Blogwork 5

"Modify the PC Model to allow for the simulation of a stagflation-type episode in the economy"

Stagflation describes a prolonged period of inflation combined with slow or negative growth. Episodes of stagflation occurred in the world economy in the late 1970s and early 1980s, and much of the current macroeconomic news points to it taking place in the US at the moment. Stagflation is typically thought to be caused by unfavourable supply side shocks or inappropriate macroeconomic policies, both of which (arguably) have occurred during 2008. Firstly, the price of oil is at historic highs due to both OPEC restricting oil supplies and commodities in general being a natural hedge against inflation. Secondly, in attempting to remedy recent market turmoil and stave off recessionary fears, the federal reserve has aggressively cut interest rates and injected hundreds of billions into the money markets. It is the effects of these interest rate cuts in particular on model PC that is addressed here.

The equation system for model PC is given below.

It is assumed in model PC that the price of bills do not change during the duration of their lives (r = rbar, eq12). This assumption has to be relaxed to allow for the Fed's recent cutting of interest rates, which, as noted above, could be a cause of stagflation. When interest rates fall, the price of bills rise. This increase induces an immediate increase in wealth. A fall in interest rates also increases demand for a time. This could be achieved by an increase in consumption expenditure through an increase in the wealth term in the consumption function (eq5). Thus, interest rate decreases have a positive effect on real demand, but this positive effect is only a temporary one. The long-run effect of decreasing interest rates is in fact lower aggregate income, despite the initial positive wealth effect. What happens is that the lower yields on government debt decrease the flow of payments that arise from the government sector, which will eventually lead to less consumer spending on the part of households. Furthermore, a decrease in the desire to hold bills (a decrease in gamma zero in eq7) will decrease the proportion of government debt taking the form of bills, and hence lower the average rate of interest payable on the overall amount of government liabilities, thus leading to a decrease in the steady state value of national income.

If economic stagnation as described above is combined with a supply-side shock as described below and currently thought to be happening with commodities (most notably oil and gold), then the result is stagflation.

Blogwork 4

Question 1 - Model PC - summary of Godley & Lavoie, pages 99-107:

In model PC, households make a portfolio choice between money and short-term government securities. The quantity of money held thus depends on the rate of interest obtainable on Treasury Bills. The table below shows the new balance sheet matrix with the addition of the new row for T-bills, and an additional column introducing a central bank. The sum of household wealth is now V, which also equals public debt. There is no production as this is still a pure service economy, where capital is instantaneously created and destroyed (haircut economy). In model PC the central bank is considered as an institution in its own right. It purchases bills from government, provides money to households and has zero net worth.

In the transaction matrix for model PC below, the rows and columns once more sum to zero but now the flow of funds accounts comprises two financial assets. We also have to take account of interest payments arising from government debt. Interest payments each period are generated by stocks of assets at the end of the previous period, at a rate set at the end of the last period, t-1. The central bank sector has a current account describing inflow and outflow of interest payments, and a capital account describing changes in the balance sheet of the central bank, for instance when it purchases new bills. The central bank’s net worth is zero as all profits are paid to the government. Therefore, the government only pays interest on debt held by households.

The model below is built on perfect foresight. The national income identity in Eq1 is thus unchanged. Disposable income is enlarged by the interest payments households receive on government debt (Eq2). Taxable income is similarly enlarged (Eq3). Eq4 states that the difference between disposable income and consumption is equal to the change in wealth, not just money as was the case of model SIM. Similarly, the consumption function of model PC now has wealth instead of money as its second argument. The key behavioural assumption made in this new model is that households make a two stage decision; first on how much they will consume, and second on how they will allocate their wealth, including any newly acquired wealth. The quandary of how wealth is allocated between money and bonds has thrown up two prevailing theories – the quantity theory of money and liquidity preference theory, which are embodied in Eq6, Eq7 and Eq8. If households wish to hold a certain proportion l0 of their wealth in bills, they must want to hold 1-l0 in money. However, the proportions are modulated by the interest rate on T-bills, and YD relative to wealth. For example if interest rates increase, then households will want a higher proportion of their wealth yielding this higher return. Conversely, if household disposable income comprises a high proportion of total wealth then households will hold the majority of their wealth in cash.

