A MODEL OF THE UK ECONOMY
AN AID TO UNDERSTANDING ECONOMIC BEHAVIOUR
G D Hobbs
ICI, Central Management Services,
Fulshaw Hall, Wilmslow, Cheshire, United Kingdom
Throughout the 1970's Corporate Managers, among others, have had a
need to understand better the economic environment in which they operate. It
is a need that was not so apparent in the two previous decades when the world
economy was evolving along a relatively stable path. Since then we have
entered a period of instability and uncertainty which has made the running of
a company increasingly difficult. In this uncertain environment Corporate
Managers have found that they can no longer rely, in the way that they used
to, on the professional economic forecast. They have an increasing need to
understand the assumptions on which it is based, their relative importance,
the way different parts of the economy interact and to monitor for themselves
the extent to which these assumptions remain valid as time progresses. In
the UK there is always a dialogue in progress between industry and Governnent
although it fluctuates in intensity over time. The pursuit of that dialogue
in the present clinate 1s often hampered by the lack of a shared framework of
understanding ~ a framework through which disagreements about principles,
causes, effects, etc. can be explored.
In short - there ts a need for a model. There are, of course,
already many economic models in existence, but the need here is for a model
which promotes understanding and aids communication; not a model for
327
economists ~ but for the well informed layman. Conventional large
econometric models, because of their technical opacity, have little to offer
to the solution of this problem. The System Dynamics approach, or something
conceptually related to it, seems to hold out more promise.
The paper describes a model of the UK economy which is being
developed to try to meet these needs. It is not intended as a forecasting
tool, although, hopefully, better forecasting might ‘result from its use. The
prime objective is the promotion of understanding and the improvement of
communication. Within this prime objective the development of the
model has been constrained by a number of guideline:
@ It must be a model of the economy, not of the National Account:
There is more to economic life than is measured and reported by the
Government's statistical service. A set of National Accounts (albeit
simplified) should be just one of the output documents from such a mdel.
(41) Tt must differentiate as clearly as possible between the physical
entity that is the economy and the human behaviour processes which determine
the way it operates. It is the author's belief that the description of the
physical structure fs the most easily achieved phase of the modelling and
that it then provides a firm foundation upon which to build the much more
contentious representation of the human behaviour processes. This
differentiation is, therefore, aimed at focusing attention and argument on
those aspects of economic life which are most open to question+
(441) Te must represent decision making processes explicitly, modelling
thea in terms that are recognisable to the decision makers themselves. It
must permit each identifiable group of decision makers (a decision centre) to
have its ow objectives. These objectives need not, indeed often will not, be
compatible one with another. Each decision centre will base its actions on
different flows of information. It will never be possible to model the full
complexity of a decision centre's behaviour. There may be circumstances in
which greater learning can be achieved by not even trying, and by
substituting one or more real persons for programmed algorithms and operating
the model in an interactive simulation or game playing mode. To this end
attempts are being made to improve the man-model interface by exploiting high
quality colour graphics.
(iv) It must strike a balance between excessive complexity and over—
simplification. Large, complex models are not good aids to understanding and
communication - although greater complexity can probably be tolerated where
it is expressed in every-day terms. There are complementary dangers,
however, in oversimplification. The world is complex and there will be
occasions when that complexity will lead to unexpected behaviour. The aim
aust be to reduce the number of those occasions to a minimum without
defeating the prime objective.
() It must allow for inevitability. Some factors that are likely to
influence economic activity, e+g+ demographic ones, are already almost fully
determined for sone years ahead. Similarly, decisions are heavily
constrained and it may only be possible to bring about significant change
over a period of years.
328
The model is directed towards an understanding of the mechanisms at
work during the business cycle of between four and five years duration. Ite
time horizon is therefore no greater than ten years, with the main emphasis
on the next five. It is frequently argued that cycles of longer period than
the business cycle exist, e-g- the 50 year long wave. It is not intended
that this model should capture in detail the mechanisms producing them.
However, their role in determining the underlying trend must be recognised,
and their effects incorporated exogenously, perhaps by reference “offline” to
other modele designed to look at these more distant horizons.
In the first instance the number of decision centres has been limited
to six: Households (in aggregate), Trading Companies (with no distinction
between public and private ownership), Government (as administrator and
supplier of public ‘services), Financial Managers (who invest the financial
surpluses of Households), Banks (as creators of credit) and Overseas-
Each of these decision centres attempts to manage a set of resource
networks. The systems currently represented are the stock and flow networks
for Money (readily realisable purchasing power), Financial Assets (long term
lending), Goods and Services (distinguishing between perishables and
durables), Fixed Assets (plant, machinery, building, etc.) and People. The
term “manage” is defined to include the formulation of objectives (e-g- the
Government's desired inflation rate), the collection of relevant information
(e.ge Companies’ profit and loss accounts), the making of decisions and the
taking of action (e+g. Households" ordering of goods).
The whole system can usefully be thought of as a set of planes
stacked vertically one above the other. The topmost planes define the
decision centres and their objectives. Each of the lower planes contains a
representation of the stock and flow network of one resource, the stocks
being identified by ownership between the decision centres.. Resources do not
flow between planes; each plane represents a conservative (where
appropriate) sub-system. Information flows upwards to the decision centres
so that the state of the relevant parts of the economy can be monitored and
compared with the objectives. Action then flows vertically downward:
The full paper concentrates on the conceptual framework for the model
rather than the results. It describes in more detail the overall structure,
and the way in which the physical description of the economy and the decision
making processes governing its behaviour have been modelled.
