Journal of Economic Issues

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The Creation and Circulation of Endogenous

Money: A Circuit Dynamique Approach

Louis-Philippe Rochon

To cite this article: Louis-Philippe Rochon (1999) The Creation and Circulation of Endogenous
Money: A Circuit Dynamique Approach, Journal of Economic Issues, 33:1, 1-21, DOI:
10.1080/00213624.1999.11506132

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 •
Jer JOURNAL OF ECONOMIC ISSUES
Vol. XXXIII No. I March 1999

The Creation and Circulation of Endogenous

Money: A Circuit Dynamique Approach
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Louis-Philippe Rochon

Endogenous money has traditionally been recognized as the quasi-exclusive do-

main of Post Keynesian political economy, and many authors consider it the "coping
stone" of Post Keynesian macroeconomics [Chick 1995; Palley 1992].
But as the paradigm developed, disagreements over how money becomes endo-
genous lead to crucial debates about the nature and mechanics of endogeneity. In
this journal, L. Randall Wray [1992] has summarized the various approaches to
money both in orthodox and heterodox traditions. This led to a subsequent debate,
again in this journal, between Wray [1995] and Basil Moore [1995]. This has raised
questions as to whether Post Keynesians are united in their views on money [Traut-
wein 1995]. Robert Pollin [1991] had previously identified two distinct approaches
within Post Keynesian thought: the structuralists and the accommodationists-or
horizontalists, following Moore. And while some [Pollin 1996] see the differences
as irreconcilable, others [see Moore 1996; Lavoie 1996a] insist the differences are
largely a matter of emphasis rather than substance. Since then, it has appeared that
these differences have widened rather than narrowed.
These debates, however, have masked crucial arguments with respect to Post
Keynesian monetary theory. In particular, most Post Keynesians have failed to no-
tice that, in some respect, Post Keynesian monetary theory shares many insights

The author is the Stephen B. Monroe Assistant Professor of Economics and Banking at Kalamazoo
College, Michigan. He is also affiliated with the Transfonnational Grawth and Full Employment Project
at the New School for Social Research, under Edward Nell. All emphasis as in original unless Wren
otherwise indicated. This paper was made possible due to the generous financial support of the Social
Sciences and Humanities Research Council in Canada. The author would like to thank, in alphabetical
order and without implicating them, Garret Bekker, Riccardo Bellofiore, Augusto Graziani, Marc Lavoie,
Marcello Messori, Edward Nell, Alain Parguez, Emesto Screpanti, Mario Seccareccia, John Smithin,
Matias Vemengo, and the members of the Transfonnational Grawth Project.

1
 2 Louis-Philippe Rochon

with orthodox theory. Emphasis is placed on the supply and demand of money as an
asset and where the existence of money itself is linked to uncertainty (yet again,
money as an asset). The treatment of money resulting from a credit-flow and discus-
sion of its creation, circulation, and destruction have become secondary issues.
These shortcomings have generated an alternative Post Keynesian approach, one
that is critical of orthodox monetary thought, but also of "mainstream" Post Keynes-
ian economics, or what I have elsewhere called "neo-Post Keynesianism" [Rochon
1999a]. According to these heterodox economists, alternatively labeled circulation-
ists or circuitists, Post Keynesian monetary theory does not constitute a clear
enough alternative to orthodox monetary thought.
While there is significant common ground between these two Post Keynesian
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groups, there are also some important differences. In fact, Stephen Rousseas [1996,
677] claims that both approaches are "related." For Marcello Messori [1985, 210]
they are "complementary," while for Richard Arena [1996, 431] they are "more
complementary than analogous." While they are definitely complementary, the the-
ory of the monetary circuit must be seen as a more "general" approach and a better
foundation for developing a monetary theory of production in the heterodox tradi-
tion, while neo-Post Keynesian theory can be inserted within this more global ap-
proach.
An interesting way of seeing each approach is to argue that both are rooted in
Keynes, although a very different Keynes. Post Keynesians take the General Theory
as the starting point and then try to reconcile Keynes's later writings in the Eco-
nomic Journal with it. These articles are then seen as an attempt by Keynes to clar-
ify or to defend the General Theory. The other approach [see Rochon 1997] sees the
post-General Theory articles as wholly different, an attempt by Keynes to distance
himself from some aspects of the General Theory. In this sense, it is the General
Theory that ought to be interpreted in light of the views developed within the Eco-
nomic Journal articles. Circuitists have developed a different aspect of Keynes, see-
ing him as more radical than Post Keynesians would care to admit (see also
Keynes's Treatise on Money).
The purpose of this article, however, is not to explore the intricate differences
between the two approaches; I will leave this to the reader upon which to carefully
reflect. Rather, I propose to outline the broad themes of this Post Keynesian alterna-
tive approach to credit and money endogeneity.
To develop a Post Keynesian monetary theory without the "vestigial traces" of
orthodox thought, it is suggested here that Post Keynesians turn to the writings of
their European cousins, the French and Italian circuitists who have emerged in the
last 30 years. Due to their history, circuitists have been largely shielded from Conti-
nental or British monetary developments. In a sense, the development of their views
on money was not a response to Friedman, as was the case for Hyman Minsky, Paul
Davidson, and even Nicholas Kaldor [Rochon 1999a]. Rather, they were influenced
 The Creation and Circulation of Endogenous Money 3

