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1 - Notes on the Stock-Flow Consistent Approach to Macroeconomic Modeling Introduction The aim of this paper is to present and discuss the general features of the StockFlow Consistent Approach to Macroeconomic Modeling (SFCA, from now on). Although the SFCA is still not widely adopted, its our contention that (i) it is crucial for sound macroeconomic reasoning in general1 and, therefore, (ii) its widespread adoption would increase both the transparency and the logical coherence of most macro models2. In order to support our claims, we chose to divide these notes in four parts. The first describes what exactly we mean by the stock-flow consistent approach to macroeconomic modeling. As the distinguishing features of the SFC approach are perhaps clearer when its contrasted to other approaches, we decided to dedicate the next two parts of the paper to such comparisons. Therefore, the second part attempts to relate the SFC approach to current mainstream macroeconomics, while the third (briefly) relates it to conventional Post-Keynesian macroeconomics. The fourth and last part of this paper attempts to summarize the state-of-the-art of this line of research as we see it and, hopefully, share with the reader some of the excitement felt by SFCA authors about the possibilities of this line of research. A couple of concluding remarks is presented in the end of the paper.

The same opinion is expressed, for example, in Tobin (1980 and 1982), Godley and Cripps The same opinion is expressed, for example, in Lavoie and Godley (2001-02).

(1983), Taylor (1997) and Godley and Shaikh (2002).


1.1 - Stock-Flow Consistent Macroeconomic Models: An Introduction Although the 1970s marked the end of its hegemony in macroeconomics, Keynesian thought showed vitality in that period. Indeed, in a series of seminal articles, a distinguished group of economists at Cambridge (UK), MIT and Yale developed an entirely new family of models very different in nature from the popular textbook version of Keynesianism3. The 1981 Nobel Prize lecture by James Tobin one of the main architects of this new family of models is perhaps the most well known and clear exposition of the Keynesian frontier at that time. In the second page of that lecture, Tobin (1982) writes that:
Hickss IS-LM version of keynesian [theory]() has a number of defects that have limited its usefulness and subjected it to attack. In this lecture, I wish to describe an alternative framework, which tries to repair some of those defects. (). The principal features that differentiate the proposed framework from the standard macromodel are these: (i) precison regarding time (); (ii) tracking of stocks (); (iii) several assets and rates of return (); (iv) modeling of financial and monetary policy operations (); (v) Walrass Law and adding-up constraints.

This alternative framework mentioned above is probably one of the best definitions of SFCA4,5. This approach has been continuously developed in the last twenty

See Brainard and Tobin (1968), Tobin (1969), Foley and Sidrauski (1971), Blinder and Solow

(1973 and 1974), Foley (1975), Cripps and Godley (1976), Tobin and Buiter (1976), Turnovsky (1977), Backus (1980), Tobin (1982), and Godley and Cripps (1983), among others. Most of these papers aimed to address issues raised by Ott and Ott (1965) and Christ (1967, 1968).

Even though Tobin himself didnt call it that way. Yale people (like Fair, 1984, for example)

called it the pitfalls approach, in a reference to the seminal paper by Brainard and Tobin (1968). The expression stock-flow consistent is commonly associated with the works of Wynne Godley [though used also by Davis (1987a and 1987b) and Patterson and Stephenson (1988), among others], but it seems to us that it can and should be applied more generally. Moudud (1998), for example, preferred to use the term Social Accounting Matrix (SAM) approach - also widely

years, especially by a relatively small group of macroeconomists associated with the Bank of England, the University of Cambridge, the Levy Economics Institute-NY, the New School for Social Research and the University of Ottawa6, and despite its Keynesian origins, its regarded as indispensable for sound macroeconomic reasoning in general7. Most authors in this tradition would probably agree with Solow (1983, p.164) that perhaps the largest theoretical gap in the model of the General Theory was its relative neglect of stock concepts, stock equilibrium and stock-flow relations. It may have been a
used by Taylor - but that doesnt emphasize enough the crucial importance these authors give to the coherent and explicit treatment of the inter-relationships between macroeconomic stocks and flows at a given moment and through time. Indeed, Taylor himself (1990) provides examples of SAMs in which only flows are taken into consideration and, therefore, the fact that a macroeconomic model is SAM-based does not mean that it is stock-flow consistent. On the other hand, the original version of the Godley and Cripps model (1983) is an example of a stockflow consistent model not presented in a SAM. The SFCA is also, clearly, a subset of what Taylor (1997, chapter 1, p.1) calls the structuralist approach to macroeconomics.

Although the neoclassical concept of Walrass Law is considered unnecessary by most SFC See Rosensweig and Taylor (1984), Anyadike-Danes et al. (1987), Davis (1987a and 1987b),


Patterson and Stephenson (1988), Godley and Zezza (1989), Taylor (1990), Godley (1996, 1999a and 1999b), Alemi and Foley (1997), Taylor (1997, 1998a, 1998b, 1999 and 2001), Moudud (1998), Lavoie and Godley (2001-2002) and Godley and Shaikh (2002), among many others. Godleys intelectual debt to Tobin is explicit, for example, in Anyadike-Danes (1987) and Godley (1996), while Taylors is explicit in Taylor (1990, chapter 1) and Foleys in Foley and Sidrauski (1971).

Godley and Cripps (1983, p.44), for example, argue that the SFCA is what () [they] mean by

macroeconomic theory. Taylor (1997, ch.1, p.1) expresses a similar opinion stating that macroeconomic frameworks which constrain sectoral and micro level social and economic actors and their actions are the topic of () [macroeconomics]. For SFC models in the tradition of the classical economists and Marx, see Moudud (1998). Foleys formalizations of Marxs

necessary simplification for Keynes to slice the time so thin that the stock of capital goods, for instance, can be treated as constant even while net investment is systematically positive or negative. But those slices soon add up to a slab, across which stock differences are perceptible. Besides, it is important to get the stock-flow relationships right; and since flow behavior is often related to stocks, empirical models cannot be restricted to the shortest of the short runs8. Note, however, that explicit recognition of stock-flow relationships Tobins item (ii) above - necessarily implies a dynamic approach to modeling and this is in sharp contrast with conventional Keynesian economics, which generally assumes a static short run equilibrium. Indeed, in a SFC model current flows - which are in part determined by past stocks end up changing (either increasing or decreasing) current stocks and, through this channel, future flows as well9. This point is made very clearly by Tobin (1982, p.189), according to whom, a model of short run determination of macroeconomic activity must be regarded as referring to a slice of time, whether thick or paper thin, and as embedded in a dynamic process in which flows alter stocks, which in turn condition subsequent flows. The dynamic context necessarily implied by the explicit recognition of the stockflow relationships creates, by its turn, two related needs. First, one needs to be precise

circuit of capital (Foley, 1982, 1986a and 1986b) also have many elements in common with the SFCA.

Tobin (1980, p.75 and 1982, p.188) and Godley (1983, p.170), at least, express essentially the As Turnovsky (1977, p.xi) puts it [SFC] relationships necessarily impose a dynamic structure

same opinion. Well have more to say about this issue in section 1.1.3 below.

on the macroeconomic system, even if all the underlying behavioural relationships are static. Turnovsky calls this SFC dynamics the intrinsic dynamics of the macroeconomic system.

about how one treats the passage of time Tobins item (i) above. In practice, as put by Tobin himself (1982, p.189) most SFC models:
() count time in discrete periods of equal finite length. Within any period each variable assumes one and only one value. (). From one period to the next asset stocks jump by finite amounts. Therefore, the demands and supplies for these jumps affect asset prices and other variables within the period, the more so the greater the length of the period. They will also, of course, influence the solutions in subsequent periods.

Of course, nothing prevents one from using the same strategy with continuous time, instead of with discrete time, but as Tobin (idem)10 reminds us:
Either representation of time in economic dynamics is an unrealistic abstraction. We know by common observation that some variables, notably prices in organized markets, move virtually continuously. Others remain fixed for periods of varying length. Some decisions by economic agents are reconsidered daily or hourly, while others are reviewed at intervals of a year or longer except when extraordinary events compel revisions. It would be desirable in principle to allow for differences among variables in frequencies of change and even to make those frequencies endogenous. But at present models of such realism seem beyond the power of our analytic tools. Moreover, many statistical data are available only for arbitrary finite periods.

The second need, related to the first, is the need for what Wynne Godley calls an accounting framework with no black holes [in which] every flow comes from somewhere and goes somewhere (Godley, 1996, p.7)11. Indeed, if we want to track the process of change of stocks by flows and the feedback of the new stocks in future flows, we have to make sure that current stocks are exactly the result of past flow decisions. If we dont do that, we literally have no idea of what determined current stocks and, as a
10 11

Foley (1975) expresses a similar opinion as well discuss in more detail below. The treatment of time and the appropriate accounting are related because often the second is

determined by the first.

result, we cant say that we are modeling the process of change of stocks by flows in an adequate way. The national accounting issue is, therefore, unavoidable to the SFCA. In these days of neoclassical hegemony it is probably important to stress right from the start, however, that national accounting schemes are based on a pre-conceived view about the economically relevant sets of people and institutions () [within an economy] (Taylor, 1990, p.3). As Godley (1996, p.3) puts it, it is a matter of ascertainable fact that the real world is characterized by a huge and complex structure of interdependent institutions such as governments, firms, banks and households. I do not accept that these institutions are veils with nothing more to do than passively sponsor or facilitate the optimizing aspirations of individual agents; and wish, rather, to start from a conceptual framework which has cognisance of (something remotely approaching) the real world as we know it12. Taylor (1997, p.1) expresses the same opinion as follows: () social accounts and social relations frame macroeconomics. The social accounts are a skeleton, and social relations change its position over real, historical time. Specifying just which relations drive the motions is not a trivial task (). But the objects that move the observable phenomena in macro are mostly the numbers comprising the national income and product accounts (or NIPA) and allied systems. Of course, a huge number of theoretical and applied macroeconomic models probably beginning with Quesnays famous Tableau Economique were phrased as (or

It is conceivable, however, to think about a SFC model based on several representative agents

(like a representative household, a representative bank, a representative non-financial firm and so forth). In general, however, SFCA authors dont use representative agents. Tobin (1989, p.18) is probably expressing the view of most SFCA authors when he remarks that why this representative agent assumption is less ad hoc and more defensible simplification than () constructs of early macro modelers () is beyond me.

were based on) some kind of (implicit or explicit) social accounting matrix (or SAM13) and, therefore, one must emphasize the importance of the allied systems mentioned above by Taylor. Indeed, most of these models are based on some sort of flow accounting (like the NIPA) and, therefore, either focus only on flows or deal with stocks and flows inconsistently. Although for many applications references to stocks and/or the bias introduced by stock-flow inconsistency may not be relevant, SFCA authors strongly believe that for most kinds of macroeconomic analysis it is. SFC models (applied or theoretical), therefore, are necessarily based on sophisticated accounting frameworks that consistently integrate flows of income and product with flows of financial funds and a full set of balance sheets14. To put it briefly, the adjectives SAMbased and SFC are not synonyms, although many SAM-based models are indeed SFC15.


Taylor (1990, p.7) traces the concept of SAMs back to Stone, R (1966), The Social Accounts

from a Consumer Point of View, Review of Income and Wealth, series 12, n.1. Although Stones rigorous concept must be differentiated from the more generic idea that a SAM is any kind of matrix portraying any kind of social accounting (like, for example, Quesnays Tableau Economique), the literature not always does that. Here well use the generic meaning of the term.

In applied work this is achieved (or approximated) through the (non-trivial) integration of

NIPA accounts with Flow of Funds accounts. The relevance of this integration has been increasingly emphasized by the United Nations System of National Accounts as well. Dawson (1996) is a good source for both the details of this integration and the intellectual history of the Flow of Funds Accounts. As Dawson makes clear, FoF authors are, in many aspects, intellectual ancestors of the SFCA approach.

SAM-based (Computable General Equilibrium) models, in Stones sense (see footnote 15),

are widely used in the development literature, both by orthodox and non-orthodox economists. Taylor (1990) and Alarcn (1991), two surveys of this SAM-based development

It also true that a huge number of theoretical and applied macroeconomic models discuss some sort(s) of stock-flow relation(s)16. Harrods famous analysis of a growing economy and all the literature that followed it is one of the examples that quickly come to mind. Harrods case is important in our argument for two reasons. First, because he was one of the first to point out the need for intrinsically dynamic analyses of the kind proposed by the SFCA17. Second, because even though his model explicitly theorizes about stock-flow ratios it is not SFC, in the sense that not all macroeconomic stocks and flows implicit in its hypotheses are accounted for. Who finances investment in Harrods model? Given that savings are non-negative, wealth is certainly being accumulated, but wheres the stock of wealth in Harrods model? This list could go on. In other words, a model may very well say something about some stock-flow relation(s) without being SFC18. And, again, even though the bias introduced by stock-flow inconsistency may be of little relevance for the fundamental message of many macroeconomic models (as argued by Moudud, 1998 and subsequent papers, in the case of Harrod), this has to be proved rather than simply asserted.

literature, present many SFC and non-SFC models. Rosensweig and Taylor (1984) is often cited as a pioneer SAM-based SFC model.

The same is true, by the way, for microeconomic models. Obvious examples are models of real As he put it it is necessary to think dynamically () once the mind is accustomed to thinking

estate markets and commodities in general.


in terms of trends of increase, the old static formulation of problems seems stale, flat and unprofitable (Harrod, 1939, p.16).

A survey of all the authors that have theorized about specific stock-flow ratios or relations

without presenting a formal SFC model would be a very large one, though, well beyond the scope of this paper.

In practice, most SFC macro models follow conventional national accounts and assume that the economy can be adequately depicted as consisting of 5 sectors, which are (aggregations of) (i) Households, (ii) Non-Financial Firms, (iii) Financial Sector (Banks), (iv) Government and (v) Rest of the World19,20. Of course, further aggregation or disaggregation of some sectors and/or the elimination of a few others are possible and, in fact, desirable depending on the nature of the analysis and the aesthetic judgement of the model-builder. It is our contention, however, that the choice of the appropriate (SFC) accounting structure is far from obvious and can be seen as the first fundamental hypothesis of a SFC model. Indeed, this choice implies a huge number of non-trivial theoretical assumptions (explicit or not) about the players in the game and the moves they make (Cohen, 1986, p.3) and perhaps the best way to see it is as something equivalent to the creation of a simple artificial economy21. As a consequence, different people will have different opinions concerning the optimum size/degree of disaggregation of the accounting structure22 and what exactly must be accounted for23.

Making the models especially appropriate for the discussion of items (iii) and (iv) of Tobins The main exceptions are recent models (see, Godley, 1999b or Taylor, 1999, for examples) of Note that, as Brainard and Tobin (1968, p.99) remind us, [this procedure] guarantees us an

passage mentioned above.


two interdependent economies which together make up a whole world (Godley, 1999b, p.1)

Olympian knowledge of the true structure that is generating the observations. (). [But it] () cannot tell us anything about the real world. You cant get something for nothing. We realize further that the lessons derived or illustrated by simulations of our particular structure will not be very convincing or even interesting to people who believe that the model bears no resemblance to the process which generate actual statistical data.

Given that, as put by Taylor (1990, p.1) any economy is a maze of structural detail more than

one could ever build into equations or use in policy design, the choice of what to include and what to leave out of a macroeconomic model is more an art than a science.


Second, we should not forget that even if we agree on the level of aggregation of the accounting structure and on what it must account for, the facts remain that (i) the choice of the accounting conventions is basically theory determined24 and (ii) even within the boundaries of a given theory, in general theres a lot of room for discretion25. This last point is clearly put by Wynne Godley and Francis Cripps in the first paragraph of the first chapter of their seminal book (1983, p.23): definitions of national income, expenditure and output, although generally chosen to make it as easy as possible to reach conclusions about major objectives of macroeconomic policy, are in last resort arbitrary. As a consequence, different authors would very likely disagree not only on what to account for, but also on the level of aggregation of the accounts and on how to account for what they think is right to account for26. Given all these degrees of freedom one might very well ask why someone would bother to use any national accounting framework or data whatsoever. There are several


Perhaps the clearest example of this fact is the distinction between the neoclassical accounting

of, for example, Buiter (1983) - that emphasizes future (fundamentally uncertain) revenues of agents (like, for example, governments future tax revenue) - and the ones in, for example, Godley (1996) and Taylor (1997) that dont even mention them.

See Shaikh and Tonak (1994) for a thorough discussion about theoretical determinants of NIPA There is no terribly compelling reason, say, to consider consumption goods (like pens, or a pair

accounting conventions.

of jeans) that last longer than a year to be an investment by households as it is the current practice in the U.S Flow of Funds accounts. NIPA accounts, for example, treat them as consumption.

This, by the way, helps to explain why it is almost impossible to find any two different SFCA

authors that use the same accounting framework/conventions. Of course, papers with different goals would probably use different accounting structures but this doesnt explain all the differences one finds in the accounting of SFC authors.


(mutually compatible) arguments for the use of models explicitly based on such things, though. One of them, at the same time simple and compelling, is provided by Buiter (1990, p.2), according to whom without measurement there can be no science. Also, the way we measure things, organize data and try to map them into their theoretical counterparts will color our understanding of the processes we are monitoring. A second one, perhaps more pragmatic and probably implicit in Taylors views mentioned above, is that - despite all their possible problems - national accounts of a specific type have been made available to the public for more than 50 years now and are, certainly, the most comprehensive set of data available about any national economy. Most economists, whatever their persuasion, agree that not to take advantage of such an amount of data would not make sense, although many (like Buiter, 1983 or Shaikh and Tonak, 1994) would argue in favor of the use of modified national accounts data. A third argument Tobins item (v) above, first pointed out by Brainard and Tobin (1968) and especially emphasized in the work of Wynne Godley - is that the use of consistent accounting frameworks constrains what can be said to happen with the economy they portray27. As Godley and Cripps (1983, p.18) eloquently put it, the fact that money stocks and flows must satisfy accounting identities in individual budgets and in the economy as a whole provides a fundamental law of macroeconomics analogous to the principle of conservation in physics28. The fact that these constraints can be presented in a concise and intuitive manner in SAMs explains why the SFC literature
27 28

See, for example, Godley and Shaikh (2002) and Taylor (1999) for details. Fair (1984, p.35) also makes this point, although with considerably less enthusiasm. After

emphasizing that a macro model should try to incorporate as good micro foundations as possible


since Tobin (see, for example, Bakus, 1980) has increasingly used these matrices to summarize the accounting framework of macroeconomic models. Fourth, accounting frameworks provide skeletons (Taylor, 1997, p.1) that come to life as (...) economic model(s) (Backus, p. 262) when behavioral assumptions are added to the accounting framework. As put by Taylor (1991, p.41), the accounting serves as a basis to the definition of closures of a () macro model, to adopt a methodology from Sen (1963) and a term from Taylor and Lysy (1979). Formally, prescribing a closure boils down to stating which variables are endogenous or exogenous in an equation system largely based upon macroeconomic accounting identities, and figuring out how they influence one another. As stressed by Taylor (1990, 1991 and 1997), its often possible to phrase the views of different authors as different closures for the same accounting framework. Note, however, that different authors are likely to disagree also on the choice of the appropriate skeleton itself and therefore this procedure may imply a significant bias a kind of home court advantage for some views over the others.

1.2 - The SFCA and mainstream macroeconomics The first thing we need to do in order to relate the SFCA to mainstream macroeconomics is to define the later. This is not an easy task, though. As Fair (2000, p.2) reminds us, at least since Lucass (1976) critique of macroeconometric models, [mainstream] macroeconomics has been is a state of flux. Beginning in the 1970's,

and account for the possibility of disequilibrium, he adds that a model should also (somewhat less importantly) account explicitly for balance sheet and flow of funds constraints.


macroeconomic research scattered in a number of directions and many puzzled as to whether the field is going anywhere". So, rather than trying to accomplish the huge task of surveying all mainstream lines of research in macroeconomics, well try here to paint a general (and impressionist) picture of mainstream macro based on a few, widely accepted, mainstream methodological beliefs and families of models and then compare it to the SFCA. This is what well do in what follows.

1.2.1 - Parables and all that As James Tobin aptly noted more than a decade ago: In journals, seminars, conferences and classrooms macroeconomic discussion has become a babble of
parables. The parables are often specific to one stylized fact, for example the correlation of nominal prices and real output in cyclical fluctuations. Their usual inability to fit other stylized facts appears not to bother the authors of papers of this genre. The parables always rely on individual optimization, across time and states of nature. They differ in the arbitrary institutional restrictions they specify on technology, markets, or information

(Tobin, 1989, p. 19)

Indeed, one of the distinguishing features of todays mainstream macroeconomics is that it doesnt care at all to build models that look like the real world as we know it. On the contrary, it seems that the predominant view among mainstream economists is that any model that is well enough articulated to give clear answers to the questions we put to it will necessarily be artificial, abstract and patently unreal (Lucas, 1980, quoted in Hoover, 2001, p.139) and, therefore, insistence on the realism of an economic model subverts its potential usefulness in thinking about reality (Hoover, 2001, p.139). As a result, mainstream discourse about classic macroeconomic issues is now spread


among different branches of the profession (i.e, labor, development, monetary, international and public economics) besides macroeconomics proper, each of which using their own set of nice optimizing parables to explain reality either directly or with the help of very simplified macroeconomic models. As it should be clear from the previous section, this trend goes against the SFCA view. One of the main goals SFC model builders seek to achieve is to capture the essential interdependences (Brainard and Tobin, 1968, p.99) between (real) macroeconomic sectors, a feature of reality considered too important to be simplified away from the analysis. This potential advantage, however, doesnt come without a cost because a more detailed approach implies an increase in the complexity of the relevant model. On the other hand, its undeniable that in actual economies each macroeconomic sector interacts with all the others in many different and complex ways. Bonds issued by the government, for example, are held and traded by firms, banks, households and possibly also by the rest of the world, often in many differentiated markets; goods produced by firms are also bought by all the other macroeconomic sectors as well; banks provide loans to many other macroeconomic sectors; and the list goes on. It is also true that a given financial asset is often issued by several different macroeconomic sectors. For example, banks, firms and the rest of world can all issue equity, all these sectors and the government can issue bonds, etc. In other words, each actual sectoral balance sheet consist of a very large number of assets (which are also liabilities of other sectors) and liabilities (which are also assets of other sectors). As a consequence, as put by Godley and Zezza (1989, p.3), the simplest realistic [SFC] model requires a relatively large number of accounting equations. Most SFCA


authors deal with this problem by imposing simplifying assumptions to the accounting structure like, say, only domestic firms issue equity, or only banks buy bonds from the rest of the world and, while its true that in many real economies some holdings of assets by sectors can indeed be neglected, the choice of simplifying assumptions is bound to be controversial. As put by Taylor (1990, p.4) the degrees of freedom available to any actor depend on institutions and history of the economy at hand; incorporating them in a convincing fashion is part of the model-building art29. The bottom line is that, although


The issue at hand is somewhat analogous to the specification problem in econometrics. We can

either underestimate or overestimate the importance of sectoral interdependence (by analogy to underparametrize/overparametrize a regression). In the first case, well probably get biased results in the sense that our model fails to capture essential interdependences between sectors and, therefore, gives us a distorted picture of reality. In the second case we lose precision, in the sense that the relevant causal mechanisms are obscured by the irrelevant ones. In order to fully understand what is involved in over-aggregating a SFC model, one has to (i) have in mind that sectoral accounts are obtained by simply adding up the individual accounts of the members of the sector; and (ii) note that by following this procedure one loses trace of all intra-sectoral transactions. If, for example, a bank repays a loan to another bank, this transaction will not appear in the accounts of the banking sector as a whole (since the payment of one bank will cancel out with the receipt of the other). The fact that these transactions are neglected in SFC macromodels is not supposed to mean, of course, that they are not relevant per se, but that they are not crucial to the understanding of the behavior of the economy as a whole. The risk of working with an over-aggregated model is therefore to neglect differences among sub-sectors which are indeed important to the understanding of the economy as a whole. Note also that overaggregation is not the only possible form of under-parametrization Another important kind is the omission of relevant kinds of transactions among sectors. If, for example, the households sector is responsible for a significative part of the aggregate demand for, say, bank loans, its clear that an assumption like households dont have access to credit will add a bias to the model. The case of overparametrization is somewhat easier to analyze. No qualitative detail is likely to be added if we disaggregate the households in, say, basketball lovers, football lovers or neutral, but the increased number of equations/variables in the model will certainly make the


SFCA authors have no problems acknowledging the trivial fact that all models are unrealistic in some degree, ceteris paribus they prefer more realism to less.

1.2.2 - Isnt the current mainstream SFC, after all? The mainstream emphasis on unrealistic parables is not enough to characterize it as stock-flow inconsistent. The very fact that SFC requirements are not even mentioned by most mainstream practitioners implies they are considered either trivial or irrelevant. It might, indeed, be the case that, as unrealistic as they are, mainstream models would perform well in all Tobins five items above. In order to address these issues we must dig a little deeper and thats what well do in what follows. Of course, as both the number of neoclassical parables available in the market and the number of possible mainstream macroeconomic models based on these parables (or combinations of these parables) are very big, well have to deal here only with the ones we deem more important and/or popular. We shall begin with the most rigorous neoclassical model, i.e, Arrow-Debreus general equilibrium model with perfect markets for all present and contingent commodities. This model is relevant not only because of its intellectual prestige, but because in this situation each individual knows all future prices in all contingencies, and these future prices actually occur. Each firm or household can choose a path for investment or consumption, and the choice of path simultaneously implies a portfolio of

analysis of its properties more difficult. Indeed, given that its often impossible to find analytic solutions even for relatively simple systems of difference/differential equations, the comparative statics/dynamics properties of most SFC models can only be studied by means of repeated computer simulations, a procedure that gets more complicated as models grow in size.


assets at each instant. Under these strong hypotheses there is no need to distinguish () between stock decisions and flow decisions, because they are always mutually consistent (Foley and Sidrauski, 1971, p.4). So, assuming a competent auctioneer, we can be sure that flows increase/decrease stocks exactly as they must. The problem here, as is well known, is that this model has clear problems with at least two features of Tobins definition, i.e, the careful treatment of time (since its static) and the explicit modeling of monetary operations (because it has no obvious place for money). This difficulty in dealing with money is also present in the mainstream workhorses, i.e, the Ramsey and OLG models30. This is not to say that money cannot be included in these models, but that this inclusion is somewhat artificial. One way to do it that brings the models closer to the SFC paradigm is through the introduction of the socalled Clower constraint condition (or cash in advance constraint), i.e, the fact that money buys goods and goods buy money but goods do not buy goods (Blanchard and Fischer, 1989, p.165)31. A good example of such models is David Romers OLG-Cash in advance model (idem, p.165-180), which does get reasonably good grades in many of Tobins items, even if one considers that it simplifies things a little too much assuming that the government creates money by giving it to newborn babies as transfers (even though there are banks in the model!). This problem isnt that important, though, since Romers model could conceivably be adapted to provide a better treatment of financial

See, for example, the textbook expositions of Blanchard and Fischer (1989, ch.4) and Romer Another is the inclusion of money in the utility function of agents. The Clower constraint is


somewhat problematic because credit also buys goods. The money in the utility function hypothesis is problematic because people in general derive utility from goods not from painted pieces of paper. See Blanchard and Fischer (1989, ch.4) for a discussion.


and monetary operations and improve its SFC grade32. What is relevant to our point and will be further discussed in the next section - is that, even though its possible to make most mainstream models SFC, most mainstream macroeconomists simply dont care to do it. Before discussing some possible reasons for this last fact, it must be mentioned that despite all their academic predominance, the mainstream workhorses are rarely, if at all, used in practice by applied macroeconomists. As put by John Taylor (2000, p. 90, quoted in Fair, 2000, p.2), at the practical level, a [new] common view of macroeconomics is now pervasive in policy-research projects at universities and central banks around the world. According to Fair (2000, p.3) this view, summarized in Clarida, Gal, and Gertler (1999), is based on three basic equations, which are: (i) an interest rate rule: The Fed adjusts the real interest rate in response to inflation and the output gap (deviation of output from potential)33. The real interest rate depends positively on inflation and the output gap. Put another way, the nominal interest rate depends positively on inflation and the output gap, where the coefficient on inflation is greater than one; (ii) a price equation: Inflation depends on the output gap, cost shocks, and expected future inflation; and (iii) an aggregate demand equation: aggregate demand (real) depends on the real interest rate, expected future demand, and exogenous shocks. The real interest

As Blanchard and Fischer (1989, p.179) put it, the model gives a flavor of the complexity of

money flows in an actual economy. SFCA authors expect models to do much better than that, though.

