral. No individual will voluntarily accept money for real goods unless she is
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confident that she will be able to convert her money back into the real goods she
requires, as the loss from failing to do so is potentially greater than any liquidity
gain to her as an individual from eliminating the requirement for a double
coincidence of wants. A purely conventional basis for money’s acceptance may be
equilibrium, as Kiyotaki and Wright (1989) have shown, but there can be no
guarantee that it will become one, or that one will be regenerated after some shock
that damages trust in money.
While the two features listed above need not be part of the same process; state
or central bank money is not issued in a production process, and workers are sometimes
paid in kind for their labour, it is the claim of the TMC that in a modern economy the
bulk of money is created in the monetary production circuit.
In a modern economy by far the largest part of transactions and the largest part
of money stocks are in the form of bank deposit money, unbacked by state money
(either in the form of cash or central bank deposits). The only plausible source for this
money is the issue of bank credit to the private sector. The only plausible reason for its
valuation is the prospect of exchange for output valued by households.
The TMC shares with the Post-Keynesian school, eg: Wray (1990), Rousseas
(1992), and the Stock-Flow view, eg: Godley and Lavoie (2000, 2004), Godley (2004),
a consistent view of the nature of money in a modern economy. There is an
acknowledgement that the modern economy has three types of money, whose quantities
are linked in a way that maintains balance sheet equality for all agents at all times. One
of these types of money, cash, I am going to ignore for the sake of clarity and brevity in
this discussion.1 State or central bank deposit money (SBDM) is held by the central
1
Cash is a small and decreasing proportion of modern money, and is essentially a more tangible form of
Central Bank Deposit Money.
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bank in the name of individual commercial banks. These deposits come into existence
when the government makes payments into individuals’ bank accounts that are matched
by commercial bank deposit money (CBDM) (defined below), or when commercial
banks borrow from the central bank. These deposits are cancelled by the reverse
operations: when individuals pay taxes from their bank accounts and when banks repay
their central bank loans. Central bank deposits can only directly be used to settle
transactions between different commercial banks and between commercial banks and
the central bank.
The third type of money - commercial bank deposit money (CBDM) - is itself
acceptable as a means of payment and can moreover be created by the lending of
commercial banks. For this latter reason the amount of CBDM exceeds the amount of
central bank money, and is the chief form of money used in transactions and as
precautionary deposits. CBDM is destroyed when the assets for which they are a
matching liability are terminated, whether this is on the repayment of a commercial
bank loan or on the payment of taxes to government, in which latter case a
corresponding quantity of SBDM also disappears from the system.
2.2 A Desert Island Economy
A brief thought-experiment can give us an idea as to how money might
plausibly have arisen and been valued, and serve as a point of reference as we try to
unravel a consistent way of envisaging the modern monetary economy.
We imagine two individuals on a desert island, one of whom is expert at
climbing trees to find fruit (let’s call him F) and the other has a knack for digging to
find water sources (we’ll call him W). They exchange fruit and water but wonder if
there might not be a better way to do things. They consider an arrangement to work
together to plant fruit trees near their living area. W must expend more time and effort
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to find water, and F promises to give him a share of the extra fruit grown. W doesn’t
quite trust F to give him the agreed share when the fruit is ready for gathering, so this
Pareto-improving plan fails to be carried out.
It so happens that a few days later a big, strong, numerate, but otherwise
unskilled individual (henceforth named B) is washed up on the island. When he hears
the plan of the others, he offers to ensure that the fruit-grower fulfils his side of the
bargain in return for his own share of the fruit. All three believe that this will still leave
them better off than before, so now the plan goes ahead. To make it easy for everyone
to remember who owes what to whom, B gives F some specially marked leaves to be
handed to W when the water is handed over. When the crop of new fruit is ripe these
marked leaves are handed back to F by W in exchange for his fruit share. F then returns
the leaves to B along with B’s fruit share as a signal that the fruit production process
has been completed satisfactorily.
As time goes by more unfortunates become shipwrecked on the island. First to
arrive is a talented rock-climber (to be known as R). He is able to get access to the cliffs
on the island where millions of seabirds live and manages to collect a considerable
amount of guano to fertilise the fruit trees and increase the crop. So B gives a few more
marked leaves to F who in turn gives some of these to R in exchange for guano. Like
W, R exchanges these for fruit when the crop is ready. Once again F returns all the
leaves to B, along with his share of the fruit (now increased thanks to the guano).
