I’m just going to expand slightly here on comments on a wonderful blog post by Nick Rowe on reformulating the New Keynesian model.
Of course the NK model is the main model taught to post grad economics students, and I agree with Brad-De-Long that is a minimally tweaked Prescott RBC model designed to produce Keynesian like results, whilst not being Keynesian at all.
Of course the NK model is none monetary and so never produce Keynesian results like an excess demand for money and can only fake things like unemployment.
Nick Rowe in an earlier post was coruscating.
That Neo-Wicksellian/New Keynesian nonsense is what the best schools have been teaching their best students for the last decade or so. They have been teaching their students to just assume the economy eventually approaches full employment, even though there is absolutely nothing in the model to say it should…New Keynesians simply must put money back into the model.
There has been some traction recently with the critique of the representative agenct basis of RBC models. Rowes response is different, seeing the root of the problem being the lack of money in such model.
So he creates a Crusoe type economy with identical agents and one good and a single bank – a central bank.
Simplify massively, to clear the decks of anything that is not required for me to make my points. Large number of identical infinitely-lived self-employed agents who produce and consume haircuts (the only good). So wages and prices are the same thing, and output, consumption, and employment are the same thing. All agents set the same price (which may be sticky or flexible). The central banks sets a rate of interest (somehow, and this is a question that must and will be answered). To make it even simpler, we can assume the central bank indexes the nominal interest rate to the inflation rate, so it sets a real rate of interest. No shocks, nothing fundamental ever changes, and full employment equilibrium is 100 per period.
Now it gets interesting
Suppose we change the model so agents can’t cut their own hair, to motivate trade. Can we get unemployment now?
No. Two unemployed agents would simply do a barter deal to cut each other’s hair.
We need to change the model so that monetary exchange is essential — they can’t trade without using money as a medium of exchange. So let’s do that….
You can’t cut the hair of anyone who cuts your hair. So we get a Wicksellian triangle. And agents can only meet pairwise, and have bad memories for names and faces and can only remember the central bank. Or whatever. So they have to use central bank money to buy haircuts. Every agent has a chequing account at the central bank. The central bank pays a rate of interest r on positive balances, and charges the same rate of interest r on negative balances. And the sum of the positive balances equals the sum of the negative balances, so the central bank has no other assets or liabilities and zero net worth and zero income.
Now we can get unemployment if the central bank sets the real interest rate too high. Each individual wants to accumulate a positive balance in his chequing account by spending less money than he earns, which is impossible in aggregate….
Assume that the central bank sets a spread between the interest rate it charges on negative balances and the interest rate it pays on positive balances. Assume it is costly for agents to synchronise their payments and receipts of money (for example by agents with a positive balance lending to agents with a negative balance). We now have a demand for gross money as a negative function of the spread set by the central bank.
I like Wicksell’s triangle as it explains why there is a need for money in an exchange economy with three or more agents wheras a simple double coincidence of wants with two agents is insufficient. It goes beyond this however, with Arrow-Debrau securities and in the absence of a complex options/securities/contracts framework it explain how with the value of goods varying in time and space there is a need for the third party to offer credit. Hence we move from a Wicksell triangle to a Graziani triangle with the third party being a bank. Hence we dont need the residual loanable funds in Rowe’s Crusoe model, it is neither necessary or sufficient to explain the value of a monetary instrument. All that is needed are real goods that vary in time and space and variations in preferences amongst agents for those variations.
Whilst this might explain a tally stick type economy it does not explain why one token circulates as a medium of exchange, how it becomes a full monetary economy.
So my starting point would be to build a toy model with a private bank functioning to intermediate between any variation of preferences amongst agents. As long as it can gather equity by making a profit (charging interest) it can make money ‘out of thin air’ and lend. Loanable funds does not come into it.
But in such a tally stick economy the value of the tally stick is indeterminate, one can value one tally stick against another, a numeraire, but that is a shadow currency that is complex to value with inflation and multiple lenders. We need a second tier Grazini triangle between two banks and a ………. you guessed it
We know that RBC type models are indeterminate with regards to this numeraire, this was the origin of so called fiscal theories of the price level. At the heart of these are equations for the so called government budget constraint. This is misnamed, for sovereign currency issues there is no such things, being a limit at which currency issued would affect the value of the numeraire i.e. affect price stability.
If we have real growth of productivity of x% this price stability will shift deflationary unless their is a government deficit of x% per annum. This is basic accounting identities.
If we add balance sheets of both state and central bank we find a mechanism between the central bank and private banks to affect monetary circulation. Governmemnt spending forces money into circulation, and tax creates a liability monetarising value creation in the state numeraire. The direction of causation though is the opposite of that in the text book. The State spends money into existence and taxes less of it out of existence. This net balance ends in private balance sheets which enables investment in bank equities which enables lending. There is a secondary less important channel form excess reserves not invested (like the famous dutch diamond cutters vault) but this is secondary and just acts as a form of leverage from state money spent into existence adding to the base of bank issued money. (see this classic article from Humprhy which explains the Orthodoxy until Samuleson and Frideman got monetary theory backwards and reversed the multiplier). Luckily we now find this endogenous approach standard in some finance textbooks such as Burton and Brown and (almost) in Bank of England papers.
There is some controversy on whether the States equity in the central back is real or nominal. Im firmly on the real side, there are no phantom liablities in economics. Such a model is essential to understand the complex overlaps and linkages between fiscal and monetary policy which are finally garnering attention.
In a tweet Nick Rowe said he implied a consolidated banking sector in his ‘central bank’ but deconsolidating TBA. Im firmly with Steve Keen that you cant understand a monetary economy without at least a three party deconsolidation, agents, banks, central bank and state with intersecting balance sheets.
Consolidating agents is problematic though, this is not a capitalist economy it is everyone a gig economy. There is no real investment or savings as it assumes all profits unspent on consumption are immediately recycled to maintaining the capital base. There is no need to clamp an IS-LM model with all its many flaws on here if agents anticipate a cut in demand and cut back on consumption income and investment both plunge and we get unemployment and one of many potential unemployment equilibriums. All we need is a money demand function for agents.
Certainly we can make this model more sophisticated by modelling the changes to bank balance sheets, but with IS-LM being based on loanable funds it wont do. I argued that the LM part be replaced by a model for a demand for credit, then we can use Ole Peters concept of ‘rational leverage’ to model the demand for credit. And we can also model the lending power ‘charter value’ of banks – this LP-RL model fully replaces IS-LM with no loanable funds in sight and a real banking sector and real money not faked ‘financial frictions’.
This gives us a series of equations with linked balance sheets. State variables are necessary to model state of assets and liabilities – there will be imbalances. In other words the model needs to be fully stock flow consistent. Only possible with traditional NK models with identical agents with identical preferences – which assumes away the very need for money and market exchange. But it is not necessary to throw all NK equations away, you can still have Ramsey/Euler type intertemporal consumption equations, but based on empirical reality, such as when interest rates down up people save more as they have a target date for retirement etc.
With these changes you can still have a very simple ‘Crusoe’ type model for students but with the additional of real world capitalist institutions. The only fundamental change is not a universe of identical hairdressers standing on a pin, but one of many hairdressers providing minimally different products across time and space and with a minimally probabilistic variation in preferences. This is sufficient to generate demand for goods and a variety of prices and hence the need for money, banks and credit, with that embodies in the system – with that embodies you can still model in aggregate, around such minimal distinction as between hairdresser workers, Hairdresser firms and Hairdresser capitalists but without the absolute need for atomistic statistical computer modelling, one can still find use in toy student models which are deterministic within bounds (though not necessarily linear) and teachable in many circumstances.