An introduction to mainstream versus Post Keynesian economics.

This post provides a brief introduction to mainstream and Post Keynesian economics, highlighting some of the profound differences between the two schools. It is basically a more-handholding version of a four-page section (pages 5 to 9, called “Post Keynesian economics“) from the introduction of John Harvey’s 2009 book, Currency, Capital Flows and Crises: A Post Keynesian analysis of exchange rate determination [Referred to in the rest of this post as “JTH”].

I found this section to be particularly enlightening and challenging, providing an excellent introduction to some fundamental mainstream concepts and the Post Keynesian response. (As I understand it, although made up of several components, Post Keynesianism forms the most important pillar upon which Modern Money Theory, or MMT, is built.)

At the end of this post you will find a list of expert-sources to read in order to get more of an introduction to mainstream and Post Keynesian economics.

This post is a work in progress. In addition to being an attempt to just learn stuff, it’s also in preparation for an interview I’m doing in late November… which is in preparation for an interview I’m doing in mid December. When this paragraph disappears, it’s final 🙂 .


These resources were created by Activist #MMT, the podcast (Twitter, Facebook, web, please consider becoming a monthly patron). This post was last updated October 18, 2020.

Disclaimer: I am a layperson who has studied MMT since February of 2018. I’m not an economist or academic and I don’t speak for the MMT project. The information in this post is my best understanding but I don’t assert it to be perfectly accurate. In order to ensure accuracy, you should rely on the expert sources linked throughout. If you have feedback to improve this post, please get in touch.

Our scenario: setup

Imagine a world with a single country. Or a far away, remote island nation. That country’s economy contains only a private sector; no government and no other countries. In other words, it’s a closed economy. (Every country’s economy has three sectors: government, private, and foreign. This is the idea of sectoral balances. Here is the MMT view of the sectoral balances.) In our simplified private sector, there are only households and firms (businesses).

Given this, consider two equations, the first from the household point of view, the second from the firm point of view:

Y = C + S

Y = C + I

For clarity, let’s use:

Yh = Ch + S

Yf = Cf + I


Y is equal to all of the following, all at the same time.

  • Aggregate output (Yf): the total value of the consumption goods (Cf) produced by, and capital investment (I) made by, all firms.
  • Aggregate expenditures (Yf): the total spending by all firms used to produce consumer goods (Cf) or for investment (I).
  • Aggregate income (Yh): the total income taken in by all households for working at those firms. The income is used to either consume products (Ch) or save (S).

Under normal conditions (in equilibrium, when the economy comes to rest), all three (aggregate output, expenditure, and income) have the same value.

Ch and S

In our scenario, households can only use their income (Yh) for consumption (purchase) of products and services from firms (Ch) or savings in a bank (S). In our simplified example, savings can only be in the form of cash or bonds.

Cf and I

In our scenario, firms can only produce consumption goods (Cf) or invest in capital goods (I). Capital is the physical equipment, etc. used for future production, to increase future profit.

To be clear, in this simplified example, only households can earn, consume, and save. Firms can only borrow, and it can only be used for investment.

Equilibrium: S = I

Given all the above, it is implied that, in our two equations , S is equal to I. (As must be Ch and Cf.) More specifically, the amount saved by households is the same amount as used by (loaned to) firms to invest*.

(*I say this to emphasize that S and I don’t refer to the same pile of money, but rather two piles that happen to contain the same amount: the bonds held by households and the money invested by firms. This is analogous to the computer programming concept of pass-by-reference versus pass-by-value. Basically, assume a number, eight, exists in a box [variable] in a computer. The box has a unique address in the computer’s memory, such as 5A7FD. Pass-by-value accesses the value of the number itself: eight. Pass-by-reference accesses the address of the box in which the number exists. This is analogous to you existing in your house and your house having an address of 123 Sesame Street.)

Back to our scenario, if I and S ever differ, it is always and only a temporary condition. S and I always tend to work their way back to equilibrium (equality, being equal).

All said so far is agreed upon by both mainstream and Post Keynesian economics.

The assumptions and equilibrium of mainstream economics

According to mainstream economics, all agents (individuals in the economy) are assumed to know the future with reasonable certainty. Although it‘s not believed that people can truly know the future, it is believed, when modeling the behavior of the economy, that the assumption “makes the underlying argument simpler without changing the basic result“ [JTH, chapter 1, note 6].

