Economics 827

1. Economics 827 Conditional Forecasting and Macroeconomic Models

2. Multiple Variable Forecasting Models Forecasts conditional on specific future events

3. Conditional Forecasts • Forecasting frameworks discussed so far use only historical data as inputs to forecasting process. • Suppose that you want to generate conditional forecasts: • e.g. What path will the economy follow from the the slow recovery turns into a depression for Southeast Asian economies?

4. Conditional Forecasts • Forecasting approaches that we have discussed would produce the same forecasts in either event, independent of whether such an event really would affect the economy. • Such a depression (or its absence) is a future event and not included in the history of the economy that is input into the forecasting process • You need to be able to form some idea as to what the current shock will be, and how its effects will spread through the system.

5. Conditional Forecasts • To conduct such forecasting exercises you need a different type of framework • Such a framework is provided by Macroeconomic or Macroeconometric Models

6. Macroeconomic Forecasting Models • Such models distinguish two types of variables: • Exogenous or conditioning variables. The future values of such variables are not forecast by the macroeconomic model, but are used as inputs into the forecasting process • Endogenous variables. Future values of these variables are the output of the forecasting process and are conditional upon the assumed values of the exogenous variables

7. Examples of Exogenous Variables • Monetary Policy Variables: • how will economy behave if Fed keeps the Funds rate target at present level (5.25) for rest of year vs. increasing it 50 basis points (5.75) this spring and holding at that for the rest of the year. • Fiscal Policy Variables: • what is the impact of a 15 % income tax reduction vs, maintaining the current rates.

8. Examples of Exogenous Variables II • World Economic Events • Dollar is now trading at about 125 yen and 1.8 D-marks compared with 110 and 1.50 a two years ago. What are the consequences of major (permanent) changes in exchange rates for U.S. economy? for foreign economies? • World Crude Oil Prices dropped substantially with reduced demand from SE Asia, then rebounded. What are the implications for the U.S. economy if such price decreases are repeated?

9. Examples of Endogenous Variables • Real GDP or its Growth Rate • GDP components such as Consumption, Investment, Exports, Imports • Inflation - determined by how “hot” the economy is running • Interest Rates • Short-term Interest Rates • Long-term Bond Rates • Employment and/or Unemployment Rate

10. Sources of Economic Forecasts I • Building your own wheel • Borrowing someone else’s wheel • lots of publicly available forecasts at present. • Congressional Budget office prepares forecasts semi-annually (typically two year horizon) • Council of Economic Advisers prepares annual forecast (two year horizon) • FED publishes estimate of “central tendencies”

11. Sources of Economic Forecasts II • Private Forecasts - publicly available • Wall Street Journal publishes forecasts from a sample of economists semiannually. • University of Michigan forecast summary available: • http://rsqe.econ.lsa.umich.edu/forecast/table.html • Survey of Professional Forecasters (Philly FED) • http://www.phil.frb.org/econ/spf/spfpage.html • “Livingston Survey” of Economists (Philly FED) • http://www.phil.frb.org/econ/liv/welcome.html

12. Forecasts: Who to Believe? • Faced with a large number of conflicting forecasts, how to choose? • remember, none of these forecasters is really exceptionally accurate - a lot of randomness in economic behavior that just isn’t predictable • look at track records of particular forecasters

13. Combining Forecasts • Large technical literature on how to best combine forecasts to minimize forecast error variance. • problem is similar to constructing a minimum variance asset portfolio (except you can sell a forecaster who is consistently wrong short -- negative weight) • difficulty is in getting long enough individual forecasting record to get any precision on the optimal weights of individual forecasters • typically people just construct a simple average

14. Macroeconomic Models A. Basic Structure

15. Prototype Macro Models • Who Purchases the output that is produced (Real GDP)? • Households -- consumption demand (C) • Firms -- Investment Demand (I) • Government -- Government Purchases (G) • Foreigners -- exports (X) - open economy case

16. Measuring Investment Demand • Investment as used in should not be confused with Investments as used in finance • Investment here refers to purchases of newly produced plants and equipment (including houses) plus changes in stocks of inventories (+/-) held by firms

17. Investment Demand • Simple Investment Function - Investment depends negatively on real interest rates. • theory is that at lower real interest rates there are more profitable opportunities for firms to exploit • Problems • accurately measuring real interest rates = nominal interest rates - expected future inflation • Investment a very volatile component of real GDP • Lags between initiation of project and completion

