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Quarterly Economic Model

Nico van der WindtMarián VávraMichal Andrle

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Introduction

Joint development of the quarterly economic model (QEM) with SEOR, Erasmus Univ.

Two parts of the project:• Development of the core model• Upgrade and refinement of the model

The model is a story-telling device, with focus on medium term consistency of economic scenaria

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Choice of the modelling paradigm (I)

Variety of possibilities to choose from Capacity, time and technical constraints command

compact structural model

The model is a structural keynesian model with neoclassical supply side

The model is built using top-down approach – emphasis put on joint and compact derivation of main behavioral relationships

Emphasis on long-run properties of the model

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Choice of the modelling paradigm (II)

Fitting data

Theoretical rigor

VAR’s

DSGE with solid microfoundations

Large-scale fully estimated Keynesian models

Structural neoclassical top-down models (QEM)

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Models

Structural neoclassical models: Euroarea-Wide Model (AWM), ECB NiGEM (NIESR, UK) JADE (CPB, NL) redesigned in 2003 TRYM (Australian Treasury) … and many others

DSGE: IMF’s GEM (Laxton, Pesenti et al.) Multicountry DSGE model,2004 Bank of Canada QPM Bank of England (BEQM) 2005

October 2005 – Beneš, Hlédik, Kumhoff and Vávra: An Economy in Transition and DSGE: What the Czech National Bank’s New Projection Model Needs, CNB WP, Unpublished DRAFT

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Treatment of expectations

Not much explicit treatment of the expectations In the course of derivation of main behavioral eqs.

adaptive expectations imposed

Idea – adjustment to new information is costly, partial adjustment used extensively

The model is fully backward-looking

We are not able to simulate expected shocks, etc

It is technically demanding to work with model-consistent expectations in medium-size nonlinear models. It also requires a lot of “tricks” (habit formation, ROT consumers…) to bring the model closer to stylized facts.

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Estimation vs. Calibration

Earlier versions of the model mostly estimated with theoretical priors imposed

Current version mostly calibrated using all relevant information, strong reliance on theoretical priors

The model is not suited to capture short-term dynamics, but provides consistency needed in medium-term

ALL results are model-dependent and are subject to great uncertainty

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Structure of the model (I)

Small Open Economy Significant import intensity of exports Sizeable ER pass-through

Elasticity of substitution between K and L lower than unity Labor and goods market nominal and real rigidities

Markets do not clear in the model output-gap

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Supply Side (I)

Aggregate good in the economy produced using domestic value added (GDP) and imported goods (total supply)

Domestic value added (GDP) formed by services of labor (L) and capital (K)

F(K,L) assumed CES with low elasticity of substitution (approx 1/3)

F(GDP,M)

F(K,L)MK

L

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Supply Side (II)

Demands for labour and capital are linked with the same price elasticity (elasticity of substitution) and unit income elasticity… -> consequence of using CES

Total factor productivity is exogenous exponential trend

Cost-per-unit of output derived as a theoretical counterpart to GDP deflator

Output gap is a part of the supply side

LR properties – Open-Economy Solow Model

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Labour Market

Demand for labour derived together with demand for capital from the production function

Labour supply and population exogenous

Wage bargaining – “right-to-manage” approach to derive the wage equation

Reliance on theoretical priors

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Investment and Capital Stock

Aggregate capital-stock in the economy enters the PF

Private investment derived from the firm’s profit optimization problem – demand for capital with large adjustment costs and investment/capital identity

Government nominal investment exogenous, entering PF and thus productive and capacity-enhancing

Initial (1993) government capital stock set approx 20 % of the total

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Household sector

Consumption derived using RA model, assuming households view their wage income to follow random walk

Households are backward-looking in their decisions

Limited scope for wealth effects – empirical ambiguities, data problems…

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Foreign Trade

Export demand driven by world trade and real exchange rate (demand approach)

Import demand driven by domestic demand, including exports, to account for the import intensity of exports(due to the supply side structure, where it is derived)

Price elasticity of exports twice as high as the one of imports

Current version does not distinguish goods and services

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Price Block (I)

Price deflators derived as a theoretical counterparts to quantity variables

Cost-per-unit of output is the cost-of-living index from domestic value added PF. It is the weighted index of the price of labour and price of the capital.

Cost-per-unit of output is a counterpart to GDP deflator

Domestic/foreign content of the price indices calibrated. The domestic component consist of cost-per-unit of output, foreign component is the import deflator

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Price Block (II)

Export deflator is derived under Semi-Small Open Economy Assumption, i.e.

The cycle-sensitive markup is represented by the output gap

The CPI is decomposed into administrative prices and core inflation, which is modeled. Overall CPI is then linked with consumption deflator

The existence of CPU allows us to treat GDP deflator as a residual variable, I.e. YP/Y

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Fiscal Block (I)

Expenditures: Government Investment (exog) Government Wage Bill (LG exog, WG exog/rule) Goods Consumption (exog in nominal terms) Transfers and Benefits (UR Benefits, Pensions,…) Interest rate payments

Incomes Corporate and Personal Income Tax VAT and excise tax Social security contributions

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Fiscal Block (II)

Disaggregated expenditure and revenue side allows us to assess the fiscal effects of economic shocks

Debt accumulation in the model moderately affects interest rates

Data issues: The model has its own definitions not corresponding exactly

to GFS or ESA… Add-variables used to rescale the debt and deficit

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Fiscal and Monetary Policy…

Monetary policy operates through simple IR rule (a la Taylor – inflation and output gaps sensitive)

What is the definition of the fiscal policy… ?? Tax-rates and expenditures set.. Do we need more?

