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A Foxy Hedgehog Wynne Godley and Macroeconomic Mod
A Foxy Hedgehog Wynne Godley and Macroeconomic Mod
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A foxy hedgehog: Wynne Godley and
macroeconomic modelling
The fox knows many things, but the hedgehog knows one big thing (Archilochus, seventh
century BCE)
At first glance, Wynne Godley, in his macroeconomic modelling, looks like one of Isaiah
Berlin’s (1993) hedgehogs. After all he is best known for constructing rather large computer-
based simulation models in which the accounting has no ‘black holes’. An income inflow to
an ‘institutional sector’ (households, firms, government, finance and the rest of the world) is
made up of outflow(s) from other sector(s). Similar rules apply to financial transactions such
as borrowing or lending, sale or purchase of securities, etc. The flows are cumulated over
time so that the model is ‘stock–flow consistent’. The effects on wealth of gains and losses in
asset prices are carefully accounted for, as are differential inflation rates in prices for goods
and services. Surely someone who puts so much effort into one complicated construct is
more like Plato than Aristotle, Einstein than Feynman, Proust than Joyce.
In fact, Wynne’s important contributions are foxy—brilliant innovations (or ‘tricks’,
using the word in its sense of a neat technical advance) that feed into the architecture of his
models. I have appropriated quite a few of them myself (illustrated below). I will evaluate
them here in the context of his recent book with Marc Lavoie (2007), a major update of
a previous synthesis by Godley and Francis Cripps (1983).
1
As with the postulate that national income equals output, FOF accounting was more of an American
institutionalist than a British innovation (Copeland, 1952). But it fits perfectly into a NIPA/FOF/FAM matrix
formulation.
2
The fundamental equations boil down to an income 5 expenditure balance for a two-sector (consumer
and capital goods) economy feeding into the definition of an overall price index with the twists that nominal
‘saving’ and ‘income’ are defined not to include windfalls (so saving cannot equal investment unless windfalls
are zero). The famous widow’s cruse (Keynes, 1930, vol. 1, p. 125) says that if entrepreneurs choose to save
less of their ‘normal’ profits, then in a new equilibrium windfalls will rise just to offset the higher spending,
squeeze out consumption from wage income and hold real investment constant.
3
Kalecki was thinking along similar lines (Kreisler and McFarlane, 1993), and visited Cambridge in 1955.
642 L. Taylor
G is government spending, and E and M are, respectively, inflows from and outflows to the
rest of the world on current account.
‘Demand’ and ‘supply’ relationships for each entry could be written down, making 14
variables in all, subject to equation (3) and seven equations setting values of demand (price 3
quantity) equal to supply.1 If all budget constraints are satisfied, then because of equation
(3) only six of the seven demand–supply balances will be independent. Demand and supply
for one ‘last’ variable (say, imports M) will be equal if all other balances clear.
The Godley–Lavoie analysis of closure often involves treating variables as alternatively
endogenous or exogenous. For example, if the domestic currency value of the banking
system’s foreign reserves is eR* with e as the exchange rate (units of local currency per unit
of foreign currency) and R* as reserves in foreign currency, then the relevant demand–
In one closure (discussed below), Godley and Lavoie fix e and point out that equation (4)
will hold as an equality when there are separate behavioural equations (essentially balance
sheets of the home and foreign banking systems) for reserve demand R*d and supply R*s
and all other demand–supply balances are satisfied. Or else they target R*d and allow
a floating exchange rate e to equilibrate the open economy macro system.
Switching the causal role of key variables is one way of addressing closure but the issue
goes slightly deeper—Keynes in the 1930s had a worldview and policy priorities distinct
from those of Keynes in the 1920s and Kaldor in the 1960s—with implications that deserve
to be explored. Nevertheless it is clear that discussions of closure always involve
mechanical counting of equations and variables, or otherwise keeping track of degrees of
freedom within a model.
