Summary of Godley Chapter 3

SUMMARY OF GODLEY CHAPTER 3: THE SIMPLEST MODEL WITH GOVERNMENT MONEY:

The Model SIM is based on the following assumptions:

• The only money in the economy is government money (represented in the model by H) i.e. that issued by central banks.
• The economy is closed i.e. no imports, exports or foreign capital flows.
• No inventories, capital equipment or profits – it is a pure labour economy.
• Production is demand-led - whatever is demanded will be produced.

It is introduced using a balance sheet matrix describing each sector’s financial assets and liabilities. These are inter-related i.e. what is a financial asset (represented by a +) for one sector is a financial liability (represented by a -) for another. All rows and columns in the matrix therefore sum to zero. There are three columns – households, production and government – and six rows – consumption, government expenditure, output, factor income (wages), taxes and changes in money stocks. Eleven equations then complete Model SIM:

• The first four equate supply and demand for consumption (Cs=Cd), government expenditure (Gs=Gd), taxes (Ts=Td) and employment (Ns=Nd) in line with earlier assumptions that whatever is demanded will be supplied within the period.
• Disposable income is defined as the wage bill earned minus taxes paid – YD=W.Ns–Ts.
• Tax paid is defined as Td=θxW.Ns, where θ is the tax rate imposed by government.
• Consumption function is defined as Cd=α1YD+α2Hh-1. Hh-1 represents stocks of money inherited from previous periods - α1 and α2 represent respectively the portion of disposable income and accumulated wealth spent on consumption.
• The budget constraint of the government is defined as ΔHs=Hs–Hs-1=Gd–Td and of households as ΔHh=Hh–Hh-1=YD–Cd. As there is no investment or saving in the model, overall saving must be zero and these terms must be equal.
• The determination of output and the determination of employment is described by the national income identity – Y=Cs+Gs (or from point of view of income as Y=W.Nd)

The evolution of such models is usually described by the standard Keynesian multiplier process i.e. that injections into the economy have ripple effects through all sectors. However, this view lacks coherence here because such a process is modelled on the short run equilibrium, therefore isn’t considered a steady state. Our model here is based on a steady state. This is one where key variables remain in a constant relationship to each other, including both flows and stocks (not flows only as seen with short run equilibria).

The Model SIM also omits growth, holding all other levels in the state constant, i.e. is a stationary steady state. In such state:

• There is no change in the stock of money
• Government expenditure must equal tax receipts and therefore there is neither a government surplus nor deficit.
• Consumption must be equal to disposable income.
• Household saving converges to zero.

When the consumption function was first presented, it was viewed as a decision based on flows of income and stocks of wealth. However, it can also be viewed in terms of a wealth accumulation function i.e. households will save at a certain rate so they can accrue a target portion of wealth. When this target wealth is higher than actual wealth, households reduce consumption.

Model SIM was based on the assumption consumers have perfect foresight as to their income but we now introduce uncertainty thus substituting actual income for expected income. This assumes households estimate the income they will receive and base consumption over the current 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 upon, any additional income received will be saved to cash balances.

The inclusion of uncertainty yields a more recursive picture of system and allows us to define model SIMEX. Here, as periods succeed periods, people amend their consumption decisions as they find their wealth stocks unexpectedly excessive or depleted, and as expectations about future income get revised.

The graphical representation of Model SIM seeks to determine the level of production compatible with aggregate demand, given consumption and fiscal policy constraints. From the graph we can see that the accumulated wealth of households increases due to saving causing consumption demand in the next period to increase and the aggregate demand curve to shift upward. Total income and disposable income also increase. This allows the economy to move towards the steady state. This is seen in the second quadrant of the graph. Here, the target level of wealth and actual wealth are equal and there is no need to save.

In conclusion, we now know how money enters and leaves the system. It is the way that people receive income, settle debts pay taxes and store wealth. Thus money is an asset which always has a corresponding liability and each time period is linked to the previous one.

MPC Calculation

Marginal Propensity to Consume Calculation


Injections and Withdrawals

The first part of the calculation was to determine the size of the injections and withdrawals in the economy. The injection figures came from the random number generator in the Excel program. According to the Circular Flow of Income, in a closed economy, injections always equal withdrawals. Therefore, the withdrawals equal the injections.


Aggregate Expenditure

According to Keynesian macroeconomics, aggregate expenditure is the sum of income, consumption and injections, less withdrawals. This was the method used to calculate this variable. The formula is shown below:
E= (Y+CD+J) – W


MPC Calculation

The Marginal Propensity to Consume (MPC) is defined as the proportion of every extra unit of income received that is spent on consumption. It is calculated by dividing the change in consumption from one year to the next by the change in income.

MPC = dC Change in Consumption
dY Change in Income

In Excel, the MPC was calculated as 0.73, meaning that €0.73 of every extra €1 received is spent on consumption.


Equilibrium Level of Income

At equilibrium, income and aggregate expenditure are equal. Therefore, in order to find this level of income, one adjusts the withdrawals figure until income equals aggregate expenditure.

