GDP is a flow and is the sum of the all expenditure flows over a given period

I have two days of teaching left in Helsinki and my next stop on Friday is Dublin where I will be discussing unification and exit. Should be a fun topic. Its Wednesday back home already and today I consider a matter that came up in one of my classes that I am taking in macroeconomics at the moment at the University of Helsinki. Students really struggle when first introduced to the idea of a stock and a flow. They can easily be led into defining a flow as a stock. Getting this absolutely right is one of the key building blocks in understanding basic macroeconomics and the links between the expenditure system and financial accumulation. Modern Monetary Theory (MMT) builds heavily on the difference between stocks and flows and is also what we call stock-flow consistent. So all flows that inform stocks are accounted for in a consistent way. So, for example, we know that when households save, which is the residual of disposable income that is not consumed and a flow, this accumulates into a stock of financial wealth. Today, I am seeking to clarify the issue in my class that we did not have sufficient time to deal with in detail last week. And after that, some music to restore sanity.

GDP is a flow

In my classes last week at Helsinki University we discussed stocks and flows and how they fed into understanding national accounting and financial balances (flow of funds).

I was asked by a student to comment on the so-called ‘bath tub’ analogy that was often used in mainstream macroeconomics textbooks and is still in vogue in some circles.

Within the core MMT group this analogy came up some years ago and my comment then was that it was not a valid representation of the concepts being discussed because it confused stocks with flows.

It also cannot reasonably be used to establish definitive causalities between injections into and leakages from the spending stream, because of the interdependence between the two types of flows.

Here is why.

It was first proposed in Kenneth Boulding’s 1946 book – The Economics of Peace (Prentice-Hall) – where he outlined the basic Keynesian model in the context of the Post WW2 reconstruction requirements in Europe and Asia, which he described as the challenge of “capital rebuilding”.

Capital was defined as:

… the sum total of the valuable things possessed by the individuals of a society, excluding ‘claims’, that is, mere titles to property. The word is used to mean both the inventory of these valuable things – the houses, factories, machines, livestock, stocks of raw materials, and goods in all stages of production – and also to meant he sum of the values of these things.

So Kenneth Boulding was really talking about what economists call ‘stocks’.

It gets tricky here.

He says that:

If, for instance, production in a community is worth 1,000,000 dollars a year, and consumption amounts to 900,00 dollar’ worth a year, there will be a net increase of 100,000 dollars in the value of the stock of capital. Thus a community can increase its rate of accumulation of capital only by increasing production, by decreasing consumption, or by some combination of both.

He says that “this difference is sometimes called ‘saving’, but since this word is ambiguous, it should be avoided as far as possible.

He later noted that ‘saving’ resulted from “the difference between earnings and spendings … an increase in the holdings of money. There is no point in an individual merely accumulating money, that is, cash, beyond a certain point”.

He then says that individauls will make portfolio choices and perhaps “buy securities of some kind”.

So implicit in this construction is the notion that income flows (more about which later) that are not fully recycled back into the spending stream and thus constitute what we consider to be a flow of saving in each period, form the basis of wealth accumulation (a stock of financial assets).

So in this case: income minus consumption equals saving (all flows).

Saving then accumulates to wealth (a stock), which can be held in different forms.

So you can see that Kenneth Boulding is jumping from a difference between flows to an accumulation of a stock, which is fine in the context he is working in – a concentration on wealth construction.

In Chapter 7 Unemployment: The Problem, Kenneth Boulding rehearses the basic Keynesian model that was becoming mainstream in the academy by this point.

This is where he introduces his “Bathtub Theorem”.

He writes in terms of quantities:

The rate of accumulation of the stockpile of goods is equal to the rate of production less the rate of consumption … just as the rate at which water accumulates in a bathtub is the difference between the rate at which it runs in from the faucet and the rate at which it runs out through the drain, so the rate of accumulation of goods is equal to the difference betwen the rate at which goods are added to the stock and the rate at which goods are drained away … If production (the flow from the faucet) is greater than the consumption (the flow down the drain) it is clear that the water in the economic bathtub (the total stock of goods) must rise.

He then applies the ‘Theorem’ to the monetary system – where “expenditure is income”. He rehearses the argument that what applies to the individual “are not true of the system as a whole” – this is the standard Keynesian argument about the fallacy of composition.

He writes to illustrate the point:

To an individual, his money income flows into his pocket, again rather as water flows into a bathtub, and his money expenditure flows out of his pocket just as water disappears down the drain The amount in his pocket (or his bank balance) obviously depends on the relative size of income and expenditure; when he is getting money faster than he is spending it, the amount of money in his pockets increases, just as a bathtub will fill up if water is running in faster than it runs out ….