As put by Blinder (1998, p.27-28) ferocious instabilities in estimated LM curves in the U.S,

U.K, and many other countries, beginning in the seventies and continuing to the present day, led economists and policy makers alike to conclude that money-supply targeting is simply not a


rate effect is negative. In empirical work the lagged interest rate is often included as an explanatory variable in the interest rate rule. This picks up possible interest rate smoothing behavior of the Fed (Fair, 2000, p.2-3). Although the model described above looks pretty much like a conventional AD/AS model with endogenous money, the authors take great pride in the fact that these equations are based on a general equilibrium model with optimizing representative agents. For us what is important to note is that - like its distant cousin, the old IS/LM equilibrium - the new consensus leaves aside important stock-flow relations34. As Fair (2000, p.28-29) points out, this view is unrealistically simple, among other things because all stock effects are omitted (including wealth effects) as well as the interest income effect that arises from the undisputed fact that households hold a large amount of short term securities of firms and the government, and when short term interest rates change, the interest revenue of households changes. We finish this quick (and partial) survey of current mainstream macroeconomic models based on rigorous microfoundations, reminding the reader that a a variety of ad-hoc models have played, and continue to play, important roles in influencing the way [mainstream] economists, and perhaps more importantly, policy-makers, think about the role of monetary policy (Walsh, 1998, p.3)35. The same point is made by Krugman (2000, p.42), according to whom ()microfounded models have not lived up to their promise (in the particular sense that they didnt add noticeably to our ability to match the
viable option. () As Gerry Bouey, a former governor of the Bank of Canada put it: we didnt abandon the monetary aggregates, they abandoned us.

For details about the New Consensus view, see Taylor, J.B (2000), Clarida, Gali and Gertler

(1999) and Fair (2000).


phenomena, ibid, p.39) and, therefore, after 25 years of rational expectations, equilibrium business cycles, growth and new growth, and so on, when the talk turns to the next move by the Fed, the European Central bank, or the Bank of Japan, when one tries to see a away out of Argentinas dilemma, or ask why Brazils devaluation turned out relatively well, one almost inevitably turns to the sort of old-fashioned () [IS-LM] model macro ().

1.2.3 - Why should one care about SFC issues? A mainstream perspective Considering that many neoclassical authors stressed the importance of SFC issues in the sixties and seventies36, the careless approach of current mainstream concerning these issues may strike some as surprising. Foley (1975), however, offers an elegant explanation of this apparent paradox. Indeed, well before the rational expectations hypothesis became hegemonic in the mainstream, Foley proved that, under the assumption of perfect foresight on average37, the distinction between stock and flow equilibria in asset markets is non-existent. In other words, under the assumption of rational expectations theres no logical problem in phrasing macroeconomic models just in terms of flows (or stocks), since a flow (stock) equilibrium would necessarily imply a
35 36

For a detailed account of central banking in practice, see Blinder (1998). See, for example, Christ (1967, 1968), Foley and Sidrauski (1971), Foley (1975), Turnovsky Foley uses the term perfect foresight without the qualification on average, but explains that

(1977) and Buiter (1980, 1983).


in more complex models of where expectations are represented as probability distributions, () [my] notion of perfect foresight corresponds to the assumption that the mean of that distribution is correct (Foley, 1975, p.315). We decided to include the qualification to avoid confusion with the more intuitive notion of perfect foresight as a synonym of zero expectational error. We also made a couple of (convenient and harmless) small changes in Foleys notation.


stock (flow) equilibrium as well. Given that Foleys reasoning touches a series of important methodological points of the SFC literature well discuss it in some detail in what follows38. Although this section is slightly more technical than the others, nontechnical readers can skip it without any major loss in continuity. It seems convenient for our purposes to start from Foleys views on the treatment of time in macroeconomic modeling. On this issue, he (p.310) agrees with Hahn that while in reality people may take decisions discontinuously, not all people take decisions at the same time and, therefore, that both continuous time models (that assume decisions made continuously) and period models (that assume that all transactions of a certain class occur in some synchronized rhythm) are unrealistic abstractions. Having established that, Foley (p.311) then concludes that a theorist using a period model must either establish a natural period in which decisions of many different agents are synchronized or accept the position that a period model is, like a continuous time model, an approximation of reality in which case outcomes of the macroeconomic model should not depend in any important way of the period used. Indeed, it seems natural to think that if one has no knowledge at all about the actual timing of the decisions of the aggregate of the agents, then one simply should not propose models that depend crucially on this timing. This conclusion has non-trivial implications, though. If the extent of the period (implicit in a period model) doesnt matter, then we must be able to decrease it, say, from a quarter to a week, or a day, or even a second without changing the qualitative outcomes of the model. What this means in practice is that a sound period model in


Even though we will not be particularly interested in the details of Foleys mathematical proof.

For those, see Foley (1975) and Buiter and Woglom (1977).


Foleys sense can always be transformed into a continuous time model by taking the limit of the size of the period equal to zero. A second important point made by Foley is that, even if we limit ourselves to period models, we still have at least two different concepts of equilibrium in asset markets, i.e, the beginning-of-period and the end-of-period equilibria39. In order to illustrate these concepts Foley assumes an economy with just two assets, money (M) and capital (K). If we also assume, a la Tobin and Foley, that the aggregate demands for these assets depend on both the aggregate wealth and their expected rates of return, well have the following equations: Md(t)=[1/pm(t)]* L{W(t), [(pm(t+t)-pm(t))/tpm(t)], [r(t)/pk(t) + (pk(t+t)-pk(t))/tpk(t)]} Kd(t)=[1/pk(t)]* J{W(t), [(pm(t+t)-pm(t))/tpm(t)], [r(t)/pk(t) + (pk(t+t)-pk(t))/tpk(t)]} where, Md(t) and Kd(t)= aggregate demands for money and capital at time t. pm(t) and pm(t+t) = expected price of money (i.e, the inverse of the price of goods) in times t and t+t L{}and J{}= real functions W(t) = expected aggregate wealth r(t) = expected profit rate at time t pk(t) and pk(t+t) = expected price of capital in times t and t+t and, of course, [(pm(t+t)-pm(t))/tpm(t)] = real rate of return on M

And, he adds that, although these two distinct characterizations () have quite different

theoretical consequences (p. 307), the () literature does not always recognize the distinction between () [them] and occasionally confuses them (p.304)


and [r(t)/pk(t) + (pk(t+t)-pk(t))/tpk(t)] = real rate of return on K In the end-of-period equilibrium, according to Foley (p.309), demands and supplies [of assets] are offered as of the end of the period. Agents can offer to sell K, for instance, which does not exist at the trading moment but which they plan to produce during the period. Contracts are made for labor and capital services and consumption during the period and asset deliveries at the end. So, in this case we have that the relevant supplies of assets are the supplies available at the end of the period (i.e, the supplies available in the beginning of the period, M(0) and K(0), plus the additions created within the period, M and K) and the relevant demands for assets take into consideration the portfolio the agents will want to have in the beginning of the next period (and, therefore, are functions of the expected returns two periods ahead). Formally: M(0)+M=[1/pm(t)]*L{W(t),[(pm(2t)-pm(t))/tpm(t)],[r(t)/pk(t)+(pk(2t)pk(t))/tpk(t)]} K(0)+K=[1/pk(t)]*J{W(t),[(pm(2t)-pm(t))/tpm(t)],[r(t)/pk(t)+(pk(2t)pk(t))/tpk(t)]} In the beginning-of-period equilibrium, on the other hand, trading in and delivery of assets are assumed to take place at the same time, that is, the beginning of the period. Within period consumption is contracted for but within-period production is done on a kind of speculation (Foley, p.310). So, in this case we have that the relevant supplies of assets are the supplies available at the beginning of the period (M(0) and K(0), i.e, the stocks inherited from the previous period) and the relevant demands for


assets take into consideration the portfolio the agents will want to have in the beginning of the period (and, therefore, are functions of the expected returns one period ahead). Formally: M(0)= [1/pm(0)]* L{W(0), [(pm(t)-pm(0))/tpm(0)], [r(0)/pk(0) + (pk(t)-pk(0))/tpk(0)]} K(0)=[1/pk(0)]* J{W(0), [(pm(t)-pm(0))/tpm(0)], [r(0)/pk(0) + (pk(t)-pk(0))/tpk(0)]} After having defined both kinds of asset equilibrium in period models, Foley then checks if they are indeed sound taking the limits of both sets of equilibrium conditions as t tends to zero40. By doing that, Foley is able to find two different continuous time types of equilibrium in asset markets (i.e, the different limit versions of the two different concepts of equilibrium in period models). Foley calls the continuous time analogue of the beginning-of-period equilibrium the stock equilibrium, since it equates an instantaneous demand to hold a stock of an asset with an instantaneous demand supply(p.315). The continuous time analogue of the end-of-period equilibrium, on the other hand, is called by Foley flow equilibrium, since it equates instantaneous flow demand[s] for () asset[s] with instantaneous flow () [supplies] (p.314). Foley then is able to prove that these two kinds of equilibrium have very different qualitative properties despite the subtlety of their differences and, in fact, are only equivalent under the perfect foresight on average hypothesis (and, therefore, under rational expectations as well). Foleys result, therefore, may explain why new classical macroeconomists often use flow and stock equilibria as perfect substitutes in rational expectations models.


Foley actually modifies a little bit the concept of end-of-period equilibrium, but well skip

the technicalities here. For details, see Foley (1975) and Buiter and Woglom (1977).


1.3 - The SFCA and Post Keynesian Macroeconomics The aim of this part of the paper is to discuss in an introductory and nonexhaustive way - the case for the wide adoption of the SFCA by Post-Keynesians as presented by Lavoie and Godley (2001-02, p.131). According to these authors: Post Keynesian economics, as reported by Chick (1995), is sometimes accused of lacking coherence,
formalism, and logic. (). The stock-flow monetary accounting framework provides (...) an alternative [logical] foundation [for Post-Keynesian macroeconomic modeling] that is based essentially on two principles. First, the accounting must be right. All stocks and all flows must have counterparts somewhere in the rest of the economy. The watertight stock flow accounting imposes system constraints that have qualitative implications. This is not just a matter of logical coherence; it also feeds into the intrinsic dynamics of the model.

Well discuss this claim in two steps. First, well present the SFC critique of the Keynes/Kalecki conventional short run macroeconomic equilibrium, still widely used by Post-Keynesians in general41. Second well discuss in more general terms what may go wrong when one doesnt take SFC requirements into consideration. While the arguments that follow are hardly new, we hope they will convince the reader of the crucial importance of the issue at hand.

1.3.1 - Stock-flow inconsistency in the GT As mentioned in the first part above, the SFC critique of the Keynes/Kalecki notion of short run equilibrium was the reason why the SFCA appeared in the first place. We chose to discuss it here for three reasons. First because it is an important particular example of the general point that Lavoie and Godley are trying to make, i.e, that the


See, for example, Davidson (1994), Lavoie (1992) and Palley (1996).


adoption SFCA offers more insight than (and may correct logical problems of) current practices. Second because, as mentioned before, versions of the Keynes/Kalecki short run equilibrium are still widely used today despite their logical problems. Third, because we strongly believe that Keynes and Kalecki were essentially right in their particular formulations and we hope this will highlight the constructive nature of the SFC critique42. One of the reasons why the discussion of Keyness short run equilibrium is useful to highlight the distinguishing features of the SFCA though certainly not the most important is that the exact meaning of this particular concept has been the object of intense controversy over the years43. SFC authors, on the other hand, use formal models of the whole economy that enable the reader to pin down exactly why the results come out as they do, as opposed to other writings on monetary theory that rely solely on a narrative method which puts a strain on the readers imagination and makes disagreements difficult to resolve (Godley, 1999, p.394). Be that as it may, well avoid here all the discussion about what Keynes really meant and follow chapter XVIII of the General Theory as closely as possible. As it is well known, in chapter XVIII Keynes divide the variables in his model in three groups, i.e. given, independent and dependent. He called the first two groups the deteminants of the economic system (the third comprises his endogenous variables) and added:


Even though the following discussion will focus on Keynes, we hope it will be clear that the For two of the many different interpretations of the exact meaning of Keyness short run

critique is valid for both authors.


equilibrium, see Amadeo (1989) and Asimakopulos (1991). Many others exist and we dont want to imply here that none of them is SFC.


the division of the determinants of the economic system into two variables is, of course, quite arbitrary
from any absolute standpoint. The division must be made entirely on the basis of experience, so as to correspond on the one hand to the factors in which the changes seem to be so slow or so little relevant to have only a small and comparatively negligible short term influence in our quaesitum [i.e, the given variables]; and on another hand to those factors in which the changes are found in practice to exercise a dominant influence in our quaesitum [i.e, independent variables]. (Keynes,

GT, ch. XVIII, p.247)

As is also well known, Keynes explicitly listed the stock of capital and labor among the given variables and, therefore, as noted by Hicks and Asimakopulos, Keyness short run represents an interval of time sufficiently brief so that changes during this interval in productive capacity, that occur continuously in any economy with positive net investment, are small relative to the initial productive capacity so that they can be legitimately ignored. This interval, however, must also be sufficiently long for most of the multipliers effects of a change in investment to have been completed within that period (Asimakopulos, 1991, p.68). But what about other macroeconomic stocks? What did Keynes have to say in the GT, for example, about macroeconomic stocks like the public debt, private wealth or the economys foreign debt? Not much, really. However, as Tobin (1980, p.75) points out, though Keynes was not explicit about assets other than capital, the spirit of the approach is presumably the same: the time span for which the model is intended is too short for flows to make noticeable changes in stocks (Tobin, 1980, p.75). At this point, we must be ready to understand the SFC critique of Keyness notion of short run equilibrium as described in chapter XVIII of the GT. The problem to put it briefly is that if one thinks about stocks in general (and not only the stock of capital), especially financial stocks, it doesnt really make sense to think of them as given


variables. As noted by Tobin in his Nobel Conference, thats precisely why "the interpretation of the solution to a Keynesian short-run macroeconomic system has always been ambiguous. () Is the solution an equilibrium in the sense of a position of rest? This can hardly be the case for a model whose very solution implies changes in the stocks of capital, wealth, government debt, and other assets. Since the structural equations of the model depend on those stocks, they will not replicate the solution when the stocks are moving. Keynes himself recognized the problem but excused himself for ignoring the dynamics of accumulation by defining the horizon of the analysis as short enough so that flows make insignificant difference to the size of stocks. The excuse makes tolerable sense for the stocks of physical capital and total wealth, but unbalanced government budgets, monetary operations and external imbalances can alter the corresponding asset stocks quite rapidly. A model whose solution generates flows but completely ignores their consequences may be suspected of missing phenomena important even in a relatively short-run, and therefore giving incomplete or even misleading analyses of the effects of fiscal and monetary policies". (Tobin, J, 1982, p. 188).

1.3.2 - What exactly are the problems? - A Summary A lot of things happen when one takes explicitly into account all stock-flow relations implicit in Keyness equilibrium. First, as mentioned before, Keyness static system turns into a dynamic one. Second, one gets a series of new variables to explain. Clearly, for example, the flow of net investment adds to the size of capital stock. What is then the influence of this increased stock in the subsequent flows of investment and income? Any explicit theoretical answer to this question, whatever it might be,


necessarily involves an assertion about stock(of capital)-flow(of investment or of income) ratios. Stock-flow ratios are at the core of most of current policy-relevant issues. How does the size of government debt affect interest rates (and through this channel) GDP? Whats the optimum external debt to exports ratio for under-developed countries? How does the private stock of wealth (including the stock market part of it) affect the flows of consumption and imports? What does conventional Post Keynesian (or Keynesian, for that matter) economics have to say about these crucial issues? The first general point to be made here is precisely that stock-flow ratios play a crucial role in modern capitalist economies and, therefore, models of these economies must necessarily include them. Surely one cant do that without theorizing about them. The need for this continuing theorizing effort is a second general point being made here. To state that Post-Keynesians in general dont know much about stock-flow ratios doesnt mean, of course, to state Post-Keynesians dont now anything at all about them. There are, of course, many Post-Keynesian models dealing with stock-flow issues44. The problem here is that it is not clear how much their conclusions are affected by the stockflow inconsistency bias. So, the third general point being made here is precisely the one made by Tobin about Keynes. If a model generates flows it has to deal with all their consequences, otherwise it may very well give misleading analyses. The fourth and last point we want to make here related to the third above - is that, as well discuss below, when one explicitly takes into consideration all the flowflow, stock-flow and stock-stock relations implicit in a given macroeconomic model of

Again, a detailed list would be beyond the scope of this paper. Two examples are Thirwalls

growth model (see, for example, McCombie and Thirwall, 1994, ch.3) and Davidsons interpretation of chapter 17 of the G.T (see, for example, Davidson, 1972, ch.4).


hypotheses (that is, if one works with a closed system in which every flow comes from somewhere and goes somewhere), one gets to know all the (often non-trivial) systemwide logical requirements implicit in the system at hand and these impose a lot of structure in the models.

1.4 - Some notes on the state-of-the-art of SFC work SFC model building has gone a long way in the last two decades, especially since the second half of the 1990s45. A common SFC methodology based on the pioneering work by Brainard and Tobin (1968) and refined by Wynne Godley in a long series of papers has been established and its application to a series of socially relevant policy issues has shed light on many previously dark areas. Yet, the SFCA is still relatively recent and a lot remains to be done. In what follows well attempt to summarize the main features of the recent SFC literature. Hopefully, this summary will convince the reader that this line of research is a clear and progressive alternative to current mainstream macroeconomics.

1.4.1 - The Tobin-Godley methodology for theoretical work in macroeconomics In somewhat schematic terms, the consensual methodology implicit or explicit in the recent SFC literature consists of three steps, which are: (i)do the (SFC) accounting first; (ii)establish the relevant behavioral relationships after that; and then (iii) perform comparative dynamics exercises (generally with the help of computer simulations) to see how the model behaves. As this description makes clear, as does our interpretation of


See footnote 6 for a representative sample of recent SFC work.


the SFCA as a natural development of the Keynesian research program, this TobinGodley methodology has close similarities to the one implicit in the old Keynesian models. As this fact may give the reader the wrong impression that theres nothing really new being said in the recent SFC literature, it seems appropriate to emphasize here the differences between these two methodologies46. Beginning with the first point, we mentioned before several reasons why SFCA authors rely so much on consistent accounting frameworks. In practice this means that the first thing a SFC theorist must do in order to analyze a given issue is to make sure he or she has an adequate SFC accounting framework to deal with it47. There are no exceptions to this rule, no matter the kind of issue being analyzed. If no such accounting framework exists, the SFC theorist has to design it herself. Data availability is, in fact, irrelevant in this first step. What the theorist gets from this accounting exercise is the whole set of system-wide logical requirements that are relevant to the issue at hand. These come in three kinds. First, there is the intrinsic SFC dynamics of the system, i.e, the fact that flows necessarily increase or decrease stocks and these, by their turn, influence future flows. Second, there are the sectoral budget constraints, i.e, the fact that in each accounting period the decisions of economic agents alone and in the aggregate are constrained by what they have in the beginning of the period48, what they earn during the period and their access to credit. Third, there are the adding up

See, for example, Klein and Young (1980) for a nice example of an old neoclassical

Keynesian flow macroeconometric model. Modern expositions of the Cowles Commission approach (like Fair, 1984) are very close to the Tobin-Godley methodology, though.

We dont want to imply that the choice of the adequate accounting framework is independent Subject also to liquidity constraints, as Keynes would have emphasized.

of theoretical considerations, though. The contrary is true, as argued in the first part of this paper.


constraints, i.e, the fact that accounting identities imply that the whole must necessarily equal the parts and certain (combinations of) stocks and flows must necessarily equal others. Concentrated attention on these logical requirements differentiates SFC macro models from conventional Keynesian ones. Many authors explored some implications of some of these logical requirements in the past, but very few of them realized/emphasized the importance of always trying to explore all the implications of all of them. A careful analysis of these requirements has important implications also for the choice of the behavioral equations of the model, the second step of the Tobin-Godley approach49. First, the use of SFC accounting frameworks makes clear the necessity to theorize about stock-flow ratios (since they have non-trivial dynamic implications). Second, and perhaps more obvious, the use of any accounting framework implies a given number of degrees of freedom to the system and this limits the number of possible model closures as discussed in the first part of this paper. Note, however, that in complex accounting structures the nature of these degrees of freedom may not be obvious at first sight. In particular, the use of a water-tight SFC accounting framework implies that in an economy with n sectors, the financial flows of the nth sector are completely determined by the financial flows of the other n-1 sectors of the economy50. This fact has nothing to do with the neoclassical concepts/assumptions such as Walrass Law, utility maximizing individual agents, market equilibrium and etc. It happens simply because what sectors 1 to n-1 (in the aggregate) pay to sector n is equal to what sector n receives from these sectors and vice-versa.

Along, of course, with other theoretical considerations and more traditional concerns with the See Godley, 1996 and 1999.

structure of the economy at hand (that are also present in the choice of the accounting itself).


After the first two steps what one generally gets is a complicated system of nonlinear difference/differential equations. The third step, naturally, is to perform a series of comparative dynamics exercises to evaluate the sensitivity of the model dynamics to changes in parameters and key exogenous variables. Given that analytic solutions to these systems are seldom available, SFC practitioners often must use computer simulations to try to approximate them. As Godley (1996, p 22) puts it, this approximation is often good in practice:
() with numerical solutions (), we can gain insights into how the system as a whole functions, by first obtaining a base solution and then changing one exogenous variable at a time to see what difference is made. It might seem as a though any particular model run depends so much on the particular numbers used that the results are completely arbitrary and have no general application at all. However, it is my experience that repeated simulation, combined with iterative modification of the model itself, does progressively lead to improved understanding, for instance, of what the stability of the system turns on, what combinations of parameters are plausible and how the whole thing responds when subjected to shocks.

The schematic presentation above should not lead the reader to believe the three steps are taken independently. There is a lot of back and forth movement between them and, as mentioned before, a lot of art is involved in the model building process. However, SFCA authors strongly believe that this methodology provides a logical and coherent way to approach macroeconomic issues.

1.4.2 - Recent Developments and Unknown Territory The recent SFC literature has both destructive and constructive sides. In fact, many recent papers have used the SFCA to find inconsistencies in existing macroeconomic models. So Taylor (1998a, 1999 and 2002), for example, has argued that


the famous Mundell-Fleming model is logically inconsistent because when full SFC accounting is respected it can be shown that it has one fewer independent equation than one usually thinks, while Godley and Shaikh (2002) have argued that the standard (neo) classical macroeconomic model is also stock-flow inconsistent and, although it can be fixed with minor changes, the consequences of these changes are far from minor. One must not overemphasize this destructive side of the SFCA literature, though. Indeed, not only does the use of the SFCA help to identify inconsistencies in existing macroeconomic models, but it also (almost simultaneously, in fact) helps to fix them. So all the papers mentioned above offered SFC alternatives to the previously inconsistent models they criticized. Also on the constructive side, the SFCA has recently been used to shed light on a number of policy relevant issues. So, while Taylor (1998b) has used it to criticize the plausibility of current mainstream models of speculative attacks and financial crises and propose a new one, Godley and Lavoie (2002) have used it to study complex monetary arrangements like, for example, the European Monetary Union and Izurieta (2002) has used it to analyze the consequences of dollarization schemes. As mentioned before, new SFC work sometimes requires the construction of new SFC accounting frameworks. Indeed, both Taylor (in his critique of the Mundell-Fleming model) and Godley and Lavoie(2002) and Izurieta (2002) (in their analyses of the EMU and dollarization schemes), for example, used versions of Godleys original accounting of two interdependent economies which together form the whole world in their papers51.


See Godley (1999b) for details.


The frontier of the SFCA is not limited to finding inconsistencies in existing macroeconomic models and developing new SFC accounting frameworks and models for new problems, though. Although a discussion of empirical SFC models would have extended this paper far too long, these models have continuously been used for policy analysis in the last decades52. Empirical specifications of SFC models involve a large number of unsettled issues related to the transition from theoretical to empirical macroeconomic models. Theres no consensus, for example, about applied issues such as the choices of (i) the size of models, (ii) their degree of aggregation, (iii) the relevant accounting period, (iv) the relevant econometric techniques and etc. Research on SFC models, therefore, can conceivably benefit from current research in selected fields of the mainstream, like those related to computer simulated agent-based models (that might illuminate issues related to aggregation), application of optimal control theory to policy analysis and advances in macroeconometric techniques, for example.

1.5 - Conclusion Stock-Flow consistency can be seen from different angles. As we tried to argue, people that strongly believe in the efficiency and speed of the self-adjusting properties of markets tend to see it as a mere detail that can be trivially met and probably can be ignored without it causing any major problems. People that dont believe that markets and agents are (or even can be) so rational and informed, on the other hand, tend to


See, for example, Davis (1987a and 1987b), the SFC papers in Taylor (1990) and Alarcon

(1991) and the series of applied papers by Wynne Godley both at the Department of Applied Economics of the University of Cambridge and at the Levy Economics Institute (like, for example, Godley, 1999c).


believe (or, at least, should admit the possibility) that SFC requirements impose a great deal of structure in an otherwise extremely unpredictable economic environment. Therefore, although both sets of economists are advised to pay careful attention to these requirements and issues, this paper tried to argue that the second set has much more reasons to do so than the first. This paper also attempted to present a summary of the current state-of-the art of the SFCA research. Although its impossible to make justice to both the breadth and the potential implications of current research in a couple of pages, we hope to have given enough evidence of the continuous progress made by SFC authors in the last two decades and of the possibilities of this line of research.


2 - Cambridge and Yale on Stock-Flow Consistent Macroeconomic Modeling Introduction The last 5 years have witnessed a revival of the stock-flow consistent approach to macroeconomic modeling (SFCA) that was at the frontier of Keynesian research in the seventies and eighties53. SFC models didnt receive proper attention at that time dominated by the endless debates that followed the so-called New Classical counterrevolution and, with notable exceptions, practically disappeared from the literature for a while. However, with most of the profession now convinced that New Classical economics doesnt offer convincing explanations for the dynamics of actual economies in historical time, macroeconomists of all sorts are increasingly rediscovering old truths. This process is not an easy one, though. Its just symptomatic that the modern New Keynesian consensus has been criticized precisely for neglecting the stock-flow relations emphasized by the SFCA54. Part of the problem is that, given their emphasis on water tight accounting frameworks, SFC authors and models are often perceived as either national accountants (accounting) or applied economists (economics). This is a truth, but only a half-truth55. Proper stock-flow consistent accounting imposes a great deal of structure to macroeconomic models by making their system-wide logical implications clear to the analyst. It also makes explicit the need for theorizing about a whole lot of forgotten
53 54 55

As discussed in section 1.4.2 above. As seen in section 1.2.2 above. Its true, in particular, that SFC macro models are often used (as any good macro theory

should) in applied research and are based on national accounting schemes. E.P Davis (1987a and 1987b), L.Taylor (1990), Alarcn (1991) and Godley (1999b) provide many examples of applied SFC macro models.


variables (i.e., the ones that do not appear in stock-flow inconsistent models, though logically implied by their hypotheses), especially stock-flow ratios56. These are all theoretical issues, not applied ones. Of course, we dont want to imply here that there hasnt been any economic theorizing about stock-flow ratios in the past. What we do want to imply is that most people that did this theorizing either assumed problems away with strong hypotheses about rationality of agents and instantaneous market-clearing57 or didnt care to phrase their arguments in a proper SFC model58. Although the later group is clearly more interesting than the first, their message is at best incomplete. As put by Tobin (1982, p.188), a model whose solution generates flows but completely ignores their consequences may be suspected of missing phenomena important even in a relatively short-run, and therefore of giving incomplete or even misleading analyses (). Indeed, even though the number of possible closures for any reasonably realistic SFC accounting framework is huge59, very few authors have written reasonably complete SFC models in the proper sense of the term and one can clearly distinguish in these writings a Yale (or Brainard-Tobin-type) and a (New) Cambridge (or Godley56

Which, by the way, are at the core of many unresolved policy issues. Just to mention two

among many other possible examples, what policy-makers think about the public debt to gdp ratio and the external debt to exports ratio will probably determine to a good extent the supply of public and imported goods that will be made available to the people. Its symptomatic that most Keynesian macro has focused only on static variables like the public debt or the rate of inflation and (to a reasonable extent) neglected dynamic ones.