by Keynes (his Treatise and post-General Theory articles), Michael Kalecki, and
Knut Wicksell, not to mention Karl Marx and Joseph Schumpeter.
Rather than seeing money based on demand functions for money balances
(which plays a secondary role), circuitists place the emphasis on the creation and
the ultimate destruction of "money" where banks are at the center of credit creation,
and the creation of profits is necessary to extinguish all debt. The emphasis is on a
flow approach to credit endogeneity and not on portfolio decisions, uncertainty, or
contracts. 1 A good collection of their views can be found in Edward Nell and Ghis-
lain Deleplace [1996] and in past issues of Economies et Societes: Monnaie et Pro-
duction.
It will be argued that money endogeneity is unrelated to the role and powers of
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the central bank. Rather, it is part and parcel of the production process, with the
emphasis placed on commercial banks as ex nihilo creators of money. In other
words, money is endogenous because of production and not because of the accom-
modative role of the central bank. As Marc Lavoie [1984, 778] makes clear,
"Money is in some way endogenous whether central banks are dynamic or not."
Also, "Accommodation or the lack of it, liability or the lack of it and financial inno-
vation or the lack of it are second-order phenomena to the crucial causal story that
goes from debt to the supply of the means of payment" [Lavoie 1996a, 533].
In this respect, circuitists part company with many Post Keynesians who have
traditionally argued that endogeneity rests on the accommodative role of the central
bank [see Moore 1979]. While the central bank does have a role, it is constrained to
setting the level of the real (and nominal) rate of interest, thereby influencing the
term structure of interest rates.
Finally, this analysis will show why the theory of the monetary circuit is also
called a theory of the "dynamic circuit,"2 or, as Lavoie [1987, 91] calls it, a theory
of the "dynamic history of the production process. " In this respect, the theory of the
monetary circuit is not only a theory of the creation of money, but is also a theory
of distribution and accumulation. As Augusto Graziani [1996, 4] explains, "The
very formation of profits is explained by the presence of money, as well as by the
way in which money is created and introduced into the market circuit. "
As a last note, this article is not meant to be an exegesis of Keynes, but rather a
general presentation of the circuit approach, which, it is hoped, Post Keynesians
will accept and help to develop.

Credit and Money: An Alternative View

From the Treatise on Money to his articles in the Economic Journal (1937-1939)
and through the General Theory, Keynes's intellectual development and his attempt
at building the foundations of a monetary economy of production slowly progressed
 4 Louis-Philippe Rochon

toward the recognition of credit-money as the central institution of modem capital-

ism.
For Keynes, modem economies cannot adequately be described as barter econo-
mies (or real-wage economies), and attempts by neoclassical theorists (whom
Keynes called "classical") to do so could only lead to "fundamental misunderstand-
ing of the way the economy in which we live actually works." In a chapter con-
tained within the first proofs of the General Theory, but which did not make it to the
final version, Keynes [1979, 67-68] describes his endeavor as follows: "It is to the
theory of a generalised monetary economy ... that this book will attempt to make a
contribution." Elsewhere, Keynes [1973b, 411] makes a similar statement: "Accord-
ingly I believe that the next task is to work out in some detail a monetary theory of
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production, to supplement the real-exchange theories which we already possess. At

any rate that is the task on which I am not wasting my time. "
Keynes's mistake was precisely his ambitious objective, however. In attempting
to build a theory of a monetized economy of production, he failed to produce a the-
ory of money. Of course, there are passages in the Treatise that can be interpreted
within the context of endogenous money, as there are some other passages in the
post-General Theory articles in the Economic Journal that can certainly be seen as
defending even a horizontalist position of endogenous money [see Rochon 1997].
Some may want to argue that the General Theory can be made consistent with a the-
ory of endogenous money, or, as Gladys Parker Foster [1986] claims, it requires
money to be endogenous. But Keynes did not clearly spell out the proper sequence
of events leading to the creation of money. He never really argued in terms of re-
versed causalities between deposits and loans. Ironically, this is also the criticism
raised by Jean de Largentaye [1979, 12] against Keynes's General Theory. Accord-
ing to the author, the General Theory is not "in a subsidiary way a theory of money,
but rather a theory of a monetized economy . . . [where] the theory of employment
and the theory of money are merely two facets of one and the same analysis. "
Because credit-money enters into entrepreneurs' decisions to carry out planned
production and investment, there cannot be an analysis of economic activity-at nei-
ther the micro nor the macro level-without a prior understanding of-and a simul-
taneous discussion of--<:redit and the process of money creation. As Graziani
[1990, 8] claims, "The existence of money alters the structure and inner workings
of economic systems, and modifies the behavioral functions of the agents." Money
therefore becomes a "social reality within the system: a non-commodity in a uni-
verse of commodities" [DeVroey 1984, 383]-that is, a social institution. Money
cannot be added to models as a simple afterthought. As Lavoie [1984, 773] argues,
"The integration of money in the economic system must not be done when output is
already specified, as in the exchange economy of general equilibrium models or
even in models ii la Clower-Leijonhufvud ... but rather must be introduced as part
of the production process. "
 The Creation and Circulation of Endogenous Money 5

But a clear distinction should be made between credit and money, as they are not
the same. The simplest way to differentiate between them is to say that credit is an
asset of banks, while money is their liabilities. But there is more: credit holds a spe-
cial place because it creates money. With respect to production, credit precedes pro-
duction, while money is created during the process of production, as the entre-
preneur draws down his or her bank account to pay wages or to purchase other raw
materials. As Graziani [1985, 164] argues, "If a bank's finance, while guaranteed,
has not yet been used, the corresponding liquidity has not yet been created, and it is
not possible to talk of the existence of liquidity." As Gerard Mondello [1985, 387]
has made clear, the central question becomes the "penetration of bank money in a
capitalist economy of production." This view is echoed by Christian Goux [1987,
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601]: "Finance becomes a monetary advance necessary for firms to distribute in-
comes as production begins. "
Right away, this represents a considerable difference between circuitists and
Post Keynesians. Whereas Post Keynesians emphasize the relationship between
money and contracts and uncertainty [Davidson 1972; Carvalho 1995], circuitists
stress the relationship between banks and firms. For Post Keynesians, therefore,
money is primarily a unit of account in which contracts are expressed. According to
F.C. Carvalho [1995, 20], the "cornerstone of Post Keynesian monetary analysis is
the relation between money and contracts." For circuitists, money is foremost a unit
of circulation. The Franco-Italian circuitists have emphasized the role of credit-
money as purchasing power, rather than as a stock of wealth [Parguez 1987; Graz-
iani 1985, 1990, 1996; Schmitt 1984; Lavoie 1984, 1992].