Mainstream also assumes agents to be insatiable with an infinite demand for products and services. This implies they have no desire to save or, conversely, always choose to spend all their income (there is an exception as discussed below).

These assumptions have profound implications. If all agents in the economy are insatiable and spend all their income, then total demand in the economy (aggregate demand) must always be maximized. This means firms can always be confident that their product will sell and that they will always need more workers in order to meet the demand.

For workers and households, there is no fear of spending all income because there is no fear of not having future income. This is because all agents are insatiable and able to see the future (implying all agents know this of all other agents). Even if a worker did lose their job (or, for example, had to leave in order to relocate their family) always-maximized aggregate demand means another job is always ready and waiting.

Because of all the above, mainstream economics logically assumes the economy to always trend to truly-full employment. In other words, equilibrium is assumed to be where household savings (S) is equal to firm investment (I), and also when everyone who wants a job can have a job.

To emphasize, mainstream equilibrium is:

S = I, at full employment

The phenomenal cosmic power of mainstream interest rates

There is an exception to household agents wanting to spend every dollar of income and that is when they’re provided with more incentive to not spend. In the mainstream view, that incentive is in the form of interest rates as set by banks. (Since the government doesn’t exist in our secenario, neither does the central bank. So rates are set by local, commercial banks.) When the interest rate is high enough, agents will invest at least some of their income into bonds at their local bank.

The agent gives the bank cash and gets a bond certificate in return. Under the mainstream assumption of loanable funds, the bank now has more cash available to lend out to firms. According to loanable funds, banks can only lend out money they have on hand in their vaults. In other words, they can only lend out other people’s money. This implies that banks don’t, or can’t, create money.

A bank’s cash-on-hand provides it with valuable information on the condition of the economy, for both households and firms. The very existence of cash in their vaults (excess balances) may mean that interest rates are too high. Bond holders may be happy with their interest income, but firms are not taking out loans due to it being too expensive.

This is a state of disequilibrium: S > I

(The danger being that insatiable spending will continue unabated, but at some point may no longer be met by productivity.)

Conversely, if firms are clamoring for loans when the bank has no cash in its vault, then interest rates are too low. Firms are willing to pay more, but a higher interest-rate is required to incentivize households into spending less and instead purchasing more bonds.

This is also disequilibrium: S < I

When there is disequilibrium of any kind, banks are in the position to immediately adjust their interest rates which can quickly stabilize the economy. The banks’ incentive for doing so is provided by their own natural desire for profit.

Regarding the mainstream view, John Harvey concludes [JTH, pg 6, original emphasis]:

In short, whenever S > I and a recession looms, interest rates automatically fall to reinvigorate spending in the form of rising consumption and investment. Thus in a world where the future is known, the financial sector responds directly to the needs of the real sector and there is never an obstacle to reaching full employment.

(The assumption of full employment by mainstream economics is directly contradicted by our current reality. Millions of Americans are deliberately kept unemployed [and underemployed], left to greatly suffer, in order to fight the never-before-seen Boogeyman of runaway inflation. This is academically justified by mainstream economics with their theory of NAIRU.)

The unique reality of banks in the mainstream, closed-economy, loanable-funds world

Given the mainstream assumptions of loanable funds and households that spend every dollar of income (given low-enough interest rates), banks in this simplified scenario (with no government sector) are quite unique. (Also note that, because aggregate demand is always maximized, firms always borrow all available funds from the bank.)

Banks’ only source of income are the proceeds from bond sales to households and loan payments from firms. Their only expenditures are paying interest to household bondholders and (the risk taken by) lending (their loanable-funds cash) to firms.

Because the interest-rate in our scenario applies to both loans and bonds, the banks make little to no profit. In fact, because interest rates fluctuate over time, it is very likely that there will soon not be enough money in the economy to cover loan payments (principal plus interest). This implies the loanable funds model, in which banks can’t create money, is an impossibility.

The Post Keynesian view

According to mainstream economics, the natural state of the economy is when both S = I (when savings by households equals investment by firms), and it is at a state of full employment. Because this is the market’s natural state – its equilibrium – it implies that any outside interference, such as by a government, is at best redundant. At worst, government interference in the market will cause people to lose their jobs and firms to lose their profit, having obviously devastating effects on the economy and the actual human beings it consists of.

Post Keynesian agrees that equilibrium is when S = I. It disagrees, however that this will also be a state of full employment, except by unusual or random occurrence. This implies that the only way for full employment to be reliably attained and maintained – In both good times and bad – is with ongoing intervention by an outside force.

