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Monetary circuit theory assumes that the money supply is endogenously determined by the banking system. Money is provided by banks through loans and overdraft facilities demanded by firms (and households) undertaking real sector activities. Within monetary circuit theory money is only considered as a means of payment, not as a store of wealth. Unfortunately, Keynes’s important distinction in his Treatise on Money between industrial and financial circulation seems to have been lost. Industrial circulation is the part of bank credit that goes to firms and households for current business purposes related to production and consumption - the focus of monetary circuit theory. Although financial circulation is an important part of banks’ balance sheet in the form of savings deposits, this is hardly discussed in monetary circuit theory. In this paper, we shall argue that monetary circuit theory would be more coherent if it were expanded to incorporate some aspects of Keynes’s view on financial circulation. In a modern context, it has become apparent that it is financial circulation which contributed significantly to the inflated asset bubble in the first place and the credit crunch in the second round. Hence, bank lending, which creates means of payment, should be regulated and monitored closely. Banks’ industrial activities, notably the creation of means of payment, could be separated from speculative activities. Highly liquid stores of wealth, i.e. savings deposits, do not have to be means of payment. Hence, banks should be divided into two categories: industrial/business banks, where deposits are used as means of payment (and covered by a state guarantee), and financial banks, where deposits carry an interest, but are not guaranteed by legal arrangement. This regulation would limit the amount of means of payment to what is required for production and trade and still make it possible for the Central bank to pursue a flexible monetary policy. This insight can be obtained by a combination of monetary circuit theory and Keynes’s analysis of industrial and financial circulation put forward in his Treatise on Money.
Keywords: Keynes’s monetary theory, monetary circuit theory, regulation of banks, financial crisis
JEL classification: E12 E44 E51 G21