Reconciling Krugman and Keen using nef model

Reconciling Krugman and Keen

Emanuele CampiglioGiovanni Bernardo

New Economics FoundationLondon

23/07/2012

An analysis of the relation between debt and aggregate demand using nef model

Outline

1. Introduction: the Keen – Krugman debate2. The relation between debt and aggregate demand3. Our contribution to the debate4. The theoretical model5. Scenario simulations6. A step further: the supply side7. Conclusions

Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

Introduction: the two contenders

Paul Krugman, everybody knows him. Nobel Prize for economics in 2008 for his work on trade and international economics. Prolific political commentator, he writes a blog in the New York Times (link).

Steve Keen, professor in economics and author of “Debunking Economics”. Keen is developing a formal analysis of the intuitions of American economist Hyman Minsky (1919-1996), focusing on the role of debt in macroeconomic dynamics. A quite recent version of the model can be downloaded here.


http://krugman.blogs.nytimes.com/

http://debunkingeconomics.com/

http://debunkingeconomics.com/

http://www.debtdeflation.com/blogs/qed/

The bone of contention

• In March/April 2012 the two have been the protagonists of a heated debate on money, debt and aggregate demand.

• All was sparked by a paper prepared by Steve Keen for the INET conference in Berlin, in which he asserted that changes in the levels of debt add to the economy’s aggregate demand.

• Krugman disagreed, and replied with a post on his NYT blog. Keen replied to Krugman, and so on. The feud went on for a while, involving other economists and generating a wide debate on the blogosphere.

• A (slightly pro-Keen) chronological summary can be found at this link.

Emanuele Campiglio – Giovanni Bernardo – New Economics FoundationEmanuele Campiglio – Giovanni Bernardo – New Economics Foundation

http://ineteconomics.org/sites/inet.civicactions.net/files/keen-steve-berlin-paper.pdf

http://unlearningeconomics.wordpress.com/2012/04/03/the-keenkrugman-debate-a-summary/

Debt and aggregate demand

• What is Keen’s idea exactly, and why has it generated such a passionate reaction from Krugman?

• A formal explanation by Keen can be found here, but in a nutshell, what Keen argues is that the aggregate demand in an economy can be different from income, and that the difference builds up to the net change in the level of debt.

• In other words: Aggregate Demand = Income + Net change in debtAD=Y+ΔD• This sounds very different from what Krugman so often repeats: “Your spending is my

income, and my spending is your income”.

• Although both Keen and Krugman can be considered as “demand-side economists”, their visions are strongly different when it comes to debt and how this affects the economic dynamics. As Krugman himself wrote in one of his blogs:


“Keen then goes on to assert that lending is, by definition (at least as I understand it), an addition to aggregate demand. I guess I don’t get that at all. (..) I think it has something to do with the notion that creating money = creating demand, but again that isn’t right in any model I understand.”

http://www.debtdeflation.com/blogs/2012/07/03/european-disunion-and-endogenous-money/

http://krugman.blogs.nytimes.com/2012/03/27/minksy-and-methodology-wonkish/

Our contribution (1)• In this presentation we use nef macroeconomic model to clarify Keen’s analysis.

We do so by explicitly identifying two different variables:1. Realized expenditures (ER);2. Planned (or desired) expenditures (EP).

• We show how the main difference between him and Krugman (and the main source of confusion in the debate) is the way they think of aggregate demand:

– Krugman identifies Aggregate Demand with Realized Expenditure;– Keen instead defines Aggregate Demand with Planned Expenditure.

• Using numerical simulations, we show that, both Keen and Krugman are right in their own logic:

– Realized Expenditure (Krugman’s Aggregate Demand) is indeed equal to Aggregate Income. That is equivalent to say that at the end of each period recorded income will be equal to recorded expenditure. What has been actually spent will result to be someone else’s income.

– Planned Expenditure (Keen’s Aggregate Demand) can instead be different from Aggregate Income and the discrepancy is, as Keen argues, equal to the net change in the levels of debt.


What is demand?• The question then becomes:

What is the right definition of Aggregate Demand? • We tend to agree with Keen on this: planned expenditures (what firms,

households and governments plan today to spend tomorrow) are the crucial variable when defining the aggregate demand of an economy.