329
e
A MODEL OF THE UK ECONOMY
AN_AID TO UNDERSTANDING ECONOMIC BEHAVIOUR
G D Hobbs
‘ICI, Central Management Services,
Fulshaw Hall, Wilmslow, Cheshire, United Kingdom
1. INTRODUCTION
Throughout the 1970's Corporate Managers, among others, have had a
need to understand better the economic environment in which they operate. It
is a need that was not so apparent in the two previous decades when the world
economy was evolving along a relatively stable path. Sinee then we have
entered a period of instability and uncertainty which has made the running of
a@ company increasingly difficult. In this uncertain environment Managers
have found that they can no longer rely, in the way that they uged te, on the
professional economic forecast. They have an increasing need to understand
the assumptions on which it is based, their relative importance, the way
different parts ef the economy interact and to monitor for themselves the
extent te which these assumptions remain valid as time progresses. In the UK
there is always a dialogue in progress between induetry and Government,
although it fluetuates in intensity over timee The pureuit ef that dialegue
in the present elimate is often hampered by the lack ef a shared framework of
understanding ~ a framework through which disagreementa about principles,
eauses, effects, etee can be explored.
In short = there is a need for a model. There are, ef course,
already many ecenemie models in existence, but the need here is fer a medel
whieh prometes understanding and aids communication; net a model fer
‘
economists = but fer the well infermed layman. Genventienal large
econometric wedels, beeause of theiz teehnieal opacity, have lictle te offer
te the solution ef this preblem The System Dynamies approach, oF something
eonceptually related te it, seems te held: eut mere premise.
Gerporate management is concerned with monitoring the state of its
business on a monthly er quarterly basis, with assessing finaneial
performance and profit prespecte one to two years ahead and with the timing
ef new capacity in relation to market growth expectations anything ee ten
years aheads Questions that are frequently asked are: where are we in
the bueineee eyele?s have we reached the bottem (or top)?; how is current
Government policy affeeting the course of the cycle/depth of the
recession/atrength of the boom?; what has happened to the trend?
The model degeribed in this paper is, therefore, directed towardg an
waderstanding of the mechaniams at work during the UK business cycle. ths
time horizon is no greater than ten years, with the main emphasis on the next
five. It ie frequently argued that cycles of longer period than the business
eyele exist, e.g. the 50 year long wave. ‘ It is not intended that this model
should try to capture in detail the mechanisms believed to produce them
However, their role in determining the underlying trend must be recognised,
and their effects incorporated exogenously, perhaps by reference “off~line
to other models designed to look at these more distant horizons.
The paper concentrates on the conceptual framework for, the model.
. Section 2 sets out the objectives and guidelines and indicates briefly the
relationship of the work to two other System Dynamics economic models. The
overall structure of the model ‘is described in Section 3. Sections 4 and 5
discuss in more detail the physical description of the economy and the
decision making processes governing its behaviour.
The model exists tn progranned form but is not complete. Most of the
ideas described in the coulowtng Paragraphs have been incorporated, at least
in a simple form, but several still await attention. The paper should,
therefore, be regarded more as a progress report and as a stimulant to
discussion rather than as a report on a finished product.
2. OBJECTIVES. AND_ MODELLING. GUIDELINES
The prime objective is the promotion of understanding and ‘the
impeévenent of communication. Within this prime objective the developnait of
the model has been constrained by a number of guidelines:
(i) It must be a model of the economy, not of the National Accounts.
There ig more to economic life than is measured ‘ana reported by the
Government's statistical service. A set of National Accounts (albeit
simplified) should be just one of the output documents from such a model.
(14) It must differentiate as clearly as possible between the physical
entity that is the economy and the human behaviour processes which determine
the way it operates. In this respect it might be thought analogous to a
piece of electronic equipment in which the physical description of the
economy is represented by the circuit boards and the decision making
processes are encoded on micro~processors plugged into them. It is the
author's belief that the description of the physical structure is the most
easily achieved phase of the modelling, that differences of opinion on the
adequacy of that description can be speedily resolved and that it provides a
firm foundation upon which to build the much more contentious representation
of the human behaviour processes. This differentiation is, therefore, aimed
at focusing, attention and argument on those aspects. of economic life which
are most open to question.
(i41) “It must’ represent. ‘decision making itetisies ey, odelling
them in terms that are recognisable to the decision makers themselves. It
must permit each identifiable group of decision makers (a decision centre) to
have its ow objectives. These objectives need not, indeed often will not, be
compatible one with another. Each decision centre will base its actions on
different flows of informations It will never be possible to model the full
complexity of a decision centre’s behaviour. There may be circumstances in
which greater learning can be achieved by not even trying, and by
substituting one or more real persons for the inadequate microprocessors and
operating the model in an interactive simulation or game playing mode. To
_this end attempts are being made to improve the man-model interface by
exploiting high quality colour graphics.
(iv) It must strike a balance between excessive complexity and over
simplification. Large, complex models are not good aids to understanding and
communication. There are complementary dangers, however, in
oversimplification. The world is complex and there will be occasions when
that complexity will lead to unexpected behaviour. The aim must be to reduce
the number of those occasions to a minimum without defeating the prime
objective.
(v) ‘It must allow for inevitability... Some factors, that are likely to
influence economic activity e«g. demographic: ones, are. already almost fully
determined for some years ahead Similarly, decisions are heavily
constrained and it may only be posetble to bring about significant change
over a period of years.
‘The guidelines outlined ‘above:lead naturally to a modelling approach
‘based on System Dynamics concepts and .it;is,.,therefore, similar to. that. used
at MIT. (Ref. 1). However, it differs:in:two important respects. Firstly,
the model is at ‘least an order:of magnitude simpler in.terms of the amount of
@etail ‘it represénts and in.tertis of ‘the. number sof equations it contains...
