hermin portugal

~UTTERWO~RTH E'~IIE I N E: M A N N

Economic Modelling, Vol. 12, No. 3, pp. 275-294, 1995 Elsevier Science Ltd

Printed in Great Britain. 0264-9993/95 $10.00 + 0.00

0264-9993(95) 00009-7

HERMIN Portugal

Leonor Modesto and Pedro D Neves*

This paper describes the main features of HERMIN Portugal, a four-sector macroeconometric model of the Portuguese economy. This model is part of a research project, involving teams from Greece, Ireland, Portugal and Spain, intended to build comparable macro models for these four countries of the European periphery to be used in the assessment of the effects of the Community Support Framework (CSF) on growth.

This paper describes the main features of HERMIN Portugal, a macroeconometric model of the Por- tuguese economy. The basic philosophy underlying the construction of the HERMIN Portugal model was to obtain a rather simple and flexible core model of the Portuguese economy that could, nevertheless, replicate its main economic mechanisms. The structure of HERMIN Portugal follows very closely the theoretical framework described in the introductory paper of this issue (Bradley, Modesto and Sosvilla-Rivero, p 221), allowing for strict com- parability with similar models built for Ireland (see Bradley et al [2]) and Spain (see Herce and Sosvilla- Rivero in this issue). Nevertheless, the main specific- ities of the Portuguese economy do show up in the model.

Following the general structure of the HERMIN framework, HERMIN Portugal considers four sectors; agriculture (A), a non-market services sector (N), which is mainly government, the tradable goods sector (T) covering manufacturing industry, and finally the non-traded goods sector (S) which includes marketed services, building and construction and

Universidade Cat61ica Portuguesa, Palma de Cima, 1600 Lisboa, Portugal.

Many helpful comments and suggestions from other teams mem- bers: John Bradley, JosE-Antonio Herce and Sim6n Sosvilla- Rivero are gratefully acknowledged. Excellent research assistance by Rui Coimbra is also gratefully acknowledged.

energy. This choice of disaggregation is justified by the desire to keep the model as small and simple as possible, while separating sectors driven by different forces and types of behaviour. HERMIN Portugal can be considered a much reduced and simplified version of the HERMES Portugal model that included nine sectors. 1 However, in some ways, HERMIN Portugal is more sophisticated than HERMES Portugal. Indeed, for the non-agricultural private sectors, T and S, the supply block in HERMIN Portugal is fully consistent and jointly estimated and exports are endogenous, which was not the case in HERMES Portugal.

This paper is organized as follows. The next section provides a brief overview of the HERMIN Portugal dataset. The third section presents the econometric results obtained in the estimation of HERMIN Portugal and justifies some choices that differ from the general framework described in the paper by Bradley, Modesto and Sosvilla-Rivero in this issue (p 221). Key parameters and elasticities of HERMIN Portugal are compared to the ones obtained in HERMES and QUEST, two macroeconometric models of the Portuguese economy developed respectively at Universidade Cat61ica Portuguesa (Modesto et al [8]) and by the European Commis- sion (Brandsman et al [3]). The fourth section describes the results of some tests designed to ensure

1See Modesto et al [8].

275

HERMIN Portugak L Modesto and P D Neves

that the model plausibly replicates the functioning of the Portuguese economy, and the final section concludes.

The HERMIN Portugal data

This section contains a summary description of the HERMIN Portugal database, which serves to high- light the evolution of the most important macroeconomic variables of the Portuguese economy over the period 1977-90.

Figure 1 shows the growth rate of GDP at market prices. After the deep recession of 1984, the recov- ery of the Portuguese economy is quite impressive: growth rates around 3.5-5% per year. Figure 2 shows the development of the ratios of private consumption, public consumption and investment over GDP. Government expenditure increased regularly over the period. Investment follows very closely the ups and downs of the economy. After the 1984 recession and the 1985-86 stagnation, investment

started to increase in 1987, reflecting, among other things, a strong increase in foreign investment.

At current 1990 prices, agriculture (A), the non- market services sector (N), manufacturing (T) and the non-tradable goods sector (S) represented respectively 13.8, 20.2, 24.1 and 41.9% of total value- added at factor cost. Figure 3 shows that the increase in the share of the N sector over the period 1977-90 was offset by a decline in the share of sector S. Total output grew at an average rate of 3.4% over the period 1977-90 although, when the sample is broken into the 1977-84 and 1985-90 subperiods, it is apparent that larger growth rates were observed in the last five years. The pattern of growth was driven by sectors T and S, as the rates of growth in sectors A and N remained virtually constant over the 14-year period.

Sectoral employment is illustrated in Figure 4. It is interesting to note the important sectoral shifts, namely the dramatic decline in the level of employment in the agricultural sector (around one third, over the 1980s). This reduction was offset by strong increases in the employment levels of sectors N and

e . o [ . . . . . . . . . . . . .................. i ................... T ............... : . . . . . . . . . . . . . ~ . . . . . . - - ~ - - - i

l i t ~ ':

2 ~ k i i i i I i ; i

o / ......... I! , i • o r .............. ! r . . . . ~ .......... i ................... ! ................ !~_i!

i i i ! ................. 1 ...................... ! .............................. 7 \ / J . . . . . . , ..................

| ! ~ : V i - 4 . 0 | ' i , l , . i , i 1 i

1 1 7 7 1 9 7 9 1981 t 9 8 8 1985 19117 1986

Figure 1 Growth rate at GDP (1977-90)

52 .0

D.

44 .0

3 8 . 0 ua

o

~ 2 8 . 0 uJ 0 i [ i $ ~,o .o . . . . . . i . . . . . . . . . . . . . r ~ ....... t .........

1 2 . o ~ 1 9 7 7 1 9 7 9 1981 1 9 o s l l i l i 5

AGRIOULI~RE ADOED VALUE PUBLIC ~ VALUE NON-I~ADABI.E ADGED VALUE . ~ TRADABLE ADOI-'n VALUE . ,,

............... ~ ............... r ..................... r .................. ~ ................... ~" ............... T . . . .

• % _ . . . . . - i - . . . . . " r . . . . ~ . . . - , . . . . . . . . + . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . _~ . . . . . . . . . . . " ~

i i I

............................................... 7 _ i, r

. . . . . . . . .

1 9 8 7 1989

Figure 3 Changing sector shares (1977-90)

:} I ~ i r i O ( 9O

ft.

7 o lib o ILl

z U i

l O 1 9 7 7 19TI) 1981

ImflIVA~ ~ O i q OONiIUilqlOil

mN'vEinlliINT

................. I~ ................................... 1, .................. il ..................................... V - - } I !

I *, t

1

, J i . . . . . . . i ................................................... 4 ........ i

l

.............. ~ ....... • .......... i . . . . . . . . . . . . . i j

_ _ i i i ~ . L . i . i . i . I . l i

1 9 0 3 1 9 8 5 1 9 6 7 1 9 8 0

Figure 2 Percentage of GDP to private consumption, public consumption and investment (1977-90)

1 6 0 0

1 4 0 0

1 2 0 0

~ 1 0 1 ~

8 0 0 ----

6 0 0 :

4 0 0 ~ i , J J 1977 1 9 7 9 1981 1983 1985

AGRICOLTUIRE EMPLOYMENT PUBLIC EMPLOYMENT NON-TRADABLE EMPLOYMENT TRADABLE EMPLOYMENT

r I

1 9 8 7 1989

Figure 4 Sectoral employment (1977-90)

276 Economic Modelling 1995 Volume 12 Number 3

HERMIN Portugal: L Modesto and P D Neves

0.220

0 . 2 0 0

0 . 1 8 0

0 . 1 6 0

0 . 1 4 0 L 1 9 7 7 1 9 7 9 1 9 8 1 1 9 8 3 1 9 8 5 1 9 8 7 1 9 8 9

Figure 5 Public and private employment (1977-90)

1 . 1 0 ... . . . . . . . . T . . . . . . . . . . . . F .............. F . . . . . . . . . . - - - . . . . . . . . ~- . . . . . 7 -

o.oo - ~--- : ........... 4 ................. ~ .............. ~ ................. 4 ..... y

0 7 0 .... i .... i ........ i ....... + ................. ~ . . . . . . . . . . . . . . . . . . .

0.50

1 9 7 7 1 9 7 9 1 9 6 1 1 9 8 3 1 9 8 5 1 9 8 7 19111) AQRICULTURE U.LABOUR C06T PUBLIC UNIT lABOUR COlT NON-~qNDABI.E U.LAB. COqlT TRADABLE UNIT LABOUR £:O81"

Figure 7 Evolution of sectoral unit labour costs (1977-90)

S. In these sectors employment increased regularly over the sample period. Employment in sector T remained fairly stable over the period 1977-90. Fig- ure 5 shows the balance between public and private sector employment. The public to private employment ratio rose steadily from 15% in 1977 to some 22% by the end of the 1980s.

