Lecture Notes in Economics and Mathematical Systems 366

Josef Gruber Editor

Econometric Decision
Models
New Methods of Modeling and Applications
 Lectu re Notes
in Economics and
Mathematical Systems
Managing Editors: M. Beckmann and W. Krelle

366

J. Gruber (Ed.)

Econometric Decision Models

New Methods of Modeling
and Applications
Proceedings of the Second International Conference
on Econometric Decision Models
University of Hagen, Held in Haus Nordhelle
August 29 - September 1, 1989

Ii Springer-Verlag Berlin Heidelberg GmbH

Editorial Board

H.Albach M. Beckmann (Managing Editor)

P Dhrymes G. Fandel G. Feichtinger W. Hildenbrand W. Krelle (Managing Editor)
H. P Kunzi K. Ritter U. Schittko P Schonfeld R. Selten W. Trockel

Managing Editors
Prof. Dr. M. Beckmann
Brown University
Providence, RI 02912, USA

Prof. Dr. W. Krelle

Institut fur Gesellschafts- und Wirtschaftswissenschaften
der Universitiit Bonn
Adenauerallee 24-42, W-5300 Bonn, FRG

Editor
Prof. Dr. Josef Gruber, Ph. D.
University of Hagen
Chair of Statistics and Econometrics
Feithstr. 140, W-5800 Hagen 1, FRG

ISBN 978-3-540-54373-2 ISBN 978-3-642-51675-7 (eBook)

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Preface
This volume contains a refereed selection of revised papers which were originally presented at the
Second International Conference on Econometric Decision Models, University of Hagen (FernUni-
versitat). The conference was held in Haus Nordhelle, a meeting place in the mountainous area
" Sauerland" , some 50 kilometers south of Hagen, on August 29 - September 1, 1989. Some details
about this conference are given in the first paper, they need not be repeated here.

The 40 papers included in this volume are organized in 10 "parts", shown in the table of contents.
Included are such "fashionable" topics like "optimal control", "cointegration" and "rational expec-
tations models". In each part, the papers have been arranged alphabetically by author, unless there
were good reasons for a different arrangement. To facilitate the decision making of the readers, all
papers (except a few short ones) contain an abstract, a list of keywords and a table of contents. At
the end of the proceedings volume, there is a list of authors.

More than ten years ago, I began to organize meetings of econometricians, mainly called "seminar"
or " colloquium". One major purpose of these meetings has always been to improve international
cooperation of econometric model builders (and model users) from "the East" and "the West".
Unprecedented changes to the better have taken place recently ("perestroika"). For a large fraction
of participants from the Soviet Union, the 1989 conference was the first conference in a Western
country.
This improvement in international scientific cooperation regrettably shows up in publications only
with a rather long lag. This proceedings volume is no exception to this rule.

I wish to thank very cordially all persons and institutions which have directly or indirectly con-
tributed to this volume. To mention but a few: the authors of the papers, the anonymous referees,
the editors of the Lecture Notes in Economics and 1Iathematical Systems and the Springer- Verlag
in Heidelberg.

I gratefully acknowledge financial support from the Deutsche Forschungsgemeinschaft (DFG), the
University of Hagen, the Gesellschaft der Freunde der FernUniversitat, Siemens AG, IBM, Com-
merzbank AG (Hohenlimburg and Elsey), Sparkasse Hagen and Sparkasse Witten. PCs for the
demonstration of software and decision support systems have been made available during the con-
ference by IBM and Siemens AG.

Last but not least I want to thank the staff members of the Chair of Statistics and Econometrics,
University of Hagen. Special thanks go to Mrs. Elke Greber, my secretary. She has shared with
me the burden of organizing the conference and of preparing this proceedings volume. Above all,
her admirable skills in text processing have shaped this proceedings volume in a very favorable way.

To alleviate poverty and misery in the world, to contribute to the sustainable existence of mankind,
decision errors in all fields of human activity have to be minimized. In a small but nonetheless
extremely important area, econometric decision models can contribute significantly to reduce de-
cision errors. Considerable gains can accrue to society from the more widespread use of improved
econometric decision models, built on the basis of better data, especially microdata. May this
proceedings volume strongly stimulate appropriate developments. We bear great responsibility!

Hagen, June 10, 1991

Josef Gruber
Table of Contents
Preface
Josef Gruber

PART 1: ECONOMETRIC DECISION MODELS: INTRODUCTION TO THE

CONFERENCE AND SURVEY OF SOME RECENT DEVELOPMENTS

1. Introd uction to the conference on econometric decision models:

for better balanced research and more interdisciplinary and
international cooperation 3
Josef Gruber

2. Some recent developments in policy making with macroeconometric models 15

Kenneth F. Wallis

PART 2: OPTIMAL CONTROL OF ECONOMETRIC DECISION MODELS 37

3. Optimal stabilization with a macroeconometric model for Hungary: investigating the

effects of different objective functions and time horizons 39
Glibor Bagdy

4. On causality and control in economic systems 51

Michael Leserer

5. Optimal control of nonlinear stochastic macroeconometric models: an algorithm and

an economic example 57
Josef Matulka and Reinhard Neck

6. Game theoretical approach to optimal control of economic systems 79

f( rystyna Strzala

7. Nonlinear optimal control simulations of development strategies 94

Ivan Sujan and Osvald Vasicek

8. On some properties of the solution of the optimal control problem for the original
long-term macroeconomic model 119
Vladimir Vasiliev

PART 3: MULTIPLE CRITERIA DECISION MAKING (VECTOR

OPTIMIZATION) WITH ECONOMETRIC MODELS 129

9. Implementing the refercnce-point approach to multi-criteria decision making in

econometric modcls in the computerprogram LOS 131
Gyorgy Barabas

10. Optimal economic policy making with an econometric model using interactive methods
of vector optimization 149
Bernhard Bohm and Peter Brandner
 VI

PART 4: CONSTRUCTING OBJECTIVE SCALARVALUED FUNCTIONS FOR

ECONOMETRIC DECISION MODELS 165

11. Public preferences and their role in the design of economic policy 167
Andrew Hughes Hallett

12. Least squares estimation of quadratic preference functions for econometric decision
models based on survey data 185
Hartmut Hiisges and Josef Gruber

13. Operationalizing a macro-economic preference function 205

Arnold H. Q.M. Merkies and ivfarjan W. Hofkes

14. On constructing objective functions 222

Andranick S. Tanguiane and Josef Gruber

15. Optimal dictatorial and multi-dictatorial choice in Arrow's model with applications to
multicriteria decision making 248
Andranick S. Tanguiane

PART 5: RATIONAL AND ADAPTIVE EXPECTATIONS MODELS 267

16. Rational versus adaptive expectations in present value models 269

Gregory C. Chow

17. The Finnish rational expectations QMED model: estimation, dynamic properties and
policy results 285
Ari Lahti and Matti Viren

18. Qualms about the linearized expectations hypothesis and variance-bounds studies of
the interest rate term structure 305
Gary S. Shea

PART 6: COINTEGRATION: ESTIMATORS, TESTS AND APPLICATIONS 321

19. The power function of the likelihood ratio test for cointegration 323
S{Jren Johansen

20. Long-run relations in a well-defined statistical model for the data generating process.
Cointegration analysis of the PPP and the UIP relations for Denmark and Germany 336
/(atarina Ju.seiiu.s

21. Interest rate linkages between EC countries participating in the European monetary system:
an application of cointegration 358
Wilhelm Fritz
 VII

PART 7: ECONOMETRIC ESTIMATORS AND TESTS FOR VARIOUS MODELS

AND THEIR PROPERTIES 383

22. Estimating the second moments of random coefficients 385

Karsten-Dietmar Freimann

23. Tighter bounds for the effects of ARMA disturbances on tests for regression coefficients 404
Jan F. [(iviet

24. True vs. nominal size of the F-test in the linear regression model with autocorrelated
disturbances 419
Walter [(ramer, Jan [(iviet and Jorg Breitung

25. Asymptotic and small-sample properties of the fixpoint-estimator for rational

expectations models 429
Manfred Losch

26. The analysis of non-metric endogenous variables in latent variable models:

The MECOSA approach 459
Andreas Schepers, Gerhard Arminger and Ulrich L. Kiisters

27. Econometric modelling with interval coefficients - a non-stochastic approach 473

llIax Christoph Wewel

PART 8: ANALYZING THE STRUCTURE AND SENSITIVITY OF ECONO-

METRIC MODELS 485

28. Optimal triangulation of a matrix and a measure of interdependence for a linear

econometric eq uation system 487
Jilrgen Bartnick

29. Evaluating the number of zero eigenvalues in a dynamic model 496

Myriam Garbely and Manfred Gilli

30. Forecast and multiplier sensitivity analysis with respect to changes of structural
equations and submodels in dynamic systems 502
Johann Elker

31. Structural sensi t i vi ty analysis in econometric models: an application to the model of

the \Vest Germany textile and apparel industry 516
Wiltrue! Terlau
 VIII

PART 9: ECONOMETRIC MODELING OF ENVIRONMENTAL AND ENERGY

PROBLEMS 537

32. The optimum price of energy: a thermoeconomic analysis 539

Helmuth-At. Groscurth and Reiner Kummel

33. Energy resources depletion and economic growth 546

Oleg A.. Eismont

34. Econometric methods as an instrument for estimating external costs per unit of
emission: the case of a groundwater model 551
A/onika Vorreyer

PART 10: ECONOMETRIC MODELS OF COUNTRIES, MARKETS ETC.,

BASED ON MICRODATA AND MACRODATA, AND THEIR
PERFORMANCE IN POLICY ANALYSES 557

35. Microeconometric research at the Sonderforschungsbereich 3 559

Heinz P. Galler

36. Income and price policy making with an econometric model of financial incomes and
expenditures of Poland's population 570
Wieslaw Debski

37. Keynesian or classical unemployment in West Germany? - an empirical analysis

with a disequilibri um model 588
Hermann-losef Hansen

38. A macroeconometric disequilibrium model for Poland 591

lerzy Romanski and Wladyslaw Welfe

39. Evaluating econometric models: the 1988 forecast of the RWI-business cycle model
in retrospect 610
Ullrich fIeilemann

40. The macroeconometric model of the Deutsche Bundesbank - a brief review 626
Max Christoph Wewel

Alphabetical list of authors 635

 PART 1:

ECONOMETRIC DECISION MODELS: INTRODUCTION TO THE CONFERENCE

AND SURVEY OF SOME RECENT DEVELOPMENTS
Introduction to the conference on econometric decision models:
for better balanced research and more interdisciplinary and in-
ternational cooperation

Josef Gruber
Fern Uni versitat Hagen
Lehrgebiet Statistik und Okonometrie
Feithstr. 140, D-5800 Hagen 1, FRG

Abstract
This paper contains (with only very minor changes) the introductory remarks I made at the opening
of the Second International Conference on Econometric Decision Models, University of Hagen, held
in Haus Nordhelle, August 29 - September 1, 1989. The major objectives of the conference are
stated in section 2. In this connection some imbalances in our research efforts and in university
education are briefly discussed. Section 3 is about types of econometric decision models; some
historical facts and (in a rather selective manner) some recent developments are briefly indicated,
thus also informing about my motivation for organizing this conference. In section 4 it is stressed
that successfully constructing and applying econometric decision models requires interdisciplinary
and international cooperation, and some concrete measures are suggested.
Keywords: Types of econometric decision models; specifying scalarvalued objective functions;
multiple criteria decision making; vector optimization; E.E. Rosinger's interactive procedure; ref-
erence point approach; generalized small sample research; improved data bases.

Contents
A cordial welcome to the international audience and a plea for more cooperation

2 Major objectives of the conference

3 Types of econometric decision models: some history and selected recent developments

4 Interdisciplinary and international cooperation as a major stimulant of decision modeling

References

1 A cordial welcome to the international audience and a plea for

more cooperation
I cordially welcome all participants in the Second International Conference on Econometric Decision
Models of the University of Hagen! It is a great privilege for me that so many distinguished
econometricians have accepted my invitation. Considering you, the audience, there is a very good
chance that the conference will be successful, that your and my objectives of the conference will be
reached.
The very fine facilities of Haus Nordhelle, the beautiful mountainous environment and the fine
weather will also contribute to the success of the conference.
My efforts in organizing this conference bear fruit already now: Haus ~ordhelle is filled to capacity.
In total there are some 90 registered participants. More than one third of all participants come
 4

from the Federal Republic of Germany, somewhat less than one third from neighbouring countries
in the West (including the USA) and about one third from eastern countries (including the USSR).
From West Germany, there are, for example, colleagues from universities, from the "large" institutes
for economic research and, what is very important for me, from Federal Ministries in Bonn, from
the Bundesbank in Frankfurt and from the Bavarian Ministry of Agriculture in Munich.
This mixture of econometricians with different backgrounds, with different tasks in their daily life
(from purely theoretical work to purely applied econometric work) is an important condition for
a fruitful conference on econometric decision models: Econometric decision models can bear full
fruit to society only if they are seen as a multidisciplinary (an interdisciplinary) effort.
I again very cordially welcome all of you.
I am especially pleased that so many distinguished colleagues from the Soviet Union have been able
to attend this conference: Almost one fourth of all participants come from the USSR, mainly from
the large research institutes of the Academy of Sciences in Moscow, Kiev, Novosibirsk and Tashkent.
This large group of colleagues from the USSR is something new. In other international conferences
(like those of the Econometric Society) in recent years at most one percent of all participants came
from the USSR.
I hope that this large delegation from the USSR signals some important new development: the
improved possibility of international cooperation, the long-run cooperation beyond the borders
of political, social and ideological blocks. I encourage, I even urge all of you to establish strong
personal contacts during this conference, which, as a rule, are a condition for cooperation to the
mutual benefit of all partners involved.
On the last day of the conference it is exactly 50 years that Hitler-Germany began World War II.
Now the so-called cold war, which has lasted some 40 years, seems to come to an end. If this is
true large parts of the gigantic defense budgets in the west and the east can be used to fight such
everlasting enemies of mankind like illiteracy, illness, poverty, overpopulation and the destruction
of nature.
Never before in recent decades the chances have been so good for the development of long-run and
large-scale international cooperation between east and west. If this conference brought nothing but
a strong stimulus to such a cooperation in econometric modeling, it alone would already be worth
the effort and the funds invested in it.

2 Major objectives of the conference

What are the major objectives of this conference? Instead of listing and explaining the objectives
of this conference, as I see them, I simply ask some questions. In doing so, I sometimes also make
some assertions (which, in their brevity, may look and sound like exaggerations). Now and then, I
also try to give a partial answer. I also indicate briefly some imbalances in our research efforts. A
major objective of the conference will be to give more satisfactory answers to questions like those
posed below.

a) \Vhat are recent developments in theory, methods, algorithms and software systems, which
are promising for one or the other phase of constructing and applying econometric decision
models?

b) What has been learned, what can be gained from solid applications of recently developed
theories and methods?
A very large portion of the papers to be presented at this conference will be relevant for
answering these two questions.

c) Are there important developments in the field of data quality and of data availability?
Since even very powerful new methods often bring only a very small return to society if
 5

applied to data of poor quality, I am convinced that it is important to be concerned also with
ways and means for improving the data base for econometric modeling. The improvement
may refer to the quality of existing data sets. It may also refer to new data sets which are
required for modeling new problems (e.g. environmental problems).
I would like to mention here the following three areas of promising activities in West Germany
concerning data quality and data availability.

1. In the DFG-Sonderforschungsbereich 3 (mainly at the University of Frankfurt), large

sets of microdata are obtained by sampling and survey methods. They are econometri-
cally analyzed to answer many questions concerning especially social policy (e.g. social
security, unemployment, tax policies). Professor Galler and Mr. Hansen from this DFG-
Research project are in the audience and will present papers (which are included in this
volume).
2. Pathbreaking, even unique work on creating large data bases on a very detailed regional
level for agriculture in Bavaria has been done during the last 15 or 20 years in a research
division of the Bavarian Ministry of Agriculture in Munich. Data from many different
sources are pulled together in a system called BALIS - Bavarian agricultural information
system. The regional breakdown goes as far as individual plots of land on a farm. BALIS
is used intensively in evaluating the effects of actual or possible measures of agricultural
policy (or of other policies affecting agriculture), from the aggregate level down to the
individual farm level.
The principles put to work in BALIS deserve to be applied also in other branches of
industry and in other sections of society. Dr. Bergermeier will give a report on BALIS
on the last day of this conference, and I am very grateful to him for doing this.
3. A national and regional accounting system especially for environmental problems has
been established in the Statistische Bundesamt in Wiesbaden. This system causes in-
teresting discussions and is well-known in the FRG under the name "ecological book-
keeping". It will become an important data base for environmental modeling and related
policy decisions.

d) \Vhy are econometric decision models not used more frequently as an instrument for preparing
policy decisions?
Behind this question stands my conviction that such models are a powerful tool, that they
should be applied much more often.

e) \Vhat can be done to give the required training in the field of econometric decision models to
a sufficiently large number of model builders and especially to a sufficiently large number of
potential model users?
This question is based on my assertion that, above all, the lack of well-trained people hampers
the more widespread use of econometric decision models.
I guess, for example, that in the Federal and State Ministries in West Germany in which
econometric decision models should playa major role, at most one percent of all employees are
engaged in constructing and applying various types of econometric decision models. Perhaps
only additional two or three percent of the employees are sufficiently well trained so that
modeling results obtained by others can be interpreted correctly and be integrated into the
decision finding process.
What can be done? In view of the problems in public finance (huge public debts etc.), there
is only little chance that a sufficient number of new positions will be created in the ministries.
Maybe that existing positions become available because of retirement. In view of the age
 6

structure of the employees in our ministries, I doubt, however, that this could really solve the
problem in the next 10 or 15 years.
What can nonetheless be done'!
I think, it is extremely important to give additional training in econometric decision models
to people already now working in places like ministries where econometric decision models
should be used more frequently.
The econometrics courses of the University of Hagen, written mainly for students working
towards an academic degree in economics, are also available for students in continuing edu-
cation. Without further effort, these econometrics courses alone will not really solve the
problem. They should probably be combined with seminars, summer schools etc. which are
designed in particular to serve the needs of people in continuing education in econometric
decision models. The only summer school on econometric models in West Germany I am
aware of was organized in 1988 for the first time by RWI, the Rhinian-Westfalian Institute
for Economic Research in Essen. I am very glad that Dr. U. Heilemann, the originator of
this summer school, is in the audience.
Let me now say a few sentences on the situation concerning the basic training in econometrics,
especially in West Germany.

1. Students of economics can complete their program of study at most German universities
without any formal training in econometrics. Since very many students of economics
avoid subjects in which more than elementary mathematics is applied, most of our
graduates in economics today still do not study econometrics. In contrast to this, in
the United States most students in economics do take econometrics courses before they
graduate.
2. In West Germany, there are no programs of study in econometrics for which an academic
degree like Bachelor of Science or Master of Science (in German called "Diplom- ... ") is
awarded. Econometrics can be chosen only as one out of four or five fields in programs
of study in economics (leading to the degree" Diplomvolkswirt", "Diplom6konom" or
"Diplomkaufmann"). As a rule, only some 10 to 20 % of our economics graduates take
econometrics as a field of study. At some universities, econometrics can also be selected
by students in informatics and mathematics. In contrast to this, in the Netherlands
there is a program of study in econometrics: Undergraduates specialize in econometrics
already in their first year and later graduate in econometrics.
3. Doctor's degrees based on a dissertation in econometrics can be earned, as a rule, only
in faculties of economics (there are no faculties of econometrics). Graduates in fields
other than economics at some places have to take additional examinations in economics,
before they can be awarded the doctor's degree.
4. Some colleagues at West German universities tend to teach mainly pure mathematical
statistics in courses labeled econometrics. This does not make econometrics attrac-
tive for students of economics. I know several leading applied econometricians who, as
economists, studied a nonmathematical introduction to econometrics. I know hardly
any leading applied econometrician who learned econometrics from a book or course on
mathematical statistics in econometrics.
For these reasons there are even today not enough young people trained well in econometrics
in Germany. This will seriously hamper the more widespread use of econometric decision
models for decades, unless special efforts are made in continuing education.

How can the credibility of econometric models and modelers be improved?

Economics as a science is plagued with the charge that often different economists give differing
answers to a certain question of economic or social policy.
 7

The best way to overcome this problem is to state preferences explicitly. In case of econometric
decision models this leads to optimization models with a scalarvalued objective function. For
different sets of preferences, the corresponding sets of values of instrument and target variables
can be calculated. Several sessions of this conference deal with this problem. Of great help
may also be model comparison projects like those of the Econometric Modeling Bureau at
the University of Warwick at Coventry, UK. Prof. Kenneth Wallis, the founder and director
of this Bureau and the speaker in the following session, will have to say something also on
this topic.

g) What are areas of research which are most promising, which therefore deserve more research
input?
Standard economic theory tells us that funds (e.g. research funds) are optimally allocated if
the marginal return is the same in each alternative.
I simply assert here the following:

1. The marginal return to society from research for constructing scalarvalued objective
functions for econometric decision models is large. It is probably considerably larger than
the marginal return from developing estimation and testing procedures for traditional
econometric models, especially if these new methods have to be applied to data of poor
quality.
2. The marginal return to society of research and organizational activities for improving
the data base is also large. Microdata on individual households and firms (cross section
data, panel data) can be obtained by sampling and survey methods. In many developing
countries and in all countries with unprecedented changes in society and in the economy
(like in the former East block), econometric models based on time series suffer from
structural breaks. Especially in such cases microdata collection and analyses may be of
great importance.
3. The marginal return from generalized finite sample research is considerable. The applied
econometrician who has to select an estimation method would have to rely almost entirely
on the hope that asymptotic properties of estimators in the correct model are also valid
for small samples under the correct and especially under the incorrect specification, if
no results were available from statistical experiments on the computer (Monte Carlo
studies, MC studies, for short). Such studies are also called "experimental finite sample
research" in contrast to "analytical finite sample research" (see e.g. Mittag 1987, 1989).
It seems advisable to base the choice of an estimation method not on such hopes but
rather on knowledge. Varying a theme of Leontief (1971), it can be stated: Observe
the small sample properties (SSP) of estimators under empirically relevant conditions
(like specification errors) instead of working with irrelevant theoretical assumptions and
unwarranted hopes!
MC studies playa very important role in providing this information on SSP in the near
and probably also the intermediate future. A good case in point is the study of Kramer
(1980) on the rehabilitation of the ordinary least squares estimator (OLS) in economet-
rics. See also Gruber/Fusek/Fuskova (1987). But MC studies produce a voluminous
output that needs to be analyzed statistically in order to "extract" the information
contained in the output. What is even more important: Results of MC studies are
presently often "less general", "more specific" than analytically derived results. But
the "specificity" of MC results can be decreased, their "generality" can be increased
by several measures. They essentially use knowledge about the object modeled (e.g.
about a commodity market or ilbout an economy as a whole), about properties of an
appropriate model (e.g. dynamic stability) and they apply principles and methods of
statistics (e.g. methods of sampling and of regression analysis). Some suggestions for
 8

generalizing finite sample research along these lines have recently become available in
Gruber (1991). See also Hendry (1984), Mariano (1982), Phillips (1983, 1984, 1985).

This concludes my statements on major objectives of this conference. Further objectives will
be referred to below. I would be grateful if further objectives could be added and especially
if we could cooperate during the conference and afterwards to reach the objectives as closely
as possible. We bear great responsibility.

3 Types of econometric decision models: some history and se-

lected recent developments
The central topic of this conference are econometric decision models. There are great variations
in the definition of this term. This may cause misunderstanding and confusion. Therefore, let me
say a few words on the types of econometric decision models which in the Anglosaxon tradition of
econometrics I prefer to distinguish. In doing this, I very briefly indicate some historical facts and
(in a very selective manner) some recent developments. This may also supply some information
about my motivation for organizing this conference on econometric decision models.

3.1 Econometric model with fixed instruments

In this group of econometric models, usually interdependent, recursive and blockrecursive versions
of the structural form are distinguished.
The efforts of econometricians during the last five decades have been concentrated on the eco-
nometric model with fixed instruments: How to estimate the structural parameters and to test
hypotheses about parameters of this model? How to make forecasts of the endogenous variables,
what are the properties of such forecasts?
This type of econometric model is used as a decision model in the following sense: For given
values of the exogenous variables (some of which are used as instruments, often also called control
variables), the corresponding values of the endogenous variables are calculated. In spite of its
simplicity relative to other types of decision models, it can greatly contribute to improved decision
making.
One field of application of this type of model with a very long tradition is the analysis and the
forecasting of business cycles.
In the Federal Republic of Germany, this type of model is used in many places: in the "large" insti-
tutes for economic research (which are located in Essen, Hamburg, Kiel, Munich and Berlin), in the
Bundesbank in Frankfurt, in some ministries at the Federal and the State level, in universities and
in private companies of different size. I am very pleased that so many prominent econometricians
from such model building and model using institutions are participating in and contributing to this
conference.

3.2 Fixed target model

In this type of econometric decision model the reduced form of an econometric model is transformed
in such a way that for fixed values of the target variables the corresponding values of the instrument
variables are determined.
The application of these two types of econometric models to policy decision making was propagated
and successfully practiced al ready in the 19.50s by J an Tin bergen (1952, 1956), one of the fathers of
the theory of quantitative economic policy. He received in 1969, together with Ragnar Frisch, the
first!\" obel prize in economics. For related work on econometric business cycle models Lawrence
Klein was awarded the Nobel prize in 1980.
 9

3.3 Optimization model with a scalarvalued objective function (control theory

model)
This type of econometric decision model avoids a disadvantage of the two types of models mentioned
above: It leads to an optimal set of values of target variables and instrument variables.
It consists of a scalarvalued objective function and of constraints subject to which the objective
function is optimized.
The constraints consist of or are derived from

a) an econometric equation system (an econometric model in the narrow sense of this word, as
used in section 3.1) and/or

b) an input-output model (developed by Wassily Leontief, the Nobel laureate in economics in

1973, and his followers) and/or

c) a system of definitional equations, identities (i.e. equations in which there are no statistically
estimated parameters) and, frequently,

d) inequality constraints (e.g. some resources can be left unused or a positive deviation of a
target variable (like employment) from a desired value is to be treated differently than a
negative deviation).

The objective function of this type of econometric decision model has, among others, the following
properties:

a) It is scalarvalued, i.e. it "aggregates" so to speak all individual target variables (like growth
of GNP, unemployment rate, inflation rate, external balance) into a single measure.

b) It models the preferences of the decision maker (or of a group of decision makers) concerning
the decision problem with the same thoroughness as the constraints model other aspects of
the decision problem.

All information required for obtaining the optimal solution (i.e. the set of optimal values of target
and instrument variables) is put into the setup of the model. The optimal solution is calculated on
the computer without interaction with the decision maker.
Econometric decision models with a scalarvalued objective function are in the tradition of the
founders of the theory of quantitative economic policy. To mention but a few names and books: Jan
Tinbergen (1952, 1956), Ragnar Frisch (1981), Henry Theil (1964), Karl A. Fox, Jati K. Sengupta
and Eric Thorbecke (1966, 1973). A landmark in the combination of this type of decision model
with control theory is the book of Gregory C. Chow (1975). Further important steps of development
are well documented, e.g. in the volumes of Benjamin M. Friedman (1975), of Gregory C. Chow
(1981), of David Kendrick (1981,1988). See also Szegii (1982), Gruber (1983), Carraro and Sartore
(1987), Rao (1987) and Sengupta and Kadekodi (1988).
1 apologize for being unable to cite corresponding names and books from eastern countries.
These and other prominent econometricians have propagated during the last four decades the use
of econometric decision models with a scalarvalued objective function. Reports on the present state
of development are given in this conference in sessions on optimal control of econometric models.
By and large, the construction of such optimization models (mainly with a quadratic objective
function and constraints in the form of linear equations) has, at least in Germany, been confined to
universities. Even here, the objective function is not based on any estimation; its parameter values
are usually obtained by assumption.
This points to a weakness of this type of econometric decision model: The modeling of preferences,
i.e. constructing scalarvalued objective functions, is much less developed or at least much less po-
pular than the modeling of the constraints (1 have already referred to this imbalance in section 2).
 10

An account of the present state of affairs is given in this conference in several sessions on construc-
ting objective functions. The econometric decision models which are optimization models with a
scalarvalued objective function are mathematically closely related to mathematical programming
models (activity analysis models, models of computable general equilibrium). See e.g. Stephan
(1989) and literature stated there.
In modeling oflarge-scale policy problems, one often finds a combination of such models, of econo-
metric models and of input-output models (on the latter, see e.g. Toyomane 1988).

3.4 Optimization model with a vectorvalued objective function (multiple crite-

ria decision making, vector optimization)
This approach to econometric decision models avoids problems connected with explicitly specifying
a scalarvalued objective function. There is no explicitly specified scalarvalued ("overall") objective
function in an econometric vector optimization model. Instead, the preference structure of the
decision maker (or of someone close to hi m, e.g., the econometric analyst) is revealed in part (locally)
by an interactive question-answer procedure. The reduced form equations of the econometric model
are used not only as constraints but also as "individual" objective functions. For example, the
reduced form equation explaining the number of unemployed persons may be such an "individual"
objective function. Therefore, in the econometric vector optimization model there is no need for
incorporating observed or hypothetical information about the type of the scalarvalued objective
function and the numerical values of the parameters of this function. This is of advantage in
applications.
In all interactive vector optimization procedures the "optimality" of the solution is directly deter-
mined by the decision maker. Therefore, the optimum is "subjective". The decision maker may
change his preferences from one solution session to the next (e.g. because of learning about the
feasible solutions available to him). Therefore, the econometric vector optimization model is not
as well suited for simulation studies as the decision model with an explicitly specified scalarvalued
objective function. Since simulation studies often serve the important purpose of exploring decision
alternatives and to "check" the econometric equation system, the vector optimization approach can
be no substitute for the control theoretical approach; it is rather a complement of it. Both approa-
ches have to be applied if better use is to be made of the econometric models for improved decision
making.
In several interactive vector optimization procedures, a feasible combination of instrument and
target variables ("local point", " alternative" , "scenario", "menu") is presented to the decision
maker for evaluation. He then makes his choice. In this respect vector optimization is similar to
decision making on the basis of econometric forecasting systems (without any objective function).
This property of interactive vector optimization algorithms enhances the likelihood that they are
used almost as frequently as econometric forecasting models.
The interactive vector optimization approach to econometric decision models works usually in the
mathematical programming framework. Therefore, inequality constraints ("policy constraints" in
the terminology of quantitative economic policy; see Fox et al. 1973) and nonnegativity conditions
for the solution can be taken into account.
For interactive work, powerful hardware and software is of great importance.
In a research project at the University of Hagen started in the early 1980s, several interactive
methods for multiple criteria decision making in connection with econometric models were reviewed:
E.E. Rosinger's algorithm seemed most promising for this purpose (Rosinger 1981,1982). It was
programmed on the computer and applied to the solution of a "realistic" (but still small) macro-
economic decision problem. Reports on this project are available in Streuff (1983) and in Streuff
and Gruber (1983); see also Gruber (1987).
Later, the reference point approach to interactive vector optimization in econometric decision
models was also investigated at Hagen. Reports are available in Gruber (1983a), Olbrisch and
 11

Gruber (1986), Olbrisch (1988) and Barabas (1991, this proceedings volume).

4 Interdisciplinary and international cooperation as a major

stimulant for decision modeling
For constructing and applying econometric decision models successfully, one needs

• a sound knowledge of theory and subject matter (including data bases) in the field of appli·
cation (e.g. economics, ecology, engineering)

• econometrics (and/or other ... metrics)

• operations research/optimal control

• computer science/informatics and

• systems theory / cy bernetics.

