SFC models are a type of macroeconomic model that originated from the national accounting principles developed by Morris Copeland (Copeland [1947, 1949]). These models have a number of key features20:
(1) SFC models include a number of macroeconomic sectors.
(2) SFC models can incorporate a number of assets with different rates of return. (3) SFC models are based on a comprehensive accounting framework that logically and
consistently integrates flows and stocks.
(4) SFC models contain behavioural equations that draw on post-Keynesian theory. (5) SFC models are precise with regards to time.
The first characteristic of the SFC approach is that the model is divided up into several sectors, which transact with each other in a number of ways. They are able to produce real assets (e.g. capital, housing, inventories) and issue financial assets (e.g. equities, bonds, bills), each with their own rate of return (the second feature of SFC models outlined above).
Sectors typically found in SFC models are: a government sector, a central bank sector, a banking sector, a firm sector, a household sector, and a foreign sector. However, other combinations are possible. For example, sectors may be aggregated together to simplify the model. Common aggregations include the government with the central bank (to create a public sector), the central bank with banks (to create a banking sector) and firms with households (to create a private sector). It is also possible to split sectors into a number of smaller sectors. Common types of disaggregation include splitting the household sector between different types of income earners (e.g. wage earners versus profit and interest earners) and the firm sector into a number of subsectors (e.g. a power
20 In his Nobel memorial lecture, Tobin (1982) also identifies a number of these features as being characteristic of his approach to model building. However, Tobin’s approach differs from the SFC approach (as defined here) in that its behavioural component draws on mainstream economic theory. Nevertheless Tobin’s contribution undoubtedly inspired and was crucial to the development of the post-Keynesian SFC models.
sector and an ‘everything else’ sector, as in Berg et al. [2015]). The types of sectors and assets that are included in an SFC model will of course depend on the aims of the modeller.
As mentioned above, the sectors in SFC models transact with each other in a number of different ways. Typically, sectors engage in two types of transactions – buying and selling. These transactions can be further broken down between GDP related transactions and non GDP related transactions. Common GDP related transactions on the expenditure side include consumer spending, government spending, investment spending, and spending on exports and imports. Common GDP related
transactions on the income side include wage payments, profits payments, interest payments and rent payments.
The second type of transaction relates to non-GDP related transactions (i.e. those transactions related to the sale and purchase of financial and pre-existing real assets), as well as the second component of SFC models – that SFC models can incorporate a number of assets with different rates of return. Examples of financial assets that are commonly found in SFC models include central bank reserves, cash, bank deposits, bills, government bonds, commercial bonds and equities. Examples of pre-existing real assets that have been included in SFC models and that are available for resale (and so do not count in GDP) include housing and gold (in some open economy SFC models). Non-GDP transactions are used by sectors to cover their surplus or deficit positions (financing decisions), to alter the composition of the assets side of their balance sheet (portfolio allocation) and to adjust the liabilities side of their balance sheet (funding decisions). Taken together, these decisions affect the composition and size of each sector’s balance sheet.
This leads us to the third characteristic of SFC models – that transactions between sectors (i.e. flows) and the asset and liability positions that result from them (i.e. stocks) are logically and consistently integrated with each other through a comprehensive accounting framework. Four principles
underpin the accounting framework used in SFC models (Nikiforos and Zezza, 2017). First, the model should be ‘flow consistent’ – i.e. each payment should come from somewhere and go to
somewhere. Second, the model should be ‘stock consistent’ – i.e. each financial asset should have an offsetting financial liability. Third, the model should be ‘stock-flow consistent’ – i.e. an imbalance between a sector’s total inflows and total outflows means that its asset/liability position is changing. Fourth, the model should adhere to the ‘quadruple entry principle’ – i.e. each transaction must
involve four accounting entries.21 Taken together, these four principles reduce the degrees of
freedom in the model and so the possible outcomes (e.g. not every sector can run a surplus at the same time; in fact, the sum of net lending across all sectors must always be equal to zero). The accounting framework of SFC models is explained in more detail in Section 3.1.3.
