Documenti di Didattica
Documenti di Professioni
Documenti di Cultura
Kaoru Yamaguchi
Ph.D.
Contents
I
1 System Dynamics
1.1 Language of System Dynamics . . . . . . . . . . . . .
1.2 Dynamics . . . . . . . . . . . . . . . . . . . . . . . . .
1.2.1 Time . . . . . . . . . . . . . . . . . . . . . . . .
1.2.2 Stock . . . . . . . . . . . . . . . . . . . . . . .
1.2.3 Stock-Flow Relation . . . . . . . . . . . . . . .
1.2.4 Integration of Flow . . . . . . . . . . . . . . . .
1.3 Dynamics in Action . . . . . . . . . . . . . . . . . . .
1.3.1 Constant Flow . . . . . . . . . . . . . . . . . .
1.3.2 Linear Flow of Time . . . . . . . . . . . . . . .
1.3.3 Nonlinear Flow of Time Squared . . . . . . . .
1.3.4 Random Walk . . . . . . . . . . . . . . . . . .
1.4 System Dynamics . . . . . . . . . . . . . . . . . . . . .
1.4.1 Exponential Growth . . . . . . . . . . . . . . .
1.4.2 Balancing Feedback . . . . . . . . . . . . . . .
1.5 System Dynamics with One Stock . . . . . . . . . . .
1.5.1 First-Order Linear Growth . . . . . . . . . . .
1.5.2 S-Shaped Limit to Growth . . . . . . . . . . .
1.5.3 S-Shaped Limit to Growth with Table Function
1.6 System Dynamics with Two Stocks . . . . . . . . . . .
1.6.1 Feedback Loops in General . . . . . . . . . . .
1.6.2 S-Shaped Limit to Growth with Two Stocks . .
1.6.3 Overshoot and Collapse . . . . . . . . . . . . .
1.6.4 Oscillation . . . . . . . . . . . . . . . . . . . .
1.7 Delays in System Dynamics . . . . . . . . . . . . . . .
1.7.1 Material Delays . . . . . . . . . . . . . . . . . .
1.7.2 Information Delay . . . . . . . . . . . . . . . .
1.8 System Dynamics with Three Stocks . . . . . . . . . .
1.8.1 Feedback Loops in General . . . . . . . . . . .
1.8.2 Lorenz Chaos . . . . . . . . . . . . . . . . . . .
1.9 Chaos in Discrete Time . . . . . . . . . . . . . . . . .
1.9.1 Logistic Chaos . . . . . . . . . . . . . . . . . .
1.9.2 Discrete Chaos in S-shaped Limit to Growth .
3
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CONTENTS
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II
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Macroeconomic System
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CONTENTS
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9 A Macroeconomic System
9.1 Macroeconomic System Overview . . . . . . . . .
9.2 Production Function . . . . . . . . . . . . . . . .
9.3 Population and Labor Market . . . . . . . . . . .
9.4 Transactions Among Five Sectors . . . . . . . . .
9.5 Behaviors of the Complete Macroeconomic Model
9.6 Conclusion . . . . . . . . . . . . . . . . . . . . .
III
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CONTENTS
10.11Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
IV
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325
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348
Preface
My O-Road Journey for A Better World
Futures Studies
In early 1980s, I was told by one of the graduate colleagues at the University of
California, Berkeley, that if I continue the research involving Marx and Keynes
in addition to neoclassical theory, I would never get a good job oer in the United
States. He was right. It was a time for Reganomics which has eventually evolved
to the era of globalization in 1990s. Paying little attention to his thoughtful
suggestion, I pursued my Ph.D. thesis on the subject Beyond Walras, Keynes
and Marx - Synthesis in Economic Theory Toward a New Social Design, which,
alas, became a start of my o-road journey. Main part of the thesis was luckily
published with the same title [58], yet it has been left unnoticed among main
stream economists.
When I started teaching at the Dept. of Economics, University of Hawaii
at Manoa, I almost lost my energy to continue the research on neoclassical
mathematical theory for academic survival, because the theory seemed to be
totally detached from the economic reality. It was in those lost days when my
introduction to the futures studies and Prof. Jim Dator, then secretary general
of the World Futures Studies Federation, took place by chance in Hawaii in
1987. Upon arrival to Japan next year, I immediately joined the Federation,
and became very active on futures studies for more than ten years since then.
Among the activities of futures studies I have been involved, a major one
was the organization of futures seminar series in Awaji Island, Japan, with an
objective to establish a future-oriented higher institution dubbed the Network
University of the Green World (http://www.muratopia.org/ NUGW). The seminars had been held for seven years from 1993 through 1999, then suspended
due to the lack of fund. In the book based on the rst seminar in 1993, I have
proclaimed that
Thus, what has been missing in industrial-age scientic research, and
hence in the academic curricula of present-day higher institutions, is
a study of interrelated wholeness and interdependences [61, p.200].
In order to ll the missing niche, I have tried, with a help by the seminar
participants, including Novel laureate Jerome Karle, to establish a new wholistic
7
CONTENTS
eld of study dubbed FOCAS, meaning Future-Oriented Complexity and Adaptive Studies, in vain. Yet, my conviction on the need for such futures studies
for higher education continued to remain as worth being upheld. Faced with
the threat of our survival due to climate changes and environmental disasters,
future-oriented studies of interrelated wholeness and interdependence is, I believe, more urgently needed for solving these complex problems, since solutions
oered by fragmented professionals at the current higher institutions might be
the causes of another problems as Asian wisdom connotes. For our survival and
sustainability, we need future-oriented higher education which provides wholistic visions and solutions to the present complex problems caused by fragmented
science and technology of the present-day higher education. This conviction
became a fruit of reward for me at the cost of abandoning neoclassical economic
research in a traditional academic stream.
System Dynamics
Throughout the future-oriented activities later on, I was luckily led to the systems view, specically a method called system dynamics, by chance. It seemed
to me a totally new eld of study that makes a heavy use of computer simulation for analyzing dynamic behaviors of system structures in physics, chemistry,
engineering, environmental studies, business and economics, and public policies,
to name a few, in a uniform fashion. In short, its methodology can uniformly
cover many fragmented elds of studies, and in this sense it seemed for me to
be able to share a similar interdisciplinary vision with future-oriented studies.
After many years frustration on the futures studies, Ive jumped in the led by
attending its international conference in Istanbul, Turkey, in 1997. Since then I
have been continually attending the system dynamics conferences up to the the
present day.
It didnt take much time to realize that, due to its interdisciplinary nature,
system dynamics is also facing the similar diculty in nding an academic
position as a discipline in the highly fragmented current higher educational
system, as future-oriented studies have bee suering similarly. In other words,
system dynamics and futures studies can have no comfortable places in the
current universities. The only dierence is the use of computer in the former,
and the use of our brain in the latter.
Hence, it seemed to me that future-oriented studies and system dynamics
constitute two major elds of futures higher education, using our brain on the
one hand and computer on the other hand for a study of interrelated wholeness
and interdependence in order to attain human and environmental sustainability.
In fact, it has been repeatedly argued at the international conferences whether
system dynamics is merely a tool or discipline. For me it seemed to be not to
the point and accordingly a fruitless argument,
On the contrary, the following description by Prof. Jay Forrester, a founder
of system dynamics, on the nature of system dynamics looked to me to the
point.
CONTENTS
10
CONTENTS
[34], [35], [51] and [52], since my knowledge of accounting was limited in those
days1 . Through such readings, I have been convinced that system dynamics approach is very eective not only for understanding the accounting system, but
modeling many types of business activities. This conviction fruitfully resulted
in my presentation on the principle of accounting system dynamics at the 21st
international conference of the System Dynamics Society in New York in 2003
[63], which became a turning point in my o-road journey.
CONTENTS
11
National Model
I was a late comer to the research community of system dynamics. While my
step-by-step macroeconomic modeling was advancing, some researchers have
kindly suggested at the conferences that I should review the research papers on
the National Model project that was led by Prof. Jay Forrester with several
Ph.D. students at MIT.
Unfortunately, the national model itself was not available and its related papers were scattered around. Under such situation, my survey managed to cover
the following papers [13], [14], [15], [16], [18], [19], [20], [21], [22], [23], [24], [25],
[28], [32], [46], [47]. Yet, the review of these papers only gave me an impression
as if I were, with my eyes closed, touching various parts of an elephant without
knowing what the elephant looks like. During the 23rd international conference
of System Dynamics Society in New York, July, 2005, in which I presented a
SD-based Keynesian model, I have strongly felt that my research cannot advance without understanding a whole picture of National Model, because my
modeling approach, I feared, might have been already taken by the National
Model project team.
Without losing time, in September of the same year, I visited Prof. Jay
Forrester in his oce at MIT. We spent almost two hours on discussing about
his National Model. He told me that the national model is still going on, and
I may have no chance to take a look at it until its completed. Even so, the
conversation turned out to be a very fruitful to me, out of which I got convinced
that my modeling approach on the basis of accounting system dynamics is quite
dierent from his modeling method. This conviction gave me an energy to
continue my o-road journey in my own way. At the same time, I truly hoped
that the national model would be completed in the near future.
In the spring of 2007, I was invited to review the Ph.D. dissertation by
David Wheat at the University of Bergen, Norway, whose title is The Feedback
Method: - A System Dynamics Approach to Teaching Macroeconomics [56].
His model, written by Stella software, seemed to me to be a simple version of
the National Model. In this sense it became the rst complete macroeconomic
model ever presented to the public, and his eort should be congratulated. In
the following year, at the 26th international conference of System Dynamics
Society, Athens, Greece, I have presented a complete macroeconomic model,
written by Vensim, on the basis of accounting system dynamics [68].
12
CONTENTS
August, 2010
Awaji Island, Japan
Kaoru Yamaguchi
Acknowledgments
At the 28th International Conference of the System Dynamics Society, held in
Seoul, Korea, July 29, 2010, I have oered the SD Workshop: An Introduction to
Macroeconomic Modeling Accounting System Dynamics Approach in which
the draft of this book was distributed, for the rst time, to the participants
to obtain their feedbacks. Then, two months later, it is distributed to the
participants at the 6th Annual AMI Monetary Reform Conference in Chicago,
the United States, Sept. 30 - Oct.3, 2010. Following are those who gave me
comments and suggestions.
. , .
I do gratefully acknowledge their cordial feedbacks. All remaining errors,
however, are mine.
October, 2010
Kaoru Yamaguchi
Part I
Accounting System
Dynamics
13
Chapter 1
System Dynamics
This chapter1 introduces system dynamics from a dynamics viewpoint for beginners who have no formal mathematical background. First, dynamics is dealt
in terms of a stock-ow relation. Under this analysis, a concept of DT (delta
time) and dierential equation is introduced together with Runge-Kutta methods. Secondly, in relation with a stock-dependent ow, positive and negative
feedbacks are discussed. Then, fundamental behaviors in system dynamics are
introduced step by step with one stock and two stocks. Finally, chaotic behavior
is explored with three stocks, followed by discrete chaos.
1.1
What is system dynamics? The method of system dynamics was rst created
by Prof. Jay Forrester, MIT, in 1950s to analyze complex behaviors in social
sciences, specically, in management, through computer simulations [11]. It
literally means a methodology to analyze dynamic behaviors of system. What
is system, then? According to Jay Forrester, a founder of this eld, A system
means a grouping of parts that operate together for a common purpose [12],
page 1-1. For instance, following are examples of system he gave:
An automobile is a system of components that work together to provide
transportation.
Management is a system of people for allocating resources and regulating
the activity of a business.
A family is a system for living and raising children.
1 This chapter is based on the paper presented at the 17th International Conference of the
System Dynamics Society: Systems Thinking for the Next Millennium, New Zealand, July 20
- 23 ,1999; specically in the session L7: Teaching, Thursday, July 22, 1.30 pm - 3.00 pm,
chaired by Peter Galbraith.
16
Stock
Flow
1.2. DYNAMICS
1.2
1.2.1
17
Dynamics
Time
1.2.2
Stock
Let us now consider four letters of system dynamics language in detail. Among
those letters, the most important letter is stock. In a sense, system could be
described as a collection of stock. What is stock, then? It could be an object to
be captured by freezing its movement imaginably by stopping a ow of time, or
more symbolically by taking its still picture. The object that can be captured
this way is termed as stock in system dynamics. That is, stock is the amount
that exists at a specic point in time , or the amount that has been piled up
or integrated up to that point in time.
Let x be such an amount of stock at a specic point in time . Then stock
can be dened as x( ) where can be any real number.
18
Non-Physical Stock
Information
Psychological Passion
Indexed Figures
1.2.3
Stock-Flow Relation
1.2. DYNAMICS
19
and t = 0, 1, 2, 3,
(1.1)
(1.2)
(1.3)
or
When the beginning balance of the stock equation (1.2) is applied, the stockow equation (1.1) becomes as follows:
x(t + 1) = x(t) + f (t)
t = 0, 1, 2, 3,
(1.4)
20
t = 1, 2, 3,
(1.5)
In this way, two dierent concepts of time - a point in time and a period of
time - have been unied. It is very important for the beginners to understand
that time in system dynamics always implies a period of time which has a unit
interval. Of course, periods need not be discrete and can be continuous as well.
1.2.4
Integration of Flow
Discrete Sum
Without losing generality, let us assume from now on that x(t) is an amount of
stock at its beginning balance. If f (t) is dened at a discrete time t = 1, 2, 3, . . .,
then the equation (1.4) is called a dierence equation. In this case, the amount
of stock at time t from the initial time 0 can be summed up or integrated in
terms of discrete ow as follows:
x(t) = x(0) +
t1
f (i)
(1.6)
i=0
t0
x(t) x(t t)
dx
t
dt
(1.7)
(1.8)
dx
= f (t)
(1.9)
dt
This formulation is nothing but a denition of dierential equation. Continuous
ow and stock are in this way transformed to dierential equation, and the
amount of stock at t is obtained by solving the dierential equation. In other
words, whenever a stock-ow diagram is drawn as in Figure 1.2, dierential
equation is constructed behind the screen in system dynamics.
21
(1.10)
Here, dt is technically called delta time or simply DT. Then an innitesimal (or
continuous) ow becomes a ow during a unit period t times DT.
Continuous sum is now written, in a similar fashion to a discrete sum in
equation (1.6), as
f (u)du
x(t) = x(0) +
(1.11)
This gives a general formula of a solution to the dierential equation (1.9). The
notational dierence between continuous and discrete ow is that in a continuous
case an integral sign is used instead of a summation sign. A continuous stock
is, thus, alternatively called an integral function in mathematics.
In this way, stock can be described as a discrete or a continuous sum of
ow2 . This stock-ow relation becomes a foundation of dynamics (and, hence,
system dynamics). It cannot be separable at all. Accordingly, among 4 letters
of system dynamics language, stock-ow relation becomes an inseparable new
letter. Whenever stock is drawn, ows have to be connected to change the
amount of stock. This is one of the most essential grammars in system dynamics.
1.3
Dynamics in Action
22
Another examples would be trigonometric ow, present value, and timeseries data, which are left uncovered in this book.
1.3.1
Constant Flow
(1.12)
(1.13)
(1.14)
On the other hand, a continuous interpretation of stock-ow relation is represented by the following dierential equation:
dx
=a
dt
(1.15)
x(t) =
x(0) +
a du
0
= x(0) + at.
(1.16)
1.3.2
23
f (t) = t
(1.17)
Let the initial value of the stock be x(0) = 0. Then the analytical solution
becomes as follows:
x(t) =
u du =
0
t2
2
(1.18)
Stock x
Flow f(t)
37.5
unit
25
1
12.5
1
0
0
2
1
2
1
Stock x : Current
"Flow f(t)" : Current
1
2
2
1
4
5
6
Time (Week)
1
1
2
1
2
1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2
10
24
Discrete Approximation
In general, the analytical (integral)
solution of dierential equation is
very hard, or impossible, to obtain. The above example is a lucky exception.
In such a general case, a numerical approximation is the only way to obtain a
solution. This is done by dividing a continuous ow into discrete series of ow.
Let us try to solve the above equation in this way, assuming that no analytical
solution is possible in this case. Then, a discrete solution is obtained as
x(t) =
t1
(1.19)
i=0
dt
)dt
2
(1.20)
25
Table 1.2: Linear Flow Calculation of x(10) for dt=1 and 0.5
t
x(t) dx
t x(t)
dx
t
x(t)
dx
0
0
0
0.0 0.00 0.00
5.0 11.25 2.50
1
0
1
0.5 0.00 0.25
5.5 13.75 2.75
2
1
2
1.0 0.25 0.50
6.0 16.50 3.00
3
3
3
1.5 0.75 0.75
6.5 19.50 3.25
4
6
4
2.0 1.50 1.00
7.0 22.75 3.50
5
10
5
2.5 2.50 1.25
7.5 26.25 3.75
6
15
6
3.0 3.75 1.50
8.0 30.00 4.00
3.5 5.25 1.75
8.5 34.00 4.25
7
21
7
4.0 7.00 2.00
9.0 38.25 4.50
8
28
8
4.5 9.00 2.25
9.5 42.75 4.75
9
36
9
10.0 47.50
10
45
where dt = 0.5 and dx = f (t)dt = 0.5t.
where dt = 1 and
dx = f (t)dt = t.
In our simple linear example here, it is calculated as
f (t +
dt
dt
)=t+
2
2
(1.21)
Applying the 2nd-order Runge-Kutta method, we can obtain a true value even
for dt = 1 as shown in Table 1.3.
1.3.3
(1.22)
Let the initial value of stock be x(0) = 0. Then the analytical solution is
obtained as follows:
t
t3
x(t) =
u2 du =
(1.23)
3
0
At the period t = 6, a true value of the stock becomes x(6) = 72. Figure 1.5
illustrates a stock and ow relation for this solution. Stock is shown as a height
at a time t, which is equal to an area surrounded by a nonlinear ow curve and
a time-coordinate up to the period t.
26
60
1
unit
1
1
40
1
2
2
2
2
1
2
20
1
2 2 1
2 2 1 1
12 12 12 1 2 1 1
Stock x : run
"Flow (t)" : run
2
21 1
2
2 1
12
12
3
Time (Month)
2
2
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
x(t) =
i2
(1.24)
i=0
27
f (t) + 4f (t +
dt
2 )
+ f (t + dt)
dt
(1.26)
6
Table 1.4 and 1.5 show that the 4th-order Runge-Kutta method are able to
attain a true value even for dt = 1. The reader, however, should be reminded
that this is not always the case as shown below.
Table 1.5: 2nd- and 4th-Order Runge-Kutta Method (dt = 1)
t
x(t) Runge-Kutta 2
x(t) Runge-Kutta 4
0
0
0.25
0
0.33
1
0.25
2.25
0.33
2.33
2
2.5
6.25
2.66
6.33
3
8.75
12.25
9
12.33
4
21
20.25
21.33
20.33
5 41.25
30.25
41.66
30.33
6
71.5
72
1.3.4
Random Walk
(1.27)
Figure 1.6 is produced for a specic random walk. It is a surprise to see how
a random price change daily produces a trend of stock price.
4 Fore
detaied explanation, see [9], section 2.8, pp.103 - 107 and 388 - 391.
28
20
Dollar
14.5
3.5
-2
0
20
40
60
80
100 120
Time (Day)
140
160
180
200
1.4
System Dynamics
1.4.1
Exponential Growth
t = 0, 1, 2,
(1.28)
(1.30)
29
Stock x
Flow f(t)
x(t) = x(0)e
where e = 2.7182818284590452354
(1.32)
It should be noted that the initial value of the stock x(0) cannot be zero, since
non-zero amount of stock is always needed as an initial capital to launch a
growth of ow.
What happens if such an analytical solution cannot be obtained? Assuming that ow is only discretely dened, we can approximate the equation as a
discrete dierence equation:
x(t + 1) = x(t) + ax(t), t = 0, 1, 2,
(1.33)
(1.34)
A true continuous solution of the equation could be obtained as an approximation from this discrete solution (1.34), rst by dividing a constant amount of
ow a into n sub-periods, and secondly by making n sub-periods into innitely
many ner periods so that each sub-period converges to a moment in time.
[
(
a )n ] t
x(t) = x(0) lim 1 +
n
n
[
(
) n ]at
1 a
= x(0) lim 1 + n
n
at
= x(0)e
(1.35)
Let an initial value of the stock be x(0) = 100 and a = 0.1. Then, a true
value for the period t = 10 is x(10) = 100e0.110 = 100e1 = 271.8281828459 .
This is to obtain a compounding increase in 10% for 10 periods. The amount
of initial stock is shown to be increased by a factor of 2.7 when a growth rate is
10%. Table 1.6 shows numerical approximations by the Eulers, 2nd-order and
4th-order Runge-Kutta methods. It is observed from the table that even the
4th-order Runge-Kutta method cannot obtain a true value of the exponential e.
30
f (t)\dt
Euler
Runge-Kuttta 2
Runge-Kutta 4
1/16
270.984
271.8264
271.828182
0.693147
a
(1.36)
For instance, when a = 0.02, that is, an annual growth rate is 2%, then
doubling time of the stock becomes about 35 years. That is to say, every 35
years the stock becomes twice as big. When a = 0.07, or an annual growth
rate is 7%, stock becokes dobled about every 10 years. Consider an economy
growthing at 7% annually. its GDP becomes 8 folds in 30 years. This enormous
power of exponential is usually overlooked or under estimated. See the section
of Misperception of Exponential Growth on pages 269 - 272 in [48].
Examples of Exponential Growth (Reinforcing Feedback)
In system dynamics, this exponential growth is called positive or reinforcing feedback. Figure 1.8 illustrates some examples of these reinforcing stockdependent feedback relation. Left-hand diagram illustrates our nancial system
in which our bank deposits keeps increasing as long as positive interest rate is
guaranteed by our banking system. This nancial system creates the environment that the rich becomes richer exponentially.
1.4.2
Balancing Feedback
31
aim of the system as already quoted in the beginning of this chapter. In other
words, it has to be stabilized to accomplish its aim.
To attain a self-regulating stability of the system, another type of feedback
is needed such that whenever a state of the system x(t) is o the equilibrium
x , it tries to come back to the equilibrium, as if its being attracted to the
equilibrium. If system has this feature, it will be stabilized at the equilibrium.
In economics, it is called global stability. Free market economy has to have this
price stability as a system to avoid unstable price uctuations.
Structurally the stability is attained if stock-ow has a relation
such that an increase in ow
Stock x
a decrease in stock a decrease
Flow f(t)
in ow. This stabilizing relation is
called a balancing or negative feedback in system dynamics. Figure
1.9 illustrates this balancing feedAdjusting
back stock-dependent relation.
x*
Time
Mathematically, this is to guarantee the stability of equilibrium.
Figure 1.9: Balancing Feedback
Let x be such an equilibrium
point, or target or objective of the
stock x(t)). Then stabilizing behavior is realized by the following ow
f (x) =
x x(t)
AT
(1.37)
x(t) x
AT
(1.38)
t
+ C,
AT
(1.39)
Interest
Interest
Rate
Bank
Deposits
Population
Birth
Birth Rate
32
x(t) x = e AT eC
t
(1.40)
(1.41)
(1.42)
Inventory
Employment
Production
Desired
Inventory
Inventry
Adjusting
Time
Employment
Adjusting Time
Desired
Workers
Exponential Decay
When x = 0, system continues to decay or disappear. In other words, stock
begins to decrease by the amount of its own divided by the adjusting time.
f (x) = x(t)
AT
(1.43)
This decay process is called exponential decay. Whenever exponential decay appears, ow has only
Stock x
negative amount. In this case in
Outflow f(t)
system dynamics we draw ow out
of stock so that it becomes more intuitive to understand the outow of
stock. Figure 1.11 illustrates such
Adjusting
stock-outow relation.
Time
At an annual declining rate
of 10%, for instance, the initial
Figure 1.11: Exponential Decay
amount of stock decreases by half
in seven years, by one third in 11
years, and by one tenth in 23 years, balancing to a zero level eventually. Righthand diagram in Figure 1.14 illustrates such a negative feedback decay.
33
Population
Death
Depreciation
Depreciation
Period
Death Rate
1.5
1.5.1
We have now learned two fundamental feedbacks in system dynamics; reinforcing (exponential or positive) feedback and balancing (negative) feedback. Let us
now consider the simplest system dynamics which have these two feedbacks simultaneously. It is called rst-order linear growth system. First-order implies
that the system has only one stock, while linear means that its inow and
outow are linearly dependent on stock. Figure 1.13 illustrates our rst system
dynamics model which has both reinforcing and balancing feedback relations.
Stock
Inflow
Outflow
Outflow
Fraction
Inflow
Fraction
34
Stock
100
1,500
75
1,000
unit
unit
Stock
2,000
500
50
25
0
0
10
12 14 16 18
Time (Year)
20
22
24
Stock : Growth
26
28
30
0
0
10
12 14 16 18
Time (Year)
20
22
24
26
28
30
Stock : Decay
35
tion is greater than outow fraction. Population explosion is a good example. To stabilize the system, the exponential growth ax(t) has to be curbed
by bringing another balancing feedback which plays a role of a break in a car.
Specically, whenever x(t) grows to a limit x , it begins to be regulated as if
population is control ed and speed of the car is reduced. This is a feedback
mechanism to stabilize the system. It could be done by the following ow:
f (x) = ax(t)b(t), where b(t) =
x x(t)
x
(1.44)
100
4
unit
unit/Year
75
3
unit
unit/Year
50
2
unit
unit/Year
25
1
unit
unit/Year
0
0
unit
unit/Year
0
10
20
30
40
50
60
Time ()
70
80
Stock x : Current
"Flow f(t)" : Current
90
100
unit
unit/Year
1.5.3
Another way to regulate the growth of x(t) is to increase b(t) to the value of a
as x(t) grows to its limit x as shown below.
f (x) = (a b(t))x(t)
(1.45)
Specically, any functional relation that has a property such that b(t) approaches a whenever x(t)/x approaches 1 works for this purpose.
One of the simplest function is
b(t) = a
x(t)
x
(1.46)
36
x x(t)
x
)
x(t)
(1.47)
Stock x
Outflow
Inflow
Inflow
Fraction
Outflow Fraction
x*
0
0
Table: Outflow
Fraction
100
20
unit
unit/Year
75
15
unit
unit/Year
50
10
unit
unit/Year
1
1
1
1
25
5
unit
unit/Year
0
0
unit
unit/Year
1
2
1
2
1 12 2 2
1
2
123123123123123 23 3 3 3 3 3 3
0
Stock x : Current
Inflow : Current
Outflow : Current
10
20
1
1
23 23 23 23 23
2
2
2
2
3
3
30
40
Time (Year)
50
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
60
70
1
unit
unit/Year
unit/Year
1.6
1.6.1
1.6.2
= f (x, y)
(1.48)
= g(x, y)
(1.49)
Flow x
Stock y
37
Stock x
Flow y
Behaviors in system dynamics with one stock are limited to exponential growth
and decay generated by the rst-order linear growth model, and S-shaped limit
to growth. To produce another fundamental behaviors such as overshoot and
collapse, and oscillation, at least two stocks are needed. System dynamics with
two stocks are called second-order system dynamics.
Let us begin with another type
of S-shaped limit to growth behavior that can be generated with two
Stock y
stocks x and y. When the total
Stock x
Flow
f(x,y)
amount of stock x and stock y is
limited by the constant available resources such that x + y = b, and the
a
amount of stock x ows into stock
Limit
y as shown in Figure 1.20, stock y
begins to create a S-shaped limit to
Figure 1.20: S-shaped Growth Model
growth behavior. A typical system
causing this behavior is described as
follows.
dx
dt
dy
dt
f (x, y)
f (x, y)
ax(t)y(t)
a(b y(t))y(t)
(1.50)
(1.51)
38
100
4
unit
unit/Year
75
3
unit
unit/Year
50
2
unit
unit/Year
25
1
unit
unit/Year
0
0
unit
unit/Year
0
10
20
30
40
50
60
Time ()
(1.52)
70
80
Stock x : run
Stock y : run
"Flow f(x,y)" : run
90
100
unit
unit
unit/Year
1.6.3
39
Stock x
Outflow x
Inflow x
Inflow
Fraction
Outflow
Fraction
Stock y
Table: Outflow
Fraction
Outflow y
0
Initial
Stock y
Outflow y
Fraction
unit x
unit x/Year
unit y
4
4
4
unit x
unit x/Year
unit y
1
1
40
20
50
4
1
4
0
0
0
unit x
unit x/Year
unit y
1
1
0
Stock x : run
Inflow x : run
Outflow x : run
Stock y : run
23
2
3
1
2
2
3
3
4
2
3
2
3
2
3
12
1
2
1
2
3
4
18
34
1
3
4
2
3
1
2
3
4
1
2
3
4
2
3
42
1
2
48
1
2
3
3 1
2
23 123 123
1
2
4
4
3 1
24 30 36
Time (Year)
2
3
3
2
23
2
3
2
3
54
60
1
unit x
unit x/Year
unit x/Year
4
4 unit y
1.6.4
Oscillation
Another behavior that can be created with two stocks is oscillation A simple
example of system dynamics with two stocks which is illustrated in Figure 1.24
40
Stock x
flow x
dx
= ay, x(0) = 1, a = 1 (1.53)
dt
a
dy
= bx, y(0) = 1, b = 1 (1.54)
dt
Stock y
flow y
unit
unit
-3
-3
-6
-6
0
Stock x : Euler
10
12
14
Time (Week)
Stock y : Euler
16
18
20
-4
-3
-2
-1
0
1
Stock x
Stock y : Euler
unit
unit
41
-1
-1
-2
0
10
12
Time (Week)
14
16
18
Stock x : Rung-Kutta2
Stock y : Rung-Kutta2
20
-2
-1.50
-1.10
-0.70
-0.30
0.10
Stock x
0.50
0.90
1.30
Stock y : Rung-Kutta2
1.7
1.7.1
42
Material in
Transit
100
4
unit/Day
unit/Day
75
3
unit/Day
unit/Day
50
2
unit/Day
unit/Day
25
1
unit/Day
unit/Day
0
0
unit/Day
unit/Day
Outflow
Inflow
-2
Inflow
Amount
8
10 12
Time (Day)
Inflow : Current
Outflow : Current
Delay Time
14
16
18
20
unit/Day
unit/Day
Material in
Transit 1
Inflow
Material in
Transit 2
Outflow 1
Outflow 2
Delay Time
Inflow
Amount
100
6
unit/Day
unit/Day
75
4.5
unit/Day
unit/Day
50
3
unit/Day
unit/Day
25
1.5
unit/Day
unit/Day
0
0
unit/Day
unit/Day
2
2
3 23
2
3
12 3 1 1
-2
Inflow : run
Outflow 1 : run
Outflow 2 : run
2
1
1 1
2
1
3
3
3 3
2 2
3 3
3 3
2
1 1 1 2 1 2 1 2 12 12 1 23 123 12 3 12 31 2 31 2
8
10 12
Time (Day)
14
16
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
18
20
unit/Day
unit/Day
unit/Day
1.7.2
Information Delay
43
Dmnl
200
Perceived
Output
150
Output
100
Adjusted Gap
50
-2
Actual
Input
8
10
Time (Day)
12
14
16
18
20
Adjustment Time
Perceived
Output 1
Adjusted Gap 1
Perceived
Output 2
Adjusted Gap 2
Output
Adjustment Time
Actual
Input
250
1
200
1 1
value
1 1
2
2
2
150
2
2
100
123 1231 23
3 3
1 1 1 1 2 12 12 1 2 12 12 12 1 2 12 12 12 1 2 12 1
3
2 2
3 3 3 3
2 2
3 3 3
3 3
3 3
3
3
3 3
3
50
-2
6
1
3
8
10
Time (Day)
1
12
14
16
18
20
1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
44
Output
Adjusted Gap
Actual
Input
Adjustment Time
Stock Value
Stochastic
Flow
20
2 12
1
2 1
14.5
value
2
12
1
1
2
1
2
1
2
2 1
12 1 12
2
2 1
2 1
2 12 12
2 1
1
2 12
1
1 1
2
3.5
3
3
3
-2
0
20
3
3
40
1 1
Output : run
Stock Value : run
Stochastic Flow : run
60
3 3
3
3
80
100 120
Time (Day)
3
3
140
3
3
160
3
3
180
200
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
1.8
1.8.1
It has been shown that system dynamics with two stocks can mostly produce
all fundamental behavior patters such as exponential growth, exponential decay, S-shaped limit to growth, overshoot and collapse, and oscillation. Actual
behaviors observed in complex system are combinations of these fundamental
behaviors. We are now in a position to build system dynamics model based on
these fundamental building blocks. And this introductory chapter on system
45
1.8.2
f (x, y, z)
(1.55)
g(x, y, z)
(1.56)
h(x, y, z)
(1.57)
Lorenz Chaos
46
a(x y)
(1.58)
xz + bx y
(1.59)
xy cz
(1.60)
where initial values are assigned as x(0) = 0, y(0) = 2 and z(0) = 0 and
parameters are as originally set at a = 10, b = 28 and c = 8/3 by Lorenz. (See
Chapter 14 The Lorenz System in [33]).
x
x dot
a
z
y dot
c
z dot
y
47
80
50
52.5
30
25
10
-2.5
-10
-30
-30
-18
-14
-10
-6
-2
2
X
10
14
18
22
follows. Suppose a true initial value of the stock y in the Lorenz equations is
y (0) = 1.0001 instead of y(0) = 1.0, and denote its true value by y . At the
period t = 10.25 those two values of the stock are calculated as y(t) = 5.517,
and y (t) = 5.518. The dierence is only 0.001 and they stay very close each
other. This makes sense, because both started at the very close distance of
0.0001. To our surprise, however, at the period t = 27, they are calculated as
y(t) = 2.546, and y (t) = 13.77; a large dierence of 16.316 is made. Small
amount of dierences at an initial time eventually turns out to cause a big
dierence later. In other words, stock values sensitively depend on their initial
conditions. Figure 1.36 illustrates how values of the stock y begin to diverge
from a true value y around the period t = 18.
y
40
hp
20
-20
-40
0
y : y0001
10
12 14 16 18 20
Time (Second)
y : y0000
22
24
26
28
30
48
Why could it be possible? It is caused by the power of exponential magnication empowered by feedback loops. As illustrated in Figure 1.14, for instance,
a simple calculation yields that an initial dierence of 0.001 is exponentially
magnied to 22.02 by the time t = 100, more than twenty-two thousand factors
larger, because of a positive feedback loop. Chaos is a region called strange
attractor to which innitely many iterated and exponentially magnied values
are conned. Hence, it is intuitively understood that exponentially magnied
values in a chaos region sensitively depend on initial conditions; in other words,
values whose initial conditions dier only very slightly cannot stay close and
begin to diverge eventually.
This chaotic feature creates annoying problem in system dynamics: unpredictability in the future. It is almost impossible in reality to obtain true initial
values due to some observation errors and round-o errors of measurement and
computations. These errors are magnied in a chaotic system dynamics to a
point where predictions of the future and forecasting become almost meaningless
and misleading. If analytical solutions of dierential equations could be found,
this would never happen, because solutions are continuous function of time and
we could easily predict or approximate the future behavior of the system even
if initial conditions are missed slightly. Without the analytical solutions, the
future has to be iterated step by step, causing an exponential magnication
by feedback loop. Unfortunately as discussed above, it is almost impossible
to nd analytical solutions in a nonlinear dynamics and system dynamics. In
such cases, if a true initial value fails to be specied, then we cannot predict
the future at all, even if we try to make calculations as precise as possible by
employing Runge-Kutta methods and making sub-periods smaller as discussed
in the previous sections. Hence, system dynamics becomes inecacious as a
forecasting simulation method.
Whats a good use of system dynamics, then? If a dynamic system is chaotic,
all values of stocks are attracted to a region of strange attractor; in other words,
information of initial conditions will be lost eventually and only patterns or
structures of the system begin to reveal themselves. In system dynamics, these
patterns and structures help us learn the behavior of the system we want to
explore. System dynamics is a very eective learning method in that direction,
not in the direction of futures prediction.
1.9
1.9.1
t = 0, 1, 2, 3,
(1.61)
49
f (t) = axt (1 xt ) xt
(1.62)
0.75
0.75
Dmnl
Dmnl
x
1
0.5
0.25
0.5
0.25
10
20
30
40
50
60
Time (Day)
70
80
90
100
0.20
0.40
0.60
0.80
"x(-1)"
x : a=395
x : a=395
1.9.2
The equation (1.51) in the S-shaped limit to growth can be rewritten in a discrete
format as
t = 0, 1, 2, 3,
150
150
102.5
102.5
unit
unit
yt+1 = yt + ayt (b yt )
55
7.5
(1.63)
55
7.5
-40
-40
0
10
Stock x : a=023
20
30
40
50
60
70
Time ()
Stock y : a=023
80
90
100
10
Stock x : a=0272
20
30
40
50
60
70
80
Time ()
Stock y : a=0272
90
100
50
(1.64)
which also becomes the same as the right-hand side of the equation (1.61) for
b = 1.
To our surprise, it turns out that the ow (1.64) can also produce chaos if
f (t) is allowed to take negative values. In other words, S-shaped limit to growth
behavior turns out to be chaotic if ows move forward and backward between
stocks x and y.
Left-hand diagram of Figure 1.38 is a two-period cycle of stocks x and y for
a = 0.023 and right-hand diagram is chaotic movements for a = 0.0272.
51
dx1
= f (t, x)dt
dx2
(1.66)
(1.67)
(1.68)
dx1
dx2
dx3
dx4
dx
= f (t, x)dt
dt
dx1
= f (t + , x +
)dt
2
2
dx2
dt
)dt
= f (t + , x +
2
2
= f (t + dt, x + dx3 )dt
dx1 + 2dx2 + 2dx3 + dx4
=
6
(1.69)
(1.70)
(1.71)
(1.72)
(1.73)
52
number of calculations. Even so, from the results in Table 1.6, it can be easily
veried that the Runge-Kutta methods produce better approximations for the
same number of calculations.
Chapter 2
2.1
Adam Smith!
Theres a person who has inuenced upon us more than Jesus Christ! Whos
he? An instructor of Economics 1, an introductory course for undergraduate
students at the Univ. of California, Berkeley, challenged his students cheerfully.
I was sitting in the classroom as a Teaching Assistant for the course. This was
in early 80s when I was desperately struggling to unify three schools of economics in my dissertation; that is, neoclassical, Keynesian and Marxian schools
of economics.
Hes the author of the Wealth of Nations written in 1776; his name is Adam
Smith!, claimed the instructor. Adam Smiths idea of free market economy has
been a core doctrine throughout the so-called Industrial Age which started in
the middle of the eighteenth century. It has kept inuencing our economic life
even today with a simple diagram such as Figure 2.1.
Those who have studied economics are very familiar with this diagram of
demand and supply, which intuitively illustrates a market mechanism of price
adjustment processes. Price is taken on vertical axis and quantity is taken on
1 This chapter is based on the paper presented at the 27th International Conference of the
System Dynamics Society, Albuquerque, New Mexico, USA, July 26-30, 2009. It is written
during my short-term sabbatical leave at the Victoria Management School, Victoria University
of Wellington, New Zealand in March 2009.
54
Demand
Excess Demand
<0
Down
Equilibrium
Up
Quantity
55
market denotes full employment. If wage rate is higher than the equilibrium,
unemployment comes o and eventually workers are forced to accept a wage cut.
In the case of lower wage rate, labor shortage develops and eventually wage rate
is pushed up. In this way, price adjustment mechanism works similarly in the
labor market.
In a nancial capital market, price on the vertical axis becomes an interest
rate, and it become a foreign exchange rate in a case of a foreign exchange
market. Price mechanism works in a similar fashion in those markets.
In this way, workings of a price adjustment mechanism could be explicated
uniformly in all markets by the same framework. Our daily economic activities
are mostly related with these market mechanisms governed by the invisible hand.
This is why the instructor at the UC Berkeley amused his students, saying that
Adam Smith has been more inuential than Jesus Christ!
Unfortunately, however, this doctrine of invisible hand, or neoclassical school
of economic thought has failed to obtain unanimous acceptance among economists,
and two opposing schools of economics eventually have been struggling to ght
against the workings of market price mechanism depicted by Figure 2.1 They
are Keynesian and Marxian schools. Mutually-antagonistic dissents of these
school created the East-West conicts, Cold War since the World War II, and
domestic right-left wing battle till late 80s when these battles of ideas nally
seemed to have ended with a victory of neoclassical school. Since then, the
age of the so-called privatization (of public sectors), and globalization with the
help of IT technologies have started as if the doctrine of the invisible hand has
been the robust foundation of free market fundamentalism similar to religious
fundamentalisms.
Accordingly most of us believed there would be no longer conicts in economic thoughts as well as in our real economic life until recently when we were
suddenly hit by severe nancial crises in 2008; the worst recession ever since the
Great Depression in 1929. The battle of ideas seems to be re-kindled against
the doctrine of the invisible hand. Indeed, the instructor at the UC Berkeley
was right. Today Adam Smith seems to be getting more inuential globally,
not because his doctrine is comprehensive enough to accomplish a consensus on
the workings of a market economy, but because it caused many serious socioeconomic conicts and wars instead.
2.2
As a graduate student in economics in late 70s and early 80s, I was struggling to
answer the question: Why did three schools disagree? As a proponent of Adam
Smiths doctrine, neoclassical school believes in a price adjusting mechanism in
the market. As shown above, however, this price mechanism only works so long
as prices and wages move up and down exibly in order to attain an equilibrium.
Therefore, if disequilibria such as recession, economic crisis and unemployment
happen to occur, they believe, its because economic agents such as monopoly,
government and trade unions refuse to accept price and wage exibility and
56
2.3. TATONNEMENT
ADJUSTMENT BY AUCTIONEER
57
framework for the information age. In this way, the Third Wave became a
turning point of my academic research in economics, and since then my work
has been focused on a new economic system of the information age. My eort
of synthesizing three schools in economics and creating a future vision of a
new economic system fortunately resulted in a publication of the book [58].
Its main message was that three schools in economics are eete in a coming
information age, and a new economic paradigm suitable for the new age has to
be established2 .
My idea of economic synthesis was to distinguish logical time on which neoclassical schools way of thinking is based, from historical time on which Keynesian and Marxist schools of economic thought are based. Yet, the working tools
available in those days are paper and pencil. Under such circumstances I was
fortunate to encounter by chance system dynamics in middle 90s through the
activities of futures studies. Since then, system dynamics modeling gradually
started to re-kindle my interest in economics. This chapter examines a true
mechanism of the working of market economy, which is made possible by the
application of system dynamics modeling.