The Circuit of Money

The division of society prevalent in Kaleckian macro theories of income distribu-

tion and economic growth also forms the foundation of the circulationists' theory of
credit and money. Within the context of credit economies, circuitists' macro models
of money are traditionally divided according to a specific hierarchy of agents. These
three macro sectors-or what Graziani [1990, 8] refers to as the "relationship
among macro-groups"~onsist of banks, firms, and wage earners. Banks supply
the much-needed credit to firms that undertake production and investment. As such,
they determine the allocation of productive resources. Wage earners supply the in-
tellectual and physical labor. The theory of the circuit is set within what Kalecki has
called the "pseudo-monopoly"--that is, where firms are further subdivided into
goods-producing and investment-producing [Vallageas 1988].3 As Alain Parguez ex-
plains, "The Keynesian circuit is the entire hierarchy of flows corresponding to the
global process of production" [quoted in Poulon 1990, 384].
In what follows, the circuit is defined as both a theory of credit, money, and
production (i.e., the level of economic activity is not independent of the supply of
 6 Louis-Philippe Rochon

credit and of how money circulates) and as a theory of profits and distribution. The
division of society among the various groups helps in understanding the income dis-
tribution role of money, that is, the ability of capitalists to determine their own lev-
els of profits through their access to credit [Kalecki 1971). As such, the ex nihilo
creation of money is the result of the complexity of the relationship between three
specific causal relationships: banks and firms, firms and workers, and banks and
households. At the heart is the notion that money is part of a circuit, and as such it
is first created by credit, then circulated, and finally destroyed. A monetary econ-
omy is therefore viewed as existing through a specific sequence of irreversible
events where the principle factor is the "essentiality of money" [Parguez 1986, 24).
Before turning to a discussion of the circuit itself, a further clarification is
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needed with respect to what is meant by the short period. As is well known, Keynes
set the General Theory within Marshall's short period of "a few months to a year,"
where the stock of capital (and money) is considered fixed. This definition is prob-
lematic within the context of a circuit, however, since it does not allow for accumu-
lation. Taking this fact into consideration, circuitists define the short period as
"merely the consequence of the duration of the credit" [Nell and Deleplace 1996,
13). This suggests that the Keynesian short-period is defined as the average interval
of time needed for banks to evaluate the ability of firms to generate a profit from an
initial expenditure. Alternatively, the circuit is not only defined as the time neces-
sary for money to circulate, i.e., from the time it is created by bank credit to the
time it is destroyed, 4 but also the time needed for firms to reevaluate their produc-
tion decisions based on the refinancing of all debt at the end of the period with the
liquid saving of households. As such, it tracks the complete circuit irrespective of
whether the goods produced in 1996 were consumed the same year or years later.
There is evidence that, in fact, Keynes [1979, 81) had this concept of the circuit
in mind. First, we know he understood the Marxian notion of the production circuit,
M-C-M. But Keynes also clearly alluded to the ciruitists' interpretation of the cir-
cuit as distinct from the Marshallian short period. As can be seen from Keynes's
rough notes from his 1937 lectures:
Time relationship between effective demand and income incapable of being
made precise. In case of factors other than entrepreneurs and rentiers the two
are more or less simultaneous. For the latter income becomes determinant
and is transferred at varying subsequent dates. Not definite relationship be-
tween aggregate effective demand at one time and aggregate income at some'
later time. This does not matter. . . . When one is dealing with aggregates,
aggregate effective demand at time A has no corresponding aggregate income
at B. All one can compare is the expected and actual income resulting to an
entrepreneur from a particular decision [Keynes 1973b, 179-180; emphasis
added).
 The Creation and Circulation of Endogenous Money 7

Also, while simplification requires us to deal exclusively with a single circuit, it

must nonetheless be understood within the greater context of time. It is evident that
many circuits exist simultaneously and that the economy does not operate in such a
neat pattern-that is, circuits do not begin and end at the same moment; they are
constantly overlapping. While this complicates the story, it does not alter it in any
significant way.

The First Phase of the Circuit: Production and Investment Decisions

The monetary circuit begins with the firm's production and investment deci-
sions. Planned production and investment are therefore different from realized pro-
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duction and invesment, and the difference is precisely the ability of firms to secure
the proper amount of credit. As suggested by Keynes, the level of production is in-
fluenced by the expectations of effective demand, the level of which is determined
by short-term expectations of proceeds [Barrere 1990]. As for the factors that influ-
ence investment (changes in the capital stock), the discussion is more ambiguous;
here we assume-as did Keynes-that they are influenced by expectations of market
decisions in the long run (the stream of quasi rents-see Asimakopulos [1991]).
In determining their levels of production, as well as their accumulation of capi-
tal, firms must therefore carefully weigh the expectations of the near future relative
to those of the long run. In essence, firms carefully assess the future flow of income
generated by production. Once firms have a clearer picture of their production ac-
tivities, they then set the wage level, employment, markup, and thus prices. While
prices will be determined by a markup based on a target rate-of-return, this in no
way suggests that the markup is fixed. In this respect, there is plenty of room for in-
troducing uncertainty into the picture: firms face an uncertain future, and their ex-
pectations of profits may not be realized. The result is that they will not be able to
reimburse their debts. It is in this sense that Parguez [1996, 159] claims that firms
must "bet on the short-run profits that should be both the outcome of their current
sales and the proof banks need to support the rise in the effective capital value. "
But given that economies exist in historical time, there necessarily exists a pe-
riod of time between the production of commodities and the revenues originating
from the sales. Although this argument is made in the General Theory [Keynes
1973, 46], it is made more explicit in A Tract on Monetary Reform: "During the
lengthy process of production the business world is increasing outgoings in terms of
money-paying out in money for wages and other expenses of production-in the
expectation of recouping the outlay by disposing of the product for money at a later
date" [Keynes 1971, 33; emphasis added].
As opposed to Post Keynesians, circuitists argue that even if the costs of produc-
tion in the current period were the same as the costs incurred in the last period,
 8 Louis-Philippe Rochon

