Sfc Modelling Together With Regime Finance Catastrophes
I am at nowadays looking at using Stock-Flow Consistent (SFC) modelling to depict (central) authorities finance. This is a much simpler chore than attempting to model everything inside the economy, so I exercise non own got to worry close a lot of thorny problems. In this article, I explicate a dominion of pollex to bargain alongside long-term financial policy expectations. To illustrate, I give an representative of an patently unsustainable financial policy that gives rises to an expected futurity inflationary catastrophe. This article is mainly close model-building; I volition verbalise over inwards a futurity article how this relates to the existent globe financial outlook.
As an immediate disclaimer, I volition province that I am approaching this from the exterior of the field. I own got a lot of sense alongside mathematical modelling as well as applied economics, but I exercise non know the economical literature. As a result, it seems probable that what I am writing hither was discussed before, but I own got non seen prior versions of it (that I tin give notice remember; I may own got read something similar as well as but internalised the idea). In consequence, I brand no endeavour to offering references of who discussed this technique first.
I own got been looking at developing SFC models (further description here) of financial dynamics using a framework that is similar to that described inwards the text past times Godley as well as Lavoie. (Affiliate link: Monetary Economics: An Integrated Approach to Credit, Money, Income, Production as well as Wealth.)
Since I am interested inwards long-term trends, I am able to ignore a lot of things that complicate other modeling approaches. (For an representative of a to a greater extent than complicated SFC model, see Nick Edmonds’ model of the UK.) I typically daze the economic scheme alongside a recession, so allow the economic scheme become dorsum to a “steady state” configuration (as the economic scheme is stabilised past times the automatic stabilisers of the welfare state), which is the technique used inside Godley as well as Lavoie. I exercise non endeavour to model futurity recessions, which agency that the long-term trajectory is unrealistically smooth. But if y'all thought the model trajectory every bit existence a tendency that the economic scheme volition bounce around, this is non a large problem.
Similarly, I typically duck the query of modelling inflation past times oftentimes assuming that inflation is exogenous – unremarkably a constant value. (See this article for an explanation of exogenous.) However, inwards doing that, I assume that the policy involvement charge per unit of measurement is varying inwards response to the economy; inwards other words the “exogenous” inflation charge per unit of measurement supposition is actually but assuming that the Central Bank is ever hitting its (exogenous) inflation target. If nosotros are explicitly ignoring the wiggles inwards the economy, such an supposition is a reasonable approximation of reality.
However, assuming that inflation is exogenous is inwards obvious contradiction to Functional Finance, which holds that the endangerment associated alongside loose financial policy is inflation. I own got therefore assumed away the negative effects associated alongside financial deficits, as well as so my models, taken at confront value, would allow a modern authorities to run deficits of 75% of gross domestic product alongside no sick effects. (Huge deficits were run during wartime, but at the cost of effectively nationalising production, which is patently non existence done at present.)
The argue I am willing to own got this somewhat dubious supposition is that my models are meant to gauge financial settings nosotros run into over the past times duet of decades, which tend to last stable as well as somewhat tight. They correspondingly own got petty measurable conduct on on inflation, and/or Central Banks own got been real effective inwards hitting their inflation targets. The models exercise non exit this zone of operation, despite broad swings inwards the model debt/GDP ratio (which is what nosotros run into empirically).
But what happens if at that topographic point is a financial catastrophe of some sort, which forces the province out of that zone of operation? I explicate how existing models could last used, at to the lowest degree indirectly, inwards that case.
In companionship to simplify things, imagine that nosotros own got a parallel universe the States that is similar to the existent globe United States of America economy, but nosotros brand the next changes:
Imagine so that a powerful political coalition forms, as well as enacts the next policy, as well as that at that topographic point are no expectations that it volition last reversed:
I would utilization a heuristic method (a mathematical term which is a fancy way of proverb of rule-of-thumb) to gauge the response that question. I would utilization a model similar to ane of my existing SFC models, but ane inwards which inflation is genuinely endogenous (determined inside the model); inwards other words, the Central Bank tin give notice immature adult woman its target. I would so run it frontwards 20 years, as well as run into what happens.
