A Dynamic Model of General Financial Equilibrium with Policy Interventions and Stability Analysis

June Dong
School of Business, State University of New York at Oswego

Abstract

In this paper we introduce a dynamic general financial equilibrium model with policy interventions in the form of taxes and price controls formulated as a projected dynamical system. The model assumes that sectors of an economy have heterogeneous expectations and the markets are not perfect in that there are taxes and price controls. Each sector of the economy seeks to maximize its utility in the presence of both taxes and price ceilings by determining its optimal composition of both assets and liabilities, subject to constraints. The instrument prices serve as the market signals reflecting the economic market conditions that are determined via the economic interaction of the supplies and demands for the financial instruments.

The paper proposes a dynamic financial adjustment process, which simulates how the sectors of the economy adjust the composition of their portfolios and how the economy responds with the price signals that balance the supplies and demands for the financial instruments. Stability analysis is then presented to study the asymptotical behavior of the adjustment process.