That is:
"Econometric Society econometrics" which is emphasizing almost exclusively mathematical sta-
tistics and mathematical economic theory is not enough. Interdisciplinary cooperation is required
for modeling problems of economic (or other) policy. Several developments in hardware and soft-
ware for handling large models facilitate such a cooperation. The political developments have never
before been so favorable for international cooperation; they have never before required so much in-
ternational cooperation. For example, new economic cooperation among regions and states requires
also new cooperation among model builders and model users.
This conference should help not to ignore in the future so much of the work of colleagues abroad.
How many econometricians from, say, West Germany have ever taken into account in their research
and teaching the publications of colleagues from, say, the Soviet Union? I fear that an investigation
of this question would show a disastrous situation. We almost entirely ignore what is not available
in one's mother tongue or in English.
That we ignore so many research results obtained in the Soviet Union may have many reasons which
need not all be stated here (see e.g. Gruber 1986, 1988). One major reason certainly is that in the
USSR the division of sciences into branches often differs from the division we have in "western"
countries. For example, during my ten weeks' stay in the USSR as a guest of the Academy of
Sciences I have hardly ever met the term "econometrics", neither in oral communication nor in
papers, preprints and reprints received. Another reason is that often only summaries or only rather
short papers are available in English, and are hardly" digestible". What can be done to facilitate
international cooperation of econometric model builders and model users? Only two groups of
concrete measures are mentioned here:

1. Translate full-length papers into English, always using the internationally accepted termi·
nology. In full-length papers the reasoning of the author(s) is easier to follow; they can also
contain the data input used for constructing econometric models, the structural equations in
detail (including criteria usually applied for assessing the quality), and numerical results from
forecasting and simulation. The use of the internationally accepted terminology in English can
best be guaranteed if an authoritative dictionary of statistical/econometric terms can be used
(I am not sure that such a dictionary is available e.g. in Russian/English). The translation
into English by professional interpreters who are not also specialists in econometric modeling
will hardly lead to the required legibili ty in English.

2. It deserves at least some thought how to organize an econometric modeling bureau which
works on a scale beyond individual countries. In section 2 of this paper I referred to the
 12

Econometric Modeling Bureau at the University of Warwick, UK. One of its main objectives
is to compare econometric models for Great Britain. Its activities have to be transferred to
larger economic and political areas, e.g. to the European Common ~Iarket and, hopefully, to
the United States of Europe. Modeling efforts like in the HER~1ES project and in EFOM
(energy flow optimization model) may serve as a starting point for model comparison projects
beyond individual countries in Europe. On the global level the project LINK could serve a
similar purpose. Will it be desirable, necessary and/or feasible to establish e.g. a separate
modeling bureau in Europe, in the world? I don't know. Maybe it suffices to enlarge the tasks
of already existing institutions, instead of creating entirely new institutions. To continue the
examples just mentioned: In Europe something related to the European Communities may
provide the institutional frame; at the globalleyel one or more organizations of the United
Nations may serve this purpose.
The activities of international modeling bureaus would include meetings of international work-
ing groups, international seminars etc., thus also strengthening the international cooperation
of econometric model builders and model users, like this conference.

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Interactive algorithm for multiobjective optimization. Journal of Optimization Theory and Appli-
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Ein interaktives Verfahren der Vektoroptimierung angewandt auf okonometrische Entscheidungs-
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The interactive multiobjective optimization method by Elemer E. Rosinger: a computer program
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SZEGO, G.P. 1982
New quantitative techniques for economic analysis. Academic Press, New York.
THEIL, H. 1964
Optimal decision rules for government and industry. North Holland Publishing Company, Amster-
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TINBERGEN, J. 1952
On the theory of economic policy. North Holland Publishing Company, Amsterdam.
TINBERGEN, J. 1956 - 1967 (rev. 4. ed.)
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Multiregional input-output models in long-run simulation. Kluwer Academic Publishers, Dordrecht,
Boston, Lancaster.
SOME RECENT DEVELOPMENTS IN POLICY MAKING WITH
MACROECONOMETRIC MODELS

Kenneth F. Wallis
ESRC Macroeconomic Modelling Bureau
University of Warwick
Coventry CV 4 7AL
England

Abstract

In many areas of economics competing models coexist, and the decision maker is
typically given little guidance on how to choose between them. Many countries have
competing macroeconometric models of their national economies. This paper describes
some recent developments in policy making with macroeconometric models, drawing on
the research programme of the ESRC Macroeconomic Modelling Bureau. This unique
project was established to improve the accessibility of models of the UK economy and to
undertake comparative research which improves understanding of the reasons for
differences between them and, where possible, resolves those differences. The paper first
reviews the techniques employed in model-based policy analysis. Next, the issues that
arise in designing and implementing model comparison exercises based on their use are
considered. Finally, a recent development in the structure of the models, namely the
incorporation of expectations variables treated in a rational or model--{;onsistent
manner, is described. This is an important challenge to conventional policy analysis,
because the analogy between economic and engineering systems on which it rests no
longer holds. A pervasive theme is that model-based policy analysis should be fully
documented and entirely open. When differences between models cannot be resolved,
the reasons for their existence should be made completely transparent.

Keywords: Macroeconometric models Model comparisons Rational expectations

Economic policy Simulation Optimization

Contents

1 Introduction
2 Policy analysis in conventional macroeconometric models
3 Model comparisons
4 Models with forward expectations variables
References
 16

1 INTRODUCTION

In many areas of economics competing models coexist, and the decision maker is
typically given little guidance on how to choose between them. Many countries have
competing macroeconometric models of their national economies. The properties of such
models are often summarized through dynamic multipliers or ready-reckoners, which
describe the response of key endogenous variables to changes in policy instruments,
treated as exogenous. Different models, constructed for different purposes and from
different theoretical perspectives, perhaps also emphasizing different features of the
economy, may give different estimates of these responses. Likewise, different models
may give different answers to more elaborate questions, such as those that arise in policy
optimization exercises or in the design of feedback policy rules. Such disagreement
places the policy analyst or adviser in a difficult position, moreover little information on
the relative reliability of the different estimates is typically available. The policy maker
ultimately has to make a choice, however, hence it is important to seek to reduce such
disagreement, and where this is not possible, to make clear the reasons for its existence,
so that an informed choice can be made.

This paper describes some recent developments in policy making with macroeconometric
models, drawing on the research programme of the ESRC Macroeconomic Modelling
Bureau. This is a unique research project which brings together the different
econometric models of a national economy, in this case the UK economy, makes these
models accessible to other researchers, and conducts its own independent comparative
and methodological research (see, for example, Wallis et at., 1984-87). Section 2 first
surveys the techniques employed in model-based policy analysis, and Section 3 then
considers the issues that arise in designing and implementing model--{:omparison
exercises based upon their use. A recent development in the structure of
macroeconometric models is the incorporation of explicit future expectations variables,
treated in a model--{:onsistent or "rational" manner, and this is the subject of Section 4.
This development presents some challenges to conventional policy analysis, in particular
acknowledging that "the analogy between engineering and economic systems which
inspired much of the early work on control theory in economics is, quite simply,
misleading. Economic systems, like all systems of social interaction, are intelligent in a
way that engineering systems are not. In economics, we are concerned with the control
of intelligent systems that think about what policy-makers do to them and act
accordingly" (Currie, 1985). Some recent responses to these challenges, in the context of
model-based policy analysis and its associated numerical procedures, are described in
the closing part of Section 4.
 17

An important requirement of model-based policy analysis, as with any other

model-based work, is that it should be fully documented. Large--scale models of
national economies, by their very size and the way in which they continuously evolve,
give particular difficulties of presentation, nevertheless basic reporting standards are
improving and it is essential that this trend be maintained. Equally necessary is a full
account of all the additional assumptions and adjustments to the model that are
typically made in policy exercises, so that the results can be replicated by others and the
particular contribution of each element of the calculation can be assessed. Comparative
research that seeks to explain and resolve cross-model differences clearly requires
openness and accessibility of the individual models, and itself contributes to openness
and accessibility more generally. Noting the remarks of Atkinson (1988) in discussing
the different microeconometric estimates that have been obtained of the effects of
unemployment insurance on the duration of unemployment, we observe that the need to
reduce the amount of disagreement, or at least to make completely transparent the
reasons for its existence, is not confined to macroeconomics.

2 POLICY ANALYSIS IN CONVENTIONAL MACROECONOMETRlC MODELS

The techniques used in model-based policy analysis are reviewed in this section. We
begin with the standard linear simultaneous equation model, to fix ideas, and then
consider the more realistic nonlinear model. Extensions to models with explicit future
expectations variables are reserved until Section 4.

The linear simultaneous equation model

The model describes the relations between the elements of a vector of current
endogenous variables Yt and a vector of predetermined (exogenous and lagged
endogenous) variables Zt' and is written in structural form as

(1)

Estimates of the structural parameters Band C provide information about elasticities,

marginal propensities, reaction coefficients, and so forth. Identities are distinguished as
equations in which the numerical values of the parameters are given a priori and there is
no error term. As the estimation of the model is not our present concern, no separate
notation is used to distinguish a parameter and its numerical value. The
 18

contemporaneous feedbacks among the endogenous variables are solved out in the
reduced form

For those elements of the vector Zt that are policy instruments, the associated
reduced-form coefficients give the policy multipliers or ready-reckoners, describing
theresponse of the endogenous variables (targets) to a unit shock in a policy instrument.
In a linear model such ready-reckoners may be combined to describe the effect of a
policy package. For presentational purposes, however, the impact of the policy change
is often described in terms of the difference between two solutions of the model, which,
of necessity, is the procedure followed once the linearity assumption is relaxed. First a
control solution or base run Yt , t = l, ... ,T, satisfying the equations

(2)

is obtained over some historical or simulation period for given values of the exogenous
variables. Then the vector Zt is replaced by Zt + 0t' t = l, ... ,T, where the vector 0t has
most of its elements equal to zero, with non-zero values corresponding to perturbations
in selected policy instruments. The perturbed solution or simulation Yt' t = l, ... ,T,
satisfying the equation

(3)

is obtained, and the differences Y - Yt estimate the effect of the policy change. The
differences obey the relation

(4)

and this is the equation that must be solved for 0t if it is desired to find the policy
change that achieves a given deviation in target variables. Clearly, as stated by
Tinbergen's (1952) counting rule, at least as many instruments as targets are required;
other conditions are discussed below.

In forecasting exercises, the econometric model is often subjected to residual

adjustments, and in policy analysis it may be the case that the policy under
consideration cannot be represented as a perturbation to elements of Zt. The perturbed
 19

solution is then obtained from the given model augmented by residual adjustments,
namely

(5)

and the problem is to assign appropriate values to the relevant elements of at. The
standard case of the preceding paragraph corresponds to this equation if at = - Ct5t ,
but in many cases the model does not immediately provide the information required for
this calculation. A simple example is that of the introduction of a new tax. If the tax
serves to augment a price variable that appears in the model in an appropriate way,
then the relevant adjustment is given as the tax multiplied by the price coefficient, in
every equation in which the price variable appears. However, if the price variable does
not appear in the model, perhaps because it has exhibited insufficient variation in the
historical data to allow its coefficient to be estimated, then evidence from statistical or
accounting sources, or from other econometric or survey research, must be drawn on to
calculate the relevant adjustment; such evidence should always be fully documented.

Assumptions about a policy often relate not to its effect on a particular behavioural
equation but to its impact on the solution (the reduced-form values) for particular
endogenous variables. Indeed in many cases the central questions are how to achieve
target values of endogenous variables, and what are the consequences of doing so. There
are various methods of obtaining a model solution in which certain endogenous variables
are constrained to have given values. First, this may be achieved by the choice of
appropriate values for the variables' own residual adjustments, and procedures for
producing these adjustments automatically are known as type 1 fixes. A second
procedure, known as exogenization, is to include the endogenous variables with
preassigned values among the predetermined variables, delete the equations which are
normalized on those variables, and solve the slimmed model for the remaining
endogenous variables.

To consider these possibilities we partition the vector y t into subvectors y 1t and Y2t'
and assume that the variables whose values are constrained are collected in the first
subvector. Partitioning the structural form conformably, equation (1) may be rewritten
as

(6)
 20

Denoting the preassigned (target) values of the endogenous variables in the first block
by Yit, the associated solution for the unconstrained variables is then obtained (with u 2t
= 0) as

(7)

In this calculation the variables Ylt are treated in the same way as Zt' hence the term
exogenizationj one might alternatively say that the first block of equations has been
switched out. The type 1 fix that ensures that Yit and Y2t also represent a solution to
the first block of equations is

The solution obtained from the general model

with this residual adjustment, the subvector a2t being zero, is clearly identical. Thus
using alt to control y 1t is numerically equivalent to switching out the first block of
equations, that is, treating y 1t as predetermined in the second block.

These methods assume that yi t can be achieved, and concentrate on the consequences
for the remaining variables as given in (7). The exogenization approach is completely
silent on the question of how Yit is achievedj with a type 1 fix some explanation may be
offered if a specific residual adjustment is given a policy intervention interpretation, as
an incomes policy intervention in a wage equation, for example. A further method of
achieving yi t is to adjust some other variable(s) to which y 1 is related, and the more
explicit is this assignment and the more transparent the relationship, the more likely it
is that a sensible discussion about the policy and its implications can be pursued. A
price variable may be adjusted in order to achieve a desired variation in a quantity
variable, for example. The calculation and imposition of the required adjustment is
known as a type 2 fix. It can be accomplished by adjusting the residuals on other
endogenous variables, or by adjusting appropriate exogenous variables (policy
instruments) by an amount Dt , using the vector notation introduced in equation (3). In
the context of the partitioned model (6), the adjustment required to achieve the target
value of the first subvector satisfies the equation
 21

(8)

Given Yit, the existence of a solution for 8t rests on the existence of appropriate
channels of influence, which may be direct, as represented by the matrix C I , or indirect,
as represented by C2 and B 12 . In the context of a single equation, the required
calculation amounts to an inversion of the equation, obtaining the value of the
explanatory variable that is needed to produce the desired value of the dependent
variable. For example, the required adjustment to interest rates that achieves a
monetary target might be calculated in a single-equation context by inverting a
demand-for-money equation. Note that the classification of variables as endogenous or
exogenous is not changed by this calculation. In this example it is precisely because
interest rates are treated as exogenous that they can be manipulated to produce the
desired response of endogenous money.

In a type 2 fix, the associated solution for the variables that are not targeted is

This differs from the case of exogenization or a type I fix, given in equation (7), by
including the explicit policy adjustment. If the policy instruments used in targeting y 1
have a direct effect through the second block of equations, that is, the relevant elements
of C2 are non-zero, then the solution for Y2 given by the exogenization procedure is
biased. For example, the exchange rate might be targeted via adjustments to
short-term interest rates calculated and imposed in a type 2 fix. If, on the other hand,
the exchange rate is exogenized then the influence of the required interest rate
movements on the rest of the economy is neglected, and hence biased estimates of the
response of output, inflation, employment, and so forth are obtained.

Nonlinear dynamic models

The foregoing discussion has neglected the nonlinearity of the practical models, and has
paid no attention to their dynamic nature. In practice, however, dynamic aspects of the
relations among variables are of concern, and the time form of the reaction of a target
variable to a policy instrument is often as important as the overall magnitude of the
reaction. To consider dynamic models explicitly we distinguish between exogenous and
lagged endogenous variables, partitioning Zt into a vector of purely exogenous variables
 22

xt and the lagged endogenous variables yt-l' Yt-2'.... The nonlinear system with
first-order dynamics may then be written formally, in its structural form, as

where f is a vector of functions having as many elements as the vector yt' and a is a
vector of parameters. This notation is convenient, although it is more general than is
necessary, since the equations of empirical macroeconomic models are usually linear in
simple instantaneous transformations (such as logarithms) or simple functions (such as
products, ratios or proportionate changes) of variables. Nonlinearity in parameters is
relatively rare.

It is assumed that a unique solution for the current endogenous variables exists,
although in general it does not have an explicit analytic form. It can be approximated
numerically to any desired degree of accuracy, and there is a large literature on
numerical solution methods, to which we refer below. Forecasting and policy analysis
exercises usually ignore the impact of the random error term and utilize the dynamic
deterministic solution of the model. This is obtained, for given x-values and given
initial conditions, as the period-by-period numerical solution, to the desired degree of
accuracy, of the equations

f(y t , Yt-l' x t ' a) = 0, t = 2, ... ,T.

Policy multipliers are calculated as the difference between base and perturbed solutions,
and residual adjustments, type 1 and type 2 fixes, and exogenization exercises likewise
proceed through numerical solution methods. The underlying concepts are exactly as
discussed above, although in the nonlinear case we are no longer able to express them in
convenient linear algebra. In particular multipliers no longer correspond to constant
coefficients, but are potentially base dependent, that is, they depend on the values of the
predetermined variables around which they are calculated.

Adjustments and interventions also need to take account of the model's dynamics. For
example, a residual adjustment held at a constant level typically has a cumulative
effect, and fixes designed to achieve a constant deviation in an endogenous variable
typically vary over time. The instrument sequence bt , t=I, ... ,T, determined in a type 2
 23

fix, is described by a generalization of equation (8), first to incorporate dynamics (by

converting the constant matrices to polynomial lag operator matrices) and then to
accommodate nonlinearities (whereupon the possibility of an explicit equation is
typically lost). In practice the instruments may exhibit considerable variation over
time, if not instability, particularly when the impact effect of a perturbation is of
opposite sign to the long-run response, or in various kinds of over-shooting models.
When the magnitude and frequency of the required changes in a policy instrument
appear implausible and unrealistic, given institutional constraints, for example,
alternative methods may be employed that trade off the exact achievement of the target
against the desirability of a relatively smooth instrument trajectory, as discussed next.

Control techniques

The application of control theory to problems of macroeconomic policy making has a

long history; see, for example, Chow (1975) and Preston and Pagan (1982). The recent
control-theory literature has been principally concerned with optimal control. Here, an
objective function is first specified, which is a scalar function of the values of the
endogenous variables (targets) and policy instruments over the planning period. The
optimal control problem is then to find the values of the policy instruments that,
together with the resulting predicted values of the endogenous variables, minimize the
objective function. The objective function may depend on the deviations of actual
values of endogenous variables and policy instruments from their desired values.
Relative weights attached to terms in the target variables reflect the policy maker's
priorities, as between inflation and unemployment, for example, or between consumption
now and consumption later. Terms in the instrument variables may reflect institutional
constraints on the extent to which certain policy instruments can be used, or the
desirability of relatively smooth changes in instruments. In a linear model, with a
quadratic objective function, optimal control theory gives a control policy in the form of
a linear feedback rule for the instruments; in the nonlinear case, a time series of policy
instrument settings is obtained by numerical methods, conditional on the trajectories of
exogenous variables.

In a simple one target-Dne instrument case a multi-period quadratic loss function may
be written
 24

where Yidenotes the target value of the endogenous variable and x t the base-run value
of the instrument. The k2-{;oefficients indicate the relative cost of changing the
instrument from one period to the next, and the k3-{;oefficients the cost of departing
from the base setting. Type 2 fixes are a special case in which such costs are absent,
thus k2t = k3t = 0 in all periods, and a minimum loss of zero is achieved by attaining
the target in all periods. As noted above, the most common difficulty with this
technique is that the resulting instrument paths may be unreasonably erratic or may be
unstable, in turn destabilizing other variables. This instability may reflect hitherto
unsuspected dynamic properties of the model, or it may simply reflect an inadequate
formulation of the policy problem, in that inappropriate target values have been chosen
or instrument instability has not been penalized.

The classical control-theory literature is more concerned with stability and robustness
than with narrow notions of optimality. The emphasis is on the design of linear
feedback rules for policy instruments that yield acceptable behaviour of the controlled
system, which leads to the proportional, integral and derivative (PID) controller
introduced into economics by Phillips (1954).

Some recent research - see, for example, various papers in Britton (1989) and references
therein - attempts to link the classical and more recent strands of the control-theory
literature by seeking explicit feedback rules that approximate the fully optimized
solution in large nonlinear models. This research is motivated on the one hand by the
technical challenge, and one procedure is to linearize the nonlinear model, then apply
linear techniques to the resulting approximation, and finally apply the optimal feedback
rule so obtained to the original nonlinear model. On the other hand a second motivation
is a desire to obtain simple policy rules whose ease of understanding and verification
helps overcome the credibility problem, discussed below. Since the optimal rule involves
feedback on the whole state vector, which moreover is difficult to interpret in the linear
approximation case, these requirements are in conflict, and simplicity is often achieved
by arbitrary selection of a small number of indicator variables; the PID approach
suggests that these should include target variables. Similarly the choice of target values
is often treated in an arbitrary fashion, although in principle these should be obtained as
the fully optimized solution of the nonlinear model, which at least ensures that the
targets are attainable.
 25

3 MODEL CaMP ARlSONS

Any characteristic or property of a model that is used for descriptive or analytic

purposes can be used for comparative purposes. Then the tasks are, first, to ensure that
the comparison is valid and second, to explain the differences that emerge or, even
better, to resolve them. In this section we consider some issues that arise in
comparisons of models based on their use in policy analysis. Of course in emphasizing
this particular use, the fact that different models may be constructed for different uses is
neglected. In policy applications attention is usually restricted to a small number of key
macroeconomic aggregates; this limited focus may have an effect on model comparisons,
because the fact that a larger, more detailed model provides information on several
matters about which a smaller model has nothing to say is also neglected.

Experimental design: base run

Given that in nonlinear models multipliers are base dependent in principle, to ensure
comparability experiments should be conducted relative to the same base, as far as
possible. This may be a historical or a forecast base.

If a historical base is chosen, then it is common practice to impose residual adjustments

or type 1 fixes to ensure that the model solution coincides with the actual data, giving a
"perfect-tracking" solution. Perturbed solutions are then obtained subject to the same
residual adjustments; thus multipliers are obtained as deviations from actual data.
Running simulations over a period for which economic and political history is known
might be thought to aid interpretation. There are, however, both practical and
theoretical difficulties. First, in some circumstances a sufficiently long data base over
which the complete model can be solved may not be available because of changes in the
policy regime, structural breaks, or, at a more mundane level, inconsistencies and other
vagaries in official statistics. Second, the historical record usually has greater variance
than does a forecast projection, and thus problems of base dependence are increased.
Furthermore, there are usually some episodes that are particularly difficult to explain
and that require excessive fixing up, again possibly distorting the underlying properties
of the model.

A forecast base avoids most of these difficulties by projecting relatively smooth

trajectories for exogenous variables and by expecting relatively smooth solution paths
for endogenous variables, once short-run dynamic effects work themselves out. In
 26

dynamic models the only problem that remains from the paragraph above concerns
initial conditions, for if the starting period represents a current or recent past episode
that is difficult to model for one reason or another, then base--dependence problems are
not completely avoided. In principle a forecast data base can be continued into the
indefinite future, or at least sufficiently far to allow an assessment of the model's
stability and of its convergence (or otherwise) in the absence of shocks. In practice
statistical models are local approximations, valid within the range of sample experience,
and some difficulties may be expected when the model is driven far outside that
experience.

In a relatively open model with a relatively large number of exogenous variables, the
construction of exogenous forecast assumptions in an internally consistent manner
requires a certain amount of care. Implicit relations among exogenous variables and
restrictions on their range are not usually included in a model's specification because
they are satisfied automatically, in principle, in historical data. It is necessary to ensure
that they are also satisfied in projected data. Examples are stock-flow identities (with
stocks remaining positive), adding-up requirements, the government budget constraint,
and the foreign reserve position.

To aid model comparisons and to avoid base dependence, the solution over the forecast
period for key endogenous variables might be required to be common to all models,
analogous to a common perfect-tracking solution in the case of a historical base. This
was a stated objective in the Brookings exercise on multicountry model comparisons
(Bryant et at., 1988), where the project organizers specified a common base to be
implemented by each model proprietor. However this caused as many problems as it
solved, as they report (p.30):

Unfortunately, many of the model groups could not or did not follow the
instructions for the baseline path precisely. Establishing a common baseline was
found to be considerably more difficult than running the simulation experiments.
For some models, considerable model manipulation and trial and error were
required to generate the baseline even approximately. Thus, although the
baseline paths for most variables for most model groups conform moderately
closely to the specified common paths, complete conformity was not achieved.

Some model ~roups were concerned that the "add factors" necessary to generate
the baseline l adjustments to the constant terms or residuals of equations or to
the values of exogenous variables) were very large in relation to the specified
baseline values of the variables in question. Although such add factors
incorporated in linear equations do not affect the absolute differences between
baseline and simulation values, they can affect the percentage differences and
thereby give misleading indications of model responses.
 27

Three of the model groups ... experienced especially great difficulties in

generating the common baseline. Consequently, they chose to use
forward-looking projections of their own, developed in connection with their
regular forecasting work, as the baselines for their simulation results.

In our own analysis of the UK models (Wallis et al., 1984-87; Fisher et al., 1988, 1989)
simulations are performed relative to the modellers' own published forecasts and
supplied forecast assumptions. Although the forecasts are not identical, there tends to
be a broad consensus, which also applies to the different modellers' views of external
developments, and there is no evidence that the observed forecast differences distort
multiplier comparisons. (However if a particular endogenous variable is temporarily
exogenized in a forecast, this must be changed to the equivalent residual adjustment
before simulations begin.)

Experimental design: perturbed solution

Policy multipliers or ready-reckoners are calculated as the difference between a base

and a perturbed solution for the endogenous variables of interest. The perturbations to
policy instruments, treated as exogenous variables, are typically relatively small, and so
represent examples of "normal policymaking", not "permanent shifts in policy regime",
in Sims' (1982) terms. As such they can be sensibly analyzed in existing models without
respecification.

Additional assumptions about the general policy environment are invariably required,
however, and must be implemented in a standard manner across different models. For
any perturbation, some view must be taken of the accompanying stance of monetary
and fiscal policy, and again this must be made explicit. In general, policy changes lead,
directly or indirectly, to changes in the public sector borrowing requirement (PSBR),
and different results may be obtained according to the way in which this is financed.
The standard possibilities are that the change in the PSBR is accommodated by
additional money creation (money finance), financed by the sale of government debt to
the non-bank public sector (bond finance), or offset by a change in other elements of the
PSBR, such as additional taxes (tax finance). Each may be adopted on its own, or some
combination of these methods may be employed, for example, balanced money and bond
finance. Policy in the foreign exchange market, and its relationship with monetary
policy, must also be specified. More generally a statement of an overall stance of policy,
such as that suggested by a nominal income target, might be relevant, which would
require the specification of policy instruments and the way in which they adjust to
 28

ensure the achievement of such a target. In many cases, therefore, some modification of
policy instruments other than those of immediate concern is necessary in order to retain
the internal consistency of the overall policy stance. Then the sensitivity of the
simulations to different policy environments may be of interest.

Differences among models

Differences in policy simulations might be expected to emerge from models constructed

from difference perspectives, nevertheless they should be capable of a full explanation.
A contrast between short-term forecasting models and more medium-term models
might emerge, for example, because the latter emphasize factor mobility and
substitutability, which tend to be neglected in the former. Running a short-term model
over an extended simulation period does not necessarily provide "long-run" answers.
Similarly, attention has recently shifted from cyclical variations in productivity growth
around an autonomous trend to the explanation of "trend" productivity growth itself.

After such broad differences in model type have been taken account of, what of the
remaining differences? Their resolution is a matter for econometric analysis. There is
after all only one data generation process, and different models are simply different
approximations to it, whose relative quality can be assessed by econometric techniques.
Data can often discriminate between rival models; if this is not possible the choice rests
on other criteria, which econometric analysis helps to focus more sharply. Exercises in
which cross-model simulation differences are explained and resolved by detailed
empirical investigation of model structures are presented by Turner et al. (1989) and
Fisher et al. (1990).

As a final (comparative) note on model comparisons, the experiences of projects such as

the Brookings multi country model comparison project, referred to above, and the ESRC
Macroeconomic Modelling Bureau may be contrasted. Numerous examples of the former
kind of project are to be found in the literature: a conference organizer determines the
broad outlines of some comparative exercise, model proprietors attempt to implement
these on their own models, the results are discussed at a conference, and the proceedings
are published. There is seldom any serious comparative analysis, nor any attempt to
learn from one exercise to the next - indeed, the reaction of most organizers of such
exercises seems to be "never again"! Although the Brookings exercise stands out by
virtue of the attention given to experimental design ex ante and the depth of
comparative analysis by third parties ex post, the execution of the experiments remained
 29

in the hands of the model proprietors, hence complete standardization was not achieved.
Giving the whole exercise to an independent third party avoids most of these problems.
Direct comparisons across models can then be made at all stages of the project - design,
execution, and analysis - and if particular side assumptions or adjustments are required
in particular circumstances, these can be made completely explicit, rather than have
model proprietors taking them for granted as part of their normal modus operandi and,
perhaps, forgetting to write them down.

4 MODELS WITH FORWARD EXPECTATIONS VARIABLES

Introduction

Expectations of future values of endogenous variables, such as inflation or exchange

rates, are often an important determinant of current behaviour. A traditional way of
handling such unobserved expectations is to assume that they are functions of the
current and lagged values of a few observed variables and so substitute them out, giving
a conventional backward-looking dynamic model : the simplest example of this
approach is the adaptive expectations hypothesis. Such a model is unlikely to remain
invariant across policy regimes, as noted by Lucas (1976). Increasingly common,
however, is the explicit treatment of expectations variables incorporating the hypothesis
of rational expectations, namely that expectations coincide with the conditional
expectations of the variables based on the model itself and on information up to the
current period. Treating expectations variables explicitly, rather than substituting them
out in distributed lag form, provides a practical response to the Lucas critique, as noted
some years ago (Wallis, 1980). Then, in solving the model for the endogenous variable
values over a forecast period, an internally consistent forward-looking solution is
calculated, in which each period's future expectations variables coincide with the
model's (deterministic) forecasts for the future period. This approach is more
appropriately and perhaps less controversially termed "model-consistent" expectations.

The rational expectations literature is usually assumed to start with Muth (1961),
although following much older discussions of the influence of forecasts on outcomes
Grunberg and Modigliani (1954) had already shown that where agents react to forecasts
and thereby alter the course of events, this reaction can be taken into account to yield a
correct, self-fulfilling forecast. This is the same kind of internal consistency achieved by
modern algorithms for calculating model-consistent expectations. Whereas Muth
introduced the term rational expectations into the English language, Keuzenkamp
 30

(1989) has recently drawn attention to a remarkable early paper by Tinbergen (1932),
published in German, which anticipates much of Muth's analysis. Muth's paper in turn
had little impact on empirical econometrics for a while, perhaps because its leading
example was one in which rational expectations and adaptive expectations coincide, and
so might have been thought to provide further justification for the then rather new
adaptive expectations hypothesis. In the United States the eventual adoption of the
rational expectations hypothesis was associated in addition with new classical
equilibrium business cycle models and the policy ineffectiveness proposition, which again
hindered its wider dissemination, although Barro and Fischer (1976) drew a clear
distinction between the rational expectations hypothesis as a theory of expectations and
the type of equilibrium model in which the hypothesis was typically embodied at the
time. This distinction was seen more clearly in other countries, including the United
Kingdom, where explicit forward-looking expectations handled in a model-<:onsistent
manner have been incorporated in mainstream "sticky price" and quantity adjustment
models.

Early macroeconometric model-building exercises in the United States and the

Netherlands were undertaken in association with survey research on anticipations, and
given this tradition and the extreme informational assumptions of the rational
expectations hypothesis it is not surprising that forecasters retain a preference for
models that utilize directly-<>bserved expectations (see, for example, Klein, 1987).
However, when forecasting beyond the horizon of the directly-<>bserved anticipations,
for example, forecasting two years ahead given one-year-ahead business investment
anticipations, it is necessary to forecast the anticipations too, and here the use of
model-<:onsistent expectations provides a natural solution.