2.3
T
atonnement Adjustment by Auctioneer
Quantity Demanded
D = D(p)
100
73
57
45
35
28
22
18
14
10
Quantity Supplied
S = S(p)
0
40
57
68
77
84
89
94
97
100
58
Demand Function
100
0
5
50
Equilibrium
Does this market economy work? This question includes two dierent inquiries:
an existence of equilibrium and its stability. If equilibrium does not exist, the
2.3. TATONNEMENT
ADJUSTMENT BY AUCTIONEER
59
auctioneer cannot nish his work. If the equilibrium is not stable, its impossible
to attain it. Let us consider the existence problem rst.
The auctioneers job is to nd an equilibrium price at which demand is equal
to supply through a process of the above-mentioned tatonnement or groping
process. Mathematically this is to nd the price p such that
D(p ) = S(p )
(2.1)
In our simple demand and supply schedules in Table 2.1, the equilibrium
price is easily found at $ 15. The existence proof of general equilibrium in
a market economy has annoyed economists over a century since Walras. It
was nally proved by the so-called Arrow-Debreu model in 1950s. For detailed
references, see Yamaguchi [58]. Arrow received Nobel prize in economics in 1972
for his contribution to general economic equilibrium and welfare theory. He
was a regular participant from Stanford University to the Debreus seminar on
mathematical economics when I was in Berkley. Debreu received Nobel prize in
economics in 1983 for his contribution to new analytical methods into economic
theory and for his rigorous reformulation of the theory of general equilibrium.
I used to attend his seminar on mathematical economics in early 80s, and still
vividly remember the day of his winning the prize, followed by a wine party
spontaneously organized by faculty members and graduate students.
Stability
The second question is how to nd or attain the equilibrium. From the demand
and supply schedules given above, there seems to be no diculty of nding the
equilibrium. In realty, however, the auctioneer has no way of obtaining these
schedules. Accordingly, he has to grope them by quoting dierent prices. To
describing this groping process, a simple SD model is built as in Figure 2.3
[Companion model: 1 Auctioneer.vpm].
Excess Demand
Change in
Supply
Demand
Supply
Adjustment
Coefficinet
Time for
Chage in
Supply
Supply
Function
Change in
Price
Price
Time for
Change in
Demand
Demand
Function
Initial Price
Change in
Demand
60
dp(t)
= f (D(p) S(p), )
(2.2)
dt
where f is excess demand function and is a price adjustment coecient. In
the model f is further specied as
f =
D(p) S(p)
p
D(p) + S(p)
(2.3)
From the simulations in our simple model the idea of tatonnement seems
to be working well as illustrated in Figure 2.4. The left-hand diagram shows
that the initial price of $10 tends to converge to an equilibrium price of $15.
Whatever values of initial price are taken, the convergence can be similarly
shown to be attained. In this sense, the market economy can be said to be
globally stable. With this global stability, the auctioneer can start with any
quotation of initial price to arrive at the equilibrium successfully.
In the right-hand diagram, demand schedule is suddenly increased by capricious buyers by 20 units at the week of 15, followed by the reactive increase of
the sellers in the same amount of supply at the week of 30, restoring the original
equilibrium. In this way, the auctioneer can easily respond to any changes or
outside shocks and attain new equilibrium states. These shifts of demand and
supply curves are well known in microeconomics as comparative static analysis.
Price
Price
20
20
1
1 1
1 1
17
17
1 121212 2
1 121212 2
1 121212 1
2 2 2 2
2 121212 1
2 1212
1 121212 2
1
1
14
1
11
Dollar
Dollar
14
2 2 2 2
2 2 2 2
1 1 1
1 121212 2
1 1212
2 2 2 2
11
2 2 2 1
2 1212 2 2
1
1
8
0
12
Price : Current
Price : Equilibrium
18
1
24
30
36
Time (Week)
42
48
54
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
60
12
Price : Current
Price : Equilibrium
18
1
24
30
36
Time (Week)
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
Chaos
So far, neoclassical price mechanism seems to be working well. To attain the
equilibrium in our model, a price adjustment coecient is set to be 0.4. What
will happen if the auctioneer happens to increase the adjustment coecient
from 0.4 to 3 in order to speed up his tatonnement process? Surprisingly this
has caused a period 2 cycle of price movement with alternating prices between
10.14 and 18.77, as illustrated in the left-hand diagram of Figure 2.5. When
the coecient is increased a little bit further to 3.16, price behavior suddenly
becomes very chaotic as the right-hand diagram illustrates. I encountered this
2.3. TATONNEMENT
ADJUSTMENT BY AUCTIONEER
61
30
1 1 1 1
1 1 1 1
1 1 1 1
1 1 1
17
22.5
2 2 2 2
2 2 2 2
2 2 2 2
2 2 2 2
2 2 2 2
2 2 2 2
2 2
14
Dollar
Dollar
1
2
1
1
15
2 2 2
1
2 2 2 12 2 2
1
2 2 2
2 2 2
2 2 2
2 2 2
1
2 2 2
1
1
11
1 1
7.5
1 1 1 1
1 1 1 1
1 1 1 1
1
0
0
12
Price : Current
Price : Equilibrium
18
1
24
30
36
Time (Week)
42
48
54
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
60
Price : Current
Price : Equilibrium
12
18
1
24
30
36
Time (Week)
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
Short-side Transactions
Tired with an endless struggle by the auctioneer to attain an equilibrium in a
chaotic price behavior, buyers and sellers may force their actual transactions
to resume at a short-side of demand and supply. In other words, if demand
is greater than supply, the amount supplied at that price is traded, while the
amount demanded is purchased if supply is greater than demand.
To allow this o-equilibrium transactions, the auctioneer has to have enough
amount of inventory at hand before the market starts. To calculate the enough
amount of inventory, a slightly revised model is built as shown in the left-hand
diagram of Figure 2.6 [Companion model: 2 Auctioneer(Inventory).vpm].
When the auctioneer quotes an initial price below equilibrium at $5, allowing
the short-side trade, unrealized excess demand keeps piling up as backlog due to
an inventory shortage and the amount accumulates up to 325.30 shirts. When
market price is initially quoted above equilibrium at $25, excess supply causes
inventory of unsold shirts to piles up to 137.86 shirts, as illustrated in the righthand diagram of Figure 2.6. If the auctioneer is allowed to have these amount
of inventories from the beginning, he could nd an equilibrium price even by
allowing these inter-auction transactions. Since no shirts are made available
until the equilibrium contract is made and production activities start under the
neoclassical rule of market game, this short-side o-equilibrium deal is logically
impossible. In other words, no feedback loop is made available without inventory
from the viewpoint of system dynamics. In conclusion, the existence of chaotic
price behavior and neoclassical assumption of market economy are inconsistent.
62
Initial Inventory
400
Inventory
200
Excess Demand
shirts
1
Demand
Supply
Adjustment
Coefficinet
-200
1
Change in
Price
-400
Supply Function
Demand Function
Price
Initial Price
12 18 24 30 36 42 48 54 60
Time (Week)
Inventory : Price=5
Inventory : price=25
Inventory : Equilibrium
1
2
1
2
1
2
1
2
1
2
1
2
1
2
1
2
1
2
2
3
2.4
The above analysis indicates its time to abandon the neoclassical framework
based on logical time. In reality, production and transaction activities take
place week by week, and month by month at short-side of product availability,
accompanied by piled-up inventory or backlog. Time ow on which these activities keep going is called historical time in [58]. In system dynamics, demand
and supply are regarded as the amount of ow per week, and ow eventually
requires its stock as inventory to store products. Thanks to the inventory stock,
transactions now need not be waited until the auctioneer nishes his endless
search for an equilibrium. This is a common sense, and even kids understand
this logic. In other words, a price adjustment process turns out to require inventory from the beginning of its analysis, which in turn makes o-equilibrium
transactions possible on a ow of historical time.
This disequilibrium approach is the only realistic method of analyzing market
economy, and system dynamics modeling make it possible. The model running
on historical time for simulations, which is based on [57], is drawn in Figure 2.7
[Companion model: 3 Inventory.vpm].
Price no longer need to respond to the excess demand, instead it tries to
adjust to the gap between inventory and desired inventory. To avoid a shortage
under o-equilibrium transactions, producers usually try to keep several weeks
of the demanded amount as inventory. This amount is called desired inventory.
An inventory ratio is thus calculated as the inventory divided by the desired
inventory. And market prices are assumed to respond to this ratio. Table 2.2
species the eect of the ratio on price. For instance, if the actual inventory is
20% larger than the desired inventory, price is assumed to be lowered by 25%.
Vice versa, if its 20% smaller, then price is assumed to be raised by 35%.
Mathematically, the model is formulated as follows:
63
Price
(Inventory)
Demand Function
Desired Price
Supply Function
Change in
Price
+
Change in
Supply
Price Change
Delay
Demand
Supply
Change in
Demand
Effect on Price
Desired Inventory
Coverage
Table of Price
Effect
Desired Inventory
Inventory Ratio
+
+
Inventory
Shipment
Production
0.6
1.8
0.7
1.55
0.8
1.35
0.9
1.15
1
1
1.1
0.875
1.2
0.75
1.3
0.65
1.4
0.55
dp(t)
p p(t)
=
(2.4)
dt
P CD
where P CD is a parameter of price change delay, and p is a desired price such
that
(
)
x(t)
p = p(t)g
(2.5)
x
Function g is a formal presentation of the numerical relation in Table 2.2, and
x(t) and x denote inventory and desired inventory, respectively, such that
dx(t)
= S(p) D(p)
dt
(2.6)
x = D(p)
(2.7)
1
x(t)
, where x =
xe
x
(2.8)
dg dx
dg x
e x
/
=
= e+1
=e
g x
dx g
x
g
Hence, the function g has a uniform elasticity e over its entire range.
(2.9)
64
Under such circumstances, the initial price is set here at $10 as in the case of
the auctioneers t
atonnement. Price (line 5) now uctuates around the equilibrium price of $15 by overshooting and undershooting alternatively, then tends
to converge to the equilibrium as illustrated in Figure 2.8. Inventory gap (= desired inventory - inventory) is the gap between line 4 and 3, and price responds
to this gap rather than the excess demand (the gap between line 1 and 2). The
reader can easily conrm that price tends to rise as long as the inventory gap
is positive, or inventory ratio is lower than one, and vice versa.
300
320
40
shirts/week
shirts
Dollar
4
3
3
4
150
160
20
shirts/week
shirts
Dollar
3
4
34
4
3
34
34
34
5
5
5
shirts/week
shirts
Dollar
2
1
10
1
1
Demand : Current
2
2
Supply : Current
3
Inventory : Current
Desired Inventory : Current
"Price (Inventory)" : Current
2
1
12
20
30
1
2
12
1
2
2
3
1
3
4
5
1
2
3
4
5
1
2
4
5
70
1
2
2
3
3
4
3
5
12
80
1
2
3
4
4
5
12
12
40
50
60
Time (week)
1
3
12
12
5
5
0
0
0
34
3
4
4
5
12
90
12
100
shirts/week
shirts/week
3
shirts
4
shirts
5
Dollar
1
xe
(2.10)
Price adjustment processes are constructed in this fashion in our macroeconomic models below.
65
Price (Inventory)
40
30
30
20
1
2
10
2 2
1 1
2 2
1
2
1
2 12
2 2 2
1 1 1
1
2
1 1
1
2 2 12 12 2 2 1 2 12 2 12 1 2 12
1 1
Dollar
Dollar
Price (Inventory)
40
1
1
2 2
10
20
1
2
2
1
2 2
1
1
1
21 2 2
1
2
1
1
1
2 2
1
2
1
2
1
1
1
2 2
2
1
2 2
1
0
0
10
20
30
40
50
60
Time (week)
1
70
80
90
100
1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2
10
20
30
40
50
60
Time (week)
1
70
80
90
100
1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2
Figure 2.9: Eects of the Changes in Demand, Supply and Inventory Coverage
2.5
A combined model is created in Figure 2.10 to compare how the above two price
adjustment processes behave dierently; one is running on logical time and the
other on historical time [Companion model: 4 Comparison.vpm].
Left-hand diagram of Figure 2.11 is produced to show similar patterns by
setting the auctioneers adjustment coecient to be 2.7. In both cases it takes
about 100 weeks to attain the equilibrium. The dierence is that under logical
time production and transactions never take place until the equilibrium is attained around the logical time of 100 weeks, while a real economy running on
the historical time is suering from the uctuation of inventory business cycles
for 100 weeks until a real equilibrium price is attained.
What will happen if the demand suddenly increases by 20 at week 50. Righthand diagram illustrates the real economy can no longer attain the equilibrium
in 100 weeks. In this way the market economy is forced to be uctuating around
o-equilibrium points forever in face of continued outside shocks, compared with
a quick realization of the equilibrium by the auctioneer around the logical time
of week 70.
The meaning of logical and historical times is now clear. Microeconomic
textbooks are full of logical time analyses when dynamics of price movements
are discussed. The reader now has the right to ask if the time in textbooks is
logical or historical. If historical, price has to be always accompanied by the
inventory on historical time.
66
Change in
Price
Adjustment
Coefficient
Price
(Auctioneer)
Demand
Supply
Initial Price
Price
(Inventory)
Time for
Change in
Supply
Change in
Supply
Time for
Change in
Demand
Demand Function
Supply Function
Price Change
Delay
Desired
Price
+
Supply
(Inventory)
Demand
(Inventory)
Change in
Price
(Inventory)
Change in
Demand
Effect on Price
Desired
Inventory
Coverage
Inventory
Ratio
+
Table of Price
Effect
Desired
Inventory
+
Inventory
Production
Shipment
Prices
30
25
2
2
20
2
2
1
2
2
15
1
2
1
12
1
2
12
12 1
2
12 1
1
1 12
2 2
12
2
1
2
2
2 2
1 1 1 2 1 12 12 1 1 12 12 12 12
2
Dollar
Dollar
23.75
2
17.5
11.25
10
1 1
2 2
1 1 1 1
1 1 1 12 1
1
2
2
2 2
2
2 2
2
2
2
1
2 1 1 12 1 1 1 1 1 1 12 1 1
2
2
2
2
5
0
5
0
10
20
30
40
50
60
Time (week)
70
80
90
10
20
30
100
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
40
50
60
Time (week)
70
80
90
100
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
2.6
Which path, then, should we follow to analyze free market economic activities?
Neoclassical analysis of logical time is mathematically rigorous, yet free price
behavior is no longer stable, as preached by market fundamentalists, due to the
appearance of chaos as shown above. In other words, market economy could be
chaotic even on the basis of neoclassical doctrine.
67
(2.11)
(2.12)
(2.13)
Prices
Prices
30
30
23.75
Dollar
2
2
17.5
12
11.25
2 2
2
1
2 1 1
2
1
1
12 1
2
2 2
2 2
2
1 1 1 1 12 1 1 1 12 1 1 12 12 1
2 2 2
2
1
2
Dollar
23.75
11.25
1
2
12 12
12
17.5
2
1
1
2
1 12
2
2
1
2
1 12 2 2
1 1 12 12 12 12 12 12 12 12 12 12 12 12 1
1
2
5
0
10
20
30
40
50
60
Time (week)
1
70
80
90
100
1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
10
20
30
40
50
60
Time (week)
1
70
80
90
100
1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
Figure 2.12: Historical Price Stability with Adjusted Supply Schedule (1)
Left-hand diagram of Figure 2.12 illustrates how price behaviors are different between logical time (line 1) and historical time (line 2) when demand
is increased by 20 units at the week of 15, followed by the increase in the
same amount of supply at the week of 30 [Companion model: 5 Comparison(Supply).vpm)]. In both cases prices try to restore the original equilibria,
though their speed and meaning are dierent. In the right-hand diagram, newly
adjusted supply schedule is now applied with the inventory adjustment time of
3 weeks. To our surprise, almost the same price behavior is obtained as the one
on logical time.
In the left-hand diagram of Figure 2.13, price behavior on the logical time
is illustrated as line 1 for the initial price at $10, while the same price behavior
on the historical time is illustrated as line 2 for the inventory coverage of 2.3
weeks, similar to the right-hand diagram of Figure 2.9. Now the new supply
schedule is applied to the same situation, which results in line 3. Again, the line
3 becomes very similar to the price behavior (line 1) on the logical time.
68
Prices
Prices
30
30
2
Dollar
2
2
17.5
11.25
23.75
2
2
2
2
2
1 3 1 3 123 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 1 3 123 1 3 1 3 1 31
2
13
2
2
2 2
2
13
2 2
2
2
2
2
Dollar
23.75
17.5
1 12 12 12 12 12 12 12 12 12 12 1
2
2
1
2
1 1
1
2 2 2 12 12 12 12 12 12 12
11.25
2
5
0
10
20
30
40
50
60
Time (week)
70
80
90
100
1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3
5
0
10
20
30
40
50
60
Time (week)
1
70
80
90
100
1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
Figure 2.13: Historical Price Stability with Adjusted Supply Schedule (2)
Finally let us apply the new supply schedule to the right-hand diagram of
Figure 2.11, that is previously explained as the case in which the real economy
can no longer attain the equilibrium in 100 weeks. Right-hand diagram of
Figure 2.13 is the result obtained by newly adjusted supply with the inventory
adjustment time of 3 weeks. Again almost similar price behavior is restored as
the one on the logical time.
These simulation results may indicate that our market economy could behave
as close as the one predicted by neoclassical equilibrium analysis on logical time
so long as economic agents behave appropriately on the historical o-equilibrium
time. In other words, we no longer need a help from auctioneer running on
logical time to attain an equilibrium in a market economy. Price, inventory and
their interdependent feedback relations can do the same job in a real market
economy.
2.7
2.7.1
69
70
Excess
Demand
Prices
+
Adjustment
Coefficient
Demand
+
Supply
Preferences
+
Income
Initial
Endowment
2.7.2
T
atonnement Processes on Logical Time
71
Adjustment
Coefficient
Prices
relative
changes
Change in
Price
Initial Prices
Pmax
Pmin
Excess
Demand
Total Demand
Demand for
Consumer 1
Total Supply
Demand for
Consumer 2
Tastes of
Consumer 1
Tastes of
Consumer 2
Income of
Consumer 1
Income of
Consumer 2
<Prices>
Initial
Endowment of
Consumer 2
Initial
Endowment of
Consumer 1
(, )
Pt+1
?
Pt+1 = Pt + f (Pt , )
Pt
Figure 2.16: T
atonnement Adjustment Process
stable.
To our surprise, however, something strange happened as the value of the
coecient increased. As Figure 2.17 indicates, the adjustment process begins
to produce a clear bifurcation, or an oscillation of prices in period 2 when price
adjustment coecient is = 0.148. Furthermore, an increasing adjustment
coecient continues to create new bifurcations or price oscillations of period
72
1.5
1.5
yen/goods
yen/goods
Period 1
2
0.5
0.5
0
0
20
40
60
80
100 120
Time (Month)
140
160
180
200
Prices[x2] : Coefficient142
20
40
60
140
160
180
200
140
160
180
200
Chaotic
PeriRG
yen/goods
\HQJRRGV
80
100 120
Time (Month)
Prices[x2] : Coefficient148
0
7LPH0RQWK
3ULFHV>[@&RHIILFLHQW
20
40
60
80
100
120
Time (Month)
Prices[x2] : Coefficient21
..... .. ......
............ ... .. ... .
... ....... . .... . .
........ . ... . . . ...
...................... ...... ..........
. . . .. . ...
....................... . .. .......... ..
.... ...... .. . .... ... ............. ..
....... ... ....... .............
....... ... . .............
................. ...................... ....................
... . .. .. . .. . . ..
.......... ...... ............. ............. ......
..................... .......... ..... .. .. ...........
... ............... . ..... .. ..... .............
... .......... ........ ............ ...... .....................
.......... ....................... .................... ...................
.
... ... ... . . .. ..
.............. ...... .. . ............. .. ............
............... ........ . ... ........... ... . .. .
................. ................ ........................ ......................
......................
. ... ....... . .. . . .
........ ................................... .. ............. ............................. .......................
.
.
.
............ ..... ........ .. .. . ..... .... . ... ..... .........
................ .................. .................................................. .......................
.... ....... ......... ... ..................
.................................... ....... .................
.
.
.
.. . . . ... .. . .. . .. . . ... . ..
...................... .............. ....... ......... ......... ............... ........................ ...................
...................... ........ ..... .... .......... ............................. ........................................................... ............................
.....
........... ....... ..... .. ....... ......... ...............................................................
...
....... ............................................. ............................................................
.........
........... ........................................................................................................................ ............................. ...................................... ..............................
.
.
.
.
.
.
.
.
.
.
................. .................... ........................... ......................................... .....................
.........
....... .......... ........ ........................... ............. .................. ..................
.........
..................................................... ................ ..................... ........... ....
......
............ . ................ .......... .............. ...... ........
.............................................
.................... ........................ .............. ......... .......... .... ..........
.................
..................................................................................................................................................................................... ............................................................................... ..................................
................................................ ............................. ............... ........................ ...................
.................................... .................... ......................... ......................
.. . ................................. ....................
... ...........
P2
0.14
0.16
0.18
Coefficient
0.20
0.22
0.24
73
prices as time-series data. In Figure 2.19 dotted and real lines represent a timeseries of two prices whose initial values only dier by 0.0001. Line 1 is obtained
at = 0.21001, while line 2 is obtained at = 0.21002. Evidently two lines
begin to diverge as time passes around month 20, which proves that prices are
indeed chaotic (See [59] for details).
Prices
4
Dollar/goods
3
2
2
1
2
1
1
2
1 1 1 1
2
1 1
2
2
1
1
1
2
21
2
1
212
1
21
0
0
12
Prices[x2] : Chaotic1
Prices[x2] : Chaotic2
18
24
30
36
Time (Month)
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
2.7.3
74
1.5
1.5
yen/goods
yen/goods
Period 1 (Tastes)
2
0.5
0.5
0
0
20
40
60
80
100 120
Time (Month)
140
160
180
200
Prices[x2] : Tastes05
20
40
60
Period 4 (Tastes)
140
160
180
200
160
180
200
Chaotic (Tastes)
1.5
4.5
yen/goods
yen/goods
80
100 120
Time (Month)
Prices[x2] : Tastes06
0.5
1.5
0
0
20
40
60
80
100 120
Time (Month)
140
160
180
200
Prices[x2] : Tastes07
20
40
60
80
100 120
Time (Month)
140
Prices[x2] : Tastes082
.
.... . ......
... . . .
...... ..... ...........
... ... .... . .. . ..
.. ...... . . . ...........
.. .. ... . .. .. . ..
.... ..... . . ..... ...
.. .... . . . .... ..... .. .
.......... ..... . .. ...... ..
.. ....... ...... .. .......... .......
.
.
.......... .... . . . .. .. ... ......
...... ....... ............. ...... . .. ...........
.
........... .. ....... . . . ... .
..... ............ . . ....... ..... ........ ....
...................... ..... ...... .............. . ..... ...
. .
..
. .
............ ... . . . ........ ..... . . ..... ...
......................... .... ................ ...... . ............ ...
.
.
........ . .. ..... .. . .. ..... .. . ..... . .
............... ..... . .... . .. .... ...... .. . .. ... .... ....
..... ..................... ...... ............................................. ..................... .
.
.
...... .. . . .... . ... .. .... .. . . .. .
......... . ........ ... ... . . ...... . ... ..... . .. . .. .....
.............. ........ . ..... ......... ..... . . ... .. ... ........
................. .. ..... .. ......... ...... .... ... ......... .... ... ..
.............. ......... ..... .. ..... ............ ....... .. .... . .. .........
............. ...... ..... .... .. ...... .......... . ........ .............. .... .. ..... ...
....................................... ....................... ..................................................... .......................... ....................
.
.
.
.
.
.
.
.
............. .... ... . . . . .... . ...... . . . . . . . .. .. ... . . . .
....... ........................... ............. ............................. ...................................................... ................................ ..............
.
. ... . ..
.. . . . . . .
........
................... ............ ............................................................................................................................................................................................... ...............
.............
.................
.................................... ...... ..... ............................................ ...................................
...................... ...........
............ ............ ...................... .......................................... ... ........ ..................... . .
...........
........................................................ ................. .......... .......... .............................................
.......
.. ..... .... ..... .
................
... .... .. ..... ... ....... . . .. . . ....
.............................................................................................................................................. ................................................................... ...................................................................
........................................................................................... .................................................... ......................................................
........................................................................................ ............................. ..................
.....................................................................................
......................
P2
0.6
0.8
Coefficient
1.0
1.2
1.4
75
2.7.4
76
Market economic analysis now has to be based on o-equilibrium transactions on historical time. Once economic analysis is freed from the control of
invisible hand, market disequilibria such as recession and unemployment can be
better handled on historical time with system dynamics method.
MuRatopian Economy
After the collapse of the former Soviet Union in 1989, a capitalist market economy has become the only remaining alternative, no matter how violent and
chaotic it is. Accordingly, free market principles are enforced globally such as
market and nancial deregulations, restructuring and re-engineering by business corporations, resulting in recessions and higher unemployment rates. And
government tries repeatedly to exercise traditional scal and nancial policies
in vain.
In the book [58], information age is shown to be incompatible with a capitalist market economy and a mixed economy of welfare state. It then poses a
necessity of new economic paradigm suitable for the information age. As one
such new paradigm, I have proposed an economic system called MuRatopian
economy. Interested readers are referred to Sustainability and MuRatopian
Economy [61, Chapter 5] and Toward A New Social Design [58, Chapter 8].
Now that disequilibria on historical time are shown to be normal states in a
capitalist market economy, the doctrine of Adam Smith should not be inuential
anymore in the information age of the 21st century. We need to change the way
we think about a market economy. We have to create a new economic system
that is beyond a chaotic capitalist market economy and is preferable in the new
information age. This will be challenged in the last part of this book.
Before going so far, we have to explore how market economies and macroeconomies running on historical time work.
2.8
Goods in
Use
Demand
Money
(Producer)
Payment
Money
(Consumer)
77
78
h H.
x
i =
x
hi , i = 1, 2, . . . , n.
(2.15)
(2.16)
hH
h H.
pi x
hi ,
(2.17)
i=1
ih log xhi .
(2.18)
i=1
Ih (p)
,
pi
h
where
ih = n i
h
i=1 i
i = 1, 2, . . . , n,
and
ih = 1.
(2.19)
(2.20)
i=1
xi (p) =
xhi (p), i = 1, 2, . . . , n.
(2.21)
hH
1 h
i Ih (p) x
i ,
pi
hH
i = 1, 2, . . . , n.
(2.22)
79
(2.23)
0
p1
a11 x
1
a12
a1n
p2 0
a
a
a
21
22
2
2n
(2.24)
.. = .. .
..
..
..
..
.
. .
.
.
.
0
pn
an1
an2
ann x
n
where aij = hH
ih x
hj .
It is shown in [31, p.100] that there exists a non-trivial positive equilibrium
price p >> 0. The existence of equilibria in an exchange economy is more
generally shown by Smale[45]. Such an equilibrium price is known to be unique
up to n-1 prices. This can be easily conrmed by the fact that the column sums
of the above matrix are zero, or from the Walras law: p(p) 0. That is to
say, only relative prices are determined in the equilibrium.
(2.27)
11 x
12 +
=
.
p2 |1 =0
(1
11 )
x11 + (1
12 )
x21
(2.28)
p1
(1
21 )
x12 + (1
22 )
x22
=
.
1
1
2
2
p2 |2 =0
2 x
1 +
2x
1
(2.29)
From a relation: 1
1i =
2i , i = 1, 2, it can be shown that these two relative
equilibrium prices are equal, that is,
p1
p1
=
p2 |1 =0
p2 |2 =0
(2.30)
80
Constructing T
atonnement Processes
How can we attain an equilibrium price when it cannot be directly computed?
In such a case, a t
atonnement price adjustment process is the only available
method to determine an equilibrium price or even estimate it. A standard
adjustment process that is often used in the literature is the following in which
an adjustment coecient is given exogenously.
pi (t + 1) = Max {pi (t) + i (p(t)), 0},
i = 1, 2.
(2.31)
As an alternative t
atonnement adjustment (a), the following process is also
employed:
pi (t + 1) = pi (t) + Max {i (p(t)), 0}, i = 1, 2.
(2.32)
When prices are bounded by some minimum and maximum values, the following
minmax t
atonnement adjustment (m) is occasionally applied:
pi (t + 1) = Min {
pi , Max {pi (t) + i (p(t)), pi }},
i = 1, 2.
(2.33)
i = 1, 2,
(2.34)
and call these revised coecients composite coecients. Thus, these composite
coecients are applied to the above three adjustment processes respectively as
follows.
Standard composite tatonnement adjustment (c)
pi (t + 1) = Max {pi (t) + i (t)i (p(t)), 0},
i = 1, 2.
(2.35)
i = 1, 2.
(2.36)
i = 1, 2.
(2.37)
In this way six dierent tatonnement price adjustment processes can be constructed.
81
Global Stability
Can any arbitrarily-chosen initial price attain an equilibrium in an exchange
economy? If it can, the economy is called globally stable. Arrow, Block and
Hurwicz [1] proved such a global stability under the assumptions of Walras law,
homogeneity of excess demand function and gross substitutability. Since then it
has been generally adopted in the literature on microeconomics and mathematical economics, for instance [49, pp.321-329]. Walras law and homogeneity are
already shown to hold in the exchange economy. It is also shown here that for
(p1 , p2 ) > 0 a gross substitutability holds in the simplied economy as follows.
1 (p)
1 1 1
= (
x
+
12 x
22 ) > 0.
p2
p1 1 2
(2.38)
2 (p)
1 1 1
= (
x
+
22 x
21 ) > 0.
p1
p2 2 1
(2.39)
Equilibrium prices are attained under a condition that an adjustment coefcient is xed at its original default value. Hence, the simplied exchange
economy turned out to be globally stable.
Chapter 3
Accounting System
Dynamics
Understanding nancial statements is imperative for better management of corporations, while system dynamics (SD) oers dynamic modeling and simulation
skills for better strategies of management. This chapter1 tries to present a
consolidated principle of accounting system dynamics on the basis of simple
principles from SD and accounting system. It is, then, specically applied to
model corporate nancial statements (income statement, balance sheet and cash
ow statement) described in the book [34]. It is shown that cash ow statement
is indispensable for modeling nancial statements. At the same time, a limitation of the current accounting system as a dynamic guidance for management
strategies is pointed out. This demonstrates the importance of SD modeling in
the eld of accounting system.
3.1
Introduction
Business accounting system consists of three nancial statements such as income statement, balance sheet and cash ow statement. Success or failure of
corporations has been measured by these nancial statements. In this sense,
accounting system has been and will be a foundation for our business activities,
on which macroeconomic activities are further built.
Accounting system is recently undergoing radical reforms in Japan in order
to catch up with its global defacto standard of the American accounting system.
The so-called Japanese version of nancial Big Bang began to be implemented
in March 2000. One of its major reforms is a legal requirement of cash ow
statement which had been neglected in the Japanese accounting system until
recently. Since then many introductory accounting books focusing on cash ows
1 This chapter is based on the paper: Principle of Accounting System Dynamics Modeling
Corporate Financial Statements in Proceedings of the 21st International Conference of the
System Dynamics Society, New York City, USA, July 20-24, 2003, ISBN 0-9672914-9-6.
84
85
3.2
Stock
Inflow
Outflow
86
3.3
Assets
(Current Assets)
Cash
Account
Receivable
87
Liabilities
(Current Liabilites)
Account
Payable
Accrued
Expenses
Current
Portion of
Debt
Inventories
Income Taxes
Payable
Prepaid Expenses
(Long-Term Debt)
-------------------------
Long-Term
Debt
Other Assets
Shareholders' Equity
Capital Stock
Retained
Earnings
88
Property, Plants
and Equipments
PP&E Purchase
Book Value of
PP&E
Depreciation
Accumulated
Depreciation
19
T: Sales &
Marketing (AE)
<Net Sales>
Revenues
Sales &
Marketing
24
22
20
<Scrap>
Cost of Goods
Sold
T: Sales &
Marketing (AP)
89
29
<Cost of Goods
Sold>
29
T: Researh &
Development
Gross Margin
9
5
T: General &
Administrative (AE)
26
25
T: Insurance
Premium Paid
24
T: Write-off
Cost
29
29
General &
Administrative
<Operating
Expenses>
Income
from
Operations
Retained
Earnings
Operating
Expenses
T: Interest
Expenses
Interest
Expenses
<Interest
Expenses>
Income
before Tax
Income Tax
Rate
Income Taxes
<Income
Taxes>
Dividends
Net Income
booked on the left side of debit, while all outows from Assets and all inows
to Liabilities and Equity are booked on the right side of credit. That is to say,
each transaction has to be booked simultaneously on both sides of debit and
credit to keep the balance sheet in balance a very simple rule!. It is formally
summarized as follows:
90
Flow Statement
Beginning Cash Balance
Cash Receipts
Cash Disbursements
Cash Flow From Operations
PP&E Purchase
Net Borrowings
Income Taxes Paid
Sale of Capital Stock
Ending Cash Balance
Credit
Debit
Credit
Liabilities
Assets
Increase in
Liabilities
Decrease in
Liabilities
Increase in
Assets
Decreased in
Assets
Equity
4
Decrease in
Equity
Capital
Stock
Increase in
Equity
Retained
Earnings
Costs, Expenses
and Dividends
Revenues.
3.4
91
Book Value of
PP&E.
Cash
Disbursements
Accrued Expenses
Incuured
Operationg
Expenses
Retained
Earnings 1
92
Net Sales
Accounts
Receivable
Retained
Earnings
Revenues
Accounts
Payable
Cash
Disbursements
Account Payable
Paid
3.5
On the basis of the PASD, we are now in a position to model corporate nancial
statements by identifying all corresponding ows and stocks that are aected
by transactions. Examples of transactions in the book [34] are used for this
purpose. That is, all transactions below are quoted from the book, so this
section can be better followed with the book and our accounting SD model at
hand simultaneously.
According to PASD, all transactions have to be booked on both debit and
credit sides simultaneously. This bookkeeping rule is formally described here as
follows:
Transaction
[Stock 1 ] [Stock 2 ]
Stock 1 is a primary stock that is changed by the inow or outow of a transaction, and Stock 2 is its corresponding stock to be changed to keep the balance
sheet in balance. For example, if an item in the accrued expenses is paid in cash,
this transaction decreases both Cash and Accrued Expenses, and it is described
as follows:
T: Accrued Expenses Paid
[Cash -] [Accrued Expenses -]
93
This formula implies that payment of accrued expenses lowers both the levels of
cash and accrued expenses. Such an identications of a primary stock aected
by the transaction and its corresponding stock is essential for modeling nancial
statements.
In the book [34], 31 transactions are explained to describe the start-up business activities of AppleSeedd Enterprises, Inc. In our modeling here each transaction is assumed to be taken in a week, so that 31 transactions are done in 31
weeks. There are 28 transaction items, starting with sux T:, that are used as
model parameters.
Transaction 1 A group of investors is willing to exchange their $1.5 million in
cash for stock certicates representing 150,000 common shares of AppleSeed Enterprises, Inc.
Note: When you formed the company you bought 50,000 shares of founders
stock at $1 per share for a total investment of $50,000 in cash. Thus after
this sale to the investor group there will be 200,000 shares outstanding.
They will own 75% of AppleSeed and you will own the rest.
T:New Issue of Shares (= 150,000 common shares)
[Capital Stock +] [Cash +]
Transaction 2 Book all payroll-associated company expenses totaling $6,230
including salary, employers contribution to FICA (Social Security) and
various insurance expenses. Issue yourself a payroll check for $3,370 (your
$5,000 monthly salary minus $1,250 in federal and state withholding tax
and $380 for your own contribution to FICA).
T: General & Administrative (= $6,230)
[Accrued Expenses +] [Retained Earnings - : Operating Expenses]
T: Accrued Expenses Paid (= $3,370)
[Accrued Expenses -] [Cash -]
Transaction 3 Borrow $1 million to purchase an all-purpose building. This
term note will run for 10 years, calling for yearly principal payments of
$100,000 plus interest at a rate of 10% per annum.
T: Long-Term Borrowing (= $1 million)
[Long-Term Debt +] [Cash +]
T: Principal Payments (= $100,000)
[Long-Term Debt -] [Current Portion of Debt +]
Transaction 4 Purchase 100,000 square foot building and land for $1.5 million
in cash. This facility will serve as AppleSeed Enterprises headquarters,
94
95
Installation (= $250,000)
[Book Value of PP&E +] [Other Assets -]
Transaction 9 Book supervisors salary and associated payroll expenses as a
General & Administrative expense since we have not yet started production. Issue rst months salary check. Make no entries for hourly workers
since they have not yet reported for work.
T: General & Administrative (= $4,880)
[Retained Earnings -] [Accrued Expenses +]
T: Accrued Expenses Paid (= $2,720)
[Accrued Expenses -] [Cash -]
Transaction 10 Order and receive 1 million applesauce jar labels at a cost of
$0.02 each for a total of $20,000 to be paid 30 days after delivery.
T: Raw Material Purchase (= $20,000)
[Raw Material Inventory +] [Accounts Payable+]
From this transaction on, production activities are booked under the stock
account of inventory, which is, accordingly, separated from the balance
sheep of assets here, though it is still its part. Moreover, inventories are
further broken down as illustrated in Figure 3.10.
Transaction 11 Receive a two months supply of all raw materials (apples,
sugar, cinnamon, jars, caps, boxes) worth $332,400 in total. (That is,
$8.55 total materials per case less $0.24 for the already received labels
times 40,000 cases.)
T: Raw Material Purchase (= $332,400)
[Raw Material Inventory +] [Accounts Payable+]
Transaction 12 Pay production workers wages and supervisors salary for the
month. Book associated fringe benets and payroll taxes. (Now that we
are manufacturing product, these salary and wages are costs that increase
the value of our product, and are shown as an increase in inventory.)
T(Cash-): Wages (= $9,020)
[Work in Process Inventory +] [Cash -]
T: Payroll-associated Fringes and Taxes (= $8,160)
[Work in Process Inventory +] [Accrued Expenses +]
T: PP&E Purchase
T: Other Assets Purchase
T: Account Payable Paid
T: Accrued Expenses Paid
T: Current Debt Paid
Transactions
Week
T: Account Receivable Paid
T: Long-Term Borrowing
T: New Issue of Shares
T: Wages
150,000
T1
1
6,230
3,370
T2
2
100,000
1,000,000
T3
3
1,500,000
T4
4
T6
6
7,680
7,110
7,960 9,690
T5
5
T8
8
125,000 125,000
T7
7
4,880
2,720
T9
9
T11
11
20,000 332,400
T10
10
20,000
8,160
9,020
T12
12
7,143
8,677
T13
13
20,000
T14
14
19,500
500
T15 T16
15 16
150,000
T17
17
20,000
19,000
7,143
8,160
166,200
8,677
150
9,020
T18
18
103,250
T19
19
1,000
318
-0.24
15,000
4,698
4,698
-318
15,900
T23 T24
23
24
234,900
6,500
26,000
T25
25
25,000
25,000
25,000
T26
26
18,480
T27
27
T29
29
0.24
176,400
26,000
26,435
212,895
162,900
20,000
19,500
64,287
75,000
75,000
150,000 82,907
T28
28
75,000
0.375
20,000 20,000
19,500 19,500
T30
T31
30
31
1,404,000
96
CHAPTER 3. ACCOUNTING SYSTEM DYNAMICS
97
Inventories
10
11
Raw Material
Inventory
Raw
Material
Purchase
18
Work in Process
Inventory
Raw Material
Price
<T: Production>
Finished Goods
Inventory
Production Factor
Value
Accounts
Payable
Shipment Value
Completion Value
Scrap
<Unit Cost>
Account
Payable
Incurred
18
13
12
Accrued
Expenses
16
T: Payroll-associated
Fringes and Taxes
Accrued
Expenses
Incurred
Manufacturing Costs
29
18
<Order Fulfilment>
T: Scrapped
Cases
Unit Cost
18
12
18
Scrapped
Total Production
T: Wages
Cash Disbursements
Scrapping
<Depreciation>
Finished Goods
Work in Process
Completion
Production
12
18
T: Production
29
30
15
31
18
Shipment
T: Completion
29
30
31
98
99
$166,200
$171,000
$17,180
$7,143
$8,677
$193,800
$1,530
100
Net Sales
Account
Receivable
Price
Customer
Order
Inventories
Shipment
Unit
Cost
Raw Materials
Wages
Retained
Earnings
Cost of Goods
Sold
Revenues
101
record a SALE and the associated COST OF GOODS SOLD. Yet, this
could be recorded as an increase in backlog order.
Transaction 22 Ship 15,000 cases of applesauce and send a $234,900 invoice
to the customer.
T: Customer Order (= 15,000 cases)
[Retained Earnings +] [Accounts Receivable +]
Shipment Value (= 15,000 cases * $ 10.2 per case = $153,000)
[Finished Goods Inventory -]
[Retained Earnings -: Costs of Goods Sold]
T: Sales & Marketing (= $4,698)
[Retained Earnings -] [Accrued Expenses +]
Transaction 23 Receive payment of $234,900 for shipment that was made in
Transaction 22. Pay the broker his $4,698 selling commission.
Note: A customers cash payment for goods in no way changes the Income
Statement. The Income Statement recorded a sale when rst, we shipped
the goods, and second, the customer incurred the obligation to pay (our
accounts receivable).
T: Accounts Receivable Paid (= $234,900)
[Cash +] [Accounts Receivable -]
T(Cash-): Accrued Expenses Paid (= $4,698)
[Accrued Expenses -] [Cash -]
Transaction 24 Write o the $15,900 accounts receivable that was entered
when you made the 1,000 case shipment. Also, reduce the amount payable
to our broker by what would have been his commission on the sale. If we
dont get paid, he doesnt either !
Note: Our out-of-pocket loss is really just the $10,200 inventory value
of the goods shipped. Remember that in Transaction 20 we booked a
prot from this sale of $5,382 the $15,900 sale minus the $10,200 cost
of goods minus the $318 selling commission. Thus, if you combine the
$15,582 drop in RETAINED EARNINGS booked in this transaction plus
the $5,382 increase in RETAINED EARNINGS from Transaction 20, you
are left with our loss of $10,200 from this bad debt.
T: write-o (= $15,900)
[Retained Earnings -: Operating Expenses]
[Accounts Receivable -]
102
Transaction 25 With this transaction we will pay a full years insurance premium of $26,000, giving us three months prior coverage (the amount of
time we have been in business) and also coverage for the remaining nine
months in our scal year.
