Blogwork 5---Modifying the PCEX Model to accommodate the possibility of stagflation in the economy

Stagflation

Stagflation is thought to occur when there is an adverse supply shock (a sudden increase in the price of oil or a new tax, for example) that causes a subsequent jump in the “cost” of goods and services (often at the wholesale level). In technical terms, this results in contraction or negative shift in an economy's aggregate supply curve. Stagflation results when economic growth is inhibited by a restricted supply raw materials. That is, when the actual or relative supply of basic materials (fossil fuels (energy), minerals, agricultural land in production, timber, etc.) decreases and/or cannot be increased fast enough in response to rising or continuing demand. The resource shortage can be caused either by an actual physical shortage of a resource or because other factors such as taxes or bad monetary policy have affected the “cost” or availability of raw materials and created a “relative scarcity” of resources. This is consistent with the “cost-push” inflation factors in neo-Keynesian theory.

Below is the PC Model where the circular flow approach to money and the stock approach are combined. While the PC model is not suitable for simulation the event of stagflation, it can assist in establishing how policy can be modified to deal with the event. Analysing the PC Model with expectations provides a way to study the possible effects of stagflation.

PC Model



PCEX Model

Y = C + G (4.1)

In stagflation times then Ywill remain the same, or decrease. Government Expenditures remain the same or decrease in stagflation times; however the government must try to battle stagflation maintain or increase Y.

YD = Y – T + r-1 . Bh-1 (4.2)

Stagflation is a period of inflation combined with stagnation. The disposable income of households remains the same or decreases marginally.

T = Ø . (Y + r-1 . Bh-1) (4.3)

The personal income tax rate remains the same but if Y and r-1 decrease and Bh-1 increase, taxes fall.

V = V-1 + (YD – C) (4.4)

The wealth of households will remain the same or decrease as consumers start to save in stagflation times. However consumers have to spend more for domestic products, i.e. groceries, since inflation rises C (consumption) increases. Therefore less wealth is saved in the present period and so less wealth saved overall.

C = α1 . YDe + α2 . V-1 (4.5E)

The consumption during stagflation will increase since inflation rises in stagflation - the consumer has to spend more for to get the same amount of goods as before.

Hh = V - Bh (4.6)

The money held by households will be the same or less since households invest more in Treasury bills since they benefit from higher interest rates. However a liquidity trap may arise if the interest rates are so low that there is no difference between household cash and household bonds e.g. treasury bills.

Bh/Ve = λ0 + λ1 . r - λ2 . (YDe/Ve) (4.7E)

The amount held in bonds depends on the marginal propensity to consume, the marginal propensity to consume out of regular income and the marginal propensity to consume out of past wealth (λ0, λ1 and λ2). Due to stagflation the proportion to consume out of past wealth and regular income will rise due to inflation and decreasing interest rates.

∆Bs = Bs – Bs-1 = (G + r-1 . Bs-1) – (T + r-1 . Bcb-1) (4.8)

This equation describes the government budget constraint, which is an identity illustrated by column 3 as shown in the PC model above. The equation simply says that the government deficit is financed by bills newly issued by the Treasury department (over and above bills which are renewed as they mature). The first term (G + r-1 . Bs-1) represents the total outlays of the government expenditures on services, purchased from the production sector and interest payments that must be made on the overall outstanding debt. The second term of the equation (T + r-1 . Bcb-1) represents the revenues of the government: its income tax revenue, and the profits which it receives from the central bank. Government expenditure will increase as many households invested in bonds while tax revenue will decrease so as to remain a growing economy to battle stagflation.

∆Hs = Hs – Hs-1 = ∆Bcb (4.9)

This equation describes the capital account of the central bank, as given in column 4 of the PC Model above. The additions of the stock of high powered money ∆Hs is equal to the additions in the demand for bills by the central bank ∆Bcb. The government issues bills to cover debt and so the amount issued in bills will be equivalent to the amount of money placed to cover all bills.

Bcb = Bs - Bh (4.10)

The demand for bills by the central bank is determined. The central bank is the residual purchaser of bills: it purchases all the bills issued by the government that households are not willing to hold given the interest rate. At present, this will be very small since mostly all households would have purchased the bills since they would be giving a greater interest rate than the nominal interest in the bank.

Hd = Ve - Bd (4.13)

This equation simply says that the money holdings are the discrepancy between the total household wealth and the demand for bills by households.

Ve = V-1 + (YDe - C) (4.14)

Total expected wealth accumulated depends on the expected current income and wealth accumulated in the previous period. During stagflation expectations will probably be never right as it is difficult to determine income in times of constant rising inflation and a stagnant economy. Therefore the expected wealth accumulated will be small due to rising inflation, and so very little income generated to save.

Bh = Bd (4.15)
Households invest in bills on the basis of their expectations with respect to disposable income that were made at the beginning of the period. The amount of bills held by households at the end of the period is exactly the same as the amount of bills demanded by households at the beginning of the period. Since interest rates are falling, there will be a hugh demand by households to invest their savings in bills. Also during stagflation the best households can do to battle this is through saving, so as to be prepared in hard times.