See Foley (1975) for a proof that stock and flow equilibria are indistinct under rational This is the case of heavy-weights like Friedman, Harrod, Hicks, Meltzer and Modigliani,


among many others.


type) types of closures60. As mentioned before, most of these ideas were written in the seventies and eighties and, yet, we hope to demonstrate in what follows that they deal in a careful and profound way with many theoretical issues that are still open as of today. In fact, a second goal of this paper is precisely to provide a context for the current SFC discussion. Note, however, that SFC authors have written extensively about issues so different as the behavior of banks, financial markets in general, industrial pricing, wage determination and open-economy macroeconomics. Although all these issues can be seen as part of the broad SFCA research program, we will restrict ourselves here to the discussion of what these authors had to say about macroeconomic models of closed economies with Fixprice goods market and Flexprice financial markets61. This decision means that one must regard this paper as an introductory effort. In particular, most SFC discussion in the seventies and eighties (especially at Cambridge) dealt with inflation accounting and open-economy issues and these are neglected here. In what follows we do four things. First, we present the (SFC) accounting framework of the closed artificial economy that will be used in this paper and a couple
59 60

As stressed by Taylor (1990, p.46) Examples of Yale-type models are Brainard and Tobin (1968), Foley (1975), Tobin and Buiter

(1976), Braga de Macedo and Tobin (1979), Backus (1980) and Tobin (1982). The British team is represented by Cripps and Godley (1976), Godley and Cripps (1983), Anyadike-Danes (1987) and Godley and Zezza (1989), among others. We dont want to imply, of course, that other authors didnt write related material at that time. Fair (1974, 1984 and 1994) is an obvious example from Yale, but note that, as he put it himself, what is commonly referred as Yale macro is quite different in emphasis from () [his] own work (Fair, 1984, acknowledgments).


of generic theoretical issues related to the SFCA. After that, we discuss formally the characteristics of both our (somewhat stylized) Yale-type (in section 2.2) and (New) Cambridge-type (in section 2.3) closures of the accounting framework presented before. The fourth section discusses briefly some recent work by Godley (1996, 1999) and Lavoie and Godley (2001-2002) that propose a synthesis of the two pure models presented in the previous parts.

2.1 - The Accounting framework and its implications This part of the paper is divided in two sections. Section 2.1.1 below presents the artificial economy we will use as a neutral theoretical court in which the arguments of both schools can be presented and compared62. Section 2.1.2 discusses a couple of theoretical issues that usually arise in such discussions.

2.1.1 - The artificial economy In our artificial economy there are (a) four macroeconomic sectors, i.e., households, government, (non-financial) firms and banks, (b) six assets, i.e., highpowered money (currency and bank reserves), demand deposits, time deposits, government bonds, business equity and business loans and (c) one produced good63. Table 1 below summarizes the main characteristics of the economy at hand.

In other words, well be reducing important theoretical issues either to specific behavioral We leave to the reader the task of judging the neutrality of our framework, though. This one good economy hypothesis is characteristic of Yale-type models (see Backus,

hypotheses or to specific parameters of a macro model of a closed economy.

62 63

1980, p.263). Cambridge economists, on the other hand, have always tried to theorize directly about aggregates. For convenience, we chose here to phrase Cambridge models in terms of Yale


Beginning with the households, our simplifying assumptions made only for convenience - are that (i) they dont have access to credit, (ii) they dont invest, (iii) their wealth is divided among five possible assets (i.e., cash, money and time deposits, equity and government bonds), (iv) they dont pay taxes, and (v) their total income consists of wages, dividends and interest payments on bonds and time deposits. A close look at Table 1 below is probably more informative than any written description, though. The upper part of the table accounts for the current transactions made in the economy64, so hypotheses (ii), (iv) and (v) should be obvious just by inspection of the upper part of the households column (note that a plus sign before a variable indicates that money is being earned, while a minus indicates that money is being spent). The lower part of the table accounts for the consequences of the transactions in the first part over the total wealth of the sectors (summarized by the current savings of the sectors) and the capital transactions, i.e., the changes in the composition of these stocks of wealth (a plus sign in this case indicates a source of funds, while a negative sign indicates a use of funds). Again, it takes only a look at the lower part of the households column to get assumptions (i) and (iii) right.

ones. The alternative unavoidable in empirical work would have forced us to deal with complicated price and volume indexes.

With the exception of purchases of capital and inventory accumulation by firms. These are

both current receipts (from the point of view of firms that sold them) and capital expenditures (from the point of view of firms that acquired them).


Table 1: Flows of funds at current prices in our artificial economy

Sectors Transactions P.Consumption G.consumption Inv. in fixed K inventories Wages Taxes Int. on loans Dividends Int. on Bonds Int. on time deposits Current Savings: Savings cash demand deposits time deposits Loans66 Bonds Equities -PBBh -PEE Sh + Net capital transactions = 0 +PEE Sf + Net capital transactions = 0 Sg + Net capital transactions = 0 Sb + Net capital transactions = 0 -Mt + L -R +PBB +Mt -L+ R -PBBb +F +XBh-1 +imMt-1 Sh Sh Sf Uses and Sources of Funds Sf Sg - Hh -Md + H Sg Sb=0 - Hb +Md +WB Households Current -C Capital Firms Current +C +G +PK +IN -WB -T -il*L-1 -Ff -XB-1 +T +igR-1 +ilL-1 - igR-1 -Fb +XBb-1 -imMt-1 Sb=0 -PK -IN

Government Capital Current -G Capital

Banks Current Capital

Accounting memo: Y C + G +PK +IN National Income

65 66

Yale-type models generally value investment differently (see section 2.2.2 below). Technically, R (the change in discount loans) should be included in H and Hb. See section

2.2.3 below for details.


Turning now our attention to businesses, we assume for simplicity that all the goods and services of the economy are produced by firms (so banking services, for example, are not assumed to be part of GDP). As should be clear from the inspection of the upper part of the firms column of Table 1 above, retained profits of firms are assumed to be equal to their total (final) sales (C+ G+PK) plus their net acquisition of inventories minus their payments of wages, taxes, interest on loans and dividends to owners. The inspection of the firms uses and sources of funds, on the other hand, makes clear that we are assuming that they finance their accumulation of capital with loans, equity emissions and retained earnings (Sf). We are, therefore, assuming away (i) private bonds as a possible source of funds for firms and (ii) financial speculation by firms (since they dont keep wealth in the form of financial assets). The government (assumed here to include a central bank), by its turn, gets its income from taxes (assumed, for simplicity, to be paid only by firms) and interest payments received on discount loans to banks. Its expenses are purchases of goods and services from firms and interest (on debt) payments to banks and households67. Again for simplicity, government debt is assumed to consist only of perpetuities, i.e. bonds that pay a fixed amount of money ($X) per period. The assumption is that these bonds are traded in a market and, therefore, have a price PB. As a consequence, the value of the stock of public bonds at any given period will be PBB, i.e. the price of each bond (PB) times the number of bonds owned by the public (B). Public deficits (surpluses) are supposed to be financed (used) either by (with) increases (decreases) in high-powered money or by (with) sales (purchases) of public bonds.


Finally, banks receive interest payments from firms (on their loans) and government (on their government bonds). Their expenses consist of interest payments on time deposits and rediscount loans. To avoid unnecessary accounting complications, we are assuming that (i) banks dont need workers or fixed capital to operate and (ii) all their profits are distributed to their owners. Their assets consist of reserves, public bonds and loans to firms (but, for simplicity, no equities) and their liabilities consist of their deposits and (if necessary) discount loans from the Central bank.

2.1.2 - Some specific theoretical issues related to the SFCA A matrix like the one in Table 1 above implies a huge number of theoretical issues that ultimately have to do with the very definition of macroeconomics. We are well aware, in particular, that analyses about aggregates necessarily imply a large number of more or less arbitrary assumptions, all of which can very well be questioned. However, as our present purpose is not to discuss the macroeconomic method in general, we will restrict ourselves to a couple of theoretical issues closely related to the SFCA. First, wed like to discuss more closely the system-wide implications mentioned above. The first thing to note is that ex-post all rows in Table 1 above add up to zero68. This is a straightforward consequence of the fact that what one sector pays to the others is exactly equal to what the others receive from it, but has the non-trivial implication that the accounts of the n-th sector of the economy are completely determined by the accounts


So other assumptions made only for convenience and explicit in the Table 1 above - are that This is not true ex-ante, though. See Moudud (1998, ch.5) and the discussion below for details.

the government doesnt invest and all public workers are volunteers.


of the other n-1 sectors69. Second, the vertical sums of the columns can easily be transformed in ex-ante sectoral budget constraints. Indeed, note that from the households column, for example, we have that: Sh = WB + F + imMd-1 + XBh-1 C Now note that the change in the (net) stock of households wealth (W) in any given period is given by households savings plus the (net) capital gains/losses on households assets (CGLhe). We can, therefore conclude, that the households ex-ante budget constraint is given by: We = CGLhe + She or, equivalently, Hhe - Mde -Mte PBBhe PEEe = CGLhe + WBe + Fe + ime Md-1 + XBh-1 Ce

Note that these budget constraints are important because they make explicit several stock-flow relations that are somewhat obscured in non-SFC models71. First, they make clear that current flows of savings and capital gains/losses accumulate in (or decrease the) stocks of wealth that subsequently will affect the future behavior of the


What is particularly important for applied studies in under-developed countries in which data Note that these ex-ante budget constraints only apply if agents are rational (while the ex-post

availability is a serious issue. See Dawson (1996, part IV) for details.

ones apply anyway). If this is the case, the column sums of Table 1 above are zero even ex-ante. The row sums, by their turn, will only be zero ex-ante if the (aggregated) plans of the all the sectors are mutually compatible. As well discuss in section 2.2.6 below, this is never the case in practice.

We are well aware, of course, that these budget constraints are not particularly easy to measure

in practice and are likely to vary a lot with slight changes in the accounting definitions used to measure them. To make matters worse, the definitions used in FoF and NIPA accounts are not always the same (see the discussion in section 1.1, especially footnote 25, for details) what implies that their integration is not an easy task.


economy72. Second, they remind us that the extent to which flows (stocks) are affected by stocks (flows) depends crucially on their relative sizes. Third, and related to the second, they make clear that several stock-flow processes are unsustainable73, like for example the ones that imply a sustained growth of debt to income ratios of some sectors (and, necessarily, sustained growth of wealth to income ratio of the others). In other words, they remind us of things that cannot happen (say, the sum of the parts be smaller than the total) but also of things that are not likely to happen (say, a rapid growth of the debt to income ratio of households or firms continue for a long time74). A second important theoretical issue to mention is that the accounts above dont imply anything about equilibrium concepts or the extent of the (finite) accounting period used. In other words, they are valid whether the economy is in or out a state of equilibrium (whatever this might be) and whether the (finite) accounting period under consideration is an hour or a year75. As Foley (1975) has shown, in period models (i.e., models in which the accounting period is finite) there are at least two qualitatively different (neoclassical) concepts of assets equilibrium. As well see in what follows, Foleys point is more relevant to the Yale closure than to the Cambridge one (since Cambridge-type models dont depend on neoclassical concepts of equilibrium). Be that as

Turnovsky (1977, p.xi) calls this stock-flow dynamics the intrinsic dynamics of the In the sense of Godley (1999c) Because ceteris paribus this would imply a rapid and continuous increase of the share of

macroeconomic system.
73 74

income spent with interest payments and, therefore, a rapid and continuous decrease of the share of income spent with everything else. The same would be true to the external debt/exports ratio of a small economy.

Changes would have to be made (particularly in the way interest payments are modeled) if the

analysis was in continuous time, though.


it may, in what follows whenever a reference is made about events happening in historical time the assumption will be that the accounting period is a quarter.

2.2 - A Yale-type closure As phrased by Backus (1980, p.272-273), the main hypothesis of the Yale story is that subject to the budget constraint imposed by () prior claims (i.e., items that are pre-determined by earlier decisions or by inherited stocks) a sector is imagined to formulate long-run target asset and wealth positions, based on current and expected interest rates, incomes and other relevant variables. Actual positions are then adjusted toward these targets. Transitory factors like windfall gains and losses will also influence these adjustments. Formally this means that, in any given accounting period, all (aggregate) decision variables of all sectors of the economy should in principle be modeled as functions of (i) all the variables that determine the sectors budget constraint in that particular period and (ii) all the variables that determine the sectors long run target asset and wealth positions (basically expected future income and real rates of return of the various assets)76. Indeed, this general equilibrium approach is not only a trademark of Yale-type authors but, in fact, the very starting point of their research program. As early as 1968, for example, Brainard and Tobin (1968, p.99) wrote that all of us seek and use simplifications to oversee the frustrating sterility of the clich that everything depends on everything else. But we all know that we do so at some peril. () we argue for the importance of explicit recognition of the essential interdependencies of markets in theoretical and empirical specification of financial markets.


As one would expect from a research program that extended for several years, there are many (often subtle) variations of the basic Yale-type story. In what follows well discuss these subtleties in some detail and try to come up with a representative Yale-type model. For clarity, well denote variables valued at constant prices and all kinds of rates and ratios by lower case letters and variables measured at current prices and all kinds of physical stocks by upper case letters.

2.2.1 - Households behavioral equations in Yale-type models: From Table 1 above, its clear that the variables in control of the households of our artificial economy are (i) C (and, given the households disposable income, therefore Sh77) and (ii) the allocation of their stock of wealth W=Hh+Md+Mt+PEE+PBB. As noted by Fair (1984, p.42), one could also assume that households try to affect their wage bill (WB) choosing the hours they want to work. Here, however, well work with the Keynesian version of Yale-type models and assume that both the nominal wage and the general price level (P) are fixed and that the labor supply is perfectly elastic at the given real wage. In other words, well assume that (in the beginning of each accounting period) households treat their expected disposable income (to be earned within the period) as a pre-determined variable. As put by Tobin (1982, p.187), the innovation of the [Yale] approach () is the integration of saving and portfolio decisions. This integration is modeled by assuming that households are aiming for end-of-period stocks of value () in terms of

In disequilibrium specifications one needs also the variables that influence the adjustment Keep in mind, however, that our table doesnt include capital gains or losses.

process of the portfolios to their long run targets.



consumption goods at prices of the period. These are functions () of current-period variables interest rates and expected asset yields, incomes, taxes and etc and of state variables determined before the period. The latter include households beginning of period asset stocks (Tobin, 1980, p.87). In other words, the assumption in Yale-type models is that the decision variables of the households are all their real demands for assets and these are assumed to be functions of all the variables that determine the sectors (expected, real) budget constraint and its long run target asset and wealth positions78. Here well follow Backus (1980, p.263) and model these demands as follows79:


As mentioned above, its crucial in Yale-type models that all demands for assets are modeled as

functions of the same variables. This point, first made by Brainard and Tobin (1968), is summarized by Tobin (1982, p.173) as follows: () if demand functions are not explicitly specified for the whole range of assets, the function for the omitted category implied by the wealth demand function and the explicit asset functions may be strange in ways unintended by the model-builders. For example, if money demand is related negatively to an interest rate and total wealth demand is not, the implication is that nonmoney asset functions carry the mirror image of the interest effect on money. The best practice is to write down all the functions explicitly, even though one is redundant, and to put the same arguments in all the functions.

Yale authors have progressively included more and more variables in the households demands

for assets. In the 1968 version of the model, for example, only (within-period) wealth, income and interest rates are used. Real/nominal distinctions and capital gains and losses werent discussed and savings and portfolio decisions werent integrated back then. Tobin (1982, p.184), on the other hand, presents a maximalist specification that includes four kinds of variables: those that are within period endogenous () lagged variables of the within period endogenous, expected future variables of within period endogenous; exogenous variables, past contemporaneous or future. The within period endogenous variables of the (closed economy) Keynesian version of the model are income and the relevant real rates of return. Tobin was less specific about the exogenous variables, though, pointing out (1982, p.186) that detailed specifications of the models would include also considerations about the income distribution and


[ad] = f (rhe , rme, rbe, ree, a-1, yde) where, a = [Hh/P, Md/P, Mt/Pt, (PB/P)Bh , (PE/P)E] = (hh, md, mt, pBBh , pEE) represents the households real stocks of the various assets; the superscripts d and e mean desired (or demanded) and expected; rhe , rme, rbe and ree are the (expected, one period) real returns in money (either in cash or money deposits), time deposits, government bonds and equities (respectively, including capital gains); yde is the expected households real disposable income [(WB+F+ imMd-1+XBh-1) /P]e and f: R9R5 expresses the households demands for assets as functions of the various expected real rates of return and the households expected income and previous portfolio. Therefore, the desired change in households real net wealth is given by : whd= hhd+ mdd+ mtd+ (pBBh) d+(pEE)d) i.e., the sum of the components of: ad - a-1= [hhd, mdd, mtd, (pBBh) d, (pEE) d] Its important to notice a couple of things in the formalization above. First, as put by Coutts and Godley (1984, p.14), it contains virtually no mention of aggregate () consumption (). The explanation, of course, is that consumption is implied by households savings and expected disposable income. Note, however, that whd is not in general equal to households desired real savings (shd) because, as put by Tobin (1980, p.88), households are assumed to () take full account of appreciations of existing

age structure of the economy, as well as human capital, expected future wages, taxes and transfers ().


holdings associated with each vector of asset prices when making their plans80. What this means in practice is that whd = shd + cglhe (expected real capital gains or losses in householdsassets) and, as a consequence, yde and ad (and, therefore, whd) are not enough to determine desired real aggregate consumption (cd). One needs shd (=whd cglhe), as well. Given yde, ad, and cglhe, however, one trivially finds shd and cd(= yde- shd)

. Second, to get to know precisely all the real rates of return and capital gains

involved in the formalization above, well need to add a little more notation. So, lets call PA the vector of the prices of assets, so PA = (PH, PMt, PMd, PB, PE) = (1,1,1, PB, PE), meaning that it costs $PB to buy a government bond, $PE to buy a stock and $1 to get $1 either in ones wallet or in a bank (either in a money or in a time deposit). Analogously, lets call A=(Hh, Md, Mt, Bh, E) the vector of quantities of assets. Its clear, then, that in the beginning of the period the total nominal stock of wealth of households will be: W-1=Hh-1+Md-1+Mt-1+ PB-1Bh-1+ PE-1 E-1 = PA-1A-1 and its real counterpart will be: w-1 = W-1/P-1 = (Hh/P+Md/P+Mt/P+ PBBh/P + PEE/P)-1 = (hh+ md+ mt+ pBBh , pEE)-1 or, equivalently, w-1 =(PA-1A-1)/P-1


Tobin (1980, p.88) recognizes that this hypothesis () may be unrealistic. Household

portfolios may adjust to capital gains and losses only partially within the period they occur, remaining adjustments occurring later but adds that it is used only to simplify matters (since, it would be possible to modify the specification in this direction). See section 2.2.6 below for more on this issue.

Note that given, our hypotheses about both banks and non-financial businesses (see below),

households disposable income will be equal to the private sectors disposable income and therefore YDh Sh = Ch = C.


Now note that, even if the households dont save/dissave anything (so, A=A-1) their wealth in the end of the period (both in real and nominal terms) is likely to be different. Indeed, always keeping in mind that we are assuming inflation away, in this case we would have82: W(with Sh=0)= Hh+Md+Mt+ PBBh-1+ PE E-1= PAA-1 = PAA and, therefore, W (with Sh=0)= W-W-1 =(PB- PB-1)*Bh-1 + (PE -PE-1)*E-1= CGLh = P*cglh Note, finally, that in the general case, Sh wont be zero. Indeed, (nominal) households savings are given by: Sh=W CGL h=(Hh+Md+Mt+PBBh+PEE)-(Hh-1+Md-1+Mt-1+PB-1Bh-1+PE-1E-1) -CGLh or equivalently, Sh=W CGL h= PAA - PA-1A-1 - (PB- PB-1)*Bh-1 + (PE -PE-1)*E-1 and, naturally, sh = Sh/P = wh - cglh. The cookbook recipe to calculate the (one period) expected real rates of return of the relevant assets is the following: first add the expected real value of each asset in t+1 to the expected real value of the receipts associated with the asset in t+1; then divide this sum by the real value of the asset today and subtract one from the result. The one period expected real rate of return on bonds (rbe), for example, is given by: rbe =[(PB+1e/P+1e + X/P+1e) / (PB/P)] 1 (note that $X= nominal payment for bond in t+1) or, assuming that P+1e = P, rbe =[(PB+1e+ X) /PB] 1 Analogously, rme=[(1/P+1e+ im/P+1e) /(1/P)] 1 (note that im=interest received per dollar in t+1), or, assuming that P+1e = P, rme = im ; rhe =[(1/P+1e) / (1/P)] 1 or, assuming that P+1e = P, rhe = 0 ;

As Coutts and Godley (1984, p.14-17) remind us, the accounting gets a little bit more


and ree=[(PE+1e/P+1+Ff+1e/EP+1)/(PE/P)] 1 (note that Ff+1e/E=expected dividends per equity in t+1), or, assuming that P+1e = P, ree = [(PE+1e+ Ff e/E) /PE] 1 A third thing to note on the formalization above has to do with the concept of equilibrium implicit in Yale-type models. We took special care with superscripts (that, by the way, dont appear in actual Yale-type models) to emphasize a series of unresolved issues that appear when one thinks about what exactly this equilibrium would mean in real historical time83. Note, for example, that all current variables in the equations above are only known for sure in the end of the current period (so, in the beginning of the period they are expected as well). A complete macroeconomic equilibrium, then, can only be reached by either an incredible coincidence or a very competent auctioneer. Well return to this issue in sections 2.2.5 and 2.2.6 below. Note, however, that Yale authors have emphasized in several passages that their use of the concept of equilibrium is merely instrumental84. Note, finally, that the framework above has the advantage of being flexible enough to accommodate several changes in the hypotheses of the models. In particular, it can be easily modified to deal with changes in the degree of aggregation of the model and more financial assets. For example, Yale authors often mention the importance of distinguishing between wealth-constrained (rich) and liquidity constrained (young, poor or both) households and, therefore, one could conceivably present the model (and a
complicated when inflation enters the picture.

For a discussion on the exact meaning of equilibrium positions in period (macro) models, see

section 1.2.3 above, Foley (1975), Buiter and Woglom (1977) and Buiter (1980).


corresponding artificial economy) with a more disaggregated householdssector. Note also that, although Brainard and Tobin dont model expected income explicitly as a target variable of households85, their model could conceivably be extended to allow for distributive conflict stories.

2.2.2 - Firms behavioral equations in Yale-type models As put by Backus (1980, p.265-266), in Yale-type models business holdings of financial assets are ignored () The [business] sector has two decisions, investment and financial structure. The later could be further analyzed into two subchoices: how to finance its new investment, as between loans and equity, and whether and how to refinance its initial capital. So it seems fair to say that Yale-type models dont deal with the production decisions of firms explicitly (neglecting them in the same way they do with the income targets of families). This doesnt mean, of course, that they are not there. Yale-type models are, in fact, presented in Keynesian, Monetarist and mixed versions meaning, respectively, models with (i)fixed prices in the goods markets, (ii)fixed quantities in the goods markets and (iii)a Phillips curve relation between quantities and prices in the goods market. As mentioned before, here well work with the Keynesian fix-price version of the model and, therefore, well interpret the silence of Yale-type authors about production decisions and inventories as implicit assumptions that (i) firms are price takers in the market for labor, (ii) their technology is

So much that Tobin (1980, p.92) makes reference to the need of a Walrasian auctioneer to solve

it in practice.


given, (iii) production is financed by loans repaid in the same period86 and (iv) they are able to predict (or quickly adjust to) the necessary production levels, so IN (the change in inventories of firms) = 087. Yale-type models are not particularly clear also about the financial decisions of firms. As stressed by Taylor (1997, ch.1 and 7) and admitted by Tobin (1980, p.90) the implicit formal hypothesis in Yale-type models is that the Modigliani-Miller theorem applies and, therefore, the value of the firms liabilities (i.e., equities and loans, in Backus, 1980 or just equities in simpler versions of the model like the ones in Tobin, 1980 and Tobin, 1982) exhaust all the value of its assets (or, in other words, the net worth of firms is zero). Indeed, if this is the case, businesses can be modeled as if they are pure equity firms (Tobin,1980, p.90), what justifies the explicit hypothesis made in Yale-type models that increases in equity occur either by issue of shares or by retention of earnings; retained earnings are considered as dividends paid matched by sales of shares

As mentioned in the main text households are assumed to target a certain stock (and a certain

composition) of wealth, given their expected disposable income and their total stock of previous wealth. Fair (1984, p.42) makes a similar point.

This seems the only possible way to rationalize it, given that the all profits are distributed and Although Yale authors generally assume that aggregate investment as a whole (including the

financial assets of firms are assumed to be always zero.


change in inventories) is a function of q (see, for example, Tobin, 1982, p.179), it seems possible to interpret this assumption as a simplifying one. Indeed, we cant find any reason why changes in inventories might be considered functions of q and, besides that, almost all American Keynesian literature has neglected inventory behavior assuming, like Keynes (quoted in Asimakopulos, 1991, p.39), that the theory of effective demand is substantially the same if we assume that short period expectations are always fulfilled. It seems reasonable, then, to rationalize the lack of importance given to inventory behavior in Yale-type models this way. As we shall see below, this


(Backus, 1980, p.266). As stressed by Crotty (1990), this can be interpreted as an assumption of no conflict between ownership and management, either because they are both the same or because the first dominates the second. Things are apparently clearer as far as the investment decisions of firms are concerned. Indeed, one of the trademarks of Brainard and Tobin is their q-theory of investment and q explains by itself all investment behavior in Yale-type models. As is well known, q is the ratio between the market valuation of firms capital and its replacement (not historical) cost and first appeared in the literature in Brainard and Tobin (1968). According to these authors (p.104) the q-theory can be summarized as saying that investment is stimulated when capital is valued more highly in markets than it costs to produce it [i.e., q>1] and discouraged to when its valuation is less than its replacement cost [i.e., q<1]. Another way to state the same point is to say that investment is encouraged when the market yield on equity () is low relative to the real returns to physical investment. Note, however, that Brainard and Tobins (1990) response to Crotty (as well as a passage in Tobin, 1980, p.90) makes clear that (i)Yale authors are not convinced that the Modigliani-Miller theorem works so nicely in practice88 and (ii) they are convinced that the q-theory of investment doesnt depend on their simplifying hypotheses about ownership and management. In fact, M-M conclusions are heavily dependent, among other things, on the existence of perfect financial markets without information assymmetries of any kind and Yale-type authors have always emphasized the problems
view contrasts with the view of Cambridge-type models, according to which production decisions and inventory cycles play a major role in the dynamics of the economy in historical time.

