Blog Homework 5: Stagflation

Stagflation is the term used to describe the combination of inflation, low economic growth and rising unemployment levels.

It came to prominence in the 1970’s when the UK and the US both experienced stagflation. The initial cause of this was the oil crisis of the 1970’s which saw world oil prices rise dramatically. In conjunction with this developed countries were experiencing low economic growth. Therefore the inflation associated with the rising prices was not offset by any economic conditions and stagflation arose.

There are two main causes of stagflation:

The first cause occurs when an economy is slowed by an unfavorable supply shock. For example an increase in the price of oil for an oil importing country, tends to raise prices while at the same time it is responsible for slowing the economy by making production less profitable



The second cause can be inapproporiate macroeconomic policies which are responsible for increasing inflation and causing stagnation. For example Central Banks may cause inflation by permiting excessive growth in money supply, and governments may be responsible for stagnation by the over regulation of goods markets.

In a period of stagflation consumption of goods will remain steady as households will save in order to prepare for more difficult time ahead. Govt expenditure remains the same or decreases in stagflation periods however the govt must try to increase their spending in order to fight the problem of stagflation and try to stop Y from decreasing.

In the PC model the price of bills does not change throughout their duration. This assumption is relaxed in order to allow the Fed to cut interest rates which as we know could be a cause of stagflation. When interest rates are cut, the price of bills will rise causing increases in wealth. This increased wealth will result in an increase in consumption expenditure. (equation5) Therefore, a reduction in interest rates will result in an increase in demand for the short run. The long run outcome of a reduction in interest rates will cause a reduction in long term aggregate income. This is because the lower yields on govt debt reduce the flow of payments from the govt sector leading to less money available to the consumer.

Wikipedia - http://en.wikipedia.org/wiki/Stagflation

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

EC6012 Blogrork 4

Question 1

Model PC introduces government bills, interest payments and the central bank into Model Sim.

Bills (B) are short term government securities which pay interest at a rate r. Each bill has a price of one unit and does not fluctuate during the life of the bill. It is not possible to make capital gains from the changing prices of financial assets. This relies on the assumption that treasury bills are for example three-month assets and that each period is of similar length. Provided bills are issued once every three months, interest rates will not change during the period and as a result there will not be any change in the price of bills. If this assumption was relaxed and r was to reflect real life and became variable, the price of bills would be determined by the market and will be lower than the face value. This discount is the price agents are willing to pay for a promise that a given amount of money will be paid in the future. This discount figure will be the prevailing interest rate.

The flow matrix for the PC model is similar to the Sim Model. All rows and columns sum to zero this ensures all transactions are taken into account. The Central Bank, which was part of the Government in the SIM Model, is now considered an institution in its own right.

There are some major differences

Flow of Funds Accounts: two rows, which are inserted between the two lines at the bottom of the table, comprise of two financial assets.

Interest Payments arising from government debt: Government interest payments are paid to households and the central bank. These interest payments are generated by stocks of assets in existence at the end of the previous period.

Central Bank:
Current Account- inflows and outflows from current operations
Capital Account- changes in balance sheet of the central bank i.e. purchase of new bills

Net Worth = Zero – all profits are distributed. It makes profit since Bills yield interest payments whereas its liabilities pay no interest. All profits are paid to the government.

PC model is built on perfect foresight, which producers sell whatever is demanded and households have correct income assumptions

Y = C + G Unchanged
YD = Y – T + r-1.Bh-1 Disposable Income increases by interest payments on
Government debt
T = 0. (Y + r-1. Bh-1) Taxable Income increases by adding interest payments on
bills held by households.

Households decide how much they will save out of their income and decide how they will allocate their wealth. The difference between disposable income and consumption is the change in total wealth.Households hold some of their wealth in the form of bills and in the form of money. The proportion held in the form of bills is negatively related to the interest rate and positively related to the level of disposable income. The interest rate must equalize the supply and demand for bills. Holdings of money are the difference between total household wealth and their demand for bills.



Question 2

1)Keynes defines liquidity preference as the demand for money as an asset, as a means of holding wealth. Keynes believes interest rates are not a reward for savings because if a person hoards his savings in cash he will receive no interest, although he has refrained from consuming all his current income. Instead of a reward for saving, Keynes states that interest is a reward for parting with liquidity.