An Adverse Supply Shock
Below is an example of an adverse supply shock like a sudden doubling of the world price of oil, hits an economy and the dilemma of stagflation. Firstly here is the simple aggregate supply and demand curve given the potential output and the expected price level.

Such an adverse supply shock moves the economy up and to the left on the AS – AD diagram.

If the central bank wants to keep the supply shock from causing a recession, it increases the money supply and so pushes the aggregate demand curve up and to the right. Therefore it keeps production at a new equilibrium equal to potential output.

However increasing the money supply and pushing the aggregate demand curve up and to the right allows the price level to jump and inflation to accelerate.

If the central bank wants to keep inflation from accelerating in response to the supply shock, it must contract the money supply, raise interest rates and so shift the aggregate demand curve down and to the left (Bradford DeLong, 1998).

Although, trying to keep inflation from accelerating at the price of sharp fall in output, a deep recession and high unemployment is then likely.

Neither alternative is attractive. Being a central banker in a time of adverse supply shocks is not much fun.

Stagflation occurs when the economy isn’t growing but prices are, which is not a good situation for a country to be in (Investopedia ULC, 2008). The economy will first try to maintain momentum - that is, consumers and businesses will begin paying higher prices in order to maintain their current level of demand. The central bank may exacerbate this by increasing the money supply in an effort to combat a recession, for example by lowering interest rates. The increased money supply props up the demand for goods and services when it would normally drop during a recession. The solution to stagflation is to restore the supply of materials. In the case of a physical scarcity, stagflation is mitigated either by finding a replacement for the missing resource(s) or by developing ways to increase economic productivity and energy efficiency so that you can produce more with less input.
If the resource scarcity is being caused by flawed market intervention (i.e., bad government, etc.) then the solution is to eliminate the disrupting force on the market (e.g., better monetary policy, changes in tax laws) (Wikipedia, 2008).

The real factors that determine output and unemployment affect the aggregate supply curve only. The nominal factors that determine inflation affect the aggregate demand curve only. When some adverse changes in real factors are shifting the aggregate supply curve left at the same time that unwise monetary policies are shifting the aggregate demand curve right, the result is stagflation. Therefore so as to adjust to stagflation one must create a balance between the aggregate supply and aggregate demand so that the economy is neither in a recession or in stagflation. Therefore by modifying the PCEX model as discussed above and the simulation of a sudden shock to the system such as a double increase in oil, one can accommodate for the possibility of stagflation. The recessionary situation is exacerbated when a central bank expands the money supply as a means of fighting the recession - for example by lowering interest rates. The economy borrows more money to pay for defaults in loans and rise of oil but because oil is a non renewable resource and that it is very scrace, oil prices rise still further but only over the short-run (Wikipedia, 2008).

The economy must firstly restore the supply of materials, find a replacement for the missing resources, for example oil, and develop new ways to increase productivity and energy efficiency so as to produce more with less input so as to accommodate the possibility of stagflation. The economy must have better monetary policies and changes in the tax laws. If the economy increases government expenditure by enhancing skills in the workplace, the economy will start to boom by been more efficient, creating more exports and less unemployment and so the aggregate supply curve will move down and to the right. Furthermore being more efficient in the workplace creates cheaper output which contains only value added and not at the price of the inclusion of non value added. Therefore supplies will increase along with competition since been more skillful than other countries and so the aggregate demand will move down and to the right and so inflation will drop. If the aggregate demand moved down and to the left it would be in a recession.

Due to the subprime mortgage crisis, many banks and finacial service institutions are writing off huge amounts of debt since many loans are defaulting rapidly. To restore the money back in the economy that the banks have lost, banks must increase production by selling more products yet these products have to be to an extent riskfree, by taking on the correct client that has good credit ratings and will not default on their loans. Furthermore by increasing the sale of many of their products, they must take on more employees and decrease the price of their products, e.g. less interest paying rates, and so end the rise in inflation and stagflation. Governments must increase growth at the expense of giving grants to institutions to enhance workplace skills, i.e. skillnet, forfas and also decrease taxes. However at the expense of decreasing taxes, jobs in the government sector would be a concern.


References:

Bradford DeLong, J. (1998) “Supply Shocks: The Dilemma of Stagflation” [Online] available at: http://econ161.berkeley.edu/multimedia/ASAD1.html (accessed 20th March 2008)

Godley, W., and M. Lavoie (2007) Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, Palgrave Macmillan.

Investopedia ULC. (2008) Stagflation [Online] available at:
http://www.investopedia.com/terms/s/stagflation.asp (accessed 20th March 2008)

Wikipedia (2008) Stagflation [online] available at: http://en.wikipedia.org/wiki/Stagflation (accessed 20th March 2008)

Blogwork 4 - PC and Keynes

Question 1

Godley and Lavoie combine the circular flow of money approach from the model SIM with the stock approach to create the model PC for portfolio choice. The SIM model is extended by adding a central bank which can issue T-bills. These bills will give an interest rate, r, and have the same price over their lifetimes. There is a need to endogenise money creation to close the model, as well as breaking the household’s decisions up into two stages:

- Consumption / saving decision
- Allocation decision.