Note: As time goes by, we will take this remaining $19,500 as an expense
through the Income Statement. The transaction at that time will be to
book the expense in the Income Statement and at the same time lower
the amount of PREPAID EXPENSE in the Balance Sheet.
T: Insurance Premium (= $26,000)
[Prepaid Expenses +] [Cash -]
T: Insurance Premium Paid (= $6,500)
[Prepaid Expenses -] [Retained Earnings -: Operating Expenses]
Transaction 26 Make a quarterly payment of $25,000 in principal and also a
$25,000 interest payment on the building mortgage.
T: Current Debt Paid (= $25,000)
[Current Portion of Debt -] [Cash -]
T: Principal Payment (= $25,000)
[Long-Term Debt -] [Current Portion of Debt +]
T: Interest Expenses (= $25,000)
[Retained Earnings -] [Cash -]
Transaction 27 Pay payroll taxes, fringe benets and insurance premiums.
Write checks to the government and to insurance companies totaling $18,480
for payment of withholding and FICA taxes and for payroll associated
fringe benets.
Note: The Income Statement and RETAINED EARNINGS are not affected by this payment transaction. Because AppleSeed runs its books
on an accrual basis, we already expensed these expenses when they occurred not when the actual payment is made.
T: Accrued Expenses Paid (= $18,480)
[Accrued Expenses -] [Cash -]
103
Transaction 28 Pay suppliers a portion of what is due for apples and jars.
Cut a check for $150,000 in partial payment.
T: Accounts Payable Paid (= $150,000)
[Accounts Payable -] [Cash -]
Transaction 29 Book a series of entries in the Income Statement, Cash Flow
Statement and the Balance Sheet summarizing transactions that take
place in the remaining nine months of AppleSeed Enterprises rst scal
year.
( Transaction Items beyond this transaction are not specied in the
book [34]) The reader who followed our description up to this point can
easily ll in the transactions given in Table 3.4.
Transaction 30 On a pretax income of $391,687 AppleSeed owes 34% in federal income taxes ($133,173), and $6,631 in state income taxes for a total
income tax bill of $139,804. We will not actually pay the tax for several
months.
Income tax is calculated as Income before tax times Income tax rate of
34%, and built in the program.
[Income Tax Payable +] [Retained Earnings -]
Transaction 31 Declare and pay a $0.375 per share dividend to AppleSeeds
shareholders. (With 200,000 shares outstanding, this dividend will cost
the company $75,000.)
T: Par Share Dividend (= $0.375 per share)
[Cash -: Dividends Paid to Stockholders]
[Retained Earnings -: Dividends]
Modeling corporate nancial statements are now completed. They consists
of Income Statement (Figure 3.4) and Balance Sheet (Figure 3.12). Inventories
(Figure 3.10) is a part of the balance sheet and Cash Flow Statements (Figures
3.14 is a part of balance sheet.
104
14
<T: Wages>
29
28
T: Account
Payable Paid
<Interest
Expenses>
23
30
<Net Sales>
T: Account
Receivable Paid
Operating
Activities
2
Prepaid
Expenses
Prepaid
Expenses
Incuuured
27
Prepaid
Expenses
Covered
Accrued
Expenses
Incurred
<T: Pa
26
PP&E
Purchase
Accumulated
Depreciation
Depreciation
Installation
<Long-Term
Borrowing>
Other Assets
Purchase
Other
Assets
13
18
29
Current
Borrowing
30
Long-Term
Debt
Long-Term
Debt Paid
Net
Borrowings
Financing
Activities
Full Payment
Par
value
T:
Debt
Payment
Capital Stock
Purchase of
Capital Stock
Sale of
Capital Stock
Long
Borr
Principal
Payments
Long-Term
Debt (total)
<Capital Stock
Issue>
T:
B
T: Principal
Payments
T: Depreciation
T: Other Assets
Purchase
Current
Portion of
Debt
26
3
29
7
<Current
Borrowing>
Income Taxes
Payable
T: Current Debt
Paid
Current Debt
Paid
Book Value
of PP&E
<
T: Income
Taxes Paid
Property,
Plants and
Equipments
T: PP&E
Purchase
Investing
Activities
<
Accrued
Expenses
Accrued
Expenses
Paid
Income Taxes
Paid
Cash
<T
<T: Insurance
Premium Paid>
Accounts
Receivable
Write-off
23
T: Accrued
Expenses Paid
T: Insurance
Premium
Cash
Receipts
Account Payable
Incurred
<T
Cash
Disbursements
25
<T: Write-off
Cost>
Accounts
Payable
Account
Payable Paid
Dividends Paid to
Stockholders
Capital Stock
Redemption
Capital
Stock Issue
Retained Earnings
Dividends
31
Revenues
T: Par Share
Dividend
3.6
Transactions given in the book [34] are not arranged as monthly data. To
run the SD model, those data need to be reinterpreted as monthly data. For
instance, Transaction 5 has to be regarded as the one in the 5th month. This
is what is assumed here for the SD modeling.
There are two methods to import transaction data into the model. They
could be put in the table functions, whose names are given in the list of Figure
3.13.
Almost half of the names in the list are related with the stock: Cash. This is
Account Receivable
105
Account Payable
T: Raw Material Purchase
T: Long-Term Borrowing
Data: Price Change
T: Principal Payments
T: Write-off Cost
Inventories
T: Production
Cash (Disbursements)
T: Completion
Accrued Expenses
T: Depreciation
T: Wages
T: PP&E Purchase
T: Scrapped Cases
T: Other Assets Purchase
Prepaid Expenses
T: Insurance Premium
T: Interest Expenses
106
Time(Month)
Cash
Accounts Receivable
Inventories
Prepaid Expenses
Current Assets
Other Assets
Book Value of PP&E
Assets
Accounts Payable
Accrued Expenses
Current Portion of Debt
Income Taxes Payable
Current Liabilities
Long-Term Debt
Capital Stock
Retained Earnings
Shareholders Equity
Liabilities & Equity
1
50,000
0
0
0
50,000
0
0
50,000
0
0
0
0
0
0
50,000
0
50,000
50,000
5
1.046M
0
0
0
1.046M
0
1.5M
2.546M
0
2,860
100,000
0
102,860
900,000
1.55M
-6,230
1.543M
2.546M
10
776,260
0
0
0
776,260
0
1.75M
2.526M
0
2,160
100,000
0
102,160
900,000
1.55M
-25,900
1.524M
2.526M
15
747,240
0
385,400
0
1.132M
0
1.742M
2.875M
341,077
10,320
100,000
0
451,397
900,000
1.55M
-25,900
1.524M
2.875M
20
588,220
0
577,970
0
1.166M
0
1.735M
2.901M
469,204
18,480
100,000
0
587,684
900,000
1.55M
-135,780
1.414M
2.901M
3.7
Structure of the corporate nancial model developed above is very static in the
sense that accounting system is merely to keep records of all transactions of
the past business activities. In other words, transaction data are just imported
to the inows and outows of the model as the outside parameters. In this
sense, accounting system is not a SD system. To be a truly dynamic SD system,
information for dynamic decision-making needs to be obtained within the system
through the information feedback loops as depicted in Principle 3.
In the accounting system, balance sheet could become a main source of information from which many important feedback loops originate for management
strategies and policies. Traditional method of obtaining such feedback information is a so-called nancial ratio analysis. In the book [34], eleven such ratios
are dened and grouped into four types as follows.
107
<T: Wages>
<Interest
Expenses>
23
30
<Net Sales>
T: Account
Receivable Paid
Operating
Activities
Cash
Disbursements
25
T: Insurance
Premium
<T: Insurance
Premium Paid>
Accounts
Receivable
Cash
Receipts
Write-off
<T: Write-off
Cost>
Prepaid
Expenses
Prepaid
Expenses
Incuuured
Property,
Plants and
Equipments
T: PP&E
Purchase
Cash
PP&E
Purchase
Investing
Activities
<Current
Borrowing>
<Capital Stock
Issue>
Book Value
of PP&E
T: Depreciation
Other Assets
Purchase
Net
Borrowings
Installation
Other
Assets
Purchase of
Capital Stock
Sale of
Capital Stock
Dividends Paid to
Stockholders
Liquidity Ratios
Current Ratio =
Quick Ratio =
Current Assets
Current Liabilities
13
Full Payment
Debt
Payment
Financing
Activities
Accumulated
Depreciation
Depreciation
T: Other Assets
Purchase
<Long-Term
Borrowing>
Prepaid
Expenses
Covered
18
29
108
Net Sales
Assets
Net Sales
Accounts Receivable
Protability Ratios
Return on Assets (ROA) =
Net Income
Assets
Net Income
Shareholders Equity
Net Income
Net Sales
Gross Margin
Net Sales
Leverage Ratios
Debt-to-Equity =
Debt Ratio =
3.8
109
<Current Assets>
<Cost of Goods
Sold>
Current
Ratio
Inventory
Turnover
<Current Liabilities>
<Inventories>
Quick
Ratio
<Cash>
Account
Receivable
Turnover
<Net Sales>
<Accounts Receivable>
<Accounts
Receivable>
<Current Liabilities>
Asset
Turn
Ratio
<Net Sales>
<Assets>
Leverage Ratios
Profitability Ratios
Return on
Assets
(ROA)
Return on
Equity
(ROE)
<Assets>
Return on
Sales
(Profit
Margin)
<Net Income>
<Net Sales>
<Current
Portion of
Debt>
<Net Income>
<Net Income>
Gross
Margin
(Gross
Profits)
<Long-Term
Debt>
Debt-toEquity
<
Shareholders'
Equity>
<
Shareholders'
Equity>
<Gross Margin>
Debt
Ratio
<Current
Portion of
Debt>
<Net Sales>
<Assets>
<Long-Term
Debt>
110
0.28
1/Month
0.19
1
0.1
2
1
0.01
2 1
2
2 1
2 1 1
2 1
2 2 1
2 1
2 1 2
1 2 2
1 1
2 1
2 1
1
2 1
2 1
2
2 1 1
1
2 1 2 1
2
2 1
1
1
2
-0.08
1
13
17
21
Time (Month)
1 1 1 1 1
"Return on Assets (ROA)" : Current
2 2 2 2 2
"Return on Equity (ROE)" : Current
25
1
1
2
29
1 1 1 1 1
2 2 2 2
2M
1
1
Dollars/Month
1M
1
2 2 2 2
1
1 1 2
1 2 2
1 2
1 2
1 2
1 1 2
1 2 2
1 1 1 2
1 2 2 2
1 2
1 2 2
1 2
1 1 2
2
1
1
2
2 2
1
-1 M
1
-2 M
1
13
17
Time (Month)
2
21
25
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
29
111
Conclusion
We have demonstrated how to construct a SD model of corporate nancial statements such as given in the book [34], by establishing the principle of accounting
system dynamics (PASD) that consists 5 principles obtained from system dynamics and accounting system. It is shown that cash ow statement is indispensable, contrary to the practice that it has been long neglected in the Japanese
nancial statements. The model is shown to be static in the sense that all
transaction data are given as parameters outside the system and no information
obtained from the stocks in the balance sheet is utilized for better management
practices - a limitation of the current accounting system. To make it a truly
dynamic SD model, information feedback loops have to be incorporated in it.
Part II
Macroeconomic System
113
Chapter 4
Macroeconomic System
Overview
This chapter tries to apply the method of accounting system dynamics developed in the previous chapters to the macroeconomic modeling. We start with
the description of a simple capitalist market economy with the traditional budget equations. Then it is shown how they are constructed into an accounting
system dynamics model of simple macroeconomy, which will be a fundamental
framework of the macroeconomic models in the following chapters.
4.1
Macroeconomic System
Macroeconomics is one of the core economic subjects which has been widely
taught, with the use of standard textbooks, all over the world by many macroeconomists. Under such circumstances, are there still something remaining to
which system dynamics can contribute, I posed. An armative answer to
this question has led me to work on the series of macroeconomic modeling in
[64, 65, 66, 67, 68]. For instance, macroeconomic variables such as GDP, inventory, investment, price, money supply, interest rate, etc, could be more precisely
presented by using a basic concept of stock and ow in system dynamics. Moreover, using SD modeling methods, determination of GDP and creation process
of credits and money supply - two essential ingredients of macroeconomics- could
be more precisely described as dynamic macroeconomic adjustment processes,
compared with a traditional static approach.
System dynamics approach requires to capture macroeconomy as a wholistic
system consisting of many parts that are interacting with one another. Specifically, macroeconomic system is viewed here as consisting of six sectors such
as the central bank, commercial banks, consumers (households), producers
(rms), government and foreign sector. Figure 4.1 illustrates an overview of
such macroeconomic system and shows how these macroeconomic sectors interact with one another and exchange goods and services for money.
115
116
Central Bank
Money Supply
Banks
Loan
Saving
Export
Wages & Dividens (Income)
Consumer
(Household)
Consumption
Gross
Domestic
Products
(GDP)
Production
Producer
(Firm)
Foreign
Sector
Import
Investment
(Housing)
National Wealth
(Capital
Accumulation)
Investment (PP&E)
Public Services
Investment (Public
Facilities)
Income Tax
Government
Public Services
Corporate Tax
4.2
Market economy is an economic system in which goods and services are traded in
the markets. A market economy we are currently living in is not the only market
economy. For instance, a self-sucient community, if any, may partly exchange
goods and services with another community, or former socialist economies used
to trade with another socialist economies. Accordingly, if we extend our concept
of economic activities to cover all communities or international economies, their
economy also form a kind of market economy. Or the MuRatopian economy
consisting of co-workers I proposed in [58] as a most suitable economy to the
information age is also a market economy.
To distinguish our market economy from other types of market economy
117
(4.1)
(4.2)
118
pI = I d
(4.3)
When all of these desired budget equations are added, the following equation
is obtained. Since it holds all the time, it becomes an identity, and called Walras
law.
p(CW + CO + I Y ) + w(Ld Ls ) + (SW + SO I d ) 0
(4.4)
The rst item implies an excess demand for goods and services in commodity
market, the second item is an excess demand for labor, and the third item
is an excess demand for money in nancial capital market. Once a capitalist
market economy is formalized as above, the major question is whether there exit
market prices which clear excess demand in all markets. To be precise, from
Walras law, whenever two markets are in equilibrium, the remaining market
attains equilibrium automatically. This problem is called the existence of general
equilibrium. As already discussed in chapter 2, it is proved by Arrow and
Debreu.
The next major question is how to nd the equilibrium prices. Such a nding
process is said to be globally stable if any initial prices can eventually attain the
equilibrium through tatonnement processes. As already discussed in chapter
2, the existence of chaos makes it impossible under some circumstances. It is
worth noting again that under the neoclassical framework of price adjustment,
transactions can only start when equilibrium is attained. Until that moment,
their budget equations are not the actual ones based on the actual receipts
and payments. That is why above budget equations are called desired budget
equations.
4.3
119
Produces
<Investment>
<Consumption>
Inventory
<Output(GDP)>
Sales
Wages
Cash
(Producers)
Profits
(Dividends)
Investment
Capital
(PP&E)
Retained
Earnings
Output(GDP)
Depreciation
Fund-Raising
<Wages>
<Profits
(Dividends)>
Consumption
Cash
(Consumers)
<Income>
Net
Assets
Income
Saving
120
4.4
Bank Loans
<Borrowing>
<Output(GDP)>
Inventory
<Income>
Fund-Raising
Sales
Cash
(Consumers)
Cash
(Producers)
<Investment>
<Consumption>
Saving
Depreciation
Profits
(Dividends)
Wages
Deposits
Capital
(PP&E)
Consumption
Investment
Produces
Net
Assets
Retained
Earnings
Debt
(Producers)
Income
<Wages>
<Profits
(Dividends)>
Output(GDP)
<Lending>
Borrowing
<Saving>
Vault Cash
(Banks)
Lending
Loan
Banks
Equity
(Banks)
Debt
(Banks)
<Saving>
<New Issues
of Shares>
<New Issues
of Bonds>
<Borrowing>
<Output(GDP)>
Inventory
<Income>
Fund-Raising
Sales
Cash
(Consumers)
Cash
(Producers)
<Investment>
<Consumption>
Purchase of
Shares
Purchase of
Bonds
Saving
Depreciation
Profits
(Dividends)
Wages
Securities
(Consumers)
Deposits
Capital
(PP&E)
Consumption
Investment
Produces
Net
Assets
Retained
Earnings
Capital
Shares
Debt
(Producers)
Borrowing
Income
<Wages>
<Profits
(Dividends)>
Output(GDP)
New Issues
of Shares
New Issues
of Bonds
<Lending>
<Saving>
Purchase of
Securities
<New Issues
of Shares>
Securities
(Non-Banks)
<Purchase of
Shares>
Sales of
Securities
<New Issues
of Bonds>
Cash
(Non-Banks)
Loan
Lending
<Purchase of
Bonds>
Vault Cash
(Banks)
Banks
Equity
(Banks)
Debt
(Banks)
Equity
(Non-Banks)
<Saving>
122
CHAPTER 4. MACROECONOMIC SYSTEM OVERVIEW
4.5. SECURITIES
4.5
123
Securities
Next fund-raising system is through the use of bonds and stocks (shares), which
are called securities. We need non-bank investment institutions that handle
these transactions as illustrated in Figure 4.5.
Problem with this fund-raising system is that there exists no way of creating
money within the system that is needed to match the increasing demand for
money in a growing economy.
Historically, the above two fund-raising systems with banks and non-bank
investment nancial institutions co-evolved. And consumers have a portfolio
choice among savings, bonds, and shares, while producers have three sources of
fund-raising: loans, bonds and shares.
However, the role of banks and non-bank investment institutions has been
separated by laws; for in stance in the United States by Glass-Stengall Act in
1933. The Act was overruled in 1999 by Gramm-Leach-Bliley Act, and no clear
distinction of nancial transactions is made between banks and investment institutions under the deregulation forces of free nancial activities. This excessive
freedom became the cause of global nancial crisis starting in 2007.
Produces
<Investment>
<Consumption>
Inventory
<Output(GDP)>
Sales
Income
Cash
(Producers)
Retained
Earnings
Investment
Capital
(PP&E)
Output(GDP)
Depreciation
Consumers (Co-Workers)
<Income>
Cash
(Consumers)
Consumption
Net
Assets
<Income>
124
4.6
Retained Earnings
Finally, producers may be allowed to save retained earnings for futures investment. Japanese auto maker, Toyota, is known for this self-sustained nancial
management.
System dynamics is the method not only for solving problems, but designing
better systems. An ideal economic system of fund-raising would be the one in
which producers are possessed by consumers, and no distinction is made between
workers and shareholders. Accordingly, retained earnings become main source
of fund. It is called MuRatopian economy in [58]. In this economy, investment
is made rst, and the remaining is distributed for consumption, as illustrated
in Figure 4.6.
Chapter 5
5.1
Analytical Methods
125
126
existing macroeconomic sectors in our model. Yet, it does not justify its existence for sustainable macroeconomy, whose analysis will be explored in chapter
12: Designing a new macroeconomic system.
Central Bank
Money withdrawn
Circulation
from Circulation
Money in Circulation
Non-Financial
Deposits
Commertial
(Consumers,
Banks
Producers &
Government)
Loans
(5.1)
127
Debit
Credit
Assets
Decreased in Assets
Increase in Assets
---------------------------------------------------------------------------------
Liabilities
Decrease in Liabilities
Increase in Liabilities
(Shareholders' Equity)
Capital Stock
Decrease in Equity
Increase in Equity
Retained Earnings
Costs, Expenses
and Dividends
Revenues
5.2
What is Money?
In this book, money, money supply and money stock are synonymously used.
What is money, then? Most economists agree that anything, tangible or intangible, could be money if it can play the following three roles.
Medium of Exchange
Unit of Account
Store of Value
In short, anything playing these roles becomes money that is generally accepted and has a purchasing power. Money we can immediately imagine, in
this sense, is coinage and bank notes. Coins are minted by the government as
subsidiary currency, while bank notes are issued by the central bank as main
currency. In this book currency in circulation is dened as consisting of coinage
and bank notes. In addition, its deposits held by commercial banks can also
play similar roles, and thus become money.
128
5.3
(5.2)
129
such as gold, discount loans and government securities against which currency
outstanding is issued.
In any case, this amount of currency outstanding becomes monetary base,
out of which currency begins to circulate among macroeconomic sectors. Once
currency outstanding is put into circulation, it begins to be used for transaction
payments. If more than enough currency is in circulation, it will be deposited
with commercial banks. Money in this way begins to be used as currency in
circulation and deposits.
Does its dierent use aect money supply, then? To see this, let us dene
currency ratio () as follows:
Currency Ratio () =
Currency in Circulation
Deposits
(5.3)
Then, one dollar put into circulation is divided into currency in circulation and
deposits according to the following proportion:
{
1
+1
1
+1
: Currency in Circulation
: Deposits wit Banks
(5.4)
Once commercial banks receive deposits, what do they do with them? Their
role was to keep the deposits at a safe place to meet the request of depositors for
withdrawal in the future. However, they gradually realized that only a portion
of deposits were to be withdrawn. Accordingly, they started to make loans out
of deposits at interest. In this way, once-prohibited usury became a dominating
practice - a start of modern banking.
To meet an insuciency of deposits against a sudden withdrawal, private
banks secretly formed a cartel. One such example is the Federal Reserve System
in the United States that was created in 1913. Fascinating story about its birth
was described in [29]. Though it is a privately owned bank, it pretends to be
the American public central bank.
Once the central bank is established in many capitalist economies, it begin
to request a portion of deposits from commercial banks to protect their liquidity
shortage problem. Specically, they are required by law to have an account with
the central bank and keep some portion of their deposits in it in order to meet
unpredictable withdrawal by depositors. These deposits of commercial banks at
the central bank are called required reserves. Now commercial banks can freely
make loans out of their deposits (less required reserves) without any risk. This
modern banking system is called a fractional reserve banking system.
130
Reserves
Deposits
Required Reserves
Excess Reserves
=
+
Deposits
Deposits
= r + e .
Reserve Ratio () =
(5.5)
That is, reserve ratio becomes the sum of required reserve ratio r and excess
reserve ratio e .
Let us now consider how one dollar put into circulation is transacted. From
the equation (5.4), 1/( +1) dollars are deposited rst, out of which commercial
banks are allowed to make maximum loans of (1 )/( + 1) dollars. This
amount will be put into circulation again as a loan to non-nancial sector. In
a capitalist market economy, producers in a non-nancial sector is always in a
state of liquidity deciency as discussed in chapter 4. In this way, one dollar put
into circulation creates additional dollars to be put into circulation. Total sum
of currency created by the original dollar and put into circulation is calculated
as follows.
(5.6)
+1
+1
=
+
+ r + e
(5.7)
Since 1 0, we have
1
m1
(5.8)
Hence, money multiplier can be easily calculated if currency ratio and required reserve ratio as well as excess reserve ratio are given in a macroeconomy.
Three sectors in Figure 5.1 play a role of determining these ratios. Depositors in
the non-nancial sector (consumers & producers) determine the currency ratio:
how much money to keep at hand as cash and how much to deposit. Central
bank sets a level of required reserve ratio as a part of its nancial policies, while
1+
131
commercial banks decide excess reserve ratio: how much extra reserves to hold
against the need for deposit withdrawals.
In this way, an additional dollar put into circulation will eventually create its multiple amount of money supply, which are being used as currency in
circulation and deposits with banks as follows:
{
+1
: Currency in Circulation
+ = +
1 +1
(5.9)
1 +1
1
=
: Deposits wit Banks
+1 +
+
In a real economy, then, how much real currency or cash is actually being put
into circulation? It is the sum of currency in current circulation and reserves that
commercial banks withhold at the central bank. This sum indeed constitutes a
real part of money supply issued by the central bank through which creation of
deposits and money supply are made as shown above. In this sense, it is called
high-powered money.
High-Powered Money = Currency in Circulation + Reserves
(5.10)
(5.11)
This ratio becomes exactly the same as money multiplier calculated above in
equation (5.7). Thus, money supply can be uniformly expressed as3
Money Supply = m High-Powered Money
(5.12)
In the above denitions, currency in circulation appears both in money supply and high-powered money. However, it is hard to calculate it in a real economy and in practice it is approximated by the amount of bank notes (currency)
outstanding which is recorded in the balance sheet of the central bank. Accordingly, high-powered money is also approximated by the sum of currency
outstanding and reserves. It is called
3 When money multiplier is calculated as the equation (5.7) and applied to the equation
(5.12) to obtain money supply, it turns out that money suddenly jumps from the money supply
dened in (5.2) as the currency ratio and reserve ratio are changed during a simulation. To
avoid this problem, currency and reserve ratios need be constantly recalculated during the
simulation. In the money supply model below, they are done as actual currency and reserve
ratios.
132
(5.13)
because this is the amount of currency that the central bank can control. And
most macroeconomic textbooks treat high-powered money equivalently as monetary base. For instance, a well-established textbook says: This is why the
monetary base is also called high-powered money [41, p. 394]. However, SD
modeling below strictly requires them to be treated dierently.
If high-powered money is approximated by the monetary base, money supply
could also be estimated similar to the equation (5.12) and it is called here money
supply(base).
Money Supply (Base) = m Monetary Base
(5.14)
It could be used as a reference amount of money supply with which true money
supply is compared (or to which true money supply converges, as it turns out
below).
In a real economy, however, money supply is calculated from the existing
data as follows:
Money Supply (Data) = Currency Outstanding + Deposits
(5.15)
5.4
To examine a dynamic process of money supply and its creation, let us now
construct a simple money supply model [Companion model: Money(Gold).vpm].
Without losing generality it is assumed from now on that excess reserve ratio
is zero, e = 0 so that reserve ratio becomes equal to required reserve ratio
r . Vault cash of commercial banks in the model could be interpreted as excess
reserves. The model is then built by assuming that the only currency available
in our macroeconomic system is gold, or gold certicates (convertibles) issued
by the central bank against the amount of gold. In short, it is constructed under
gold standard. By doing so, we could avoid complicated transactions of discount
loans by the central bank and government securities among three sectors, and
focus on the essential feature of money supply per se. This assumption will be
dropped later and discount loans and government securities will be introduced
into the model.
Figures 5.3 and 5.4 illustrate our simple money supply model under gold
standard. In the model, currency outstanding in the central bank and currency
<Borrowing>
<Gold
Certificates>
Cash Inflow
Gold (Public)
Deposit Time
Deposits
(Public)
Gold
deposited
Adjusted
Deposits
Cashing
Depositing
(Public)
Currency Ratio
Equity (Public)
Debts (Public)
<Gold
Certificates>
Borrowing
<Adjusting
Reserves>
<Reserves
Deposits>
Gold Certificates
Reserves by
Banks
Gold (Central
Bank)
Amount of
Gold Deposits
Cashing Time
Currency
in
Circulation
<Gold deposited>
Currency
Outstanding
Central Bank
<Deposits in>
Vault Cash
(Banks)
Lending
Excess
Reserves
Loan
<Cashing>
Reserves
(Banks)
Reserves
Adjustment Time
Adjusting
Reserves
Reserves
Deposits
Deposits
out
Deposits
(Banks)
Net Deposits
Excess
Reserve Ratio
Required
Reserve Ratio
Required
Reserves
Commercial Banks
<Depositing
(Public)>
Deposits in
134
<Currency in
Circulation>
Actual Currency
Ratio
Money
Multiplier
<Reserves
(Central Bank)>
<Deposits
(Banks)>
High-Powered Money
Monetary Base
Actual Reserve
Ratio
<Currency
Outstanding>
Money
Multiplier
(Data)
Money Multiplier
(Initial Ratio)
Money Supply
(Data)
<Required
Reserve Ratio>
<Currency
Ratio>
135
1,000
1
750
Dollar
2
3
4
5
2
3
1
2
4
5
1
2
3
2
3
4
5
4
5
1
3
2
3
2
1
2
1
3
2
1
2
1
3
2
5
4
5
4
5
4
5
4
22
24
500
3
2
250
5
0
0
3
2
1
4
5
10 12 14
Time (Year)
1
2
3
4
5
18
1
2
1
2
3
3
4
16
2
4
5
2
3
3
4
1
2
3
4
4
5
20
1
3
1
2
3
2
4
5
3
4
5
(5.16)
Latter part of the inequality implies that actual money supply(data) overestimates true money supply. Since money supply(data) is the only gure actually
obtained by using real data of the currency outstanding (liabilities of the central
bank) and deposits (liabilities of commercial banks), the overestimation of true
money supply might mislead economic activities in the real economy.
Second, monetary base turns out to be greater than high-powered money.
Monetary Base > High-Powered Money,
(5.17)
which then leads to the following inequality from the denitions in equations
(5.12) and (5.14):
Money Supply (Base) > Money Supply.
(5.18)
(5.19)
It also leads to
(5.20)
136
(5.22)
240
1
6
Dollar
180
1
2
120
6
2
6
2
3
6
3
2
3
2
3
2
3
2
3
6
2
6
2
6
3
3
2
3
2
60
3
5
4
5
4
3
2
1
1
Monetary Base : Current
Currency Outstanding : Current
Currency in Circulation : Current
"Vault Cash (Banks)" : Current
"Reserves (Central Bank)" : Current
Cash outside Central Bank : Current
10 12 14
Time (Year)
1
1
2
1
2
2
4
3
4
6
18
1
2
2
3
4
16
3
4
5
6
1
2
3
5
6
4
5
6
20
22
1
2
3
4
5
24
1
2
3
4
3
4
6
5
6
137
outside the central bank (line 6). Hence, we have correctly arrived at the equation:
Vault Cash(Banks)
= Currency Outstanding Currency in Circulation
= Monetary Base High-Powered Money > 0
(5.23)
which in turn leads to the above inequality relations of equation (5.17) so long
as vault cash is positive.
Furthermore, it is easily proved that
Money Supply > Money Supply (Data).
(5.24)
Hence, we have
Money Supply (Base) > Money Supply (Data) > Money Supply.
(5.25)
All three expressions of money supply are shown to converge as long as vault
cash tends to diminish, and overestimation of money supply will be eventually
corrected.
How to Create Money
Since currency ratio of 0.2 cannot be controlled, money multiplier can take the
range of 6 m 1. When monetary base is $200 in our example, this implies
that money supply can take the range between $1,200 and $200.
Loan Adjustment Time
There is a case in which such a convergence becomes very slow and overestimation of money supply remains. In Figure 5.7 loan adjustment time is assumed
to triple and become 3 periods. This is a situation in which a speed of bank
loans becomes slower, or commercial banks become reluctant to make loans.
Accordingly, money supply might converge to money supply (data), but extremely slow. In other words, money supply will not converge to the money
supply(data) for a foreseeable future and overestimation of money supply remains. Specically, money supply(data) (line 2) is always greater than money
supply (line 3) during the simulation of 24 periods.
Excess Reserves / Vault Cash
How can the amount of money supply be changed or controlled by the central
bank? Under the gold standard, monetary base is always xed, and the central bank can only inuence money supply by changing a required reserve ratio.
Even so, money supply may not be under the control of the central bank in a
real economy. It could be aected by the following two situations. First, commercial banks may be forced to hold excess reserves in addition to the required
138
1,000
1
Dollar
750
500
2
2
4
5
0
0
3
2
1
3
4
2
3
2
3
2
3
4
5
1
2
1
2
3
4
5
4
5
22
24
250
2
3
2
3
2
3
3
4
4
5
4
5
4
5
4
5
4
5
10 12 14
Time (Year)
1
2
3
1
3
4
5
4
5
16
18
1
2
1
2
3
2
4
5
2
3
3
4
1
2
3
4
4
5
20
1
3
1
2
3
2
4
5
3
4
5
Currency Ratio
Let us now consider the second situation in which non-nancial sector prefers to
hold more liquidity. To analyze its eect on money supply, let us assume that at
t = 8 consumers suddenly wish to withhold cash by doubling currency rate from
0.2 to 0.4. Money multiplier is now calculated as m = (0.4 + 1)/(0.4 + 0.1) = 2.8
and money supply(base) becomes 560 dollars (= 2.8 * 200).
Figure 5.9 illustrates how money supply is reduced due to a sudden increase
in liquidity preference in the non-nancial sector. Three expressions of money
supply tend to converge again.
139
1,000
1
2
3
4
5
Dollar
750
2
500
2
2
250
4
5
0
0
3
2
1
2
3
1
2
3
2
3
1
2
3
1
2
1
2
3
1
2
1
2
3
4
5
4
5
4
5
22
24
3
3
4
4
5
4
5
4
5
4
5
4
5
10 12 14
Time (Year)
1
2
3
4
5
18
1
2
1
2
3
3
4
16
2
3
3
4
4
5
1
2
3
4
4
5
20
1
2
3
2
3
3
4
4
5
1,000
1
750
Dollar
2
3
3
2
500
2
1
5
4
3
2
1
3
2
5
4
5
4
3
2
1
3
2
2
1
3
2
1
2
1
5
4
5
4
4
5
4
5
22
24
3
2
1
3
2
250
5
0
0
3
2
1
4
5
4
5
10 12 14
Time (Year)
1
2
3
4
5
18
1
2
1
2
3
3
4
16
2
4
5
2
3
3
4
1
2
3
4
4
5
20
1
3
1
2
3
2
4
5
3
4
5
140
wealthy out of the process of money creation under a fractional reserve banking
system? Apparently, if 100% fractional reserve is required; that is, = 1,
commercial banks have to keep the same amount of deposits as deposited by
the non-nancial sector. Accordingly, money supply remains the same as the
original gold certicates of $200. Thus, equity, assets and money supply remain
the same amount as Figure 5.10 illustrates.
1,000
1
750
Dollar
3
2
500
3
2
2
3
5
1
4
2
5
1
250
5
0
0
3
2
1
4
5
3
2
4
3
5
4
2
1
5
3
1
2
5
1
4
3
2
4
5
3
1
2
3
2
4
1
4
5
3
4
5
2
1
5
3
2
1
4
2
1
5
3
4
5
3
2
1
1
4
5
10 12 14
Time (Year)
1
2
3
4
5
18
1
2
1
2
3
3
4
16
2
4
5
2
3
3
4
1
2
3
4
4
5
20
4
5
24
1
2
3
2
3
22
3
4
5
5.5
800
1
141
1
1
Dollar
600
1
3
3
3
400
1
3
3
200
2
1
0
0
2
1
2
3
10 12 14
Time (Year)
16
18
20
22
24
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
142
central bank, and as a result was forced to borrow from the central bank. A
complete upside-down transaction.
Let us consider a money creation of the central bank out of bank debts.
This process of money creation is easily modeled as an expansion of the gold
standard model by adding a stock of discount loan in the assets account of the
central bank, and that of debt in the liabilities account of commercial banks, as
illustrated in Figure 5.12 [Companion model: Money(Loan).vpm].
Under the gold standard in the above model, the maximum amount of money
supply to be created is limited to $800 when = 0.1. Suppose the demand for
money from the economic activities is $1,000. To meet this additional demand
for money of $200, the amount of $50 worth of gold is further needed under
the gold standard, since the economys money multiplier is 4. Line 1 and 2 in
Figure 5.13 illustrates how money supply is increased under the amount of gold
deposited increases to $250 from $200.
Under the limitation of gold production, it eventually becomes impossible
to meet the increasing demand for money by adding more gold to the currency
system. Historically, currency system of gold standard has been abandoned
repeatedly. To save the currency system, at money is forced to be introduced
into circulation by giving the central bank an exclusive authority to print money.
In this case, it now becomes very easy to increase money supply. The central
bank just print a paper money worth of $50 and make loans to commercial banks,
which in turn make loans to non-nancial sector. Line 3 in Figure 5.13 illustrates
how money supply is increased to $1,000 when the central bank makes a loan of
$50 at the period of 6. Vice versa, money supply is contracted when the central
bank retrieves loans from commercial banks. In this way, by abandoning the
gold standard, the central bank has an almighty power to create money by just
making a discount loan to commercial banks; a process of money creation as
commercial bank debt.
For instance, according to Richard A. Werner [54], the bank of Japan used to
exercise a so-called window guidance - a hidden monetary policy, in which previous presidents of the bank intentionally assigned the amount of discount loans
to the commercial banks according to their own preferences. Moreover, money
can buy military weapons, economic hit mans, drags, and media information to
control political and economic activities in favor for those who control money
supply. That is, a free-hand control of the economy is endowed to the central
bank, so long as people are willing to accept printed money of the central bank
notes. This implies the central bank has to be under the control of democratic
government and people in exchange for getting the right to create money out of
nothing.
Finally, let us examine that non-nancial sectors equity or wealth remains
the same at $200, though its assets increases to $1,000. As already examined
under gold standard, the increased amount of $800 is made available by the
same amount of increase in debt of $800 as illustrated in Figure 5.14.
<Borrowing>
<Gold
Certificates>
Amount of
Gold Deposits
Deposit Time
Deposits
(Public)
Gold
deposited
Adjusted
Deposits
Cashing
Depositing
(Public)
Currency Ratio
Gold (Public)
Currency
in
Circulation
Reserves
(Central Bank)
Reserves by
Banks
Currency
Outstanding
Note Newly
Issued
Equity (Public)
Debts (Public)
<Gold
Certificates>
Borrowing
<Adjusting
Reserves>
<Reserves
Deposits>
<Discount Lending
(Central Bank)>
Discount Loan
(Central Bank)
Lending Period
Cashing Time
Lending Time
Cash Inflow
Amount of
Discount Lending
Discount Lending
(Central Bank)
<Gold deposited>
Gold (Central
Bank)
Gold Certificates
Central Bank
<Discount Lending
(Central Bank)>
<Deposits in>
Vault Cash
(Banks)
Lending
Reserves
Adjustment Time
Adjusting
Reserves
Reserves
Deposits
Excess
Reserves
Loan
(Banks)
<Cashing>
Reserves
(Banks)
Deposits
out
Excess
Reserve Ratio
Required
Reserve Ratio
Required
Reserves
Commercial Banks
Debt (Banks)
Deposits
(Banks)
Net Deposits
Borrowing
(Banks)
Deposits in
<Discount Lending
(Central Bank)>
<Depositing
(Public)>
144
Money Supply
1,000
2
2
2
Dollar
750
2
2
500
2
3
1
2
3
2
3
2
3
2
3
2
3
2
3
2
3
2
3
2
3
2
3
2
3
2
3
2
3
2
3
2
3
3
3
1
3
1
3
1
3
1
3
1
250
2
3
1
0
0
3
2
1
10 12 14
Time (Year)
16
18
20
22
24
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
1,000
1
1
1
750
1
Dollar
500
3
3
250
2
1
0
0
2
1
2
3
3
3
2
10 12 14
Time (Year)
16
18
20
22
24
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
5.6
145
them as assets and issue its bank notes against them as liabilities [Companion
model: Money(Fiat).vpm]. Under the introduction of government securities,
our expanded money supply model becomes a little bit complicated. To avoid a
further complication the model is now split into four submodels based on four
dierent macroeconomic sectors as discussed below.
Non-Financial (Public and Government) Sectors
First, let us consider the balance sheet of non-nancial sector. Due to the
introduction of government securities, the non-nancial sector is now split into
public (consumers and producers) and government sectors.
Figure 5.15 illustrates a new non-nancial sector (public), in which stock of
government securities held by the public is newly added to the assets side of its
balance sheet.
On the other hand, Figure 5.16 illustrates a new non-nancial sector (government), in which stock of cash held by the government is added to the assets
side of its balance sheet, and stocks of debts by the government and its equity(government) are added to its liabilities side.
Apparently money supply is not aected by the introduction of government
securities as long as they are purchased by consumers and producers, and government spends the money it borrowed within the non-nancial sector, as shown
below.
Commercial Banks
Stock of government securities held by commercial banks has to be newly added
to the assets side of the balance sheet of commercial banks. Now commercial
banks have a portfolio choice of investment between loans and investment on
government securities. Figure 5.17 illustrates a sector of commercial banks.
Money supply is not aected by the introduction of government securities
as long as they are purchased by commercial banks and government spends the
money it borrowed within the non-nancial sector, as shown below.
Central Bank
Stock of government securities held by the central bank has to be newly added
to the assets side of the balance sheet of the central bank. It can now purchase
government securities with its newly issued bank notes in the case of securities
held by the public, and by increasing the same amount of gure to the reserves
account of the commercial banks in the case of securities held by the commercial
banks4 . These transactions increase the same amount of the central banks
liabilities such as currency outstanding and reserves, and accordingly monetary
base.
4 Direct purchase of government securities, or direct loan to government by the central bank
is prohibited in Japan. Therefore, such purchases has to be indirectly done through market.
<Government
Spending>
<Borrowing>
<Gold Certificates>
Money put
into
Circulation
Cash Inflow
Cashing Time
Cash (Public)
Adjusted
Deposits
Cashing
Depositing (Public)
Currency Ratio
Amount of
Gold Deposits
Government
Securities
(Public)
Deposit Time
Gold
deposited
Gold (Public)
Deposits
(Public)
<Holding Ratio
(Banks)>
Investing
(Public)
<Government
Securities Issued>
Equity (Public)
Debt (Public)
<Lending
(Banks)>
<Government
Spending>
<Gold Certificates>
Borrowing
146
CHAPTER 5. MONEY AND ITS CREATION
Government
Revenues
Cash
(Government)
Government
Spending
Government
Spending Time
The Amount of
Security Issues
Government
Securities
Issued
Equity
(Government)
Debt
(Government)
Borrowing
(Government
<Discount
Lending (Central
Bank)>
Vault Cash
Inflow
<Deposits in>
Vault Cash
(Banks)
Lending (Banks)
<Deposits out>
Vault Cash
Outflow
<Government
Securities Issued>
Investing (Banks)
Loan
(Banks)
Excess
Reserve
Ratio
<Cashing>
<Investing
(Public)>
Required
Reserve Ratio
Excess
Reserves
<Open Market
Sale (Banks
Purchase)>
Holding Ratio
(Banks)
Government
Securities
(Banks)
Reserves
(Banks)
<Open Market
Purchase
(Banks Sale)>
Reserves AT
Adjusting
Reserves
Reserves
Deposits
Required
Reserves
Deposits out
Debt (Banks)
Deposits
(Banks)
Net Deposits
<Discount Lending
(Central Bank)>
<Depositing (Public)>
Borrowing
(Banks)
Deposits in
148
CHAPTER 5. MONEY AND ITS CREATION
<Government
Securities
(Public)>
Open Market
Purchase
(Public Sale)
Lending Period
Discount Lending
(Central Bank)
Open Market
Purchase Time
Open Market
Purchase
Operation
Lending Time
Amount of
Discount Lending
<Gold deposited>
<Government
Securities
(Banks)>
Open Market
Purchase
(Banks Sale)
Government
Securities
(Central Bank)
Discount Loan
(Central Bank)
Gold
Open Market
Sale Operation
Open Market
Sale Time
Gold Certificates
Open Market
Public Sales Rate
Notes Withdrown
Reserves
(Central Bank)
<Open Market Purchase
(Banks Sale)>
<Cashing>
<Adjusting
Reserves>
<Required Reserves>
Reserves by
Banks
Currency
Outstanding
<Discount Lending
(Central Bank)>
150
If it sells government securities to the non-nancial sector (public) and commercial banks, currency in circulation is withdrawn back to the central bank,
decreasing its currency outstanding, and reserves by commercial banks are reduced by the same amount, and hence monetary base as a whole. Purchase
and sale of government securities by the central bank are known as open market operations. Figure 5.18 illustrates these operations of the central bank. In
this way, with the introduction of government securities, the central bank has a
discretionary control of monetary base and money supply.