Is the “fiscal policy rule necessary” in the model…??

Technically – NO, since expectations are not model-consistent and current response of the model is NOT affected by steady-state result and the model is solvable…

Economically – YES, • since permanent shocks let the debt explode/implode, which is even

aggravated by interest response• Solvency of the government must be assured

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Fiscal and Monetary Policy…

Fiscal policy then must be specified…

Intuitive and often questions: “What is the effect of increase in XY on … output, inflation… holding fiscal policy

variables unchanged?”

ARE problematic…

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Example from using the model…

Variants of the model are used

2003 – Pre-Accession Economic Program sensitivity analysis carried out using previous version of QEM

2004 2005 2006

Gross domestic product -0,40 -0,65 -0,77Private consumption -0,22 -0,47 -0,71Exports of goods and services -0,83 -1,47 -1,99GDP deflator -0,06 -0,32 -0,64Private consumption deflator -0,07 -0,27 -0,47

Unemployment rate 0,03 0,09 0,16Current account deficit (% of GDP) 0,23 0,38 0,46Gen. government deficit (% of GDP) 0,10 0,22 0,33

change from the baseline scenario (in %)

absolute change from the baseline scenario

2004 2005 2006

Gross domestic product 0,15 0,51 0,66Private consumption -0,09 -0,12 -0,15Exports of goods and services 0,37 1,02 1,35GDP deflator 0,12 0,41 1,00Private consumption deflator 0,30 0,93 1,75

Unemployment rate -0,02 -0,06 -0,12Current account deficit (% of GDP) -0,08 -0,22 -0,32Gen. government deficit (% of GDP) -0,02 -0,12 -0,23

change from the baseline scenario (in %)

absolute change from the baseline scenario

World Trade Shock (Negative) Foreign Prices Shock

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Example from using the model…

Since 2004 – more elaborated sensitivity analysis using scenaria is presented in the Convergence Program

Baseline, optimistic and pessimistic scenaria defined

Year Year Year Year Year

2004 2005 2006 2007 2008

UK Brent

Optimistic USD/barrel 51,3 49,5 45,8 42,3

Baseline USD/barrel 38,3 55,5 60,5 57,8 54,3

Pessimistic USD/barrel 61,8 77,0 75,8 72,3

GDP EU 15

Optimistic y/y in % 1,7 2,3 2,7 2,7

Baseline y/y in % 1,2 1,5 1,9 2,4 2,5

Pessimistic y/y in % 1,2 1,3 1,9 2,2

PPI EU 15

Optimistic y/y in % 2,4 0,8 1,2 1,6

Baseline y/y in % 2,3 3,1 2,0 1,7 1,7

Pessimistic y/y in % 4,1 3,7 2,4 1,9

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Example from using the model…

GDP (y-o-y, in %) Unemployment rate (in %)

Current account (in % GDP) Public debt (in % GDP)

-2

-1

0

1

2

3

4

5

6

1995 1997 1999 2001 2003 2005 2007

Baseline

Optimistic

Pessimistic

3

4

5

6

7

8

9

1995 1997 1999 2001 2003 2005 2007

Baseline

Optimistic

Pessimistic

-8

-7

-6

-5

-4

-3

-2

-1

0

1995 1997 1999 2001 2003 2005 2007

Baseline

Optimistic

Pessimistic

10

15

20

25

30

35

40

1995 1997 1999 2001 2003 2005 2007

Baseline

Optimistic

Pessimistic

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EX1: Government Consumption/Investment

What is the result of the same increase (in bill CZK) of Government consumption? Government investment?

Both are government expenditures… BUT investment is assumed to be productive and thus enhance the potential output of the economy…

Higher capacities lower the output gap and demand pressures, allowing for higher and more persistent growth of the economy.

The higher domestic prices, the lower exports and higher imports

Impact on unemployment… output effect vs. increase of real wages

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EX1: Government Consumption/Investment

99.9

100.0

100.1

100.2

100.3

100.4

100.5

100.6

2000 2005 2010 2015 2020

Investment Consumption 99.96

100.00

100.04

100.08

100.12

100.16

100.20

100.24

100.28

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IGP GGP

99.9

100.0

100.1

100.2

100.3

100.4

100.5

00 02 04 06 08 10 12 14 16 18 20

IGP GGP-.16

-.12

-.08

-.04

.00

00 02 04 06 08 10 12 14 16 18 20

IGP GGP

GDP (scenario/baseline)

Nominal Wages

GDP deflator

UR (p.b. from baseline)

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EX2: Increase in World Demand

Assume permanent increase in foreign demand (level shift, not growth shift)

Exports reacts immediately… Import intensity of exports pulls imports upwards

Income effects also stimulates imports… Positive output gap slowly increase domestic prices… Having ER unchanged, changing RER shifts domestic demand to foreign goods

In the model, export prices are moderately affected by domestic prices, which have increased…

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EX2: Increase in World Demand

99

100

101

102

103

104

00 02 04 06 08 10 12 14 16 18 20

M (Perm. vs. Baseline) E (Perm. vs. Baseline)

Imports and Exports response to the level shift in Y*

(scenario/baseline)

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EX2: Fiscal Rules Sensitivity

The model must contain fiscal rules, specifying the behaviour of the government

“No policy change” simulations are biased and/or inconsistent