As noted above, stock variables shift over time via cumulation of flows from NIPA and
FOF accounts combined with capital gains and losses due to shifting asset prices.
Accounting for these processes leads naturally into SFC modelling. Godley has always
preferred to work in discrete time, responding to the way the data are presented. For
example, eR* at the end of a period (a quarter or a year) is the value at the beginning shifted
by the sum of capital and current account surpluses in foreign currency over the period (an
increase in R*) and nominal depreciation (an increase) or appreciation (a decrease) in e
between the beginning and end.
Keynes assumed that the markets for the financial stocks making up investors’ portfolios
clear in the same time frame as flows such as investment and saving on the real side of the
economy. James Tobin and Godley extended flow-flow analysis by inventing models
incorporating stocks and flows in ‘Yale’ (Brainard and Tobin, 1968) and ‘New Cambridge’
(Godley and Cripps, 1976, 1983) variants.2 Both projects petered out by the late 1980s.
Monetary Economics takes up the effort again.
On the usual interpretation, the General Theory emphasised interest rate adjustment,
which clears one of two markets for money and bonds in which supplies are fixed (if one
1
For example, consumption demand will be Cd and supply Cs, with Cd 5 Cs in equilibrium. The
quotation marks in the text are meant to signal that both behavioural relationships and accounting balances
influence demand and supply. The ‘supply’ of tax revenue, for example, follows from income levels and tax
rates. ‘Demand’ might be set by government spending less net borrowing.
2
The ‘New Cambridge’ label was applied to the work of Godley and colleagues by Kahn and Posner
(1974), with emphasis on interactions between domestic and foreign net borrowing as discussed below. Dos
Santos (2002) gives a complete review of the Godley and Tobin approaches to financial modelling.
Wynne Godley and macroeconomic modelling 643
market clears then so does the other, as discussed above). When they introduce financial
markets, Godley and Lavoie also use a limited spectrum of securities (money, bonds,
equity, and not much else) but reverse the closure along post-Keynesian lines. They fix the
interest rate and let money supply adjust via endogenous open market operations to meet
demand.1
At the time, Tobin and Godley’s specification of dynamic models with complete and
consistent dynamic accounting was a major advance. Many modellers followed in their
path—real business cycle (RBC) practitioners in the mainstream, Chiarella et al. (2005)
among Keynesians and the people who construct computable general equilibrium (CGE)
models, among others. Godley and Lavoie are certainly correct in emphasising the
desirability of consistent accounting, but they are not alone because a lot of people have
C 5 a 1 D 1 a2 V ð5Þ
Household disposable income is D 5 (1 – t)Yp. Plausible parameter values might be a1 5
0.9 and a2 5 0.04.The dimension of a1 is (flow per unit time)/(flow per unit time),
independent of the choice of the unit of time. In contrast, the dimension of a2 is (flow per
unit time)/stock. The value of 0.04 (maybe a bit low, given recent econometrics) for a2
1
That is, the variables represent nominal values divided by ‘appropriate’ price indexes. Nominal (price 3
quantity) valuations show up with a vengeance in Table 3.
Wynne Godley and macroeconomic modelling 645
Table 1. Social accounting matrix for a simple macro model
(A) C G X
(B) V jH Yp
(C) tYp Yg
(D) Sp 2H _ 0
(E) (Sg) H_ 0
Totals X Yp Yg 0
H V
refers to US consumption per year, i.e 4% of wealth is consumed annually. They change
later in the book, but Godley and Lavoie set their initial parameter values to a1 5 0.6 and
a2 5 0.4. The number for a2 is remote from all econometrics I have seen—the unit of time
looks more like a decade than a year. Apparently the parameters were chosen to be
‘reasonable’ in an introductory model that does not include investment but some
discussion about time dimensionality would have helped.
