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.