Sectoral average productivity is shown in Figure 6. It is not surprising that average productivity of sector A is clearly below the other three. However, as a result of the reduction in the number of employees in agriculture, productivity in sector A increased considerably. It is also interesting to note that the productivity of sector S, the largest out of the four sectors until 1990, was overtaken by the end of our sample by the corresponding figures for sectors N and T. The effects of the Portuguese entry into the EC on the productivity of sector T are quite impressive. The evolution of sectoral unit labour costs is illustrated in Figure 7. It is interesting to note the decline of unit labour costs in sectors A, S and T. The reverse happened for sector N.

Figure 8 shows the evolution of relative factor

prices (cost of capital over cost of labour) for sectors S and T. Note the strong decrease in the relative price of capital over the last five years of the sample. This relative factor price is a crucial variable in the determination of factor demands, given the reasonably large degree of substitution between labour and capital (see below).

The strong decline in the relative price of capital over the period 1985/90; referred to above, justifies the strong increase in investment illustrated for this period in Figure 2. In Figure 9 we show the sectoral decomposition of investment. Sectors S and T react more to the ups and downs of the economy, as one could expect. The share of these sectors in total non-residential investment varied from 55 and 35% respectively in 1977, to 48 and 21% in 1990. The share of sector N in total investment increased by 8 percentage points between 1977 and 1990. Finally, it is interesting to note the somewhat surprising increase in the share of sector A, of 2.5 percentage points.

In Portugal, working age population increased at an average annual rate of 1.3% over the period

~ o r i o d 1 ~ ) 7 7 ~ 9 9 C

2 9 0 . . . . . v .......................... ~ . . . . . . . . . . . . . : ..................... r . . . . . . . . . . . . . . . . . . . . - - - [ - - - ~

25o - .......... i ......... ~ ................ ~. ~.

2 1 0 ............ ~ . . . . . . . . . . ~ ......

1 7 0

1 3 0

9 0

5 O 1 9 T 7 1 9 7 9 1 9 6 1 1 ~ 1985

A G R I G U I . ~ .Iq~L~"__ _ _mlwllrY P t J l l t ~ ~ N O N - ~ I, It00UOTlVITY ....... ~ .PRm~__ _ _mTNITY

19117 1 9 8 9

Figure 6 Sectoral average productivity (1977-90)

0 . 0 1 6 0

o_ 0 . 0 1 4 0

o

~ 0 . 0 1 2 0 u .

0 . 0 1 0 0

ILl f i r

0 . 0 0 8 0 ' ; , 1 9 7 7 1 9 7 9 1 9 8 1 1 9 8 3

NON-TRADABLE TRADABLE

1 9 8 5 1 9 8 7 1 9 8 Q

Figure $ Evolution of relative factor prices (1977-90)

Economic Modelling 1995 Volume 12 Number 3 277


100000

800OO e)

840000 E

2OO00

0 1 9 7 7 1 9 7 9 1981 1 9 8 8 1 9 8 5 1 9 8 7 1 9 8 9

AGIIlCULTURE INvEInMENT PI3m.IC I N ~ NON-1II l IAI~WI~ INVE81MENT _ - ........ TRNDABLE INVE81MENT

Figure 9 Sectoral decomposition of investment (1977-90)

1 9 7 7 1 9 7 9 1981 1 9 8 3 1 9 8 5 1 9 8 7 1 9 8 9

Figure II Trade balance (1977-90)

1977-90. The labour force decreased in this period, namely in the last six years of the sample reflecting an increase in years of schooling. Figure 10 shows the rate of unemployment, where the 3.5 percentage point decrease between 1986 and 1990 is clearly illustrated.

The trade balance is shown in Figure 11. It is clear that there exists a structural deficit in the trade balance, usually exceeding 12% of the GDP. The openness of the Portuguese economy, measured by the share of imports and exports in GDP, increased dramatically since 1985; exports increased 8 percentage points, from 28.0 to 36.4; imports increased from around 32.0 to 50.3%.

Figure 12 shows government net borrowing, expressed as a percentage of GDP. The evolution over time of government expenditures and government revenues, as a percentage of GDP, is illustrated in Figure 13. After a strong increase in the first half of the decade, these figures seem to have stabilized. Figure 14 illustrates the evolution of the rates of indirect taxes (ITR), of direct taxes paid by households (DTHR) and of direct taxes paid by firms

~ e r i o d 1 9 7 7 - 1 9 9 C

9 . 7 0 . . . . . . . ~ . . . . . . . . . . F . . . . . . T - - ' - - - 7 - . . . . . - - ' T - . . . . . . . . T - - ~

9 . 0 0 . . . . . . . ~ ...................... ~ . . . . . . . ~ . . . . . . . . . ~ . . . . . . . . . . . . . .

I l i

8 . . . . . . . . . , . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i ........ i

7 . 6 0

8 . g o . . . . . . . . . . . . i ................ .......... i ......... i ...................... i . . . . . . . . . . . . . ! ...... i

6 . 2 0 . . . . . . . . . . . . r .................. i . . . . . . . . . . . . . . . . . . . . . . . . . r .................. I" .......................

5 . 5 0 ! ~ i , i 1 9 7 7 1 9 7 9 1981 t 9 8 S 19115 1 9 8 7 19119

Figure 10 Unemployment rate (1977-90)

12 .0 I

9 . o ~ - - - . . . . . . . . . . . . . _ N

6 . 0

3 . 0 F - ........... I

- 0 . 0 ~ - . . . . .

I. - 6 . 0 ! ' ~ ' ~

1 9 7 7 1 9 7 9 1981 1983 1 9 8 5 1 9 8 7 1989

Figure 12 Government net borrowing (1977-90)

3 9 . 0

3 7 . 0

0 ~3 3 5 . 0

3 3 . 0

3 1 . 0 =o

2 9 . 0

2 7 . 0 1 9 7 7 1 9 7 9 1981 1 9 8 3

GOVERNMENT EXPENDITURE8 GOVERNMENT REVENUES

- T ~ . . . . . . . . . [ . . . . . . . i I

! I ! ' . . . . . . . . . . . . i i . . . . . . . . . . . . ! - i !

[ J i i ; !

- ~ i i ; ~

1985 1987 1989

figure 13 Government expenditure and revenues as a percentage of GDP (1977-90)

(DTFR). Note that one important characteristic of the Portuguese tax system is the predominance of indirect taxation: indirect taxes (IT) are roughly two thirds of total taxes.

Figure 15 shows the inflation rate. It is worth noting that the inflation rate was above 20% until


0.240

0 .200

0 .160

0 .120

0 .080

0 .040 , • 1977 1979 1981 1983 1985

INDIREOT TAX RATE D~RECT TAX RATE - H O U ~ . H . Dl f lEOT TAX RATE - FIRM8 n ~

. . . . . ~ . . . . ~ . . . . . . . . . ~ . . . . . . . . . . . . . . ............. r - -

i i ..'N i : i .................... ~ .............. .,": ~ -"~ . . . . . . i ......... ~ ................. +- ~' \

. . . . . . . . . . . ~ . . . . . . . . . . . . . . . . . . . . ; . . . . . . . 1 . . . . . . . . . . . . . . . . . . ; - 2

i i , ~ . ~ . , , 1987 1989

Figure 14 Evolution of rates of indirect taxes (1977-90)

\ r l ( ) r J t e a

1977 1979 1981 1983 1985 1987 1989

Figure 15 Inflation rate (1977-90)

1986; after that, a strong reduction occurred. In spite of this, by 1990 a reasonably large differential between Portuguese and EU inflation rates per- sisted.

Estimating HERMIN Portugal HERMIN Portugal follows very closely the broad lines of the theoretical framework described in the introductory paper of this issue (Bradley, Modesto and Sosvilla-Rivero, p 221). However, the specifici- ties of the Portuguese economy and the nature of the data justified some particular choices. For exam- ple, the behaviour of imports is modelled in HERMIN Portugal, constituting an important difference when compared with HERMIN Spain and HERMIN Ireland. These models determined imports residually, once output, domestic demand and exports had been estimated, in order to assure the closing of the model. Instead HERMIN Portugal determines residually the volume of stocks, in order to make up the difference between supply and demand. This option was chosen mainly because Por-

HERMIN Portugal." L Modesto and P D Neves

tuguese imports react strongly to international prices and to the consumption element of demand, justify- ing the need for explicit behavioural imports equations.

The behaviour of firms was also modelled in a slightly different way. HERMIN Portugal follows a profit maximization procedure, described below, that leads to essentially the same empirical formulations of factor demand functions derived in HERMIN Ireland and HERMIN Spain, obtained through a cost minimization procedure. Output of the tradable sector in HERMIN Portugal is driven by a mixture of world and domestic demand, as described below. This differs from the approach taken in HERMIN Ireland, where output of the tradable sector is driven only by world demand.

This section reports the econometric results obtained in the estimation of HERMIN Portugal. Key parameters and elasticities of HERMIN Portugal are compared to the ones obtained in HERMES and QUEST, two macroeconometric models of the Por- tuguese economy developed respectively at Universi- dade Cat61ica Portuguesa (Modesto et al [8]) and by the European Commission (Brandsma et al [3]). Despite the simultaneity of the system, the equations were estimated by ordinary least squares (OLS), except when there were cross equation restrictions. In some cases, correction for first order serial correlation was performed.

