Stagflation and the PC Model

Stagflation is a term that describes an economic period whereby inflation and stagnation occur at the same time. Inflationary pressures drive down the price of goods while stagnation results in rising unemployment and a decrease in economic growth. Up until the 1970’s, when stagflation was first witnessed, these two processes were deemed mutually exclusive by macroeconomists. They believed that if high inflation was present restrictive monetary policies by a central bank would reduce its effect. Stagnation on the other hand could be combated through the use of expansionary monetary policy. Clearly the two solutions cannot work in unison leaving Central banks seemingly helpless in the face of mounting stagflation.

There are two main bodies of thought as regards the causes of inflation. We shall now examine them in order to determine the necessary changes we should make to our PC model in order to simulate stagflation in an economy.

The first cause of stagflation is when an economy experiences a severe supply shock. This was precisely what happened in the 1970s when the members of the Organization of Arab Petroleum Exporting Countries (OPEC) ceased supplying oil to the United States, Western Europe and Japan in retaliation for their support of Israel in the 1973 Yon Kippur War. This drastic reduction in the supply of oil caused sharp inflation across these nations as the cost of all goods soared. Central banks enacted excessive monetary stimulus policies to counteract the resulting recession which only further increased inflation. Thus a vicious cycle began whereby a slow-down in the economy was countered with more money being pumped into the market which only further exasperated inflation.

Stagflation can also be caused by inappropriate macroeconomic polices being pursued by central banks. Central banks can cause inflation by permitting excessive growth of the money supply, and the government can cause stagnation by excessive regulation of goods markets and labour markets.

As one will have by now noted, the second cause of stagflation, poor central bank management, was intertwined with the supply shock of the 1970s. However the second cause of stagflation can occur on its own through gross mismanagement of an economy by a central bank and government. Case in point is Zimbabwe where a prosperous and healthy economy was ruined though incompetence, stubbornness and racism. Zimbabwe now suffers from hyperinflation, with some estimates putting annual inflation over 2007 at 100,000%, and “official” unemployment levels of 80%.

Simulating this through the PC model:

By inputting a supply shock to the PC model the central bank will act to prevent a recession. The money supply will be increased though reducing interest rates. However increasing the money supply causes the price level to rise and inflation will accelerate. Rather than contracting the money supply by raising interest rates to prevent inflation from accelerating, the central bank will leave interest rates as they are. This may cause stagflation effects in the economy.

Inflation and employment are typically inversely related to one another. The principal is that high demand for goods drives up prices and companies then hire more employees. Similarly, high unemployment reduces demand. As outlined this relationship is not the case in a stagflation world so the adapted model must first be adjusted for this fact. The assumption should remain however that eventually stagflation will fall off and the initial inverse relationship should return.

As interest rates are now lower this will increase the value of bills, increasing wealth and consumption. However the increase in inflation will counter this nominal increase in household wealth.

The supply shock to the system will take the form of the figure below. Due to the general reduction in supply, prices will increase and output will reduce. As output (Y) falls consumption will decrease.



http://www.answers.com/topic/economics-supply-shock-png-1

In the 1970s stagflation period it was found that workers expectations and demands for higher wages and living standards exceeded the paying capacity of the economy which was already severely limited. Applying these factors to the PC model may also yield us a stagflation effect.

A modeller could also apply some additional fiscal policies to try and simulate stagflation. These could take the form of increasing taxes and reducing government expenditure. The former will increase inflation while the latter will reduce output and growth.

Sources:

Wikipedia; Article Titles: Stagflation, 1973 Oil Crisis, Philips Curve, Economy of Zimbabwe.

Tran, D.T.; A Conflict Model of Stagflation, Eastern Economic Journal; Vol. No. 13; Jan 1987

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

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.

Lecture 4 Exercise

As can be seen below, the value of the capital output ratio, u, has a slight fall then gradually improves slightly over time. However, when the interest rate on bonds is changed from 0.07 to 0.1, the capital output ratio improves a much higher steady state value.




There is a similar occurence with the value of households improving again as it moves towards a steady state value. This can also be seen below.





Now, if we were to change the value of alpha to 0.7 from 0.3, we can see that there is a negative effect on both the capital output ratio and the value of households.

For the value of u, there is a slight sudden increase however it gradually returns to its original value which is slightly less than if this change was not made, as can be seen graphically below.



For the value of households though, the reaction is that the value diminishes quite rapidly to zero which is not desirable in any case.

Blogwork 3

Question 1

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

For SIM model, wealth is the equilibrium mechanism similar to the buffer in the SIMEX model.

