Social Europe

  • EU Forward Project
  • YouTube
  • Podcast
  • Books
  • Newsletter
  • Membership

Modern monetary theory: a simple macroeconomic model

Dirk Ehnts 4th June 2019

Why has modern monetary theory come out of the academy? Because it helps model the current economic predicament and how to get out of it.

modern monetary theory

Dirk Ehnts

Anything we can actually do we can afford. Once done, it is there.

John Maynard Keynes (1942)

Modern monetary theory (MMT) has received a lot of attention recently. Alexandria Ocasio-Cortez, rising star of the US Democratic Party, builds her policies—such as the Green New Deal—on MMT and asks the media to read up on monetary theory. Bernie Sanders, presidential runner, is advised by Stephanie Kelton, one of the leading MMT economists.

In Europe, according to Germany’s biggest newspaper, MMT is on its way to becoming the economic theory of the left. And the Social Europe columnist Peter Bofinger, formerly a member of Germany’s Council of Economic Experts, has written that ‘the combination of expansive fiscal policy and expansive monetary policy is a very powerful tool, which should be used if needed and at the same time handled with great care’.

Insights confirmed

The new thing about MMT is its focus on balance sheets. It examines how governments spend and tax, how central banks and other banks lend and how the private sector borrows and repays. MMT, which is based on more than a quarter century of academic work and cannot be explained in one blog post, has produced insights which have been confirmed since the start.

The biggest insight is that one must divide currency issuers from currency users. Currency issuers are free from technical balance-sheet constraints. If they wanted to, they could increase spending without limit. This works best if there is no outstanding public debt in foreign currency and there is a flexible exchange rate. Countries where this applies include the United States, Canada, Japan, the United Kingdom, Sweden, Switzerland and many more. There are also political constraints, such as the public debt limit in the US, national ‘debt brakes’ in Europe or the Stability and Growth Pact in the eurozone. Rules are however not always enforced, so technically the eurozone is just like any other currency area, even if politically it is not.

The simple macroeconomic model below is based on the insight that (national) income is caused by spending, and that spending has to come from somewhere. Increases in short-term spending and hence short-term debt—private, public or foreign—lead to a rise in income. Be it an increase in government spending, in debt-financed private investment and/or in exports, all these transactions create new net (bank) deposits in the economy. Deposits are in turn drained away by private saving (repayment of debts, for instance), taxation and imports. It is thus plausible that there is a relatively stable connection between changes in net deposits and income. An injection of net deposits is expansionary, whereas their leakage is contractionary. This is shown below. (We ignore inflation and the quantity equation relating the price level and the quantity of money, P(/V)=M/Y.)

ehnts1

Stressing that incomes (Y) and expenditures (AD) have to balance, we can then plot one against the other on a 45-degree line. Assuming that private investment I, government spending G and exports are exogenous and that consumption C, private saving Sp, taxes T and imports depend on national income, we arrive at the following figure (including net exports NX).

ehnts2

We examine the sectoral balances that are derived from the model. The changes in financial savings of the private sector are private saving minus investment (Sp-I), those of the public sector equal tax income minus government spending (T-G) and those of the external sector (the rest of the world) equal imports minus exports. The way that the above diagrams are drawn—and adding the assumption that tax income (not shown above) is equal to government spending—the change in net financial savings of the private sector is zero. This follows from the balanced current account and the public budget’s balance.

ehnts3

We can now move to the total model, which consists of the three parts from above.

modern monetary theory

Simulating an increase in private investment I, the economy will improve as employment rises with the rise in national income. This resembles the real-estate bubbles that we saw in the 2000s in Spain and Ireland.

modern monetary theory

Since what cannot last forever has to stop at some time, we then move to the collapse in private investment I that is caused by a change in expectations regarding future real-estate prices and the likelihood of the next generation of young people being willing to load up with debt to buy a house or flat.

modern monetary theory

Note that the economy contracts, with imports falling below exports. Still assuming a balanced government budget, this allows the private sector to end up with positive net financial savings (Sp-I>0). These are needed to repay old debts and rebuild net wealth. The fall in national income means that we have substantial unemployment as the level of private spending (C+I), given public spending G and rest of the world spending, is too low to lead to full employment. If private investment I cannot be stimulated through a zero-interest rate policy at the European Central Bank, then government spending G is the only game in town. As Hyman Minsky argued, the inherent instability of the capitalist economy can be dampened by relying on Big Bank and Big Government.

modern monetary theory

The increase in government spending G allows the private sector to rebuild its balance sheet while sustaining a level of demand that is compatible with full employment. In the eurozone, the situation is complicated by the fact that the monopoly supplier of currency, the ECB, is allowed to lend to banks but not to governments.

Political constraints

The eurozone’s economic woes are due to political constraints which derive from the construction of the eurozone itself—not from a lack of competitiveness or too much (private or public) debt or technical constraints. These constraints can be addressed politically and fixed. A euro area Treasury would be one way to move forward, as envisaged by the European Commission.

Modern monetary theory thus helps to understand where the eurozone’s problems come from—and how to fix them.

Dirk Ehnts

Dirk Ehnts is a research assistant at the Technical University of Chemnitz and spokesperson of the board of Pufendorf-Gesellschaft eV in Berlin.

Harvard University Press Advertisement

Social Europe Ad - Promoting European social policies

We need your help.

Support Social Europe for less than €5 per month and help keep our content freely accessible to everyone. Your support empowers independent publishing and drives the conversations that matter. Thank you very much!

