The Process of Capital Formation: the finance-investment-savings-funding circuit in a Keynesian Stock-Flow Consistent Model

The current article has two main objectives. The first one is to make a historical reconstruction of the debate between Keynes and Classical economists in the period just after the publication of the General Theory (1937-1939) in order to highlight the differences between Liquidity Preference and Loanable funds theory of interest rate determination. In opposition of what seemed to be a consensus in economic literature (See Oreiro, 2001), both theories had very different implications about the nature of the rate of interest and the role of money in economic process. The second objective is to build a simple Keynesian Stock-Flow consistent model for the funding stage of the process of capital formation, represented by the Finance-Investment-Saving-Funding circuit. This simple model makes clearly that long-term interest rate for corporate bonds is a strict monetary variable, being dependent of liquidity preference of households and the monetary policy conducted by the Central Bank. In such framework, an increase in the households´ s propensity to save will increase, rather then decrease, the long term interest rate over corporate debt since it will decrease corporate profits which are the main source of internal funding for firms´ s investment plans, forcing then to issue more corporate debt in order to get the money required for funding investment, thereby reducing the price of corporate bonds and hence increasing the rate of interest over corporate debt.