Including banks in macroeconomic models

8 August 2012

Including banks in macroeconomic models - finally

http://www.neweconomics.org/blog/2012/08/08/including-banks-in-macroeconomic-models-finally

Emanuele Campiglio
Economics researcher

We present the banking part of our macro model, explaining its theoretical framework and offering some numerical simulations.

 By wallyg

The absence of money, debt and banks from the overwhelming majority of “mainstream” economic models has been one of the more pressing criticisms aimed at economists after the financial crisis exploded: how were they supposed to foresee the crisis - or even reach a proper understanding of its mechanisms afterwards - if conventional economic theory didn’t acknowledge the role of banks, nor consider money and debt as influential variables?

Given the fundamental importance that banks have in the process of credit creation and allocation, excluding them from the picture would instinctively sound like an unwise choice. And it is. Nonetheless, banks have been mostly absent from economic theory for many decades. Even some of the major central banks use macroeconometric models where private banks play no role whatsoever (see for example the models of the Bank of England, the European Central Bank and the Federal Reserve).

The situation now looks more hopeful. Discussion is underway within the discipline as to how banking and credit can be included in macroeconomic theory, and many researchers have started building models where their role in shaping the wider economy is explicitly recognised.

nef is hoping to contribute to this challenging task. We have been developing a model with the objective of offering an original and sound perspective on the functioning of the economic system, and study the macro mechanisms linking the 'real' economy to environmental variables (energy and climate change), on one side, and to the financial and banking system on the other.

At this link you can find an introduction to the field we insert our research in, ecological macroeconomics (or macroeconomics of sustainability). More recently, we published a presentation where we use our model to contribute to the debate between Paul Krugman and Steve Keen on debt and aggregate demand. Here we present the way in which we are currently modeling the banking system:

As with every model, this is a simplified representation of reality where we make a number of limiting assumptions and impose exogenous parameters. We believe that it is still able to grasp some of the crucial features of the process of credit creation by central banks, and therefore can positively contribute to the ongoing debate.

More specifically, in this presentation:

• We present a reduced version of nef’s macroeconomic model, composed of a macro “core unit” and a set of sectoral accounts that represent the agents populating the economy (non-financial firms, banks and the central bank).
• We offer an original tractation of the banking system and its interactions with the “real” economy. We explicitly model the crucial role that banks play in the creation of credit by operating a distinction between plannedexpenditures and current income.
• We show that a strong connection exists between the process of credit creation and the growth experienced by the economy: a confident banking system, willing to grant credit to firms for productive investments, is a necessary prerequisite for the economy to prosper.
• We argue that modelling the monetary dynamics of the economy as driven by the decisions of the private banking system - rather than the central bank – offers a more realistic representation of the economic system. We show some evidences supporting our approach and discuss the recent measures of “Quantitative Easing”.
• We build the model using system dynamics methodology, which allows us to run simulations of dynamic scenarios. We also employ a double-entry bookkeeping technique to represent the agents operating in the economy and ensure the consistency of the model.
• Finally, we present some numerical simulations to show how our model reacts to shocks. The level of confidence of the banking system and the propensity to invest of entrepreneurs appear to be two crucial variables in determining the dynamic of the system.