A Foxy Hedgehog Wynne Godley and Macroeconomic Mod

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A Foxy Hedgehog: Wynne Godley and Macroeconomic Modelling
Article in Cambridge Journal of Economics · January 2008

DOI: 10.1093/cje/ben017 · Source: RePEc
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Cambridge Journal of Economics 2008, 32, 639–663
doi:10.1093/cje/ben017
Advance Access publication 11 June 2008
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A foxy hedgehog: Wynne Godley and
macroeconomic modelling
Downloaded from http://cje.oxfordjournals.org by Ramanan V on April 30, 2010

Lance Taylor*
Wynne Godley has made enormous contributions to macroeconomic modelling.

They are reviewed here in connection with his recent book with Marc Lavoie,
Monetary Economics: An Integrated Approach to Credit, Money, Income, Production, and
Wealth.
Key words: Macroeconomic modelling, Stock–flow consistent modelling

JEL classifications: C1, E1
1. The foxiness of Wynne
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).
Manuscript received 30 November 2007; final version received 11 March 2008

Address for correspondence: PO Box 378, Washington ME 04574, USA; email: lance@blacklocust.com
* New School for Social Research. Comments by Francis Cripps, Duncan Foley, Wynne Godley, Alex
Izurieta, Codrina Rada von Arnim, Willi Semmler, Adrian Wood and the referees are gratefully
acknowledged.
The Author 2008. Published by Oxford University Press on behalf of the Cambridge Political Economy Society.
All rights reserved.
640 L. Taylor
Chapter by chapter the book builds up to quite complicated computerised models, set
out in loving detail with hundreds of equations and dozens of simulation plots in the later
chapters. Before diving into the models, however, I want to emphasise that Wynne Godley
has been the moving force behind keeping quantitative non-mainstream macroeconomics
alive and flourishing for the last several decades. The achievement is outstanding, even
if—as described below—recent literature points toward questions which Godley and
Lavoie do not address.
2. Stock–flow consistent modelling

Godley’s most important idea is the stock–flow consistent (SFC) approach to constructing

macro models. Like much of his work, it is firmly grounded in Cambridge economic
tradition. Along with Michal Kalecki, Keynes (1936) was the original innovator with
regard to relationships among payments flows. He identified national income with national
output in value terms (Mirowski, 1989) in a clear break between the Treatise on Money
(1930) and the General Theory.
Around 1970 Wynne’s own work took off from Keynes–Kalecki ‘flow–flow’ consistency.
Taking into account balances between incomes and expenditures for institutional sectors in
an open economy the formula
ðPrivate expenditure 2 incomeÞ 1 ðgovernment expenditure 2 incomeÞ
ð1Þ
1 ðinflows from the rest of the world 2 outflowsÞ 5 0
immediately follows from the identification of income with output. For the private sector in
particular, one also has that
ðPrivate expenditure 2 incomeÞ 5 ðhousehold investment 2 savingÞ
ð2Þ
1 ðbusiness investment 2 savingÞ
These ‘injections’ and ‘leakages’ are a key element in Wynne’s models, in at least four ways.
Each term in parentheses in equation (1) measures the ‘net borrowing’ (increase in
liabilities minus increase in assets) required by a sector to finance its excess of expenditure
over income.1
Both components of each sector’s net borrowing—expenditure versus income, in-
vestment versus saving or injections versus leakages—must be consistent with overall
macro balance. Many people had a hard time grappling with this idea when Wynne and
a few others put it forward. For example, Christ (1968) pointed out that the fiscal
accounting balance or ‘government budget constraint’ should enter policy consideration.
Such thoughts were seen as almost (counter) revolutionary at the time.
The entries in equation (1) are linked to one another to a greater or lesser extent, e.g.
taxes add to government income but presumably hold down private spending. Even so,
each term in parentheses can be broadly interpreted as the corresponding sector’s
contribution to effective demand (augmenting demand if the term is positive, reducing
it otherwise). The rationale is that the sectors are sufficiently distinct as collective actors to
make their net borrowing relatively autonomous.2 A sustained surplus of private income
over expenditure, for example, will hold down economic activity unless it is offset by fiscal
1
With its sign reversed, net borrowing becomes net lending, ‘net acquisition of financial assets’, or NAFA
in Godley-speak.
2
Models built around collective actors are anathema to the mainstream but intrinsic to the political
economy of Godley and his predecessors (Taylor, 2007).
Wynne Godley and macroeconomic modelling 641
expansion or strong net exports. Ex ante, in a formal model each term in equation (1) can
have a distinct relationship with the level of output; ex post the equation must hold in
Keynes–Kalecki macro equilibrium.
Foreign net borrowing (the rest of the world’s inflows minus outflows) must be exactly
offset by domestic net lending. In the USA over the last 25 years, for example, the rest of
the world’s NAFA has been strongly positive to counterbalance very high private and
government net borrowing.
Broad swathes of applied economics come out of such accounting. Working to quantify
Keynesian theory under wartime conditions, Richard Stone, James Meade and others put
together the original national income and product accounts (NIPA). Together with inter-
industry flows and flows of funds (FOF) accounts,1 they were consolidated in the form of