The difference between model SIM and PC is the introduction of a central bank sector in the economy. This has two sections: capital and current. The current account describes the inflows and the outflows of the central bank, e.g. interest payments on existing assets or liabilities. The capital account describes changes in the balance sheet of the central bank, e.g. when it purchases new bills. The structure of model SIM is different to model PC as seen in figure 1 and figure 2.

Figure 1 Behavioural (transactions) matrix for Model SIM

Figure 2 Transaction – flow matrix of Model PC

The main assumption in Model PC is that producers sell whatever is demanded. Government bills and interest payments are in the PC model and not in the SIM model as seen in the equation below.

Y* = G + R-ı βң-ı (1- θ)

The disposable income and tax equations change from the model SIM versions to account for the interest received from holding bills as part of the households’ wealth as seen in equation 1 and the government taxes the interest received as it is added to the income of the household in equation 2.

1) YD = Y – T + r-1 . Bh-1
2) T = θ . (Y + r-1 . Bh-1)

A key behavioural assumption is that households make a two stage decision:

i) Households decide how much they will save out of their income.
ii) Households decide how they will allocate their wealth, including their newly acquired wealth.

The consumption decision determines the size of the expected end of period stock of wealth. The portfolio decision determines the allocation of the expected stock of wealth. The difference between disposable income and consumption is equal to the change in total wealth where:

V = V-1 + (YD-C)

The new consumption function now contains total wealth instead of money where:

C = α1.YD + α2.V-1 0 < α2 < α1 < v =" (1" v =" λ0" align="justify">
Households will hold a certain proportion (λ0) of wealth as bills and a certain proportion (1 - λ0) as money. The two factors which determine these proportions are: Interest rates and level of disposable income YD. Thus the sum of ‘constants’ ((1 - λ0) and λ0) must be unity because the decision to hold some proportion of wealth in the form of cash implies a decision to hold the rest in the form of bills.

If a change in interest rates (or incomes) causes people to wish to hold a higher proportion of their wealth in the form of money, they must simultaneously be wishing to hold an equivalently lower proportion in the form of bills. The interest rate must be fixed to stop the bills changing value during time periods to prevent capital gains which are not accounted for in the model PC. Therefore:

r = ŕ

r is endogenous as it reaches an equilibrium point of the supply and demand of bills for that period. If it varies no symmetry would be established in the allocation decision.

Question Two

1. How does Keynes define liquidity preference?

According to Keynes, liquidity preference refers to the decision made by households on what form they will hold the command over future consumption which they have reserved, whether out of current income or from previous savings (Keynes 1936). Households may want to hold the command over future consumption in immediate, liquid forms such as money or its equivalent, or in specific goods forms. This decision is made after specifying the propensity to consume, which determines how much of their income households will consume and how much they will reserve for future consumption.

Liquidity preference is given by a schedule of the amount of resources, valued in terms of money or of wage-units, which will be retained by households in the form of money in different sets of circumstances.

The quantity of money, when combined with liquidity preference, determines the interest rate. “Liquidity preference fixes the quantity of money which the public will hold when the rate of interest is given” (Keynes 1936). Thus the interest rate determines liquidity preference in part, as the interest rate is the bribe households get to give up liquidity. It is the reward for not “hoarding” cash. Where M is the quantity of money, L is the function of liquidity preference and r is the interest rate:

M = L(r)

Keynes states that liquidity preference exists because of the existence of uncertainty in relation to future interest rates. He defines three divisions of liquidity preference: the transactions-motive (the need of cash for current transactions), the precautionary-motive (the money held by individuals in case of emergencies), and the speculative-motive (to take advantage of a profit-making opportunity that may arise in the future).

As a rule, we can assume that the schedule of liquidity preference relation the quantity of money to the interest rate shows the rate of interest falling as the quantity of money increases, however Keynes points out that this does not always hold. For example, if the liquidity preference of the public is increasing faster than the increase in the quantity of money.

2. Is PC a faithful representation of Keynes’ original version of household decision making? If so, why? If not, why?

Yes, the PC model faithfully presents Keynes’ original vision of household decision-making. PC introduces the central bank. The central bank issues T-bills which are introduced as a part of wealth allocation and give a fixed interest rate, r. Thus, the household consumption decision must be split into two elements. This is consistent with the transactions-motive of Keynes’s liquidity preference theory and his idea of distinguishing between disposable income and consumption.

The first element is households’ propensity to consume, where they decide how much to save out of their income. Households should first consider how much to be used as consumption from income and how much to reserve in some form of command over future consumption.

In the second step, households decide how they will allocate their wealth, including their newly acquired wealth (Keynes 2007). Here, households can either allocate their wealth to cash or bills or both. This is again based on Keynes’ liquidity preference theory.

H_h/V= (1-λ₀)-λ₁*r+λ₂*(YD/V)

B_h/V=λ₀+ λ₁*r –λ₂ (YD/V)

These equations exhibit the following features: the cash holdings over the wealth (H_h/V) is negatively related to the interest rate and positively related to disposable income (YD), while the bill holdings over the wealth (B_h/V) is positively related to the interest rate and negatively related to disposable income. According to Keynes, the transaction and precaution motives for cash holdings have a positive correlation with income and the speculative motive has a negative correlation with interest rate. Hh/V+ Bh/V=1, which implies wealth is divided into cash and bills.