151
1,200
1
900
Dollar
1 2
1
1
3
2
3
2 3
600
2
2
1 3
1
1
1
2 1 3
2
2 3 3
2 2 3 2 3 3
1 3
2
1
1
1
2 2 3
3
2
3
1
2 3
300
4 4 5 4
0
0
3
2
1
4
5 5
4
5
4
5
4 4 5 4
5
5
4
5
4
5
5
4 4 5 4 5 5
4
5
4
10
12 14 16 18
Time (Year)
1
1
2
2
3
3
4
3
4
4
5
1
2
20
1
2
3
2
3
4
5
3
4
22
24
26
28
1
2
2
3
4
5
2
3
3
4
4
5
3
4
4
5
30
1,200
900
Dollar
1
2
3
2
3
600
2
1
4 4 5
4
5
2
3
1
2 3
1
1 1
2
3
2
3
2
3
1
2 1
3
2 3 1
3
2
3
2
300
0
0
3
2
1
4
4 4 5 5
5
4
5
2
1
4
5
4 4
5
4
5 5
5
4
3
2
3
1 1 2
2
1
5
4 4
5
4
4 5 4
10
12 14 16 18
Time (Year)
1
2
3
4
5
1
3
4
5
1
2
2
3
4
5
22
1
2
3
3
4
20
1
2
4
5
1
2
2
3
3
4
24
1
2
3
4
4
5
26
4
5
30
1
2
2
3
28
3
4
3
4
5
Conclusion
From the overview of macroeconomic system, six sectors are rearranged to three
sectors: central bank, commercial banks and non-nancial sector. Then a simple
model of money supply under gold standard is constructed to examine some
essential features of money supply and creation of deposits. This modeling
process inevitably requires a distinction between currency in circulation and
152
1,200
Dollar
900
1
600
1
1 1
3 3
3 3
2 2 2 2
2 2 2 2
1 1
1 1
3
3 3
1 1 1 1
3 3 3 3
3 3 3
1
1
1
1
3 3
2 2 2 2
3
3
3
3
1 3
300
2 1
1
2 2 2
3
0
0
3 3
10
2 2
2 2
2 2 2 2
12 14 16 18
Time (Year)
1
1
2
2
3
20
2 2 2 2
22
24
26
28
30
1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3
153
Chapter 6
6.1
What is Interest?
In the previous chapter, it is argued that money is created as debt by nonnancial sectors such as public and government, and commercial banks under
a fractional reserve banking system. If money is created this way to meet
the growing demand for economic transactions as a medium of exchange, the
banking system becomes essential sector for economic activities.
Debt is, however, not free in our economy. When non-nancial sector borrows money from commercial banks, they have to pay interest. In other words,
commercial banks charge interest to make loans. What is interest, then? According to a typical macroeconomic textbook, Interest is the price for the use
of money. It is the price that borrowers need to pay lenders for transferring
purchasing power to the future (259 page in [40]).
If extra money is sitting idle at hand without a specic plan to be used in
the near future, why cant we let someone in need of medium of exchange use it
free of charge? As a matter of fact, usury has been historically prohibited. Yet
greedy bankers began to charge interest when loan were made. Eventually, to
secure more fund for loans from those who have extra money in non-nancial
sector, bankers began to attract those extra money at interest. And in a capitalist market economy, as the above quotation of the textbook justies, no one
now doubts that interest is the price for the use of money.
Since system dynamics is a method for designing a better system, its worth
while to consider whether its possible to design an economy free of interest
155
156
charge. To examine this question, let us expand our models of money creation
in the previous chapter one by one.
6.2
<Interest paid by
Banks>
<Borrowing>
<Gold
Certificates>
Cash Inflow
Adjusted
Deposits
Cashing
Depositing
(Public)
Deposit Time
Cashing Time
Deposits
(Public)
Interest paid by
Public
Equity (Public)
Prime Rate
Debts (Public)
<Interest paid by
Public>
<Interest paid
by Banks>
Vault Cash
Inflow
<Deposits in>
<Gold Certificates>
Borrowing
<Adjusting
Reserves>
<Reserves
Deposits>
Gold Certificates
Reserves by
Banks
Reserves
(Central Bank)
Gold (Central
Bank)
Currency Ratio
Amount of
Gold Deposits
Gold (Public)
Currency in
Circulation
<Gold deposited>
Currency
Outstanding
Central Bank
Lending
Vault Cash
Outflow
Reserves
Vault Cash
(Banks) Adjustment Time
Adjusting
Reserves
Reserves
Deposits
Loan
Excess
Reserves
<Cashing>
Reserves
(Banks)
Interest Rate
Interest
paid by
Banks
Deposits
out
Excess
Reserve Ratio
Required
Reserve Ratio
Required
Reserves
Commercial Banks
Equity (Banks)
Deposits
(Banks)
Net Deposits
<Interest paid
by Public>
Deposits in
<Depositing
(Public)>
158
Equity
1,000
300
2
1
2
1
2
2
750
2
1
225
2
1
1
2
500
Dollar
Dollar
1
2
1
1
2
150
2
2
2
2
3
75
250
2
1
10 12 14
Time (Year)
16
18
20
22
1
2
24
1
2
10
12
14
Time (Year)
1
1
3
1
3
1
3
16
1
18
1
1
3
20
2
1
3
22
1
3
24
1
3
6.3
What happens if the central bank make a discount loan of $50 to commercial
banks, as in the previous chapter? To examine this eect, let us assume that the
discount rate charged by the central bank is 0.01 [Companion model: MoneyInterest(Loan).vpm]. In this case, money multiplier remains almost the same,
yet high-powered money increases from $190 to $230. Accordingly, money supply increases from the above $878 to $1,068 (in the previous chapter it was
$1,000) as illustrated in the left-hand diagram of Figure 6.3.
Money Supply
Equity
2,000
2
1
200
2
1
1
2
2
2
2
150
1,500
1,000
500
3
2
1
2
2
1
3
2
3
1
2
1
3
1
2
1
3
2
Dollar
Dollar
2
3
100
2
3
50
3
2
3
1
2
1
10 12 14
Time (Year)
1
2
16
1
2
18
1
2
20
1
2
22
1
2
3
24
1
2
3
4
3
3
4
10
12
14
Time (Year)
1
1
3
1
3
18
20
22
24
16
2
1
3
1
3
1
3
1
3
3
2
1
2
1
2
1
3
3
2
2
3
Equity (Banks)
1
200
2
3
150
2
3
2
3
150
3
Dollar
100
Dollar
2
1
200
3
3
0
2
10 12 14
Time (Year)
1
3
1
3
1
3
16
1
18
1
1
3
20
2
1
3
22
2
1
3
24
1
3
3
2
50
2
1
3
1
3
2
2
1
3
1
2
1
2
3
1
1
3
10 12 14
Time (Year)
3
2
3
2
100
3
50
159
1
3
1
3
16
1
1
3
18
1
3
20
1
3
1
3
22
2
24
1
3
6.4
Let us now expand the above model to the economy where government is allowed to borrow by newly issuing its securities [Companion model: MoneyInterest(Fiat).vpm]. Security interest is assumed to be the same as the interest
rate of 2% non-nancial sector (public) receives for its deposits. Under this
new environment, the same activities are assumed as in the section of Open
Market Operations of the previous chapter. To repeat, government issues securities (and borrow money) of 100 dollars at the period t = 3, 30% of which
are assumed to be purchased by the public (consumers and producers) and 70%
by commercial banks. At the period t = 10 central bank purchases 50% of
government securities held by the public and commercial banks through open
market purchase operation. At the period t = 20 the central bank sells 50% of
the government securities it holds, and monetary base decreases to 225 dollars.
Under such situation, money supply is illustrated as line 4 in the left-hand
diagram of Figure 6.5. Lines 2 and 3 are money supplies under gold standard and
bank debt as discussed above for comparison. Right-hand diagram shows the
new distribution of equity among non-nancial sectors (public and government),
commercial banks and central bank.
Let us take a closer look at the equity distribution of non-nancial sectors (public and government). Left-hand diagram of Figure 6.6 illustrates the
changes of public sectors equity. Compared with the previous cases (lines 2
and 3), government borrowing jumps the public equity as illustrated in line 4,
which is caused by the government spending in the non-nancial sector (public). This seems that government borrowing increases the public equity. It is,
however, balanced by the decrease in the government equity of -$100 as shown
in the right-hand diagram. (Only government is allowed to suer from negative
equity!) To be worse, this increased public equity continues to decline as line 4
of the left-hand diagram indicates.
To sum, nothing new has happened to the distribution of equity when gov-
160
400
2,000
290
4
1,000
3
500
3
4
3
2
4
3
4
2
4 2
1
2
1
4
3
3
1
2
1
180
1 2
1
2
70
3
3 4
3
4
2 3
3
3 4
1 3
3
3
2
Money
Money
Money
Money
1
4
2
1
Dollar
Dollar
1,500
4 2 4
-40
2
1
Supply
Supply
Supply
Supply
:
:
:
:
10
12 14 16 18
Time (Year)
Gold Standard
1
Gold Standard (interest)
Discount Loan (interest)
Government Debt (interest)
20
22
2
3
3
4
24
1
2
3
26
28
3
4
30
1
2
3
3
4
10
12
14 16 18
Time (Year)
1
3
1
3
20
22
1
24
1
26
1
3
28
30
1
Equity (Government)
400
2 3 1
1
4 2 3 1 2 3 1 2 3 1 2
3
300
1 2
3
2 3
1
2 3 1 2 3 1 2 3 1 3
1
2
-50
4
4
200
2 3 4
1
1 2 3 1
1
2 3
2
3
4 1
2
3
2
3
0
12
16
Time (Year)
1
-150
2
3
2
3
100
-100
Dollar
Dollar
1
3
20
1
24
1
1
3
28
1
3
0
1
-200
12
16
Time (Year)
1
1
3
20
1
24
1
1
3
28
1
3
1
3
6.5
The introduction of interest always plays in favor of commercial banks and the
central bank in terms of the equity distribution. This is a negative side of the
coin. The positive side is that through the banking system wit interest, nonnancial sector obtains enough money for productive investment that enables
economic growth and eventually an increase in non-nancial sectors equity.
The fundamental question is whether this increase in the non-nancial sectors equity is large enough to compensate the exploitation of its equity by
banking system. In system dynamics, this nancial (interest) system of deposits and debts can be described by a simple model illustrated in Figure 6.8.
161
Equity (Non-Financial)
2 3 4
1
1 2
1
1
3
4
2 4
3
200
1
2 4
3
40
2
3 4 2
140
30
3 4 2
4
Dollar
Dollar
4
3
80
4
3
2
3
4
4
20
20
10
4
4
-40
0
0
12
16
Time (Year)
1
1
3
20
1
24
1
1
3
28
1
3
0
1
3 4
2 3 4
1
1 2 4
3 1 2
3 4 1 2
2
1
3
1 2
1 2
1 2
12
16
Time (Year)
1
1
3
1
3
1
2
20
2
1
3
24
1
1 2
1 2
28
1
1
3
Figure 6.7: Non-Financial and Central Bank Equities under Government Debt
That is, this nancial system guarantees the innite inow of interest to the
owner of deposits and lenders.
This is nothing but the example of exponential growth explained
Bank
in chapter 1. And the reader can
Deposits /
remember its power with a built-in
Interest
Debts
doubling time. In other words, this
nancial system makes the haves
richer and richer. Once we are enslaved with debt, we are forced to
Interest
Rate
work indenitely to attain endless
economic growth for the payments
of interest if we want to avoid the Figure 6.8: Financial (Interest) System of
decline in our equity values. Oth- Deposits/ Debts
erwise, as we have seen above, our
equity eventually will be totally exploited by bankers. In other words, considering the power of exponential growth, this nancial system of distorted equity
distribution does not work consistently, and its re-settings eventually need be
necessary with nancial and economic crises and wars as our economic history
indicates.
This may lead to our ultimate question: Can the resettings together with indenitely forced economic growth work well for attaining a sustainable economy
under a nite world of resources? The answer seems to be negative. Accordingly it is always expedient to think about the option of designing an interest-free
economy as a system designer. Well challenge this in chapter 12. Until we arrive
to that chapter, let us continue to model our capitalist market macroeconomy
by focusing on the production side in the chapters to follow.
Conclusion
To create money supply out of a limited monetary base, banking system of
deposits and debts play a crucial role. This system seems to be better managed
162
Chapter 7
Aggregate Demand
Equilibria
This chapter 1 tries to model dynamic determination processes of GDP, interest
rate and price level on the same basis of the principle of accounting system
dynamics. For this purpose, a simple Keynesian multiplier model is constructed
as a base model for examining a dynamic determination process of GDP. It is
then expanded to incorporate the interest rate, whose introduction enables the
analysis of aggregate demand equilibria as well as transactions of savings and
deposits, and government debt and securities. Finally, a exible price is introduced to adjust an interplay between aggregate demand equilibrium and full
capacity output level. A somewhat surprise result of business cycle is observed
from the analysis.
7.1
163
164
consumers, banks and government. Since money supply is assumed to be exogenously determined in this chapter, central bank is excluded. Our analysis is also
limited to a closed macroeconomic system and foreign sector is not brought to
the discussion here. Figure 7.1 illustrates the overview of the standard macroeconomy in this chapter.
Commercial Banks
Loan
Saving
Consumer
(Household)
Consumption
Gross
Domestic
Products
(GDP)
Production
Producer
(Firm)
Investment
(Housing)
Public
Services
Income Tax
National Wealth
(Capital
Accumulation)
Investment
(Public Facilities)
Government
Investment (PP&E)
Public
Services
Corporate Tax
7.2
A Keynesian Model
165
Y = AD (Determination of GDP)
(7.1)
AD = C + I + G (Aggregate Demand)
(7.2)
(7.3)
Yd = Y T K (Disposable Income)
(7.4)
T = T (Tax Revenues)
(7.5)
I = I (Investment Decisions)
(7.6)
(Government Expenditures)
G=G
(7.7)
dK
= I K (Net Capital Accumulation)
dt
(7.8)
(7.9)
(7.10)
(7.11)
2 In this model, demand for and supply of labor, L, is not analyzed. To do so we need to
add another equation of population (labor) growth such as
dL
= nL
dt
which will be done in the chapters to follow.
3 Whenever price is explicitly introduced, all variables have to be expressed (or interpreted)
as real values.
166
167
, G,
L).
with 7 exogenously determined parameters (C0 , c, T, I,
C0 cT + I + G
1c
(7.12)
G,
T) =
Let us assign some numerical values to these parameters (C0 , c, I,
(24, 0.6, 120, 80, 40), then we have Y = 500.
How can such a Keynesian equilibrium GDP be attained if aggregate supply
and aggregate demand are not equal initially? The Keynesian model assumes
that aggregate supply is determined by the size of aggregate demand. Fig 7.3
illustrates how an initial GDP of Y0 continues to increase until it catches up
with the aggregate demand, and eventually attains a Keynesian equilibrium Y .
In this way the equilibrium can be always gained at a point where aggregate
demand curve meets aggregate supply curve. Comparative statics is a wellknown analytical method in standard textbooks to compare with two points of
equilibria for two dierent levels of aggregate demand.
To model these static comparisons dynamically, the determination equation
of GDP (7.1) has to be replaced with the following dierential equation:
dY
= (AD Y )/AT
dt
(7.13)
168
(7.14)
169
Determination of GDP
Determination of GDP
600
600
3
3
3
500
3
2
2
2
2
3
2
1
3 3 3 3 23 23123123123123123123123123123123123123123
1
2 2
2 12 1 1 1
2
2
2
2
400
3 3 2
2
3
2
2
1
3
2
1
3 2
2
3 3 3 3 3 23 23123 12312312312312
2 2 2 1 1
2 2 1 1 1
1
1
1
1
1
3
2
300
500
Dollar/Year
Dollar/Year
2
2
400
3
2
1
1
1
1
300
200
200
10
1 1 1 1
GDP : Current
Aggregate Demand : Current
Equilibrium GDP : Current
12 14 16 18
Time (Year)
20
22
24
26
28
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
30
1 1 1 1
GDP : Current
Aggregate Demand : Current
Equilibrium GDP : Current
10
1
12 14 16 18
Time (Year)
20
22
24
26
28
30
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
Y =
cT + I + G
1c
(7.15)
(7.16)
Suppose that Yf ull = 560. Then, to attain a full capacity level of GDP, we
need to increase Y = Yf ull Y = 60. This could be done by increasing
the investment or government expenditure by 24 (that is, Y = 2.5 24), or
decreasing tax by 40 (that is, Y = (1.5) (40)). Figure 7.3 illustrates
how Yf ull is attained by increasing aggregate demand such as investment and
government expenditures.
170
(7.17)
with the introduction of inventory stock, Inv . This adds another new unknown
variable to the macroeconomic system. Accordingly, we need an additional
equation to solve the amount of inventory. To do so, let us rst dene the
amount of desired production as a sum of the amount of inventory replacement
and aggregate demand forecasting:
YD =
(7.18)
(7.19)
Figure 7.6 illustrates our revised SD model of the Keynesian model [Companion model: 2 Keynesian(Revised).vpm]. When this model is run, we observe
that aggregate demand and production overshoot an equilibrium as illustrated
by the left-hand diagram of Figure 7.7. This overshooting behavior vividly
contrasts with a smooth adjustment process of the Keynesian model.
In the right-hand diagram investment and government expenditures are respectively increased by 10 at the periods 5 and 10, while tax is reduced by 10 at
the period 15 in the exactly same fashion as the right-hand diagram of Figure
7.5. However, output and aggregate demand do not catch up with new equilibrium levels smoothly here, instead they are shown to overshoot the equilibrium
levels. This suggests that Keynesian adjustment process is intrinsically cyclical or uctuating o equilibrium, rather than smoothly adjusting as illustrated
by many standard textbooks. This behavior may be the rst nding in our
SD macroeconomic modeling against standard Keynesian smooth adjustment
process.
171
'HWHUPLQDWLRQRI*'3
600
600
550
23
550
23
1
3
231 23
1 2 3 1 2 3 1 2 3 1 2 3 1 2 3 1 2 3 1 23 1 2
'ROODU<HDU
'ROODU<HDU
500
1
31 2 3 2 3 1 23 1 2 31 2 3 12 3 1 2
10
2
1
500
3
2
1
450
1
3
1 2
12
1 2
450
400
400
10 12 14 16 18 20 22 24 26 28 30
Time (Year)
3URGXFWLRQ&XUUHQW
1
$JJUHJDWH'HPDQG&XUUHQW
(TXLOLEULXP*'3&XUUHQW
1
2
1
2
1
2
1
2
1
2
1
2
2
3
1
3URGXFWLRQ&XUUHQW
$JJUHJDWH'HPDQG&XUUHQW
(TXLOLEULXP*'3&XUUHQW
12
14 16 18
Time (Year)
1
2
1
2
2
3
20
1
2
3
22
1
2
24
1
26
1
2
3
2
3
28
30
1
2
3
7.3
In the above Keynesian macroeconomic model, taxes, investment and government expenditures are assumed to be exogenously determined. To make it
more complete, we now try to construct these variables to be endogenously de-
172
termined. Let us begin with government taxes by assuming that they consist
of three parts: lump-sum taxes such as property taxes (T0 ), income taxes that
are proportionately determined by an income level, and government transfers
such as subsidies (Tr ):
T = T0 + tY Tr
(7.20)
Ms
V = aY bi
(7.22)
P
where V is velocity of money having a unit 1/year, a is a fraction of income for
transactional demand for money, and b is an interest sensitivity of demand for
money. P is a price level and it is treated as a sticky exogenous parameter.
From the equilibrium condition in the goods market, a relation between GDP
and interest rate, which is called IS curve, is derived as follows:
Y =
C0 + I0 + G + c(Tr T0 )
i
1 c(1 t)
1 c(1 t)
(7.23)
On the other hand from the equilibrium condition in the money market, a
relation between GDP and interest rate, called LM curve, is derived as
1 Ms
b
V + i
(7.24)
a P
a
Equilibrium GDP and interest rate (Y , i ) are now completely determined
by the IS and LM curves. For instance, the aggregate demand equilibrium of
GDP is obtained as
Y =
Y =
C0 + I0 + G + c(Tr T0 )
/b
Ms
+
V
1 c(1 t) + (a/b)
1 c(1 t) + (a/b) P
(7.25)
173
i
Co + Io + G + c(Tr T0 )
Curve
Curve
Equilibrium
i*
(Y * ,i* )
Y
1 Ms
V
a P
Y*
Co + Io + G + c(Tr To )
1 c(1 t)
(7.26)
174
(7.27)
C0 + I0 + ( c)(T0 Tr )
i
1 c ( c)t
1 c ( c)t
(7.28)
Y =
C0 + I0 + ( c)(T0 Tr )
/b
Ms
+
V
1 c ( c)t + (a/b)
1 c ( c)t + (a/b) P
(7.29)
(7.30)
(7.31)
7.4
Now we are in a position to construct our SD macroeconomic model of aggregate demand equilibria based on IS-LM curves [Companion model: 3 GDP(ISLM).vpm]. To do so, the equilibrium condition (7.22) in the money market
175
(7.33)
i
)e
V /(aY bi)
(7.34)
<Growth Rate>
Change in Money
Supply(g)
Change in
Interest Rate
Effect on
Interest Rate
Velocity of
Money
Supply of
Money
Money
Supply(g)
Initial
Interest Rate
Desired
Interest Rate
Money
Ratio
Interest Sensitivity of
Money Demand
Demand for
Money
Money
Supply
<Aggregate
Demand>
Initial Money
Supply
Change in
Money Supply
Time for
Monetary Policy
176
Producers
Let us now describe some fundamental transactions which are missing in the
standard textbook framework. We begin with producers. In the macroeconomic
system, they face two important decisions: production for this year and investment for the futures. We have already assumed that production decision is made
by the equation (7.19) by following a system dynamics approach of inventory
management, while investment decision is assumed to be made by a standard
macroeconomic investment function (7.21).
Based on these decisions, major transactions of producers are, as illustrated
in Figure 7.10, summarized as follows.
Producers are constantly in a state of cash ow decits as analyzed in
chapter 4. To make new investment, therefore, they have to borrow money
from banks and pay interest to the banks.
Out of the revenues producers deduct the amount of depreciation and pay
wages to workers (consumers) and interests to the banks. The remaining
revenues become prots before tax.
177
Consumers
Consumers have to make two decisions: how much to consume and how much
to invest the remaining income between saving and government securities - a
portfolio choice. Consumption decision is assumed to be made by a standard
consumption function (7.3). (It could also be made dependent on their nancial
assets). As to the portfolio decision we simply assume that consumers rst save
the remaining income as deposits, out of which, then, they purchase government
securities.
Transactions of consumers are illustrated in Figure 7.11, some of which are
summarized as follows.
Consumers receive wages and dividends.
In addition, they receive interest from banks and the government that is
derived from their nancial assets consisting of bank deposits and government securities.
Financial investment of government securities is made out of the account
of deposits. (In this model, no corporate shares are assumed to be purchased).
Out of the cash income as a whole, consumers pay income taxes, and the
remaining amount becomes their disposal income.
Out of their disposal income, they spend on consumption. The remaining
amount is saved. Accordingly, no cash is assumed to be withheld by the
consumers.
Government
Government faces decisions such as how much taxes to levy as revenues and
how much to spend as expenditures. Tax revenues are assumed to be collected
according to the standard formula in (7.20), while expenditures are determined
either by growth-dependent amount (7.26) or revenue-dependent amount (7.27).
In the model, expenditures are easily switched to either one. Revenue-dependent
expenditure is set as default.
Transactions of the government are illustrated in Figure 7.12, some of which
are summarized as follows.
Government receives, as tax revenues, income taxes from consumers and
corporate taxes from producers. It also levies excise tax on production.
Fund-Raising
Amount
<Borrowing>
<New C apital
Stock>
C ash
Flow
<Dividends>
<Interest paid by
Producer>
Inventory
Borrowing
Ratio
<Full Production>
Production
<Desired Production>
<Dividends>
<Interest paid
by Producer>
<Investment>
<Payment by
Producer>
<Sales>
Borrowing
Sales
<Aggregate Demand>
Financing
Activities
C ash (Producer)
Investing
Activities
Operating
Activities
<Wages>
Distribution
Ratio of Wages
<Interest paid
by Producer>
Depreciation
Dividends
Wages
Tax on Production
C hange in Excice
Tax Rate
Depreciation
Rate
C apital
(PP & E)
<Investment>
Payment by
Producer
<Tax on
Production>
Retained
Earnings
(Producer)
C apital Stock
Debt
(Producer)
Profits
Profits
before Tax
Revenues
C apital Stock
Newly Issued
C orporate Tax
Rate
C orporate
Tax
<Interest paid
by Producer>
<Depreciation>
<Wages>
<Tax on
Production>
<Production>
<Borrowing>
178
CHAPTER 7. AGGREGATE DEMAND EQUILIBRIA
<Income>
Cash
(Consumer)
Disposable
Income
Saving
Initial Shares
(Consumer)
Shares
(Consumer)
<Government De
bt Redemption>
Securities
sold by
Consumers
<Government
Securities>
Financial
Investment
(Shares)
<Capital Stock
Newly Issued>
Marginal
Propensity to
Consumer
Initial Deposits
(Consumer)
<Disposable
Income>
Consumption
Basic
Consumption
Income Tax
Government
Transfers
Lump-sum
Taxes
Income
Tax Rate
Consumer
Equity
Income
Distributed Income
Income Distribution
by Producers
<Interest paid by
Banks>
<Dividends>
<Wages>
<Depreciation>
<Interest paid by
Producer>
<Income>
<Corporate Tax>
<Dividends>
<Wages>
180
Banks
In our model, banks are assumed to play a very passive role; that is, they
only make loans to producers by the amount asked by them. In other words,
they dont purchase government securities and accordingly need to make no
portfolio decisions between loans and securities. This assumption is dropped
in the following chapters. Transactions of banks are illustrated in Figure 7.13,
some of which are summarized as follows.
Banks receive deposits from consumers, against which they pay interests.
They make loans to producers and receive interests. Prime interest rate
for loans is assumed to be the same as the interest rate for deposits. This
assumption is dropped in the following chapters.
Their retained earnings thus become interest receipts from producers less
interest payment to consumers.
7.5
(7.35)
Moreover, the full capacity output level in equation (7.14) is specied as follows:
1
Yf ull = et K
(7.36)
where is an annual increase rate of technological progress, and is a capitaloutput ratio. For simplicity, labor force is not considered here. The production
process of GDP in our SD model is illustrated in Figure 7.14.
Government
Deficit
<Government
Securities>
<Tax Revenues>
<Government Debt
Redemption>
Government
Borrowing
C ash
(Government)
Switch
(Government)
Government
Expenditure
Primary Balance
Ratio
<Tax Revenues>
Base Expenditure
Growth-dependent
Expenditure
C hange in
Expenditure
C hange in Government
Expenditure
Revenue-dependent
Expenditure
<Interest Rate>
<Growth Rate>
Debt Period
Government Debt
Redemption
Retained
Earnings
(Government)
Debt
(Government)
Tax Revenues
Government
Securities
<Income Tax>
<Tax on
Production>
<Government
Deficit>
<Interest paid by
Producer>
Cash in
Cash
(Banks)
Lending
Cash out
<Borrowing>
Loan
Interest paid by
Banks
<Financial
Investment
(Securities)>
Deposits out
<Interest Rate>
Retained
Earnings
(Banks)
Deposits
(Banks)
<Saving>
Interest paid
by Producer
<Loan>
<Securities
sold by
Consumers>
Deposits in
182
CHAPTER 7. AGGREGATE DEMAND EQUILIBRIA
Capital
(PP & E)
Desired
Production
Depreciation
Capital-Output
Ratio
Technological
Change
Full
Production
Inventory
Sales
<Investment>
Change in
AD
Forecasting
Desired
Inventory
Normal Inventory
Coverage
Errors of Initial AD
Forecasting
Aggregate Dem
and Forecasting
Adjustment for
Inventory
Inventory Adju
stment Time
Production
Forecasting Adj
ustment Time
Aggregate
Demand
Consumption
<Disposable Income>
Government
Expenditure
Investment
Interest Sensitivity
of Investment
<Interest Rate>
Investment Base
<Growth-dependent
Expenditure>
<Revenue-dependent
Expenditure>
<Depreciation>
Net Investment
Marginal Propensit
y to Consumer
Basic
Consumption
184
Top diagram in Figure 7.15 shows mostly equilibrium growth path of production around full capacity level. Bottom diagram is loci of aggregate demand
equilibrium (Y , i ) such as an intersection between IS-LM curves as illustrated
in Figure 7.8. Our model can capture these dynamic movements of the aggregate demand equilibria in contrast with comparative static ones in standard
textbooks. This may be another contribution of SD macroeconomic modeling.
1 2
300 Dollar/Year
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12
12
0 Dollar/Year
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12
10
12
15
20
Time (Year)
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185
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Monetary Policy
How can we, then, attain a true Yf ull equilibrium in which full capacity output
is completely sold out? As already illustrated in Figure 7.3, it could be done by
an increase in aggregate demand. The essence of the Keynesian theory is that
aggregate demand can be stimulated by monetary and scal policies; that is,
macroeconomy is manageable!
Let us examine monetary policy rst by increasing the amount of money
supply by 8 at period 12. According to textbook explanation, this increase in
money supply shifts the LM curve to the right, and accordingly i is lowered
186
while Y increases. In the top diagram of Figure 7.17 a full capacity equilibrium
is shown to be attained again around Yf ull = Y = 440 at period 17. Unfortunately, however, this equilibrium cannot be sustained, because capital continues
to accumulate and accordingly production capacity also continues to increase,
eventually exceeding aggregate demand.
Bottom diagram shows how interest rate begins to decline due to the increase
in money supply. However, it eventually begins to increase as aggregate demand
fails to sustain a full capacity equilibrium.
12
1 2
300 Dollar/Year
-0.26 1/Year
10
1
2
2
3
3
4
5
6
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1
3
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20
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Production
1
443
1
461
1
Fiscal Policy
Now we try to attain a Yf ull equilibrium through scal policy in place of monetary policy. Specically we try to increase government expenditures by 16 at
period 14. According to textbook explanation, this increase shifts the IS curve
187
to the right and stimulates the economy by increasing Y . However, as illustrated in the bottom diagram of Figure 7.18, it also pushes up i , and eventually
discourages investment, which is a well known crowding-out eect of government
expenditures.
12
1 2
300 Dollar/Year
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12
10
6
12
12
12
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188
Interest Rate
2.5
Percent/Year
2.125
3
3
1
1.75
2
3
3
12
1.375
23 1
1 2 31 2 3 1
2
2
1
0
10
15
20
Time (Year)
1
1
2
1
2
25
1
2
1
2
30
1
2
1
2
35
2
3
Government Debt
Figure 7.20 shows how government debt has accumulated by this scal policy
from 0 at the period 14 to 417 at the period 35, which is close to the GDP of
427. In reality the increasing government debt will lower the price of government
securities, and further increase the interest rate. This will not only cause a loss of
government credibility, but also bring investment activities simultaneously to a
complete standstill; in short, a total breakdown of national economy eventually.
In standard textbooks scal policy is usually introduced as a very eective
policy to stimulate the economy, while the skyrocketing eect of government
debt, the other side of the coin, is left out from the picture, giving an impression
to the students that scal policy works well without any problem. Our system
dynamics analysis is able to successfully capture the other side of the coin.
Hence, this could be another contribution of our SD macroeconomic modeling.
In this Keynesian aggregate demand analysis, no feedback structure is built
in to reverse the situation of hyper-ination and a possible collapse of the economy, simply because price is assumed to be xed, which will be dropped in the
next section.
7.6
Price Flexibility
189
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450 Dollar
160 Dollar/Year
5
80 Dollar/Year
225 Dollar
80 Dollar/Year
2
1 2
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5
1
3
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Ms
V,
P
(7.37)
where A and B are combined constant amounts. Then it becomes clear that
this equation only provides a relation between Y and P . Hence, Y is called
an aggregate demand function of price. It is now obvious that, unless price is
exible, there exists no mechanism to attain a true equilibrium such that
Yf ull = Y (P )
(7.38)
It is shown in the previous section that, even though monetary and scal
policies can attain a full capacity production equilibrium, central bank and government need to constantly ne-tune their policies to sustain such equilibrium.
Can they really perform the task under a sticky price in the short run? If so,
how short is a short run, practically speaking, to apply such policies?
From a dynamic point of view, its very hard to specify how short is a short
run. Is this moment in the short run or in the long run? It depends on when
to specify an initial point. This moment could be in the short run to justify
current policies. Or it could be already in the long run, and a long-run price
adjustment mechanism, to be discussed below, may be under way. If so, current
policy applications might worsen economic situations.
190
= (Y D Yf ull , Iinv
Iinv ).
(7.39)
dt
Let us specify the equation, as in the interest equation (7.33), as follows:
dP
P P
=
dt
Delay Time
(7.40)
P
(1
Y
) Yf ull
D
)e
(7.41)
+ Iinv
inv
191
Delay Time of Interest
Rate Change
Interest Rate
<Growth Rate>
Change in Money
Supply(g)
Change in
Interest Rate
Effect on
Interest Rate
Velocity of
Money
Desired
Interest Rate
Money
Ratio
Supply of
Money
Money
Supply(g)
Initial
Interest Rate
Interest Sensitivity of
Money Demand
Demand for
Money
Money
Supply
<Aggregate
Demand>
Initial Money
Supply
Change in
Money Supply
Time for
Monetary Policy
Delay Time of
Price Change
Ratio Elasticity
(Effect on Price)
<Full
Production>
<Desired
Production>
Price
Change in Price
Production
Ratio
Effect on Price
<Inventory>
<Desired
Inventory>
Initial Price
Level
Desired
Price
Inventory
Ratio
Weight of
Inventory Ratio
192
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193
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Figure 7.26: Growth, Price, Money Supply, Demand and Interest Rate
195
Supply of Money
Interest Rate
100
85
123 1 3
2
3
1 2
70
12
3 1
1 2
3
3
3
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3
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15
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20
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3
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1
1
3
Figure 7.27: Growth-dependent Money Supply and its Eect on Interest Rate
stimulate an economic growth incessantly, but destabilize the economic behaviors, contrary to a monetarist belief that constant growth of money according
to the economic growth stabilizes the economy.
Growth Rate
0.06
Production
600
0.03
400
1 231 2
1 2
12
3
12
1 2
1
12
12
3 12
12
12
3
1 2
1
3
1
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1 2
300
12
-0.03
1/Year
Dollar/Year
500
3
2
200
-0.06
0
10
15
20
Time (Year)
25
1
2
1
2
1
2
30
1
2
3
1
2
35
1
2
3
1
2
10
2
15
20
Time (Year)
1
1
3
1
3
1
3
25
1
1
3
30
1
1
3
35
1
1
3
7.7
Keynesian IS-LM model has a serious limitation; that is, money supply is exogenously given. On the contrary our SD approach of IS-LM model can treat
money supply endogenously, which is now presented in this section [Companion model: 4 GDP(IS-Money).vpm]. Money supply is dened in the previous
chapters as follows:
Money Supply = Currency in Circulation + Deposits
(7.43)
196
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2
2
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3
3
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372
403
434
465
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1
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1
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1
2
1
2
1
2
1
2
1
2
1
2
1
2
2
3
i
Supply of Money
Demand for Money
)e
(7.44)
Figure 7.30 shows a revised processes of interest rate and price adjustment.
In this way, our IS-LM model now becomes more comprehensive. Yet, it has
a serious theoretical aws. First, money supply cannot be changed without the
central bank, and secondly, real and monetary quantities are being mixed up.
These will be xed in the next chapter by integrating real and monetary sectors
presented in this and previous two chapters.
Even so, its worth a while to observe how our comprehensive SD model
behaves in comparison with a traditional Keynesian IS-LM model presented
above.
<Desired
Inventory>
<Inventory>
<Desired
Production>
<Full
Production>
<Cash (Banks)>
<Cash (Government)>
<Cash (Producer)>
<Cash (Consumer)>
Change in
Deposits
Ratio Elasticity
(Effect on Price)
<Deposits
(Banks)>
Currency in
Circulation
Velocity of
Money
Weight of
Inventory Ratio
Inventory
Ratio
Effect on Price
Delay Time of
Price Change
Money
Supply
Supply of
Money
Production
Ratio
Desired
Price
Change in Price
Actual
Velocity of
Money
Money
Ratio
Effect on
Interest Rate
Price
Initial Price
Level
Demand for
Money
Desired
Interest Rate
Interest Rate
Initial Interest
Rate
<Lending>
<Cash out>
<Government
Expenditure>
<Interest paid by
the Government>
<Government Debt
Redemption>
<Saving>
<Consumption>
<Income Tax>
<Dividends>
<Investment>
<Payment by Producer>
198
Price Flexibility
Let us now trigger disequilibria in a dierent way by introducing a technological
progress of 0.3 % annually.
As Figure 7.31 indicates, aggregate demand and production fail to catch up
with full production around the period of 14 due to the increase in its productivity. Under the circumstance, let us allow a price exibility by setting a value
of ratio elasticity of eect on price to be 1.5.
Figure 7.32 illustrates how a production gap can be lled with business
cycles.
Figure 7.33 illustrates aggregate demand and supply curves.
7.8
Conclusion
7.8. CONCLUSION
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Yf ull
=
=
1
K (Full Capacity Output)
(Inv
Inv ) + AD (Desired Production)
Y AD (Inventory Adjustment)
(7.48)
=
=
C + I + G (Aggregate Demand)
C0 + cYd (Consumption Decisions)
(7.49)
(7.50)
Yd
T
=
=
(7.51)
(7.52)
Y T K (Disposable Income)
T0 + tY Tr (Tax Revenues)
I0
i (Investment Decisions)
i
(7.54)
(7.55)
(7.56)
Y
dInv
dt
AD
C
dK
dt
dG
dt
dP
dt
ms
md
di
dt
Ms
V (Real Money Supply)
P
aY bi (Demand for Money)
(7.45)
(7.46)
(7.47)
(7.53)
(7.57)
(7.58)
(7.59)
This macroeconomic model consists of 15 equations with 15 unknown variables; that is, Yf ull , K, Y, Y D , Inv , AD, C, I, G, Yd , T, I, P, M S, M D).
Chapter 8
8.1
This chapter tries to integrate real and monetary parts of the macroeconomy
that have been so far analyzed separately in the previous chapters [Companion model: Nominal GDP.vpm]. For this purpose, at least ve sectors of the
macroeconomy have to play macroeconomic activities simultaneously; that is,
producers, consumers, banks, government and central bank. Figure 8.1 illustrates the overview of a macroeconomic system in this chapter, and shows how
these macroeconomic sectors interact with one another and exchange goods and
services for money. Foreign sector is still excluded from the current analysis.
The reader will be reminded that the integrated model to be developed
in this chapter is a generic one by its nature, and does not intend to deal
with some specic issues our macroeconomy is currently facing. Once such a
generic macroeconomic model is build, we believe, any specic macroeconomic
issue could be challenged by bringing real data in concern to this generic model
without major structural changes in this integrated model.
1 This chapter is partly based on the paper: Integration of Real and Monetary Sectors with
Labor Market SD Macroeconomic Modeling (3) in Proceedings of the 24th International
Conference of the System Dynamics Society, Nijmegen, The Netherlands, July 23 - 27, 2006.
(ISBN 978-0-9745329-5-0)
Central Bank
Money Supply
Banks
Loan
Saving
Consumer
(Household)
Consumption
Gross
Domestic
Products
(GDP)
Production
Producer
(Firm)
Investment
(Housing)
National Wealth
(Capital
Accumulation)
Investment (PP&E)
Public Services
Investment (Public
Facilities)
Income Tax
Government
Public Services
Corporate Tax
8.2
Let us now start to explain some major changes made to the previous models
in order to integrate them.
205
(8.1)
Investment Function
The amount of desired investment is obtained as the dierence between desired
and actual capital stock plus depreciation such that
I(i) =
K (i) K
+ K
Time to Adjust Capital
(8.2)
I0
i
i
(8.4)
Technological
Change
Capital-Output
Ratio
Depreciation
Rate
Full Capacity
GDP
<Interest Rate>
Interest
Sensitivity
Desired Capital
(real)
Initial Capital
(real)
Capital under
Construction
Change in AD
Forecasting
Net Investment
(real)
<Capital-Output
Ratio>
Time to Adjust
Capital
Investment
(real)
<Price>
Time to Adjust
Forecasting
Government
Expenditure (real)
<Investment
(real)>
Consumption
(real)
<Price>
<Full Capacity
GDP>
Growth Rate
Growth Covertion
to %
Long-run
Production Gap
<Switch>
Government
Expenditure
<GDP (real)>
Production(-1)
Growth Unit
<Effect on
Consumption>
<Price>
Consumption
Time to Adjust
Forecasting (Long-run)
Change in AD
Forecasting (Long-run)
Aggregate
Demand
Forecasting
(Long-run)
Aggregate
Demand (real)
Gross Domestic
Expenditure (real)
<Investment>
Normal Inventory
Coverage
Time to Adjust
Inventory
Sales (real)
Desired
Investment (real)
Capital
Completion
Construction
Period
Aggregate
Demand
Forecasting
Desired
Inventory
Desired Inventory
Investment
<Initial Inventory>
Inventory (real)
<Excise Tax
Rate>
Exponent
on
Capital
Depreciation
(real)
Desired Output
(real)
GDP (real)
Inventory
Investment
207
Consumption Function
In the previous model, consumption is assumed to be determined by a constant marginal propensity to consume as expressed in equation (7.3). Now that
nominal price is explicitly used in the integrated model, its appropriate to consider that consumers respond to a price level. Specically, marginal propensity
to consume is now assumed to be dependent on a relative price elasticity of
consumption such that
c(P ) = (
c
P
P0
)e
(8.5)
(8.6)
The consumption function thus dened has a feature of a downward-sloping demand function, similar to a demand curve of microeconomic level of consumers.