social accounting matrixes (SAMs) (Stone, 1966). Godley and Lavoie operate in this
framework, setting up a series of models based on NIPA and FOF concepts. They use
a SAM that they call a ‘transaction-flow’ matrix, supplemented by a ‘balance sheet’ matrix
(or financial accounting matrix—FAM) summarising asset and liability positions of
different sectors. Evolution of balance sheets from period to period follows from the
FOF, supplemented when necessary by a ‘revaluation matrix’ capturing capital gains and
losses as asset prices change.
The double entry bookkeeping in a transaction-flow matrix or SAM imposes numerous
restrictions on the variables included in a model based upon it. Keynes’s transition
mentioned above is the premiere example. In the ‘fundamental equations’ in the Treatise he
allowed ‘windfall’ profits (or losses) due to prices above (or below) costs to vary to assure
overall equilibrium.2 The General Theory concentrated on how employment and output
adjust to make sure that an equilibrium condition such as that illustrated in equation (1) is
satisfied with prices determined by costs including all forms of profit.
Kaldor (1956) was among the first to point out that different causal patterns can be
imposed on the variables in a consistent macro accounting framework to bring it into
balance.3 The Treatise’s causal chain led to his preoccupation with the profit rate as the
central macro adjustment variable (shifting to make saving equal to investment) in his full
employment growth models circa 1960. Drawing on a Cambridge education, Sen (1963)
provided a taxonomy of half-a-dozen channels. Taylor and Lysy (1979) seem to have been
the first to attach the label ‘closure’ to the process of selecting specific behavioural
assumptions to impose on a macro model.
Godley and Lavoie treat these issues as a variation on Walras’s Law. For example, in
current prices equation (1) can be restated as
ðC 1 I 1 T 2 Y Þ 1 ðG 2 T Þ 1 ðE 2 MÞ 5 0 ð3Þ
Where, for the record, C is private consumption, I is investment (gross fixed capital
formation plus change in inventories).T stands for ‘taxes’ broadly construed, Y is income,
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–

supply balance would be
R*d 5 eR*s ð4Þ
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.
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