My electrical flow models are backward-looking, inwards that they exercise non explicitly endeavour to model the future. They could embed pseudo-expectations, inwards that model entities utilization historically available information to brand guesses close the future, but without explicitly running the model frontwards inwards time.
The implication is that the model output appears rather perverse:
However, this could last right away seen, fifty-fifty alongside my backward-looking model. The model output is incompatible alongside the supposition of cost stability, as well as inventory hoarding would last extremely profitable for model entities. Therefore, at the minimum, ane tin give notice province the policy is “unsustainable” nether electrical flow policy settings (in the sense the output violates reasonable assumptions close the demeanour of the province trajectory).
But it would last possible to convey this a pace further, as well as forcefulness inflation to follow some trajectory defined past times a unmarried parameter (at the simplest, a constant inflation rate). It would so last possible to so solve for what inflation charge per unit of measurement would give a trajectory that would last consistent alongside reasonable marketplace seat behaviour.
For example, y'all powerfulness discovery that a constant inflation charge per unit of measurement of X% gives a sensible-looking frontwards trajectory, inwards the sense that at that topographic point is no overwhelming incentive for entities inside the model to hoard inventories. You discovery X by repeatedly solving the model, as well as searching for a value of inflation that appears consistent alongside “reasonable” behaviour. (You would in all probability desire the inflation charge per unit of measurement to last somewhat front-loaded than a constant inflation charge per unit of measurement over the 20 years. So y'all would cook some functional degree for the inflation rate, as well as solve for the costless parameter value(s) that give a “reasonable” model trajectory.)
Although I own got no thought what the exact marketplace seat response would last (panic, presumably), using this rule-of-thumb, y'all may own got a promise of existence inside an companionship of magnitude of existence correct.
(As an aside, my modelling framework differs from the Lavoie/Godley models every bit a termination of this employment of thought. My models are non specified straight every bit equations, rather every bit a grouping of programming entities that are linked past times rock-solid accounting identities. It is possible for a model entity to embed some other consummate SFC model inside its determination function, allowing it to run models iteratively to solve problems every bit I stated above. However, I own got non nevertheless attempted this detail feat of software engineering, which is why I am non reporting simulation results.)
This physical care for in all probability looks ridiculously primitive to a mainstream economist – “This employment was solved a long fourth dimension ago, y'all ignorant blogger. You but model this inwards a state-of-the-art Dynamic Stochastic General Equilibrium (DSGE) model. Expectations are explicitly built into the model. Case closed.”
My response tin give notice last summarised:
In a follow upwards article, I volition verbalise over how this representative applies to the existent globe financial catastrophe that is supposed to last facing Western governments every bit the termination of demographics.
* As I banking concern complaint inwards my response to Palley, at that topographic point are 2 parts to the Inter-temporal Budget Constraint. The offset component is an accounting human relationship which describes during a unmarried budget period, which is patently correct, but contains no behavioural information. The 2nd component – a constraint which allegedly holds over the demeanour every bit fourth dimension passes to infinity – is what I refer to every bit “Ricardian Equivalence”, as well as is the component that is either wrong or tautological (a contention that is trivially implied past times assumption).
(c) Brian Romanchuk 2014
As an immediate disclaimer, I volition province that I am approaching this from the exterior of the field. I own got a lot of sense alongside mathematical modelling as well as applied economics, but I exercise non know the economical literature. As a result, it seems probable that what I am writing hither was discussed before, but I own got non seen prior versions of it (that I tin give notice remember; I may own got read something similar as well as but internalised the idea). In consequence, I brand no endeavour to offering references of who discussed this technique first.
Introduction
I own got been looking at developing SFC models (further description here) of financial dynamics using a framework that is similar to that described inwards the text past times Godley as well as Lavoie. (Affiliate link: Monetary Economics: An Integrated Approach to Credit, Money, Income, Production as well as Wealth.)
