Modeling of Monetary Financial Flows in System Dynamics

Background: The relationship between public debt and private sector profitability has long been emphasized in economic theory in the context of sectoral balances. According to Post-Keynesian economics, private debt accumulation, under certain conditions, may be a source of private sector profits. Moreover, public debt dynamics may have a strong relationship to the evolution of firms’ sector debt. Aim: This paper develops a monetary financial model of a small open economy using the stock-flow consistent and system dynamics frameworks, focusing on the interplay between the public and the private sector debts, and public debt and private sector profitability. The aim is to test – using the model – the hypothesis that public debt as an injection of net financial assets into the economy may positively influence private sector profits. Additionally, the model assesses the relationship between the public debt and the firms’ debt sector dynamics. Methodology: Stock-flow consistent approach together with nonlinear differential equations and non-equilibrium approach are used to build the model. System dynamics is used for model simulations. The model works with quarterly time periods, six sectors – central bank, government, banks, households, firms and the rest of the world, consolidated sector balance sheet items acting as stocks, and inflows and outflows changing the value of those items - as flows. Behavioral equations define the model behavior, and interest rate mechanism is used as the global feedback loop. The model tracks how monetary flows across consolidated sectors change the accumulation of stocks and a variety of real and nominal macroeconomic variables. Baseline, boom and negative shock scenarios are used to simulate the outcome of the model on simulated data. Results: According to the simulation results, public debt accumulation may contribute to private sector profitability. Public debt may also have an inverse relationship with the dynamics of firms’ sector debt. However, the introduction of export shocks can trigger a systemic decline. The model highlights a strong link between public debt and private sector debt dynamics, as well as high sensitivity of real macroeconomic variables to external flows for a small open economy. Recommendations: This paper underscores critical influence of the foreign sector, policy rule design and endogenous debt dynamics across different sectors on a small open economy and variety of its macroeconomic variables. Although it is highly recommended to apply SFC framework and system dynamics with a high level of parametrization and a variety of feedback loops – the model provides aluable insights into the discussions of public debt evolution and its implications. Relevance: This paper addresses a key topic in practical economic policy: the dynamics of public debt, its potential drivers and causes. It develops a mathematical model based on complex nonlinear relationships with a useful simulation framework. This framework might help economists and policymakers better understand the causes, implications, and intersectoral relationships associated with the public debt. Originality: This paper is original, based on the ideas of Wynn Godley, Randall Wray, Steve Keen, Marc Lavoie and Thomas Palley, providing an originally developed consolidated balance sheet of foreign sector (rest of the world), and dynamic interest rate and inflation mechanisms. Additionally, original dependencies are introduced to the model – banks’ CAR ratio, advanced interest rate feedback loop mechanism and advanced logic of sectoral flows.