Toward the Integration of Economic Science:
The Keynesian Model

Completing the Keynesian and monetarist revolutions
by integration of concepts and national accounts
in a dynamic money-flow perspective
John Atlee, 4/10/90

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  1. The problem with the Keynesian model
  2. The financial gap in the NI perspective
    1. The Keynesian/NI equations
  3. The credit-money conceptual confusion
  4. Exogeneity and the multiplier
  5. Investment/saving relationships
    1. The assumed saving/investment dichotomy
    2. The Keynesian focus on business investment
    3. Gross vs net investment
    4. Household Investment
    5. Government investment
  6. Policy confusions
  7. Political liabilities

The problem with the Keynesian model
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Because the Keynesian model is still the one most generally used for macroeconomic analysis and policy, its basic concepts will be summarized here to illustrate some of the most important traditional conceptual confusions and why there is need for a basically different paradigm for both analysis and policy.

The most fundamental of these confusions are:

But there are subsidiary confusions regarding exogeneity, the multiplier, investment/saving relationships, liquidity preference, the IS/LM apparatus (discussed in Appendix B), and resulting policy prescriptions.

The financial gap in the NI perspective
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The Keynesian model uses the traditional NI concept of a circular flow of spending and income, in which each person's spending is the recipient's income. But the NI accounts measure only the money value of "real" (physical) production and the income claims on that production. As a result, they:

Thus, there is financial gap in the money-flow between saving and investment. Keynesian economics reflects this financial gap in its theoretical analysis. equations, empirical applications and policy prescriptions.

The Keynesian/NI equations

The financial gap is most explicit in the (static, ex post) macroeconomic equations:

Y (GNP) = Investment + Consumption + Govt + net eXports (1)
Saving = Investment (2)

The financial gap forces Keynesian income-determination theory to focus on investment spending rather than on the way the spending is financed, and also causes it to ignore important intrasector financial flows, particularly in the household (consumer) sector.

The credit-money conceptual confusion
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Both the Keynesian and monetarist models accept the traditional credit concept of money, in which all money is treated as a credit liability of government or the banking system. This concept prevents any precise distinction between money and credit. In the credit-money perspective, there is merely a continuum of decreasing 'liquidity" from currency and checkable deposits through "near money" credit assets such as savings deposits, money market accounts and repurchase agreements (repos), to CDs and bills, to notes, mortgages and bonds. (This liquidity definition of money is implicit in the use of the term "money market" for the short-term credit market.)

As will be explained in the section covering the Integrated Dynamic Money-Flow model (IDMF), the traditional credit-money concept makes impossible a dynamic money-flow analysis of the process of money creation and its economic effects. As a result, Keynesian theory can make no direct conceptual or national accounts-based empirical connection between money growth and economic growth. It is forced to use interest rates and the complex and abstract liquidity preference schedule and IS/LM apparatus for the analytical linkage. (See Appendix B)

This inability to deal with money creation also makes necessary the confusing (and essentially static) ex ante/ex post dichotomy for explaining the dynamics of economic growth: an increase in "planned" (ex ante) investment generates the additional saving which finances it (ex post) by increasing GNP and incomes.

Exogeneity and the multiplier
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How is exogenous spending initially financed? Keynesian theory implicitly assumes that most of the needed money is released from surplus (idle?) money balances by a change in the public's liquidity preference.

This assumption was not too unrealistic during the 1930s. Short-term interest rates were close to zero and there was little incentive to "economize on cash." The Money Demand Ratio ( MDR = M1/GNP ) then averaged about 35%, more than double its present 15%. The "printing press" financing of World War II and wartime controls held short-term interest rates close to zero, and by 1946 the MDR was over 50%. Since then, as real interest rates have increased even on overnight deposits, the incentive to 'keep loaned up" and "economize on cash" has become imperative, with resulting computerization of "cash management."

In Keynesian theory even newly created money must go through speculators' portfolios and become "surplus" before it will be used to "buy bonds" and thus contribute to economic growth. But under the present conditions it is likely that truly exogenous spending -- and overall economic growth -- must be financed almost entirely by new money supplied directly by the banking system, rather than by a further drawing down of existing speculative demand deposit balances.

For this reason, structural (full-employment) federal deficits incurred to "stimulate" the economy can actually do this only to the extent that they bring forth, (or otherwise coincide with) actual money growth. Otherwise they merely tend to "crowd out" other borrowing and increase interest rates. [ 1 ] (The general confusion in this regard is evident in references to Reagan's deficits as "Keynesian.")

In the Keynesian explanation of the multiplier effect, exogenous investment (or government deficit spending) injects additional spending into the circular flow of income and spending. Then, in successive spending/income transactions, each recipient (on average) spends the propensity to consume portion of the additional income and saves the rest. This process continues until the initial investment spending has increased the total flow of income and spending (GNP) by (theoretically) the reciprocal of the saving rate. The economy has then reached a new ex post equilibrium GNP where aggregate saving is again equal to aggregate investment, at the higher level.

But to the extent that new money is the effective primary source of exogenous spending the amount of the multiplier is determined (as explained pp. 8-9) by the reciprocal of the MDR, as the new money progressively leaks out of the circular flow into the ever larger money balances needed to service the growing GNP.