Despite his climbing skills, however, R finds that his guano-harvesting exploits are not
providing him with enough to eat. He collects some of the eggs he finds on the cliffs,
but doesn’t much like the taste. But he takes them back to W who finds them quite
acceptable. Unfortunately W is a bit low on fruit at the moment, as F is between crops,
and cannot exchange any with R. R suggests to W that he will take some of W’s
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marked leaves, which he knows he will be able to exchange for fruit when it is ready to
be picked.
As the island obtains more residents, who all have different skills and tastes, it
turns out that these sort of transactions involving exchange of the leaves for goods or
services rendered becomes more and more common, since they allow people to delay
their consumption or decisions about consumption and save on the time spent searching
for someone else to make a direct exchange with. Others opt to grow fruit or other food
crops as F did and in each case B (or someone else trusted to enforce production
agreements) is willing to enforce these arrangements in exchange for a share of the
extra output produced, and each time he issues more of his specially marked leaves
which are returned to him as each process is completed.
It should be clear the role that B’s marked leaves are playing here. They are
being used as a means of exchange; when held they are a store of value and it seems
likely they will be used as a unit of account. In other words, the marked leaves are
money, and they are accepted because they always represent a claim on consumption
that has been deferred to a later date as a consequence of the growing (production)
process.2
2.3 Analysing the Desert Island model
No collective agreement or convention is required to establish the acceptance or
valuation of money in this case. Moreover, by ensuring W of his due share in F’s
increased output an improved use of available resources is enabled that allows the
production of goods that would not otherwise have been achieved.
2
I think this approach can be differentiated from that of characterising money as ‘assignable debt’. If a
debt is a contract to repay money, then I am not sure that defining money as a contract to repay money –
even if assignable – provides us with the insight we seek.
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Of course the desert island economy is very different from a modern economy.
There is initially only one productive ‘firm’, only one ‘bank’ and no bank deposits,
government sector or central bank. Given the limited consumption possibilities on the
island, B is happy to accept his ‘interest’ in produced goods rather than cash. It can,
however, be said that B’s leaves follow a circuit.
3. The Monetary Circuit
Proponents of the Theory of the Monetary Circuit insist that money is primarily
an outcome of the production process which cannot take place, because of time and
uncertainty, without an issue of credit, in the form of Commercial Bank Deposit
Money, which allows firms to pay the wages of their workers before production is
completed. The determination of the level of economic activity is thus the process of a
‘triangular’ negotiation over credit between commercial banks and firms. (Graziani
2003, p62) Wage-earners spend the wages thus received and these expenditures (in the
form of CBDM) can return to the firms in payment for their produced goods, or as the
purchase of bonds to individuals at the cost of a long-term interest rate. The Monetary
Circuit allows, however, a third possibility, which is the holding of precautionary
deposits of CBDM.
The two aspects of the circuit can be divided into ‘Initial Finance’, which is the
bank credit supplied at the cost of a short-term interest rate, and ‘Final Finance’ which
is the return of money to firms following sales of production. If consumer goods firms
can capture all of the expenditure arising from their borrowing, then at the end of the
production process (Initial Finance matches Final Finance) they can repay the full value
of their loans and so will be solvent without any further intervention. If CBDM is held
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up in the form of precautionary deposits, then the firms’ solvency (within the pure
TMC described) requires the rolling over of bank credit into the next circuit.
3.1 The Monetary Circuit as a Constraint
The adoption of the Monetary Circuit as the model for money implies a
constraint that must be included in any model of the macroeconomy. At the conclusion
of the term of each production loan, the nominal expenditure by a firm that results from
that loan is matched by an equal nominal quantity of purchases of consumer goods,
capital goods and financial assets; bank deposits being included in the latter category.
In an economy where all money is the issue of commercial banks that insist on the strict
repayment of all loans, then this constraint will apply to any firm that takes out a
production loan.
The problem faced by the Circuit Theorist is to account for profits, saving and
interest payments given this constraint. Augusto Graziani (Graziani 2003, 1989) and
Alain Parguez (Parguez 1996, 2004) have probably put the most effort into resolving
this problem and they have arrived at a similar solution. They allow the price of output
to be determined by firms and/or banks before the start of production, so that given a
fixed labour productivity, when they determine their level of employment and the
nominal wage they also fix their level of sales receipts.