• As Hyman Minsky put it:

“For real aggregate demand to be increasing, (..) it is necessary that current spending plans, summed over all sectors, be greater than current received income and that some market technique exist by which aggregate spending in excess of aggregate anticipated income can be financed.”

(Minsky, H. P., 1982, Can "it" happen again? : essays on instability and finance. Armonk, N.Y., M.E. Sharpe)


Banks and credit• Who finances the gap between the current spending plans and current income? Banks.• The private banking system is responsible for the creation of the overwhelming majority of the money

supply in circulation.

• “By far the largest role in creating broad money is played by the banking sector.. When banks make loans they create additional deposits for those that have borrowed.”(Bank of England, 2007)


Ryan-Collins et al. (2011) Where does money come from?, New Economics FoundationBerry et al. (2007) Interpreting movements in Broad Money, Bank of England Quarterly Bulletin 2007 Q3

The role of banking• Krugman and Keen differ in the way they look at debt and banking.• As far as we understand, Krugman looks at banks essentially as intermediaries, moving

money from where there is an excess of savings to where credit is needed. • This is a crucial role of banks, but that’s not all: banks are able to indipendently create

new credit and allocate it in the economy, thus significantly influencing its shape.


Ryan-Collins et al. (2011) Where does money come from?, New Economics Foundation

Our Contribution (2)

• Our model explicitly includes the mechanisms through which banks create new money supply. We will here present a simplified version of the model that assumes no credit rationing, but if you want to have a taste of the overall structure you can read the presentation we gave at the Ecological Economics conference in Rio de Janeiro last June.

• Our numerical simulations show that, in the simple model we present here, no growth can take place without the creation of credit by banks, the net change in the level of debt being the the crucial variable affecting the dynamics of the economy.

• Finally, we expand Keen’s idea to include the supply side (i.e. the production process) into the picture. This allows us to consider the case in which planned expenditure doesn’t become realized expenditure because of a supply bottleneck.


http://www.slideshare.net/emacampiglio/nef-macro-model-isee-rio-2012

But enough with words: Let’s look at the model

• nef has developed a consistent macro framework using system dynamics that we use for a variety of research questions.

• The overall structure of the model is pictured below:

• We will here present a simplified version of our macro “core unit”, abstracting from the sectoral accounts.

Aggregate macroeconomic framework

Sectoral accounts

Demand

Government

Production Employment

Banks Central Bank

Gilt sellers

Households

Non financial

firms

Every agent in the economy is modelled using a double-entry book-keeping representation in order to ensure consistency in the model.

Sectoral accounts are connected to an macro “core unit” where demand, supply, investment and employment dynamics are modelled.


A word on system dynamics

• The model is built employing system dynamics, a methodology used to study the behaviour of complex systems and based on the explicit representation of feedback loops. Its basic units are:– Stocks and Flows (basically, differential equations)– Connectors (parameters or simultaneous equations)

See this simple example where Population is a stock, new born and deaths are flows affecting the level of the stock, and the rest of variables are exogenous parameters or defined by simultaneous equations.


Output, inventories and sales

First of all, imagine the production of output as a flow of goods and service that enters a stock of inventories. Imagine this as firms producing and then storing their production in warehouses.

Output is produced according to some production function. We are currently using a standard Cobb-Douglas function of physical capital and labour, but the functional form is not relevant for the point we want to make here.

InventoriesOutput Sales

Goods and services leave the Inventories stock once they are sold.

We will for now assume that supply is not an issue: everything that is demanded is available to be purchased. This is made to focus on the demand side dynamics. We will relax this assumption later on.


Wages and Profits

Sales are distributed among workers and firms in the form of wages and profits..

Workers then plan their consumption on the basis of their wages. For simplicity, we assume that workers want to consume their entire wage, without saving nor asking for loans.

Wages (W)

Sales (S)

Profits (Π)

Planned Consumption (CP)


..That is, in our model Sales are always equal to Income.

What happens to Profits?

For simplicity, assume that firms pay no interests on loans, but just have to repay a portion of the debt already contracted. Profits less the repayment of debt are equal to Net Profits.

Net Profits (ΠN)

Planned Investments (IP)

Debt Repayment (DR)

Credit Creation (CC)

Net Profits are then entirely invested in new physical capital. If firms desire to invest more than their net profits they need to ask banks for new loans.