A very simple approach to econometric estimation has been taken, in the line of HERMIN Ireland and HERMIN Spain. In the Portuguese case, this approach is mainly justified by the shorter length of the time series available, 1977-90, so that more sophisticated techniques would be of limited value. We have therefore taken little account of the issues of possible non-stationarity of time series and dynamic specification of the equations. Alternatively, our approach to the modelling choices was to select a stylized formulation, backed by common priors and other empirical studies on the functioning of the Portuguese economy, and effectively impose it on the data. Note that this approach is close in spirit to the parameterization procedure of CGE models.

The behaviour of firms and ouOgut equations

HERMIN Portugal models behaviourally sectors T and S. The agriculture sector is treated as mainly exogenous, while the public sector is handled through exogenous policy instruments. HERMIN Portugal assumes different firm behaviour in the tradable and the non-tradable sectors. Firms of the tradable sector (T) are price takers in both the output and input markets. In this way, firms minimize costs subject to


H E R M I N Portugal." L Modesto and P D Neves

the production function. Firms operating in the non-traded goods sector (S) are price setters in the output market and price takers in the inputs markets. They therefore maximize profits subjects to the production function.

The problem of each firm is the following:

oo

max ~ /3t{PtQt - wtLt - - g,l,} t=O

with

1

~ = l + r

subject to

Qt -= F ( K t , L , )

I t = K, - (1 - 8 ) K t _ 1

Pt = O y n a o l / n

were Q, L, K and I are respectively, value-added, employment, the capital stock and investment. Note that for sector T the elasticity of demand 77 is infinity.

A value-added production function of the CES type with constant returns to scale is considered for both sectors:

Qt = At{ a[exp( AL t ) L t ] -p

+(1 - cl)[exp( A r t ) K t ] - ° } -1/p

Here A is a scale parameter, 8 = 1(1 + p) is the elasticity of substitution, a is a factor intensity parameter, and AL and At: are the rates of technical progress embodied, respectively, in labour and capital.

Factor demand equations are then given by:

W t

log L t = const t + logQt - Or log - - Pt

- ( 1 - Or)Azt

Ct log K t = const r + logQt - Orlog--

Pt

- ( 1 - Or)Art

where c is the cost of capital. For both sectors S and T, it is assumed that the

stock of capital follows a partial adjustment mechanism so that:

log K t = A 1 log K* + (1 - A)IogK t_ 1

with

c , log K* = const r + logQt - o'log--:-"

Pt

- ( 1 - Or)Art

Assuming now that the logarithm of stock can be approximated a s : 2

a o

log K t = ~ (1 - h)log It_ i i=O

the capital

we derive:

log K t - (1 - A1)log K t _ 1 -- log I t

implying the following specification for investment:

Ct log I t = const 1 + A 1 log Qt - AIor log--

Pt

- Xl(1 - Or)Art

For employment an extended error correction mechanism for both sectors is considered:

log L, = / 3 1 1 A l o g Qt - / 3 1 2 o r A l o g wt - /313( 1 - or ) ) Pt

+/321ogL*t_l + (1 - /32) logLt_ 1

with

Iv, log L* = const L + log Qt - tr log -=

Pt

- ( 1 - Or)ALt

so that:

w, log L t = const L, + fl11Alog Qt - fl12orAl°g -

Pt

+/32 log Qt- 1

- / 3 2 o r l o g wt-1 - / 3 2 ( 1 - a)AL(t - 1) P t - 1

+(1 - /32)1og Lt_ 1

Remark that the specification encompasses both the traditional error correction mechanism, the partial adjustment mechanism and the static formulation.

Tradable sector behaviouraI equations. Output of the tradable sector ( Q V O T ) is driven by final de-

2The sample type of approximation was used in the derivation of some of the investment equations in the HERMES model. See Italianer [5] and Modesto et al [8].


mand directed to manufacturing goods ( F D O T ) , being F D O T defined as:

F D O T = 0.531 * CO + I O M E + 0.854"XO

The weights used are the 1990 proportion of total consumption, investment in machinery and equip- ment and exports satisfied by manufacturing goods regardless of whether these goods are produced domestically or imported. This equation was estimated by AR1 for the period 1977-90 and produced the following results:

Q V O T = 69000.3 + 0.216 F D O T

(6.64) (11.2)

R 2=0 .947 D W = 1.20

A competitiveness measure did not came out significantly in the estimation)

For the estimation of the CES production function parameters we retained for estimation the static formulation for labour, while for capital we kept a partial adjustment mechanism. Estimation by FIML, for the period 1978-90, produced the following re- suits:

log ( nt / qvot ) = nt l - sig* log( wrt / p q v t ) - nt 2 * t

R 2 =0.933 D W = 0 . 8 5

Parameter Estimated Standard t-statistic coefficient error

n t l - 1.33886 1.02054 - 1.31191 nt2 0.031003 0.00629915 4.92177 s~ 0.797520 0.224918 3.54582

log( iot ) = iot l* log( qvot ) - iotl* sig* log( pk t / p q v t )

- iot2*t

R 2 = 0.079 DW = 0.58


lot1 0.909340 0.024481 37.1455 iot2 0.040843 0.040222 1.01544

Note that the econometric evidence, namely in what concerns the fit of the investment equation, is extremely weak and should not be overinterpreted. However, although the choice of alternative dynamic specifications for the above equations produced a

3The competitiveness measure used was the ratio of Portuguese unit labour costs and world labour costs. This last variable was simply proxied by the world price.

H E R M I N Portugal." L Modesto and P D Neves

much better fit over the sample period, indicating also the absence of serial auto correlation, the set of parameters reported above proved to be more reasonable when simulating HERMIN Portugal.

The value obtained for or the long-run elasticity of substitution is 0.80. A very similar elasticity was obtained in HERMIN Spain (0.78). In the Irish HERMIN model the estimated elasticity of substitution is 0.34. Thus, the Cobb-Douglas Portuguese and Spanish technologies in the tradable sector con- trast with the near Leontief nature of the Irish production technology. This finding is consistent with the extreme openness or the Irish economy.

Technical progress is factor saving both for capital and for labour in HERMIN Portugal. However, the estimated equation does not reject the neutrality hypothesis as far as the use of capital is concerned. HERMIN Spain obtains technical progress to be capital using and labour saving.

Non-tradable sector behavioural equations. Output in the non-tradable sector ( Q V O S ) is driven by final demand directed to this sector. Two components were isolated: FDOS1 aggregating consumption and exports directed to sector S; and F D O S 2 consider- ing investment in building and construction directed to this sector and all residential investment ie

FDOS1 = 0.359"CO + 0.127"XO F D O S 2 = 0 .96" IOBC + I R O

The weights used are the 1990 proportions of total consumption, investment in building and construction, residential investment and exports satisfied by the type of goods produced by this sector regardles of whether these goods are produced domestically or imported. A value of unity for the parameter associated with FDOS2 has been imposed, reflecting the fact that these type of goods are not imported. The estimation results obtained using OLS over the period 1977-90 are presented below:

Q V O S = 127120 + 0.458 FDOS1 + F D O S 2

(5.9) (4.5)

R z --- 0.624 DW = 0.44

For the system of factor demand equations considered for the non-tradable goods sector we retained an extended error correction mechanism for labour and a partial adjustment formulation for capital. Estimation by FIML for the period 1977-90 yielded the following results:

log(ns) = ns l + ns2* log (qvos /qvos ( - 1))

- ns3*sig* log(wrs /wrs ( - 1)

* pqvs( - 1)* / p q v s )


HERMIN Portugal." L Modesto and P D Neoes

+ ns4* log(qvos( - 1)) - ns4*

sig* log(wrs( - 1)/pqvs( - 1))

- ns4*(1 - sig)*ns5*t(- 1)

+ (1 - ns4)* log(ns( - 1))

R 2 = 0.975 DW = 1.87


nsl -2.06443 1.01550 -2.03292 ns2 0.356951 0.555960 0.642044 ns3 0.320978 0.149638 2.14503 ns4 0.658239 0.483242 1.36213 ns5 0.026390 0.017205 1.53389 sig 0.479802 0.349036 1.37465

log( ios ) = los1* log( qvos ) - ios l* sig* log( pks /pqvs )

- iosl*(1 - sig)*ios2*t

R 2 = 0.816 DW = 1.99

Parameter Estimated Standard t-statistic coeffident error

iosl 0.894598 0.00898195 99.5995 ios2 0.033671 0.022365 1.50556

The value obtained for ~r the elasticity of substitution is 0.48 suggesting that substitution possibilities are smaller in this section. 4 This value is very similar to that found with HERMIN Spain: 0.51. Once again, these substitution possibilities differ from the HERMIN Ireland ones: in the Irish case the elasticity of substitution elasticity was estimated to be 0.19.

Technical progress in sector S is again capital and labour saving respectively at rates of 3.4% and 2.6% per annum. Very similar values were found for the Spanish economy 2.8 and 2.3 respectively.