(8.7)
(8.8)
<Desired
Inventory>
<Inventory (real)>
<Desired
Output (real)>
<Full Capacity
GDP>
Currency in
Circulation
Weight of
Inventory Ratio
Inventory
Ratio
Money
Supply
Velocity of
Money
Delay Time of
Price Change
Effect on Price
Ratio Elasticity
(Effect on Price)
<Deposits (Banks)>
Production
Ratio
<Vault Cash
(Banks)>
<Cash (Government)>
<Cash (Producer)>
<Cash (Consumer)>
Desired
Price
Change in Price
Supply of
Money
(real)
Initial Price
level
Demand for
Money
(real)
Price
Actual
Velocity of
Money
Money
Ratio
Desired
Interest Rate
Initial
Interest
Rate
Interest Rate
(nominal)
Inflation Rate
Price (-1)
Demand
for Money
Interest Rate
<Discount Rate>
Change in
Interest Rate
Effect on
Interest Rate
Discount Rate
Change Time
Discount Rate
Change
Demand for
Money by Banks
Demand for
Money by the
Government
Demand for
Money by
Consumers
Demand for
Money by
Producers
<Inflation Rate>
<Lending
(Banks)>
<Payment by
Banks>
<Securities
purchased by
Banks>
<Cash out>
<Government
Expenditure>
<Interest paid by
the Government>
<Government Debt
Redemption>
<Cash Demand>
<Saving>
<Consumption>
<Income Tax>
<Dividends>
<Interest paid
by Producer>
<Desired
Investment>
<Payment by
Producer>
45
0.2
Dmnl
Dollar/Year
30
-0.2
15
-0.4
0
0
0
10
15
20
25
30
Time (Year)
35
40
45
10
15
20
50
25
30
Time (Year)
35
40
45
50
Figure 8.4: Lending by the Central Bank and its Growth Rate
In this way, the central bank begins to exert an enormous power over the
economy through its credit control. What happens if the central bank fails to
supply enough currency intentionally or unintentionally? An inuential role
of the central bank which caused economic bubbles and the following burst in
Japan during 90s was completely analyzed by Warner in [54, 55]. Our macroeconomic model might provide an analytical foundation to support his new ndings
in the role of the central bank.
(8.9)
The dierence between these two interest rates is made large enough to
avoid negatively retained earnings of banks. Moreover, it is assumed here that
positive earnings, if any, will be completely distributed among bank workers as
consumers.
With the introduction of credit loan by the central bank, another type of
interest rate needs to be applied to the transaction, which is called a discount
211
rate. The central bank is given a power to set its rate as a part of its monetary
policies whenever making loans to commercial banks. It is set to be 0.8%, or
0.008 in our model.
Now the economy has four dierent types of interest rates; discount rate,
real rate of interest, nominal rate of interest, and prime rate6 . How are they
related one another? It is assumed that the initial value of the real rate of
interest (which is set to be 0.02 in our model) is increased by the amount of
discount rate such that
Initial value = initial interest rate + discount rate
(8.10)
Nominal rate of interest and prime rate are assumed to be determined in our
previous models as
Interest rate (nominal) = real interest rate + ination rate
(8.11)
(8.12)
and
where prime rate premium is set to be 0.03 in our model to attain positive prots
to the banks. Accordingly, discount rate aect all of the other three types of
interest rate, giving a legitimacy of monetary policies to the central bank.
8.3
Let us now describe some transactions by the central bank that is additionally
brought to the model here. For the convenience to the reader, let us also repeat some of the transactions, with some revisions, by producers, consumers,
government and banks that were already presented in the previous chapters.
Producers
Major transactions of producers are, as illustrated in Figure 8.5, summarized as
follows.
Out of the GDP revenues producers pay excise tax, deduct the amount of
depreciation, and pay wages to workers (consumers) and interests to the
banks. The remaining revenues become prots before tax.
They pay corporate tax to the government out of the prots before tax.
The remaining prots after tax are paid to the owners (that is, consumers)
as dividends.
6 To be precise, an overnight rate needs to be added, which is called a federal fund rate
in the United States, or a call rate in Japan. It is the interest rate applied to the loans of
reserved fund at the central bank by commercial banks. Current monetary policy is said to
use this rate as a target rate so that it could inuence all the other interest rates. In this
model, it is represented by the discount rate for simplicity.
Consumers
Transactions of consumers are illustrated in Figure 8.6, some of which are summarized as follows.
Consumers receive income as wages and dividends from producers.
Financial assets of consumers consist of bank deposits and government
securities, against which they receive nancial income of interests from
banks and government. (In this chapter, no corporate shares are assumed
to be held by consumers).
In addition to the income such as wages, interests, and dividends, consumers receive cash whenever previous securities are partly redeemed annually by the government.
Out of these cash income as a whole, consumers pay income taxes, and
the remaining income becomes their disposal income.
Out of their disposal income, they spend on consumption. The remaining
amount are either saved or spent to purchase government securities.
Government
Transactions of the government are illustrated in Figure 8.7, some of which are
summarized as follows.
Government receives, as tax revenues, income taxes from consumers and
corporate taxes from producers as well as excise tax on production.
Government spending consists of government expenditures and payments
to the consumers for its partial debt redemption and interests against its
securities.
Government expenditures are assumed to be endogenously determined
by either the growth-dependent expenditures or tax revenue-dependent
expenditures.
If spending exceeds tax revenues, government has to borrow cash from
banks and consumers by newly issuing government securities.
<Lending
(Banks)>
<New Capital
Shares>
Cash
Flow
<Desired
Investment>
<Dividends>
<Producer Debt
Redemption>
<Interest paid
by Producer>
Desired
Borrowing
(Producer)
Direct Financing
Ratio
Desired
Financing
<GDP
(Revenues)>
Sales
<Interest paid by
Producer>
<Producer Debt
Redemption>
<Investment>
<Payment by
Producer>
<Sales>
<Lending (Banks)>
New Capital
Shares
<Dividends>
Inventory
<Price>
<Sales (real)>
Financing
Activities
Cash (Producer)
Investing
Activities
Operating
Activities
Investment
Desired
Investment
Capital
(PP&E)
<Price>
<Desired
Investment
(real)>
<Producer Debt
Redemption>
Distribution Ratio
of Wages
<Corporate Tax>
<Interest paid
by Producer>
Depreciation
Dividends
Wages
Tax on Production
Excise Tax
Rate
Producer Debt
Redemption
Producer
Debt Period
<Depreciation
(real)>
<Corporate Tax>
<Wages>
<Initial Capital
(real)>
Payment by
Producer
<Tax on
Production>
Dividends Ratio
Retained Earnings
(Producer)
Capital Shares
Debt (Producer)
Profits
Corporate
Tax
Corporate
Tax Rate
Profits
before Tax
GDP (Revenues)
<Tax on
Production>
<Depreciation>
<Interest paid
by Producer>
<Wages>
<New Capital
Shares>
<Price>
<GDP (real)>
Capital Shares
Newly Issued
<Lending (Banks)>
<Gold
Certificates>
<Income>
Disposable
Income
Currency Ratio
Table
Cash
(Consumer)
Currency
Ratio
Cashing
Time
Cash
Demand
Saving
<Disposable
Income>
Securities sold
by Consumer
<Government
Securities Newly
Issued>
<Price>
Price Elasticity
<Government Debt
Redemption>
Initial Security
Holding Ratio
held by
Consumer
Government
Securities
(Consumer)
<Initial Capital
Shares>
Shares
(held by
Consumer)
<Debt Redemption
Ratio by Banks>
Debt Redemption
Ratio by Consumer
Securities purchased
by Consumer
Financial
Investment
(Shares)
<Capital Shares
Newly Issued>
Effect on
Consumption
Initial Deposits
(Consumer)
Deposits
(Consumer)
Marginal Propensity
to Consume
Consumption
Basic
Consumption
Income Tax
Government
Transfers
Income Tax
Rate
Lump-sum Taxes
Consumer Equity
Distributed
Income
Income
Distribution
by Producers
Income
<Gold Deposit>
<Interest paid by
Banks (Consumer)>
<Dividends>
<Wages (Banks)>
<Wages>
<Depreciation>
<Interest paid by
Producer>
<Income>
<Corporate Tax>
<Dividends>
<Wages>
Government
Deficit
<Government
Securities Newly
Issued>
<Tax Revenues>
Initial Cash
(Government)
<Government Debt
Redemption>
Government
Borrowing
Cash (Government)
Base Expenditure
Growth-dependent
Expenditure
Change in
Expenditure
Change in Government
Expenditure
Primary
Balance
<Tax Revenues>
Primary Balance
Ratio
Revenue-dependent
Expenditure
Government
Expenditure
Switch
<Interest Rate
(nominal)>
<Growth Rate>
Primary Balance
Change Time
Primary Balance
Change
Government Debt
Redemption
Government
Debt Period
Retained Earnings
(Government)
Initial Government
Debt
Debt (Government)
Debt-GDP ratio
Tax Revenues
Government Securities
Newly Issued
<GDP
(Revenues)>
<Income Tax>
<Corporate Tax>
<Tax on
Production>
<Government
Deficit>
Banks
Transactions of banks are illustrated in Figure 8.8, some of which are summarized as follows.
Banks receive deposits from consumers, against which they pay interests.
They are obliged to deposit a fraction of the deposits as the required
reserves with the central bank (which is called a fractionalreserve banking
system).
Out of the remaining deposits they purchase government securities, against
which interests are paid from the government.
Then, loans are made to producers and they receive interests for which a
prime rate is applied.
Their retained earnings thus become interest receipts from producers and
government less interest payment to consumers. Positive earning will be
distributed among bank workers as consumers.
Central Bank
In this integrated model, the central bank plays a very important role of providing a means of transactions and store of value; that is, currency. To make a
story simple, its sources of assets against which currency is issued are conned
to gold, discount loans and government securities. The central bank can control
the amount of money supply through the amount of monetary base consisting
of currency outstanding and reserves over which it has a direct power of control. This is done through monetary policies such as a manipulation of required
reserve ratio and open market operations as well as direct lending control.
Transactions of the central bank are illustrated in Figure 8.9, some of which
are summarized as follows.
The central bank issues currency or money (historically gold certicates)
against the gold deposited by the public.
It can also issue currency by accepting government securities through open
market operation, specically by purchasing government securities from
the public (consumers) and banks. Moreover, it can issue currency by
making discount loans to commercial banks. (These activities are sometimes called money out of nothing.)
It can similarly withdraw currency by selling government securities to the
public (consumers) and banks, and through debt redemption by banks.
Banks are required by law to reserve a certain fraction of deposits with
the central bank. By controlling this required reserve ratio, the central
Desired
Borrowing
(Banks)
<Payment by
Banks>
Cash Flow
Deficit
(Banks)
<Interest Income
(Banks)>
<Producer Debt
Redemption>
<Securities sold
by Banks>
<Desired
Borrowing
(Producer)>
<Securities
purchased by
Banks>
<Reserves
Deposits>
<Cash out>
Cash in
<Lending
(Central Bank)>
<Deposits in>
Vault Cash
(Banks)
<Excess
Reserves>
<Desired
Borrowing
(Producer)>
Lending (Banks)
<Government Securities
Newly Issued>
Securities
purchased by
Banks
Reserves
AT
Adjusting
Reserves
Reserves
Deposits
Cash out
<Deposits out>
<Banks Debt
Redemption>
Loan
(Banks)
Debt Redemption
Ratio by Banks
Government
Securities
(Banks)
<Producer Debt
Redemption>
Securities sold by
Banks
Interest paid by
Banks
(Consumer)
Banks Debt
Redemption
Wages (Banks)
Interest paid
by Banks
Interest paid by
Banks (Central
Bank)
Deposits out
Banks Debt
Period
<Securities
purchased by
Consumer>
<Financial
Investment
(Shares)>
<Cash
Demand>
<Government Debt
Redemption>
Debt
(Banks)
Retained
Earnings
(Banks)
<Saving>
Profits (Banks)
Interest Income
(Banks)
<Loan (Banks)>
Prime Rate
Premium
<Interest paid by
Banks>
Interest paid by
Producer
Prime Rate
Deposits in
Borrowing
(Banks)
<Lending (Central
Bank)>
<Debt (Banks)>
Discount
Rate
<Interest Rate
(nominal)>
Deposits
(Banks)
Net Deposits
Excess Reserve
Ratio
Excess Reserves
Open Market
Operations
Reserves
(Banks)
Required
Reserves
Required
Reserve
Ratio
RR Ratio Change
8.4
(8.13)
If the economy is not in the equilibrium state, then actual GDP is determined
by
GDP = MIN (Full Capacity GDP, Desired Output )
(8.14)
In other words, if desired output is greater than full capacity GDP, then actual
GDP is constrained by the production capacity, meanwhile in the opposite case,
GDP is determined by the amount of desired output which producers wish to
produce, leaving the capacity idle.
Does the equilibrium state, then, exist in the sense of full capacity GDP? By
trial and error, mostly equilibrium states are acquired in the integrated model
when a ratio elasticity of the eect on price e is 1, and a weight of inventory
ratio is 0.1, as illustrated in Figure 8.10.
The reader may wonder why this is a state of mostly equilibria, because
growth rates and ination rates still uctuate as shown in Figure 8.11. Specifically, growth rates uctuates between 0.8% and - 0.2%, and ination rates
between 0.2% and - 0.2%. Our heart pulse rate, even a healthy person, uctuates between 60 and 70 per minute. This is a normal state. In a similar fashion,
it is reasonable to consider these uctuations as normal equilibrium states.
In what follows, these equilibrium states are used as a benchmarking state
of the comparison, and illustrated by line 2 or red lines in the Figures below.
<Government
Securities
(Consumer)>
Open Market
Purchase (Public Sale)
Lending
Time
Lending by
Central Bank
Lending (Central
Bank) (-1)
Growth Rate of
Credit
Open Market
Purchase Time
Purchase Period
Open Market
Purchase Operation
(temporary)
Open Market
Purchase Operation
(permanent)
Open Market
Purchase
Lending
Period
Gold
<Initial Gold held
by the Public>
Sales Period
Open Market
Sale Time
Monetary Base
Notes Withdrown
Decrease in
Reserves
<Interest Income
(Central Bank)>
Gold Certificates
<Banks Debt
Redemption>
<Government Securities
(Banks)>
Open Market
Purchase (Banks Sale)
Government
Securities
(Central Bank)
Discount Loan
(Central Bank)
Window Guidance
Gold Deposit
Lending (Central
Bank)
<Desired Borrowing
(Banks)>
Deposit Time
Gold Deposit by
the Public
Retained
Earnings
(Central Bank)
Reserves
(Central Bank)
<Lending
(Central Bank)>
<Interest paid by
Banks (Central Bank)>
Increase in
Reserves
<Open Market
Purchase (Banks Sale)>
<Adjusting
Reserves>
<Reserves
Deposits>
Notes Newly
Issued
Interest Income
(Central Bank)
Reserves by
Banks
Currency
Outstanding
<Open Market
Purchase (Public
Sale)>
450
12
DollarReal/Year
1 23
1 23
1 23
23
1 23
1 23
300
4
12
12 3
150
5
0
0
10
15
20
25
30
Time (Year)
1
2
4
1
3
35
1
40
1
45
1
3
50
0.007
0.001
1/Year
1/Year
Growth Rate
0.01
0.004
0.001
-0.001
-0.002
-0.002
0
10
15
20
25
30
Time (Year)
35
40
45
50
10
15
20
25
30
Time (Year)
35
40
45
50
Fixprice Disequilibria
We are now in a position to make some analytical simulations for the model.
First, let us show that without price exibility its hard to attain mostly equilibrium states. When price is xed; that is, ratio elasticity of the eect on price
is set to be zero, disequilibria begin to appear all over the period. Figure 8.12
illustrates how xprice causes disequilibria everywhere. The economy seems to
stagger; that is, economic growth rates become lower than the equilibrium ones
over many periods.
221
Growth Rate
GDP(real)
0.01
500
1
2
2
0.0065
12
12
387.5
1
1
0.003
1
1
1
1
12
2
2
425
1/Year
DollarReal/Year
462.5
-0.0005
2
1
350
-0.004
0
10
15
20
25
30
Time (Year)
1
2
1
2
35
1
2
1
2
40
1
45
1
2
50
10
15
1
2
20
25
30
Time (Year)
1
2
1
2
1
2
35
40
1
2
1
2
45
1
2
50
1
2
*URZWK5DWH
500
0.04
1
1
462.5
2
2
425
387.5
12
12
12
12
12
12
0.02
12
<HDU
'ROODU5HDO<HDU
12
1
2
1
12
1
2
12
12
12
-0.02
350
-0.04
0
10
15
20
25
30
Time (Year)
1
2
1
2
35
1
2
1
2
40
1
45
1
2
1
2
50
10
15
*URZWK5DWH,QYHQWRU\
*URZWK5DWH(TXLOLEULXP
20
25
30
Time (Year)
1
2
1
2
35
1
2
1
2
40
1
45
1
50
1
2
Growth Rate
0.048
500
425
2
387.5
12
12
12
2
1
12
12
0.024
1/Year
'ROODU5HDO<HDU
462.5
12
2
1
1
1
12
12
-0.024
-0.048
350
0
10
15
20
25
30
Time (Year)
1
1
2
35
1
2
1
2
40
1
45
1
2
10
15
1
2
50
20
25
30
Time (Year)
35
40
1
45
1
2
50
1
2
0RQH\6XSSO\
0.04
1,700
2
0.035
2
1
1,250
1,025
12
12
2
1
2
1
1
1
2
2
1
1
1/Year
'ROODU
1,475
1
1
0.03
12
12
12
12
1
2
0.025
800
0.02
0
10
15
0RQH\6XSSO\&UHGLW&UXQFK
0RQH\6XSSO\(TXLOLEULXP
20
25
30
Time (Year)
1
1
2
35
1
2
1
2
40
1
45
1
2
1
2
50
10
15
20
25
30
Time (Year)
1
2
1
2
35
1
2
1
2
40
1
45
1
50
1
2
223
Growth Rate
GDP(real)
0.02
500
2
2
0.01
2
2
2
425
387.5
12
12
12
1/Year
DollarReal/Year
462.5
1
2
12
2
1
-0.01
1
350
-0.02
0
10
15
20
25
30
Time (Year)
1
1
2
35
1
2
1
2
40
1
45
1
2
1
2
50
10
15
20
25
30
Time (Year)
1
1
2
1
2
35
1
2
1
2
40
1
45
1
50
1
2
1,700
60
1
1
DollarReal/Year
Dollar/Year
1,475
45
1
1
1
30
12
0
0
12
15
1,250
1
1
1
1,025
1
12
12
12
12
12
2
2
2
2
800
5
10
15
20
25
30
Time (Year)
35
1
40
1
2
45
1
50
1
2
10
15
20
25
30
Time (Year)
35
1
40
1
45
1
50
1
Interest Rate
0.0350
500
34
1/Year
0.0312
12
0.0275
12
'ROODU5HDO<HDU
1
2
234
450
400
1 23 4 12 3
0.0237
12
34
1
4
12 3 4
2
23 4
2 34
34
23 4
350
0
0.02
0
10
15
20
25
30
Time (Year)
1
2
1
2
35
1
2
1
2
40
1
45
1
1
2
10
15
20
50
)XOO&DSDFLW\*'30RQHWDU\3ROLF\
1
'HVLUHG2XWSXWUHDO0RQHWDU\3ROLF\
*'3UHDO0RQHWDU\3ROLF\
3
$JJUHJDWH'HPDQGUHDO0RQHWDU\3ROLF\
25
30
Time (Year)
1
2
3
4
1
2
3
4
50
1
2
3
4
45
1
2
3
4
40
1
2
3
4
35
1
2
2
3
Government Debt
So long as the equilibrium path in the real sector is attained by scal policy, no
macroeconomic problem seems to exist. Yet behind the full capacity aggregate
demand growth path attained in Figure 8.18, government debt continues to
accumulate as the left diagram of Figure 8.19 illustrates. Primary balance ratio
is initially set to one and balanced budget is assumed in our model; that is,
government expenditure is set to be equal to tax revenues, as lines 1 and 2
overlap in the diagram. Why, then, does the government continue to suer
from the current decit?
In the model government decit is dened as
Decit = Tax Revenues - Expenditure - Debt Redemption - Interest
(8.15)
225
Government Expenditure
Income Tax
100
60
40
12
12
90
2
Dollar/Year
Dollar/Year
50
80
1
20
0
10
15
20
25
30
Time (Year)
1
2
1
2
1
2
35
1
40
1
2
1
2
45
1
50
1
2
2
2
12
60
12
10
15
20
25
30
Time (Year)
2
2
2
70
30
1
2
35
1
40
1
2
1
2
45
1
50
1
2
1
2
Interest Rate
0.0350
DollarReal/Year
462.5
1
1
1/Year
0.0325
1
0.0300
1
1
1
1
12
0.0275
12
425
2
2
387.5
12 34
34 1
34
3 41
3 41
1
23
234
4
12 3
23
350
0
0.0250
0
10
15
20
25
30
Time (Year)
1
2
1
2
35
1
2
1
2
40
1
45
1
50
1
2
10
15
20
25
30
Time (Year)
1
2
3
35
1
2
3
1
2
3
4
50
1
2
3
4
45
1
2
3
4
40
3
4
Figure 8.18: Fiscal Policy: Change in Income Tax Rate and Interest Rate
ing and accumulating its debt. Initial GDP in the model is obtained to be 386,
while government debt is initially set to be 200. Hence, the initial debt-GDP
ratio is around 0.52 year (similar to the current ratios among EU countries).
The ratio continues to increase to 1.98 years at the year 50 in the model as illustrated in the right diagram of Figure 8.19. This implies the government debt
becomes 1.98 years as high as the annual level of GDP (which is comparable to
the Japanese debt ratio of 1.97 in 2010).
Can such a high debt be sustained? Absolutely no. Eventually this runaway
accumulation of government debt may cause nominal interest rate to increase,
because the government may be forced to pay higher and higher interest rate in
order to keep borrowing, which may in turn launch a hyper ination7 .
On the other hand, a higher interest rate may trigger a sudden drop of
government security price, deteriorating the value of nancial assets of banks,
producers and consumers. The devaluation of nancial assets may force some
banks and producers to go bankrupt eventually. In this way, under such a hyper
inationary circumstance, nancial crisis becomes inevitable and government
is destined to collapse. This is one of the hotly debated scenarios about the
consequences of the abnormally accumulated debt in Japan, whose current debtGDP ratio is about 1.97 years; the highest among OECD countries!
Let us now consider how to avoid such a nancial crisis and collapse. At
the year 6 when scal policy is introduced to restore a full capacity aggregate
demand equilibrium in the model, the economy seems to have gotten back to
7 This feedback loop from the accumulating debt to the higher interest rate is not yet fully
incorporated in the model.
100 Dollar/Year
500 Dollar
12
12
2
1
1
3
1.5
10
15
7D[5HYHQXHV)LVFDO3ROLF\
1
*RYHUQPHQW([SHQGLWXUH)LVFDO3ROLF\
2
*RYHUQPHQW'HILFLW)LVFDO3ROLF\
3
,QWHUHVWSDLGE\WKH*RYHUQPHQW)LVFDO3ROLF\
'HEW*RYHUQPHQW)LVFDO3ROLF\ 5
20
25
30
Time (Year)
1
1
2
35
1
2
3
5
40
2
3
4
45
1
2
3
4
3
4
Year
4
5
0.5
50
'ROODU<HDU
'ROODU<HDU
'ROODU<HDU
'ROODU<HDU
'ROODU
12
12
12
12
12
12
12
12
2
2
1
1
3
3
Debt-GDP ratio
3
1 2
1 23
12
5
3
0 Dollar/Year
0 Dollar
12
1 2
1 2
2
2
12
0
0
10
15
20
25
30
Time (Year)
1
2
35
1
40
1
2
1
2
45
1
50
1
2
the right track of sustained growth path. And most macroeconomic textbooks
emphasize this positive side of scal policy. A negative side of scal policy is
the accumulation of debt for nancing the government expenditure. Yet most
macroeconomic textbooks neglect or less emphasize this negative side, partly
because their macroeconomic framework cannot handle this negative side eect
properly as our integrated model does here. In our example the debt-GDP ratio
is 0.61 years at the introduction year of scal policy.
At the face of nancial crisis as discussed above, suppose that the government
is forced to reduce its debt-GDP ratio to around 0.6 by the year 50, To attain
this goal, a primary balance ratio has to be reduced to 0.9 in our economy. In
other words, the government has to make a strong commitment to repay its
debt annually by the amount of 10 percent of its tax revenues. Let us assume
that this reduction is put into action around the same time when scal policy
is introduced; that is, the year 6. Under such a radical nancial reform, as
illustrated in Figure 8.20, debt-GDP ratio will be reduced to around 0.64 (line
1 in the right diagram) and the accumulation of debt will be eventually curved
(left diagram).
*RYHUQPHQW%XGJHW&XUUHQW'HILFLWDQG'HEW
80 Dollar/Year
400 Dollar
1
40 Dollar/Year
250 Dollar
12
1
2
Debt-GDP ratio
5
2
2
0 Dollar/Year
100 Dollar
10
15
20
25
30
Time (Year)
7D[5HYHQXHV3ULPDU\5DWLR
1
1
*RYHUQPHQW([SHQGLWXUH3ULPDU\5DWLR
2
*RYHUQPHQW'HILFLW3ULPDU\5DWLR
3
,QWHUHVWSDLGE\WKH*RYHUQPHQW3ULPDU\5DWLR
'HEW*RYHUQPHQW3ULPDU\5DWLR
5
1
2
3
5
3
4
45
2
3
40
1
2
3
35
4
5
50
'ROODU<HDU
'ROODU<HDU
'ROODU<HDU
'ROODU<HDU
'ROODU
2
23
23
1
1 23
12 3
0.5
3
12 31 2
23
1
3
3
1.5
Year
3
3
23
0
0
10
15
20
25
30
Time (Year)
1
2
2
3
35
1
2
3
40
1
2
1
2
45
1
2
3
50
1
2
1
2
227
Even so, this radical nancial reform becomes very costly to the government
and its people as well. At the year of the implementation of 10 % reduction
of a primary balance ratio, growth rate is forced to drop to minus 4.1 %, and
the economy fails to sustain a full capacity aggregate demand equilibrium as
illustrated in the left diagram of Figure 8.21. In other words, the reduction of
the primary balance ratio by 10% nullies the attained full capacity aggregate
demand equilibrium by scal policy. The right diagram compares three states
of GDP; line 3 is when price is xed, line 2 is when scal policy is applied, and
line 1 is when primary balance ratio is reduced by 10 %.
)XOO&DSDFLW\*'3*'3UHDODQG$JJUHJDWH'HPDQG
GDP(real)
500
500
3
462.5
DollarReal/Year
'ROODU5HDO<HDU
462.5
1
1
1
425
1
1
1
1
1
1
387.5
12 34
23 4
23
2 34
2 34
23 4
234
234
10
15
20
)XOO&DSDFLW\*'33ULPDU\5DWLR
'HVLUHG2XWSXWUHDO3ULPDU\5DWLR
*'3UHDO3ULPDU\5DWLR
3
$JJUHJDWH'HPDQGUHDO3ULPDU\5DWLR
25
30
Time (Year)
1
2
35
1
2
2
3
4
45
1
2
3
4
40
2
3
50
1
2
2
3
10
15
20
3
4
350
350
5
3
3
12 31 23
387.5
23
2
2
3
3
425
2
23
3
3
25
30
Time (Year)
1
2
3
35
1
2
40
1
2
1
2
45
1
2
50
2
3
Price Flexibility
Is there a way to reduce government debt without sacricing equilibrium? Monetary and scal policies above are applied to the disequilibria caused by xprice.
Let us make price exible again by setting price elasticity to be 0.7 under the
above scal situation of primary balance deduction. Left diagram of Figure 8.22
shows that equilibrium is attained at the peaks of business cycle, while right
diagram shows that government debt is reduced by 10 % deduction of primary
balance ratio.
)XOO&DSDFLW\*'3*'3UHDODQG$JJUHJDWH'HPDQG
*RYHUQPHQW%XGJHW&XUUHQW'HILFLWDQG'HEW
80 Dollar/Year
400 Dollar
500
1
1
1
12
'ROODU5HDO<HDU
462.5
425
2
1 3
387.5
12 34
12
1 3
2
34
1 23
4
41 2
12 3 4
12 34
23
0 Dollar/Year
100 Dollar
10
15
)XOO&DSDFLW\*'3)OH[LEOH3ULFH
1
'HVLUHG2XWSXWUHDO)OH[LEOH3ULFH 2
*'3UHDO)OH[LEOH3ULFH
3
$JJUHJDWH'HPDQGUHDO)OH[LEOH3ULFH
20
25
30
Time (Year)
1
2
1
2
3
4
50
1
2
3
4
45
1
2
3
4
40
1
2
3
4
35
1
2
3
4
350
5
34
40 Dollar/Year
250 Dollar
2
3
10
15
7D[5HYHQXHV)OH[LEOH3ULFH
1
*RYHUQPHQW([SHQGLWXUH)OH[LEOH3ULFH
2
*RYHUQPHQW'HILFLW)OH[LEOH3ULFH
3
,QWHUHVWSDLGE\WKH*RYHUQPHQW)OH[LEOH3ULFH
'HEW*RYHUQPHQW)OH[LEOH3ULFH
1
2
3
3
4
45
2
3
4
5
40
1
2
3
35
1
2
3
3
20
25
30
Time (Year)
1
4
5
50
'ROODU<HDU
'ROODU<HDU
'ROODU<HDU
'ROODU<HDU
'ROODU
*'3UHDO
500
'ROODU5HDO<HDU
462.5
2
1
387.5
123 45
23
51
51
3
2
425
40
45
350
0
10
15
20
25
30
Time (Year)
35
1
2
3
2
3
4
5
1
2
3
4
1
2
50
3
4
8.5. CONCLUSION
8.5
229
Conclusion
Chapter 9
A Macroeconomic System
In the previous chapter, monetary and real parts of macroeconomies are integrated to present a macroeconomic dynamic model. In this chapter1 , population dynamics and labor market is to be brought to make the integrated model
complete. This complete model is aimed to be generic, out of which diverse
macroeconomic behaviors are shown to emerge.
9.1
This chapter tries to bring population and labor market to the stage to make
the integrated model complete [Companion model: MacroSystem.vpm]. For
this purpose, at least ve sectors of the macroeconomy have to play macroeconomic activities simultaneously as in the previous integrated model; that is,
producers, consumers, banks, government and central bank. Figure 9.1 illustrates the overview of a macroeconomic system in this chapter, and shows how
these macroeconomic sectors interact with one another and exchange goods and
services for money. Foreign sector is still excluded from the current analysis.
The reader will be reminded that the complete macroeconomic model to be
developed below is a generic one by its nature, and does not intend to deal
with some specic issues our macroeconomy is currently facing. Once such a
generic macroeconomic model is build, we believe, any specic macroeconomic
issue could be challenged by bringing real data in concern to this generic model
without major structural changes in this integrated model.
9.2
Production Function
232
Central Bank
Money Supply
Banks
Loan
Saving
Consumption
Consumer
(Household)
Gross
Domestic
Products
(GDP)
Production
Producer
(Firm)
Investment
(Housing)
National Wealth
(Capital
Accumulation)
Investment (PP&E)
Public Services
Investment (Public
Facilities)
Income Tax
Public Services
Government
Corporate Tax
1
Yf ull = et K
(9.1)
where is an annual increase rate of technological progress, and is a capitaloutput ratio. In order to fully consider the role of employed labor L, it needs
to be replaced with Cobb-Douglas production function:
Yf ull = F (K, L, A) = AK L
(9.2)
(9.3)
where LF is the total amount of labor force which is dened as the sum of the
employed and unemployed labor.
233
P
(1
Y
) potential
YD
)e
(9.4)
inv
+ Iinv
(
Yf ull = et Ypotential
) (
LF
(9.6)
)
(9.7)
Now let us dene prots after tax. In our integrated model, three types of
taxes are levied: tax on production (excise tax), corporate tax and income tax.
The former two taxes are paid by producers (Figure 9.5), while income tax,
consisting of lump-sum tax and a proportional part of income tax, is paid by
consumers (Figure 9.6). With these into consideration, prots after tax are
now dened as
= ((1 t)P Yf ull (i + )PK K wL)(1 tc )
(9.8)
where t is an excise tax rate, tc is a corporate prot tax rate, i is a real interest
rate, is a depreciation rate, and w is a nominal wage rate.
One remark may be appropriate for the denition of capital cost iPK K.
The amount of capital against which interests are paid are the amount of debt
outstanding by producers (which is the same as the outstanding loan by banks)
in the integrated model, yet at an abstract theoretical level it is regarded the
same as the book value of capital from which depreciation is deducted. Our
model based on double accounting system enables to handle this distinction.
Specically, capital cost (= interest paid by producers) are calculated in the
model as
iPK K Prime Rate x Loan (or Debt by producers)
(9.9)
First order condition for prot maximization with respect to capital stock is
calculated by partially dierentiating prots with respect to capital as
234
1
1 tc
(
) ( )1 ( )
Yf ull
K
L
= (1 t)P e
(i + )PK
K
K
L
( ) ( ) ( )
Y
K
L
(1 t)P et fKull
K
L
=
(i + )PK
K
t
(1 t)P Yf ull
=
(i + )PK
K
= 0
(9.10)
(1 t)P Yf ull
(i + )PK
(9.11)
(1 t)Y
i+
(9.12)
In our model desired output Y is represented by the variable: Aggregate Demand Forecasting (Long-run) as illustrated in Figure 9.2 (see also [26]).
The amount of desired investment is now obtained as the dierence between
desired and actual capital stock such that
I(i) =
K (i) K
+ K
Time to Adjust Capital
(9.13)
K
(1 t)
=
Y
i+
(9.14)
( (i) )Y
+ K
Time to Adjust Capital
(9.15)
The new investment function obtained above replaces our previous investment function in equation (7.21) that is determined by the interest rate:
I0
ai
i
where a is an interest sensitivity of investment.
I(i) =
(9.16)
235
First order condition for prot maximization with respect to labor is calculated as follows:
(
1
1 tc
(
) ( ) ( )1
K
L
Yf ull
w
L
K
L
( ) ( ) ( )
Y
K
L
(1 t)P et fLull
K
L
w
L
(1 t)P et
=
=
(1 t)P Yf ull
w
L
0
(9.17)
(1 t)P Yf ull
.
w
(9.18)
(9.19)
(9.20)
The determination of the wage rate will be discussed in the following section.
Net employment decision is now made according to the dierence between
desired and actual amount of labor such that
L (Y , we ) L
Time to Adjust Labor
Net employment thus dened has a downward-sloping shape such that
E(Y , we ) =
E
(1 t)Y
1
=
< 0.
e
w
Time to Adjust Labor (we )2
(9.21)
(9.22)
(9.23)
(9.24)
<GDP (real)>
Capacity
Idleness
Technological
Change
Initial
Potential
GDP
Potential
GDP
Initial
Labor
Force
Exponent
on Labor
<Excise Tax
Rate>
Exponent
on Capital
Full Capacity
GDP
<Labor Force>
Initial
Capital
(real)
<Employed
Labor>
Depreciation Rate
Depreciation
(real)
Capital-Output
Ratio
Desired Output
(real)
<Interest Rate>
Interest
Sensitivity
Desired Capital
(real)
Capital under
Construction
Change in AD
Forecasting
Net Investment
(real)
<Capital-Output
Ratio>
Time to Adjust
Capital
Investment
(real)
<Price>
Time to Adjust
Forecasting
Government
Expenditure (real)
<Investment
(real)>
Consumption
(real)
<Price>
<Full Capacity
GDP>
Time to Adjust
Forecasting (Long-run)
Change in AD
Forecasting (Long-run)
Aggregate
Demand
Forecasting
(Long-run)
Aggregate
Demand (real)
Gross Domestic
Expenditure (real)
<Investment>
Normal Inventory
Coverage
Time to Adjust
Inventory
Sales (real)
Desired
Investment (real)
Capital
Completion
Construction
Period
Aggregate
Demand
Forecasting
Desired Inventory
Desired Inventory
Investment
<Initial Inventory>
Inventory (real)
Inventory (real)
Change
GDP (real)
Inventory
(real) (-1)
Inventory
Investment
Growth Rate
Growth Covertion
to %
Long-run
Production Gap
<GDP (real)>
Production(-1)
Growth Unit
<Normalized
Demand Curve>
<Switch>
Government
Expenditure
<Price>
Consumption
236
CHAPTER 9. A MACROECONOMIC SYSTEM
237
9.3
(9.25)
where L denotes demand for desired labor, while Ls indicates supply of labor
forces. Labor demand (and net employment) is in return determined by a real
wage rate in equation (9.18).
Let us further specify the wage rate equation, as in the interest rate and
price equations, as follows:
dw
w w
=
dt
DelayTime
(9.26)
(9.27)
births
High
School
College
Education
college
attendance
ratio
HS Graduation
deaths
15 to 44
Population
15 To 44
initial
population
15 to 44
<Labor Force>
Going to
College
High
schooling
time
<Voluntary
Unemployed>
maturation
14 to 15
Productive
Population
mortality
0 to 14
deaths
0 to 14
Population
0 To 14
<High School>
total fertility
reproductive
lifetime
initial
population
0 to 14
College
schooling
time
College
Graduation
Total
Graduation
mortality
15 to 44
maturation
44 to 45
Population
15 to 64
Portion to
15 to 44
Population
Voluntary
Unemployed
Initially
Unemployed
Labor
Unemployed
Labor
initial
population
65 plus
Time to Adjust
Labor
Desired
Labor
Initially
Employed
Labor
deaths 65
plus
mortality 65 plus
<Expected Wage
Rate>
<Price>
<Desired
Output
(real)>
<Excise Tax
Rate>
<Exponent
on Labor>
<Capacity
Idleness>
Labor Market
Flexibility
Retired
(Employed)
Population
65 Plus
Net
Employment
Employed
Labor
labor force
participation ratio
Retired
(Voluntary)
maturation
64 to 65
Labor
Force
New
Unemployment
Unemploy
ment rate
New
Employment
mortality
45 to 64
deaths 45
to 64
Population
45 To 64
initial
population
45 to 64
initial
population
15 to 64
238
CHAPTER 9. A MACROECONOMIC SYSTEM
239
= (Y D Ypotential , Iinv
Iinv ).
dt
(9.28)
With the introduction of wage determination in equation (9.26), it now becomes possible to add cost-push forces to the price adjustment process. Theses
forces are represented by a change in the nominal wage rate such that
d log(w)
(9.29)
dt
The price adjustment process is now inuenced by demand-pull and costpush forces as well such that
wg =
dP
= 1 (Y D Ypotential , Iinv
Iinv ) + 2 (wg )
(9.30)
dt
Figure 9.4 illustrates our revised model for adjustment processes of price and
wage rate as well as interest rate.
9.4
Let us now describe some major transactions by producers, consumers, government, banks and central bank, most of which are already described in the
previous chapter. For the convenience to the reader, they are repeated here.
Producers
Major transactions of producers are, as illustrated in Figure 9.5, summarized as
follows.
Out of the GDP revenues producers pay excise tax, deduct the amount of
depreciation, and pay wages to workers (consumers) and interests to the
banks. The remaining revenues become prots before tax.
They pay corporate tax to the government out of the prots before tax.
The remaining prots after tax are paid to the owners (that is, consumers)
as dividends.
Producers are thus constantly in a state of cash ow decits. To continue
new investment, therefore, they have to borrow money from banks and
pay interest to the banks.
<Desired
Inventory>
Currency in
Circulation
Inventory
Ratio
Production
Ratio
Money
Supply
Effect on
Price
Delay Time of
Price Change
Velocity of
Money
<Deposits (Banks)>
Weight of
Inventory Ratio
<Inventory (real)>
<Desired
Output (real)>
<Potential
GDP>
Ratio Elasticity
(Effect on Price)
<Full Capacity
GDP>
<Vault Cash
(Banks)>
<Cash (Government)>
<Cash (Producer)>
<Cash (Consumer)>
Cost-push (Wage)
Coefficient
Desired
Price
Change in Price
Supply of
Money
(real)
Initial Price
level
Real Wage
Rate
Desired
Wage
Initial Wage
Rate
Wage Rate
Inflation Rate
Price (-1)
<Inflation Rate>
Effect on
Wage
Change in
Wage Rate
Expected
Wage Rate
Demand for
Money by Banks
Demand for
Money by the
Government
Demand for
Money by
Consumers
Labor Ratio
Elasticity
Labor Ratio
<Desired Labor>
<Labor Force>
<Securities purchas
ed by Banks>
<Lending
(Banks)>
<Payment by
Banks>
Delay Time
of Wage
Change
<Cash out>
<Interest paid by
the Government>
<Government
Expenditure>
<Government Debt
Redemption>
<Cash Demand>
<Saving>
<Consumption>
<Income Tax>
<Dividends>
<Desired Investment>
<Payment by Producer>
<Discount Rate>
Demand for
Money by
Producers
Initial
Interest
Rate
Interest Rate
(nominal)
Demand
for Money
Interest Rate
Desired
Interest Rate
Wage Rate
Change
Price
Actual
Velocity of
Money
Money
Ratio
Effect on
Interest Rate
Demand for
Money
(real)
Discount Rate
Change Time
Discount Rate
Change
240
CHAPTER 9. A MACROECONOMIC SYSTEM
<Dividends>
<Lending
(Banks)>
<New Capital
Shares>
Cash
Flow
<Producer Debt
Redemption>
<Interest paid
by Producer>
Desired
Borrowing
(Producer)
Direct Financing
Ratio
Desired
Financing
<GDP
(Revenues)>
Sales
<Sales (real)>
<Interest paid by
Producer>
<Producer Debt
Redemption>
<Desired
Investment>
<Payment by
Producer>
<Sales>
<Lending (Banks)>
New Capital
Shares
<Dividends>
Inventory
<Price>
Financing
Activities
Cash (Producer)
Investing
Activities
Operating
Activities
Investment
Desired
Investment
Capital
(PP&E)
<Price>
<Desired
Investment
(real)>
<Producer Debt
Redemption>
<Wage Rate>
<Employed
Labor>
<Corporate Tax>
<Interest paid
by Producer>
Depreciation
Dividends
Wages
Tax on Production
Excise Tax
Rate
Producer Debt
Redemption
Producer
Debt Period
<Depreciation
(real)>
<Corporate Tax>
<Wages>
<Initial Capital
(real)>
Payment by
Producer
<Tax on
Production>
Dividends Ratio
Retained Earnings
(Producer)
Capital Shares
Debt (Producer)
Profits
Corporate
Tax
Corporate
Tax Rate
Profits
before Tax
GDP (Revenues)
<Tax on
Production>
<Depreciation>
<Interest paid
by Producer>
<Wages>
<New Capital
Shares>
<Price>
<GDP (real)>
Capital Shares
Newly Issued
<Lending (Banks)>
<Gold
Certificates>
<Securities sold
by Consumer>
<Income>
Disposable
Income
Currency Ratio
Table
Cash
(Consumer)
Currency
Ratio
Cashing
Time
Cash
Demand
Saving
<Disposable
Income>
<Capital Shares
Newly Issued>
Financial
Investment
(Shares)
<Government
Securities Newly
Issued>
Shares
(held by
Consumer)
<Debt Redemption
Ratio by Banks>
<Government Debt
Redemption>
Securities sold
by Consumer
Debt Redemption
Ratio by Consumer
Initial Security
Holding Ratio
held by
Consumer
Government
Securities
(Consumer)
<Initial Capital
Shares>
<Price>
NDC Table
Securities purchased
by Consumer
Initial Deposits
(Consumer)
Deposits
(Consumer)
Normalized
Demand Curve
Marginal Propensity
to Consume
Consumption
Basic
Consumption
Income Tax
Government
Transfers
Income Tax
Rate
Lump-sum Taxes
<Open Market
Purchase (Public Sale)>
Consumer Equity
Distributed
Income
Income
Distribution
by Producers
Income
<Gold Deposit>
<Interest paid by
Banks (Consumer)>
<Dividends>
<Wages (Banks)>
<Wages>
<Depreciation>
<Interest paid by
Producer>
<Income>
<Corporate Tax>
<Dividends>
<Wages>
242
CHAPTER 9. A MACROECONOMIC SYSTEM
243
Consumers
Transactions of consumers are illustrated in Figure 9.6, some of which are summarized as follows.
