“Introduction to Post-Keynesian Economics”, part 2: Demand, Employment, and Boxes

Chapter 3: A Macroeconomic Monetary Circuit

“The principle of effective demand … — that is, the causality that runs from investment to saving — is best understood within the context of a macroeconomic explanation of the monetary circuit.” Post-Keynesians reject monetarism and the quantity theory of money, instead following endogenous money theory. They believe that “the banking system fixes a rate (or a set of rates) for the money market and then lends however much borrowers ask for, provided that they can offer satisfactory collaterals”. In other words, banks will make a loan as long as the person taking on the loan is a credible borrower.

3.1 Main characteristics of post-Keynesian monetary analysis

A key feature of this approach is that loans create deposits, which reverses the causation of mainstream economics. How does this work, exactly? Say the bank finds a credible borrower. To make the loan, they simply create and deposit money in the borrower’s account. Put another way: bank reserves are not required to make loans. They are only kept to follow rules set by the central bank, or to allow folks to withdraw cash if they want.

3.2 The relationship between commercial banks and the central bank

High-powered money (HPM) consists of currency supplied by the central bank, as well as bank deposits (reserves) held by commercial banks at the central bank. Reserves are a liability to the central bank, and an asset to private banks, as private banks can withdraw from them at any time. Similarly, your deposits at at bank are a liability to the bank, but an asset for you. And just as loans by banks create deposits, the central bank can create reserves by buying up assets.

3.3 The relationship between banks and firms

Lines of credit are a contract between a bank and a borrower which specify the maximum amount that can be borrowed, the rate at which it is borrowed, and any conditions on the loan. When a firm has higher debt, the risk to the bank of default is higher, so they charge higher rates to compensate for this. This is illustrated by Kalecki’s principle of increasing risk, as mentioned in the last article and shown below.

3.4 A systematic view of the monetary economy

Here, we’ll systematize a mesoeconomic approach, which lies between the microeconomic analysis of individual agents, and the macroeconomic analysis of effective demand. This approach focuses on sectoral balance sheets and financial flows, displayed with matrices. It’s important to start with a model that’s stock-flow consistent, where every movement of money has a source and destination, and overall balance sheets always sum to zero. Such a model should include both real assets (like inventory and real estate) and financial assets (like loans).

Chapter 4: The Short Period: Effective Demand and the Labor Market

A core idea in post-Keynesianism is that economies are demand-led. In other words, increases in demand lead to increases in supply. One result of this, contrary to neoclassical economics, is that a decrease in real wages does not increase the demand for labor. In face, it’s the opposite: lower real wages mean lower consumption, so firms will hire less labor. This chapter expands on this idea by focusing on the short period, defined here as ignoring the effect of investment on the capital stock, and assuming the goods market is in equilibrium.

4.1 Effective demand and its components

In neoclassical models, aggregate demand is a basically a function of fiscal policy and the money supply. However, money supply is endogenous to post-Keynesians. Simplifying by assuming a closed economy with no government, what then determines aggregate demand?

4.2 The Kaleckian Model

Let’s rewrite that profit equation a bit. Let P = pa, where P are profits, p is price, and a is real autonomous expenditures (real consumption out of profits plus real investment). Furthermore, let wages equal the average annual wage rate w times the number of workers, N. In this simplified model without government, income is again just wages plus profits, which is equal to aggregate demand.

4.3 Further Developments of the Kaleckian model

Many labor economists think that the labor supply curve is “backward-bending”. At first, higher wages induce more people to join the workforce. But as wages get high, workers will be richer and decide to take more leisure time. Below, we can see this implies two equilibrium employment positions, denoted by H and L.

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