The macroeconomic significance of Household Lending demonstrated in. relation to a Stock-Flow Consistent model

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1 The macroeconomic significance of Household Lending demonstrated in relation to a Stock-Flow Consistent model Diarmid J G Weir PhD student University of Stirling d.j.g.weir@stir.ac.uk Abstract Post-Keynesian economic thought largely rejects utility maximisation by households, price equilibrium in the goods and labour markets, and firms profit maximisation subject to these given prices, as organising features of the monetary macroeconomy. This rejection is based on these features being at odds with the observable realities of economic institutions, such as money, banks and the distinct objectives of firms. An alternative framework is therefore required to explain the degree of economic order and predictability that does exist, and how policies might affect this order. Wynne Godley and Marc Lavoie have built a series of macroeconomic models based on double-entry accounting, rigorous matching of stocks and flows across all sectors of the economy through integrated balance sheets and transaction matrices, along with the assumption of behavioural norms in terms of stock-flow ratios for households, firms and the government. Godley and Lavoie introduce money into their models in three ways: government purchases, firms loans for production and household lending. In each case the formation of assets in the form of debt is matched by counterpart liabilities in the form of bank deposits. Godley and Lavoie explicitly claim that their transactions flow matrices set the monetary circuit where private money is explicitly viewed as the result and counterpart of initial production loans (as described by Graziani, Parguez and others) within a comprehensive accounting framework. As a consequence the supply of loans to firms and the holding of private money deposits by households and firms must always be equal. In Godley and Lavoie s models, however, money once created is primarily a portfolio asset that acts as a residual buffer for households. Godley and Lavoie do not explicitly trace, as the monetary circuit does, the return of monetary revenue to firms to repay their production loans and neither do they address the issue of how a monetary surplus is generated by firms to purchase capital goods. I discuss the ways in which the monetisation of profits has been addressed in relation to the monetary circuit, drawing particularly on the work of Edward Nell who suggests a two-sector solution, and adapt some of Godley and Lavoie s models to bring this issue into focus. In doing this additional restrictions are placed on firms, and I show the importance of household loans - as a source of money from outwith firms and outwith the productive sector in providing firms with the flexibility to adjust prices to generate monetary and/or goods surpluses. 1. Introduction This paper is part of a wider thesis in which I am investigating the role of the Monetary Circuit Approach in understanding macroeconomic problems. The particular problem of interest in this paper is the role of household debt. In the simple analysis of this paper, this includes secured debt such as that acquired for home ownership or 1

2 unsecured debt such as credit cards. I start off by discussing the problems of addressing macroeconomic problems created by the need to account for the co-ordination of so many individual transactions, particularly if money is realistically to be included in its proper role in the flow of these transactions. I therefore propose Stock-Flow Consistent models as a starting point for consideration of macroeconomic problems. I point out with relation to a specific very simple model of this type the issues raised by a strict Monetary Circuit Approach and how these might be affected by the addition of household loans. Following the technique of Godley and Lavoie (2007) I have run some computer simulations based on the resulting equations and discuss the results. 2. The Problems of Macroeconomic Modelling The study of the macroeconomy requires us to understand why there appear to be persisting features in terms of institutions, rates of flow and levels of stocks in particular sectors of the economy. If we cannot model their persistence we have little chance of understanding the changes that take place from period to period. To bring about this stability neoclassical economic models rely on regular behaviour by consumers, workers and firms and more-or-less automatic equilibrium at the macroeconomic level of supply and demand in the markets for consumption and capital goods and for labour. There is much to debate in all of these assumptions. Theories about the behaviour of consumers, workers and firms can be tested empirically, and has been, with much evidence to suggest that consumers and workers behaviour is far from rational or consistent (Camerer 2004) and that firms are unlikely to be pure profit maximisers (Godley, Coutts and Nordhaus 1978). These facts create difficulties for the neoclassical model, but can often be overcome, and all models of the economy must make some assumptions about these behavioural functions. Much more problematic is the reliance on 2

