Chapter 3 – The Simplest Model with Government Money


Money is created in two ways:

Outside money – this is government money issued by pubic institutions e.g. the central bank

Inside money – this is private money created by commercial banks

For this simple model it is assumed that there is no private money i.e. no banks


Assumptions of this Model SIM:

The economy is closed.
All production is done by service providers making it a pure labour economy.
All transactions occur with government money.
There is an unlimited quantity of government money
This is a demand led economy; therefore whatever is demanded will be produced.


This Model SIM can be shown on an accounting balance sheet matrix which shows each sector’s stocks of assets and liabilities and their relationship with each other.


Change in the stock of money is used to complete the system of accounts. Each sector must equal to zero. Production [Y] is not a transaction between 2 sectors and hence only appears once.


This SIM model can also be shown on a behavioural transaction matrix.
S= supply, d=demand, h=households’ end period holdings of cash, W.N= Wage rate by employment

From the tables we can state the equations which equalize demands and supplies:

Cs = Cd => Consumption
Gs = Gd => Government Expenditure
Ts = Td => Taxation
Ns = Nd => Total Labour


There are a few mechanisms that lead to the result that sales are equal to purchases where production could be different to supply and where supply could be different to demand:

Neo classical theory:
Variations in price clear the market. Excess demand leads to higher prices which reduces excess demand. Godley and Lavoie believe that this is only appropriate in the case of financial markets.

Rationing theory:
This approach imposes some rigid prices. If demand is less than supply, sales will equate demand and vice versa.

General disequilibrium approach:
Firms hold a buffer of inventories large enough to absorb any discrepancy between demand and production. Godley and Lavoie believe that this is the most realistic approach.

Keynesian:
Production is flexible. Producers produce exactly what is demanded and there are no inventories. Sales are equal to production. This approach is appropriate for the services industry.


In Model SIM, Godley and Lavoie make two behavioural assumptions:


Firms sell whatever is demanded.
There are no inventories; Sales are equal to output.


3.3 Equations of Model SIM

Disposable Income (YD) is the wage bill earned by households less paid taxes:

YD = W.Ns – Ts

Taxes are levied on a proportion of income, at a rate θ.

Td = θ.W.Ns Where θ < 1

Consumption Function:

Cd = α1.YD + α2.Hh-1 Where 0< α2< α1<1

YD is disposable income of the current period, the percentage of which is consumed depends upon α1 (the marginal propensity to consume). However, consumption in the current time period also depends upon the stock of accumulated in the past (Hh-1). Godley and Lavoie argue that a certain percentage of this accumulated wealth is consumed in each time period, determined by α2.

The change in money supply (ΔHs) is given by the difference between government receipts (Td) and outlays (Gd) in that period. Since the only money in the model is government money this means that when government expenditure exceeds tax receipts debt must be issued. However, there are no interest payments in the simple model; therefore cash money is the debt.
ΔHs = Hs - Hs-1 = Gd - Td


3.4 The Keynesian Multiplier

A government injection has a multiple effect on income and a ripple effect throughout the economy.

Multiplier = 1/ [1-α1.(1-θ)] Where α1 is MPC & θ is the tax rate.

The drawbacks of standard multiplier analysis are:

Views Y as short run equilibrium
Results cannot repeat itself for large number of periods
Doesn’t take into account that flows will generate changes in stock

3.5 Steady State

A steady state is a state where key variables remain in a constant relationship with each other. In general the steady state is a growing economy where ratios of variables remain constant.

Most of Godley and Lavoie assumptions omit growth and hence they deal with stationary states, as is the case with Model SIM. In this state neither stocks nor flows change and government expenditure must equal to tax receipts. There is not a government deficit or surplus. In this stationary state consumption must be equal to disposable income, i.e. There is no savings in the steady state.

3.6 The Consumption Function as a stock-flow norm:

Consumption is disposable income minus the household savings of the period.

C = YD - ΔHh

Godley and Lavoie argue that given the existing wealth of households and the disposable income of the period, households have a target level of wealth (VT) they wish to achieve by the end of the period. If the target level is below the realized level households will save in order to achieve their target.
Because households save in order to reach this target level of wealth consumption will always be below disposable income until the target is met. In this stationary state saving will discontinue.

3.7 Expectations Mistakes

Thus far in the SIM Model Godley & Lavoie have assumed that all decisions made by households have had the benefit of perfect information; i.e. the actual level of future income is known. The concept of uncertain expectations is now introduced and the impact on the model is noted. The role that money stocks play is very important in an uncertain world.

Hh – Hd = YD - YDe Where Hh = Cash balances held
Hd = Demand of money at start of period
As households can no longer perfectly predict their disposable income at the start of a period the best they can achieve is an estimate (YDe). As a result if realized income is above expected income the difference will be held in larger cash balances. This highlights the role that money plays when uncertainty is present; it allows the transactional matrix to remain balanced. This is also due to the fact that people have the ability to amend their consumption decisions as their wealth changes unexpectedly over time.