Agricultural sector behavioural equations. HERMIN Portugal does not model the agricultural sector behaviourally. Nevertheless, we kept in the model separate equations for agricultural output (QVOA) and employment (NAA) that are modelled by simple time trends, while assuming agricultural investment to be exogenous. These results obtained by OLS for the period 1977-90 are as follows, where no attempt is made to correct for serial correlation

4Note, however, that this parameter is not very precisely estimated.

in the case of QVOA:

Iog(QVOA) = 11.24 + 0.0349t

(281.2) (7.4)

R 2 = 0.821 DW = 0.81

log (NAA/QVOA) = - 4.13 - 0.0679t

( - 98.6) ( - 13.8)

R 2=0 .941 D W = 1 . 9 6

Public sector behavioural equations. In the Por- tuguese national accounts, public sector production is only delivered to public consumption and to a much lesser extent to private consumption. There- fore, in HERMIN Portugal real public sector output (QVON) is driven by government real consumption (GO) and an unity coefficient for the impact of GO on QVON has been imposed in the structure of the model.

Output price determination

The price of tradable sector output (PQVT) is a weighted average of world prices (PWE) and unit labour costs (ULCT). A dummy variable for the period 1986-90 accounts both for the introduction of VAT and for the increased degree of openness of the Portuguese economy after joining the European Economic Community. Econometric results obtained for the period 1977-89 are as follows:

log(eQVT) = 0.128 + 0.702 log (PWE) + (1 - 0.702)

(2.0) (6.4)

log (ULCT) + 0.183 dummy

(5.4) R 2 = 0.998 DW = 1.71

Note that, as we might expect, output prices in the tradable sector are mainly determined by world prices (70%) but there is also room for price mark up (30%). This indicates that the Portuguese economy is much less open than the Irish economy, where a full price taking procedure was found.

Output prices in the non-tradable goods sector (PQVS) are determined by a mark up on unit labour costs (ULCS). Homogeneity of degree one was not rejected by the data and was therefore imposed in estimation. Output price of the agricultural sector is assumed to be exogenous. The price deflator of


sector N (PQVN) follows the deflator of public consumption (PG). Estimation by OLS yielded:

log (PQVN) = 0.0026 + 0.855 log (PG)

(0.2) (72.8)

R 2 = 0.997 DW = 1.39

Homogeneity has not been imposed in this equation because the N sector also delivers to private consumption.

Wage determination and wage bargaining

HERMIN Portugal assumes that wages are the out- come of bargaining between unions and employers allowing for a Phillips curve mechanism. Thus, wage equations can be viewed as augmented Phillips curve mechanisms. Of the many elements that are relevant in this process (see Layard et al [6]), HERMIN Portugal considers only consumption prices, labour productivity and the unemployment rate. Consump- tion prices are included because trade unions are not willing to accept reductions in real wage; the inclusion of productivity of labour accounts for the fact that, in the bargaining process, unions try to enjoy some of the gains resulting from productivity increases; the inclusion of the unemployment rate accounts for the Phillips curve effect, reflecting that trade unions power is affected by unemployment.

In HERMIN Portugal, we model wages for sectors T and S and we assume that public wages follow the wages of sector S. For both sectors T and S, the dependent variables are nominal wage rates (WRT and WRS) net of employers social security contributions (SSFT and SSFS). OLS estimation over the period 1977-90 produced the following results:

Iog(WRT/(1 + SSFRT))

1.5 - 0.464 UR + 0.614 log

(1.5)(-0.5) (3.3)

(QVOT/NT) + 0.89 log(PC)

(28.1)

R 2 = 0.999 DW = 1.83

log (WRS/(1 + SSFRS))

-0 .08 - 2.76 UR + 0.897 log

( - 0 . 0 3 ) ( - 3 . 1 ) (2.1)

(QVOS/NS) + 0.95 log (PC)

(28.6) R 2=0 .998 D W = 1.49

It is interesting to note that, for both sectors T and S, neither price increases nor productivity gains are


fully translated into wages. This result indicates that the neutrality doctrine 5 is not valid for wage determination in the Portuguese manufacturing sector and is consistent with previous empirical work for Portugal. 6 Note, however, that the estimated parameters are larger for sector S, suggesting the existence of a dual labour market.

Notice also the response of wages to unemployment. The coefficients obtained imply that 1 percentage point increase in the unemployment rate will lower wages by 0.46% in sector T and by 2.76% in sector S. The Phillips effect that we found for sector T, although significantly smaller than that obtained for Ireland, 7 is consistent with those found for other European countries. 8 However, the estimated value for sector S is significantly bigger than the ones usually found for other European countries 9 and also much bigger than the one obtained for the T sector reinforcing the idea of a segmented labour market (see also Modesto and Monteiro [10]).

The estimated parameters with HERMIN Portu- gal are in line with those obtained with QUEST where no sectoral disaggregation is considered: the Phillips effect estimated by QUEST is - 1.95 and it is clearly above the corresponding figures for the Portuguese EU partners; the productivity effect presented in QUEST is 0.70; finally, QUEST also sug- gests some degree of money illusion, as the parameter associated to consumption price inflation is 0.84 in the short run and 1.0 in the long run.

As already said, HERMIN Portugal assumes that wages in the public sector (WRN) follow the wages of the services sector: ie it is assumed that the same proportional wage increases are observed for both sectors. As our N sector includes other non government non market activities a similar behaviour was assumed for government wages (WBGR).

Finally, wages in the agricultural sector (WRA) follow the price deflator of final consumption (PC).

Labour force participation HERMIN Ireland and HERMIN Spain model labour force participation in a more detailed way than HERMIN Portugal does. For instance, HERMIN Ireland deals with quite complex migration mecha-

5See Neumann et al [13] for a definition of neutrality and a study on its validity for the German case. 6See Modesto et al [9] and Modesto and Monteiro [10]. 7Bradley et al [2] obtain a Philips curve effect o f - 1.45 in the short run that is double of that in the long run for the Irish tradable goods sector. aSee Dr~ze and Bean [4]. 9See Dr~ze and Bean [4].



nisms. Here, the participation rate (NAR) is simply modelled as a function of time, following an expo- nential trend. Estimation result by OLS for the period 1977-90 were as follows:

log (NAR) = - 0.269 - 0.0201t

( - 19.9) ( - 12.7)

R 2 = 0 . 9 3 D W = 0 . 7 3

The negative sign obtained for the trend reflects mainly the increase in years of schooling.

Private consumption

Private consumption is the largest single item in absorption, accounting for some 60% of domestic demand. The macroeconomic consumption function considered in HERMIN Portugal corresponds to the permanent income hypothesis. Per capita real consumption ( C O / N P O ) is simply a function of per capita real disposable income (YDHH/NPO) . Esti- mation by AR1 for the period 1978-90 yields:

log(CO/NPO)

= -0 .12 + (1 - 0.478)1og (YDHH/(NPO*PC))

( - 2 . 4 )

+ 0.478 log ( C O 1/NPO_ 1)

(3.0)

R 2=0.825 D W = 1.20

A unitary long-run elasticity of consumption to income has been imposed in estimation, in line with the expectation that consumption is a relatively constant proportion of income. This is a common as- sumption in macroeconometric modelling for the Portuguese economy. Note that QUEST also im- poses a unitary long-run consumption elasticity. The short-run elasticity implied by HERMIN Portugal is 0.52 and the short-run and long-run marginal propensities to consume obtained, when evaluated at the sample means are 0.403 and 0.772 respectively. These values are in line with previous findings for the Portuguese economy. 1° Moreover, the consumption specification chosen worked well when simulating and shocking the model, implying pat- terns of consumption response consistent with common priors on the way the Portuguese economy function.

Total investment

Total (gross) fixed investment, I0, results as follows:

I 0 = I P O + IRO

1°See Modesto et al [8].

where IRO is gross fixed capital formation in construction of dwellings and IPO is the total gross fixed capital formation of the branches as follows:

IPO = 10S + 10T + ION + IOA

The behavioural equations for 10S and 10T have been described above. Public investment and investment in the agricultural sector are set to be exogenous.

Residential investment (IRO) is a function of real disposable income and of the interest rate (LI). The results obtained, for period 1977-90, by OLS are presented below:

log( IRO )

= -11.4 - 3.648 LI + 1.711 log(YDHH/PC)

( - 3 . 1 ) ( - 4 . 2 ) (6.2)

R 2=0 .838 D W = 1.67

Note that in estimation we used the nominal instead of the real interest rate. In fact the real interest was never statistically significant and turned out to dis- play a positive sign. We believe that this is due to the high values shown by the nominal interest rate during the estimation period. In fact, when the nominal interest rate is quite high, people tend to reason in terms of the nominal burden of interest payments and become less sensitive to its real magnitude. Moreover, it may also reflect some rigidities in the capital market, like the existence of liquidity constraints.

Exports imports and the balance of trade Exports. Both T and S sector exports react to

supply and demand determinants and are therefore determined by world demand, relative prices and production capacity. The following supply and demand functions for exports were considered:

PX logX s =/30 +/31 logQ + flzlogpQ

PX logX a = a 0 + a 1 log WD - a 2 l o g p w

Then we solved for the equilibrium values of exports and export prices and obtained the following reduced forms equations:

log X = ao 32 + 0/2 30 0/1 32

+ - - log WD [32 "1- 0/2 [32 + O/2

0/2 [31 0/2 [32 P Q + - - log Q log - -

[32 + 0/2 [3 + a2 PW


log PX = - - 0/0 -- /30 + /32 + 0/2

/3, /32 + 0/2

/32 + - - /32 -'F 0/2

0/1 - - log WD /32 + a2

0/2 - - l o g Q +

/32 + a2 - - l o g PW

log PQ

When the country is a price taker in the world market a 2 = oo and the previous system collapses to:

PX log X =/30 +/3110g Q + /3210g- -

PQ

log PX = logPW

ie export prices are determined in the world market and firms produce to export according to their supply function.