Thus it can be observed in the PC model that the difference between disposable income (YD) and consumption (C) is equal to the change in total wealth and not just money as in the Model SIM.

The consumption function now has total wealth instead of money:

V = V_-1 + (YD – C)

C = α_1. YD + α₂. V_-1

- where V_-1 represents past household wealth, α₁ is propensity to consume out of current income and α₂ propensity to consume out of current income.

The definition of YD is enlarged by adding interest payments on government debts. Taxable income is also enlarged by adding interest payments on government debt.

Furthermore, PC model assumes the money supply is endogenous and demand-led which can be expressed with these equations:

Bs= Bs-Bs-1= (G+r-1*Bs-1) - (T+r-1*Bcb-1);

ΔHs=Hs-Hs-1=ΔBcb;

Hcb=Bs-Bh;

The interest rate r is exogenous. It is clear that central bank acts as residual purchaser of bills. It purchases all the bills issued by the government that household are not willing to hold given the interest rate. In other words, the central bank is providing cash money to those who demand it. While introducing money into Keynes’ liquidity preference, we can also see autonomic mechanism would change the quantity of money supplied necessary to maintain a given rate of interest. In both models, the rate of interest is the equilibrium in the desire to hold wealth in cash form and the availability of cash. The quantity of money held depends on the rate of interest that can be obtained on other assets, in accordance with the speculative motive (the object of securing profit from knowing better than the market what the future will bring forth).

In conclusion, it’s reasonable to say that PC model faithfully present Keynes’ original vision of household decision-making.

References

Keynes, J. (1936)‘The General Theory of the Rate of Interest’, The General Theory of Employment, Interest and Money, [online] available at: http://www.marxists.org/reference/subject/economics/keynes/general-theory/ch13.htm

Accessed 29^th February 2008

Godley, W. & Lavoie, M. (2007) Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, Palgrave Macmillan

Equilibrium Shocks

Excel Sheet Homework:

As can be observed in the graphs below, the capital output (u) increases when the interest rate on bonds increases from 0.07 to 0.1. When the interest increases, there is a substantial increase in the steady state value of household output, vh, as households invest in more bonds and yield higher returns from these bonds:












When alpha (α) increases from 0.3 to 0.7, it has a negative effect on the economy, particularly in relation to household output which drops dramatically. Capital output increases initially in this shocked state but is less affected in the long run as it tends towards it’s original value.

Blogwork 3

Homework 3

Question 1

1) Below are the differences between SIM and SIMEX when both models are in their steady states.

Firstly, a steady state is a state where the key variables remain in a constant relationship to each other. This must include both flows and stocks. When in addition, the levels of the variables are constant; the steady state is a stationary state. In general the steady state will be a growing economy, where ratios of variables remain constant.

In Model SIM we are thus making two behavioural assumptions: first, that firms sell whatever is demanded and secondly, that there are no inventories, which implies that sales are equal to output. In Model SIM there is no investment. This implies that social saving, the saving of the overall economy must sum to zero (Godley and Lavoie, 2007).

The Model SIM deals with the stationary state. As we omit growth we assume a stationary steady state in which neither stocks nor flows change, government expenditure must be equal to tax receipts, that is, there is neither a government deficit nor a government surplus. This is the condition for a zero change in the stock of money (i.e. government debt). Therefore we have:

G = T* = θ.W.N* = θ.Y*

Hence the stationary state flow of aggregate income must be:

Y* = G / θ

The G / θ ratio we call fiscal stance. This is the ratio of government expenditure to its income share (Godley and Cripps, 1983:111). It plays a fundamental role in all of our models with a government sector, since it determines GDP in the steady state.

Another property of the stationary state is that consumption must be equal to disposable income. In other words, in a model without growth, the average propensity to consume must be equal to unity. Finally we must compute the stationary value of stock of household wealth, that is the stationary value of cash money balances which is also the stationary value of the stock of government debt (Godley and Lavoie, 2007).

Furthermore the difference between SIM and SIMEX Model in their steady state is the addition of four more equations with the SIMEX Model as described below. Model SIM was based on the assumption consumers have perfect foresight as to their income but we now introduce uncertainty thus substituting actual income for expected income (SIMEX Model). This assumes households estimate the income they will receive and base consumption over the current period on this. Money stocks that will be held at the end of the period are also estimated. As the level of consumption has already been decided upon, any additional income received will be saved to cash balances. The inclusion of uncertainty yields a more recursive picture of system and allows us to define model SIMEX. As period succeeds period, people amend their consumption decisions as they find their wealth stocks unexpectedly excessive and as their expectations about future income get revised. In sequences, the realized stock of money links each period to the period which comes after. The wealth acts as an equilibrium mechanism similar to the buffer in SIMEX model. Also the convergence rate is different; it’s much slower for a fix or falsified expectations. But stationary equilibrium is the same in both models.