This ‘ts intentional for the reasons already outlined; the associated risks
have been accepted. Secondly, the model is being constructed from the outset
asa total system even if, initially, oversimplified descriptions of the
decision making processes have to be tolerated... Although individual sectors
are researched ‘off-line' they are incorporated into the overall framework at
the earliest possible stage. Thus approxiuately equal emphasis has been
placed on the interconnections between the sectors and the behaviour of the
sectors themselves-. The availability of the network diagrams, particularly
that for the money flows, has contributed significantly to our own
understanding of the way influences propagate within the economy. It is
regrettable that such diagrams are so hard to find in economics text books.
There are also similarities with the work of Tomkins (Ref. 2, 3). In
Tomkins' model the physical description of the economy plays a very secondary
role, at least at the explicit level, and the sodel is formulated in terms of
a ‘small number of subsystens, each Tepresenting @ key decision making ,
process. It is the feedback loops assocfated with these processes that ;
dictate the model structure. Since theid ete:a:nixture: of the physica and
behavioural dimensions, Tomkins’ formulation cuts diagonally across our own.
3- MODEL STRUCTURE,
|The model is structured in terms of a number of decision centres who
seck to manage @ set of resource networks. ‘The term “manage” 1 defined to
include the formulation of objectives, the collection of relevant inforeation,
Hoe
the making of decisions and the taking cad action. The definition of the
ait. Nase obo hoats
‘decision centres and the resources ete eutlioed in vee following parageaphs.
‘Figure 1 The Multi=Layer Structure
Building further on the analogy introduced earlier, the whole system
can usefully be thought of as a set of citcuit”boards ‘stacked vertically one
ardé define the’décision centres
above the other (Figure 1). The ‘topmost |
and their objectives. Each of the lower boards contains ‘a’ representation of
the stock and flow network of one resource. Each board represents. either a
conservative sub-system or one with identifiable sources’ and sinks.
Information flows upwards to the decision centres so that the state of the
relevant parts of the economy can be monitored and compared with the
objectivese Action then flows vertically downwards.
The Decision Centres
In the first instance the number of decision centres has been limited
to six: Households, Companies, Government, Financial Managets,‘ Banks and
Overseas.
(4) Households:
The model is formulated in terms of a single aggregate household
sector ~ the ensemble of all households. It is assumed that an average
behaviour can be attributed to the ensemble, even though there aré
considerable variations in individual behaviour. ‘No attempt has yet been
made to divide households into high and low tncome groups or: into
professional and non-professional. Although ‘it is recognised that
purchasing power and spending patterns vary throughout the life of a
household, no attempt has been made to represent the household age
distribution. This could be a serious omission for the UK in. the. 1980s.
(14) Companies: :
: This sector includes all trading orgenisations which sell goods and
services in retura:-for payment, ‘whether private or State evaed. e is ;
assumed that, at least to a first approxination, the behaviour of the
ensemble of all companies cen be fepresented. by a single “typical” company
pursuing a set of average objectives. The validity of such an approximation
can be challenged on many grounds. in « mixed economy such as the UK it is
well known that the State owned corporations pursue different aims to the
private sector. Similarly, there will be differences of emphasis in i
behaviour of manufacturing and service companies. Nevertheless, there is :
sufficient commonality of purpose and behaviour to make the assumption a good
Starting point.
ane tS MR
(141), Government
Since all State owed trading activities have been absorbed into the
Company sector, the decision making role of the Government is limited in ‘the
model to macro-economic management and the free provision of public services.
(iv) Financial Managers:
The Financial Managers include the pension funds, life assurance
companies and other financial institutions who manage the financial surpluses
of Households. They are deemed not to hold stocks of assets on their own
behalf and operate essentially as a avitehing mechanism, directing :
Households’ funds into different tenes ‘of ‘assets.
Bef
Peron
"@) Banks:
A limited number of financial ‘gnstdtutiones have the power to create
money. In the accepted sense of the ‘word a bank has three roles: as a
profit-making trading organiacticn! asa a safekeeper of uoney stocks owned by
others; and as a exeator of credit. it is only the. last ‘function that is
included under “Banks”. Decisions concerning normal commercial operations
fall under the Companies headings Those who Possess money stocks perceive
them as their own, even if they are on “deposit with a bank. In the
diagramatic representations of the model all money stocks are therefore
identified with their owners rather than with the Bankes
(vi). Overseas: 7
The Resources
Five resources are currently included in the model: People, Goods
and Services, Fixed Assets, Financial Assets and Money.
(4) People:
People form Households, are employed by Government and Companies in
the production of goods and services, can be unemployed, purchase and consume
goods and services, and manage i a portfolio of assets. ‘which include their
stocks of goods, financial’ assets and money- :
(it) Goods and Services:
iG
There is a aad to differentiate be ween goods o on the one hand and
ae 8
services on the other, and between different types ‘of goods. Goods and
-10-
service fora @ continuus vith @ spectrum of lives ranging from zero (a
service) to more than 100 yeare (e dwelling). It is a useful simplification
to divide this continuum into three parts: services, perishable goods and
durable goods. “8 ;
Services are intangible and cannot (by and large) be stocked by |
either producer or consumer. They are consumed immediately they are
produced. . Goode are tangible. but are, nevertheless, valued more for the:
service they provide than intrinsically for theaselves. Perishable goods
provide « flow of service which te related to thete rate of consunption,
ieee they are valued a8 @ flow. Perishables have a (near) sero life, ate not
stocked in any significant quantity by coneuners, but may be stocked by
producers. Durable goods provide « flow of service vhich ts related to the
quantity owned: snd in beneficial operation, te. they are ‘valued as a stock.
