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Quarterly Economic Model

Explore the joint development of the Quarterly Economic Model (QEM) focusing on medium-term economic scenarios with a structural neoclassical approach. Learn about the model's construction, treatment of expectations, calibration methods, and structural components like labor markets, investments, and foreign trade.

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Quarterly Economic Model

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  1. Quarterly Economic Model Nico van der Windt Marián Vávra Michal Andrle

  2. 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

  3. 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

  4. Choice of the modelling paradigm (II) Fitting data VAR’s Large-scale fully estimated Keynesian models Structural neoclassical top-down models (QEM) DSGE with solid microfoundations Theoretical rigor

  5. 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and Vávra: An Economy in Transition and DSGE: What the Czech National Bank’s New Projection Model Needs, CNB WP, Unpublished DRAFT

  6. 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.

  7. 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

  8. 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

  9. 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) K M F(K,L) L

  10. 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

  11. 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

  12. 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

  13. 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…

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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

  20. 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…

  21. 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 World Trade Shock (Negative) Foreign Prices Shock

  22. 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

  23. Example from using the model… GDP (y-o-y, in %) Unemployment rate (in %) Current account (in % GDP) Public debt (in % GDP)

  24. 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

  25. EX1: Government Consumption/Investment GDP (scenario/baseline) GDP deflator Nominal Wages UR (p.b. from baseline)

  26. 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…

  27. EX2: Increase in World Demand Imports and Exports response to the level shift in Y* (scenario/baseline)

  28. 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

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