In policy evaluation exercises, the use of consistent expectations allows policies to be

tested under conditions in which their effects are understood. As Currie (1985) argues,
good performance in these circumstances is a necessary condition for a satisfactory
policy - "a policy that performs badly when its effects are understood must be
unsatisfactory" .

Solution methods and terminal conditions

In solving a model with forward expectations variables in a consistent manner over a

forecast period, it is necessary to ensure that the expectations variables coincide with
the model's forecasts, as noted above. For the linear model, Blanchard and Kahn (1980)
 31

give a closed form, analytic expression for the solution and consider its uniqueness and
stability; a solution satisfying the uniqueness and stability conditions is referred to as a
saddlepoint path. For the nonlinear model numerical solution methods are necessary.
Again it is not possible to use period-by-period solution techniques appropriate for
backward-looking dynamic models; at least conceptually it is necessary to iterate over
the complete solution path, as in the method of Fair and Taylor (1983), although further
research has led to improved methods (Fisher et al., 1986; Fisher and Hughes Hallett,
1987). Often there exists a multiplicity of consistent solution paths, of which only one
is stable, and it is necessary to impose additional conditions to ensure that this stable
path is selected. Typically this selection is made via terminal conditions that specify
the forecast values and expectations at the end of the forecast horizon or beyond.

If the nature of the stable path is known a priori, from analysis of the equilibrium
properties of the model, for example, then the terminal conditions may explicitly
incorporate this knowledge. This may require a relatively long solution period, to ensure
that the model has reached an approximate equilibrium. In the absence of such
information, or in a shorter solution period, terminal conditions should be specified that
approximate the stable path after the end of the solution period, typically by requiring
constant growth rates of relevant variables. In order to ascertain whether the time
period is sufficiently long or whether appropriate terminal conditions have been used, so
that the solution over the period of interest is unaffected, numerical sensitivity analysis
may be undertaken. The sensitivity of the solution to variations in the terminal date
indicates how much of the solution can be regarded as a genuine product of the model
rather than a product of the assumed terminal conditions. Changes in the type of
terminal condition, together with evidence from the different solution periods, can also
suggest whether or not a unique stable solution exists. Examples of such sensitivity
analysis are presented by Wallis et al. (1986, Ch.2.5).

Experimental design

In standard simulation exercises it is usually assumed that all perturbations to policy

instruments are unanticipated and permanent. In models with forward expectations,
however, differences may arise depending on whether the intervention is anticipated or
unanticipated, and whether it is permanent or temporary.

Conventional backward-looking models react no differently to anticipated or

unanticipated effects. If the shock is anticipated in a model with forward consistent
 32

expectations, however, a change in behaviour prior to the actual shock might be

expected. In general models do not allow for different reactions to
anticipated/unanticipated shocks through the specification of individual equations, and
differences emerge only in complete model solutions for appropriately designed
experiments. Simulation of anticipated effects is typically achieved by introducing the
perturbation at an intermediate point of the solution period, while solving over the
whole period under consistent expectations. Results indicate that the principal
difference concerns the dynamic response, with the long-run solution being the same in
either case. With anticipated shocks, some effects may be experienced in advance of the
shock, perhaps up to one year ahead, in current models.

Permanent and temporary shocks have no differential impact in conventional

backward-looking models during the period they are in force, but once a temporary
shock is removed, such models tend back to the original steady state. This distinction
in respect of the long-run response also applies in models with forward consistent
expectations, but in addition they may react differently to a shock during the period in
which it is in force, depending on whether it is known to be permanent or temporary.
Forward-looking economic agents may anticipate the future removal of a temporary
intervention, with effects on their current behaviour. Again models typically do not
distinguish different reactions to permanent or temporary external stimuli through the
specification of individual equations, and the difference between permanent and
temporary shocks occurs through a complete model solution. It depends not only on the
nature and role of the forward expectations variables, but also on the model's dynamic
adjustment, since a protracted period of lagged adjustment following the ending of a
temporary shock also has an impact on current behaviour through future expectations
variables. In practice differences in reaction are observed, with the response during the
common period of temporary and permanent shocks being smaller in the temporary case.
As with the previous question, however, the dynamic response is altered, but not the
long-run position.

Policy optimization

Models with forward expectations introduce an additional complication for policy

optimization exercises, since current economic behaviour may be affected by
anticipations of future policy. In an influential paper, Kydland and Prescott (1977)
argued that "there is no way control theory can be made applicable to economic theory
when expectations are rational"; in particular the application of optimal control
 33

methods results in policies that are time-inconsistent, in that it is not optimal to

continue with an initial policy in subsequent periods. There is an incentive for the
policy maker to renounce previously-announced policies, but this in turn can be
anticipated, hence the announcement, or more generally the time-inconsistent optimal
policy, lacks credibility in the absence of an enforcement or pre-commitment
mechanism. Blackburn (1987) surveys the substantial literature inspired by this
"fundamental dilemma". In much of the work surveyed the policy problem is
formulated as a dynamic game between intelligent players - policy maker and private
sector - and different possibilities arise according to the assumed information structure
and the types of strategic behaviour considered. An important strand of this literature
is that concerned with international policy coordinatiop., where the players are separate
national policy makers; see, for example, the papers and commentaries in the volume
edited by Buiter and Marston (1985).

The single-economy policy game typically assumes noncooperative behaviour, with the
two players interacting according to Nash or Stackelberg assumptions. In the former
each player takes the other's actions as given, and an equilibrium position is one that
provides no incentive for either player to move, again taking the other player'S (optimal)
policy as given. In the latter one player acts as a leader, anticipating the reactions of
the follower to announced policies and optimising accordingly. For practical
implementation in large-scale empirical models the Stackelberg assumption presents
fewer difficulties, since the econometric model describes the behaviour of economic
agents who form expectations on the basis of the announced policy, which they treat as
given, and the policy maker proceeds to optimize this. Under Nash assumptions,
however, the policy maker must optimize taking agents' expectations as given, and an
additional level of iterations is necessary to ensure that the expectations are consistent
with the optimized policy. Nevertheless it might be argued in an open government
context that this is more in keeping with the rational expectations hypothesis - that
economic agents understand and hence correctly anticipate the policy maker's actions -
and the resulting policy is time consistent.

Empirical applications are relatively few to date, as a result of the computational

difficulties presented by the foregoing complications. Optimization algorithms usually
require a Jacobian matrix of first derivatives of targets with respect to instruments in all
time periods, constructed by numerical differences. To minimize the required number of
model solutions, some structure is usually imposed on this matrix, and in conventional
backward-looking models it is assumed first that target variables respond only to
current and lagged instruments, and secondly that this response is invariant to the
 34

timing of the perturbation - a kind of stationarity assumption. In models with forward

expectations, the derivatives must reflect the nature of the Nash or Stackelberg game.
Each derivative evaluation requires a model-consistent expectations solution, and the
first of the above assumptions is therefore no longer valid. Furthermore, the second
assumption becomes less reliable, particularly in the neighbourhood of the initial and
terminal conditions. Hence the computational burden in obtaining the required
Jacobian matrix is much increased. Hall (1986) presents a Nash-type exercise in a
model with a single forward expectations variable, and Wallis et al. (1987, Ch.3) use the
Stackelberg approach in calculating an inflation-unemployment trade-off by optimal
control in a model with three forward expectations variables. Fisher (1990, Ch.7)
appraises the performance of these and other methods in such exercises. In the face of
these difficulties it is perhaps not surprising that none of the exercises reported in
Britton (1989) uses a full optimization approach, those based on forward-looking models
restricting attention to policy simulations and the derivation of feedback control rules.
Blackburn and Christensen (1989) note the scope for further empirical work, and this is
a continuing area of research.

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WALLIS, K.F. (ed.), ANDREWS, M.J., BELL, D.N.F, FISHER, P.G. and WHITLEY,
J.D. (1984). Models of the UK Economy: A Review by the ESRC Macroeconomic
Modelling Bureau. Oxford: Oxford University Press.

WALLIS, K.F. (ed.), ANDREWS, M.J., BELL, D.N.F., FISHER, P.G. and WHITLEY,
J.D. (1985). Models of the UK Economy: A Second Review by the ESRC
Macroeconomic ModeUing Bureau. Oxford: Oxford University Press.

WALLIS, K.F. (ed.), ANDREWS, M.J., FISHER, P.G., LONGBOTTOM, J.A. and
WHITLEY, J.D. (1986). Models of the UK Economy: A Third Review by the ESRC
Macroeconomic ModeUing Bureau. Oxford: Oxford University Press.

WALLIS, K.F. (ed.), FISHER, P.G., LONGBOTTOM, J.A., TURNER, D.S. and
WHITLEY, J.D. (1987). Models of the UK Economy: A Fourth Review by the
ESRC Macroeconomic Modelling Bureau. Oxford: Oxford University Press.
 PART 2:

OPTIMAL CONTROL OF ECONOMETRIC DECISION MODELS

OPTIMAL STABILIZATION WITH A MACROECONOMETRIC MODEL FOR HUNGARY:
INVESTIGATING THE EFFECTS OF DIFFERENT OBJECTIVE FUNCTIONS AND
TIME HORIZONS

Gabor Bagdy
Institute of Economics
Hungarian Academy of Sciences
H-1502 Budapest, Pob 262
Hungary

Abstract

The purpose of this paper is to analyze how optimal control re-

sults respond to variations in the objective function and the
policy maker's time horizon. On the basis of a macroeconometric
model for Hungary we attempt to address the question of whether
a smoother growth path or a lower level of foreign debt could
have been achieved. The results show that the taxes and sub-
sidies linked to foreign trade variables - as instruments of the
optimal control problem - are effective in the short run, but in
the long run they do not decrease considerably the level of for-
eign debt.

Keywords: Optimal control of econometric models, large scale

optimization, last period effects.

Contents

1 Introduction
2 The decision model
3 Specification of the objective function
4 The numerical results
1 Introduction
A possible application of econometric models is to make control
experiments based on them. An econometric model is usually a
system of simultaneous discrete-time difference equations, that
involve endogenous, exogenous and policy variables. If a crite-
rion or welfare function is added to the model, the question is,
what values the instruments should have in order to maximize
welfare. In this paper we try to answer the question: To what
extent do different scalar-valued objective functions and the
length of the time horizon influence the results of the optimal
control exercise?
Two approaches are used to solve the optimal control problems.
In the first case, the model is assumed to be linear and the ob-
jective function quadratic. This approach is used in most cases.
The linear-quadratic problem can be formulated in the follmling
way. Assume that the following reduced-form linear econometric
model is given:
 40

Here the state vector Xt is a column vector referring to the en-

dogenous variables, u t 1S a column vector of policy variables, A
and B are constant and known coefficient matrices. The column
vector b t includes the effects of all exogenous variables and
constants. The error term e t is assumed to have zero mean. The
form of the quadratic objectlve function is as follows:

T
w(X,u) Z(Xt-x*t)TQ(xt-x*t) + (Ut-u*t)TR(Ut-U*t),
t=l

where, x t * and u t * are the given target vectors and Q and Rare
given symmetric matrices.

As its name implies, the linear-quadratic approach assumes two

strict conditions: The system of equations has to be linear, and
the objective function quadratic. If we remove the first assump-
tion, we must solve the following problem:
T
min w(x,u) Z(xt-x*t)TQ(xt-x*t) + (Ut-u*t)TR(Ut-U*t>
t=l

subject to

i=l, ... ,ni t=l, ... ,T.

Here x t and Ut are henceforward the vector of endogenous and

policy variables; gi is a linear or nonlinear function with
first derivatives; and L is the maximum number of lags. For
solving this and the original linear-quadratic problem, the al-
gorithm described in Chow (1975) is appropriate. In optimal con-
trol exercises of econometric models, the linear-quadratic ap-
proach is frequently used, see e.g. Brada et al. (1981), Neck-
Posch (1982), Frommholz and Wolters (1983). But the quadratic
objective function has some well-known disadvantages. The most
important one is that it penalizes the over-fulfilment of
targets just as it penalizes their under-fulfilment. One way to
compensate for this flaw is to give idealistic target values,
which of course can not be attained. In this way one can insure
that the symmetry of the quadratic Objective function is not ef-
fective. In spite of this, however, the quadratic objective
function is still not attractive. But if we choose another form
for the objective function, ChoW'S method is not applicable.
When using optimal control methods for practical economic prob-
lems, one often gets unrealistic results. This could be caused
by the fact that the model, which is merely a poor description
of real life, does not include all the important connections
between variables. These kinds of errors can be avoided by
 41

giving upper and lower bounds to the variables, especially to

the policy variables in the model. The constraints should be
chosen so that the resulting trajectories are realistic.
Unfortunately, these sorts of constraints go beyond the linear-
quadratic model.
The other possibility for solving an optimal control problem is
to approach it as a large scale mathematical programming prob-
lem. In this case the equations of the econometric model are the
constraints, and the welfare function is the objective function
of the programming problem. The problem to be solved is the fol-
lowing:
T
min w ~ f(x t , xt - 1 ' ... , x t - L ' u t ' u t - 1 ' ... , u t - L )
t=l

subject to

and

t=l, ... ,T,

where at and f3 t are the vectors of upper and lower bounds,

f(x,u) lS the objective function with continuous first order
derivatives.
For our optimal control exercise we have not followed the lin-
ear-quadratic approach. Instead, we used CONOPT, an optimization
code based on the Generalized Reduced Gradients method (GRG-
method), see Drud (1978), Drud and Meeraus (1979). CONOPT is
suitable for solving nonlinear dynamic optimization problems.
The advantages of the GRG algorithm are twofold. First, it en-
ables us to choose not only quadratic, but also other forms of
the objective function. Secondly, one can give upper and lower
bounds on both the state and control variables. For an empirical
application of CONOPT to the optimal control of an econometric
model, see Sandblom and Banasik (1985).

2 The decision model

It is often debated whether or not exchange rates affect foreign
trade quantities in Hungary. The contradictory conclusions aris-
ing from this debate can be explained by the fact that in a
closed economy, the change of exchange rates alone may not have
any economic effects.

Based on the ideas of Oblath (1988), Halpern (1989) in his

macroeconometric model takes into account the so-called de facto
exchange rates. Under de facto exchange rates, Oblath means that
import taxes and export subsidies have to be added to nominal
exchange rates.
 42

Our optim~l control computations are based on Halpern's (1989)

econometr~c model. The model is aggregated; it contains 48 equa-
tions, 14 of which are stochastic. Using annual data from 1968
to 1986, the model was estimated by three stage least squares.
It is highly nonlinear, and thus it appeared important to de-
sign SOme optimal control exercises in order to understand the
structure of the model, and the interaction between the vari-
ables.

The economic problem we would like to address is the following:

Hungary's foreign trade is divided into two parts, dollar trade
and rouble trade. The first part is trade in convertible
currencies and contains mainly trade flows with developed and
developing countries. The second part refers to trade with
communist countries settled in transferable roubles. Rouble
trade, is based mainly on agreements between governments, not on
firms' economic interests. In this paper we are interested
especially in dollar trade flows.
since 1974 Hungary's foreign debt in dollar trade has rapidly
increased. This phenomenon made a debt-reduction policy unavoid-
able. At the beginning of the 1980's this effort was successful,
but later it failed. One main reason for this is that the struc-
ture of the economy has not changed considerably, and still does
not support the more effective, less material-intensive
branches. The question has been raised as to whether an exchange
rate policy could have been more effective in decreasing Hun-
gary's indebtedness. Another interesting question is whether
smoother economic growth would have been more successful than
the unbalanced growth of the eighties.

In spite of the large role played by foreign trade, Hungary I s

economy still cannot be regarded as truly open. Several barriers
exist which make Hungary's transactions with foreign countries
difficult. These barriers originate partly in the" organizational
structure, and partly from conscious economic policy interven-
tions. The goal of our exercise is to investigate whether these
interventions are useful instruments in influencing the foreign
trade balance and the balance of payments.
To formulate the optimal control problem we had to give some
supplemental elements to the original econometric model. Firstly
we chose the objectives. Secondly we introduced some constraints
on the variables. And thirdly we selected the variables we
wanted to use as instruments.

3 Specification of the objective function

Hungary's special economic situation required the formation of
exercises using different forms of the objective function.
We used several objective functions for our optimal control ex-
ercises. In this paper we will give the numerical results ob-
tained by using the following three objective functions:
 43

1. To minimize the foreign debt for the last period of the

planning horizon:
w1 = DSS (last period) ~ min,

where DSS means the foreign debt in dollars.

2. To minimize the annual average of the foreign debt:

T
w2 :E DSS (t) IT ~ min.
t=l
3. To achieve smoother growth in the ec?nomy. The optimal
path should avoid fluctuations as much as poss~ble:

w3= + +

where the notations are the following:

CQ consumption at constant prices,
IQ investments at constant prices,
XQP gross output at constant prices.
The target paths WCQ, WIQ and WXQP mean a smooth path of CQ, IQ
and XQP. This smooth path is determined by fitting a linear
trend onto the original variables over the planning horizon.
Th.e first objective function needs no explanation. It is clear
that for the heavily indebted Hungarian economy, it is extremely
important to come up with ideas as to how a lower level of for-
eign debt could have been achieved for the last period of the
time horizon.
The second objective function differs from the first in that it
takes into account the foreign debt for the whole time horizon,
not only for its last year. ·In this way we tried to eliminate
the possibility that a decrease in foreign debt occurs at the
expense of higher indebtedness in earlier periods.
The third objective function implies the following con-
siderations: Since 1979 a restrictive economic policy has dom-
inated in Hungary. The growth rate of the economy has decreased
substantially. The severity of economic restriction differed
each year. This was partly the cause of the extreme fluctuation
of some important variables of the model. One can ask what
effects smoother economic growth would have had on the level of
indebtedness. In this case we used a quadratic objective
function. In order to be able to compare variables with
different means, in the welfare function we penalize. the per-
centual deviations from the target values.

At first sight, the optimal control problem with the third ob-
jective function appears to be linear-quadratic. However, we
chose to use the GRG code instead, and added constraints on sev-
 44

eral variables of the model. Thus it is clear that the instru-

ments such as export subsidies and import taxes have a great in-
fluence on the state budget. The state budget was endogenous in
the original model. It had to be constrained in the optimal con-
trol model in order to avoid an unacceptably high budget
deficit.
The instruments we used in this exercise were export subsidies
and import taxes linked to foreign trade. We gave constraints on
these instruments directly; this is why they were not included
in the objective function.

4 The numerical results

To tr,ace out the dynamic effects of the instruments on the ob-

jective functions, we made optimal control exercises on four
time horizons: from 1979 to 1984, from 1979 to 1985, from 1979
to 1986 and from 1981 to 1986. The results for the following
variables can be seen in four charts:
The instruments:
exchange rates plus relative export subsidies, com
pared with the actual values,
exchange rates minus relative import taxes, compared
with the actual values.
Other variables:
consumption at constant prices,
foreign debt in dollars at current prices,
dollar exports at constant prices
dollar imports at constant prices
investments at constant prices,
gross output at constant prices.
Chart 1 and chart 2 show the effects of different objective
functions, chart 3 and chart 4 the effects of different time
horizons.

4.1 The effects of different objective functions

The results in charts 1 and 2 make it clear that the optimal
values of consumption, gross output and dollar exports react
only slightly to the differences in the objective functions (see
section 3). Foreign debt, investments and dollar imports, on the
other hand, react more dramatically.
The following common characteristics (not shown in the charts)
exist among the optimal control results for the periods 1979-
1984, 1979-1985 and 1979-1986: The goal of minimizing the
foreign debt for the last period of the exercise (wI) up to 1983
resulted in lower investments, dollar exports, export subsidies,
dollar imports and import taxes, but also in a higher foreign
debt and higher consumption, than the goal of achieving smoother
economic growth (w3) would have allowed. The year 1983 seems to
be a turning point. From 1983 on the order of the level of
instruments concerning the objective functions wI and w3
changes. After 1983 export subsidies and import taxes were
higher for wI than for w3. As a result, from 1983 on,
 Chart 1.
Effoct. of 4. . Uo,.t",t object I",. 'unet Ion.
I"ect. of dllt.rent Dl!.Joctive Iu.netlon. 11979-198& )
11979-198&)
688
12a
598

S8e ___ -:;.';ioo

\ I '?~
11B I 578
I /'
" I
I 568 -' W3
.xcl....nl ..... t •• \ I I Wl
I , ---- ... ""' "'
pi ", . . . xport con.",.pt Ion sse - ,,2
.uhs: Ld Ie .. [ ]
- 002
,aid lor I.I.fllt 188 \\ " , ,/"'\
. , ~,'
, :
,i/ ~"'':'-:::,........ G.. , "" 1
doll.,. export. - 003 548 ' .
(ac.t ual ., !ee)
.' / 538
,~ , ' ./
/ :./'\ \.... '
\ \ .. ~-"......
98 , /" ...~-................ .................. 528

"' SIB

see I I I I I I I I
88 I ~ I 79 sa 81 12 83 84 85 86
79 98 81 82 83 84 8S 8&
."."f'.I
ye .. r ..

~
(J1

Et'.ct .. of d IIlerent obJ.cth,"e l",n-cUan.s Ef'fect. of dltl.rent obJect I",. 'unction.

( 1919-19&6) (1979-1986 )
128 228

118 2eB
•• • • • •• •• ••• •• ~. - •• • - " • • • •• • ••• •• • • • • • ••• •• •••• • • • - - _ _ . ft . . . . . . .

I ... ,
I .." 199
18B I "\
I \
excJotan, ..... t •• I \
.. I nUl. i.port "3 168 , W3
I ~.
"t .. xo. / Y', lorelrn debt ,,
98 / ~ [- ;
w2] [- ;
.. 2]
paU lor unit I ~ (1979 , 18B)
.011 .. ,. IMport. , I ,\ ~~ w1
( .. ctr.l .. l ~ 1Be)
... wi 14e
v ~
'. .... ~~ ...,Jt. /·~<··""·
,, '. . .....~~ ,. . . . .~-.~ .... ....... ....••
~
,,' 128 .,;,;:-::'--- "... ...
- _ ..........•......;.;: ....
,,<> - - - ...... -"
78
188

68~1 -----+-----+----~----~----~~----~--~ 8e~

I ----~----+---~-----r----~----+---~
79 88 81 82 83 84 8S 86 ~ 88 81 82 83 84 85 86
s·ar .. !!lear ...
 Chart 2.
1'1' .eta ot 4 it '.f'.nt object Iva Iu.nct lons E" lett or "ltlltlnt ohJect lv, fu.net lo"a
(131~13961 (U1~19861
228

~
218 228
218
" /.#... ./f-
'~ ~ .
288 1
288 '\ ,
\ "l
198 "l
Iln..... stl'llsn1.:I 198 "., - ,,2 do 1 lI:r exports .. t ~ .
- ,,2
conatlknt pric ••
....· 1.11
" 188 ... wi

188
\ ..',.~ ~
',,~,~,.~, /-"",
B B
" '" ,. 118
,.•..,:.:---- ,---,,/'
178 ....., ....•" .,.., ......., ...
--' 168
168 I I I ·,··,·, .. ' ..····r...... ....... ,. I I
1581 I I I I I I
13 sa 81 92 8J 8i es 86
13 88 81 82 B3 84 BS 86
v· .. r. 'Y."Z".:II

.I>-
m

Ellects 01 dirt.rent objective fL,tnctions Ettec::t. or 411/erent ohJect l\ol'8 I'u. nct Ions
(1~1~1~961 ( 191~198 6 1
2488 2ee

1ge

2388
18e

I
,r-, -,
. ,,;-, /
.•. .....••. 118 ,,
2288 /
"3 I "3
dol1&f' i .. ports .t 168 I
gross ou.lp"" t - .. 2 con.t .. nt pr Ice. [ ]
- .. 2
~!--y"it"~' ,.",;''''/
••• 1011 ... t..I1
2188
B 148
\ ~"~J-~:// .......,.,.,.,...,........ ..
..., ..., .....~ ..~ .........
118

ne81 I I I I I I I 128 ' I I I I I I I

73 sa 81 92 8J 8>1 8S 86 19 88 81 82 83 8>1 85 86
y.ars 'Y.&r ....
 47

consumption and foreign debt stayed at a lower level for the

optimal control exercise, thus minimizing the foreign debt for
the last period instead of achieving a smoother growth path in
the economy. The second objective function (w2) - minimizing the
annual average of the foreign debt - yields results between w1
and w3. The shorter the planning horizon, the closer is w2 and
w3 to be found. Controlling the model from 1979-1984, w2 and w3
produce almost the same results. But if the planning horizon
ranges from 1979 to 1986, the results of w2 and w1 are very
similar.

Comparing the simulated values with the results of each time

horizon, we can conclude that even if the w3 objective function
is used, striving to achieve a smoother growth rate, one does
not obtain significantly better results than those without op-
timization.

It also goes against our preconception that the scenario of min-

imizing the foreign debt for 1986 accumulates more foreign debt
up to 1983 than the other scenarios.

Let us have a look at the instruments. Dollar export subsidies

move perfectly parallel to dollar import taxes, that is export
subsidies paid for unit dollar exports coincide with the in-
crease in taxes on one unit of dollar imports. This means that
on the aggregated level, the system of taxes and subsidies
1 inked to the foreign trade variables could be replaced by an
exchanqe rate pOlicy. This conclusion may not be valid at the
disaggregated level.

4.2 The effects of different time horizons

In optimal control calculations it is common for some variables

to sharply increase in the last period of the pl~nning horizon.
This may augment the value of the social welfare function, but
the delayed disadvantageous outcomes may appear only beyond the
planning horizon. Optimal control results are also often sensi-
tive to the length of the planning horizon. By comparing the re-
suI ts on different time horizons, one can get an impression of
whether these failures are present in our exercise.

By comparing the scenarios which resulted from exercises on dif-

ferent time horizons, one can conclude that the differences are
rather small. As it can be seen in the charts 3 and 4, the
optimal trajectories from 1979-1984, 1979-1985 and 1979-1986
differ from each other only in details. This means that the
modification of the end-period has only minor effects on the
results. It also means that the sharp increase in the taxes and
subsidies linked to dollar exports and dollar imports does not
originate from an end-period effect. Rather, it follows from the
special situation of the Hungarian economy in 1986.

It is much more surprising that there is a significant differ-

ence between the traj ectories resulting from the control exer-
cise depending on the beginning of the planning horizon. While
the trajectories beginning in 1979 are very similar, independent
of the end period, the trajectories from 1981 to 1986
 Chart 3,

Elt.ct. at ,au ' ..... nt t.l •• hal" lzon. Ett.ch 01 ,. IF' et'o "''t. t. SIilO "'ot'13:0"'.
( w2 ) ( w2 )
59B 13B
/~:~'::::::.:::.::
seB
12B

- 01-86
- 79-84 ex c"ange rates 118t\
plu.s export '.,
.l.Ibsid,l •• - 79-86
- 79-85
consWlptlan paid. fo ... "nit
.., •.. 79-85
_. 79-8£ dol hI" ex.rort.s
s.S (actu.a 1.. lUI )
1eet ·". \, . ,/ .,\~ /" .- 79-8.
.- 81-8£
53S ,......\ , ~~~ '~ "".;
.'\ ... ~'1t.:: : :.:...... \....J'"
,,'" \ . . -....-~-
S2S ge J. "tI"

S19

sS8 ~1-----+----~----~------~----r-----r---~ I I 82 83 8-1 85

8879 t 8B 81 "" ;,
~ 88 81 82 83 8. 85 86
~.a.r:l
Ij • .,rs .I>-
0:>

Et'.ct. 01 d.ltttlf'ont tl lllll. hor'hons ItF.cts 01 dlU.rent t t •• },orhans

( ... 2 ) ( wZ l
178

1&8
--- ....
.... ' ...
118 ..... .... '\
lS8
/>' ";
148 I ,. J
;/.,/
- 79-04
138 // /</ - 79-84 .xc:h .. nf. rat.*
.lnus Illiport
"'~>
98
1 "" .\,\\
- 79-85
- 79-85 t.x ... '\ \
lor.lin d.lI.t
1 / . . ... . ..=:-,.....
~
..... ",,,,' ....... , .... , .•.• .' ,aU (or unit
(1970:.188) 1Ze .•. ,... ,r , , / ' " ,,\~..... " •••"" / ... 79-86 do 1 hr t_,ports
"' \ ··· 79-86
CactuAl ll:188 ) \ \ .- 81-86
..- 81-86 "
';~:~~<:~~? \ \\;
76
:::r'
98
. . ..................,.' \\
;
..
8S I I I I I I 68 I I I I I I I i
79 8B 81 82 83 8i 85 86 79 08 81 02 83 84 OS 86

\018"1'. v·· rs
 Chart II •

EII.ct. 0' dlllerent tl.e horizons ItI.ct. 0' d.Uret'.nl tt •• lIorl:rons

( w2. ) ( ... z )
238 238

228 ./~o
228

218 //
//)/' 218 '.,
"~,'\. >, .//
288 - 79-84 .....\ .,l' - 79-84
,~" 288 .
- 19- 85 - 79-85
dol Jar- e .ports at 198 InveJl:t. e"tJl: ",,/
const.nt prleaS" ... 79-86
I _. 79-86
.,.,
\ \. ' '","
198
188 .- 81-86 -- 81-86

188
118
\<~~~~--~:<:~:>,/
178 ......... -.................
16et ..~.:.:>·

15~:19~~~--~---+--~----+----+--~ 168 +1----~~----+-----~-----+----~~----+_----~

88 81 82 83 84 85 86 79 88 81 82 83 84 85 86
!II •• rs \j ... rs
~
CO

Elleet. of d.11I.rent tt •• J!or I:zans

( ... z ) Ett.ct. at clUler.nt tt •• lIorh.ons
( ",2 )
288
2388

198 1: . ..---...·- .,. /

'I ~-:);:~~'>'
" i
188
//'-;.(/ ............... 2288 /}{~~i;;:;"
118 ~ i .... - 19-81
~;' i.·.. - 79-84
, // - 79-85
".~-;:;.,
do 11101' tMP01't .. at 168 - 7 9-85
constant p.ric •• ~,/ ;.~~/ .-. 79-86 .:ro :.. out'1,lt 2lee ,.-'.,,'"
".. "",.f ... 79-86
\, \ ,..,;,~ / ,:."' .- 81-86 ,,/
\ ,~ ..."
""\\ ... \~' .- 81-86
". .•:-:,;1 , ./ '
148 ".
"<\oJ- o
<-::"
,/
'\ '
138

128' I I I I I I I
79 88 81 82 83 84 85 86 1988~
1 ----~----+-----~--~-----+----~----~
79 88 81 82 B3 84 85 86
v.·,.. \iI.ars
 50

are very different. Subsidies and taxes linked to foreign trade

are on the average higher on the shorter time horizon than on
the longer one. The results show that from 1981 on a higher
level of consumption and investments, and a lower foreign trade
deficit and a lower indebtedness could have been achieved by
using any of the three objective functions. One can easily
conclude that Hungary was in a better economic situation in 1981
than in 1979.

Another important conclusion can be drawn from the control exer-

cises: Because of the rigid structure of the Hungarian economy,
export subsidies and import taxes alone are insufficient for
substiantially reducing the country's indebtedness.

References

Brada, J.C.,A.E.King and D.E.Schlagenhauf (1981), 'The

optimality of Socialist Development Strategies: An
Empirical Inquiry', Journal of Economic Dynamics and
Control, yolo 2., pp. 1-27.

Chow, G.C. (1975) Analysis and Control of Dynamic Economic Sys-

tems, Wiley.

Drud, A. (1978) 'An Optimization Code for Nonlinear Econometric

Models Based on Sparse Matrix Techniques and Reduced Gradi-
ents', Annals of Economic and Social Measurement~,Vol. 6.,
pp. 563-580.
Drud, A. and A. Meeraus (1979), 'CONOPT - A System for Large
Scale Dynamic Nonlinear Optimization - User's Manual', De-
velopment Research Center, World Bank, Washington, D.C.