For the SIMEX model the important buffer is the role of money.

Some notional income level is reached given fixed expectations and perfect foresight.

Stationary equilibrium is the same in both models.

2. What does it mean for the stability of the model when the presence of mistakes allow household's incomes to suffer? Can you draw any general conclusions about the real world from this model?

People act on wrong expectations underestimating disposable income. Savings are higher that expected and hence the stock of wealth grows faster than in the perfect foresight case. Consumption eventually reaches the same steady state value that it would in a perfect foresight model. Expectations about income never changes, however wealth does rise faster than it would otherwise have done and it is this which causes consumption to rise.

A couple of conclusions that can be made from this model are that if expected income is always lower than actual income (people act in wrong expectations) stock of wealth grows. Likewise, if expected income is always higher than actual income, stock of wealth falls.

3. Solve SIMEX for the following values for 3 periods: G = 30, α_{1 = 0.6,} α₂ = 0.4,θ = 0.2. Follow the format of table 3.6 on page 81 of GL in presenting your results.

Those figures in the table above are calculated as follows:

Period 1, it is assumed that there is no economic activity and none has ever existed. Therefore, the cells of first column are all equal to zeros.

Period 2, we start from expected disposable income YD^e, which is equal to G*(1-Ө) =30*(1-0.2) =24. Secondly, since there is a marginal propensity to consume of 0.6, this indicates that actual consumption C is 14.4 (=α₁*YD^e+α₂*H_-1=0.6*24+0.4*0) and hence income Y is 44.4 (=G+C=30+14.4). Thirdly, tax T is 8.88 (=ө*Y=0.2*44.4). Finally, the rest of columns 2 are calculated on the basis of the previous calculation.

Period 3, expected disposable income YD^e is YD from period 2. We calculated C using H_-1 (H from period 2).

Period ∞, Y*=G/Ө is steady state, which is 150.

Question 2:

1. Is it possible to specify a version of SIM that replicates the ISLM model?

Yes, although it does not have all the properties of the consumption function;

C_d = α₁YD + α₂H_-1

2. Write one down and comment on the stability of this model.

Consumption Function: C = α₀ + α₁YD

α₀ represents a positive constant, which represents autonomous consumption, independent of current income.

α₁ represents the Marginal Propensity to Consume.

This version of SIM replicates the ILSM model and will allow us to obtain a coherent stationary state. This is because the average propensity to consume can be unity, i.e. we can have C = YD in the stationary state even though the marginal propensity to consume out of disposable income is below 1. This is due to the constant term α₀ which plays a role similar to that of the consumption out of wealth.

Homework 2

Part 1.1

Why must the vertical columns sum to zero?

The vertical columns must sum to zero because the change in the amount of money held must always be equal to the difference between receipts and payments. Hence, within a household, the difference is between household receipts and payments and for the government it’s the difference between government receipts and outlays.

Part 1.2

Why must the horizontal rows sum to zero?

The horizontal rows must sum to zero because within the matrix, it is implied that supply equals demand. For example, in the consumption row, the sale of household consumption (+Cd) is naturally equal to the purchase of that consumption (-Cs), where Cd = Cs. This is shown by the Circular Flow of Income theory which implies that ‘everything comes from somewhere and everything goes somewhere’.

Part 2 - Explanations for each row

Consumption

Consumers have a need or demand for products and services. They purchase these products with their income (-Cd).
Producers provide what is needed or demanded by consumers and this generates income (+Cs).
Thus products or services purchased by the consumer are supplied by producers and the –Cd & +Cs terms will sum to zero.

Govt Exp

Government expenditure is similar to consumer or household expenditure in that the government spends its income on products or services (e.g. roads and make-up for Bertie), -Gd.
The producers provide these products and services and derive their own income from it. +Gs.
+Gs & -Gd terms will sum to zero.

Output

Output is the sum of all the production on goods and services in an economy by the production sector. It is not a transaction between two sectors and hence only appears once, in the production column. Total production is defined in a standard way used in all national accounts either as the sum of all expenditures on goods and services or as the sum of payments of factor income.
It is represented by Y = C + G, indicating the goods and services consumed by households and the government.

Factor Income

Factor Income represents the cost and supply of labour in an economy. The household sector provides labour to the production sector. This provides income to the households in terms of wages, +W.Ns. Labour is required in order to produce goods and services and this labour is an expenditure for the production sector, -W.Nd.
The sum of household wages and labour cost is zero; +W.Ns – W.Nd = zero

Taxes

Household income(e.g. wages) is taxed by the government. This is represented by –Ts in the household column. This tax is collected by the government and is represented by +Td. Naturally tax paid out by households equates to the tax collected by the government and +Td – Ts equals zero.

