PCEX Modification

Modify PCEX to accommodate the possibility of stagflation in this economy.

Stagflation is an economic phenomenon that occurs when increasing inflation rates are coupled with a period of stagnation, i.e. little or no economic growth in the economy.

One of the main causes of stagflation is the occurrence of an unfavourable supply-side shock which can have the effect of driving up prices in an economy while at the same time, slowing the economy by making production less profitable and thus having the effect of a drop in output.

(www.wikipedia.com)

For the purpose of this assignment, we will introduce a supply-side shock to the economy using Model PCEX to reflect the current stagflation concerns in the US economy brought on by the effects of the subprime mortgage crisis.

This model introduces expectations on household’s disposable income. The following is the equation list for the Model PC with expectations (PCEX)

• · Y = C + G (4.1)
• · YD = Y – T + r_-1 . B_h-1 (4.2)
• · T = Θ . (Y + r_-1 . B_h-1) Θ <>
• · V = V_-1 + (YD – C) (4.4)
• · C = α₁ . YD^e + α₂ . V_-1 (4.5E)
• · B_d/V^e = λ₀ + λ₁ . r - λ₂ . (YD^e/V^e) (4.7E)
• · H_d/V^e = (1 – λ₀) – λ₁ . r + λ₂ . (YD^e/V^e) (4.7E)
• · H_d = V^e – B_d (4.13)
• · V^e = V_-1 + (YD^e – C) (4.14)
• · H_h = V - B_h (4.6)
• · B_h = B_d (4.15)
• · ∆B_s = B_s – B_s-1 = (G + r_-1 . B_s-1) – (T + r_-1 . B_cb-1) (4.8)
• · ∆H_s = H_s – H_s-1 = ∆B_cb (4.9)
• · B_cb = B_s - B_h (4.10)
• · r = ȓ (4.11)
• · YD^e = YD . (1 + Ra)

The following is the modified version of model PCEX to accommodate the possibility of stagflation in this economy.

• · Y = C_s + G (4.1)
• · C_d > C_s (*1)
• · W.N_s = W.N_d (*2)
• · YD = Y – T + r_-1 . B_h-1 (4.2)
• · T = Θ . (Y + r_-1 . B_h-1) Θ <>
• · V = V_-1 + (YD – C_s) (4.4)
• · C_s = α₁ . YD^e + α₂ . V_-1 (4.5E)
• · B_d/V^e = λ₀ + λ₁ . r - λ₂ . (YD^e/V^e) (4.7E)
• · H_d/V^e = (1 – λ₀) – λ₁ . r + λ₂ . (YD^e/V^e) (4.7E)
• · H_d = V^e – B_d (4.13)
• · V^e = V_-1 + (YD^e – C_s) (4.14)
• · H_h = V - B_h (4.6)
• · B_h = B_d (4.15)
• · ∆B_s = B_s – B_s-1 = (G + r_-1 . B_s-1) – (T + r_-1 . B_cb-1) (4.8)
• · ∆H_s = H_s – H_s-1 = ∆B_cb (4.9)
• · B_cb = B_s - B_h (4.10)
• · r = ȓ (4.11)
• · YD^e = YD . (1 + Ra)

A supply side shock is introduced into the economy. This may take the form of a sudden scarcity of natural resources due to an event outside the control of the production firms in the economy i.e. war, natural disaster etc. This reduces the supply of goods and services in the economy. Equation *1 is introduced to accommodate the excess demand now evident in the economy. Households’ pay higher prices for the same goods and services to obtain the same level as consumption in period t_-1. This increases the level of inflation in the economy. In subsequent periods households’ will revise their expectations to account for the increased inflation. Equations 4.1, 4.4 and 4.14 have to be altered to account for the fact that the consumption demanded is no longer equal to consumption supplied.

Equation *2 is introduced to account for the stagnation influence on the model. Factor income is a function of national income and is used to account for changes in the wage agreements. In the long-term the households take into account the increased inflation when negotiating wage agreements. This increases the costs incurred by the production firms in the economy, thus making the firms less profitable, and as aforementioned, total output is reduced. As total output decreases, unemployment increases.

Therefore, the Model PCEX now accounts for stagflation as inflation and unemployment are increasing in conjunction with one another.