Durables have a wide spectrum of lives and are stocked by both consumers and
producers. ‘They include dwellings, cers, clothing, white goods, etc.
These distinctions are important for two reasons. Firstly: if the
flow of perishables ceases so also does the flow of service derived from it
and dissatisfaction will grow rapidly. ‘In contrast, if the flow of new
durables is interrupted, the flow of set¥ice, and hence satisfaction,
continues. It msy decline as the durable stock is reduced by scrappage, but
"even then lives can be extended and the level of service maintained.
Secondly: the UK economy is shifting steadily from manufacturing towards
services. If the business cycle has its origins in the mechanisms of
inventory control then its charactertetiits will change as the stock holding
parts of the economy become of less tnportance.
oo
-ll-
(441) Fixed Assets: “ Mah Eee
Fixed assets are the means of’ “increasing ‘the power ‘of human.labour in
the provision of goods and services. There’ xé‘only ‘two stocks in the model:
one owned by Companies (plant and ‘machinéty; “batYdings ‘and’ works~and
vehicles), one owned by Government (schools, “hospitals, roads, etc.)s: By
definition Households do not own fixed assets; dwellings are categorised as
durables.
(tv) Financial Assets:
Financial Assets are pieces of paper (bonds, etc.) which, although
they represent purchasing power, ‘are ‘Kot normally ‘used’ for ‘transactions
involving goods and services. ‘They até récéipts acknowledging the lending of
the purchasing power tempo: raly ‘to ‘othiers: “Shey have’ d° spectrum of lives
“which range from infinity down ‘to a’ few ndithé. ‘As8et¥ “at “the "short* ‘end
are sometimes used for transaction purpéses ‘and ‘there is; therefore, a
difficult grey area between Financial Assets aid Morley - which is’ in itself
only a very short dated financial asset. © For: thé purpose of this model
Financial Assets are defined to include lives down to about a year. Any
asset with a shorter life is classified as Money. A distinction is drawn
between Government issued bonds and Company. issued equity. Stocks of
Financial Assets are owned by all the decision ‘centres.
(v) Money:
Money is defined as “instantly realisa le purchasing power". Thus it
includes notes and coins, current account deposits, other short term bank
- deposits and financial assets having a life of “less than one: year. All
decision centres own money stocks (their liquidity) although that maintained
by Government is small. The “noney supply” is made up of the four stocks of
sterling owned by Households, Geenrameni. Gonpdites and Foreigners. In
addition, there are two stocks of foreign currency: the official repeuvas,
owned by the Governnent and managed by the Bank of Engiand, and a non-
governmental stock owned predominantly by Companies.
4. RESOURCE SY:
“People:
|The stocks and flows of people ate shown in Figure 2. Most people
enter the systes 88 young dependants. On leaving school they enter the stock
of potential enployees. Net every potential exployee seeks paid eaploynent.
Most men do, but many women do note The fraction of an age group vio do seek
paid employment is quantified in terns of “activity rates". "Significant:
changes over time are observed in their magnitude. Z poy
Figure 2 ‘Stocks and Plows of People ,
scaled Tee ew oY
a
H
'
‘
‘
a
+ tanour
Input
4
oi BIOX OF Pe --- ene ee ee eee eH nose -L)
pean
-13-
. These changes | are complex and can | only: really be described adequately
by a full demographic model representing the detailed age distribution of the
population. For simplicity the broad changes in ‘the future ‘stocks and flows
are computed “off-line” and incorporated exogenously. Some allowance is made
=) ty E
within the model, hovever, for feedback ‘fron ‘the Yevel of unemployment to
overall activity rates.
When seeking paid eaployment it ts ageined that everyone enters or
_Terenters the stock of unemployed, if only instantaneously. From there they
are recruited into either Government or Corporate enploynent. There is a
considerable turnover aaaccrates with these two labour forces: While in
employment people receive a remuneration and in return provide a flow of
labour, measured in person 7 hours per yeare This, in combination with the
fixed assets currently in operation, provides the: output “of goods ‘and
services being demanded by the economy.
Ultimately people retire from employment and ‘re-enter. the household
stock of dependants. Death in employment does, of course, occur but is
negligible in relation to other flows. For the UK, net immigration and
foreign labour flows are small and have, therefore, been omitted.
Each of the groups of people shown’ in Figure 2 places demands on the
economy, resulting predominantly in flows of goods and services and/or money.
The magnitudes of these flows are 2 often dtrectay’ proportional to the
numerical size of the group and once the per capita demand or payment is
specified these flows represent some of the nevi CAbELIEtesy:¢ “at vate in the
short term, faced by those managing the economy.
= Ihe
: -, The otcck’ and flow system for goods and services: is shown: in Figure 3.
Raw materials are mined or imported: and enter the. corporate sector's. Raw.
Material. stock... From there they are drawn. into the production:-process, ‘being
cycled through: the: companies’ fixed assets, part going to waste, the _
remainder flowing into. the stock of work-in-progress. These intermediate
goods are further. processed, drawing in additional raw materials, until they
emerge finally. into the stock of finished goods. Services are also produced
by the corporate sector, and may require the usage of raw materials. They:
are delivered directly to the consumer. The stock of finished goods, largely
in the hands of the wholesale: and. retail trades will. be supplemented directly
by, imported manufactures. re
i ; _ : EO Rae wee
Goods. are delivered’ frou: stock: to: Households, Government. and: Overseas.
For simplicity, no distinction 1s made at the production stage between.
