Posted by: Dirk | March 4, 2019

A simple macroeconomic model based on Modern Monetary Theory (and published in 2014 in a peer-reviewed journal)

There is a lot of talk about how MMT would lack a “model”. Some commentators on Twitter even claim that MMT would have “no model” and that they just created one themselves. Others believe that stock-flow consistent (SFC) models are basically SFC models. All of that is not quite right!

I think that the only model that can really claim to be a “MMT model” is the one I published in a peer-reviewed journal in 2014. The article in the International Journal of Pluralism and Economics Education (IJPEE) was named “A simple macroeconomic model of a currency union with endogenous money and saving-investment imbalances” (link). With hindsight, it was not a good title, since there is nothing specific about “currency union” or (private!) “saving-investment imbalances” in the model. It is really a replacement of the IS/LM-model and nothing else. The working paper version is accessible freely and was written in 2012 (link). During that year, I was at the Hyman-Minsky summer school at the Levy Institute of Bard College, NY. I showed the model to Randy Wray and Scott Fullwiler and some other people and they all liked it. Given that my model has the sectoral balances at its core that did not surprise me.

Since the model has not gotten a lot of attention so far – I presented it at University of Cassino in Italy after being invited there to spend a week with SFC modeler Gennaro Zezza and in some other place – I would like to use this blog post to explain the model briefly. Of course, the IJPEE paper is the long version. (The working paper contains some minor flaws that had been fixed in the journal version.) For those who can’t wait to see it, you can download a spreadsheet file of the ISMY model here. It has all the equations and is solvable by toying around with it.

(For those interested in MMT and European Macroeconomics please have a look at my 2016 book of that very same name published with Routledge.)

Why should we get rid of the IS/LM model?

  1. There is always “equilibrium” in the money market. It does not make sense to claim that supply and demand interact. Banks borrow reserves against collateral, so demand determines supply.
  2. Central banks don’t use open market operations to influence interest rates – they set some interest rates that establish a corridor for the interbank market interest rate.
  3. An increase in government spending does _not_ increase the rate of interest.
  4. While the IS/LM-model features Saving (excess of income over expenditure), there is no corresponding change in (net) debt (excess of expenditure over income).
  5. Investment is negatively dependent on the interest rate, which is highly doubtable.
  6. There is no external sector, hence there are no imports and exports.

In my model, I fixed all these things and I added the sectoral balance equation. Change in net financial saving by private, public and external sector has to add up to zero. I equation form: (Sp-I) + (T-G) + (IM-EX) = 0. All changes in net financial debt of the sectors can be read off the graphical model, which I think is an important innovation. An economy that shows an increase in private debt is not “sustainable” – private debt cannot grow forever. If something cannot go on forever it will stop. So, the discussion of how flows translate into stocks is what is important.

The graphical model

So, here is the short version of the IS/MY-model (I=S, change in M changes Y). You find the long version in the paper (see link above). We start with the SE quadrant, where income (real GDP; in the base scenario inflation is zero and hence nominal is real) is determined by the changes in net deposits (given everything else!). If there is net injection of bank deposits through any combination of increases in private investment (financed by loans), government spending (“financed” by the central bank via banks if necessary – remember that the central bank is the monopoly issuer of currency and hence cannot finance its expenditures. It just spend!) , or exports (leading to an increase in net deposits as well).

Given some rate of inflation, changes in net deposits translate into changes in income (GDP) as additions to net deposits are created to be spend – and they are, creating higher income along the way. We assume that there is some unemployment, so that increases in spending translate into changes in income only. However, you would be free to shift the P/V=M/Y curve (which is an identity!) around as you like. So, if you think that increases in government spending are inflationary, just turn the line around clockwise and then an increase in net deposits leads only to a small increase in (real) income. If you come out of  a depression (preferably with no private debt overhang), the line might be even flatter then the line I’ve drawn – an increase in net deposits creates a large increase in GDP.

bank deposits and income.png

The NE quadrant is the heart of the IS/MY-model since it is here that changes in net deposits translate into changes in the macroeconomic variables. Note that government spending (G), private investment (I) and exports are exogenous variables. They do not depend systematically on any other macroeconomic variables in the model. Government spending is what the budget says plus some changes due to relatively strong/weak economic growth (automatic stabilizers). Investment depends on animal spirits and financing conditions (Minsky) and past validations of investments (Minsky again) more than on the nominal rate of interest set by the central bank. Once private investment grows there is a strong tendency to continue to grow. This resembles what Gunnar Myrdal called “cumulative causation”. Exports depend on what the rest of the world wants to buy at current exchange rates (or whatever expected exchange rates you can imagine).