Change In Money Stock

Households accumulate excess cash over time and use it to purchase assets (e.g. Government bonds). In the simplified model the supplier of these financial assets is the government. By issuing these assets, the government can raise income to fund their public works.

References:

1. Godley, W., and M. Lavoie (2007)

2. Wikimedia, Consumption (Economics), http://en.wikipedia.org/wiki/Consumption_%28economics%29

3. Glossary of Political Economy Terms, Dr. Paul M. Johnson, http://www.auburn.edu/~johnspm/gloss/money_stock

Lecture 2, Exercise 3

Question: What do you think will happen to the steady state value(s) of output when θ changes? Why does this happen?

Answer: If the tax rate, θ, goes up, (assuming government expenditure remains the same) national income, Y, would decrease as would households disposable income and consumption. Since government expenditure must equal tax receipts in a steady state, the tax receipts will remain unchanged. The perfect foresight national income equals government expenditure divided by the tax rate, i.e. Y* = G/ θ.

Homework 1: Definitions and Examples

1. Aggregate Demand Relation

Total demand for goods and services in the economy from within and outside its borders.


Example

As Price level drops national income and/or quantity of output increases.


Reference:

1. http://fxtrade.oanda.com/help/glossary/glossaryA_C.html
2. http://www.sparknotes.com/economics/macro/aggregatedemand/section2.rhtml

2. Animal Spirits

According to Keynes, these are “spontaneous urges to action rather than inaction” and are the driving force behind investments.

An example of this is that entrepreneurs often put aside the thought of failure when setting up a business and just go ahead even if it may seem irrational.

Reference:
1. Matthews, R. C. O. (1984): Animal spirits, Proceedings of the British Academy, 70, 209-229.

3. Bank Run

This can be defined as the concerted action of depositors who try to withdraw their money from a bank because the think it will fail.

Example
During the Economic Crisis in Argentina, there was a massive bank run when the people feared that they would lose their money and they withdrew huge amounts until the accounts were frozen.

Reference:
1. http://wordnet.princeton.edu/perl/webwn

4. Bond

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.

Example
US Treasury Bond, which is a bond issued by the US Government to raise money for different operations and expenses. Its maturity can be from 10 to 30 years and has a fixed interest rate.

Reference:
1. Wikipedia; http://en.wikipedia.org/wiki/Bond_%28finance%29
2. http://www.investorglossary.com/us-treasury-bond.htm

5. Capital Account

The net of investment flowing in and out of a country.

Example
In Greece, say that foreigners invest 1 billion Euro in that country (capital inflow) and at the same time Greek investors invest 400 million Euro abroad (capital outflow). These investments include all assets such as companies, property, stocks and bonds and holdings in loans, bank accounts and currencies. In this example the capital account would record all these transactions and would have a balance of 600 million Euro (1 billion – 400 million).

Reference:
1. http://fxtrade.oanda.com/help/glossary/glossaryA_C.html

6. Debt to GDP ratio

This is a measure of a country's federal debt in relation to its gross domestic product (GDP) which indicates the country's ability to pay back its debt.
http://www.investopedia.com/terms/d/debtgdpratio.asp

Example
Reflecting both the stability of the Debt and the rapid growth of the Irish economy in recent years, the Debt GDP ratio has fallen from over 90% during the first half of the 1990s to an estimated 25.1% at end 2007. This can be seen in the table below.



Reference:
1. http://www.ntma.ie/NationalDebt/debtGDP.php

7. Effective Demand

A qualifying term meaning the ability to pay as well as desire to buy.

Example
If a new product comes out that is highly desired by the population there will be a high demand for it, however, if half the population cannot afford it due to it being too expensive then the effective demand will be only by half of the population.

Reference:
1. http://www.google.com/url?sa=X&start=0&oi=define&q=http://www.alpineescrow.net/terms.htm&usg=AFQjCNEMX8EjjspeIP7Wssnf7kZqz9f0yw

8. Deflation

Deflation is the opposite of inflation. It is a decrease in the general price level of goods and services over a period of time. During deflation, while consumers can buy more with the same amount of money, they also have less access to money, as jobs and wages are dictated by returns on the sale of products and services.

A notable example of deflation was when Japan experienced a period of deflation in the late 90s and early part of the 2000s.