According to Graziani (1989), the marginal theory of distribution, by which the
level of real income is determined by equating the real wage with the marginal
productivity of labour, is thus to be rejected in favour of the power of banks and firms
to determine the allocation of the economy’s real resources. It is not clear whether he
regards this proposition as independently supported by the empirical evidence or
whether it follows inevitably from the constraint imposed by the monetary circuit. He
goes on to endorse the view, put forward by Kalecki, for example Kalecki (1971), that
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real consumption and investment are decided on by capitalists, and that this is achieved
by their setting a price to equalise demand and supply in the consumption goods
market. The higher the price set, the lower is the proportion of consumption goods
going to wage-earners, but the greater nominal quantity of money firms must borrow.
Graziani’s view seems to have shifted slightly between 1989 and 2003, but his
final position is that firms borrow an additional amount of money to purchase capital
goods, and if they have set the price of the goods they sell correctly this money spent
on capital goods will return to the firm as profit.
It is not quite straightforward for firms, however, since wage-earners wish to
save a proportion of their wage-income. If money is thus withdrawn from the circuit in
the form of CBDM, this eats into firms’ profits to the extent that should the wageearners’ saving coincidently equal the capital expenditure of the firms, they will make
zero profits. To counter this, firms offer interest-bearing securities to wage-earners. The
cost to them is not in fact the full value of the interest since a proportion of interest
returns to the firms for the purchase of goods. Graziani anticipates a steady state in
which the level of CBDM deposits is constant, and so profits, investment and the
interest rates and price level required to maintain them is constant. Firms can acquire
whatever finance they need as long as no increase in CBDM deposits is anticipated.
Parguez (1996) describes the process similarly. Firms, he states, exist to grow
capital, and thus must make money profits. When they are offered for sale,
consumption goods must have a pre-determined set of values that reflect the profit
constraint determined by agreement between banks and firms. In Parguez’ view the
monetary circuit is an ordered series of stages explaining the determination of the
present state of the economy and so is an open, path-dependent system. Firms borrow
from the banks in two rounds; one for the payment of wages which workers can
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exchange for a pre-determined output of consumption goods, thus allowing the firms to
extinguish this debt, and one for the purchase of additional output of capital goods by
the firms themselves. This allows capital goods firms to repay their debt, and leaves
firms holding an additional amount of real wealth in the form of new capital goods.
Since profits are generated by investment expenditures, they cannot exist before
investment as an available liquid fund and so it cannot be true that saving is required
for investment. Moreover, if wage income and wage rate are the sole adjusting factors
for firms and banks to achieve profits, then wage-earners have no role in their
determination.
Parguez (2004) goes on to suggest that, in conjunction with banks, firms target a
desired monetary growth of their capital since banks target their own accumulation of
wealth in the form of the liabilities of firms (both short and long term). This wealth of
the banks thus depends in turn on the money value of the capital of firms. To avoid
inflation reducing the real value of this capital, banks insist as a condition of lending on
a price level that ensures their targeted growth of capital. The monetary wage rate is set
by the firms’ required rate of return and price level for the target capital accumulation,
not the marginal productivity of labour (MPL). In fact for any given targeted return on
capital, a rise in MPL would presumably simply lower the demand by firms for labour.
In Graziani’s description there is a single product used both for consumption
and as the capital used in production. Firms acquire a fraction of aggregate product for
themselves firms as capital at a price that achieves equilibrium between demand and
supply. The rate of return on expenditure is given by the ratio of capital expenditure to
the monetary cost of production, and Graziani’s result can be shown to be equivalent to
that of Parguez except for an expression for the saving ratio, reflecting the presence of
securities in Graziani’s model.
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3.2 Interest Payment to Banks
There is the additional problem of how interest payments to the banker in
payment for the provision of loans can be accounted for when these payments are
outwith the standard production cycle encompassed by the theory.
There seem to be three possible solutions to the problem:
1) The services of the banker in the model do not require the employment of workers.
Her status is essentially an institutional and non-market acquired one. Since she has
no need to employ workers for their central function as modelled she has no need to
borrow and so interest receipts are pure ‘profits’ and can be spent on the market for
goods and services. Of course if productive output is confined only to that paid for
in wages, then there will be no goods for these bank ‘profits’ to be spent on, with
consequences for the price level. But if the worker/consumers are a party to the
arrangement of a production loan and its consequences and as long as an overall
gain from the availability of the new goods remains, then they will be prepared to
manufacture extra goods, which they will not themselves consume, to the value of
the bank profits. When these goods are purchased from the firm the money with
which the interest is paid returns to the firm and can then be used to pay workers
who purchase the firms output allowing them to repay the loan principal and
complete the production circuit.