Frommholz, H. and J.Wolters (1983), 'A Controltheoretic Analysis

for a Small Econometric Model of the Federal Republic of
Germany', in J.Gruber, ed., Econometric Decision Models,
Springer.
Halpern, L. (1989) 'Foreign Trade in Macroeconomic Context in an
Econometric Model' Institute of Economics, Budapest, Hun-
gary (in Hungarian) .
Neck, R. and U.Posch (1982), 'On the 'Optimality' of
Macroeconomic Policies: An Application to Austria', in
G.Feichtinger ed., Optimal Control Theory and Economic
Analysis, North Holland.

Oblath, G. (1988) 'Exchange Rate policy in the Reform Package'

Acta Oeconomica, Vol. 39, pp. 81-93.

Sandblom, C.L. and J.Banasik (1985), 'Economic Policy with

Bounded Controls', Economic Modelling, Vol. 2., pp. 135-
148.
On Causality and Control In Economic Systems

Michael Leserer"
Institut fur Agrarokonomie
Universiiit Gottingen
Platz der Gottinger Sieben 5
D-3400 Gottingen

Abstract
Starting from a "behavioristic point of view" causality is discussed in the framework of
"networks of decisions" (NOD's) in which a conditional probability formalism is used in
order to represent causal relations. A worked example confronting the analysis of NOD's
with the usual "mapping analysis" of causality leads to some conclusions about (mecha-
nistic) optimal control models. It can be shown that a constant structure of decision
making in a dynamic NOD implies a "variable parameter model" and a time dependent
incontrollability problem in the traditional control model formulation.
Keywords: Causality and its representation; networks of decisions; control in variable
parameter models.

Contents
1 Orientation
2 Example
3 Discussion
References
Appendix

1 Orientation
Causality is a fundamental concept in human thinking. The ability of man to ask for cau-
ses behind phenomena implies model building in order to visualize causal relations. But
in our mechanical world the "picture" of causality is solely determined by the "heritage of
Newton" [1] in the following sense: If one formalizes causality then one automatically
constructs a mapping from causes to effects. This procedure is totally motivated by expe-
rimentation in the natural sciences: Mathematical mappings are the natural analogies of
"experimental mapping" which is done by setting causes and observing their effects. But
this is not the usual situation in economics! Here the behavior of economic agents origina-
tes causal phenomena far from experimentation facilities. Thus a necessary condition for
I am indebted to Lidwina \\"ohlfahrt for her engagement in managing the numerical part
of this paper.
 52

causality in economics is the psychologically or legally based possibility for agents to influ-
ence other agents, and a sufficient condition for causality is that economic agents behave
or must behave in order to make this influence possible. Thus in many cases, the origin
of causality in economics is not a physical "transfer of energy" ("Energieubertrag") [ 4]
but an accepted voluntary interaction for realizing economic intentions. So in my opinion
this "non-experimental causality" implies a causal analysis which is not originally based
on the ideas of mappings. I have investigated this matter including the implications for
control analysis "in foregoing papers [2], [3]. In this paper I confront a dynamic version of
my analysis of "networks of decisions" (N 0 D) with the traditional analysis of mapping.
In this context, the philosophy of NOD's is the following: Like in chemistry, it is assumed
that economic variables are explained in terms of atomistic decision structures consisting
of causally connected sets of alternatives which can be chosen in a probabilistic way, i.e. in
each period economic agents may have an economically well-defined finite set of decision
alternatives. These alternatives are chosen with a certain probability. Such a chance of
realisation may be derived from utility aspects. But typically, one agent's alternative - if
it is chosen - may induce reactions of other agents. This phenomenon defines causality.
Thus, a NOD may be seen as an economically well-defined reaction scheme.
Based on such decision structures, economic accounting systems then define economIC
variables which are random. In the space of these random variables it is possible to
reconstruct the causal structure in a NOD phenomenologically by regressing effect random
variables on cause random variables. In this way the causal structure of a NOD determines
the causal representation of economic variables. The following example will show that
constancy in a dynamic NOD over time (equal number of agents, equal number of decision
alternatives per agent, constant probabilities, constant mode of causality described by
directed arrows) induces temporarily non-constant parameters in affine transformations if
they are used for a causal representation in the space of random variables.

2 Example

Let ..1ij(t) (i = 1, . . , L , j = 1, ... , Af" • t = 1,2. L. Ali' eN) be the decision alternatives
of L agents (or groups of agents) over time where there are Mit alternatives for the i-th
agent in period t. Let further Bij(t) denote the set composed of decision alternatives
which influences ..1ij(t) in the sense that ..1<j(t) occurs if and only if Bij(t) occurs. Finally
let PI3,,(t) (..1ij(t») be the conditional probability of .4,)(1) under the restriction of Bi)(I)
Then the pair ( ..1ij(t), PI3.,(t) may be called a network of decisions.
In order to illustrate this definition let us introduce the following example which also may
be the basis of further statements.
 53

period agent 1 ag~nt 2

t =1

t =2

Figure 1: Dynamic NOD with two agents and with time invariant causal structure

For all periods two agents can choose between two decision alternatives each, for simplicity
both equally probable, but agent 2 in period t = 1 only chooses if agent 1 chooses
alternative A 11 (l) , in period t = 2 he decides only if agent 1 has chosen A 11 (2) and he
himself has chosen A 21 (1) in period t = 1 and so on. Thus, for example, the probability of
choosing A21(2) is conditional on 8 21 (2) = .'1 11 (2) n A 21 (1), whereas .4 21 (1) is conditional
on 8 21 (1) = A11{l). In this way alternatives constitute causality.
For further analysis note that these alternatives induce a probability space over which
random variables are defined. So one may define the following:

C "'. = (Al1(t) , . )
~t (.;) t = 1,2, ...
otherwise

C
I)t("')
w =( .421(t) )
1=1.2, ..
othenvise

Now, in a mechanistic frame\vork the caused variable would be represented by an affine

transformation I); = at + b lt l)t-l + b2t~t ,\vhich may then be the basis for a (mecha-
nistic) control analysis. For such control purposes the coefficients at, bit, b2t must be
determined. This can be done from the \'ariance-covariance matrices of Tit, 1)1-1 and ~t
 54

for t = 1,2,. which are derived from the (time dependent) common probability mass
functions of these random variables (see Appendix) by :

[:: ]
where bt = [bit b2tl', (= ['1t-l ~.]' L( (
(assumed to be regular) ,
= cov( ()
O"(ry = cov('1t) , p.ry = E'lt and p.( = E( With these settings one optimizes the
representation of 'It via at + b1l 'lt-l + b2t~t according to min E ('It - at - b;()' ('It - at - b;() .
at ,b j
The results of this procedure are listed in Table 1:

Table 1: Parameters of the representation '1* = at + blt 'lt-l + b2t~t for t = 1,. .. ,10

t at b1l b2t

1 0 0 0.5
2 -0.062 o .y
.~o 0.125
3 -0.01526 0.25 0.031252
4 -0.003906 0.25 0.007812

10 -0.000001 0.25 0.000002

3 Discussion

First note that this paper does not intend to establish generallmvs 01' even a final theory.
Rather its only purpose is to demonstrate an effect which may serve as a starting point
for further \vork and which is best described as follows:
Considering the causal structure described in Figure lone intuitively receives confirmation
that there is a constancy in the influencing characteristics. Precisely this structure offers
a time invariant mode of causal dependence. It is the main implication of the analysis
carried out in section 2 that this constancy in a NOD is obviously not transferred to the
"Newtonian" causal analysis using affine transformations. NOD's generally would lead to
"variable parameter models"! But, if \'alues of the random variables defined for a NOD are
observed, a "data"-based analysis of such models by methods of inferential statistics may
or may not regard this variability of parameters. (Time dependence for all parameters
in the proposed example is obtained if the lagged random variable having a cumulative
memory over the entire history of the system is defind as '1t-l:= II + ... + It-I, where It IS
the indicator function for A2dt).) :\Ioreover one can observe a sequence of ~t-coefficients
converging monotonically towards zero as t grows. This results in serious consequences
for the controllability of systems over many period,,: There lIlay exist a time dependent
kind of incontrollability if "structure wins over mechanism"!
 55

References

[1] Ching-Yao Hsieh and Stephen L.Mangum, A Search for Synthesis in Economic Theory.
::Jew York-London 1986, pp.71-75.
[2] Leserer,:VI. Kogniti\'e Inferenz als okonometrische Aufgabe - Einige Bemerkungen
zur okonometrischen Grundsatzdiskussion. "J ahrbucher fur Nationalokonomie
und Statistik", Bd.201/2(1986), S.97-106.
[3] Leserer.:VI. Zur Kontrolle aus Regressionen erster Art. In: H.Isermann et al.
(Eds.). Operations Research Proceedings 1986. DGOR-Vortrage der 15.Jah-
restagung. Berlin-New York 1987. S.557-567.
[4] Vollmer, G. \Vas konnen wir wissen? Bd.2: Die Erkenntnis der Natur. Stuttgart
1986.

Appendix

Common probability mass functions and variance-covariance-matrices of '1, (ETAt),

and ~t (KSlt) for t = 1,2,3,4,10.
'It-l

period t=l

PROBABILITY MASS FUNCTION: VARIANCE-COVARIANCE-MATRIX:

ETAl 0 ETAl KSIl
ETAl 0.187500
KSIl RowSum KSIl 0.125000 0.250000

a 0.500000 0.000000 0.500000

0.250000 0.250000 0.500000

ColSum 0.750000 0.250000 1.000000

period t=2

PROBABILITY MASS FUNCTION: VARIANCE-COVARIANCE-MATRIX:

ETA2 0 ETA2 ETA1 KSI2
ETA2 0.058594
ETA1 KSI2 RowSum ETA1 0.046875 0.187500
KSI2 0.031250 0.000000 0.250000
o o 0.375000 0.000000 0.375000
1 o 0.125000 0.000000 0.125000
o 1 0.375000 0.000000 0.375000
1 0.062500 0.062500 0.125000

ColSum 0.937500 0.062500 1.000000

 56

period t=3

PROBABILITY MASS FUNCTION: VARIANCE-CQVARIANCE-MATRIX:

ETA3 ETA2 KSn

ETA3 0
---------- --------------- ---------------- ETA3 0.015381
RowSum ETA2 0.014648 0.058594
ETA2 KSI3
------------------------ ----------------- KSI3 0.007813 0.000000 0.250000
o o 0.468750 0.000000 0.468750
1 o 0.031250 0.000000 0.031250.
o 1 0.468750 0.000000 0.468750
0.015625 0.015625 0.031250
----------------- ------------------------
ColSum 0.984375 0.015625 1.000000

period t=4

PROBABILITY MASS FUNCTION: VARI&~CE-COVARIANCE-MATRIX:

ETA4 0 ETA4 ETA3 KSI4

ETA4 0.003891
ETA3 KSI4 RowSum ETA3 0.003845 0.015381
KSI4 0.001953 0.000000 0.250000
o o 0.492188 0.000000 0.492188
1 o 0.007813 0.000000 0.007813
o 1 0.492188 0.000000 0.492188
1 0.003906 0.003906 0.007813

ColSum 0.996094 0.003906 1.000000

period t=10

PROBABILITY MASS FUNCTION: VARIANCE-CQVARIANCE-MATRIX:

ETA10 0 ETA10 ETA9 KSI104

ETA10 0.000001
ETA9 KSll0 RowSum ETA9 0.000001 0.000004
KSI10 0.000000 0.000000 0.250000
o o 0.499998 0.000000 0.499998
1 o 0.000002 0.000000 0.000002
o 0.499998 0.000000 0.499998
0.000001 0.000001 0.000002

ColSum 0.999999 0.000001 1.000000

Optimal control of nonlinear stochastic
macroeconometric models: An algorithm and an
economic example

Josef Matulka and Reinhard Neck

Vienna University of Economics and Business Administration
Augasse 2-6, A-lOgO Vienna, Austria

Abstract

We describe a new algorithm for the optimal control of nonlinear stochastic models subject
to quadratic objective functions and report on its application to a small macroeconometric
model of the Austrian economy. In addition to the usual additive uncertainty the algorithm
allows for random parameters in the model. The optimal values of the control variables are
computed in an iterative fashion: First, the time-invariant nonlinear system is linearized
around a reference path and approximated by a time-varying linear system. Second, this
new problem is solved by applying Bellman's principle of optimality. The resulting feed-
back equations are used to project expected optimal state and control variables. These
projections then serve as a new reference path, and the two steps are repeated until con~
vergence is reached. The algorithm has been implemented in the statistical programming
system GAUSS. This implementation, called OPTCON, has been used to perform con-
trol experiments with an IS-LM-type model of the Austrian economy. The optimal policy
derived without considering parameter uncertainty is compared with two scenarios where
stochastic parameters are considered in order to assess the influence of model uncertainty
on the optimal trajectories of control and state variables.

Keywords: Optimal control, stochastic control, nonlinear models, control algorithm, ap-
plication to a macroeconometric model for Austria.

Contents
1 Introduction
2 OPTCON - An algorithm for the optimal control of nonlinear stochastic models
3 Derivation of the algorithm
4 An application to a macroeconometric model for Austria
5 Concluding remarks
References

Financial support from the "Fonds zur Forderung der wissenschaftlichen Forschung" (re-
search project no. P .5846) is gratefully acknowledged.
 58

1 Introduction

Several algorithms for the optimal control of stochastic econormc systems have
already been published. Typically, they either allow for additive uncertainty
only [Chow & Butters 1977] or rule out nonlinear system equations [Coomes 1985]
[Kendrick & Coomes 1984J [Norman 1979J [MacRae 1975] or have not been implemented
[Kendrick 1981, Chapt. 9J.

In this paper we describe a new algorithm for the optimal control of nonlinear economic
models that allows for additive uncertainty as well as for the presence of a stochastic
parameter vector in the system equations. In Section two, we describe some elements
of the class of problems to which the algorithm can be applied, and some devices used
within the algorithm. Section three gives the derivation of this algorithm, which has been
developed following the lines of [Chow 1981, Chapt. 3J. Section four presents a small
nonlinear macroeconometric model of the Austrian economy consisting of eight equations.
The design of the control experiments and the results obtained are described. Section
five lists some experiences got in the course of the implementation of the algorithm and
indicates directions of further research.

2 OPTCON - An algorithm for the optimal control

of nonlinear stochastic models

We start the description of the algorithm by specifying the form of the objective and
system function. We introduce the notation used and discuss first and second derivatives
of the system equations. Furthermore, we evaluate certain expectations which are needed
in the main part of the derivation, the application of Bellman's principle of optimality
to our problem. This principle enables us to show by induction the validity of the main
recurrence equations of the algorithm.

2.1 Objective function

In its most general form, the objective function of a control problem is described by

(1)

where Xt denotes an (n x 1 )-vector of state variables, Ut denotes an (m xl )-vector of control

variables,S denotes the initial and T the terminal time period of the planning horizon.

In our algorithm we constrain this function to be additive in time

T
L = L Lt (Xt,Ut), (2)
t=S
 59

and quadratic in the deviations of state variables Xt and control variables Ut from their
"ideal" levels Xt and Ut, respectively:

(3)

with W t defined as
t = S, ... ,T. (4)

Furthermore, we require W t to be constant apart from a constant discount rate a:

t = S, ... ,T, (5)

where W is a constant matrix. Without loss of generality it is assumed that W is symmet-
ric, which entails that
(6)

The quadratic tracking form of the objective function defined in (3) has an obvious inter-
pretation: Deviations from "ideal" values are punished. The so-called "general quadratic"
form, however, simplifies notation and computation. It will therefore be used for the
derivation of the algorithm:

(7)

The equivalence of these two forms can be easily demonstrated by setting:

-Wt (~:), (8)

~ ( ~:)' W (~:)
t •
(9)

2.2 System equations

The system dynamics (the equations of the econometric model) are assumed to be given
by
xt=f(Xt-l,Xt,Ut,(),Zt)+E t , t=S, ... ,T, (10)
where Xt-l denotes an (n X 1 )-vector of lagged state variables,
Xt denotes an (n X I)-vector of state variables,
Ut denotes an (m X 1 )-vector of control variables,
() denotes a (p x 1 )-vector of unknown parameters,
Zt denotes an (l x I)-vector of non-controlled exogenous variables, and
Et denotes an (n X 1 )-vector of stochastic disturbances.

() and ft, t = S, . .. ,T, are assumed to be independent random variables with known finite
expectations and covariance matrices:

() (O,L;88), (11)
E ~ (O,L;«). (12)
 60

f(.) in (10) thus describes the following mapping:

and can be interpreted as a vector of real-valued functions

f1(.) )
f(.) = ( : (13)
m(. )

2.2.1 Derivatives of the system equations

We demand that the first and second derivatives of the system function with respect to
:l:t-1, Xt,Ut and () exist and are continuous. The following notation is used:

f"._1 denotes an (n x n)-matrix the elements of which are defined by

i = 1, ... ,n
(14)
j = 1, ... ,n.
f". denotes an (n X n )-matrix the elements of which are defined by

(f ) .. = 8£i(.) i = 1, ... ,n (15)

x • • ,) 8Xt,j j = 1, ... ,n.
fu. denotes an (n X m )-matrix the elements of which are defined by

(f ) . = 8£i(.) i = 1, ... ,n
(16)
u. ',) BUt,j j = 1, ... ,m.
fo denotes an (n X p )-matrix the elements of which are defined by

(£) .. = 8£i(.) i = 1, ... ,n

(17)
o ',) 8() . j = 1, ... ,p.
J

Matrix calculus allows us to specify these derivatives in a convenient and well-established

way [Basilevsky 1983, pp. 139f1".]. Representing second derivatives of a vector-valued func-
tion within matrix calculus is a more cumbersome task. In this paper we will use a notation
similar to that suggested by [MacRae 1974].

f"._1,8 denotes an (n . p X n )-matrix which has the following structure:

(,..'::", ) (~'~:'" )
ofl af l

:'"
OX._I.109. a"._I,nD9p

(,. ':;", ) (,. )

f"._1,9 = (18)

ofn
OX._l.106. 8 X t_l,n OO p
 61

f",. ,9 denotes an (n . p x n )-matrix the structure of which is very similar to the above save
that all occurences of Xt-1 are replaced by Xt.

f u ,,9 denotes an (n . p X m )-matrix of the following structure:

( au~fa91 )
af'
8u,t,Tn88 p
(19)

2.2.2 Linearization of the system equations

The system dynamics given in equation (10) are very comfortable for economic applications
of control theory. In most practical cases the so-called structural form of an economic
model can be easily transformed into the given system dynamics. For the derivation of an
algorithm, however, the state-space representation used in most control-theoretical texts
[Aoki 1967] is more adequate. It differs from (10) mainly in that it does not include Xt
at the left-hand side. We will show how one can eliminate this variable in the course of a
linearization of the system dynamics (cL [Chow 1981, pp. 15ff.]).

For known values of Xt-1, Ut, e, and Et we can compute a value Xt such that

(20)

by straightforward application of a nonlinear equation-solving method such as the well-

known Gauss-Seidel approximation algorithm. Then we can linearize the system function
f(.) around these reference values and get the following approximative system equations

t = S, ... ,T, (21)

where we have defined

(In - f"")-1 f",,_,, (22)

(In - f"")-lf",, (23)
Xt - AtXt-1 - BtUt, (24)
~t (In - f",,)-lEt, (25)

and In denotes the (n X n) identity matrix.

Equation (25) implies for the expectation and the covariance matrix of ~t, conditional on
the information given at t - 1, that:

E t - 1 (tt) 0, (26)
COV t _ 1 (tt,tt) (I - ['",)-1 COY h, Et) [(1 - f""rT. (27)
 62

It has to be kept in mind that all these matrices are functions of the reference path along
which they have been evaluated. If this path changes the matrices will also change. Thus,
we have been able to show how one can approximate the time-invariant nonlinear system
f(.) by time-varying linear system functions.

2.3 Parameter covanances

From the section above it is obvious that the matrices At, B t and the vector Ct are functions -
of the random parameter vector () and are, therefore, random themselves. Of course, both
matrices can be written as collections of their column vectors

At = (-at,l t =S, ... ,T, (28)

B t = (bt,l bt,m) , t = S, ... ,T. (29)

Each of these column vectors as well as Ct are functions of (), which we indicate by the
notation

at,i at,;((), ... ), i=l, ... ,n, (30)

bt,j bt,j ( (), ... ), j = 1, ... ,m, (31 )
Ct Ct( ()). (32)

While in general these functions will be nonlinear it is possible to approximate them by

linear functions and thus to write

Da•.i() i = 1, ... ,n (33)

at,i
t = S, ... ,T,
Db"j () j=l, ... ,m
bt,j (34)
t = S, ... ,T,
Ct D C ,()
t = S, ... ,T. (35)

In order to obtain the matrices DB"i, Db"j, and DC, introduced above, one has to calculate
the derivatives of At, Be, Ct with respect to (). We use analogous notations as for the second
derivatives of the system equations.

DA, denotes an (n . p X n )-matrix which has the following structure:

(~)
8e,

8a,,11
CO.)
8e,

8at-ln
ae;- ao;:-
DA, = (36)

C~) (~)
86, 86,

8 a t,nl Bat,nn.

~ an;-
 63

DB, denotes an (n. p x m )-matrix and DC, an (n· p x 1 )-vector of the following structures:

( ~) ( ~)
80, ao;-
8b",m) 8e,
(
8b~'11
88
8b,~,m
ao p
aCt,!
ae;;
p
DC, = (37)
8;;;n)
( ~) ( ~) (
88, 80 ,

8b t ,n.l 8bttfiTn aCt.n

88 p ae p 80 p

The relationship between the matrices defined above and the matrices Da"i, Db"j, and
DC, can be found through inspection of their structure and is expressed by the following
identities:

[vec ((D a", ),) , ... , vec ((Da',i)') , ... , vec ((Da"n)')] , (38)

[vec ( (Db',,)') , ... , vec ( (Db',j)') , ... , vec ( (Db"m )') ] , (39)

[vec ((DC')')] . (40)

Using the matrix differential calculus established by [MacRae 1974] it is possible to prove
that the matrices introduced above can be evaluated as follows:

[(In - f",,)-l 0 Ip] [f",.,oA t + f""_,,O] , (41)

[(In - f",,)-l 0 Ip] [f"",eBt + fu"e], (42)

vec [((In - f",.)-l fe )'] - D 'Xt_1 - DB'Ut.

A (43)

Thus, we have found a way to compute the linear approximations (33)-(35) and can evalu-
ate the expectations and covariances of the parameters of the linearized system equations:

COV t _ 1 (at,i,at,k) D a,,iCOV t _ 1 (B, B) [Da"<],, (44)

COV t _ 1 (at,i, bt,j) Da"iCOV t _ 1 (B, B) [Db!.;]' , (45)
COV t _ 1 (at,i,Ct) D a"iCOV t _ 1 (B, 6) [DC']', (46)
COV t _ 1 (bt,q, bt,j) D b"qCOV t _ 1 (B, B) [Db'j]' , (47)
COV t _ 1 (bt,j, Ct) D b"jCOV t _ 1 (B,B) [Dc,]" (48)
COV t _ 1 (Ct,Ct) DC'COV t _ 1 (O,B) [Dc,]" (49)

foralli,k=l, ... ,nj j,q=l, ... ,m.

2.4 Evaluation of some expected values

In the process of deriving a control algorithm for this model it will become necessary to
evaluate expecations such as E t- 1 (~A~KtBt), where K t denotes a deterministic symmetric
 64

(n X n)-matrix. Following [Kendrick 1981, Appendix B] we evaluate E t - 1 (A~KtBd as

(50)

where

tr [KtCOVt~l (b t.m, at.d]) .

(51)
tr [KtCOV t_1 (b t •m , at.n)]

This means that l:KB

is an (n X m)-matrix the element in the ith row and jth column
of which is given by the formula

i = l, ... ,n
(52)
j = l, ... ,m·

i = l, ... ,n
[l:KA] ..
'.J
= tr [KtDa •.iCOV t_1 (0,0) (Dat,.)'],
j = I, . .. ,n,
(53)

i = 1, ... ,m
[l~KA] .. tr [KtDa.,iCOVt_l (0,0) (Db •.• )'] , (54)
t,J j = 1, ... ,n,
i = 1, .. . ,m
[l~KB] .. tr [KtDb"i COVt-d 0,0) (Db •• )'] , (55)
'.J j = 1, ... ,m,
[l;tKt tr [KtDc'COV t _1 (0,0) (Dat .• )'] , i = ,n,
1, ... (56)

[l~Kt tr [KtDCtCOVt_l (0,0) (Db.,.)'] , i = 1, ... ,m, ( 57)

[l~Kc] tr [KtDc'COV t _ 1 (0,0) (DC')'] , (58)

the expectations E t - 1 (A~KtAt), E t - 1 (B;KtA t ), E t - 1 (B;KtBt ), E t - 1 (A;KtCt),

E t - 1 (B;KtCt), and E t - 1 (A;KtA t ), which will be needed later in the derivation of the
algorithm, can be evaluated in an analogous way. In the above definitions we have already
substituted the approximations derived in the previous section for the covariances of the
parameters of the linearized system.

3 Derivation of the algorithm

The key idea of our new algorithm is to use Bellman's principle of optimality:

(59)

where J;( Xt-l) denotes the loss which is expected at the end of period t-1 for the remaining
periods t, . .. , T if the optimal policy is implemented during these periods. E t - 1 (.) denotes
 65

conditional expectation; Xk-l, k = S, ... t, and Uk-I, k = S + 1, ... t, are known at the
time when we have to decide about Ut.

We are going to show by induction that J;( Xt-l) can be expressed as a quadratic function
of Xt-l:
(60)
for all periods t = S, . .. , T + 1.
Obviously, this is true for J T+1 (XT), as we do not count any losses after the end of the
optimization horizon and can thus define

HT+l 0, (61)
hr+l 0, (62)
h~+1 0, (63)
hY+1 0, (64)
hj+1 0. (65)
As the second step of the induction proof, we now have to show that if J;+1 (Xt) can be
expressed as a quadratic function of Xt then J;(Xt-d will also be quadratic in Xt-I' For
this purpose we define some auxiliary variables:

Kt Wt'" + Ht+l> (66)

k'"t w~ + h~+I' (67)

A"'x
t y~KA + E t- 1 (Ad K t E t- 1 (At), (68)
A XU
t (A~"')' , (69)
AU"
t y~KA + E t- 1 (E t )' KtE t- 1 (At) + WtXE t _1 (Ad, (70)
AtUU y~KB + E t- 1 (E t )' K tE t_1 (Et) + 2E t- 1 (Ed Wt" + W t U
", (71)

AXt y~Kc + E t - I (At)' KtE t - 1 (Ct) + E t - 1 (At)' k~, (72)

AUt y~Kc + E t- I (Ed KtEt- 1 (Ct) + E t- I (Ed k~ + Wi""E t- 1 (Ct) + w~, (73)
).'
t !tr [KtCOV t_1 (~t,~t)l + h:+l' (74)
>.Pt t y~Kc + hf+I' (75)
),ct tEt-1 (cd KtE t- 1 (Ct) + E t - I (Ct)' k~ + w~ + h~+l' (76)

These definitions render it possible to combine L t( Xt, Ut) and J~+l (Xt) and write J t( Xt-l, Ut),
the function of expected accumulated loss, in a compact manner:

(77)

Minimization of this function with respect to 1lt yields the following feedback rule

(78)
 66

where
_ (A,",")-1
t
AtU:C , (79)
_ (A~,")-l A~. (SO)
By substituting the feedback rule for Ut into J t(Xt-1,Ut) we can derive J;(Xt-I), the func-
tion of IlliIlliIllal expected accuIllulated loss, as
(Sl)
where
A"""
t
- A"'u
t
(A uu
t
)-l AU'"
t , (S2)
X"t - A"'u uu
t (A t )-l AU t , (S3)
A~ - ~ (An' (A~u)-1 A~, (S4)
A:, (85)
Af· (86)

Thus, it has been proved by induction that J;(X t _1) is a quadratic function of Xt-1 for all
periods t = S, ... , T.

As can be seen from the derivation, it would be necessary to evaluate several conditional
expectations such as E t - 1 (At), E t - 1 (B t ), and E t - 1 (Ct). To simplify the problem, we
exclude any learning about the parameters and substitute ES-1 (.) for E t - 1 (.) for all t =
S + 1, ... ,T +1. Analogous assumptions are used for the covariance matrices, all occurences
of COV t _ 1 (.,.) are replaced by COY S-1 (., .). These simplifying assumptions make the
algorithm which is summarized in Figure 1 fully operational.

4 An application to a macroeconometric model for

Austria

In this section we report about an application of the optimal control algorithm described
in the previous sections to a small macroeconometric model of the Austrian economy. The
primary purpose of this exercise is to test the algorithm and its implementation in the
programming system GAUSS. Moreover, to some extent the results of the optimal control
experiments may also serve as a first basis for an evaluation of Austrian macroeconomic
stabilization policies, although for this purpose the interpretations must be very carefully
carried out due to the simple nature of the model and of the objective function applied.
An optimization experiment is described which considers all the parameters of the model
as deterministic; this is supplemented by two experiments where the stochastic nature of
some key parameters is taken into account.

4.1 A small econometric model of the Austrian economy

We consider a small macroeconometric model for Austria, which is a slightly revised and
updated version of the model OPTPOL-1 previously used for optimal control experiments
 67

1. Use the Gauss-Seidel algorithm and a tentative policy path (Ut);=s (which has to be
submitted as input) to calculate a trial solution (Xt);=s'

2. Execute the following steps for time periods t = T, T - 1, ... ,S:

(a) Linearize the system equations around the reference values Xt-I, Xt, Ut, 0, and
€ = On to get At, B t , Ct, and COV t _ 1 (~t, ~t).
(b) Compute influence of stochastic parameters. Obtain TfKA, TfKA, TfKB,
TfKc, TfKc, T~Kc.

(c) Convert the objective function from quadratic-tracking to "general" quadratic

format, thus getting w:, w~, and w~.
(d) Compute parameters of feedback rule and expected minimal loss function: G t ,
gt, H t , h~, h~, h;, and hf.

3. Use the computed feedback rules and the system equations to project expected op-
timal state (x;);=s and control trajectories (u;);=s'

4. Compute expected welfare loss:

5. Check convergence. If for all state and control variables the relative deviations of the
reference values (Xt);=s, (Ut);=s used for linearization from the projected optimal val-
ues (x;);=s, (u;);=s are smaller than a predefined tolerance (e.g. 0.001), then STOP.
Otherwise, if the number of iterations already exceeds a predefined maximum, then
STOP without convergence. Otherwise, use the projected optimal state variables
(x~);=s and the projected optimal control variables (u;);=s as the new reference path
(Xt)t=s, (ut);=s and go to step 2 to start a new iteration.

Figure 1: OPTCON: A quadratic-nonlinear control algorithm

 68

with the Chow program [Neck & Posch 1982] [Neck & Posch 1984]. Its theoretical basis
is a Keynesian one in the sense of textbook-IS-LM-models. The model consists of four
behavioral equations and four identities. Data have been taken from the database of the
Austrian Institute of Economic Research (WIFO). All real data have dimension Billions
of 1976 Austrian Schillings.

The model contains eight endogenous (state) variables: real private consumption (CR),
real fixed investment (IR), real imports of goods and services (MR), the long-term bond
yield as an interest rate variable (R), real gross domestic product at market prices (YR),
real total aggregate demand (VR), the total-demand deflator (1976 = 100) as a measure
for the general price level (PV), and the rate of inflation (PV%). There are three control
variables: the net tax rate (net tax receipts as percentage of GDP, T%) and real public
consumption (G R) as instruments of fiscal policy, and the nominal stock of money supply
M1 (M1) as an instrument of monetary policy. Finally, three exogenous non-controlled
variables are present: the deflator of imports of goods and services as a measure of the
import price level (PM), real autonomous expenditures (real exports of goods and services
plus inventory changes including errors and omissions from the national income accounts
statistics, AR), and the deflator of GDP at market prices as a measure for the domestic
price level (PY).