3.8 Out of the steady state

The authors attempt to analyse the ability of the model outlined above to return to a steady state after a shock is delivered to the model. For example, it is shown that an increase to the MPC will initially increase national income; however, this is cancelled out later by the fall in money balances (as less is saved) and eventually by the fall in consumption using accumulated wealth.

Conclusion

In conclusion it is found that a long-run equilibrium is indeed achievable under this model. It occurs due to the fact that households have a target level of wealth and in order to achieve this saving takes place. This saving leads to higher accumulated wealth in the next period and therefore higher consumption out of wealth. The authors argue that eventually the economy will reach its target level of wealth and savings will no longer need to occur. This is their definition of the stationary state.
However, one wonders if this is actually achievable as it seems logical that households would adjust upwards their target level of wealth over time as they begin to approach the steady state.

Problem 4

Question 1

1.1

The vertical columns must inevitably sum to zero because in the case of households, the amount of money held must always be equal to the difference between the households’ receipts and payments. In other words the wages earned by the household (+W.Ns) minus the consumption (-Cd), the taxes paid (-Ts), and the end period holdings of cash (-Hh) must equal zero. This is also the case with production as it is assumed that producers hold no cash, therefore producers receipts (+Cs and +Gs) must equal their outlay on wages (-W.Nd). Similarily the amount of money created (+Hs) must be equal to the differences in government receipts in the form of taxes (+Td) and their outlays in the form of government expenditure (-Gd).

1.2

The rows reperesent the circular flow of income which move in a zero sum space. Basically every component in the matrix has an eqivalent component whose sumation will always come to zero. In the case of consumption it is a receipt for businesses but is a payment for households.


Question 2:

Row 1 Consumption:
The Household sector purchase services from the production sector. Denoted by -Cd as it is a liability to the household. Conversely the production sector supplies services denoted by +Cs as they receive income in return for providing the service. The services demanded by the household are immediately supplied by the production sector, hence –Cd and +Cs cancel out.

Row 2 Government Expenditure:
Like households the government also demand services which are again provided by the production sector. This represents an asset for the production firm (+Gs) and a liability for the government (-Gd).

Row 3 Output:
This represents total production and is not a transaction between two sectors. It is the sum of all expenditures on goods and services. Y= C + G

Row 4 Factor Income:
This is the income received by the household for supplying labour, this is an asset for the household and is denoted by +W.Ns. For the production firm it is a liability as they must pay money out. The amount paid out by the production firm equals the amount received by the household thus they sum to zero.

Row 5 Taxes:
Households must pay taxes therefore it is a liability for them and denoted by –Ts. The amount paid by the households is received by the government, thus it is an asset for them denoted by +Td.

Row 6 Changes in Money stock:
Another way that households use their income is to purchase financial assets, it is denoted by –ΔHh as it is an outflow. Consequently, the government supply these financial assets, it is revenue for them denoted by + ΔHs.

Keynesian Multiplier

Definition:

The effect on demand of any exogenous increase in spending, such as an increase in government outlays is a multiple of that increase—until potential is reached. If economy is in equilibrium the change in GNP = the initial change in GNP * Multiplier. Multiplier = 1/1-mpc
If the government spends, the people who receive this money then spend most on consumption goods and save the rest. At each step, the increase in spending is smaller than in the previous step, so that the multiplier process tapers off and allows the attainment of an equilibrium.

Example:

Simply stated, if the government increased expend. by 1Billion and this resulted in a GNP of 5 Billion then the multiplier is 5.

References:

http://en.wikipedia.org/wiki/Keynesian_economics
Walsh & Leddin, Chp. 3 pp.53-59
Godley & Lavoie Chp. 3 p.70

Reporter: Eoin O Shaughnessy
Group Members: Dave Hickey, Maciej Woznica, Eoin O’Shaughnessy, Noreen O’Hanlon, Paul O’Brien, Thomas Harty, Jackie Brosnan.

Definitions

1. What is a growth rate?

• A growth rate is the rate of change in a variable from one period to another.

2. Name 2 Measures of Economic Performance

• Trade Surplus/Deficit
• Unemployment

3. Describe the GDP deflator.

• The GDP deflator shows how the cost of different bundles of goods would vary holding prices constant.
• The GDP deflator holds base period prices fixed while the CPI holds base period quantities fixed.

P = Current year prices * Current year quantities * 100
Base year prices * Current year quantities

4. Define Inflation.

• Inflation is the rate of change in the Consumer Price Index / representative bundle of goods.

5. Name 2 leakages from the circular flow.

• Imports
• Savings

6. How do we measure unemployment?

Amount of people unemployed * 100
Amount of people willing to work
(i.e. people b/w 15-64)

Classwork Week 4

Group 3 Team Members: Dave Hickey, Maciej Woznica, Eoin O’Shaughnessy, Noreen O’Hanlon, Paul O’Brien, Thomas Harty, Jackie Brosnan.

