Krugman’s misapplication of neoclassical growth models

30 Dec, 2017 at 11:11 | Posted in Economics | 5 Comments

The fallacies loanable funds theory commits might be explainable by the misapplication​ of some ideas and concepts of neoclassical growth models … to the sphere of money and finance …

The+Bankruptcy+of+Neoclassical+EconomicsThe Ramsey and Solow models are models of real investment only. Financial markets, financial assets and financial saving do not play any role in those models. There is only one good which, for simplicity, will be called “corn”. Corn has three functions: it can be consumed, invested and used as a means of payment since wages and interest payments are made with it. Full employment is assumed … Without money and other financial assets, the only way units can save is to increase their tangible assets, i.e. to invest …

Since the problems of different financial saving plans are not dealt with in Solow’s model, the model cannot be used to make any predictions about economic units’ financial saving behavior, its inconsistencies and thus about the paradox of thrift – neither in the short, medium or long run. There is no miraculous way of short-run financial saving somehow being transformed into long run investment in tangible assets. The two are simply quite different phenomena …

How pervasive this approach is, is shown by Eggertsson and Krugman (2012) who add some features … to a basic neoclassical model. Again, no money but goods are borrowed and lent. Naturally, potential lenders have to save some of their goods before they can lend them to borrowers. But since in the real world money is normally not eaten or planted and keeps circulating in the economy when it is spent or lent, those models cannot be any guide for the analysis of a monetary economy. Specifically, what is true in a one good economy – units have to consume less to lend and invest more – is fundamentally wrong in a monetary economy.

Fabian Lindner

This should come as no surprise. Paul Krugman has repeatedly over the years argued that we should continue to use neoclassical hobby horses like Ramsey style growth, IS-LM, and AS-AD models.

Money and finance don’t​ matter in mainstream neoclassical macroeconomic models. That’s true. According to the ‘classical dichotomy,’ real variables — output and employment — are independent of monetary variables, and so enables mainstream economics to depict the economy as basically a barter system.

But in the real world in which we happen to live, money certainly does matter. Money is not neutral and money matters in both the short run and the long run:

The theory which I desiderate would deal … with an economy in which money plays a part of its own and affects motives and decisions, and is, in short, one of the operative factors in the situation, so that the course of events cannot be predicted in either the long period or in the short, without a knowledge of the behaviour of money between the first state and the last. And it is this which we ought to mean when we speak of a monetary economy.

J. M. Keynes A monetary theory of production (1933)


  1. The theory (or, system) which I desiderate would supply me as needed, independent of money mediation.

    I think Keynes wants to use money as a means of causing certain desired behaviors in others, such as employment and output.

    I disagree that public policy should try to maximize employment and output. I think public policy should encourage mindfulness and knowledge. The more you know, the less you need. Markets assume the opposite; public policy should empower me to live with as minimal interaction with markets as possible.

    I am not interested in what Keynes thinks I should do. I don’t value predictability of behaviors or tastes. We should stop listening to economists who use faith-based assumptions to justify societal hierarchical control mechanisms … /rant

    • P.S. They can add “Covered Interest Parity” to the list of wrongs in Neoclassical theory. Fair pricing of financial derivatives depends upon the assumption of no arbitrage but arbitrage in the $57 trillion currency swap markets has been persistently violated since 2008. Without the no arbitrage assumption, prices are essentially arbitrary. Interest can go negative, riskless profits persist, prices far from fundamental value can persist for a decade.


      • Correcting a sentence:

        “Fair pricing of financial derivatives depends upon the assumption of no arbitrage but the no arbitrage assumption has been persistently violated in the $57 trillion currency swap markets since 2008.”

    • “I think Keynes wants to use money as a means of causing certain desired behaviors in others, such as employment and output. ”
      Where’s this come from?
      Keynes was not about causing, he was about explaining. He was about explaining economic reality and money is part of economic reality.
      “I disagree that public policy should try to maximize employment and output.”
      So you would be happy to be without a job?
      It seems you would just like to kick Keynes in the pants. 🙂

      • I am happiest pursuing knowledge as I wish, not lying to keep a job.

        Jobs, in my experience, are much more about social games, human dominance games, than efficiency of production. I think business culture stifles most disruptive innovation, throttling progress by, for example, hoarding knowledge.

        I do not want to control access to anything, such as code, I may produce. But jobs exist because of enclosure. You must participate, support, enclosure to hold a job. Since I strive to have intransitive preferences and consume less as I learn more, I am an irrational agent and markets have no use for me …

        I also think measurement of output, and employment, is woefully inadequate. GDP does not account for finance. Housing prices are increasing because money is entering the economy in the form of housing loans, but money markets with little connection to Fed interest rates are the uncaptured source. Output is a terrible measure and a terrible social goal. Knowledge should be the goal. Leisure should be the goal, not employment. Basic income should be the policy …

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