2) An alternative assumption is that the interest paid on a loan in one period can only
be paid with money obtained by a further loan in the next period. This would mean
that the amount borrowed would initially increase each period even when the
monetary value of production was constant. However the additional borrowing
would approach an asymptotic value and so an approximate steady-state would be
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reached, in which the loan value was very close to being a constant amount after
each circuit
3) The final option and the one that Graziani (1989) describes is that firms include
their bank interest payment in their targeted surplus, when the price level is fixed.
When the bank pays wages, and other costs this money is returned to the firms who
repay this part of their debt in the usual way. The banks’ employees and
shareholders’ consequent acquisition of real goods will thus further squeeze the real
value of the wages of workers in the real goods sector.
3.3 The Relationship between Capitalists and Wage-earners
Circuit theory generally, assumes as Parguez and Graziani do, that production
and investment decisions and thus decisions about the quantity of credit and thus the
quantity of CBDM, are wholly in the hands of the banks and the firms acting together.
Yet there are some problems with this solution to the questions of the monetary circuit.
(Cartelier 1996) points out that the traditional description of a clear social
division between capitalist entrepreneurs and dependent wage-earners is not necessarily
clear in economic terms. He believes that the relationship between wage-earners and
entrepreneurs is an open question with the following possible solutions:
1. The specificity of the wage relationship is ignored and the wage treated
just like another cost, such as that for fuel or animal feed. This ignores
the freedom of the wage-earner to choose between work and leisure, and
spend his wage as desired.
2. The wage is assumed to be determined in the same way as other
commodities in competitive markets. This, in turn, ignores the unequal
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relationship between entrepreneurs and wage-earners in that only the
former can decide the level and nature of economic activity.
In Cartelier’s view it is the access to the means of payment by entrepreneurs
that shifts the economic relation between them and wage-earners in favour of the
former. But Cartelier emphasises that wage-earners are not slaves and have the same
market power as other economic agents within the limits of their budget constraint.
The Desert Island model, however, illustrates that money is likely to come into
existence from a triangular agreement, so that once the banks and firms have control of
the creation of money and households do not then there must be some strain on the
continuation of a monetary economy. The money received by the agents in the Desert
Island model is acceptable to them because they know exactly how much fruit it
represents and they believe that they are getting a fair share that justifies the extra effort
they have put into producing the extra fruit. Households in the Graziani and Parguez
models, on the other hand, are passive acceptors of whatever real wage is left to them
once the price level has been set by the firms and/or banks, to allow for that part of
output the firms wish to reacquire as profits for re-investment. For this to be plausible
we must completely abandon the possibility that there is any approach to the
equalisation of the marginal utilities of work and leisure for wage-earners. This seems
unlikely in a modern economy, with firms in competition with each other for market
share and for skilled labour. Many skilled workers also have the option of selfemployment, which may well give them access to borrowed funds themselves. There is
in fact much more overlap than the traditional division suggests – with many wageearners being direct or indirect shareholders, and many wage-earners the beneficiaries
of the profits of firms.
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Moreover, it is not clear that the sequence of events envisaged by Parguez and
Graziani corresponds to reality. They imagine that investment decisions are made at the
time bank loans are negotiated, and so ‘profits’ are simply that part of the loan that is
spent on acquiring capital goods. But in fact the nature of profits in the real economy is
rather different from this. Profits are ‘retained’ and often not spent immediately as they
must be if already acquired as a consequence of pre-arranged investment, and secondly
they can be quite unpredictable for individual firms.
To accept the Parguez-Graziani picture it may be that we must assume
extraordinarily forward–thinking households that are willing to give up a share in
current production to see production increase in the future as a consequence of the
application of that share to capital investment. In an economy which distinguishes
between the return to capital and the return to labour, this seems most unlikely.
One thing that the monetary circuit allows, that neoclassical models cannot, is to
introduce some separation between firms and households. In most neoclassical models
that do have a production sector decisions about saving and investment are taken at the
same time, whereas the existence of credit and money as explicitly modelled by the
monetary circuit theory allows the possibility of the preferred outcomes to differ
between firms and households. The consequence is that consumption need not match
the output of consumption goods as savings do not automatically become investment
goods but may be held up as deposits.