Therefore, Planned Investments are equal to Profits plus Net Credit Creation, where Net Credit Creation is equal to Credit Creation less Debt Repayment.


Profits (Π)

Planned Aggregate Expenditure

Finally, Planned Aggregate Expenditure is equal to Planned Consumption plus Planned Investments.

Wages

Profits

Planned Consumption

Planned Investments

SalesPlanned

Aggregate Expenditure

Net Credit Creation


Planned Aggregate Expenditure represents the amount that agents today plan to spend tomorrow.

Realized Expenditure

Planned Aggregate Expenditure become Realized Expenditure only in the following period. That is, Realized Expenditures at time t are equal to Planned Expenditures at time t-1.

Time t Time t+1

Planned Aggregate

Expenditure

RealizedAggregate

Expenditure

Remember that for the moment we are assuming that everything is demanded can be found on the market, so everything that firms plan to spend (either coming from profits or new credit) is actually spent on something.


The overall picture (time t)

Wages t

Profits t

Planned Consumption t

Planned Investments t

Planned Aggregate Expenditure t

Net Credit

Creation t

Sales t

Inventories t

Realized Aggregate

Expenditure t

All this happens during the same period (time t)

At time t+1 the Planned Expenditure become Realized Expenditure.

Realized Aggregate

Expenditure t+1


The overall picture (time t+1)

Wages t+1

Profits t+1

Planned Consumption t+1

Planned Investments t+1

Planned Aggregate Expenditure t+1

Sales t+1Inventories t+1

Realized Aggregate

Expenditure t+1

Net Credit

Creation t+1

Plus, planned consumption at time t becomes consumption at t+1 and planned investments at time t become investments at t+1. Realized Consumption and Investments then affect other model sectors, not shown here.

Realized Aggregate

Expenditure t+2

In the same period (t+1) all the other variables are determined, including the new Planned Aggregate Expenditure.

At time t+2 the Planned Expenditure become Realized Expenditure, and so on..


In analytical terms:The model can be described by the following equations:

1) St = ERt

2) Wt=α St

3) Πt=St-Wt

4) CPt=Wt

5) IPt= Πt+ΔDt

6) Dt+1 = Dt+CCt-DRt

7) DRt=Dt/r

8) CCt=η(Πt-DRt)9) EP

t=CPt+IP

t

10) ERt+1=EP

t

Where:S : SalesER : Realized ExpenditureW : Wages Π : ProfitsCP : Planned ConsumptionIP : Planned InvestmentsD : DebtCC : Credit CreationDR : Debt RepaymentEP : Planned Expenditureandα : Labor Sharer : Debt Repayment Timeη : Propensity to Invest


Some scenarios

On the left, you can see how this reduced version of our model looks on the system dynamics software we’re using, Stella.


For the first run, we set:• Initial Realized Expenditure:

100• Initial level of debt = 0• Infinite inventories

(remember assumption: all demand is satisfied)

• Eta (η) = 1.4• Debt repayment time (r) = 5• Alpha (α) = 0.7

1. Controlled growth• Realized Expenditure is

always equal to Income (and to Sales of course).

• Planned Expenditure is higher than Income.

• The difference between Planned Expenditure and Income is equal to Net Credit Creation (right Y-axis).

• In this case Net Credit Creation converges to zero in the long-term as debt and its repayment become larger.

• Income (and the whole economy) grows until reaching a plateau.

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Realized Expenditures Planned ExpendituresIncome Net Credit Creation

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2. Exponential growth

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• Change of parameters: o Eta = 2;o r= 10.

• In this case the expansion of Net Credit Creation (Credit Creation growing at a faster pace than Debt Repayment) allows for exponential growth.

• But still the same applies:

o Realized Expenditure = Income;

o Planned Expenditure > Incomeo Planned Expenditure – Income

= Net Credit Creation.


3. No growth

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• What happens when eta = 1, that is firms invest just their net profits and therefore no new credit is created?

• The economy doesn’t grow!• Recalling the Minsky quote:

For real aggregate demand to be increasing, it is necessary that current spending plans be greater than current received income and that some market technique exist by which aggregate spending in excess of aggregate anticipated income can be financed.”


