Written by Steve Keen, Steve Keen’s Debtwatch

Minsky’s Financial Instability Hypothesis (FIH) is an emergent property of macroeconomic models derived directly from macroeconomic definitions.

This is Part 2 of a paper presented at the International Conference Minsky at 100 Revisiting Financial Instability, December 16-17 2019 – Universita Cattolica del Sacro Cuore Milano.

Please share this article – Go to very top of page, right hand side, for social media buttons.

This paper will be posted in five parts:

Part 1: Deriving a Minsky Model

Part 2: Simulating Loanable Funds and BOMD (this article)

Part 3: Accounting For The Great Moderation & The Great Recession

Part 4: Nonlinearity and Realism

Part 5: Appendix and References

Simulating Loanable Funds and BOMD

The macroeconomic significance of BOMD (Bank originated money and debt – also called endogenous money) can be easily illustrated by converting a simple model of Loanable Funds in Minsky to a model of BOMD. The Loanable Funds model is fashioned on the model in ( – Eggertsson and Krugman 2012), where the consumer sector lends to the investment sector via a bank which operates as an intermediary, and which charges an introduction fee to the consumer sector. The model is completed by the employment of workers by both sectors, intermediate goods purchases by each sector from the other, and purchases of goods by workers and bankers.

The five accounts in the banking sector’s Godley Table are Reserves on its Assets side, three deposit accounts on its Liabilities – one each for the Consumer Sector , Investment Sector and workers – and the Bank’s Equity account . The transaction of lending, repayment, interest payments and the bank fee all operate through the Liability side of the Banking sector’s ledger: its Assets are unaffected (see Figure 6).

Figure 6: Banking sector view of Loanable Funds

Conversely, the financial operations all occur on the Asset side of the Consumer (lending) sector’s Godley Table (see Figure 7). Lending reduces the amount of money in the consumer sector’s deposit account, and increases the debt that the investment sector owes to it (see Figure 7).

Figure 7: Consumer (lender) sector view of Loanable Funds

For the borrower, the financial operations alter its Assets and its Liabilities equally. Credit increases its Asset the deposit account it has with the Banking Sector, and identically increases its liability of , its debt to the consumer sector (see Figure 8).

Figure 8: The Investment Sector’s (borrower’s) view of the economy

The core differential equations of this model, shown in in Equation (1.6), can be derived directly by summing the columns of Figure 6 and Figure 7 (the flows that will be affected by the later conversion of this model to BOMD are highlighted in red) (9):

(9) They are also generated as LaTeX output by Minsky, and shown on its Equations tab.

All flows are defined in terms of first-order time lags related to the relevant account.(10) In particular, lending by the consumer sector is shown as being based on the amount left in its bank account , while repayment by the Investment Sector is based upon the level of outstanding debt:

(10) All flow definitions and parameter values are detailed in the Appendix (Part 5).

The parameters and are time constants, (11) which can be varied during a simulation – reducing increases the speed of lending while reducing increases the speed of repayment. These are varied in the simulation shown in Figure 10. Substantial variations in the speed of lending and repayment dramatically alter the private debt to GDP ratio, but only transiently affect economic activity. In fact, because the rate of spending of the investment/borrowing sector (set by other parameters in the model) is slightly lower than that for the consumer/lending sector, an increase in credit reduces economic growth. Conversely, a slowdown in lending and an increase in the speed of repayment causes credit to go negative, drastically reduces the debt to GDP ratio, and causes a transient increase in economic activity.

(11) These are widely used in engineering, and state the response of a system using its fundamental time units. See https://en.wikipedia.org/wiki/Time_constant for a simple explanation.

This simulation confirms the Neoclassical conditional logic that, if banks were mere intermediaries as Loanable Funds portrays them to be, then banks, debt and money could be ignored in macroeconomics. Large changes in credit have negligible impact upon GDP growth – and in fact credit and GDP growth move in opposite directions in this simulation, because the borrower has a lower overall propensity to spend than the lender, so that an increase in lending actually reduces GDP via a fall in the velocity of money (and vice-versa: see Figure 9).

Figure 9: Loanable Funds in Minsky. Credit has no significant impact on macroeconomics

Click for large and super-large image. Hit return arrow to return to paper.

With the macroeconomic impact of credit depending on idiosyncratic characteristics of the borrower and lender, there is no systemic benefit for including banks, debt, and arguably money, in a world where Loanable Funds is true.

Figure 10: Varying lending & repayment rates in Loanable Funds; no significant macroeconomic effects

However, in the real world, banks originate money and debt, and the impact of banks, debt and money on macroeconomics is highly significant. This can be illustrated by making the technically minor but systemically huge changes needed to convert this model of Loanable Funds into Bank Originated Money and Debt (BOMD) – by shifting debt from being an asset of the Consumer Sector to an asset of the Banking Sector (and deleting the superfluous “Fee”, since the Banking Sector now gets its income from the flow of interest).(12) Credit thus increases the Assets of the banking sector and its Liabilities (the sum in the Investment Sector’s account ) by precisely the same amount.

(12) Actual banks of course charge fees, but the “Fee” in this model is one for the mythical function of intermediation, which exists only in the minds of Neoclassical economists.

Figure 11: Banking sector view of BOMD

The financial equations of this system are shown in Equation (1.8). These are simpler than the equations for Loanable Funds: the mythical intermediation is deleted, the three financial operations are removed from the equation for CD , and the interest payment Int now goes to the Banking Sector’s Equity account BE.

These structural changes are the only differences between the two models in this paper. Strictly speaking, the flow of new debt

should have been redefined, but this was left as is, to illustrate that the change in the structure of lending alone is sufficient to drastically transform macroeconomics from a discipline in which banks, debt and money can be ignored, into one in which they are critical.

Figure 12: Bank Originated Money and Debt in Minsky. Credit plays a critical role in macroeconomics

Click for large and super-large image. Hit return arrow to return to paper.

These simple structural changes lead to credit having an enormous impact on the economy. Credit and GDP growth now move in the same direction, and GDP grows when credit is positive and falls when it is negative. In keeping with the logical analysis of the previous section, credit adds to aggregate demand and income when it is positive, and subtracts from it when it is negative.

Figure 13: Varying lending & repayment parameters in BOMD: significant macroeconomic effects

See Part 3: Accounting For The Great Moderation & The Great Recession

.

include(“/home/aleta/public_html/files/ad_openx.htm”); ?>