picked up Wynne’s ideas over the years.
Given the financial events of summer 2007 it is reasonable to ask whether a macro model
with a few institutional sectors holding portfolios made up of a few securities plus physical
capital can provide an adequate treatment of modern securities and derivatives markets.
Certainly, an aggregated system can signal potential risks. For example, in numerous
policy notes dating from the 1990s for the Cambridge Endowment for Research in Finance
and the Levy Economics Institute at Bard College, Godley had pointed out that household
net borrowing in the USA was becoming very large. ‘Business as usual’ projections in
numerical models implied that household debt to income ratios would, sooner or later,
reach historically unprecedented levels.2
But the projections in no way could capture the complexity of transactions that occurred
when financial markets based on securitised debt unravelled (problems first arose for sub-
prime mortgages but subsequently for other liability classes as contagion spread). For the
UK, one could, in principle, ‘model’ the crash of Northern Rock by bringing in markets for
commercial paper and various flavours of residential mortgages. There was a big shift in
preferences on the part of market players away from the securitised mortgage packages
(originated on the basis of short-term commercial paper liabilities) that the bank had on
offer and toward more liquid instruments (first more secure liabilities and then increasingly
assets such as highly rated bonds). But this story leaves out the drama behind the
preference jump and the other events occurring with structured investment vehicles,
conduits, collateralised debt obligations (all with derivatives piled upon them) and the rest.
A FAM detailed enough to include the major positions (both on and off balance sheets)
and allow one to understand the relevant valuations would be as complicated as a Bruegel
painting with all the peasants in action. Such a matrix will not see the light of day anytime
soon. Nor could it depict potential spillover effects from the spreading crisis to the real
economy (see the discussion of net borrowing patterns below).
The crucial question is how to design a tractable accounting scheme and associated
model that could adequately summarise all the transactions taking place within the
financial sector in the years leading into 2007. Godley and Lavoie construct FAMs with
complicated cross-holdings of various classes of (on balance sheet) securities by the private
1
Despite its appropriation by post-Keynesians, the notion of endogenous money goes back, in different
variants, to Malthus, the Banking School, Wicksell, Keynes in the Treatise, and notably Robertson (1922)
who observed that given bank rate, the Bank of England had no choice but to provide the reserves that
commercial banks needed to support the amount of debt the government had on issue.
2
Similarly, risks of an Asian crisis in the late 1990s (or a German crisis in the early 1930s, for that matter)
would have been more apparent had people bothered to notice that national wealth positions were
imbalanced, with hazardous biases toward short-term foreign liabilities and long-term domestic assets under
(essentially) fixed exchange rate regimes. Both currency and maturity mismatches were acute.
644 L. Taylor
sector, government, central bank and commercial banks. The detail is interesting and
instructive, but leaves out decades of financial innovation. They seem to be talking about
a bank-based financial system as it existed 20 or 30 years ago, rather than using a model to
explore the macro implications of the financial engineering that has proliferated and will
probably not completely go away. The same observation applies to models of financial
cycles based on Minsky’s (1975) ideas as discussed below. If SFC modelling is to thrive in
the future, its practitioners will have to grapple with how to extend the work of Monetary
Economics to deal with contemporary finance, or whatever may emerge as the system
contracts back toward the teetering banks.

3. Stock–flow norms
Another of Wynne’s major themes is the analysis of steady states in dynamic macro models
through the use of ‘stock–flow norms’ or ‘magic ratios’ as they are styled below. Two appear
in the basic Godley macro model.
The first emerges from a bare-bones accounting framework in a SAM (Table 1) with an
associated FAM (Table 2). Because it simplifies notation and leads naturally to differential
equations and phase diagrams, I prefer to set up models in continuous time.
Variables in the SAM are in ‘real’ terms, so no prices appear.1 In Table 1, row (A) gives
the aggregate demand–supply balance (C and G are private and government consumption)
and X is output. Private income Yp in row (B) is the sum of value-added V and interest
payments jH from the government on its outstanding liability H (or ‘money’). For the
moment, set the ‘real’ interest rate, j (discussed in more detail below), to zero. In row (C),
government income Yg is equal to tax receipts tYp from the private sector.
Rows (D) and (E) present flows of funds, or private and government budget balances,
which are constrained by macro equilibrium. The accounting convention is that ‘sources’
of funds (saving and increases in financial liabilities) have positive signs while ‘uses’
(investment and increases in assets) have negative signs. In row (D) private saving Sp is
used to acquire new government liabilities H _ (with H5dH
_ dt as the instantaneous
increase in H). In row (E), government saving is negative (hence the parentheses around
Sg), balanced by H._
Corresponding rows and columns must have equal totals in a SAM. Column (1) shows
that income equals output à la Keynes, and columns (2) and (3) are the income–
expenditure balances for the private sector and government. In column (4) the flow market
for government liabilities clears.
Table 2 simply states that the private sector’s money holding H is equal to its net worth V.
Godley’s simplest stock–flow norm comes from a consumption function incorporating
a ‘wealth effect’ based on V,
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.
Table 1. Social accounting matrix for a simple macro model
(1) (2) (3) (4) Totals
(A) C G X
(B) V jH Yp
(C) tYp Yg
(D) Sp 2H _ 0
(E) (Sg) H_ 0
Totals X Yp Yg 0