Eq9 describes an endogenous credit money economy. It is the budget constraint of the government as per column 3 – the deficit is financed by bills newly issued by treasury department. Eq10 describes the capital account of the central bank as per column 4 – additions to the stock of high-powered money are equal to the additions in the demand for bills by the central bank. In this sense, the central bank sector is said to provide cash money on demand. Cash money is therefore endogenous (internal) to the system. The interest rate on the other hand is said to be exogenous (external) or, put another way, a facet of monetary policy. It is assumed interest rates remain constant throughout the life of a T-bill (eq12), for example 3 months. If eq12 were not to hold true, there could be capital gains arising form price changes, to which no transaction between different sectors correspond. The transactions matrix above will therefore not balance without a memo for capital gains. If eq12 holds, we have 10 independent equations and 10 unknowns. The interest rate represents monetary policy, and is given of that policy.

Question 2.1

John Maynard Keynes defined liquidity preference as the relationship between the quantity of money the public wishes to hold and save and the interest rate. According to Keynes, the public holds money for three purposes:

1. Transaction motive: this is the need for cash for the current transaction of personal and business exchanges.

2. Precautionary motive: this is the desire for security and the holding of cash for extraordinary situations e.g. Sickness.

3. Speculative motive: this is the opportunity to take advantage of a profit making opportunity.

The most significant point of Keynes theory was essentially that when interest rates are cut, increases in the money supply set aside will not encourage further investment but instead will be absorbed by increases in people's approximate balances. This will occur because the interest rate is too low to induce wealth holders to exchange their money for less liquid forms of wealth and because in the long run people expect interest rates to rise in the future.

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 Re, people hold Ms1 of money, whereas if the rate of interest were to go down to R0, people would increase their assets to Ms2 or Ms3.With a potentiality or functional tendency L, which fixes the quantity of money which the public will hold when the rate of interest r and income level y are given, the schedule of liquidity preference (represented by quantity of money held M) in relation to interest rate and income is presented as follows: Md = L1(y) + L2(r), where transaction and precautionary motive mainly are influenced by y while speculative motive by r.

Source: (http://courseware.ecnudec.com/zsb/zgs/zgs02/zgs023/zgs02303/zgs023030.htm)

Keynes used the concept of liquidity preference to explain the prolonged depression of the 1930s.

Question 2.2

Definitely, PC model is a good representation of Keynes’ original vision of household decision-making. The model includes Keynes three elements of liquidity preference the precautionaty, transitionary and speculative motives.

Firstly, the PC model distinguished between disposable income and consumption and idea also inbuilt in Keynes’ theory. The equation V= V-1+ (YD-C) straightforwardly exemplifies that the difference between disposable income and consumption is equal to the change in total wealth. Keynes writings also bounced upon this thought, in his words “how much of his income he will consume and how much he will defer or save in some form of command over failure consumption.” (Keynes, 1936)

Secondly, 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 of these models, the rate of interest is the equilibrium in the desire to hold wealth in cash form and the availability of cash.

According to PC theory, Hh/V= (1-λ0)-λ1*r+λ2*(YD/V) and Bh/V=λ0+ λ1*r -λ2 (YD/V) are established. These equations exhibit the following features: the cash holdings over the wealth is negatively related to the interest rate and positively related to disposable income.
This exactly reflects Keynes’ liquidity preference: transaction and precaution motives for cash holdings positively correlate with income Y and speculative motive is negatively related with interest rate r. Clearly we can see Hh/V+ Bh/V=1, which implies wealth must be divided into cash and bills.

Furthermore, PC model assumes the money supply is endogenous and demand-led which can be expressed with these equations: Bs= Bs-Bs-1= (G+r-1*Bs-1) - (T+r-1*Bcb-1); ΔHs=Hs-Hs-1=ΔBcb; Hcb=Bs-Bh; r is exogenous. One thing is clear: central bank acts as residual purchaser of bills--- It purchases all the bills issued by the government that households are not willing to hold given the interest rate. In other words, the central bank is providing cash money to those who demand it. While introducing money into Keynes’ liquidity preference, we can also see autonomic mechanism would change the quantity of money supplied necessary to maintain a given rate of interest. (Godley & Lavoie, 2007:103-107).