Economic Models and Economic Policies

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Economic Models and Economic Policies

• Nico van der Windt
• 5 December 2005

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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

3
Economic Policies

• Welfare Function
• W W(Y,X,p)
• Objectives (Y)
• Instruments (X)
• Preferences (p)

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Economic Policy Problem

• Max W W(Y,X,p)
• Subject to
• Y f(Y, X, Z)
• in which
• Y is a subset of Y
• Z is vector of other variables

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Objectives (Y)

• Economic growth
• Employment
• Inflation
• Balance of Payments
• Distribution of income
• ---------------------------
• Government Deficit

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Instruments (X)

• Quantitative instruments
• Fiscal instruments
• Monetary instruments
• Non-quantitative instruments
• Legal instruments
• Institutional instruments

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Fiscal instruments

• Taxes tax base tax rates and various types of
  taxes
• Government expenditures consumption and
  investment expenditure
• Below the line different modalities to finance
  the deficit

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Monetary instruments

• Interest rates
• Money supply
• Quantitative restriction in for example credit
  provision by banks

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

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Institutional instruments

• Public Institutions for support to private sector
  activities
• Examples Competition Agency Energy agency
  Chambers of Commerce Foreign Investment
  agencies, etc.
• Reduction of red tape

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Problems with welfare function

• W W(Y,X,p)
• Quantitative only
• Preferences not known
• Preferences not stable over time
• Mathematical function not known
• (Theils Certainty Equivalence require quadratic
  function)

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Economic Models

• Y f(Y, X, Z, e)
• Large variety of different models
• Different models for different purposes
• Long run models, focus on supply
• Short term models, focus on demand
• Hybrid models
• Macro Sector models
• General Equilibrium Models

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Long-term models

• Focus on supply
• Production function
• Volume and quality of Capital and labour
• Important role of prices on adjustments
• (Stable) long-term growth path
• Functioning of markets
• Short term aberrations do not have an impact on
  long term growth path

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Short-term models, main features

• Focus on various components of demand
• Focus on short-term fluctuations
• Overall capacity is considered exogenous
• Minor influence of prices on volumes

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Hybrid models

• Focus on medium term, say up to 5 to 7 years
• Combination of supply and demand
• Long term solution comparable with that of
  long-term models
• Short-term fluctuations around long-term growth
  path

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Macro versus sector models

• Macro models focus on aggregate, assuming that
  the sector composition does not matter for total
• Sector models focus on industrial structure of
  the economy, assuming that sector composition is
  important for the aggregate

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General Equilibrium Models

• Main assumption prices generate equilibrium
  between supply and demand
• Often static, describing one state of equilibrium
  and compares this with an equilibrium under
  different assumption of exogenous variables
• Recently also dynamic, describing the path from
  one equilibrium to another state of equilibrium

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Problems with models - 1

• Y f(Y, X, Z, e)
• Models give only a simplified and stylised view
  of a complex real world

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Problems with Models - 2

• Models are always incomplete
• Uncertainty in behavioural equations
• Instability of parameters
• Instability over time
• Parameters not invariant under policy change
  (Lucas critique)
• Local validity

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Advantages of Models

• Structure and focus the discussion
• Coping with complexity
• Consistency
• Accountability
• Yet, always question the validity of the model
  for the problem at hand

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Sensitivity of results

• Results are in particular sensitive for
  specification of
• Wage equation
• Investment
• Exports and imports

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Example Wage Equation

• WPRPC
• 1.00 (0.66PCNPC 0.34PYPC)
• 1.00 LABPROD
• 1.00 WEDGE1
• 0.75 WEDGE2(-1)
• - 0.36 (UR(-4) 10.00)
• R-squared 0.92

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Implications wage equation - 1

• Terms of trade effect through (PC/PY)
• Shifting indirect taxes to employers (PC)
• Shifting burden of taxes and social security
  premiums to employers (WEDGE)
• Additional real wage increases if unemployment
  rate is above 10 (UR)

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Implications wage equation - 2

• Taxes and contributions to social security
  affects cost per unit of output
• Balanced budget multiplier (that is expenditure
  increase financed through additional taxes)
  negative

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Example Imports and Exports

• Observations Czech economy
• both export and import GDP ratios have increased
  considerably over past decade
• Difficult to find satisfactory econometric fit
• Both demand and supply approach not satisfactory