Table 2. Household balance sheet for a simple
macro model
Assets Net Worth
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

G 1 a2 V
Yp 5
1 2 a1 ð1 2 tÞ
The paradox of thrift applies because a higher propensity to consume a1 increases Yp for
given levels of government spending G and wealth V.
D,
The paradox does not apply in steady state. With C5 equation (8) shows that

p 5G t
Y ð9Þ
Steady state income Y p is determined by the ratio of government spending to the tax rate or
the ‘fiscal stance’. Disposable income becomes D5ð12tÞ p and long-term desired
Y
household wealth follows from equation (7). Godley and collaborators thus provide
a model which is Keynesian in the short run but ‘classical’ in the long run, at least insofar as
Y p is unaffected by the propensity to consume. The steady state is ‘fiscalist’ in the sense
that output is determined exclusively by the government’s decisions about how much to tax
and spend.
Many models ‘gravitate’ around magic ratios or rates like a3 and G/t, e.g. the
unemployment and inflation rates in NAIRU fables, the saddlepoint capital–labour ratio
in Ramsey machines, the stable level of velocity in monetarist inflation models and so on.
The beauty of using any such ratio to determine a steady state must surely lie in the eye
of the beholder. At least Godley and Lavoie’s ratios (with the values given them at the
end of the book) emerge naturally from the data. Even so, their approach is shared by RBC
economists, who also fetishise accounting consistency and hope to ground results on a few
‘deep parameters’ describing technologies and tastes together with assumptions of full
employment and saving-determined investment in a stochastic rational-expectations
Ramsey world.1
An immediate question is how rapidly wealth will converge to a new steady state V (or

income to a new Y p ) when, say, government spending changes. Is the fiscalist future near
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.
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

@V
5
@G 1 2 a1 ð1 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.
4. Net borrowing but no cycles

In a preface to Monetary Economics, Wynne recalls that in early 1974 ‘I first apprehended
the strategic importance of the accounting identity which says that, measured at current
prices, the government’s budget deficit less the current account deficit is equal, by
definition, to private saving minus investment’ (p. xxxvi, emphasis in original). Another
way to say the same thing is that after the raw data have been massaged (or cooked, or

mangled) to fit into Keynes–Stone NIPA/FOF/FAM accounting schemata, the numbers
satisfy balances such as those in equations (1) and (2). Macro equilibrium is built into the
basic information that modellers use. Recognising that fact and bringing plausible
economic analysis to bear upon it is one of Wynne’s foxiest tricks.
One example that has come to the fore in recent years is widespread use of diagrams,
designed by Wynne, showing net borrowing flows as shares of gross domestic product
(GDP) for households, business, government and the rest of the world. From NIPA
accounting, the four flows must sum to zero. Such analysis does not figure in Monetary
Economics, but is certainly worth pursuing here. Figures 1 and 2 display the data for the
USA, with the series presented separately in Figure 1 and superimposed (to highlight
comparisons) in Figure 2. The shaded areas are periods of peak-to-trough recessions
according to the standard NBER methodology.1
A few immediate observations stand out. After the early 1980s there are obvious rising
and falling trends in household and foreign net borrowing, respectively (the latter
interrupted around 1990 because of recession, dollar devaluation and export of military
services during the Gulf War). In his policy pieces Wynne has hammered away at the
external gap, arguing that without an expansionary fiscal deficit under George W. Bush
(however it was justified!) the USA would have suffered a significant recession in the early
2000s. But as far as I know he has not devoted much effort toward explaining the rapid rise
in household net borrowing.
A somewhat related point is that aside from the Reagan and Bush II periods, US data do
not reveal ‘twin’ fiscal and foreign deficits—there is a more apparent linkage between
private and foreign net borrowing. Reversing the usually presumed fiscal-to-foreign twin
deficit causality (beloved of the International Monetary Fund, for example) Godley and
Lavoie develop an open economy model with a fixed exchange rate in which the fiscal
deficit responds positively to a widening external gap. Tax receipts fall off as economic
activity drops in response to lower foreign effective demand. But such twinning does not
jump out of the data.
With regard to cycles, Figure 3 reveals two important points. First, the private net
borrowing share of GDP is pro-cyclical, rising during trough-to-peak upswings in
economic activity (with cyclicality apparent for both households and business in Figures
1 and 2). Such behaviour is not consistent with the counter-cyclical ‘consumption-
smoothing’ behaviour built into much macroeconomics. The consumption share of
household income does vary counter-cyclically, but it is offset by higher taxes and not more
saving as theory from Keynes (1936, p. 120) to Ricardian equivalence and real business
1
The source is Barbosa-Filho et al. (2008). Similar diagrams show up in policy analyses by Wynne and
colleagues, and with cyclical regularity in the Financial Times.