Reference:
1. Wikipedia; http://en.wikipedia.org/wiki/Deflation
2. Japanese Statistics Bureau, Ministry of Internal Affairs and Communications; http://www.stat.go.jp/english/data/cpi/index.htm


9. Consumption Function


The consumption function calculates the amount of total consumption in an economy. It is made up of autonomous consumption that is not influenced by current income and induced consumption that is influenced by the economy's income level.


The simple consumption function is shown as the linear function:

C = c0 + c1Yd

where C = total consumption, c0 = autonomous consumption, c1 = the marginal propensity to consume, and Yd = disposable income (income after taxes and transfer payments). The second term (c1Yd) is induced consumption.


Reference:
1. Wikipedia; http://en.wikipedia.org/wiki/Consumption_function
2. Macroeconomics, Olivier Blanchard, page 44


10. Consumer Price Index


A consumer price index (CPI) is a measure of the average price of consumer goods and services purchased by households. The percent change in the CPI is a measure of inflation.
Irelands CPI has remained positive and in the single digits for approximately 20 years. In the 70s and 80s it reached levels as high as 20%. During this period Ireland’s economy suffered from high unemployment and slow growth.

Reference:
1. Wikipedia; http://en.wikipedia.org/wiki/Consumer_Price_Index
2. Central Statistics Office Ireland; http://www.cso.ie/statistics/conpriceindex.htm

11. Investment Function

Also known as the Keynesian investment function, it accounts for the fact that with an excess supply of goods, producers cut back on their stocks of capital and hence there is generally less investment demand. It includes the level of output and is similar to the consumption function.

Reference:

1. Macroeconomics, Robert J. Barro, page 772

12. Fiscal Expansion

An increase in the deficit, either due to an increase in government spending or to a decrease in taxes is called a fiscal expansion.

Reference:

1. Macroeconomics, Olivier Blanchard, page 87

13. GDP Deflator

The GDP Deflator is a measure of the change in prices of all new, domestically produced, goods and services in an economy.

It is similar to Consumer Price Index but differs in that is it not based on a fixed basket of goods and services. The basket changes with consumers consumption and investment patterns, i.e. as consumers expenditure patterns or choices change due to changing prices the GDP Deflator will accommodate for this.

For example, if the price of product A increases relative to product B and people spend more money on product B as a substitute to product A, a consumer price index will not take this into account while a GDP Deflator will. Without this the GDP figure may underestimate the degree to which improving technology and quality-level are increasing the real standard of living.

Reference:

1. Wikipedia; http://en.wikipedia.org/wiki/GDP_Deflator
2. Wikipedia; http://en.wikipedia.org/wiki/Gross_domestic_product

14. Imports

Imports are goods or services that are purchased in a country that were not produced in said country. Without imports, nations would be limited to the goods ands services produced within their own borders.

An example of an import is a …. banana! (in Ireland)

15. Monetary contraction

Monetary contraction is a monetary policy that seeks to reduce the size of the money supply.

Source: http://en.wikipedia.org/wiki/Contractionary_monetary_policy

16. Nominal GDP

Nominal GDP reflects Gross Domestic Product in today’s prices.
For example, if today’s Nominal GDP is $105billion, and the GDP Deflator is 3%, the Real GDP is $105B/1.05, or $100billion.

Source: http://www.fxwords.com/n/nominal-gdp.html

17. Propensity to consume

The ratio of total consumption to total income is known as the average propensity to consume. An increase in consumption caused by an addition to income divided by that increase in disposable income (income after taxes and transfers) is known as the marginal propensity to consume.

For example, if Tom earns one extra Euro of disposable income, and the marginal propensity to consume is 0.4, then he will spend €0.4 and save €0.6 of that Euro.

Source: http://www.britannica.com/eb/article-9061553/propensity-to-consume


18. Short run

In economics, the concept of the short-run refers to the decision-making time frame of a firm in which at least one factor of production is fixed.

Source: http://en.wikipedia.org/wiki/Short-run

19. Real exchange rate

The real exchange rate (RER) is defined as , where P is the domestic price level and P * the foreign price level. P and P * must have the same arbitrary value in some chosen base year. e is the nominal exchange rate, which is the price in domestic currency of one unit of a foreign currency.

Source: http://en.wikipedia.org/wiki/Exchange_rate

20. Trade surplus

A positive balance of trade is known as a trade surplus and consists of exporting more than is imported. The balance of trade is the difference between the monetary value of exports and imports in an economy over a certain period of time.

For example, in 2007, Chinese exports were $1.2 trillion, while imports were $955.8 billion. Therefore, the trade surplus was $244.2billion.

Source: http://en.wikipedia.org/wiki/Trade_surplus