Homework 2 - SIM Model

1. (Fill in the blanks)
Field 2.2 +Gs
Field 5.1 -Ts
Row 3; Sum = Blank
[Y] is not a factor in the same way as the other factors; rather it is another expression of the economic otput, which in the simple model is all paid out as wages. Hence [Y] = -W.Nd, and [Y] = (+Cs + Gd). It is not a separate line item for summation purposes.

1.1 Why must the Vertical Columns sum to zero
Each verticle column represents one element of the economy; Households, Production (Businesses) and Government in the simple example. Each individual column reflects that component's interactions with the other parts of the economy. Each column has a 'balance sheet' element, labeled as "change in money stock". This is akin to a balancing figure.
Economic Intuition Example - Taking the example of the Households column, Income is derived from Wages (+W.Ns). Expenditures arise from Consumption (-Cd) and Taxes paid (-Ts). If Incomes exceed expenditures, the net position of the household is that money is invested in increasing the money stock (savings). Money stock will be increased by the excess of income over expenditure, so the entry on field 6.1 will be -Savings for the period. Like a balance sheet or a double-entry system, the +'s must equal the -'s, so the net total must always equal zero.

1.2 Why must the horizontal rows sum to zero
The horizontal rows demonstrate how one expenditure (say Wages for Businesses/ Production) is an income in another column (Households). Again, using simple double-entry principal for each item, the sum of each row must be nil.
Economic Intuition Example- The economic effect of taxes:- an increase in taxes increases the income of the government, and decreases income (or increases expenditures) of the households, by the same figure.


2. Explanation for each row

2.1 Consumption
Consumption from the household's point of view is the expenditure incurred during the period, and this amount is an income from the businesses point of view. Consumption will be related to household income by the factor of the propensity to consume, plus to the savings at the start of the period by the propensity to spend from savings.

2.2 Government Expenditure
Government expenditure is another income source from the point of view of the production element of the economy. Expenditure by Government on infrastructure & services moves money from the exchequer to businesses.

2.3 Output
Output reflects the value added by the producing element of the economy.

2.4 Factor Income
Factor Income is income from the point of view of the household, and is an expenditure (wages) on the books of the production element. An increase in business output can benefit the household from increased wage income.

2.5 Taxes
Taxes are deductions from wages earned and are the source of income for the government. An increase in taxes reduces the income available for the household to use/consume, and would thereby reduce consumption and/or savings.

2.6 Change in Money Stock
An increase in savings is a use of income by the household and (absent changes to income or taxes) will result in a reduction in consumption. Increased savings can be infleunced by factors such as increased interest rates, fear of shocks to employment or to asset values, or other factors.

Further Reading: From http://www.univ-paris13.fr/CEPN/m_w4_22.pdf

4.2 The matrices of Model PC
Model PC introduces government bills and interest payments into Model SIM. It also takes a major step in the direction of realism by introducing a central bank. Bills (B) are short-term government securities which pay interest at a rate r. These bills are often called Treasury bills, since they are usually issued by the Treasury Department of central governments. It is assumed that each bill has a price of one unit, and that its price does not change during the duration of its life.1 As a result, we need not worry about possible capital gains that could arise from price changes in financial assets.

This assumption will be relaxed when we introduce long-term government liabilities, i.e., when we introduce bonds in the next chapter. We can imagine that economic agents purchase government bills at that unit price, and then, one month or three months later, when the bills reach maturity, households receive back the principal plus the interest. In the real world, things usually go the other way around. The bill states that a given amount of money will be paid, say three months later: this
is the coupon rate. The price which the market determines, i.e., the price which agents are willing to pay for such a promise, implies an interest rate.

We start, as always, with a pair of matrices which describe the whole system of stocks and flows. Table 4.1 shows the new balance sheet matrix. Here we have added, in the lowest row, balance items that ensure that all columns, as well as all rows, sum to zero. Column 1 shows the assets of households: they may hold either cash money H or bills Bh. The sum of the two is private wealth (V).

The production sector has no entry in the balance sheet. This is because, as in Model SIM, we assume the existence of a pure service economy, with neither circulating nor fixed capital. As a result, the net worth of the household sector is also the net worth of the private sector.

The counterpart of the net worth of the private sector is public debt. It follows that private wealth, in Model PC, is equal to the sum of cash money and bills held by households. Also, as can be read from column 3, public debt is equal to the amount of outstanding bills B issued by government to households and the central bank combined.

Column 4.1 introduces the central bank. The central bank is sometimes amalgamated with the government sector, and indeed, this is what was done implicitly in Model SIM. Here, the central bank is considered as an institution in its own right. The central bank purchases bills from government, thereby adding to its stock of assets (Bcb). On its liability side, the central bank provides cash money to households. It is assumed that central banks have zero net worth.