Transcript Chapter 4 - A simple stock-flow consistent model with porfolio choice

A simple stock-flow consistent
model with porfolio choice and a
government sector
Chapter 4 of Godley and Lavoie 2007
Monetary Economics: An Integrated
Approach to Credit, Money, Income,
Production and Wealth
The model …
• Can be found as E-views files or (soon)
Modler files on the web sites:
– gennaro.zezza.it/software/models
– http://www.modler.com/LearningTools.html
Preliminaries
• “I have found out what economics is; it is
the science of confusing stocks with flows”
• Michal Kalecki (circa 1936), as told by
Joan Robinson (1982).
Objective of the presentation
• To show what a SFC model is.
• To show some of the main features of a
SFC model is within a simple framework
• Provide some experiments (simulations)
with this simple model: changing some
parameter values and draw charts.
What is the stock-flow consistent
approach? SFC ?
• All sectors face budget constraints
• Financial interdependence between
sectors
• Stock variables arise from flows and
capital appreciation: historical time
• There exist stock-flow norms (which may
change through time)
• People react and adjust to disequilibria
SFC of some form in PKE and
other heterodox economics
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Davidson, Minsky
Eichner 1985
Peter Skott 1989
Institutionalists: Copeland 1947
Origins
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Two strands of research linking stocks and
flows:
Godley and Cripps (1982) at Cambridge,
Cambridge Economic Policy Group,
New Cambridge school (1970’s).
Tobin (1982) and his associates at Yale,
the ‘pitfalls approach’ (1969)
the New Haven school.
General features
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Tobin (1982, Nobel Lecture)
Models ought to track stocks;
Models should have several assets and rates
of return;
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Models include financial and monetary
operations
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Models include the sectoral budget
constraints
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and the adding-up constraints in portfolio
equations
Other key features
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There cannot be any black holes.
• “The fact that money stocks and flows must
satisfy accounting identities in individual budgets
and in an economy as a whole provides a
fundamental law of macroeconomics analogous
to the principle of conservation of energy in
physics” (Godley and Cripps 1983).
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There are intrinsic dynamics, Turnovsky
(1977)
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There are lag dynamics, to avoid telescoping
time (Hicks, 1965)
The PC model
• The PC Model (PC for Portfolio choice) is the second
model of our book, and the first to introduce portfolio
choice.
• We find that it is the simplest model that can reproduce
most of the main features of stock-flow consistency.
• It has four sectors: firms, households, government, and
the central bank.
• The economy is highly simplified: firms have no fixed
capital, and there are no commercial banks.
• As in all cases, it is best to start with the stock matrix and
the transactions-flow matrix
The stock matrix
(the balance sheet)
The transactions-flow matrix
•
There cannot be any black holes
(Godley 1996).
• Therefore, all columns and all rows must
sum to zero.
• The economy is closed, and there is no
investment (since there is no fixed capital)
The transactions-flow matrix
The PC model:
national accounting equations and taxes
(4.1)
(4.2)
(4.3)
Y
C+G
YD 
Y - T + r-1.Bh-1
T = .(Y + r-1.Bh-1)
Portfolio decisions,
based on expected wealth and values:
The Brainard-Tobin formula amended
(4.7E)
(4.6E)
(4.13)
(4.14)
Bd/Ve = 0 + 1.r - 2.(YDe/Ve)
Hd/Ve = (1 - 0) - 1.r + 2.(YDe /Ve)
Hd = Ve - Bd
Ve 
V-1 + (YDe - C)
Realized and expected values
The stock of money held by households is
the buffer
(4.4)
(4.5)
(4.15)
(4.6)
(4.16A)
(4.16)
V
V-1 + (YD - C)
e
C=
1.YD + 
2.V-1
Bh = Bd
Hh = V- Bh
YDe = YD-1
YDe = YD.(1 + Ra)
0 <
1, 
2< 1
The consumption function with propensities to consume out
of income and out of wealth (the so-called Modigliani
consumption function) is equivalent to a wealth
adjustement mechanism with a target wealth to disposable
income ratio. The assumption of stable stock-flow norms
(Godley and Cripps 1982) is derived from the assumption
of relatively stable propensities to consume
Vh = 
2.(
3.YD - Vh-1)
T
Vh = 
2.(
3.Vh - Vh-1)
where 
3 = (1 - 
1)/
2.
The wealth to income ratio is: V/YD = 3
The government, the central bank, and the
hidden equation
(4.8)
(4.9)
(4.10)
(4.11)
Bs 
Bs - Bs-1 
(G + r-1.Bs-1) - (T + r-1.Bcb-1)
Hs 
Hs - Hs-1 
Bcb
Bcb = Bs - Bh
r = r
The hidden equation
(4.12)
Hh = H s
Money as a buffer against mistaken expectations (Here we assume
that expectations about current income fluctuate randomly)
Money held changes more than money demand
Raising the interest rate: impact on portfolio shares
The surprising impact of an increase in interest rates !!!!!
An increase in the propensity to consume out of disposable income:
Anti-Keynesian in the long run …
The impact of a higher propensity to consume
Higher interest rates must lead to
higher income in this model
• Income is depends on a multiplier relationship, inversely
tied to the tax rate, and where the multiplicand is
government expenditure, which includes debt service.
 G     3(1  ) r * 
Y *   

      3 (1  )r * 
The impact of a rise in interest rates is still positive in the long run even when
higher interest rates have a short-run negative impact on income,
Because they are assumed to induce lower propensities to consume
(4.30)

.r1
1= 
10 
Evolution of tax revenues and government expenditures including net debt servicing,
following an increase of 100 points in the rate of interest on bills,
where the propensity to consume reacts negatively to higher interest rates
The hike in interest rates produces a recession, which pushes up the public debt
to income ratio. Governments have little control over the evolution of
the debt to GDP ratio, as long as households don’t modify their wealth to income ratio.
Alternative closures
It is possible to have an alternative closure, a
neoclassical one, by assuming the following changes
• Replace the equation:
• Bcb = Bs – Bh
• Set Bcb as a constant
(through open market
operations)
• Delete the interest rate
equation (where r was a
constant)
• Add the equation
• Bh = Bs – Bcb
• We now have two
equations that set Bh. The
rate of interest must
become a price-clearing
variable (in the portfolio
equation)
Neoclassical closure: Central bank sells T-bills on the open market in 1961
As an exercise …
• Go to the website of Gennaro Zezza
• Introduce the neoclassical closure into the
PC model with expectations and random
errors.
• Check what happens to interest rates and
income with the random shocks.