Although they assume it does in their models.


with these assumptions (see, for example, Brainard and Tobin, 1990, p.544). Its precisely because financial markets are not perfect that Backus (1980, p.261), for instance, state that we should not be surprised if current cash-flow, as well as long run calculation of profitability, affects business investment [of liquidity-constrained firms]. Indeed, Tobin and Brainard (1977 and 1990) make clear that q is to be understood as a determinant of investment, not the determinant of it. So one way to interpret the assumptions of pure equity firms and q as the only determinant of investment is as simplifications that would need to be removed in more sophisticated versions of the Yale model. Be that as it may, one possible way to understand the behavior of the firms in Yale-type models would be the following: given q (which, as well see below, is a function of rle and ree) the managers (thinking about the welfare of owners) decide their investment demand PK d (i.e., how many units of the only good of the economy they want to invest)89. Having decided that, they incorporate this demand in their other decision variables i.e., their supply of equities and demand of loans (that are also functions of the loan interest rate and the price of equity). Formally, this behavior could be modeled as: Kd(q) = Kd (ye, rle, ree) = Ks(expectation errors in production of K are assumed away) Ld (PKd, rle, ree) = Ld (rle, ree , ye) PEEs = PEE-1 +PKd (Ld- L-1) (because new investment is financed either by new loans or by equity emissions)90

Keep in mind that we are assuming depreciation away, so gross investment equals net Given that PKd = Ld + PEEs , PEEs is completely determined by PKd and Ld.



with q = (PE*E-1+ L-1)/ P*K-1 and K =K - K-1 (we are assuming away depreciation) The formalization above follows the Yale convention (see Tobin, 1980, p.89) and assume that each physical unit of capital stock [that wasnt acquired with loans] represents an equity claim. However, we valued investment (i.e., purchases of K goods) at replacement cost (i.e., PK, the money that firms that buy the capital goods have to pay to firms that sell them) as opposed to follow the Yale-type procedure of valuing it at asset markets prices (i.e., PqK, or how much the stock market thinks the value of this capital is)91. Note also that to understand the investment equation above one needs to keep in mind that (as seen in section 2.2.1 above and assuming zero expected inflation): ree = [ (PE+1e + Ff e/E) /PE] 1 and rle = il92. Rearranging the expression for ree we get: PE = (PE+1e+ Ff e/E) / (1 + ree) Now note that from Table 1 above, we have that Ff =C+ G+ PK +IN WB T - il.L-1 (because the net worth of firms = 0, Sf = 0) or, rearranging, Ff =Y WB T - rle.L-1 Replacing the expression above in our expression for PE we have that: PE = [PE+1e+ (Ye WBe Te - rle.L-1)/E)] / (1 + ree)


According to Tobin (1982, p.180) the reason of this peculiar Yale-type accounting convention

is that the deviations of q from1 represent real costs of adjustment, including negative or positive rents incurred by investing firms in changing the size of their installed capital.

To get rle just apply the formula we used in section 2.2.1 to get rme changing im for il.


Finally, replacing this last expression in the expression for q above, we arrive to the conclusion that q = f((ye rle, ree).

2.2.3 - Governments behavioral equations in Yale-type models From the values in governments column of Table 1 above, we have that: Sg = T G + igR-1 XB-1 and - Sg = H + B Yale-type models usually assume G, X and T as exogenous93. Besides that, the government controls also ig (the discount rate) and (the banksrequired reserve over deposits ratio). As R-1 is (pre-)determined by the banks (the Central bank is assumed to give discount loans as demanded), the public deficit is all exogenous in Yale-type models. As put by Backus (1980, p.267) the specific hypothesis about H and B is that the budget deficit in dollars () is financed in fraction b by selling bonds at their current market price Pb and in fraction h by printing high-powered money b+h =1. In addition, the government may engage in open market operations, selling bonds in the amount Zb for money in the amount Zh [therefore, Zb + Zh = 0]. Formally, this means that: HS = h (G T - igR-1 + XB-1) + Rd + Zh BS = b (G T - igR-1 + XB-1) + Zb


Although Backus (1980, p.267) point out that taxes are net of transfers and may be

modeled as endogenous. Note also Yale authors seem to treat the interest payments received by the governments from the banks as negative transfers, since they dont appear in their accounting.


As mentioned before, Yale-type models dont explicitly account for discount loans. According to Tobin (1980, p.91), the reason for this is that in a system like that of the United States, it is convenient to regard bank borrowing as from the central bank as a negative demand for base money and regard the supply of base money as excluding borrowed reserves. The formalization above, however, has the merit to make clear that sometimes the government has to print money even if it has a zero deficit.

2.2.4 - Banks behavioral equations in Yale-type models As mentioned above, banks are forced by the government to keep a fraction of their (uncertain) total deposits (i.e., Md + Mt = aggregate money and time deposits) in the form of reserves. Banks are assumed to use their (expected) free reserves (1-)*(Md + Mt- R-1)e to do three things94: (i) give loans to businesses (L); (ii) buy government bonds (Bb) and (iii) keep holdings of base money reserves (Hb). According to Backus (1980, p.265) this allocation is assumed to depend on the discount rate (ig) and the expected real rates of return of these assets (rle,rbe and rhe but note that, assuming inflation expectations away, rhe=0). One way to formalize this assumption is the following: Ls = fl(rle,rbe,ig)*(1-)*(Md + Mt- R-1)e Bbd = fb(rle,rbe,ig)*(1-)*(Md + Mt- R-1)e Hbd = fh(rle,rbe,ig)*(1-)*(Md + Mt- R-1)e and, of course, fl + fb + fh = 1

Keep in mind that our notation in this part is unconventional. As mentioned before, Yale

authors dont deal explicitly with discount loans and dont emphasize expectational errors of banks either.


Note that the implicit hypothesis in the specification of the free reserves above is that banks try to pay all their discount loans in the next period. Note also that it implies that: Rd = -R-1, if (Md+Mt) [Md +Mt - R-1 - (1-)(Md +Mt -R-1)e(fl+ fb) ] 0 and Rd = -R-1 {(Md+Mt) [Md +Mt - R-1 - (1-)(Md +Mt -R-1)e(fl+ fb) ] }, otherwise. where (1-)(Md +Mt -R-1)e(fl+ fb) is the money that banks allocate in loans and government bonds and [Md +Mt - R-1 - (1-)(Md +Mt -R-1)e(fl+ fb) ] is their effective reserves. If this last value is smaller than the required reserves (Md+Mt), banks have to get new discount loans to match these requirements. Note finally that Yale-type models always assume in line with US institutional realities of their time that interest on demand deposits is fixed at zero and interest in time deposits is fixed by law at some arbitrary value im* (and, therefore, assuming inflation expectations away, that rme = im*). The only determinant of banks portfolio choice that is in the banks control is, therefore, rle (since $X is fixed by the government)95. Both rl and rb, however, are assumed to be such that the banks will gladly accept any deposits the public wants to make and, therefore, Md = Mdd and Mt = Mtd


As well see below, in equilibrium specifications of the model rle is assumed to be completely

flexible. Given the Wicksellian influence on Yale-type authors, one is not surprised to know that they explicitly admit that another and perhaps more realistic possibility () is that banks regard business loans as a prior claim on their disposable funds and meet these demands at the prevailing rate, only later adjusting this rate in the direction that brings loan demand closer to the banks desired supply. (Backus, 1980, p.265). This and other simplifying assumptions bring Yale-type models much closer to Cambridge ones, as we shall see in more detail below.


2.2.5 - General equilibrium in Yale-type models The discussion above has provided us with all the equations we need to discuss the general equilibrium of Yale-type models96. Note that future expected variables (like PE+1e, for example) are all supposed to be exogenous and in equilibrium - current expected variables (like ye, for example) are all assumed to be equal to realized ones97. 1)Phhd(rhe, rme, rbe ,ree, a-1, ye) + fh(rle, rbe, ig)(1-)(Md + Mt - R-1)e = Hs= H-1 + h(GTigR-1+XB-1)+R+Zh 2)Pmdd(rhe ,rme, rbe, ree, a-1, ye) = Md 3)Pmtdf(rhe ,rme, rbe, ree, a-1, ye) = Mt 4)Pbhd(rhe ,rme, rbe, ree, a-1, ye) + fb(rle, rbe, ig)(1-)(Md + Mt -R-1)e = Bs= B-1+b(G T igR-1+XB-1)+Zb 5)Ped(rhe, rme, rbe, ree, a-1, ye) = PEEs = PEE-1 +PKd (Ld- L-1) 6)Ld (ye, rle, ree) = Ls = fl(rle,rbe,ig)*(1-)*(Md + Mt -R-1)e 7)Kd = (ye, rle, ree) 8)rhe = 0 9)rme = im* 10)ig = ig* 11)PE = [PE+1e+ (Ye WBe Te - rle.L-1)/Es)] / (1 + ree) 12)Pe = P = P+1e = P+1


The only difference is that we changed yd for y in the specification of the assets demands.

Note, however, that this is an innocuous procedure because YD = Y T - igR-1 + XB-1 and T, ig, X, B-1 and R-1 are all exogenous or pre-determined variables.

So R = Rd = -R-1.


Now note that substituting equations (7)-(12) into equations (1)-(6) above one gets to the core of the model, i.e., the equations that determine the equilibrium in the assets markets. The specifications of the functions above are supposed to be such that this 6x6 system has just one solution (rbe, ree, rle, y, Md, Mt) that is obtained as function of all the other pre-determined, exogenous and future expected variables. Now note that from (11) above and (13) below, we can compute PB and PE and, therefore, the capital gains and losses in equation (14) and savings and consumption (in equations 15-16). 13)rbe =[(PB+1e/P+1e + X/P+1e) / (PB/P)] 1 14)CGL =(PB- PB-1)*Bh-1 + (PE -PE-1)*E-1 15)S W CGL = P(hh + md + mt + bh + pEe) CGL = W CGL 16)C YD - S = Y T - igR-1 - S One way to interpret the equilibrium above is as a super orthodox hypothesis that financial markets are cleared solely by adjustments in asset prices and rates of return (Taylor,1997, Ch.4, p.21)98. As put by Tobin (1982, p.187), the hypothesis is that the markets handle simultaneously flows arising from saving and accumulation and those arising from reshuffling of portfolios, both by private agents on the demand side and by monetary authorities on the supply side. By the end of the period, simultaneously

Whether this hypothesis is considered super-orthodox or not depends on the author, though.

Foley (1975, p.319), for example, reminds us that asset markets are in fact among the best organized of markets; information about prices of many (especially financial) assets is disseminated widely and rapidly, and the great bulk of the total wealth in industrialized capitalist economies is held in very large portfolios for which fixed transaction costs will be negligible in relation to portfolio shifts. Even Cambridge authors like Godley and Lavoie (2002, ch.12, p.2)


with the determination of asset prices for the period, these market participants have the stocks of assets and of total wealth they desire at this time at the prevailing prices. Therefore, the general equilibrium modeled above is not simply an equilibrium of stocks99 because it implies the flow equilibria of the economy as well. In particular, the equilibria in the assets markets take in full consideration all major flows of the economy (i.e., income, investment and savings/consumption), which together with the exogenous amount of government expenditures determine the (keynesian, flow) equilibrium in the goods market. Yale-type models can be seen, therefore, as general (stock-flow) equilibrium ones.

2.2.6 - Disequilibrium and hierarchical decisions in Yale-type models Yale authors are, however, far more heterodox than they seem. First, they clearly admit that the general equilibrium stated above strains credibility (as put by Tobin, 1982, p.189). Second, they recognize that its often desirable to work with simpler specifications (based on the notion of hierarchical decisions) of the behavioral equations above. In what follows, we discuss first the disequilibrium specifications and then (very briefly) the hierarchical decisions as they appear in Yale-type models. As put by Brainard and Tobin (1968, p.105), no one seriously believes that either the economy as a whole or its financial subsector is continuously in equilibrium. () Consequently analysts and policy-makers can hope to receive no more than limited guidance from comparative static analyses of the full effects of changing exogenous
have recently worked with markets for financial assets that clear instantaneously and all the time

Although it surely is a stock equilibrium in Foleys (1975) sense of the term.


variables, including the instruments of policy. They need to know also the laws governing the system in disequilibrium. () We are pleading in short for a general disequilibrium framework for the dynamics of adjustment to a general equilibrium system. Of course, as Brainard and Tobin (1968, p.105) promptly recognize, there are non-trivial problems associated with disequilibrium specifications. First, () there are many dynamic specifications that have the same static equilibrium () [and] economic theory, () has almost nothing to say on mechanisms of adjustment. Second, despite all the advancements of econometric theory in the last 30 years, Brainard and Tobin are still right to point out that its precisely in the estimation of lag structures and autoregressive effects that statistical and econometric techniques encounter greatest difficulties. Be that as it may, Yale-type authors always tried to deal with the disequilibrium dynamics of their models with the use of generalized versions of the familiar partial adjustment dynamic specification100. The basic hypothesis (for households) is presented in Backus (1980, p.275) as follows: anx1 = Enxn [a* a -1] nx1 + Fnxp (S Se)px1 + Gnxq z qx1 where, a is again the vector of (the n, = 5 in our case) households financial assets (the superscript * denotes the long run equilibrium given the current effective (expected) real rates of return and flow of disposable income), SSe is the vector of the p sources of unanticipated changes in disposable assets (such as unplanned savings or capital gains), z is the vector of the q variables that are supposed to influence adjustment behavior directly and E, F and G are matrixes with the relevant coefficients.


Also used by Cambridge authors, as well see below.


Although our purpose here is not to present a complete disequilibrium specification of the model presented in the previous sections, its important to spend some time discussing the qualitative implications of the equation above. As put by Brainard and Tobin (1968, p.106), the first expression in the right hand side of the equation above means that the deviation of a variable from its desired level() is diminished by a certain proportion at each time, with special attention to the fact that the adjustment of any one asset holding depends not only on its own deviation but also on the deviation of the other assets. The public might have exactly the right amount of demand deposits and yet change this holding in the course of adjusting other holdings to their desired levels. So all the first expression in the right hand side of the expression means is that the changes in the holdings of any given asset (say, bh) is assumed to be a linear function not only of the deviation of the holdings of this asset from its desired level (say, bh* - bh-1) but also on the deviations of the holdings of the other assets as well [i.e., (hh*- hh-1), (md*-md-1), (mt*-mt-1) and (e*-eh-1)]. The second and third terms of the right hand side of the generalized partial adjustment mechanism used above say similar things with respect to both the unexpected sources of resources and other variables that affect the adjustment process. To illustrate the point lets assume that the households had underestimated their disposable income (so, yd yde >0) and their capital gains in equity [so (PE - PEe)*E-1 > 0] and no variable affects the adjustment process directly. In this case, the change in any given asset ai would be:


ai =i1(bh*-bh-1)+ i2(hh*- hh-1)+ i3(md*-md-1)+ i4(mt *-mt-1)+ i5(e*-eh-1)+ i1(yd yde) + i2(PE - PEe)*E-1101 Naturally, a complete disequilibrium specification of the model would have to include the adjustment processes of all the sectors and, as we saw above, those deal with different variables than the ones that influence households behavior. As far as we know a complete disequilibrium Yale-type model is still to be published [Backus (1980) is the paper that comes closer to do it, presenting sophisticated specifications of both the households and the banking sectors though not one for firms], but this doesnt change the general message about the importance of disequilibrium specifications in Yale-type models. Note, in particular, that disequilibrium specifications allow the analyst to drop the artificial hypotheses about the expectations of the agents that appear in equilibrium ones and, therefore, to come closer to pure theorizing about aggregates102. Finally, its important to mention that the degree of heterodoxy of Yale-type models is substantially increased by their use of hierarchical decisions. This use is justified in Backus (1980, p.273) on the grounds that in some cases, its convenient to imagine agents who make decisions sequentially or hierarchically. In practice, the main hierarchical decisions assumed by Yale-type authors are consumption and

Note that, given that a change in any proportion must be at the expense of remaining

proportions (Backus, 1980, p,272), we have that (i j)i=1 to n = 0. Indeed, this means is that if one unit of the (bh*-bh-1) deviation increases, say, the holdings of asset a1 by i1 it has to decrease the other ais in such a way that the sum of the parts keep being equal to total wealth. By a similar reasoning one arrives to the conclusion that the same is true to the gijs. Note also that (i j)i=1 to n= 1 because an increase in disposable assets must be held somewhere (idem).

This allows, for example, one to think of current prices and income as they are, i.e.,

complicated and debatable averages over many products and over time, as opposed to assume them as end-of-period results of auctioneer-type market processes.


investment decisions103. Consumption is often assumed, a la Modigliani, to depend only on currently disposable income and the total stock of wealth (therefore being hierarchically superior to households decisions on the allocation of their wealth). Investment, by its turn, is assumed to be hierarchically superior to financial decisions. As the authors recognize, these hypotheses are in sharp contrast to neoclassical microeconomics104. As well see below, they also bring Yale-type models much closer to Cambridge ones than otherwise.

2.2.7 - Yale-type models: A possible summary As mentioned before, there are several versions of Yale-type models and none of them is exactly equal to ours (that was chosen to make the comparison with Cambridge authors easier). They differ in emphasis, level of abstraction and aggregation but all of them emphasize a common set of issues. First, all of them (since the seminal 1968 paper) specify wealth demand functions (that at least since 1978105 - are assumed to be integrated with the savings decisions of households) and assume that the desired allocation of this wealth depends on the relative real rates of return of the various financial assets of the economy. Second, all of them assume that financial markets are driven by a tendency toward a complete stock (of financial wealth) equilibrium, that takes
103 104

And possibly also the loan decisions of banks. See footnote 94 above. As they put it themselves (p.273), although [neoclassical] theory tells us that separations of

this type are legitimate only under rather strong assumptions, theres often a compelling need for plausible rough approximations in empirical work. Indeed, separations of this type are much closer to post-Keynesian models than to neoclassical ones. See Lavoie (1992, ch.2) for more on this issue.


fully into consideration the flow (i.e., consumption/savings and investment) decisions of the agents and, therefore, implies also the usual Keynesian flow equilibrium in the goods market (or the real economy, as they portray it). Third, and related to the second, all of them assume that investment is determined (or, at least heavily affected) by q. Fourth, all of them deal with these crucial interdependences between financial markets and the real economy (in principle, at least) with the use of stock-flow consistent accounting frameworks in which, to use Godleys (1996, p.7) words, there are no black holesevery flow comes from somewhere and goes somewhere. This accounting framework is, then, brought to life (at least in the theoretical versions of the model) with explicit general (dis)equilibrium hypothesis of the everything depend on everything else kind. Theoretical Yale-type models are completely general in this sense106. They are not general, however, in the sense that they dont deal explicitly with the production and pricing decision of firms (although they could conceivably be extended to do it) and their treatment of the financial decisions of firms (based on the Modigliani-Miller theorem) is less than satisfactory.

2.3 - A (New) Cambridge-type closure As Cambridge-type SFC modeling has a long history and has changed relatively more than its Yale counterpart, we chose to discuss it in two sections. In this one well focus on the first Cambridge-type models, i.e., those written in the seventies and eighties


Tobin (1980) presents a published version of his 1978 Yrjo Jahnsson Lectures, in which he Although, as we mentioned before, empirical versions of the model often replace these general

states this point very clearly.


specifications by simpler ones, based on the hypothesis of hierarchical decision making.


by Wynne Godley and his team at the Department of Applied Economics, Cambridge. As most of this early Cambridge-type SFC theorizing (baptized as New Cambridge view by journalists) aimed to influence the public debate about macroeconomic policy-making in the United Kingdom its not surprising that it dealt basically with applied openeconomy models. These models were, however, based on a very distinctive theoretical view according to which the tendency of the [macroeconomic] system as a whole is governed by stock-flow norms rather than () equilibrium (or disequilibrium) conditions postulated by neoclassical theory (Godley, 1999a, p.396). This view was carefully presented in a textbook by Godley and Cripps (1983 from now on G&C)107, from which the present section will draw heavily.

2.3.1 - The level of aggregation in early Cambridge-type models One distinguishing feature of the Cambridge approach is its emphasis on direct theorizing about aggregates108. Indeed, as put by G&C (1983, p.18, emphasis in the

A book prepared especially for this task. Indeed, in April 1980, the Cambridge Economic

Policy Group (CEPG) acknowledged that () our publications have fallen well short of a comprehensive statement of our views (). There is no satisfactory solution [to this problem] other than write, in due course, our own textbook (CEPG, 1980, p.35). Godley and Cripps (1983) is precisely the textbook they were talking about.

Again, the difference between Cambridge and Yale is not as large as one would think. Tobin

(1982, p.173-174) explicitly recognizes that Yale-type models are only loosely linked to optimizing behavior of individual agents. Following an older tradition, economy-wide structural equations are an amalgam of individual behavior and aggregation across a multitude of diverse individuals. This view is not completely outdated either, since it is at the very core of the influential LSE approach to macroeconometrics. As put by Hendry (in Backhouse and Salanti, Macroeconomics in the Real World OUP, 2000, p.156) the theoretical models underlying what I am doing are much more like the hydrologists theoretical model. It is simply


original) since human behaviour is so varied, our objective will be to establish principles of analysis which capitalize on adding-up constraints so as to confine behavioural processes to a relatively small number of variables, each of which can then be object of empirical study. The smaller the number of behavioural variables which govern how the system must function in the view of the logical constraints, the more powerful will be our theory as a model of organizing and interpreting data. This emphasis implies that the level of aggregation of any New Cambridge-type model that aims to describe the dynamics of a real economy in historical time is in principle an open issue (though subject to the minimum requirement of separating the public, the private and the external sectors of the economy)109. The New Cambridge-type procedure, to put it briefly, appears to be to choose the level of aggregation in which the stronger empirical regularities can

unimaginable where hydrology would be today if hydrologists had insisted on working out the theory of turbulence from quantum dynamics. They wouldnt have made one iota of contribution to understanding it because it is a system property and it is enormously complicated how turbulence behaves, how waves behave, how they propagate, etc. They have theories about these things that are macro theories. They are not based on individual agents. I dont work with that kind of model [i.e., the mainstream representative agent ones] because I simply dont know how one agent trades with itself in the stock market, and forms all these expectations and carries out intertemporal optimization, etc, etc. I simply dont see how it is done and I dont know how to do it with a hundred million heterogeneous agents (). Finally, note that the bulk of the methodological literature is also critical of the representative agent hypothesis. For one among many methodological critiques of models based on this hypothesis, see Hoover (2001, chapter 5).

These points are explicitly made, for example, in G&Cs methodological chapter (1983, p.42-

43) and in the discussion of the relevant concept of wealth to be introduced in a Cambridge-type model (see G&C, p.265).


be found110 about the minimum possible number of behavioral hypotheses (generally about stock-flow ratios). For this particular reason, early Cambridge-type models usually worked with the notion of the private sector as a whole (i.e., the aggregation of households, banks and firms in Table 1 above). Indeed, as put by Godley and Fetherston (1978, p.34), the explicit hypothesis associated with the term New Cambridge is that virtually all disposable income of the private sector as a whole will be spent on goods and services with a fairly short lag. In our econometric work () a persistent feature of the results is that with the total private expenditure [i.e., C+PK in Table 1 above] as the dependent variable, the coefficients on current and (one year) lagged nominal private disposable income sum to very nearly unit. Note that this aggregation had the further advantage to allow Cambridge economists to avoid complicated matters related with firms financial decisions. As summarized by Cripps and Godley (1976, p.336), given the well-known difficulty of modeling the corporate sector there is an advantage in aggregation provided the overall relationship is empirically robust. To make a long story short, the New Cambridge hypothesis generated a good deal of controversy (especially in the UK111) but wasnt well accepted mainly because the bulk of the economics profession at the time considered the aggregation of personal consumption with corporate investment () inadmissible in principle (Anyadike-Danes, 1982, p.33). Be that as it may, what is relevant for us here is to note that the New


At least this is what one can infer from the discussion mentioned in the previous footnote (see See, for details, Vines (1976), Cuthbertson (1979) and McCallum and Vines (1981).

G&C, p.266).


Cambridge model can be seen as a (formally) simplified version of the Yale-type model discussed in section 2.2 above. Thats our topic in the following sections.

2.3.2 - The constant stock (of private wealth)-flow (of private disposable income) hypothesis The crucial hypothesis of New Cambridge models is that the private sector as a whole has a relatively constant desired stock(of wealth)-flow(of disposable income) ratio. If, for example, this desired stock-flow ratio is, say, and the flow of disposable income is 100 per period, then the desired stock of wealth would be 75. The potential problems of this hypothesis (or, as called by G&C, this behavioural axiom) are acknowledged by G&C (p.60) but the authors give no solution to them other than stating (p.42) that the formal status of the axiom is akin to that of an exogenous variable. Its something that the model itself cannot explain. We admit without reservation that if stock-flow norms were to move about too wildly most of the theory () would be rendered useless. Formally, the axiom means that: W* = YD, where is the exogenous stock-flow, W* is the households desired stock of wealth112 and YD is households disposable income. Before we discuss the implications of this hypothesis, its probably illuminating to compare it with the Yale view on this matter. As we saw in section 2.2.1 above, in Yaletype models the desired long run wealth target of households is assumed to be a (not specified, but probably complicated) function of (i)the real rates of return of financial assets, (ii)current disposable income and (iii)other factors like income distribution, age


structure, the stock of human capital and expected incomes (that are implicitly taken as exogenous in the analysis). In other words, in Yale-type models the desired stock (of wealth)-flow (of disposable income) depends in a very complicated and unspecified way on many endogenous and (sometimes implicit) exogenous variables. In such a circumstance, it seems reasonable as an intermediate step, at least to treat it as an exogenous variable113. Indeed, as Solow (2000, p.98, emphasis in the original) reminds us to treat a parameter as exogenous is not the same thing as to treat it as a permanent constant or as inexplicable. The rate of population growth [for example] was () generally treated as exogenous in old growth theory. But everyone knew that fertility and mortality change from time to time (). Moreover everyone knew that sometimes one can understand, especially after the fact, why population growth is now faster or slower than what used to be. What is lacking [when one treats something as exogenous] is a good, systematic, generally acceptable theory [to explain this thing]114. Of course, one must keep in mind that while the Yale-type assumption concerns the households sector only, the (New) Cambridge assumption is about the private sector as a whole. But note that, given the Yale-type assumptions about the validity of the Modigliani-Miller theorem for non-bank businesses (and the simplifying assumptions it makes about banks), households (net) wealth and disposable income are exactly equal


What exactly must enter in the concept of wealth is a non-trivial issue, as well discuss in more But see the discussion on section 2.3.6 below. Note also that Cambridge authors explicitly recognized the possibility of perturbations on

detail below.
113 114

their postulated asset/income norm (see discussion below) but argued that it enables so much to be explained with so little that it serves as a very powerful organizing principle even if the norm has a time-trend or is moderately unstable (Godley, 1983, p.140).


to the private sectors (net) wealth and disposable income. In one sense this result is obvious (remember that M-M implies that the net worth of firms and banks is zero and, therefore, the only private wealth left is households wealth) but we should be able to check it by ourselves anyway (with the help of Table 2 below). Table 2: Balance Sheets of all the sectors of our artificial economy
Households Assets Hh Md Mt P BB h P EE Liabilities and NW Firms Assets PqK IN NW = total assets Liabilities and NW L P EE NW = 0 Banks Assets Hb P BB b L Liabilities and NW Md Mt R NW = 0 Government Assets R Liabilities and NW H P B B NW= R - total liabilities

Table 2 above is almost directly derived from the uses and sources funds part of Table 1 above. The only difference is that Table 1 doesnt discuss capital gains and losses but these affect the balance sheets of the sectors [so, its sensible to value firms capital at (stock) market prices PqK, where q is Tobins q]115. Anyway, consolidating the first three balance sheets to get the net wealth of the private sector as a whole one gets:


This is a non-trivial issue, though. As put by G&C (1983, p.268-270), there is an element of

arbitrariness about when capital gains or losses are brought in. They must be included when an asset is sold but need not to be included before. Capital gains on assets which have been sold are called realized capital gains; those on assets which have not yet been sold are unrealized capital gains. The value and timing of the later depends on perceptions and anticipations, not on logical requirements of accountancy.


