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.