In continuous time, wealth accumulation is
dV dt 5 V _ 5D2C ð6Þ
_
Combining equations (5) and (6) and setting V50 to determine a stationary solution gives
5 1 2 a1 D
V 5 a3 D
ð7Þ
a2
with the bars signaling the steady state. The a2 coefficient summarises the relationship
between income and wealth that households desire. It is the model’s stock–flow norm.
D,
When equation (7) is satisfied, equation (5) shows that C5 i.e. when V5V household
saving is zero. For my parameter values quoted above a3 5 2.5, in the same ballpark as the
observed household ratio in the USA. Godley and Lavoie initially get a3 5 1, which is too
low. In a growth model including investment at the end of Monetary Economics, a3 takes
a value of 3.9 with a propensity to consume from income a1 5 0.75. The implied value of
the wealth coefficient a2 is 0.064, a much more reasonable number.
Steady state stock–flow ratios like a3 show up elsewhere in macroeconomics.
Monetarists would view the norm as the inverse of velocity (a flow per unit time divided
by a stock) in a relationship such as money 3 velocity 5 nominal income.1 Another
1
If the money demand function is written as H 5 kYp with Yp interpreted as nominal income, then k 5 1/
V with V as velocity is the ‘Cambridge constant’ famous in the early decades of the last century. Post-World
War II monetarist thought focused on a target velocity toward which current value adjusts under inflation
(Cagan, 1956).
646 L. Taylor
interpretation in terms of the period of production in Austrian capital theory is suggested
below.
In the present set-up, the steady state also determines the long-term level of income
and generates Godley’s second magic ratio. The macro balance in equation (3) can be
restated as
C 2 D 1 G 2 tYp 5 0 ð8Þ
If C < D, household saving exceeds zero as in Table 1. Correspondingly G > tYp and
government net borrowing H _ is positive.
Solving equation (8) together with equation (5) we get the short run income level as
1
Which is not to say that Frank Ramsey, had he lived to a ripe old age, would have enjoyed the sight of his
growth model supplanting the ideas of Maynard (Taylor, 2004). Although they do not go so far as to invoke
Say’s Law (except insofar as observing toward the end of the book that the fiscal stance can be utilised to
target full employment), in several models Godley and Lavoie push steady states further in the classical
direction by setting the real interest rate, j, to a positive level. In the short run, household saving builds up
wealth, which is augmented by interest receipts. By the time the system reaches a steady state, higher
spending induced by accumulated interest raises the level of income. Higher interest and saving rates thereby
increase long-term output—classical results based on the government budget constraint (perhaps first noted
by Blinder and Solow, 1973) that emerge from a fiscalist macro model. The driving mechanism is weak,
however, because in practice interest receipts on government bonds are just a few percent of household
income. In an RBC-style growth model Sargent (1987) sidesteps the whole muddle by setting taxes
proportional to full capacity output plus the government’s interest payments.
Wynne Godley and macroeconomic modelling 647
or far away? Besides the velocity of money, the issue harks back to the period of production
in Austrian capital theory. Godley and Lavoie invoke a ‘bathtub theorem’ that Dorfman
(1959) quoted long ago. If the level of water in the tub stays constant, it flows in and out at
the same rate. The average number of minutes a drop stays in the tub (or the period of
production) is equal to the stock of gallons divided by the flow rate in gallons per minute.
Note that a unit of time—a minute—enters this calculation.
How rapidly does the water level change
when the flow rate shifts? The contemporary
_ @G when V5V
answer is to evaluate the derivative @ V initially. After some grinding we get
the formula
_ ð1 2 a1 Þð1 2 tÞ
The partial derivative of the right-hand with respect to a1 is negative, meaning that
convergence will be slower for a higher marginal propensity to consume. For a1 5 0.9 and
_ @G turns out to be 0.19.
T 5 0.3, @ V
This convergence rate can be compared to the steady state value of V, or
5 ð1 2 a1 Þð1 2 tÞG 5 1 V G
V
a2 t
The expression 1/V multiplying G on the right-hand side is another stock–flow norm.