firms still could not use present proceeds from the sale of commodities produced in
the past to finance current production:
If the level of production is constant, firms receive constant revenues from
the sale of their output. But the liquidity they receive must be reimbursed to
the banks, which means that immediately after, even if firms desire to keep
output constant, they must first obtain new credit. All that can be said is that
a constant level of output requires a constant level of finance, but in no cases
can it be suggested that in a stationary state the need for finance disappears
[Graziani 1985, 167].
Thus, given the general state of a lack of finance, it becomes imperative for
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firms to have access to credit. As Alfred Eichner [1979] argues, any production
must be accompanied by the emission of loans [see also Lavoie 1984, 779]. This ap-
plies equally well to firms in the investment-goods sector as to firms in the con-
sumption-goods sector.
The primary constraint operating on firms' production plans is therefore their
ability to secure the proper amount of credit, given a level of effective demand. It
naturally follows that "credit," rather than "money," must be at the heart of any
analysis that claims to study a "monetary economy of production. "5 There is thus no
need to extend the definition of money to included other assets. The differences be-
tween Ml, M2, and other definitions of money become a secondary issue.

The Second Stage: Initial Finance and the ex nihilo Creation of Money

The second step in the monetary circuit is firms' actual access to bank credit,
which consists of an initial financing of planned production-Keynes's finance mo-
tive. This is largely achieved through the extension of loans by commercial banks.
In this sense, commercial banks-not effective demand-are at the heart of the pro-
duction process, although effective demand remains a crucial argument. 6
This subject of what costs are financed by bank credit is at the heart of consider-
able debate among circuitists. At issue is whether investment is financed by credit.
Mario Seccareccia [1988, 1996], Parguez [1987, 1997], and Louis-Philippe Rochon
[1999a] have all argued that it is. Others, for instance Graziani [1984, 1996], claim
that only wages are financed by bank credit, 7 while Nell [1998, 213] is even more
restrictive, claiming that only a portion of the wages of workers in the consumption-
goods sector is financed by bank credit. The velocity of money would then endure
that the entire production of goods circulates-otherwise, there would be too much
money. This controversy is not covered here [see Rochon 1999a]. While all these
scenarios carry important implications, they do not change the essence of the mone-
tary circuit and the notion of initial finance. The real issue is that banks play an im-
portant role in financing production. There can be no production without a prior
 The Creation and Circulation of Endogenous Money 9

bank credit. Production, as Seccareccia [1988, 51] reminds us, is "a process of debt
formation," and "bank credit is the primary mode of financing productive activity"
[Seccareccia 1996; see also Terzi 1986]. 8 This is the stage of initial finance.
In order to carry out planned production, firms must first hire labor and pur-
chase raw materials and capital goods [Seccareccia 1996]. Credit will also be
needed to cover other costs such as the payment of dividends and interest on past
debts. This is their total demand for bank credit. Once firms have obtained the nec-
essary credit, provided banks approve this request, the funds will be deposited in the
firms' accounts at the lending banks. As such, the banks' balance sheets will be per-
fectly balanced, with the loans appearing on the asset side and the initial deposits on
the liability side.
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Given the fact that bank deposits (demand and checkable) are part of any defIni-
tion of money, money is created ex nihilo [Aglietta 1979, 335] as soon as credit is
granted to firms and deposited into firms' bank accounts. Money becomes "debt
which circulates freely" [Schmitt 1975, 160; see also Maricic 1985]. Initially, there-
fore, the "money stock" increases by the exact amount of the credit-flow no matter
what the immediate needs are of the firm. Money is therefore endogenous, as in
Post Keynesian theory, but the analysis rests neither on the accommodative role of
the central bank nor on the nature of contracts, uncertainty, and portfolio analysis.
Production is what gives money its endogenous nature. But this initial increase in
the money stock is only temporary; the final quantity is dependent on household be-
havior. This point is discussed below.

The Third Step: A Theory of Banking Decisions9

Once firms have formulated their demand for credit, they must have their de-
mand validated by banks if production is to proceed. This supply of credit is not
automatic. Banks will not meet all the demand for credit that is forthcoming at a
given price, as is often implied. Banks are treated like firms who also want to gen-
erate profits, but they also face an uncertain future and must incorporate that within
their lending practices.
This step in the theory of the circuit requires an explanation of bank behavior as
well as the relationship between banks and firms. Banks are the primary channel
through which production can be carried out, and they are thereby at the heart of the
production process. However, banks are not passive players in the circuit. They are
profit-seeking firms in the business of selling a product-credit. Like other com-
modities, the demand for credit is made at the initiative of the customers. Banks
cannot lend if there are no customers willing to enter into debt. This was recognized
by Joan Robinson [1952, 29], who argued that "the amount of advances the banks
can make is limited by the demand from good borrowers. "
 10 Louis-Philippe Rochon

Post Keynesians and circuitists alike have generally failed to develop a sound
theory of banks. Graziani [1990, 9] writes: "In general, the attitude would be
that . . . the post-Keynesian school . . . still ignores the fundamental role of banks
and does not analyze the relationship between banks and firms. " This is certainly an
acceptable commentary, given Tom Palley's [1996, 529] own assessment, which
claims that for circuitists "the creation of liabilities is therefore principally driven by
the demand side. ,,10
This said, however, the same criticism can be raised against circuitists who have
failed to develop a clear theory of banking decisions~ ironic observation, given
their emphasis on bank credit. What follows is an attempt to fill this gap in the cir-
cuit theory. While banks are firms, they cannot be aggregated into a single sector
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[Graziani 1989]. They must be analyzed separately.

