1. Model SIM used the strong assumption that consumers have perfect foresight with regard to their income – something which is inconceivable in a world dominated by uncertainty. Therefore, expected disposable income is substituted for actual disposable income in the model SIMEX. At the beginning of a period, households decide on the amount of additional money they desire to hold by the end of the period. If realised income is above expected income, households will hold the difference in the form of larger than expected cash money balances. However, despite mistakes in expectations, as time goes on, the steady state achieved with SIMEX will be the same as that achieved with SIM (Figure 1). This is because, as period succeeds period, households will amend their consumption decisions as they find their wealth stocks unexpectedly excessive or depleted, and as their expectations about future income get revised.
2. Mistaken expectations concerning income make no difference to the stability of the model.
If income turns out to be continually higher than expected, the accumulation of wealth also continues to be larger than expected, which makes consumption grow. Growth ceases when wealth has risen to a level at which additional consumption out of wealth is exactly equal to consumption which is lost because of mistaken expectations about income. Therefore, it doesn’t matter if expectations are falsified because there is a sequential system with a built in mechanism for correcting mistakes. For example, assuming a permanent step increase in government expenditures, consumption eventually reaches, albeit slower, the same steady state value that it would have reached in a perfect foresight model (Figure 2). If expectations about income never adapt to the new circumstances, which is a real world possibility given households would not intuitively equate an increase in government spending with an increase in consumption, then wealth increases – faster than it would otherwise have done – and it is this which causes consumption to rise (Figure 3). This rise only tails off as consumption reaches its new steady state. Actual wealth and therefore public debt would be larger than that of an economy where forecasts are correct.
Question 2:
2.1
It is possible to specify a version of SIM that replicates the ISLM model. The point of intersection of the IS curve (market for goods and services) and LM curve (money market) represents a simultaneous equilibrium in both the goods and money markets as illustrated below.
This point of equilibrium can be compared to the steady state of the SIM model.WhereYD*= C*; and both models have comparable consumption functions.
Private consumption C depends on three factors. First, there is some exogenous level of private consumption (defined by c0) even at zero levels of disposable income. Second, consumption depends on disposable income (Y-T) according to the parameter "b" that represents the marginal propensity to consume: i.e.if b=0.8, when income goes up by a dollar, consumption goes up by 80 cents. Third, consumption is a negative function of the interest rate r; as interest rates go up, consumers will save a larger fraction of their income and consume a smaller fraction of their income.
C=c° + b(Y-T) – a r
2.2
Q3 Show changes in U-VH space if parameters changes
Changes in U-VH space provided interest rate on bond set from 0.07 to 0.1
1 comment:
Good summary, liked the graphs.
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