In the SIMEX model consumers do not know precisely what their income is going to be , thus the only change which has to be made to the model is to substitute expected for actual disposable income in the consumption. The new consumption function is therefore:

C_d = α₁ . YD^e + α₂ . H_h-1 : where the superscript e denotes an expected value.

The model SIM uses the assumption that consumers have perfect foresight regarding their income. It assumes that households make some estimate on their income. Demand is added to the equation as households decide at the beginning of a period how much money they desire to have at the end of the period.

∆H_d = Hd – H_h-1 = YD^e – C_d

This equation below shows that if realized income (YD) is above expected income (YD^e), households will hold the difference in the form of larger than expected cash money balances.

H_h – H_d = YD – YD^e

As households can no longer perfectly predict their disposable income at the start of a period the best they can achieve is an estimate (YD^e). Therefore let us for the time being assume that expected income YD^e is equal to the realized income of the previous period YD-1.

YD^e = Y_d-1

2)

i) Mistaken expectations concerning income are relatively unimportant in a stock flow model, that is in a model where changes in stocks are taken into consideration and where some flows depend on the values taken by the stocks, as is the case here with the consumption function. Uncertainty is introduced into the model here by making consumption depend on expected income – not actual income, which households can only guess. A new and extremely important function for money is that it acts as a ‘buffer’ whenever expectations turn out to be incorrect, i.e. “when the presence of mistakes allow household’s incomes to suffer”

ii) Model SIM was built under the assumption of a stationary steady state. We saw that in such a steady state, the government budget had to balance. However, in the real world e.g. a growing system, the private sector will be accumulating wealth, here cash money. The rate of accumulation of wealth will be equal to the rate of growth of GDP. This implies that, in a steady state, the government budget position must be such that cash money is continuously being issued by government. In a growing steady state, in a model such as ours, the government has to be deficit. Thus to sum up, ‘if nominal income is growing, the appropriate equilibrium condition calls not for a balanced budget but for a deficit big enough to keep the debt growing in proportion to income, the income being determined by portfolio considerations’(Solow in Worswick & Trevithick, 1983 : 165).

3) The Impact of $30 of government expenditures, with mistaken expectations

Question 2

Yes, it is possible to specify a version of SIM that replicates the ISLM model.

Let’s start from the consumption function in model SIM.

Households consume on basis of two influences: their current disposable income YD and the wealth they have accumulated in the past H-1. So consumption is determined

as some proportion α1 of the flow of disposable income and some smaller proportion α2 of the opening stock of money.

C_d =α1 × Y D +α2 ×Hh-1 0<α2<α1<>

The cash being held by household equals

∆Hh= Hh-Hh-1= Y D- C_d

So,

C= Y D - ∆Hh = α1 × Y D + α2 × Hh-1

We turn the consumption function into a wealth function, hence:

∆Hh= (1-α1) × Y D-α2 ×Hh-1

∆h = α2 × (α3 × Y D-Hh-1)

α3= (1-α1)/ α2

Households now have a target level of wealth, given by α3× Y D. The α3 coefficient is the stock-flow norm of households.

When reaching the steady state, the target wealth equals to YD since α3=1, the realized wealth remained lower than the target wealth. As a result, consumption is systematically below disposable income, until the new stationary state is reached, at which point Hh =α3× Y D= YD= C.

When the target is reached, no more saving will occur. However we cannot accept the version of consumption function as C=α1 × Y D 0<α1<>α1 is less than unity, the equation implies that if ever a flow stationary state were reached, there would have to be a stock disequilibrium, with C and YD constant, the money stock and government debt must be rising forever (by an amount equal in each period to YD-C).

However, the equation C=α0+α1 × Y D with α0 a positive constant, represents autonomous consumption, independent of current income.

This can replicate IS-LM model.

With this function, it is possible to achieve a coherent stationery state. The average propensity to consume can be unity, we can have C=YD in the stationary state even though α1 is below one. The constant term α0 plays a role similar to that of the consumption out of wealth.

References:

Godley, W., and M. Lavoie (2007) Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, Palgrave Macmillan.

Godley, W. and Cripps, F.(1983) Macroeconomics, London : Fontana.

Mankiw, G. (1997), Principles of Macroeconomics, 3rd Ed. Worth Publishers: New York

Solow, R. M. (1983) ‘Comment on Godley’ in D. Worswick and J. Trevithick (eds), Money and the Modern World, Cambridge: Cambridge University Press

http://pages.stern.nyu.edu/~nroubini/NOTES/CHAP9.HTM#topic1

web.mit.edu/rigobon/www/Cursos/islmclosed.pdf

http://www.egwald.com/macroeconomics/basicislm.php

EC6012 Homework 2

The Behavioural Transaction Matrix explains each sectors stock of assets and liabilities and how each sector relates to another such that all columns and rows in this matrix sum to zero. Below is the Behavioural Transactions Matrix for SIM.