Since banks are a part of the same uncertain economy as firms, uncertainty and
expectations must be allowed to influence their decisions to extend credit. Given the
inherent uncertainty regarding markets and effective demand, there always exists a
risk that borrowers will be unable to repay loans; it becomes the banks' responsibil-
ity to evaluate this credit risk on an individual basis. Banks must seek creditworthy
customers. In return, firms must be able to show that they are able to repay the
loans. Firms' profits become the validation of their demand for credit. The role of
the banks is to identify the creditworthiness of the firms and to determine if the
firms meet the requirements needed to obtain a loan. W. Barker and L.-R. Lafleur
[1994,83] argue that the "role of banks depends largely on information systems that
allow banks to determine the solvency of their customers. Their success will depend
heavily on the intuition of their credit officers and their ability to identify the capac-
ity and willingness of borrowers to repay loans. " Banks will therefore take into con-
sideration several factors, including the economic environment and prospects for the
industry, the quality of management, the past business relationship with the bank,
the firm's ability to generate profits (dictated to a large degree by the banks them-
selves), the firm's net worth and collateral, the firm's ability to withstand transitory
shocks, and certain key financial ratios such as cash flow and debt/equity.
This does not imply-as it has been erroneously suggested-that banks extend
credit on demand. On the contrary, banks refuse credit to many customers-
Keynes's "fringe of unsatisfied borrowers" prevails. But provided the customers'
reasons for borrowing funds are sound and they have sufficient assets or income
collateral (creditworthiness), then they are granted loans virtually on demand [Le-
Bourva 1992]. We may claim therefore that banks meet not the "demand" for credit,
but the "creditworthiness" demand for credit. And once credit has been extended,
banks will maintain and develop a close working relationship with customers to en-
sure minimum disturbances.
How can credit crunches be explained in terms of the circuit approach? Quite
easily. What it is not is a leftward shift in the supply of credit. This is probably the
 The Creation and Circulation of Endogenous Money 11

dominant interpretation in the mainstream literature. For instance, in the New

Keynesian literature, a credit crunch is defined as a significant leftward shift in the
supply curve for bank loans (given the central bank's decision to cut reserves), hold-
ing constant both the safe real interest rate and the quality of potential borrowers.
In circuit theory, no such leftward shift occurs. In fact, banks may still be will-
ing to supply the same amount of credit as before. Demand may even increase, or it
may decrease. What will change is the bank's creditworthiness criteria, resulting
from its changing expectations of the future.
In deciding to whom to extend credit, banks will typically have basic credit re-
quirements, such as collateral, past relationships, etc., that firms must meet. As
long as firms meet the banks' basic creditworthiness criteria, they will have their
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demands for credit met. However, there is no reason to believe that these criteria
will remain fixed. On the contrary, they will change with the cycle. When economic
times are good, banks will become more generous in their lending. This is because
they see no real difficulty for firms to repay their loans in the future. Their credit-
worthiness requirements will be low. However, they will also keep an eye on the
uncertain future. As they become more pessimistic, they will raise the requirements
for loans, leaving some firms unable to meet them. Credit crunches arise precisely
because the supply of credit is not forthcoming despite possible strong demand. This
is not the result of an exogenous or predetermined (scarce) supply of credit. If all
firms are able to meet the new requirements, then banks will continue supplying as
much credit. Credit crunches arise because firms are typically unable to meet the
new stringent collateral requirements set by banks.
Another way of looking at a credit crunch then is to compare the banks' expecta-
tions of the future with the borrowers' expectations. If banks are more pessimistic
than borrowers, they will raise their creditworthiness requirements, making credit
more difficult to obtain. A credit crunch then arises. It is perhaps best to refer to
asymmetric expectations between banks and bank borrowers.
This analysis is in some ways very Keynesian since it treats banks on the same
level as firms in letting uncertainty affect their "supply." As uncertainty influences
the firms' decisions to produce, so will it also impact on banks' decisions to extend
credit to firms. Another way of saying this is, as banks become more pessimistic,
their preference for liquidity increases, thereby lowering the supply of credit. How-
ever, the decision to extend credit still remains a policy decision.

The Fourth Step: The Creation of Income Flows and the Efflux Principle

The fourth step of the circuit consists of the disbursement of credit-funds to

workers as their paid remuneration. Once credit is secured-usually in the form of a
line of credit-.funds are distributed to workers and rentiers, who then deposit the
total value of wages and rents in bank accounts. This step is important. Bank credit
 12 Louis-Philippe Rochon

needs to be released into the system in order to circulate. It is the payment of money
to workers that allows money to circulate and the circuit to exist. If there were no
workers to remunerate, then money could not circulate and hence exist.
Moreover, incomes must be created during the production process for firms to
recapture their initial outlays at a later date. If incomes are not created, then goods
cannot be sold. As Parguez [1997, 5] writes: "This ... stage depicts the paramount
characteristic of the capitalist economy: firms must be able to recoup money from
the sale of their output." The payment of wages and the disbursement of dividends
are the firms' outlays. This is what is referred to as the "efflux" principle.
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The Last Stage: Monetary Reflux, the Creation