From the bathtub theorem, it is the average time a demand injection takes to pass through
the macro system or, in Godley’s usage, a ‘mean lag’ toward full adjustment. For the
parameters at hand it takes a value of 5.8 so that the ‘velocity’, V, of government spending
with respect to steady state wealth is 1/5.8 5 0.17. Unlike @ V _ @G, V is an increasing
function of a1. More importantly, a time unit of one year is built into my illustrative values
of a1 5 0.9 and a2 5 0.04. Whether calculated using @ V _ @G or 1/V the time needed to
reach half the adjustment (the mean lag) is 5 or 6 years. Godley and Lavoie initially quote
4 years for 1/V, for unrealistically low and high values of a1 and a2, respectively.
In a higher order dynamical system, mean lags break down. The derivative @ V _ @G
would become a matrix of partials and one would have to examine speed of convergence
using matrix methods. See the discussion of Goodwin cycles below.
One last point on accounting: Godley and Lavoie for the most part adopt the five-way
classification of institutional sectors mentioned above.1 New Cambridge thinking in the
1970s, however, tended to consolidate households, firms and the business activities of
finance into a single private sector and then applied the foregoing analysis to come up with
a medium-term functional relationship between total private spending (not just consump-
tion) and the fiscal stance.2 The consolidation elides distinctions among consumption
(undertaken by households), residential capital formation (mostly undertaken by house-
holds) and non-residential capital and inventory accumulation (undertaken by firms). The
following section takes up a four-way disaggregation with households and the rest of the
1
That is: households, firms, government, finance and the rest of the world. Together with productive
activities, these collective actors or ‘institutions’ made up the twin pillars around which the Stone–Meade
national accounts were constructed.
2
Again there is a partial parallel with RBC models with an aggregated private sector, which automatically
directs its income not consumed into capital formation.
648 L. Taylor
private sector (including financial business) treated separately. It shows that the distinction
between business and households is of considerable practical import.
cycles suggests. The absence of ‘expenditure-smoothing’ by households in the data has not
been widely discussed because economists have tended to ignore their role in capital
formation. Residential investment is a key contributor to pro-cyclical private net
borrowing. As of spring 2008, how it will respond to the financial turmoil discussed above
remains to be seen (the early returns are not heartening).
Second, government net borrowing varies counter-cyclically, as in traditional fiscal
analysis of automatic stabilisers, pro-cyclical tax revenues, etc. Wynne’s point about the
counter-cyclical expansionary effects of Bush II fiscal policy early this decade shows up
clearly in Figure 3.
In his writings on policy, Wynne is keenly aware of cyclical patterns of net borrowing and
the counter-cyclical role of the government but they do not figure strongly in Monetary
Economics with its focus on steady states. In one of their models, Godley and Lavoie build
in what amounts to Metzler’s (1941) inventory cycle, but scarcely note its presence as they
plot simulation trajectories with variables oscillating as they approach a steady state. By
contrast, Chiarella et al. (2005) highlight Metzler’s inventory dynamics in their Keynesian
cyclical growth models.
immediately arise—how to set up the demand model and how to describe price formation,
inflation and income distribution. Finally, do demand and distribution interact? Godley
has made contributions on all three fronts.
With regard to price formation, he has been formulating cost-based models since the late
1950s. Monetary Economics has an intriguing chapter on the topic. Of particular interest is
the treatment of inventories and interest costs. Table 3 sets out a SAM illustrating the basic
ideas.