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4. Elements of a Consistent Monetary Model of the
Macroeconomy
4.1 Assumptions of the Model
Bearing in mind the issues we have discussed I want to start to formalise some
of the relationships that will exist in a circuit macroeconomy.
There are a large number of firms and households. In this version of the model
we have not specified a production process, beyond stating that it requires a
combination of labour and capital goods. Thus we make no profit-maximising
assumption, but wish to examine the conditions for a positive money profit and the
maintenance of that particular level of profit under alternative conditions.
Because production takes time, production credit must be borrowed from banks
to the quantity that matches the output created and available for sale to households by
the firm in that cycle. Because this credit is provided by a trusted third party and is
demanded by firms in exchange for goods to allow them to repay their loans, it fulfils
the role of a medium of exchange and so can be used for the purchase of goods already
produced. Indeed it makes such exchanges easier since it eliminates the need to find a
double coincidence of wants for each exchange. In this way the credit issued to
facilitate production becomes money. This money is demanded for a further reason, and
this is because if not immediately exchanged for real goods it represents a store of value
that can be used to allow the delaying of the decision to allocate expended labour or the
proceeds of the sale of other goods to different goods and/or services. It is a critical
insight of the TMC that when this store of value is kept in the form of bank deposits it
is not just withdrawn from consumption but from the monetary circuit as a whole, and
so leaves some firms unable to repay their loans within the circuit in which this
withdrawal takes place.
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When firms find that their sales receipts (including those from other firms) fall
short of that required for them to fully repay their loans, they have the choice of
attempting to have their bank loans ‘rolled over’, or of converting their loans into longterm securities to be purchased by households. The extent to which each will happen,
depends on the relative interest rates, the liquidity preference of households and the
willingness of banks to extend loans.
By treating the production cycle as a discrete time period and confining our
analysis to the position at the end of each period, transaction balances can be regarded
as zero. Precautionary balances are determined by subjective uncertainty and by the
interest rate that can be earned on the only alternative means of saving: bonds issued by
firms. Bonds are issued by firms for the purpose of economising on the cost of bank
loans. If they can capture money that would otherwise have remained stationary in bank
deposits, then they can repay more of their loans and save on the interest costs. To
capture this money they themselves will offer a rate of return on these bonds. In this
first attempt at outlining the model, all values are in nominal terms, and are represented
by upper-case letters.
4.2 Firms
Irrespective of their production function, in a monetary circuit where money
arises from production agreements only, firms as a whole face the following budget
constraint:
Lt = (1 + itL ) Lt −1 + (1 + itL )Wt N t + itB Bt − CtW PtW N t − CtF Pt F Ft − ( Bt − Bt −1 ) ,
(1)
where Lt is the outstanding nominal quantity of all loans to firms at the end of period t;
Wt is the nominal wage paid to each worker in period t; Bt is the outstanding nominal
value of firms’ bonds at the end of period t; is the average nominal consumption per
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wage-earner in the private sector; CtF the average nominal capital expenditure by
firms; Ft the number of firms at time t; PtW is the average price of consumption goods;
Pt F is the average price of capital goods; itL is the period t interest rate paid by firms to
the banks and itB is the interest paid by firms to their bond-holders. The period t money
surplus for the firms’ sector as a whole is thus given by:
π t = CtW PtW N t + ( CtF Pt F − CtF Pt F ) − (1 + itL )Wt N t − itL Lt −1 − itB Bt .
(2)
The two identical expressions in the brackets cancel each other out as they are
both expenditures and receipts of the firms’ sector, and so have no bearing on the level
of surplus. Assuming that PtW = Pt F = 1 , and combining equations (1) and (2), we find
π t = Bt −1 − Bt + Lt −1 − Lt ,
(3)
which implies that for a positive profit, π t > 0 , even assuming no saving so that Wt =
Ct,
Bt −1 − Bt > Lt − Lt −1 .
