Justificación Metodológica

Under this section, we take a brief overview of the nature, roles of money, and monetary policy in macroeconomics as postulated by Post Keynesian economists. Post Keynesian monetary theory is one among many theories that defines the body of heterodox economics.39 There are two main features that define all Post Keynesian theory, these include the principle of effective demand and dynamic historical time (Lavoie, 2009). By the former, Post Keynesians imply that the demand excludes extra goods that unemployed workers would buy if they were able to get a job; while the latter emphasizes the transition from one equilibrium to another and the effect of conditions that prevailed during the transition period on the final outcome (Lavoie, 2009). Furthermore, (Lavoie, 2009) explains effectively by pointing out that it is this demand that determines the economy both in the short and long run of how supply adapts to demand. Other features that differentiate Post Keynesians include endogenous money, the emphasis on exogenous interest rate, and asset based reserve requirements as a complementary instrument with which to conduct monetary policy (Palley, 2003). In general most prefer the use of government fiscal policy to boost spending and investment during economic contraction and for government to restrain speculation during booms (Fontana, 2006).

In Post Keynesian monetary theory, the concept of endogenous money is the cornerstone. Adherents believe that endogenous money is the outcome of purposeful interaction between economic agents in reserve, credit, and financial markets. According to this argument, money supply is determined by the demand for bank credit from the households and firms’ financial market to finance production. For example, Bain and Howells (2003) reveal that central banks having set the official interest rate […], must meet such demand for reserves as is forthcoming. Thus, central banks must fulfil their mandates as the ‘lender of last resort’ irrespective of whether the money supply growth rate is above the monetary target. In addition post-Keynesian theory assumes that credit

39 _{Heterodox economics is shaped by the works of Michael Kaleci (1971), Minsk (1949), and Kaldor (1908).}

In general, many heterodox economists agree with the works of Maynard Keynes especially on the areas of unemployment, uncertainty, role of expectation in financial markets, and effective demand. However, the analyses in heterodox economics start from microeconomic problems, this is in contrast with macroeconomic analysis in Keynesian economics.

creates deposits which cause new loans (Bain & Howells, 2003; Lavoie, 2009). This assumption is opposed to mainstream assumption that deposit determines the amount credit bank are ready to create in the economy.

Post Keynesians made a barrage of criticisms against several aspects of neoclassical economics, and these criticisms had been used constantly to define what they stand for. First, PK theory utterly rejects the ‘savings-determine-investments hypothesis as postulated by neoclassical economists. In the PK perspective, savings-determine investments is against the view that the economy is ‘demand determined’ (Lavoie, 2009). Early Keynesian held the view that economy is demand driven, even so post Keynesians argue that investment determines savings as against the contrary. Extending this further, post-Keynesian individual’s resolve to invest is independent from the savings level in the economy. Thus, the proposition savings-determines-investment is at odds with the investment-determines-savings which is prevalent in the post Keynesian economics.

1.3.1 Monetary Theory of Post Keynesian Economics

Lavoie (2009) reveals that the monetary theory of the Post Keynesians has a long tradition that dates back to the 1830s and 1840s. Large part of this theory concentrates on the nature of money supply; which was why the endogenous money was developed to counter the classical quantity theory of money and the currency theory. Arestis and Sawyer (2006) assert that this view about money is now incorporated in the new macroeconomics consensus by economists in the new Keynesian. Although endogenous money seems to only take centre stage in mainstream economics now, it has been a long-held theory of money.40 We observe that this recognition has made the monetary policy of interest rate setting clearly relevant and coherent with practical operations of central banking.

Money in Post Keynesian theory originates within the economic system when firms and households began to borrow from the banks (or repay loans as well). Thus, in this process, deposits and bank money are created or destroyed. They are created when banks issue new loans and are destroyed when loans are repaid back. In this view, money is more than a medium of exchange or a stock as commonly expounded in mainstream economics. Money is integrated within the economy and supply arises as a result of the creation of new banks’ liabilities within the income generation process (Fontana & Venturino, 2003). Of course, this nature is laid bare in the modern economy where money supply expands as banks allow for overdrafts or extend lines of credit to finance production or new investment projects.

Money assumes an active role in the Post Keynesian monetary theory, as opposed to the passive role it plays in the neoclassical family. Its role is very central in post Keynesian monetary theory; this is because it affects nominal variables both in the short and longer term. Money supply is tied to production as it finances the production process or the upsurge of speculative purchases in financial markets (Fontana & Venturino, 2003). Some argue that money represents the wheels of trade and growth. It goes beyond the so- called ‘helicopter drops’ as it is labelled in the quantity theory of money and utility models such as Cash-In-Advance models (Mankiw & Taylor, 2007).

