Cambridge Journal of Economics 1997, 21, 633-639

NOTES AND COMMENTS

Money, fiscal policy and the Cambridge

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theorem
Thomas I. Palley*

This paper extends the Cambridge theory of income distribution to a monetary

economy, and explores the implications of fiscal deficits that are money financed.
It is shown that the Pasinetti Paradox represents a special case applicable to either
a non-monetary economy or a monetary economy with constant prices. Once
steady-state inflation is introduced, this generates an inflation tax on money
holdings which affects saving. If the distribution of money holdings depends upon
relative consumption shares, then the savings propensity of workers affects the
distribution of the burden of the inflation tax, which in turn affects the profit rate
and profit share.

1. Introduction
Pasinetti's (1961/62) Cambridge theorem, regarding the irrelevance of workers' savings
behaviour for the determination of the steady-state distribution of income, has recently
been the subject of investigation once again. At issue has been the question of
whether the introduction of a government sector invalidates the theorem. Fleck and
Domenghino (1987) produced a model in which the Cambridge theorem was invali-
dated when government operated a budget surplus. Dalziel (1991/92) then showed that
this result followed from the violation of a steady-state condition, since government was
modelled as saving at a faster rate than capitalists, thereby ultimately driving the
capitalists out of existence. Most recently, Dalziel (1991) has generalised the Cam-
bridge theorem to allow for changing stocks of financial assets resulting from bond-
financed government deficits, and has shown its continuing validity under a number of
alternative assumptions regarding the conduct of fiscal policy and agents' savings
behaviour in the presence of deficits.1
However, all the above papers treat the economy as if it were non-monetary, and there-
fore fail to account for the monetary effects of steady-state price change. The current
paper extends the analysis to a monetary economy. This allows for money-financed
deficits which introduce concerns with changing money stocks and inflation. While
retaining the core insight of the Cambridge theorem, regarding the macroeconomic

Manuscript received 18 January 1995;finalversion received 9 February 1996.

* New School for Social Research, New York.
1
Pasinetti (1989) also provides a survey of the impact of government activity with a variety of taxes and
a steady-state budget deficit.

© Cambridge Political Economy Society 1997

634 T. I. Palley
character of income distribution, the paper shows that the Pasinetti Paradox represents a
special case in which the price level is constant along the steady-state growth path. Once
steady-state inflation is introduced into the analysis, this gives rise to an inflation tax
effect requiring that agents steadily augment their nominal money balances to maintain
their steady-state real balances, and this affects savings. If the distribution of money
holdings depends upon relative consumption shares, then the saving propensity of
workers affects the distribution of the burden of the inflation tax, thereby affecting the
determination of the steady-state income distribution.

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2. The Cambridge theorem with capital and bonds
We begin with a derivation of the Cambridge theorem with capital and bonds. Owner-
ship, savings, and profits are governed by the following accounting relations:
K=KW + KK (1)
B = B w + BK (2)
P = P w + PK (3)
S = S w + SK (4)
[K, + Bj\/[K +B] = [Pj + iBj\/[P + iB] = S/S=z, )=W,K (5)
z w + zK = 1 (6)
where K = aggregate capital stock; B = aggregate stock of bonds; P = aggregate prof-
its; S = aggregate savings; z, = ownership share of the j * class. The subscript W denotes
workers; the subscript K denotes capitalists. Equations (1) - (4) divide the aggregate
capital stock, the government debt, profits, and savings between workers and capital-
ists. Equation (5) has the share of the capital and bond stock owned by a class equal to
its share of profits and interest, which in turn is equal to its share of savings. Equation
(6) has ownership shares summing to unity.
Capitalists' income derives from profits and interest on the government debt, out of
which they must finance a share of aggregate investment and the government deficit
equal to their ownership share of the capital and bond stock. This implies that:
zK[I + D) = 5K[1 - tP] [PK + iB*} (7)
where / = aggregate investment; D — government deficit; sK = capitalists' propensity to
save; tp = tax rate on profits. In steady state the debt:output and capital:output ratios
are both constant, which implies
B = bY (8)
K = kY (9)
IIK=DIB = gY (10)
where gY = rate of growth of output. Lastly, the interest rate is equal to the rate of
profit so that
i = PIK (11)
 Money, fiscal policy and the Cambridge theorem 635
Appropriate substitution in equation (7) then yields
P/K = I/sK[l - tP]K (12)
P/Y = I/sK[l - tP]Y (13)
These are the Cambridge conditions augmented for the existence of a profit tax, and
they correspond to the conditions derived by Steedman (1972). The key equation in
this derivation is equation (7), which requires that gross profit and interest income
adjust such that capitalists' after-tax income is sufficient to meet their funding obliga-

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tions. This is the intuition behind the post-Keynesian claim (Dalziel, 1991, p. 298) that
taxes are always shifted away from profits on to wages.