(4)
In words, firms can only make a profit in a period if they redeem bonds to a
greater value than their additional borrowing from the banks in this period. Such a
surplus cannot be achieved for an indefinite period. As we have discussed above,
Graziani and Parguez’ addrerss this problem by suggesting that profit is equivalent to
expenditure by firms on investment, citing the work of Kalecki as precedent. Firms
themselves purchase some of their own collective output, thus reducing that proportion
of output available to households. This is achieved either by firms themselves, in the
case of Graziani, or, in the case of Parguez, banks that have a stake in the capital value
of firms requiring a mark-up on prices at which households can purchase the output of
firms. Since firms can borrow their total expenditure, the price level is therefore only a
limit to the purchasing power of wage-earners. It should be clear from examining the
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profit equation (2) how this works, given a fixed nominal wage. Although this results in
a greater proportion of real resources going to firms for investment, it does not achieve
a monetary surplus at the end of the period. But we know that it is an empirical fact that
the firms sector in a modern economy does indeed achieve a surplus of receipts over
their expenditure as shown in the first column of Table 1. The only way to account for
this and maintain the integrity of the monetary circuit is to allow for the possibility of
additional money entering the firms’ budget constraint that is not borrowed by firms.
The two main sources of this are SBDM of the government and central bank, and loans
to households. The possible relative significance of these to profits are suggested by
Table 1 and Chart 1. At any particular price level the proportion of this money that
firms must recycle in wages is pre-determined, but they do not need to repay any of it
to the banks since they did not borrow it. The effect of this additional money is to scale
up the production process, and create a monetary surplus without any further increase
in the price level. Looking at the profit equation we can see that if we increase CtW to
CtW + ε , and increase Wt to Wt + ε and Pt > 1 has previously been set to allow the firm
to purchase capital goods, then ε PtW − ε > 0 , and equation (2) will yield a positive
result for t.
4.3 Money and Production Loans
The money stock created by the private sector at the end of period t must equal
the amount of outstanding loans:
M tP = Lt .
(5)
Note that since bonds are long-term loans, movements in bonds are not included in the
calculation of profits, although changes in bond interest will affect them. The money
stock created by the private sector at the end of period t must equal the amount of
outstanding loans:
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M tP = Lt .
(6)
All bank loans demanded are supplied at interest rate itL (determined as shown
below), so that
M tP = Lt (itL ) ,
∂L
∂i L
<0
(7)
4.4 Households Utility and Deposits
Households are assumed to be utility maximisers, subject to a budget constraint.
They divide their income between consumption Ct, and saving St. New saving is
defined as that part of the wage that is not consumed in the period in which it is earned:
St − St −1 = Wt − Ct ,
(8)
where St is the total amount of saving per worker at the end of the period and where
saving is comprised of two parts; new bond purchases and addition to bank deposits.
Total saving is thus given by
St = Dt + Bt ,
(9)
where Dt is the quantity of bank deposits held at the end of the period by each
household. The period budget constraint applying to each household is therefore
Wt + itB Bt = Ct + ( Dt − Dt −1 ) + ( Bt − Bt −1 ) .
(10)
Bank deposits are assumed to earn zero interest, but are held for precautionary
motives depending on a subjective uncertainty factor µt . It is important to note that this
factor is one viewed by households as affecting them individually, and not one that
affects the value of money. A constant level of confidence in the production economy
as a whole is assumed. The utility of each household in each period (the felicity
function) is assumed to be
U t = g (Ct ) + µt h( Dt ) − ωχ t ;
- 20 -
(11)
h′ > 0, h′′ < 0; ω > 0 ;
g ′ > 0, g ′′ < 0;
where
t
is the hours of labour performed in each day.
Equation (11) implies that utility increases in consumption and in deposits held,
but with declining marginal utility in each case. Utility declines with constant marginal
utility in the number of hours worked.
If we set up a Lagrangian for the household as follows:
Lt = g (Ct ) µt h( Dt ) − ωχ t − λt ( wt χ t − Ct − ( Dt − Dt −1 ) − ( Bt − Bt −1 ) + itB Bt
−λt +1 ( wt +1 χ t +1 − Ct +1 − ( Dt +1 − Dt ) − ( Bt +1 − Bt ) + itB+1 Bt +1
,
(12)
we obtain the following first-order conditions:
∂L
∂L
∂D
=) g ′(Ct ) + λt ,
(13)
= µt h′( Dt ) + λt − λt +1 ,
(14)
∂C
∂L
Setting ∂L
∂χ
∂χ
= −ω − λtWt ,
(15)
= 0 and rearranging equation (4.31) we obtain
ω = −λtWt ,
(16)
confirming that in our model maximising households will aim to make the marginal
disutility of work equal to the asset-equivalent value of wages.