Fig. 1. Sectoral net borrowing flows normalised by GDP and NBER reference cycles.
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.
5. Price formation, income distribution and cycles

Structuralist macro models typically determine output and growth by effective demand
and prices from costs, again following Keynes and Kalecki. Questions of closure
650 L. Taylor

Fig. 2. Superimposed net borrowing flows normalised by GDP and NBER reference cycles.
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.

Fig. 3. Government and private net borrowing normalised by GDP.
Table 3. Social accounting matrix for a model with inventories and mark-up pricing
(1) (2) (3) (4) (5) (6) Totals
(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

impact.
The notion that the price level (and, by extension, the inflation rate) depends positively
on the interest rate has a chequered history. It flies in the face of conventional wisdom,
which always advocates raising interest rates to combat inflation. An early opponent of
tight money on the basis of interest rate cost-push was Thomas Tooke, a founding member
of the Banking School who wrote an influential History of Prices. A century later in his
Treatise, Keynes labelled the positive interest rate/price level correlation that Tooke
emphasised (and which many others have observed) the ‘Gibson paradox’. He and
Wicksell explained it away on the grounds that the money rate of interest lags the business
cycle.
Despite this impressive weight of authority against it, interest rate cost-push continues to
appeal to both business people and expansionist economists. In the USA Tobin called it the
‘Wright Patman effect’ in honour of an easy-money Texas Congressman who jousted with
the Federal Reserve in the 1950s. The current Latin American label is the ‘Cavallo effect’
after the Argentine Minister of Economy of the 1990s who provided empirical support for
the phenomenon in his Harvard PhD thesis 20 years previously. He later found it politic to
repudiate the doctrine.
Godley and Lavoie use mark-up formulas like that in equation (11) to lead into the idea
that inflation results from conflicting distributive claims. Such theories have a long history,
dating back at least to the German hyperinflation of the early 1920s (Block, 2002). Recent
manifestations were in Latin America in the 1950s and around Cambridge 20 years later.2
Conflicting claims are best understood in terms of the functional income distribution and
have implications for cycles.
Dropping the interest rate terms to simplify, equation (11) can be rewritten as a formula
for the wage share of value-added,
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.
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

c1p51 ð14Þ
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

cycles but treats shifts in liquidity preference (as opposed to the marginal efficiency of
capital or investment demand) as the major driving force. Specifically, in an upswing the
speculative demand for money drops off more than transactions demand goes up. The
interest rate thereby tends to rise less than the profit rate, stimulating investment demand.
All goes well until increasing debt used to finance extra capital formation cuts into net
profits and sets off a downswing (Taylor, 2004). The scenario is plausible, but is based on
a bank-centred financial system. As discussed above, the ‘Minsky moment’ in financial
markets in 2007 took place in a decentralised system in which banks and ‘money’ liabilities
played a diminished role.
Finally, in the inflationary 1970s Godley took the lead in setting out techniques for
inflation-proof national accounting. There is much less interest in the topic nowadays so I
will not go through the details. But the next time that inflation rolls around (maybe
beginning in 2008?) proper accounting will be on the shelf because Wynne put it there.
6. Open economy macro