Consumers receive wages and dividends from producers.
Financial assets of consumers consist of bank deposits and government
securities, against which they receive nancial income of interests from
banks and government. (No corporate shares are assumed to be held by
consumers).
In addition to the income such as wages, interests, and dividends, consumers receive cash whenever previous securities are partly redeemed annually by the government.
Out of these cash income as a whole, consumers pay income taxes, and
the remaining income becomes their disposal income.
Out of their disposal income, they spend on consumption that is determined by their marginal propensity to consume and price elasticity. The
remaining amount are either spent to purchase government securities or
saved.
Government
Transactions of the government are illustrated in Figure 9.7, some of which are
summarized as follows.
Government receives, as tax revenues, income taxes from consumers and
corporate taxes from producers as well as excise tax on production.
Government spending consists of government expenditures and payments
to the consumers for its partial debt redemption and interests against its
securities.
Government expenditures are assumed to be endogenously determined
by either the growth-dependent expenditures or tax revenue-dependent
expenditures.
If spending exceeds tax revenues, government has to borrow cash from
banks and consumers by newly issuing government securities.
Banks
Transactions of banks are illustrated in Figure 9.8, some of which are summarized as follows.
Banks receive deposits from consumers, against which they pay interests.
Government
Deficit
<Government
Securities Newly
Issued>
<Tax Revenues>
Initial Cash
(Government)
<Government Debt
Redemption>
Government
Borrowing
Cash (Government)
Base Expenditure
Growth-dependent
Expenditure
Change in
Expenditure
Change in Government
Expenditure
Primary
Balance
<Tax Revenues>
Primary Balance
Ratio
Revenue-dependent
Expenditure
Government
Expenditure
Switch
<Interest Rate
(nominal)>
<Growth Rate>
Government Debt
Redemption
Government
Debt Period
Retained Earnings
(Government)
Initial Government
Debt
Debt (Government)
Tax Revenues
Government Securities
Newly Issued
<Income Tax>
<Corporate Tax>
<Tax on
Production>
<Government
Deficit>
244
CHAPTER 9. A MACROECONOMIC SYSTEM
245
They are obliged to deposit a portion of the deposits as the required reserves with the central bank (which is called a fractional banking system).
Out of the remaining deposits they purchase government securities, against
which interests are paid from the government.
Then, loans are made to producers and they receive interests for which a
prime rate is applied.
Their retained earnings thus become interest receipts from producers and
government less interest payment to consumers. Positive earning will be
distributed among bank workers as consumers.
Central Bank
In this complete macroeconomic model, the central bank plays a very important
role of providing a means of transactions and store of value; that is, money or
currency. To make a story simple, its sources of assets against which currency
is issued are conned to gold, loan and government securities. In short, money
is mostly issued as debt by the government and commercial banks. The central
bank can control the amount of money supply through the amount of monetary
base consisting of currency outstanding and reserves over which it has a direct
power of control. This is done through monetary policies such as a manipulation
of required reserve ratio and open market operations as well as direct lending
control.
Transactions of the central bank are illustrated in Figure 9.9, some of which
are summarized as follows.
The central bank issues currency or money (historically gold certicates)
against the gold deposited by the public, though this practice is currently
insignicant and only reects its historical origin of modern banking system.
It can now mainly issue currency by accepting government securities through
open market operation, specically by purchasing government securities
from the public (consumers) and banks. Moreover, it can issue currency by
making discount loans to commercial banks. (These activities are sometimes called money out of nothing.)
It can similarly withdraw currency by selling government securities to the
public (consumers) and banks, and through debt redemption by banks.
Banks are required by law to reserve a certain amount of deposits with the
central bank. By controlling this required reserve ratio, the central bank
can also control the monetary base or currency in circulation directly. The
central bank can, thus, control the amount of money supply through monetary policies such as open market operations, reserve ratio and discount
rate.
Desired
Borrowing
(Banks)
<Payment by
Banks>
Cash Flow
Deficit
(Banks)
<Interest Income
(Banks)>
<Producer Debt
Redemption>
<Desired
Borrowing
(Producer)>
<Securities
purchased by
Banks>
<Reserves
Deposits>
<Cash out>
Cash in
<Lending
(Central Bank)>
<Deposits in>
<Securities sold
by Banks>
Vault Cash
(Banks)
<Excess
Reserves>
<Desired
Borrowing
(Producer)>
Lending (Banks)
<Government Securities
Newly Issued>
Securities
purchased by
Banks
Reserves
AT
Adjusting
Reserves
Reserves
Deposits
Cash out
<Deposits out>
<Banks Debt
Redemption>
Loan
(Banks)
Debt Redemption
Ratio by Banks
Government
Securities
(Banks)
<Producer Debt
Redemption>
Securities sold by
Banks
Interest paid by
Banks
(Consumer)
Banks Debt
Redemption
Wages (Banks)
Interest paid
by Banks
Interest paid by
Banks (Central
Bank)
Deposits out
Banks Debt
Period
<Securities
purchased by
Consumer>
<Financial
Investment
(Shares)>
<Cash
Demand>
<Government Debt
Redemption>
Debt
(Banks)
Retained
Earnings
(Banks)
<Saving>
Profits (Banks)
Interest Income
(Banks)
<Loan (Banks)>
Prime Rate
Premium
<Interest paid by
Banks>
Interest paid by
Producer
Prime Rate
Deposits in
Borrowing
(Banks)
<Lending (Central
Bank)>
<Debt (Banks)>
Discount
Rate
<Interest Rate
(nominal)>
Deposits
(Banks)
Net Deposits
Excess Reserve
Ratio
Excess Reserves
Open Market
Operations
Reserves
(Banks)
Required
Reserves
Required
Reserve
Ratio
RR Ratio Change
246
CHAPTER 9. A MACROECONOMIC SYSTEM
9.5
(9.31)
If the economy is not in the equilibrium state, then actual GDP is determined
by
GDP = MIN (Full Capacity GDP, Desired Output )
(9.32)
In other words, if desired output is greater than full capacity GDP, then actual
GDP is constrained by the production capacity, meanwhile in the opposite case,
GDP is determined by the amount of desired output which producers wish to
produce, leaving the capacity idle, and workers being laid o.
Even though, full capacity GDP is attained, full employment may not be
realized unless
Potential GDP = Full Capacity GDP
(9.33)
Does the equilibrium state, then, exist in the sense of full capacity GDP and full
employment? To answer these questions, let us dene GDP gap as the dierence
between potential GDP and actual GDP, and its ratio to the potential GDP as
GDP Gap Ratio =
Ypotential GDP
Ypotential
(9.34)
By trial and error, mostly equilibrium states are acquired in the complete
macroeconomic model whenever price is exibly adjusted by setting its coefcient to be 1, together with all other adjusted parameters, as illustrated in
Figure 9.10.
Labor market is newly introduced in this model. Therefore, our analyses in
what follows are focused on the behaviors of GDP gap and unemployment. Figure 9.11 illustrates detailed behaviors of the GDP gap ratio and unemployment
rate at the almost equilibrium states. Both gures tend to converge less than
1% after the year 5, and can be well regarded as the states of almost equilibria.
In what follows, these equilibrium states are used as benchmarking states of
the comparison, and illustrated by line 2 or red lines in Figures.
Gold Standard
<Government Securities
(Consumer)>
Open Market
Purchase (Public Sale)
Lending
Time
Lending by
Central Bank
Lending (Central
Bank) (-1)
Growth Rate of
Credit
Open Market
Purchase Time
Open Market
Purchase Operation
Open Market
Purchase
Lending
Period
Gold
<Banks Debt
Redemption>
<Government Securities
(Banks)>
Open Market
Purchase (Banks Sale)
Government
Securities
(Central Bank)
Loan
(Central
Bank)
Gold Deposit
Lending (Central
Bank)
<Desired Borrowing
(Banks)>
Deposit Time
Gold Deposit by
the Public
Monetary Base
Open Market
Sale Time
Decrease in
Reserves
Retained
Earnings
(Central Bank)
Reserves
(Central Bank)
<Interest paid by
Banks (Central Bank)>
Increase in
Reserves
<Adjusting
Reserves>
<Lending (Central
Bank)>
<Open Market
Purchase (Public
Sale)>
<Reserves
Deposits>
Notes Newly
Issued
<Vault Cash
(Banks)>
<Monetary Base>
Interest Income
(Central Bank)
Reserves by
Banks
Currency
Outstanding
Currency Outstanding
(-Vault Cash)
Notes Withdrown
<Interest Income
(Central Bank)>
Gold Certificates
Monetary Base
(-Vault Cash)
248
CHAPTER 9. A MACROECONOMIC SYSTEM
350 DollarReal/Year
-0.2 1/Year
0 DollarReal/Year
-0.6 1/Year
0
10
15
20 25 30
Time (Year)
2
3
4
4
5
5
6
35
1
2
12 3
1 23
12 3
123
12 3
123
40
45
50
DollarReal/Year
DollarReal/Year
DollarReal/Year
3
4 DollarReal/Year
DollarReal/Year
1/Year
6
Unemployment rate
0.02
0.0300
0.0225
Dmnl
Dmnl
0.015
0.01
1
1
1
0.005
0.0075
0.0150
0
10
15
20
25
30
Time (Year)
35
40
1
45
1
50
10
15
20
25
30
Time (Year)
1
35
40
45
50
Figure 9.11: GDP Gap Ratio and Unemployment Rate of the Equilibrium States
Fixprice Disequilibria
We are now in a position to make some analytical simulations for the model.
First, let us show that without price exibility its hard to attain mostly equilibrium states. When price is xed; that is, price coecient is set to be zero,
disequilibria begin to appear all over the period. Left-hand diagram of Figure
9.12 illustrates how xprice causes to expand GDP gap to 17% at the year 50.
Right-hand diagram shows the unemployment rate uctuates with its peak of
3.8% at the year 7. In this way under xprice the economy seems to stagger.
250
Unemployment rate
0.2
0.04
1
1
1
0.02
0.01
1
2
12
0.05
1
1
0.1
0.03
Dmnl
Dmnl
1
1
0.15
10
15
20
25
30
Time (Year)
1
2
1
2
35
1
2
1
2
40
1
1
2
45
50
10
15
20
25
30
Time (Year)
1
2
1
2
35
1
2
1
2
40
1
45
1
50
1
2
Unemployment rate
0.1
0.1
0.075
Dmnl
Dmnl
0.075
0.05
0.025
0.05
1
1
0.025
1
2
2
12
0
0
12
10
12
2
15
2
1
12
20
25
30
Time (Year)
35
1
2
1
2
1
2
40
1
45
1
50
1
2
0
0
10
1
1
15
20
25
30
Time (Year)
1
1
2
35
1
2
40
45
50
1
2
Unemployment rate
0.1
0.06
1
0.075
0.045
1
1
0.05
Dmnl
Dmnl
1
1
1
1
1
0.025
1
1
1
1
0.03
0.015
1
2
12
0
0
10
15
20
25
30
Time (Year)
1
2
1
2
35
1
2
40
1
2
1
2
45
1
50
10
15
20
25
30
Time (Year)
1
2
1
2
35
1
2
40
45
50
1
2
Unemployment rate
0.06
0.04
0.045
0.03
Dmnl
Dmnl
1
1
0.03
0.02
12
0.015
2
1
0
0
10
1
1
15
1
2
0.01
1
2
1
2
12
20
25
30
Time (Year)
1
35
1
2
1
2
40
1
45
1
50
1
2
12
10
12
15
20
25
30
Time (Year)
1
1
2
35
1
2
1
2
40
1
1
2
45
50
1
2
252
3ULFH:DJH8QHPSOR\PHQW5DWH
0.02 1/Year
0.07 Dmnl
1
1
12
12
-0.01 1/Year
0.035 Dmnl
4 2
1
3
3
4
4
1
4
-0.04 1/Year
0 Dmnl
2
2
12
10
15
:DJH5DWH&KDQJH&RVWSXVK
,QIODWLRQ5DWH&RVWSXVK
8QHPSOR\PHQWUDWH&RVWSXVK
*'3*DS5DWLR&RVWSXVK 4
1
2
35
1
2
40
1
2
20
25
30
Time (Year)
2
3
50
<HDU
<HDU
'PQO
'PQO
1
2
45
Figure 9.16: Wage, Ination and Unemployment Rates and GDP Gap
produce these dierent behaviors of business cycles and economic uctuations
indicates a richness of our macroeconomic generic model.
Interest Rate
0.04
1,200
900
2
2
750
12
2
1
2
1
2
1
0.035
1
2
2
1/Year
'ROODU5HDO<HDU
1,050
1
1
1
1
0.03
1
12
12
12
2
2
0.025
600
0.02
0
10
15
20
25
30
Time (Year)
35
1
2
1
2
40
1
45
1
2
1
2
50
1
10
15
20
25
30
Time (Year)
1
2
1
2
35
1
2
1
2
40
1
45
1
50
1
2
Figure 9.17: Money Supply and Interest Rate caused by Credit Crunch
Figure 9.17 illustrates how money supply shrinks and, accordingly, interest
Unemployment rate
0.06
0.06
0.045
Dmnl
Dmnl
0.045
0.03
0.03
0.015
2
1
2
2
10
1
2
15
12
1
2
1
2
35
1
2
1
2
1
1
20
25
30
Time (Year)
0.015
1
1
40
1
45
1
50
1
2
0
0
10
15
12
20
25
30
Time (Year)
1
1
Unemployment rate : Credit Crunch
2
2
Unemployment rate : Equilibrium
12
12
35
40
12
1
2
12
45
50
1
2
254
Interest Rate
100
0.04
75
1
1
50
1
1
12
2
2
12
12
12
1
1
1
0.02
5
10
15
20
25
30
Time (Year)
1
2
35
1
40
1
2
45
1
2
1
2
1
2
50
10
15
1
2
20
25
30
Time (Year)
1
2
1
2
35
1
2
40
1
2
1
2
45
1
50
1
2
Unemployment rate
0.2
0.04
2
2
2
0.15
0.03
Dmnl
0.1
2
2
Dmnl
0.025
0
0
0.03
2
2
2
12
0.035
25
1/Year
Dollar/Year
12
0.02
2
2
2
0.05
2
12
0.01
10
15
20
25
30
Time (Year)
1
2
1
2
1
2
35
1
2
1
2
40
1
2
45
1
2
50
0
0
10
15
20
25
30
Time (Year)
1
1
Unemployment rate : Monetary Policy
2
2
2
Unemployment rate : Fixprice
1
2
35
40
1
2
45
50
1
2
Government Debt
So long as the equilibrium path in the real sector is attained by scal policy, no
macroeconomic problem seems to exist. Yet behind the full capacity aggregate
demand growth path attained in Figure 9.20, government debt continues to
accumulate as the left diagram of Figure 9.21 illustrates. Primary balance ratio
is initially set to one and balanced budget is assumed in our model; that is,
government expenditure is set to be equal to tax revenues, as lines 1 and 2
overlap in the diagram. Why, then, does the government continue to suer
from the current decit?
In the model government decit is dened as
Decit = Tax Revenues - Expenditure - Debt Redemption - Interest
(9.35)
Interest Rate
0.04
0.035
70
12
50
12
12
1/Year
Dollar/Year
60
1
1
0.03
1
1
12
12
12
12
0.025
0.02
40
0
10
15
20
25
30
Time (Year)
1
2
35
1
40
1
2
45
1
2
50
10
15
1
2
20
25
30
Time (Year)
1
2
1
2
35
1
2
1
2
40
1
45
1
50
1
2
8QHPSOR\PHQWUDWH
0.2
0.15
1
1
1
0.15
0.1125
0.1
'PQO
2
2
2
Dmnl
0.075
1
1
2
2
0.05
1
12
12
10
12
12
0.0375
12
15
1
2
1
2
20
25
30
Time (Year)
35
1
2
40
1
2
1
2
45
1
2 1
2
1
10
1
2
15
20
25
30
Time (Year)
1
1
8QHPSOR\PHQWUDWH)LVFDO3ROLF\
2
2
2
8QHPSOR\PHQWUDWH)L[SULFH 2
50
35
40
1
2
45
1
2
50
1
2
Figure 9.20: Fiscal Policy of a Change in Income Tax Rate and GDP
*RYHUQPHQW%XGJHW&XUUHQW'HILFLWDQG'HEW
200 Dollar/Year
1,000 Dollar
Debt-GDP ratio
4
3
5
12
1 2
3
3
1 2
5
3
0 Dollar/Year
0 Dollar
3
3
51
1 2
12
5 1
2
12
Year
100 Dollar/Year
500 Dollar
10
7D[5HYHQXHV)LVFDO3ROLF\
1
*RYHUQPHQW([SHQGLWXUH)LVFDO3ROLF\
2
*RYHUQPHQW'HILFLW)LVFDO3ROLF\
3
,QWHUHVWSDLGE\WKH*RYHUQPHQW)LVFDO3ROLF\
'HEW*RYHUQPHQW)LVFDO3ROLF\ 5
15
1
2
5
3
4
45
2
3
40
1
2
3
35
1
2
3
5
12
20
25
30
Time (Year)
1
4
5
50
'ROODU<HDU
'ROODU<HDU
'ROODU<HDU
'ROODU<HDU
'ROODU
12
12
12
12
12
12
12
2
2
0
0
10
15
20
25
30
Time (Year)
1
2
35
1
40
1
2
1
2
45
1
50
1
2
256
Debt-GDP ratio
1
1 2
12
2
5
5 2
40 Dollar/Year
250 Dollar
3
2
2
3
3
Year
2
23
0 Dollar/Year
100 Dollar
10
15
20
25
30
Time (Year)
7D[5HYHQXHV3ULPDU\5DWLR
1
1
*RYHUQPHQW([SHQGLWXUH3ULPDU\5DWLR
2
*RYHUQPHQW'HILFLW3ULPDU\5DWLR
3
,QWHUHVWSDLGE\WKH*RYHUQPHQW3ULPDU\5DWLR
'HEW*RYHUQPHQW3ULPDU\5DWLR
5
1
3
5
31
1 2 31 2
50
4
5
'ROODU<HDU
'ROODU<HDU
'ROODU<HDU
'ROODU<HDU
'ROODU
23
2 3 12 3 1
1 23 1 2
31 2
23
0
0
3
4
45
2
3
40
1
2
3
35
1
2
3
3
10
15
20
25
30
Time (Year)
1
2
2
3
35
1
2
3
40
1
2
1
2
45
1
2
3
50
1
2
1
2
0.4
0.2
0.1
0
0
1
12 3
12 31 23
23
10
15
2
1
0.05
1
3 12
3
35
40
1
2
1
2
45
1
2
3
12
31
10
23
50
2
1
20
25
30
Time (Year)
GDP Gap Ratio : Primary Ratio(-13%)
1
1
2
2
GDP Gap Ratio : Fiscal Policy
3
3
3
3
GDP Gap Ratio : Fixprice
2
2
0.1
23
23
1
1
0.15
Dmnl
Dmnl
0.3
15
20
25
30
Time (Year)
2
35
1
2
1
31
2
3
31
45
1
40
2
3
50
1
2
1
2
Price Flexibility
Is there a way to reduce government debt without sacricing equilibrium? The
monetary and scal policies introduced above are applied to the disequilibria
caused by xprice. Let us make price exible again by setting price elasticity
to be 1. Left diagram (line 1) of Figure 9.24 shows that GDP gap ratio is again
reduced to be below 0.1, while right diagram (line 1) shows that unemployment
rate gradually gets reduced to zero.
Unemployment rate
0.4
0.2
0.1
0
0
12
34 1
10
15
1
2
50
2
3
45
1
2
3
40
1
2
3
3
4
23
41
23
0
Unemployment
Unemployment
Unemployment
Unemployment
5
rate
rate
rate
rate
10
:
:
:
:
4
1
15
1
3
1
2
2
3
35
40
1
2
3
4
23
1
50
1
2
3
45
1
2
3
20
25
30
Time (Year)
Flexible Price
Primary Ratio(-13%)
Fiscal Policy
Fixprice
4
2 34
35
0.05
3
2
20
25
30
Time (Year)
0.1
1
1
2 34
34
34
0.15
Dmnl
Dmnl
0.3
3
4
Figure 9.24: GDP Gap and Unemployment Rate under Price Flexibility
In this way, the reduction of the government debt by diminishing a primary
balance ratio is shown to be possible without causing a sustained recession by
introducing exible price. A nancial reform of this radical type seems to allude
to a soft-landing solution path for a country with a serious debt problem such
258
*'3UHDO
'ROODU5HDO<HDU
450
1
400
1
3
350
51
300
1 2 34
5 12
34
234
23
23
250
0
10
15
20
25
30
Time (Year)
35
1
2
2
3
3
4
50
1
2
3
4
45
1
2
3
5
40
4
5
9.6
Conclusion
Labor market is newly brought to the integrated model of the real and monetary
sectors that is analyzed in the previous chapter. Accordingly, several changes are
made in this chapter to make the model a complete macroeconomic model. First,
production function is revised as Cobb-Douglas production function. Second,
population dynamics is added and labor market is newly introduced. This also
enables the price adjustment process by cost-push forces.
Under such a complete macroeconomic model, ve macroeconomic sectors
are brought to the model such as producers, consumers, government, banks
and the central bank. The model becomes generic in the sense that diverse
macroeconomic behaviors will be produced within the same model structure.
To show such a capability, some macroeconomic behaviors are discussed
in this chapter. First, the existence of mostly equilibria is shown. Second,
disequilibria are triggered by xprice and business cycles caused by two dierent
9.6. CONCLUSION
259
Part III
Open Macroeconomic
System
261
Chapter 10
10.1
As a natural step of the research, we are now in a position to open our macroeconomy to a foreign sector so that goods and services are freely traded and nancial assets are eciently invested for higher returns. The analytical method
employed here is the same as the previous chapters; that is, the one based on
the principle of accounting system dynamics.
1 It is based on the paper: Balance of Payments and Foreign Exchange Dynamics SD
Macroeconomic Modeling (4) in Proceedings of the 24th International Conference of the
System Dynamics Society, Boston, USA, July 29 - August 2, 2007. (ISBN 978-0-9745329-8-1)
Cent r al Bank
For ei gn Cent r al Bank
For ei gn
Money
Suppl y
Money Suppl y
Expor t
Commer ci al Banks
Loan
Savi ng
For ei gn
Loan
I mpor t
For ei gn Wages &
Di vi dens ( I ncome)
Cons umpt i on
Cons umer
( Hous ehol d)
Gr os s
Domes t i c
Pr oduct s
( GDP)
Pr oduct
n io
For ei gn
Cons umpt i on
For ei gn
Cons umer
( Hous ehol d)
Pr oducer
( Fi r m)
Di r ect and
Fi nanci al
I nves t ment
Publ i c
Ser vi ces
I ncome Tax
Nat i onal
Weal t h
( Capi t al
Accumul at i on)
For ei gn
I nves t ment
( Hous i ng)
I nves t ment
( PP&E)
For ei gn
I nves t ment
I nves t ment
( Publ i c
Faci l i t i es )
Gover nment
For ei gn
Pr oduct i on
For ei gn
Pr oducer
( Fi r m)
For ei gn Labor
& Capi t al
I nves t ment
( Hous i ng)
For ei gn
Gr os s
Domes t i c
Pr oduct s
( GDP)
Publ i c
Ser vi ces
For ei gn
Nat i onal
Weal t h
( Capi t al
Accumul at i on)
For ei gn Publ i c
Ser vi ces
For ei gn I nves t ment
( Publ i c Faci l i t i es )
For ei gn
I ncome Tax
For ei gn
I nves t ment
( PP&E)
For ei gn Publ i c
Ser vi ces
For ei gn
Cor por at e Tax
10.2
265
Producers
Major transactions of producers are, as illustrated in Figure 10.2, summarized
as follows.
GDP (Gross Domestic Product) is assumed to be determined outside the
economy, and grows at a growth rate of 2% annually.
Produces are allowed to make direct investment abroad as well as nancial investment out of their nancial assets consisting of stocks, bonds
and cash2 , and receive investment income from these investment abroad.
Meanwhile, they are also required to pay foreign investment income (returns) to foreign investors according to their foreign nancial liabilities
and equity .
Produces now add net investment income (investment income received less
paid) to their GDP revenues (the added amount is called GNP (Gross National Product)), and deduct capital depreciation (the remaining amount
is called NNP (Net National Product)).
NNP thus obtained is completely paid out to consumers, consisting of
workers and shareholders, as wages to workers and dividend to shareholders.
Producers are thus constantly in a state of cash ow decits. To make
new investment, therefore, they have to borrow money from banks, but
for simplicity no interest is assumed to be paid to the banks.
Producers imports goods and services according to their economic activities, the amount of which is assumed to be 10% of GDP in this chapter.
Similarly, their exports are determined by the economic activities of a
foreign country, the amount of which is also assumed to be 10% of foreign
GDP.
Foreign producers are assumed to behave similarly as a mirror image of
domestic producers as illustrated in Figure 10.3.
2 In this chapter, nancial assets are not broken down in detail and simply treated as
nancial assets. Hence, returns from nancial investment are uniformly evaluated in terms of
deposit returns.
I mpor t s
Demand Cur ve
I mpor t s
Coef f i ci ent
<Expor t s >
Cas h Fl ow
Def i ci t
<I ni t i al For ei gn
Exchange Rat e>
Demand I ndex
f or I mpor t s
I mpor t s ( r eal )
GDP
( r eal )
Pr i ce
Pr i ce of
Expor t s ( FE)
Gr owt h Rat e
of GDP
Ti me f or
Change i n
GDP
Change i n
I ni t i al
GDP
I ni t i al GDP
Pr i ce Change
Ti me
Pr i ce Change
<For ei gn
Exchange Rat e>
<NNP>
<Expor t s
( r eal ) >
Inventory
<Gover nment
Expendi t ur e>
I nves t ment
<Pr i ce of
I mpor t s >
I mpor t s
GDP
<GNP>
Fi nanci al
As s et s
Fi nanci al
I nves t ment
Fi nanci al
I nves t ment
Abr oad
Fi nanci al
I nves t ment
I ndex
Fi nanci al
As s et s
Abr oad
<I nt er es t
Ar bi t r age
Adj us t ed>
NNP
<GNP>
Di r ect
I nves t ment
I ncome
Fi nanci al
I nves t ment
I ncome
I nves t ment
I ncome
<GDP>
For ei gn Di r ect
I nves t ment Abr oad
<For ei gn
Exchange Rat e>
Ret ai ned
Ear ni ngs
( Pr oducer )
Capi t al
Debt
( Pr oducer s )
<Expect ed
Ret ur n on
Depos i t s
Abr oad>
For ei gn
I nves t ment
I ncome
<For ei gn
I nves t ment
I ncome ( FE) >
Depr eci at i on
Di r ect
I nves t ment
Rat i o
Capi t al
( PP&E)
Depr eci at i on
Rat e
<For ei gn Di r ect
I nves t ment Abr oad>
Di r ect As s et s
Abr oad
Di r ect
I nves t ment
I ndex
Di r ect
I nves t ment
Abr oad
Di r ect
I nves t ment
<For ei gn
I nves t ment
I ncome>
I nves t ment
Abr oad
Cas h/ Depos i t s
( Pr oducer s )
Fi nanci al
I nves t ment Rat i o
<For ei gn Fi nanci al
I nves t ment Abr oad>
Bor r owi ng
<Pr i ce>
Expor t s
Domes t i c
Abs or pt i on
1
Fi nanci al
Li abi l i t i es
Abr oad
For ei gn Fi nanci al
I nves t ment Abr oad
<For ei gn
Fi nanci al
I nves t ment
Abr oad ( FE) >
GNP
<For ei gn
Di r ect
I nves t ment
Abr oad ( FE) >
<For ei gn
Exchange
Rat e>
Gr owt h Rat e of
For ei gn GDP
I ni t i al
For ei gn GDP
Ti me f or Change
i n For ei gn GDP
Change i n
I ni t i al For ei gn
GDP
For ei gn Pr i ce
Change Ti me
For ei gn Pr i ce
Change
<For ei gn
Exchange Rat e>
<I mpor t s
( For ei gn
Expor t s ) >
<For ei gn
Domes t i c
Abs or pt i on>
Expor t s
Demand Cur ve
For ei gn I mpor t s
Coef f i ci ent
For ei gn
GDP
( r eal )
For ei gn
Pr i ce
Pr i ce of
I mpor t s
<For ei gn Di r ect
I nves t ment Abr oad
( FE) >
For ei gn Cas h
Fl ow Def i ci t
Demand I ndex f or
Expor t s ( r eal )
Expor t s ( r eal )
<Expor t s
( For ei gn
I mpor t s ) >
<For ei gn
I nves t ment >
<For ei gn NNP>
<I ni t i al
For ei gn
Exchange Rat e>
<I mpor t s
( r eal ) >
Foreign
Inventory
<Pr i ce of
Expor t s ( FE) >
Expor t s
( For ei gn
I mpor t s )
For ei gn GDP
<For ei gn
GNP>
<Fi nanci al
I nves t ment
Abr oad ( FE) >
For ei gn
Bor r owi ng
<For ei gn
I nves t ment
I ncome ( FE) >
<For ei gn
Pr i ce>
I mpor t s
( For ei gn
Expor t s )
For ei gn
Domes t i c
Abs or pt i on
For ei gn Fi nanci al
I nves t ment Rat i o
For ei gn
Fi nanci al
As s et s
For ei gn
Cas h/ Depos i t s
For ei gn
Di r ect As s et s
Abr oad
For ei gn Fi nanci al
I nves t ment ( FE)
For ei gn
Fi nanci al
As s et s Abr oad
<Fi nanci al
I nves t ment I ndex
Tabl e>
Di r ect
I nves t ment
Abr oad ( FE)
<For ei gn
Bor r owi ng>
Fi nanci al
I nves t ment
Abr oad ( FE)
For ei gn Fi nanci al
I nves t ment I ncome
( FE)
For ei gn
I nves t ment
I ncome ( FE)
<For ei gn
GDP>
For ei gn Di r ect
I nves t ment I ncome
( FE)
<For ei gn
Exchange Rat e>
For ei gn
Ret ai ned
Ear ni ngs
For ei gn
Capi t al
For ei gn Debt
( Pr oducer s )
<Expect ed
Ret ur n on
Depos i t s Abr oad
( FE) >
I nves t ment
I ncome( FE)
For ei gn
NNP
<For ei gn
GNP>
For ei gn
Depr eci at i on
For ei gn
Depr eci at i on
Rat e
For ei gn Di r ect
I nves t ment Rat i o
For ei gn
Capi t al
( PP&E)
Fi nanci al
I nves t ment ( FE)
I ndex
For ei gn Fi nanci al
I nves t ment Abr oad
( FE)
For ei gn
I nves t ment
Abr oad ( FE)
4
<Di r ect
I nves t ment
Abr oad ( FE) >
For ei gn Di r ect
I nves t ment
Abr oad ( FE)
For ei gn Di r ect
I nves t ment ( FE)
<For ei gn
I nves t ment >
<Expor t s
( For ei gn
I mpor t s ) >
For ei gn
Fi nanci al
Li abi l i t i es
Abr oad
<Fi nanci al
I nves t ment
Abr oad>
For ei gn
GNP
<Di r ect
I nves t ment
Abr oad>
<For ei gn
Exchange
Rat e>
Cons umpt i on
<Cons umpt i on>
Savi ng
<NNP>
Depos i t s
( Cons umer s )
<NNP>
I ncome Tax
I ni t i al Depos i t s
( Cons umer s )
Net For ei gn
I nves t ment
Cas h
( Gover nment )
Gover nment
Expendi t ur e
Ret ai ned
Ear ni ngs
( Gover nment )
Tax Revenues
Banks
Transactions of banks are illustrated in Figure 10.5, some of which are summarized as follows.
Banks receive deposits from consumers and make loans to producers.
Banks are obliged to deposit a portion of the deposits as required reserves
with the central bank, but such activities are not considered in this chapter.
Banks buy and sell foreign exchange at the request of producers and the
central bank.
Their foreign exchange are held as bank reserves and evaluated in terms
of book value. In other words, foreign exchange reserves are not deposited
with foreign banks. Thus net gains realized by the changes in foreign
exchange rate become part of their retained earnings (or losses).
269
Central Bank
In the integrated model of the previous chapter, the central bank played an
important role of providing a means of transactions and store of value; that
is, currency, and its sources of assets against which currency is issued were
assumed to be gold, loan and government securities. Transactions of the central
bank here are exceptionally simplied, as illustrated in Figure 10.7, so long as
necessary for the analytical purpose in this chapter.
The central bank can control the amount of money supply through monetary policies such as the manipulation of required reserve ratio and open
market operations. However, such a role of money supply by the central
bank is not considered here.
The central bank is allowed to intervene foreign exchange market; that
is, it can buy and sell foreign exchange to keep a foreign exchange ratio
stable. These transactions are manipulated with commercial banks, which
inescapably change the amount of currency outstanding and, hence, money
supply. In this chapter, however, such an eect of money supply on interest
rate is assumed to be out of consideration.
Foreign exchange reserves held by the central bank is assumed to be deposited with foreign banks so that it receives interest payments.
The central bank of foreign country is excluded simply because foreign
currency is assumed to be a vehicle currency, and it needs not to hold
foreign reserves (that is, its own currency) to stabilize its own exchange
rate in this simplied open macroeconomy.
10.3
All transactions with a foreign country such as foreign trade and foreign investment (that is, payments and receipts of foreign exchange) are booked according
to a double entry bookkeeping rule, and such a bookkeeping record is called the
balance of payments. According to [36] in page 295, all payments are recorded
in the debit side with a minus sign, while all receipts are recorded in the credit
side with plus sign. Hence, by denition, the balance of payments are kept
in balance all the time. It consists of current account, capital and nancial
account, and net ocial reserve assets.
<Foreign
Exchange Rate>
<Foreign
Exchange
(FE)>
Foreign
Exchange
(Book Value)
Net Gains
Adjustment
Time
<For ei gn
I nves t ment
Abr oad>
<Exports>
<Foreign
Exchange Sale>
Net Gains by
Changes in
Foreign
Exchange Rate
For ei gn
Exchange i n
Vaul t Cas h
( Banks )
Foreign
Exchange
(Banks)
Lendi ng
<Foreign
Exchange
Purchase>
<Foreign
Exchange
Sale>
<Foreign
Exchange
Purchase>
For ei gn
Exchange out
Loan
Required
Reserves
(Banks)
<Foreign
Exchange Sale>
<Foreign
Investment
Income>
<Imports>
Depos i t s
out
Retained
Earnings
(Banks)
Cas h/
Depos i t s
( Banks )
<Net Gains by
Changes in
Foreign Exchange
Rate>
Depos i t s i n
For ei gn
I nves t ment
Abr oad
<Expor t s >
<Savi ng>
<For ei gn Fi nanci al
I nves t ment Abr oad>
<For ei gn Di r ect
I nves t ment Abr oad>
<For ei gn
Exchange
Pur chas e ( FE) >
<For ei gn
I nves t ment
I ncome ( FE) >
<I mpor t s
( For ei gn
Expor t s ) >
For ei gn
Cas h i n
For ei gn
Vaul t
Cas h
( Banks )
For ei gn
Cas h out
<For ei gn
Exchange Rat e>
I nt er es t on FE
Res er ves ( FE)
<For ei gn
Exchange Sal e
( FE) >
<For ei gn
I nves t ment
Abr oad ( FE) >
<Expor t s
( For ei gn
I mpor t s ) >
For ei gn
Depos i t s out
<I nt er es t on
FE Res er ves >
For ei gn
Depos i t s i n
For ei gn Exchange
Res er ves ar e
ci r cul at i ng wi t h
For ei gn Bank Depos i t s
For ei gn
Cas h/
Depos i t s
( Banks )
For ei gn
Li abi l i t i es
<For ei gn
Exchange
Pur chas e ( FE) >
<For ei gn
I nves t ment
I ncome ( FE) >
I nves t ment
Abr oad ( FE)
<I mpor t s
( For ei gn
Expor t s ) >
<Fi nanci al
I nves t ment
Abr oad ( FE) >
<Di r ect
I nves t ment
Abr oad ( FE) >
I nt er es t on
FE Res er ves
<For ei gn
I nt er es t Rat e>
Ret ai ned
Ear ni ngs
( Cent r al Bank)
I ni t i al Res er ves
( Cent r al Bank)
I ni t i al Reat i ned
Ear ni ngs ( Cent r al
Bank)
I ni t i al
Cur r ency
Out s t andi ng
I ni t i al For ei gn
Exchange Res er ves
<I nt er es t on
FE Res er ves >
Foreign
Exchange
Purchase
For ei gn
Exchange
Lower Bound
For ei gn Exchange
Pur chas e Amount
<For ei gn
Exchange
Rat e>
Foreign
Exchange
Reserves
Foreign
Exchange
Sale
For ei gn
Exchange Sal es
Amount
For ei gn
Exchange
Upper Bound
<Foreign
Exchange
Sale>
Currency Outstanding
<Foreign
Exchange
Purchase>
<Foreign
Exchange
Purchase>
Current account consists of trade balance of goods and services and net
investment income. Capital account is an one-way transfer of fund by the government that is excluded from our analysis here. Financial account consists of
direct and nancial foreign investment. Figure 10.8 illustrates all transactions
which enter into the balance of payments account.
Figure 10.9, obtained from one of our simulation runs, displays relative positions of current account, capital and nancial account, and net ocial reserve
assets (or changes in reserve assets). A numerical value of the balance of payments is shown in the gure as being in balance all the time; that is a zero value.
Bal ance of
Payment s
Cur r ent
Account
Capi t al &
Fi nanci al
Account
Fi nanci al
Account
<I nves t ment
Abr oad>
Ret ai ned
Ear ni ngs
and
Cons umer
Equi t y
I ncome
<I ni t i al
I nvent or y>
I nvent or y
<For ei gn
Exchange
Pur chas e>
<Ot her
I nves t ment >
Li abi l i t i es
Abr oad
As s et s
Abr oad
<For ei gn
Exchange Sal e>
<For ei gn
I nves t ment
Abr oad>
<For ei gn
I nves t ment
Abr oad ( FE) >
<Expor t s
( For ei gn
I mpor t s ) >
Change i n
Res er ve As s et s
For ei gn Cas h/
Depos i t s
( Banks )
<For ei gn
Exchange
Pur chas e ( FE) >
For ei gn
Depos i t s
in
<For ei gn
Savi ng>
<For ei gn
Exchange
Pur chas e>
<I mpor t s
( For ei gn
Expor t s ) >
<I nt er es t on FE
Res er ves ( FE) >
<For ei gn
I nves t ment
I ncome ( FE) >
<For ei gn
I nves t ment
I ncome>
Ot her
I nves t ment
( Cr edi t )
For ei gn
Exchange
out
<For ei gn
Exchange Sal e
( FE) >
For ei gn
Depos i t s
out
<For ei gn
Exchange Sal e>
For ei gn
Exchange
( Banks )
For ei gn
Exchange
in
<Net Gai ns by
Changes i n For ei gn
Exchange Rat e>
<For ei gn
I nves t ment
Abr oad>
<Expor t s >
Ot her
I nves t ment
( Debi t )
( FE Rec ei pt s
f r om Abr oad)
<I nt er es t on FE
Res er ves ( FE) >
<I nt er es t on
FE Res er ves >
<Net Gai ns by
Changes i n For ei gn
Exchange Rat e>
Ear ni ngs i n
<Expor t s >
<For ei gn
I nves t ment
I ncome>
Balance of Payments
8
2
2
2
Dollar/Year
34
2
341 34
2
34
34
34
34
34
34
2
1
-4
2
34 2341 34
1
1
34
2
34
34
34
34
34 34
2 1
1
48
54
34
-8
0
12
18
24
30
36
Time (Year)
1
1
1
Current Account : run
"Capital & Financial Account" : run
Change in Reserve Assets : run
4
Balance of Payments : run
42
1
2
3
4
3
4
3
4
1
2
3
4
2
3
1
2
1
3
1
2
2
3
60
1
2
2
3
3
3
4
4
4
10.4
Determinants of Trade
Let M and X be real imports and exports, and Y and P be real GDP and its
price level, respectively. Counterpart variables for a foreign country is denoted
with a subscript f . A foreign exchange rate E is dened as a price of foreign
currency (which has a unit of FE here) in terms of domestic dollar currency; for
instance, 1.2 dollars per FE. Then, a price of imports is calculated as PM = Pf E.
Imports are here simply assumed to be a function of real GDP and price of
imports such that
M = M (Y, PM ), where
0
0
Figure 10.10:
mand Curve
Normalized De-
M
M
> 0 and
< 0.