When the country is a price setter in the world market /32 = oo and the reduced form system be- comes simply:

PX

PW log X -- 0/0 + all°g WD - 0/21og -

log PX = log PQ

ie firms set the price and produce to meet demand. In the Portuguese case the hypothesis of the

country being a price taker seems, at a first glance, more appealing and reasonable. However, previous studies on Portuguese exports (see Manteu, [7]) show that world demand is an important factor in explaining the performance of Portuguese exports. We, therefore, retained for our export equations the general reduced form equation:

1910 /32 -I- 0/2 /30 0/1 /32 l o g X = + - - logWD

/32 q- Og2 /32 q- a2

0/2 /3, 0/2 /32 P Q + - - logQ - - l o g -

/32 -1"- 0/2 /32 q- 0/2 P W

In this way, exports of the T sector (QXOT) are determined by world demand (WD), relative prices (PQVT/PWE) and sector T output (QVOT). The results obtained for the period 1977-90 by OLS are as follows.

Iog(QXOT)

= -3.407 + 1.947 log(WD) - 0.839

( -0 .6) (6.5) ( -2 .7 )

log ( PQVT/PWE) + 0.506 Iog(QVOT)

(0.9) R 2=0.973 D W = 6 . 7 8


Export performance of sector T responds very strongly to world demand and price competitiveness. Similar findings have been obtained with HERMIN Spain: the elasticities are, respectively, 2.18 and - 0 . 7 2 . The price elasticity is slightly lower than the one reported in QUEST, where an estimate of 1.1 was obtained. 11 Given the small number of observations and the structural break in 1986, the pattern of residuals lead to a low Durbin-Watson statistic. No attempt was made to correct this fact.

The export of the sector S (QXOS) are estimated in a similar way. The results obtained for the period 1977-90 by OLS are the following:

log(OXOS)

= 6.77 + 0.891 log(WD) - 0.341

( - 0.8)(2.5) ( - 1.1)

log ( PQVS/PWE) + 0.977 log (QVOS)

(1.3)

R 2 = 0.878 DW = 2.06

Once again, these results are very similar to those found for the Spanish economy. HERMIN Spain obtains elasticities with respect to world output of 0.91 for non-tourism exports and 1.05 for tourism exports.

Agricultural exports are taken to be exogenous.

Imports. The behaviour of imports is modelled in HERMIN Portugal. This constitutes a major difference when compared to both HERMIN Ireland and HERMIN Spain, as in these models imports are determined residually, once output, domestic demand and exports had been estimated, in order to assure the closing of the model.

Imports of the T sector (QMOT) are a function of final demand directed to manufacturing goods (FDOT) and of relative prices (PQMT/PQVT). Estimation for the period 1977-90 by OLS yielded: '2

log (QMOT)

- 7.25 + 1.473 log(FDOT)

( -3 .0 ) (8.0)

- 1.004 log (PQMT/PQVT)

(-2.0) R e=0.921 D W = 0 . 6 9

nNote that QUEST reports a long run price elasticity for Por- tuguese exports that corresponds to an average of three exporting zones: EU, US and others. lz Here again the small number of observations and the structural break in 1986 implied a low Durbin-Watson statistic. However, we did not correct for this fact as the current specification worked better when simulating the model.



The elasticities obtained with QUEST are reasonably similar to these results: 13 final demand elasticities of 0.97 and 1.15 (short and long run, respectively), and price elasticities of -0.86 and -1.02 (also short and long run). The larger final demand import elasticity obtained with HERMIN Portugal is probably due to the recent phase of openness of the Portuguese economy, following a long period of pro- tection from outside competition, and that constitutes one stylised fact of the HERMIN Portugal data set.

Imports of the S sector (QMOS) are decomposed into energy imports (QMOE) and other imports of the S sector (QMOSS) ie QMOS = QMOE + QMOSS. QMOSS is modelled as a function of the fraction of private consumption directed to the type of non energy goods produced by this sector (FDOMS1 = 0.308* CO) allowing for a dynamic adjustment. The weight used corresponds to the value observed in 1990. The results obtained for the period 1978-90 by OLS are presented below:

log (QMOSS / FDOMS1)

= -0.201 + 0.873 log (QMOSS_I/FDOMS1)

( - 0 . 4 ) (3.8)

R 2=0 .567 D W = 1.52

Once again, these results are very close to the ones reported in QUEST: the corresponding elasticity varies between 0.81 (short run) and 1.00 (long run).

Energy imports (QMOE) are driven by the level of aggregate activity measured by value added at factor cost (VO). The results obtained for the period 1978-90 by OLS are the following:

Iog(QMOE) = - 11.20 + 1.622 log (VO)

( - 6 . 7 ) (13.0)

R 2=0 .934 D W = 1.83

No corresponding elasticity is obtained in QUEST, as real final demand (0.11 and 1.00) and relative price elasticities ( - 0.57 and - 0.50) were estimated instead.

Agricultural imports (QMOA) were simply modelled as a function of time. The results obtained for the period 1977-90 by OLS are presented below:

log QMOA = 10.48 + 0.0383t

(356.0) (11.1)

R 2=0 .91 D W = 1.27

13QUEST decomposes imports in three groups, in a very similar way to HERMIN Portugal: non-energy imports, imports of energy and imports of services.

Income determination behavioural equations Households social benefits (SBH). social benefits

received by households (SBH) are linked to government wages (WBGR) and to movements in the number of recipients captured by the part of the population that is of non-working age (NPO-NPA):

SBH = - 83018.2 + 0.196 WBGR (NPO-NPA)

( - 5 . 2 ) (33.7)

R 2=0 .91 D W = 0 . 5 6

Households investment (IHU). Households' investment (IHU) is simply determined as a fraction of total investment:

IHU = 17650.9 + 0.308 IU (2.0) (40.7)

R 2 = 0 . 9 9 D W = 1 . 7 0

Net interests, dividends and other income from property entrepreneurship. The net interest equations have the same form regardless of referring to interest payments (the case of government) or to interest receipts (the case of households). They were expressed as linear functions of the cumulative sum (from 1977) of either households or government net lending multiplied by the interest rate. The results obtained by OLS for the period 1978-90 are as follows:

Interest received by households (IDH):

IDH = 95835.5 + 0.826 SI*FLHA_ 1

(2.5) (9.5)

R 2----0.89 D W = 0 . 6 4

Interest paid by government (IDG):

IDG = 13810.9 - 1.541 SI*FLGA_ 1

(0.6) ( - 12.5)

R 2---0.93 D W = 1.59

The negative sign obtained above is explained by the fact that both FLHA and FLGA are defined as the cumulative sum (from 1977) of households and government net lending. Note that in the case of households FLHA is always positive while for govem- ment, as government is a net debtor, FLGA is always negative.

Absorption price determination equations The majority of the deflators of absorption compo-


nents are modelled in the following way:

log(Pabs) -- al + a2 log(PY) + (1 - a2)log(PM)

where PY is the deflator of GDP at market prices and PM is the deflator of total imports. The results obtained for the period 1977-90 by either OLS or AR1 are as follows:

Price of T sector investment (PIT):

log (PIT/PM) = 0.104 + 0.809 Iog(PY/PM)

(1.6) (7.6)

R 2=0.924 D W = 1.95

Price of S sector investment (PIS):

log (PIS/PM) = 0.058 + 0.856 log (PY/PM)

(2.8) (9.9)

R e=0.952 D W = 1 . 4 4

Price of agricultural investment (PLA):

log (PIA/PM) = -0.006 + 0.556 log (PY/PM)

( -0 .3) (4.3)

R 2=0.604 D W = 0 . 7 9

Price of N sector investment (PIN):

log (PIN/PM) = -0.089 + 0.825 log (PY/PM)

( - 1.1) (6.4)

R 2=0.78 D W = 1 . 1 9

Price of private consumption (PC):

log (PC/PM) =

-0.91 + 0.699 log (PV/PM)

( -4 .7 ) (24.0)

+ 0.996 (ITR-SUBR)

(7.3)

R 2=0.98 D W = 1 . 7 8

In this case a term to account for the influence of indirect taxes on consumption was added, and in order to avoid double counting, the deflator of GDP at factor cost (PV) is used instead of PY. Note that an increase of one percentage point in the net indirect tax rate (ITR-SUBR) will increase the consumption deflator inflation by 0.996 per cent, ceteris paribus.

As public consumption is mainly constituted by labour inputs expenditures we simply relate the deflator of public consumption (PG) to the government wage rate. Finally HERMIN Portugal assumes that the price of exports of the T sector (PQXT), the price of imports of T sector (PQMT),


the price of non-energy imports of the S sector (PQMSS) are homogeneous of degree one in the world price. Energy import prices are exogenous.