When we look at our whole society, however, and add up all incomes of all people, and add up all the expenditures of all people, it is clear … that not only must these totals be equal, but that they are simply different ways of looking at exactly the same thing!

We don’t see much more of the ‘bathtub’ after this.

The point is that the individual with a net inflow of income (a flow) can save (a flow) and accumulate those savings in the form of a bank balance (a stock).

The ‘bathtub’ analogy was meant to describe the initial income flows (in and out) and the way in which the difference between the two flows would accumulate as wealth (or a water storage) in the bath.

Using it that way is fine but somewhat confusing as I will explain.

In macroeconomics, we define a ‘steady-state’ or ‘equilibrium’ as a situation where there are no forces present to change the current flow of output and income being produced.

This concept of ‘equilibrium’ is not defined as a ‘market clearing’ state, which means it does not necessarily mean that all the productive resources are being employed.

An economy can come to rest in the macro sense and be plagued by elevated levels of persistent unemployment.

This is why Keynes advocated ‘exogenous’ injections of government spending and/or reductions in tax rates in order to provide an external stimulus to the economy when it is stuck in a undesirable ‘steady state’.

The basic macroeconomic relations tell us that total income (GDP) = total spending = total output.

If spending changes so does output and income in the same direction.

Which should disabuse anyone of the IMF type claims during the GFC that a nation could enjoy a fiscal contraction expansion. That was claptrap.

So equilibrium means GDP remains constant and we can define this in terms of the condition that total injections into the spending stream equal total leakages from the spending stream.

The idea is that in any period, spending is creating income which then leads to household saving (leakage), government taxation rising (leakage) and import spending (leakage).

If there was no offsetting injections into the expenditure stream next period, these leakages would mean that the initial income created would not fully cycle back into the spending stream.

So, to balance the leakages, spending injections have to come from outside the cycle in the form of government spending, business investment and export revenue.

When the leakages equal the injections then the system comes to rest.

Note also that these leakages are themselves dependent on the level of income (and hence spending).

Further, we consider that Gross Domestic Product (GDP) to be the sum of the expenditure coming from Household consumption, Private investment (capital formation), Government spending (recurrent and capital) and Exports minus Imports.

The national account expenditure components (consumption, investment, government spending, exports minus imports) are flows and sum to GDP, which is also a flow.

GDP – that is the market value of all final goods and services produced in a period – is a flow of dollars (or whatever currency that is relevant).

The leakages from the income-expenditure system are also flows – saving from disposable income, taxation revenue to government and import expenditure that flows to the rest of the world.

A flow is measured as a quantity over time, not at a point in time.

A stock is a level measured at a point in time.

So your weekly income is a flow, while your bank balance (if you are lucky enough to have one) is a stock.

So why is the ‘bath tub’ analogy problematic.

The water in a bath or a reservoir is a stock not a flow.

Mountain streams are channelled into dams (reservoirs) to accumulate water. The streams are flows, the accumulation is a stock.

The bath tub analogy constructs the spending injections as water flows into the bath coming from the taps.

The leakages are characterised in the analogy as water draining from the bath via the drain hole.

And, according to the analogy, if the flows in from the tap equals the flows out into the drain, then GDP will be stable.

Which is where the analogy fails.

The failure is because it characterises GDP as a stock – a reservoir of water in the bath.

Considering GDP to be a stock is a basic error that students often make.

Clearly, the ‘bath tub’ analogy is not a good pedagogic device because it perpetuates the confusion that students have in terms of stocks and flows.

On the one hand we go to great length to teach students that GDP is a flow of spending, income and output, but then they come across the ‘bath tub’ analogy which tells them that GDP is the water level in a bath, which is a stock.

A better (but still not perfect) analogy is that is that the expenditure-income process is like a river flowing endlessly into some unspecified horizon.

Accordingly, the injections are the flows into the river from its source (or tributaries) and the leakages are the outflows from the river to other places.

The level of the river will rise and fall according to the inflows and outflows but it will still be flowing.

It also allows us to understand dynamic shifts in equilibrium as the volume of water moving down the river increases and decreases according to inflow shocks and the adjustments that follow via the leakages.

Further, trying to isolate causality between the injections (say, government spending) and leakages (say, tax revenue) is impossible in this type of framework.

That is because there are three injections in the standard framework pushing water into the GDP flow which generates income, which triggers the three leakages.

Which spending source caused the income that allows taxes to be paid, for example?

I didn’t get time in the class last week to clarify these details.

