Economic Models and Economic Policies

1. Economic Models and Economic Policies Nico van der Windt 5 December 2005

2. Content of the presentation • Economic Policies • Economic Models • Use of Economic Models in Economic Policies • Usefulness of Economic Models in Economic Policies • Czech example • Some Conclusions

3. Economic Policies Welfare Function: W = W(Y,X,p) • Objectives (Y) • Instruments (X) • Preferences (p)

4. Economic Policy Problem Max W = W(Y*,X,p) Subject to Y = f(Y, X, Z) in which: Y* is a subset of Y Z is vector of other variables

5. Objectives (Y*) • Economic growth • Employment • Inflation • Balance of Payments • Distribution of income --------------------------- • Government Deficit

6. Instruments (X) Quantitative instruments: • Fiscal instruments • Monetary instruments Non-quantitative instruments: • Legal instruments • Institutional instruments

7. Fiscal instruments • Taxes: tax base; tax rates and various types of taxes • Government expenditures: consumption and investment expenditure • Below the line: different modalities to finance the deficit

8. Monetary instruments • Interest rates • Money supply • Quantitative restriction in for example credit provision by banks

9. Legal instruments • Articles in the law about for example competiton and regulation of markets • Bankruptcy law • Law and regulations related to private sector activities

10. Institutional instruments • Public Institutions for support to private sector activities • Examples: Competition Agency; Energy agency; Chambers of Commerce; Foreign Investment agencies, etc. • Reduction of “red tape”

11. Problems with welfare function W = W(Y*,X,p) • Quantitative only • Preferences not known • Preferences not stable over time • Mathematical function not known (Theil’s Certainty Equivalence require quadratic function)

12. Economic Models Y = f(Y, X, Z, e) Large variety of different models Different models for different purposes: • Long run models, focus on supply • Short term models, focus on demand • Hybrid models • Macro & Sector models • General Equilibrium Models

13. Long-term models • Focus on supply • Production function • Volume and quality of Capital and labour • Important role of prices on adjustments • (Stable) long-term growth path • Functioning of markets • Short term aberrations do not have an impact on long term growth path

14. Short-term models, main features • Focus on various components of demand • Focus on short-term fluctuations • Overall capacity is considered exogenous • Minor influence of prices on volumes

15. Hybrid models • Focus on medium term, say up to 5 to 7 years • Combination of supply and demand • Long term solution comparable with that of long-term models • Short-term fluctuations around long-term growth path

16. Macro versus sector models • Macro models focus on aggregate, assuming that the sector composition does not matter for total • Sector models focus on industrial structure of the economy, assuming that sector composition is important for the aggregate

17. General Equilibrium Models • Main assumption: prices generate equilibrium between supply and demand • Often static, describing one state of equilibrium and compares this with an equilibrium under different assumption of exogenous variables • Recently also dynamic, describing the path from one equilibrium to another state of equilibrium

18. Problems with models - 1 Y = f(Y, X, Z, e) Models give only a simplified and stylised view of a complex real world

19. Problems with Models - 2 • Models are always incomplete • Uncertainty in behavioural equations • Instability of parameters: • Instability over time • Parameters not invariant under policy change (Lucas critique) • Local validity

20. Advantages of Models • Structure and focus the discussion • Coping with complexity • Consistency • Accountability Yet, always question the validity of the model for the problem at hand

21. Sensitivity of results Results are in particular sensitive for specification of: • Wage equation • Investment • Exports and imports

22. Example Wage Equation WPRPC = + 1.00 * (0.66*PCNPC + 0.34*PYPC) + 1.00 * LABPROD + 1.00 * WEDGE1 + 0.75 * WEDGE2(-1) - 0.36 * (UR(-4) – 10.00) R-squared = 0.92

23. Implications wage equation - 1 • Terms of trade effect through (PC/PY) • Shifting indirect taxes to employers (PC) • Shifting burden of taxes and social security premiums to employers (WEDGE) • Additional real wage increases if unemployment rate is above 10% (UR)

24. Implications wage equation - 2 • Taxes and contributions to social security affects cost per unit of output • Balanced budget multiplier (that is expenditure increase financed through additional taxes) negative

