Money, Finance, and National Income Determination: An Integrated Approach

Traditional economic models have largely failed to account adequately for the roles of money and finance in economic operations. For example, traditional models assume an exogenously determined, fixed money stock and ignore the outcomes of spending changes that result from changes in bank loans. As such, traditional models take place outside of historical time and have no role for institutions in determining economic outcomes other than to promote optimizing behavior. In this working paper, Distinguished Scholar Wynne Godley presents a formalized stock-flow model consistent with the ideas of Keynes, Kaldor, and especially Hicks. Godley's model takes place in historical time and under conditions of uncertainty and incorporates a role for the financial sector in providing funding for both capital investment and firm operations, should expectations prove false. The model was subjected to numerical simulation and found solvable and stable. Godley used Table 11.1 of the National Income Blue Book as a starting point for his stock-flow matrix. The model is of a closed economy consisting of firm, household, banking, and government sectors. The setting the model in historical time and the prominent role of finance are apparent in the matrix's specification, most noticeably in the addition of the banking sector to the model. For example, investment, which originates in the firm sector, is funded by any combination of undistributed profits, securities issues, and the change in bank loans net of cash stocks. Profit is an endogenous variable, with gross profit defined as "the flow which can potentially be appropriated by the owners of firms and their creditors (subject to a liquidity constraint) while leaving the firm intact" and derived as sales less indirect taxes and the wage bill, plus any change in inventories. Net profit, then, is defined as the flow "potentially extractable by the entrepreneur" and is derived as gross profits less the cost of holding goods after they are produced and before they are sold (defined as the loan rate of interest times the value of inventories at the beginning of the period). Net profit may be either distributed or undistributed, with the latter, as mentioned above, a source of funds for fixed investment. Firms set prices with the expectation of making profits, with the distribution of national income determined by the difference between the value of realized sales and costs.