Transcript a simple model of three economies with two currencies

A SIMPLE MODEL OF
THREE ECONOMIES WITH
TWO CURRENCIES:
THE “EUROZONE” AND
“THE USA”
W. Godley & M. Lavoie
Goals of the model
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An exemplar of the stock-flow consistency
method, as prescribed by Wynne Godley
To illustrate the evolution of a world economy,
Euroland and the USA, describing the whole
complex of financial flows, including interest
payments, starting from a stationary equilibrium,
following an increase in the propensity to import
of one of the Euroland countries.
A complex, but still elementary model
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The simplifying assumptions are enormous.
There is no domestic or foreign investment in
fixed or working capital
No holdings of financial assets by firms;
No wage inflation
No commercial banking
No “hot money”.
The treatment of expectations is elementary.
Yet the model contains nearly 80 equations!
A three-country model …
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The euro zone is in a flexible exchange rate
regime with the USA (the Rest of the world)
The Federal Reserve holds no foreign reserves
The ECB is the central bank of both European
countries, each with its own government, but
with a unique currency, the euro
Households hold foreign securities but hold cash
only in their own currency
Imports depend on foreign income and on the
exchange rate
Main endogenous variables of the
main closure of the model
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In all three countries:
 GDP,
disposable income, taxes, sales, consumption
 Capital gains, household wealth and its allocation
between cash and securities
 Central bank assets and liabilities
 Exports, imports, and hence, the trade account, the
current account and the capital account
Main exogenous variables of the
main closure
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In all three countries:
 Pure
government expenditures (excluding
debt servicing)
 The tax rate
 The interest rates set by central banks
 Propensities to consume and the parameters
of portfolio behaviour
 Import elasticities
Main results of the main closure
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The twin deficit principle (which occurs in a stationary or
semi-stationary state in the two-country case) does not
hold anymore for individual countries of the eurozone.
Flexible exchange rates do not bring back anymore the
current account towards equilibrium (zero).
Interest rates can remain constant, but the ECB must
accept a transformation of the composition of its assets
(it will hold more assets issued by the deficit eurozone
country).
Eurozone countries cannot all converge towards
balanced or surplus budget positions, unless deficit
countries decide to self-impose fiscal austerity measures
(or unless surplus countries decide to give up fiscal
austerity).
Notations
# represents Germany in the eurozone
 & represents Italy or Greece in the
eurozone
 $ represents the USA
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USA Balance sheet
HH
Firms
Govt
Fed
Cash
+H$
# Bills
+B$#
& Bills
+B$&
$ Bills
+B$$
-B$
+BFED$
-V$
Debt =+B$
0
0
0
Balance
Sum
0
-H$
0
The net worth of the Fed is zero (all profits are distributed to government).
Assets with plus (+) sign, liabilities with a minus (-) sign.
Eurozone balance sheet
HH#
Govt #
HH&
Govt &
+H&
-(H# + H&)
+B&#
+BECB#
Cash
+H#
# Bills
+B##
& Bills
+B#&
+B&&
$ Bills
+B#$
+B&$
Balance
-V#
Debt =+B#
-V&
Debt =+B&
Sum
0
0
0
0
-B#
BCE
-B&
+BECB&
+BECB$
…..
The BCE net worth could be positive because of capital gains or losses on foreign
exchange reserves. We are cheating: ECB cannot buy T-bills directly.
The transactions flow matrix
Too big to be shown !
 The matrix includes standard NIPA but
also flows of funds
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Behavioural equations
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Standard Keynesian equations wrt to:
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Consumption equations
Import equations (and hence exports)
Tobin portfolio equations
Production supply responds to demand
Taxation
Central banks set interest rates and the
supply of cash money is endogenous
An experiment using the main
closure
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Starting from a full stationary state
(constant wealth, balanced budget,
balanced current account) we impose an
increase in the propensity of the & country
(Italy, Greece) to import goods from the $
country (the USA).
Figure1.1: Effect on the domestic product of each country of an
increase in the propensity of the ‘&’ (Greece) country to import products
from the ‘$’ country (main closure).
Figure 1.2: The euro (measured in dollars) depreciates, following the
increase in the propensity of the & country (Greece, Italy) to import
goods from the $ country (USA)
Figure 1.3: Effect on various balances of an increase in the propensity
of the ‘&’ country to import products from the ‘$’ country (main closure).
Figure 1.4: Evolution of the assets and liabilities of the European
Central Bank following an increase in the propensity of the ‘&’ country
to import products from the ‘$’ country (main closure, with rates of
interest remaining constant in both countries
Figure 1.5: Relative evolution of the debt to GDP ratios, in a world
where pure government expenditures grow at an exogenous rate
Variant 2:
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The interest rate of country & (Italy, Greece) becomes
endogenous.
To get this variant, a series of equations must be
inverted.
Here it must be supposed that the ECB refuses to
purchase additional Italian or Greek Treasury bills,
(BECB&d is a constant). As a result, the interest rate on
Italian or Greek bills or bonds becomes endogenous, to
clear the financial markets.
Figure 2.1: Effect of an increase in the propensity of country & (Italy) to
import goods from the USA ($), when the interest rate & on Italian or
Greek securities is endogenous.
Figure 2.2: Effect of an increase in the propensity of country & (Italy,
Greece) to import goods from the USA ($), when the interest rate & on
Italian or Greek securities is endogenous.
Variant 2: The adjustment through interest
rates leads to instability.
The adjustment through interest rates
brings the asset market to equilibrium for a
single period. A continuous readjustment
is needed, pushing up the interest rate for
countries with a deficit current account.
 The model explodes.
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Variant 3: Alternative closure: endogenous
government expenditures by deficit country
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If the ECB does not want to take on more assets
issued by the deficit country (Italy, Greece), or if
the deficit country does not want to let its debt to
GDP ratio drift upwards, then the deficit country
may decide to impose fiscal austerity, having
endogenously falling government expenditures.
The Italian government then acts as if it were
facing a loanable funds constraint: the supply of
bills must adapt to the demand for bills by
households.
Figure 3.1: Effect on GDP of an increase in the propensity of the ‘&’
country to import products from the ‘$’ country, when government
expenditures of deficit country are endogenous
Figure3.2: Effect on current account balances of an increase in the
propensity of the ‘&’ country to import products from the ‘$’ country,
when government expenditures of deficit country are endogenous
Figure3.3: Effect on debt/GDP ratios of an increase in the propensity of
the ‘&’ country to import products from the ‘$’ country, when
government expenditures of the deficit country are endogenous
#
Conclusion
Eurozone countries cannot all converge
towards balanced or surplus budget
positions, unless deficit countries decide to
self-impose fiscal austerity measures
 But then fiscal austerity is incompatible
with full employment goals
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