Reporter: Dave Hickey

Wages: Income / Expenditure
Compensation received/paid out for labour.

Consumption: Expenditure / Income
Expenditure on goods and services. Income for service and good providers.

Rent: Income / Expenditure
Income received/expenditure made for the use of a capital asset.

Government Expenditure: Expenditure/Income/Output
Expenditure on public goods and services.

Manufacturing output: Output
Output as a result of a manufacturing process.

Interest Payments: Income/Expenditure
Income/ Expenditure from the provision of capital/cost of capital.

Loans: Income/Expenditure
Money received to be paid back at a future date.

Bank Deposits: Expenditure
Stock of capital (opposite of a loan)

Bonds: Expenditure
Type of loan.

Equities: Expenditure
Investment in shares of a company.

Money Balances: Income
How much money – wealth in the form of readily available purchasing power – consumers and firms actually hold.

Question 3 – Each entity described above forms part of the economic circular flow model which shows how the economy is interlinked.

Summary of Chapter 6

Firstly let us define what is meant by income. In order to do so let us define a number of components which can be used to assist us in our definition.

Define A as the Finished Output sold to the consumer. This also constitutes the Gross Income of the entrepreneur.
Define A1 as the cost of purchase of other entrepreneurs output which is also considered expenditure.
Let G represent Capital equipment (Stocks, unfinished goods and working capital)

Income can then be quantified as A + G – A1 less a certain sum contributed by the previous period. There are two methods used to calculate this sum which are as follows:

If entrepreneur decided not to produce output there is still an optimal sum (B’) which it would have paid him to maintain his Capital equipment.

G’ is max value of G at the end of the time period after spending B’.

Therefore G’-B’ is the max net value of G if no production had taken place but B’ had been spent maintaining/improving the equipment.

(G’ – B’) – (G – A1) is the User Cost of A denoted as U.

· The (F) Factor cost of A is the amount paid by the entrepreneur for other services.

· The sum of F and U are known as the prime cost of A.

· Aggregate income is A – U.

· Aggregate consumption (C) of the period is equal to ∑ (A – A1).

· Aggregate investment (I) is equal to ∑ (A – U).

· The effective demand is the aggregate income entrepreneur expects to receive.

(ii)
Supplementary cost = unquantifiable but those deductions from his income the entrepreneur makes before reckoning what he considers his income for the purpose of declaring a dividend.

Involuntary loss = Supplementary cost = V = involuntary depreciation

Net income = A – U – V



What is saving?
Saving is the “excess income over expenditure on consumption”, where expenditure on consumption means the value of good sold over a period.
If income if defined as A – U, and consumption is defined as A – A1 it follows that saving is equal to A1 – U. ( A – U – (A – A1) )
Net Savings then = A1 – U – V where V = supplementary costs.

Finally what is investment?
Income = value of output = consumption + investment
Saving = income – consumption
Substituting equation …. Saving + consumption = consumption + investment
Thus Saving = investment

Summary of Chapter 7

Savings as we already know is the “excess of income over what is spent on consumption”. Therefore any problems arise out of the definition of investment or income.

Keynes states that the popular definition of Investment is “the purchase of a capital asset of any kind out of income”. However, under his definition one must include the increment of capital equipment, whether it consists of fixed capital, working capital or liquid capital.

Keynes emphasises the “total change of effective demand and not merely that part of the change in effective demand which reflects the increase or decrease of unsold stocks in the previous period”.

The volume of employment is determined by entrepreneur’s expectations regarding his present and future profits (maximisation of profits), whilst the volume of employment that maximises his profits is dependent on his views on proceeds resulting from consumption and investment. Therefore the volume of employment is determined then by entrepreneurs’ effective demand and expected increase of investment to saving.

Change in a the volume of output and employment causes a change in income as measured in wage-units and further change in latter causes redistribution of income between borrowers and lenders and also causes change in aggregate income.

Keynes defines forced savings as ‘the excess of actual saving over what would be saved if there were full employment in a position of long-period equilibrium”. However, this is unlikely to occur in the real world as full employment is unachievable and this usually results a forced deficiency of saving.

In Section V Keynes highlights the interdependence of savings and investment. He states that investment, in the aggregate, cannot take place without savings. However, this cannot be taken to mean that savings increase investment by an equal amount.

Keynes also notes that savings and investment have an impact on incomes. It is impossible for all individuals to increase savings by reducing consumption without having an impact on aggregate income.

In conclusion, it must be noted that in the aggregate savings and investment are not autonomous nor is the level of demand or cash held by individuals.

Team Members

Jackie Brosnan, David Hickey, Paul O'Brien, Noreen O'Hanlon, Eoin O'Shaugnessy, Maciej Woznica