Over the past decade or so, Godley has restated open economy macroeconomics on his
own terms. We first take up his representation of flow equilibrium on the real side in an
elegant SAM, and go on to portfolio choice.
Table 4 shows a Godley SAM for a two-country open economy world. The home
country is to the left and the foreign to the right. To save space, households and business
are consolidated into a single private sector. An N-country set-up would be similar, a scroll
of national SAMs one beside the other with N – 1 exchange rates built in.
The cost decompositions in columns 1 and 1* show that values of output (PX in the
home country) break down into value-added (price Q or the GDP deflator and real
quantity V) and imports, which are treated as a cost because business in the first instance
does the importing. The value of imports is foreign exports E* with price P* converted to
home prices by the exchange rate e. Value-added is decomposed into wage payments wL
and surplus or profits pQV 5 pY. If the non-labour input K can be valued at the output
price P, then the rate of profit is r 5 pQV/PK.
The second columns show that private income Y from row B breaks down into
consumption PC, tax payments Z and saving SY. Presumably SY is influenced by the
income distribution. Government tax income from row E is used in the third columns for
spending PG and saving SG (assumed negative in the home country). Rows F and G give
flows of funds (‘sources’ are positive, ‘uses’ are illustrated with a negative sign). Private
saving is used to finance investment PI and acquire new ‘T-bills’ T_ issued by the
government (interest payments are ignored). In the balance sheets in Table 5, home and
Table 4. Illustrative two-country social accounting matrix
Wynne Godley and macroeconomic modelling

1:costs 2:Y 3:G 4:E 5:I 6:Debt 7:Aid 8:Totals 1* 2* 3* 4* 5* 6* 7* 8*
A: Output PC PG PE PI PX P*C* P*G* P*E* P*I* P*X*

B: VA QV Y Q*V* Y*
C: Wages wL Yw w*L* Y*w
D: Profits pY Yp p*Y* Y*p
E: Taxes Z YG Z* Y*G
F: Y FOF SY –PI 2T_ 0 S*Y –P*I* 2T ’* 0
G: G FOF (SG) T_ eD* 0 S*G T ’* –D* 0
Exch. rates
H –PE 3 (–1/e)/ PE/e
I eP*E* ) 3 (–e)
J –eD* ) 3 (–e) D*
K: Totals PX Y YG 0 0 0 0 P*X* Y* Y*G 0 0 0 0
655
656 L. Taylor
Table 5. A two-country financial accounting matrix
Liabilities
Home Foreign Home Foreign

government government bank bank Total
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*

Total T eT* M eM*
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
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

economy.
Now consider balance sheets. Table 5 presents a FAM for two countries with financial
systems in which the only assets are government bonds and money.2 They are held by
home and foreign private sectors and banks. The accounting is an obvious open economy
extension of textbook versions of the General Theory, and supports a ‘portfolio balance’
model dating back to Tobin. As will be seen, its behaviour under different closures can be
surprising.
The rows describe asset positions. In the first, home banks hold home government
bonds (Tb) and foreign reserves eR*, which sum to the home money supply or M.
*
Analogously, in the third row the foreign money supply eM (valued in terms of the home
currency) is the sum of local bonds eT*b and reserves R. The second and fourth rows are
balance sheets of the home and foreign private sectors. Their levels of wealth are V(e) and
V*(e) which are functions of historical accumulation and the exchange rate.
Down the columns are listed outstanding liabilities of various groups of financial actors.
Thus, in the first column home government liabilities T are held by home (Tb) and foreign
banks (R) and private sectors (Th at home and Tf abroad). Foreign bonds valued in terms of
the home currency (eT*) are similarly distributed to all holders in the second column.
Columns one and two can be interpreted as market-clearing conditions for home and
foreign government bonds. The third and fourth columns must be supplemented by
clearing of money markets, M5M and eM*5eM*.
To see how the portfolio balance model hangs together, begin by observing that the
FAM contains 17 variables. Of those, four are naturally pre-determined: T and T* from
previous government borrowing, and V(e) and V*(e) from previous private sector saving,
with the caveat that wealth levels can change from capital gains or losses due to exchange
rate changes.
That leaves 13 ‘potentially endogenous’ variables: home private sector asset holdings Th,
T*h and M; foreign private holdings Tf , T*f and M*; home and foreign money supplies M

and ; central bank domestic assets Tb and T*b; reserves R and R* and M* the exchange
rate e.
In the FAM, the row totals are always satisfied. The rows for the banks simply define the
money supplies, and the rows for the private sectors must balance because all the securities
out there must be held by somebody. There can, however, be excess supply levels. The
demand entries in the top four rows of the first and second columns do not have to sum to
bond supplies and money demands do not have to equal supplies.
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,