Week 5: Problem 4

Week 5: Problem 4

Q1

1.1: Why must the Vertical Columns sum to zero?

The change in the amount of money held by the sector must equal the difference between receipts and the payments made by the different sectors, i.e. the households and the Government.

1.2: Why must the Horizontal Rows sum to zero?

Each component of the matrix must have an equivalent component elsewhere in the matrix, in line with the Circular Flow of Income theory.

Q2

2. Production: Cs and Gs both represent sources of revenues i.e. the income that is collected by the production sector. They represent the sales of consumption and government services in the economy. The sum of these two figures (i.e. total production – [Y]) defines the national income identity and appears in brackets as it doesn’t represent a transaction between sectors. The production sector then supplies the household sector and the government with services and demands a certain volume of employment (Nd) at a given wage rate (W). This figure appears as a negative here as it is seen as a cost for the sector.

3. Government: Here, Gd represents the purchase of government services and therefore appears as a negative figure as it represents a cash outflow. Taxes are levied by the government as some proportion of household and production income – Td. Td represents a source of revenue for the sector and therefore appears as a positive figure. Hs represents the change in the stock of money issued by the government. Hs is given by the difference between government receipts and outlays during the period. As the change in Hs (ΔHs) is said to be equal to Gd-Td, the column therefore sums to zero.

Q1. Week 4

Recorder: Ailbhe Bruen
Reporter: Joan Doherty


Wages:

Broadly speaking they are a kind of return to labour. Specifically, income to a person in current employment, or expenditure by businesses to their employees, varies depending on hours worked, qualifications of the individual etc.

Wages = Unit of labour * hours worked * productivity

(Income, Expenditure)


Consumption:

Expenditure by private individuals on goods and services. Income for the provider of the good or service.

(Expenditure, Income)


Rent:

Income paid to the owner of an asset in exchange for use of the asset for a specified period of time. It is expenditure by the person paying the rent, but income for the person receiving it.

(Income, Expenditure)


Government Expenditure:

Money paid out by the government to finance the day to day running of the country.

C + I + G = Y

I= purchase of public goods such as roads, universities, transport etc.
C= consumption as defined above.
G= government expenditure as defined above

(Expenditure)


Manufacturing Output:

The end product of industrial activity, to meet aggregate demand.

(Output)


Interest Payments:

Are the costs of acquiring capital by private individuals or businesses. It can also be a source of income through interest on deposits.

Financial institutions view interest as income both on loans and deposits. However, it is also expenditure for the financial institutions as they must pay out interest to individuals on their private savings.

Interest can be considered output; the output of an economy is a sum of the money made by all the individuals in the economy.

(Income, Expenditure, Output)


Loans:

A sum of money borrowed from financial institutions in order to finance economic activities of individuals and businesses, based on agreed lending terms.

Can also be considered a stock, i.e. a stock of cash (when not being used, known as reserves or deposits, reserves are the legally required levels of money that banks must hold). It can be turned into an asset class to be made available for lending out.

(Income, Expenditure, Output)

[Borrowing should only be used to finance future (not current) expenditure]


Bank Deposits:

Money held by banks on behalf of businesses and private individuals, on which interest is paid.

Liability for the bank because the bank must pay them back.

(Income, Expenditure)




Bonds:

Debt instruments issued, usually for a period of longer than a year, as a method of raising external finance. Governments, cities, corporations and many other institutions sell bonds. The bond holder receives payments known as coupons throughout the maturity of the bond, and at maturity the Issuer repays the principal amount .

(Income, Expenditure)


Equities:

Shares of ownership issued by an institution, in the form of preferred stock or common stock.

(Income, Expenditure)


Money Balances:

Balances of money, consumers and firms actually hold at a given moment. It represents the wealth in the form of readily available purchasing power.

(Income)





Class Questions:

Recorder: Catherine Davis

Q1: What is growth rate?

Rate of change in economic activity from one year to the next. (Using a base period)


Q2: Name 2 measures of Economic Performance

GDP – Gross Domestic Product – Value of all final goods produced in an economy
Employment – The more people employed the more an economy can produce
Others include; inflation, trade surplus, GNP etc

Q3: Describe the GDP Deflator

Strips out the influence of price changes over a price index. Allows for continuous assessment and comparability.


Q4: Define Inflation

Rate of change in the consumer price index (bundle of goods)

Note: What are the side effects of inflation? Harms people on fixed incomes, harms the value of equity

Q5: Name 2 leakages from the circular flow

Savings
Imports

Q6: How do we measure unemployment?

The amount of people actively seeking work but unable to find it and divide by the working population.

summary chapter 7

Chapter 7

Saving and Investment have previously been defined as merely different aspects of the same thing.

Saving is the excess of income over consumption spending. Investment, generally, means the purchase of a capital asset, of any kind, using the income of an individual or a corporation. Investment includes the increment of capital equipment, whether it consists of fixed capital, working capital or liquid capital. In terms of liquid capital, Keynes prefers to emphasise the total change of effective demand rather than part of the change. Moreover, in the case of fixed capital, the change of unused capacity is in accordance with the change of unsold stocks in its effect on producing decisions. It is concluded by the Austrian School of Economics, that capital formation and capital consumption are not identical. The former occurs when there is a lengthening of the period of production, whereas the latter occurs where there is no net decrease in capital equipment.