3 equilibrium to close the model once the behavioural equations are in place. This assumes that it is only reasonable and meaningful to analyse the economy with respect to points in time where demand and supply are equal. Leaving aside whether this condition is acceptable in a dynamic economy there are several serious problems that arise from the attempt to establish equilibrium macroeconomic models from complex microeconomic assumptions. The main issue is that it is very doubtful that macroeconomic aggregates can be analysed using the type of representative agent analogy required by the neoclassical microeconomic approach. By applying microeconomic theory that describes economic relationships at the individual level and applies them by analogy to aggregate data, expecting them to hold up assumes that the relationship between elements of the structure will be preserved at higher levels. The logical requirement of consistent linear aggregation restricts the functional form of the decision-making processes of representative agents (whether they are individuals or firms). The reality of limited information, bounded rationality, diverse tastes and endowments of individuals, along with differing technologies and goals on the part of firms and with the presence of mediating institutions, macroeconomic externalities and feedback from macro events mean that such constraints are too severe a limitation. Without them rational choice-theoretic foundations have very few aggregative consequences. As Colander (1996, p2) points out, the solution to a system of simultaneous equations complex enough to describe the economy realistically with its interdependencies at the level of individuals and individual firms has multiple equilibria and complex dynamics, Thus a realistic neoclassical Walrasian micro model is consistent with a wide range of phenomena at the macro level. The above analysis leaves us with the 3

4 problem of how to explain why the real world of the economy does not exhibit the chaotic results anticipated. Consistency of stocks and flows as used by Godley and Lavoie (2007) to build a series of macroeconomic models may provide the answer to this and the further issues that I outline in the following two sections 3. Matching Supply and Demand without Price Equilibrium The market-clearing by price assumption of mainstream macroeconomic models is widely challenged. Colander and van Ees (1996) go so far as state that the modern economy is by no means ideally co-ordinated by the price mechanism, nor could it conceivably be so co-ordinated. Godley and Lavoie (2007) describe the objection as follows: Excess demand leads to higher prices, which is assumed to reduce excess demand. This mechanism is put into effect within the period, before transactions are made. When transactions occur, as reflected in the transactions-flow matrix, supply and demand have already been equated through the priceclearing mechanism. We believe that such a market clearing mechanism, based on price variations, is only appropriate in the case of financial markets. In the case of goods and services markets, and in the case of the so-called labour market, we believe that the hypothesis of market-clearing equilibrium prices is wholly counterfactual, inappropriate and misleading. (Godley and Lavoie 2006 p64) Eichner (1989 p246) also argues that price-clearing is the exception rather than a rule in an advanced economy. It is only in commodity markets where individual sellers are so numerous and lacking in market power that they are unable to exert any significant influence on the price. When prices are given, the firm decides how much to produce and then puts all of its output on the market at this price. Any imbalance between demand and supply is then eliminated through an appropriate change in price. Eichner distinguishes 4

5 the firms in such markets by their direct control by a small number of ownerentrepreneurs and the small number of plants which they control By contrast, it is what Eichner terms industrial markets that predominate in the modern economy. In such markets, sellers are sufficiently few in number and with a wellprotected market position such that they can influence the market price directly. These firms, therefore, can both decide on the quantity they will produce and the price at which buyers will have to pay. Under these conditions, the firm sets the price and then sells whatever quantity it can at that price. Thus when there is an imbalance between demand and supply, the necessary adjustment occurs through the quantity variable rather than the price variable. A decline in demand is experienced as a decline in sales rather than as a weakening of the market leading to a fall in the industry price. Similarly, an increase in demand is experienced as an increase in sales rather than a rise in price. Here there are no organised market frameworks such as those that exist for shares or commodities, but suppliers who create their own markets. Relevant to Godley and Lavoie s view then, is that the equality of income and output seen in national accounts or flow of funds tables is not evidence of a real equilibrium between investment and non-consumption, or income and output but arises purely as a consequence of the definitions of profit and residual income; i.e.: any discrepancy between what is earned by individuals and what is spent by them becomes automatically matched by the gap between firms revenue and what they must pay out (overwhelmingly, ultimately, as labour costs) 4. The Macroeconomic Role of Money At the macro level, it is clear that money cannot be realistically introduced into a framework resting on general equilibrium assumptions. As Clower and Howitt (1996) 5