1.1 Why must the Vertical Columns sum to zero?

The vertical columns must sum to zero because the amount of money created (Hs) must always be equal to the difference between the government receipts and outlays (Godley & Lavoie, 2006).
The government demands taxes which it receives by taxing the factor income on households; the households are therefore supplying the revenue for the government. The government then uses this income to fund government expenditure. The difference between what the government earns through tax and what it spends through government expenditure equals the change in the money supply.
This is represented by the following equation:
-Gd + Td = Δ Hs


1.2 Why must the Horizontal Rows sum to zero?

For every output in the matrix, there must be an equivalent input to achieve equilibrium. For example, producers supply exactly what is demanded by households. Thus in relation to household consumption (C):
Cs = Cd
-Cd + Cs = 0
The exception is output, which represents total production. Due to the fact that this is not a transaction, there is only one entry (Y) in this row.


2. 0 Explanation for each row of the Behavioural Transactions Matrix for SIM

2.1 Consumption:
Households purchase (demand) goods and services (-Cd) and firms supply what is demanded by households, thus generating income (+Cs). Consumption consists of some proportion of disposable income (the wage bill earned by households less taxes) and some proportion of the wealth accumulated by households in previous periods.

2.2 Government:
Governments demand goods and services from firms (-Gd) and pay for these orders using the taxes they collect from households. Producers supply these items as a means for generating their own income (+Gs).

2.3 Output Line:
Output (Y) is the total goods and services produced during a certain period of time as a result of economic activity. The government (G) spends money on goods and services, and households spend money on consumption (C). The sum of this expenditure is referred to as the total expenditure on output.
Y= C + G

2.4 Factor Income
Factor Income concerns the sectors of households and production, and consists of the wage rate*employment (W.N). Households earn income in the form of wages (+W.Ns), which are supplied by the production sector. The production sector demands a certain volume of employment, and must consequently pay wage bills to households, hence the negative entry in the matrix (-W.Nd).

2.5 Taxes
At what rate do governments collect money from households? In each period, governments must collect some proportion alpha of the output of workers as a source for their expenditure (+Td). Therefore households must pay taxes on their income (-Ts) which is collected by the government. Tax revenues collected by the government sector must by logical necessity be equal to the sum of the taxes paid by the other sectors of the economy (Godley & Lavoie, 2006).

2.6 Change in Money Stock
This row describes the changes in stocks of financial assets and liabilities which correspond, in principle, to the Flow-of-Fund Accounts and which are necessary to complete the system of accounts as a whole (Godley & Lavoie, 2006).
The money stock held by the government is the difference between government income and expenditure. Cash money held by households in the current period equals the balance of their disposable income minus their consumption. An increase in this amount constitutes household savings. If the amount decreases, households consume more than they earn. Thus the government must spend in order for firms to increase production to meet the demand of households’ consumption. Therefore the decrease in the money stock of households results in an increase of the same amount in the government sector.

References

Godley, W., and M. Lavoie (2007) Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, Palgrave Macmillan.

Wikimedia Foundation, Inc., ‘Consumption (Economics)’, February 2008, [Online] [accessed 14th February 2008], available at: http://en.wikipedia.org/wiki/Consumption_%28economics%29

Homework 1 Macroeconomic Terms

1. Aggregate Demand relation[1]
Aggregate demand is the total expenditures on gross domestic product. It relates the economy’s price level, usually measured by the GDP price deflator, and aggregate expenditures on domestic production, usually measured by real gross domestic product. The aggregate demand relation between aggregate expenditures and price level is inverse. A higher price level is related to a decrease in aggregate expenditures and a lower price level is related to an increase in aggregate expenditures. Above is an example of an Aggregate Demand curve showing the relationship between GDP and Price.
The curve shown below is aggregate demand curve.


2. Animal Spirits
According to Keynes one of the essential ingredients of economic prosperity is confidence and that animal spirits are a particular sort of confidence, “naive optimism”.[2] Undertaking responsibility for a commercial venture or middling between producers and consumers involves risk. The willingness to undertake such risks are what Keynes called the “animal spirits”.[3] An example of animal spirits in macroeconomic terms is where an investor converts a substantial amount of Euros into Dollars and sells the Dollars back to Euros in a year’s time without hedging their risk. The investor is anticipating the Dollar to strengthen over the course of the year and not to weaken even further. Therefore making reasonable profits without hedging their portfolio.

3. Bank Run
A bank run (also known as a run on the bank) is a type of financial crisis. It is a panic which occurs when a large number of customers of a bank fear it is insolvent and withdraws their deposits.[4] An example of this occurrence was the credit crisis in September 2007 where Northern Rock had to ask the Bank of England for an emergency financial assistance which led to an immediate“bank run”.

4. Bond
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and is obliged to repay the principal and interest (the coupon) at a later date, termed maturity. Other stipulations may also be attached to the bond issue, such as the obligation for the issuer to provide certain information to the bond holder, or limitations on the behavior of the issuer. Bonds are generally issued for a fixed term longer than ten years. U.S. Treasury securities issue debt with life of ten years or more, which is a bond. New debt between one year and ten years is a “note” and new debt less than a year is a “bill”.[5] There are several different types of bonds: Fixed rate bonds, Floating rate notes, High yield bonds, zero coupon bonds, Inflation linked bonds, Subordinated bonds, Perpetual bonds, Bearer bond, Bear bond, Municipal bond, Lottery bond and War bonds. Below is an example of a Zero Coupon Bond: Assuming that the investor wishes to buy a 5 year zero coupon bond today that costs $200 with zero rates of 5%, on maturity the investor will receive 200e(5 *0.05) = $256.5.