The accounting is tricky, but illuminating. In principle all entries in the uses-of-output
row (A) should bevalued at the same price P, as are consumption C and the change in
_
inventories Z5dZ dt with Z as the total stock. So what does the term PZ _ in cell A6
_
represent? In the language of national accountants, P is an ‘inventory valuation
adjustment’ or IVA applied to Z within the relevant accounting period. If the price of
inventories moves during the period, then the capital gain or loss should figure into
nominal output P X̃ with X̃ as ‘real’ output incorporating the IVA.1
Column (1) gives a decomposition of costs of production into the wage bill (with w as the
money wage and b the labour–output ratio), profits (with p as the profit share of the value
of output PX) and interest costs of holding inventories (with i as the nominal interest rate
and PZ the value of existing stock). This accounting is somewhat non-standard because
interest payments are not normally treated as costs, but rather as transfer payments as in
cell B3 of Table 1. But as anyone who has ever driven past an American car dealership can
realise, the owner’s outlays for interest on the finance to display 500 slowly selling Ford or
GM vehicles must be appalling.
Rows (B)–(D) in Table 3 summarise income flows. In row (D), banks get an income
Yb 5 iPZ from firms’ interest payments, which are transferred over to total profits in cell
C4. Another source of profits is pPX from production in C1. If the cost of inventories rises,
then producers take a capital loss 2PZ _ in cell C6. Column (3) says that all profit income
Yp from row (C) is saved, to be invested in inventory accumulation P Z_ in cell E5 in the row
1
The correction makes more sense in discrete than continuous time, but we retain the latter because of its
more compact notation.
Wynne Godley and macroeconomic modelling 651
Table 3. Social accounting matrix for a model with inventories and mark-up pricing
(A) PC P Z_ _
PZ P X̃
(B) wbX Yw
(C) pPX Yb _
2PZ Yp
(D) iPZ Yb
(E) Sp 2P Z_ 0
Totals PX Yw Yp Yb 0 0
for flows of funds. Finally, row (B) defines wage income Yw, which is spent on consumption
PC in column (2).
Now we can bring in pricing. Standard mark-up theory is based on column (1). If firms
set their stock of inventories in proportion to output,1
Z 5 jX
then the decomposition into costs of the total value of output PX running down the column
is
Pð1 2 pÞX 5 ðwb 1 ijPÞX ð10Þ
Godley and Lavoie, however, believe in full-cost (or normal-cost) pricing along lines
proposed by _
Hall and Hitch (1939). They include the producers’ IVA loss 2PZ52P̂jPX
_
(with P̂5P P being the rate of price inflation) as an additional component of cost on the
1
That is, j is another stock–flow norm. The Metzler inventory cycle model mentioned above adds partial
adjustment dynamics such as Z5f_ ðjX2ZÞ.
652 L. Taylor
right-hand side of equation (10). Rearranging gives a mark-up pricing equation of the
form,
wb
P5 ð11Þ
1 2 p 2 ði 2 P̂Þj
In words, the price level is formed as a mark-up on wage cost, with the mark-up rate
increasing as a function of the profit share p and the real interest cost ði2P̂Þj of financing
inventory.1 The partial derivative of P with respect to i2P̂ is equal to Pj/c where c is the
labour share. With P normalised to 1 initially, the implication is that an increase in the
interest rate of 1% might raise the price level by, say, (0.15/0.75)% 5 0.2%—a non-trivial
c 5 v=e or ĉ 5 v̂ 2 ê ð12Þ
where the ‘hats’ alternatively can denote logarithmic differentials or growth rates and c is
the wage share, v 5 w/P the real wage, and e 5 1/b average labour productivity. Because
the wage share fluctuates within a well-defined range (less than 10 percentage points of
1
Equation (11) is Godley’s rationale for setting the real interest rate as j5i2P̂, in contrast to the usual
invocation of Fisher (1930) arbitrage. Note that P̂ from the IVA is in principle observable, while the arbitrage
argument rests on an expected rate of inflation.
2
Latin American inflation theory was in part stimulated by Kalecki in lectures delivered in Mexico City in
1953, available in English (Kalecki, 1979). The model is not far from Keynes’ in the Treatise.
Wynne Godley and macroeconomic modelling 653
GDP in the USA) it is a useful variable to analyse. The same is true of another ratio,
‘capacity utilization’.