6 point out in general equilibrium there are no transaction costs to be alleviated by it since these are ruled out by the presence of the Walrasian auctioneer. In Clower and Howitt s words: [T]he problem of accounting for monetary exchange is just the problem of explaining why the firms that make markets do not routinely deal in direct barter of goods for goods. (Clower and Howitt 1996, p26) They do not go on to detail these explanations, but I would tentatively suggest they are as follows: 1. They do not have to, because money is introduced into the economy in the process of acquiring loans to pay for wages or investment goods. 2. Firms need to acquire money to repay debts 3. They can dispose of their products more easily if they are willing to exchange them for money, since a. It is easier for consumers to buy on impulse what they are foregoing the do not yet have and so cannot value b. Firms can facilitate (or even provide directly themselves) credit for consumers to make purchases Under a credit-based system of money an increase in the amount of money in circulation occurs as an endogenous response whenever one of the non-financial sectors uses loans to finance outlays. There is then a circular flow of these funds among the various sectors of the economy. This flow occurs alongside the flow of produced goods to consumption and a flow in the opposite direction of labour from households to firms. The strict accounting of these flows is the distinguishing feature of the Monetary Circuit Approach as described by for example Graziani (2003). 6

7 Eichner (1986) describes the significance of this. If there is a change in one sector s financial position without an increase in the overall amount of funds in circulation, i.e.: its gross savings have increased relative to tangible investment this can only be at the expense of some other sector. On the other hand, if there is a change in the overall amount of funds in circulation, subsequent to a payment made that has been financed by a loan from a bank, the sector making the payment will have both increased its financial liabilities (in the form of the loan) and increased its financial assets (in the form of additional deposits). Following the payment some further physical or financial asset is acquired it being on this basis that the loan was likely to have been made in the first instance. Thus no intrinsic limitation on the amount of funds in circulation exists. 5. Monetisation of Macroeconomic Models To understand the role played by lending or a flow of money from a particular source, as I wish to do in this paper we must understand that we are dealing with a monetary economy i.e.: an economy where virtually all transactions of significance are carried out using money, and so for those transactions to take place money must be in the hands of the purchaser of a real good immediately preceding that purchase. This only makes sense if transactions are considered sequentially in the way that the monetary circuit approach does. The real economy consists of overlapping transactions and circuits which have started at different times, so it may seem unhelpful to isolate individual circuits. But unless we do this it is difficult to analyse how the flow of money where it comes from and where it goes - affects the economy. In Nell s words: An account of why money is held does not explain how money is used. An account of the demand by individual agents for (real) cash balances (the average demand over a period) tells us nothing about the sources and destinations of inflows or about their regularity. The approach assumes that balances are attributable to individual decisions, based on preferences, and does not consider the way agents interact with each other as they 7

8 carry out their duties according to their institutional roles. (Nell 2004, p174-5) In particular, the problem of accounting for the flow of a particular sum of money arises each time there is an increase in the firm s financial input that is converted into an additional profit. While we can account for a greater than one for one productive increase by a firm s position on an increasing returns portion of its production function, no such explanation can suffice to account for an incremental increase in monetary profit. Nell asks how a sum of money exchanged against all the goods and services produced in the economy, can be put into circulation as capital to buy inputs and then return as a larger sum to allow profits to be extracted from revenue. Nell rightly distinguishes between productivity; the transformation of a larger set of outputs from given real inputs; and the increase in a sum of money where money is not itself productive. Nell s explanation proceeds from the establishment of a two-sector model. The first sector is that of the equipment sector, the second that of the consumer sector. This recognizes, as do circuitists such as Graziani (2003) that ultimately, the overwhelming expense of the productive sector as a whole is spent on labour; even of course that of the mining and extractive sector. In the case of two sectors, it can be postulated that the consumer goods sector earns its profits in the form of the wages paid to the employees of the equipment sector, since these must be paid to the consumer sector to acquire the means of support. Thus the consumer sector borrows to pay its wage bill, but can pay for its supply of equipment goods with the money received in payment from the workers of the equipment goods sector. The problem is thus solved arithmetically, since the initial finance borrowed by the capital goods sector to pay its wage bill passes through both sectors before returning to the equipment goods sector to allow it to repay its debt. Even this leaves the equipment goods sector without profit, so that no increase in the production of equipment can take place. Nell s solution to this problem is that the capital 8