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Use of Economic Models in Economic Policies

• Forecasting (baseline)
• Uncertainty simulations
• Sensitivity analysis
• Policy simulations

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Forecasting

• Y A Y S (B(i) Y(t-i))
• S(C(i) X(t-i1))
• S (D(i) XROW(t-i1)) i 1,,n
• Parameter uncertainties (A, B(i), C(i), D(i))
• Uncertainty policy reactions (X)
• Uncertainty outside world (XROW)

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Forecasting errors

• CPB main errors in variables external world
• Errors in estimated parameters
• Bias omitted variables
• Lack of fiscal policy rules, difficult to
  estimate
• Unclear monetary policy rules

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Use of Models in Economic Policy

• W W(Y,X,p)
• Example quadratic loss function
• L a(i) (Y(i) Y(i))2
• b(j) (X(j) X(j))2
• With model Y F(Y,X) as constraint

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Problems

• Welfare/Loss function not known
• Welfare/Loss function not stable
• Model uncertainty
• Certainty Equivalence only valid for quadratic
  welfare function
• Technical approach to optimization of welfare
  function tends to yield useless results

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Trial and Error

• Discussion between model builder and experts
• Discussion between model builder and policy maker

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Trial and error procedure

• Policy maker suggests particular set of
  instrument values
• Analysis and translation into model input by
  model builder
• Model results supplemented with expert knowledge
• Overall results translated for policy maker
• Discussion between model builder, expert and
  policy maker
• Revised set of instrument values

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Preferences through trial and error process

• Policy makers unlikely to provide well-defined
  welfare function, because they
• Do not have the technical skills
• They dont know the consequences of their
  preferences
• They are not willing to reveal their preferences

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Preferences through trial and error

• Confrontation with likely outcome of concrete
  policy proposal forces them to
• Formulate better set of instrument values
• Define additional targets
• Think about additional conditions

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Requirements model builder

• Be clear and comprehensive in his reporting
• Show trade offs between objectives
• Show trade offs between instrument values
• Show feasibility of various policy packages

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Usefulness of Economic Models in Economic Policy
making

• Structuring of discussion through
• Focusing of the discussion
• Quantification of the problems
• Clarification of the relative importance of the
  problems
• Clarification of feasibility of policy options

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Usefulness of Economic Models in Economic Policy
making

• Although they simplify reality models can cope
  with complexity
• Models indicate 2nd and higher order effects
  through feed backs
• Models cope with simultaneity
• Models calculate accurately
• Models have a good memory

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Usefulness of Economic Models in Economic Policy
making

• Models are consistent if specified correctly
  within the national accounting system

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Usefulness of Economic Models in Economic Policy
making

• Accountability
• Models and model calculations can be checked by
  3rd parties
• Models and model calculations can be compared
  with competing alternatives

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Czech example

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

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Similarities and Differences

• Similarities
• Similar theoretical basis
• Optimising behaviour economic agents
• Supply and demand in relevant markets
• Similar Production functions
• Mark-up in prices
• Consistent accounting framework
• Dynamic

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Similarities and Differences

• Differences
• Macro lt-gt sector
• Quarter lt-gt annual
• Calibration/estimation lt-gt calibration

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Use of Models in Czech Republic

• Quarterly model
• Short- to Medium-Term forecasting
• Fiscal policies (aggregate)
• Sensitivity analysis exogenous variables
• Sensitivity analysis policy options

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Use of Models in Czech Republic

• Sector Model
• Long-term forecasting
• Fiscal policies -gt sector impact
• Sector policies
• Sensitivity analysis -gt sector impact

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Use of Models in Czech Republic

• It would be useful to confront model forecasts
  and simulations with expert knowledge in
  systematic way
• It would be useful to systematically use the
  models in a trial and error setting as described
  above
• It would be useful to systematically compare the
  model simulations and explain differences

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Some Conclusions - 1

• Models useful for understanding main economic
  mechanisms
• Models useful in discussion on economic policy
  packages

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Some Conclusions - 2

• Models as basis for economic policy preparation
  available
• Modelling continuous activity
• Continuous re-estimation of parameters required
• More discussions between model builders and
  experts
• More discussions between model builders/experts
  and policy makers

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Some Conclusions - 3

• Strengthening model building departments
• Procedures for use of models in policy
  discussions
• Further research