Since I am interested inwards long-term trends, I am able to ignore a lot of things that complicate other modeling approaches. (For an representative of a to a greater extent than complicated SFC model, see Nick Edmonds’ model of the UK.) I typically daze the economic scheme alongside a recession, so allow the economic scheme become dorsum to a “steady state” configuration (as the economic scheme is stabilised past times the automatic stabilisers of the welfare state), which is the technique used inside Godley as well as Lavoie. I exercise non endeavour to model futurity recessions, which agency that the long-term trajectory is unrealistically smooth. But if y'all thought the model trajectory every bit existence a tendency that the economic scheme volition bounce around, this is non a large problem.
Similarly, I typically duck the query of modelling inflation past times oftentimes assuming that inflation is exogenous – unremarkably a constant value. (See this article for an explanation of exogenous.) However, inwards doing that, I assume that the policy involvement charge per unit of measurement is varying inwards response to the economy; inwards other words the “exogenous” inflation charge per unit of measurement supposition is actually but assuming that the Central Bank is ever hitting its (exogenous) inflation target. If nosotros are explicitly ignoring the wiggles inwards the economy, such an supposition is a reasonable approximation of reality.
However, assuming that inflation is exogenous is inwards obvious contradiction to Functional Finance, which holds that the endangerment associated alongside loose financial policy is inflation. I own got therefore assumed away the negative effects associated alongside financial deficits, as well as so my models, taken at confront value, would allow a modern authorities to run deficits of 75% of gross domestic product alongside no sick effects. (Huge deficits were run during wartime, but at the cost of effectively nationalising production, which is patently non existence done at present.)
The argue I am willing to own got this somewhat dubious supposition is that my models are meant to gauge financial settings nosotros run into over the past times duet of decades, which tend to last stable as well as somewhat tight. They correspondingly own got petty measurable conduct on on inflation, and/or Central Banks own got been real effective inwards hitting their inflation targets. The models exercise non exit this zone of operation, despite broad swings inwards the model debt/GDP ratio (which is what nosotros run into empirically).
But what happens if at that topographic point is a financial catastrophe of some sort, which forces the province out of that zone of operation? I explicate how existing models could last used, at to the lowest degree indirectly, inwards that case.
Fiscal Catastrophe 2034
In companionship to simplify things, imagine that nosotros own got a parallel universe the States that is similar to the existent globe United States of America economy, but nosotros brand the next changes:
- Government policy has achieved cost stability - 0% inflation – as well as this policy is seen every bit existence credible for all concerned. The cost story (and the story of wages) are where they are at nowadays (in 2014).
- Fiscal policy settings are such that nobody (other than a few financial nutters) has whatsoever worries close the long-term financial seat of the United States of America Federal Government. (This helps reinforce Assumption #1.)
- There are no worries close the external balance, or natural resources/ecological catastrophes over the adjacent xx years.
Imagine so that a powerful political coalition forms, as well as enacts the next policy, as well as that at that topographic point are no expectations that it volition last reversed:
- In companionship to cook the retirement planning employment for everyone aged 45 as well as nether inwards 2014, starting inwards 2034 (in 20 years) every citizen who reaches historic menses 65 volition last given a tax-free lump heart as well as someone payment of $1 million.
- To “pay” for this programme, everyone who volition last inwards that historic menses bracket has to pay a particular 2% increment on their income taxes. (Therefore, people over historic menses 45 volition non have the payment, but exercise non pay the extra tax.)
The Heuristic Response
I would utilization a heuristic method (a mathematical term which is a fancy way of proverb of rule-of-thumb) to gauge the response that question. I would utilization a model similar to ane of my existing SFC models, but ane inwards which inflation is genuinely endogenous (determined inside the model); inwards other words, the Central Bank tin give notice immature adult woman its target. I would so run it frontwards 20 years, as well as run into what happens.
My electrical flow models are backward-looking, inwards that they exercise non explicitly endeavour to model the future. They could embed pseudo-expectations, inwards that model entities utilization historically available information to brand guesses close the future, but without explicitly running the model frontwards inwards time.
The implication is that the model output appears rather perverse:
- Since at that topographic point is an immediate tightening of financial policy, at that topographic point would last a contraction of growth, as well as the cost story would presumably fall.