9 goods sector is further subdivided so that each subdivision provides the profit for another until we reach the machine tools sector. It is Nell s argument that this sector makes its own capital goods and so does not require a monetary surplus. There are several possible objections to Nell s approach. Firstly while it is true that arithmetically, the double use of capital goods firms wages as the profits of consumer goods firms partially solves the profits problem, it is not clear that it solves it economically. The practical sequence of events is presumably (assuming that capital goods firms need no raw materials, or already have access to them without expenditure) that some proportion at least of capital goods (and in the case of a factory this is not enough) must be produced and be ready for use before the consumer goods firm can commence operations. This implies that the capital goods firm has borrowed its wage bill, and paid its workers, but as yet no revenue has accrued to the consumer goods firm as it has produced no output at this stage. In all probability, the consumer goods firm must borrow the sum it must pay the capital goods firm for its output. However this loan returns quickly to the bank, before the consumer goods firm commences output and the workers of both sets of firms start acquiring it in return for their wages. Of course there will be variations, with some capital goods firms prepared to wait until consumer goods firms have made their monetary surplus before being paid. The difference between these scenarios is that the consumer goods firms will have to pay interest on their loan for acquiring the capital goods. Nell would dismiss this as a bridging loan that he regards of little importance (Nell 2004, p179), yet a high enough interest rate on this loan or unwillingness on the part of banks to advance it may prevent production taking place. A second consideration is that in the real economy it is much more difficult to distinguish capital goods and consumer goods firms. Construction firms may build dwelling houses and factories; food manufacturers may supply supermarkets and plant 9

10 canteens. Because of this the sequence of production is not as clear-cut as Nell suggests. Because of this we cannot be sure that money can always complete the double circulation necessary to ensure that the consumer goods firms have their monetary surplus when their wage-bill loans come due. Thirdly Nell s conception of the machine tools sector that makes its own capital goods seems somewhat far-fetched. It is unlikely that machine tools firms actually build their own factories! Lastly, it is an empirical fact (Corbett and Jenkinson 1997) that firms do not generally spend their profits in the same period as they acquire them, and they may indeed accumulate funds for several periods before making a major investment 6. The Stock-Flow Consistent Approach as an Organising Framework Godley and Lavoie (2006) have attempted to replace the organising power of equilibrium, utility maximisation and profit maximisation with a different framework based on rigorous stock-flow accounting, the conscientious matching of stocks and flows and the assumption of stable stock-flow norms. Using this framework they have constructed a series of macroeconomic models of increasing complexity. Godley and Lavoie claim that within broad parameter limits the response of their models can be reliably traced in simulations. The arguments in favour of stock-flow norms as an organising principle for macroeconomic behaviour are largely laid out in Godley and Cripps (1983). Here the authors argue that these norms are a better approximation to actual behaviour than, for example, utility maximisation; that they are more predictable, and so allow the coordination of behaviour that is seen in the actual economy; and that they allow straightforward linking from individual to aggregate behaviour. 10

11 For firms, the existence of cost-plus pricing combined with a quantity response to changes in demand means that sales are equal to effective demand since the firm has finished goods to act as buffer. Transactions in each period have results from stocks at the end of the period and these stock variables are critical. They also emphasise the importance of money creation by government purchasing and of production loans to firms by banks. There are important roles for various buffers (residuals) for each sector whose quantities depend on other decisions that have been taken previously. Their modelling largely follows the arguments of Eichner (1987) in his incomplete outline of a more empirically-based approach to macroeconomics. Godley and Lavoie point out (2007) that individual welfare maximisation is not consistent with firms having an independent existence with distinct motivations, because optimum prices, output and employment are decided for them by the location of aggregate demand and supply schedules. They object that when households and firms are amalgamated into a single sector, as they usually are in neoclassical models, the problem of co-ordination between consumption and production is assumed away. Moreover, the fact that there is no time element to production, and no excess demand or supply in these models means that there is no place for loans or credit money, and thus no role for banks. Their argument is that on the contrary, in a modern industrial economy, firms have a separate existence with a distinct set of objectives such as to make profits for growthmaximising investment. Since firms operate under imperfect competition and increasing returns, they must decide for themselves how much to produce and how many workers to employ, what pieces to charge, how much to invest and how to obtain finance. It is then the pricing decision of firms rather than the marginal productivity of capital and labour that determines the distribution of the national income between wages and profits. And thus, since production really is a time-consuming process and expectations are frequently 11