Figure 3. Stocks and: Fl. Services:
(Wer) EXPORTS OF SERVICES
Ee a ey ee es
EXPORTS OP GOODS:
‘DELAVERIES)
IMPORTS OF MANUFACTURERS
g
-15-
perishable and durable goods. It is dasumed that industry ‘has perfect
flexibility in responding to any shift ‘tn the balance of demand between the
two. :As outlined above, services and perishables are consumed
instantaneously by | households, while durables enter a stock from which they
are scrapped (retired) with an average life hp» (tees s a fraction Liny
of the stock is. retired each year). Government ig also assumed to consume
services and perishables instantly. Its durable purchases are recategorized
as investment in fixed assets. For simplicity, and because State owned
manufacturers are defined to be part of the Company sector, Government is
assumed. to supply only services.
Fixed Assets:
The flows of, materials and capital s00ds which are 2 accumulated “into
stocks. of fized assets are _ghown in Figure 4
Figure 4 Stocks and Flows of Fixed Assets
EXPORTS —_
7.0. = FINISHED Goops
WAP. = WORK IN PROGRESS
RM. = RAW MATERIALS She AY :
—+— nap assers DELIVERIES *
ceceesss MATERIALS p
t
Gach a» INDIGENOUS
. 1 ' RAW WAPERTALS
toy ~
‘ :
1 H
' :
. 1
loovennMenr''s' 1 | conpanzes®
FIXED “FIXED
ASSETS ASSETS
PURCHASES, i PURCHASES L
RENREMENT RETIREMENT
‘The mechanics of producing capital goods is essentially the same as
that for producing consumer goods described in the previous section.
: Fixed assets have a specttua of lives ranging from @ yeat or two to
decades. Two repreventations of the way the capital stock ie accunulated
have been exploted. The first assumes capital goods to be perfectly
homogeneous with a single average Life Tig. Once an investment is made it
loses its identity within the stock (etirred tank approximation). and a
fraction "/tyy of the stock is retired each year. All assets tiave the
same capital productivity Coutpet/plant-hour). The second, allove for
several different Lives and permite investeent to retain its identity as it
agen by acciimulating it in @ pipeline, the length of which is related to the
“asset Lifetioe. Investecat io different years con have, ood retain, —
different capital prodvctivitiess The torner sodel is staple; undenanding ia
terns of data, but @ poor representation of the dynasties of capital
accumulation. ‘The latter is a bettér representation but carries a heavy:
penalty in the need to know the Investaent ‘history for a time Ty prior to
t = Oe
Ta the first Wersion of the model. the fixed asset and consumer goods
han
systems have beef combined and no distinction is made at the production stage
between the two types of outputs
Ast
wee
Financial Assets:
The current vérsion of the model ‘contains only a very rudimentary
a ak
financial asset system (Figure 5). Companies create liabilities by issuing
; eet
-17-
new share capital; similarly Government, by providing a flow of new
bonds: Only net flows are taken into account.
Newly issued equity and bonds are purchased by Financial Managers,
who then re-issue them in the form of life policies, pension rights, etc. to
Households, by Government, by Coipsnition aud Overeens. Stocks of Financial
Assets are thasutea in volume terms and continuously revalued at current
prices.
Figure 5 Stocks and Flows of Financial Assets
| PuncHASE OF
‘STOCK OF
FINANCIAL
‘ASSETS: =
LIFE POLICIES
‘AMD PENSION
RIGHTS
areceen, BONDS. asc |
A= ASSETS
L © LIABILITIES
Money:
The stock: and flow network for money» the most complex of all the
networks is shown in Figure 6. There is a_flow in this system mirroring each
of the flows in the other diagrams. Corresponding pairs of flows are closely
related (e-g. through price). There are, in addition, purely monetary flows
having no counterpart elsewhere.
All stocks and flows to the left of the foreign exchange market in
-Be-
Figure 6 refer to £ sterling. Everything to the right 1s in other
currencies. Within the sterling systen-soney ts conserved except for the one
eource (or sink) represented by the “nanks". As explained in a previous:
section “Banks” are deemed not to. own stocks of money in their own right.
{ Pioenehel Acsetal
beneeees
Parchese of
Fined Assets
ie
These are owned by the other decision.centres although part, indeed the. bulk,
ot 2
of the money stock will be held in safel eping for them by thé Banks and will
influence the extent to which the Bank ‘can create additional credit by making
loans. The stock of sterling represented by the Foreign exchange market is -
. ak
very small indeed. Thus, to a first approximation, the flows of sterling
* dnto and out of the foreign exchange market must at all times. balance. +
=-19 +
The network of money flows is Hest E summarised by considering the
income and expenditure of each decision centre ae turn.
Households receive wages from Government and Companies and a range of
. ze - ls 5 Brot ie, toe,
benefits from Government + They also receive private pensions and other forms
of investment incomes; for simplicity these are aggregated with wages.
Households pay income tax and national insurance contributions. They pay for
goods and services received, financed in part by loans raised from Banks.
Their. savings flow. to the Financial Managers who use them to purchase a
portfolio of financial. assets. _
, Government income. comes. in the form of dtrect taxes on Households and
Companies and also indirectly, from canes on expenditure. Payments a are made
for goods. and services, wages are paid to employees and tevveaemaiie is
undertaken in. fixed assets. Benefits are disbursed to Households and
grants and loans, net of subsidies, are = to Companies. Interest payments
on outstanding Government debt are subsumed tate wages. Since Government
carries only a very small money stock, expenditure not financed out of tax
revenues must be financed by borrowing. ots As: sccompl ished by selling
bonds and, in the last resort, by raising short term deans: from the Banks.