Behavioral equations for CR, IR, MR and R have been estimated for annual data by OLS,
using the software system lAS. The estimation period has been 1964 to 1988. All behav-
ioral equations are of a form that allows their immediate input into the optimal control
algorithm. They are formulated according to the partial-adjustment hypothesis. Thus
the consumption function conforms to the permanent-income and the habit-persistence
hypothesis; in addition, it takes into account an influence of the real rate of interest on
consumption expenditures. The investment function embodies an accelerator and an influ-
ence of the real rate of interest on investment expenditures. Imports depend on aggregate
total demand and on the relative price of imports. The equation for the rate of inter-
est is a reduced-form version of a demand-for-money function, assuming real demand for
money to depend on real GDP and the nominal rate of interest, and to be equal to real
money supply. Although some of the estimated coefficients are not significant according
to the usual statistical criteria, the present version has been used for the optimization
experiments; those coefficients which are not significant qualify as natural candidates for
stochastic parameters in the experiments where random parameters are taken into account.

Figure 2 shows the results of the estimations and the identities of the model, together with
the statistical characteristics of the four regressions. Values in brackets below regression co-
efficients denote estimated standard deviations, t-values and standardized beta-coefficients
of the parameters, respectively. R2 is the coefficient of determination, R~ the coefficient of
determination adjusted for the degrees of freedom, SE ist the estimated standard error of
the equation, MAPE ist the mean absolute percentage error, DW is the Durbin-vVatson
statistic for serial correlation, and p is the estimated first-order autocorrelation coefficient
of the residuals.

As can be seen from the equations in Figure 2, the model is nonlinear. For simulations, it
has to be solved numerically; in the optimal control algorithm, this is done by the Gauss-
 69

1. Private consumption, real

T%t
CRt = 0.3061 CR t _ 1 + 0.63312 Y R t (1- - ) - 1.81043 (Rt - PV%t) + 5.27457
(0.14364) (0.13237) 100 (0.74461) (5.904)
(2.13) ( 4.78) (2.43) (0.89)
(29.1) (66.9) ( 4.0)

R2=0.996 R~=0.996 SE=5.55399

MAPE=0.99 DW=1.972 p=O.Ol

2. Fixed investment, real

0.93547 IR t _ 1 + 0.2359 (VR t - VRt_d- 0.42742 (R t - PV%d + 8.95606

(0.03425) (0.04793) (0.59133) ( 6.18576)
(27.31) ( 4.92) (0.72) (1.45)
(83.0) (14.8) (2.2)

R2=0.975 R~=0.972 SE=5.40704

MAPE=2.19 DW=1.559 p=0.22

3. Imports of goods and services, real

PMt
MR t = 0.21599 M R t - 1 + 0.28844 V R t - 0.93284 ( - ·100) + 13.43473
(0.14035) (0.05414) (0.55423) PVi (69.10811)
(1.54) (5.33) (1.68) (0.19)
(20.8) (73.1) (6.1)

R2=0.993 R~=0.992 SE=8.66294

MAP E=2.92 DW=1.163 p=0.35

4. Rate of interest, nominal

MIt
Rt = 0.792 R t _ 1 - 0.01857 (-·100)+ 0.00169 Y R t + 2.76811
(0.1604) (0.01755) PVi (0.00228) (1.31912)
( 4.94) (1.06 ) (0.74) (2.10)
(57.5) (24.7) (17.8)

R 2=0.616 R~=0.558 SE=0.67843

MAP E=5.64 DW =1.323 p=0.32

5. GDP at market prices, real

YR t = CRt +IR, +GR, +AR, -MRt

6. Total aggregate demand, real
V R, = Y R, + l\;f R,
7. Deflator of total demand
YR, MR,
PVt = - P Y i + --PM,
VR, VR,

8. Rate of inflation
PV%, = (PVi - PVi-tl/PVi-l ·100

Figure 2: Small Model of the Austrian Economy

 70

Seidel method. In a dynamic simulation of the model over the estimation period using
historical values for all exogenous variables, it turns out that the dynamic behavior of total
demand and its components is rather close to the historical movements of these variables;
thus the model gives a satisfactory picture of Austrian macroeconomic developments. One
major drawback of the model is its neglect of the supply side of the Austrian economy;
it is essentially a demand-side model with the price sector being in fact exogenous. Most
of the macroeconometric models for Austria that include aggregate supply are fairly com-
plex; so far, we have not been able to integrate any of them into a model to be used
for optimization experiments. Furthermore, it should be mentioned that for the present
purpose we assume that fiscal and monetary policies are conducted by the same authority;
thus, government and central bank are considered to be one homogeneous policy-maker.
In Austria, this might be not too unrealistic since the independence of the central bank
from the government is rather limited.

4.2 Set-up of the optimization experiments

In addition to the model, we have to specify an intertemporal objective function for the
optimal control experiments. Unfortunately, economic theory or the theory of economic
policy do not provide much support for this task; thus the objective function is inevitably
rather ad-hoc. For the present purpose, we assume the quadratic-tracking function as used
by our algorithm. The time horizon for the optimal control experiments has been chosen
to be 1971 to 1988. From mid-1970 to 1986 the Austrian government was dominated
by the Socialist Party (SPO); thus, it may be suspected that during this period historical
stabilization policies were relatively homogeneous. The last two years are included because
it is well known that in finite-horizon dynamic optimization problems the controls may
exhibit strange behavior during the last years due to the neglect of the future. Thus,
even if we are only interested in optimal policies until 1986, it is advisable to extend the
optimizations a few years further.

For the "ideal" values of the state and control variables, we make the following assumptions:
For 1970, historical values of all variables are assumed to be given. For the following years
(1971 to 1988), we postulate growth rates of 3.5% p. a. for real total demand and its
components, i. e. for real GDP, private and public consumption, fixed investment and
imports of goods and services. A growth rate of 2% p. a. is considered as "ideal" for the
price level (the deflator of total demand) and a constant value of 2 is assumed as "ideal"
rate of inflation. The rate of interest has an "ideal" constant value of 2 for all periods. For
the control variable net tax rate, the historical value of 1970 is used as "ideal" value for
all periods. For nominal money supply, we assume an "ideal" growth rate of 5.5% p. a.
from its 1970 historical value.

This choice of the "ideal" values for state and control variables can be justified as follows:
We assume that the values of the economic variables in 1970 cannot be influenced by a
fictitious government starting to plan for a time horizon which coincides with the period
when the Socialist-dominated government was in office. Thus, the initial values of 1970
are regarded as the heritage from the previous administrations. The aim of the fictitious
government is to stabilize the economy in the sense of achieving smooth growth paths of real
 71

and nominal variables without excessive inflation. The value of 3.5% for the growth rate of
real variables is slightly above the average growth rate of historical GDP at market prices
over the planning horizon and can therefore be regarded as a realistic goal. Attaching the
same "ideal" growth rates to all real variables of the model means that the hypothetical
policy-maker has the aim of achieving a "balanced growth" of all components of total
demand. The rate of interest and the money supply can be interpreted as intermediate
targets; a low rate of interest may serve to expand aggregate demand, and a money stock
growing at the same rate as "ideal" nominal GDP (3.5% real plus 2% price level growth)
may be interpreted to be neutral with respect to inflation.

For the weighting matrices W t we assume constancy over time (a = 1); all off-diagonal
elements of this matrix are zero, and the main diagonal elements have the following weights:

variable CR IR MR R YR VR PV PV% T% GR M1
weight 5 5 5 2.5 10 0 5 0 5 5 1

Real GDP at market prices is regarded as the main target variable; its components and
real imports get smaller weights to express the idea of "balanced growth" and to achieve
stabilization of the shares of the components of total aggregate demand which itself is
not penalized directly for deviations from its "ideal" values. The general price level is
also penalized, although this will not result in a visible effect since this variable (though
formally endogenous) is in fact determined by the exogenous price level variables PM and
PY. The constant growth target for real public consumption and the constant level target
for the net tax rate have the same weights; in this way, the aim of a constant allocation
between the private and the public sector is expressed. This device may also be regarded
as a substitute for a government budget constraint absent from our model. The weights
given to the intermediate target variables rate of interest and money supply are intended
to prevent excessive fluctuations of these variables.

Three different control experiments are performed: In the first one, all parameters of the
model are regarded known with certainty. The only stochastic influences considered are
the additive error terms in the behavioral equations, whose variances contribute to the
optimal value of the objective function but do not alter the optimal policies as compared
to a purely deterministic set-up. Since we have only 01S estimates at our disposal, we
have no estimate of the variance-covariance matrix of the additive error terms. Instead,
we assume it to be a diagonal matrix, with the squared estimated standard errors of the
behavioral equations in the main diagonal. Also, the values ofthe exogenous non-controlled
variables are assumed to be known for all time periods in advance.

In the second and third experiments we tentatively introduce some stochastic parameters.
In the second experiment those parameters whose estimates have the lowest t-values are
regarded as stochastic. These are the interest rate coefficient in the investment function
and the money stock and the GDP coefficient in the interest rate equation. The estimated
values of the regression coefficients and their estimated standard deviations are used as
expected values and standard deviations, respectively, of these parameters in the algorithm.
Since these insignificant coefficients are exactly those which are crucial for the monetary
 72

policy multiplier, by this experiment we can also investigate what happens to optimal
policies when the effectiveness of monetary policy becomes more uncertain.

In the third experiment the marginal prospensity to consume (the disposable-income coef-
ficient in the consumption equation) is added as fourth stochastic parameter, again taking
the estimated coefficient and its estimated standard deviation as the first and second mo-
ments of that parameter, respectively. This allows us to study the effects of making fiscal
policy multipliers stochastic. Although the effectiveness of fiscal policy depends on several
parameters in our model, the one chosen here is particularly crucial for both the tax rate
and the public consumption multiplier.

Fully taking account of the stochastic nature of all the parameters of the model would
require an estimate of the entire variance-covariance matrix of the coefficients of the model.
It could be obtained from a simultaneous-equations estimation, but the running time of
the current version of the computer program would be very high.

One final remark should be made concerning the interpretation of the optimization ex-
periments. We do not claim to have a positive model of stabilization policy-making in
Austria. Obviously, for that purpose many additional features would have to be intro-
duced, apart from the question whether Austrian policy-makers really want to optimize
an intertemporal objective function. Also, a normative interpretation should be subject
to several caveats. In particular, the policies calculated are optimal only under the par-
ticular objective function and provided that the structure of the model is in fact valid.
Moreover, using a model which is estimated with data up to 1988 and assuming all values
of exogenous variables up to that year to be known, means using more information than
a policy-maker of 1970 could have obtained even under ideal circumstances. Instead, the
optimization experiments could be regarded as exercises in an "experimental evaluation"
of the model and the objective function; by performing optimal-control experiments, we
want to learn about the response of the model economy to variations in the assumptions
about the objectives of policy-making and about the uncertainties inherent in the model.
Thus we are performing extended simulation experiments guided by an objective function
to be optimized. Needless to say, even this restricted interpretation of the optimal control
framework for macroeconomic policies would be meaningless if the Lucas critique were
fully valid; a Keynesian view of the potential effectiveness of monetary and fiscal policies
is a necessary requirement for these optimization experiments.

4.3 Results of the optimal control experiments

The three optimal control experiments described above were carried out on an IBM com-
patible 12 MHz PC-AT with a 80287 mathematical coprocessor. The algorithm was imple-
mented in the programming language GAUSS. It took about 20-30 minutes to arrive at an
approximately optimal solution. 'With a tolerance level of 0.001, on average, 6 iterations
were required for the Gauss-Seidel algorithm to converge, and the optimal policies were ob-
tained after three to five iterations of the stochastic control algorithm. Thus, convergence
appears to be rather rapid for our small econometric model, but the running time on the
PC is unsatisfactory and prevents the use of larger (and hence more realistic) econometric
 73

models with the present version of our program.

The time paths of the expected optimal control variables are displayed in Table 1. Addi-
tionally, in Figure 3 and in Figure 4 historical and target values are compared with the
expected optimal values for two selected variables, namely the control variable real public
consumption and the main target variable real GDP. All data in Table 1 and Figures 3
and 4 are given in Billions of Austrian Schillings. In Figures 3 and 4 the labels 'Stoch(3)'
and 'Stoch( 4)' refer to the control experiments with three and four stochastic parame-
ters, respectively, and the label 'Determin' denotes the results of the experiment without
stochastic parameters.

The upper portion of Table 1 shows the results when all parameters are assumed to be
deterministic. This experiment shows that fluctuations of the main objective variables can
be stabilized to some extent by optimal policies. The optimal values of the control variables
exhibit counter-cyclical behaviour; particularly fiscal policies (the variables T% and GR)
are set in a more active way than historically to combat the recessions in 1975 and 1981.
During most years the optimal net tax rate is lower and real public consumption is higher
in the optimization experiment than they were historically; thus fiscal policy is exerted in
an expansionary way, which is plausible given the Keynesian features of our econometric
model. On the other hand, optimal money supply has a relatively smooth path over
the optimization horizon, with values higher than historical until 1973 and lower values
afterwards. This results in higher values for the rate of interest, which nevertheless do not
seem to crowd out either real private consumption or fixed investment. The optimal values
of real imports and real GDP are below the historical values during the initial years and
above afterwards. Thus, within our model optimal policies are capable of obtaining smooth
growth paths for the main target variables and can effectively overcome the prolonged
period of low growth of the eighties following the two oil price shocks.

The central part of Table 1 shows the results of the experiment where the three parameters
relating to monetary policy are assumed to be stochastic. The differences to the previously
described run are minor. Money supply is smaller during most years; this, however, has no
visible effect on the endogenous variables apart from the rate of interest which is slightly
higher. This indicates that monetary policy is rather ineffective in our model. Making its
impact more uncertain means that it is even less used for stabilization purposes and kept
closer to its "ideal" path (which is unrealistically low due to the low "ideal" values of the
price level).

Finally, the lower portion of Table 1 shows the results from a run where in addition to the
above the marginal propensity to consume is regarded stochastic. Here we can observe
much more pronounced differences to the first run: The net tax rate is much higher, and
so are real public consumption and the money supply which counteract the restrictive
effects of high taxes on real GDP. As must be expected, this scenario results in lower levels
of consumption and imports and also of real GDP, whereas investment is higher due to
lower rates of interest as compared to the run where the parameters were assumed to be
deterministic. Similar results were obtained from a run where only the marginal propensity
to consume was regarded as stochastic. These outcomes are somewhat surprising because
they indicate that when fiscal policy effects become more uncertain higher levels of fiscal
 74

/I CR I IRI MR I R YR I VR PV PV% T% GR M1
no stochastic parameters
1971 324.620 148.225 166.493 7.151 586.280 752.773 70.930 5.856 38.841 108.607 94.278
1972 335.023 155.289 182.030 7.028 604.576 786.606 75.401 6.304 39.469 111.426 98.482
1973 341.049 163.356 199.151 7.020 626.022 825.173 80.755 7.100 41.193 109.380 103.155
1974 349.097 170.733 206.420 7.206 649.048 855.469 90.004 11.453 43.606 108.295 107.555
1975 373.661 174.037 216.951 7.393 663.989 880.940 95.302 5.887 37.140 126.251 113.147
1976 377.100 180.654 233.373 7.593 690.086 923.458 100.000 4.929 39.971 120.291 118.283
1977 390.756 185.480 248.294 7.793 712.147 960.440 104.992 4.992 38.980 125.131 123.931
1978 407.213 189.984 264.636 7.986 734.144 998.780 109.623 4.411 37.866 132.678 129.576
1979 413.458 195.505 279.784 8.194 762.988 1042.772 114.623 4.561 39.943 128.935 135.092
1980 423.592 200.452 292.070 8.453 791.198 1083.268 121.772 6.238 40.955 128.815 140.462
1981 446.513 203.622 301.723 8.773 814.377 1116.100 130.756 7.377 39.080 141.702 145.477
1982 468.262 207.219 318.270 9.097 838.257 1156.527 137.277 4.987 37.113 153.073 150.497
1983 489.637 210.414 337.466 9.378 863.715 1201.181 140.761 2.538 35.372 163.856 155.725
1984 499.887 215.947 357.276 9.684 896.047 1253.322 147.322 4.661 37.630 162.225 160.723
1985 516.852 219.377 375.330 9.967 926.303 1301.633 151.708 2.977 36.702 167.352 166.395
1986 548.483 221.745 400.401 10.176 950.108 1350.509 153.081 0.905 33.207 187.307 172.422
1987 574.419 225.636 425.612 10.337 981.300 1406.912 154.354 0.832 32.645 200.762 178.603
1988 588.865 233.136 451.485 10.491 1027.241 1478.726 156.692 1.514 34.804 201.884 185.649
three stochastic parameters
1971 324.556 148.060 166.412 7.383 586.082 752.494 70.930 5.856 38.725 108.558 85.413
1972 335.010 154.958 181.919 7.417 604.364 786.284 75.401 6.304 39.262 111.448 90.140
1973 341.109 162.835 199.024 7.498 625.791 824.816 80.755 7.101 40.937 109.485 95.758
1974 349.235 170.032 206.283 7.693 648.806 855.089 90.004 11.453 43.341 108.479 102.245
1975 373.857 173.184 216.800 7.832 663.721 880.521 95.302 5.887 36.889 126.491 110.380
1976 377.348 179.691 233.216 7.974 689.812 923.028 100.000 4.929 39.746 120.576 116.488
1977 391.044 184.436 248.134 8.124 711.871 960.005 104.992 4.992 38.777 125.452 122.284
1978 407.530 188.884 264.476 8.273 733.868 998.345 109.623 4.411 37.681 133.024 128.050
1979 413.799 194.374 279.627 8.443 762.721 1'042.347 114.623 4.561 39.778 129.301 133.744
1980 423.949 199.305 291.917 8.666 790.938 1082.855 121.772 6.237 40.808 129.193 139.379
1981 446.874 202.477 301.573 8.946 814.123 1115.697 130.755 7.377 38.951 142.082 145.115
1982 468.618 206.094 318.123 9.226 838.006 1156.129 137.277 4.988 37.004 153.444 151.085
1983 489.984 209.326 337.325 9.471 863.476 1200.801 140.761 2.538 35.279 164.216 156.401
1984 500.228 214.907 357.145 9.752 895.830 1252.975 147.322 4.661 37.552 162.576 161.103
1985 517.178 218.388 375.208 10.017 926.098 1301.306 151.708 2.977 36.635 167.687 166.707
1986 548.795 220.805 400.286 10.221 949.916 1350.202 153.082 0.906 33.144 187.627 171.903
1987 574.726 224.740 425.508 10.394 981.129 1406.637 154.355 0.832 32.583 201.076 176.832
1988 589.181 232.279 451.400 10.570 1027.110 1478.510 156.692 1.514 34.740 202.210 182.778
four stochastic parameters
1971 300.690 145.926 162.899 5.660 577.442 740.341 70.924 5.848 45.185 122.405 150.664
1972 308.530 153.957 177.357 4.528 595.749 773.106 75.399 6.309 44.857 125.751 151.437
1973 314.524 163.555 194.365 3.865 617.699 812.064 80.759 7.108 46.574 122.598 153.662
1974 324.787 172.736 201.987 3.689 641.728 843.715 89.996 11.438 48.508 118.850 156.291
1975 341.660 176.851 211.766 3.603 654.533 866.299 95.298 5.892 43.816 140.798 163.852
1976 346.109 185.179 228.279 3.647 681.403 909.682 100.000 4.934 45.777 132.980 168.353
1977 357.673 191.314 243.079 3.778 703.093 946.172 104.993 4.993 45.129 138.111 173.392
1978 370.866 196.925 259.109 3.962 724.397 983.506 109.629 4.415 44.337 146.809 178.437
1979 377.350 203.811 274.325 4.216 753.651 1027.976 114.627 4.559 45.943 141.941 182.949
1980 387.635 209.960 286.723 4.575 782.102 1068.825 121.770 6.232 46.714 140.823 187.103
1981 407.573 213.853 296.082 5.039 804.488 1100.570 130.747 7.372 45.140 154.881 190.938
1982 425.675 217.982 312.156 5.519 827.402 1139.557 137.275 4.993 43.381 167.927 195.058
1983 442.255 221.502 330.712 5.962 851.621 1182.334 140.767 2.543 41.973 181.303 198.370
1984 454.014 227.879 350.616 6.477 884.663 1235.279 147.329 4.662 43.465 178.123 198.978
1985 469.371 231.667 368.512 6.986 914.457 1282.969 151.715 2.977 42.590 i
183.879 200.744
1986 494.122 233.719 392.707 7.442 936.194 1328.901 153.103 0.915 39.771 1208.086 201.244
1987 514.881 237.365 417.106 7.906 966.029 1383.134 154.384 0.837 39.315 224.793 198.612
1988 516.275 243.940 441.520 8.430 1008.979 1450.499 156.721 1.514 42.719 235.443 194.537

Table 1: Results of the experiments

 75

OPTCOlf ~O J.&D. ". 151","0 I , : 13:M .....

o
Re 1 public consumption
....
C\l

o
C\l
C\l

,.
0 - ~-!
C\l ./
o
co -: /
. I' "
/::-... ,..... - ~---

o
C\l

7 1 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88

Hi s toric Sloch( 4)
Targel Stoch(3)
----. --- Determ in
Figure 3: Real public consumption

ea l g r oss do m tic product

M
o
,
.' ",,/"' ~

.-~
CD " ;~ /; ---:_/.
o
. ...
. ..-
~ .
.
/ "

",.... r-- .
t --:
<0
c:i
.-r. --t ---

~ L-~~__~-L~~~~__L--L~__~-L~__~-L~__~~
71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88

Historic Stoch(4)
Targ l Stoch(3)
---- ~ --- Determ in

Figure 4: Real gross domestic product at market prices

 76

policy variables become optimal, which is difficult to interpret in economic terms. Further
experiments are required to check whether this conclusion holds more generally.

5 Concluding remarks

In this paper, we have developed an algorithm for the optimal control of nonlinear dynamic
macroeconometric models with stochastic additive error terms and stochastic parameters
under a quadratic intertemporal objective function. This algorithm has been implemented
in the programming language GAUSS and applied to a small econometric model of the
Austrian economy in order to show the feasibility of the algorithm. The optimization
experiments show that optimal policies lead to a considerable stabilization of the time paths
of the main objective variables of the model. Results of two different runs with stochastic
parameters have been presented to demonstrate the influence of parameter uncertainty.

Several directions of further research may be suggested. More optimization experiments

are required in order to study the results under a greater variety of stochastic parameter
patterns and different economic models. These models should include those with alterna-
tive theoretical foundations, e. g. monetarist ones. This should lead to an analysis of the
sensitivity of optimal policies with respect to the underlying model, as has been done for
Austria with a model including elements of the supply-side [Neck & Posch 1984] and with
a model including a real-balance effect [Neck 1988]. Also, alternative objective functions
should be applied, and the numerical sensitivity of the optimal policies to the choice of the
"ideal" values of the objective variables and the elements of the weighting matrix in the
objective function has to be examined.

For the currently available PC version of the program, runtime is a serious concern. The
most time-consuming part of the program happens to be the Gauss-Seidel solution of the
system. Thus, the projection of the state variables is a very expensive operation. Also,
computing first and second derivatives of the system equations accounts for an important
part of the runtime as it has to be done for each time period. The use of a symbolic
instead of a numerical derivation algorithm could certainly help reducing the runtime by
a considerable amount.

For the algorithm itself, there exist several possible extensions. By adding updating equa-
tions for the stochastic parameters such as the ones used by [MacRae 1975] it could be
expanded into a passive learning algorithm. A more difficult task would be the exten-
sion of the algorithm to include active learning, i. e., the derivation of approximations
to closed-loop policies in the sense of [Kendrick 1981]. Another interesting extension to
be considered in the future will be the examination of the effects of decentralized policy-
making; here results of decentralized control theory (dynamic team theory) and dynamic
game theory will have to be incorporated.
 77

References

[Aoki 1967] Masanao Aoki. Optimization of Stocbastic Sytems: Topics in

Discrete-Time Systems. New York: Academic Press, 1967.
[Basilevsky 1983] Alexander Basilevsky. Applied Matrix Algebra in tbe Statisti-
cal Sciences. New York: North-Holland, 1983.
[Butters 1977] Ettie H. Butters. Nonlinear Optimal Control Program Pro-
grammer's Guide. February 1977.
[Chow 1975] Gregory C. Chow. Analysis and Control of Dynamic Economic
Systems. New York, London: Wiley, 1975.
[Chow 1981] Gregory C. Chow. Econometric Analysis by Control Methods.
New York, Chichester: Wiley, 1981.
[Chow & Butters 1977] Gregory C. Chow und Ettie H. Butters. Optimal Con-
trol of Nonlinear Systems Program User's Guide. Research
Memo #209, Econometric Research Program, Princeton Uni-
versity. Princeton, April 1977.
[Coomes 1985] Paul Coomes. PLEM: A Computer Program - Passive Learn-
ing Stocbastic Control for Reduced-Form Econometric Models.
Discussion Paper 85-4, Center for Economic Research, Univer-
sity of Texas, Austin.
[Kendrick 1981] David Kendrick. Stocbastic Control for Economic Models. New
York: McGraw-Hill, 1981.
[Kendrick & Coomes 1984] David Kendrick und Paul Coomes. DUAL: A Program for
Quadratic-Linear Stocbastic Control Problems. Discussion Pa-
per 84-15, Center for Economic Research, University of Texas,
Austin.
[MacRae 1974] Elisabeth Chase MacRae. "Matrix Derivatives with an Appli-
cation to an Adaptive Linear Decision Problem", Tbe Annals
of Statistics, 2/2 (1974), pp. 337-346.
[MacRae 1975] Elisabeth Chase MacRae. "An Adaptive Learning Rule for
Multiperiod Decision Problems", Econometrica, 43 (1975),
pp. 893-906.
[Neck 1988] Reinhard Neck. "Policy Simulations and Optimal Control with
a Small Econometric Model for Austria". In: A. Sydow,
S. G. Tsafestas, R.Vichnevetsky (eds.). Systems Analysis and
Simulation 1988. Berlin: Akademie-Verlag, 1988, pp. 249-252.
[Neck & Matulka 1989] Reinhard Neck and Josef Matulka. "Optimal Control of Dy-
namic Economic Models: A Comparison of Three Computer
Programs". In: P. Borne et al. (eds.). Computing and Com-
puters for Control Systems. Basel: Baltzer, 1989, pp. 63-68.
 78

[Neck & Posch 1982J Reinhard Neck and Ursula Posch. "On the 'Optimality' of
Macroecononric Policies: An Application to Austria". In:
G. Feichtinger (ed.). Optimal Control Theory and Economic
Analysis. Amsterdam et al.: North Holland, 1982, pp. 209-
230.
[Neck & Posch 1984J Reinhard Neck and Ursula Posch. "On the Sensitivity of Opti-
mal Macroecononric Policies to Econometric Models: An Em-
pirical Analysis for Austria". In: T. Basar, L.F.Pau (eds.).
Dynamic Modelling and Control of National Economies 1983.
Oxford et al.: Pergamon Press, 1984, pp. 91-98.
[N orman 1979 J Alfred 1. Norman. "First Order Dual Control", Annals of Eco-
nomic and Social Measurement, 5/3 (1976), pp. 311-321.
 Game Theoretical Approach to Optimal Control of Economic Systems

Krystyna Strzala
Department of Econometrics
University of Gdansk
Armii Czerwonej 101
PI-81-824 Sopot

Abstract

Some features introduced into economic models (rational

expectations) and new hypotheses on the behavior of the
policymakers (risk aversion, strategic planning) have forced
economists to derive generalized control methods. Game theory
seems to be a natural framework in such a case. As opposed to a
standard optimal control solution different outcomes occur
depending on the information available to players and on the mode
of the play. Two types of information structures are distinguished
and discussed in the context of a policy model with a discrete
time econometric model as a part of it.

Keywords: Optimal control of economic systems; optimal control

algori thms; dynamic game; Nash-game; decentralized
policy design.

Contents

1 The basic optimal control problem formulation and its

criticism
2 Open-loop and closed-loop decision rules in dynamic games
3 Open-loop Nash game
4 Closed-loop Nash game
5 Some remarks about application of Nash game to the empirical
economic analysis
References

1. r~~ __ ~~~!~ __ Q2!!!~! __ ~Q~!~Q! __ 2rQ~!~! __ fQ~~~!~t!Q~ _and ___ !t~

criticism

To focus the discusf;ion, WP pres'~nt at first a standard dynamic

stochastic optimal control problem as used for deriving
stabilization policies in a linear-quadratic setup (see Chow
(1975, 1981)).
 80

min E(W) (1 )
x E X
subject to:

Yt = At Yt - 1 + CtX t + b t + v t (2 )

YO given (3 )

where:
Yt p-vector of state variables,
xt m-vector of control variables,
At' C t pxp and pxm nonstochastic parameter matrices,
Et expectation operator conditional on information
available at the beginning of period t,
at p-vector of targets towards which Yt is aimed,
K positive semi-definite matrix (often diagonal),
t
T planning horizon,
bt p-vector which measures the influence of
noncontrollable exogenous variables,
v p-vector of random disturbances with expectation
t
2
(pxp)-covariance matrix E(vtv )=a
s v t
for s=t and E(Vtvs)=O otherwise.
Diagonal elements of the K matrix are penalty weights of squared
deviations of the state and control variables from their
targets. Therefore, a linear-quadratic stochastic optimal control
problem is to minimize the expectation of the quadratic loss function
(1) given a linear stochastic dynamic model in a state-space form
(2) and initial conditions (3).
General techniques used for solving a linear-quadratic optimal
control problem are the Minimum Principle and Dynamic Programming
(in the former case, see: Pontriagin et al. (1962), Intriligator
(1971), Feichtinger and Hartl (1986), in the latter case: Bellman
(1957), Chow (1975, 1981).
The most favored algorithm in economic applications is that
proposed by Chow (197 5) which leads to a set of time-varying
feedback control rules of the form :

t=1,2, ... ,T (4 )

where: Ht ; Kta T = hT ; c T =

-(CtHtCt)-1(CtHtAt)

-(CtHtCt)-lCt(Htbt - h t ) ( 5)
 81

h t - 1 = Kt - 1 a t - 1 - (At + ctG t )' (Htb t - h t )

c t - 1 = at-1Kt-lat-1 + (b t + ctg t ) 'Ht(b t + ctg t }

-2(b t + ctg t } 'h t + ct + Et_lVtHtvt'
This solution in a closed-loop feedback form obeys the principle
of multiperiod certainty equivalence as well (see separation
theorem Simon (1956) , T1H?i.1 (19,)7)).