5.Capital Account
In economics, the capital account is one of two primary components of the balance of payments, the other being the current account. The capital account is referred to as the financial account in the IMF's (International monetary fund) definition; the IMF has a different definition of the term capital account. [6]
Capital Account = Increase in foreign ownership of domestic assets - Increase in domestic ownership of foreign assets = Foreign direct investment + Portfolio investment + Other investment The capital account measures monetary flows between countries used to purchase financial assets such as stocks, bonds, real estate and other related items.[7] An example of a capital account is when a foreign saver purchases shares of a U.S. corporation on the New York Stock Exchange, or a hotel located in the U.S., they are sending money into the U.S., leading to an increase in the capital account balance of the United States. In this case, the value of the assets (stocks bought and sold on the New York Stock Exchange) or the assets itself (the hotel) remains in the United States. If you decide to buy shares of a foreign company on the London exchange, you are sending money out of the U.S. through the capital account. A capital account surplus indicates that more foreign money in entering the U.S. than leaving it.

6. Debt to GDP Ratio
This is a measure of a country’s federal debt in relation to its gross domestic product (GDP). By comparing what a country owes and what it produces, the debt-to-GDP ratio indicates the country's ability to pay back its debt. The ratio is a coverage ratio on a national level. This measure gives an idea of the ability of a country to make future payments on its debt. If a country were unable to pay its debt, it would default, which could cause a panic in the domestic and international markets. The higher the debt-to-GDP ratio, the less likely the country will pay its debt back, and the higher its risk of default.[8] Below is a graphical representation of the Debt to GDP ratio for the Irish economy which has fallen from over 90% during the first half of the 1990s to an estimated 25.1% at end 2007. [9]



7.Effective Demand
Effective demand (in macroeconomics usually regarded as synonymous with aggregate demand), is an economic principle that suggests consumer needs and desires must be accompanied by purchasing power (money) to be considered effective in discussions of supply and demand for the determination of price.[10]
The term effective demand is used to differentiate between individuals and groups who have the will and the means to buy a product and those who have the will but not the means to buy the product. For example, the willingness of low income individuals to purchase an expensive car may be very strong, but they do not have the means to purchase the car. Effective demand only includes those individuals who have the will and the means to purchase a product. [11]

8. Deflation
Deflation is a reduction in national income and output.[12] Alternatively, it might refer to a sharp fall in the prices of financial assets or a sustained decrease in the general price level (a negative rate of inflation). The 'general price level' comprises the price of wages, consumption goods and services. The term ‘deflation’ was used by the classical economists to refer to a decrease in the money supply. The meanings are closely related, since a decrease in the money supply is likely to cause a decrease in the price level.
Below is a graph which illustrates deflation in Japan from 1990 to 2005. The reasons for this included the fall in asset prices which reduced the money supply, and a high level of non-performing loans.[13]




9. Consumption Function
The consumption function is the relationship between total consumer expenditures and total disposable income in the economy, holding all other determinants of consumer spending constant.[14]
The slope of the consumption curve is set by the marginal propensity to consume (the proportion of an increase in national income that is consumed). The higher the MPC, the steeper the curve will be. The consumption function can be represented by a graph showing how much is spent by households at different income levels. The example below illustrates the relationship between real income and spending from 1980 to 2005 in the U.K.









10. Consumer Price Index
The Consumer Price Index (CPI) is an index number measuring the average price of consumer goods and services purchased by households. It is one of several price indices calculated by national statistical agencies. The percent change in the CPI is a measure of inflation. The CPI can be used to index (i.e., adjust for the effects of inflation) wages, salaries, pensions, or regulated or contracted prices.[15]
Below is a graph of the U.S. Consumer Price Index CPI from December 2006 to April 2008
Past Trend Present Value & Future Projection





11. Investment Function
The relationship between the level of real investment and the value of the real interest rate; also called the investment schedule.[16]Investment is often modeled as a function of income and interest rates, given by the relation I = f(Y, r). For example, an increase in income encourages higher investment, whereas a higher interest rate may discourage investment. The interest rate represents an opportunity cost of investing funds rather than loaning them out for interest.[17]

12. Fiscal Expansion
Fiscal policy is the use of the government budget to affect an economy. The most immediate impact of fiscal policy is to change the aggregate demand for goods and services. A fiscal expansion raises aggregate demand through increasing government purchases or decreasing taxes. The resulting rise in consumption will raise aggregate demand. [18]Below is a graph showing the shift of the DD (equilibrium output) curve caused by an increase in government spending:[19]













13. GDP deflator
GDP, gross domestic product, deflator is a method to measure the price change of all new domestic goods and services in the economic system. It gives the net value of all goods and services procured over a specific time. Like consumer price index, GDP deflator doesn't rely upon a constant market basket. The basket is changeable, so new consumption patterns can be shown through this deflator according to the people's reaction to the changing market prices.
The GDP deflator can be depicted mathematically by this equation given below: GDP deflator = ( Nominal GDP / Real GDP)*100.
The graph below shows the U.S. GDP implicit price deflator from 1947 to 2007.[20]





14. Imports
Goods, services and capital assets purchased from overseas countries.[21]
An example of an importing is merchandise that is made in a foreign country and sold domestically, such as importing bananas from Africa and selling them on the Irish market.