25. Example Imports and Exports Observations Czech economy: • both export and import GDP ratios have increased considerably over past decade; • Difficult to find satisfactory econometric fit • Both demand and supply approach not satisfactory

26. Use of Economic Models in Economic Policies • Forecasting (baseline) • Uncertainty simulations • Sensitivity analysis • Policy simulations

27. Forecasting Y = A * Y + Σ (B(i) * Y(t-i)) + Σ(C(i) * X(t-i+1)) + Σ (D(i) * XROW(t-i+1)) i = 1,…,n • Parameter uncertainties (A, B(i), C(i), D(i)) • Uncertainty policy reactions (X) • Uncertainty outside world (XROW)

28. Forecasting errors • CPB: main errors in variables external world • Errors in estimated parameters • Bias omitted variables • Lack of fiscal policy rules, difficult to estimate • Unclear monetary policy rules

29. Use of Models in Economic Policy W = W(Y*,X,p) Example quadratic loss function: L = a(i) * (Y*(i) – Y*(i))2 + b(j) * (X(j) – X(j))2 With model Y = F(Y,X) as constraint

30. Problems • Welfare/Loss function not known • Welfare/Loss function not stable • Model uncertainty • Certainty Equivalence only valid for quadratic welfare function • Technical approach to optimization of welfare function tends to yield useless results

31. Trial and Error • Discussion between model builder and experts • Discussion between model builder and policy maker

32. Trial and error procedure • Policy maker suggests particular set of instrument values • Analysis and translation into model input by model builder • Model results supplemented with expert knowledge • Overall results translated for policy maker • Discussion between model builder, expert and policy maker • Revised set of instrument values

33. Preferences through trial and error process Policy makers unlikely to provide well-defined welfare function, because they: • Do not have the technical skills • They don’t know the consequences of their preferences • They are not willing to reveal their preferences

34. Preferences through trial and error Confrontation with likely outcome of concrete policy proposal forces them to • Formulate better set of instrument values • Define additional targets • Think about additional conditions

35. Requirements model builder • Be clear and comprehensive in his reporting • Show trade offs between objectives • Show trade offs between instrument values • Show feasibility of various policy packages

36. Usefulness of Economic Models in Economic Policy making Structuring of discussion through • Focusing of the discussion • Quantification of the problems • Clarification of the relative importance of the problems • Clarification of feasibility of policy options

37. Usefulness of Economic Models in Economic Policy making Although they simplify reality models can cope with complexity: • Models indicate 2nd and higher order effects through feed backs • Models cope with simultaneity • Models calculate accurately • Models have a good memory

38. Usefulness of Economic Models in Economic Policy making Models are consistent if specified correctly within the national accounting system

39. Usefulness of Economic Models in Economic Policy making Accountability • Models and model calculations can be checked by 3rd parties • Models and model calculations can be compared with competing alternatives

40. Czech example Current situation: • Quarterly (econometric) model • Sector model for MIT • Sector model for MoF

41. Similarities and Differences Similarities: • Similar theoretical basis • Optimising behaviour economic agents • Supply and demand in relevant markets • Similar Production functions • Mark-up in prices • Consistent accounting framework • Dynamic

42. Similarities and Differences Differences: • Macro <-> sector • Quarter <-> annual • Calibration/estimation <-> calibration

43. Use of Models in Czech Republic Quarterly model: • Short- to Medium-Term forecasting • Fiscal policies (aggregate) • Sensitivity analysis exogenous variables • Sensitivity analysis policy options

44. Use of Models in Czech Republic Sector Model: • Long-term forecasting • Fiscal policies -> sector impact • Sector policies • Sensitivity analysis -> sector impact

45. Use of Models in Czech Republic • It would be useful to confront model forecasts and simulations with expert knowledge in systematic way • It would be useful to systematically use the models in a trial and error setting as described above • It would be useful to systematically compare the model simulations and explain differences

46. Some Conclusions - 1 • Models useful for understanding main economic mechanisms • Models useful in discussion on economic policy packages

47. Some Conclusions - 2 • Models as basis for economic policy preparation available • Modelling continuous activity • Continuous re-estimation of parameters required • More discussions between model builders and experts • More discussions between model builders/experts and policy makers

48. Some Conclusions - 3 • Strengthening model building departments • Procedures for use of models in policy discussions • Further research