Anybody familiar with macro models will then no be surprise by the way the endogenous variables work. Taxes (not visible), consumption (C) and imports depend on domestic income (real GDP). There is a tax rate of t that, multiplied with Y, determines T. Also, consumers spend a share c of their income. Some share imp of total income is spend on imports. Since expenditures and income have to add up, we must be on the 45 degree line. And that is it!

real economy.png

The last (NW) quadrant is the change in net financial savings of the private sector. Since in the last quadrant you can read off current account (EX-IM) and government budget surplus or deficit (imagine a tax line that starts at zero/zero and then increases with income), you can determine the net financial savings of the private sector: Sp – I.


If you end up on the left half, the private sector is net saving. This is connected to relatively low levels of demand. If you end up on the right half, then the private sector is investing more than it is saving (which leads to an increase in its debt). Starting to view the economy from this quadrant you can easily think about private sector deleveraging and private investment driving the economy in a (real estate) boom.

The business cycle and economic policy

Now here is a stylized account of the business cycle. We start in a situation where the current account is in balance, the public budget is in balance and hence the private sector balance is in budget as well. We assume that there is some unemployment so that income (GDP) can rise during a boom. Obviously, there must be a resource constraint somewhere to the right of the initial equilibrium but since in the last 50 years we never reached it there is no discussion of it. (That does not mean that it does not matter!)


We then have a business boom financed by loans which shifts private investment up, pulling the economy along. Note that net deposit creation is positive as more new loans are taken out than old loans are repaid. The private sector moves into more debt, the current account moves into deficit. The economy expands, GDP and employment go up.


At some point, the boom stops. Private investment collapses (for whatever reason), restoring the private sector’s traditional surplus (upper left). Net deposits are destroyed by loan repayment as the private sector deleverages (lower right). GDP falls as a result of less investment, the current account swings from deficit to surplus as GDP falls. (By assumption, the public sector’s balance is zero.)


In order to increase employment the government spends more, which allows the private sector to continue to be a net saver. The deficit is now with government. The current account is balanced. Since government spending does not crowd out private investment or increase interest rates there is no problem with this policy. Public debt is just the outstanding amount of tax credits that the government has injected into the economy in the past.


As you can see, the model and the macroeconomic MMT story fit quite well. We have some exogenous variables, for very good reasons. Some are endogenous and well-established. Who would doubt that with a rise in income the variables taxes, imports and consumption go up? Of course, what the actual relationship should be depends mostly on real world data. So, the numbers in the spreadsheet are not to be taken as carved in concrete!

Of course, there are things missing that need to be explained in more detail – like the role of inequality, the role of wage growth, the effects of an export strategy (China, Japan, Germany), Colonial monetary systems, the twin deficits (public and external sector), the role of inflation (turning and shifting that line in the SE quadrant), the role of monetary operations and policy and the legal origins of money, the connection to environmental sustainability, the role of digital currency, the effects of a Job Guarantee and a Green New Deal. The model presented so far is just the basic version – all these things can be thought about in terms of the model! (Obviously, not all issues have [significant] macroeconomic effects, but it is sometimes interesting to see why not – think about QE.)


I hope that it now clear why I believe that the IS/LM-model should be replaced and why my IS/MY model would be a good candidate to do that. I believe that this model helps students and scholars alike to better understand the economy. It definitely passes the market test as it explains the sectoral balances that, for instance, the chief economist of Goldman Sachs has been using for years. It includes the latest writings on endogenous money as published by MMT authors (I am deeply indebted to Randy Wray, Stephanie Kelton, Scott Fullwiler, Pavlina Tcherneva, Fadhel Kaboub, Warren Mosler and all the others!) and recently confirmed by central banks worldwide. There is no hiding of the fact that a government cannot go broke if indebted in its own currency and being supported by its central bank (like in Japan). Also, the discussion of balance sheets prior to looking at the macroeconomic model – this is basically where MMT comes in directly – provides realistic “microfoundations” (actually, a description of behavior of economic agents) of the economy.

I hope that in the area of simple, graphical models it is now also wrong to say: “There is no alternative”. There is!

(c) 2019 Dirk Ehnts (



  1. “Others believe that stock-flow consistent (SFC) models are basically SFC models. “

    What does this mean? Seems to be a typo. Should the second SFC be “MMT”?

    • Yes, thanks.

  2. […] A simple macroeconomic model based on Modern Monetary Theory… […]

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