However, the nature and roles of endogenous money are divisive issues in Post- Keynesian monetary economics. As a result, there are two sprinter-groups that emphasize endogenous money in microanalysis of the behaviour of banks in the economy (Ahmad & Ahmed, 2006; Dow, 2006; Fontana & Venturino, 2003). The first group holds the view that monetary authority fully accommodates the demand for money (cash and credit) from banks and the public. This group is widely known as the Accommodationists. The Accommodationists claim that the money supply curve is flat because at the prevailing interest rate, banks must meet the demand for money from all credit worthy firms and the public (Lavoie, 2009). The second group called the Structuralists agrees with the endogenous view of money put forth by the Accommodationists, although their emphasis extends further than the Accommodationists’. They argue that Accommodationists have neglected the structural characteristics of banks and central banks. This will be clarified here. Fontana and Venturino (2003) claim that the differences between these two groups are centred on three arguments. First, the disagreement is based on the degree of control that the central banks exercise over the demand for reserves. They argue that to some extent, central banks exert influence on monetary conditions particularly by setting interest rates, and in addition, the lender of last resort facility is limited (Arestis, P., 2007b). This means there is a limit to its exercising the lender of last resorts function and therefore accommodation is not infinitely elastic. Commercial banks diversify their portfolios to limit risk exposure to a single market or one single large borrower. The second disagreement is based on the meaning and relevance of liquidity preference of commercial banks. For instance, if commercial banks have preferences over the different types of assets they would like to hold, then it would be very difficult to accommodate new credit demand even if it is from credit-worthy agents. The third argument relates to the controversy about the liquidity preferences of the non-banking public (wage earners).

Understanding how the two views of endogenous money work enriches our understanding of the behaviour of central banks in the reserve market, and commercial banks in the credit markets, as well as the interaction between banks and wage earners in the financial markets. For example, it is clear now that the change in the price of reserves sets off the transmission mechanism from reserves market to credit market, and subsequently to the rest of the economy. Generally, most economists whether Post- Keynesians or otherwise believe that money is non-neutral and it matters in the short term. Notwithstanding, there exists a divergent opinion about the influence of money on real activity in the long term. This view is supported by David (2008) who reveals that ‘‘very few macroeconomists would attempt to argue that money and monetary phenomena are unimportant and undeserving of any attention’’. He further asserts that the contentious issue among macroeconomists concerns the relative importance of money vis-à-vis other factors in determining real as opposed to nominal economic outcomes.

In all, we see that the differences between Accommodationists and Structuralists are based on how each camp view the behaviours of banks in the credit markets (Fontana & Venturino, 2003; Lavoie, 2009). Accommodationists assume that during the adjustment process of money supply, banks are not affected either by changes in their own liquidity ratios or those of their customers. While Structuralists uphold the view that over the business cycle, banks change their requirements for credit in both price and non-price terms in order to maintain their preferred liquidity positions. The structure of loan portfolios will affect the desired level of liquidity each bank would like to hold.

1.3.1.1. What is the Nature and Role of Monetary Policy in Post Keynesian Monetary theory?

Palley (2003) purported that the literature on the implications of Post-Keynesian theory of endogenous money on monetary policy is very thin, as this is still in an infant stage. Unlike mainstream economics where the macro analysis about the nature and roles of monetary policy is abundant and well-documented; it is simply not the same with Post Keynesian economics. Post Keynesian monetary theory has been largely confined to the microanalysis of the theory of endogenous money, with fewer details about the transmission mechanisms from interest rate and endogenous money to inflation, output and employment.

In spite of the fact that many Post-Keynesians have been occupied with debates around endogenous money, the current approach in the new macroeconomic consensus on monetary policy has much bearing on the rudiments from Post-Keynesian monetary theory.

Thus, Palley (2003) claims that, although there are wide theoretical differences stemming from various assumptions, the PK recommends interest rate setting monetary policy as is the case in the new consensus. The differences are: mainstream economists claim that monetary targeting and interest are competing strategies for monetary policy implementation. So, it is the contest between money supply and nominal interest rate. However, because money demand is allegedly unstable, and there is a weak relationship between money supply and inflation therefore, interest rate became the monetary policy instrument.41 Post-Keynesian monetary theory recommends the nominal official interest rate as the controlling instrument for monetary policy to fight inflation because holding down the growth rate of money supply at particular level will generate high interest rates volatility. In addition, many argue that money is an IOU and therefore given the price that is, the bank rate, the private sector has the ability to create inside money to meet excess demand. Hence, interest targeting policy allows money to be demand-determined within the financial system while monetary authority sets the price for liquidity. Achieving inflation target through interest rate setting policy is the ultimate goal in the mainstreams. It is pertinent to mention here that it is not the ultimate target for many post-Keynesians who argue that inflation is the secondary objective in order words, the means to the end and not the end in itself; even though the ultimate target is full employment (Palley, 2003). Furthermore, there are economists within and without who hold the view that interest rate fixing is insufficient to achieve stability and full employment. Therefore, some post-Keynesians suggest a complementary instrument (such as asset-based-reserve requirements) to address systemic problems that emanate from the balance sheets in the asset markets. The asset-based-reserves requirement is necessary to address asset related problems form the balance sheets of which some do not pose an immediate threat or significant shock to inflation; but however, they present an imminent danger to financial stability, output and employment. In support of this complementary tool, (Palley, 2003) argues that such an instrument is necessary because effective monetary policy should attend to both the real economy and the financial markets. This additional policy instrument is not really new to the debates about monetary policy strategies because many economists have extensively discussed on whether monetary policy should also be addressed to asset prices (Capie & Wood, 2006). In the recent past, Taylor (2008) and McCulley and Toloui (2008) suggested a spread-adjusted Taylor rule which is the standard

monetary policy augmented with spread to achieve price and financial stability simultaneously.