Download - 1 Chapter 9 Policy Tools for Macroeconomic Analysis © Pierre-Richard Agénor The World Bank
1
Chapter 9 Policy Tools for
Macroeconomic Analysis
© Pierre-Richard Agénor
The World Bank
2
Assessing Business Cycle Regularities Assessing the Effects of External Shocks Financial Programming
The Polak Model An Extended Framework
The World Bank RMSM Model The Merged Model and RMSM-X Three-Gap Models Lags and Behavioral Functions
3
Assessing Business Cycle Regularities
4
Little attention paid to developing countries in recent past:
Why? Limited data quality and frequency. Cycle-spotting problematic; prone to sudden
crises.
5
Analysis of macroeconomic fluctuations beneficial: Helps specify applied macroeconomic models that
capture some of the most important correlations. Unconditional correlations can provide insight to
the type of shocks that dominate fluctuations in some macroeconomic aggregates
Design of stabilization programs; insight gained in assessing pattern of leads and lags between aggregate time series and economic activity.
6
Four Step Process Step 1: choose a measure of real activity Step 2: decompose all series into trend and cyclical
components. Step 3: assess comovement of series with
measure of real activity (output). Step 4: determine phase shift of series with respect
to output.
7
Step 1: choosing a measure of real activity Real GDP often chosen. Can be inappropriate:
Agricultural output, frequently contingent on non-macroeconomic variables (e.g. weather conditions) comprises a large percentage of GDP.
Nonagricultural output may be a preferable measure in select developing countries.
Figure 9.1.
8
Figure 9.1aStructure of Output
(Value added, in percent of GDP)
Source: World Bank.
Agriculture Industry Services
Benin
Burundi
Cameroon
Côte d'Ivoire
Ethiopia
Ghana
Kenya
Malawi
Nigeria
Tanzania
Zambia
Zimbabwe
0 20 40 60 80 100
Africa
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
Bangladesh
India
Indonesia
Korea
Malaysia
Nepal
Pakistan
Philippines
Sri Lanka
Thailand
0 20 40 60 80 100
Asia
9
Argentina
Bolivia
Brazil
Chile
Colombia
Costa Rica
Ecuador
Jamaica
Mexico
Peru
Uruguay
Venezuela
0 20 40 60 80 100
Latin America
Figure 9.1bStructure of Output
(Value added, in percent of GDP)
Source: World Bank.
Agriculture Industry Services
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
19801995
Algeria
Egypt
Jordan
Mauritania
Morocco
Oman
Syria
Tunisia
Turkey
Yemen
0 20 40 60 80 100
Middle East and North Africa
10
Step 2: nonstationary and stationary components Augmented Dickey-Fuller (ADF) test
Most techniques rely on stationary (cyclical) data.
ADF: test for unit roots.
xt = + t + ( - 1)xt-1 + h xt-h + ut
ut : error term;k 0; For xt to be stationary, - 1 should be negative
and significantly different from zero.
11
Step 2: nonstationary and stationary components. Given
xt = xt* + xtc,
xt* : trend component
xtc : cyclical component
Hodrick-Prescott (HP) filter can be used to estimate and filter the trend component, xt
*. Criticism of HP filter:
removes potentially valuable information and may impart spurious cyclical patterns to data;
assumes independent relationship between trend and cyclical components.
12
Step 3: assessing the comovements Contemporaneous correlation coefficient, (0),
between filtered components of yt (series) and xt (output):
Procyclical if (0) is positive. Countercyclical if (0) is negative. Acyclical if (0) is zero.
With 10% significance threshold, series yt is;
Strongly contemporaneously correlated:
.3 (0)< 1. Weakly contemporaneously correlated:
.1 (0)< .3.
13
Contemporaneously uncorrelated:
0 (0)< .1.
