Completing the Keynesian Revolution:
A Conceptual Framework For Macroeconomic Science
Brief Summary

  1. Keynesian Theory
  2. The Money-Flow Conceptual Framework

1.  Keynesian Theory

"Classical" economic theory (Adam Smith, etc.) assumed that a "free-market" economy is a "self-regulating" system that continually tends towards a full-employment equilibrium, with optimum economic benefits for everyone. Therefore, the best government economic policy is to "get out of the way" and give maximum freedom to individual enterprise.

A key element of the "Keynesian revolution" was its demonstration that these basic assumptions are false, both in theory and practice, and its assertion that, therefore, the most appropriate government macro-economic policy is to view the whole economy as if it were a single huge business enterprise which needs to be managed as one.

In a large individual business enterprise, a basic tool of management is the accounting system which enables management to analyze its operation and performance. Thus, it was probably no accident that Keynes developed his macroeconomic theory during the same period that national economic statistics were becoming good enough to provide the basis for development of national economic accounts.
Some economic basics

To understand how a money-flow conceptual framework outlined here revises Keynesian theory, it helps to review some economic basics.

In a modern money economy the most basic element is the individual transaction in which money is exchanged for something else of value. This is the basis for modern "double-entry" accounting systems, both "micro" (individual enterprise) and "macro" (whole economy). (In the case of an actual barter transaction, the accounting system has to treat it, in effect, as a dual transaction, in each of which money is exchanged for something else.)

In each transaction, the expenditure of the buyer is the income of the seller -- two sides of the same coin, so to speak. That is why, in the NIP accounts, total income and spending are equal "by definition." This is the basis for the traditional Keynesian/National Income (KNI) macroeconomic equation:

Income = Expenditure
Income = Consumption + (business) Investment + Government (spending)

The "Achilles heel" of Keynesian theory

A basic weakness of this framework is that the NIPA exclude the economy's functinally-vital credit flows and money-creation. This has had very negative effects on both economic analysis and policy:

  1. It prevents household, business and government financial saving from being independently measurable, leaving an empirical financial gap between saving and investment. This forces the theory to resort to an esoteric analytical complex of non-empirical ex-anti/ex-post dichotomies, marginal propensities, liquidity preference schedules, IS/LM curves and equilibrium theory.

  2. Because the NIP accounts also exclude the Federal Reserve's functionally-exogenous management of money growth, traditional Keynesian theory focuses wrongly on profit-seeking business investment and its "multiplier effect" as the primary "exogenous" source of GDP growth, and on interest rates, rather than money growth, as the key factor in GDP growth.

  3. In the other direction, the accounts try to accommodate the basically two-sector (consumer-business) focus of Keynesian theory by putting functionally-important but non-profit-seeking consumer-owned housing in the business sector and treating most other non-profit-seeking household and government investment spending as "consumption."

  4. The basic macroeconomic (above) is valid only for the whole economy, not for individual sectors or transactors.

The resulting analytical disarray and inability of policy to deal adequately with economic instability and structural imbalance left an opening for Friedmanite "monetarism," "supply-side" tax cuts, "rational expectations" and other neo-classical theoretical and policy fads.

2.  The Money-Flow Conceptual Framework

The Flow of Funds (F/F) Accounts, which aim to fill the financial gap between saving and investment, have been published by the Federal Reserve since 1958. But because of basic conceptual flaws their analytical usefulness has been so limited that they are not even mentioned in the index of leading economic textbooks and are little used even by the Fed itself.

The money-flow conceptual framework summarized here fills the savings/investment gap by addressing and fixing the conceptual flaws in the F/F Accounts.

The circular flow of money

In economic transactions, money, the "medium of exchange" is never "used up"; it continues to "circulate" from buyer to seller all around the economy. This is the basis for the circular flow diagram traditionally used in explanations of Keynesian theory and NIP accounts.

Non-Credit Money

One of the most important requirements for a real economic science is a precise definition of money -- one which clearly distinguishes "money" from other forms of wealth. As most economic textbooks readily admit, there is still an abysmal lack of such a definition in mainstream economic theory.

The basic key to such a definition is a non-credit concept to replace the fractional-reserve "credit money" concept invented by the medieval goldsmiths

Money is what we buy things and pay bills with -- the "medium of exchange" In effect, this "pseudo-commodity" concept avoids the confusing traditional concepts of "credit money" and "credit creation" by conceptually assuming that banks are required to maintain 100% reserves against their checking account liabilities, so that all money is created by the Federal Reserve (Fed) and the Treasury "by printing thousand-dollar bills" -- instead of being created by banks through loans to depositors. This conceptual definition of money makes possible a clearcut distinction between "money" and "credit." It also shows clearly why M1 is the most appropriate empirical measure of money stock -- and the absurdity of using the Fed's "M2."

Primary Credit

The money-flow conceptual framework defines credit as money loaned to someone else with the expectation of repayment -- usually with compensation for its use (interest or profits).

Primary Credit is money borrowed to finance GDP spending (as distinguished from money borrowed for the purpose of lending to someone else). In national economic accounts this concept is needed to "net out" intermediate ("pass-through") credit flows (e.g., when an auto company borrows from a bank or sells bonds to finance its consumer instalment credit) by a process similar to the way the NIP Accounts use "value added" to net out intermediate income and product flows.

Since the Federal Reserve's F/F accounts have not yet adopted this conceptual framework, their utility for analysis of credit flows and stocks has been reduced by double-counting, by excessive intra-sector discrepancies (between sources and uses), and by large quarterly revisions.

Together, the Primary Credit and Non-Credit Money concepts make possible effective functional integration of the NIP and F/F accounts by filling the "financial gap" between saving and investment with analytically-incisive empirical data, and by a functionally-realistic analysis of the relation between money growth and economic growth.
The Money-Flow Equation. Conceptual and statistical integration of the economic accounts also makes possible a basic money-flow sources-and-uses of funds equation which, unlike the NIP accounts, is valid and empirically measurable in both macro and micro perspectives:

Income + Primary Borrowing + New Money
= Spending + Primary Financial Saving + Increase in Money Stock

The Money-Growth/Economic-Growth Equation. In the money-flow conceptual framework an empirically-measurable Money Demand Ratio (MDR = M1/GDP) replaces the abstract Keynesian "liquidity preference schedule" and monetarist "velocity." This makes possible a simple formula which opens the monetarists' conceptual "black box" and makes it possible to analyze empirically the real functional relationship between money growth and GDP growth. This formula is valid in either nominal or real terms) when both money and GDP are expressed in the same terms. (In the formula, "gr" stands for growth rate.

GDP gr   =   M1 gr   -   MDR gr

In this form, this equation, like other macroeconomic equations, is, of course, a conceptual "identity" -- its two sides are equal "by definition" in an ex post accounting sense.

Policy application. But if the empirical values for M1 growth and GDP growth -- and the MDR ratio itself -- are precisely enough adjusted for seasonal and other statistical "noise," so that they accurately represent their current basic trend values, this formula becomes the key basis for systematically managing the economy to achieve and maintain full-employment growth. The Fed can maintain the appopriate stable GDP growth rate by systematically monitoring the MDR trend value and adjusting the M1 growth rate accordingly.

Empirical data based on these conceptual tools make it possible to systematically coordinate monetary and fiscal policy:

Written: June 25, 1997
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