Any direct intervention in. the foreign exchange market also creates an income
or expenditure attributable to Government's ;
2 5 Php
Companies receive income from feeding. in consumer goods, capital
goods and services, both at home and overseas. This is supplemented by net
grants from Government, by the issue of new share capital and by the raising.
of loans from the Banks. They pay wages to their employees, interest and
dividends on their liabilities (included {n.wages) and taxes and national
insurance contributions to Coverament. Payments are made for goods and
services, purchased predominantly as intermediates from other UK companies,
but also imported from abroad. The tntermediate transactions le wholly
within the Company. sector and have been omitted from Figure 6 in the .
interests of clarity. Payments are made for the putchase of fixed assets.
(investment), some supplied from the UK, others imported. Funds also flow
abroad to finance investment overseas.
The description of foreign involvenent ia the domestic money supply
has been pared to the very minieum. Foreigners transfor money into the
country by purchasing sterling on the foreign exchanges. They also, raise
sterling loans fron the Bankes They are assueed either to hold their-funds
in liquid fora or to use them to purchase equity and bonds.
"Banks" in their defined role of credit creators provide a (net) flow
of sterling loans to Households, Coverneent, Companies and Foreigners.
Sterling flows into the foreign exchange market shen currency has to
be bought to pay For imported goods and sérvices or finance soucsentl
investment... It flows from the market Ante -the economy: when there are capital
inflows or payments being received for ‘ékports in currencies which are then
converted into sterling. Finally, if ends is an imbalance between these
flows and the Government wishes to defend the existing exchange rate then it
can buy and sell ‘sterling using the offiétal reserves as its source (or sink)
eet
* of currency.
-21-
5. THE DECISION MAKING PROCESSES
s
The modelling of the decision processes for Households, Companies and
Government are discussed:in the following paragraphs. Since the decisions of
Financial Managers, Banks and Overseas are.currently modelled only in terms
of simple allocation:rules- they are not. described in detail.
Households: a
Household decisions aré primarily concerned with the management of
income in relation to perceived material needs. _
bors
Figure 7 Households’ Cash Flow
pecenesn ee
Vepen-pe<--
%. ”
‘WET THCOME
b> _ INTEREST AND. LOAN REPAYMENTS
| __=-.>, parsers FoR, PERTSHABLES
pi": ____> - voniiwtaRy PURCHASES OF FIRANCIAL ASSETS
ven [T > ‘vonummaay abprizons 10 Li@uIprry
Mey BORROWING —>—_ fs PAYMENTS FOR DURABLES
+> INVOLUNTARY PURCHASES OF FINANCIAL ASSETS
Ls ENVOLUNTARE ADDITIONS 10 LIQUIDITY
Households are assumed to have two sources of income: gross wages
and: benefits (including investment: income) received from Government, private
pension and life assurance funds.
; Two charges take s prewemptive strike at this gross income: Tax plus
National Insurance, and contributions to private pension and life assurance
funds. The residual income will be referred to as Houscholds' net income
(Figure 7). <It-4s what is.seen on the salary slip or in the wage packet
” Paymente to pension and life assurance fuads ate assumed to be a straight
percentage of gross wages. ‘
. Athird deduction is also treated “ pre-emptive: repayment
(including interest) of outstanding loans. It. is assumed that loans have an
average life of T, years and that. a fraction wie of the outstanding
loans is repaid each yeare
The residual income, supplemented ‘by new borrowing, is then used for
four purposes: (4) establishing and maintaining liquidity, (11) the
: purchase of perishable goods and services, (111) the purchase of durable
goods, and (iv) the purchase of financial, assets (discretionary saving).
The problem now is to assign priorities*to these expenditures for households
in aggregate. Most households will give priority to perishables; these
might ‘be regarded.as “necessities”. In newly formed households, saving will
have a low-priority relative to durablé’ purchase, while in older households
the priorities are likely to be reversedi’ In the version of the model
described in this paper, the purchase of %pertohables ts assumed to be have
top priority. Second priority goes to"the ‘maintenance of liquidity. Third
- 23 -
priority is a minimum level of discretionary saving, leaving expenditure on
durables, financed in part by néw. borrowing, as the lowest priority. Any
LEE eels Ryne
income remaining unspent is regarded as involuntary saving and allocated
between liquidity and financial assets.
ae ak
Expenditure on perishables is assumed to be “volume and flow" driven,
eg. - households need so many kilograms of food per day- In contrast,
expenditure on durables is “value and stock” driven; households having
available a sum of money with which to establish cen maintain their stock of
durable. goods. .
The rate, measured in volune terms, at which perishable goods are
ordered will be determined predominantly by. the rate of ordering at previous
times... However, if households perceive that they have become more affluent,
the amount desired might be expected to increase. Households will feel more
affluent if their surplus income increases relative to their net income, or
if they shave excessive bank balances. Actual expenditure will depend on
price (a corporate decision) and the level of indirect Taxation (a Government
decision).
. The allocation of income: to the maintenance ot liquidity is assumed
to be determined by the stock of money desired, “the dtacrapaney between the
actual and desired stock and the degen with which the discrepancy is to be
eliminated (measured in terms of the household liquidity reaction time). The
desired. stock of money is assumed to be directly proportional to net income.
sf
Discretionary saving is assumed to be proportional to surplus income.
For simplicity discretfonsry and iavoluntary savings are aggregated: with. non-
discretionary saving: and channelled to the ‘Financial Manewere for investment
fa: a portfolio: of Findoctat Aseets.
Durable. goods: are. valued by households for the flow of services’ they
provide, ai flow which. fs broadly: proportional to the stock omed. Decisions
on durable purchase will be governed by the ‘desired magnitude of this stock.