Step 4: determining the phase shift Phase shift of yt relative to output: cross-
correlation coefficients, (j), j {+/-1,+-2,…}: yt leads the cycle by j period(s) if (j)is
maximum for a negative j; yt lags the cycle if (j) is maximum for a
positive j; yt is synchronous if (j) is maximum for j = 0.
14
Table 9.1: results for Kenya and Venezuela, private consumption, investment and private sector
credit are procyclical but less volatile than output; fiscal stance is countercyclical in Kenya,
procyclical in Venezuela; trade ratio is countercyclical in Venezuela; broad money seems to lag movements in activity; terms of trade is countercyclical in Venezuela; inflation is countercyclical.
15
Assessing the Effects of External Shocks
16
McCarthy, Neary, and Zanalda (1994)
Step 1: estimate impact of three components on BOP, expressed as a percentage of output.
Terms of trade, interest rate effect, changes in global demand.
Terms of trade shock: measured as the market value of the net import effect.
Interest rate effect: change in world interest rates multiplied by stock of interest rate sensitive external debt.
Changes in global demand: deviation of growth of world export volumes from estimated trend multiplied by initial export volume.
17
McCarthy, Neary, and Zanalda (1994) Step 2: estimate economy’s response to shocks.
Level of demand: adjustment in imports from reduction in aggregate demand; difference between expected import volumes using historical import elasticity of GDP using trend growth versus actual GDP growth.
Expenditure-switching measures: captured by changes in export performance and the degree of import intensity.
Step 3: calculate additional net external financing as the difference between the effect of all shocks and the economy’s responses.
18
Financial Programming
The Polak Model An Extended Framework
19
The Polak Model
20
Considers small open economy, with fixed exchange rate.
Four Equations:
Ms = L + R (4)
Ms: money supply, L: domestic credit, R : official foreign exchange reserves
R = X - Y + F, 0 < < 1, (5)
F: capital inflows
Md = v-1Y, v > 0, (6)
21
v: income velocity of money
Ms = Md (7)
Polak focus: Determine effects of changes in domestic credit on
foreign exchange reserves.
Using (4), (6), and (7),
R = v-1Y - L . Reserves will only increase when nominal money
demanded exceeds change in domestic credit.
22
Polak model structure:
Target Variables: R.
Endogenous Variables: M, Y, J = Y.Exogenous Variables: X, F.
Policy Instruments: L.
Parameters: v, .
23
Polak example: Consider increase in L at period t = 0, by L0 ,
Ms rises by L0, by (4), Md rises by L0 , by (7),
nominal income, Y, must rise, by vL0, by (6),
thus, imports rise by Y = vL0,
reserves fall -vL0 on impact,
Ms then increases only (1 - v)L0 .
24
Consider increase in L at period t = 0 by L0 ,
cumulated fall in reserves at end of period 1:
Rt=1 = -vL0 - v(1 - v)L0,
over an infinite time horizon (t ):
Rt = -L0 ,
in long run, initial expansion in money supply via increase in domestic credit is completely offset by the reduction in official reserves.
25
Given a targeted level of reserves,
L = v-1Yp - R
R: targeted reserves,
Yp: projected level of nominal income
L: required change in credit, allows policy makers to estimate a credit ceiling.
Domestic credit expansion levels crucial in obtaining BOP objective:
note: exports, capital flows and income velocity of money treated as exogenous variables.
~
26
Monetary Approach to the Balance of Payments (MABP):
Assumptions: stable demand for money, purchasing power parity, continuous stock equilibrium in money markets
Results in an instantaneous absorption by reserves of credit change, unlike Polak which assumes a more gradual absorption.
27
Limitations of the Polak Model: Assumes that changes in domestic credit have no
effect on domestic money demand; in many developing countries the bank credit-supply side link is a critical feature of the economy.
Assumes a stable money demand function; in practice money demand tends to be unstable as a result of volatile inflation expectations.
28
An Extended Framework
29
Khan, Haque, and Montiel (1990) Distinguishes between real and nominal output and
the sources of credit growth.