NWpriv=Hh +Md + Mt + PBBh +PEE + PqK + IN+ Hb +PBBb +L L - PEE Md Mt -R or, equivalently, NWpriv = Hh + PBBh + PqK + IN + Hb + PBBb -R (= H + PBB + PqK + IN -R) But now note that from the balance sheet of firms we know that PqK + IN = L + PEE. Replacing this result above we get: NWpriv = Hh + PBBh + PEE + L + Hb + PBBb -R (= H + PBB + PEE + L - R) To get the result we stated above all one needs to do now is to note that from the balance sheet of banks we have that L + Hb + PBBb= Md + Mt +R and, therefore, NWpriv = Hh + PBBh + PEE +Md + Mt In other words, one possible way to think about the New Cambridge axiom above is as a simplified, easy to handle, version of its complicated Yale counterpart116. Note also that the New Cambridge axiom implies a (stationary) steady-state in which the stock of wealth and income are such that the marginal propensity to consume is equal to one117. While this may be interpreted as a private sectors Says Law118, one must remember that (i) to argue in favor of a steady-state private sectors Says Law is

A similar point was made by Coutts and Godley (1984, p.28). Note also that Yale authors

implicitly recognize this when using Modigliani-type consumption functions in simplified versions of their models (based on hierarchical decisions). See next page for more on the issue. Note, finally, that both schools might differ on the relevant concept of wealth used and Cambridge authors dont base their conclusions on the M-M theorem. See discussion on section 2.3.5.

And, possibly, also a steady-growth state in which this is not true. See the third essay of this Especially if the adjustment to this stationary steady-state is quick (as originally assumed by

dissertation for more details.


New Cambridge authors see section 2.3.7). This point was brought to my attention in a private communication with Franklin Serrano


very different than to argue in favor of Says Law119 and (ii) it seems difficult to deny that households vary greatly () from extremely liquidity-constrained consumers who live hand-to-mouth and spend quickly any cash receipts, to lords of dynasties who save all extra income for descendents (Tobin, 1982, p.185-186). But if this second point is true, i.e., if the consumption function of households depend a la Modigliani on both their current disposable income and stock of wealth120, then the existence of the New Cambridge steady state is in general guaranteed (as stressed by Coutts and Godley, 1984, p.28). To see this last point, note that in the steady-state, W=0 (because, wealth is already at its desired level, W*) and, therefore, C=YD121. So, given that C = f (YD, W-1), we would have that YD = f (YD, W*) and, assuming that f is well behaved, this equality allows us to find = W*/YD122


In modern capitalist economies government and foreign (net) expenditures are too important to

be neglected, so the point is supposed to be more serious to the analysis of the early stages of capitalism. Note, however, that the private sectors marginal propensity to consume is equal (or very close) to one either when the stock of wealth is already at its desired level or when income is so small that has to be completely used with subsistence consumption. As put by Taylor (1997, ch.2) this last reason (and not, of course, the first) may explain why the classical economists of 18th and 19th century considered Says Law a good approximation of reality.

As, by the way, is implied by models that deal with autonomous consumption by nationals Net investment and changes in debt are assumed to be zero in such a steady-state. This implies

that neither work for the government nor are capitalists.


that either depreciation is being neglected or gross investment is financed entirely by purchases of equity by households and, therefore, C+I = YD. In this case, of course, the derivation above must be changed to assume that C+I = f (YD, W-1).

The linear example is trivial. If C = aYD + bW-1 , then = (1-a)/b


2.3.3 - Production decisions and their financing in New Cambridge-type models Besides the exogenous stock (of wealth)-flow (of private disposable income) ratio hypothesis, another trademark of Cambridge-type SFC modeling is its emphasis on the importance of taking explicitly into consideration that (i) production and distribution take time and future is always uncertain (Godley,1999, p.394); (ii)entrepreneurs have to pay out money for working [and fixed] capital to keep production going in advance of receiving money from the sales of goods (G&C, p.66) and, therefore, (iii) finance must be forthcoming if the private sector is to grow; hence the need for a representation of commercial banking system, debt and inside money (Anyadike-Danes, 1987, p.1011). This Cambridge emphasis on the financing of firms production is in sharp contrast with the Yale-type story, which, as we saw in section 2.2.2 above, completely neglects these issues123. The New Cambridge story about production decisions by firms is pretty conventional. In the beginning of the production period firms are assumed to formulate expectations about the quantities they will be able to sell at given normal prices and decide what to produce based on these expectations plus the change in inventories they want to bring about (Godley, 1996, p.14). Note that, as much as their Yale counterparts (see footnote 86 above), early Cambridge models didnt pay too much attention to expectation errors by firms, always assuming that they have sufficient foresight or flexibility to adjust their stock of inventories to a given desired proportion of some


An explicit Cambridge critique to the lack of attention given by Yale authors to production

decisions by firms can be found in Anyadike-Danes (1987, p.10-11), according to whom, this is one of a number of respects in which the Tobinesque tradition can usefully be further developed.


relevant flow124. New Cambridge authors have also worked, again as much as their Yale counterparts, with simplified models in which the change in inventories is zero or fixed (see for example, G&C, chapters 13 and 14). The practical difference is that while Yale authors worked - in more sophisticated models with the hypothesis that IN =f(q), New Cambridge authors assumed, say, that IN =FE =(C+G+PK) or IN =YD (depending on which relation happened to be more reliable in practice). To keep the algebra simple, well assume in the next sections that inventory accumulation is exogenous, though125 As we mentioned before, things get really different between the two schools when it comes to explicitly theorizing about how firms finance production. The New Cambridge hypothesis (heavily influenced by Kaldorian ideas) is that firms finance all necessary advancements through borrowing and, therefore, capitalists can spend all their (net) profits and yet remain solvent because their debt is matched by realizable assets [i.e, their inventories] (G&C, p.72). To make the content of this assumption clear lets assume (as in G&C, ch.4) that the total cost of production of a firm is 100 and that it marks up each unit by 10%. Assuming also that the firm correctly forecasts its final

In G&C (1983, p.108) the relevant flow is the flow of past final sales, while in Godley (1983,

p.147) it is the flow of disposable income. These changes are probably based on the Cambridge emphasis on using empirical regularities discovered at the macro level, as discussed above. Note also that New Cambridge authors give a lot of importance to inventory-dynamics. As put by G&C (1983, p.86) it is important to discuss the consequences of treating financed inventories as endogenous (...) [because] small changes in the desired ratio of inventories to income could alter the whole dynamic of income-expenditure flows (...).

See the third essay of this dissertation for a New Cambridge model with inventory dynamics.

As well discuss below, current Godley-type papers invariably assume a desired stock (of inventories)-flow (of final sales) and deal with firms expectation errors explicitly.


demand (and, therefore, its final sales), it is clear that the total sales revenue of the firms is 110. If it had borrowed 100 to finance production, the firm would be able to pay the bank (in this example we are assuming, for simplicity reasons only, that the interest rate is 0%) and get 10 as a profit126. As the firm, by assumption, can always borrow what it needs to finance its production next period, the whole profit can be spent without imposing any restriction on the level of production. Now lets assume that in the first period of production the firm didnt sell anything borrowing (100) to produce inventories to match next periods demand. In this case, it is clear that the firms debt in the end of the production period (100) is matched by its assets (100), since the firm used the borrowed money to buy/produce the inventories. It is also clear that in the second period, when the firm sells its previous production and borrows (say, 100 again) to rebuild its inventories, its revenues (110) wont be enough to pay all its debt (100+100 = 200). However, revenues less profits(110 - 10 = 100) will be big enough to avoid a further increase in the debt. The firm will only need to increase its debt again if it needs to increase its inventories either to prepare for an increase in sales in the future or in case of an unexpected decrease in sales. In both cases it would need to borrow more than its current total revenue excluding profits, increasing its debt as a consequence. Applying a similar reasoning, it is easy to notice that if a firm needs to reduce its inventories, it will be decreasing its debt as a consequence.


Our definition of profits here is a loose one and means what is left from what is sold after one

pays for what it did cost. A more sophisticated definition would incorporate at least the changes on the stock of inventories (see Godley and Cripps p.68). Yet more sophisticated definitions can be found in Alemi and Foley (1997) and Godley (1996).


In other words, the assumption here is that whenever they increase (decrease) their inventories of working capital, firms borrow (pay) from (to) banks the exact amount required (available) to do so. Formally, IN = L (where, L is the firms stock of debt with banks and is a real number such that 0 1127).

2.3.4 - Governments behavioral equations in New Cambridge models The crucial hypotheses are two. First, the government is supposed to keep its net income (YG= T+igR-1-XB-1, in our case) as a fixed proportion () of national income. Second, the government is supposed to choose the amount of money it will spend in goods and services (G). In other words, the government is assumed to choose the fiscal stance (G/) of the economy. Other hypotheses are that: (i) the central bank is supposed to give discount loans to banks whenever necessary and (ii) the government chooses both X (i.e., the amount of money per bond it pays in each period to the owners of government bonds) and the supply of bonds it will offer to the public (B) to control the price of bonds (PB) and, therefore, their (implicit) interest rate. As a consequence, the composition of public debt (in particular, the quantity of money available in the economy) is chosen by the public exclusively.

2.3.5 - Wealth, consumption and investment in New Cambridge models As seen in section 2.3.2 above, a crucial New Cambridge assumption is that the private sector as a whole has a desired stock (of wealth)-flow (of disposable income) ratio

Remember that in our artificial economy households dont get loans but firms can get loans to


. Contrarily to what happens in Yale-type models (in which the relevant concept of wealth is clearly defined128), however, the relevant concept of wealth is an open issue in New Cambridge-type models. As put by G&C (p.266), the minimum requirement of a definition of the stock of assets in a macroeconomic model is that it should permit us to pin down precisely the flow budgets of the private sector and the government (and, in an open economy, the external world). () Beyond this the choice of definition is essentially an empirical question, the key issue being which measure of the stock of assets will yield the greatest behavioural regularity of stock-flow ratios. As transactions in assets like durable goods, equities and land are almost all confined to the private sector (and, therefore, do not affect the budget constraints of neither the private sector as a whole nor of the public sector and of the rest of the world), their introduction in the relevant concept of wealth would be questionable. As put by G&C (p.267): If a narrow definition of the stock of assets is adopted, adjustments to stocks of assets that have been excluded (e.g., equity and fixed capital) may perturb the stock-flow norm and dynamics of adjustment of assets which have been included (e.g., money and bonds). The extent of these disturbances() is strictly a behavioral issue. Of course, one might very well find these disturbances to be in fact very strong. If this is the case, according to G&C (ibid) themselves, () models ought ideally to be expanded to allow for this. There will, however, be a cost as well as a gain. For although it should be possible to give a better representation of asset adjustments, the processes which generate changes in stocks of assets will now include such things as rises and falls in stock market and property values, which are themselves hard to understand and predict.
finance investment in fixed capital as well as inventories.


As the passages above make clear, New Cambridge authors saw Yales concept of wealth and assumptions about assets being gross substitutes in households portfolios as questionable theoretical choices/empirical issues and preferred to look for (relatively) stable stock-flow ratios in the data129. For the sake of comparison, however, well assume here that the relevant concept of wealth is the same for both schools, i.e., that the desired stock-flow norm applies to net private wealth as defined in section 2.3.2 above. Formally this means that: NW* =(Hh + PBBh + PEE +Md + Mt)* = YD = (1- )Y 130 Now note that, as much as their Yale counterparts, Cambridge authors explicitly acknowledge that real economies are not in general in (stock-flow) equilibrium and often use a partial adjustment dynamic specification in their models131. Accordingly, well assume here that: NW=(NW* - NW-1) = ((1- )Y - NW-1) [equation 1]
128 129

See discussion in section 2.2.1 above. As far as we know, Yale authors havent written about the implications of alternative concepts

of wealth. Note, in particular, that households dont invest in their models, so durable goods (including housing) and land are assumed away in their concept of wealth. Yale-type models could conceivably be extended to deal with more complex definitions of wealth, though.

See, for example, Godley (1983, p.152) for a similar formalization. Here, however, we assume

that net wealth includes past capital gains. As put by Solow (1983, p.164, emphasis in the original) a problem [with the formalization in Godley (1983)] is that it define[s] aggregate financial assets as the sum of all past differences between disposable income and private expenditures, a total unaffected by capital gains and losses on existing assets. The problem is that its not clear why anyone should wish to achieve and maintain a fixed ratio of this total to disposable income.


where is the speed-of-adjustment parameter132 So, again we are assuming something that is closely related to a Yale-type assumption. Indeed, one possible way to look at the equation above is as an aggregated and simplified version of Yales general disequilibrium framework presented in section 2.2.6 above, one that, as Godley (1983, p.152) admits, heroically () [ignores] problems associated with the distribution of wealth within the private sector133. To understand how this hypothesis is used in Cambridge-type models, one first has to note that: 'NW = GD + PD + CGL -R [equation 2] where, GD = G YG = G Y = G - T - ig R-1 + XB-1 = - Sg = H + PBB = public sectors deficit (excluding capital gains or losses in public bonds) PD =PEE + L = change in firms liabilities (excluding capital gains or losses in stocks) CGL = PEE-1 + PBB-1 = capital gains or losses in stocks and public bonds134


See, for example, G&C (1983, ch.6) or the third essay of this dissertation for Godley-type

models with a partial adjustment mechanism. See also G&C (1983, p.48, last paragraph) for a very concise exposition of their views on steady-states and disequilibrium.

See G&C(1983, p.126). Most Cambridge-type models (like, for example, the ones in G&C

ch.13 and 14) assume special hypotheses about to simplify the algebra (see section 3.2.4 below for details). Here, however, well keep the model as pure as possible.

Again, its important to emphasize that Cambridge-type models dont rely on M-M To see why equation 2 holds, note first that NW = H + PBB + PEE + L -R (see section 2.3.2

conclusions but on empirical regularities found at the macro level.


above). Therefore:

NW = H + PBB + PEE + L -R (H-1 + PB-1 B-1 + PE-1 E-1 + L-1 -R-1),

or equivalently:

NW = H + L - R +( PBB - PB-1 B-1) + (PEE PE-1 E-1) GD+PD+CGL-R.


Indeed, a simple way to find the one-period solution of our Cambridge-type model is precisely to replace equation (1) above in equation (2), to get [(1- )Y - NW-1]= GD + PD + CGL -R = G Y + PD + CGL -R Or, rearranging, assuming exogenous PD, R and CGL (see next section) and solving for Y: Y=(G + PD + CGL- R + NW-1) where, = 1 /[ + (1- )] Given the similarities between Cambridge-type models and Yale-type models it is not surprising that we were again able to find the flow of income, without any reference to consumption or investment135. The answer, again, is that the flow behavior of the system is taken in full consideration in the derivation of the stock adjustment process. To find (the aggregate of) consumption and investment, all one needs to do is to rearrange the national income identity for a closed economy: C + I = Y - G - N136 or, using the one period solution for Y derived above: C + I = ['PD + CGL -'R + NW-1] (1- )G + IN where the expression above is a version of the New Cambridge private expenditure function137.
To derive the identity above is important to note that PBB + PBB-1= PBB - PB-1 B-1 and an equivalent result holds for equities as well.

As we did in section 2.2.5 above (see also the discussion in section 2.2.1). This time, however, Keep in mind that we are simplifying things here by assuming that IN is exogenous. The differences of this expenditure function from, for example, the one in Godley and

theres no implication that this flow of income is an equilibrium one.

136 137

Fetherston (1978, p.42) that states the quintessential New Cambridge Hypothesis mentioned in


Finally, to disaggregate between C and I, all one has to do is to use the fact that I PD - IN (both of which are being treated as exogenous variables here see section 2.3.6 below).

2.3.6 - The financial side of the economy in New Cambridge-type models A perennial critique of New Cambridge models (and in fact of Kaldorian Keynesianism in general) is that they (it) trivialize(s) monetary policy and financial issues138. Indeed, although one finds some interesting passages about the financial side of the economy in the writings of New Cambridge authors139, these considerations do not affect the formal solution of New Cambridge models140. So it seems fair to say that New Cambridge-type models assume financial decisions of agents (including portfolio decisions of households and banks and financing decisions of firms related to investment in fixed capital) and their consequences (as far as the determination of interest rates and capital gains is concerned, for example) as roughly exogenous141 what explains the assumptions made above. The only explicit hypotheses about these issues (as discussed in
section 2.3.1 above, are due to the particular concept of wealth and partial adjustment mechanism assumed here.
138 139

This view is expressed, for example, by Blinder (1978, p.83). All of them very close to Yale-type hypotheses. See, for example, Godley and Fetherston

(1978, p.43) and its formalization by Blinder (1978, p. 71-73) or G&C (1983, ch.8, especially p.160-161 and also ch.13, especially p. 264-265).

As far as we know these insights have only been formalized in more recent papers Two exceptions are the models in Godley and Cripps (1983, ch.7, appendix) and Godley

(particularly Godley, 1996 and 1999). See below for more on recent Cambridge-type models.

(1983) that assume a fixed stock (of aggregate debt of both firms and families)-flow (of private disposable income) norm, probably based on some empirical regularity observed at the macro level.


sections 2.3.3 and 2.3.4. above) are that (i) the government acts to control the interest rate on bonds and (ii) a large part or all inventory accumulation is financed by bank loans. The contrast of these assumptions with the Yale-type emphasis on real-financial interdependencies is striking and was noted, for example, by Solow (1983, p.165):
I have some sympathy with Godleys analytical device of getting monetary policy out of the way by assuming it to be permissive in the sense that the central bank holds the interest rate constant. But one can hardly stop there, for both practical and analytical reasons. The modern economy generates a wide and changing menu of financial assets that are imperfect substitutes for one another on both the supply side and the demand side. There are as many interest rates as assets. A completed Keynesian model must certainly contain a lot of portfolio theory; it will have to model asset exchanges as thoroughly as exchanges of goods and services. This vein has been most thoroughly mined by Tobin (). I would hope Godley could follow suit.

As well discuss in more detail below, Godley did follow suit indeed. Note, however, that whether the New Cambridge assumptions are too simplified or not depends on ones point of view. In particular, Yale-type assumptions have never been tremendously successful empirically and its not clear what exactly to put in their place. As far as capital gains are concerned, for example, most modern economists would probably agree to treat them as exogenous. Given the lack of alternatives, the use of empirically reliable stock-flow ratios seems less arbitrary than otherwise. Before we continue its important to notice that New Cambridge authors were not clear also about (i) the determinants of the disaggregation of private expenditure on consumption and investment and (ii) the potential impact of changes in the interest rates on the private sectors desired stock (of wealth)-flow (of disposable income) norm. Well finish this section commenting on these two issues, beginning by the first.


As we mentioned before the desired stock (of wealth)-flow(of disposable income) ratio affects directly the aggregate of consumption and investment in New Cambridge models. Indeed, nothing is said in these models about the disaggregation of consumption and investment and, as put by Blinder (178, p.69) the [New Cambridge] message may be that any such division should not be attempted. Whether this was or not the case, the fact is that current Cambridge type models do disaggregate between consumption and investment decisions, as well discuss below. Its interesting to note, however, that Blinders argument that such a complete consolidation of individuals and corporations () [was] somewhat fanciful [to him] under (.) [1978s] financial and tax arrangements, particularly because taxation and the erratic stock market make dividends and retention quite imperfect substitutes from the shareholders point of view applies to Yale-type models (and to all models based on the M-M theorem) as much as to New Cambridge ones142. Last, but not least, one finds some passages in New Cambridge writings pointing out that the stock (of wealth)-flow (of disposable income) norm could conceivably be affected by interest rates and real rates of return143 - something that Godley (1983, p.150) finds unlikely to happen but that Malinvaud (1983, p.158), for example, seems to consider a fact of life. If this is the case, as should now be obvious, the New Cambridge model gets much closer to its Yale counterpart).


One can only imagine the reaction of New Cambridge authors to this Cambridge-type critique

coming from an American mainstream economist in a conference organized by Carneggie-Mellon University-PA and the University of Rochester-NY.


2.3.7 - Stock-flow dynamics in New Cambridge-type models The only dynamic mechanism of the model discussed above is the interplay between the stock of net wealth of the private sector (NW) and the flows of private expenditures (C+I) and (therefore) income144. This is a classic stock-flow dynamic mechanism in which current stocks affect current flows that will subsequently affect future stocks and flows as well. Given the simplifying assumptions adopted, the formalization of this mechanism is pretty simple. Indeed, the key equations in this respect are: Y=(G + PD+ CGL - R + NW-1) [equation 3] and NW=(NW* - NW-1) = ((1- )Y - NW-1) or, equivalently, NW=(1- )Y + (1 -) NW-1 [equation 4] Now replacing the equation for income in the equation for wealth, one gets: NW= (1- )(G + PD + CGL- R + NW-1) + (1 -) NW-1 or, equivalently, NW= 1 + 2 NW-1 [equation 5] where 1 = (1- )(G + PD + CGL - R) 2= [2 (1- ) + 1 -) Equation (5) above is the characteristic (difference) equation of the simple dynamic system formed by equations (3) and (4) and its long run equilibrium solution is given by: NW*= 1 /(1- 2 ).


See, for example, Cripps and Godley (1976, p. 338), G&C (1983, p.149) or Godley (1983, As discussed in the third essay of this dissertation, things get more complicated in models with


inventory dynamics.


Note that in this (stationary) equilibrium NW = 0 and, therefore, (1- )Y* = NW* (or, equivalently, NW*/(1- )Y* = ). A couple of things are worth mentioning about the dynamic process assumed above. First, it will be stable only if the absolute value of 2 is smaller than one. This will happen, for example, if (the speed of adjustment parameter), (the desired stock of wealth - flow of disposable income ratio) and (the share of governments net income in total national income) are equal (respectively) to .5, 2 and .2 but not if they are equal to, say, .7, 3 and .1. The potential instability of New-Cambridge models is well-known and the typical response of New Cambridge authors is that the issue, again, is an empirical one145. Second, the adjustment process depends crucially on . Indeed, if capital gains are excluded from the relevant concept of wealth one can prove (see, for example, Godley 1983, p.141) that the mean lag of the response of expenditure behind income (i.e, the average length of real historical time it takes to a dollar earned to be spent) is exactly equal to . New Cambridge authors attributed a great importance to this result because they thought that (i) the relevant dynamic process (i.e., the one with the adjusted concept of wealth) would be monotonically stable146; (ii) capital gains could be seen as an exogenous noise that wouldnt change the result qualitatively (especially because most of it would not be realized in the relevant time length); and (iii) if both (i) and (ii) are


See, for example, Malinvaud (1983, p.159) for the critique and Godley and Zezza (1989, p.6)

or Crippss comment in Worswick, G. and Trevitchick,J (1983, p.176) for the Cambridge position. Note also that the same critique and response could be formulated to Yale-type models (whose dynamic properties are essentially unknown in general).

Otherwise, as noted by Solow (1983, p.165) the mean lag is simply not informative.


true, it provides a rationale for the quintessential New Cambridge empirical finding discussed in section 2.3.1. Third, in the steady-state its assumed that NW = Y = R = PD = GD = CGL = 0. But if GD = 0, we necessarily have that Y = G or, equivalently, Y = G/ 147. In other words, the government determines by itself the steady-state aggregate demand of the economy (and, in the absence of supply constraints) therefore its steady-state aggregate income. Note that in principle the same conclusion applies to Yale models as well, although it is not emphasized by Yale authors (probably because of the stability issues that would arise due to the endogenous variations on CGL, R, PD and ).

2.3.8 - (New) Cambridge-type models: A possible summary The relation between New Cambridge-type and Yale-type SFC modeling is a subtle one. In one (formal, mathematical) sense, some closed economy New Cambridgetype models can be seen as simplified special cases of Yale-type models148. On the other hand, the emphasis of Cambridge authors on (i) the production-finance link and inventory dynamics; (ii) the dynamic consequences of assuming (reasonably) stable stock-flow norms and (iii) the crucial importance of looking for empirical regularities directly at the macro level (as opposed to seek for microfoundations of any kind), have set them apart and led them to quite unique (even polemical) conclusions. We hope to have demonstrated the (often neglected) connection between Yale and New Cambridge


As noted, for example, by Blinder and Solow (1973), a paper that is closer to New Cambridge Notably the ones that abstract from inventory dynamics, like the one above and the ones, for

theorizing in the seventies than any of Yales .


example, in C&C (1983, ch.13 and 14).


types of SFC modeling and that the Cambridge constructs offer contributions that cant be found in Yale ones149. Besides that, the simpler New Cambridge-type specifications can be seen as more parsimonious versions of their (somewhat difficult to handle) Yale counterparts and, therefore, may be better suited for empirical use - especially if one can find in the data the empirical regularities assumed by Cambridge authors.

2.4 - Current Godley-type models: An introduction The last two sections summarized the state of the debate as it was seen in, say, 1985. In a long series of papers, however, Cambridge authors have refined their models (incorporating many Yale-type features along the way), while Yale authors, as far as we know, have either stuck with old views or followed the bulk of the profession and changed the focus of their research150. In what follows well briefly review the main features of the recent vintage of Cambridge SFC models (in particular, Godley, 1996 and 1999 and Lavoie and Godley, 2002-2002) and discuss in an introductory and non-


This is also the opinion of both Pasinetti (1984, p.111) and Solow (1983, p.164). According to

the first, Godley and Cripps have made definite contributions to macroeconomic theory which may have lasting effects. The stock-flow relation which they present, the sequential adjustment mechanisms which they describe, the mean-lag theorem which they prove, the overall picture of an economic system in terms of flows and stocks which they offer, all are splendid pieces of macroeconomic theory. According to the second, [Godley] follows the lyfe-cycle theorists (Modigliani and Ando, for example) in deriving a private expenditure function from target-wealth considerations, although his definitions are different. They are designed to allow him to exploit the interesting restrictions that the stock-flow mechanisms place on the lag relations among flows, at least in the linear case. These are new results, so far as I know, and useful ones.

As far as we know, the last Yale-type model published is Brainard and Tobin (1992). It deals

with open economy extensions of the conventional model, though.


exhaustive way whether or not they can be seen as a possible synthesis of the old pure New Cambridge and Yale models151. At the risk of oversimplification, it seems possible to identify four major changes in the Cambridge story. First, current Cambridge models now explicitly disaggregate private expenditures in consumption and investment. Second, current Cambridge models now use (weak versions of) Yale-type assumptions about the portfolio choice of banks and households152. Third, the financial side of the economy is now explicitly modeled (with non-M-M assumptions). Fourth, current models explicitly deal with the effects of the falsified expectations of agents. Well begin our brief discussion of these changes by the household sector.

2.4.1 - Households behavioral equations in current Cambridge-type models: The story here is simple. The models use a Modigliani-type consumption function and therefore are formally very close to the New Cambridge hypothesis of a desired wealth-income norm with partial adjustment mechanism (though now the hypothesis is restricted to the households sector)153. Indeed, weve already seen in section 2.3.2 above

Note, however, that a great part of the recent developments on Cambridge-type SFC modeling

has to do with open economy issues that are beyond the scope of this work. See, for example, Godley (1999c) and Taylor (2002) for more on these issues.

In particular, savings and portfolio decisions are not integrated. See below for more on this The exception is Lavoie and Godley (2001-2002) that assume a consumption function that


depends only on income and (lagged) capital gains. It seems to us, however, that one can criticize this hypothesis on the same grounds that Godley (1999a, p.396) criticizes the usual textbook one that makes consumption some proportion, less than one, of income () but has no sensible implication regarding wealth accumulation.


that this kind of consumption function implies a long run desired stock-flow ratio. What remains to be seen is that, in the linear case, a Modigliani consumption function (with lagged wealth) implies also a partial adjustment mechanism very similar to the one presented in section 2.3.5 above. Fortunately, the proof is trivial (see Godley, 1999a, p.406) and is based on the fact that if C = a1YDe + a2 NWh-1 and NWhe=YDeC154, we can replace the first equation in the second to get: NWhe = a2 (a3YD - NW-1), where [a3 = (1 a1 )/ a2]= (as in section 2.3.2) and a2 = (see section 2.3.5) 155. Now note that the equation above determines the expected change in wealth (including capital gains, see footnote 154 below) and realized consumption (that doesnt depend on interest rates or rates of return of any kind156). The expected allocation of expected savings is then decided along simple Tobinesque lines, i.e., the assumption is that the desired allocations depend linearly on the realized rates of return of the assets and on expected disposable income157. Households expectation errors are dealt with by assuming a hierarchical effective allocation in which money deposits take all the burden


The reader may very well ask at this point if we are not forgetting capital gains in this

definition. The answer is no. Recent Cambridge papers have used the Haig-Simons definition of income (which includes capital gains).