Testing the policy model HERMIN Portugal can be tested in at least two different ways. First, its ability to reproduce the evolution of the relevant macro and sectoral variables over the sample period. Analysis of the differ- ences between the simulated and historical values of the endogenous variables show that HERMIN Por- tugal performs quite well from this point of view as the within-sample simulation errors were reasonably small.

A second way of testing HERMIN Portugal con- sists in the analysis of the consequences of some selected shocks. It is then possible to compare a benchmark or baseline evolution of the data with the one that would take place if some exogenous variable(s) were shockedJ 4 This type of analysis requires a full understanding of the model's linkages between different variables, not all of which will be easy to understand from an isolated analysis of the different equations. This second form of testing is more relevant, as HERMIN Portugal was not con- structed to be a short-term forecasting model.

Shocks in selected exogenous variables allow us to estimate the partial derivatives or multipliers implied by our model and, at the same time, constitute a test of its theoretical coherency. In this section we analyse the effect of variations in the settings of some policy instruments or other exogenous variables included in the specification of HERMIN Por- tugal, by comparing their effects on a baseline pro- jection for the years 1991-2020.

A shock in world demand

It was pointed out above that there was a clear increase in trade flows over the 1980s. The Por- tuguese economy became therefore increasingly dependent on the level and growth of activity in the world economy. To analyse the effects of this crucial variable, we shock world output by increasing it permanently by 1% above a stylized benchmark path over the period 1991-2020. We then compare the effects on the evolution of some relevant endogenous variables.

The main conclusions drawn from this exercise are illustrated in Figure 16 and in Table 1. It is possible to conclude that the Portuguese economy

14 It is also possible to carry out a sensitivity analysis to some key parameters of the model.


H E RMIN Portugal." L Modesto and P D Neves

T a b l e 1 S u s t a i n e d 1 % i n c r e a s e i n w o r l d d e m a n d

1991 2005 2020

Gross domestic product 0.25 0.29 0.31 at market prices a Unemploymen t rate b - 0 . 0 8 - 0 . 1 2 - 0 . 1 3 Consumpt ion deflator a 0.25 0.36 0.37 Government savings as 0.05 0.12 0.19 per cent of G D P b Public borrowing as per - 0.06 - 0.14 - 0.21 cent of G D P b Trade balance as per 0.25 0.22 0.21 cent of G D P b

apercentage deviation f rom baseline. bDeviation f rom baseline.

responds strongly to the stimulus in the world demand. As we might expect, the tradable sector reacts more vigorously: we obtain an increase of 0.7% in its output level. The non-tradable sector output reacts more modestly, increasing by 0.3%.

Portuguese GDP increases by around 0.3%. This effect is somewhat larger than that found with HERMINP3.15 This result indicates that, for open

lSHERMINP3 is a three sector H E R M I N type model developed for the Portuguese economy. The sectors considered were: agriculture, government and private non agricultural sector. See Modesto and Neves [12].

economies, models that do not distinguish between tradables and non-tradables are not well suited to analyse this type of shock and may produce mislead- ing results. Notice that in the Irish case an increase of 0.25% of GDP is obtained with a three-sector model 16 whereas with a four sector model GDP increases by 0.67%. 17 The stronger response of the Irish economy is due to its greater degree of openness and the closer links of the Irish-based multina- tional firms to the world economy.

The evolution of consumption, determined by that of households disposable income, and investment follows very closely the increase in GDP. The increase in investment is justified by the pattern of relative prices of production factors. The relative price of labour went up and so more capital inten- sive technologies became relatively more attractive.

The effects on the cost of labour were mainly due to gains in productivity, namely in sector T. This is illustrated by the increase in the output levels of both sectors that exceed the corresponding employment gains.

Effects on trade flows are also illustrated in Fig-

16See Bradley and Wright [1]. 17See Bradley e t a l [2].

1 . 1 0

0 . 9 0 : I 0 O . 7 0 el, u

0 . 5 0

0 ~,. 0 . 3 0

o 0 . 1 0

o. - 0 . 1 0

................ ! ...................... T - . . . . . . . . i .................. T .................... 7 ~

!

. . . . . . . . . . . . . . . . i

1 9 9 0 1 9 9 4 1 9 9 8 2 0 0 2 2 0 0 6 2 0 1 0 2 0 1 4 2 0 1 8 WORLD DEMAN(} N O N - ~ OUTPtr[ TRADABLE OUTPUT . . . . .

, ! i 1 [ 0.50 . . . . . . . i . . . . . ! . . . . . . i ................. i ............................. '--...-i

0 . 7 0 ............ : . ~ . ...... i ............. ~ . . . . . . i F : i

[

0 . 5 0 i . ! . . . .

f O . l O i . . . . ~ ' ' - "

!

- 0 . 1 0 ' J . . . . . . i . . , . . . . . 1 9 9 0 1 9 9 4 1 9 9 8 2 0 0 2 2 0 0 6 2 0 1 0 2 0 1 4 2 0 1 8

WORLD OEMMIO V A L U E A D D E D A T F A C T , C O S T

F i g u r e 16

7 o o 0 - - - T . . . . . . . . 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 - - i i i

, ] ] : . l i l

[ 3 0 o 0 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . r . . . . . . . . . . . . . . . . . . . . . . . . . ! . . . . . . . . . . . ~

i

~ o . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . , . . . . . . . . . . . . . . . . . . . . . . . . . . . i . . . . . . . . . . . . . i . . . . . . . . .

i

-lOOO i . . . . i . . . . ~ : l

. . . . . . . . . . . . . . i . i

1 9 9 0 1 9 9 4 1 9 9 8 2 0 0 2 2 0 0 6 2 0 1 0 2 0 1 4 2 0 1 8 E X P O R T 8 I M P O E ~ 8

Sustained 1% increase in world demand

288 E c o n o m i c M o d e l l i n g 1 9 9 5 V o l u m e 1 2 N u m b e r 3

ure 16. Exports react immediately to the shock in world demand and go up by an average yearly amount of 2%. Imports take more time to react and by the end of the sample period the percentage increase in total imports, determined by estimated elasticities, reaches 1.1%.

Finally, it is worth noting the effects on public accounts. The effect on economic activity induces an increase in government revenues. Therefore, government gross savings show a slight improvement.

A shock in public expenditure

We turn now to the analysis of the effects of some domestic policy shocks. Let us start by an increase in public expenditure. We consider the case of a permanent increase of public sector employment by 5%, taking place in 1991. This corresponds to a permanent increase of public sector employment by 34000 jobs. In this simulation, tax rates are exogenous and the extra public expenditure is financed by public borrowing at fixed interest rates.

The main conclusions drawn from this exercise are illustrated in Figure 17 and in Table 2. Total employment increases by less than 34000. This is


due to a decrease in the level of employment in sector T that more than offsets the increase of sector S employment. The crowding out of the Por- tuguese traded sector is due to a loss of price competitiveness. The evolution of sectoral real wages paid by firms explains this evolution.

This change in fiscal policy increases GDP by an average annual figure of 1.27%. Consumption and investment also go up, following very closely the pattern of income. Like in the world demand shock, the increase in investment is mainly due to a decrease in the relative price of capital.

This expansionary fiscal policy leads to an increase of 1.59% in the consumption deflator. Im- ports react in a quite elastic way to this domestic shock. As exports remain virtually unchanged, the trade balance is seriously affected. This boost in economic activity produces a strong increase in tax revenue. By the end of the period indirect taxes increase 3.6% and taxes on income and wealth also go up, by an approximate figure of 3%. Neverthe- less, the current budget deteriorates as a result of this fiscal policy shock.

In this simulation it is of interest to examine the magnitude of the fiscal multiplier ie the change in

tu z .J U,l (n < m :E 0 In"

Z o_

40 ........ ~ ......... .... . . . . : .... ~ .......... [ ....

" i

aO ................. ~ ......................... ! ............ + .............. + ....

i + !

2 0 . . . . r . . . . . i ........... ....................

l O . . . . . . i " ~ .... T ............. .................... :~

0 ~ + , . . . . . . . +

i + i + ! i

-20 , , i , , , i . . . . . . i , , , i . + , , , i . +

1 9 9 0 1 9 9 4 1 9 9 8 2 0 0 2 2 0 0 6 2 0 1 0 0 0 1 4 0 0 1 8 I 'OlllJG EMPLOYMENT NON-11RAD/MII.E EMPLOYMENT

ImPLOYMENT ~ - -

34.0

i . . . . . i " 2~.o ~ i ....................... ! ~ ~ ........ ~ ~

2

0 0 . 0 : ~ +

13 .0 : . . . . . . . . . i i - - + -+

6 . 0 ................................................. ............... ; T----!

i i i

- 1 . 0 , . . . . . . i ~ ..h . , . . . . . . i . i

1 9 9 0 1 9 9 4 1 9 9 8 2 0 0 2 2 0 0 6 0 0 1 0 0 0 1 4 0 0 1 8 Em't.OYItlENT

TOT/¢ EMPLOYMBCr

5 ° 0 f-- . . . . . . . . t . . . . . . . . . : . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i

, . o t i ..................... + .................................. + ................... + ...... :

, . o . . . . ............. .......... - . . . . . . . . i

I.O . ........... ; ............. 4 ................. ~ -~ ............. :- .................... :-4

o.o ..... .................... ; ....................... ...... !

