1. Reconciling Krugman and Keen
An analysis of the relation between debt and
aggregate demand using nef model
Emanuele Campiglio
Giovanni Bernardo
New Economics Foundation
London
23/07/2012

2. Outline
1. Introduction: the Keen – Krugman debate
2. The relation between debt and aggregate demand
3. Our contribution to the debate
4. The theoretical model
5. Scenario simulations
6. A step further: the supply side
7. Conclusions
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

3. Introduction:
the two contenders
Paul Krugman, everybody knows him. Nobel Prize for
economics in 2008 for his work on trade and
international economics. Prolific political
commentator, he writes a blog in the New York Times
(link).
Steve Keen, professor in economics and author of
“Debunking Economics”. Keen is developing a formal analysis
of the intuitions of American economist Hyman Minsky (1919-
1996), focusing on the role of debt in macroeconomic
dynamics. A quite recent version of the model can be
downloaded here.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

4. The bone
of contention
• In March/April 2012 the two have been the protagonists of
a heated debate on money, debt and aggregate demand.
• All was sparked by a paper prepared by Steve Keen for the
INET conference in Berlin, in which he asserted that
changes in the levels of debt add to the economy’s
aggregate demand.
• Krugman disagreed, and replied with a post on his NYT
blog. Keen replied to Krugman, and so on. The feud went
on for a while, involving other economists and generating a
wide debate on the blogosphere.
• A (slightly pro-Keen) chronological summary can be found
at this link.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

5. Debt and
aggregate demand
• What is Keen’s idea exactly, and why has it generated such a passionate reaction from
Krugman?
• A formal explanation by Keen can be found here, but in a nutshell, what Keen argues is that
the aggregate demand in an economy can be different from income, and that the difference
builds up to the net change in the level of debt.
• In other words:
Aggregate Demand = Income + Net change in debt
AD=Y+ΔD
• This sounds very different from what Krugman so often repeats: “Your spending is my
income, and my spending is your income”.
• Although both Keen and Krugman can be considered as “demand-side economists”, their
visions are strongly different when it comes to debt and how this affects the economic
dynamics. As Krugman himself wrote in one of his blogs:
“Keen then goes on to assert that lending is, by definition (at least as I understand it), an
addition to aggregate demand. I guess I don’t get that at all. (..) I think it has something to
do with the notion that creating money = creating demand, but again that isn’t right in any
model I understand.”
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

6. Our contribution (1)
• In this presentation we use nef macroeconomic model to clarify Keen’s
analysis. We do so by explicitly identifying two different variables:
1. Realized expenditures (ER);
2. Planned (or desired) expenditures (EP).
• We show how the main difference between him and Krugman (and the
main source of confusion in the debate) is the way they think of aggregate
demand:
– Krugman identifies Aggregate Demand with Realized Expenditure;
– Keen instead defines Aggregate Demand with Planned Expenditure.
• Using numerical simulations, we show that, both Keen and Krugman are
right in their own logic:
– Realized Expenditure (Krugman’s Aggregate Demand) is indeed equal to
Aggregate Income. That is equivalent to say that at the end of each period
recorded income will be equal to recorded expenditure. What has been
actually spent will result to be someone else’s income.
– Planned Expenditure (Keen’s Aggregate Demand) can instead be different
from Aggregate Income and the discrepancy is, as Keen argues, equal to the
net change in the levels of debt.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

7. What is demand?
• The question then becomes:
What is the right definition of Aggregate Demand?
• We tend to agree with Keen on this: planned expenditures (what firms,
households and governments plan today to spend tomorrow) are the
crucial variable when defining the aggregate demand of an economy.
• As Hyman Minsky put it:
“For real aggregate demand to be increasing,
(..) it is necessary that current spending plans,
summed over all sectors, be greater than
current received income and that some
market technique exist by which aggregate
spending in excess of aggregate anticipated
income can be financed.”
(Minsky, H. P., 1982, Can "it" happen again? : essays on instability and finance. Armonk, N.Y., M.E. Sharpe)
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

8. Banks and credit
• Who finances the gap between the current spending plans and current income? Banks.
• The private banking system is responsible for the creation of the overwhelming majority of the
money supply in circulation.
• “By far the largest role in creating broad money is played by the banking sector.. When
banks make loans they create additional deposits for those that have borrowed.”(Bank of
England, 2007)
Ryan-Collins et al. (2011) Where does money come from?, New Economics Foundation
Berry et al. (2007) Interpreting movements in Broad Money, Bank of England Quarterly Bulletin 2007 Q3
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

