A dynamic model of financial balances for theUnited Kingdom

Antoine Godin1

THE 12TH INTERNATIONAL POST KEYNESIANCONFERENCE, Sept 26, 2014.

1University of Limerick, Ireland. antoine.godin@ul.ie

Joint work with

I Oliver Burrows and Stephen Millard, Bank of England.I Stephen Kinsella and Sean Ryan, University of Limerick.I Views expressed are ours and not those of the Bank of England.

What we want to do

I We are building a new dynamic macroeconomic model offinancial balances for the United Kingdom using flow of fundsdata from 1987 to the present.

I The model contains six sectors: households, non-financial firms,the government, banks, insurance companies and pensionfunds, and a simplified rest of the world.

I Using forecasts for key macroeconomic driving variables, weplan to show how we can use our model to performmedium-term scenario analyses on developments in the housingmarket, the supply of credit, demographic change, and changesin portfolio allocation between multiple financial assets.

Motivation

I Need to modify and augment standard modeling approachespost-crisis. There is no model ‘to rule them all’ anymore.Models should be interoperable and empirically-based.

I Clearly we need coherent incorporation of financial and realstocks and flows via the Flow of Funds into the apparatus ofmodern Bank models.

I Need to understand portfolio effects, housing markets, debtand demographic change simultaneously.

I Understanding the relationship between developments in thereal economy and in financing flows, balance sheets and assetprices when looking for financial vulnerabilities.

I . . . which clearly syncs with forecasts from COMPASS, theBoE’s suite of DSGE models.

Questions we’re asking (and able to ask):

I How do changes in the portfolio allocation of sector i affectfinancial stability and output?

I How do credit quality and funding shocks to banks affect thereal economy and financial system, through supply of credit tohouseholds and firms?

I How does bank credit creation (including via mortgage lending)affect the evolution of the real economy and financial system?

I How do changes in demand in subsectors of the housing market(i.e. changes in the share of BtL / movers / FtBs) affecthousing market dynamics and the broader evolution of thefinancial system?

I How do changes in import/export propensity affect thefinancial system?

Directed Acyclic Graph of the 6 sector model:

ROWStock

Banks'Stock

Central Bank'sStock

ICPFStock

Households'Stock

Firms'Stock

Assets Price

Nominal Demand of

Assets

Expectations

Expectations

Pension Contribution

Households' income

Taxes

Government Deficit

Government expenditure

Capital Account

Current Account

Current account flows

Households' consumption

Expectations

Firms' profits

Sales

Labor Market

Output

Interest rate settings

Investment and targets

Expectations

Housing market

Demographics

ExpectationsExpectations

Real Supply of Liabilities

Expectations

Endogenous flows

End of Period Stock

Exogenous flows

Demographics

Inputs

Legend

Dynamicfeedback

Figure 1: Directed Acyclic Graph

Aggregate Balance Sheet of the Economy

Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities!m_HH +m_b

+l_f !l_f+d_HH !d_b +d_icpf

!adv +adv+res !res

Bank !B_b +B_b_icpf +B_b_wGovernment !B_g +B_g_cb +B_g_icpf +B_g_w

Foreign +B_w_icpf !B_wPrivate !eq_b +eq_bFirms !E_f +E_f_icpf +E_f_wForeign +E_w_icpf !E_w

Inventories +inventHouses +h_HH

+itr_HH !itrITR

DepositsAdvancesReserves

Bonds

Equities

Real@Assets

Central@Bank Firms ICPF ROW

MortgagesLoans

ItemHouseholds Banks Government

Figure 2: Balance Sheet

Housing, Debt, and Demographic structure are related

Figure 3: Demography drives housing demand/supply

Housing market price dynamics

pH,X = min

DSRXrS

YDeX

SHY,

rentX + cgeX

iM,X ,−1 + µ1,X

pH,A =

∑wipH,i

peH,X = pH,X ,−1(1 + p̂e

H,A)

ICPF and retirment

∆Ann = DITRMR + pHM · SHRM − pR · SHMR

ap = ∆Ann20∑

i=1(1 + iCB)i

AR =20∑

i=1ap,−i

∆ITR =∑

Pcon,i +FICPF −DITRMR−AR+pHM ·SHRM−pHR ·SHMR

Closing the model: The current account-capital accountnexus

I Trade Balance and Current Account of Balance of Paymentendogenously determined (except exports)

I Assuming no change in reserves and no change in exchangerate, Capital account = current account

I First, ROW buys all remaining Government bonds thenallocates the residual between domestic bank bonds anddomestic firms’ equities, given the nominal demand fromdomestic banks in foreign bonds and equities

Households’ Balance Sheet:

Figure 4: Assets, Liabilities, residual

Banks’ Balance Sheet:

Figure 5: Assets, Liabilities, residual

Non Financial Corporates’ Balance Sheet:

Figure 6: Assets, Liabilities, residual

ICPF’ Balance Sheet:

Figure 7: Assets, Liabilities, residual

Government Balance Sheet:

Figure 8: Assets, Liabilities, residual

Calibration and next steps

I Model takes parameter values from COMPASS and othereconometric studies.

I Equation system c. 250 Identity, Balancing, and Behavioralequations.

I Calibration ongoing (roughly 90% of the process done), takingeach experiment we discussed above into account.

Thanks

I Comments and questions most welcome toantoine.godin@ul.ie