The idea that the financial sector can amplify the business cycle dates back to the early 1900s. The main focus of finance and growth literature is the way in which financial markets influence the main drivers of growth (such as investment and savings) and the fluctuations of business cycle indirectly, via their impact on the firms and consumers. Keynesians and post-Keynesians believe that aggregate demand is responsible for achieving full employment and economic equilibrium, and investment is placed at the centre stage to stimulate aggregate demand. Classical theorists favour equilibrium with equalised profit rates, process of production, and full utilisation of productive capacity. Accordingly, this chapter extensively discusses the post-Keynesian literature in investment and productivity analysis, and their approaches to macroeconomic modelling.
Top4.1 Introduction
The current crisis has made obvious the power of the financial sector to amplify business cycle dynamics. Two of the most foretelling indicators of a crisis looming in the financial sector were the strong increase in leverage and managers’ appetite for risk due to compensation schemes based on incentives to boost performance (Panetta et al., 2009).
The idea that the financial sector can amplify the business cycle dates back at least to Fisher (1933). In this original view, however, financial factors have an asymmetric role; financial frictions limit the availability of external finance to firms and households, worsening downturns; however, they do not have a symmetric positive role during upturns. The so called financial accelerator theory works mainly through the value of collateral. In its modern reformulation (Bernanke & Gertler, 1989), it predicts that a rise in asset prices makes it easier for households and firms to obtain loans, while a decline makes it more difficult. This mechanism is pro-cyclical because the value of collateral tends to be positively correlated with the business cycle and because credit availability feeds back into investment and consumption, and hence into economic growth. Within the financial accelerator, the focus is on the way in which financial markets influence the business cycle indirectly, via their impact on the non-financial sector (firms and households).
Since the elements of theoretical and empirical analysis in this study follow the Post-Keynesian models of economic growth, in this chapter we start to present an extensive discussion of the literature on investment analysis and macroeconomic modelling. In this chapter macroeconomics short and long term will be argued in Post-Keynesian fashion. In particular Kaleckian and neo-Kaleckian hypotheses about the relation between profit share and capacity utilisation (Bhaduri & Marglin, 1990; Blecker 1999) will be explored. And finally, the theoretical model which will be finalised and used for our empirical objectives will be presented.
Two major schools of thought exist within heterodox economics which share many common elements but diverge on a number of basic issues. Keynesians (including Kaleckian, Post-Keynesian, etc.) emphasise the issue of effective demand and equilibrium at different levels of utilisation of resources. Keynesians and Post-Keynesians believe that aggregate demand is responsible for achieving full employment and economic equilibrium, and investment is placed at the centre stage to stimulate aggregate demand. Classical theorists (including neo Ricardians, Marxists, etc.) favour equilibrium with equalised profit rates, process of production, and full utilisation of productive capacity.
Following the Post-Keynesian monetary approach, the supply of credit-money at any point in time is endogenous and demand-driven, at an exogenously given nominal interest rate. Saving, in turn, is generated by, and concurrently with, investment. The important variable is therefore investment rather than saving, with investment being financed by credit-money generated by entrepreneurial borrowing from the banking system and not by prior saving.
The chapter is structured as follows: Section Two highlights the importance and significance of investment function as an essential driver of economic growth in a Post-Keynesian sense. Development finance and financial fragility is discussed in Section Three and the transformation of financial markets over the last couple of decades is addressed in this section. Section Four reviews the Post-Keynesian growth models in general and the incorporation of financial variables such as interest rate and profit rate into these models. Section Five presents the Kaleckian growth model in particular and its versions and theoretical foundations are discussed in this section. Section Six discusses equilibrium issues in Post-Keynesian tradition and the convergence of short- to long-run process is addressed. Section Seven highlights the commonality between Post-Keynesian theoretical assumptions and New Growth theory which is an inspiration to integrate the theory of financial intermediary into the Kaleckian growth model. Section Eight provides a brief summary.