According to Keynes there are three divisions of liquidity-preference which may be defined as depending on:
· The transaction-motive; the need of cash for the current transactions
· The precautionary-motive; the desire for security in the future
· The speculative-motive; the object of securing profit by beating the market


The Liquidity Preference Curve

In the diagram, we show the quantity of money on the horizontal axis and the interest rate on the vertical axis. For example, if the rate of interest is Ra, people want to hold Ma of money, whereas if the rate of interest were to go down to Rb, people would increase their demand for monetary assets to Mb.

2)The PC model encompasses Keynes ideas of the transaction, precautionary and speculate motive.

The equation V=V-1+ (YD-C) simply illustrates that the difference between disposable income and consumption is equal to the change in total wealth. This idea is also inherent in Keynes theory that reveals how much of income will be consumed and how much will be reserved in some form of command over future consumption.

The PC decision has two steps, Savings is decided on and how savings is allocated respectively which are made within the same time frame in the model. In the both models, the rate of interest is the equilibrium in the desire to hold wealth in cash form and the availability of cash.

In the PC model, the quantity of money held depends on the rate of interest that can be obtained on other assets.

In general, the PC model is faithful representation of Keynes’ original vision of household decision-making.

References:

http://en.wikipedia.org/wiki/Liquidity_preference

Godley and Lavoie, 2006

Keynes, J.,"The General Theory of Employment, Interest and Money"

EC6012 Blogwork 3

Question 1

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

In a steady state the key variables remain in a constant relationship to each other. This must include both flows and stocks. In general, the steady state will be a growing economy where ratios of variables remain constant.

The model SIM omits growth, holding all other levels in the state constant, i.e. a stationary steady state. In such a state:
· There is no change in the stock of money
· Government expenditure must equal tax receipts
· Consumption must be equal to disposable income
· Household savings converges to zero

Model SIM is based on the assumption that consumers have perfect foresight as to their income. When uncertainty is introduced, actual income is substituted for expected income. This assumes households estimate the income they will receive and base consumption over a period on this. Money stocks that will be held at the end of the period are also estimated. As the level of consumption has already been decided any extra income received will be saved.
The existence of uncertainty provides a more recursive picture of the system and allows us to define the model SIMEX. Here as periods succeed period’s people amend their consumption as they find their wealth stocks unexpectedly excessive or depleted and as expectations about future income get revised.

In the SIM model wealth is the equilibrium mechanism similar to the “buffer” in the SIMEX model. In comparison the role of money has a much greater importance in the SIMEX model. The same national level of income is reached in both models given fixed expectations in the SIMEX and perfect foresight in the SIM. The convergence rate is different for both models been much slower for fixed or false expectations. Stationary equilibrium is the same in the two models.

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

The introduction of expectations into the Sim Model introduces the possibility of mistakes. If people act on wrong expectations i.e. overstating disposable income saving is lower than expected and the stock of wealth which was built up decreases. This wealth fall off is due to consumption being above expectations of disposable income. Future income expectations will get revised in this scenario. The stability of the model will remain unchanged but differences in income expectations and current income will cause a convergence towards the same figure.

People continue to consume even when expectations are not met. Consumption (spending today) is seen to be more important than saving (saving for tomorrow).


3) Solve SIMEX for the following values for 3 periods: G = 30, α1 = 0.6, α2 = 0.4, θ = 0.2. Follow the format of table 3.6 on page 81 of GL in presenting your results?

Question 2

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

Yes, it is possible to specify a version of SIM that replicates the ISLM model. The ISLM model is in equilibrium at the intersection of the IS and the LM curve which could be compared to the steady state of the SIM model. To replicate a version of SIM to the ISLM curve we believe that the intersection of the IS and LM curve is equal to YD=C in the SIM model. Both models have similar consumption functions.

In the IS/LM curve consumption depends on three factors. First, there is some autonomous level of consumption defined c° even at zero levels of disposable income. Second, consumption depends on disposable income (Y-T) which is subject to parameter “b” that represents the marginal propensity to consume; i.e. when income goes up by a dollar, consumption goes up by 80cents when b=0.8. Third, consumption is a negative function of the interest rate r; as interest rates goes up, consumers will save a larger fraction of their income and consume a small fraction of their income.
C=c° + b(Y-T) – a r

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

As we look at the wealth function, ∆Hh=α2*[(1- α1) *YD / α2 -Hh-1], households now have a target level of wealth, given by VT= (1- α1) *YD / α2. The α3 = (1- α1) / α2 coefficient is the stock-flow norm of households. When the target wealth is equal to disposable income since α3 =1, it means that the target wealth is higher than realized wealth, so that households save in their attempt to adjust their historically given level of wealth to their target wealth. As a result, consumption is systematically below disposable income, until the new stationary state is reached, at which point Hh=VT=YD=C, as we mentioned above.