0/ Pro/its, and the Destruction 0/ Money
The circuit ends when income is spread over the system in the form of consump-
tion expenditures and saving. This last step represents the final financing of the in-
itial loan. It occurs when commodities are brought to the market and sold at a price
determined by the firm. Consumption becomes an income for the firm, which then
uses the proceeds from sales of its commodities to reimburse previous loans---Qt
which point money is destroyed. According to Frederic Poulon [1990, 381], "When
the cancellation date of money comes into effect, firms reimburse their credit to the
fmancial intermediaries using the revenues generated by the sales. Firms then ask
for new credit in order to continue their production activities." Jacques LeBourva
[1992, 454] has called this process "alternating movements of creation and cancella-
tion of money." Firms therefore try to "recapture" their outlays by selling their
products to households. This is the "reflux" principle.
There is, however, a second source of final finance that allows firms to pay hack
their loans. On top of the receipts from consumption, firms can capture a part of
household saving by selling new securities to households. Money therefore flows
back to firms through consumption and saving, that is, the part of saving that house-
holds do not hoard in their bank accounts. It would appear that from the point of
view of firms, consumption and financial saving (saving used to purchase securities
on financial markets) playa similar role. Firms get back part of their initial outlays
[Graziani 1990]. In his 1937 Economic Journal articles, Keynes is clear on this
point: "For consumption is just as effective in liquidating the short-term finance as
savings is" [1973b, 221].
Total saving can be divided into two components: that part of saving used to
purchase securities (financial saving) and that part hoarded and kept as idle balances
in hank accounts (hoarded saving). The amount of saving allocated to either use is
determined by two opposing forces: the spread between the short- and long-term
rates of interest and the liquidity preference of households. Even though the loog-
term rate of interest (as represented by securities) is greater than the short-term rate
 The Creation and Circulation of Endogenous Money 13

(deposits), households may still prefer holding idle balances, given their desire to
hold money in case of unexpected events. As Graziani [1996, 144] explains, the de-
cision to allocate saving between deposits and securities will be based, in part, on
"the rate of interest that firms offer on the securities they issue [which] must be high
enough to balance the liquidity preference of savers. "
Liquidity preference is then consistent with the circuitist story, although it ap-
pears at the end of the monetary circuit. It is not a decision between consumption
and saving, but a decision with respect to how to allocate total saving. The amount
saved and hoarded becomes households' demand for money. Whereas the circuit be-
gins with the demand for bank credit, it ends with the demand for money. The
proper sequence of events begins with the demand for credit and follows with the
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supply of credit, the payment of incomes, consumption, liquidity preference, and

the demand for money. Whereas the demand for credit is always positive at any
level of output, the demand for money may conceptually be nil.
As households consume, they will draw on their deposits and transfer funds to
firms. As of yet, the money supply is unchanged, given it is a mere transfer of
funds-the decline in household deposits is exactly compensated by the increase in
firms' bank deposits. However, firms use these proceeds to repay their loans. As
loans are repaid, firms exhaust their deposits, money is destroyed, and the money
stock diminishes. This sequence of events also applies to that part of savings used to
purchase securities: money is transferred from households to firms, and from firms
to banks.
At the end of the circuit, the final (observed) increase in the money stock is
given by the quantity of saving that is hoarded by households. Michael DeVroey
[1984] has labeled this "extra-money." The final amplitude of these changes will de-
pend on the saving behavior of households. As such, changes in the "stock" of
money-as well as hoarded savings-are a residual of the system, that is, a result of
the pattern of circulation of money. This point was well expressed by Malcolm
Sawyer [1996, 51]: "Whether the money thereby created remains in existence de-
pends on the demand for money as a stock." Lavoie [1992, 156] also defends this
point: "There is the no difference between the outstanding amount of loans and the
stock of money. "
These savings represent a net drainage on the overall system. Firms will not be
able to reimburse the totality of their initial finance, implying that they will be per-
manently indebted toward the banks.

Some Implications of the Circuit Approach

The explanation of the circuit developed above raises a number of questions and
has a number of implications. Of course, not everything has been discussed. I as-
sumed here a closed economy with no government. The story can be altered to deal
 14 Louis-Philippe Rochon

with these elements, although this will not be done here since it goes beyond the im-
mediate scope of this paper.
The above discussion does raise a number of implications, in particular, with re-
spect to the role of the central bank, the role of the financial market, and the multi-
plier.
As for the central bank, it is certainly an important component of the story, but
its consideration is different than in Post Keynesian theory. In circuit theory, the
role of the central bank is not limited to supplying reserves to prevent a crisis, but is
an integral and permanent component of the circuit. It does not play according to
the "firefighter's" rule~umping in whenever the system is near collapse. This
analogy---Qlbeit a more politically correct one-is attributed to G. Deleplace [1996,
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325], who argues that the lender-of-last-resort role "is not only of the fireman's
type, which bursts into action when a crisis occurs; it is part of the monetary re-
gime. "
The central bank sets exogenously the real (and the nominal) rate of interest
from which all other rates depend, given liquidity preference. For instance, the rate
charged by banks on loans will be a markup over the central bank rate where the
markup itself will depend on the strength of the creditworthiness of the borrower.
But if the rate of interest is exogenous and money is endogenous, it does not
mean that the proper graphical representation should be a horizontal money supply
curve, although the analysis can be useful in order to remain within the elegant
framework of "standard normalcy." It remains nonetheless a "second-best solution"
as pointed out by Lavoie [1996b, 4].
Circuitists see considerable problems in using a standard supply and demand
analysis. Given the interdependence between the two curves, such an analysis be-
comes irrelevant. If supply increases with demand, then they are one and the same:
supply is demanded [Parguez 1985, 273]. In fact, some accommodationists refuse to
even speak of money supply. For instance, Renato DiRuzza [1984,6] writes: ll
It appears to me that the use of supply and demand analysis with respect to
money gives rise to more inconveniences than advantages. If we assume that
the supply of money is endogenous, and determined by demand, the notion
of a supply itself loses all its significance. The only quantity of money fore-
seeable, possible and normal, would be the "desired" quantity, i.e. that aris-
ing from the internal economic needs of the system. A money supply
function is unthinkable because apart from the precise intersection with the
demand function, all other points on the supply curve represent something
which is not money. . . . Hence there is no such thing as a money market
where a supply and demand for money interact. To consider supply and de-
mand functions for money, irrespective of their characteristics, implies fore-
most the definition and acceptance of a certain separation between money
and the "real economy."
 The Creation and Circulation of Endogenous Money 15