To see what that means, suppose that besides labour there is another ‘input’, say
‘capacity’ as estimated by a Hodrick–Prescott filter or some such smoothing procedure
applied to a time series of real GDP, or ‘capital’ as estimated by perpetual inventory
methods. Let r be the real return to the input (call it K), u 5 X/K be capacity utilisation
and p 5 1 – c be the non-labour share. Then parallel to equation (12) we have
p 5 r=u or p̂ 5 r̂ 2 û ð13Þ
with
This equation looks innocuous, but in reality has both cyclical behaviour and
distributive conflict built in. One useful closure of equations (12)–(14) can be written as
c
p̂ 5 r̂ 2 û 5 ðê 2 v̂Þ ð15Þ
p
With c in the range of 0.6–0.7 (depending on how one classifies proprietors’ incomes, wage
taxes and subsidies, etc.), the growth rate of the profit share is strongly affected by the
difference between the growth rates of labour productivity and the real wage. Quite a bit is
known empirically about equation (15).
In an economy with positive per capita income growth, there will be a trend component
of ê and possibly û. Even though they are crucial for growth analysis, for the moment we
ignore productivity trends and possibilities for endogenising them along Kaldorian lines.1
Cross-sectional ‘wage equations’ and the bulk of evidence from time series suggest that the
real wage is related positively—certainly not inversely—to capacity utilisation (itself, of course,
an endogenous variable in a fully specified system). Conflicting claims on inflation theories
usually postulate that the money wage w is an increasing function of capacity utilisation. The
price level P, in turn, may respond to cost-push as well as demand. To generate a pro-cyclical
real wage the mark-up factor (1 – p)21 must vary with demand. Chiarella et al. (2005)
develop several models using separate nominal wage and price Phillips curves.
Most people believe that average labour productivity is also related positively to capacity
utilization.2 If productivity, to an extent, leads utilisation while the real wage lags, then
from equation (15) the profit share can be expected to increase early in an upswing and
drop off closer to the top. If effective demand itself responds to distribution, then the scene
is set for a distributive cycle along Goodwin’s (1967) lines. In a discrete-time econometric
model, ‘profit-led’ demand (as appears likely in the USA) and a ‘profit squeeze’ at the top
of the cycle naturally generate counter-clockwise Goodwin cycles in a phase diagram in the
(u,c) plane (Barbosa-Filho and Taylor, 2006). Without ongoing shocks the cycles would
converge to a steady state ð with magic ratios for capacity utilisation and the labour
u; cÞ
1
For the past several decades, rapidly growing East Asian economies have had upwardly trending capital–
output ratios, to a large extent as an algebraic consequence of their fast labour productivity growth and
increasing capital–labour ratios. See Rada and Taylor (2006) who also deal with Kaldorian growth models
built upon SAM-style accounting.
2
The usual rationales are blue collar labour-hoarding by firms at the bottom of the cycle, or else the
presence of overhead labour as a ‘fixed cost’. RBC models made their initial popular breakthrough by linking
pro-cyclical real wages with productivity-increasing technological shocks.
654 L. Taylor
share. But in practice there are always perturbations and parameter changes so the steady
state itself is shifting. Cycles persist.
Coming back to the questions posed at the beginning of this section, price formation on
the basis of conflicting claims and output determination by effective demand interact. If
rising productivity is brought back into the picture, a cyclical growth model begins to
appear. It is still under construction but may be worked out over the next few years.
Monetary Economics does not consider cyclical growth explicitly, but it is a natural
extension of its authors’ modelling philosophy.
Nor do Godley and Lavoie address possible financial cycles. They point out overlaps
between their accounting approach and Minsky’s (1975) view of macroeconomics. The
model in his book on Keynes broadly follows the General Theory’s chapter 22 on trade
655
Downloaded from http://cje.oxfordjournals.org by Ramanan V on April 30, 2010
656 L. Taylor
Table 5. A two-country financial accounting matrix
Liabilities
Assets
Home bank Tb eR*
M
Home private Th eT*h M V
Foreign bank R eT*b
eM*
Foreign private Tf eT*f eM* eV*
foreign banks and the foreign private sector also hold T-bills. The corresponding flow terms
are omitted in Table 4 to keep its size down, but could be included by using more FOF
accounting balances in a fully consistent model.
