A monetary Minsky model of the Great Moderation and the Great Recession
Abstract: Steve Keen's model of Minsky's Financial Instability Hypothesis ( Keen, 1995 ) displayed qualitative characteristics that matched the real macroeconomic and income-distributional outcomes of the preceding and subsequent fifteen years: a period of economic volatility followed by a period of moderation, leading to a rise of instability once more and a serious economic crisis. This paper extends that model to build a strictly monetary macroeconomic model which can generate the monetary as well as the real phenomena manifested by both The Great Recession and The Great Moderation.
Summary (2 min read)
- The trend for recessions to become less frequent and milder abruptly gave way to a sharp decline in output, a doubling of unemployment, and a temporary fall into deflation.
- The causes of this economic calamity will be debated for decades, but there should be little debate with the proposition that it was not predicted by any variant of mainstream economic analysis available at the time.
The Financial Instability Hypothesis—Genesis
- These are questions that naturally follow from both the historical record and the comparative success of the past thirty-five years.
- In addition to being based on unfamiliar theoretical and philosophical foundations, Minsky’s work has mainly been published in non-mainstream journals such as the Journal of Post Keynesian Economics and the Journal of Economic Issues, and minor journals such as the Nebraska Journal of Economics and Business.
- The abstract model of the neoclassical synthesis cannot generate instability.
The Financial Instability Hypothesis—a Précis3
- The cause of this high and universally practised risk aversion is the memory of a not too distant system-wide financial failure, when many investment projects foundered, many firms could not finance their borrowings, and many banks had to write off bad debts.
- Such businesses will find themselves having to sell assets to finance their debt servicing—and this entry of new sellers into the market for assets pricks the exponential growth of asset prices.
- As the boom collapses, the fundamental problem facing the economy is one of excessive divergence between the debts incurred to purchase assets, and the cash flows generated by them—with those cash flows depending both upon the level of investment and the rate of inflation.
- Though debt was modeled in the preceding system, money was not explicitly considered, and therefore price dynamics were absent.
- There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth… if anything, the monetary base lags the cycle slightly….
- From this he derived the proposition that banks, as the creators of these tokens, must be modeled as separate agents from firms and households, and that all transactions are single-commodity, monetary exchanges involving three agents: any monetary payment must therefore be a triangular transaction, involving at least three agents, the payer, the payee, and the bank.
Modeling Minsky III: Endogenous Money
- There are 5 accounts in the basic model:6 1. A Bank Vault (BV) representing the banking sector’s monetary assets; 2. A Bank Transactions Account (BT) through which all expenditure and interest payments pass;7 3.
- Payment of wages (row 7) 5. Payment of interest on workers’ account balances (row 8) 6.
- Recording the endogenous creation of new money (row 13) One is the crucial step of endogenous money creation in response to the investment desires of firms (in this simple model, all capital expansion is shown as funded by borrowing money from the banking sector): 13.
- The monetary functions are expressed as time constants9 whose value at any given time depends upon the rate of profit.
- The wages share of output declines as debt levels rise, while the profit rate cycles around its equilibrium value before the final collapse (when exponential growth in the debt ratio means that bankers’ share of income explodes as income collapses).
- Though much could be done to enhance its realism, in its present form it provides an explanation not only of the Great Recession, but also the Great Moderation that preceded it.
- The fact that this model is relevant to today’s economic predicament vindicates Minsky’s stricture from 1982 that, if the authors are to fully comprehend how market economies really behave, “it is necessary to have an economic theory which makes great depressions one of the possible states in which their type of capitalist economy can find itself.”.
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