A Stock Flow Consistent Model of a Closed Economy with Defaults of Firms

Abstract

Sequentially examining the full chain of events starting from the default of firms through the fire-sale of goods towards write-offs of bad loans, a new matrix of financial transactions was developed. It was shown that if firms have no equities, the cost of default of those firms is equal zero. Indeed, firms suffer from losses on fire-sales but at the same time, they have a benefit from write-offs of their loans. Whereas, banks incur only the losses on bad loans. This situation may restrain lending to the economy. The considered matrix of financial transactions was incorporated in the transactions-flows matrix of the closed economy consisting of households, firms, and banks. The obtained matrix significantly differs from Goodley’s and Lavoie’s matrix that the flows caused by write-offs of bad loans were taken to flows of incomes and expenses, not to the flows generated by changes in operating assets and liabilities. On the basis of the balance sheet and transactions-flows matrices, a mathematical model of the economy was developed. The used stock-flow consistent framework allows us to be sure that nothing will be lost neither in stocks nor in flows. The model allows studying how such the key parameters as the probability of default, the rate of fire-sales (new injected parameter), recovery rate, interest rates on loans and deposits affect the performance of banks and firms, observing economic dynamics in time under different macroprudential policy rules. Numerical simulation of the model was carried out. Under chosen parameters of the models, the net wealth of firms rises due to the cost of default is zero, while both the net wealth of banks and households at the beginning run high and then falls. Reasons for such behavior of the net wealth are significantly different. The net wealth of banks begins to fall due to the accumulation of credit losses. Whereas, the net wealth of households does begin to fall due to profit paradox, when workers of households have no sufficient money in order to buy out all produced goods, due to there is price markup.