- The effect of tightening would dampen out, as well as the economic scheme is largely at “steady state” past times 2034 (as the termination of monetary policy as well as the automatic stabilisers).
- In 2034 (and thereafter), a massive financial stimulus hits, every bit the offset moving ridge of payments inwards the programme are made. Inflation would scream higher inwards response to higher need (since provide has non increased). Even if the fundamental banks reacts, it volition non help; if anything, hyperinflation would ensue. This is because the financial deficit would become hyper-exponential every bit a termination of involvement costs.
However, this could last right away seen, fifty-fifty alongside my backward-looking model. The model output is incompatible alongside the supposition of cost stability, as well as inventory hoarding would last extremely profitable for model entities. Therefore, at the minimum, ane tin give notice province the policy is “unsustainable” nether electrical flow policy settings (in the sense the output violates reasonable assumptions close the demeanour of the province trajectory).
But it would last possible to convey this a pace further, as well as forcefulness inflation to follow some trajectory defined past times a unmarried parameter (at the simplest, a constant inflation rate). It would so last possible to so solve for what inflation charge per unit of measurement would give a trajectory that would last consistent alongside reasonable marketplace seat behaviour.
For example, y'all powerfulness discovery that a constant inflation charge per unit of measurement of X% gives a sensible-looking frontwards trajectory, inwards the sense that at that topographic point is no overwhelming incentive for entities inside the model to hoard inventories. You discovery X by repeatedly solving the model, as well as searching for a value of inflation that appears consistent alongside “reasonable” behaviour. (You would in all probability desire the inflation charge per unit of measurement to last somewhat front-loaded than a constant inflation charge per unit of measurement over the 20 years. So y'all would cook some functional degree for the inflation rate, as well as solve for the costless parameter value(s) that give a “reasonable” model trajectory.)
Although I own got no thought what the exact marketplace seat response would last (panic, presumably), using this rule-of-thumb, y'all may own got a promise of existence inside an companionship of magnitude of existence correct.
(As an aside, my modelling framework differs from the Lavoie/Godley models every bit a termination of this employment of thought. My models are non specified straight every bit equations, rather every bit a grouping of programming entities that are linked past times rock-solid accounting identities. It is possible for a model entity to embed some other consummate SFC model inside its determination function, allowing it to run models iteratively to solve problems every bit I stated above. However, I own got non nevertheless attempted this detail feat of software engineering, which is why I am non reporting simulation results.)
Relation To The Mainstream
This physical care for in all probability looks ridiculously primitive to a mainstream economist – “This employment was solved a long fourth dimension ago, y'all ignorant blogger. You but model this inwards a state-of-the-art Dynamic Stochastic General Equilibrium (DSGE) model. Expectations are explicitly built into the model. Case closed.”
My response tin give notice last summarised:
- The inter-temporal governmental budget constraint (“Ricardian Equivalence”) that is embedded inwards these models is incorrect, inwards that term endangerment premia innovate arbitrarily large pricing errors into the “equation”*. Even if nosotros brand the supposition that term endangerment premia are nothing (which is patently wrong), the constraint is either tautological or wrong (my formal proof of this assertion is on my “To Do” list.)
- In general, these models are non genuinely solved, as well as my thought is that the truthful solutions exercise non facial expression anything similar what the mainstream economists think they facial expression similar (article link). They alone endeavour solve for small-scale deviations from a constant steady province (“linearisation”), which is patently non a expert description of my example.
Up Next: What About The Real World?
In a follow upwards article, I volition verbalise over how this representative applies to the existent globe financial catastrophe that is supposed to last facing Western governments every bit the termination of demographics.
Footnote:
* As I banking concern complaint inwards my response to Palley, at that topographic point are 2 parts to the Inter-temporal Budget Constraint. The offset component is an accounting human relationship which describes during a unmarried budget period, which is patently correct, but contains no behavioural information. The 2nd component – a constraint which allegedly holds over the demeanour every bit fourth dimension passes to infinity – is what I refer to every bit “Ricardian Equivalence”, as well as is the component that is either wrong or tautological (a contention that is trivially implied past times assumption).
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