Economic Model part II

The first part the economy is about three processes: Industry, banks and humans.
The third part Economic Model part III is about the consequences for import and export. In the third section also the crisis in Greece is discussed
In this part we will subdivide the three processes more further.

We will get the next picture: (Not all flows are drawn)

 Raw materials ---.                                       ======= 
  Trade & Trafic  |                                      | (20)  |
                  V                                      ^       V       
     ..........................          (1)         ..................        ..............
    .                          .------------------->.                  . (14) .              . 
    .       Industry           .         (2)        .       Banks      .<---->.  Insurances  .<--
    .                          .<-------------------.                  .      .              .   |
     ..........................                      ..................        ..............    |
              ^ |       ^ |                            ^ |   ^ |    ^                            |
              | |    (7)| |(8)                         | |   | |    |                        (13)|
              | |       | |       ................  (9)| |   | |    |          ..............    |
              | |       |  ----->.                .----  |   | |    |  (16)   .   Pension    .   |
              | |       |        .  Government    .  (10)|   | |     -------->.              .   |
              | |        --------.                .<-----    | |              .    Funds     .   |
              | |                 ................           | |               ..............    |
              | |                       ^  |                 | |                      ^          | 
           (5)| |(6)                (11)|  |(12)          (4)| |(3)                   |          |
              | |                       |  V                 | |                      |(15)      |
              | |                 ................           | |                      |          |
              |  --------------->.                .----------  |                      |          |
              |                  .    Humans      .<=========> | <=====================----------
               ------------------.                .<-----------  
                                  ................
                                    ^     ^    ^
               (17)                 |     |    |          (19)
         .--------------------------      |     ---------------------.
         |                                |(18)                      |
         V                                V                          V   
   ..............                 ................             .............                  
  .   Military   .               .    Health      .           .             .
  .              .               .                .           .  Education  .
  .   Industry   .               .     Care       .           .             .
   ..............                 ................             .............                  
Each of the nine processes are characterised by three quantaties: Possessions, Capital and Energy (Labour and knowledge). The arrows show the changes in these quantaties.

If you consider the total picture than this is a very complex network of connections between which all types of transport (trafic) takes place of money, products, services and labour. Beside that also internal transportation takes place.
The issue is to give values to all the quantities and flows (That means the changes of the quantities) involved and to describe the relations between those quantities and flows (how they interfer with each other, mathematically) This is very difficult because the issue is to predict what happens if you start to produce more, what happens if you increase taxes and or what happens if you start to print more money. In fact and that is the tragical part: nobody knows this exact.


Money flows part 1

If you consider the total picture than you can see that the whole a complex network of quantities (products) and flows (changes) is.
To get an idea how this works let us first study the money flows between the industrial processes, the banc, the government and the people. The total number of flows is 12.
What we are studying here are 6 pairs of flows. The flows 1 and 2 are a pair. The flows 3 and 4 are a pair etc.
The simplest situation that can occur is that all the pairs are equal. That means each day the same amount of money goes between the Industrial Processes and the banks, between the banks and the government etc. This is the ideal situation. The system is than in equilibrium, in balance. What is special in this case is that the amount of capital (money) which in each of the 4 processes stays constant.

The reality of course is different. The people want something else, they want more.

Let us consider a certain company that wants to produce the same product at a complete different way. That means you need different raw materials and you have to build a new plant (production process) If you want to do that with the same people (assume they are flexible) the only solution is to completely stop the present production plant. The immediate consequences are:

If the company has enough capital there is no problem. If not than the company has to borrow money from the banks (money stream #2 will increase). The result is that money flow #6 (wages) will stay equal.
The final result is capital transport from the banks towards the people. This proces stops when the new production plant is finished and there is production. Moneystream #2 will decrease until its old value and moneystream #5 ( counterpart product stream) will increase.


Money flows part 2

The conclusion of part 1 is the clasical law in economics: Saving = Investing. But is this true ? The purpose from all this is to show that, as a result of a simple renovation there are a number of possibilities (based on different assumptions) with complete different result. Those results, because the different processes involved depent on each other, can be quite complex.


A mathematical model.