.
V 5 T 1 N and V* 5 T * 2 N e
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.
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

system. We have to trace through the channels via which capital movements can perturb
portfolio balance.
Solve for interest rates in the equations, which set excess supplies of bonds equal to zero,
2 hV 2 eh*V* 5 R 1 Tb 2 T
and
2 fV 2 ef*V* 5 eðR* 1 Tb* 2 T *Þ
and then derive the rest of the variables.
Changing interest rates clear these two equations. The exchange rate cannot be
determined by portfolio balance when money supplies are set exogenously and interest
rates (or asset prices) adjust. There is no ‘duality’ between R* and e as in the Mundell–
Fleming model (if it were in fact valid). For around 40 years it had been thought that the
FAM model under closure 1 had three independent equations which could determine i, i*
and e. That turns out not to be true.
To look at the effects of a capital inflow to the home country, assume a foreign portfolio
shift whereby eTf* falls by ed* and Tf goes up by the same amount. Intuitively, excess
demand for home bonds increases, which would normally be associated with a reduction in
the home interest rate.1 As seen from the perspective of closure 1, an interest rate rise after
the inflow would have to be the result of contractionary monetary policy or a strong
increase in economic activity, which increases money demand.
Closure 2. As good post-Keynesians, Godley and Lavoie prefer to fix interest rates i and i*
as well as (for the moment) e. All money and bond demand levels will thereby be
determined. Can all components of money supplies—Tb, Tb*, R and R*— be endogenous?
To check we can use the money and bond demand-supply balances (all variables on the
right-hand sides are frozen historically or by the fixed values of i, i* and e):
Home money : Tb 1 eR* 5 M
Foreign money : R 1 eTb* 5 eM* ð18Þ
Home bonds : R 1 Tb 5 T 2 Th 2 Tf
Foreign bonds : eR* 1 eTb* 5 eT 2 eTh* 2 eTf*
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

independent financial demand-supply balances in closure 2 determine Tb, eTb* and eR*.
Godley and Lavoie call the resulting automatic sterilisation a ‘compensation principle’. In
emerging markets it appeared not to apply—at least not to the tune of 100%.
Closure 3. The alternative assumption (also pursued by Godley and Lavoie) is to hold
home reserves R* constant and let the exchange rate be endogenous or ‘float’. With interest
rates being used as the monetary policy instruments the Mundell–Fleming duality between
R* and e does apply. The obvious question is which way will a capital inflow make the
exchange rate move?
The answer is that e will decrease, or appreciate. This result shows up in Godley and
Lavoie’s computer simulations, and is analysed in the Appendix here. The intuition is as
follows: to maintain the demand–supply balance for home money when reserves are held
constant after the inflow, home banks’ holdings of home bonds have to go up, private
sectors’ holdings of home bonds have to go down, and/or demand for home money has to
decline. Through both wealth and substitution channels, appreciation has just these effects.
Back to the emerging markets, closure 1 suggests that an interest rate increase after
a capital inflow must be due to restrictive monetary policy or higher economic activity.
Closure 2 asserts that with pegged interest rates there should be a degree of automatic
sterilisation after the inflow. But closure 3 says it cannot be complete because appreciation
is often observed.1 Policy-makers appeared to operate somewhere amongst the three
closures. Rising domestic asset prices are likely to be related to increased activity and
arbitrage linking them to the stronger exchange rate.
Macro models are obtuse. They do what their closures tell them to do. The fact that observed
economic outcomes fall between the closures is an excellent reason not to take the results of any
particular model and its closure too seriously. But the range of results may tell you something
about the possibilities at hand. As Godley and Lavoie put it (p. 489) ‘It must be emphasized
that the use of different closures . . . does not correspond in any straightforward way to
different policy regimes. . .. [W]hatever the institutional background, some results are being
systematically achieved when any particular closure is being adopted.’
7. Wynne the hedgehog