SFC models also contain a behavioural component (explained in more detail in Section 3.1.4). This component consists of a series of equations that determine all the non-accounting relationships contained in the model. Thus, the behavioural component determines the magnitude of the transactions specified by the accounting section of the model. For example, while the accounting component of a model might specify that households purchase consumption goods from firms, the behavioural component will determine how many of these goods are purchased. So far, the SFC literature has mainly constructed its behavioural relationships along post-Keynesian lines (the fourth feature of SFC models outlined above). However, in a few cases, the SFC methodology has been used with more mainstream theoretical approaches. Examples include the constant elasticity of
substitution production function in Jackson and Victor (2016) and the Cobb-Douglas production function in Burgess et al. (2016).
Finally, the fifth characteristic of SFC models is that they are precise with regards to time. The concept of time enters into SFC models through the interactions and links between periods. One of the ways in which periods can be linked together is through lags in equations. As pointed out by Godley and Lavoie (2007a, p.13), the inclusion of lags ensures “that causes precede effects, so that we keep the time-sequence right and understand the processes at work”. Lags may also be used in relation to the formation of expectations. A second way in which periods are linked together is through each sector’s stocks, and the effect these stocks have on each sector’s flows. In SFC models, the long-run is simply a succession of short periods. In each short period, sectors transact with each other, with these transactions eventually leading to a temporary equilibrium characterised by a stability of flows both between and within sectors. As long as the model is not in a ‘steady state’ (i.e. a long-run equilibrium – see below for a definition), these transactions will lead to a redistribution and/or a repricing of the stocks held by each sector. At the start of the next period, the new stock position (relative to the position at the beginning of the previous period) will lead to new flows and therefore a new temporary equilibrium. Thus, the model’s stocks, as represented in the balance
21 For example, the sale of a good requires an increase in the seller’s income and therefore an increase in their assets (or a reduction in their liabilities), as well as an increase in the buyer’s expenditure and so a reduction in their assets (or an increase in their liabilities).
sheet matrix, form a link between each period. Only once both the flows and stocks are in a constant relationship to each other has the model reached a long-run equilibrium or ‘steady state‘.
In SFC models, the terms ‘steady state’ or ‘stationary state’ imply the model is in a long run equilibrium. Godley and Lavoie (2007a, p.71) define these two states as follows:
“[a steady state is] a state where the key variables remain in a constant relationship to each other. This must include both flows and stocks, and not flows only as with short-run (temporary)
equilibria. When, in addition, the levels of the variables are constant, the steady state is a
stationary state. In general, the steady state will be a growing economy, where ratios of variables remain constant. Whether we are in a stationary state or a steady state with growth, we may then speak of the long-run solutions.”
A number of the features outlined above will be crucial to investigating the economic effects of stranded assets. Being able to divide the model economy into a number of sectors that transact with each other in different ways will be important in modelling both different transitions to a low-carbon economy and the extent to which unexpected changes in market conditions (identified in Section 2.3) might lead to stranding. For example, splitting the firm sector into a fossil fuel sector, a low- carbon sector and a sector that sells non-energy goods will be crucial in looking at the effects of different types of transitions and changes in energy efficiency, policies, financing conditions and social norms. Likewise, splitting the household sector in two will be crucial to investigating the distributional effects of part of the household sector divesting from fossil fuel company goods or financial assets.
Similarly, that SFC models are able to include a number of financial assets with different rates of return, and that SFC models are based on a comprehensive accounting framework that logically and consistently integrates flows and stocks, will be crucial in looking into one of the main arguments of the stranded assets thesis (as laid out in Chapter 2) – i.e. that the stranding of capital or fossil fuel reserves is likely to affect the economy via its effect on the market value of fossil fuel firms. For example, and as laid out in Chapter 2, a divestment campaign is likely to affect the value and rate of return of fossil fuel firms’ securities, which may then feed in and affect these firms’ costs, prices and investment expenditures, as well as how other non-divesting agents choose to allocate their wealth between different financial assets. Price changes are likely to affect the demand for different types of energy goods and consequently firm profits, and through this, the rate of return and value of each sector’s financial assets. These changes may then feedback and affect firm costs, prices, etc. Thus, divestment is likely to affect both the financial and real sides of the economy, and these impacts may interact with and reinforce each other through time. As such, a model is required that is able to
includes multiple financial assets and interactions between the real and financial sides of the economy.