Moreover, there is another consumption function C= α0+ α1*YD with α0 a positive constant, which is similar to the equation C= α1*YD, 0< α1<1. c="YD">

Reference: Godley, W., and M. Lavoie (2007) Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, Palgrave Macmillan. http://pages.stern.nyu.edu/~nroubini/NOTES/CHAP9.HTM#topic1

EC6012 Homework 2

1 Why must the Vertical Columns sum to zero?

First, it is very important to understand that the agent buying a service is engaged in a completely different activity from that performed by the seller of that service and the motivation behind the two types of activity is completely different. Then, the reason that the Vertical Columns must sum to zero is that the change in the amount of money held must always be equal to the difference between households’ receipts and payments, however these are determined. Similarly the change in the amount of money created must always, by the laws and logic, be equal to the difference between the government receipts and outlays. Moreover, as they are assumed to hold no cash, producers’ receipts from sale must equal their outlays on wages.

2 Why must the Horizontal Row sum to zero?

The following equations equalize demands and supplies.
Cs = Cd (1)
Gs = Gd (2)
Ts = Td (3)
Ns = Nd (4)

These four equations imply that whatever is demanded (services, taxes and labour) is always supplied within the period. These (apart possibly from (3)) are strong assumptions implying, obviously enough, that we are describing an economy that has no supply constraints of any kind. In particular, equation (4) implies that there is reserve army of unemployed workers, all eager to work at the going wage, whenever their labour services are being demanded.

Furthermore, Cs and Gs represent the sales of consumption and government services, Cs and Gs carry a positive sign in production column of the matrix. They thus represent sources of income-revenues that collected by the production sector. Similarly, Cd and Gd represent the purchase of consumption goods and government services. Of course, we know that the sales have to equal purchase.

In general, ‘everything comes from somewhere and everything goes somewhere’ (Godley & Lavoie, pg. 6). Every component in the matrix must have an equivalent component elsewhere. Therefore flows must always equal zero.

Row 1 Consumption:
In each period households consume their disposable income (YD) and the wealth they have accumulated in previous periods, H(t-1),H(t-2),etc. Households buy goods with this income, -Cd and producers supply these goods and receive +Cs for them. Therefore, -Cd+Cd=0.

Row 2 Govt Expenditure:
Governments demand goods and services similar to households. Government’s purchase these products –Gd and similarly producers supply these goods and services and receive +Gs. Hence, -Gd+Gs=0.

Row 3 Output:
Y, total production can be defined as the sum of all expenditures on goods and services or as the sum of all payments of factor income in an economy. In this matrix, Y is not a transaction between two sectors and hence only appears once.
Y=C+G.

Row 4 Factor Income:
The income received by a household for supplying labour, is denoted as a wage rate (W) times employment (N). It is an asset for the household and is a liability for the production firm as they must pay money out. The s and d denote supply and demand. The household earns income (+W.Ns) while the production firm pays employees (-W.Nd).Both amounts are equal therefore they sum to zero.

Row 5 Taxes:
When Households earn income they are subject to tax on their wages. This is a liability for the household and is denoted as (-Td). The amount paid by the households is received by the government, it is therefore an asset for the government and is denoted by (+Td).Both amounts are equal which means this row will sum to zero.

Row 6 Changes in Money stock:
Over time the household accumulates excess stocks of money, as income may exceed the demand for goods or services. When this occurs households can use their excess income is to purchase financial assets, it is denoted by –ΔHh as it is an outflow. In the model the government is the supplier of the financial asset therefore they receive additional income which is denoted by +ΔHs.

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

EC6012 Homework 1

Aggregate Demand relation: In economics, aggregate demand is the total demand for final goods and services in the economy (Y) at a given time and price lever. This is the demand for the gross domestic product of a country when inventory levels are static. In a general aggregate supply-demand chart, the aggregate demand curve (AD) which describes the relationship between price levels and the quantity of output that firms are willing to provide. (http://en.wikipedia.org/wiki)


An aggregate demand curve is the sum of individual demand curves for different sectors of the economy. The aggregate demand is usually described as a linear sum of four separable demand sources.