15. Monetary Contraction
This occurs when the size of money supply is reduced with the aim of affecting interest rate and the level of aggregate demand.

16. Nominal GDP
The production of goods and services valued at current prices, while real GDP is the production of goods and services valued at constant prices.[22]
Imagine we want to compare output in 2005 and output in 2006 in our apple-and-orange economy. We could begin by choosing a set of prices, called base-year prices, such as the prices that prevailed in 2005. Goods and services are then added up using these base-year prices to value the different goods in both years. Real GDP for 2005 would be
Real GDP= (2005 Price of Apples*2005 Quantity of Apples)+(2005 Price of Oranges *2005 Quantity of Oranges).
Similarly, real GDP in 2006 would be
Real GDP = (2005 Price of Apples*2006 Quantity of Apples)+(2005 Price of Oranges*2006 Quantity of Oranges).
Nominal GDP in 2006 would be
Nominal GDP= (2006 Price of Apples*2006 Quantity of Apples)+(2006 Price of Oranges*2006 Quantity of Oranges).

17. Propensity to consume
The functional relationship between income level and consumption. The amount of consumption depends mainly on the amount of income, objective surroundings and people’s subjective needs, psychological propensity, habits and the rule of income distribution.[23]

18. Short run
The period of time in which quantities of one or more production factors cannot be changed, relative to long run which means amount of time needed to make all production inputs variable.[24]

For example, taking three factors of production - raw materials, labour and factory space - it is possible in the short run to increase production by increasing the first two variables, however it is only in the long run that all three are variable.

19. Real exchange rate
The rate at which a person can trade the goods and services of one country for the goods and services of another, while nominal exchange rate means the rate at which a person can trade the currency of one country for the currency of another.[25]
nominal real exchange rate= real exchange rate*(P*/P)

20. Trade surplus
An excess of a country’s exports over its import in a specific period of time. [26]

Reference:

[1]http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=aggregate+demand
[2]http://www.economist.com/research/Economics/alphabetic.cfm?letter=A#animalspirits
[3]http://members.shaw.ca/h-chartrand/Macro%20+%201.0.htm
[4]http://en.wikipedia.org/wiki/Bank_run
[5] http://en.wikipedia.org/wiki/Bond_(finance)
[6]http://en.wikipedia.org/wiki/Capital_account
[7]http://www.colorado.edu/Economics/courses/econ2020/section12/section12.html
[8]http://www.investopedia.com/terms/d/debtgdpratio.asp
[9]http://www.ntma.ie/NationalDebt/debtGDP.php
[10]http://en.wikipedia.org/wiki/Effective_demand
[11]http://www.extension.iastate.edu/agdm/wholefarm/html/c5-204.html
[12]http://www.bized.co.uk/glossary/econglos.htm
[13]http://www.scotland.gov.uk/Publications/2006/06/27171110/10
[14]Baumol, W. & Blinder, A. (2005) Macroeconomics, Principles and Policy, Thomson & Western: Ohio
[15]http://en.wikipedia.org/wiki/Consumer_price_index
[16] http://www.google.ie/search?hl=en&client=firefox-a&rls=org.mozilla:en-GB:official&hs=HhT&defl=en&q=define:investment+function&sa=X&oi=glossary_definition&ct=title
[17] http://en.wikipedia.org/wiki/Investment
[18]http://www.econlib.org/library/Enc/FiscalPolicy.html
[19] http://images.google.ie/imgres?imgurl=http://www.federalreserve.gov/boarddocs/Speeches/2005/20050420/figures1.gif&imgrefurl
[20]The St.Louis Federal Reserve Bank; U.S. Department of Commerce: Bureau of Economic Analysis - www.data360.org
[21]http://www.investordictionary.com/definition/imports.aspx
[22]Mankiw, G. (1997), Principles of Macroeconomics, 3rd Ed. Worth Publishers: New York
[23]Eatwell, J., Milgate, M. & Newman, P. (1987). The New Palgrave: A dictionary of economics. The Macmillan Press
[24]Pindyck, R., Rubinfeld D.L, (2001). Microeconomics. Prentice Hall
[25] Mankiw, G. (1997), Principles of Macroeconomics, 3rd Ed. Worth Publishers: New York
[26] Mankiw, G. (1997), Principles of Macroeconomics, 3rd Ed. Worth Publishers: New York

Homework 2 Exercise 3

When θ changes, the steady state value of output will remain the same.
Y*= G/θ
Y*= output
Θ = Personal Income Tax Rate
G = Government Expenditure
When θ increases, government expenditures increases by the same amount. This is due to the correlated relationship between the two variables.
So in the long run, we can see that in the steady state condition, Y* (output) remains the same when θ changes.