4. Decline

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 2080

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• If we allow for a positive value of initial loans (D0=30), debt repayment can bring income down, even if eta>1 (new credit is created). In this case eta=1.1.

• That is, when Net Credit Creation is negative (look at the right Y-axis) Planned Expenditures are lower than income, and this brings the economy in a recession.


A step further: Supply


Sales t

Realized Aggregate

Expenditure t

Output t

Planned Aggregate Expenditure t-1Inventories t

Capital Stock tEmployment t

As we have seen, Planned Aggregate Expenditure at t-1 determines Realized Aggregate Expenditure at t.

That’s not all. In our macro model Planned Expenditure is also used by firms to decide how many workers they want to hire.

It’s reasonable to say that in the model supply adapts to demand dynamics.

Together with the Capital Stock (whose dynamics is governed by investments and depreciation) these two factors of production determine the level of output.

Some adjustments


Sales t

Realized Aggregate

Expenditure t

Output t

Planned Aggregate Expenditure t-1Inventories t

But let’s keep it simple and forget about the adjustment of production factors for a moment.

The point that we want to make here is that this representation is also capable of modelling the case in which in the economy suffers from a supply bottleneck and it’s not possible to satisfy the entire demand.

Sales, which are still equal to Aggregate Income by definition, are now redefined as the minimum between the Attempted Expenditure and Output plus Inventories. This allows us to take into account that it’s not possible to purchase what hasn’t been produced. Sales are now the Realized Expenditures.

We rename Realized Aggregate Expenditure as Attempted Aggregate Expenditure. That is, Planned Expenditure at time t-1 is what the economy tries to spend at time t. If there is enough output, every attempted expenditure will be realized; otherwise, just a portion of it.

Attempted

= Realized Expenditure

A simple example


• For the first 10 periods of the simulation, output is set to be equal to whatever the economy attempts to spend in that period. We are in the same situation as previous simulations, where supply always satisfies demand.

• At time 10, we impose a shock: supply is now capable of satisfying just 90% of demand (Attempted Expenditures).

• At time 13, the situation goes back to the previous situation: supply is able to satisfy the entire demand again.

• All the parameters and initial values are set equal to Scenario n.1 (Controlled growth). The initial value of Inventories is set equal to 30.

A supply constraint


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Output Attempted ExpenditurePlanned Expenditure Income (Realized Expenditure)

• The shock imposed to output appears very clearly.

• For a couple of periods, the economy doesn’t seem to suffer much: this is because the stock of inventories is being depleted.

• When Inventories run out, demand (Attempted Expenditure) can’t be satisfied. Income ( = Realized Expenditure) decreases.

• Planned Expenditure also go down, as Desired Investments become lower than Profits, thus leading to a negative Net Credit Creation.

• With a lag of one period, also Attempted Expenditure drops.

• At period 13, when the shock is over, there’s little left to do: the economy is stuck in a steady state that is lower than the potential one.

Some conclusionsThe model presented here is very simple and characterized by a variety of limiting assumptions:

– There are no interest payments;– The demand for loans is completely satisfied by banks;– There is no price dynamics;– etc.

Still, we believe it’s capable of grasping some core features of how modern economies work, and in particular the role of debt in influencing aggregate demand. We have also been able to:• Clarify Keen’s analysis by explicitly separating realized and planned expenditures.• Show how Keen and Krugman have different definitions of aggregate demand. • Show through numerical simulations that both Keen and Krugman are right in their own logic:

– Realized Expenditure (Krugman’s Aggregate Demand) is equal to Aggregate Income. – Planned Expenditure (Keen’s Aggregate Demand) can instead be different from Aggregate Income and

the discrepancy is, as Keen argues, equal to the net change in the levels of debt.• Argue that Keen’s definition of Aggregate Demand is more appropriate, especially if the role of

credit creation by private banks in shaping macroeconomic dynamics is to be understood.• Show how in our simple model no growth can take place without the creation of credit by

banks. The net change in the level of debt (Net Credit Creation) is the single most important variable affecting the dynamics of the economy.

• Expand the framework to include the supply side of the economy, and show how a production bottleneck could complicate the dynamics.

Thank you!

[email protected]

Reconciling Krugman and Keen using nef model

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