economic models and economic policies
DESCRIPTION
Economic Models and Economic Policies. Nico van der Windt 5 December 2005. Content of the presentation. Economic Policies Economic Models Use of Economic Models in Economic Policies Usefulness of Economic Models in Economic Policies Czech example Some Conclusions. Economic Policies. - PowerPoint PPT PresentationTRANSCRIPT
2
Content of the presentation
1. Economic Policies2. Economic Models3. Use of Economic Models in Economic Policies4. Usefulness of Economic Models in Economic
Policies5. Czech example6. Some Conclusions
3
1. Economic Policies
Welfare Function:
W = W(Y,X,p)
Objectives (Y) Instruments (X) Preferences (p)
4
Economic Policy Problem
Max W = W(Y*,X,p)Subject to
Y = f(Y, X, Z)
in which: Y* is a subset of Y Z is vector of other variables
5
Objectives (Y*) Economic growth Employment Inflation Balance of Payments Distribution of income--------------------------- Government Deficit
6
Instruments (X)
Quantitative instruments: Fiscal instruments Monetary instruments
Non-quantitative instruments: Legal instruments Institutional instruments
7
Fiscal instruments Taxes: tax base; tax rates and
various types of taxes Government expenditures:
consumption and investment expenditure
Below the line: different modalities to finance the deficit
8
Monetary instruments Interest rates Money supply Quantitative restriction in for
example credit provision by banks
9
Legal instruments Articles in the law about for example
competiton and regulation of markets
Bankruptcy law Law and regulations related to
private sector activities
10
Institutional instruments Public Institutions for support to
private sector activities Examples: Competition Agency;
Energy agency; Chambers of Commerce; Foreign Investment agencies, etc.
Reduction of “red tape”
11
Problems with welfare function
W = W(Y*,X,p)
Quantitative only Preferences not known Preferences not stable over time Mathematical function not known
(Theil’s Certainty Equivalence require quadratic function)
12
2. Economic ModelsY = f(Y, X, Z, e)
Large variety of different modelsDifferent models for different purposes:
Long run models, focus on supply Short term models, focus on demand Hybrid models Macro & Sector models General Equilibrium Models
13
Long-term models Focus on supply
• Production function• Volume and quality of Capital and labour
Important role of prices on adjustments (Stable) long-term growth path Functioning of markets Short term aberrations do not have an
impact on long term growth path
14
Short-term models, main features
Focus on various components of demand
Focus on short-term fluctuations Overall capacity is considered
exogenous Minor influence of prices on volumes
15
Hybrid models Focus on medium term, say up to 5
to 7 years Combination of supply and demand Long term solution comparable with
that of long-term models Short-term fluctuations around long-
term growth path
16
Macro versus sector models Macro models focus on aggregate,
assuming that the sector composition does not matter for total
Sector models focus on industrial structure of the economy, assuming that sector composition is important for the aggregate
17
General Equilibrium Models Main assumption: prices generate
equilibrium between supply and demand Often static, describing one state of
equilibrium and compares this with an equilibrium under different assumption of exogenous variables
Recently also dynamic, describing the path from one equilibrium to another state of equilibrium
18
Problems with models - 1
Y = f(Y, X, Z, e)
Models give only a simplified and stylised view of a complex real world
19
Problems with Models - 2 Models are always incomplete Uncertainty in behavioural equations Instability of parameters:
• Instability over time• Parameters not invariant under policy
change (Lucas critique)• Local validity
20
Advantages of Models Structure and focus the discussion Coping with complexity Consistency Accountability
Yet, always question the validity of the model for the problem at hand
21
Sensitivity of results
Results are in particular sensitive for specification of:
Wage equation Investment Exports and imports
22
Example Wage Equation
WPRPC =
+ 1.00 * (0.66*PCNPC + 0.34*PYPC)
+ 1.00 * LABPROD
+ 1.00 * WEDGE1
+ 0.75 * WEDGE2(-1)
- 0.36 * (UR(-4) – 10.00)
R-squared = 0.92
23
Implications wage equation - 1 Terms of trade effect through (PC/PY) Shifting indirect taxes to employers (PC) Shifting burden of taxes and social
security premiums to employers (WEDGE) Additional real wage increases if
unemployment rate is above 10% (UR)
24
Implications wage equation - 2 Taxes and contributions to social
security affects cost per unit of output
Balanced budget multiplier (that is expenditure increase financed through additional taxes) negative