Wynne has long been aware of the stupidity of models when you ask them to say something
useful about practical policy problems. He has spent a fruitful career trying to make models
more sensible and using them to support his policy analysis even when they are obtuse. As
we have seen, this quest has led him to many foxy innovations.
1
Indeed, ‘inflation targeting’ in emerging markets usually works by setting high interest rates to bring in
capital inflows, which lead to anti-inflationary exchange rate appreciation.
But there is an enduring hedgehog aspect as well. Wynne has focused his energy on
combining the models with his acute policy insight based on deep social concern to build
up a large and internally coherent body of work. He has disciples and is widely influential.
One might wish that he had pursued some lines of analysis more aggressively and perhaps
put a bit less effort into others. And maybe not have written down so damn many
equations. But these are quibbles. His work is inspiring, and will guide policy-oriented
macroeconomic modellers for decades to come.
Appendix: Exchange rate appreciation in response to a capital inflowTo show

that a capital inflow leads to appreciation, we can begin by combining

equations (18) for the home money and bond demand–supply balances. The
result is

eR* 5 M 1 Th 1 Tf 1 R 2 T 5 ðm 1 hÞV 1 h*eV* 1 R 2 T ðA1Þ
with the term in parentheses in the middle expression being equal to –Tb.
Assume that foreign holdings of home bonds jump up by a ‘small’ amount dTf 5 ed*, offset
by a decrease –edTf * in foreign holdings of foreign bonds. We have to figure out how the
model will respond when it is forbidden to increase R* in response to the capital inflow but
Tb can vary. Beginning with substitution effects, the standard assumption is that portfolio
shares for home money and bonds respond to changes in asset returns i and i* 1 (e/e) with
e as the expected change in the spot exchange rate. In line with Godley and Lavoie, signs of
the partial derivatives of asset shares are usually assumed to be:
i i* 1 e=e e
m 2 2 1
h 1 2 1
h* 1 2 1
The overall substitution effect of a ‘small’ (positive) change, de, in the exchange rate is
equal to
Sde 5 ½ðme 1 he ÞV 1 h*eV*de > 0
with subscripts denoting partial derivatives with respect to e.
Turning to revaluation effects, equation (A1) can be rewritten as

N
eR* 5 ðm 1 hÞðT 1 NÞ 1 eh* T * 2 1R2T
e
5 ð1 2 f 2 hÞN 1 eh*T * 1 R 2 T
using the condition m 1 h 1 f 5 1.
Noting that eh*T* 5 Tf 1 h*N and using the NFA balance, this expression becomes
0 5 2 fN 1 eT * 2 T
Differentiating and recalling from equation (17) that dN/de 5 Th* 1 R* we get a final
formula:
½ 2 fðTh* 1 R*Þ 1 T * 1 Sde 1 dTf 5 0
Because T* > Th* 1 R* and f < 1 we find that de/dTf < 0 unambiguously.
662 L. Taylor
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A Foxy Hedgehog: Wynne Godley and Macroeconomic Modelling

Article in Cambridge Journal of Economics · January 2008

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Wynne Godley has made enormous contributions to macroeconomic modelling.

Key words: Macroeconomic modelling, Stock–flow consistent modelling

1. The foxiness of Wynne

Manuscript received 30 November 2007; final version received 11 March 2008

2. Stock–flow consistent modelling

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R*d 5 eR*s ð4Þ

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(1) (2) (3) (4) Totals

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Assets Net Worth

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4. Net borrowing but no cycles

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5. Price formation, income distribution and cycles

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(1) (2) (3) (4) (5) (6) Totals

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6. Open economy macro

Wynne Godley and macroeconomic modelling

A: Output PC PG PE PI PX P*C* P*G* P*E* P*I* P*X*

Home Foreign Home Foreign

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7. Wynne the hedgehog

Appendix: Exchange rate appreciation in response to a capital inflowTo show

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Rd 5 eRs ð4Þ

A: Output PC PG PE PI PX PC PG PE PI PX