Y
PM
(10.1)
275
(10.2)
(10.3)
M PM
M
M
=
=
Pf < 0
(10.4)
E
PM E
PM
These relations imply that imports decrease as foreign price of imports increases
and/or foreign exchange rate appreciates.
In our model, imports function is further simplied as a product of imports
determined by the size of GDP and a normalized demand curve such that
M = M (Y, PM ) = M (Y )D(PM ) = mY D(Pf E)
(10.5)
X
X
> 0 and
< 0.
Yf
PM,f
(10.6)
This implies that exports increase as foreign economic activities, hence foreign
GDP, expand, and decreases as price of imports in a foreign country rises as a
standard downward-sloping demand curve conjectures.
Price of imports in a foreign country is calculated by a domestic price and
foreign exchange rate such that PM,f = P/E. Hence, we obtain the following
relations:
X = X(Yf , PM,f ) = X(Yf , P/E),
(10.7)
X
X PM,f
X 1
=
=
<0
P
PM,f P
PM,f E
(10.8)
X
X PM,f
X
P
=
=
( 2 ) > 0.
E
PM,f E
PM,f
E
(10.9)
(10.10)
(10.11)
Then we have
T B
M
T B
X
=
< 0,
=
> 0,
Y
Y
Yf
Yf
(10.12)
T B
X
T B
M
=
< 0,
=
> 0.
P
P
Pf
Pf
(10.13)
X
M
T B
=
> 0.
(10.14)
E
E
E
The last relation indicates that a trade balance is an increasing function of
foreign exchange rate. The relation is also conrmed in our model as illustrated
in the two diagrams of Figure 10.11 in which upward-sloping blue curves are
obtained from our simulation runs. As an mirror image, foreign trade balance
is shown to be a decreasing function of foreign exchange rate, as indicated by
downward-sloping red curves.
Tr ade Bal ance vs E
8 Dol l ar / Year
8 FE/ Year
8 Dol l ar / Year
8 FE/ Year
4 Dol l ar / Year
4 FE/ Year
4 Dol l ar / Year
4 FE/ Year
0 Dol l ar / Year
0 FE/ Year
0 Dol l ar / Year
0 FE/ Year
- 4 Dol l ar / Year
- 4 FE/ Year
- 4 Dol l ar / Year
- 4 FE/ Year
- 8 Dol l ar / Year
- 8 FE/ Year
0. 940
- 8 Dol l ar / Year
- 8 FE/ Year
0. 950
0. 990
Dol l ar / Year
FE/ Year
1
1. 020
1. 040
For ei gn Exchange Rat e
Tr ade Bal ance : r un
" For ei gn Tr ade Bal ance ( FE) " : r un
1. 060
Dol l ar / Year
FE/ Year
(10.15)
That is to say, GDP is the sum of consumption spending, investment, government expenditure and trade balance. In our model of foreign trade, investment
is calculated to make this equation an identity all the time.
Private saving is dened as Sp = Y T C. Government saving is dened
as Sg = T G. Then national saving is obtained as a sum of these savings such
that
S = Sp + Sg = Y C G,
(10.16)
277
which reduces to
S I = T B(E).
(10.17)
Saving less investment is called net foreign investment, which is equal to trade
balance. This becomes another way of describing the above national income
identity in terms of net foreign investment and trade balance.
10.5
(10.18)
Ee
1
E
(10.19)
Thus we obtain
Rf
(1 + if )E e
=
<0
(10.20)
E
E2
Rf
(1 + if )
=
>0
(10.21)
E e
E
This implies that a rate of return from foreign nancial investment decreases if
foreign exchange rate appreciates, but it increases when foreign exchange rate
is expected to appreciate.
Let us dene an expected return arbitrage as
A(E, E e ; i, if ) = Rf (E, E e ; if ) R(i)
(10.22)
(10.23)
This is the amount of capital we receive from foreign countrys investment less
the amount we invest abroad. Under the assumption of an ecient nancial
market, if expected returns are greater in a foreign country and an expected
return arbitrage becomes positive, then nancial capital continues to outow
1. 1
- 0. 4
- 1. 1
- 0. 2
0. 2
- 0. 2
0. 2
N CF
<0
A
(10.25)
It is important to note, however, that this functional relation holds only in the
279
(10.26)
N CF
N CF A
N CF Rf
=
=
<0
(10.27)
e
e
E
A E
A E e
Whenever a foreign exchange rate begins to appreciate, an expected return
arbitrage declines, and capital begins to inow, causing a positive net capital
ow. When foreign exchange rate is expected to appreciate, an expected return
arbitrage increases and capital begins to outow, causing a negative net capital
ow. In this way, changes in a foreign exchange rate and its expectations play
a crucial role for nancial investment.
It is examined in our model that these relations only hold in the neighborhood of equilibrium. In Figure 10.13, net capital ow is shown to be an
NCF vs E
NCF vs E
4. 5
Dol l ar / Year
Dol l ar / Year
-1
-2
-3
-4
0. 940
1. 5
0. 950
0. 960
0. 970
0. 980
For ei gn Exchange Rat e
Net Capi t al I nf l ow : r un
0. 990
1
1. 010
1. 020
1. 030
1. 040
1. 050
For ei gn Exchange Rat e
Net Capi t al I nf l ow : r un
1. 060
1. 070
10.6
How are the foreign exchange rate and its expectations determined, then? Foreign exchange rate is here simply assumed to be determined by the excess demand for foreign exchange; that is, a standard logic of price mechanism in
economic theory. From the left-hand diagram of Figure 10.8, demand for foreign exchange is shown to stem from the need for payments due to imports,
direct and nancial investment abroad, and foreign investment income, as well
as foreign exchange purchase by the central bank. Supply of foreign exchange
(10.29)
(10.30)
Thus, expected foreign exchange rate can be easily adjusted to the actual trends
and volatilities of various economic situations by rening values in mean and
standard deviation. Figure 10.14 illustrates how foreign exchange rate and its
expectation are modeled in our economy.
Foreign
Exchange (FE)
Effect on Foreign
Exchange Rate
Initial Foreign
Exchange Rate
Change in Expected
Foreign Exchange Rae
Adjustment Time of
Foreign Exchange
Expectation
Expected Foreign
Exchange Rate
<Foreign Exchange
Purchase>
Expected Change
seeds
in FER
Foreign Exchange
Purchase (FE)
standard
deviation
mean
<Investment
Abroad (FE)>
<Imports (Foreign
Exports)>
<Foreign Investment
Income (FE)>
Foreign Exchange
Rate
Desired Foreign
Exchange Rate
Change in Foreign
Exchange Rate
Adjustment
Time of FE
Foreign Exchange
Sale (FE)
<Investment
Income(FE)>
<Foreign
Exchange Sale>
Supply of Foreign
Exchange
<Foreign Investment
Abroad (FE)>
<Exports (Foreign
Imports)>
Supply of Foreign
Exchange
(10.31)
Price (Pf)
Interest
Rate (if)
Price (P)
Foreign
Exchange
Rate
Trade
Balance
Interest
Rate (i)
Net
Capital
Flow
GDP (Y)
GDP (Yf)
Expected
Foreign
Exchange Rate
Random Normal
Distribution
10.7
800
1.2
1
1
2
1
1
400
2
3
0
0
200
3
45
6
45
6
3
45
6
12
3
45
3
45
45
6
18
1.1
2
2
24
30
36
Time (Year)
45
45
45
45
45
42
48
Dollar/FE
Dollar/Year
600
45
45
6
54
1
1
1
1
1
1
1
1
Consumption : Equilibrium
2
2
2
2
2
2
2
2
2
Investment : Equilibrium
3
3
3
3
3
3
3
Government Expenditure : Equilibrium
4
4
4
4
4
4
4
4
4
4
Exports : Equilibrium
5
5
5
5
5
5
5
5
5
5
Imports : Equilibrium
6
6
6
6
6
6
6
6
Trade Balance : Equilibrium
60
2
1 12 12 1
1
2
1 1
2
2 2
2
2 2 2 2
12 12 12 12 1 1 1 12 12 12 1 1 1 1 1 1 12 12 12 1
2
2 2
2
0.9
0.8
0
12
18
24
30
36
Time (Year)
1
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
Figure 10.16: Equilibrium State of Trade and Foreign Exchange Rate (S)
283
(10.32)
Trade Balance
1.2
8
2
2
Dollar/FE
3 3
1 31 1 1 31 1
3
1 1 1
3
31 31 31 3 3
1 1
1
3
3
12312 12 12 2 2 2 2 2 2 2 2 2 2
3 3 3
1 31
3 3
2 2 2 2
2 2
3
1 1 31 1 1 1
3 3 3
2
2
Dollar/Year
1.1
0.9
12 12 12
2
1
2
1
2
1
12 12 12 12 12 12 12
-4
1
1
1
0.8
0
12
18
24
30
36
Time (Year)
1
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
-8
0
12
18
24
30
36
Time (Year)
1
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
Figure 10.17: Foreign GDP Plunge and Restoring Trade Balance (S1)
Trade Balance
1.2
6
1
1
1.1
1
1
3
12312 12 12 12 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 23 2 2 2 2
3
1 31 31 3
3
1 31 31 1 31 1 31 31 31 31 1 1 31 31 1 31 1 1 1
3
3
3 3 3
3
3
3
0.9
Dollar/Year
Dollar/FE
12 12 12
2
1
2
1 1 12 12 12 12 12 12 12 12 12 12
2 2
2
2
-3
2
2
0.8
0
12
18
24
30
36
Time (Year)
2
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3
-6
0
12
18
24
30
36
Time (Year)
1
42
48
54
10.8
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
285
for nancial investment for both economies. The actual nancial investment,
however, depends on the scale of investment indices illustrated in Figure 10.12
above.
Figure 10.19 illustrates a revised equilibrium state under free ows of capital. Top-right gure shows the existence of the expected return arbitrage under
the uctuations of expected foreign exchange rates. The emergence of the arbitrage undoubtedly trigger capital ows of nancial investment for higher returns,
breaking down the original equilibrium state of trade balance, as shown in the
bottom two diagrams. In this way, the original equilibrium state of trade is easily thrown out of balance by merely introducing random expectations of foreign
exchange rate under an ecient capital market. In other words, random expectations among nancial investors are shown to be a cause of trade turbulence,
and hence economic uctuations of boom and bust in international trade. A
exible foreign exchange rate can no longer restore a trade balance. This is an
unexpected and surprising simulation result in this chapter.
Foreign Exchange Rate
Interest Arbitrage
1.2
0.02
1.1
0.01
2
2
2
2
2
1/Year
Dollar/FE
2
1 1 1
3 31
1
3
12312 12 12 12 2 2 2 2 2 2 2312 12312 3 2312312 2 123 2312 12 23 23 23
1
1
3
1
3
3
3
1 3 3 31 31 31 3
3
3 1 1
1 1
0.9
-0.01
12
2 1
1
12 2
12 12
1
1
1
0.8
0
12
18
24
30
36
Time (Year)
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
-0.02
0
12
18
2
2
Dollar/Year
2
12
1
2
2 1
2
1
1
1
-5
2
1
2
1
1
1
1
2
-10
0
12
18
24
30
36
Time (Year)
1
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2
Exports-Imports
1
1
2
Trade Balance
10
2
24
30
36
Time (Year)
42
48
54
200
10
Dollar/Year
Dollar/Year
150
5
Dollar/Year
Dollar/Year
100
0
Dollar/Year
Dollar/Year
50
-5
Dollar/Year
Dollar/Year
0
-10
Dollar/Year
Dollar/Year
31 2
12
312 12
3
2 12
3 3
3
2 12 1 3
2
1
3
2 2 1
3
12 1 2 1 1
12 12
3
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
12
1
2
3
1
3 3
3
3
3
3 3
0
60
2
3
2 1
12 1
31
2
12
Exports : Expectation(s3)
Imports : Expectation(s3)
Trade Balance : Expectation(s3)
18
1
1
2
24 30 36
Time (Year)
1
42
1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3
48
54
Dollar/Year
Dollar/Year
Dollar/Year
60
Interest Arbitrage
1.2
0.04
1
1
1 3 1
3
1 1 1
1 1 31 3 3
1 3 3
1 3 3 3
1
1
3 3
1 1
3
1 3 3
1 31 3
1 3
3
3
12312 12 12 12 12 2312 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
1
3
3
3
3
0.02
1 1
1/Year
Dollar/FE
1.1
1 1
1 1
1
1
12
2 2
2 2
0.9
-0.02
12
18
24
30
36
Time (Year)
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3
-0.04
0
12
18
1 1
1
Dollar/Year
1
12 12 12 12 12 12 12 12
2
200
40
Dollar/Year
Dollar/Year
150
29.5
Dollar/Year
Dollar/Year
2
2
-20
2
2
12
18
24
30
36
Time (Year)
1
42
48
54
60
1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2
42
48
54
Dollar/Year
Dollar/Year
50
8.5
Dollar/Year
Dollar/Year
0
-2
Dollar/Year
Dollar/Year
12
2 12
2 12 1
12 1
12
12 2
1
23
1 1
2 2
2 3
2 2
3 3
3
2
3
2
2
3
3
3
3
3
3
3
3
3 3
0
6
-40
0
1
1 3
100
19
Exports-Imports
20
1
24
30
36
Time (Year)
Trade Balance
40
2
2
0.8
12 12 12 12
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
12
18
24 30 36
Time (Year)
42
1 1 1 1 1 1 1 1 1 1 1 1
Exports : Interest Plummet(s4)
2 2 2 2 2 2 2 2 2 2 2
Imports : Interest Plummet(s4)
3 3 3 3 3 3 3 3 3
Trade Balance : Interest Plummet(s4)
48
54
60
Dollar/Year
Dollar/Year
Dollar/Year
287
Balance of Payments
Balance of Payments
20
80
1
2
10
2
Dollar/Year
2
2
2
123412341 234
34 34
34
34
34
34
34
34
34
34 34
34
2
34 34
34
40
34
1
1
1
-10
34 34
2 2
34
34 34
34
1
123412341 23412341234123412 34 34
2
Dollar/Year
34
34
34 34
34
-40
2
2
1
-20
0
12
18
1
Current Account : Expectation(s3)
"Capital & Financial Account" : Expectation(s3)
Change in Reserve Assets : Expectation(s3)
Balance of Payments : Expectation(s3)
24
30
36
Time (Year)
1
1
3
1
3
4
2
3
1
2
4
1
3
1
3
-80
42
2
1
3
4
2
3
48
1
2
4
1
3
54
1
3
1
3
4
2
3
4
60
1
2
1
3
4
12
18
24
30
36
Time (Year)
1
3
4
2
3
1
2
4
1
3
42
1
3
1
3
4
2
3
48
1
2
4
1
3
1
3
54
2
1
3
4
2
3
4
60
1
2
1
3
4
Trade Balance
1.2
20
1
2
3
12312 12 12 12 2 2
3 3
1
3
3 31 1
3 31
3 3
1
1
3
3
1
1 31 1
1 31 3 31 3
3
1
31
3
1
3
1
2 2 1 23 23 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
31 3
0.8
18
24
30
36
Time (Year)
1
42
48
54
1
2
1
2
2 1
1
12
2
1
2
1
1
12
12 12 12
-10
0.9
2
2
10
Dollar/Year
Dollar/FE
1.1
-20
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3
12
18
Balance of Payments
24
30
36
Time (Year)
1
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
20
800
2
2
Dollar/Year
34
34
2
2
12
34
34 34
34
34
34
34
34
2
34
34
34 34
34
34
1
1
-10
1
2
1
34 34 34 3
2
1
-20
0
12
18
1
Current Account : GDP-Capital Flow(s5)
"Capital & Financial Account" : GDP-Capital Flow(s5)
Change in Reserve Assets : GDP-Capital Flow(s5)
Balance of Payments : GDP-Capital Flow(s5)
24
30
36
Time (Year)
1
4
1
3
4
2
3
1
2
4
1
3
1
3
42
2
1
3
4
2
3
1
2
4
48
1
3
1
3
54
2
1
3
4
60
1
1
2
2
2
3
3
3
4
4
400
200
1
1
1
1
600
Dollar
10
1 1
1 1
1 1
1 1 1
12 12 12 2 2 2 2 2 2 2
24
30
36
Time (Year)
2 2
2 2
2 2
0
6
12
18
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
10.9
289
Trade Balance
1.2
20
1.1
10
3
12312 12 12 12 2 2
3 3
1
3
3 31 1
Dollar/Year
Dollar/FE
-10
12
18
24
30
36
Time (Year)
42
48
54
34
1
34
1
2
34
1
34
400
34
2
34
4
1
34
34
1
3
12
18
24
30
36
Time (Year)
1
4
1
3
1
3
4
2
3
1
2
4
1
3
1
3
1
1
1 1
1
54
60
12
18
1
24
30
36
Time (Year)
1
42
48
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
3 3
3
3 3
3 3 3
31 31 31 1 1 1 1 1
1 31 31 31
12312 312312312 3 2 2 2 2 2 2 2 2 2 2 2 2 12 12 2 2 2
1 1
1
2
1
42
2
1
3
4
2
3
1
2
2 2
1
-400
48
1
3 3
3 3
3 1 3 1 3
3
1
-60
0
1
3
-30
1
Current Account : Intervention(s6)
"Capital & Financial Account" : Intervention(s6)
Change in Reserve Assets : Intervention(s6)
Balance of Payments : Intervention(s6)
1 1
Dollar
Dollar/Year
2
2
2
2
2
12
1 41
4
4
23 234 3 1 3 34
800
2 2
Balance of Payments
60
-20
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
30
2 2
1
1
0.8
12 12 12
0.9
2
2
3
1 1 1
3
3 3 3 1
31
3
1 31 1 1
3 3 3
1 1 1 31 31 1 1 1
2 2 123 23 2 2 2 2 2 2 2 23 2 2 2 2 2 2 2
3
31 3
1
3
54
2
2
3
3
4
4
60
1
2
1
3
4
-800
0
12
18
24
30
36
Time (Year)
1
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
Trade Balance
1.2
60
1.1
30
3
31 31 31 31 31 1 31 31 31 31 31 1
1
1 3 3
31 1 1 1 31
12312 23 23 2 2 2 2 2 2 2 2 2 2 2 2 2 2 23 2 1 2 23 2 2 2 2
3
1
3
1
3
3
1
1
1 3 3
2
12 12 12
1 1
2 2
1 1
2
1
2
1
2 2
2
1
1 1
2 2
1 1
1
1
0.8
6
12
18
24
30
36
Time (Year)
42
48
54
12
2
2
-400
41
2
41
3
1
4 234 23412 4 34 3 41 34 34 1234 34
12
1
2
3
Dollar
-1,600
-100
-2,800
1
1
-200
0
12
18
1
Current Account : Default(s7)
"Capital & Financial Account" : Default(s7)
Change in Reserve Assets : Default(s7)
Balance of Payments : Default(s7)
24
30
36
Time (Year)
1
4
1
3
1
3
1
3
4
2
3
1
2
4
1
3
1
3
42
2
1 1
24
30
36
Time (Year)
42
48
54
1
3
4
2
3
1
2
4
48
1
3
1
3
54
2
2
3
3
4
4
1
2
60
1
3
4
3 3 3 3
3 3 3 3
3 3 3 3 3 3 3
123 1231 23123 1231 23 23 23 23 23 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
1 1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
-4,000
0
12
18
24
30
36
Time (Year)
1
42
48
54
We have now presented eight dierent scenarios of international trade and nancial investment, which indicates capability of our open macroeconomic modeling.
Yet, our generic model is far from a complete open macroeconomy, because signicant economic variables such as GDP, its price level and interest rate are
treated as outside parameters, and no feedback loops exist in the sense that
they are aected by the endogenous variables such as a foreign exchange rate
and its expectations. Schematically, one-way direction of decision-making in the
equation (10.31) has to be made two-way such that
(Y, Yf , P, Pf , i, if , Nrandom ) (E, E e , T B)
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
10.10
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
18
Balance of Payments
100
-60
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3 3 3
200
Dollar/Year
-30
0.9
2
Dollar/Year
Dollar/FE
2
2
(10.33)
Mundell-Fleming Model
Compared with our model, one of the repeatedly used open macroeconomic
model in standard international economics textbooks is the Mundell-Fleming
291
Trade Balance
1.3
40
1
Dollar/FE
1 1 31
1
3
123 123123 23 2 2 2
1.05
1
1 3
1 3
31 3
2 2
2 2
2 2
2 2
2 2
1 3
3 3
1
1
2 2
1
1 31 3
1
2 2
2 2
20
2 2
0.8
12
18
24
30
36
Time (Year)
1
42
48
54
1 1
12 12 1
2
2 1
1 2 1 2 12 12
2
2
2
2
2
-20
31 31
0.925
Dollar/Year
1
1 1 31 31 3 3
1 3 3
3
1.175
2 2
-40
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3
12
18
Balance of Payments
24
30
36
Time (Year)
1
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
200
800
1
600
1
1
1 1
1 1
12341 234123412 3412341 3 4 34 34 34 34 34 34 34 34
2
2
2
2
2
2
2
2 2
-100
34 34
34
34 34
2
2
Dollar
Dollar/Year
1
1
100
54
60
400
200
-200
0
12
18
1
Current Account : No Intervention(s8)
"Capital & Financial Account" : No Intervention(s8)
Change in Reserve Assets : No Intervention(s8)
Balance of Payments : No Intervention(s8)
24
30
36
Time (Year)
1
1
4
1
3
4
2
3
1
2
4
1
3
1
3
42
2
1
3
4
2
3
1
2
4
48
1
3
1
3
1
1
2
2
2
3
3
3
3
4
4
4
1 31
31 3
31 31
1 31
1 31 3
3 1 31 3
3
1
1
3
12 2 2 2 2 2 2 2 2 2 2 2 2 2
1
31 3
31
31
31
2 2
31
31
31
31
31
31
31
2 2
31
0
0
12
18
24
30
36
Time (Year)
1
3
42
48
54
60
1 1 1 1 1 1 1 1 1 1 1 1 1 1
2 2 2 2 2 2 2 2 2 2 2 2 2
3 3 3 3 3 3 3 3 3 3 3 3 3 3
(10.34)
(10.35)
(10.36)
This macroeconomic model indeed determines Y, E and i. In other words, signicant economic variables such as GDP and interest rate are simultaneously
determined in the model, though interest rate is restricted by a competitive
world interest rate. In comparison, our model consisting of the three equations:
(10.15), (10.29), and (10.30), determines only three variables E, E e and T B,
and fails to determine Y and i.
Hence, Mundel-Fleming model could be said to be a better presentation of
open macroeconomy. Yet, it lacks a mechanism of determining money supply
M s and a price level P . In this sense, it is still far from a complete open
macroeconomic model.
Missing Loops
It is now clear from the above arguments that for a complete open macroeconomic model some missing feedback loops have to be supplemented. They could
Net Exchange
Reserves
Official
Invervention
Price (Pf)
Interest
Rate (if)
Price (P)
Trade
Balance
Foreign
Exchange
Rate
Net
Capital
Flow
Interest
Rate (i)
GDP (Y)
GDP (Yf)
Expected
Foreign
Exchange Rate
<Official
Invervention>
Random Normal
Distribution
Investment
Figure 10.26: Missing Feedback Loops Added to the Foreign Exchange Dynamics
10.11. CONCLUSION
293
Obviously, our open macroeconomic model is not complete until these missing loops are incorporated in the model. Specically, the previous chapter has
presented a model of macroeconomic system which determines GDP, money supply, a price level, investment and interest rate, to name but a few. Therefore,
our next challenge is to integrate the model with our present foreign exchange
model by crating a whole image of domestic macroeconomy as its foreign sector
macroeconomy.
10.11
Conclusion
Our open macroeconomic modeling turned out to need another model of the
balance of payments and dynamics of foreign exchange rate. Consequently, the
approach in this chapter led by the logic of accounting system dynamics became
an entirely new one in the eld of international economics.
Under the framework, a double-booking accounting of the balance of payments is modeled. Then determinants of trade and foreign direct and nancial
investment are analytically examined together with an introduction of dierential equations of foreign exchange rate and its expected rate.
Upon a completion of the model, eight scenarios are are produced and examined by running various simulations to obtain some behaviors observed in
actual international trade and nancial investment. It is a surprise to see how
an equilibrium state of trade balance is easily disturbed by merely introducing
random expectations among nancial investors under the assumption of ecient nancial market. To indicate the capability of our model furthermore,
the impact of ocial intervention on foreign exchange and a path to default is
discussed.
Finally, several missing feedback loops in our model are pointed out for
making it a complete open macroeconomic model. This task of completion will
inevitably lead to our next research in this system dynamics macroeconomic
modeling series in the next chapter.
Chapter 11
Open Macroeconomies as A
Closed Economic System
This chapter1 tries to expand the integrated model to the open macroeconomies
according to the framework developed in the previous chapter. It provides a
complete generic model of open macroeconomies as a closed system, consisting
of two economies, a foreign economy as an image of domestic economy. As a
demonstration of its analytical capability, a case of credit crunch is examined to
show how domestic macroeconomic behaviors inuence foreign macroeconomy
through trade and nancial capital ows.
11.1
This chapter nalizes our series of macroeconomic modeling on the basis of the
principle of accounting system dynamics. Chapters 5 and 6 constructed a model
of money supply and its creation process, followed by the introduction of interest
rate to the model. Chapter 7 modeled dynamic determination processes of GDP,
interest rate and price level. For its analysis four sectors of macroeconomy were
introduced such as producers, consumers, banks and government. Chapter 8
and 9 integrated real and monetary sectors that had been analyzed separately
in chapters 5, 6 and 7, by adding the central bank, then labor market. Chapter
10 built a model of a dynamic determination of foreign exchange rate in open
macroeconomies in which goods and services are freely traded and nancial
capital ows eciently for higher returns. For this purpose a new method was
needed contrary to the standard method of dealing with a foreign sector as
adjunct to macroeconomy; that is, an introduction of another macroeconomy
as a foreign sector.
1 It is based on the paper:Open Macroeconomies as A Closed Economic System SD
Macroeconomic Modeling Completed that is presented at the 26th International Conference
of the System Dynamics Society, Athens, Greece, July 23-27, 2008.
295
Central Bank.f
Money Supply
Money Supply
Banks
Banks.f
Export
Loan
Saving
Loan
Saving
Import
Wages & Dividens (Income)
Consumer
(Household)
Consumption
Gross
Domestic
Products
(GDP)
Production
Producer
(Firm)
Consumer
(Household).f
Consumption
Investment
(Housing)
National Wealth
(Capital
Accumulation)
Income Tax
Government
Production
Producer
(Firm).f
Investment
(Housing)
Investment (PP&E)
Public Services
Investment (Public
Facilities)
Gross
Domestic
Products
(GDP).f
National Wealth
(Capital
Accumulation)
Investment (PP&E)
Public Services
Public Services
Corporate Tax
Investment (Public
Facilities)
Income Tax
Public Services
Government.f
Corporate Tax
11.2
297
dened does not by all means reect the ongoing current exchange rate in the
real world economy.
Real foreign exchange rate (RFE) is the amount of real goods worth per unit
of the equivalent foreign real goods such that
RF E =
F E Pf
P
(11.1)
Producers
Main transactions of producers are summarized as follows. They are also illustrated in Figure 11.15 in which stocks of gray color are newly added for open
economies.
Out of the GDP revenues producers pay excise tax, deduct the amount of
depreciation, and pay wages to workers (consumers) and interests to the
banks. The remaining revenues become prots before tax.
They pay corporate tax to the government out of the prots before tax.
The remaining prots after tax are paid to the owners (that is, consumers)
as dividends, including dividends abroad. However, a small portion of
prots is allowed to be held as retained earnings.
Producers are thus constantly in a state of cash ow decits. To make
new investment, therefore, they have to borrow money from banks and
pay interest to the banks.
Producers imports goods and services according to their economic activities, the amount of which is assumed to be a portion of GDP in our model,
though actual imports are also assumed to be aected by their demand
curves.
Similarly, their exports are determined by the economic activities of a
foreign economy, the amount of which is also assumed to be a portion of
foreign GDP.
Produces are also allowed to make direct investment abroad as a portion
of their investment. Investment income from these investment abroad are
paid by foreign producers as dividends directly to consumers as owners
of assets abroad. Meanwhile, producers are required to pay foreign investment income (returns) as dividends to foreign investors (consumers)
according to their foreign nancial liabilities.
Foreign producers are assumed to behave in a similar fashion as a mirror
image of domestic producers
Consumers
Main transactions of consumers are summarized as follows. They are also illustrated in Figure 11.16 in which stocks of gray color are newly added for open
economies.
Sources of consumers income are their labor supply, nancial assets they
hold such as bank deposits, shares (including direct assets abroad), and
deposits abroad. Hence, consumers receive wages and dividends from
producers, interest from banks and government, and direct and nancial
investment income from abroad.
Financial assets of consumers consist of bank deposits and government
securities, against which they receive nancial income of interests from
banks and government.
In addition to the income such as wages, interests, and dividends, consumers receive cash whenever previous securities are partly redeemed annually by the government.
Out of these cash income as a whole, consumers pay income taxes, and
the remaining income becomes their disposal income.
Out of their disposable income, they spend on consumption. The remaining amount is either spent to purchase government securities or saved.
Consumers are now allowed to make nancial investment abroad out of
their nancial assets consisting of stocks, bonds and cash. For simplicity,
however, their nancial investment are assumed to be a portion out of
their deposits . Hence, returns from nancial investment are uniformly
evaluated in terms of deposit returns.
Consumers now receive direct and nancial investment income. Similar
investment income are paid to foreign investors by producers and banks.
The dierence between receipt and payment of those investment income
is called income balance. When this amount is added to the GDP revenues, GNP (Gross National Product) is calculated. If capital depreciation
is further deducted, the remaining amount is called NNP (Net National
Product).
NNP thus obtained is completely paid out to consumers, consisting of
workers and shareholders, as wages to workers and dividends to shareholders, including foreign shareholders.
Foreign consumers are assumed to behave in a similar fashion as a mirror
image of domestic consumers.
299
Government
Transactions of the government are illustrated in Figure 11.17, some of which
are summarized as follows.
Government receives, as tax revenues, income taxes from consumers and
corporate taxes from producers.
Government spending consists of government expenditures and payments
to the consumers for its partial debt redemption and interests against its
securities.
Government expenditures are assumed to be endogenously determined
by either the growth-dependent expenditures or tax revenue-dependent
expenditures.
If spending exceeds tax revenues, government has to borrow cash from
consumers and banks by newly issuing government securities.
Foreign government is assumed to behave in a similar fashion as a mirror
image of domestic government.
Banks
Main transactions of banks are summarized as follows. They are also illustrated
in Figure 11.18 in which stocks of gray color are newly added for open economies.
Banks receive deposits from consumers and consumers abroad as foreign
investors, against which they pay interests.
They are obliged to deposit a portion of the deposits as the required
reserves with the central bank.
Out of the remaining deposits, loans are made to producers and banks
receive interests to which a prime rate is applied.
If loanable fund is not enough, banks can borrow from the central bank
to which discount rate is applied.
Their retained earnings thus become interest receipts from producers less
interest payment to consumers and to the central bank. Positive earnings
will be distributed among bank workers as consumers.
Banks buy and sell foreign exchange at the request of producers, consumers and the central bank.
Their foreign exchange are held as bank reserves and evaluated in terms
of book value. In other words, foreign exchange reserves are not deposited
with foreign banks. Thus net gains realized by the changes in foreign
exchange rate become part of their retained earnings (or losses).
Central Bank
Main transactions of the central bank are summarized as follows. They are also
illustrated in Figure 11.19 in which stocks of gray color are newly added for
open economies.
The central bank issues currencies against the gold deposited by the public.
It can also issue currency by accepting government securities through open
market operation, specically by purchasing government securities from
the public (consumers) and banks. Moreover, it can issue currency by
making credit loans to commercial banks. (These activities are sometimes
called money out of nothing.)
It can similarly withdraw currencies by selling government securities to the
public (consumers) and banks, and through debt redemption by banks.
Banks are required by law to reserve a certain amount of deposits with
the central bank. By controlling this required reserve ratio, the central
bank can control the monetary base directly.
The central bank can additionally control the amount of money supply
through monetary policies such as open market operations and discount
rate.
Another powerful but hidden control method is through its direct inuence
over the amount of credit loans to banks (known as window guidance in
Japan.)
The central bank is allowed to intervene foreign exchange market; that is,
it can buy and sell foreign exchange to keep a foreign exchange ratio stable
(though this intervention is actually exerted by the Ministry of Finance in
Japan, it is regarded as a part of policy by the central bank in our model).
Foreign exchange reserves held by the central bank is usually reinvested
with foreign deposits and foreign government securities, which are, however, not assumed here as inessential.
301
Net Exchange
Reserves
Official
Invervention
Price (Pf)
Interest
Rate (if)
Price (P)
Trade
Balance
Foreign
Exchange
Rate
Net
Capital
Flow
Interest
Rate (i)
GDP (Y)
GDP (Yf)
Expected
Foreign
Exchange
Rate
<Official
Invervention>
Random Normal
Distribution
Investment
Figure 11.2: Fixed Missing Loops in the Foreign Exchange Dynamics Model
11.3
300 YenReal/Year
-0.2 1/Year
0 YenReal/Year
-0.6 1/Year
0
10
15
1
5
1
4
1
3
35
2
40
1
4
5
20
25
30
Time (Year)
3
6
123
6
1 23
6
1 23
12 3
12 3
123
45
50
YenReal/Year
YenReal/Year
3 YenReal/Year
YenReal/Year
YenReal/Year
1/Year
303
Balance of Payments
Trade Balance
2
1
2
2
2
Yen/Year
2
2
Yen/Year
2
34
34
2
34
34
34
34
34
34
34
1
1
-1
-1
34
2
1
1
2
2
1
-2
-2
0
10
15
20
25
30
Time (Year)
1
2
35
1
40
45
1
1
2
50
10
15
20
1
2
25
30
Time (Year)
1
1
3
1
3
35
40
45
1
50
1
)LQDFLDO,QYHVWPHQW
Interest Arbitrage
2
0.01
0.005
<HQ<HDU
1/Year
12
1
2
1
2
12
2
1
-0.005
1
2
1
1
2
-1
2
2
2
-2
-0.01
0
10
15
20
25
30
Time (Year)
1
35
2
40
1
45
2
50
1
10
15
20
25
30
Time (Year)
)LQDQFLDO,QYHVWPHQW$EURDG(TXLOLEULXP7UDGH
1
)RUHLJQ)LQDQFLDO,QYHVWPHQW$EURDG(TXLOLEULXP7UDGH
35
1
40
1
45
1
50
1
business cycles are triggered out of the mostly equilibrium states such as the
ones by inventory coverage, price uctuation and cost-push wages, as well as an
economic recession by credit crunch. It would be interesting, as a continuation
of our discussions, to examine how these domestic business cycles and recession
aect foreign macroeconomies through trade and capital ows.
Let us rst consider a business cycle caused by inventory coverage. Suppose
a normal inventory coverage is set to be 0.7 or 8.4 months instead of the initial
value of 0.1 or 1.2 month as done in chapter 9. As expected again a similar
business cycle is being generated in the domestic economy as illustrated in Figure
11.6.
Does this business cycle aect a foreign economy? Figure 11.7 illustrates
the foreign countrys GDP and its growth rate. It clearly displays that business
cycles are being exported to the foreign economy through trade and capital ows.
This means vice versa that our domestic economy cannot be also free from the
inuence of foreign economic behaviors. In this sense, open macroeconomies can
be said to be mutually interdependent and constitute indeed a closed economic
system as a whole.
*'3UHDO
440
12
12
2
360
320
12
12
12
12
12
0.04
12
0.02
1
1
1/Year
<HQ5HDO<HDU
400
12
12
12
12
12
-0.02
280
-0.04
0
10
15
20
25
30
Time (Year)
1
1
*'3UHDO7UDGH,QYHQWRU\ 1
2
2
*'3UHDO(TXLOLEULXP7UDGH
35
1
40
1
45
1
50
10
15
20
25
30
Time (Year)
1
2
1
2
35
1
2
40
1
2
1
2
45
1
50
1
2
Figure 11.6: Inventory Business Cycles under Trade and Capital Flow
Growth Rate.f
*'3UHDOI
0.06
440
400
360
320
12
12
12
12
12
12
0.03
12
1
1
1/Year
'ROODU5HDO<HDU
2
12
1
2
1
1
-0.03
12
280
-0.06
0
10
15
20
25
30
Time (Year)
1
1
*'3UHDOI7UDGH,QYHQWRU\
2
2
*'3UHDOI(TXLOLEULXP7UDGH
35
1
40
1
45
1
50
0
5
10
15
20
25
30
Time (Year)
1
1
"Growth Rate.f" : Trade(Inventory)
2
"Growth Rate.f" : Equilibrium(Trade)
1
2
35
40
1
2
1
2
45
1
50
1
2
*'3UHDO
440
0.04
2
2
2
2
0.02
2
2
2
360
2
2
320
2
2
12
280
1/Year
<HQ5HDO<HDU
400
12
2
1
2
1
2
1
-0.02
-0.04
0
5
10
15
20
25
30
Time (Year)
1
*'3UHDO&UHGLW&UXQFK7UDGH 1
2
2
*'3UHDO(TXLOLEULXP7UDGH
35
1
40
1
45
1
1
2
50
10
15
20
25
30
Time (Year)
1
2
35
1
2
1
2
40
1
45
1
50
1
2
305
and capital ows. This means vice versa that our domestic economy cannot
be also free from the inuence of foreign economic behaviors. In this sense,
open macroeconomies can be said to be mutually interdependent and constitute
indeed a closed economic system as a whole.
Growth Rate.f
*'3UHDOI
0.02
440
360
320
12
12
12
12
12
12
12
12
12
12
12
0.01
1
2
1/Year
'ROODU5HDO<HDU
400
2
1
12
12
2
1
-0.01
280
-0.02
0
10
15
20
25
30
Time (Year)
1
2
35
1
2
1
2
40
1
45
1
1
2
50
1
10
15
20
25
30
Time (Year)
1
2
35
1
2
1
2
40
1
45
1
1
2
50
1
11.4
(11.2)
11.5. CONCLUSION
307
11.5
Conclusion
This is the nal chapter that completes our series of building macroeconomic
system. The integrated model in chapter 9 is extended to the open macroeconomies on the basis of the balance of payment in the previous chapter. Its
main feature is that two similar macroeconomies are needed to analyze international trade and capital ows through direct and nancial investment.
With a completion of building the open macroeconomies this way, many
possibilities are made available for the analysis of economic issues. Our analyses
are conned to the issues of inventory business cycles and credit crunch. Then,
it is shown that a business cycle and an economic recession triggered in the
domestic economy causes similar recessions in a foreign economy through the
transactions of trade and capital ows. In this sense, open macroeconomies are
indeed demonstrated to be a closed system in which economic behaviors are
reciprocally interrelated.
Though the model is still far from being complete and genetic by its nature,
its time, I believe, to make it open to the public for further ne-tunings and
revisions by the peers and macroeconomists as well as those who are interested
in our approach of macroeconomic system. The following appendix presents our
complete macroeconomic dynamic model.
Population
Labor Force.f
Currency
Circulation
Currency
Circulation.f
GDP
GDP.f
Producer.f
Consumer
Consumer.f
Government
Government.f
Banks
Banks.f
Balance of
Payments
GDP
Simulation
GDP
Simulation.f
Fiscal Policy
Fiscal Policy.f
Monetary
Policy
Monetary
Policy.f
Economic
Indicators.f
B/S C
heck.f
3 In this illustrated section of the model, only domestic macroeconomy is presented. The
model called MacroDynamics version 2.3 is available in the attached CD in this book.