Setting ∂L
∂C
= 0 and combining (13) and (15) we get
ω = g ′(Ct )Wt ,
(17)
or that the disutility of labour is equal to additional utility provided by the wage. This
makes it clear that there is a conflict between utility-maximising wage-earners and
Parguez-Graziani motivated firms. Finally, by setting ∂L
= 0 and combining (13)
∂D
and (14) we obtain
- 21 -
µt h′( Dt ) = g ′(Ct ) − g ′(Ct +1 ) ,
(18)
or that the marginal utility of deposit holdings in period t is equal to the change in
marginal utility from consumption between periods t and t+1. Because both h′′( Dt ) < 0
and g ′′(Ct ) < 0 , this translates to an association between an increase in the utility from
deposit holding (either because of an increase in deposits Dt or an increase in
uncertainty t) and decreasing consumption over time.
To analyse the effect of changes in bond interest rates we obtain
∂L
∂B
= λt − λt it − λt +1
from the Lagrangian (12). Setting ∂L
∂B
(19)
= 0 and combining (13), (14) and (19) we can
show that
it =
µt h′( Dt )
g ′(Ct )
(20)
so that an increase in the interest rate will produce an increase in the ratio of
consumption to deposits, assuming a constant level of subjective uncertainty
the other hand,
t increases
t.
If, on
while the interest rate remains constant we will see a switch
from consumption to deposits to maintain the equality.
4.5 The Role of Central Bank Money
Central Bank Deposit Money money (SBDM) is issued by the central bank on
behalf of the state. It can enter the economy in two ways. Firstly it is used by the
government to make purchases from households and firms. When this happens the
SBDM issued becomes part of the reserves of the commercial banks and an equal
quantity of commercial bank money is transferred to the accounts of those from whom
the government purchases were made. At the end of each period t
H tE = H tE−1 + Gt − Tt ,
- 22 -
(21)
where H tE is the total quantity of SBDM entering via the government expenditure route
present in the economy at the end of period t; Gt is government expenditure in period t
and Tt is tax received by the government in period t. In our model, which for the sake
of clarity has no government bonds, if Ht-1 = 0 and Gt - Tt-1 then no SBDM from this
route will be present in the economy.
SBDM adds to the circulating medium of exchange M t so that
M t = M tP + H t = Lt + H t ,
(22)
In its role as regulator the central bank imposes a minimum reserve ratio φ on the
banks3, so that H t / Lt ≥ φ . If H tE / L < φ then the banks are required to borrow
additional SBDM from the central bank, at an interest rate of itH to maintain the reserve
ratio. Clearly the greater the government deficit the less reliant the banks are on
borrowing from the central bank, and the less influence the central bank has of
influencing commercial bank lending through manipulating the interest rate.
5. Conclusions
5.1 Taking the Theory of the Monetary Circuit Seriously
There are strong arguments for taking the TMC seriously as a tool for modelling
the monetary economy in the light of its plausibility as a mechanism for the initiation
and maintenance of the monetary economy.
5.2 The TMC and Profits
The constraint of the TMC presents a problem of accounting for profits. In the
explanations of Parguez and Graziani, there is a clear conflict between the power of
3
In most modern economies, such as that of the UK, there is no prescribed ratio, but banks themselves
ensure a prudential reserve ratio to allow for possible cash demands. In our modelled non-cash economy
we replace this with an imposed ratio.
- 23 -
firms to control the real distribution of goods and the neoclassical assumption of an
equilibrium equality between the real wage, the marginal productivity of labour for
firms and the marginal disutility of labour to wage earners. Graziani and Parguez
conclude that the conflict is resolved entirely in the favour of firms. But their
conclusion appears not entirely convincing and may in part be as a result of not
considering the possibility of alternative sources of money from the government and
consumption loans. This model shows how this might allow firms to earn a money
surplus without further manipulation of the real economy or the price level.
5.3 The Role of Deposits
The introduction of precautionary deposits into the model which are significant
to the budget constraints of firms and households but not that of the government is
significant for the anticipated effects of exogenous interest rate changes.
5.4 Implications for Interest-rate Policy
An exogenous increase in the interest rate charged by the central bank to
commercial banks may have the following consequences:
a) An increase in the interest rate offered to firms and/or a reduction in the number
of loans offered. Our model suggests this effect can be mediated by the level of
the government deficit.
b) Firms have to meet higher interest-rate payments. They may seek to meet these
by:
i) passing on the extra cost to wage-earners by increasing the prices of
consumption commodities and /or
ii) reducing employment and output levels and/or
- 24 -
iii) offering a higher return on their bonds.