9. The role of banking
• Krugman and Keen differ in the way they look at debt and banking.
• As far as we understand, Krugman looks at banks essentially as intermediaries,
moving money from where there is an excess of savings to where credit is needed.
• This is a crucial role of banks, but that’s not all: banks are able to indipendently
create new credit and allocate it in the economy, thus significantly influencing its
shape.
Ryan-Collins et al. (2011) Where does money come from?, New Economics Foundation
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

10. Our Contribution (2)
• Our model explicitly includes the mechanisms through which banks
create new money supply. We will here present a simplified version
of the model that assumes no credit rationing, but if you want to
have a taste of the overall structure you can read the presentation
we gave at the Ecological Economics conference in Rio de Janeiro
last June.
• Our numerical simulations show that, in the simple model we
present here, no growth can take place without the creation of
credit by banks, the net change in the level of debt being the the
crucial variable affecting the dynamics of the economy.
• Finally, we expand Keen’s idea to include the supply side (i.e. the
production process) into the picture. This allows us to consider the
case in which planned expenditure doesn’t become realized
expenditure because of a supply bottleneck.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

11. But enough with words:
Let’s look at the model
• nef has developed a consistent macro framework using system dynamics that
we use for a variety of research questions.
• The overall structure of the model is pictured below:
Aggregate macroeconomic framework Sectoral accounts are connected to an
macro “core unit” where demand,
Production Demand Employment supply, investment and employment
dynamics are modelled.
Sectoral accounts Every agent in the economy is
modelled using a double-entry
Non
Banks
Central Gilt House
financial
Govern book-keeping representation in
Bank sellers holds ment order to ensure consistency in
firms
the model.
• We will here present a simplified version of our macro “core unit”,
abstracting from the sectoral accounts.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

12. A word on
system dynamics
• The model is built employing system dynamics, a methodology
used to study the behaviour of complex systems and based on
the explicit representation of feedback loops. Its basic units are:
– Stocks and Flows (basically, differential equations)
– Connectors (parameters or simultaneous equations)
See this simple example
where Population is a stock,
new born and deaths are
flows affecting the level of
the stock, and the rest of
variables are exogenous
parameters or defined by
simultaneous equations.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

13. Output,
inventories and sales
Inventories
Output Sales
First of all, imagine the production of
output as a flow of goods and service Goods and services leave the
that enters a stock of inventories. Inventories stock once they are
Imagine this as firms producing and sold.
then storing their production in We will for now assume that
warehouses. supply is not an issue:
everything that is demanded
Output is produced according to some is available to be purchased.
production function. We are currently using This is made to focus on the
a standard Cobb-Douglas function of demand side dynamics. We
physical capital and labour, but the will relax this assumption
functional form is not relevant for the point later on.
we want to make here.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

14. Wages and Profits
Planned
Wages (W) Consumption (CP)
Workers then plan their
Sales are distributed among consumption on the basis
workers and firms in the of their wages. For
form of wages and profits.. simplicity, we assume
Sales (S) that workers want to
..That is, in our model Sales consume their entire
are always equal to Income. wage, without saving nor
asking for loans.
Profits (Π)
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

15. What happens
to Profits?
Profits (Π) Net Planned
Profits (ΠN) Investments (IP)
For simplicity, assume that
firms pay no interests on
loans, but just have to
repay a portion of the debt Debt Credit
already contracted. Profits
less the repayment of debt
Repayment (DR) Creation (CC)
are equal to Net Profits.
Net Profits are then entirely
invested in new physical capital. If
Therefore, Planned Investments are equal firms desire to invest more than
to Profits plus Net Credit Creation, where their net profits they need to ask
Net Credit Creation is equal to Credit banks for new loans.
Creation less Debt Repayment.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

16. Planned
Aggregate Expenditure
Wages Planned
Consumption
Finally, Planned Aggregate Expenditure Planned
Sales is equal to Planned Consumption plus Aggregate
Planned Investments. Expenditure
Planned
Profits Investments
Planned Aggregate Expenditure
represents the amount that agents
today plan to spend tomorrow. Net Credit
Creation
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

17. Realized
Expenditure
Planned Aggregate Expenditure become Realized
Expenditure only in the following period. That is, Realized
Expenditures at time t are equal to Planned Expenditures at
time t-1.
Time t Time t+1
Planned Realized
Aggregate Aggregate
Expenditure Expenditure
Remember that for the moment we are assuming that everything is demanded
can be found on the market, so everything that firms plan to spend (either
coming from profits or new credit) is actually spent on something.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

