A SIMULATION STUDY OF A DISEQUILIBRIUMKACRO MODEL -WITH SPECIAL REFERENCE TO THE THEORY OF CREDIT RATIONING. A Thesis

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1 A SIMULATION STUDY OF A DISEQUILIBRIUMKACRO MODEL -WITH SPECIAL REFERENCE TO THE THEORY OF CREDIT RATIONING JAMES ALLAN By BROX, M.A A Thesis Submitted to the School of Graduate Studies in Partial Fulfilment of the Requirements for the Degree Doctor of Philosophy McMaster University September 1975 "~ J~S AlLAN BRoX 1976 I

2 Q, t ~.,. ~.". ~'. ~:,. ", A SIMULATION STUDY OF A DISEQUILIBRIUM MACRO MODEL

3 /. I /,,... "......,... ~... :-.- '-... \ r DOCTOR OF PHILOSOPHY (1975) McMASTER UNIVERSITY (Economics) ~ Hamilton, Ontario TITLE: ~ Simulat~on Study of Disequilibrium ~. Macro Model with.speci 1 Reference to the Theory of Credit R tioning! AUTHOR: James Allan Brox, B.A. (University of Toronto) M.A. (McMaster University) SUPERV~SOR: Professor William M. Scarth NUMBER OF PAGES: xii, 131, I \ ----., I o

4 ., -, "~ ~ "."., '.,...',. ~ ".'.' I ACKNOWLEDGEMENTS " ' \ owe a 'general debt of gratitude.to all my instructors, bot~'at McMaster and at the' University \ of Torqnto, for developing in me a strong interest in the field of economics. In,particular~I would like to thank ProfessorsM. th1 members of the thesis committee, L. Kliman, J. D. Welland and especially! my thesis supervisor Professor W. M. Scarth, for their encouragement and patience. I always found discussions with the me~ers of the committee very proficable in terms of constructive criticism.and valuable suggestions. Perhaps the greatest debt is owed to my wife,. Tiina, who earned the funds to support our family and ran the household so smoothly during the time required to c9mplexe this research., I am also extremely grateful to my mother who gave so generously of her time to type the manuscript. I alone am responsible for any remaining deficiencies. iii,,

5 , ABSTRACT The purpose of this,study is to exp~ore tne im~i~ations,for. v~rious ~!'vern~ent, stabilizat~on. pol1c1es of expl1c1t cons d~rat1on of market d1sequ1- librium. especially cre in the commercial bank loan market. The analysis centers in each case on the value of the government expenditure multiplier. First. a control or equilibrium ver~ion of the model is developed which is consistent with standard macrotheory and which contains a welldescribed b~nking sector. The results of the simulations with this version of the model confirm that the impact multiplier is larger when'the deficit is, financed by printing mone~ than when bonds are issued... 1 I ';). ~' ;.,,,,.'., to meet the requir~meht for ~nds. However. it is shown that in the long run the bond-financed multiplier is greater than the money-financ~d multiplier. This version of the model also confirms the possibility '.,- 'raised in the current literature that the bondfinanced case may be unstable.,iv

6 ....' Since the current model has a wel~ develo banking sector,.the theory' of the gover~~nt finance restraint is extended to,~o~sider the c~se in which', the deficit is financed by transferring, the ownership of government bank d~posits to the private sector. This case closely resembles the bond-financed case in the" short run but it is statically stable. The deposit-financed cas~ is limit~d', 'of course, by the \nitial size of the government deposits. Therefore, the restoration of the level of government deposits by one of the other means of financing is considered. Next, a disequilibrium versi~ the control model is developed consistent with current literature on disequilibrium phenomena. This version of the. model contains a feedback mechanism by which a disequilibrium in one market will affect the. decisions. in all other markets. The results of the simulations with the disequi~ibrium. model show that the government. expenditure impact multiplier may be inc~ased by the presence of credit rationing. In fact the bond-financed case which is unstable in the control version becomes v

7 ." /,-.---«-' I.. stable u~der "equ librium" credit rationing, "" the loan rate does not adjust at all, i whejre,. Since the model used in this study is - ad hoc, sensitivity analysis is used to inv~stigate the importance of t e exact values of the key parameters of th~ systemj- The policy implications of the study do appear to hkpg, on the values of the feed- I back coefficients. If the force of credit rationing, ') is mainlyrelt' in the real sector, the government expenditur~ \ disequilibrium version the other,hand, if the impact multiplier will be smaller,in the than in the control model. impact~f credit ~ationing mainly felt in the financial sector, the opposite result will occur However, the range of'values tnat the multiplier may take on, depending on the i~pact of the credit rationing, is quite small. 'OD Thus, given the size of the error of predic-," tion of standard model~, this study concludes tha:t it, is unlikely that the inclusion of credit rationing will is allow a better evaluation of government stabilization policies. This is especially true if the impact of credit rationing is believed to be in roughly the same vi.-

8 ,. proportion as n~rmal expenditures in the various markets.,0 Cl, ', - vii."