Extended framework equations: Consider single good economy where,
Y = Py
Y: nominal income, P: overall price index, and y: real output.
Y = Py-1 + P-1y
30
Price changes: function of domestic price changes, PD and exchange rate adjusted foreign prices changes by,
P = PD + (1 - )(E + P*), 0 < <1 Domestic credit
L = Lp + Lg, Lp : private sector credit
Lg : government credit
Lp : f(demand for working capital), proportional to changes in nominal output:
Lp = Y;
31
Money supply identity:
M = L + R;with
R = ER*
R = X - J + F
X: Exports (exogenous); J: Imports in nominal terms,
J = EQJ,
QJ : import volume; E : nominal exchange rate
32
Changes in import volume, related to the change in
output and the relative price of foreign goods,
QJ = y + [PD - (E + P*)]
> 0: import elasticity to relative price changes.
Nominal value of imports:
J = J-1 + (QJ-1 - E-1)E
+ E-1[y + (PD - P*)] (16)
33
With relatively small QJ-1, a devaluation in the nominal exchange rate (E > 0) will lower the nominal value of imports, improve the trade balance and increase
official reserves. Income velocity: constant as in Polak model, money
market assumed to be in flow equilibrium. Government Budget Constraint: G - T = L + Fg,
budget deficit is financed by foreign borrowing or
changes in central bank credit.
34
Structure of Extended Framework:
Target variables: R, PD
Endogenous variables: Y, Lp, M, P, J, G-T
Exogenous variables: y, P*, X, F = Fp + Fg
Policy instruments: Lg, E
Predetermined: y-1, P-1, QJ-1
Parameters: v, , , , .
35
Target variable equations:
R = (v-1 - )y - 1 PD = (20)
with
= (v-1 - )[y-1(1 - )(E + P*) + P-1y] -Lg.
R + PD = X + F - J-1 + (QJ-1 - E-1)E
+ P* - E-1y (21)
36
Positive and programming mode solutions Positive Mode: for given values of exogenous
variables and policy instruments, determine simultaneously the target variables.
Programming Mode: R, PD are targets and equations are solved for
the policy instruments, Lg, E.
~ ~
See Figure 9.2 for graphical representation of (20) and (21) in R-PD space as the MM and BB curves respectively.
37
Figure 9.2The Extended Financial Programming Model
R
PD
R~
~PD
E
E'
B
B
M
M
Source: Adapted from Khan, Montiel, and Haque (1990, p. 161).
38
Programming Mode Given the objective of lowering inflation and
increasing official reserves, policymakers can, reduce Lg, shift MM curve left in Figure 9.2, or depreciate the nominal exchange rate, shift MM
left and BB right in Figure 9.2.
39
The World Bank RMSM Model
40
Revised Minimum Standard Model: Precursor to the RMSM-X model. Developed in the early 1970s. Objective: make explicit the link between medium-
term growth and its financing.
41
Five relationships (prices taken as given):
I = y/ (22)
: incremental capital-output ratio (ICOR). Imports:
J = y, 0 < < 1 (23)
Cp = (1 - s)(y - T), (24) 0 < s < 1: marginal propensity to save.
42
Balance-of-payments identity:
R = X - J + F (25)
National income identity:
y-1 + y = Cp + G + I + (X - J) (26)
43
The structure of RMSM:
Target Variables: R, y.
Endogenous Variables: I, Cp, J.
Exogenous Variables: X .
Policy Instruments: G, T, F
Predetermined: y-1
Parameters: , s, .
44
Target equations:
(s + )y-1 + (1 - s)T - (X + G)y =
-1 - (s + )(27)
(28)
Substituting (23) in (25),
R = X - (y-1 + y) + F.
45
Solutions:
Positive or Policy Mode Recursive: first equation can be used to determine
second equation. See Figure 9.3: for given values of exogenous
variables and policy instruments, equilibrium is found at the interception of the horizontal YY curve and the BB curve, equations (27) and (28) respectively.