According to Modern Money Theory, or MMT, the only outside force with the economic flexibility to attain and maintain truly full employment is a free-floating currency issuer, such as the central governments of the United States, United Kingdom, Japan, Canada, and Australia. This 1999 paper by Mat Forstater describes the many unique and powerful advantages that free-floating currency issuers have regarding implementing a jobs guarantee (and why it’s impossible and undesirable for for-profit business).

The idea of a closed system requiring power from an external system is the second law of thermodynamics. The law states that “the entropy of a closed system can only increase.” Here are two other ways of saying the same thing:

  • the energy of a closed system can only decrease,
  • the energy of a reaction always contains less than what caused it.

In other words, unless a closed system receives energy from an external source, it will eventually cease to function. The natural state of things, therefore, is maximum entropy, or complete loss of power. The idea that a market system can only be truly free when it is truly free from government interference (or indeed, when there is no government), is no different than the idea of a smartphone or laptop that never needs a charge. Without government, there can be no economy. According to chartalism, this has been the case for thousands of years. The invisible hand is not just invisible, it doesn’t exist.

Post Keynesian flatly rejects most of the above mainstream assumptions and therefore the story that depends on them. It rejects the idea that economic agents (individuals in the economy) can see the future in any sense. The past is already written and the future is unknowable and uncertain (this is called historical time). It means that households will not always spend all their income, because saving is sometimes necessary to prepare for potential future crises. Agents are still insatiable, but not just for products and services (consumer goods). They also desire money – which, in part, represents the potential for future products and services.

Post Keynesian also rejects the idea of loanable funds (that banks can only lend other people’s money). Banks in the real world create money (issue credit) every time they lend (not unlike central governments, which issue currency every time they spend). They are authorized agents of the government. (Watch John Harvey explain how banks do indeed create money, every time they make a loan: video, audio.)

For households, in the mainstream view, higher interest rates are incentive to not spend. In the Post Keynesian view, higher interest rates are incentive to reduce liquidity – that is, to hold less in cash and more in bonds*. The amount saved by a household is mostly unaffected by the interest rate.

*Liquid means easier to spend. Cash is liquid but earns no interest. Bonds earn interest but must be transferred back into cash before it can be spent (which can take time and result in extra fees).

Posts related to liquidity:

According to mainstream, a bank’s interest rates are adjusted exclusively in response to its stock of loanable funds. In order to maximize profit, it must minimize the cash in its vaults. This is also necessary in order to satisfy the insatiable desires of firms to borrow and households to spend. Since loanable funds does not match reality, banks must alter their interest rates for another reason.

According to Post Keynesian, “Interest comes to rest at the point where the market for liquidity clears [JTH, 7].” Banks continue to adjust their interest rate until the amount of cash households want to have a satisfied. The amount of liquidity desired by households is what they feel is necessary to prepare for an unknown future. In other words, liquidity preference, and therefore banks’ interest rate, is fundamentally based on psychological factors; something nearly impossible to represent in a math-based model.


Fifty years of neoliberal policy has lavished the few, neglected the many, and brought us to the brink of worldwide societal collapse. That policy has been academically justified by mainstream theories and models, such as the above, claiming to describe more than is possible, based on assumptions disconnected from reality.

Yet those who develop, advocate, and defend those theories are rewarded handsomely by those who have been lavished; those with the wealth and power to weather the inevitable and growing storms – substantially caused by those very theories, models, and absurd assumptions.

Post Keynesianism, and its offshoot, MMT, endeavors to be a lens through which to see the economy as it actually is. The economy is made up of human beings. Humans have psychology, politics, and culture; they’re impulsive and can be influenced. They can’t know the future and are forever marked by the past. Only by acknowledging that we cannot model the entire world, do we have a chance to analyze it in the most accurate way possible. As society and its institutions change, so must our economics.

From page eight in John Harvey’s 2009 book, Currency, Capital Flows and Crises:

… Post Keynesians do not expect their models to be deterministic predictors of the real world. Our analysis is a guide and it helps us create a common vocabulary and organize our thoughts. But the real world is too complex and changing to assume more than this. The evolution of history and institutions must be taken into account and they must be allowed to lead us to change our minds about how the economy works.

Further reading: Expert-created sources introducing mainstream versus Post Keynesian economics.

Top image from overjupiter on Pixabay (license)