9 TABLE OF CONTENTS I. INTRODUCTION II. A CONSTRAINED MARKET CLEARING MACRO MODEL WITH A BANKING SECTOR II~. 1. Introduction 2. The Control Model 3. Constraints in a Discrete Time Model 4. Results of the Simulation Experiments on the Control Model 5. Summary A DISEQUILIBRIUM SIMULATION MODEL 1. Introduction 2. A Survey of Disequilibrium Theory 3. Possible Sources of Disequilibrium 4. The Model ' 5. Summary IV. THE SIMULATION EXPERIMENTS 1. Introduction 2. The Simulation Results 3. Sensitivity Analysis 4. Summary V. SUMMARY AND CONCLUSIONS \ APPENDIX A THE DEFINITION OF NQTATION AND ASSUMED FOR THE CONTROL MODL INITIAL ~ONDITIONS APPENDIX B THE CONTROL MODEL APPENDIX C 'THE DISEQUILIBRIUM MODEL APPENDIX D THE COMBINATIONS OF THE a's USED IN THE ANALYSIS BIBLIOGRAPHY VALUES OF SENSITIVITY ] viii,

10 LIST OF TABLES ~ ') TABLE 2-1 GOVERNMENT EX~ENDITURE MULTIPLIER FOR THE CONTROL HODEL TABLE 2-2 CHANGE IN PRICE LEVEL PER UNIT INCREASE IN GOVERNMENT EXPENDITURE IN THE CONTROL HODEL 3S. TABLE 2-3 GOVERNMENT EXPENDITURE MULTIPLIER WITH)DEPOSIT FINANCING IN THE. CONTROL HODEL 112 3S TABLE 3-1 THE FEEDBACK COEFFICIENTS 68 TABLE 11-1 THE GOVERNMENT EXPENDITURE MULTIPLIER FOR THE DISEQUILIBRIUM MODEL WITH A=O TABLE 11-2 GOVERNMENT EXPENDITURE MULTIPLIER FOR DEPOSIT FINANCING IN THE DISEQUILIBRIUM MODEL WITH A=O 81 TABLE 11-3 DISTRIBUTION OF MULTIPLIER VALUES FOR A GIVEN PERCENTAGE IMPACT OF RATIONING ON ~HE REAL SECTOR UNDER BOND FINANCING 101 TABLE II-II DISTRIBUTION OF MULTIPLIER VALUES FOR A GIVEN PERCENTAGE IMPACT OF RATIONING ON THE REAL SECTOR UNDER DEPOSIT FINANCING 101 TABLE ll-s DISTRIBUTION OF MULTIPLIER VALUES FOR A GIVEN PERCENTAGE IMPACT OF RATIONING ON THE REAL SECTOR UNDER TAX FINANCIN.G 102 TABLE 11-6 DISTRIBUTION OF MULTIPLIER VALUES FOR A GIVEN PERCENTAGE IMPACT OF RATIONING ON THE REAL SECTOR UNDER MONEY FINANCING 102 7S "\ ) '- ix

11 . l."", ", LIST OF FIGURES ~ FIGURE -2-1 FIGURE 2-2 FIGURE 2-3 ADJUSTMENT OF THE STANDARD TEXTBOOK IS-LM HODEL UNDER BOND FINANCING 32 ADJUSTMENT OF THE STANDARD TEXTBOOK IS-LM MODEL WITH EXOGENOUS TAX FINANCING TIME PATH OF THE GOVERNMENT EXPENDITURE MULTIPLIER FOR VARIOUS METHODS' OF FINANCING IN THE CONTROL MODEL 39. J FIGURE 2-~ TIME PATH OF THE TAX-TRANSFER LEVEL FOR'VARIOUS METHODS OF FINANCING THE BUDGET.DEFICIT. IN THE CONTROL MODEL "0 (, FIGURE 2-5 TIME PATH OF THE GOVERNMENT EXPENDITURE MULTIPLIER FOR DEPOSIT FINANCING AND VARIOUS METHODS OF SECONDARY FINANCING IN THE 'CONTROL MODEL'... FIGU!a: 2-6 TIME PATH OF THE TAX-TRANSFER LEVEL FOR DEPOSIT FINANCING AND VARIOUS METHODS OF SECONDARY ; FINANCING IN THE CONTROL MODEL "5 FIGURE ~-l TIME PATH OF THE GOVERNMENT EXPENDITURE MULTIPLIER FOR VARIOUS METHODS OF FINANCING THE BUDGET DEFICIT IN THE DISEQUILIBRIUM HODEL 76 FIGURE ~-2 TIME PATH OF THE TAX-TRANSFER" LEVEL FOR VARIOUS METHODS OF FINANCING THE BUDGET DEFICIT IN THE DISEQUILIBRIUM MODEL 79 FIGURE ~-3, TIME PATH OF THE GOVERNMENT EXPENDITURE MULTIPLIER FOR DEPOSIT FINANCING AND VARIOUS METHODS or SECONDARY FINANCING IN THE DISEQUILIBRIUM MODEL 82 n ~ x