This interpretation is explicit in Godley (1999a, p.396), according to which ()underlying

the assumption [of a Modiglini-type consumption function]() is the idea that, aggregated across the [households] sector, wealth is accumulated at a particular rate and that there exists a desired long run wealth-income ratio.
156 157

Or, to use the Yale jargon, savings and portfolio decisions are not integrated. The exception are the holdings of cash that are determined entirely by a need for transactions

purposes (Godley, 1999a, p.406).


of the errors and, if they are not enough, time deposits take care of the rest158. Finally, although generalized partial adjustment mechanisms a la Yale havent been used in recent Cambridge models, Godley (1996, p.18) implies they should.

2.4.2 - Firms behavioral equations in current Cambridge-type models As summarized in Lavoie and Godley (2001-2002, p.107-112), current Godleytype models assume that firms have 4 categories of decisions to make, i.e., (i)they must decide what the mark up on costs is going to be; (ii) they must decide () how much to produce; (iii) they must decide the quantity of capital goods that should be ordered and added to the existing stock of capital K their investment; and (iv) once the investment decision has been taken, firms must decide how it will be financed. Given that we have limited ourselves to the discussion of models with fixed prices, well skip the first decision and assume that both the mark up and the costs of firms are constant159. In what follows, well discuss the hypotheses made in current Cambridge papers about the other three decisions, beginning by the second. As mentioned in section 2.3.3, Cambridge authors assume that firms decide what to produce based on their expected final sales and desired change in inventories. They formalize it assuming that firms have adaptative expectations as far as sales are concerned and a desired stock (of inventories) flow (of final sales) norm. The specification of the production decisions of firms is completed with the assumption of a

As put by Godley and Lavoie (2002, ch.12, p.12) mistakes about income get communicated

and hopefully rectified by the arrival of a bank statement!


partial adjustment mechanism applied to inventories analogous to the one supposed for households160. Note also that, as seen before, Cambridge authors explicitly assume that all inventory accumulation is financed by loans161. It seems fair to say that Cambridge authors do not argue in favor of any particular kind of investment function. As we saw in section 2.3.1 above, one of the advantages of assuming a private sectors wealth-income norm is that it allows one to avoid (to a certain extent) this issue. Recently, however, Cambridge authors have used an eclectic investment function that combines neo-Kaleckian with Tobinesque specifications (i.e., makes investment a positive function of q, capacity utilization and the ratio of cash flow to capital and a negative function of the ratio of interest payments to capital162). As they put it themselves, however, the possibilities [as far as the specification of investment functions is concerned] are endless(Lavoie and Godley, 2001-2002, p.111). Be that as it may, once total investment is decided, firms are assumed to finance a fixed fraction of it with new issues of equities (admittedly an oversimplification, see Lavoie and Godley, 2001-2002, p. 111). The rest is financed with the firms retained earnings (that are assumed to be a fixed fraction of total profits) and, residually, with loans (idem). No explanation is given as to why firms wouldnt look at relative prices (a la Yale) in their financial decisions, though.


Again we are oversimplifying things. An important part of the research of Cambridge authors

has been on industrial pricing and related issues. See, for example, Coutts, Godley and Nordhaus (1978) for more on this issue.
160 161

See the third essay of this dissertation for a possible formalization of this mechanism. So much that they dont even mention the financing of inventories among the decisions faced The last two variables can be seen as proxies of Minskys lenders risk.

by firms.


2.4.3 - The behavior of banks and the government in current Cambridge-type models While the government story didnt change at all in current Cambridge-type models (its still pretty much the same as the one presented in section 2.3.4 above), banks behavior has been completely formalized along (somewhat modified) Yale-type lines163. The story is, in fact, similar to the one told in section 2.2.4 above though with two major differences. First, Cambridge authors assume that banks dont ever refuse loans to firms, so their portfolio behavior is hierarchical in this sense164. Second, banks are assumed to set the interest rates on loans and time deposits, i.e., they make profits not by deciding where to invest but by setting prices in response to quantity signals (Godley, 1996, p.20). In practice, its assumed that banks have a norm () for the ratio of defensive assets () to liabilities () and increase the rate of interest on money at [some given] rate () whenever [this ratio] () falls below the norm and reduce it (at the same rate) when it rises above the norm (Godley, 1999a, p.408). The rate on interest on loans, by its turn, is either fixed as a simple mark up on the time deposits rate or, if this last rate is too low, as a simple mark up on the governments bonds rates.

2.4.4 - Current Cambridge models: A possible preliminary summary As the previous sections make clear, current Cambridge-type models have changed considerably since the beginning of the eighties and have come much closer to Yale-type formulations along the way. Cambridge authors have endogenized many of the exogenous variables of New Cambridge formulations (disaggregating the private sector

That had already been made explicit in literary terms in G&C (1983, pp.160-161).


and formulating explicit hypothesis about financial and portfolio decisions of banks, households and firms and, therefore, endogenizing them and variables affected by them, e.g., capital gains165) making their model more complete and less controversial on one hand but loosing the ability of explaining much by little that was provided by their use of fixed stock-flow norms on the other. Note, however, that Cambridge authors have kept their basic emphasis on the conditions of uncertainty in which production, investment and portfolio decisions are taken, stressing the adjustment mechanisms of agents and the crucial role played by the financial sector in providing a cushion that enables the economy to work despite all the unavoidable falsified expectations. Its precisely the recognition of these uncertainties and falsified expectations and their consequences that prevent Cambridge authors from using the strong equilibrium assumptions one often finds in theoretical versions of Yale models166.

2.5 - Final Remarks All along the text we have tried to demonstrate that Yale and Cambridge authors posed themselves roughly the same set of questions (despite their different emphases), arriving to somewhat distinct (although certainly related) answers. We hope also to have showed enough evidence to convince the reader that these questions are crucial ones in macroeconomics and despite all the problems mentioned above the answers given by

164 165 166

Its interesting to note that Fair (1994, p.21) confirms this stylized fact for the US. Or, in other words, tackling the well known difficulties of modeling the corporate sector. Though these are often relaxed when the model is used to explain the real world in which we



Cambridge and Yale authors are still among the very best the profession has to offer. It seems fair to say, in particular, that Cambridge and Yale authors together have provided a framework for an orderly analysis of whole economic systems evolving through time167 and this, by itself, justifies our claim that the mainstream of the profession is losing something important by sticking with its parables and neglecting their contributions.


That this has always been the purpose of Cambridge authors is clear in G&C (1983, p. 305).

The same point is implicit also in the introduction of Backus (1980).


3 - Notes on the Formal Properties of Simple Godley-type Models with Inventories

Introduction: Together with the economists of the Cambridge Economic Policy Group, Wynne Godley came up in the seventies with one of the very first views on how a complete system of physical and financial stocks and flows between () [macroeconomic] sectors () [evolve] through historical time (Godley, 1996, p.3). This paper aims to make a contribution to this line of research presenting a formal (albeit non-exhaustive) discussion of the dynamic and structural properties of possible simplified (or core) versions of Godley-type models with inventory dynamics. We must stress here both adjectives possible and simplified. First, Godley has had many opportunities to present his ideas - in varied degrees of development - during the last three decades and one finds many possible models in his writings. Second, Godleys models may arrive easily to 80-100 equations and, therefore, are not particularly easy to grasp. Indeed, in models of this size analytic solutions are rarely available and exercises in both comparative statics and dynamics generally require the use of computer simulations. Mainly to keep the number of equations manageable, but also because demand analysis is the heart and soul of Godleys theorizing168, well be working here with models in which supply restrictions are not binding169. The simple Godley-type model well present here (as an example) is, in fact, a possible formalization of (a somewhat modified version of) the ideas presented in chapters 3-4 and 6-8 of Godley and

So much that Malinvaud (1983, p.161), for example, makes reference to a Godleys Law()

[according to which] Demand creates its own supply. Pasinetti (1984, p.111) criticizes Godley on the same grounds.


Cripps (1983, from now on simply G&C)170. It deals explicitly with complications related to inventory dynamics and, therefore, differs from the model presented in the second essay of this dissertation (in which these issues were simplified away)171. Its our contention that the model discussed here can be seen as a (possible and simplified) core version of Godleys theorizing. According to this interpretation, Cambridge SFC models differ from their Yale-type counterparts because they emphasize following Post Keynesian, Circuitist and Marxian traditions the decision of production of firms172. Financial markets enter in the story mainly to finance production and asset choice issues are of secondary importance. Indeed, a second goal of this paper is to show how the model presented here is closely related to ideas discussed by Keynes


If the reader prefers, he is welcomed to think about this model as a simplified dynamic In this sense, its similar to (although simpler than) the model presented in Godley(1999a). On the other hand, the financial structure assumed here is much simpler than the previous one. The emphasis on production is particularly clear in Marxs analysis of the Circuit of Capital

aggregate demand of a larger model that would include also aggregate supply assumptions.
170 171 172

(see, for example, Foley, 1986a, ch.5). As put by De Carvalho (1992, p.44), it is () meaningful that it is in [this] () context () that Keynes made the only friendly reference to Marxs view that one can discover in the whole of his Collected Writings (CWJMK, XXIX, p.81). Here Keynes acknowledge the pregnant observation by Marx that the attitude of business is of parting with money for commodity (or effort) to obtain more money. As Lavoie (1992, p.160) makes clear, this is also the starting point of (the Franco-Italian) Circuit theory (see also Fontana, 2000), which claims that the causal elements [of macroeconomic dynamics] are () the production plans of firms and the bank loans which make these production plans possible and effective. The Post-Keynesian position, at least as summarized by Davidson (1972, p.35), is essentially the same: in a market-oriented monetary economy, it is the carrying of entrepreneurial resource-hiring decisions which ultimately drives the economic system. All these causal interpretations contrast with the general equilibrium stories discussed in the previous essay.


in many places (including his Treatise on Money173 and his 1937-1939 articles and, to a great extent, excluding the General Theory174) and their elaboration by Meltzler (1941), Hicks (1965, ch.X, 1974, first lecture and 1985, ch.11), Davidson (1972, especially chapters 2, 3, 11-13), Graziani (1989, 1996) and Erturk (1998), among many others. The model presented here differs from this literature, though, because it takes explicitly into consideration all the system-wide constraints (i.e., all necessary relations between the theoretical variables) imposed (implied) by a stock-flow consistent accounting framework. The model is also related to the Marxian literature, especially the works of Foley (1982, 1986a and 1986b) and Alemi and Foley (1997) about macroeconomic models based on Marxs circuit of capital and the works of Shaikh (1989) and Moudud (1998) on stock-flow consistent and dynamic specifications of the Principle of Effective Demand. The model is presented in part 2 below, that follows the current literature (see, for example, Godley 1999a or 1999b) phrasing its water-tight stock-flow consistent accounting framework in a flow of funds matrix. Then, in part 3, both the one-period solution of the model and its dynamics are discussed. The fourth and last part of this work uses the model presented in this paper to briefly summarize the main formal properties of simple Godley-type models and discuss some possible extensions. Technicalities related to mathematical proofs are presented in the appendixes. Before all

Albeit in a Flexprice context. The relevant points appear in the discussion of what Amadeo

(1989, p.33) calls the supply version of the fundamental equations (see volume I, ch.18 and volume II, ch.27-29 of the Treatise) that, by its turn, is heavily influenced by Hawtrey (especially Hawtrey, Currency and Credit, 1919). See Abramovitz (1950, ch.1) and/or Hicks (1977, ch.V) for more on the Hawtrey-Keynes connection.

See Graziani (1996) for details.


that, however, we shall provide a context for our emphasis on models with inventory dynamics and thats what well do in what follows.

3.1 Why Inventories in the first place? As mentioned in the second essay of this dissertation, most macro models simplify inventory dynamics away assuming (explicitly or not) that firms have sufficient foresight/flexibility to adjust their production to demand. This view is, in fact, widely accepted in the Keynesian literature, partly because, as put by Hicks (1974, p.12n), in the Treatise on Money Keynes gave much attention to working capital, and to liquid capital (); but in the General Theory they have nearly disappeared. He had evidently convinced himself, by the work which he had done in the Treatise, that they do not matter. Hicks himself (1965, ch.VII-X; 1974, first lecture; 1989, ch.2-3) - but also Godley and Cripps (1983), Shaikh (1989), Blinder (1990) and Erturk (1998), among others disagree(s) with Keynes on this particular matter. In this section well briefly mention some of their reasons. The first set of reasons is theoretical. One first theoretical problem with the practice mentioned above has to do with the ambiguities of the conventional Keynesian concept of short run (flow) equilibrium. Indeed, the static nature of this equilibrium is well known and as put long ago by Lloyd Meltzler (1941, p.113) an infinite number of dynamic sequences having Keynes income investment equation as an equilibrium () could be formulated. Besides that, and equally important, its doubtful that one can make any confident statement about a tendency to the equilibrium that has been here


described (Hicks, 1965, p.109)175 and even if this (supposedly short term) process ends up being stable this doesnt mean that its (system-wide and/or longer term) implications are trivial176. A second theoretical problem arises in the context of Fixprice models (like, for example, the ones in the second essay of the dissertation). As Hicks (1965, p.79) noted a while ago, the existence of stocks has a great deal to do, in practice, with the possibility of keeping prices fixed. If, when demand exceeds output, there are stocks that can be thrown in to fill the gap, it is obvious that the price does not have to rise; a market in which stock changes substitute for price changes (at least up to a point) is readily intelligible. If there are no stocks to take the strain it is harder to stick to the assumption of rigid prices. To put the same point differently, Fixprice models look much more compelling without heroic hypotheses of perfect foresight by firms. The second set of reasons is empirical. As put by Blinder (1990, p.85) the overwhelming importance of inventory movements in business cycles is one of those

Erturk (1998, p.173-174) makes a similar point: In () early writings of Keynes [including

the Treatise] the interaction of the expansion of () output and the investment in working capital that it induces, sets off a cumulative process of expansion not much different from the type of instability analysis expounded by Harrod (). After 1932-1933, Keynes () sets out to recast his theory in terms of comparative statics. () By then, he argues that convergence () to a point of equilibrium is ensured by what he calls a fundamental psychological law (). I argue that the said psychological law can produce a stable equilibrium only because Keynes has in the interim divorced the expansion (contraction) of output, which eventually became the multiplier process, from adjustments in working capital ().

See, for example, Hicks (1965, 1974) and Shaikh (1989) for more on this issue. In the model

presented in this paper, for example, inventory accumulation is the sole responsible for increases in the financial assets held by the public and this has important dynamic implications for the behavior of the economy as a whole.


basic facts that seems to be inadequately appreciated. Indeed, inventory investment is small compared to other components of GDP (about 1 percent) and this gives some the wrong impression that they can be neglected without major repercussions. The data seems to show otherwise, however, extensively supporting the view according to which inventory dynamics is a crucial part of the dynamics of the economy as a whole. As put by Blinder (ibid, p.1) its importance in business fluctuations is totally out of proportion to its size. () Inventory investment typically accounts for 70 percent of peak to through decline in real GNP during recessions. This point is hardly new. Keynes himself, for example, had made it many decades before (1930, vol. I, p.281): whenever we have to deal with a boom or a slump in the total volume of employment and current output, it is a question of a change in the rate of investment in working capital rather than in fixed capital, so that it is by increased investment in working capital that every case of recovery from a previous slump is characterized. Of course, as Blinder is quick to note, recessions are rather special episodes, so one is probably better informed if he or she takes into consideration that changes in inventory investment account[ed] for 37 percent of the variances of changes in GDP [during the period between 1959:01 and 1979:04 in the US] and, therefore, the importance of inventory fluctuations is not limited to cyclical downturns (ibid, 1990, p.2). In sum, inventories matter. They matter empirically, in the sense that inventory developments are of major importance in the propagation of business cycles; and they matter theoretically, in the sense that recognition of their existence changes the structure of a variety of theoretical macro models in some fairly important ways ((Blinder, ibid, p.1, emphasis in the original).


3.2 A Simple Godley-type Model This part is divided in six sections. Sections 3.2.1 and 3.2.2 below present the artificial economy underlying the model and discuss some of its system-wide implications. The others present the specific behavioral hypotheses assumed for each macroeconomic sector.

3.2.1 The artificial economy Well work here with an artificial closed economy with government and commercial banks and only four financial assets, i.e., cash, interest-free bank deposits, government bonds and bank loans. Indeed, for expositional purposes well try as much as possible to keep the same level of abstraction of conventional presentations of the IS/LM model, the main differences being that the model presented here abstracts from investment in fixed capital and emphasizes the role of commercial banks in the financing of production177. Table 1 below summarizes the main characteristics of the economy at hand.


These differences reflect the emphases one finds in Godleys theorizing. As discussed in the

second essay of this dissertation, Godley-type models dont have anything particularly interesting to say about investment in fixed capital. On the other hand, Godley couldnt be more emphatic about the importance of explicitly modeling bank credit. This point was made clear, for example, in Anyadike-Danes et. al. (1987, 10-11), according to whom, as production in reality takes time, finance must be forthcoming if the private sector is to grow; hence the need for a representation of commercial banking system, debt and inside money.


Table 1: Flows of funds at current prices in our artificial economy

Sectors Transactions P.Consumption G.consumption inventories Wages Taxes Int. on loans Dividends Int. on Bonds Current Savings: Savings cash demand deposits Loans178 Bonds -PBB Sh + Net capital transactions = 0 Sf + Net capital transactions = 0 Sh +F +XB-1 Sh Sf =0 +WB Households Current -C Capital Firms Current +C +G +IN -WB -T -il*L-1 -Ff -XB-1 Sg Sb=0 Sb=0 + H - Hb +Md + L -R +PBB Sg + Net capital transactions = 0 Sb + Net capital transactions = 0 -L+ R Uses and Sources of Funds Sf =0 Sg - Hh -Md +T +igR-1 +ilL-1 - igR-1 -Fb -IN -G Capital Government Current Capital Banks Current Capital

Accounting memo: Y C + G + IN Final Sales (FE) + IN National Income

Beginning with the households, our simplifying assumptions made only for convenience and summarized in the households column in the table above179- are that (i) their total income consists of wages, dividends and interest payments on bonds and can either be saved (or, equivalently, be used to acquire financial assets) or be spent in consumption goods, (ii) they dont pay taxes (iii) their wealth is necessarily divided


Again we should warn the reader that technically, R (the change in discount loans) should be Again we remind the reader that a plus sign before a variable indicates that money is being

included in H and Hb.


earned, while a minus indicates that money is being spent.


among three possible financial assets (i.e., cash, money deposits and government bonds), and (iv) they dont have access to credit. Things are not so simple (as is always the case in SFC models) as far as the nonbank business sector is concerned. To avoid both inflation accounting and aggregation complications, well assume that (i) prices and wages are fixed, (ii) the production periods of all (vertically integrated) firms are equal and syncronized (that is, all firms start and finish production at the same time and labor is the only component of their total costs) and (iii) the accounting period is the same as the production period (so the stock of unfinished goods in the end of the period is zero for all firms). Note that hypotheses (ii) and (iii) mean in practice that time periods have been chosen such that inputs purchased and work undertaken in one period emerges as sales in the next period i.e, the time periods are equal in length to the period of production. Inventories at the start of the period are sold in that period; inventories at the end of the period represent costs incurred during the period (G&C, p.170)180. We also assume that (iv) there is no fixed capital in this model, just working capital and (v) production can be financed only through bank

The aim here is to emphasize that for the goods which are being sold to-day, costs of

production were incurred sometime in the past (bread was baked last night; the field where the wheat was sown was ploughed last autumn). Sales are out of stock, and current production is replenishing stock with a view for future sales. (Robinson, 1956, p.41). As Joan Robinson was quick to notice (ibid, p.41), () from () [this] point of view all production is investment and sales disinvestments (the same point is made by Hicks, 1974, p.14) and, therefore, one can very well argue that we should have classified them as capital expenditures in Table 1 above. Note, however, that the message of the paper doesnt depend at all on this detail and, therefore, we preferred to follow the conventional practice of classifying them as current expenditures. The alternative would have forced us to split final sales in final sales valued at cost [(C+G)/(1+m), a capital revenue] and profits [or, more precisely, quasi-rents, i.e., m(C+G)/(1+m)] and, therefore, would probably have complicated matters more than clarified them.


loans, since there are no equity markets in the economy and retained earnings are assumed to be zero181. Last, but not least, we assume that (vi) the only asset of firms is their stock of inventories (and, therefore, we rule out financial speculation) and (vii) all goods and services of the economy are produced by firms. As it will become obvious in what follows, these simplifying assumptions enable a much clearer presentation of the main ideas behind Godley-type models than otherwise, although they certainly need to be relaxed if the model is meant to have any practical interest182. Turning now our attention to the government sector, the story here is basically the same of the second essay of this dissertation. The government (defined, as before, to include a central bank) is assumed to get its income from taxes (assumed, for simplicity, to be paid only by firms) and interest payments received on discount loans to banks. Its expenses are purchases of consumption goods and services from firms and interest payments to households (we are assuming, for simplicity, that the government doesnt invest and all public workers are volunteers). Again for simplicity, government debt is assumed to consist only of perpetuities, i.e. bonds that pay a fixed amount of money ($X) per period and are traded in a market (and, therefore, have a price PB, so that the value of

In other words, all (after tax) profits (in the sense of section 2.3.3 above) are assumed to be Godleys own models generally relax hypotheses (i), (iii), (iv) and (v) (see, for example, G&C,

paid to the owner(s) of the firm.


ch.9, 10 and 13) at the cost of a considerable increase in the complexity of the accounting. The (implicit) hypothesis of a big representative firm, however, appears to be maintained. Indeed, as put by G&C (1983, p.60) macroeconomists have a limited choice of observation periods. Most aggregate data are only available on a quarterly or yearly basis. We shall generally specify aggregate relationships as if decision making periods were all the same and equal to some chosen accounting period. See Foley (1975) for a discussion of some of the possible problems with this


the stock of public bonds is PBB). Public deficits (surpluses) and loans to banks are supposed to be financed (used) either by (with) increases (decreases) in high-powered money or by (with) sales (purchases) of public bonds. Finally, our admittedly very crude assumptions about banks are that: (i) their assets consist only of loans to firms and (interest free) reserves (and, therefore, their only source of income is the interest they receive on these loans); (ii) their only liabilities are the (money) deposits from households and (if necessary) discount loans from the central bank, (iii) they dont need workers or fixed capital to operate, so their only (possible) expense is with interest payments on discount loans, and (iv) their retained earnings are zero. Before we move on, its important to notice that from the capital accounts in Table 1 above, we get the following balance sheets: Table 2: Balance Sheets of all the sectors of our artificial economy
Households Assets Hh Md PBBh NW = total assets Liabilities and NW Firms Assets IN Liabilities and NW L Banks Assets Hb L Liabilities and NW Md R NW = 0 Government Assets R Liabilities and NW H PBB NW= R - total liabilities

NW = 0

3.2.2 The logical implications of the accounting framework above As discussed in the previous essays of this dissertation, the use of SFC accounting frameworks allows the analyst to identify the system-wide logical implications of his or
assumption and Foley (1986a and 1986b) for a formalization of production decisions that allows for less strict hypotheses.


her assumptions about the structure of the economy. As the identification of these logical implications is at times an arid task, some readers might want to skip this section, going directly to the ones discussing behavioral hypotheses. Its our understanding, however, that the material in this section is crucial for the story we are trying to tell, so we must encourage the reader to persevere at this point183. First of all, from the firms column in Table 1 above we know that: (AI.1) Y C + G + IN FE + IN [i.e, total expenditure and, therefore, total income is identical to final expenditure (FE C + G) plus the accumulation of inventories by firms (IN)184]. Now note that, given that ours is a closed economy: (AI.2) Y YG +YP [i.e, total income is identical to government plus private incomes]. This is true both before and after the gross incomes are altered by transfers and interest payments (becoming then net or disposable incomes), though it will be more convenient for us to use the second definition: (AI.3) YG Governments net income T + igR-1 - XB-1 Y- YP [i.e, governments net income is identical to total tax receipts plus the interest received by the government minus the interest paid by the government see Table 1 above]. Turning now our attention to the private sector (i.e., the aggregate of households, firms and banks), we saw in the second essay of this dissertation (section 2.3.2) that, if

As put by G&C (1983, p.44), we must exploit logic so far as we possibly can. Every purchase

implies a sale; every money flow comes from somewhere and goes somewhere; only certain configurations of transactions are mutually compatible. The aim here is to show how logic can help us to organize information in a way that enables us to learn as much from it as possible.

Desired or not, as we will discuss in more detail in section 3.2.3 below. Note also that in our

accounting all goods and services are provided by firms in the non-bank business sector.


the net worth of both banks and firms is zero (or, equivalently, if all their after tax profits are distributed), private disposable income equals households disposable income. But, from (the households column of) Table 1 above, its clear that: (AI.4) YP Private disposable income Y -YG WB+ F+ XB-1 [i.e, private disposable income is identical to wages plus after tax profits plus the interest received by households, if the net worth of firms and banks are both zero]. Now note that, from (AI.1) and (AI.2), we have that C + G + IN YG +YP or, rearranging, (AI.5) YP (C + IN) G YG -Sg The identity above has a clear intuition. Given that total income is identical to total expenditure (including expenditures in inventories), we have that if any sector spends more than what it gets, it will be generating more income than what is getting and therefore this deficit has to be compensated by a surplus in the other sector. From the governments uses and sources of funds in Table 1 above, we can also write that: (AI.6) GD H + PBB GYG+R -Sg+R [i.e, the increase/decrease in government debt (GD) is identical to the government current deficit (GYG) plus the (net) increase in governments loans to banks]. If the banks stock of discount loans is constant, the identity above simplifies to: (AI.6a) GDH + PBB G YG - Sg Indeed, as discussed in the second essay of the dissertation (section 2.2.3), in a model with high-powered money the change in public debt doesnt consist only of the G-YG


(-Sg, that can be called the fiscal component of public deficit) but also of (net) increases in discount window loans (R, that also changes the stock of high-powered money and, therefore, public debt). It so happens that the government is the source of great part of the private wealth in this artificial economy. As we saw in section 2.3.2 above, the stock of net private wealth is equal to the stock of net household wealth when the net worth of both banks and firms are zero185. Therefore, from the households column in Table 1 above, we have that: (AI.7) PNW HNW FAt Hht + Mdt + PBBt where the FA notation is meant to emphasize the fact that all wealth consists of financial assets. In words, if the net worth of firms and banks are both zero, the total value of the net private wealth of the economy is given by the stocks of cash and money deposits of households (or simply the stock of money of households) plus the value of the households stock of public bonds. The last two relationships above seem to imply a direct link between public deficits and private wealth. To see this, note first that from the households column in Table 1 above we have that:


In more complex Godley-type models (in which M-M type assumptions are not used), it

becomes important to differentiate between the net worth of the private sector as a whole (i.e., the sum of households, firms and banks net worth), the net worth of the non-banking private sector (i.e the sum of households and firms net worth) and the net worth of households.