There is no "supply" of credit outside the quantity of credit "desired" by firms. The
implications for a financial market stand in stark contradiction to neoclassical the-
ory, where financial markets playa dominant role in financing investment. The cau-
sality runs from saving to investment. In circuit theory, the opposite applies. Since
the sale of new securities arises only at the end of the circuit when households de-
cide what to do with their savings, financial markets can never become a way for
firms to finance investment. As Graziani explains [1996, 3], financial markets are
never a source of "fresh" liquidity for firms wanting to start production, but only
act as a source of final financing. Neither financial nor hoarded savings finance in-
vestment. This also implies, as Lavoie [1992, 159] notes, that increased household
saving only reduces retained earnings and in no way affects the financial needs of
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firms. Savings cannot have any causal influence.

The decision of households to hoard part of their savings will certainly represent
a drain on firms' profits. After all, this represents money that firms were unable to
recapture either through consumption or through the financial market. This amount
represents the outstanding debt of firms. At this point, banks become financial inter-
mediaries, pooling household savings and relending it to firms, thus allowing them
to refinance their deficit positions [Nell and Deleplace 1996, 14]. As Lavoie [1992,
155] argues: "The banks consolidate previously made loans to the firms, the amount
of which is equal to the savings that the households do not wish to hold in non-liq-
uid form."
This position is shared by many circuitists. For instance, Nell and Deleplace
[1996, 15] write that hoarded savings "creates a leakage for the firms but not for the
firms' deficits. Banks are then acting as financial intermediaries which complement
the financial markets to channel households' savings towards the firms." Similarly,
Seccareccia [1996, 16] writes that
It is only when households choose to withhold their savings from the finan-
cial capital markets and seek to hold a significant proportion of their saving
in the form of bank deposits that difficulties of reimbursement appear. This
forces banks into an uneasy "intermediation" role of re-financing debt or ac-
quiring by default business assets . . . equivalent to net accumulated house-
hold bank deposits.
Parguez [1997, 7] also wrote that "when there is an increase in the demand for
money as an asset, firms cannot repay their whole short-term debt to banks. Banks
are thus pledged to refund this debt by granting firms long term credits. " This chan-
nels the hoarded savings back to firms. As long as banks can execute this function,
crises can be avoided.
This last point also raises the issue of what is to be considered the demand for
money. In circuit theory, there is an important difference between the demand for
credit and the demand for money. Since credit is not money, and similarly money is
not credit, the demand for credit arises at the beginning of the circuit, whereas the
 16 Louis-Philippe Rochon

demand for money becomes equivalent to hoarded savings. The demand for money
is the households' liquidity preference.
Another implication of the monetary circuit approach is that capitalists, in the
Kaleckian tradition, determine their own profits. It is in this sense that the monetary
circuit, as explained at the beginning of this article, is also a theory of accumulation
and distribution. We know that for Kalecki [1971, 13], "capitalists, as a whole, de-
termine their own profits by the extent of their investment and personal consump-
tion. In away, they are 'masters of their own fate'." Profits are therefore deter-
mined by firms' access to credit to carry out investment and production. If firms
cannot secure the proper level of credit, then they will not be able to carry out
planned investment expenditures. As Graziani [1996, 4] explains, "The very forma-
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tion of profits is explained by the presence of money, as well as by the way in

which money is created and introduced into the market circuit. "
A last implication concerns the multiplier. Unlike Post Keynesians, circuitists do
not see the multiplier as anything larger than unity. Moore [1996] has also arrived at
the same conclusion. This has generated considerable debate. But opponents gener-
ally, I think, do not properly understand the context in which this is argued. In fact,
a proper understanding of the circuit position reveals that both approaches are simi-
lar. When circuit theorists mean that the Keynesian multiplier is one, they mean that
at the end of the circuit, all money returns to banks (except the hoarded savings).
Firms must repay their loans before anything else. If a firm borrows money and
uses it to purchase goods, the recipient of that income must then repay his or her
own loan. The income is not used again, over and over. It is the repayment of loans
that prevents the multiplier from assuming any value other than unity [parguez
1975, 278; Cencini 1984, 73].
Of course, firms then borrow more money and continue production, and money
circulates again. The standard "multiplier" is working, but it is simply not "auto-
matic" [Lavoie 1987, 88]. This is because firms may have their credit demand re-
fused.