3. The Cambridge theorem with money

The above derivation of the Cambridge theorem is based on an economy in which
there is no money and no effects of price change. This section explores the implications
of introducing money and price change into the analysis. The introduction of prices
introduces a distinction between real and nominal income, and also calls for a theory of
the price level and inflation. Nominal income can be decomposed into prices and real
output according to
Y = py (14)
where p = general price level and y = level of real output. The steady-state price level is
assumed to be determined according to the equation of exchange given by
MV= Y = py (15)
where M = total money stock and V = velocity. Rearranging (15) implies a steady-state
money:output ratio of 1/F. For simplicity it is assumed that velocity is constant which
implies that the rate of inflation is given by
P = gM~gy (16)
where p = rate of inflation; gM = rate of nominal money supply growth; gy = rate of real
output growth.
There are now four cases to be analysed:
(i) pure money-financed deficits;
(ii) mixed deficit financing with constant prices;
(iii) mixed deficit financing with changing prices; and
(iv) surpluses.

(i) Pure money-financed deficits

Given a growing economy, full monetisation of the deficit means that the debt:income
ratio shrinks to zero in steady state. The change in the money stock is given by
D (17)
where dM = change in the money stock. Given a fixed deficit:income ratio, the change
in the money stock is
dM = qY (18)
where q = deficitrincome ratio.
636 T. I. Palley
The introduction of money introduces complications associated with the distribution
of money holdings across classes. For this purpose, money holdings are assumed to be
distributed according to relative consumption shares, which implies that capitalists'
share of the money stock is given by
MK/M=cK (19)
where MK = capitalists' money holdings; cK = capitalists' consumption expenditures as
a share of total consumption expenditures. Capitalists' share of consumption expendi-
tures is then given by

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{[1 - * d [ [ l - tw][Y - P] + [1 - rp][l - ZK\F\ + [1 - 5K][1 - tp]zKP}
= C(SK, 4 , t~p, 4 , Z

where the signs above the functional arguments represent the signs of the partial deriva-
tives.1 Note that since there are no bonds, there is no interest income in equation (20).
Once again, capitalists must save an amount sufficient to finance their share of
investment. However, agents must use part of their income to augment their nominal
money balances in order to maintain their steady-state real balances, which would
otherwise be eroded by the inflation tax. Consequently, this requires modifying
equation (7) so that
zKI + pcKM = 5K[1 - tp]PK (21)
where the term pc^M represents the inflation tax paid by capitalists.2 Appropriate
manipulation using equation (5) then yields
PIK = / / 5 K [ 1 - tp]K + pcKM/sK[l - tp]zKK (22)

P/Y = I/sK[l -tp]Y + pcKM/sk[l -tp]zKY (23)

Equations (22) and (23) are the standard Pasinetti conditions augmented by an
expression capturing the effects of the inflation tax. If the inflation tax is positive, this
implies that both the profit rate and profit share will be higher than the no inflation
case. The economic logic is that capitalists must now use part of their income to restore
their real money balances, and they therefore require a higher profit rate and profit
share to finance their share of investment. Inflation generated by monetisation of the
deficit is therefore favourable to profits, and the inflation tax is similar to the profit tax
in the sense that is passed on to workers via a higher profit rate and profit share.
Inspection of equations (22) and (23) reveals that they include the terms cK and zK.
Both of these terms depend on the relative propensities to save of workers and capital-
ists, so that workers' savings behaviour matters for the determination of the steady-state
profit rate and profit share. The reason is that there exists a class of asset (money) that
is distributed on the basis of relative consumption shares rather than savings shares.
Consequently, relative consumption behaviours determine the distribution of this asset
and the distribution of the burden of the inflation tax. If cK = z^, so that money hold-
ings are distributed in the same proportion as capital and bonds, then these terms
1
In signing the partial derivative of PlY'u is assumed that tp > tw.
2
Note that all variables are in nominal terms, given the specification of money in terms of nominal
supply.
 Money, fiscal policy and the Cambridge theorem 637
disappear from equations (22) and (23). This restores the independence of the steady-
state profit rate and profit share from workers' savings behaviour, but the effects of the
inflation tax continue to be relevant, and are still passed on to wages.

(it) Mixed financing with constant prices

An alternative to monetisation of the deficit is to use mixed bond and money financing,
where the proportion of monetary finance is targeted to hold prices constant. The
requirement of a constant debt:income ratio requires that the nominal debt grows at
the rate of nominal income, which implies

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gB = P + gy (24)
This implies that the change in the debt is given by
dB=[p + gy]B (25)
where dB = change in the level of the debt.1 Lastly, the relationship between the evolu-
tion of the debt and the deficit is then given by
dB = aD 0< a< 1 (26)
where a = proportion of the deficit financed by bond financing.2
Once again capitalists are obliged to provide for their share of investment, but in
addition they must also provide for their share of the deficit. This requires modifying
equation (7) so that:
zK[I + aD] = i K [ l - tp] [PK + iBrf (27)
Appropriate manipulation, using (10), (11) and (25) - (27) withp = 0,
then yields
PIK = gyJsK[l - tp] = //s K [l - tp]K (28)
PIY = gyK/sK[l -tp]Y= I/sK[l - tp]Y (29)
These are the Cambridge conditions that were derived earlier, which reveal that the
Cambridge theorem can be thought of as a special case for a monetary economy diat
obtains under conditions of a fixed price level. The requirement of constant prices is
needed to prevent changes in the value of real balances, which in turn affect capitalists'
ability to finance their share of investment.