(AI.8) YP C 'WB + F + XB-1 C FA186 [or, in words, what families get (YPWB+F+XB-1) minus what they spend (C) is identical to what they save or dissave (FA)]. Now note that, from the firms column in Table 1, above we have that: (AI.9) IN L PD [i.e., the change in the value of the inventories (valued at cost) held by firms is identical to the change in the value of their bank loans and, given our hypotheses, the change in the value of their total debt]. And, from (AI.8) and (AI.9) above, we can write: (AI.10) YP (C + IN) FA - PD [i.e, the private sector surplus (YP (C + IN)) is identical to its net acquisition of financial assets (FA) minus the net increase in firms debt (PD)]. To get the precise relationship between the governments deficits and the increase in private wealth, one has to notice that, from (AI.5), (AI.6) and (AI.10), we have: (AI.11) FA PD - Sg PD + GD R [i.e, the change in households financial assets (FA) is identical to the change in the net debt of the firms (PD) plus the governments current account deficit (-Sg) which, by its turn, is identical to the increase/decrease in government debt (GD) minus the (net) increase of government loans to banks (R)]. Again, in the absence of rediscount loans, we would have: (AI.11a) FA PD + GD What this means in practice is that, in our artificial economy (and, for that matter, in all closed economies), government deficits increase private wealth in a one-to-one basis. Note also that, consolidating the balance sheets of households, firms and banks (i.e., the

Assuming that capital gains are zero (i.e., PB is constant).


private sector) in Table 2 above, its possible to get a stock version of the result above. Indeed, by doing that one gets:: FA Hh +Md + PBBh + IN + Hb +L L Md R (given that INL and Hb+L Md +R). Or, rearranging, (AI.12) FA H + PBB + IN R GD + PD R (given that PD IN and H+ PBB GD) This fact will play an important part in what follows.

3.2.3 - The behavior of the non-bank business sector The story here is pretty much Keynesian. In the beginning of the production period firms formulate expectations about the quantities they will be able to sell at given normal prices and decide how much to produce (and how to finance production) accordingly. As discussed in some detail both in the second essay of the dissertation and in the previous section, the typical assumption in Godley-type models is that all production (including inventory accumulation) is financed through bank loans and, therefore, whenever they increase (decrease) their inventories, firms borrow (pay) from (to) banks the exact amount required (available) to do so187. The accounting identity n.9 presented before formalizes this point:


See section 2.3.3 for a discussion. Note also that Circuitists, Post Keynesians and Marxists

share (a weaker version of) the same view. As put by Fontana (2000, p.33) circuitists have emphasized the distinction between firms, which are involved in income-expenditure decisions, and banks, that is, suppliers of credit-money. For any production process, it is argued, firms need to negotiate loans with banks. Davidson (1972, p. 269-270), by its turn, points out that if the demand for capital goods [including working capital goods] is to increase, it will be necessary for entrepreneurs to obtain additional command of resources. () but the obtaining of command of resources requires the co-operation of the banking system and financial markets. Finally, Foley


IN L PD (AI.9) where IN, L and PD are, respectively, the change in the value of the inventories (valued at cost188) held by firms, the change in the value of their bank loans and the change in the value of their total debt. Note also that this result is a direct consequence of the hypothesis that retained earnings (and, as a consequence, the net worth of the firms) are zero in this model and, therefore, profits189 can be seen as the capitalists family income (since we are not assuming equity markets here)190. Turning now our attention to the production decisions of firms, the hypothesis is that they are based on firms expected sales plus the change in inventories they want to bring about (Godley, 1996, p.14). In early (New) Cambridge-type SFC models the
(1986a, p.111) remarks that the capitalist borrows in the first instance in order to use the money received as money capital, to commit it to the circuit of capital (). Foley and Davidson, however, explicitly recognize that not all investment in production is necessarily financed by loans. To use Hickss (1974, p.51) concept, Godley seems to work with a 100% overdraft nonbanking business sector, i.e., one that is supported by assured (or apparently assured) borrowing power (the other extreme, according to Hicks, would be the auto sector, i.e., one which mainly relies for its liquidity on the actual possession of liquid assets).

Godley (see G&C, ch.9 or Anyadike-Danes, 1987) prefers to consider the interest rate as

a part of the variable cost of firms. This apparent detail has the important implication that, for Godley, increases in the interest rate would ceteris paribus increase prices as well. In our model, on the other hand, increases in the interest rate ceteris paribus cause the dividends paid to owners to fall. Ours seems the only way to go if one wants to discuss monetary policy issues and simultaneously avoid inflation accounting complications.

As mentioned in the second essay of this dissertation, the definition of profits used here is a

loose one and means what is left from what is sold after one pays for what it did cost. Joan Robinson (1956,p. 44) calls this concept quasi-rent.

Again, this assumption would have to be dropped in more sophisticated models since, as put

by Godley (1996, p. 8), it is absurdly unrealistic, by-passing and trivializing the role of the financial system ().


assumption is that firms correctly foresee final sales and are always able to keep the stock of inventories (valued at cost) as a fixed proportion of past final sales valued at market prices [e.g, INt = FEt-1= (C t-1+G t-1)]. This assumption makes the dynamics of the model easier to analyze but is not one that is easy to justify. G&C (p.108, footnote) try to do it arguing that this might be the case, for example, if () [firms] have enough foresight and flexibility to avoid a fall in inventories in a period when sales rise () and if they manage to catch-up with a past change in the flow of sales by the end of the period after the one in which the flow of sales changed. Note however that, even in the most favorable case for G&Cs argument, i.e., one in which the technology is flexible enough to allow changes in production within the production period and/or if the accounting period is much larger than the production period, its still difficult to explain why firms would care to adjust their inventories to past sales if they can sufficiently foresee (near) future ones. Here well proceed differently and assume that (i) firms expectations about future final sales (FE= C+G) are adaptative (in the sense that in the beginning of the production period t firms expect to sell in t+1 what they sold in t-1), (ii) the technology doesnt allow quantity adjustments within the production/accounting period and (iii) the desired (but not necessarily the actual) stock of inventories in period t (valued at cost) is proportional to expected final sales in period t+1(valued at cost)191. Formally,

In this sense our hypothesis is similar to the one in Hicks (1965, p.106) according to which

desired working capital must clearly depend upon the expected level of output; it should thus () depend upon Yt, Yt+1,...,Yt+n, where n is the number of periods that are taken by the process of production () that takes the longest. Note, however, that in our model n=1 by hypothesis and therefore it seems natural to assume that the only expectation affecting firms desired working capital will be their expectations of final sales in period t+1.


E t(FE t+1) = FEt-1 (eq. 1) and INt* =JE t(FE t+1)/(1+m) = FEt-1/(1+m)192 (eq.2) where INt* is the desired stock of inventories in the end of period t (valued at cost), is the desired stock (of inventories, valued at cost)-flow(of sales, valued at cost) ratio of the firms as a whole, FEt is the value (at market prices) of the total expenditures of the economy in final goods in period t and m is the mark-up [so FEt/(1+m) = final sales valued at cost]. Now note that, as were not assuming that firms have perfect foresight, we need to say something about how firms deal with their falsified expectations. Here well assume an extreme version of the so-called Stock Adjustment Principle (see Hicks, 1965, p.96), i.e., that in the beginning of each period firms adjust production to try to get their desired stock of inventories. To make the content of this assumption clear lets return to the example given in the second essay of this dissertation (section 2.3.3), in which a firm is in a steady state producing and selling 100 (valued at cost) at each period of production (note that in this case = 1). Now lets assume that, in a given production period t, the firm unexpectedly sells 90 instead of 100. In this case inventories at the end of period t will be 110 (100 produced + an involuntary increase in inventories of 10). Given our story so far, in the beginning of t+1 the firm will expect to sell 90 in t+2 (i.e., what it sold

The hypothesis here is slightly different from the one in G&C(1983, ch.6). G&C assume that

is the desired stock(of inventories valued at cost)-flow (of sales valued at market prices) ratio, while our is the desired stock(of inventories, valued at cost)-flow (of sales, valued at cost) ratio. To put it another way, G&Cs is equal to our /(1+m). Contrarily to what happens in G&C (that


in period t see eq.2) and its desired stock of inventories in the end of t+1 will be 90 = 1*90 (see eq.3). What our extreme version of the stock adjustment principle says is that in such a case the firm will produce 70 in t+1 (i.e, expected sales of 90 excess inventories of 20). Formally, Xt (production in t valued at cost) is given by: Xt = 1Et(FE t+1) + 1 [FEt-1 Et-1(FEt)] + 1 [Et(FE t+1) Et-1(FEt)] where, 1 = 1/(1+ m). or, given the assumption in equation (1), Xt= 1 [(2+)FEt-1 (1+)FEt-2 ] (eq 3). Note that the adjustment process assumed here is extreme in the sense that firms try to get rid of all undesired inventories in a single period of production while other more gradual kinds of adjustment are not only possible but (supposedly) more common in practice193. Note also that in practice will be bigger than one so the firms have a cushion to accommodate sudden increases in demand. Note, finally, that the actual accumulation of stocks (valued at cost) is given by what is produced (Xt) minus what is sold (valued at cost, i.e., FEt/(1+m)): IN = Xt FEt/(1+m) = 1 [(2+)FE t-1 - (1-) FE t-2 - FEt] (eq.4)

3.2.4 - The behavior of households

dont discuss stock adjustment issues), however, our stock adjustment algebra requires an explicit differentiation between market values and costs.

For nice discussions of possible adjustment mechanisms for the stock of inventories of firms,

see Hicks (1965, ch.10) and Blinder (1990, ch.5). The possibilities in this area are numerous.


Well work here with the classic Godley-type assumption that households as a whole have a relatively constant desired stock(of wealth)-flow(of disposable income) ratio. Formally, this hypothesis means that: FA* = DYP (equation 5), where FA* is the households desired stock of wealth (that in this simplified model can only be kept in either money, i.e., cash or bank deposits, or bonds), is the stock flow norm and YP is the flow of disposable income. A second assumption here is that the change in the stock of money [and bonds of households] which actually takes place in any period is a certain proportion, , of the gap between the stock of money [and bonds] inherited from the previous period, FAt-1, and the stock of money [and bonds] warranted by the current income flow, FA* (G&C, p.61). This partial adjustment mechanism is essentially the same discussed in the second essay of this dissertation and can be written formally as follows: FAt = (FA* FAt-1) (equation 6) In order to understand exactly what the assumption above means, lets consider a steady state in which the flow of disposable income is 10,000 per period, the stock-flow norm is and the stock of financial assets (wealth) is 7,500. In this case, there will be no change in FA from period to period (given that FA*= FAt-1). Now lets assume that there is a once and for all change in the flow of income per period to, say, 12,000 and that (the speed of adjustment parameter) is . In this case, we have that the new FA*= *12,000 =9,000 >7,500 = FAt-1. This means that in the first period after the change in income, FAt = *(9,000 7,500) = 750, while in the second period FAt = *(9,000 8,250) = 375 and so on. Note that, by hypothesis, households can only buy (non durable)


final goods or accumulate financial assets and dont have access to bank credit. This means that FAt is equal to the total savings of households and, therefore, in the example above households as a whole will save 750 of their YP in the first period, 375 in the second period and so on. As Moudud (1998, p.97) puts it Godley and Cripps propose a theory of an endogenous saving rate which is based on the notion of a stable stock-flow norm [and, I should add, a given process of stock (of wealth) adjustment]. Note, in particular, that in equilibrium households spend all what they get. As discussed in the second paper of this dissertation (section 2.3.2), the hypotheses above imply a linear consumption function a la Modigliani (with lagged wealth), i.e., of the kind C = c0YP + c1FAt-1.. A little bit of algebra will help us to get this point clear. Note first that from (AI.8) above we have that: YP C WB + F + XB-1 C FA (AI.8) But from (5) and (6) above we have that: FAt = (YP FAt-1) (equation 7) Now, replacing (7) in (AI.9) we have that: YP C= (YP FAt-1) and, therefore, C = (1- )YP + FAt-1 (equation 8) Here well use a convenient special case of the equation above (often used also by Godley, since it greatly simplifies the algebra) and assume that =1/(1+). G&C justify this apparently arbitrary (though harmless simplifying) assumption as follows (p.92): the total amount of funds available for spending in any period (always assuming no borrowings) is equal to the flow of income in that period plus the stock of money [and


bonds] inherited from the previous period (i.e, Y+FA-1) Let us now assume that in deciding how much of the total funds available will be spent in any period, the income flow Y, ranks one-for-one with the inherited stock of money FA-1. [For this to happen must be equal to 1/(1 + )]. Indeed, replacing = 1/(1+) in eq.8 above, we have that: C =(YP + FAt-1) /(1+) (equation 9) and, therefore, households spend the same proportion of their current and previously unspent past incomes. This is precisely what G&C mean when they say that Y ranks one-to-one with the inherited stock of money [and bonds] in the households expenditure decisions. The (algebraic) convenience of this assumption is that (its easy to prove that) it implies that: C = FA/194 (equation10). Our final hypotheses concern the portfolio choice of households. As in the IS/LM model, well assume that households have to choose between holding money (i.e, cash and deposits, for simplicity well assume here that the public only holds a small fraction, say 10%, of money in cash) and bonds based on their liquidity requirements to carry out transactions and on the assets real rates of return195. Formally we have: Bhd = householdss bond demand = (ib, Ct)* FAt (eq.11) and

Indeed, if =1/(1+) then eq.8 above turns into FAt = (YP FAt-1) /(1+). As FAt FAt -

FAt-1, simple manipulations lead us to the conclusion that FAt = (YP + FAt-1) /(1+) = *C (from equation 9). Its interesting to notice, for historical reasons, that in early New Cambridge models (in which, as discussed in the second essay of this dissertation, the stock-flow norm applied for the private sector as a whole), this assumption would implied that FAt = (C + I).

Which, given our hypothesis that prices are fixed, are ib = X /PB (for bonds) and zero (for



Mhd = households money demand = ( ib, Ct)* FAt 196 (eq.12) where, ib = X /PB = interest on bonds and + = 1 (eq.13).

3.2.5 The Behavior of Banks As mentioned before, our treatment of the Banking Sector is admittedly an extremely crude one. The main hypotheses here are that (i) banks passively provide loans to firms on the security of inventories (Godley, 1999a, p.137)197, (ii) banks are price takers, in the sense that the interest rate of their loans is exogenous to them and (iii) banks retained earnings are zero. In other words, in the beginning of the production period banks forced to give loans to (i.e, increase the deposits of) whichever firm asks, at a fixed interest rate and in the end of the production period banks pay their owners (or get from them) whatever profits (losses) they have. These are, of course, heroic hypotheses and we used them here just to keep the algebra under control198. Less controversial are the hypotheses that (i) the central bank forces the banks to keep a fixed proportion () of their deposits as minimum reserves and (ii) any liquidity problems experienced by banks are assumed to be solved by inter-bank loans (which dont appear in the aggregated


Note however that, as Godley (1999a, p.397) reminds us the term demand for money strains

language, for it badly describes a situation where people aim to keep their holdings of money within some normal range but where the sums they end up with are determined in large part by impulse purchases, windfalls and unexpected events.

Kaleckis principle of increasing risk is probably among the first of a series of models of As discussed in the second essay of the dissertation, Godleys own models assume that banks

banking behavior in which loans are much harder to get than assumed here.

are price makers.


accounts above) and/or discount window loans199. Last, but not least, we consciously avoided all matters related to banks portfolio choice assuming that banks only assets are loans to the non-bank business sector and reserves and that banks liabilities consist only of households deposits and discount window loans. Its probably important to emphasize here that, under the hypotheses above (and the ones previously made in section 3.2.1), banks have no degrees of freedom whatsoever. In particular, banks have no control over whether they will be forced or not to get discount window loans to fulfill their reserve requirements while simultaneously providing cash to the public as demanded. Indeed, the volume of discount window loans depends entirely on the initial size of banks reserves and the behavior of money demand. It may, of course, be zero if, for example, there is a decrease in the demand for bonds and people start to sell bonds back to government in a sufficiently large scale. Note, in particular, that as the volume of loans and deposits are exogenous to banks (a hypothesis kept by Godley in his most recent papers see Godley, 1996 or 1999a) and they cant buy government bonds (by our assumption), reserves can be higher than the minimum. As their loans to firms (and their related interest charges) are (sometimes only partially) paid back along the production period, banks would then be able to decrease their debt with the central bank (if necessary). Note, however, that as long as just a small fraction of households money is held in cash and the interest rate on discount window loans is not very high relative to the interest rate on their loans, banks will always be able to pay positive dividends to their owners. The assumptions above can be formalized as follows:

The hypotheses here differ from the ones in G&C chapter 8, which describes a model without


Ls = Ld (eq.14) Mds = Mdd (eq.15) Hb = Bank Reserves = max {Mdt , Mdt Lt} (eq.16) R = Discount Loans = - min {0, Hb - Mdt} (eq.17)

3.2.6 - The Behavior of the Government The important assumptions here are three. First, government is assumed to choose the amount of its expenditures with goods and services (G) and to tax people in such a way that YG (governments net income, i.e, taxes minus interest payments on public debt plus interest on discount window loans received) is a fixed proportion of the national income. Formally, YG =Y, where is also a policy variable (see G&C, p.107). In sum, the government can choose G/, the fiscal stance of the economy. Second, the central bank is assumed to set the compulsory reserves of banks and to act as a lender of last resort through the so-called discount window loans to banks (with interest rates fixed by the central bank itself) whenever necessary. Third, monetary policy is assumed to be permissive, in the sense that the central bank holds the interest rate [on public debt] constant (Solow, 1983, p.165)200. Therefore, in the present model cash is provided on demand to the public. The government, or the central bank, does not decide in advance on
high-powered money. They are used in Godley (1996 and 1999a), though.

A post-keynesian endogenous money view would probably disagree with Solows choice of

words. The control of the interest rate is seen by this school as a pragmatic and sensible decision of the central bank, given the (Minsky-type) risks of attempting to control the money supply ()by adjusting [central banks] holds of bills (thus changing the level of non-borrowed reserves of commercial banks) or by altering reserve requirements()(Taylor, 1997, ch.7, p.11).


the proportion of the deficit that will be monetized. This proportion is set by the portfolio decisions of the households, at the rate of interest set from the onset by the monetary authorities(Lavoie, 2001, p.5). The assumptions above can be formalized as follows: ib = X/PB = ib* (eq.18) Bs= Bd( ib*) = ( ib*, Ct)*FAt (eq.19) G = G0 (eq.20) YG = Y (eq.21) and, given that Y YG +YP (AI.2), YP = Y - YG = (1- )Y (eq.22)

3.3 The Within Period and Between Periods Properties of the Model After having presented the structure of the model in detail it is now time to discuss its formal solution and its dynamic properties. We do that in 4 steps. First we find the one period algebraic solution of the model (in section 3.3.1) and discuss theoretical issues related to it (in section 3.3.2). Then we formalize and discuss both the steady-state (in section 3.3.3) and the dynamics of the model between periods (in section 3.3.4). Mathematical proofs related to the necessary and sufficient conditions for the dynamic stability of the model can be found in the appendixes.

As mentioned in the section 1.2.2 above, almost all central banks of the world are now


3.3.1 - The One Period Solution of the Model From (AI.1) and (eq.4) above, we have that: Yt = FEt + 1 [FEt-1 + (FEt-1 FEt-2) + (FE t-1 FEt-2) FEt] where, 1 = 1/(1+ m). And given that FEt Ct+Gt and Gt=Go, one can rearrange the expression above to get: Yt = 1 [m* Ct + mGo + (2+)FEt-1 - (1+)FEt-2] Now, all we need to do is to replace (eq.9) and (eq.22) in the equation above and solve for Yt to get: Yt = a1*FA t-1+ a2*Go+ a3*FEt-1 + a4*FEt-2 (eq.23) where, a1 =m*[(1+m)(1+ ) m(1- )]-1 a2 =(1+ ) m*[(1+m)(1+ ) m(1- )]-1 a3 = (1+ )(2+)*[(1+m)(1+ ) m(1- )]-1 a4 = - (1+ )(1+)*[(1+m)(1+ ) m(1- )]-1 And, as we can see, Yt is function of 5 exogenous variables of the model (, Go, , m and ) and the predetermined values of FEt-1, FEt-2 and FAt-1. It is also clear that, given the value of Yt, we can easily determine the values of the other endogenous variables of the model201.

permissive in Solows sense.


Indeed, given Yt and the values of the predetermined and exogenous variables, the values of

YG, YP and C are immediately determined by equations (21), (22) and (9). But given the values of YG, YP and C, one can determine also IN (with AI.1and eq.20), L and PD (with AI.9), -Sg (with AI.5), and FA (with AI.11). The remaining of the solution is trivial if one notes that the households assets demands are fully determined (by equations 11-13), if YP and FA are known.


3.3.2 Is there a story for what happens within the period? The algebraic solution presented above implies a couple of theoretical issues that deserve some discussion. First, equation 23 above doesnt describe an equilibrium in any sense of the term. In fact, if all behavioral assumptions hold true, it gives us the precise ex-post values of total income and expenditure (as defined above) even if firms ex-ante expectations are completely falsified in practice. As discussed in the second essay of this dissertation (sections 2.2.6 and 2.3.5), this disequilibrium view underlying the model is essentially the same espoused by Yale-type SFC theorists. It doesnt mean, of course, that one cannot come up with a theoretical single period equilibrium for the model202, but that such a concept is useful mostly to the specification of the dynamics of the model between periods. Well return to these issues in sections 3.3.3.and 3.3.4 below. Second, in the model above financial variables are entirely determined by: (i)saving and portfolio decisions of households, and, especially, (ii)production decisions of firms and (iii) the fiscal stance and the interest rate fixed by the government. In other words, there is no feedback whatsoever from the monetary side over the real side in this model, for the very good reason that the interest rate is given by hypothesis203.

That would require as discussed in sections 2.2.5 and 2.2.6 above - the modeling of ex-ante

expectations of households and banks as well. Note, however, that as banks are completely passive in this model, their expectations wont make any difference to the results.

Pretty much like in the New Consensus literature (see section 1.2.2 above). Its interesting to

notice that, at least in this particular sense, mainstream economists have converged to a view long espoused by Godley, Kaldor and other Cambridge economists. Note, however, that their interpretation of this hypothesis is completely different. Neoclassical Keynesians (Old and New, as well as some Post Keynesians) would probably interpret it as a horizontal LM curve, while the concept of a LM curve (which portrays an alleged equilibrium between a stock and a flow), horizontal or not, is alien to Godley-type models.


Third, its our contention that the general view (in Schumpeters sense) of the economy underlying Godley-type models is perfectly compatible with the broad Circuitist, Post Keynesian and Marxist views on macroeconomic dynamics204. Authors from all these traditions would probably agree with Keynes (1930, vol.1. p.282) that credit cycles are somewhat akin to chess matches, in the particular sense that one can describe the rules of chess and the nature of the game, work out the leading openings and play through a few characteristic end games; but one cannot catalogue all the games which can be played. The remaining of this section will focus precisely on the leading openings and characteristic end games assumed both in Godley-type models and in a few similar Circuitist, Post Keynesian and Marxist ones. Beginning with the openings, its interesting to notice that the within the period story in Godley-type models starts pretty much like, for example, Grazianis (1996, p.143): Let us imagine a pure credit economy, in which all payments are made by bank checks. Let us consider only consolidated macro sectors: banks, firms, and wage earners. Banks grant loans to firms, the outlays of which are exhausted by the wage bill. The moment wages are paid, firms become the debtors of the banks and wage earners the creditors of the same banks. A triangular debt-credit situation, typical of any monetary economy, is thus created. A picture of the economy taken immediately after the payment of wages would review that the whole of the existing money stock is a debt of the firms and a credit of wage earners towards the banks. As mentioned before, the Post Keynesian and Marxist openings are essentially the same, with the qualification that they stress also the role of other sources of finance/funding of firms, notably retained


Even if one accounts for the flagrant heterogeneity of the authors in these schools of thought.


earnings205. But few authors in these traditions would deny that in modern capitalist economies bank credit responds for a large amount of the investment in working capital and, therefore, the pertinence of the theoretical exercise proposed here. So far so good, but what about next? Again, the story implicit in Godley-type models206 doesnt seem particularly controversial. It is, for example, similar to Davidsons (1972, p. 271), according to whom households will respond to this increase in () [their] money balances by making consumption expenditures and consequently hold[ing] some of the additional money for transaction purposes. The remainder becomes households savings [Sh] and the households must decide in what form to store wealth207. And, then again, essentially the same point is corroborated by both Graziani (1996, p.143) and Foley (1986a, ch.5). In fact, as far as households behavior is concerned, the only major difference between Godley-type models and the conventional PostKeynesian/Circuitist/Marxist stories has to do with the implications of the stock-flow norm for the precise specification of the consumption function. After this point, as much as in a chess game, its impossible to tell what will happen in practice. Surely, a very complex web of transactions both between and within


As much, by the way, as Godley himself. See, for example, Godley (1996, p.8) or Lavoie and

Godley (2001-2002, p.111). The simplifying hypothesis used above is aimed only to emphasize the importance of bank credit in Godleys story.
206 207

See, for example, G&C, chapter 3. Davidsons story is, however, significantly different from Godleys, among other things

because it includes also investment in fixed capital and complications related to transactions between firms (that are simplified away here). Moreover, despite all the complexities implied by his (literary) dynamic narrative, Davidson appears to be comfortable with the conventional Keynesian idea that the economy does arrive to a static short period equilibrium.


the macroeconomic sectors will take place208, but Godley-type authors (and, for that matter, all the other schools of thought discussed here) have nothing to say about the precise timing of these transactions in historical time. As far as we know, the best attempt to do it in this broad literature is due to Foley (1986a, ch.5 and 1986b, p.20-30), who explicitly models the lags of the various decisions of both households and firms, although leaving the determinants of these lags open209. Turning now our attention to characteristic endings, its interesting to note that the story implicit in Godley-type models is again pretty much like the one told by Graziani (1996, p.143): As soon as wage earners spend their incomes, money flows back to the firms. () If no hoarding takes place, the proceeds originating from sales of commodities () enable firms to repay the whole of their debt to the banks. It need not be added that firms, besides giving back the principal of their loans are held to pay interest on them. Four qualifications must be made here, though. First, its important to keep in mind that, as originally pointed out by Marx210 and summarized here by Kaldor (1996, p.33, emphasis in the original): even if we abstract from compulsory levies on income imposed by the government etc, and if we suppose that wage earners spend the whole of their wage income on purchasing goods in the same period, without saving anything for a rainy day or for retirement, their total outlay of goods cannot be greater than the total costs of these goods incurred by the entrepreneurs, leaving nothing over for profit, the expectation of which was the entrepreneurs sole motive in producing goods for sale. To make it possible for the entrepreneurs as a class to
208 209 210

A very nice description can be found in the introduction of Backus et. al. (1980). Foleys reasoning builds on his critique of period models presented in section 1.2.3 above. In his discussions of the Circuit of Capital (see Foley,1986, ch.5).


realize profit over and above the costs incurred, there must be an additional source of demand which is autonomous (or exogenous) in character, which does not flow directly from income receipts generated by current production, and thus will determine at what level of output total demand and supply will match one another. Second, even if we add autonomous expenditures (i.e., ones that dont depend on the income generated by current production) to the story, its by no means certain that firms will be able to repay their debts to banks. Hoarding does happen in practice and sometimes firms just cant sell what they produced. Third, even if firms expectations are not falsified, their ability to pay their loans depends in important ways on what happens with their stock of inventories and the way these inventories are financed211. All three qualifications made above are non-controversial in nature and this leads us to the fourth. Its our contention that what truly separates Godley-type models from the conventional Post-Keynesian and Circuitist ones mentioned above is that the former emphasize that the story cannot end up in one period or, for that matter, in the short run212. Indeed, up until now the story doesnt differ much from more conventional Keynesian ones, albeit stressing the importance of bank credit for the financing of firms and of wealth for the consumption of households and being less respectful as far as the Keynesian short period equilibrium is concerned. Note, however, that Godley-type models (as much as Marxist ones, for that matter) are essentially dynamic in the sense that they emphasize and aim to capture (hence their emphasis on accounting) the

If, for example, firms end up the period with a positive stock of inventories and these are

financed with loans, it not obvious that they will be able to pay the whole of their debt to banks.


precise dynamic implications of the stockflow relations between macroeconomic variables - notably between the stocks of assets and debts of the macroeconomic sectors and their (interconnected213) flows of income, expenditures, savings and net borrowing/lending214. These dynamic implications are precisely the topic of sections 3.3.3 and 3.3.4 below.