Investment/saving relationships
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The assumed saving/investment dichotomy

It is a key postulate of Keynesian theory that saving and investment are done largely by different groups of people for different reasons. But in the.real world much, and often most, investment spending is actually done by those who do the related NI saving. Moreover, because of the financial gap in the NI perspective, saving is essentially a static ar post accounting residual, and the dynamic flow of financial saving into credit-financed investment cannot be traced empirically.

The Keynesian focus on business investment

Undoubtedly this focus is mainly because most of the industrial economies for which the theory was developed are private enterprise economies, and a postulate of Keynesian theory (usually only implicit) that business investment is the key exogenous variable. This is mainly because anticipated business profit is considered the key motivating factor in the system. Thus, in the abbreviated Keynesian equation ( Y = I + C ) the investment term refers implicitly only to business investment.

In Keynesian theory the amount of business investment is determined by the intersection of the Marginal Efficiency of Capital (MEC) schedule and the interest rate. When businessmen feel more optimistic about profit prospects (due to technological developments, increased demand, tax breaks or "animal spirits" confidence) in relation to the cost of capital (interest rates) they increase their investment spending.

There are several problems with this theory.

Gross vs net investment

In Keynesian theory and the NI accounts investment spending refers to gross investment. But business plant and equipment investment (other than housing and utilities) tends to be financed mainly from internal cash flow (depreciation allowances and retained profits), rather than by other people's saving. Thus, it is not greatly affected by interest rates -- except indirectly, when consumer demand is reduced by tight money and rising interest rates.

It is net investment (gross investment minus depreciation allowances) that tends to be externally financed. But short-run ("cyclical") fluctuations of business net investment are mainly in inventory, which tends to be a functionally dependent variable which is not greatly motivated by Keynesian marginal profitability calculations and probably has low interest rate elasticity.

Household Investment

Another problem with the Keynesian framework is that one of the largest components of externally financed net investment, and one of the types of investment most affected by interest rates, is owner-occupied housing. But except in periods of rapid inflation of housing prices this type of investment tends to be motivated more by income/affordability than by business-type profitability calculations. (Partly for accounting convenience, but undoubtedly influenced by the Keynesian analytical model, the NI accounts put all housing together, implicitly in the business sector.)

Moreover, in both the NI accounts and Keynesian theory, household investment in cars, furniture, appliances, etc. is treated as consumption, with the consumer borrowing which finances it being netted it is against positive financial saving in the NI concept of personal saving. Thus, this investment and the way it is financed -- which is often quite important to the actual behavior of the economy -- is implicitly treated as unimportant. (This may have been one reason why Keynes emphasized the term propensity to consume, to correspond with the NI accounts, rather than propensity to save, which would be assumed to mean financial saving.)

The reality today is that for the vast majority of families the 'propensity to consume" is to a very significant extent determined by the "propensity" -- and the ability -- to borrow. And this depends as much on financial terms of credit (including government credit regulations) as on any consumer psychological "propensity." Thus, a more stable, and for many analytical purposes more useful, "consumption function" is consumption out of income -- i.e., total consumer spending minus consumer net borrowing. (For credit-financed investment, debt amortization payments tend to play a role similar to that of depreciation allowances for internally-financed investment.)

Government investment

This is another factor that doesn't fit well in Keynesian theory, for reasons that are closely related to the NI accounting perspective. Even in modern Keynesian equations that separate "government" from "investment," government is treated like the consumer sector, with no separation of consumption spending from economically productive and credit-worthy investment spending. This ignores the fact that some types of government investment in physical capital (dams, harbors, airports, roads, buildings, etc.), in human capital (education, training, health) and in research are fully as productive economically (i.e., have as high a real MEC as similar types of business investment). In fact, studies of the growth of economic productivity have found that the overall level of education, training and technology Household Investment. Another problem with apparently has more effect than physical capital.

Policy confusions
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The main specific policy implications of Keynesian theory is that when business investment is inadequate to achieve full employment, a compensatory fiscal policy, in the form of federal deficit spending, can pinch-hit and "stimulate" the economy with a similar multiplier effect. But there is no precise guide to the effective size of the multiplier, or the amount of federal deficit spending which is needed. As a result, the unspecific expression, "stimulate the economy," is now generally used, instead of a more precise quantitative prescription, for both monetary and fiscal policy.

This is itself a significant indication of the inadequacy of traditional Keynesian theory for a true economic science or precise policy guide.

Political liabilities
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Because Keynesian policy grew out of the Great Depression, when there was inadequate total spending, the fiscal policy emphasis has tended to be on the spending aspect (which raises a red flag to conservatives) rather than the associated deficit, which provides an outlet for financial saving when private borrowing is inadequate. (A typical example of this complex and is referring to Reagan's economic policies as "military Keynesianism.") Adding to the confusion is the fact that the NI definitions of saving and investment are not the ones most used by Wall Street, Main Street and Capitol Hill. And how many members of Congress can understand the IS/LM schedules? These are among the many reasons why there is now no professional or political agreement on the economically appropriate size of the federal deficit

To sum up, because of the financial gap in the NI perspective, the credit-money confusion, and its other conceptual confusions, Keynesian analysis is oversimplified in its spending/income aspects, overly abstruse in its money and credit confusion aspects, and increasingly obsolete and irrelevant politically and educationally.


  1. US. investment is "crowded out" by the high interest rates needed to attract the foreign saving which finances the Reagan/Bush deficits, and the deficit-related US. trade deficits create the foreign saving.
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Written: April 10, 1990
Posted: July 12, 1998 (with minor revisions)
Last revised:
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