18. Historical Evidence - Investment-GDP Ratio Fixed Nonresidential Investment 0.11 0.10 0.09 0.08 0.07 0.06 0.05 0.04 0.03 0.02 29 37 45 53 61 69 77 85 93

19. Estimated Annual Long-Term Real Rate Estimated Real Interest Rate 15 10 5 0 -5 -10 -15 30 37 44 51 58 65 72 79 86 93

20. Investment and Real Interest Rates Investment Ratio and Real Interest Rate 0.10 0.09 0.08 0.07 0.06 0.05 0.04 0.03 0.02 -15 -10 -5 0 5 10 15 realrate

21. Measuring Government Purchases • Only include government purchases of newly produced goods and services • Large portion of government expenditures are transfer payments - expenditures for which government does not get goods and services directly in return. • examples: welfare payments, social security, Medicare payments

22. Determinants of Private Demand • Consumption Demand • Real Disposable Income = Real GDP - Taxes + Transfer Payments to persons (Yd) • Real GDP = Income Earned from current production (compensation, profits, interest, rents) • Real Disposable Income = Income Received during current period. • Earnings less appropriations by government (taxes) + unearned receipts from government (transfers)

23. Consumption Demand • Simple Consumption Function • C depends on Real Disposable Income (Yd=Y-T) in a linear fashion. • Change in consumption with a one unit change in Yd is positive and less than one = marginal propensity to consume

24. Historical Evidence: Consumption Function Consumption-Disposable Income 3600 3200 2800 2400 2000 1600 1200 800 400 0 1000 2000 3000 4000 Disposable Income

25. Historical Evidence: Consumption- Yd Ratio Consumption/Disposable Income Ratio 1.040 1.000 0.960 0.920 0.880 0.840 0.800 0.760 0.720 29 37 45 53 61 69 77 85 93

26. ImportDemand • Demand for Imports usually specified to depend on both real income (or real disposable income) and the real exchange rate (rer): • M = M(Y, rer) • sign of relationship between imports and real exchange rate depends on units of measurement of real exchange rate. When foreign goods get cheaper relative to domestic goods, import demand increases

27. Commodity Market • Equilibrium Condition: • Output Produced must be purchased by someone (or end up as inventory accumulation) • Y = real GDP • Y = C + I + G + (X-M) • M = imports are subtracted out because C and I are measured as total not just domestic purchases • Macroeconomic Models typically take G and X as and exogenous variables • Are we ever in equilibrium in the US?

28. IS Curve: Definition and Construction • IS Curve: Those values of real output and real interest rates that are consistent with commodity market equilibrium; i.e agents are just willing to purchase the total amount of output that is being currently produced • Why output and interest rates? Because interest rates link both the real (goods, services) and monetary (banking, financial) sectors of the economy. Interest rates are what allow the abilities of the monetary sector to match the needs of the real sector.

29. IS Curve • The IS-curve (I.S.= Investment, Savings) assumes fixed values of G,T, X, real exchange rate, in the short term. • IS Curve : Equation • Y = C(Y-T) + I(r) + G +X - M(Y, rer) • So Output should equal expenditure

30. Slope of IS Curve • IS curve is a negatively sloped relationship between real output (Y) and real interest rate (r). Why? • What happens if r is increased holding Y constant? • Higher r means lower investment demand; so expenditures (including investment) are expected to be less than planned output. • To equilibrate planned expenditures with production requires lower output. So, as r rises, Y falls.

31. IS Curve r Along IS Curve, real output (Y) has to increase as real interest rate declines to maintain equality between actual output and planned expenditures (C + I + G +[X-M]) IS Y

32. Shifts in IS Curve • Either an increase in [government spending (G) or exports (X)] or a decrease in [net taxes (T) or imports (M)] will increase planned expenditures on output. • To restore equilibrium between actual output and planned expenditures, either Y will have to increase, or r will have to increase, or some combination of the two. Why? Because expenditures are now greater than planned output, so either output must rise, or interest rates must rise (to choke off domestic investment, and keep expenditures in line with output) • The effect is to shift the IS curve to the right (or up)

33. Shift in IS Curve: Example IS’ r Increases in G, X (or decreases in T, M) increase planned expenditure and shift the IS curve to the right (up) IS Y