18. The overall picture
(time t)
Realized
Aggregate
Expenditure t+1
Expenditure t
Planned Aggregate
All this happens during the same
Expenditure t
Inventories t
period (time t)
Sales t
At time t+1 the Planned Expenditure
become Realized Expenditure.
Wages t Planned
Consumption t
Planned Net
Profits t
Investments t Credit
Creation t
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

19. The overall picture
(time t+1)
Realized
Aggregate
Expenditure t+1
t+2
Planned Aggregate
Expenditure t+1
In the same period (t+1) all the other
Inventories t+1 variables are determined, including the
Sales t+1 new Planned Aggregate Expenditure.
At time t+2 the Planned Expenditure
become Realized Expenditure, and
Plus, planned
so on..
consumption at time t
becomes consumption
at t+1 and planned Wages t+1 Planned
investments at time t Consumption t+1
become investments at
t+1.
Realized Consumption Net
and Investments then Profits t+1 Planned Credit
affect other model Investments t+1 Creation t+1
sectors, not shown
here.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

20. In analytical terms:
The model can be described by
the following equations: Where:
S : Sales
1) St = ERt ER : Realized Expenditure
2) Wt=α St W : Wages
Π : Profits
3) Πt=St-Wt CP : Planned Consumption
4) CPt=Wt IP : Planned Investments
5) IPt= Πt+ΔDt D : Debt
CC : Credit Creation
6) Dt+1 = Dt+CCt-DRt DR : Debt Repayment
7) DRt=Dt/r EP : Planned Expenditure
and
8) CCt=η(Πt-DRt) α : Labor Share
9) EPt=CPt+IPt r : Debt Repayment Time
10) ERt+1=EPt η : Propensity to Invest
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

21. Some scenarios
On the left, you can see how this
reduced version of our model looks
on the system dynamics software
we’re using, Stella.
For the first run, we set:
• Initial Realized Expenditure:
100
• Initial level of debt = 0
• Infinite inventories
(remember assumption: all
demand is satisfied)
• Eta (η) = 1.4
• Debt repayment time (r) = 5
• Alpha (α) = 0.7
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

22. 1. Controlled growth
180 14
• Realized Expenditure is
always equal to Income
170
12
(and to Sales of course).
160 • Planned Expenditure is
10
higher than Income.
Expenditure and income
150 • The difference between
Net credi creation
8
Planned Expenditure and
140
Income is equal to Net
6
Credit Creation (right Y-
130
axis).
120
4
• In this case Net Credit
Creation converges to
2
110 zero in the long-term as
debt and its repayment
100 0
become larger.
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
• Income (and the whole
Realized Expenditures Planned Expenditures
economy) grows until
Income Net Credit Creation
reaching a plateau.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

23. 2. Exponential growth
800 500
• Change of parameters:
450
700 o Eta = 2;
400 o r= 10.
600
350
• In this case the
expansion of Net Credit
Expenditure and income
500
Net credi creation
300 Creation (Credit
400 250 Creation growing at a
faster pace than Debt
200
300 Repayment) allows for
150 exponential growth.
200
100
• But still the same
100
applies:
50 o Realized Expenditure =
Income;
0 0 o Planned Expenditure > Income
0 1 2 3 4 5 6 7 8 9 10
o Planned Expenditure – Income
Realized Expenditures Planned Expenditures = Net Credit Creation.
Income Net Credit Creation
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

24. 3. No growth
150 10
• What happens when eta =
140 8
1, that is firms invest just
130 6 their net profits and
therefore no new credit is
120 4
created?
Expenditure and income
• The economy doesn’t grow!
Net credi creation
110 2
100 0
• Recalling the Minsky quote:
For real aggregate demand
90 -2 to be increasing, it is
80 -4
necessary that current
spending plans be greater
70 -6
than current received income
60 -8 and that some market
technique exist by which
50 -10
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
aggregate spending in
excess of aggregate
Realized Expenditures Planned Expenditures
anticipated income can be
Income Net Credit Creation
financed.”
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

25. 4. Decline
100 0
• If we allow for a
98
-0.5 positive value of initial
96
loans (D0=30), debt
-1 repayment can bring
94
income down, even if
Expenditure and income
-1.5 eta>1 (new credit is
Net credi creation
92
created). In this case
90 -2
eta=1.1.
88
-2.5
• That is, when Net
86
Credit Creation is
-3 negative (look at the
84 right Y-axis) Planned
82
-3.5 Expenditures are
lower than
80 -4
income, and this
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
brings the economy in
Realized Expenditures Planned Expenditures
a recession.
Income Net Credit Creation
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