Conclusion

The main conclusion of the circuit approach in terms of the endogenous nature
of money is that money is endogenous because of how it enters the economy, i.e.,
through the normal operations of a capitalist economy of production, due to the
credit needs of firms. Money is not endogenous because of the role of central banks
or as a result of household portfolio decisions. These two last versions of endo-
genous money are more akin to Post Keynesian theory.
The above discussion of the monetary approach has left out much. For instance,
a considerable number of articles have been dedicated to the explanation of profits.
 The Creation and Circulation of Endogenous Money 17

This issue is also beyond the scope of this article, and perhaps no satisfactory con-
clusion can be reached.
The aim of this article was to present the theory of endogenous money as argued
by the proponents of the French and Italian circuit school. According to this ap-
proach, the economy consists of a constant interplay of interrelated agents within a
hierarchical system. This system consists of banks, firms, and households, with the
central bank playing a secondary-tbough nonetheless important-role.
Credit becomes the focus of analysis of a modern capitalist system; money is
therefore seen foremost as a flow, rather than as a stock (thereby undermining the
concept of portfolio theory), and as a medium of circulation responding to the needs
of trade. Credit is advanced to firms based on expectations of effective demand be-
fore production even takes place. Money---or credit-money---is hence endogenous
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and is created ex nihilo. By accepting the foundation of this approach, I conclude:

(1) money enters during the production process and not simply as an afterthought;
(2) money is not a commodity, and real analysis no longer becomes an appropriate
framework to study the dynamics of a capitalist economy; and finally (3) the theory
of money becomes distinct from the theory of interest rates. In this analysis, interest
rates (nominal and real) are exogenous and become a distributive variable deter-
mined by the central bank based on a number of economic and non-economic objec-
tives.
The circuitists' theory of endogenous money represents a clear break with main-
stream orthodox theories. As opposed to Post Keynesian theory, it has been shielded
from neoclassical influences and as such does not contain traces of orthodox
thought. As Lavoie [1996b, 4] claims, "Circuit theory . . . constitutes the proper
foundation'> to a non-orthodox monetary theory, which itself must be part of a larger
non-orthodox research programme encompassing effective demand as well as value
theory." Accordingly, circuit theory must be seen as a starting point. Despite this
observation, many aspects of modern capitalist economies are absent from its analy-
sis. In this article, I attempted to incorporate uncertainty into the analysis of the
monetary circuit. In this sense, Davidson's emphasis on ergodicity and non-ergodic-
ity can be incorporated within the theory of the monetary circuit, although I have
also introduced uncertainty at the level of the banking stage. Here, uncertainty is
linked to money as a theory of portfolio decisions (allocation of savings) and to
credit as an explanation of the very creation of endogenous money based on com-
mercial banks' decisions to extend bank credit.
Theory of the monetary circuit can also incorporate other key elements of Post
Keynesian, Kaleckian, and Minskian analysis on markup pricing and fmancial cri-
ses. However, the final conclusion remains intact: the theory of the monetary circuit
must be seen as the starting point around which we can add other insights. Only
then would we have developed a truly "general theory" of credit, money, and effec-
tive demand.
 18 Louis-Philippe Rochon

Notes
1. Messori [1985, 210] claims that Post Keynesians choose to "privilege the role of the de-
mand for active balances and changes in portfolio as opposed to bank: credit. "
2. The expression "circuit dynmnique" was coined by Parguez [1975].
3. The inclusion of a government sector, as demonstrated by Parguez [1997], changes very
little in the anslysis.
4. As will be aeen later, this definition is not necessarily different than Keynes's own defini-
tion of the multiplier circuit, as long as one postulates, as do circuitists, that the multiplier
is necessarily equal to one.
5. Horizontslists have also made this claim. Moore [1995, 263] has recently reemphasized
this argument: "Money supply is determined by demand for credit, not the demand for
money." Similarly, Forman et al. [1985, 33] claim that "it is the demand for credit rather
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than the demand for money wbich is the necessary starting point for anslyzing the role
played by monetary factors in determining the level of real economic activity. "
6. For a discussion of Keynes's finsnce motive and how it relates to the General Theory, see
Rochon [1997].
7. According to Graziani [1990, 12-14; 1994, 277], "If we consider firma as a whole, the
only externsl purchase is labour force .... Finsnce requirements depend on the monetary
cost of output in general, and are not specifically connected with the investment activity. "
For Graziani, the question of investment finsncing arises only at the end of the circuit, al-
lowing for growth in the subsequent period. They are finsnced as "internal transactions"
[Graziani 1990, 12] within the non-finsncial business sector, that is, through retained earn-
ings and the new issues market [Vallageas 1988; Graziani 1996]. Graziani [1990, 12] ar-
gues this point: "Only at the end of the production process firms buy capital goods to be
used in the following period." Otherwise, according to the author, it would represent a re-
inststement of the nstural rate hypothesis. Seccareccia defends his position [1996, 402],
noting that the "assumption regarding bank credit going exclusively towards the finsncing
of working capital is highly questionable."
8. Keynes argues that this applies equally to consumption goods industries as to investment
goods industries. The author claims [1973b, 282] that "the production of consumption
goods requires the prior provision of funds just as much as does the production of capital
goods." This point has repeatedly been made by Graziani [1985, 161]. It is often argued
that Keynes stated that only capital goods need to be financed and that their production
would create income that, through the multiplier, would finsnce the level of aggregate de-
mand for consumption goods. This view is, however, inconsistent with Keynes's later
writings in the Economic Journal [1973b, 208, 221, 282]. Keynes clearly states_bile
referring to the "funds available for investment" -that credit "covers equally the use of the
revolving pool of funds to finsnce the production of capital goods or the production of
consumption goods" [1973b, 283; emphasis added].
9. This section is taken in part from Rochon [1999b], where it appears in more detail.
10. Arens [1996, 431] has made this observation as well: "The Post Keynesian apprnach does
not consider banks as a specific group of agents. Banks belong to the group of firms, even
if they are firms of specific type. Banks and firms have an analogous purpose: the maximi-
zation of their incomes. "
11. This quote is translated from French.
 The Creation and Circulation of Endogenous Money 19

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