AD=C+I+G+(X-M)
C= Personal consumption expenditures or "consumption," demand by households and unattached individuals
I= Gross Private domestic investment, such as spending by business firms on factor construction.
G=Gross government investment and consumption expenditure.
(X-M)=Net export, such as net demand by the rest of the world for the country

Keynesian cross diagram

Animal Spirits:
(http://farmer.sscnet.ucla.edu/NewWeb/JournalArticles/ANIMAL%20SPIRITS.pdf)

The term “Animal Spirits” is closely associated with John Maynard Keynes who used it in his 1936 book, The General Theory of Employment Interest and Money to capture the idea that aggregate economic activity might be driven in part by waves of optimism or pessimism: (although Robin Mathews 1984, points out that Keynes would have been aware of its use by David Hume 1739, Part iv, Section vii).

"Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits - a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities."
(The General Theory of Employment Interest and Money, 161-162)

The idea that waves of spontaneous optimism might drive business cycles was not new to Keynes and can be traced at least as far back as Henry Thornton who attributed a central role in his theory of credit to “… that confidence which subsists among commercial men in respect to their mercantile affairs…” (Thornton 1802, p. 75).

Bank Run: A bank run (also known as a run on the bank) is a type of financial crisis. It is a panic which occurs when a large number of customers of a bank fear it is insolvent and withdraw their deposits. (http://en.wikipedia.org/wiki)


If many or most banks suffer runs at the same time, then the resulting chain of bankruptcies can cause a long economic recession.


Bond: A debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities.

Bonds are commonly referred to as fixed-income securities and are one of the three main asset classes, along with stocks and cash equivalents..

The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date). Interest on bonds is usually paid every six months (semi-annually). The main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as simply "Treasuries". (http://www.investopedia.com/terms/b/bond.asp)

Two features of a bond - credit quality and duration - are the principal determinants of a bond's interest rate. Bond maturities range from a 90-day Treasury bill to a 30-year government bond. Corporate and municipals are typically in the three to 10-year range.


Capital Account: In economics, the capital account is one of two primary components of the balance of payments, the other being the current account. The capital account is referred to as the financial account in the IMF's definition; the IMF has a different definition of the term capital account. http://en.wikipedia.org/wiki/Capital_account)

Capital Account= Increase in foreign ownership of domestic assets
- Increase of domestic ownership of foreign assets
= Foreign direct investment
+ Portfolio investment + Other investment

Debt to GDP Ratio: Debt to GDP Ratio is a measure of a country's federal debt in relation to its gross domestic product (GDP). By comparing what a country owes and what it produces, the debt-to-GDP ratio indicates the country's ability to pay back its debt.

(http://en.wikipedia.org/wiki)


Various debt to GDP ratio can be calculated. The most commonly used ratio is the National Debt divided by the Gross Domestic Product (GDP).The ratio can also be calculated by dividing total debt by the Gross Domestic Product (GDP). This suppresses the bias due to differences in consumer debt levels.

If a country were unable to pay its debt, it would default, which could cause a panic in the domestic and international markets. The higher the debt-to-GDP ratio, the less likely the country will pay its debt back, and the higher its risk of default.


Effective Demand: Effective demand (in macroeconomics usually regarded as synonymous with aggregate demand), is an economic principle that suggests consumer needs and desires must be accompanied by purchasing power (money) to be considered effective in discussions of supply and demand for the determination of price.

(http://en.wikipedia.org/wiki)

According to Keynesian economics, weak demand results in unplanned accumulation of inventories, leading to diminished production and income, and increased unemployment. This triggers a multiplier effect which draws the economy toward underemployment equilibrium. By the same token, strong demand results in unplanned reduction of inventories, which tends to increase production, employment, and incomes. If entrepreneurs consider such trends sustainable, investments typically increase, thereby improving potential levels of production


Deflation: Rate at which the price level falls in percentage terms. Opposite to Inflation. (Macroeconomics ninth edition, Dornbusch, Fischer, Startz, 2004)

After over a decade of Boom in the Irish Property Market house prices began to drop by between 5% and 15% in 2007. This deflation is expected to continue in 2008 amid fears of continued slowing down of the construction industry.