In row G, government has three sources of funds so one (or two) of them must be negative.
They are saving SG, bill issues T_ and a transfer eD* from the foreign country, valued in
foreign prices at D* and translated into local prices by e. (The foreign government’s sources
of funds are saving S*G and new bond sales T_ *, which are used to finance D*).
The exchange rate basically scales one country’s economic activity in terms of the others.
The last three rows, incorporating a neat Godley trick to fit cross-border flows into the
accounts of the SAM, show how the scaling works.
Home country exports PE in column 4 have their sign ‘flipped’ to negative down the
column. They then are transformed to foreign prices by multiplication by –(1/e) and
emerge as foreign country imports PE/e in cell (H1*). Similar manoeuvres in rows I and J
transform foreign exports P*E* into home imports eP*E* and similarly for the transfer [D*
becomes eD* in cell (G7)].
This SAM representation raises several interesting points. For the home country the
current account deficit or ‘foreign saving’ is equal to
SF 5 eP*E* 2 PE 5 eD*
This equation follows directly from double entry bookkeeping when import and export
markets clear and the transfer goes through.
In other words, there is no balance of payments per se. Import and export levels in both
countries follow from effective demand and the exchange rate. Cross-border bond
movements are determined from financial markets (see below). If interest rates were
included, factor payments would also have their own determinants. Godley and Lavoie
emphasise that the widely used Mundell–Fleming IS/LM/BP model makes no sense
because there is no independent equation for the home country’s external balance or ‘BP’.
However, there is a ‘duality’ between the exchange rate e and the transfer D*. In
a demand-driven closure for a flow–flow model based on Table 4, investment and
government spending would be pre-determined in both countries. Their price systems
would be based on cost functions anchored on nominal wages and the exchange rate. On
these assumptions, either e or D* could be pre-determined but not both. Traditional
treatments of Mundell–Fleming postulate duality between e and reserve changes R*._ But of
course there is no particular reason why home’s current account surplus (‘at world prices’),
_
–D*, should equal its change in reserves R*—as discussed below, capital movements can
Wynne Godley and macroeconomic modelling 657
easily intervene. In one scenario, the exchange rate is set in asset markets. Then current
accounts in a two-country model must be endogenous (with the same magnitudes and
opposite signs).
As Godley apprehended in 1974, after substituting through, the SAM overall macro
balance in the home country is
ðSY 2 PIÞ 1 ðZ 2 PGÞ 1 ðeP*E* 2 PEÞ 5 0
saying that the sum of all institutional sectors’ levels of NAFA must equal zero.1 This condition
is the same as equation (1) with signs reversed and can be derived directly from the SAM.
If the global accounting in the SAM is consistent, the sum of all countries’ external
deficits will be zero. Global macro balance is not an independent restriction on the world
1
The algebra is presented in an appendix to the open economy chapter in Monetary Economics.
2
Thanks to Egor Kraev for inventing the FAM set-up in Table 5.
658 L. Taylor
Walras’s Law says that the sum of excess supply levels is zero,
2 M 1e M*
M 2 M* 1 T 2 Th 2 Tf 2 Tb 2 R 1e T * 2 Th* 2 Tf* 2 Tb* 2 R* 5 0
Substituting through the balance sheets shows that Walras reduces to the world wealth
balance
V 1 eV* 5 T 1 eT *
which holds in and out of full equilibrium.