(in) Mixed financing with changing prices*

The third possible case concerns mixed financing with changing prices. This represents
the most complicated case since now there are interest income effects because the
steady-state stock of bonds is non-zero, as well as inflation tax effects because the price
level is changing. Recognising the effects of price changes requires introducing a

1
Inspection of (25) in conjunction with equation (16) reveals why pure bond financing is not feasible in
the steady state. In this case the rate of deflation would be gy, which implies that the government would
have to retire nominal debt in order to maintain a fixed nominal debt:income ratio. This involves running
a surplus, which is contrary to the assumption of deficit financing.
2
It can be shown that maintaining price level stability combined with constant debt:income and
deficit:income ratios implies a = bVI[l + bV\.
3
This case includes the case where the deficit is fully financed by bond issues. In this case the steady-
state rate of deflation is equal to the negative of the rate of output growth.
638 T. I. Palley
distinction between the rate of profit on capital and the nominal interest rate paid on
government bonds. In this case the nominal interest rate is given by
i = PIK + p (30)
The change in the money stock is given by
AM = [1 - a]D (31)
Substituting (15) into (31), and setting D = qY, yields

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*« = [1 - a\qV (32)
which implies a rate of inflation given by
p = [l-a]qV-gy (33)
As before, capitalists need to finance their share of investment and the deficit, but
now there is the additional complication of the inflation tax. This implies modifying
equation (7) so that:
zK[I + aD] + pcKM = sK[l - tp] [PK + iB*} (34)
The left-hand side of equation (34) shows capitalists' share of investment and the
deficit, plus the forced saving imposed by the inflation tax on money balances; the
right-hand side shows capitalists' savings out of income. Appropriate manipulation of
(34) then yields expressions for the rate of profit, the profit share, and the level of the
debt given by
PIK = 7/ i K [l - tp]K -p{[\- tp]sKiKB - cKM}/sKzK[K + B][1 - tp] (35)
PIY = IlsK[\ -tp]Y- p{[l - tp]sKzKB - ckM}^sKzk[K + B][1 - tp)Y (36)
B = bF (37)
K = kY (38)
Equations (35) and (36) represent modified Cambridge conditions that now include
the effects of both steady-state deficits, and the effects of steady-state inflation
operating through the inflation tax and the nominal interest rate payable on bonds.
Once again, the inclusion of an inflation tax effect means that the terms cK and zK
appear in the expressions for the profit rate and profit share. The magnitude of these
terms is not independent of workers' savings propensity, which means that workers'
savings behaviour matters for steady-state income distribution. As earlier, workers'
savings behaviour affects the distribution of money holdings and the distribution of the
burden of the inflation tax.
The effect of higher inflation is ambiguous and depends on the signing of the term
[1 ~ fpl^K^K^ ~ CK.M. If this term is positive, higher inflation lowers the profit rate and
profit share. The reason is that capitalists' nominal income gains on bond holdings
exceeds their loss attributable to the inflation tax, thereby reducing the profit income
needed to fund their share of investment and the deficit.

(iv) Surpluses
If the government runs persistent surpluses, this implies that the debt would be retired
over time, and ultimately go to zero. At this stage, surpluses would result in reduction
 Money, fiscal policy and the Cambridge theorem 639
of the money stock. Assuming a constant surplus to income ratio of q, the evolution of
the money stock and the rate of deflation would be determined by equations (16) and
(18). Moreover, the expressions for the steady-state profit rate and profit share would
be the same as equations (22) and (23), only now the inflation tax would be negative.
This implies a lower steady-state profit rate and profit share. The economic logic is that
with steady deflation, capitalists' incomes are augmented by the appreciation of their
holdings of real balances, which means that they require a smaller profit income to
finance their share of investment.

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4. Conclusion
This paper has shown how Pasinetti's (1961/2) finding regarding the irrelevance of
workers' propensity to save for determination of the profit rate and distribution of
income, represents a special case that applies to either a non-monetary economy or a
monetary economy with a constant price level. In the event that there is steady-state
inflation, this implies an inflation tax effect that affects saving, and the distribution of
money holdings across capitalists and workers becomes relevant for the determination
of steady-state income distribution. If money holdings are distributed on the basis of
relative consumption shares, workers' savings behaviour affects the distribution of the
burden of the inflation tax, and this affects steady-state income shares.

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