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"