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Economic Models and Economic Policies

Nico van der Windt5 December 2005

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Content of the presentation

1. Economic Policies2. Economic Models3. Use of Economic Models in Economic Policies4. Usefulness of Economic Models in Economic

Policies5. Czech example6. Some Conclusions

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1. Economic Policies

Welfare Function:

W = W(Y,X,p)

Objectives (Y) Instruments (X) Preferences (p)

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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

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

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Instruments (X)

Quantitative instruments: Fiscal instruments Monetary instruments

Non-quantitative instruments: Legal instruments Institutional instruments

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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

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Monetary instruments Interest rates Money supply Quantitative restriction in for

example credit provision by banks

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Legal instruments Articles in the law about for example

competiton and regulation of markets

Bankruptcy law Law and regulations related to

private sector activities

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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”

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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)

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2. Economic ModelsY = f(Y, X, Z, e)

Large variety of different modelsDifferent models for different purposes:

Long run models, focus on supply Short term models, focus on demand Hybrid models Macro & Sector models General Equilibrium Models

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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

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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

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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

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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

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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

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Problems with models - 1

Y = f(Y, X, Z, e)

Models give only a simplified and stylised view of a complex real world

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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

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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

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Sensitivity of results

Results are in particular sensitive for specification of:

Wage equation Investment Exports and imports

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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

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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)

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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

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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

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3. Use of Economic Models in Economic Policies

Forecasting (baseline) Uncertainty simulations Sensitivity analysis Policy simulations

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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)

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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

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4. 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

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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

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Trial and Error Discussion between model builder

and experts Discussion between model builder

and policy maker

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Trial and error procedure1. Policy maker suggests particular set of

instrument values2. Analysis and translation into model input

by model builder3. Model results supplemented with expert

knowledge4. Overall results translated for policy maker5. Discussion between model builder, expert

and policy maker 6. Revised set of instrument values

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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

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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

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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

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5. 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

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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

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Usefulness of Economic Models in Economic Policy making

Models are consistent if specified correctly within the national accounting system

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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

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5. Czech example

Current situation: Quarterly (econometric) model Sector model for MIT Sector model for MoF

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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

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Similarities and Differences

Differences: Macro <-> sector Quarter <-> annual Calibration/estimation <->

calibration

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Use of Models in Czech Republic

Quarterly model: Short- to Medium-Term forecasting Fiscal policies (aggregate) Sensitivity analysis exogenous

variables Sensitivity analysis policy options

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Use of Models in Czech Republic

Sector Model: Long-term forecasting Fiscal policies -> sector impact Sector policies Sensitivity analysis -> sector impact

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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

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6. Some Conclusions - 1

Models useful for understanding main economic mechanisms

Models useful in discussion on economic policy packages

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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

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Some Conclusions - 3

Strengthening model building departments

Procedures for use of models in policy discussions

Further research