Tt fs assumed that the desired stock will increase with the level-‘of
affluence and will. decline’ only under exceptionally adverse: conditions. »
‘The planned rate of acquiring durables will depend on. the rate at which —
existing durables are being retired and therefore need replacing, the
discrepancy between the actual and desired stocks, and’ the urgency with which
the shortfall ts to be eliminated. If the avatlable funds are insufficient,
purctiases will ‘be limited to what. can te afforded. In ‘extrenis this
expenditure may be insufficient even to replace the planned retivenents’ lf
it 4s. assumed that households will never give up the services to which: they
have been accustomed, then they will resist. any fall inthe durable stock by
deferring retirement and extending the life of the assets. “If funds once
more become available, an early priority: will be the acceleration of
| serappage and the replacement of these: ¥dteran durables» -
i obey
It. is assumed: thet all expenditure on: durables: will be financed: in
part by new borrowing (the seount: being determined: by a “down-payment
ratio”). Constraints may be imposed. oi’ dew borrowing: by the Governments” No
provision has yet been. wade for the runing down of financial aseete in order
+ to generate funds for durable purchase or ftor the effects: of inflationary
expectations on the desired couposit toa. of the households. asset portfoltos:
ie Bt
-25-
However, the basic information is generated and readily available for such an
extension.
vid
Companies:
In the na jority of companies, decision making is not centralized but
is delegated to individuals. and functional dapaceneneat It is therefore
: convenient. to model the aggregate corporate sector by breaking it down into a
small set: of functions: marketing, production, virehaating, personnel,
planning and: accounting. (Figure 8). It is ‘aeadaea that the easeuble of each
type of department can be represented by the behaviour of a single entity in
which the: spectrum of different, responses appearing at different times can be
represented by an average response spread over a limited time interval.
Figure 8 Corporate Functions
!
Vacencies | Recruits
‘
PERSONNEL
|
Orders | Yabour
1
~- Setara _y ~ Orders _ 5] |, orders _ pastes. 5:
MARKETING PRODUCTION |, 2 PURCHASING
Deliveries Product, Materials Purchases
T
1
Orders | Fixed
' Assete
‘ 4
—Receipta_,}
ACCOUNTS PLANNING
——
Paynenta r t
t t
Profit 4 Loss Orders | Purchases
H '
v v
(¢}) Marketing:
: The typical marketing department te concerned with the flow of orders
from, and deliveries to, customers, the managenent of the orderbook and the
level of finished goods stock, the setting of prices, the communication. of
current denands to the Production function and of forecast future demande to
Planning.
The desired production rate is determined by a classical industrial-
dynamic algorithm (Ref. 4). The rate desired is that which will
simultaneously satisfy incouing orders, eliminate the gaps between actual and
desired stock levels, and actual and desire! orderbook lengths vith an
‘urgency determined by the respective adjustment tines.
The actual price level achieved is deterained by the desired price
level modified ty a measure of denand pressure. The desired level is based
‘on a combination. of profit margin and return on capital targets. , Demand
pressure is linked to orderbook lengths, “stock levels and current plant «
occupacity.
(44) Production: : eo 2 I
Production department's obsectives are to supply Marketing with
product at the desired rate, to manage the ‘labour’ and capital resource
available to it, to anticipate changes for both, to communicate those needs
to Personnel and Planning and finally to'dtaw from stock the raw materials
required for production (Figure 9).
-27-
Figure 9 The Production Process
at She
a2
PRODUCTION ie
PRODUCTION PROCESS
‘MATERIALS
<en__|
: ‘INPUT
OPERATING f h STOCK OF ASSETS
1 2 HOURS.
The. production management require three tiipate? labour, measured in
terms of the number of employees (N) aia the aaabee of man-hours worked per
man, per year (Ty); capital measured in terms of the. number of “plants” (K)
and the number of plant-hours worked per plant per year (TR) and raw
materials. No distinction is currently made between energy and other raw
material inputs.
Under normal operating conditions ‘the capital stock operates for a
normal annual number of hours Ty,, at a normal productivity Py,
(output/plant-hr), workers are employed for normal hours Ty,, yielding a
normal output % where ;
Q" Pro? Tko* pe
There will be a normal manning ratio M, (man-hours/plant-hour)
given by
N I,
Mss — Ne
K Ty .
M, is the normal number of workers. required to be present when a
unit of plant fs in operation. It fe eassuned to be technologically
. determined and to change only slowly over time. The total number of workers
required on the payroll of each plant (N/K.men/plant) will exceed M, if
Tyo > Tyor tee> there 1s multi-shift working.
If the desired output is more or leas than Q,, management has a
number of actions available to it. In the short term tt can increase or
decrease Py by running the plant harder or wore slowly. There will be
upper and lower limits beyond which such flexibility will -be exhausted. . When
those Limits are reached, it can increase or decrease Ty» Since te will
still have the same labour force, this will taply an facresise ‘of decrease tn
| Tye dees overtine or short tise wotking for enployees.
There will be workers’ resistance to both excessive overtime and
‘excessive short. time workings . Unit costs will also rise. There will come a
point. where to reduce unit costs, and Festore profitability, management will
be forced either to shed labour or initiate the recruitment of workers. In
‘the latter case, it is being assumed that additional output can be extracted
from.the capital stock by increasing the’ sanning level. Once again there
: hae &
will be an upper limit and, if demand is any higher, the corporate sector
will have been. forced to its ultiaste short term supply limit. The focus of
attention then falls on the Planning function to invest in additional
eee
has y
capacity or, in adverse conditions, to reduce capacity by closing plant
down.