Social Europe Membership

Click here to become a member

Most Recent Articles

u42198346fb0de2b847 0 How the Billionaire Boom Is Fueling Inequality—and Threatening DemocracyFernanda Balata and Sebastian Mang
u421983441e313714135 0 Why Europe Needs Its Own AI InfrastructureDiane Coyle
u42198346ecb10de1ac 2 Europe Day with New DimensionsLászló Andor and Udo Bullmann
u421983467a362 1feb7ac124db 2 How Europe’s Political Parties Abandoned Openness—and Left Populism to Fill the VoidColin Crouch
u4219834678 41e5 9f3e dc025a33b22c 1 Funding the Future: Why the EU Needs a Bold New BudgetCarla Tavares

Most Popular Articles

startupsgovernment e1744799195663 Governments Are Not StartupsMariana Mazzucato
u421986cbef 2549 4e0c b6c4 b5bb01362b52 0 American SuicideJoschka Fischer
u42198346769d6584 1580 41fe 8c7d 3b9398aa5ec5 1 Why Trump Keeps Winning: The Truth No One AdmitsBo Rothstein
u421983467 a350a084 b098 4970 9834 739dc11b73a5 1 America Is About to Become the Next BrexitJ Bradford DeLong
u4219834676ba1b3a2 b4e1 4c79 960b 6770c60533fa 1 The End of the ‘West’ and Europe’s FutureGuillaume Duval
u421983462e c2ec 4dd2 90a4 b9cfb6856465 1 The Transatlantic Alliance Is Dying—What Comes Next for Europe?Frank Hoffer
u421983467 2a24 4c75 9482 03c99ea44770 3 Trump’s Trade War Tears North America Apart – Could Canada and Mexico Turn to Europe?Malcolm Fairbrother
u4219834676e2a479 85e9 435a bf3f 59c90bfe6225 3 Why Good Business Leaders Tune Out the Trump Noise and Stay FocusedStefan Stern
u42198346 4ba7 b898 27a9d72779f7 1 Confronting the Pandemic’s Toxic Political LegacyJan-Werner Müller
u4219834676574c9 df78 4d38 939b 929d7aea0c20 2 The End of Progess? The Dire Consequences of Trump’s ReturnJoseph Stiglitz

ETUI advertisement

HESA Magazine Cover

What kind of impact is artificial intelligence (AI) having, or likely to have, on the way we work and the conditions we work under? Discover the latest issue of HesaMag, the ETUI’s health and safety magazine, which considers this question from many angles.

DOWNLOAD HERE

Eurofound advertisement

Ageing workforce
How are minimum wage levels changing in Europe?

In a new Eurofound Talks podcast episode, host Mary McCaughey speaks with Eurofound expert Carlos Vacas Soriano about recent changes to minimum wages in Europe and their implications.

Listeners can delve into the intricacies of Europe's minimum wage dynamics and the driving factors behind these shifts. The conversation also highlights the broader effects of minimum wage changes on income inequality and gender equality.

Listen to the episode for free. Also make sure to subscribe to Eurofound Talks so you don’t miss an episode!

LISTEN NOW

Foundation for European Progressive Studies Advertisement

Spring Issues

The Spring issue of The Progressive Post is out!


Since President Trump’s inauguration, the US – hitherto the cornerstone of Western security – is destabilising the world order it helped to build. The US security umbrella is apparently closing on Europe, Ukraine finds itself less and less protected, and the traditional defender of free trade is now shutting the door to foreign goods, sending stock markets on a rollercoaster. How will the European Union respond to this dramatic landscape change? .


Among this issue’s highlights, we discuss European defence strategies, assess how the US president's recent announcements will impact international trade and explore the risks  and opportunities that algorithms pose for workers.


READ THE MAGAZINE

Hans Böckler Stiftung Advertisement

WSI Report

WSI Minimum Wage Report 2025

The trend towards significant nominal minimum wage increases is continuing this year. In view of falling inflation rates, this translates into a sizeable increase in purchasing power for minimum wage earners in most European countries. The background to this is the implementation of the European Minimum Wage Directive, which has led to a reorientation of minimum wage policy in many countries and is thus boosting the dynamics of minimum wages. Most EU countries are now following the reference values for adequate minimum wages enshrined in the directive, which are 60% of the median wage or 50 % of the average wage. However, for Germany, a structural increase is still necessary to make progress towards an adequate minimum wage.

DOWNLOAD HERE

KU Leuven advertisement

The Politics of Unpaid Work

This new book published by Oxford University Press presents the findings of the multiannual ERC research project “Researching Precariousness Across the Paid/Unpaid Work Continuum”,
led by Valeria Pulignano (KU Leuven), which are very important for the prospects of a more equal Europe.

Unpaid labour is no longer limited to the home or volunteer work. It infiltrates paid jobs, eroding rights and deepening inequality. From freelancers’ extra hours to care workers’ unpaid duties, it sustains precarity and fuels inequity. This book exposes the hidden forces behind unpaid labour and calls for systemic change to confront this pressing issue.

DOWNLOAD HERE FOR FREE

Social Europe

Our Mission

Team

Article Submission

Advertisements

Membership

Social Europe Archives

Themes Archive

Politics Archive

Economy Archive

Society Archive

Ecology Archive

Miscellaneous

RSS Feed

Legal Disclosure

Privacy Policy

Copyright

Social Europe ISSN 2628-7641