Andrew Berkeley — A simple economy with government money

Summing up

Okay, We've built a complete but highly simplified model of an economy consisting of a private sector and a government sector. Our model was built around the concept of the fiscal multiplier, in which the government spends into the economy and this induces subsequent consumption spending, taxation and saving. We simulated this process occuring repeatedly through 100 time periods. Each time step represented a distinct accounting period in which all flows of money were accounted for and any imbalances between a respective sector's inflows and outflows were reconciled as changes in stocks held.

In each accounting period we found that the private sector had larger inflows than outflows. This is because it chose to save some of its income rather than spending it. The government had the opposite: it was spending more than it was receiving in tax during each accounting period. This happened because tax is levied as an income tax and therefore requires spending (income is the mirror-image of spending). If the private sector do not spend all of their income then some money remains untaxed. The only accounting component which is carried across time periods is the value of the money stocks held by the sectors. So since the private sector has a surplus in every accounting period, these surpluses accumulate with each successive time period and their stock of saved money grows continually through time. Likewise, the government's constant spending deficit causes their negative money balance to grow continually through time.

So we have a situation with constant government spending, stable consumption spending and stable income levels, a constant rate of saving driving a persistent government deficit, and consequently a pot of private savings which grows steadily through time and which matches a steadily growing, negative government balance.

We might be tempted to ask, "How can the government spend more than it earned? How much money did the government start with? Where did it get it from? And how much does it have left?". Well we didn't set the model up with a stock of money at all. Yet we did take some care to ensure that our stocks and flows were dilligently accounted for. So how did money appear in the model? Well, what we did when we simulated government spending was to simply account for the spending by marking it as a receipt for the private sector (the business sector, in the first case) and an outlay for the government. This accounting implies the transfer of something between parties that didn't previously exist. This something is effectively an IOU - a record of a promise from one party to another. And since it is government spending that kick-starts the cycle of private consumption spending which gives rise to the fiscal multiplier effect, we can conclude that it is government IOUs that are circulating. Indeed, the entire accounting matrix is denominated in government IOUs. So we didn't start with a stock of money but we can see money in this model as accounting records representing government issued IOUs. The government is the source of money.
So what the private sector accumulates is government IOUs, which explains exactly and quite trivially why the government has an equally sized negative balance - it is the issuer of these IOUs. The private sector and government balances are simply the opposite sides of the same thing.

But if the money in the model is an IOU of the government's, what, exactly, is it an IOU for? What is the government obliged to provide in return for it's IOUs? Well, in this model, there is only one thing that money can be used for with respect to the government and that is paying taxes. So while the private sector's positive balance can be seen as it's accumulated, saved wealth, the government's negative balance can be seen as simply the record of government issued money that has yet to be taxed but that the government must be prepared to accept in return for the extinguishing of future tax obligations. This is the sense in which it is a "liability" or a "debt" of the government.

So, in summary, our model implies the following:

• The money which circulates is government issued IOUs
• The government creates this money when it spends
• Government money is a liability of the government in the sense that it can be redeemed against future tax a obligation
• Government money is effectively cancelled on payment of taxes
• If the private sector chooses to save money out of circulation this will cause an equally sized government budget deficit
• The government "debt" is a record of the outstanding (saved, untaxed) government money that can be returned in payment of taxes

Although this is a simple model which clearly has significant limitations relative to real economies, it is worth reflecting on whether these conclusions are very different to the real world.

Aside from being an obviously simple model, there is one problem that stands out. In this model, the savings of the private sector (and by implication, the government "debt") grows rapidly, seemingly without bound. This is arguably quite unrealistic, if only for the simple reason that when folk save they often spend their savings, at least at some stage, to some extent. This small but significant consideration will be the basis of the next model/post.

Misunderheard
A simple economy with government money

Andrew Berkeley