-1.o i,,,J,, i,,, ] 1 9 0 0 1 9 9 4 1 9 9 8 2 0 0 2 2 0 0 6 0 0 1 0 0 0 1 4 0 0 1 8

CONSUMIqlON PRICE N O N - ~ WAGE I~TE

W,JkQE RA'n~

2 . 0 0

1 .90

1 .80

1 .70

1 .60

1 .50

1 ,40 1 9 9 0

. . . . . . , . . ; , i . . . i . . . i . i

1 ~ 1 ~ 2 0 0 2 2 0 0 6 2 0 1 0 0 0 1 4 0 0 1 8

Figure 17 Sustained 5% increase in public sector employment

E c o n o m i c Mode l l ing 1995 Vo lume 12 N u m b e r 3 289

H ERMIN Portugal." L Modesto and P D Neves

T a b l e 2 S u s t a i n e d i n c r e a s e o f p u b l i c s e c t o r e m p l o y m e n t by 5%

1991 2005 2020

G r o s s d o m e s t i c p r o d u c t 0.99 1.22 1.27 a t m a r k e t p r i ce a U n e m p l o y m e n t r a t e b - 0.59 - 0.71 - 0.74 C o n s u m p t i o n d e f l a t o r a 1.13 1.46 1.59 G o v e r n m e n t savings as - 0.52 - 0.65 - 0.92 p e r cen t o f G D P b Publ ic b o r r o w i n g as p e r 0.46 0.57 0.85 cen t o f G D P b T r a d e b a l a n c e as p e r - 0 . 0 2 - 0 . 1 4 - 0 . 1 1 cen t o f G D P b

a P e r c e n t a g e dev ia t ion f r o m basel ine . bDev ia t i on f r o m basel ine .

real GDP at market prices induced by a unit change in public consumption:

Fiscal multiplier = A Y O / A G O

This is illustrated at the end of Figure 17. The fiscal multiplier reaches 1.8 by 1999, rising to 1.95 by the end of the period. The obtained multiplier is bigger than the one found for Ireland with a similar model (1.58 by 2020), and reflects the more closed charac- ter of the Portuguese economy.

A shock in public investment

An alternative domestic shock is an increase in public investment. This shock is particularly relevant as it may be considered as a preliminary test on the ability of the model to analyse the impact of structural funds. In this exercise, the effects of a one per cent of 1990 GDP increase in public investment, financed by public borrowing, are analysed. At this stage no specific supply side responses, such as ex- temalities are included. The main results are illustrated in Figure 18 and in Table 3.

The impact on GDP is estimated to be 1.63%. Consumption follows very closely GDP. Total investment increases by 6.3% but the effect on private investment is smaller. Although investment on sector S reacts strongly (a 3.5% increase) in sector T it remains unchanged. These findings are explained by the fact that an increase in public investment implies mainly an increase in domestic demand directed to the building and construction sector than in our model is included as a subsector of the non-traded sector. Moreover, this model does not include any channel through which infrastructure affect the supply side of the model. We also obtain some effects

. . , 3,00 . . . . . . ~ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ~ . . . . . . . . . . . . . . . . . . . . . . ~ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ~ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . , - - ~ |,.® 5.0 r ! T 4 . 0 /~-~, . - - ............ ~ .......... ~ j :

: ! / "~

o 2.4o a . o . / . ; . . . . . . . . . . ; z E !

" • i i i j [

. . . . . . . . . , . . . . , . ; . . . . . . . . . . . . . . . . . . . . . . , . o T T . . . . . . . . T ] ............. ! . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

,.,~ 1.20 f " " i r ........ - - " '~ 1.0 ]

o . ~ o . . . . . ; i . . . . . . . ~ . . . . . . . . . . . ; . . . . . . . . . . . . . ; - o . o . . . . . . . . . . . . . . ~ ~ ~ . . . . . . . . . . . . i . . . . . . . . . .

W I

1990 1994 1998 2002 2006 2010 2014 2018 1990 1994 1998 2002 2006 2010 2014 2018 TOTAL OUTPUT OONSUMFTION NON-Tl~ADABLE OUllPUT NON-I"RNDABLE WAGE R/kTE

OUTPUT . . . . . TEAD~ILE WAGE RATE . . ~

1.490

t .450

1.410

1.370

1.330

1.290

1.250 1990

. . . . . . . . . . . . . T . . . . . . . . . . . . . . . . . . . . T . . . . . . . . . . . . . . . . T . . . . . . . . . . . . . . . . 1 . . . . . . . . . . . . . T . . . . . . . . . . T . . . . . . . . . . . . . . . i - - i

i J : ] F i i l

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . i . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

- ~ . . . . . . . . t ~- ~-

........... 4 .................... 4- ~ j . . . . . ~ . . . . . ; i ; i i

........... ~ .................. ! ................... i ......................... ~ ...................... ! ....................... ~ ........................ ; [ :

_ . L . . . . . . . . . . . . . . . . . . . . . . . . ~ . . . . . . . . . . . . . . . . . ~ . . . . . . . ! . . . . . . . 1 _ L

1994 1998 2002 2006 2010 2014 2018

Figure 18 Sustained 1% of GDP increase in public investment

290 E c o n o m i c M o d e l l i n g 1 9 9 5 V o l u m e 1 2 N u m b e r 3

Table 3 Sustained 1% of 1990 GDP i n c r e a s e in publ ic invest- m e n t

1991 2005 2020

Gross domestic product 1.57 1.71 1.63 at market prices" Unemployment rate b - 0.18 - 0.73 - 0.71 Consumption deflator ~ 1.11 2.25 2.19 Government savings as 0.16 0.25 -0 .11 per cent of GDP b Public borrowing as per 0.78 0.63 0.95 cent of GDP b Trade balance as per -0 .19 - 0 . 2 8 - 0 . 2 0 cent of GDP b

Percentage deviation from baseline. bDeviation from baseline.

on the level of employment (30 000 new jobs), in spite of the reduction of the level of employment in sector T.

Imports react immediately to public investment, increasing by 2.2%. The increase in exports is 0.5% and so a deterioration of the trade balance results from this shock.

Finally, it is of interest to examine the multiplier effect on aggregate GDP. This is illustrated at the


end of Figure 18. The multiplier is initially 1.26 reaching 1.48 in the long run and is slightly bigger than the one obtained for Ireland (1.3 in the long r u n ) .

Note that in this case the multiplier effect is smaller than the one associated with the public employment shock where the effects operate directly through the income side of the model, in addition to the expenditure side.

A shock to the indirect tax rate

In this subsection we present and analyse the performance of HERMIN Portugal when submitted to a 10% increase in the indirect tax rate (ITR). The main conclusions of this simulation are presented in Figure 19 and in Table 4.

The impact of this shock on the level of economic activity is quite dramatic. GDP goes down by 1.21%. Investment decreases by 2.7% when compared to the baseline evolution of the model. Consumption is seriously affected, decreasing by 2.8%. The increase in the indirect tax rate forces the price of consumption to go up by 0.67%, reducing real private consumption.

i n < m

Z 0 n , i t

cl

i - z

o

w o.

s .o [- ........................................................................... : ........................ T ................... ~ - - J

2 o ~ ................. ~ .............................................................................. ~ .................... ;-.-

1.o ~ . i . . . . i . . . . . . . . ; - i- . i

o.o . . . . . . . . . . . . . . . . . . . . . . . . . . . ~ ! ....... ! ............... ! ~ :

i

- 1 . 0 ~- . . . . . . . . . . . . . . . . . . . . . . . . .

2 . 0 5- - : - ! . . . . ~ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . r - .

: i - I : 3 . 0 L

1 9 9 0 1 9 9 4 19@8 2 0 0 2 2 0 0 6 2 0 1 0 2 0 1 4 2 0 1 8 CONSUMFnON PRICE N O N - ~ W~kOE RATE TRAD.UlLE WAGE RATE . . . .

m

o= u.

o i- z tu

UJ B.

0 . 2 0 . . . . . . ~ ............... , .................................... ~ .................... ~ ...................... T .....................

- o . ~ o ......... . . . . . . . . . . . . . . . . . . . . . . . . . . . ............................................... i - !

............. i .................... ............. . . . . . : ,

la90 1 ~ l m area ~ 2010 2014 2018 C~lNMPI1ON

UJ z

: E o tl

o . , o .... i i ! 0 . 2 0 . . . . . i ~

- o . 4 o ~ ~ i . . . . . . . . . . . . . . . . . . i • : ! i

-1 .60 . . . .