12 falsified resulting in persistent excess demands and supplies, there is a systemic need for loans from outside the production sector if the firm wishes to continue expansion. An important further point that Godley and Lavoie raise is that sales of investment goods give rise to receipts in the business sector, which receipts must themselves arise from the business sector which is itself doing the investing. Thus they implicitly recognise an issue of profits that we will come back to in this paper. 7. Godley and Lavoie s Bank-Money World (BMW) Model Although Godley and Lavoie s models subsequently become more complex, I have chosen to base my analysis in this paper on a version of a very simple model, but one that does introduce the concept of private bank with firms requiring to borrow fixed capital. I start by analyzing this model and adapting it to conform with the monetary circuit view, or in Nell s expression monetising it (Nell 2004). This model conforms to the general principles described above, consisting of households, production firms and banks, but no government sector. There is a single financial asset, money deposits held by households, and only fixed capital expenditures are considered. Godley and Lavoie define a transaction matrix for their model as shown in Table 1 below. 12

13 Table 1 Transactions-flow matrix of Model BMW Production Firms Banks Households Current Capital Current Capital Consumption -C +C 0 Investment +I -I 0 [Production] [Y] 0 Wages +WB -WB Depreciation allowances -AF +AF 0 Interest on loans -r l-1.l -1 + r l-1.l -1 0 Interest on deposits +r m-1.m -1 - r m-1.m -1 0 Change in loans + L - L 0 Change in deposits - M + M Here components of the National Income and Product Accounts are arranged as transactions between the sectors above the first horizontal line. Below this line are the changes in financial assets and liabilities that correspond to the Flow of Funds Account. All columns and rows sum to zero, since all transactions must have an issuer and a receiver. In this model Godley and Lavoie assume an instantaneous quantity adjustment process, so that the variables in the matrix represents both quantities supplied and those demanded. 13

14 By using these equalities and particular behavioural functions, Godley and Lavoie complete their model and run computer simulations to show the consequences of varying some of the parameters. Analysing this matrix, it is important to realize that to the extent that firms can pay out the quantity AF without borrowing, depends on a transfer of investment funds from the capital account to current expenditure. This leaves open the question of where these funds come from. Godley and Lavoie s model does not start from the zero position and so cannot account for any increase in investment of the sort Eichner believes to be essential for survival. (See Eichner 1987, p360.) Godley and Lavoie claim that their transactions flow matrix sets the monetary circuit within a comprehensive accounting framework (2006, p47), but this is not strictly correct. The general assumption of the monetary circuit approach is that initial finance for firms comes in the form of a loan for the wage bill (see e.g.: Graziani 2003, p27) The flow of money arising from this loan must then be specifically traced through the series of transactions that follow until it is back in the hands of firms allowing the initial loan to be repaid. This is done in Table 2, where I have added a line (Line 5) representing the purchase of equities by households from firms, providing a route for firms to access funds not used for consumption by households. 14

15 Table 2 Phased Circuit Flow in Adapted BMW Model Circuit Phase Households Firms Banks Households Balances Firms Balances Firms Loans Outstanding 1 Initial Loan -WB 0 WB WB 2 Wages +WB -WB WB 0 WB [Production] [Y] 3 Consumption -C +C S C WB 4 First Partial Loan Repayment -C +C S 0 S=WB-C 5 Equity Purchase -E +E S-E E S 6 Second Partial Loan Repayment -E +E M 0 M=WB-C-E 7 Interest on loans -rl-1.l-1 +rl-1.l-1?? 8 Depreciation allowances -AF?? 9 Investment -I?? We can see that after the second partial loan repayment, made possible by the introduction of equities into the model, firms have no remaining funds for paying interest on their wage-bill loans, for replenishing depreciation or for new investment, and in fact they remain in debt to the banks. As the model stands they can only invest by the counterfactual method of acquiring new loans for the whole of any new investment (Corbett and Jenkinson 1997). No monetary profit can be made. From the steady state of the original BMW model any increase in output entails an increase in target investment for the next period that cannot be achieved without further loans. If the firm relies on borrowing for investment, then there is an increasing interest and debt burden which is likely to limit long-run expansion. 15