Which of these effects is most prominent will depend on the stance taken on the
relative power of firms and households.
c) Because holding bonds is now less attractive, greater consumption occurs by
households, as indicated by equation (20).
Note that b)i) and c) are potentially inflationary – contrary to the presumed intended
effect of the interest rate increase.
6. Bibliography
Buiter, W. H., "New Developments in Monetary Economics: Two Ghosts, Two
Eccentricities, a Fallacy, a Mirage and a Mythos," Economic Journal 115 (502):
C1-C31 (2005).
Cartelier, Jean. 1996. In Money in Motion: The Post Keynesian and Circulation
Approaches., edited by G Deleplace and E. J. Nell. Basingstoke and London:
Macmillan.
Cooley, Thomas and Greg Hansen. 1995. Business Cycle Models with Money. In
Frontiers of Business Cycle Research., edited by Thomas Cooley. Princeton:
Princeton University Press.
Godley, Wynne. 2004. Weaving Cloth from Graziani'
s Thread: Endogenous Money in a
Simple (but Complete) Keynesian Model. In Money, Credit and the Role of the
State: Essays in Honour of Augusto Graziani., edited by Richard Arena and
Neri Salvadori. Aldershot: Ashgate.
Godley, Wynne and Lavoie, Mark. Kaleckian Models of Growth in a Stock-Flow
Monetary Framework: A Neo-Kaldorian Model. 2000. Annandale-on-Hudson,
New York. Working paper No. 302, The Levy Economics Institute of Bard
College.
- 25 -
Godley, Wynne and Lavoie, Mark. Features of a Realistic Banking System within a
Post-Keynesian Stock-Flow Consistent Model. 2004. Cambridge, UK.
Cambridge Endowment for Research in Finance.
Graziani, Augusto. The Theory of the Monetary Circuit. 89. London.
Graziani, Augusto. 2003. The Monetary Theory of Production. Vol. . ed. Edited by .
Cambridge, UK: Cambridge University Press.
Kalecki, Michel. 1971. Selected Essays on the Dynamics of the Capitalist Economy
1933-1970. Vol. . ed. Edited by . Cambridge: Cambridge University Press.
King, Robert G. and Charles G. Plosser, "Money, Credit, and Prices in a Real Business
Cycle," American Economic Review 74 (3): 363-380 (1984).
Kiyotaki, Nobuhiro and Randall Wright, "On Money as a Medium of Exchange,"
Journal of Political Economy 94 (4): 927-954 (1989).
Parguez, A. 1996. Beyond Scarcity: A Reappraisal of the Theory of the Monetary
Circuit . In Money in Motion: The Post Keynesian and Circulation Approaches.,
edited by G Deleplace and E. J. Nell.Macmillan.
Parguez, Alain. 2004. The Solution of the Paradox of Profits. In Money, Credit and the
Role of the State: Essays in Honour of Augusto Graziani., edited by Richard
Arena and Neri Salvadori. Aldershot: Ashgate.
Rousseas, Stephen. 1992. Post Keynesian Monetary Economics. Armonk, New York:
M.E.Sharpe.
Wray, Randall. 1990. Money and Credit in Capitalist Economies: The Endogenous
Money Approach. Aldershot: Edward Elgar.
- 26 -
7. Tables and Figures
Table 1: UK Gross Operating Surplus, M0 and Household Lending
1986-2003
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Gross Operating
Surplus of UK
Firms
£ millions
95953
108273
121235
131108
136103
137840
144326
160887
180196
191594
213016
224826
231884
234738
235708
241233
258750
277165
Quantity of
M0 at year
end
£ millions
15946
16633
18040
19006
19492
20085
20581
21729
23322
24539
26153
27802
29346
32768
34566
37319
39540
42317
Amount Outstanding
Sterling Net Lending to
Individuals
£ millions
48145
62624
77863
116306
126561
133022
138571
148145
158012
186669
209901
364566
386993
420082
470917
514802
575819
620255
Sources: ONS, Bank of England
Chart 1: UK Gross Operating Surplus, M0 and Household Lending
1986-2003
700000
500000
Gross Operating
Surplus of UK Firms
400000
Quantity of M0 at year
end
300000
Amount Outstanding
Sterling Net Lending to
Individuals
200000
100000
02
00
20
98
20
96
19
94
19
92
19
19
90
88
19
19
86
0
19
£ sterling (millions)
600000
- 27 -