The literature on optimal control theory and its economic

applications is extensive, see for instance: Chow
(1972,1975,1981) , Aoki (1976), Theil (1964) , Pindyck (1973) ,
Hughes Hallett and Rees (1983) , Pau (1979), Kend'rick
(1981,1982,1977) , Feichtinger and Hartl (1986) and references
therein contained.
* * *
It is useful to stress the distinction between an open- and a
closed-loop control rule. If policy variables are fixed for the
whole planning period at the beginning of the first period, i.e.
controls are a function of time and the initial state, this is
called an open-loop control (state-independent, fixed or
non-contingent rules) (see e.g. Blackburn (1987), Meijdam and de
Zeeuw (1986)).
In a closed-loop (no memory) or feedback control rule controls
depends on new information not available at the beginning of a
planning period, i.e. controls are a function of time and actual
state. In other words, by closed-loop control it is assumed that
the decision maker has perfect information either on the present
state of a system or access to a state vector and is able to fix
the values of instruments anew from period to period. Other
notions used for a closed-loop control are: flexible,
state-dependent, conditional or contingent rules (in this paper
notions of closed-loop and feedback control rules are used
interchangeably, however, there is some difference in meaning; see
e.g. Miller and Salmon (1985), Kydland (1975), Kendrick (1988».
In a deterministic (or certainty equivalence) case these two types
of control rules yield the same value for control variables.
However, if the model does not correctly reflect reality or
uncertainty is introduced (as in (1» both rules lead to
different sequences of values of instruments. In such a case, an
optimal control rule in a closed-loop form performs better because
it permits a response to unforeseen contingencies and therefore
the expected loss under an optimal closed-loop policy rule is
smaller than the expected loss under an optimal open-loop policy
rule (see Chow (1975».
Optimal control theory which has already proved to be a wonderful
device in physical sciences seemed to be a natural choice for
solving macroeconomic policy problems, because of the assumed
similari ty between physical and economic systems. Both systems
could be described by an appropriate mathematical (or econometric)
model specifying state (endogenous), forcing (exogenous) and
control variables (policy instruments), stochastic properties of a
system and a way in which the variables are related via a set of
 82

static and/or dynamic simultaneous equations. The attractiveness

of the optimal control theory applications for evaluating
macroeconomic policies was due to these perceived, then stressed,
and advocated similarities between physical and economic systems.
During the past ten years or so, economists have become more aware
of differences between these two systems and along with ~t
conventional macroeconomic models and standard optimal control
methods have become the object of an increasing volume of doubts
and criticism.
(All parts of a standard optimal control problem have been sllbject
to criticism: an objective function, an econometric model and the
optimal control approach tor evaluating macroeconomic policies in
general (see e.g. Lucas (1976); r.how (1987), Gruber (1987,1933);
Leserer (1988,1987,1986»
The first blow was done by Lucas in 1976 which came together with
the rapidl~ growinq interest in the application of the rational
e~Dectation assumption first proposed by Muth (1961).
Lucas criticized the traditional method of evaluating the effects
of alternative qovernment policies which takes inadequate account
of effects of government policy on expe~tations formed by
economic agents. He pointed out that an economy is not a passive
systpm. Tn general, there are several independently acting
controllers in an economy. Their .1,:tiollS depend on their
expectation~ hith r0spert to actions of other decision makers. The
policy evaluation under the dssumption of rational exp8ctations
has rdised tl-wnr."tical and comput,Jti{)nel] probl.~ms nn which the
literature j,; ,·'-;t.-'nsivp (~. ;c.". e.l]. r-;lad.;burn (1987)).
80mp authors, Kydland and Pre:,r:'ott (1977) in particular, feel
st.rot1qJv thelt these problems are insoluble ,md therefore the
optimal control thf'url sh.)ulci !l('! be applied to p<'ollnmic plannin<].
Later on, hO~0ver, it hecame a common idea that the optimal
('onlro] approd(·h should be placed in a game thenry framework.

Planning prohlems in which the policy variables are under control

or influence of several decision makers and economic agents with
their own object i ve funct ions belong to a class of nonzero-sum
dynamic games (see e.g. Starr and Ho (1969 a,b)).
The solution, or equilibrium, of the game depends importantly
upon the extent to which each policy maker, or player, i:3
committed to hiG planned policy or strategy, and his perceived
influence on other policy makers.
Much of the recent literature un mdcroeconomic policy desiqn ~hich
emphasizes its game aspects does so in the r:ontext of explicit
rational expectations models (see e.g. Ruiter (1981), Miller dnd
Salmon (1984), Currie and Levine (1984)). However, as stressed in
Fischel (l980) , t.he e~;sential feature is intelligent
[orwClrci--l')okillq behavior· the ability of future expectations to
1.nflllence current decisions.
A dynamic game consistf; of the following elements:
a dynamic mndel in discrete time;
 83

an objective function for each decision maker;

an assumption on the behavior of the decision makers and
an information structure.
Two significantly different information structures have to be
distinguished, i.e. open- and closed-lrnlp.
An open-loop game is defined in terms of actions which are
essentially constant strategies and are independent of the stilte
of the system at all times. In this case control rules are only
functions of time and initial state. On the contrary, a
closed-loop game is defined in terms of rules [Ol' eadl player
which, at any time, are functions of the state .1t t:I.1l r illl".
In nccler to I',':pldin tile maIn difference bethee'en a.11 npell-1o , )p "nd a
closed-loop control rule in a game theory fram0work more
precisely, let's assume the following notation:
x t - value of the instrument vector in period t,
Qt- information set available to a policy maker at the
beginning of period t, when x t is chosen,
t=l - the beginning of a planning period and T-t >1 its end.

A rule consists of a choice at t=1 of a set of functions ft'

relating x t (t=1,2, ... T) to a particular information set.
In a game theory framework, open-loop control rules are defined
by:
t=1,2, ... ,T (6)

whereas closed-loop control rules are:

t=1,2, ... ,T (7 )

where the functions lt' t=l,2, ... ,T, are known at t=l.
In other words, under a regime of closed-loop information
structure, values of present and future policy instruments are at
t=1 known functions of some information that will be available
when values of these instruments have actually to be assigned.
Strategies or control rules are in this case functions of time and
the state of the system. If uncertainty is present, this means
that values of instruments in periods ">1 can respond to
observations (realizations) of random variables between periods 1
and T.
In both cases each player forecasts the other players' actions and
formulates his best response. An important distinction, however,
is that under a closed-loop information structure each player is
announcing a rule describing how he wi 11 respond to some new
information that may accrue during a course of a game. ThUS, each
player, when computing his response, recognizes that his decision
affects his rivals' response, because each player act ion affects
the state of a system and the state of the system determines
control rules via the closed-loop assumption.
Without loss of generality let's assume there are only two
decision makers. Following the traditional approach, (compare with
(1)-(3», a two-person nonzero-sum noncooperative dynamic game
over the horizon (1, TI can be stated straightforwardly in the
linear-quadratic setup by distinguishing between instruments under
 84

control of each player:

T
min E(L i ) L Et (Yt - a it ) 'Kit (Yt - a it ) (8 )
t=l
2
Yt = At Yt-1 + c·tx·
i=l 1 1 t
L
+ bt + vt (9)

i = 1,2
where:
x it - (m i x1)-vector of policy variables (instruments) of
decision maker i at period t, i=1,2, m1 + m2 = m;
Cit - (nxmi)-nonstochastic parameter matrices, i=1,2;
L. - loss of decision maker i after T planning periods;
1
a it - p-target vector of the i-th decision maker;
Kit - (pxp) weighting matrix of the i-th decision maker at
period t;
other symbols are defined as in (1)-(3).
The optimization problem regarding more than one decision maker
cannot be solved without assumptions about the behavior of all
decision makers. Several modes of behavior are possible e.g.
noncooperative behavior in the sense of Nash; cooperative behavior
in the Nash-Harsanyi sense; and leader-follower behavior in the
sense of Stackelberg (see Nash (1951), Harsanyi (1977), Kydland
(1975) ) .

Under the Nash assumption, all players (the government and private
agents in an economic system) have equal status in the game. They
have no perceptible influence on the behavior of the others and
therefore they treat the rivals' strategies as parametric.
The solution concept of Nash has the important prop'~rty that in
equilibrium a non-decision maker has an incentive to deviate from
his Nash-strategy if other decision makers continue to use their
equilibrium strategies (see e.g. Basar and Olsder (1982».
A noncooperative Nash-equilibrium strategy
S~ E S. is the strategy with the property:
l l

(10)

No decision maker can decrease his loss by solitary

deviation from the equilibrium strategy Sn. Such a model assumes
implicitly that commitments (i.e. agreements, promises or threats)
are not binding and the possibility of side payments is excluded;
also, communication between players has no value and it is
 85

irrelevant whether it takes place or not.

An open-loop Nash game involves each player minimizing his own
loss in equation (8) by choice of his own controls subject to
equation (9) and treating his rival's control vector as
parametric.
Thus, when choosing xl t for tl!:l, to minimize L1 subject to the
dynamics of the system described by equation (9), player one takes
Yt and X2t as given for tl!:l. Player two in minimizing L2 takes as
given the path for X1t for tl!:l.
An open-loop Nash equilibrium is defined by the requirement that
the control path which each player takes as predetermined should
match what the other player chooses as optimal. Since the behavior
of both players is symmetric the analysis needs to be carried out
for only one of them.
One way to solve an open-loop optimization problem as shown by
Kydland (1975) is to reformulate it as a one-period problem with
Tq (T-planning horizon, q-total number of policy variables)
unknowns. It can be solved then by applying any of the static
algorithms (see Chow (1975), Hughes Hallett and Rees (1983)).
The assumptions on the random disturbances allow us to use the
certainty equivalence property and to ignore disturbances in
computing the first-period decision rules. Thus the problem to be
solved is a deterministic one.
The problem is stated by a loss function (8) rewritten in matrix
form for all periods simultaneously and a constraint (9) an
econometric model rewritten for all periods in time stacked final
form:
-I< I< I< -I< I<
L. (y - ail 'Ki (y - ail i=l,2 (11 )
1

-I< 1<-1<
2 1<- I<
Y A Yo + E C.X. + b (12)
1. 1.
i=l
yO and decisions of other players are given, (13)

where: all symbols marked by a bar mean deterministic variables

and those marked by a star mean stacked vectors and matrices.
An open-loop Nash solution may be expressed as:
(14)
I< I<
where G and g are defined analogously to (5) in stacked matrix
form.

Another algorithm invented by Haas (1979) uses a recursive formula

by exploiting an open-Ioop-linkage equation in the form:
(15 )

This formula corresponds to the well known feedback decision rule,

 86

but its interpretation and usage is quite different. It is used

for computing the recursive solution of a linear syscem of
first-order conditions for a minimum.
Given the state YO and having computed matrices Gt and vectors gt
of open-loop-Iinkage equations (15) for all t, an open-loop-Nash
solution is computed by forward sUbstitution:
- -
Yt = At Yt-1 + CtX t + b t (16)

= Rt Yt-1 + r t ,

where:
Rt=At+CtG t , (17)
rt=bt+Ctg t ,
all symbols marked by a bar mean deterministic variables, other
symbols have the same meaning as in (8)-(9).
This yields an open-loop Nash solution xt for t=l, .. , T, since
vectors of policy variables are incorporated in the state vector.
As in the former case a solution is obtained for the deterministic
model,"the certainty equivalent" of the original stochastic model.
Two other algorithms for obtaining an open-loop Nash solution in
the linear-quadratic discrete time setup have been invented by
Pindyck (1976,1977) and de Zeeuw (1984).
In both algorithms the method employed for the calculation of
open-loop Nash strategies is the discrete-time minimum principle
(see Canon, Cullum and Polak (1970), Pindyck (1973)).
Formally the optimization problem is stated as follows:

Jo
1

2
+ E
j=1
(u °t-U °t) 'Ro ° (u °t- U °t) I
J J 1J J J
'* min i=1,2 (18)

subject to:

t=O,l, .... T-l (19)

where:
Xt - vector of n state variables;
U j t - vectors of q1 and q2 control variables, j=1,2, ql+q2=q;
Zt - vector of s noncontrollable exogenous variables;
A,B l ,B 2 , and nxn, and nxs matrices;
 87

X it and U jt - nominal (desired) values;

Q. and R., -- weightin,] matrices; Q.-- positive semi--definite
1 1 :1 l
Rjj - positive definite.
The optillldl str'ategies arE~ found hy solving two joint sets of
Riccati equations (with boundary conditions), two joint sets of
tracking ecpJations (with boundary conditions) and using the
obtained solutions for calculating the two sets of optimal values
for the instrument variables.
In dp Zeeuw' s formulation, dn est ima ted determinis t ic econt)metric
nwdel in ~ltate--space form (a realization of the reduced form)
forms the constraints of an optimization problem. Three groups of
variable:; are distinguished, i.e. l.objective liilriables (targets),
2.state variables and l.control variables and a measurement
(n>Cid-out) equation is added to an econometric model. The
cri terion functiona Is to be minimized are functions of objective
and control variables.
Diff(~rences between the solutions in ejp Zeeuw's and in rindyck's
proposals are caused by these differences in the constraints.

Methods employed for solving a clnsed--loop Nash game exploit the

backward recursive stxu<:·ture of dyn.lmic programming (see e.g.
Kydland (1975,1976), rindyck (1976,1977), Haas (1979,1980), Chow
(1981), Hughes Hdllet~ and Reef> (1983), de Zeeuw (1984)
Under a closed-loop information structure, each player knows that
his decision affects the state of a system. A change in the state
variables changes other player's future decisions, and this
affects his future losses. This fact is taken into account in d
feedback solution when a player mdk'~s his decision. Thus each
player instead of taking as given other player's decisions, takes
as given other player's dec is ion rules for each time period t.
These decision rules are functions of the known state variables
Yt-1·
Intuitivelv, a Nash equilibrium in a closed-loop case is a
strategy for player 1 (sI(t)} which is taken as given by player 2
and which is actually optimal for player 1

{sl (t)} = {s~(t) J (20)

and vice versa.

Formally, each player is assumed to choose the optimal control
rul,! ~;o as to minimize his loss fun'~tion (8) defined on the
variables of a linear equation system (9) conditional on the
assumption that a feedback rule of the other player is given.
These closed-loop rules:

(21 )
 88

alter the players' first-order conditions for minimization.

The method employed for solving this problem is either dynamic
programming or the discrete minimum principle. The latter is
applied in the global and the former in the stage-wise mode, which
is an inherent feature of dynamic programming.
After solving simultaneously the first-order condi tions of both
decision makers, the closed-loop Nash control rules can be written
as (see Haas (1979,1980)):
i=1,2; t=1, ... ,T (22)

where: Hit=K it ; hit=Kitait

- -1-
-(CtHtC t ) CtHtA t
- -r
-(CtHtC t ) Ct(Htbt-h t )

At + CtG t
b t + Ctg t

Hi ,t-1= Ki ,t-1 + RtHitR t

h i ,t-1= Ki ,t-1 a i,t-1 + Rt(h it - Hitr t )

equilibrium path

where all vectors and matrices are defined analogously to (5) in

appropriately stacked matrix form.
It is clear that a feedback solution is different from an
open-loop solution, even in the deterministic case.
Closed-loop (dynamic programming) strategies have the property
that they are also optimal for the remainder of the game. This
feature coincides with the perfectness concept in game theory (see
Selten (1975).
The strategy sequence
(23)

is said to be a perfect Nash equilibrium if at any O<t<T the

strategy set (23) is a Nash equilibrium for the subgame in {t,TI,
given the history of the game in (t=O,tl)
Whilst an open-loop Nash strategy is not subgame perfect, a
closed-loop Nash (dynamic programming) solution does satisfy
subgame perfection because the equilibrium conditions hold in
every subgame of the entire game. This is due to the recursive
structure of both concepts. The perfect equilibrium solution
involves players making current decisions in the knowledge that
future equilibrium decisions will be made in the same way a
backward recursive structure which is analogous to dynamic
programming.
Two other algorithms that treat the same subject (closed-loop Nash
game) are Pindyck (1977) and de Zeeuw (1984). In the former case
the solution is found by means of the discrete minimum principle,
 89

in the latter case by applying dynamic programming and the

discrete minimum principle. The problem under consideration is
deterministic and it is assumed that an economic system behaves
non-anticipating.
As pointed out by de Zeeuw (1984) in the case of a Nash game, the
linear closed-loop (feedback) global solution coincides with the
closed-loop (feedback) stage-wise solution. Differences in the
optimal closed-loop strategies in these algorithms are caused by
differences in the assumptions - the form of constraints.
Both approaches, i.e. open- and closed-loop, may be said to
represent noncooperative equilibrium solutions The information
needed in both approaches is different, and this feature could
significantly influence the choice of the solution method in
specific situations and for specific models.
Considering now very shortly the dynamic consistency property of
the Nash equilibria , it can be stated that the Nash equilibrium
appears to offer the appropriate equilibrium concept - the time
consistent equilibrium. As pointed out in Simaan and Cruz (1973a)
the Nash assumption safeguards each player against attempts by
others to seek further gains by fooling them into believing a
particular strategy.
As stated before, Nash closed-loop equilibrium strategies satisfy
subgame perfection but open-loop rules do not. However, they are
time consistent. This implies that the perfectness of equilibria
is sufficient but not necessary for the time consistency, or that
the time consistent equilibrium is merely a variant of the
stronger concept of perfect equilibrium (see Blackburn (1987».

~~_~~~~_~~~~~~~_~~~~!_~~~!~g~!~~~_~f_~~~~=g~~~_!~_!~~_~~~~~~g~!
_~g~~~~ig_~~~!Y§1~

Many conceptual and technical problems arise when linear-quadratic

models and game theory are combined and applied to econometric
policy models.
The algorithms for policy evaluation, which are presented in this
paper apply to a model which is linear in parameters and objective
function for each decision maker is quadratic.
The program CHOWM (for PCs) for obtaining open-loop and
closed-loop Nash strategies is based on Haas proposal (see Haas
(1979) and formulas (15)-~7) for open-loop and formula (22) for
the closed-loop Nash game). This is a generalization of Chow's
algorithm (Chow (1975» from the single decision maker to the case
of M noncooperative controllers with different objective functions
and individual policy instruments. The algorithm has the property
of leading to nearly identical solution schemes in the open-loop
and close-loop Nash game and the advantage that Chow's algorithm
is a special case of it.
Model W6-88A constructed for policy optimization experiments is a
simplified submodel of a new simulation version of a
disequilibrium model for Poland (W-6) (see: Romanski and Welfe
(1990». The macroeconometric model like W-6 is constantly subject
 90

to changes. The previous version of the W-6 model was elaborated

in 1986. It covered the period until 1982. The revised version of
the model (W6-85) has been estimated from the annual data over the
period 1961-1985. The theoretical foundations of W-6 model and the
resul ts of the statistical tests can be found in Romanski and
Welfe paper presented at the World Congress of the Econometric
Society - Barcelona 1990.
The structural form of the W6-88A model consists of 7 behavioral
and 3 definitional equations. The latter ones are equations for:
net material product, national income distributed and total
investment outlays. The behavioral equations are for: nominal
personal income of private farmers, nominal personal income,
personal consumption, investment outlays in MP sector, net
investment outlays, gross material product and increase of
inventories.
Considering the range of economic processes covered by the W6-88A
model, two decision centers i . e. "lobby of industrialists" and
"lobby of populists" have been distinguished. The target variables
of the former are investment outlays in MP (material production)
sector and gross material product whereas the objectives of the
latter decision center are distributed national income and nominal
personal income in the national economy. The first decision center
has the substantial influence on two of the policy instruments
i. e. investment outlays in NMS (nonmaterial services) sector and
other (social) consumption spendings whereas the "lobby of
populists" tries to influence its targets by means of two indirect
policy variables i.e. deflator of procurement prices of
agriculture products and real interest rates on the savings
deposits.
After testing the model for stability and forecasting properties,
six preliminary simulation runs have been executed (for details
see Strzala (1990)). All simulations have been run for period 1983
- 1988 . In each run the optimal values of the targets and policy
variables have been obtained as the solutions of the open-loop and
closed-loop Nash game and for each of the decision centers
separately. The desired values of the target and control variables
in each run have been slightly changed to illustrate the different
aspects of the optimal solution as well as the dynamic properties
of the model. It has been attempted to determine the diagonal
elements of the weight matrices in such a way as to reflect the
subjective importance of the targets and policy variables to each
of the decision centers.
For almost all simulation runs the open-loop and closed-loop
solutions of the Nash game differ slightly. This probably has been
caused by two reasons: "poor" dynamics (only two lagged state
variables) and linearity of the model (forced by the requirements
of the algorithm). Three of the state variables are influenced
neither by the changes in penalties nor in desired values of the
targets and instruments, whereas increase in inventories bears
almost all costs of pushing the optimal values of the rest of the
variables to their desired levels. One of the striking aspects
of the results is lack of conflicting objectives in the model.
There is almost no trade-off between target variables nor a
conflict between decision makers.
The application described above is merely an illustration of the
 91

methodology than an attempt to provide solid policy advice.

Nevertheless, it offers a new insight into the model dynamics and
behavior. This could be a good starting point for the further
improvement of the algorithm and the model itself.

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 NONLINEAR OPTIMAL CONTROL SIMULATIONS
OF DEVELOPMENT STRATEGIES

Ivan Sujan
Institute of Socio-economic Information
and Automation in Management (VUSEI-AR)
Dubravska 3, 842 21 Bratislava, CSFR
and
Osvald Vasicek
Institute for Automation of Management
in Industry (INORGA), branch Brno
n. kpt. Jarose 32, 656 01 Brno, CSFR

Abstract

The solution of the optimal control problem for nonlinear systems may be properly
approximated by an iterative procedure, in which the optimal control algorithm is
subsequently applied to specific linearizations of the original system. The weights for
target and control variables used in the optimization functional may be derived from the
variation coefficients of their deviations from nominal values and from the assigned
relative importance of variables in a given variant.

The practical application of the optimal control of a nonlinear system is demonstrated

using a nonlinear econometric model of the Czechoslovak economy, consisting of 32
equations with 74 variables. The authors present the scenarios of the baseline projection
and three alternative development strategies for the Czechoslovak economy up to the
year 2000, and the results of the optimal control simulations of individual strategies. The
results of the simulations have yielded useful information about the possible effects and
costs of selected development strategies. The recommended procedure may be applied
also to other alternative strategies, using different models and scenarios.

Keywords: Optimal control methods; nonlinear systems; econometric model; simulations

of development strategies.

Contents
Introduction
2 Application of optimal control methods to nonlinear systems
3 Constructing the weights for deviations of variables from their desired trajectories
4 The econometric model used in optimal control simulations
5 Scenarios of simulated development strategies
6 The results of optimal control simulations
7 Conclusion
References
Appendix: Structural equations of the Model CEM-4M
 95

Introduction

For the proper evaluation of alternative development strategies, it may be helpful to find
the optimal values of selected policy instruments, which are needed for reaching the
target values of individual strategies. Such problems may be solved by using recent
developments in optimal control methods applied to a properly adjusted econometric
model. The optimal control problem is to find such values of selected control variables,
which minimize the weighted sum of squares of the deviations of target and control
variables from their desired (nominal) values [see e.g. Chow (1981) ].

Applications of optimal control methods are usually limited to systems of linear equations
[King et al. (1982), Vasicek and $ujan (1987)]. In this paper we present the procedure
and a practical application of the optimal control of a nonlinear system. In section 2 we
describe the problem of optimal control of a linear system with parameters varying in
time and a procedure for the iterative approximation of the optimal control of
a nonlinear system. Section 3 contains some rules for constructing the weigths for the
squared deviations of target and control variables from their nominal trajectories. In
further sections we present the nonlinear econometric model of the Czechoslovak
economy used, the scenarios of the baseline projection and three alternative
development strategies, and the results of the optimal control simulations of individual
strategies. Conclusions are summarized in section 7.

2 Application of optimal control methods to nonlinear systems

A dynamic econometric model consisting of p simultaneous equations with p+q variables

may be described by the vector equation

where Yt' v!' and et are pX1, qX1, and pX1 vectors of endogenous, exogenous, and
residual (random) variables at time t, respectively, F is a vector of given continuous
functions, h is the maximum lag and N is the number of periods under consideration.

For the application of optimal control methods some transformations of the model (1)
are needed:

(a) elimination of the higher-order lags by introducing additional equations and

variables,
(b) partitioning of the vector of original exogenous variables vt into the rX1 vector
of control variables ut and the sX1 vector of purely exogenous variables Zt.
(c) separation of the nX1 vector of state (dynamic) variables xt from the vector of
endogenous (output) variables ypl)
(d) omitting the vector of residuals et (i.e. setting the values of et to zero),
(e) transformation of the model to its reduced form, i.e. elimination of non lagged state
variables from the dynamic core of the model,

1) This means a separation of the dynamic core of the model with lagged variables.
 96

(f) transformation of the time t to the model time i according to the relations:

(2a) i = t-1 for xI' Yt

(2b) i = t for up <; .

Let us consider first the optimal control problem under the assumption that the system
(1) is linear with parameters varying in time. In this case the system (1) after
transformations according to (a) - (f) may be written as an identified discrete dynamic
system described by the vector difference equation of the first order (state space
equation) for Xi+ 1 ' the output equation for Yj and the known initial condition for xo:

(3) X I+ 1 = Aix i + Biu j + GIZ I ,

(4) YI = Djxl '
(5) Xo = c ,

where xi' YI' uj , <; are nX1, mX1, rX1, sX1 vectors of state, output, control and
exogenous variables at time i, respectively; A., Bi , GI , Dj are given nXn, nXr, nXs, mXn
matrices of time-varying parameters and c is a constant vector of the initial state of
XI·

Let 91 and ul be the given desired (nominal) values of output and control vectors for the
optimization periods i = 0, 1, ... , N-1. Ignoring the mathematical expectations operator
E, the optimization criterion is the minimum value of the quadratic functional J given by

where OJ is an mXm positive semi-definite matrix and RI is an rXr positive definite

matrix at time L Both 0 1 and Rj are usually diagonal and constant in time, their
diagonal elements express the weights for the squared deviations of the output and
control variables from their nominal values.

In this case the optimal control problem is to find an optimal sequence of the control
vectors(l.f}such that (6) is minimized subject to the constraints (3) - (5). The
procedure of solution is given e.g. in Vasitek (1988).

Optimal control methods may also be applied to systems of nonlinear equations. Let us
assume now that the system (1) is nonlinear and after transformations (a) - (f) may be
written as

(7) x +1 =
j f(xj' u l ' Zj),
(8) Yj = g(x j ),

(9) Xo = c,

where f and g are given continuous vector functions. The optimal control problem may
be formulated like in the preceding case, Le. find the optimal sequence {un which
minimizes (6) subject to the contraints (7) - (9).

The optimal control of the nonlinear system (7) - (9) may be practically solved by an
iterative procedure as a limit of optimal control sequences for linearized systems with
 97

time-varying parameters [Vasicek (1989)]. In the starting iteration (k=D) we solve the
optimal control problem for the system (7) - (9) linearized along the trajectories of the
variables obtained as a response of the system to the nominal values of the control
vectors u, .
In further iterations the system is linearized along the trajectories obtained
as a response to the optimal vectors (k-,') u· found in the preceding iteration. For
convergent iterations the optimal control of the original nonlinear system is approximated
with the desired precision when the following relations hold simultaneously

(10a) J{k)j" - (k-l )J. I <8 J '

(10b) lI(k) u· - (k-l) u'II<8 u '

where" . II denotes the common Euclidean norm.

Linearization of the system (7) - (9) along the trajectories (k) u,1={(k-l) un and {(k) x,!,
(k)y,) (obtained as a response to {(k)U,),{Zt) and xo) yields in subsequent iterations
a linearized model for the differences

with the matrices of parameters calculated as the partial derivatives of the functions
f and g along the response trajectories in periods i = 0, 1, ... , N-1 :

(11) (k) A= " f (k) X,

U ,
(k) U 7 \
".., { ,
i5x

(12) (k) ~ = i5 f (k) x" (k) U,' Zt ),

i5u

(13) (k) 0 , = i5 g (k) X, ) f

i5x

The nominal output and control vectors for the linearized model are given in subsequent
iterations and periods by

(14) (k) 9, = 9, - (k) y, ,

(15) (k)U,=~_(k)U,.

After substitution of l:,.(k) x" l:,.(k) y" l:,.(k) U,' (k) A, (k) B" (k) 0, for x" y" u" A, Bp 0"
respectively, into (3) - (5)2) and substitution of (k) 9, and (k) 0, for 9, and into (6), the u,
optimal control problem for the linearized system (3) - (6) is solved, yielding the optimal
sequence {l:,.(k) ui1. The optimal control vectors for the original nonlinear system are in
the kill iteration approximated by

(16) (k) ui = (k) Ll; + l:,.(k) u; .

2) As the values of the exogenous variables z, do not change in subsequent iterations (t."'z, - 0), the term C,z, from (3)
may be omitted in the linearized model. The initial condition (3) becomes A"'xo - O.
 98

When (10a) and (10b) are satisfied, the iterations are finished and the sequence of the
optimal control vectors for the nonlinear system u~ is approximated by the results from
the last iteration, i.e. (k) u~

The convergence of the described algorithm has not yet been generally proved.
However, for nonlinear relations which are typical for econometric models (such as
power, exponential and logarithmic functions, products and ratios of variables, etc.) we
have always obtained satisfactory results. The algorithm is implemented by the program
RIC written in FORTRAN IV and working under the operation system OS/SVS on the
computer EC 1045 [Vasicek (1989)].

3 Constructing the weights for deviations of variables from their desired trajectories

The matrices Q I and RI in (6) are usually taken as diagonal and constant in time. Their
diagonal elements Qu and Ru represent the weights of the squared deviations of output
and control variables from their desired trajectories. These weights serve for
transformation of the deviations of individual variables to equal dimension (baSic
weights), as well as for the discrimination between the relative importance of individual
variables (relative weights).

The basic weights for the output variables Yj may be derived from the condition that the
variation coefficients which express the ratios of their mean squared deviations from the
desired values (Sj) to the average desired values (y) should be equal for all variables:

(17) §.. -- -=-,

S1 J. -- 1, 2 , •.• , m,
Yj Yl

where

_ 1 N-l •
Yj = -N L Ylj·
1-0

Substituting for Sj and Yj into (17), we obtain

From the comparison of (6) and (18) it follows for the basic weights Q(~) :

(19) q\O) = [~l

The relative importance of individual output variables may be distinguished by means of
the relative weights, which may vary in the individual variants of the optimal control
simulations. The total weights for a given variant v (qIV) are then constructed as
products of basic and relative weights:

(20) n(v)
-U
= [ItYj WVlJl2
Y.I'
j = 1,2, ... , m
 99

where 'I'Iy,)j is the relative weight for variable YI in variant v. In selecting the relative
weights, the preferences of a decision maker are brought to bear: The higher (in
absolute value) the relative weight is, the higher is the importance ascribed to a given
variable and the lower will be its relative deviations from the desired trajectory in the
optimal control solution.

If the relative weights for some output variables are set near zero, then the deviations
of these variables do not affect significantly the functional (6). Therefore the desired
trajectories may be given only for variables with non-zero weights ("target" output
variables).

The basic weights for the control variables may be constructed so that the variation
coefficients of deviations from the desired values be equal for both output and control
variables. Then the total weights for the control variables R(~) are given by

(21 ) R(V)
u
= ll1
r
~
y../,v).
u.J
]2 '
j = 1, 2, ... , r,

where

wt~\ = relative weight for the variable uj in the variant v, to be given according to the
preferences of a decision maker.

In the case that only some selected control variables should be used in a given variant,
we set up the weights of the other control variables very high (prohibitive weights).
Then these variables in the optimal control simulation are not allowed to differ
significantly from their desired values, i.e. they behave like pure exogenous variables.

Prohibitive weights may be assigned also to selected target variables, which we like to
exogenize in a given variant. On the other hand, we may in fact endogenize selected
control variables by setting their weights near zero.

4 The econometric model used in optimal control simulations

In our experimental application of the optimal control of a nonlinear system, we have

used the econometric minimodel of the Czechoslovak economy CEM-4M. It is an
abbreviated and simplified version of the econometric macromodel CEM-4 consisting of
294 structural eqations with 396 variables [see Sujan and Strauch (1988), Variantna
progn6za ... (1987)] and its aggregate version CEM-4A consisting of 65 equations with
144 variables [see Sujan (1988)]. The CEM-4M model is a nonlinear dynamic recursive
system of 32 equations (out of which 10 are stochastic) with 74 variables. 3 )

The list of variables of the CEM-4M model is given in Table 1. The second columm of
Table 1 indicates the partitioning of the endogenous variables (9 target variables and 23
other state variables) and exogenous variables (14 control variables and 28 purely
exogenous variables) according to the transformation of the model for optimal control
simulations.