Econometrics is a part of the economy involved with the study of mathematical models
The starting point of a mathematical model are different quantities and mathematical equations. The mathematical equations describe how the quatities change in time.
A very simple equation with the quantity n is:
n(t+1) = n(t) + din - dout
In words this equation looks like:
The quantity n at the moment t+1 is equal to the quantity n at the moment t plus the quantity din (delta in) minus the quantity dout (delta out)
You can also read the quation as follows:
The quantity Euro's (money) with a bank at-the-end-of-a-day is equal to the amount of Euro's at-the-start-of-the-day plus the number of Euro's that the bank has received during-the-day minus the number of Euro's that the bank has spend during-the-day.
The issue ofcourse is what are the values of din and dout. You can also combine din and dout and then the above equation becomes as follows:
n(t+1) = n(t) + dn(t)
And the probleem is what is dn(t), what is delta_n(t).
If n(t) is the amount of money at the banks than delta_n(t) depents about the economical developments in trade and industry, the governement, the military apparatus, health care, the people, the weather etc. Specific is written "the weather" because if there is a lot of snow this can easily influence the produktion processes which can result that the companies have to borrow more.
It will be clear that it is very difficult to define delta_n(t) accurately

In Nature of 12 April 2012 there is an article which discusses this problem. See: Scientists and bankers a new model army. This article als contains a comment with my name. In my opinion the writer of the article is to optimistic.


The artist

If you want to get an idea how the economy works than it is often of interest to look to special cases. One of those special cases is the influence of an artist on the economy
An artist, specific a portraitist, is also an example of an economical process. First he has to buy paint and a canvas. If he does not have the money than he has to go to the bank. If the person he wants to paint, pays in advance than there is no financial issue.
After he has bought the paint and the canvas for 50 Euro he starts to paint. Finally he sells the painting for 100 Euro and than he earns for his labour the amount of 50 Euro. What we are discussing here are the flows 5 and 6 in the above Picture.
After he has bought the paint and the canvas for 50 Euro he starts to paint. Finally he sells the painting for 100 Euro and than he has earned 50 Euro for his labour. We are discussing here the flows #5 and #6 in the above picture.
But the story is not finished yet. The original commissionner sells the painting for 200 Euro, after that it is sold for 500 Euro, for 1000 Euro and for 10000 Euro. All this is trade and it takes place within the process: People. Every one who sells is happy except economical it produces nothing.
But the story is not yet finished. The last buyer has bad luck. There is a fire and the painting burns down and is total loss. The last buyer is really unlucky because by paying 10000 Euro he losses everything and he takes care that all the others made a profit.

What is the moral value of this story ? What we are discussing here is trade within the process "The people". It is a transport of spending-power but at the end nobody get any richer because nothing new is produced.
Exactly the same happens if we trade shares. With the trade in share we do not become any richer, except the person who original bought the first shares. He is the investor. This is the person who caused an increase in production. All the others did not.
This is a wise lesson for the pensionfunds. More in the next paragraph


Pension Funds

The purpose of a pensionfund is to take care that after you stop working (65 year) you have some income to provide for your own support, that you own a pension. A part of these income you get from the government and an extra part via the companies you have worked for. This is the part you have build up during your working live.
In fact what happens during the time that you work, money is put in a "box". One part of this money comes from your salary and one part is put directly in this box by the company. In fact both part are costs for the company. You can also see this as: What is in the "box" is delayed spending-power

Not only goes money in the "box", but also out the "box". From your "box" goes money after you reached 65, but that is not the way its works.
If you consider a population who is stable (that means every year the same number of people are born and die) than the total input for each year from the working population should be identical as the pay out to the population above 65. If that is the case than the content of the "box" at the end of the year should be empty.
This is not the case. In the first place each year less children are born. The result is that the working population decreases. Besides that the average health of the population increases. The people die later. From a financial point this means that the pension funds should have created a buffer in the past, in order to pay its future obligations.

There are two important questions:

1. What is the purpose of the funds. 2. What do we do with the yearly income of the funds.

Insurance business

The purpose of an insurance is that the society pays for the possible costs of an event of an induvidual. For such an insurance you pay a premium. The issue is how much in this premium
In order to calculate the premium two issues are at stake: The first minimum estimate of the premium is than for each account: "total damage"/"total accounts". In reality you have to adapt this formula for the issured amount for each account.


Personal thoughts

It should be clear for the reader that each of these three institutions don't add any real value to the economy. A rich country is a country that produces by and for there own people. Of course countries who are rich in rawmaterials have a benefit. Top universities and research are not a necessity. The fact that most people learn a trade and use it, is the most important.

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E-mail:nicvroom@pandora.be.


Written: 22 July 2009

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