46
Figure 9.3The RMSM Model in the Positive Mode
y
E
B
B
Y Y
R
47
Programming Mode: Trade-gap mode: Given X-J, calculates F in (25). Saving-gap mode: Given X-J and F, calculates
required level of savings, y/ in (22). Total consumption assumed to be a residual of
national income identity (26),
Cp = y-1 + y - y/ - X - m(y-1 + y) - G
~
Limitation: priori expectation that private consumption will be consistent with national accounts identity unrealistic.
However, possible to use trade sap and saving gap as potentially binding constraints.
48
Two-Gap Mode: Determine financing requirements for alternative
target rates of output growth and official reserves. Determine feasibility of particular growth rate given
alternative financing scenarios.
Saving Constraint: Begin with national income accounting identity,
I = (y - T - Cp) + (T - G) + (J - X) (30)
(y - T - Cp): private sector savings;
(T - G) : public sector savings;
(J - X ): foreign savings.
49
Saving Constraint: Substituting out for Cp and J - X,
I S + F (31) with,
S = s(y-1 + y) + [(1 - s)T - G] - R.~ ~
Figure 9.4: graphs inequality in I-F space.
50
Figure 9.4The RMSM Model in Two-Gap Mode
Zone IV
Zone I
Zone II
Zone III
I
F
45º
ST
T
S
51
Substitute (23) into (32),
y = (X - R + F)/ - y-1. (33)
Trade constraint: substitute (33) into (22),
I T + F/ (34)with,
T = (X - R)/ - y-1/
J - X = F - R. (32)~
Trade Constraint: Rewrite (25) as,
52
Step 2: given target output, determine required investment,
IR = y/~
RMSM: Two Gap Mode Binding constraint: constraint yielding lowest level
of investment. Suppose foreign financing is binding constraint.
Other variables solved for using iterative process:
Step 1: Specify values for a) parameters, , s, and ; b) predetermined variable, y-1; c) exogenous variables, X and F; d) policy instruments, T and G; e) policy targets, y and R.
~ ~
53
Step 3: Determine the levels of investment, IS and IT implied by the saving constraint (31),
Imin = min(IS , IT).
Step 4: If Imin IR, no constraint is binding.
4a: If Imin IR, and if savings constraint is binding
either increase taxes, T, and/or reduce G, and/or reduce R, until constraint is relaxed or you have exhausted policy instrument options.
~
54
4b: If Imin IR and if trade constraint is binding reduce R, until constraint is relaxed or
further policy or target variable changes unfeasible.
~
4c: If Imin IR and both constraints are binding: reduce R and/or adjust T and G.
~
y = Imin ~
Step 5: If adjustments in step four do not still satisfy constraints, lower desired level of output by,
55
Step 6: determine required level of imports as
JR = (y-1 + y)
Step 7: now, given JR, X, and F, recalculate target level of reserves as,
R[1] = X - JR + F,
redo iterations in step 3-8 until R[1] R. ~ ~
~
56
Step 8: Once convergence has been achieved, model yields inter-related consistent values of the levels of investment, the change in output, imports, and the change in official reserves.
Step 9: Use equation (24) along with the new value
of output and the value of taxes to estimate private
consumption, Cp.
57
Three criticisms: Difficulty identifying binding constraint a priori.
Assumes imports as essential for investment and growth; however, saving gap can also be closed by combination of reducing imports or increasing exports, thereby freeing foreign exchange necessary for investment.
Incomplete; essentially a growth-oriented model with emphasis on a small number of real variables and no financial side.
Relative prices and induced substitution effects among production factors (and their possible impact on exports, for instance) are neglected.
58
The Merged Model and RMSM-X
59
Combines extended model and RMSM model. As in extended model, relative prices affect imports
and domestic absorption.
Equations: Changes in real output,
y = I/(1 + P),
Y = Py-1 + P-1y,
P = PD + (1 - )E,
P* = 0
The Merged IMF-World Bank Model
60
Domestic credit
L = Lp + Lg, with
Lp = Y.