Government.f
Banks.f
Government
Banks
GDP
Simulation
Monetary
Policy.f
B/S C
heck.f
B/S
C heck
Economic
Indicators.f
Economic
Indicators
Monetary
Policy
Balance of
Payments
GDP
Simulation.f
Foreign
Exchange Rate
Producer.f
Interest, Price
& Wage.f
Interest, Price
& Wage
C onsumer.f
GDP.f
GDP
Producer
C urrency
C irculation.f
C urrency
C irculation
C onsumer
Population
Labor Force.f
Population
Labor Force
Overview
Title
Income Tax
C onsumer
(H ousehold)
Public Services
Investment
(Housing)
C onsumption
Saving
G overnment
Investment (Public
Facilities)
National Wealth
(C apital
A ccumulation)
G ross
Domestic
Products
(G DP)
B anks
Money Supply
C entral B ank
Public Services
Investment (PP& E)
Production
Loan
C orporate Tax
P roducer
(F irm)
Import
Export
Income Tax
C onsumer
(H ousehold).f
Public Services
Investment
(Housing)
C onsumption
Saving
G overnment.f
Investment (Public
Facilities)
National Wealth
(C apital
A ccumulation)
G ross
Domestic
Products
(G DP).f
B anks.f
Money Supply
C entral B ank.f
Public Services
Investment (PP& E)
Production
Loan
P roducer
(F irm).f
C orporate Tax
11.5. CONCLUSION
309
births
High
School
C ollege
Education
college
attendance
ratio
HS Graduation
deaths
15 to 44
Population
15 To 44
initial
population
15 to 44
<Labor Force>
Going to
C ollege
High
schooling
time
<V oluntary
Unemployed>
maturation
14 to 15
Productive
Population
mortality
0 to 14
deaths
0 to 14
Population
0 To 14
<High School>
total fertility
reproductive
lifetime
initial
population
0 to 14
C ollege
schooling
time
C ollege
Graduation
Total
Graduation
mortality
15 to 44
maturation
44 to 45
Population
15 to 64
Portion to
15 to 44
Population
V oluntary
Unemployed
Initially
Unemployed
Labor
New
Unemployment
Unemploy
ment rate
New
Employment
mortality
45 to 64
deaths 45
to 64
Population
45 To 64
initial
population
45 to 64
Labor
Force
Unemployed
Labor
initial
population
65 plus
Time to Adjust
Labor
Desired
Labor
Initially
Employed
Labor
deaths 65
plus
mortality 65 plus
<Expected Wage
Rate>
<Price>
<Desired
Output
(real)>
<Excise Tax
Rate>
<Exponent
on Labor>
<C apacity
Idleness>
Labor Market
Flexibility
Retired
(Employed)
Population
65 Plus
Net
Employment
Employed
Labor
labor force
participation ratio
Retired
(V oluntary)
maturation
64 to 65
initial
population
15 to 64
<GDP (real)>
C apacity
Idleness
Initial
Potential
GDP
Technological
C hange
Potential
GDP
Initial
Labor
Force
<Excise Tax
Rate>
Exponent
on C apital
Full C apacity
GDP
Exponent
on Labor
<Labor Force>
Initial
C apital
(real)
<Employed
Labor>
Depreciation Rate
Depreciation
(real)
C apital-Output
Ratio
Desired Output
(real)
<C apital-Output
Ratio>
Desired
Investment (real)
C apital under
C onstruction
C hange in AD
Forecasting
Time to Adjust
C apital
Investment
(real)
<Price>
Time to Adjust
Forecasting
Aggregate
Demand (real)
Gross Domestic
Expenditure (real)
<Investment>
Normal Inventory
C overage
Net Investment
(real)
Interest
Sensitivity
Desired C apital
(real)
<Initial C apital
(real)>
C apital
C ompletion
C onstruction
Period
Aggregate
Demand
Forecasting
Desired Inventory
<Interest Rate>
Sales (real)
Inventory (real)
GDP (real)
Inventory
Investment
Aggregate
Demand
Forecasting
(Long-run)
<Full C apacity
GDP>
Time to Adjust
Forecasting (Long-run)
C hange in AD
Forecasting (Long-run)
Long-run
Production Gap
Growth
C overtion to %
Growth Rate
<GDP (real)>
Production(-1)
Growth Unit
<Real Foreign
Exchange Rate>
<Price>
Government
Expenditure
<Imports (real)>
Government
Expenditure (real)
Net Exports
(real)
<Imports (real).f>
<Normalized
Demand C urve>
C onsumption
Exports (real)
<Investment
(real)>
C onsumption
(real)
<Price>
11.5. CONCLUSION
311
<Desired
Inventory>
Inventory
Ratio
Production
Ratio
Weight of
Inventory Ratio
<Inventory (real)>
<Desired
Output (real)>
<Potential GDP>
Effect on
Price
Change in Price
Supply of
Money
(real)
Wage Rate
Change
Desired
Price
Initial Price
level
Real Wage
Rate
Demand for
Money
(real)
Price
Actual
Velocity of
Money
Money
Ratio
Effect on
Interest Rate
Desired
Wage
Initial Wage
Rate
Wage Rate
Inflation Rate
Price (-1)
Demand for
Money by the
Government
Demand for
Money by
Consumers
Demand for
Money by
Producers
Effect on
Wage
Expected
Wage Rate
<Desired Labor>
<Labor Force>
Delay Time of
Wage Change
<Lending
(Banks)>
<Payment by
Banks>
Labor
Ratio
Change in
Wage Rate
<Foreign
Exchange Sale>
<Foreign
Exchange out>
<Cash out>
<Securities purchased
by Banks>
<Government Debt
Redemption>
<Interest paid by the
Government>
<Government Expenditure>
<Cash Demand>
<Saving>
<Consumption>
<Income Tax>
<Dividends>
<Desired Investment>
<Payment by Producer>
<Discount Rate>
Demand for
Money by Banks
Initial
Interest
Rate
<Inflation Rate>
Interest Rate
(nominal)
Demand for
Money
Interest Rate
Desired
Interest Rate
Discount Rate
Change Time
Cost-push (Wage)
Coefficient
Money
Supply
Delay Time of
Price Change
Velocity of
Money
<Deposits (Banks)>
Currency in
Circulation
<Net Foreign
Exchange (Banks)>
<Vault Cash
(Banks)>
<Cash (Government)>
<Cash (Producer)>
<Cash (Consumer)>
Discout Rate
Change
<Initial Foreign
Exchange Rate>
<Lending
(Banks).f>
<New C apital
Shares.f>
C ash
Flow.f
<Producer Debt
Redemption.f>
Imports
(real).f
Demand Index
for Imports.f
<Dividends.f>
<Interest paid by
Producer.f>
Imports
Demand
C urve.f
Imports
C oefficient.f
<GDP (real).f>
Trade Balance.f
<Exports.f>
Sales.f
<Lending
(Banks).f>
New C apital
Shares.f
<Exports (real).f>
Exports.f
Investing
Activities
Operating
Activities
<Interest paid by
Producer.f>
Financing
Activities
C ash (Producer).f
<Producer Debt
Redemption.f>
<Direct Investment
Abroad.f>
<Desired
Investment.f>
<Payment by
Producer.f>
<Sales.f>
<Price.f>
<Dividends.f>
Inventory.f
Direct Financing
Ratio.f
<Price.f>
Desired Borrowing
(Producer).f
Desired
Financing.f
<Price>
<Foreign
Exchange Rate>
Imports.f
<GDP
(Revenues).f>
<Sales (real).f>
Direct Investment
Index.f
Direct Investment
Abroad.f
Direct Investment.f
Investment.f
Desired
Investment.f
<C orporate
Tax.f>
<Producer Debt
Redemption.f>
<Interest Arbitrage
Adjusted.f>
<Interest paid by
Producer.f>
Direct Investment
Index Table.f
Direct Assets
Abroad.f
Direct Investment
Ratio.f
<Initial C apital
(real).f>
<C orporate
Tax.f>
<Wage Rate.f>
<Employed
Labor.f>
<Price.f>
<Interest Rate
(nominal).f>
Dividends.f
<Dividends
Abroad.f>
Wages.f
Tax on
Production.f
Producer Debt
Redemption.f
Producer Debt
Period.f
C hange in Excise
Rate.f
<Depreciation
(real).f>
Depreciation.f
<Direct
Investment
Abroad (FE)>
<Wages.f>
<Price.f>
<Desired
Investment (real).f>
<Imports.f>
Payment by
Producer.f
<Tax on
Production.f>
Dividends
Abroad.f
Profits for
Dividends.f
Retained Earnings
(Producer).f
Initial C apital
Shares.f
C apital Shares.f
<Lending
(Banks).f>
Profits.f
Dividends Ratio.f
C orporate Tax.f
C orporate Tax
Rate.f
Profits before
Tax.f
GDP (Revenues).f
<Price.f>
<Depreciation.f>
<Interest paid by
Producer.f>
<Wages.f>
<Tax on
Production.f>
<GDP (real).f>
<Foreign
Exchange Rate>
<Direct Investment
Abroad>
Initial C apital
Liabilities Abroad.f
<New C apital
Shares.f>
C apital Shares
Newly Issued.f
Direct Investment
Abroad (FE)
Debt (Producer).f
C apital Liabilities
Abroad.f
Initial Direct
Assets Abroad.f
11.5. CONCLUSION
313
<Securities sold
by C onsumer>
<Gold
C ertificates>
C ashing
Time
Financial
Investment Index
Financial
Investment
C urrency
Ratio
C ash
Demand
Saving
<Disposable
Income>
Initial Financial
Assets Abroad
<Debt Redemption
Ratio by Banks>
Debt Redemption
Ratio by C onsumer
Initial Security
Holding Ratio
held by
C onsumer
Government
Securities
(C onsumer)
<Initial C apital
Shares>
Shares
(held by
C onsumer)
<Price>
C onsumer Equity
Distributed
Income
Income
Distribution
by Producers
<Open Market
Purchase (Public Sale)>
<Government Debt
Redemption>
Securities sold
by C onsumer
NDC Table
<Government
Securities Newly
Issued>
Securities purchased
by C onsumer
Financial
Investment
(Shares)
Normalized
Demand C urve
Government
Transfers
Financial
Investment
Abroad
Deposits
Abroad
(C onsumer)
Deposits
(C onsumer)
Marginal Propensity
to C onsume
C onsumption
Income Tax
Basic
C onsumption
Financial
Investment Ratio
<Interest Rate
(nominal)>
C urrency Ratio
Table
<Initial C urrency
Outstanding>
C ash
(C onsumer)
Financial Investment
Index Table
<Income Abroad
(C onsumer)>
<Income>
Disposable
Income
Income Tax
Rate
Lump-sum Taxes
C hange in
Lump-sum Taxes
Income Abroad
(C onsumer)
Income
<Wages>
<Dividends>
<Wages (Banks)>
<Gold Deposit>
<Depreciation>
<Interest paid by
Producer>
<Income>
<Dividends>
<Wages>
Government
Deficit
<Government
Securities>
<Tax Revenues>
<Government Debt
Redemption>
Government
Borrowing
Cash (Government)
Government
Expenditure
Switch
Base Expenditure
Change in
Expenditure
Change in Government
Expenditure
Primary
Balance
<Tax Revenues>
Change in
Primary
Balance
Ratio
Growth-dependent
Expenditure
Primary
Balance
Time
Revenue-dependent
Expenditure
<Interest Rate
(nominal)>
<Growth Rate>
Government Debt
Redemption
Government
Debt Period
Retained Earnings
(Government)
Initial Government
Debt
Debt (Government)
Debt-GDP ratio
Tax Revenues
Government
Securities
<GDP
(Revenues)>
<Income Tax>
<Corporate Tax>
<Tax on
Production>
<Government
Deficit>
11.5. CONCLUSION
315
<Foreign
Exchange
(FE)>
<Foreign
Exchange
Rate>
<Interest on
Financial Liabilities
Abroad.f>
<Dividends
Abroad.f>
<Adjusting
Reserves>
<Payment by
Banks>
<Exports>
<Securities
purchased by
Banks>
<Reserves
Deposits>
<Foreign C ash
out>
C ash in
<Foreign
Exchange Sale>
Net Gains by
C hanges in
Foreign Exchange
Rate
Foreign
Exchange in
<Lending
(C entral Bank)>
<Desired
Borrowing
(Producer)>
C ash Flow
Deficit
(Banks)
<Dividends
Abroad>
<Direct Investment
Abroad>
<Imports>
<Interest Income
(Banks)>
<Producer Debt
Redemption>
<Securities sold
by Banks>
<Deposits in>
Net Gain
Adjustment Time
Foreign
Exchange
(Book V alue)
<Foreign Financial
Investment
Abroad>
<Foreign Direct
Investment Abroad>
V ault C ash
(Banks)
Foreign
Exchange
(Banks)
Payment
by Banks
<Desired
Borrowing
(Producer)>
Lending (Banks)
<Government Securities
Newly Issued>
Government
Securities
(Banks)
Excess Reserve
Ratio
<Exports>
<Foreign Direct
Investment Abroad>
<Producer Debt
Redemption>
Securities sold by
Banks
Interest paid
by Banks
(C onsumer)
Deposits
(Banks)
Wages (Banks)
Interest paid
by Banks
Retained
Earnings
(Banks)
Interest paid
by Producer
Profits (Banks)
<Net Gains by
C hanges in Foreign
Exchange Rate>
Interest Income
(Banks)
<Debt (Banks)>
<Exports>
<Saving>
Prime Rate
Deposits in
Borrowing
(Banks)
<Lending (C entral
Bank)>
Foreign Financial
Investment Abroad
Discount Rate
<Interest Rate
(nominal)>
Interest paid
by Banks
(C entral Bank)
Deposits out
Debt
(Banks)
Financial
Liabilities
Abroad
Interest on Financial
Liabilities Abroad
Net Deposits
<Interest on
Financial Liabilities
Abroad>
<Financial
Investment Abroad>
<Government Debt
Redemption>
<Financial
Investment
(Shares)>
<Securities
purchased by
C onsumer>
<C ash
Demand>
Banks Debt
Period
Banks Debt
Redemption
<Interest Rate
(nominal)>
RR Ratio C hange
Excess Reserves
<Foreign
Exchange Sale>
<Open Market Purchase
(Banks Sale)>
<Banks Debt
Redemption>
Loan
(Banks)
Required
Reserve
Ratio
Required
Reserves
Reserves out
Open Market
Operations
Reserves
(Banks)
3
<Direct Investment
Abroad>
<Financial
Investment Abroad>
3
<Imports>
Debt Redemption
Ratio by Banks
<Excess
Reserves>
Securities
purchased by
Banks
Reserves
AT
Adjusting
Reserves
Reserves
Deposits
<Deposits out>
C ash out
<Interest on Financial
Liabilities Abroad>
<Foreign Exchange
Purchase>
Foreign
Exchange out
<Dividends
Abroad>
<Interest paid by
Banks>
<Loan (Banks)>
Prime Rate
Premium
<Foreign
Exchange Rate>
<Financial Investment
Abroad.f>
<Government Securities
(C onsumer)>
Open Market
Purchase (Public Sale)
Lending Time
Lending by
C entral Bank
Open Market
Purchase Time
Open Market
Purchase Operation
Open Market
Purchase
Lending Period
Lending
(C entral Bank)
Gold
Foreign
Exchange
Reserves
Foreign Exchange
Sales Amount
<Banks Debt
Redemption>
Monetary Base
Open Market
Sale Time
Decrease in
Reserves
<Foreign
Exchange Sale>
Notes Withdrown
<Interest Income
(C entral Bank)>
Foreign Exchange
Upper bound
Gold C ertificates
Foreign Exchange
Sale
<Government Securities
(Banks)>
Open Market
Purchase (Banks Sale)
Government
Securities
(C entral Bank)
Loan
(C entral
Bank)
Gold Deposit
Foreign Exchange
Purchase
<Desired Borrowing
(Banks)>
Deposit Time
Gold Deposit by
the Public
Gold Standard
Foreign Exchange
Lower Bound
Foreign Exchange
Purchase Amount
<Foreign
Exchange Rate>
Retained
Earnings
(C entral Bank)
Reserves
(C entral Bank)
Reserves by
Banks
C urrency
Outstanding
<Lending
(C entral
Bank)>
<Interest paid by
Banks (C entral Bank)>
Interest Income
(C entral Bank)
Increase in
Reserves
<Foreign Exchange
Purchase>
<Adjusting
Reserves>
<Reserves
Deposits>
Notes Newly
Issued
<Open Market
Purchase (Public
Sale)>
11.5. CONCLUSION
317
<Imports.f>
Foreign Exchange
in (FE)
<Foreign
Exchange Sale>
C hange in Foreing
Exchange Rate
Initial Foreign
Exchange Rate
seeds
standard
deviation
Adjustment Time of
Foreign Exchange
Expectation
mean
<Financial
Investment
Abroad (FE)>
<Direct
Investment
Abroad (FE)>
Imports (Foreign
Exports)
C hange in Expected
Foreign Exchange Rate
Expected
C hange in
FER
<Foreign Exchange
Purchase>
Foreign Exchange
Purchase (FE)
Foreign Exchange
out (FE)
Expected
Foreign
Exchange Rate
<Price.f>
Real Foreign
Exchange Rate
<Price>
Initial Foreign
Exchange (FE)
Foreign
Exchange
(FE)
Foreign
Exchange Rate
Foreign Exchange
Sale (FE)
Foreign Exchange
C oefficient
Supply of Foreign
Exchange
<Financial
Investment
Abroad.f>
<Direct
Investment
Abroad.f>
Exports (Foreign
Imports)
<Exports.f>
<Arbitrate
Adjustment Time>
Interest
Arbitrage.f
Expected Return on
Deposits Abroad.f
Expected Return on
Deposits Abroad
Interest
Arbitrage
Arbitrate
Adjustment Time
Interest
Arbitrage
Adjusted.f
<Interest
Rate.f>
<Expected Foreign
Exchange Rate>
<Foreign
Exchange Rate>
<Interest
Rate>
Interest
Arbitrage
Adjusted
<Initial Foreign
Exchange (FE)>
Balance of
Payments
C urrent Account
C apital &
Financial
Account
Goods &
Services
Financial
Account
<Direct
Investment
Abroad>
<Foreign
Exchange
Purchase>
<Foreign Direct
and Financial
Investment
Income>
Earnings out
<Imports>
Earnings in
<Exports>
<C hanges in
Reserve Assets>
<Other
Investment>
Liabilities
Abroad
Assets
Abroad
<Foreign
Exchange Sale>
Income Balance
Retained
Earnings and
C onsumer
Equity
Service Income
Inventory
(Trade)
Trade Balance
<Exports>
<Foreign
Financial
Investment
Abroad>
<Foreign Financial
Investment Abroad>
Foreign
Exchange in
<Foreign
Exchange Sale>
C hanges in
Reserve Assets
Foreign
Exchange
(Banks)
Other Investment
Other Investment
(Debit)
<Foreign Exchange
Purchase>
Foreign
Exchange out
Other Investment
(C redit)
<Financial
Investment Abroad>
<Direct Investment
Abroad>
<Imports>
<Foreign Direct
Investment Abroad>
<Foreign
Direct
Investment
Abroad>
<Direct and
Financial
Investment
Income>
11.5. CONCLUSION
319
Currency
Circulation.f
GDP.f
Currency
Circulation
GDP
Consumer.f
Government.f
Banks.f
Consumer
Government
Banks
Monetary
Policy.f
Monetary
Policy
B/S C
heck.f
B/S
Check
Circul
ation
Economic
Indicators.f
Economic
Indicators
GDP
Simulation.f
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11.5. CONCLUSION
321
Part IV
New Macroeconomic
System
323
Chapter 12
Designing A New
Macroeconomic System
This chapter 1 rst examines that the government debt is structurally built in
the current macroeconomic system of money as debt which is founded on the
Keynesian macroeconomic framework, and it becomes very costly to reduce it,
within the scheme, by raising tax or cutting expenditure. Then, it demonstrates
how the government debt could be liquidated without cost under an alternative
macroeconomic system of debt-free money that is proposed by the American
Monetary Act. Finally, it is posed that debt-free macroeconomic system is far
superior to the debt-burden current macroeconomic system in a sense that it
can not only liquidate government debt but also attain higher economic growth.
12.1
Introduction
While my macroeconomic modeling was advancing, the current world-wide nancial crises were triggered by the bankruptcy of Lehman Brothers in September, 2008, and the US government has been forced to bail out the troubled
nancial institutions with $800 billion out of taxpayers pockets, which in turn
caused furious angers among American people.
These nancial turmoils gave me, as a system dynamics researcher, a chance
to re-think about the eectiveness of current macroeconomic system as a system
design, since system dynamics is a methodology to help design a better system
as Jay Forrester, founder of system dynamics, emphasized in 1961:
Labor turmoil, bankruptcy, ination, economic collapse, political
unrest, revolution, and war testify that we are not yet expert enough
1 This chapter is based on the paper: On the Liquidation of Government Debt under A
Debt-Free Money System Modeling the American Monetary Act in Proceedings of the
28th International Conference of the System Dynamics Society, Seoul, Korea, July 25 - 29,
2010. ISBN .
325
326
12.1. INTRODUCTION
327
328
though the government, its major shareholder, is currently prohibited from the
banks decision-making process by law. In Europe, two incorporation processes
could be possible. First, EU member countries are politically integrated into,
say, the United States of Europe, which in turn establishes its own federal European government and incorporate the current European Central Bank into
its branch. Or the ECB is once again disintegrated and incorporated into the
governments of member countries, respectively.
Abolishment of credit creation
Credit can be created by the lending of commercial banks, and becomes a part
of money supply, because it plays a role of means of exchange. The credit
creation has been called money out of nothing or money out of thin air by
Keynes. It is made possible because banks are required to hold only a fraction
of deposits (with the central bank) and can lend the remaining larger portion.
This system is called a fractional reserve banking system. Heavily-criticized
practice of leveraged investment that led to the recent nancial crises is made
possible by the credit creation. Under a debt-free money system, this fractional
reserve banking system is abolished; that is, a fractional reserve ratio has to be
100%. The American Monetary Act suggests as follows:
Second, the accounting privilege banks now have of creating money
through fractional reserve lending of their credit is stopped entirely,
once and for all. Banks remain private companies and are encouraged to act as intermediaries between their clients who want a return
on their savings and those clients willing to pay for borrowing those
savings, but they may no longer create any part of the nations
money supply [71, p.12].
It will be worthwhile to clarify a position of money in an economy. Suppose
there exists N commodities in an economy. Under gold standard or commodity
money standard, one of the commodities becomes money against which the remaining N-1 commodities are exchanged. Hence, quantity of money is limited by
the production of gold or commodity money. Under a fractional reserve banking
system, credit is created and used as low-powered money in addition to monetary base or high-powered money. In other words, 2 types of money are being
used for the exchange of N commodities; that is, currency in circulation and deposits. Finally, under a system of debt-free money, only the government-issued
at money is used to exchange for N commodities. Schematically, positions of
money under dierent monetary system is summarized as follows:
Gold or Commodity Money Standard
(N - 1) + Gold
Fiat Money as Debt
N + Currency in Circulation + Credits(Deposits)
Debt-free Fiat Money
N + Money
12.1. INTRODUCTION
329
(12.1)
(12.2)
330
12.2
For the comparative analysis of the two macroeconomic systems, the integrated
macroeconomic model developed in chapter 8 is revisited in this chapter4 . According to the discussions above, the model is classied as a macroeconomic
system of money as debt, in which ve macroeconomic sectors are assumed to
play interdependent activities simultaneously; that is, producers, consumers,
banks, government and the central bank. Foreign sector is excluded from the
model.
Under the current macroeconomic system of money as debt, transactions
by producers, consumers, government, banks and the central bank remain the
same as already explained in Chapter 8. Yet, transactions of government, banks
and central bank are repeated here as a comparative reference to the revised
transactions under a macroeconomic system of debt-free money to be presented
below.
3 University of California at Berkeley, where I studied mathematical economics in late 70s
and early 80s, was named after the philosopher Berkeley.
4 This choice of the model is in accordance with my viewpoint that labor market should
be abolished from a market economy as a better economic system, which is proposed as the
MuRatopian economy in [58]. The MuRatopian economy is presented as an alternative system,
beyond capitalist market economy and planned socialist economy, suitable for the information
age of the 21st century. However, money system is missing in the economy, I admit. While
writing this chapter, I become convinced that a debt-free money system should be indeed a
monetary system of the MuRaopian economy.
331
Government
Transactions of the government are illustrated in Figure 12.1, some of which are
summarized as follows.
Government receives, as tax revenues, income taxes from consumers and
corporate taxes from producers as well as excise tax on production.
Government spending consists of government expenditures and payments
to the consumers for its partial debt redemption and interests against its
securities.
Government expenditures are assumed to be endogenously determined
by either the growth-dependent expenditures or tax revenue-dependent
expenditures.
If spending exceeds tax revenues, government has to borrow cash from
banks and consumers by newly issuing government securities.
Banks
Transactions of banks are illustrated in Figure 12.2, some of which are summarized as follows.
Banks receive deposits from consumers, against which they pay interests.
They are obliged to deposit a fraction of the deposits as the required
reserves with the central bank (which is called a fractional reserve banking
system).
Out of the remaining deposits loans are made to producers and banks
receive interests for which a prime rate is applied.
Their retained earnings thus become interest receipts from producers less
interest payment to consumers. Positive earning will be distributed among
bank workers as consumers.
Central Bank
The central bank plays an important role of issuing money or currency. Sources
of its assets against which money is issued are simply conned to gold, discount
loans and government securities. The central bank can control the amount of
money supply through the amount of monetary base consisting of currency outstanding and bank reserves. This monetary control can be carried out through
monetary policies such as a manipulation of required reserve ratio and open market operations as well as direct control of lending to the banks. Transactions of
the central bank are illustrated in Figure 12.3, some of which are summarized
as follows.
Government
Deficit
<Government
Securities Newly
Issued>
<Government Debt
Redemption>
<Tax Revenues>
Government
Borrowing
Cash (Government)
Government
Expenditure
Switch
Growth-dependent
Expenditure
Change in Government
Expenditure
Change in
Expenditure
<Money as Public
Utility>
<Tax Revenues>
Primary
Balance
Primary Balance
Ratio
Revenue-dependent
Expenditure
<Interest Rate
(nominal)>
<Growth Rate>
<Interest paid by
the Government>
Primary Balance
Change Time
Primary Balance
Change
Government Debt
Redemption
Government
Debt Period
Initial Debt
(Government)
<Corporate Tax>
<Income Tax>
<Tax on
Production>
<Government
Deficit>
Initial Retained
Earnings (Government)
Tax Revenues
Government Securities
Newly Issued
<GDP
(Revenues)>
Initial Cash
(Government)
Retained Earnings
(Government)
Debt (Government)
Debt-GDP ratio
332
CHAPTER 12. DESIGNING A NEW MACROECONOMIC SYSTEM
Desired
Borrowing
(Banks)
<Payment by
Banks>
Cash Flow
Deficit
(Banks)
<Interest Income
(Banks)>
<Producer Debt
Redemption>
<Securities sold
by Banks>
<Deposits in>
<Borrowing
(Banks)>
<Desired
Borrowing
(Producer)>
<Securities
purchased by
Banks>
<Reserves
Deposits>
<Cash out>
Cash in
Vault Cash
(Banks)
<Excess
Reserves>
<Desired
Borrowing
(Producer)>
Lending (Banks)
<Government Securities
Newly Issued>
Securities
purchased by
Banks
Reserves
AT
Adjusting
Reserves
Reserves
Deposits
Cash out
<Deposits out>
<Banks Debt
Redemption>
Loan
(Banks)
Security Holding
Ratio by Banks
Government
Securities
(Banks)
<Producer Debt
Redemption>
<Government
Securities (Central
Bank)>
<Switch
(Seigniorage)>
Interest paid by
Banks
(Consumer)
Banks Debt
Redemption
Wages (Banks)
Interest paid
by Banks
Interest paid by
Banks (Central
Bank)
Deposits out
Banks Debt
Period
<Securities
purchased by
Consumer>
<Financial
Investment
(Shares)>
<Cash
Demand>
<Government Debt
Redemption>
<Government
Securities (Consumer)>
Securities sold by
Banks
Debt
(Banks)
Retained
Earnings
(Banks)
Profits (Banks)
Interest Income
(Banks)
<Loan (Banks)>
<Interest paid by
Banks>
Interest paid by
Producer
Prime Rate
Premium
<Securities sold by
Consumer>
<Saving>
Prime Rate
Deposits in
<Debt (Banks)>
Discount
Rate
<Interest Rate
(nominal)>
Deposits
(Banks)
Borrowing
(Banks)
<Lending
(Central Bank)>
<Switch
(Seigniorage)>
<Lending (Public
Money)>
Net Deposits
Excess Reserve
Ratio
Excess Reserves
Open Market
Operations
Reserves
(Banks)
Required
Reserves
Required
Reserve
Ratio
RR Ratio Change
334
The central bank issues money (historically gold certicates) against the
gold deposited by the public.
It can also issue money by accepting government securities through open
market operation, specically by purchasing government securities from
the public (consumers) and banks. Moreover, it can issue money by making discount loans to commercial banks. (These activities are sometimes
called creation of money out of nothing.)
It can similarly withdraw money by selling government securities to the
public (consumers) and banks, and through debt redemption by banks.
Banks are required by law to reserve a certain fraction of deposits with
the central bank. By controlling this required reserve ratio, the central
bank can control the monetary base directly.
The central bank can, thus, control the amount of money supply through
monetary policies such as open market operations, reserve ratio and discount rate.
Another powerful but hidden control method is through its direct inuence
over the amount of discount loans to banks (known as window guidance
in Japan.)
12.3
(12.3)
By trial and error, mostly equilibrium states are acquired, as in chapter 8, when
a ratio elasticity of the eect on price e is 1, and a weight of inventory ratio
is 0.1, as illustrated in Figure 12.4.
These equilibrium states are used in chapter 8 as a benchmarking state for
comparisons with various disequilibrium cases such as x-price disequilibria,
business cycles caused by inventory coverage and elastic price uctuation, and
economic recession caused by credit crunch. Moreover, these disequilibria are
shown to be xed toward equilibria through monetary and scal policies. In this
chapter, our analysis is conned only to the case of liquidation of government
debt.
<Government
Securities
(Consumer)>
Open Market
Purchase
(Public Sale)
Open Market
Purchase
Securities
purchased by
Central Bank
Open Market
Purchase Time
Purchase Period
Open Market
Purchase Operation
(temporary)
Gold
<Government
Securities (Banks)>
Open Market
Purchase
(Banks Sale)
Securities
sold by
Central Bank
Open Market
Public Sales Rate
Sales Period
Decrease in
Reserves
Monetary
Base
Notes Withdrown
<Government Debt
Redemption>
Government
Securities
(Central Bank)
<Interest Income
(Central Bank)>
<Banks Debt
Redemption>
<Government
Securities (Consumer)>
Discount Loan
(Central Bank)
<Government
Securities (Banks)>
Lending
(Central Bank)
Window
Guidance
Gold Deposit
Open Market
Purchase Operation
(permanent)
Lending
(Central Bank)
(-1)
Desired
Lending
Growth Rate
of Credit
<Government
Securities Newly
Issued>
Lending
Period
Lending Time
Lending by
Central Bank
<Desired
Borrowing
(Banks)>
Deposit Time
<Securities sold by
Central Bank> Gold Deposit by
the Public
Retained
Earnings
(Central Bank)
Reserves
(Central Bank)
Gold Certificates
Interest Income
(Central Bank)
<Interest paid by
Banks (Central Bank)>
Increase in
Reserves
<Open Market
Purchase (Banks Sale)>
<Adjusting
Reserves>
<Lending
(Central Bank)>
<Open Market
Purchase (Public Sale)>
<Reserves
Deposits>
Notes Newly
Issued
<Lending (Public
Money)>
Reserves by
Banks
Currency
Outstanding
<Securities purchased
by Central Bank>
336
DollarReal/Year
450
12
1 23
1 23
1 23
23
1 23
1 23
300
4
12
12 3
150
5
0
0
10
15
20
25
30
Time (Year)
1
2
4
1
3
35
1
40
1
45
1
3
50
Money as Debt
For the attainment of mostly equilibria, enough amount of money has to be
put into circulation to avoid recessions caused by credit crunch as analyzed in
chapter 8. Demand for money mainly comes from banks and producers. Banks
are assumed to make loans to producers as much as desired so long as their
vault cash is available. Thus, they are persistently in a state of shortage of
cash as well as producers. In the case of producers, they could borrow enough
fund from banks. From whom, then, should the banks borrow in case of cash
shortage?
In a closed economic system, money has to be issued or created within the
system. Under the current nancial system of money as debt, only the central
bank is endowed with a power to issue money within the system, and make loans
to the commercial banks directly and to the government indirectly through
the open market operations. Commercial banks then create credits under a
fractional reserve banking system by making loans to producers and consumers.
These credits constitute a major portion of money supply. In this way, money
and credits are only crated when commercial banks and the government as well
as producers and consumers come to borrow at interest. If all debts are repaid,
money ceases to exit. This is an essence of a system of money as debt. This
process of creating money is known as money out of nothing.
Figure 12.5 indicates unconditional amount of annual discount loans and its
growth rate by the central bank at the request of desired borrowing by banks.
In other words, money has to be incessantly created and put into circulation in
order to sustain an economic growth under mostly equilibrium states. Roughly
speaking, a growth rate of credit creation by the central bank has to be in
337
average equal to or slightly greater than the economic growth rate as suggested
by the right hand diagram of Figure 12.5.
Growth Rate of Credit
0.4
45
0.2
Dmnl
Dollar/Year
30
-0.2
15
-0.4
0
0
0
10
15
20
25
30
Time (Year)
35
40
45
10
15
20
50
25
30
Time (Year)
35
40
45
50
Figure 12.5: Lending by the Central Bank and its Growth Rate
In this way, the central bank begins to exert an enormous power over the
economy through its credit control. What happens if the central bank fails to
supply enough currency intentionally or unintentionally? An economic recession
by credit crunch as analyzed in chapter 8. An inuential role of the central bank
which caused economic bubbles and the following burst in Japan during 1990s
is completely analyzed by Warner in [54] and [55].
Government Debt
So long as the mostly equilibria are realized in the economy, through monetary
and scal policies in the days of recession, no macroeconomic problem seems
to exist. This is a positive side of Keynesian macroeconomic theory. Yet behind the full capacity aggregate demand growth path in Figure 12.4 government
debt continues to accumulate as the line 1 in the left diagram of Figure 12.6
illustrates. This is a negative side of the Keynesian theory. Yet most macroeconomic textbooks neglect or less emphasize this negative side, partly because
their macroeconomic frameworks cannot handle this negative side of the system
of money as debt.
Primary balance ratio is initially set to be one and balanced budget is assumed here; that is, government expenditure is set to be equal to tax revenues,
and no decit seems to arises. Why, then, does the government continue to
accumulate debt? Government decit is, as discussed in chapter 8, precisely
dened as
Decit = Tax Revenues - Expenditure - Debt Redemption - Interest
(12.4)
338
Debt-GDP ratio
800
1
1
600
1.5
1
1
Year
Dollar
400
1
1
200
12
12
12
1
1
12
0.5
12
12
0
0
10
15
20
25
30
Time (Year)
2
35
1
40
1
45
1
50
2
10
15
20
25
30
Time (Year)
1
2
35
1
1
2
40
1
45
1
50
1
2
1
2
339
GDP (real)
600
1
DollarReal/Year
500
400
12
12
12
1
2
12
12
12
12
12
2
300
200
0
10
15
20
25
30
Time (Year)
1
1
"GDP (real)" : Equilibrium(as Debt)
2
"GDP (real)" : Primary Balance=91%
35
1
2
40
1
45
1
50
1
2
12.4
340
Government
Balanced budget is assumed to be maintained; that is, a primary balance
ratio is unitary. Yet the government may still incur decit due to the debt
redemption and interest payment.
Government now has the right to newly issue money whenever its decit
needs to be funded. The newly issued money becomes seigniorage inow
of the government into its equity or retained earnings account.
The newly issued money is simultaneously deposited with the reserve account of the Public Money Administration. It is also booked to its deposits
account of the government assets.
Government could further issue money to ll in GDP gap.
Revised transaction of the government is illustrated in Figure 12.8. Green stock
box of deposits is newly added to the assets.
Banks
Revised transactions of commercial banks are summarized as follows.
Required Reserve Ratio
3
23
23
23
23
23
23
0.75
2
Dmnl
0.5
2
0.25
2
123 12
0
0
3 1231
10
15
20
25
30
Time (Year)
35
40
45
50
<Government Debt
Redemption>
<Tax Revenues>
<Switch
(Seigniorage)>
Government
Crediting
Government
Borrowing
Deposits
(Government)
Government
Deficit
<Seigniorage>
<Government
Securities Newly
Issued>
Cash (Government)
Government
Expenditure
Switch
Growth-dependent
Expenditure
Change in Government
Expenditure
Change in
Expenditure
<Money as Public
Utility>
<Tax Revenues>
Primary
Balance
Primary Balance
Ratio
Revenue-dependent
Expenditure
<Interest Rate
(nominal)>
<Growth Rate>
<Interest paid by
the Government>
Primary Balance
Change Time
Primary Balance
Change
Government Debt
Redemption
Government
Debt Period
Initial Debt
(Government)
<Corporate Tax>
<Income Tax>
<Tax on
Production>
Money as Public
Utility
<Government
Deficit>
Initial Retained
Earnings (Government)
Tax Revenues
Issue Duration
Issue Time
Seigniorage
Switch
(Seigniorage)
Government Securities
Newly Issued
<GDP
(Revenues)>
Initial Cash
(Government)
Retained Earnings
(Government)
Debt (Government)
Debt-GDP ratio
342
Line 1 in Figure 12.9 illustrates the originally required reserve ratio of 5%.
In addition, two dierent ways of abolishing a fractional reserve banking system
are assumed. Line 2 shows that the 100% fraction (full reserves) is gradually
attained in 10 years at the year 25, starting from the year 10, meanwhile line 3
indicates that the 100% fraction is attained immediately at the year 10.
12.5
<Government
Securities
(Consumer)>
Open Market
Purchase
(Public Sale)
Open Market
Purchase
Securities
purchased by
Central Bank
Open Market
Purchase Time
Purchase Period
Open Market
Purchase Operation
(temporary)
Gold
<Government
Securities (Banks)>
Open Market
Purchase
(Banks Sale)
Securities
sold by
Central Bank
Open Market
Public Sales Rate
Sales Period
Decrease in
Reserves
Monetary
Base
Notes Withdrown
<Government Debt
Redemption>
Government
Securities
(Central Bank)
<Interest Income
(Central Bank)>
<Banks Debt
Redemption>
<Government
Securities (Consumer)>
Discount Loan
(Central Bank)
<Switch
(Seigniorage)>
Seigniorate
Assets
<Government
Securities (Banks)>
Lending
(Central Bank)
Window
Guidance
Lending (Public
Money)
<Seigniorage>
Gold Deposit
Open Market
Purchase Operation
(permanent)
Lending
(Central Bank)
(-1)
Desired
Lending
Growth Rate
of Credit
<Government
Securities Newly
Issued>
Lending
Period
Lending Time
Lending by
Central Bank
<Desired
Borrowing
(Banks)>
Deposit Time
<Securities sold by
Central Bank> Gold Deposit by
the Public
Retained
Earnings
(Central Bank)
Reserves
(Central Bank)
Interest Income
(Central Bank)
<Interest paid by
Banks (Central Bank)>
Increase in
Reserves
<Open Market
Purchase (Banks Sale)>
<Adjusting
Reserves>
<Lending
(Central Bank)>
<Open Market
Purchase (Public Sale)>
Gold Certificates
<Securities purchased
by Central Bank>
<Reserves
Deposits>
Notes Newly
Issued
<Seigniorage>
<Lending (Public
Money)>
Reserves by
Banks
Currency
Outstanding
<Government
Crediting>
Reserves
(Government)
344
is applied, while line 4 shows a reduction of the government debt when 100%
fraction (full reserves) is applied at the year 10. Both lines coincide, meaning
that the abolishment methods of a fractional level do not aect the liquidation
of the government debt, because banks are allowed to ll in the enough amount
of cash shortage by borrowing from the PMA in the model.
Debt (Government)
Debt-GDP ratio
1,000
2
1
750
1
1
1.5
1
1
Year
Dollar
1
1
500
1
1
1
1
250
12
34
34
34
10
34
34
12
12
0.5
15
34
34
20
25
30
Time (Year)
1
1
3
1
3
34
35
1
34
1
3
34
40
2
1
3
50
1
34
34
45
10
34
15
34
34
34
34
20
25
30
Time (Year)
1
1
3
1
3
34
35
1
34
40
45
1
3
50
1
GDP (real)
600
525
DollarReal/Year
3
3
34
12 34 12
375
34 12
34
341 2
34
1
1
12
12
34
450
4
4
300
0
10
15
1
20
25
30
Time (Year)
2
1
3
1
3
1
3
35
2
1
3
40
1
3
45
1
3
50
1
3
345
at maximum to 1.6% at the year 17, and ination rate of line 3 in the right
diagram is constantly below 0.3% at maximum.
Inflation Rate
Price
0.02
1.013
34
1234
34
0.9750
3
4
3
41
3
41
41
3
4
0.01
1
4
1/Year
Dollar/DollarReal
1.051
12
34
341
41
3
2
3
41
34
341
0.9367
41
12
12
4
34
-0.01
0.8984
0
10
15
20
25
30
Time (Year)
1
2
35
40
1
2
1
2
3
4
45
50
-0.02
0
1
2
3
4
10
15
20
25
30
Time (Year)
1
2
2
3
3
4
1
3
1
3
35
1
3
40
1
3
45
1
3
50
1
3
GDP (real)
0.04
600
2
1
2
1
0.02
500
2
1
2
1
400
2
1
2
1
2
1
2
1
2
1
2
1
2
1
2
1
2
1
2
1
2
1
1/Year
DollarReal/Year
2
1
1
1
-0.04
4
1
2
-0.02
200
3
2
1
1
2
300
2
1
2
1
7
8
9
Time (Year)
1
2
1
2
1
2
10
11
12
13
14
15
6
8
Time (Year)
1
1
2
1
2
10
1
12
1
2
1
2
14
1
1
2
346
fraction equilibrium, then assume that the government increases its spending
by mistakenly issuing new money by the amount of 10 for 3 years, starting at
the year 10; that is, the government expenditure continues to increase to 74
from 64 for three years.
As being expected, the increase in the government expenditure under the
equilibrium state surely causes ination, 2% at the year 13, as illustrated by
line 2 of the left diagram of Figure 12.15, followed by the deation of -2% at
the year 17. To be worse, this ination triggers economic recession of -6.6% at
the year 16 as illustrated by line 2 in the right diagram. Figure 12.16 shows
Inflation Rate
0.04
10
0.02
12
12
12
12
12
Percent/Year
1/Year
12
2
12
12
12
12
12
12
12
2
2
12
1
1
-0.02
-5
-0.04
-10
10
15
2
20
25
30
Time (Year)
1
35
2
40
1
45
1
50
2
10
15
20
25
30
Time (Year)
35
1
40
1
45
1
50
2
GDP (real)
600
1
1
525
DollarReal/Year
12
1
12
450
12
375
12
12
12
12
12
300
0
10
15
2
20
25
30
Time (Year)
2
35
1
40
1
45
1
50
2
347
(12.5)
(12.6)
That is to say, the maximum tolerable ination rate becomes 8% under the
system of debt-free money. The success of the system depends on the legalization
of a forced step down of the government in case of an ination rate higher than
8%.
348
by the purposive manipulation of the interest rates such as overnight call rate
and federal fund rate by the privately-owned central bank for the benets of
nancial elite. In this sense, we will be nally freed from the control of the
central bank.
Accordingly, the only tool to stabilize the monetary value is through the
public management of the amount of money in circulation. This could be carried
out through the control of lending money to commercial banks and through the
scal policy. Specically, in case of an inationary state, lending money to the
banks may be curbed, or the money in circulation could be sucked back by
raising taxes or cutting government spending. In case of deation, demand for
money by the banks would be weak, so that government has to take a strong
leadership by spending more than tax revenues with newly issued money. In
this way, complicated monetary policies such as the manipulation of required
reserve ratio, discount ratio, and open market operations under the system of
money as debt are no longer required.
Finally, it would be worth mentioning that system of debt-free money is
ecologically friendly to the environment, because forced payment of interest will
be replaced with interest-free money, and borrowers of money, mainly producers,
need not be driven into forced economic growth at the cost of environmental
destruction. System of debt-free money is indeed a foundation for sustainability.
12.6
Conclusion
This chapter investigates how to liquidate runaway government debt under the
current nancial crises. First, the current system is identied as a macroeconomic system of money as debt, under which the accumulation of government
debt is built into the system by the Keynesian theory, and the reduction of
debt-GDP ratio becomes, it is demonstrated, very costly, triggering economic
recessions and business cycles.
Then, an alternative system is suggested as the system of debt-free money,
in which only the government can issue money, and the government debt, it
is shown, can to be gradually eliminated. Moreover, it turns out that higher
economic growth is simultaneously attained.
In this sense, the alternative macroeconomic system, from a viewpoint of
system design, seems to be worth being implemented if we wish to avoid accumulating government debt, unfair income distribution, repeated nancial crises,
war and environmental destruction.
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