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.