Money supply identity
M = L + R, with
R = ER*
61
Balance of payments:
R = X - J + F, with
F = (1 + E)F*,
X: exogenous.
Nominal imports:
J = J-1 + (QJ-1 - E-1)E + E-1(y + PD).
62
Money demand:
Md = v-1Y.
Flow equilibrium of the money market:
Ms = Md
63
Government budget constraint:
G - T = Lg + Fg.
Private Sector Budget Constraint:
(Y - Cp - T) - I = Md - Lp - Fp
Cp = (1-s)(y - T), private sector budget constraint implies,
I = s(Y-1 + Y - T) + Lp + Fp - Md. (47)
64
Structure of the merged model:
Target Variables: R,PD, y
Endogenous Variables: Y, Lp, M, P, J, G-T
Exogenous Variables: X, F = Fp + Fg
Policy Instruments: Dg, E, G or T
Predetermined: y-1, P-1
Parameters: , , , , .
65
Target equations: merged model
- + (-1 - )y PD =
y-1
- (1 - )-1E
R + (y-1PD + y) =
R = X - J-1 - (QJ-1 - E-1)E
- E-1(y + PD) + F
Figure 9.5.
66
Figure 9.5The Merged IMF-World Bank Model
y
E
M
M
Y
Y
RPD
B
B
A
E'A'
R~~PD
y~
67
Expanded version of the RMSM model (see World Bank, 1997b):
Conceptual basis: merged IMF-World Bank model described earlier (adds to the RMSM model a price sector, a monetary sector, and government accounts, along the lines of the financial programming approach.
In practice, RMSM-X models fairly detailed; General RMSM-X model characteristics: often consist
of four economic sectors: the public sector, the private sector, the consolidated banking system, and the external sector.
The RMSM-X Framework
68
Budget constraints associated with each sector. National accounts derived via aggregation of the
sectoral budget constraints serve to close the RMSM-X model.
Two types of financial assets, money and foreign assets in standard model, some versions include (particularly for middle-income countries) domestic bonds.
Money demand function frequently follows Polak model; constant income velocity of money.
69
Some models disaggregate banking system structure: here Ms is not equal to the sum of central bank credit and official reserves; rather obtained as the product of the monetary base and a constant money multiplier.
Prices: assume domestic and foreign goods are imperfect substitutes, so that substitution effects can be analyzed on the demand side.
Imports: several categories with the demand a function of the real exchange rate and either real GDP or (e.g. imports of capital goods) gross domestic investment.
70
Consumption: generally assumed to depend only on disposable income---thereby excluding consumption-smoothing effects.
Model closures: Public sector closure: values for all variables
except public sector expenditure and domestic borrowing specified; latter two variables then determined by model.
Private sector closure: values for government expenditure and revenue are specified, and the model estimates private sector variables.
71
Marginal economic agent: In both approaches, likely disbursements from
external donors provide estimate of external financing.
External borrowing requirements determined separately, through the balance-of-payments identity.
Gap financed by marginal economic agent. In public sector closure, central government is
marginal borrower and foreign commercial banks are assumed to be the marginal foreign creditor.
72
Policy closure as availability mode: all external financing identified in advance and imports are adjusted to equilibrate BOP.
Programming Mode: targeted values given; RMSM-X then solved for mix of fiscal,
monetary and exchange rate policies consistent with targeted values.
73
Programming mode: solution sequence Step 1: set targets for inflation rate, potential GDP
growth rate (evaluated at full employment), real exchange rate, real interest rate, and international reserves (specified in months of imports).
Step 2: Calculate investment requirements, given estimates of ICOR and the actual growth rate of output.
Step 3: Calculate the demand-side relationships based on the projections of the exogenous variables.
74
Step 4: Estimate likely availability of foreign borrowing. Calculate reserve requirements for exogenously determined import target. Determine additional foreign borrowing required.