- 2 . 2 0 . . . . . . . . . . . . . . . . . . . . . . . . : - - ~ -

191 )0 191 )4 111@8 2 0 0 2 2 0 0 6 2 0 1 0 2 0 1 4 2 0 1 8 G O ~ I ~ I E N T NET BORROMNG TRADE BALANCE

Figure 19 Sustained 10% increase in the indirect tax rate

E c o n o m i c M o d e l l i n g 1 9 9 5 V o l u m e 1 2 N u m b e r 3 291


Table 4 Sustained 10% increase in the indirect tax rate

1991 2005 2020

Gross domestic product - 0.72 - 1.11 - 1.21 at market prices a Unemployment rate b 0.56 0.93 0.98 Consumption deflator a 1.69 0.82 0.67 Government savings as 1.46 1.85 2.77 per cent of GDP b Public borrowing as per - 1.47 - 1.83 - 2.75 cent of GDP b Trade balance as per 0.36 0.77 0.80 cent of GDP b

a Percentage deviation from baseline. bDeviation from baseline.

The main channels through which this reduction in activity occurs have to do with the performance of wages, employment and of the supply side of the model. In HERMIN Portugal output is determined by demand. A significant reduction in private consumption implies therefore a cut in production. This in turn will imply a decrease in investment, that feeds the decrease in output, and also a decrease in employment. At the same time wage rates will tend to respond to the increase in consumer prices.

Therefore, we observe in the first years an increase in wages in the tradable sector, implying a further decrease in employment. However, as the unemployment rate increases, the Philips curve effect begins to push wages downwards. This effect, however, is not sufficient to boost employment. We therefore observe an important decrease in the wage bill that reduces households disposable income implying a decrease in direct taxation and a further decrease in consumption that, in turn, feeds the reduction in supply.

Notice that indirect taxes increase less than the observed increase in ITR as a result of a decrease in the tax base resulting from the induced decrease in activity. Government revenues increase, mainly in the first years, as expected, but less than the increase in indirect taxes as direct taxes and social security contributions decrease. Government expenditures also decrease. This pattern is partially induced by the recession and by reduction in interest payments, as the outstanding debt decreases.

The main effects of an increase in indirect taxation are therefore the following: it induces a recession in the economy, lowering the level of demand,

:E o u .

) -

z

n -

I l J 0 .

0 .S0 . . . . . . . . . . . r . . . . . . . . . . . . . ..................... T . . . . . . . . . . . . . . . . . : .................... ~ . . . . . . . . . . . . . . T . . . . . . . . . . . . . T - - - " !

_-°- iii ii iiii ill iii i ii !iiiiiiiii - 1 . . o

.................... ~ " - - ~ , ~ : = ~ . . ; ..................................................... 4 ................. 4 ........ - Z i G "" ..... +- ..... ~ ...... k i - 2 . 7 0 - ! ....... " .................... I ................ ~

- 3 . 3 0 191)0 191)4 1 9 9 8 2 0 0 2 2 0 0 6 2 0 1 0 2 0 1 4 2 0 1 8

CONSUMIq'IOH Iq~lGE NON-1RADABLJ[ WAGE RATE 1RNDhR.E WAGE RATE . . . .

UJ 0 . 3 0

m - 0 . 3 0

:E O - 0 . 9 0 u

~ -1 .50

0 ~. -2 .10 Z ~ -2.70 n,- ILl n. -3 .30

............................................................. T ........................... 7 . . . . . . . . T - -

.... ' ................ i . . . . . . . . . . . . . . . . . .

1 9 9 0 1 9 9 4 1 9 9 8 2 0 0 2 2 0 0 6 2 0 1 0 2 0 1 4 2 0 1 8 GOP CONSUMI~'ION INVESTMENT . . . .

Figure 20

0 . 8 0 UJ

z 0 . 2 0

m < - o . 4 o : f

~ -2.20

a -2.1111

. . . . . . . . . i . . . . . . . . . . . i . . . . . . . . . . . T . . . . . i . . . . . . . . . . . . 1 . . . . . . . . . . . T ....................

1 9 9 0 19114 1 9 9 8 2 0 0 2 2 0 0 6 2 0 1 0 2 0 1 4 2 0 1 8 ~4[ ImMImT NET II01m0WINQ TRADE BALANCE

Sustained 26% increase in direct tax rate of households


Table 5 Sustained 26% increase in the direct tax rate of households

1 ~ 1 2 ~ 5 2 ~ 0

Gross domestic product -0.61 - 1.05 - 1.21 at market prices ~ Unemployment rate b 0.09 0.44 0.51 Consumption deflator ~ - 0.47 - 1.32 - 1.54 Government savings as 1.41 1.83 2.76 per cent of GDP b Public borrowing as per - 1.39 - 1.77 - 2.69 cent of GDP b Trade balance as per 0.22 0.60 0.63 cent of GDP b

a Percentage deviation from baseline. bDeviation from baseline.

output, investment and employment and it also raises inflation. We obtain, however, an improvement in the trade balance mainly due to a significant decrease in imports, induced by the recession, even though exports also decrease.

H ERMIN Portugal." L Modesto and P D Neves

Concluding remarks

This paper describes the main features of HERMIN Portugal a four-sector macro model of the Por- tuguese economy. Econometric results are presented and the simulation performance of the model when submitted to selected exogenous shocks is discussed.

In its present format, HERMIN Portugal proved to be able to replicate quite accurately the functioning of the Portuguese economy inside the sample period. The expected signs of the coefficients and the elasticities were always obtained and their magnitude is generally in line with corresponding values derived from alternative models of the Portuguese economy, namely the HERMES and the QUEST.

Moreover, H ERMIN Portugal proved to be very useful for policy analysis. A selected set of shocks was carried out and their consequences were analysed. A set of extremely useful multipliers and partial derivatives was obtained in this way, constituting a test to the theoretical coherency of the model.

A shock to the households income tax rate

Let us turn now to the analysis of the effects of an increase in the direct tax rate of households (DTHR), by 26%. The main conclusions of this shock are presented in Figure 20 and Table 5.18

Let us start by the main economic aggregates. Consumption is negatively affected and goes down by 3.1%. This is due to a decrease on disposable income. Investment is also negatively affected (a 2.3% reduction), through a reduction in the level of activity. The contraction in aggregate demand leads to a decrease in GDP that approaches 1.21%. The magnitude of this effect is identical to the one resulting from the increase in indirect taxation.

This shock reduces total employment, as employment on sector S goes down by 1.63% while an increase of 0.6% occurs in sector T. This is because of an increase in the competitiveness of this sector.

Note that the contraction in aggregate demand reduces the rate of inflation: the price of consumption and the implicit GDP price decrease by 1.5 and 1.9% respectively. Exports decrease by 0.6%. It is not surprising that imports, through the reduction in aggregate demand, decrease by a large amount (around 2.7% at the end of the sample).

The increase on the rate of taxation on households income does not change dramatically total government revenues. This is not surprising as the increase in direct taxes paid by households is com- pensated by reductions in direct taxes paid by firms, social security contributions and indirect taxation.

References 1 Bradley, J and Wright, J HERMIN-3: A Three-Sector

Model of the Republic of Ireland Technical Paper submitted to the European Commission (1993)

2 Bradley, J, Whelan, K and Wright, J Stabilisation and Growth in EC Periphery: A Study of the Irish Economy Avebury, Aldershot (1993)

3 Brandsma, A, op de Beke, J, O'Sullivan, L and Roger, W 'QUEST-: a macroeconomic model for the countries of the European Community as par to the world economy' European Economy 1991 47 163-237

4 Dr~ze, J H and Bean, C 'Europe's unemployment problem: introduction and synthesis' in Dr~ze J H and Bean C (eds) Europe's Unemployment Problem MIT Press, Cambridge, MA (1990)

5 Italianer, A the HERMES Model: Complete Specifica- tion and First Estimation Results Commission of the European Communities, Report EUR 10669 EN (1986)

6 Layard, R, Nickell S, and Jackman, R Unemployment." Macroeconomic Performance and the Labour market Oxford, Oxford University Press (1991)

7 Manteu, C 'Evolu~o das Exporta~6es Portuguesas no Periodo de 1978 a 1990' Boletin Trimestral 1992 14 (3) Banco de Portugal Setembro, 1992.

8 Modesto, L, Monteiro, M L, Pessanha, J M and Vasco, A HERMES-Portugal working paper, Centro de Estu- dos Aplicados, Universidade Cat61ica Portuguesa (1991)

9 Modesto, L, Neves, J C and Monteiro, M L 'Some aspects of the Portuguese labour market, 1977-1988: neutrality, hysteresis and the wage gap' in The Por- tuguese Economy Towards 1992, Amaral, J F, Lucena, D and Mello, A S Kluwer (1992)

10 Modesto, L and Monteiro, M L 'Wages, productivity and efficiency: an empirical study for the Portuguese manufacturing sector', Economia 1993 17 (1) 1-25.



11 Modesto, L and Neves, P D HERMINP3: A Three-sector Structural Model of the Portuguese Economy Work- ing paper Centro de Estudos Aplicados, Universidade Cat61ica Portuguesa (1993)

12 Modesto, L and Neves, P D HERMINP4: A Four-sector Structural Model of the Portuguese Economy' Working

paper Centro de Estudos Aplicados, Universidade Cat61ica Portuguesa.

13 Neuman, M J M, Schmidt, R and Schulte, E 'Determi- nants of contract wages in Germany' European Economic Review 1990 34 (6) 1233-1246


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