European and UK Teaching and Speaking Tour, February 2020

  • Monday, February 03, 2020 – Meetings in Helsinki.
  • Tuesday, February 04, 2020 – Teaching, University of Helsinki – 16.15-17.45 Porthania P674 – all lectures are public.
  • Wednesday, February 05, 2020 – Teaching, University of Helsinki – 10.15-11.45, Language Centre in Fabianinkatu room 207.
  • Thursday, February 06, 2020 – Teaching, University of Helsinki – 10.15-11.45 Main building, Hall 16.
  • Friday, February 07, 2020 – Presentation at Italian Parliament, Rome – details to follow.
  • Saturday, February 08, 2020 – Events in Rome with activists – details to follow.
  • Sunday, February 09, 2020 – Travel.
  • Monday, February 10, 2020 – Breakfast presentation – ‘The future of monetary policies’ – Nordic West Group, Helsinki (closed event). Later in the day: Speaking on ‘What is the meaning of political economy today?’ at Think Corner, Helsinki – 17:00 to 19:00 (public event).
  • Tuesday, February 11, 2020 – Teaching, University of Helsinki – 16.15-17.45, Porthania room 723.
  • Wednesday, February 12, 2020 – Teaching, University of Helsinki – 10.15-11.45, Language Centre in Fabianinkatu room 207.
  • Thursday, February 13, 2020 – Teaching, University of Helsinki – 10.15-11.45 Main building, Hall 16.
  • Friday, February 14, 2020 – Meetings, Dublin.
  • Saturday, February 15, 2020 – Speaking at public event at Wynn’s Hotel, 35-39 Abbey Street Lower, North City, Dublin – 14:00 to 17:00. All Welcome.
  • Sunday, February 16, 2020 – Athens.
  • Monday, February 17, 2020 – Meetings and Presentations, Athens.
  • Tuesday, February 18, 2020 – Paris, Reception, French Senat, Palace of Luxembourg – 18:00.
  • Wednesday, February 19, 2020 – Presentation to the French Treasury, Closed event. 9:00 to 12:00. Afternoon – press interviews.
  • Thursday, February 20, 2020 – Paris, Presentation to French Senate Commission, Palace of Luxembourg – 8:30-10:30.
  • Thursday, February 20, 2020 – London, GIMMS presentation, MMT education – afternoon – Details.
  • Friday, February 21, 2020 – Manchester, GIMMS presentation, The Harwood Room in the Barnes Wallis Building, University of Manchester, Details.
  • Saturday, February 22, 2020 – MMTed Masterclass Workshop, London, for Details and Tickets. Limited spaces available.
  • Sunday, February 23, 2020 – Amsterdam – private meetings.

GIMMS Events, London and Manchester, February

I encourage you to support these public events in the UK:

1. February 20, 2020 – I will speaking in London about the recent political events in the UK and how an understanding of MMT is essential to rebuild a progressive political force in Britain. Criminologist Steve Hall will also talk and will focus on the current rise of populism in the West.

The event will be at the Unite the Union (Diskus Theatre) in central London and will run from 13:30 to 17:00.

For – Details.

2. February 21, 2020 – The same show moves to Manchester.

The event will be at the Barnes Wallis Building (The Harwood Room) at the University of Manchester and will run from 13:30 to 16:30.

For – Details.

3. February 22, 2020 – MMTed – with help from – GIMMS – will hold a three-hour MMT Masterclass in London between 14:00 and 17:00.

This is a teaching seminar exclusively and will suit those who want to build their understanding of macroeconomics from an MMT perspective.

For more details – MMT Masterclass, London.

There are still vacancies available.

Keef Hartley Band

I felt like listening to some organ and guitar this morning and what better album but – Halfbreed.

I purchased my original copy in 1970 just days after it arrived via import in Australia (it was released in the UK in 1969).

The song is Born to Die.

The band is the Keef Hartley Band (named after its drummer and leader).

They were one of the few British bands to appear at the first Woodstock festival.

Keef Hartley was also the only other musician on John Mayall’s first released the Blues Alone (the first album I ever purchased as a teenager).

This was their first album and was probably their best.

They had lots of changes in line-up which Keef Hartley justified as being like a ‘jazz outfit’, where musicians can freewheel in and out and improvise.

I liked that about them and formed a penchant in the early 1970s in bands I played in for free form.

The lead guitar player on this song and album was Ian Cruickshank, one of the more competent British guitar players who few have ever heard about. He died in 2017.

After starting out in this sort of blues outfit he became a Django Reinhardt devotee and played in his band – Ian Cruickshank’s Gypsy Jazz. He also wrote several books about Django.

This song features beautifully phrased guitar (Gibson SG) and a perfect blend of Hammond B-3 through some Leslie Cabinets.

What a combination!

That is enough for today!

(c) Copyright 2020 William Mitchell. All Rights Reserved.