Step 5: Determine growth rate of money supply, given inflation targets, output growth, estimates of velocity and the money multiplier. Estimate, residually, amount of domestic credit supplied by the central bank or banking system, given the reserve accumulation target.
75
Step 6: Close the model by determining the following residuals in the relevant markets: consumption of goods and services, that is, public (private) consumption in the public (private) sector closure; borrowing from the foreign external sector; and credit allocated by the banking system (or, in more specific cases, central bank credit to the nonfinancial public enterprises).
Limitations Retains limitations of the two models that underlie
it. IMF framework rudimentary; static nature
problematic for short-term projections, given the importance of lags.
76
Missing important features of developing countries: effect of debt financing of fiscal deficit on
domestic interest rates as well as the endogeneity of private capital flows ignored;
short-run link between production and bank credit ignored, obviating a critical channel through which monetary policy can affect the real economy.
Supply-side problems: Not account for the complementarity between
public investment and private investment. Fixed-coefficient production function (the ICOR
relationship) remains subject to a number of analytical and practical difficulties.
77
Easterly (1999) found that the assumed linear relationship between growth and investment is significantly rejected by the data.
ICOR rules out capital-labor substitutability and is unable to account for observed fluctuations in real wages.
Relative prices (and the real exchange rate) influence the allocation of resources only through the demand side, not the supply side.
No role to expectations. No explicit role for the labor market, unable to
account for fluctuations in unemployment.
78
Three-Gap Models
79
Two gap RMSM approach extended to three-gap framework by Bacha (1990).
Addition of fiscal gap links foreign exchange availability directly to the rate of growth of productive capacity and only indirectly to the actual level of real output.
80
Equations: ICOR relationship:
I = y/,
81
Setting up the foreign exchange constraint:
JK = I,
XN = X - (J - JK),
XN: level of exports net of noncapital imports.
FN : F minus changes in foreign exchange reserves, R.
OS : net factor serves to rest of world (external debt services and other transfers)
82
Standard BOP identity,
R = (X - J) - OS + F.
Substitute, FN = F - R, and X = XN + J - JK, rearrange,
FN - OS + (XN - JK) = 0.
Solve for JK, then substitute I = JK/ ,
I = (XN + H)/with
H = FN - OS .
83
Suppose (non-capital) imports are invariant and there is an upper bound on exports, XN, based on external
demand. First gap: foreign exchange constraint,
I (XN + H)/~
84
Setting up the saving constraint: Using (58), basic national income identity is written as,
I = (y - Cp - G) + H,
equivalently,
I = Sp + (T - G) + H
with
Sp = y - T - C,
decomposes financing of investment into domestic and public sector savings.
85
Setting up the fiscal constraint: Suppose:
money money is only asset available; foreign capital inflows serve to finance
government’s budget deficit.
Second gap: saving constraint
I Sp + (T - G) + H~
Cp: assume exogenous.
Sp = y - Cp
with y bounded from above by full capacity output.
~ ~
86
Private sector budget constraint can be written as
Sp - Ip = M/P. Assume constant real money balances. M/P: measures both seigniorage and inflation tax. Revenue generated as function of inflation rate,
P/P and propensity to hoard, ,
M/P = h(, ).
Budget constraint of the consolidate public sector:
Ig = h(, ) + (T - G) + H.
87
Suppose: private and public investment are complements:
Ip Ig,
: ratio of private to public investment in capital stock.
Ig + Ig = I,
(1 + ) Ig = I
Third gap: fiscal constraint
I (1 + )[h(, ) + (T - G) + H]
88
Model without fiscal constraint Consider changes in level of foreign financing, H, in
presence of foreign exchange and savings constraints.
Figure 9.6: Foreign exchange and saving constraint graphed in
I-H space as FF and SS respectively. Slope of SS is unity, whereas slope of FF is 1/.
Three cases considered: Case 1: if net foreign inflows H are equal to H*
(where FF and SS curve intersect), both constraints are binding and investment is equal to I*.