16 In Godley and Lavoie s BMW model there is a transfer each period from firms capital to current accounts offset in whole or in part by a transfer in the opposite direction. If the offset is not complete, the difference is made up by an increase in loans and so by a positive L. In this way the appearance of a surplus each period in fact if there is any positive investment, this must arise from an increase in loans for firms, so that there is only loan funding of investment. If we consider a start from a point of zero capital, all capital must be funded by loans, and any new investment results in an increase in loans. If there is no other source of money, then a growing economy requires a loan that increases each period by more than new investment because of interest on the wage-bill loan and any investment loan. Firms are also vulnerable to increases in deposits held by individuals as this will reduce further their ability to pay interest in any period. This severely limits the flexibility of firms to accumulate funds until they are ready to make capital investments, and so reduces their discretion to grow as required. In Nell s two-sector model - since profits are immediately paid to firms for capital goods all profits return to firms and allow the debt that created it to be repaid; but if consumer goods firms do not purchase capital goods immediately and we are accepting the reality that they need not and often do not, spending some time in accumulating profits before enacting an investment expansion then there is an outstanding debt burden for the firms sector that cannot be repaid, and so additional interest must also be paid. As long as capital goods are not purchased this outstanding debt persists. Interest payments form the income of banks and my also be accumulated, thus depleting the quantity of money available. 16

17 8. Rewriting the Godley and Lavoie BMW model to account for the Monetary Circuit Table 3 Transactions-flow matrix of Adapted Model BMW Households Firms Banks Consumption -C +C 0 Investment -I 0 [Production] [Y] 0 Wages +WB -WB 0 Equity Purchases -E +E 0 Depreciation allowances -DA 0 Interest on loans -r l-1.l -1 + r l-1.l -1 0 Change in loans + L - L 0 Change in deposits - M + M r l-1.l -1 0 I have altered the BMW transactions matrix (Table 3) to reflect the rigorousness of the Monetary Circuit approach. In this new model the real output Y of firms is assumed, according to Circuit Theory, to be equivalent to the wage bill WB, Y = WB. (1) Tracing out the flow in Table 3, we can see the total loan requirement for firms L if they are to enter the next period without un-repaid debts, and desire to invest a positive sum: 17

18 L = L + WB C + r. L + r. WB + I + DA ( E E ). (2) 1 l 1 1 l 1 1 where C is consumption, r the real net interest rate on loans, I the level of investment and DA the amount firms require to spend to compensate for depreciation of their capital equipment. I have added the interest that must also be paid on the current wage-bill loan. If households have access to a supply of bank loans H then their disposable income is given by YD = WB + H. (3) out of which consumption takes place according to C = α + α. WB + α H. (4) where α 0 is an autonomous element to consumption, α 1 is the propensity to consume out of wage income and α 2 is the propensity to consume out of the current loan. M is the quantity of money deposits held in that period, and varies according to M = M 1 + γ ( YD C). (5) The quantity of new money deposits depends on an uncertainty parameter γ operating on the residual income remaining once consumption has been determined. The rest of unconsumed income is used to purchase equities, so that E = E 1 + YD C γ ( YD C) (6) Money holdings are responsive to uncertainty about the future. If this uncertainty increases, then money holdings will increase and ceteris paribus purchase of equities will decrease. Households demand for loans is given by 18

19 H = ε. WB. (7) Firms investment behaviour is given by I = β0 + β1k 1 + DA. (8) where β 0 is an autonomous element to investment, β 1 a constant proportion of capital accumulated in the previous period. This is to concord with Eichner s view that firms aim to keep up with general market expansion, but must also expand their market share if they are not to be outstripped by firms newly entering the market. Capital accumulates according to K = K + I DA. (9) 1 Depreciation allowances are determined according to DA = δ. K. (10) 1 The interest on bank loans is given by r l = r. (11) l Since the firm desires to achieve a monetary surplus only, and does not wish to have unsold goods remaining, we can monitor this according to X = ( py C) / p. (12) where X is the real quantity of goods manufactured in that period and left unsold. 19