3) Regarding the currendy available computers in Czechoslovakia. the application 01 optimal control methods to nonlinear
models is presentiy possible only to models with limited size and complexity.
 100

Table 1. List of Variables of the Model CEM-4M

Symbol Type 1) Unit2) Definition

Av x bil. Kcs Gross change in fixed capital stock (material sphere)

C Y Personal consumption - total
CA z - - natural
Cc x - - industrial goods, supply
C co x - - industrial goods, demand
CF x - - food
Co z - - other
EK x Exports to nonsocialist area
EKP x - - in current prices
Es x Exports to socialist area
Esp x - - in current prices
Ex x Total exports in domestic constant prices
E3 y coefficient Synthetic efficiency of production factors
G u bil. Kcs Social consumption
H z Losses and statistical discrepancies
I y Investment in fixed capital
Iv x - - in material sphere
J y Change in inventories
Kv x Fixed capital stock in material sphere
~ u mil. pers. Employment - in nonmaterial sphere
Lv u - - in material sphere
MCK u bil. Kcs Imports of consumer goods - from nonsoc. area
Mcs u - - from socialist area
MFK z Imports of food - from nonsoc. area
MFS z - - from socialist area
MIK u Imports of machinery - from nonsoc. area
MIS u - - from socialist area
MNK u Imports of raw materials - from nonsoc. area
MNS u - - from socialist area
MKP x Total imports in current prices - from nonsoc. area
Msp x - - from socialist area
Mx x Total imports in domestic constant prices
MWK z bil. USD World imports (nonsocialist area)
N x bil. Kcs Intermediate product
NE2 z bil. kWh - - of electrical energy
Pc z 19n=1 Retail price index - total
Pcc z - - industrial goods
'i Y _ target output variableS u - control variables
x - state variables z - purely exogenous variables
2! Variables are measured in constant19n prices. except where noted.
Exports. imports and trade balance are in foreign prices. except 01 Ex and Mx. which are in domestic prices (bil. Kes
- billion Czechoslovak crowns). "Socia Ii sf' and "nonsocia~isf' area are defined according to the conventions in the
Czechoslovak statistics up to the year 1989.
 101

Table 1. (continued)
Symbol Type Unit Definition

PCF z 1977=1 - - food

PEK x " Price index of exports to nonsocialist area
PES X " - - to socialist area
PMK z " Price index of imports from nonsocialist area
PMS z " - - from socialist area
PWKD z " Price index of world imports (nonsoc. area)
OCCD y percent Share of satisfied demand for industrial goods
OEJ( z " Ratio of exports in domestic and foreign prices
0, u " Investments ratio
O,y u " Share of material sphere in total investment
OKLY z " Scrapping rate of fixed capital in material sphere
°MX z " Ratio of imports in domestic and foreign prices
ON z " Share of N in gross material product
OTR x coefficient Rate of embodied technical progress
Owv u percent Ratio of average wages to labour productivity
OWN z " Ratio of avo wages in nonmaterial and mat. sphere
OX2C u " Share of light industry in gross material product
Q YOD z " Ratio of net nonlabour income to labour income
Q vw z " Ratio of labour income to total wage bill
SKP Y bil. Kts Trade balance - with nonsocialist area
SSP y " - - with socialist area
Tx z 1965=1 Time trend
Wy y thous. Kts Average wage in material sphere - nominal
WYRR x " - - real and spendable
X x bil. Kts Gross material product - actual
XHH x " - - potential
YG y " Gross national income
Yw x " Total labour income (nominal)
YRD x " Real disposable income of households
UAVM z 0, 1, -1 Dummy, for extraordinary changes in Ay
UEKL z " - - in EK
UESL z " - - in Es
UH z 0,1 Dummy, for buying paniCS in Czechoslovakia
UPEK z 0, 1, -1 Dummy, for extraordinary changes in PEK
UPES z " - - in PES
UTR z 0,1 Dummy, for specific effects of tech. progress
Ux u 0.1-1.0 Dummy, for productive effects of N

The parameters of the regression equations were estimated using annual ~time series for
the period 1967-1987.4 } The estimation methods used were ordinary least squares and
ridge regression (for the production function). The system of structural equations of the
CEM-4M model with estimated parameters is given in the Appendix (estimated standard
errors of parameters are in parentheses, estimated standard errors of residuals se are
given in percent of the average values of the dependent variables; the time index t is
omitted except of t-1 for lagged variables).
We present below a brief description of the structural equations of the model. 5}

') The authors are indebted to Milota Sujanova from the VUSEI-AR Bratislava for processing the database of the CEM-4M
model, estimation and testing of equations and for the experimental dynamic simulations of the model.
') A more detailed discussion of most equations can be found in t/1e papers on the CEM-4 and CEM-4A models [see
Sujan (1988), Sujan and Strauch 1988)].
 102

Equation 1 expresses the formation of gross change in fixed capital stock Av from
investment Iv with distributed lags (according to the Koyck model). In the following
identity, this change is transformed into the fixed capital stock Kv. Equation 3
approximates the rate of embodied technical progress Q TR as a modified share of new
fixed assets and imported machinery (from nonsocialist countries) in the fixed capital
stock.

Equations 4 and 5 represent a compound production function. First, the potential

product XHH is determined by a production function with variable elasticity of substitution
(Lovell's VES function) expressing the influences of labour, fixed capital and technical
progress. Second, the actual product X is expressed as a transformation of XHH (with
distributed lags), which is affected by raw material imports, intermediate product and
motivation factors (lagged average real spendable wage multiplied by the number of
employees). Further two identities define the intermediate product N (with the effect of
technical progress on the material intenSity of production) and the formation of gross
national income YG'

Identity 8 defines the average nominal wage in the material sphere Wv as a product of
the labour productivity and the exogenous ratio Qwv' Further identities define the
formation of labour income Ywand real disposable income YRD'

Equation 11 determines the demand for food CF as a function of disposable income,

relative prices and lagged consumption. Taking into account the specific situation in
Czechoslovakia during past two decades, we assume equilibrium on the food market
and disequilibrium on the industrial consumer goods market [see Sujan (1988)].
Therefore, for industrial consumer goods we model both demand Cco in equation 12 [we
employ the Houthakker-Taylor model modified for the case of disequilibrium, see Sujan
(1988)] and supply Cc in equation 13 (determined mainly by production and imports of
industrial consumer goods). Identity 14 measures the share of satisfied demand Q cco
(after subtracting the influence of buying panics). This share is used in the next identity
to construct the real spendable wage WVRR ' All components of personal consumption are
aggregated in identity 16.

Identity 17 defines total fixed capital investment I by means of the exogenous investment
ratio QI' A part of total investment Iv is allocated to the material sphere in identity 18.

Identities 19-21 aggregate exogenous components of imports from socialist and

nonsocialist countries .(Msp, MKP ) and total imports Mx, which is transformed into
domestic constant prices.

The volumes and prices of Czechoslovak exports are modelled under the assumption of
equilibrium, regarding some specific conditions. The volume of exports to nonsocialist
countries EK is determined by foreign demand in equation 24 and the corresponding
price index P EK is determined by domestic supply in equation 22. On the other hand,
the volume of exports to socialist countries Es is determined by supply function 25 and
its price index PES is derived from the price index of world imports with distributed lags
in equation 23. Both volumes and prices of exports are influenced (with different
intensity) by technical progress 0TR' In the following identities 26-28, the volumes of
exports are transformed into current prices (EKP ' Esp) and domestic constant prices (Ex).
Identities 29 and 30 define the trade balances SKP and SSP as differences between
exports and imports in current prices.
 103

Identity 31 is derived from the basic macroeconomic identity between the formation and
the use of gross national income, the change in inventories J being defined as
a residual component. The last identity 32 defines the synthetic efficiency of production
factors E3 as a ratio of an adjusted sum of end-use components to a specific weighted
aggregate of fixed capital and labour employed in the material sphere.

A dynamic ex-post simulation of the CEM-4A model showed its good fit to actual data:
the mean absolute error averaged across all variables (excluding balances SKP' SSP
and J) reached 0.82 percent only (the systematic part from this error was 0.09 percent
only).

5 Scenarios of simulated development strategies

In our simulations of alternative development strategies for the Czechoslovak economy in

the period 1990-2000 we have taken into consideration some previous results from
various Czechoslovak research institutes [see SedivY (1988), Souhrnna
progn6za ... (1988), Sujan (1989), Sujan and Sujanova (1987)]. Before starting our
optimal control Simulations, we have computed a baseline projection up to the year
2000 using the CEM-4M model. The scenario of this projection for the period
1988-1990 is based on the medium-term forecast from [Analyza a progn6za ... (1988)]
and for the period 1991-2000 reflects the following assumptions:

( i) expected changes in macroeconomic relationships following from the transition to

a market economy, which would wean more efficient implementation of technical
progress resulting in speeding up the growth of labour productivity, decreasing
material and energy intensity of production, increasing the quality of production and
increasing the export performance,

( ii ) expected problems in external and internal economic conditions, such as growing

competition on foreign markets, considerable disequilibria in some socialist countries
and their negative impacts on cooperation and integration within the CMEA,
continuing unfavourable structure of the Czechoslovak economy and high costs of
structural changes and other actions necessary for more intensive economic growth.

The main assumptions and results of the baseline projection are illustrated in the first
columm of Table 3. The projection reveals certain improvement over the last decade,
particularly in synthetic efficiency, personal consumption and some other indicators.
However, the speed and quality of growth according to this projection neither meet the
official targets for the economic and social development of Czechoslovakia up to the
year 2000, nor are they sufficient to diminish the lagging of the Czechoslovak economy
behind the developed marl<:et economies. The transition to a marl<:et economy itself is
a necessary, but not sufficient condition for a substantial qualitative change in the
Czechoslovak economic development. Another necessary condition for such a change is
an active development strategy adopted by the economic centre and its effective
implementation with proper economic policy instruments.
 104

Table 2. Weights for deviations of target and control variables in the optimal control
simulations (1990-2000)

Average Relative weights for variants:

Variables values of A B C
nominal Intensive Extensive Combined
trajetories growth growth strategy
acceleration acceleration

Target variables:

YG Gross national income 785.416 1 2.121 2.121

E3 Synthetic efficiency 1.710 1 0.247 0.349
Q CCD Share of satisfied demand
for indust. goods 95.536 1 0.212 0.299
C Personal consumption 330.162 1 0.142 0.285
I Investment 188.177 1 0.173 0.245
SKP Trade balance with
nonsocialist countries -5.746 1 0.016 0.032
SSP Trade balance with
socialist countries -2.994 1 0.011 0.016

Control variables:

MIK Machinery imports from

nonsocialist countries 9.774 0.024 1000 0.048
MCK Cons. goods imports from
nonsocialist countries 2.025 0.018 1000 0.037
Mcs Cons. goods imports from
socialist countries 5.772 0.048 1000 0.095
Q)(2C Share of light industry 10.023 0.136 1000 0.272
Q\W Ratio of av. wages to
labour productivity 37.195 0.282 1000 0.564
Q1 Investment ratio 25.366 0.183 0.365 0.100
Lv Employment in the
material sphere 5.916 1000 0.246 0.492
MNS Raw material imports from
socialist countries 23.065 1000 0.073 0.147
Mf'I( Raw material imports from
nonsocialist countries 7.173 1000 0.044 0.088
Ux Productive effects of
intermediate product 0.012 1000 0.007 0.014
 105

Table 3. Average annual growth rates of target and control variables simulated for the
period 1990-2000 (in percent)

Optimal control simulations

Base- Desired
Variables A B
line trajec- Extensive C
Intensive
projection tories Combined
growth growth
acceleration acceleration strategy

Target variables:

YG Gross national income 2.75 3.78 3.77 3.75 3.76

E3 Synthetic efficiency 1.21 2.56 2.53 2.17 2.36
OCco Share of satisfied demand
for indust. goods 90.0 98.2 98.2 90.4 96.0
C Personal consumption 2.04 3.78 3.76 2.74 3.17
I Investment 2.61 2.60 2.64 3.69 3.00
S;~ Trade balance with
nonsocialist countries -2.0 -10.5 -10.5 -4.8 -7.8
Ss~ Trade balance with
socialist countries -4.1 -3.7 -3.8 -3.0 -3.5

Control variables:

M'K Machinery imports from

nonsoc. countries 2.40 2.40 7.52 2.40 5.52
MCK Cons. goods imports from
nonsoc. countries 10.02 10.02 15.58 10.02 12.32
Mcs Cons. goods imports from
soc. countries 4.18 4.18 5.82 4.18 4.76
a;2C Share of light industry 9.8 9.8 11.3 9.8 10.5
~ Ratio of avo wages to
labour productivity 37.6 37.6 39.9 37.6 38.1
Qt Investment ratio 25.2 25.2 22.9 25.3 23.8
Lv Employment in the
material sphere --0.14 --0.14 --0.14 0.01 --0.08
MNS Raw material imports
from soc. countries 1.91 1.91 1.91 2.91 2.30
MNI( Raw material imports
from nonsoc. countries 0.71 0.71 0.71 2.30 1.96
eUx Productive effects of
intermediate product 0.41 0.41 0.41 0.76 0.53

*) Absolute values in percent for the year 2000

**) Cumulated values for 1991-2000 in billion USD (Ssp in billion SUR)
 106

The purpose of the further optimal control simulations is to investigate some alternative
development strategies oriented towards increasing - the rate and the quality of economic
growth in the period 1990-2000. The target (desired) values for these simulations are
given in the second column of Table 3. In comparison with the baseline projection the
target growth rate of gross national income (the main economic indicator -used in
Czechoslovakia) is higher by about 1 percentage pOint; at the same time the growth
rates of synthetic efficiency and personal consumption are higher by 1.35 and 1.74
points, respectively, while the growth rate of investment remains unchanged. Another
target is the substantial improvement in the share of satisfied demand on the
consumption goods market. As it follows from some previous model simulations [see
$ujan and $ujanova, 1987], one of the effective strategies oriented to meet these goals
may be based on a substantial increase in the imports of machinery and consumer
goods from the West even at the costs of -increasing the foreign debt. Therefore we
have added trade balances to the target variables. The target value for the balance with
nonsocialist countries is much more negative than in the baseline projection.

Employing the CEM-4M model and the iterative procedure for optimal control of
nonlinear systems (described in preceding sections), we have simulated three alternative
development strategies according to the following scenarios: 6)

A. Intensive growth acceleration

The scenario for this variant supposes a substantial increase in machinery imports from
developed market economies, which is supposed to speed up technical progress,
structural changes and other driving forces of intensive growth. This would also gradually
increase the export performance which would create real possibilities for the repayment
of foreign debt. It is obvious that for a successful implementation of this strategy the
reconstruction of the economic system towards a much greater role of the market
mechanism is necessary. Within this framework the motivation for work efforts should be
increased. Therefore. in the scenario for this simulation variant. we assume some
increase in the ratio of average wages to labour productivity (Qwv) and a considerable
increase in the suplly of industrial consumer goods, i.e. in its imports (McK' Mcs) and in
its share in total domestic output (Q x2 d. while the investment ratio 0 1would decrease.

The nominal values of all control variables were fixed at the trajectories of the baseline
projection. The deviations from the nominal values are penalized by the relative weights
given in Table 2. In the simulation variant A, greater deviations are allowed for imports
components M1K , MCK and Mcs , therefore the relative weights for these variables are
lower. On the other hand, the control variables representing extensive growth factors
(employment in the material sphere, imports of raw materials, etc.) are kept at their
nominal baseline values by prohibitively high weights. The deviations of the target
variables are penalized by equal (unity) weights. as their nominal values are consistent
with this variant.7)

.) The starting values of the state variables in 1990 (an initial condition for the optimal control procedure) were set at the
values of the baseline projection for 1990.
1) Besides the variables included in Tables 2 and 3, also some additional (less important) target and control variables

were used in our optimal control simulations.

 107

8. Extensive growth acceleration

As the strategy of intensive growth acceleration according to the scenario A calls for
high foreign indebtedness, we have also simulated an alternative strategy of extensive
growth acceleration. o) In the scenario for this simulation variant we have assumed
a higher investment ratio 01' more employment in the material sphere Lv, higher imports
of raw materials (M NS ' MNK ) and higher use of intermediate product (expressed by the
dummy variable Ux). For the last three control variables higher deviations from their
nominal trajectories are allowed by their lower penalization (see Table 2). All the
"intensive" control variables employed in the simulation A (except of 0 1) are kept at
their nominal trajectories by prohibitively high weights. As this variant is not consistent
with the nominal trajectories of all target variables, the desired nominal growth of gross
national income YG is preferred, while for other target variables (especially for trade
balances) greater deviations from their nominal values are allowed by lower relative
weights.

C. Combined strategy of growth acceleration

For the practical implementation, the most feasible strategy might be some combination
of intensive and extensive growth acceleration. The scenario for such a strategy
(simulation variant C) is, in fact, a combination of the preceding scenarios A and B. In
this variant all the control variables are employed, and their relative weights (except
of 0 1) are set to twice the unprohibitive weights from the variant A or B. The weights
for the target variables are set similarly (see Table 2).

6 The results of optimal control simulations

The main results of our optimal control simulations of the Czechoslovak economy for the
period 1990-2000 according to the scenarios A, B, C are given in Table 3 and Figures
1-10. All three simulated strategies lead to an acceleration of the growth rate of gross
national income Y G (in comparison with the baseline projection) by 1 percentage point,
yielding the growth rate of 3.75 percent p.a. However, they differ in the growth rates of
other target variables and used control variables.

In the simulation variant A, the trajectories of all the target variables are very close to
their nominal values. This means that in this variant a considerable acceleration in the
growth of synthetic efficiency E3 and personal consumption C would be achieved (the
latter growing as fast as national income). At the same time, equilibrium on the
consumer goods market (expressed by aCeD) would be improved. The price for this
would be a considerable increase of foreign debt: the cumulative passive trade balance
with nonsocialist countries (SKP) over the period 1991-2000 would reach more than 10
billion USD. rlowever, the baseline projection also imply a passive cumulative baiance of
2 billion USD. It should be noted that in the variant A a considerable increase in the
imports of advanced machinery and technology would imply an acceleration of technical

0) II should be noted that In this strategy only the acceleration of growth above the baseline projection is purely extensive.
while the baseline growth (2.75% p.a. for Y G' see Table 3) is predominantly intenSive, Le. this strategy is in fact mixed.
 108

Figure 1: C-Personal consumption

billion Kcs

370

320

270

220L-L-~-L-i~L-L-~~~~--~L-~~-i~L-~~~~

'980 '985 1990 ,995 2000

- Act.& Nom. --- -. Sim. A - - Sim. B - 31m. 0

Figure 2: aCCD-Share of satisfied demand

for industrial consumer goods
%
100 . ----------------------------------------------,

98

96

94

92

90 L-L-~_L_L~ __L_~~~~_ _~~~_L_L~_ _~~_L~

'980 1985 1990 1995 2000

- Act.& Nom. ---- . 81m. A - 81m. B - 81m. C

 109

Figure 3: E3-Synthetic efficiency

of prOduction factors
%
195 r-------------------------------------------~

185

175

165

155

145

135 ~~~~-L~~--L-~~~-L~~~L-~~~-L~~

1980 '985 ,990 '995 2000

- Act.& Nom. ---- . 81m. A - 81m. B - 81m. C

Figure 4: SKP-Trade balance

with non-socialist countries
billion Kcs
5

Or-------------~~~----~~~-------------~

-5

- 10

,980 '985 '990 '995 2000

- Act.& Nom. -- - -. 81m. A - - 81m. B - 81m. C

 110

Figure 5: MIK -Machinery imports

from non-socialist countries
billion KCB
18r-------------------------------------------~
,
,,
16
"

4~~~-L~~~~L-~~~~~~~~-L~~~~~

1980 1985 1990 2000

- Act.& Nom. ---- . 81m. A - 81m. B - 81m. C

Figure 6: MCK -Consumer goods imports

from non-socialist countries
billion KCB
6~---------------------------------------------;

"
4

- Act.& Nom. ---- . 81m. A - 81m. B - 81m. C

 111

Figure 7: QWV-Ratio of average wages

to labour productivity
%
40~------------------------------------------~

39

38

37

35 L-~~-L~~--L-~~-L-L~-- -L _~~-L-L~--L-~

19BO 1985 1990 '995 2000

- Act .& Nom. ----. Sim. A - Sim. B - Sim. C

Figure 8: QI-Investment ratio

%
30.---------------------------------------------.

28

25

24
"

2 2 ~~~~-L~--L-~~~-L~--L-~ -L-~~~~~~

'980 '985 ,990 ,995 2000

- Act .& Nom. -- - - - 81m. A - - Sim. B - 81m. C

 112

Figure 9: LV-Employment in material sphere

million persons
6.---------------------------------------------~

,/
5.9

6.8

5.7

5.6L-~~-L~--L-~~-L~~L-L-~-L~--L-L-~-L~~

1980 1985 1990 1995 2000

- Act.& Nom. - -- -. 81m. A - 81m. B - 81m. 0

Figure 10: MNS-Raw material imports

from socialist countries
billion Kcs
28r---------------------------------------------~

26

24

22

18L-~_L_L_J_ _~~_L~_J_ _~~_L~~L_L_~_L~_ _~

1980 1985 1990 1995 2000

- Act.& Nom. ---- . 81m. A - - 81m. B - 81m. 0

 113

progress and increase in export performance: The growth rate of exports to nonsocialist
countries would reach 5.5 percent (in the baseline projection only 3.5 percent), which
would create a real possibility for the subsequent repayment of foreign debt.

In the variant A, the "extensive" control variables are not employed (they remain at their
nominal trajectories), but the "intensive" control variables would grow faster, especially
the imports of machinery and consumer goods from nonsocialist countries (M 1K , McJ.
Also the share of the light industry in total output (QJ(2C) would be higher and the
investment ratio Q 1 would be lower. The growth rate of investment I would be almost
equal to the baseline projection.

In the variant B, the growth rate of personal consumption would be lower than in the
variant A by about 1 percentage point in favour of the growth rate of investment. As
a consequence, synthetic efficiency would grow more slowly. Due to higher raw
materials imports, this variant would also increase the cumulative passive balance with
nonsocialist countries to 4.8 billion USD. However, faster growth of production would not
be accompanied by an acceleration of technical progress, so the increase in exports to
nonsocialist countries would be very small. Only the exports to socialist countries would
increase significantly, so the cumulative balance with these countries (Ssp) would be less
passive than in the variant A (see Table 3).

In comparison with the baseline projection and variant A, the variant B would require
higher growth of raw materials imports, intermediate product,g) investment ratio and
employment in the material sphere. On the other hand, the trajectories of "intensive"
control variables would not differ from the baseline projection.

In the variant C, the growth rates of target and control variables would be between
those from the variants A and B (see Table 3 and Figures 1-10). The growth rate of
personal consumption (3.2 percent) would be somewhat higher than that of investment
and sufficient for the motivation of working efforts, taking into account growing imports
of consumer goods and improvement of equilibrium on the consumer goods market. 10)
The cumulative passive trade balance with nonsocialist countries would reach 7.8 billion
USD, i.e. considerably less than in the variant A. The growth rate of exports to these
countries would reach 4.65 percent with favourable developments of both exports
volumes and prices.

The size of foreign debt in this variant would be about 500 USD per capita in the year
2000. tt seems to be an acceptable risk as compared with contemporary net debt of
some other socialist countries (GOA about 600 USD, Poland 1 000 USD, Hungary 1 300
USD per capita, etc.). It may be expected that the reconstruction of economic system in
Czechoslovakia will create favourable conditions for effective use of foreign loans and for
their repayment.

"The share of intennedialB product in total product would decrease in this variant only by 0.2 percent p.a. while in the
baseline projection by 0.3 percent and In the variant A by 0.47 percent.
'0) As Shown In Figure 2. the share of satisfied demand aeco In this variant would be even higher than in the variant A.
except 01 the last year 01 the simulation.
 114

7 Conclusion

The solution of the optimal control problem for nonlinear systems may be properly
approximated by an iterative procedure, in which the optimal control algorithm is
subsequently applied to specific linearizations of the original system. The weights for
target and control variables used in the optimization functional may be derived from the
variation coefficients of their deviations from nominal values and from the assigned
relative importance of variables in a given variant (the latter expressing preferences of
a decision maker).

The optimal control simulations of real development strategies (employing a nonlinear

econometric model of the Czechoslovak economy) have shown practical feasibility and
usefulness of the recommended procedure. The results of the optimal control simulations
of the Czechoslovak economy for the period 1990-2000 have yielded useful information
about the possible effects and costs of selected development strategies. The
recommended procedure may be applied also to other alternative development strategies,
using different models and scenarios.

We are, however, aware of the limited practical use of modelling procedures. Therefore,
the presented results of the simulations should be considered only as a demonstration
of possible applications of the described methods. Official forecasts and plans of the
Czechoslovak economic centre may be substantially different.
 115

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 116

Appendix: Structural equations of the Model CEM-4M

1. Ay = 0.3569 + 0.493 Iy. T-1 + 0.512 Ay. \-1 + 5.476 UAYM

(0.061 ) (0.059) (0.463)
Se = 1.41 %, R2 = 0.9975, ow = 1.39

2. Ky = Ky. \-1 (1-QKLY 1100) + Ay

3.
MIK' 0 MX 1100 ) 0.1217 . (KY 1~.\-1
OTR -- 3.221 (Ay. 0.5) -0.4984 . 00.5
TA.\-l
(0.0030) (0.0121)
se = 0.36%, R2 = 0.9893, OW = 1.80

0.9822 0.0178 -0.00123 Ky. Ily 0.0256 Tx

0.9175 (Ky. 0 TR )
OTA
4. XHH = • ly .e .e
(0.1338) (0.00018) (0.0038)

5. X = 7.0111 X~~2444 . X~.:..~962 [(MNS + MNK ) 0MX 1100] 0.0849 .

(0.0230) (0.0233)

NO.2318 . (W • l )0.2427 . e Ux
E2 YAA. \-1 y
(0.0347) (0.0409)

ee = 0.53%, R2 = 0.9995, OW = 2.15

6. N = X . [ON - 10.0 UTA (OTA - 1.4] )/100

7. YG = X - N

8. Wy = (Y G Ily) • Owv 11200

10. Y AD = Yw (1 + OYOD 1100) IPc

11. CF = 65.267 + 0.2438 Y AD - 47.212 PCF IP c + 0.254 CF. \-1

(0.0268) (9.991) (0.073)

Se = 0.92%, R2 = 0.9982, OW = 1.73

 117

12. CCD = -7.165 + 0.5356 (YAD - Y AD .I-1) + 0.2354 YAD. 1 + 0.7547 CCD.l-1 -
t- 0.2717 CC.l-1
(0.0728) (0.0721) (0.1854) (0.1325)

Se = 0.86% R2 = 0.9980, ow = 2.08

13. Cc = 24.669 + 0.5925 (X • QX2C 1100) + 1.0062 (MCK + Mcs)

(0.1210) (0.4032)

QMX 1100 - 22.225 Pcc + 0.1892 Cc.1-1 + 3.7095 UH

(7.329) (0.1328) (0.8449)

Se = 1.51%, R2 = 0.9969, ow = 1.76

14. QCCD = 100 (Cc - 3.7095 UH ) ICCD

15. WVAR = (Wv IP c ) • Q CCD 1100

17. 1= Y G • Q I /100

18. Iv = I . QIV 1100

20. Msp = (MNS + MIS + Mcs + M FS ) • PMS

22 • PEK = 2 . 814,..,0.5241
r MK
. y'~.3531 • MO.3984. 0.0554 UpEK
G KP e
•
e
0.1 UTA (OTR -1.4)
(0.0423) (0.0838) (0.0459) (0.0059)

Se = 1.53%, R2 = 0.9981, ow = 1.36

0.2465 PO.5781 • 0.0268 UPES 0.28 UTA (QTA - 1.4)

23. PES = 1.1091 PIM(D.l-1 ES.l-1 e . e
(0.0128) (0.0240)

Se = 0.62%, R2 = 0.9994, ow = 2.48

 118

24. EK = 1.0530 M~416 • (PEK/PWKD )-0.7058 e0.0668 UEKL . e 1.0 UTA (OTR-1.4)
(0.024) (0.0544) (0.0093)

Se = 2.44%, R2 = 0.9872. ow = 1.42

25. Es = 0.3595 y~.4103 • M~~601 • p~.455 . eO.0468 UESL • eO.05 UTR (OTR - 1.4)
(0.1412) (0.111) (0.158) (0.0059)

Se = 1.47%, R2 = 0.9987, ow = 2.03

28. Ex = (EK + Es) • OEl( 1100

31. J = YG + Mx - (Ex + C + G + I + H)

32. E3 = C + G + I +J + (SKP • 0MX /P MK • 100) + (Ssp· 0MX IPMS • 100)

0.06 Kv + 41.75 Lv
'IN SOME PROPERTIES OF THE SOLUTION OF THE OPTIMAL CONTROL
PROBLEM FOR THE ORIGINAL LONG - TERM MACROECONOMIC MODEL

Vladimir Vasiliev
Insti tute I'or Systems Studies (V1UISI)
USSR Academy of Sciences
9, Prospect 60 Let Octyabrya
117312 Moscow, USSR

Abstract
A new approach to the construction of macroeconomic growth
models is considered. This approach is based on an application
of ordinary differential equations to the description of the
long-term development for large economic systems. Principles of
construction of the original macroeconomic model taking into
account a non-stationary endogenous technical progress and
non-renewable energy resources depletion influence on the
economic growth are described. The analytical properties of the
model based on this approach as well as the existence and the
behaviour of the solutIons of the optimal control problem are
investigated.

Keywords: Optimal control of economic systems, production

I'lmctions, macroeconomic models, equilibrium growth, technical
progress.

Contents

Introduction
The model description
'rhe existence and asymptotic behaviour of model trajectories
4 Statement and solution of the optimal control problem
5 Properties of the optimal solution
6 ConclUSion
References
 120

Introduction
Some years ago in the USSR in the field of macroeconomic
modelling a new approach was developed. It is based on applying
ordinary differentIal equations to Gescribe long-term economic
development of different countries and regions of the world
(see [1] - [ 4] ) •
Although at that time this approach was widely used in
different fIelds (see [5]-[8]), it was not applied to study the
analytical properties of models and the existence and behaviour
of optimal control problem solutions.
In this paper the above mentioned problems are investigated
for one verSlon of the long-term macroeconomic model described
in [9].
2 The model description
In paper [9] the followir~ macroeconomic model with non-
stationary endogenous technical progress was suggested for the
description of the development 01 large economic systems:
. ..
~ :::: (1-U 7 )Y ~ + U7Y(~ + U )
, K v L U
. (1 )
K :::: ~Y -ilK

U: : <£(t)~
K
rU
where Y(t) denotes gross output at time t,
K(t) denotes production capital,
L(t) denotes labour,
U(t) is the average level of technology in industry,
<£(t) is a flITlction reflecting the real dynamics of the de-
velopment of tecl1.'101ogies and possiblli ties of their
realization in in i1 ustry,
Uk (t) is the sh'?,re i~api tal investment,
(Y!'

uIlt) is the share

fl,):O is the d8L"'t:
Let us assume:l-~:::, _.
is 3..11
\
exogenous and known
flITlction of time 1 (C ) : : : : " - ' i / , that vI :::: const ~O, and
that gross output 1s_'::'s~2~~buted only between production
investment and consumption, 'Nr~ien means uk +U L::::1, ana that the
function <£(t) is constant <£(t)::::cn=const~O. In [9] this
assumption is considered from the economic point of view as
constant socio-economic conditions of selection and realization
of new technologies in industry.
In this case we get the following formula for describing
the rate of growth of technical progress:
 121

U
- - c U if.:':. (2 )
U - 'n l{ K

A similar approach when the growth rate of technical

progress is associated with capital investment was suggested
oy R. Solow in [10J and L.Johansen in [11]. Let us assume
further (as it is done in [11 J) that technical progress is of
Solow-neutral type (see [12J).
For some similar models, built on the basis of this approach
(see (5J,[6],[13J), the authors also took into account in dif-
ferent ways the influence of the depletion 01' natural non-
renewable energy resources on economic growth. Let us assume
in this paper that this influence is described by an exogenous
and contlnuous fLmction 8(t), limited at anyt ~ to,which is in-
cluded linearly in Y(t) on the right hand side of the first
equation of system (1).
Let us also assume that the share of capital investment
~(t) is a piecewise continuous function of time and a control
variable in the system of ordinary differential equations (1).
In this case we may rewrite the system (1) in the following
form:
.
Y

. (3 )
K ::. ~y -- ~K

~(t) E [0,1 J.