12 \., r..:rst OF FIGURES, r ;.. FIGURE 4-4, ~IME PATH OF THE TAX~T~SFER LEVEL FOR DEPOSIT FINANCING AND VA:RIOUS METHODS OF SECONDARY FINANCING IUHE DISEQUILIBRIUM MOpEL. FIGURE 4-5 TIME P~H OF CHANGE IN THE PRICE LEVEL FOR THE FIXED OUTPUT VERSIONS OF BOTH THE CONTROL AND DISEQUILIBRIUM MODELS FOR BOND FINANCING OF THE DEFICIT FIGURE 1+-6 TIME PATH OF CHANGE IN'THE PRICE LEVEL FOR THE FIXED OUTPUT VERSIONS OF THE CONTROL AND DISEQUILIBRIUM MODELS FOR MONEY FINANCING OF 'rhe DEFICIT FIGURE TIME PATH OF THE GOVERNMENT EXPENDITURE MULTIPLIER FOR MONEY FINANCING IN THE DISEQUILIBRIUM MODEL-WITH DIFFERENT INTEREST RATE ADJUSTMENT SPEEDS FIGURE 4-8 FIGURE 1+-9 TIME PATH OF THE GOVERNMENT EXPENDITURE MULTIPLIER FOR THE LAGGED DEMAND VERSION OF THE MODEL WITH INSTANTANEOUS LOAN RATE ADJUSTMENT AND VARIOUS METHODS OF FINANCING THE DEFICIT TIME PATH OF THE GOVERNMENT EXPENDITURE MULTIPLIER FOR THE LAGGED DEMAND VERSION OF THE MODEL WITH LAGGED LOAN RATE ADJUSTMENT AND VARIOUS METHODS OF FINANCING THE DEFICIT FIGURE TIME P~ OF CHANGE IN INCOME FOR A CONTINUOUS INCREASE IN GOVERNMENT EXPENDITURE OF 0.5 BILLION PER PERIOD WITH MONEY AND BOND FINANCING OF lleficit 'xi

13 " LIST OF FIGURES, FIGURE TIME PATH OF THE GOVERNMENT.EXPENDITURE MULTIPLIER WITH BOND FINANCING OF THE DEFICIT AND VARIOUS VALUES OF THE COEFFICIENT ON WEALTH IN THE CONSUMPTION ~UNCTION FIGURE TIME PATH OF THE GOVERNMENT EXPENDITURE MULTIPLIER WITH BOND FINANCING OF THE DEFICIT AND VARIOUS VALUES OF THE MARGINAL TAX-TRANSFER RATE l ' xii :

14 .~ ", I INTRODUCTION The study of market disequilibrium has become an increasingly popular topi~ in current e~onomic literature. This follows a re-interpretatfon of the J writing of Keynes as,suggested by Clower l Leijonhufvud 2 and This developme~t has been mot~ated. as Barro and Grossman have stated, by the fact that: conventional analysis has chronically attempted to coax Keynesian results out of a framework of general market equilibrium. The result has been to feave conventional ~acroeconomics with an embarrassingly weak choice-theoretic basis, and to associate with it important implications that are reconcile with observed phenomena. difficu1 3 to " '- lclower, R.; "The Keynesian Counterrevolution: A T~oretica'l App.raisal" in Hahn.. r. H. and Brechling, r,l.r.; The Theory of Interest Rates; M~cMillan;, ~oronto, Leijonhufvud, A.; On Keynesian Economics and the Economics of Keynes; New York, Oxford Un~vers1ty Press; " 3Barro, R.J. and Grossman, H.I.; "A General Diaequilibrium Model of Income. and Employment"; Am~ican Economic Review; March, 1971, p. 82. \," 1

15 '- 2 The exist~nce of markets that fail to clear each period will impose additional constraints on the.'. system. and hence the explicit inclusion of these disequilibrium ph~nomena could substantially alter the.-" pre9ic~ons of the system. Several economists 4 have " argjed that credit rationing in the commercial bank loan market is likrly to exist and to have important implications for ~he operation ation policies. of governmen~ stabiliz- This theory of disequilibrium is J;e~ing well-developed at the microeconomic level. ~t it has not as yet been adequately adapted to macroeconomic models to allow a proper evaluation of th~ importance of considering such phenomena when S~u~ying general government stabilization policy act~~n~! At the present time some policy makers 5 are attempting 4For example see JaTfee, D.M. and Modigliani. F.; "A Theory and Test of Credit Rationing"; American Economic Review; December and Tucker. D.P.; "Credit Rationing. Interest Rate.Lags and Monetary Policy Speed"; Quarterly Journal of Economics; February, For example. the Bank of Canada is currently undertaking a research project to attempt to build a credit rationing system into RDX2../

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Nº 4 On the Long-Run Inflation-Unemployment Trade-Off Francisco L. Lopes

TEXTO PARA DISCUSSÃO Nº 4 On the Long-Run Inflation-Unemployment Trade-Off Francisco L. Lopes PUC-Rio Departamento de Economia www.econ.puc-rio.br November 1979 Economic thinking on inflation has changed