89
Figure 9.6The Three-Gap Model
Source: Adapted from Bacha (1990, p. 291).
F
F
S
S
G
G
I
0 H* H
I*
(1+)[h(,) + (T-G)]
S + (T-G) ~p
X/~
90
Case 2: if H is less than H*, only FF binds. Investment determined by foreign exchange
availability. Economy suffers from excess capacity with
actual output given by,
y = Cp + G + (1 - )Ic + XN
Ic: foreign exchange constrained investment.
~
91
Case 3: if H exceeds H*, the economy will be constrained by domestic saving:
Output at full capacity; actual value of adjusted exports will be less than
maximum value, given by foreign demand; domestic demand ‘squeezes’ exports to
XN = y - Cp - G + (1 - )Ic
Ic :saving-constrained level of investment
~
92
Minding the Fiscal Gap
Adding the fiscal gap leads to the following adjustments:
In Figure 9.6, add GG curve with slope 1 + and vertical intercept, (1 + )[h(, ) + (T - G)].
Curves GG and SS have same slope. Relative heights depend on the values of and . As
long as Ip is positive, the private sector budget constraint, implies that,
Sp > h(, ).
Larger values of and raise the height of GG relative to SS.
~
93
Fiscal constraint incorporated in a variety of ways.
Two possibilities: Inflation as an endogenous variable: Fiscal constraint
serves limited purpose of determining inflation rate, , necessary for a given level of total investment.
Inflation as an exogenous policy variable: GG serves as an independent constraint; if fiscal constraint does not bind, is slack variable
and Ip is determined residually; if fiscal constraint does bind, a rise in H will
increase capacity growth. Output will rise, economy will move to full capacity with lower net exports.
94
The 1-2-3 Model
95
Developed at the World Bank by Devarajan et al. (1997),
CGE (computable general equilibrium) models. 1-2-3 captures features of CGE models: highly
disaggregated models (on both the demand and the supply side) designed to study issues such as the allocational and distributional effects of domestic and external shocks (see Bandara, 1991).
Demand side: typically consider several households. Price rigidities common.
96
Macroeconomic dimension of CGE models: Closure rules for ensuring identity between
aggregate savings and investment. Classical rule:investment endogenous and
determined by aggregate saving. Keynesian rule:investment exogenous and real
wages adjust to establish saving, investment identity.
Johansen rule: endogenous public or private consumption equates total saving to exogenous investment.
97
The Minimal setup: Small open economy. Two representative agents: a producer and a
household. Economy produces two goods: home good and
exportable good, the price of which is fixed on world markets.
Household consumes an imported good.
Assume: demand for exportables perfectly elastic; zero access to capital markets; external equilibrium
at, X - J = 0.
98
Production possibility frontier (PPF): Defines the maximum achievable combinations of
exportables and nontradables that the economy can supply, given by,
Y = F(YX, Yns ;) (71)
with Y assumed fixed (e.g. full employment to all production factors).
99
Using a constant elasticity of transformation (CET) function:
Y = [YX + (1 - )YN
]1/ ,
with
0 < < 1, 1 < < +. Elasticity of transformation, ,
1 - 1 =
100
Efficient ratio of exportables to nonexportables in output as:
YX/Yns = h1(PX , PN ) (72)
PN : price of home goods;PX : price of exportables.
Price of aggregate output:
PY = g1(PX , PN ). (74)
Thus
PYY PXYXs + PNYN
S (75)
101
Household consumption function,
Qs = q(Ynd, J; ) (76)
Qs = [YN + (1 - )J]1/ ,
0 < < 1, - < < 1
1 1 -
= : elasticity of substitution.