Keynes recognised the divergence between saving and investment as the excess of normal profit over consumption, meaning that the Entrepreneur’s output is an earning less than normal profit from his ownership of the capital equipment. Employment, as a kind of working capital, is of fixed volume as the Entrepreneur tries to maximise profits. This volume then depends on aggregate demand.

Keynes believes that an expectation of increases in the excess of investment over saving, as a way of handling profit changes, will encourage the Entrepreneur to introduce increases in the volume of output and employment. Therefore, an expected change of investment relative to saving is defined as being a criterion for an effective demand. In addition, it is said by Mr. Roberston that saving can exceed investment. When the income is falling, the excess of saving is exactly equal to the decline of income. Current expectations depend on yesterday’s realised results; whereas today’s effective demand would be equal to yesterday’s income. Such a hypothesis is vital for causal analysis between effective demand and income.

It is evident that a change in the volume of output and employment will cause a change in income. Meanwhile, changes in the quantity of money may result in a change in the volume and distribution of income, through their effect on the interest rate, perhaps leading to saving. Any increase in employment is said to involve some sacrifice of real income, however attempts to quantify are not likely to be successful.

Saving and investment can differ from one another. The banking system allows the savings of one individual to become available as investment for another. Bank-credit then allows investment to take place where “no genuine saving” corresponds. The public will exercise “a free choice” where they divide their increase of income between saving and consumption, so it is impossible the rate investment can increase faster than the rate of saving.

Although the old-fashioned view that saving always involves investment is sounder, its inference that individual saving will increase his/her aggregate investment by an equal amount is plausible and unrecognized. The reason is that increased aggregate wealth caused by individual saving might fail to allow for the possibility that an act of individual saving may react on someone else’s savings and hence on someone else’s wealth. The reconciliation between saving and investment is a two-sided affair, which the amount of money people choose to hold is not independent of their incomes or of the prices of the things, the purchase of which is the natural alternative to holding money; individual balances add up to be exactly equal to the amount of cash which the banking system has created. That is the fundamental of monetary theory.

summary chapter 6

Chapter 6

INCOME

The income generated by an entrepreneur can be given by A+G-A1 where A is the output for the period and A1 is the purchases for the period. G then is the value of capital equipment and finished stocks at the end of the period. Confusion arises over the value of G as some is derived from equipment held from previous periods. Once this can be deduced a clear definition of income arises.

There are two methods of deriving G, the production method and the consumption method. During the period the value of G is affected by maintenance and improvements carried out by the entrepreneur and by depreciation as a result of producing output.

The production method takes maintenance and improvement (B’) into account, by subtracting it from G, giving maximum net value (G’). Under the production method income is defined as the excess of the value of finished output sold during the period over prime cost. Prime cost is the sum of user cost (U) and factor costs (F). U is the maximum net value minus the excess potential value of equipment over G – A1 of what has been sacrificed to produce A. Factor costs are what the entrepreneurs pays other factors of production for their services.

The consumption method takes into account the involuntary loss (or gain) in the value of his capital equipment. Some of these losses are involuntary but not unexpected and are known as supplementary costs (V). Aggregate net income is then equal to A – U – V. Supplementary costs are those deductions from income which a typical entrepreneur makes before reckoning what he considers to be his income. Supplementary costs are important as they affect everyone’s consumption not just entrepreneurs. Unforeseen changes are known as windfall losses; however these losses have a less fundamental effect and are therefore less significant.

Income can then be defined as the excess value of finished output sold during the period over his prime cost. This definition of income is similar to that of Marshall’s. However, Professor Hayek suggested that it is a mistake to put all the emphasis on net income which only refers to consumption aspects as opposed to income proper which includes production issues.


SAVING AND INVESTMENT
Saving is said to equal excess income over consumption and therefore doubts about the definition of saving must arise from doubts about the meaning of these two terms. Income is already defined. Consumption is simply the value of goods sold to consumers, but who is a consumer? Is there a difference between a consumer-purchaser and an investor-purchaser? We need to draw the line between consumers and entrepreneurs and defining A1 (i.e. what one entrepreneur buys from another) allows us to do this. As consumption is defined as A-A1 and income as A-U, it follows that saving is equal to A1-U and net saving (i.e. net income minus consumption) to A1-U-V.
Investment refers additions to the value of capital equipment resulting from activity during the period i.e. the part of income that hasn’t yet been consumed and therefore equal to what has previously been defined as saving. Net investment is therefore equal to A1-U-V. While saving results from consumer behaviour and investment from entrepreneurial behaviour, both are equal to excess income over consumption and therefore to each other. Equivalence arises from the bilateral character of transactions between producers and consumers i.e. aggregate amount individuals decide to save is equal to aggregate amount individuals invest and occurs because psychological habits allow the market to settle at an equilibrium level where readiness to buy equals readiness to sell.