Consumption Function: Equation relating consumption to disposable income. (Macroeconomics, ninth edition, Dornbusch, Fischer, Startz, 2004)

The Keynesian Consumption Function
Disposable Income (Yd) = Gross Income - (Deductions from Direct Taxation + Benefits)

The standard Keynesian consumption function is as follows:

C = a + c Yd where,

C= Consumer expenditure

a = autonomous consumption. This is the level of consumption that would take place even if income was zero. If an individual's income fell to zero some of his existing spending could be sustained by using savings. This is known as dis-saving.

c = marginal propensity to consume (mpc). This is the change in consumption divided by the change in income. Simply, it is the percentage of each additional pound earned that will be spent.
http://www.tutor2u.net/economics/content/topics/consumption/consumption_theory.htm



Consumer Price Index: Fixed weight price index that measures the cost of goods purchased by the urban family. (Macroeconomics, ninth edition, Dornbusch, Fischer, Startz, 2004)

Consumer Price Index (Base Mid-December 2001=100)
http://www.cso.ie/statistics/consumpriceindex.htm


Investment Function: The investment function is a summary of the variables that influence the level of aggregate investments. It can be formalized as follow:
I = I(r, ΔY, q)
- + +
Where r is the real interest rate, Y the GDP and q is Tobin’s q. The signs under the variables simply tell us if the variable influences investment in a positive or negative way.

(Burda, Wyplosz (2005): Macroeconomics: A European Text, Fourth Edition, Oxford University Press)

For example: if real interest rates were to rise, investments would correspondingly fall.


Fiscal Expansion: An expansionary fiscal policy means lower taxes and higher government spending. The effect of these policies would be to encourage more spending and boost the economy.
http://www.econlib.org/library/Enc/FiscalPolicy.html

As part of his 2008 State of the Union address George Bush announced a $168 billion economic stimulus package for the US economy. This involves tax rebates for tax payers and tax breaks for businesses. The aim of this is to encourage spending and to help revive the US economy.



GDP Deflator: The GDP deflator can be viewed as a measure of general inflation in the domestic economy. Inflation can be described as a measure of price changes over time. The deflator is usually expressed in terms of an index, i.e. a time series of index numbers. Percentage changes on the previous year are also shown.

http://www.hm-treasury.gov.uk/Economic_Data_and_Tools/GDP_Deflators/data_gdp_index.cfm


A price deflator of 200 means that the current-year price is twice its base-year price - price inflation. A price deflator of 50 means that the current-year price is half the base year price - price deflation.

http://en.wikipedia.org/wiki/GDP_deflator

Imports: Goods and Services that are produced abroad and sold domestically.

Monetary Contraction: Monetary Contraction is a monetary policy that seeks to reduce the size of the money supply. http://en.wikipedia.org/wiki/Contractionary_monetary_policy

In the United States in 1931 during the Great Depression the Federal Reserve deliberately contracted the money supply and raised interest rates. This decline in the money supply caused by Federal Reserve decisions had a severely contractionary effect on output and contributed further to the depression.

http://www.britannica.com/eb/article-234443/Great-Depression


Nominal GDP: Value of all Fiscal goods and services produced in the economy; not adjusted for inflation. (Macroeconomics, ninth edition, Dornbusch, Fischer, Startz, 2004)

Propensity to Consume: The marginal propensity to consume (MPC) refers to the increase in personal consumer spending (consumption) that occurs with an increase in disposable income (income after taxes and transfers). http://en.wikipedia.org/wiki/Marginal_propensity_to_consume

For example, if a household earns one extra dollar of disposable income, and the marginal propensity to consume is 0.65, then of that dollar, the family will spend 65 cents and save 35 cents.


Short Run: 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. Costs which are fixed in the short-run have no impact on a firms decisions.

For example a firm can raise output by increasing the amount of labour through overtime.

A generic firm can make three changes in the short-run:
Increase production
Decrease production
Shut down

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

Real Exchange Rate: Purchasing Power of Foreign Currency Relative to the Domestic Currency.

$ is the Domestic Currency

€ .6813 £ .5105 Yen 106.605
$ 1 $ 1 $ 1


Trade Surplus: An Excess of Exports over Imports.

What do you think will happen the steady state value of output when Ө changes? Why does this happen?

When Ө, the personal income tax rate changes the steady state value of output will also change. If there is a reduction in Ө, the steady state value of output will increase. However, if there is an increase in Ө, the steady state value of output will fall.

If the personal income tax rate falls, individuals will have more money to spend after tax depending on their marginal propensity to consume. This will result in extra money in the economy causing an increase in output. However, if the personal income tax rate increases, individuals will have less money to spend after tax causing output to fall.

There is a major problem with reducing the personal income tax rate in order to increase the steady state value of output. When income tax rates are reduced the government may have to use some of their savings to keep the public sector financed, money which will be needed if the economy enters into a recession

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