102
Desired ratio of imported, home goods,
J/Ynd = h2(PJ , PN ). (77)
Aggregate supply of the composite good and import, nontradables demand related by,
PQQs PJ J + PNYNd . (80)
Household total income, V,
V = PYY (81)
103
With all income spent on composite goods,
V PQQd (83)
Equilibrium conditions Demand and supply of nontradables:
Yns = Yn
d (84)
Demand and supply of composite goods:
Qs = Qd (85)
104
Balanced trade:
PJ J - PXYX = 0 (86)
Constraints not independent as in Walras’ Law. Model satisfies all three identities in the following equation:
PN(Yns - Yn
d) + PQ (Qs - Qd) + PJ J - PXYX = 0
105
Figure 9.7: illustration of the model. World prices are normalized to unity, PX
* = PJ*.
Balance of trade constraint shown as 45-degree line in quadrant 1.
PPF (71) and CPF shown as mirror images with balanced foreign trade.
Absorption (maximizing (76)) occurs at point of tangency between isoabsorption curve and consumption possibility frontier.
106
Figure 9.7Equilibrium in the 1-2-3 Model
Source: Adapted from Devarajan et al. (1997, p. 164).
C
A
J
XNYd
Market for home goods
NY s
Trade balance
NP /PX
NP /PJ
NQ = q(J,Y ;s d
45º
BX = J
107
Adverse Terms-of-Trade Shock
Suppose import prices, PJ*, increase.
Figure 9.8: PN/PJ remains constant; imports decline; new equilibrium at lower utility, consumption of both
imports and home goods have declined (e.g. income and substitution effect);
value of import rises, exports must rise; real exchange rate must depreciate.
108
Figure 9.8An Adverse Terms-of-Trade Shock in the 1-2-3 Model
Source: Adapted from Devarajan et al. (1997, p. 167).
C
A
J
XNY d
Market for home goods
NY s
Trade balance
NP /PX
NP /PJ
NQ = q(J,Y ;s d
45º
C' B'
B
A'
X = J
109
Real exchange rate, depreciate?
Contingent on the elasticity of substitution between imports and home goods, .
If 0, isoabsorption curves are L-shaped, real exchange rate will depreciate
If , isoabsorption curves are flat; tangency with new CPF will occur to the left of initial equilibrium consumption point, C. Demand for home goods rises and the real exchange rate appreciates.
110
Income and substitution effects: If < 1, the income effect dominates. Reduction in
output of nontradables and an increase in output of exportables.
Real depreciation: If > 1, substitution effect dominates. Real exchange
rate appreciates If = 1, there is no change in either real exchange
rate or production.
111
Investment, Saving, and the Government
Two extensions: government sector and investment Government imposes tariff on imported goods at rate,
0 < J < 1,
PJ = (1 + J)EPJ*
112
Sales price of composite good, cost of living index, differs from PQ , by sales tax, 0 < s < 1,
PS , = (1 + s)PQ
and,
PQQs PJ J + PSYNd .
113
Houshold income, V,
V = PYY + PQNTgg + E ·NTf
h
NTgg : net transfers from government.
NTfh : net transfers from abroad.
Share of household income used on composite good,
PSQhd = (1 -sh - V)V,
sh : household savings rate.
114
Government sector: Government revenues:
T = J EPJ*J + S PQQd + V V
Government savings:
Sg = T - PQG - PQNTgh
Aggregate savings:
S = Sg + sVV
115
Market-clearing conditions: External balance:
PZ*Z - PX
*X - NTfh = 0.
Equality between saving and investment:
PsI = S
116
Lags and Behavioral Functions
117
Accounting for lags: critical for establishing short-term projections.
Two types of lags: Inside lags: legal and institutional delays involved
in implementing a change in policy. Outside lags: delay involved between
implementation of a policy and its effects on the target variables.
118
Endogeneity of lags: often affected by private agents’ expectations
about the sustainability of the various policies; highly credible policy; with low probability of
reversal may have relatively short lag. Behavioral functions often difficult to estimate in
countries undergoing comprehensive reform programs or large shifts in policy.
In this case, use of relatively sophisticated econometric techniques such as the error correction framework may not be enough to detect stable relationships.