26. A step further:
Supply
As we have seen, Planned Realized
Aggregate Expenditure at t-1 Aggregate
determines Realized Aggregate Expenditure t
Expenditure at t.
Planned Aggregate
Expenditure t-1
Inventories t
Output t Sales t
That’s not all. In our macro model
Planned Expenditure is also used
by firms to decide how many
workers they want to hire.
Employment t Capital Stock t Together with the Capital Stock (whose
dynamics is governed by investments and
depreciation) these two factors of
It’s reasonable to say that in the model
production determine the level of output.
supply adapts to demand dynamics.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

27. Some adjustments
Attempted
But let’s keep it simple and Realized
forget about the adjustment of Aggregate
production factors for a Expenditure t
moment.
Planned Aggregate
Expenditure t-1
Inventories t
Output t Sales t We rename Realized Aggregate Expenditure as
Attempted Aggregate Expenditure. That is, Planned
Expenditure at time t-1 is what the economy tries
= Realized to spend at time t. If there is enough output, every
Expenditure attempted expenditure will be realized;
The point that we want to otherwise, just a portion of it.
make here is that this
representation is also capable Sales, which are still equal to Aggregate Income by
of modelling the case in which definition, are now redefined as the minimum
in the economy suffers from a between the Attempted Expenditure and Output plus
supply bottleneck and it’s not Inventories. This allows us to take into account that
possible to satisfy the entire it’s not possible to purchase what hasn’t been
demand. produced. Sales are now the Realized Expenditures.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

28. A simple example
• For the first 10 periods of the simulation, output is set to be
equal to whatever the economy attempts to spend in that
period. We are in the same situation as previous
simulations, where supply always satisfies demand.
• At time 10, we impose a shock: supply is now capable of
satisfying just 90% of demand (Attempted Expenditures).
• At time 13, the situation goes back to the previous
situation: supply is able to satisfy the entire demand again.
• All the parameters and initial values are set equal to
Scenario n.1 (Controlled growth). The initial value of
Inventories is set equal to 30.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

29. A supply constraint
170 • The shock imposed to output
appears very clearly.
160 • For a couple of periods, the
economy doesn’t seem to suffer
much: this is because the stock of
150
inventories is being depleted.
• When Inventories run out, demand
140 (Attempted Expenditure) can’t be
satisfied. Income ( = Realized
130
Expenditure) decreases.
• Planned Expenditure also go
down, as Desired Investments
120 become lower than Profits, thus
leading to a negative Net Credit
110 Creation.
• With a lag of one period, also
Attempted Expenditure drops.
100
• At period 13, when the shock is
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
over, there’s little left to do: the
Output Attempted Expenditure economy is stuck in a steady state
Planned Expenditure Income (Realized Expenditure) that is lower than the potential one.
Emanuele Campiglio – Giovanni Bernardo – New Economics Foundation

30. Some conclusions
The model presented here is very simple and characterized by a variety of limiting assumptions:
– There are no interest payments;
– The demand for loans is completely satisfied by banks;
– There is no price dynamics;
– etc.
Still, we believe it’s capable of grasping some core features of how modern economies work, and
in particular the role of debt in influencing aggregate demand. We have also been able to:
• Clarify Keen’s analysis by explicitly separating realized and planned expenditures.
• Show how Keen and Krugman have different definitions of aggregate demand.
• Show through numerical simulations that both Keen and Krugman are right in their own
logic:
– Realized Expenditure (Krugman’s Aggregate Demand) is equal to Aggregate Income.
– Planned Expenditure (Keen’s Aggregate Demand) can instead be different from Aggregate Income
and the discrepancy is, as Keen argues, equal to the net change in the levels of debt.
• Argue that Keen’s definition of Aggregate Demand is more appropriate, especially if the role
of credit creation by private banks in shaping macroeconomic dynamics is to be understood.
• Show how in our simple model no growth can take place without the creation of credit by
banks. The net change in the level of debt (Net Credit Creation) is the single most important
variable affecting the dynamics of the economy.
• Expand the framework to include the supply side of the economy, and show how a
production bottleneck could complicate the dynamics.

31. Thank you!
emanuele.campiglio@neweconomics.org
www.neweconomics.org