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Economic Models and Economic Policies. Nico van der Windt 5 December 2005. 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. Economic Policies.
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Economic Models and Economic Policies Nico van der Windt 5 December 2005
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
Economic Policies Welfare Function: W = W(Y,X,p) • Objectives (Y) • Instruments (X) • Preferences (p)
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
Objectives (Y*) • Economic growth • Employment • Inflation • Balance of Payments • Distribution of income --------------------------- • Government Deficit
Instruments (X) Quantitative instruments: • Fiscal instruments • Monetary instruments Non-quantitative instruments: • Legal instruments • Institutional instruments
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
Monetary instruments • Interest rates • Money supply • Quantitative restriction in for example credit provision by banks
Legal instruments • Articles in the law about for example competiton and regulation of markets • Bankruptcy law • Law and regulations related to private sector activities
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”
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)
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
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
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
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
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
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
Problems with models - 1 Y = f(Y, X, Z, e) Models give only a simplified and stylised view of a complex real world
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
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
Sensitivity of results Results are in particular sensitive for specification of: • Wage equation • Investment • Exports and imports
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
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)
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
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
Use of Economic Models in Economic Policies • Forecasting (baseline) • Uncertainty simulations • Sensitivity analysis • Policy simulations
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)
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
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
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
Trial and Error • Discussion between model builder and experts • Discussion between model builder and policy maker
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
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
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
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
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
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
Usefulness of Economic Models in Economic Policy making Models are consistent if specified correctly within the national accounting system
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
Czech example Current situation: • Quarterly (econometric) model • Sector model for MIT • Sector model for MoF
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
Similarities and Differences Differences: • Macro <-> sector • Quarter <-> annual • Calibration/estimation <-> calibration
Use of Models in Czech Republic Quarterly model: • Short- to Medium-Term forecasting • Fiscal policies (aggregate) • Sensitivity analysis exogenous variables • Sensitivity analysis policy options
Use of Models in Czech Republic Sector Model: • Long-term forecasting • Fiscal policies -> sector impact • Sector policies • Sensitivity analysis -> sector impact
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
Some Conclusions - 1 • Models useful for understanding main economic mechanisms • Models useful in discussion on economic policy packages
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
Some Conclusions - 3 • Strengthening model building departments • Procedures for use of models in policy discussions • Further research