Modeling the Meltdown; Part 5: Financial Model Basics

Because we are building an economic model, all proactive agents, and the government, will have a financial model which includes the two standard elements:

• Income statement: how much the agent is making and spending over a given period of time
• Balance sheet: the amount of assets and debts (stuff) an agent holds at any specific point in time

Here is a more detailed view of the income statement and balance sheet, in terms of the elements we are using in this model (I’ve omitted the structured finance elements for the moment to keep it simple):

Income statement

• Income
  • Salary (households), sales (firms), debt interest (financial-firms)
    
  • Stock dividends
    
  • Interest paid on cash deposits
  
  
• Expenses
  • Goods purchased (households)
    
  • Salaries paid to employees (firms)
    
  • Cost to produce a good (e.g. buying mortgages)
    
  • Debt servicing (principle + interest)
    
  • Paying interest on deposits (firm)
    
  • Rent
• Profit = Income – expenses

Balance Sheet

• Assets
  • Cash
    
  • Investments
    
  • Home value (Households)
    
  • Equipment value (Firm)
    
  • Goods inventory
  
  
• Liabilities
  • Debt balance (secured & unsecured)
  
  
• Equity = Assets – Liabilities
  • For a household, equity is the net worth
    
  • Firms will be considered 100% publicly owned, though they can buy their own stock. The fundamental determination of stock price will be equity/# of shares. There will also be a market effect on the stock price

Credit Worthiness
An important aspect of this model will be the ability of one agent to evaluate the credit risk of another agent. The balance sheet and income statements make this possible, because in general a credit rating is better (the risk that the debt will not be repaid is lower) when

• profit as a percent of income is higher
• the ratio of assets to liabilities is higher
• these ratios have been stable or increasing over time
• the agent has not defaulted (left debt unpaid) in the past

Next, we'll look at how the elements of this specific model will interact.