Taylor (2004) shows that if one bond market clears then national wealth levels follow
from Walras’s Law,
with N(e) as the net foreign assets (NFA) of the home country,
NðeÞ 5 eðTh* 1 R*Þ 2 Tf 1 R 5 ðeTh* 2 RÞ 2 Tf 2 eR* ð16Þ
NFA depends on e but otherwise is determined historically from payments flows. The
expression after the second equality shows that NFA is the difference between the two
countries’ private sector holdings of external bonds and their international reserves. For
example the USA’s highly negative NFA shows up in the form of minimal reserves (eR*)
and large foreign private holdings of US liabilities (Tf) combined with substantial dollar
reserves abroad (R).
After the first equality in equation (16), home’s gross external assets and liabilities
are e(T*h 1 R*) and (Tf 1 R). For a given exchange rate, these two totals can only change
over time via a current account deficit or surplus. The T_ and T_ * flow terms in a SAM like
Table 4—appropriately expanded to include flows of funds of all the actors in
Table 5—cumulate into stocks of bonds in the FAM.
A capital inflow at a point in time can be treated as a jump upward in Tf . In the first instance
it would have to be matched at home by a jump in reserves and in the foreign country by
downward jumps in money and/or domestic bond holdings. Details appear below.
Because (T*h 1 R*) and (Tf 1 R) are constant in the short run, we get
dN=de 5 ðTh* 1 R*Þ > 0 ð17Þ
Devaluation leads to an increase in home NFA.
The NFA balance can also be used to show that in each country if the excess supply of
bonds is zero then so is the excess supply of money and vice-versa. The two-country system
resembles the traditional one-country liquidity preference model in which if the bond
demand–supply balance clears then so will the balance for money as well.
Assume that shares of home and foreign wealth devoted to money and the two flavours of
bonds satisfy the restrictions m 1 h 1 u 5 1 and m*1h*1f*51, with shares presumably
depending on interest rates i and i*, the exchange rate, the level of economic activity, etc.1
Table 5 is extremely simple, but it can be used to draw interesting conclusions about the
impacts of a ‘jump’ capital movement from the foreign to the home country. The
background is the experience of ‘emerging markets’ with capital inflows over the last four
1
Home and foreign portfolio shares respectively are m and m* for money; h and h* for home bonds; and u
and u* for external bonds.
Wynne Godley and macroeconomic modelling 659
decades of the twentieth century. Usually, they were followed by credit expansion along
with higher levels of economic activity and asset price booms. There was some sterilisation
but it was incomplete and interest rates tended to rise. Finally, the exchange rate often
appreciated. Three closures of the model help fence in these outcomes.
Closure 1. Fix Tb, Tb*, R and R* so that money supplies in both countries are determined
by the banking authorities—this is the original 1960s story about portfolio balance. Also fix
the exchange rate e. In the home bond market Th and Tf are free to vary, as are eTh* and eTf*
in the foreign bond market.
The standard adjustment story has i (i*) rising in response to an excess supply of home
(foreign) bonds so that interest rates can clear bond markets. The NFA balance holds after
this happens and money markets clear. Money demand levels adjust to equilibrate the
From Walras’s Law we know that there are only three independent equations in this
4 3 4 linear system. We need another restriction, in effect to scale the supply side. For
1
For the details see Taylor (2004).
660 L. Taylor
a ‘small’ country, the obvious assumption is that foreign banks’ holdings of home country
bonds as reserves are fixed (presumably at zero). Then R determines Tb from the home
bond market balance. Home reserves eR* follow directly from the money market balance.
The foreign money market balance determines bank assets eTb*.
All of this leads to 100% sterilisation of a capital inflow because asset demands are held
constant by assumption. For the details, consider the foreign portfolio shift discussed
above. From the home bond market balance, the home banking system’s holdings of home
bonds, Tb, fall by ed*. The home money balance shows that foreign reserves eR* go up
equally, offsetting the drop in eTf* in the foreign bond market clearing equation.
The key difference between closures 1 and 2 is that in closure 1 four variables—Tb, Tb*,
R and R*—had to be set to control money supplies. With R and e exogenous, the three