Blogwork Week 5

Chapter 4 Summary

The Matrices of Model PC

Chapter 4 of Monetary Economics by Godley and Lavoie, Government Money with Portfolio Choice introduces the PC model which expands on Model SIM explained in chapter 3. The Model PC is the Model SIM with the addition of Government bills, interest payment and a central.

In table 4.1, ‘Balance sheet of Model PC’, the first column is for Households, which is made up of money (H) and bills (Bh), the sum of these 2 is private wealth (V) and this creates the balance. There is no production sector as it is assumed to be a pure service economy. Column 3, Government, consists of public debt issued to households and the central bank by the government. The Central Bank column, column 4, is made up of bills purchased from the government (Bcb) and the money provided to households (H).



Table 4.2 consists of the Transactions-flow matrix of Model PC’. This shows the addition of the central bank which is made up of 2 accounts, current and capital. The current account refers to the inflows and outflows of daily activities and the capital account refers to changes to the balance sheet.



The Equations of the Model PC

(i) Old wine and new bottles
The first model assumes perfect foresight in that producers sell whatever is demanded and households have correct expectations regarding their incomes. The following shows explanations of the equations starting with the basics:

(4.1) Y = C+G
Shows that production is equal to consumption plus government expenditure,

(4.2) YD = Y–T + r-1.Bh-1
Disposable income is enlarged by adding interest payments on government debt, i.e.

(4.3) T = Ø.(Y+r-1.Bh-1)
Taxable income is enlarged by adding interest payments on bills held by households.

(ii) The Portfolio Decision
Portfolio decision comprises of 2 steps: (i) First of all, savings are decided on and this inherently affects consumptions. (ii) Secondly, allocation on wealth is decided on, the first decision will impact on the expected size of the end of period wealth stock and the second part decides the allocation of this.

(4.4) V=V-1+(YD–C)
Total change in wealth is made up of disposable income minus consumption.

(4.5) C=α1.YD+α2.V-1, 0< α2< α1<1
Wealth replaces Money.

(4.6A) Hh/V=(1-λ0)–λ1.r+λ2.YD/V
Households want to hold a certain amount (λ0) of wealth in bills and the rest (1-λ0) in money. The proportions are dependant on the level of interest on bills and the level of disposable income relative to wealth.

(4.7) Bh/V=λ0+λ1.r-λ2.YD/V
Shows what has to be the share that people hold in the form of bills, given eqn 4.6A.

(4.8) ∆Bs=Bs–Bs-1=(G+r-1.Bs-1)–(T+r-1.BCB-1)
This explains the government budget constraint.

(4.9) ∆Hs=Hs–Hs-1=∆Bcb
Capital Account of the Central Bank

(4.10) Bcb=Bs-Bh
(4.11) R=r
The central bank is the residual purchaser of bills. It purchases all the bills offered by the government that the householders are not will to purchase at a given interest rate.

Given these equations, household cash equals cash provided by the central bank.
(4.12) Hh=Hs


Question 1 (i)
Bills are government securities paying an interest rate, r, households use this to speculate with the hope of earning profit in the future. Portfolio decisions are future dependent (decide how much to spend based on what you expect rate to be). R is exogenous as it equals the equilibrium point of the supply and demand of bills for that period. It provides us with one of the parameters for government responses. If it varies, no symmetry would be established in the allocation decision. (Godley and Lavoie, Ch. 4)

Question 1 (ii)
It is assumed that the central bank is worth zero, this implies that if people deposited money into an account in the Central Bank they would earn no interest on this money; the profit goes to the government. The public sector does not pay interest on debt, however household borrowers do.
Portfolio decision comprises of 2 steps: (i) First of all, savings are decided on and this inherently affects consumptions. (ii) Secondly, allocation on wealth is decided on, the first decision will impact on the expected size of the end of period wealth stock and the second part decides the allocation of this.
The quantity of cash (money kept by households) is the same as the amount provided by the central bank in the steady state.

Question 1 (iii)

Government bills and interest payments are in the PC model and not the SIM model.
The PC model includes a Central Bank as a separate entity. In the SIM model it was included with the government sector.

The transactions flow matrix now has 2 financial assets, and interest payments also exist.
In the SIM model, the change in total wealth was just a function of money however in PC models it’s the difference between disposable income and consumption.


Question 2 (i)
The MPC (Marginal Propensity to Consume) decides how much of your money you will reserve (save). It’s a schedule of the amount of resources valued in terms of money or of wage units which he will wish to retain in the form of money.
The interest rate determines liquidity preference in part as it is the reward for parting with liquidity.

3 divisions of liquidity preference
1. Transactions motive – People need cash for day-to-day spending
2. Precautionary motive – Refers to money held by individuals incase of emergencies.
3. Speculative motive – Take advantage of profit making opportunity which may arise.

If you decrease the interest rate, you assume that you increase the quantity of money but that is not always true, e.g. If the liquidity preference of public is increasing faster than the increase in the quantity of money.
Interest rate is the reward for not hoarding.

Question 2 (ii)
Yes, the PC model encompasses Keynes ideas of the precautionary transactions and speculative motive.
The PC model distinguishes between disposable income and consumption, this idea is also inherent in Keynes writings. “How much of his income he will consume and how much he will reserve in some form of command over future consumption.”
A PC decision has 2 steps: (i) The savings decided on (ii) How these savings will be allocated, i.e. in what form.
Both models rate of interest is the equilibrium in the desire to hold wealth in cash form and the availability of cash.
The PC model quantity of money held depends on the rate of interest that can be obtained on other assets.