25
Example Imports and Exports
Observations Czech economy: both export and import GDP ratios
have increased considerably over past decade;
Difficult to find satisfactory econometric fit
Both demand and supply approach not satisfactory
26
3. Use of Economic Models in Economic Policies
Forecasting (baseline) Uncertainty simulations Sensitivity analysis Policy simulations
27
Forecasting
Y = A * Y + Σ (B(i) * Y(t-i)) + Σ(C(i) * X(t-i+1)) +Σ (D(i) * XROW(t-i+1)) i = 1,…,n
Parameter uncertainties (A, B(i), C(i), D(i))
Uncertainty policy reactions (X) Uncertainty outside world (XROW)
28
Forecasting errors CPB: main errors in variables
external world Errors in estimated parameters Bias omitted variables Lack of fiscal policy rules, difficult to
estimate Unclear monetary policy rules
29
4. Use of Models in Economic Policy
W = W(Y*,X,p)
Example quadratic loss function:
L = a(i) * (Y*(i) – Y*(i))2 +b(j) * (X(j) – X(j))2
With model Y = F(Y,X) as constraint
30
Problems Welfare/Loss function not known Welfare/Loss function not stable Model uncertainty Certainty Equivalence only valid for
quadratic welfare function Technical approach to optimization
of welfare function tends to yield useless results
31
Trial and Error Discussion between model builder
and experts Discussion between model builder
and policy maker
32
Trial and error procedure1. Policy maker suggests particular set of
instrument values2. Analysis and translation into model input
by model builder3. Model results supplemented with expert
knowledge4. Overall results translated for policy maker5. Discussion between model builder, expert
and policy maker 6. Revised set of instrument values
33
Preferences through trial and error process
Policy makers unlikely to provide well-defined welfare function, because they:
Do not have the technical skills They don’t know the consequences
of their preferences They are not willing to reveal their
preferences
34
Preferences through trial and error
Confrontation with likely outcome of concrete policy proposal forces them to
Formulate better set of instrument values
Define additional targets Think about additional conditions
35
Requirements model builder Be clear and comprehensive in his
reporting Show trade offs between objectives Show trade offs between instrument
values Show feasibility of various policy
packages
36
5. Usefulness of Economic Models in Economic Policy making
Structuring of discussion through Focusing of the discussion Quantification of the problems Clarification of the relative
importance of the problems Clarification of feasibility of policy
options
37
Usefulness of Economic Models in Economic Policy making
Although they simplify reality models can cope with complexity:
Models indicate 2nd and higher order effects through feed backs
Models cope with simultaneity Models calculate accurately Models have a good memory
38
Usefulness of Economic Models in Economic Policy making
Models are consistent if specified correctly within the national accounting system
39
Usefulness of Economic Models in Economic Policy making
Accountability Models and model calculations can
be checked by 3rd parties Models and model calculations can
be compared with competing alternatives
40
5. Czech example
Current situation: Quarterly (econometric) model Sector model for MIT Sector model for MoF
41
Similarities and Differences
Similarities: Similar theoretical basis
• Optimising behaviour economic agents• Supply and demand in relevant markets• Similar Production functions• Mark-up in prices
Consistent accounting framework Dynamic
42
Similarities and Differences
Differences: Macro <-> sector Quarter <-> annual Calibration/estimation <->
calibration
43
Use of Models in Czech Republic
Quarterly model: Short- to Medium-Term forecasting Fiscal policies (aggregate) Sensitivity analysis exogenous
variables Sensitivity analysis policy options
44
Use of Models in Czech Republic
Sector Model: Long-term forecasting Fiscal policies -> sector impact Sector policies Sensitivity analysis -> sector impact
45
Use of Models in Czech Republic It would be useful to confront model
forecasts and simulations with expert knowledge in systematic way
It would be useful to systematically use the models in a trial and error setting as described above
It would be useful to systematically compare the model simulations and explain differences
46
6. Some Conclusions - 1
Models useful for understanding main economic mechanisms
Models useful in discussion on economic policy packages
47
Some Conclusions - 2
Models as basis for economic policy preparation available
Modelling continuous activity Continuous re-estimation of parameters
required More discussions between model builders
and experts More discussions between model
builders/experts and policy makers