= 29 -
(111) Purchasing:
As Production draws down the stocks of raw materiais it is the role
of Purchasing to restore them to the desired level with an urgency measured
in terms of a raw material purchasing peaction time.
(iv) Personnel:
Personnel department reaponds to the labour needs of Production by
recruiting new employees and managing wastage (natural or redundancy). It is
also responsible for responding to the wage demands arising from Households.
.If, for any significant length of time, Production is forced to work its
labour force: for more or less pian *No? it will incur unit labour costs in
excess of those ‘tn | normal 0 operation. ‘The target labour force (Ng) it
communicates to Yerecunel. is that which provides just the required ‘labour
input while working normal hours Tyo* ‘Thus
= T
Ng Mk ak
Tyo].
If N> Ng» Personnel attempt to achieve a wastage rate which will
eliminate the difference in a time Tye In practice there will be upper and
lower limits to this rate. The lower limit will be set by the rate of
“natural” wastage, itself a function of the current ‘ieeapleymcnt level. The
upper limit will be determined by concepts such as social responsibility.
IfN<¢ Ng Personnel have a recruitment task. The desired
recruitment rate is set equal | fo the current wastage rate plus the additional
recruitment necessary to eliminate the difference between N and Ng ina
time Tze This rate is subject to an upper limit which is dependant on the
level of unemployment. If unemployment is high, recruitment will be “easy”
and vice versa; Since natural wastage always occurs the recruitment and
wastage activities will be going on in parallel.
(v) Accounts:
The Accountancy function receives the corporate income, makes
payments, raises finance (new borrowing), manages Mquidity and credit, draws
up profit and loss accounts and balance sheets and forecasts future profit
and cash flow.
(wi) Planning:
The Planning function anticipates, on the basis of market forecasts
“and the pressure of demand on existing assets, the capital stock requirements
of the future. It will seek to place orders for new capital which will be
auffictent both to replace expected retirenents and expand the capital stock
to its desired level within the planning horizon. If the funds available for
investment, ineluding new borrowing, are ‘inadequate then actual expenditure
will be Limited to vhat can be afforded. The level of new borrowing and its
disposition between equity and loans will depend on corporate profitability,
the state of the equity market and corpotate capital and interest géaring
levels in relation to current targets. ‘ih
‘eich
Government:
£
In modelling the Government's decision making processes three
essential elements must be taken into actount: its objectives, the actions
-31-
that are available to it and its beliefs concerning the relationships between
Be
the two (Figure 10).
Figure 10 The Government's Decision Making Process
INMLATION
EXPENDITURE ON FIXED ASSETS
COST AND AVAILABILITY OF CREDIT
PRICES AND INCOMES POLICY
LEVEL OF PUBLIC SERVICES
Government has a number of economic policy objectives which are
probably subservient to its prime objective of re-election. Its objectives
frequently: appear incompatible and it therefore has to set priorities. ‘The
order of priority depénds on the 'colour' of the Government, the economic .
theories. currently in vogue, the particular policy which is most astray and
the proximity of the next election. There appear to be three overriding
objectives: the rate of inflation, ‘the level of unemployment and the balance
of payments. Subsidiary objectives are sélatad 26) the growth of the money
supply, the level of public services and the exchange rate.
In theory, it is possible to formulate ‘an overall objective function
which is a weighted average of the percentage deviations of these variables
from their desired ‘values. ‘The weights, and the desired levels themselves,
will be functions of political philosophy ‘and current circumstances. The
practice is by no means easy!
The Covernuent, in the putsult of ite objectives, has a mnber of
economic, “levers” it can pulls These inelude direct and indirect taxation,
its own expenditure on goods and services (including the. wages of its
employees), the cost and availability of credit, and prices and. tacoma,
Policies. In none of these areas does it have total control. te cai wet the
tates of taxation but the absolute amounts ' Gollected will depend on incomes,
profits and expenditures It tan set the per capita valve of benefits ‘but the
amounts actually paid will depend on the tuaber of pensioners, entidren and
unemployed.
The extent to which Covernaent pulls. any particular combination of
levers depends on the theofy curtently influencing its thinking. The: outcome
may not always be what {s @xpected but thie will. not necessarily cause a
change.of policy. Trying harder is the most likely initial responses When
_ policy changes. do eeeur they are likely to be discontinuous, perhaps in :
association with a shanet of Government. =
. Fm
The formulation and programming of ‘an algorithm which can cepeeecat
this multi-input, multi-output decision making process is difficult. The
algorithm currently included in the model ‘fs simplistic and inadequate.
Improvement is undoubtedly possible but’ it ‘may be more valuable, in view of
* the understanding and communication objectives of the work, to model only the
“inevitabilities" and to replace the algoritha with a person operating the
-33-
model in an interactive mode, i.e. acting the role of Chancellor of the
Exchequer. It is in this direction that future developments are planned. :
REFERENCES
1. Forrester ow, Mass N.J, Ryan C J (1975) - 'The System Dynamics
National Model': Understanding Socio-Economic Behaviour and Policy
Alternatives; Report No. D-2248-2, Alfred P Sloan School of
Management, MIT, Cambridge, Mass.
2. Tomkins R (1978) -- "A System Dynamics Model of the UK Economy'; i
Proceedings of UKSC Conference on Computer Simulation, IPC, Science
and Technology Press, Guildford, Surrey. :
3. Tomkins R (1980) - ‘Structured Features of a System Dynamics Model
of the UK Economy'; Proceedings of the 6th wikeracerouat Conference
on System Dynamics and the anatyata of change, Paris.
4a Mass N J (1975) - "Economic Cycles’ : An Analysis of Underlying
Causes; Wright-Allen Press, Cambridge, Mass.
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