20 9. Results of simulations of the Circuit constrained model I have constructed a computer simulation based on the model given above and using plausible parameters. To ease interpretation, an initial arbitrary wage-bill and thus planned output by the firm of 100 is chosen. The initial parameters are as follows: Autonomous component of consumption α 0 = 25, Propensity to consume out of wages α 1 = 0.73, Propensity to consume out of loans α 2 = 0.9, Autonomous component of investment β 0 = 0, Capital increment to investment β 1 = 0, Loan demand parameter ε = 0, Deposit holding ratio (Uncertainty parameter) γ = 0.5, Rate of depreciation of capital δ =0.05, Net interest rate on loans r l = 0.0, Price level p = 1. Simulations run using this new model over 5 and then 10 periods with these parameters now show that even with zero growth in output or disposable income, and with no investment the level of current loans required by firms to avoid failing to repay wage-bill loans increases year on year, 50 after 5 periods, and 97 after 10 periods. (See chart 1) 20

21 Chart 1 Firms demand for Bank Loans with zero investment and nil household loans Demand for bank loans ( ) If the firm wishes to accumulate for new investment the loan requirement increases. If the investment parameters are β 0 = 5 and β 1 = 0.05, the 5 period loan requirement is now 130 and the 10 period requirement 287 as shown by Chart 2. As this is 130% of annual output after only 5 periods and nearly 300% after 10 periods this seems unlikely to be sustainable. 21

22 Chart 2 Firms demand for bank loans with positive investment and nil household loans 300 Demand for bank loans ( ) We might anticipate that in this situation the firm will increase its price to acquire increased revenue. If there is a 5% price increase, equivalent to raising the p parameter to 0.05 and keeping the other parameters the same as in the last simulation what we see is an unchanged loan requirement, but now an increased in period by period unsold goods from a real value of 2 to 6.7 annually. So on its own raising the price is of no benefit to firms. If, however, we make ε a positive value we can introduce a quantity of household loans. For the final simulation demonstrated here, all other parameters remain as the previous simulation, but now the loans parameter is ε = Firms are now receiving from households more than they pay out in their wage bill and this has the effect of reducing the level of loans required for firms to 85 at the 5 year period and $200 at the 10 year period if investment is continued at the same level (See Chart 3). The level of unsold goods is now only 0.7 annually. Thus the facility for households to acquire loans 22

23 reduces the level of loans firms require and so we can show how household loans can provide the funds firms need to monetize their revenue and achieve a monetary surplus. Chart 3 Firms demand for bank loans with positive investment and positive household loans 240 Demand for bank loans ( ) Conclusion The equations derived in this paper and the simulations run from them demonstrate in a very simple, and admittedly simplistic, way the potential importance of household loans to the abilities of firms to maintain sustainable growth for themselves and the economy as a whole. This may have important implications for the stability of economies where the level of household loans is very high. I intend to work with more complex and realistic Stock-Flow Consistent models, and complement them with more comprehensive monetary flow elements to extend this analysis. 23

24 11. References Camerer C. F Prospect Theory in the Wild: Evidence from the Field ; In Advances in Behavioural Economics, Camerer, C. F., Loewenstein G. and Rabin M., eds. Princeton University Press: Princeton N.J. Clower R. and Howitt P Taking markets seriously: groundwork for a Post Walrasian macroeconomics. In Beyond Microfoundations: Post Walrasian macroeconomics. Colander D., ed. Cambridge University Press: Cambridge U.K. Colander D Overview ; In Beyond Microfoundations: Post Walrasian macroeconomics. Colander D., ed. Cambridge University Press: Cambridge U.K. Colander D. and van Ees H Post Walrasian macroeconomic policy ; In Beyond Microfoundations: Post Walrasian macroeconomics. Colander D., ed. Cambridge University Press: Cambridge U.K. Corbett, J. and T. Jenkinson How is Investment Financed? A study of Germany, Japan, the United Kingdom and the United States. The Manchester School Supplement. pp Coutts, K., Godley, W. and Nordhaus, W Industrial pricing in the United Kingdom. Cambridge University Press: Cambridge U.K. Eichner A The Macrodynamics of Advanced Market Economies. M.E. Sharpe: Armonk N.Y. Godley W. and Cripps F Macroeconomics. Fontana Paperbacks: Oxford U.K. Godley W. and Lavoie M Monetary Economics: An integrated approach to credit, money, income, production and wealth. Palgrave Macmillan: Basingstoke U.K. Graziani A The Monetary Theory of Production. Cambridge University Press: Cambridge U.K. Nell, E Monetising the Classical Equations: a theory of circulation. Cambridge Journal of Economics, 28, pp