3.3.3 - The Steady-State of the Model As usual in this kind of analysis, Godley-type dynamic stories start with the consideration of a steady-state (.) [and] then consider the implications of well defined shocks to exogenous variables and see how the system reacts. Although the exposition is concerned with steady-states and shocks it will be apparent that the analysis can be readily adapted to deduce how the system should behave in more complex, realistic contexts, where the exogenous variables behave in a thoroughly disorderly way (G&C, p.48). In the present section we will discuss the steady-state of the model. The next section considers the implications of well defined shocks to exogenous variables.


In this particular sense, Godleys point is exactly the same made by Christ (1967 and 1968), Again the accounting plays a crucial role, making these interconnections explicit to the The main dynamic mechanism underlying Marxist models is, of course, the capitalist need to

Blinder and Solow (1973) and Tobin and Buiter (1976, 1980)


accumulate (and, therefore, reinvest). As a consequence, Marxist models tend to emphasize supply-side stock-flow relations (like, for example, those between the stocks of capital and the reserve army of labor and the flows of income, investment and profitability). It seems possible to make a case for the complementarity between Godley-type models (or, for that matter, demandside SFC models in general) and Marxist supply-side dynamic models, though this is beyond the scope of the present paper.


Here we will follow G&C (p.110) and define the steady state of the model as a situation in which all the stock variables of the model are constant and (p.160) () the non-bank business sector () regard(s) the composition of () [its] portfolio of assets as appropriate or sensible given banks interest rates and bond yields215. Putting it another way, the steady-state of the model is a situation in which PD = IN = Sg = GD = FA =FE = C = R = Md = Hb = Hp = B = 0. To find it, one has first to notice that from (AI.6a) we have that: (AI.6a) GD G YG - Sg and, replacing equations (20) and (21) in the expression above: GD = GoY But in the steady-state, by definition, we have also that GD = 0 and, therefore Go Y = 0 and, as a result, Y= Go/T(equation 24). Of course, given the value of Y one can easily calculate the other endogenous variables following the procedures of the previous section. There are several important issues raised by this result. First, although it depends entirely on the particular (stationary) notion of the steady-state adopted here, it can be easily extended to (flow) steady-growth notions as well216. Second, it is important to

As a matter of fact, G&C include the requirement that also banks must consider their

portfolios of assets sensible. In our model, however, banks have no way to choose their portfolios and have to be satisfied with whatever they get (see section 3.2.5 above).

Indeed, in a (flow) steady-growth state both Y and G grow at the same rate (say, g) and,

therefore, -Sg =GY (government current deficit) also grows at this rate, so that -Sg/Y is constant (equal, say, to k). Its, then, clear that in a (flow) steady-growth we have Yt = Gt/(k+).


notice that, despite acknowledging that in reality exogenous variables behave in a thoroughly disorderly way (and, implicitly, the heroic assumptions made in their simplified theoretical model) G&C appear to think that the steady-state above (or, in more realistic models, its steady-growth counterpart) is a true centre of gravity for real world economies. Indeed, they state this view quite explicitly in the following passage: The (steady-state equilibrium income) is not just a hypothetical equilibrium state in the sense of being some timeless intersection of two curves. It is a prediction of the flow of national income, which will actually become established in historical time if the government adopts a particular fiscal stance and does not thereafter change it. This level of income will be maintained continuously by flows between the government and the private sector (..) (p. 111) Third, the following discussion establishes a certain hierarchy in the exogenous variables. It is pretty clear that an once and for all change in the fiscal stance (Go/) will change the long run centre of gravity of the economy, while a change in the other exogenous variables of the model wont and, therefore, will have just temporary effects. One interesting result that stresses the importance of the fiscal stance in the long run dynamics of the economy can be derived from equation (23) when FEt-2 = FEt-1 = FEt = Y, Go = Y and FA-1 = FA. In this case, we have:

Appendix 2 discusses the necessary and sufficient conditions for the stability of this (flow) steady-growth equilibrium. Its important to notice that, beginning from an arbitrary disequilibrium point, flow steady-growth only implies a stock-flow steady growth assintotically (because the rates of growth of stocks depend also on their initial values) and, therefore, the two notions are not the same. Recent applied work by Godley (see, for example, Godley, 1999c) emphasizes yet a third related issue. i.e., the study of growth paths that do not imply explosive growth of crucial stock-flow ratios.


Y = a1FA+ a2 Y + a3Y + a4Y or, after some algebraic exercises, Y = a1FA*[1 - a2 - a3 - a4]-1 = FA / (1 - ) (equation 25) However, from (AI.12) we also have that: FA GD R + PD and, therefore, equation 25 above can be rewritten as follows: Y = (GD - R + PD) / (1 - ) = steady-state income = Go/ (equation 26) According to G&C(p.114), this equality may seem a little surprising at this stage since it has the powerful implication that fiscal stance (Go/) will somehow ultimately generate the same aggregate income flow irrespective of the amount of private debt creation (PD) and also independent of the money income norm (). So it must be implying that more or less private debt, so long as the fiscal stance is given, must give rise to a change of equal and opposite size in the total government debt. We shall shortly be showing exactly the mechanics of this displacement (our version of crowding out) The dynamics of the system (or, the mechanics of this displacement) is precisely the topic of the next section of these notes.

3.3.4 The story between periods: A formal treatment Here it is assumed that the economy is initially in a (stationary) steady state and, all of a sudden (in the first period of the analysis, it is hit by shocks in the exogenous variables. As it will become clear in what follows, the story below can be readily adapted to more complex settings217. Note that as the monetary side of the model is entirely


See, for example, the story in appendix2 below.


determined by the real side (see section 3.3.2 above), we will limit ourselves here to the analysis of the dynamics of the latter.

A - The first period Given that the underlying economic stories will depend on which exogenous variable is shocked, it seems appropriate to start with the algebra (that doesnt change as much). We then illustrate the general algebraic exercise with the story of what happens when the government increases its expenditures (Go). We begin by noticing that from equation (23) above we can write: dY #Y/*d + Y/m*dm + Y/G0*dG0 + Y/ *d + Y/*d + Y/FE-1*dFE-1 + Y/FE-2* dFE-2 + Y/FA-1*dFA-1 (expression 1218) And, therefore, the instantaneous impact on steady-state income of a change in any exogenous variable X (i.e., , m, G0, and ) can be approximated by: dY1 Y/X*dX1 (expression 2) Of course, income is not the only endogenous variable that instantaneously responds to a change in the exogenous variables. In particular, both the consumption of the private sector and private wealth (i.e., the stock of financial assets of households) are immediately affected as well. As we saw before: FE C + G (from AI.1) C = [(1- )Y + FAt-1] / (1+ )] (from equations 9 and 22) C = FA/ (eq. 10) and therefore,


dC1 C/Y*dY1 + C/X*dX1 + C/FA-1*dFA-1 (expression 3) or, given that dFA-1 = 0, dC1 C/Y*dY1 + C/X*dX1 (expression 4) dFE1 = FE/C*dC1 + FE/G*dG1 = dC1 + dG1 (equation 27) dFA1 = dC1 (equation 28). These results are important because, in the absence of further shocks, they will be responsible for the whole change in total income in the next period. The algebra above based mostly on ex-post considerations and algebraic tricks doesnt reflect clearly what supposedly happens in practice within the period. Consider, for example, the case in which government expenditures are increased. The first and obvious thing to notice in this case is that more things will be sold (throughout the period) and, therefore, more income (i.e., profits, since wages and interest payments are pre-determined in the beginning of the period) will be generated. As capitalists are also households in this model (and, therefore, also have stock-flow norms to follow), part of these extra profits will also be spent (again within the period), in such a way that C will increase as well. The total impact on income and consumption can be approximated by expressions (2) and (4) above (substituting X for Go). Its not difficult to notice also that the final impact in governments current account deficit (-Sg) can be approximated by: d(- Sg)= dGo - dY1 dGo - Y/G0*dG0 = dGo(1 a2)219 (expression 5)


If Yt depends on X linearly then the expression holds as equality. If not, the quality of this We know from equation (23) that Y/G0 = a2

(linear) approximation will be negatively related with the size of the shock in X.


And, as usual, the size of the impact will depend on the parameters of the model but its sign will be positive in all relevant cases. As noted before, up until now the story is pretty much like the conventional Keynesian with an horizontal LM. Notice, however, that while the latter ends at this point, even a simplified Godley-type story is much longer. A first difference is that, by hypothesis, firms expectations were falsified and, therefore, their stock of inventories in the end of the period is below normal. But this also means that they will be able to repay more of their debts to banks (since, from AI.10, LPDIN) within the period, what by its turn (together with governments current deficit) will affect the net stock of financial assets of the private sector (since, from AI.12, FA PD-Sg). Indeed, a second difference of Godley-type models is that all these changes in the (interconnected) debts and assets of the various sectors are explicitly quantified and their dynamic consequences analyzed (admittedly with crude hypotheses, but still). Clearly, for example: IN -dFE1/(1+m)220= [FE/C*dC1+FE/G*dG1]/(1+m) =[dC1+dG1]/(1+m) (eq.29) And, even though equation 28 above makes clear that the total impact on wealth (FA) will be positive221, we could have derived this result without its help, just by inspection of (AI.9), (AI.11), (expression5) and (equation 29).


Note that while final expenditures are measured in market prices, inventories are valued at cost. Equation (28) was derived from equation (10) which, by its turn, depends on the simplifying

Hence the need to divide dFE by (1+m)


hypothesis that = 1/(1+ ) adopted in section 3.2.4 above.


B - The second period Again beginning with generic algebra, we note that in the absence of further shocks in the exogenous variables (i.e, under the assumption that d2 = dm2 = dG02 = d2 = d2 = 0) expression (1) above reduces to: dY2 = Y/FEt-1*dFEt-1+ Y/FEt-2*dFEt-2 + Y/FA-1*dFA1 (equation 30) 222. Now note that dFEt-1 and dFAt-1 are both larger than zero (since in the previous period there were changes in the final expenditure and in the financial assets of the economy), but dFEt-2 is still zero (since in the period before the previous one the economy was still in the steady state). We have, then, the following expression for dY2: dY2 = Y/FEt-1*dFE1 + Y/FAt-1*dFA1 (equation 31) and it is also true that dC2 = C/Y*dY2 + C/FA-1*dFA1 (equation 32) dFE2 = FE/C*dC2 + FE/G*dG2 or, given that dG2 = 0, dFE2 = dC2 (equation 33) dFA2 = dC2 = dFE2 (equation 34). The story underlying the algebra above is apparently simple. Indeed, its easy to notice that the main mechanisms in effect are: (i) the increase in consumption due to the partial adjustment process assumed for households (which on one hand are now richer and on the other have a new wealth target223) and (ii) the increase in production and,
222 223

Note that now we have an equation because Yt is a linear function of FEt-1, FEt-2 and FAt-1. Since their disposable income has now changed. Note that the story here wouldnt change

much if we were to add to this income/wealth adjustment process an additional component due to


therefore, income and wealth due to the extreme adjustment process assumed for firms. The precise outcomes of these mechanisms are not generally clear, though, being heavily dependent both on the parameters and on the precise adjustment processes assumed. In the monotonic case generally assumed by Godley-type authors224, we would have a further increase in income, in inventories and in the financial assets of households, despite the reduction in government debt (due to the increase in net tax revenues).

C - The third period and after In the monotonic case the story here is the same as above, while in the nonmonotonic case things get too dependent on the specific values of the parameters. The algebra is straightforward, though. In the absence of shocks in the exogenous variables, the increase in income in the third period is: dY3 = Y/FE-1 *dFE2+ Y/FE-2*dFE1 + Y/FA-1*dFA2 (equation 35). The difference with respect to the second period is that now dFE-20 (since in both the first and the second periods there were changes in the total expenditures in final goods). Also, as before, dC3 = C/Y*dY3 + C/FA-1*dFA2 (equation 36) dFE3 = dC3 (equation 37) dFA3 = dC3 = dFE3 (equation 38).

households expectational errors (that in this case would look like the generalized partial mechanisms discussed in section 2.2.6 above). Thats a possible rationale for the little importance given to single period equilibrium concepts in earlier Cambridge models.

As discussed in section 2.3.7 above.


It should also be clear that the process will continue until infinite and that after the third period, the dynamics of the model can be summarized by the following system of difference equations: dYt = Y/FEt-1*dFEt-1 + Y/FEt-2*dFEt-2 + Y/FAt-1*dFAt-1 (equation 39). dFEt = C/Y*dYt + C/FAt-1*dFAt-1 (equation 40) dFAt = dFEt (equation 41). As mentioned before, Godley-type authors generally assume that the dynamic process described by their models will be monotonically stable in all empirically relevant cases. Whether or not this is true in the particular model presented here is not very clear, as discussed in more detail in the appendix.

D A General Point A strong conclusion of stable versions of the model above (and, indeed, of any model with a stable stationary stock-flow steady state225) is that deficits or surpluses are necessarily temporary. No matter how big is the government deficit/private surplus (or vice versa226), one knows for sure that the economy is converging to a steady-state in which all stocks (including stocks of debt) are constant by definition and, therefore, no deficits or surpluses can exist. Although this conclusion depends entirely on the particular (stationary) version of the steady-state used in Godley-type models, its interesting to notice that it does have a

225 226

Like, for example, the one presented in Blinder and Solow (1973). As seen in AI.5, the private surplus is always identical to the government deficit. Note that the

private sector has necessarily to go into deficit in this model if the steady-state disposable income falls (to enable its adjustment to a lower equilibrium stock of wealth).


more general (flow) steady-growth counterpart - widely used in Godley-type empirical analyses227. Indeed, given that a stable (flow) steady-growth path implies that private deficit/ public surplus (or vice-versa) are both constant relative to total income228, no situation that involves a continuous increase of these variables (relative to income) is sustainable229. In particular, no matter how rapid is the change in the private deficit relative to GDP, one knows for sure that it wont last. Note also that no sustainable growth is possible with zero government deficits (for that would prevent the increase in the desired private wealth caused by the increase in private disposable income)230.

3.4 - A Brief Note on the General Structure and Possible Extensions of Godley-Type Models The discussion above allows us to arrive to some general conclusions about simple Godley-type models. We begin by reminding the reader of some very simple but often forgotten points about these models and then proceed to discuss some important details in their formal structure. All the conclusions below lead to some natural (and possible) extension of the model presented above, making clear that a lot remains to be done in this line of research.


See, for example, Godley, 1999c. Appendix 2 provides a formal treatment of these issues. Things get slightly more complicated in models of open economies, but the general message The same point is made, for example, by Tobin and Buiter (1980, p.106), according to whom,


remains essentially the same.


the balance of government budget is not a requirement of long run equilibrium (). A constant real steady-state deficit per unit of output provides for the required growth in the in the nominal stocks of money and government bonds.


The simple points we want to mention are two. First, simple Godley-type models are pure demand models, in the sense that they assume away all kinds of constraints coming from supply factors231. To put it briefly, if government expenditure is quadrupled and the parameters are such that the model is monotonically stable, total income will converge pretty quickly to its new (four times bigger) steady-state value232. Second, Godley-type models are period models in the sense of Foley (1975, p.310), i.e., they assume that all transactions of a certain class occur in the same, synchronized rhythm233. In the real world, firms dont make production decisions all at the same time, and to assume this is clearly (and admittedly234) a heroic hypothesis. Turning now our attention to the details on the structure of the model, the points we want to make here are five. First, it should be clear by now that the precise dynamic behavior of the model is entirely dependent on the particular specification of the adjustment mechanisms assumed for households stock of wealth/ flow of disposable income and firms stock of inventories/flow of sales. As exemplified in the appendixes, instability often arises in certain specifications235 and, therefore, applied versions of the

This doesnt mean, of course, that Godley-type authors neglect these constraints (see, for

example, G&C, p.255), but that they are skeptical about the usefulness of theory, logic or accounting to yield useful results about the productive potential of the economy and () believe that a great deal of specific empirical knowledge is necessary to explain supply side characteristics of different sectors () and types of enterprise () in particular regions or countries at various stages of history. (G&C, p.252). On the other hand, its also true that fixed price models without capacity constraints (...) at best (...) can be viewed as providing a theory of the aggregate demand side of the economic system" (Buiter, 1978, p.100).
232 233 234 235

Due to the so-called mean-lag theorem, discussed in section 2.3.7 above. Foleys critique of period models was presented in section 1.2.3 above. See footnote 182. See the discussion of section 2.3.7


model necessarily involve some data mining as far as econometrically estimated dynamic adjustment processes are concerned. Second, one must emphasize the careful choice of accounting definitions implicit in these models. In other words, Godley-type models are in general highly sensitive to changes in their accounting definitions/hypotheses. Consider, for example, the hypothesis about taxation. As seen in section 3.2.6 above, Godley-type models generally assume that the government fixes its net share in total income () and this is precisely the reason why one doesnt need to worry, for example, with the impact of banks imbalances on banks profitability (through increases in their interest payments on rediscount loans) and, therefore (given our hypotheses), on private income. Indeed, a fixed necessarily implies that, coeteris paribus, any increase in the governments interest receipts will be completely offset by either (i) decrease(s) in some other(s) governments receipts or (ii) increase(s) in some other governments expenditures or (iii) some linear combination of the last two. The same wouldnt be true if only taxes were modeled as fixed proportions of income, as usually happens in traditional Keynesian macroeconomic modeling. The third point to be made here is, in fact, a special case of the second and has to do with the implications of the hypothesis of zero net worth of firms and banks. Indeed, it should be clear by now that a change in this assumption would change completely the structure of the model because, among other things, it would imply (i) that households wealth is different than private wealth and, therefore, FA would loose much of its intuitive appeal; and (ii) that one has a lot more to explain (notably the determinants of


banks and firms reinvestment patterns and financial portfolios and their implications236) than in the simplified versions of the model. Fourth, and for the sake of comparison with conventional IS/LM models, its important to emphasize the crucial assymmetry between the power of monetary and fiscal policies in simple Godley-type models. As mentioned before, only the latter has a permanent impact in (i.e., changes the steady-state of) national income. As a consequence, issues like the effects of the financing of the government deficits are of secondary importance in this kind of model237. The contrary is true, however, in the case of the deficits (or, in the steady-growth case, the changes in the deficit to income ratios) themselves, that are seen as necessary (though temporary) consequences of the dynamic stock-flow adjustment processes towards the (ever changing) steady-state of the economy238. A fifth and perhaps more obvious point is that open economy extensions of the model would change its structure in many ways, beginning by the accounting and extending to many qualitative conclusions239.


A point that is apparently very important for the current dynamics of most industrialized

capitalist economies but that, as far as we know, has received little attention by (SFCA, at least) theorists.

In this particular sense, Godley-type models contrast with their neoclassical-Keynesian

counterparts [like Blinder and Solow (1973) or Tobin and Buiter (1976), for example] and the current NewKeynesian mainstream.

In this particular sense, Godley-type models contrast to conventional Post-Keynesian and

Circuitist ones that are either mute or vague as far as the dynamic consequences of deficits and debts are concerned.

Like the exact nature of the steady-state and the determinants of its stability. See, for example,

G&C (1983, ch.16), Godley (1999b), Godley(1999c) and Taylor (2002).


It seems fair to say that most of the current SFCA research aims to develop one or some of the issues/problems discussed above.

3.5 Final Remarks When presented in the context of general stock-flow (dis)equilbrium models, as in the second essay of this dissertation, Godley-type models seem pretty simple. Indeed, their richness comes precisely from their treatment of factors that are not emphasized (and often are only implicit) in Yale-type general disequilibrium frameworks, i.e, the dynamic consequences of indebtedness and the links between (i) production and credit, (ii) credit and government deficits on wealth240. Seen from this (dynamic Post-Keynesian/Marxist/Circuitist) perspective and considering their possible extensions, Godley-type models are much more appealing than otherwise, although some of Godleys methodological options like his periodization and his relative negligence of supply constraints remain highly controversial.


Though its fair to say that Yale-type authors have treated some of these issues in other

contexts (see, for example, Buiter and Tobin, 1976 and 1980).


Appendix 1: The Necessary and Sufficient Conditions for the Stability of the Model with a Stationary Stock-Flow Steady-State All we need to do now is to derive the conditions for stability of the system formed by equations (39-41) above. In order to do that, well have to use the results below. First, lets make: = [(1+m)*(1+) m*(1-)]-1 (eq.A1.1) We can now prove (from, equation 23 above) that: Y/FEt-1= *(2+)*(1+ ) (eq.A1.2) Y/FEt-2 = - *(1+ )*(1+ ) (eq.A1.3) Y/FAt-1= *m (eq.A1.4) and, from equations (9) and (22): C/Y = (1- )/(1+ ) (eq.A1.5) C/FAt-1= 1/(1+ ) (eq.A1.6) and, therefore, equation the system formed by equations (39)-(41) can be written as follows: dYt = *(2+ )*(1+ ) dFEt-1 - *(1+ )*(1+ ) dFEt-2 + *m dFAt-1 (equation A1.7). dFEt =(1- )/(1+ ) dYt + dFAt-1/(1+ ) (equation A1.8) dFAt = dFEt (equation A1.9). Or, replacing (A1.7) and (A1.9) in (A1.8) and rearranging: dFEt [(1- ) *(2+ ) + (1- )* *m/(1+)+ /(1+)]dFEt-1 + (1- )*(1+ ) dFEt-2=0 (eq.A1.10) which is clearly a linear difference equation of the second order.


Note now that if the equation above is stable, then the long run equilibrium for dFEt will be zero. Indeed, its easy to show (after a little algebra) that, if dFEt = dFEt-1 = dFEt-2 = dFE, well have that: [ (m+ ) +T(2m+1) m]*dFE = 0 and, therefore, either dFE or [(m+ ) + (2m+1) m] will have to be zero. As this second expression will be bigger than zero for all relevant values of , m and , we have that dFE has to be zero. This conclusion implies that if (A1.10) above is stable then the system will eventually arrive to a steady-state after being perturbed by shocks in the exogenous variables. To understand that, note first that if (A1.10) is stable dFE eventually equals zero and, therefore, FE will eventually remain constant. But if this is true then IN be equal to zero (see eq.4 above) and, as YFE+IN, Y will be equal to FE and the steady-state will be reached. According to Gandolfo (1997, p.59-60), the necessary and sufficient conditions for the stability of a second order linear difference of equation of the kind of (A1.10), i.e, of the general form Xt +a1Xt-1+ a2Xt-2 =0, are the following: a) 1 + a1 + a2 > 0 b) 1 a2 > 0 c) 1 a1 + a2 > 0 And, from simple substitution, we arrive to the conclusion that the necessary and sufficient conditions for (A1.10) (and, therefore, the version of the model presented here) to be stable are the following: a1) [ (m+ ) + (2m+1) m] > 0 b1) (1+m)( + )s> (1- )


c1) [1+ (1- )* *(3+2 ) + (1- )*m* /(1+ ) + /(1+ )] >0 Note that while conditions (a1) and (c1) above will be satisfied in all relevant cases, the same may not occur with condition (b1). Indeed, the condition wont be satisfied whenever (1-) is bigger than (1+m)(+ ) and this doesnt seem an impossible scenario at all. Note also that (A1.10) also allows us to conclude that the dynamic path of the system will be oscillatory whenever [(1- ) *(2+ ) + (1- )* *m/(1+ )+ /(1+ )]2 < 4(1- ) *(1+ )241 (equation A1.11) Note, finally, that although the dynamic analysis sketched above is far from robust242, the general message of the model (i.e, the potential instability of simple Godley-type models for a not terribly implausible range of the parameters) appears to be.

241 242

The condition for oscillations is that (a1)2 < 4a2. Since, as discussed in section 3.4 above, it is valid only for the particular specification of the

stock-flow adjustments assumed for firms and households (in sections 3.2.3 and 3.2.4 above).


Appendix 2: The story with a steady-growth: A formal treatment As in section 3.3.4 above, well assume here that the economy is initially in a (stationary) steady state and, all of a sudden (in the first period of the analysis), government expenditures begin to grow at a rate g, so that: Gt = Go(1+g)t (eq.A2.1) The story here is, therefore, similar to the one above, with the exception that now we are talking of an uninterrupted series of shocks in G (i.e., dG1 = gGo, dG2= g(1+g)Go, dG3 = g(1+g)2Go, and etc), as opposed to a once and for all shock in G in the first period (i.e., dG1 = gGo, dG2= 0, dG3 = 0, and etc), The relevant equations are again the following: Yt = a1*FA t-1+ a2*Gt + a3*FEt-1 + a4*FEt-2 (eq.23) FEt Ct+ Gt (from AI.1) Ct = [(1- )Yt + FA t-1] / (1+ )] (from equations 9 and 22) Ct = FAt/ (eq. 10) Or, rearranging: Yt = a1*C t-1+ a2*Gt+ a3(C t-1+ Gt-1) + a4(C t-2+ Gt-2) (eq.A2.2) Ct = a5*Yt + a6* C t-1 (eq.A2.3) where, a5 = (1- )/ (1+ ), a6 = /(1+ ), and, as seen in section 3.3.1 above: a1 =m*[(1+m)(1+ ) m(1- )]-1, a2 =(1+ ) m*[(1+m)(1+ ) m(1- )]-1,


a3 = (1+ )(2+)*[(1+m)(1+ ) m(1- )]-1 and a4 = - (1+ )(1+)*[(1+m)(1+ ) m(1- )]-1 Now note that, replacing (A2.1) and (A2.2) in (A2.3), one gets: C t = b1* C t-1 + b2*C t-2 + B(1+g)t-2 (A2.4), where b1= a5 (a1+ a3) + a6 , b2= a5a4 and B= a5Go[a2(1+g)2 + a3(1+g) + a4] and, therefore, we know that the steady-growth equilibrium for Ct is given by: C t = Co(1+g) t-2 (A2.5), where, Co = B(1+g)2 / [(1+g) 2 b1(1+g) b2]. The result above sheds some light to a couple of interesting theoretical questions and, therefore, deserve some (brief) comments. First, its important to mention that the equilibrium above is stable if and only if243: a) 1 - b1 - b2 > 0 b) 1 + b2 > 0 c) 1 + b1 - b2 > 0 And its easy to prove that the stability condition in this steady-growth case is exactly the same as the one derived for the stationary growth case in appendix one above. Second, its interesting to notice that, in the stable case, the steady-growth of G implies a full (stock-flow) steady-growth state of the economy. Indeed, if Gt = Go(1+g)t and Ct= Co(1+g) t-2, its easy to prove (from equation A2.2 above) that:


As discussed in appendix 1 above. The condition for oscillations, again, is that b12 < 4b2.


Yt = Yo(1+g) t-4 where Yo = [(a1 +a3)(1+g)+ a4]Co + [a5a2(1+g)4 + a3(1+g)3 + a4(1+g)2] Go Similar results apply, coeteris paribus, to all other flows of the economy as well244. To see that the same results apply for the stock side of the model, one needs to notice that from eq.10 above, we know that FA grows at the same rate as C (and, therefore, as the other flows as well)245. Note that, as mentioned before246, steady-growth of the flows dont necessarily implies steady-growth of the stocks. Indeed, the stock-flow steadygrowth obtained here depends on the simplifying assumption about (the speed of adjustment parameter) adopted in section 3.2.4 above. Indeed, if 1/(1+ ), (eq.10) is not valid and, from (eq.7), we have that: FAt = (1- )Yt + (1 ) FAt-1 (A2.6) And, from the equation above, its easy to see that even if Yt is growing at a steady rate, it will take some time before the stock of financial assets converges to this growth rate. Third, the steady-growth generalization of the Godley-corollary about government deficits (surpluses) and private surpluses (deficits) is clarified by the result above. Indeed, as the steady-growth rate of the government deficit is exactly equal to the steady-growth rate of total income, this rules out the possibility of a sustainable rise in the private deficit/public surplus (and vice-versa) relative to private disposable income (or, for that matter, total income).

244 245

As one can easily prove following the procedures discussed in section 3.3.1 above. The extension of this result for the other stocks is obtained with the use of (AI.12), (AI.9), See footnote 216 above.

(AI.6) and (eq.17).



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