It's easy to see that in this case the first equation of

system (3) is nonlinear not only in relation to variable Y(t),
but also in relation to control variable ~(t). It will be
shown below that such nonlinearities lead to the emergence of
principally new properties of the solution of system (3) as
well as the Solutlons of optimal control problems which use
this system to describe economic development.

3 The existence and asymptotic behaviour of model trajectories

It's easy to show that in the case when Uk(t)=const, cn=o,
8 (t )=0, the general solution 01' the !'irst equation of system
(3) is the Cobb-Douglas production function. But if '~ is not
constant and en i- 0, the solution of system (3) does not exist
for any I'easible values 01' Uk (t )dO, 1 J. 'The same result is
described in paper [14J for the CES production flmction.
Let us prove that if one introduces some additional con-
straints on variable ~(t) and on parameter values of system (3),
then for any positive initial values Yo,K o and for any tE[to'co)
there exists a positive solution of the system of ordinary dif-
 122

ierential equations (3) so that by t - 00 the output-capital ra-

tio ~+t; becomes constant.
'l'heorem 1..:. If function e (t) is continuous and l1mi ted at
a.'1y tE ( to' (0) and

f :8(t):dt
00

lim 8(t) 0, < 00, (4 )

t ..... 00

to

and the function Uk(t) and the parameters cn ' VI and )J. are such
that for any t)t o the following inequality is true:

'l:
f
t
a('l:)exP[f b(Od(U Jd'l: < ~o (5 )
y
o
to to
where a('l:) = cn Uk('l:)+(1-~('l:», bl.~) = (1-~(;»)(Vl+)J.) - 8(;),
and, moreover, the function ~~t) is such that

~im ~\t) = ~ = const E [0,1 J (6 )

&-00 0

then for any initial values Yo' Ko in the semi-interval [to' (0)
;;here exists only one continuous strictly positive solution of
system (3) with the following properties:
. .
lim X1I1 qoo>O, lim Xl12 = lim ~1!1 vk>O (7 )
t ..... oo K(t) t .....oo Yl.t) t-+oo K (t )
co

Jto ,Y (t) -
1----

K(t)
~Idt < co . (8 )

IThe proof of theorem 1 is based on an investigation of the

asymptotic properties of system (3) (see (15J) and the solution
01' t11e Riccan ordinary differential equation describing the
output-capital ratio dynamics:

~-{ - -~
-- cit
[ Xl!)
Kl t )
1 = alt)q~t) ~ O(t)q(t) (9 )

Since the proof of this theorem is very bulky, only the

economic interpretation 01' the mathematical results will be
prese!1tec_ f"tere.
 123

~f Uk is constant, inequality (5) can be rewritten in the

following form:

~ ~ (10)
(HC n )

'rhis inequal1 ty means tha t i t is only in this case that

the solution of system (3) exists at any time t ~ t(y From the
economic point of view one can interprete this fact that in the
long run the economic system described by system (3) cannot de-
velop without consumption expenditures. And in the case of pre-
sence of technical progress, asymptotic equilibrium growth can
-De provided by a rather small value of production investment
share. Let us assume further that at any time t ~to' ~ E
[0,_1- 1. Note that if en ~O then inequalities (5) and (10) turn
1+Cn
into the initial constraint ~ E [0,11.
Property (7) of the solution means that if ~ is constant
and satisfies inequality (10), even if a disturbing function
8(t) is present in system (3), the growth rates of output Y(t)
and production capital K(t) become constant and equal in asymp-
toties. 'rhis means that there exists an asymptotic exponential
solution of syutcm (3) and for any initial conditions the tra-
jectories of the system will tend to approach the asymptote ra-
ther rapidly (see inequality (8».
Thus the results of theorem 1 give a possibility to formu-
late and solve different optimal control problems.
4 Statement and solution of the optimal control problem
As is well known, there are some very important problems
connected with the formulation of optimal control problems for
macroeconomic models: the problems of choosing an optimization
criterion, the time span etc. We shall not discuss these prob-
lems in this paper. ~e simply consider the following optimal
control problem with free boun2dary conditions on the right hand
side (just the same problem as the one which was considered by
F.Ramsey in [16J for the macroeconomic model without technical
progress) :

(11 )

. (12 )
K = ~y - IJ.K ,

Y(t o ) = Yo ' l1,,(t) E [0,1 J

 124

where a >0 is the discount rate and T is the time horizon.

Here, as in [16], we choose the discounted per capita con-
sumption as an optimiziation criterion.
Let uswrlte down for this problem the corresponding Hamilton
function x(t) and the conjugate system:

e-O (t-t O )(1_U.

:Je(U. ,(j),t)= -
- - K K
)~1Il
1 (t )
+ (j) lr u. Y
1K
~~=~~
.K.
+ (1-u. )V 7 y
-K ~
+

'-:>
2 Y'-
+ C",u. (13 )
u--K K

Note that both the Hamilton function (13) and the conjugate
system (14) are nonlinear in both the phase variable Y and the
control variable ~(t). Usually this situation does not occur
in the same optimal control problems using production functions.
Since the solution of thIs problem,based on the Pontrjagin
maximum principle (see [17j) is very bulky, only the statement
of the theorem about the existence of optimal control, the ex-
plicit analytical solution and the interpretation of the re-
sults will be_pre~ented in this paper. - I <
'I'heorem 2. 'Tne only control variable ~(t) satisfying the
Pontrjagin maximum principle for problem (11 )-(12) is defined
by the following expression:

r I] if t E CO,ts ]

t
*
'1, (t)=
K 1
( 15 )
1I' t E It,,,Tj
.:>
l+C n

where time Is is deI'ined as the solution of the following non-

linear equation:
 125

-Oft-t.)
, Ij
'I
. ~n
e
8(t)--.=:. e ------------ ( 16 )
KO T -o('1:-t)
e 0
J---------d'1:
8('1:)
t
If the solution of equation (16) does not exist then for*the
whole interval [to,T] for the optimal control variable ~(t)
there should necessarily be fulfilled the identity ~(t) = O.

5 Properties of the optimal solution

As seen from theorem 2, stated above, the Pontrjagin
maximum principle allows to get the tini te analytical solution
of the problem (11 )-(12). But this solution is in principle dif-
ferent lrom the solutions of various modifications of the Ram-
sey problem with diverse types of technical progress,production
ftillctions, etc. The solutions of these problems, in general,
have the following form:

t E [t o ,t 1 ],
(17 )
t E (t 1 ,t 2 ],
t E (t2'T],
where I i and t2 are times of optimal control switches, Uo and u1
are equal to 0 or 'I depending on boundary conditions, and ~* E
(0,1). In this case output-capital ratio 'iiI1 remains constant
K (t )
on the semi-interval (t 1 ,t 2 ]. This means that describing an
economic system being in the optimal equilibrium state (if, of
course, t 1 and t 2 exis t) and at this period the ou tpu t is
optimally distributed between consumption and production
investment.
In contrast to this, the solution (15) for the problem
(11) - (12) differ,s markedly from the optimal control solution
in 1,17): initially consumption is equal to zero and the whole
output is spent on capital investment and the development of
technical progress. After that, when the economic system comes
<;0 a rather high level of development, all the means are
,'3pent on (~onsuJ.'1lption. One should underline that the time of
'.:he optimal control switch t s depends, as is seen from
,=qual':ion (16), not only on the initial conditions and the
parame1:ers (JI' the model but also on the value of the discount
rate o. One may show that time ts exists only in the case that
the ini t11al conditions and the parameters of system (12)
satisfy the following inequality:
 126

(V7+~) + ------------ (18 )

Ko T -o("C-t)
e 0
f---------d"C
8('1:)
to

In the case when the inequality (18) is not satisfied the

maximum of total consumption in period [to,T] will be attained
in the case of optimal control ~(t)=O.
Such properties of the solution of the Rroblem are
explained by the fact that the original system of aifferential
equations (12) and the Hamilton function ~(~,t,~) are strictly
convex in ~ at any time te[to,T] (see fig.1), and the maximum
of the function ~(.) in the argument ~ can be achieved only in
the extreme pOints of the range of the feasible control.

t=t 1

t=r2

t2(t 1

Fig.1
Note that this property depends only on the form of system
(12) which we use for describing the economic development and
will be valid for any optimization functional linear in ~.
6 Conclusion
The results presented in this Raper show that those
trajectories of tIle macroeconomic model described above which
are the solutions of the optimal control problem have highly
 127

specific properties. Such a behaviour of these trajectories

and the solution are connected with the nonlinearity of system
(3) in the variable ~. But as available statistical data show,
in practice the constraint (10) is always met. Therefore the
described approach can be successfully used for describing eco-
nomic development and for obtaini~ satisfactory forecasts of
the future economic growth of different countries and regions
of the world.
REFERENCES
1. S. V. Dubovsky "Production Functional with Endogenous and
Guided Technical Progress", VNIISI collection of papers,
vol.9, 1978, Moscow, USSR (in Russian).
2. S. N. Golosovsky "Definition of the Influence of Technical
pr0fsess on the Basis of the Complex-Functional Method",
VNI SI collection of papers, vol. 9, 1978, Moscow, USSR (in
Russian) .
3. D. Shimon, V.S. Samovol "On the Functional of Economic
Growth", "Economics and Mathematical Methods", Vol. XVII , No.
2, 1981, Moscow, USSR (in Russian).
4. J. P. Ivanllov and others "On Production Funct ions of the
Economy", Computer Center of the Academy of Sciences, 1983,
Moscow, USSR (in Russian).
5. V.A. Gelovanl, S.V. Dubovsky, V.V. Jurchenko "Modelling of
Long-Term Regional Economic Development",Reports of the USSR
Academy of Sciences, vol.238, No.3, 1978 (In Russian).
6. V.M. Vasiliev "Analysis of the Economic and Technical Deve-
lopment of Japan by Means of a Long-Term Macroeconomic Model",
VNIISI collection of papers,1981, Moscow, USSR (in Russian).
7. S.V. Dubovsky, V.M. Vaslilev, O.A. Elsmont "Modelling of the
USA Economic Growth: with Regard to the New Tendencies of
Development", VNIISI collection of papers, vol. 3, 1983,
Moscow, USSR (in Russian).
8. S. V. Dubovsky, V.M. Vasiliev "Long-Term Economic Growth of
the Countries and Regions of the World on the Threshhold of
the Twenty-first Century", VNIISI collection of papers,vol.3,
1985, Moscow, USSR (in Russian).
9. S.V. Dubovsky "Non-Stationary Technical Progress in Global
Modelling", VNIISI collection of papers, vol.20, 1988, Moscow,
USSR (in Russian).
10. Solow R. "Investment and Technological Progress", in "Mathema-
tical Methods in the Social Science", Stanford University,
Press, 1959.
11. Johansen L. "Substitution Versus Fixed Production Coefficients
in the Theory of Economic Growth", Econometrica, vol.27, No.2,
1961 .
12. Sato R., Beckmann M. "Aggregate Production Functions and Types
of Technical Progress: a Statistical Analysis", The American
Economic Rewiew, vol.59, pp. 88-101, 1969.
13. S.V. Dubovsky, O.A. Elsmont "Macroeconomic Modelling with Re-
aard to Endogenous Technical .Progress and Energy Resources
Bepletion", VNIISI collection of papers, vol. 20, 1988, Moscow,
USSR (in Russian).
14. J.S. Pappe "Different Types of Development in the One-Sector
Models of Economic Growth with Exogenous Technical Progress",
VNIISI collection of papers, 1982, Moscow, USSR (in Fuss~an).
15. Chesary L. "Asymptotic Behaviour and Stability of the Sc,lutions
of Ordinary Differential Equations", 1962.
 128

16. Ramsey F. "Mathematical Theoryof Saving", Econometric Journal,

vo1.38, 1928.
17. L.S. Pontrjag1n, V.G. Boltyanskll. R.V. Gamkrelldze and E.F.
Mlschenko "The Mathematical Theory of Optimal Processes",
"Science", Moscow, USSR, 1962 (in Russian).
 PART 3:

MULTIPLE CRITERIA DECISION MAKING (VECTOR OPTIMIZATION)

WITH ECONOMETRIC MODELS
Implementing the reference-point approach to multi-criteria deci-
sion making in econometric models in the computerprogram LOSl

Gyorgy Barabas
Fern Universi tat Hagen
Lehrgebiet Statistik und Okonometrie
FeithstraBe 140, D-5800 Hagen 1, Germany
Since April 15, 1991:
Rheinisch- Westfilisches Institut fiir Wirtschaftsforschung (RWI)
Hohenzollernstral3e 1/3, D-4300 Essen, Germany

Abstract

The implementation of the reference-point approach to multiple-criteria decision making in the PC

program LOS (=Large Optimizing System) is described in this paper. The procedure is illustrated
on a small sample model and on a medium sized non-linear econometric model of West Germany.

Keywords: Multi-criteria decision making (MCDM); reference-point approach; achievement scala·

rizing function; econometric models; non-linear optimization.

Contents

1 Introduction
2 The sample model
2.1 The model
2.2 When only the no-derivative optimization can be used
2.3 The reference-point approach
2.3.1 Defining the objectives and instruments
2.3.2 Pareto-optimality and the achievement scalarizing function
2.3.3 Decision support matrix
2.3.4 Finding the optimum by changing the reference-point
3 Case study with an econometric model of West Germany
3.1 Selecting the objectives and the instruments
3.2 The achievement scalarizing function for the case study
3.3 The base-line forecast
3.4 Decision support matrix
3.5 Finding the optimum
4 Re fe ren ces

A research grant from the Deutsche Forschungsgemeinschaft (DFG) to Prof. J. Gruber (contract No.
Gr 410/6-2) is gratefully acknowledged.
 132

1 Introduction

The PC program LOS (=Large Optimizing System) has been developed at the University of Ha-
gen in order to optimize large, non-linear, deterministic econometric models. In this paper the
application of LOS to multi-criteria decision making (MCDM) problems is shown.

Making decisions is not an easy task. The objectives are usually in conflict: If you improve one
objective at least another suffers. Furthermore, there are a lot of uncertainties in the assumptions
which constitute a risk. The use of MCDM methods doesn't make the psychological aspect of the
decision making easier in general because a choice has to made among alternatives. But since the
alternatives rely on more information (the alternatives are more relevant) you can expect that the
decision you find will be better.

The decision you make in MCDM is "subjective". It may be good ("optimal", "a good com-
promise") for one person (or board, institute, community), but may be suboptimal for another
one.

We understand under the reference-point approach an iterative procedure in order to find the sub-
jective optimum in a model with multiple objectives, where the achievement scalarizing function
(named by Wierzbicki) plays an important role. This function leads to the scalarization of the
multiple objectives with very useful properties. It means further that for the reference-point ap-
proach you don't need to construct a utility function, that is a scalar-valued objective function
with economic meaning.

The decision-maker has to decide at the beginning of the reference-point approach whether he
wants to maximize, minimize or stabilize each of the single objectives. During the iterations he
always chooses the better from two alternatives. An alternative is a value combination of the
target variables, instrument variables and endogenous variables which are obtained by the solution
(minimization of the achievement scalarizing function) of the model.

The reference-point is a vector corresponding in its elements to the objectives (target variables)
and therefore may have economic meaning. In the mathematical sense the reference-point is a
parameter of the achievement scalarizing function. If you change the reference-point and minimize
the achievement scalarizing function (i.e. you make an iteration), changing the reference-point
influences the solution like changing the aspiration level or the goal value (desired value) of the
objectives.

Nonetheless the achievement scalarizing function works differently than the commonly known
quadratic objective function (see e.g. Chow, 1975) with the vector of desired values. The lat-
ter works actually like goal programming in order to find the smallest distance to the goals. On the
other side the reference-point approach respects the initial aims, i.e. maximization or minimization
of the objectives, and if possible it yields a better solution in this sense than the corresponding
reference-point elements would suggest as goal values. The task of the quadratic goal function is
equivalent to the stabilization with the reference-point approach.

There are some computer codes wich apply the reference-point approach with a better user-interface
than LOS (Bohm, Brandner, 1989). In LOS you have to manipulate manually the achievement
scalarizing function. However, other codes are specialized on small linear models, and making even
small changes in the model or the data may be difficult. The flexibility of LOS in changing the
 133

goals, the restrictions and even the scalarizing function (and everything with non-linearities and
not necessarily derivable) is the main advantage of LOS.

The topic of this paper is a rather technical discussion of the implementation of the reference-point
approach, especially of the achievement scalarizing function. Therefore some remarks should be
made:

(i) The mathematical description of the reference-point approach can be found in Lewandowski,
Wierzbicki (1987) and Olbrisch (1988). However, if you are interested mainly in economic
aspects of decision making it is not important to know it in detail.

(ii) This paper shows a relatively simple procedure how you can determine your optimium by
means of the decision support matrix and by making iterations after changing the reference-
point. The flexibility of LOS allows you to apply also other, more sophisticated procedures
which converge more quickly to the optimum.

(iii) No detailed economic analyses and conclusions are made in this case study.

(iv) It might be helpful to read the User's Guide of LOS before this paper. However, if you
read subsection 2.1 of this paper and if you are familiar with some model solving code, that
subsection could be sufficient to understand the terminology of LOS in this paper.

(v) You shouldn't be confused by the different contexts of the word iteration in this paper. Firstly,
if you change the reference-point and minimize the achievement scalarizing function you
make an iteration of the reference-point approach. Secondly, LOS uses for the optimization
of a function (e.g. the achievement scalarizing function) iterative optimization procedures.
Thirdly, LOS solves an interdependent model (system of equations) by an iterative method
(Gauss-Seidel) in each iteration of its optimization procedures.

(vi) Everything written by typewriter type letters refers to computer input/output or similar
statements in LOS. Quarters are referred to as, for example, <1990q3> which means the 3rd
quarter of 1990. The notation <1987y1> means simply the year 1987 in an annual model.

In this paper the phrase 'guess' appears rather often. This means that economic modelling and
decision making remains a kind of art, where feelings, heuristics and external information play an
important role.

Since this paper deals with econometric models there are some aspects to take in account. The
decision maker is in most cases an expert or research worker and not a real decision maker. A very
important role of modelling is the learning effect of the expert by which he gets more knowledge
not only of the operation of the model but also of the real economy.

2 The sample model

A relatively simple model with two objectives helps YOll to understand the reference-point approach
and its implementation in LOS.
 134

2.1 The model

In this subsection we introduce the sample model and give information about the terminology
and inputs of LOS. The scalar-valued objective function in this subsection is a commonly known
quadratic goal function which has nothing to do with the reference-point approach. It will be
compared to the achievement scalarizing function of the reference-point approach in subsection
2.3.2.

The sample model in this paper is the same as in the User's Guide of LOS (Barabas, 1990a).
This is not a real econometric model, but nonetheless illustrates some essential similarities: The
variables denote time series, the model is dynamic, the problem contains besides linear constraints
also a non-linear constraint. The sample model differs from the usual econometric models, since
the equations have no economic meaning, the equations form no interdependent (simultaneous)
system, the structure of the problem is not the same in all periods.

The diagrammatic layout of the variables used in the sample model is the following, where variables
beginning with the same letter can be considered as the coordinates of a two-dimensional point,
for example (Il,I2) , (G1,G2) , (Yl,Y2):

-----
1st period II-Yl Y2- 12
------ ! !
2nd period Yl Y2
------ ! !
3rd period Yl Y2
G2
Gl ~/
----: z:'----
- - - -- - - - - -

The function Z measures the distance in the third period between the points (Yl,Y2) and (Gl,G2)
by the following formula:

Z = J( Yl - G1)2 + (Y2 - G2)2 . (1)

If this problem were only a simple simulation task, the initial values of (11,12) in the first period
and of (Gl,G2) in the third period would determine the value of Z in the third period.

But now let us define a control problem: What (11,12) values are required in order to minimize the
distance Z ?

The variables Il and 12 are the instrument (control) variables. Z as a function is the objective
 135

(goal) function, Z as a variable is the objective variable to be minimized. The exogenous point
(Gl,G2) is the goal point, it consists of "desired" values. The functions Yl and Y2 define the
structural dependences of the system. In our sample model, they have the following simple form
(Yl<-I> denotes the one period lag):

In the first period Yl=11 and Y2=12 .

In the other periods Yl=Yl<-I>+2 and Y2=Y2<-I>+1.5 .

Explicit restrictions are applied for the I1 and 12 variables, see also exhibit 1:
Q), [) and [) are constant restrictions: 12 ~ 1 and 12 2: -1.5 and 11 2: -1.9 ;
® and Q) are linear restrictions: 12 ~ -0.5*11+1 and 12 ~ -2*11+4 ;
Q) is a non-linear restriction: 12 2: 1l~2 - 2 (II 2: -1.9 !) .

The closed set in exhibit 1 denoted by A is the restricted set of the 11,12 variables. C is the feasible
set of the Yl,Y2 variables in the third period. It has the same form as A, but has been shifted by
(4,3). This shift comes from the functional dependences between (11,12) and (Yl,Y2), see above.
The coordinate system involves both the (11 ,12) space in the first period and the (Yl,Y2) space in
the third period.

12 in the 1st period

Y2 in the 3rd period

®
-3 1 2 4 5 6 11 in the 1st period
-I A YI in the 3rd period
[)

-2

Exhibit 1. Restrictions and feasible sets of the sample model

The problem we defined above is the mode! definition in the terminology of LOS and is written
into a file in the following form:

Y1 if(firstperiod(O» + then(I1) +
e1se(Y1<-1>+2)
Y2 if(firstperiod(O» + then(I2) +
e1se(Y2<-1>+1.5)
Z sqrt(sqq(Y1-G1)+sqq(Y2-G2» +
ubound(I2,1) + 1bound(I2,-1.5) + lbound(Il,-1.9) +
ubound(I2,-O.5*I1+1)+ubound(I2,-2*I1+4)
+ lbound(I2,1/(Il+2)-2) ;
 136

The if(firstperiod(O)) ... then... else ... functions act upon the condition whether
the computation is running in the first or in later periods.

In the Z equation sqrt is the square root, sqq the square function. The restrictions, i.e. the upper
and lower bounds, are defined by the ubound and lbound functions.

In the model definition we did not state what we want to optimize. This information comes next
into the control file. We set the three computation periods from 1985 to 1987 by the period
command. The output, model and vari commands define the output, model and variant files.
Computation (simu command) is to be made for all periods, dynamically already from the first
period on. The format of the result-table is set by the ptable command and the tab1 file.

After the minimize command we state the variable whose value we want to minimize. This is Z
in the last period: minimize Z<last>. We choose the I1 and 12 variables as instrument variables
in the first period (1985):. .. instrument I1<first> I2<first> ... The whole control file is
as follows:

period <1985yl> <1987y1>

output out 1 ;
model mod1 ;
vari bank1 ;
simu <first> <last> dynam <first> ;
minimize Z<last> konv 5e-7 maxit 65535 Gradient
instruments
0.5 I1 <first>
I2<first>
ptable tabl <first> <last> actual <first>

The values of the goal point (reference point) and the initial values of the instrument variables are
defined in the variant file. The goal point (G1,G2) takes the value (3,3.5) in 1987. The initial
point of (Il,12) is (3, -2.4), that is an infeasible (outside of the restrictions) value. The variant file
then is as follows:

Gl <1987yl> 3
G2 <1987yl> 3.5
Ii <1985yl> 3
I2 <1985y1> -2.4

2.2 When only the no-derivative optimization can be used

LOS uses two types of numerical optimization methods (Barabas, 1990b) in order to compute the
maximum or minimum of a scalar-valued function (in our case this is the quadratic goal function and
the achievement scalarizing function). One method is no-derivative (actually in two modifications:
the Neider-Mead and Turn-the-worst), the other is a gradient method (steepest descent).

In many cases the gradient method is faster than no-derivative methods, but in this subsection
I show an example in our sample model when the gradient method fails to obtain the optimum.
 137

This causes no problem for LOS. A no-derivative method is started automatically in LOS to check
whether the optimum is correct.

Exhibit 2 shows the situation when the gradient method fails to obtain the optimum. The quadratic
goal function (1) is now in use with the goal point of G = (8,4). The initial values of the instruments
(Ii, 12) have been set in 1987 to (2, -1.5) in order to determine an initial value of Pl=(6, 1.5) in
the space of the objective variables Yl, Y2. The procedure starts by this way from the PI initial
objective point.

Y2<1987>

4
®
°G
3

2
@
PI

-3 -2 -1 2 3 4 5 6 7 8 9
Yl<1987>
-1

-2

Exhibit 2. The gradient method fails to reach the point P3 starting from P 1

The gradient method in LOS can reach only the point:

Yl <1987yl> 6.461479
Y2 <1987yl> 2.077041

which is P2 in exhibit 2 after the 54th iteration. Continuing the computation from P2 the Turn-
the-worst method stops after the 361th iteration in the point P3:

Yl <1987yl> 6.001
Y2 <1987yl> 2.999

Actually (6,3) is the accurate value.

If you work from the beginning with the NeIder-Mead method instead with the gradient method,
the solution is reached in only 195 iterations. One iteration of the optimization method means one
evaluation of the objective function (model solution).
 138

2.3 The reference-point approach

No real decision problem is formulated by the sample model because the feasible solution is known
as you see in the exhibit, i.e. you could determine a good objective combination in C looking at only
the picture (exhibit 2). In real problems you don't know explicitly the feasible set and therefore an
MCDM method should be used. By the reference-point approach you scan the feasible set you are
interested in and choose a point which you accept as your optimum.

2.3.1 Defining the objectives and instruments

The objective and instrument variables should be chosen by economic reasoning. You should also
take into account the time consumption of the computation by LOS and reduce therefore the
problem size (the number of objective and instrument variables) if possible. The optimization of
the sample model takes only some seconds, but the optimization oflarge models often takes several
hours.

At the beginning you should define the social preferences of your objectives: Which of the objectives
to maximize, minimize or stabilize? The stabilization means that you want to achieve a particular
constant value (a desired value).

Let's define two objectives (target variables) and two instruments in the sample model. The I1
and 12 in 1985 are the instrument variables, while Yl and Y2 in 1987 the objective variables. We
want to maximize both objectives.

2.3.2 Pareto-optimality and the achievement scalarizing function

A point in the objective variable space is (roughly speeking) Pareto-optimal if you cannot find
another point which is better with respect to (at least) one objective without sacrificing with respect
to (at least) another objective. This means that a different point improves (some) objectives but
deteriorates at least one objective. Obviously the decision maker should be able to select the better
point. But the aim of introducing the definition of the Pareto-optimal set is to reduce the size of
the set to be investigated in a general way. Especially the case when the number of Pareto-optimal
points is very large and many of these points differ greatly in the opinion ("the preferences") of
the decision maker is of interest for applying the reference-point approach.

Looking again at exhibit 2 the points on the sections (edges) tID - © - @ are Pareto-optimal if
your social preferences are to maximize both Yl and Y2. If you want to increase for example the
first objective Yl on the Pareto-optimal set you should decrease (deteriorate) Y2 in order to remain
in the feasible set.

The aim of the decision making is to select one point among all the Pareto-optimal points which can
be accepted as a compromise solu tion ("optimal solution"). The difficulty is that you don't know
the Pareto-optimal set in an econometric decision model. Your task is to scan the Pareto-optimal
surface in a small number of steps. The small number is important because the determination and
evaluation of one Pareto-optimal point may cost a lot of computation time.
 139

In this paper the main topic is the implementation of the achievement scalarizing function, which is a
central concept in the reference-point approach. This function scalarizes the vector of the objective
variables and yields a point on the Pareto-optimal set (Pareto-optimal point) if the function value
is minimized.

A simple form of the achievement scalarizing function s(w) to be minimized is the following:

(2)

where (as far as yp is positive)

Wi== (yf - Yi)/yf if Yi is to be maximized
Wi= (Yi - yf)/yf if Yi is to be minimized
(3)
Wj= (max{(yf - Yi, Yi - yf} )/yf if Yi is to be stabilized (to
get exactly the value of yf)

yf is the i-th component of the reference-point, Yi the i-th objective variable, yf is a weighting
factor. p is the number of the objective variables. { is a small constant, e.g. 0.0001.

yf is proposed by 'Wierzbicki to be the absolute value of the mean of the available actual values
(think e.g. of time series) of Yi.

Without the term E* 2::;=1 (Wi) the minimization of s(w) could yield also weakly efficient points, i.e.
points on the section ® - ® excluding ® in exhibit 2.

More sophisticated forms of achievement scalarizing functions can be found in Wierzbicki (1986)
and Olbrisch (1988).

The next two equations should be added to the model file of LOS implementing the achievement
scalarizing function in the sample model, when Y1 and Y2 are the objectives to be maximized in
1987:

S = max(G1-Y1 ,G2-Y2) + EPSTAG

EPSTAG= 0.0001*(Gl-Yl+ G2-Y2) ;

S represents the function s(w) in (2). The equation EPSTAG defines the term £ * 2::f=I(Wi). Gl and
G2 are the elements of the reference-point. The value of { is 0.0001 . The weighting factor yf is
set to 1 and therefore not represented in the equations.

How could the main difference between the achievement scalarizing function and the quadratic goal
function be represented? If you start the minimization of S by the reference-point (goal point)

G1<1987> 0
G2<1987> 0

the achievement scalarizing function respects the aim of maximizing the objectives and yields
 140

Y1 <1987> 4
Y2 <1987> 4

while the quadratic function yields the smallest distance to the goal values, as:

Y1 <1987> 2.878
Y2 <1987> 2.139

the latter is not Pareto-optimal.

Y2<1987>
S=3 S=2 S=l S=O

4
G
3

2 c

-3 -2 -1 2 3 4 5 6 7 8 9
Yl<1987>
-1
L
-2

Exhibit 3. Contours of the function S = max;=l (w;) if both objectives are to be maximized and the
reference-point G is (8,4)

With the reference-point (8,4) the achievement scalarizing function yields

Yl <1987> 6.333
Y2 <1987> 2.333

which is a slightly different solution than the solution of the quadratic goal function:

Y1 <1987> 6.001
Y2 <1987> 2.999

as computed in section 2.2 .

The contours of the achievement scalarizing function reported above consist of two half-lines like
in exhibit 3. The vertices of the half-lines form the line L through the reference-point. The angle
of L to the coordinate axes is 45 degrees if the weighting factors yf
are equal. The angle between
 141

the two half-lines is 90 degrees if only the term max;=l (Wi) is used and a bit obtuse (i.e. slightly
greater than 90 degrees) if the term E * I:f=l(Wi) is added. The contours of the quadratic goal
function (not presented) are concentric circles around the goal point.

2.3.3 Decision support matrix

The decision support matrix helps you to make a first guess in the exploration of the region of the
objective variables you are interested in.

The decision support matrix is built up by the partial optimization of the objectives.

If you maximize Y2<1987> in the sample model, Y2 takes its maximal value anywhere on the section
® - ® (refer to exhibit 2) while Y1 changes from 2.33 to 4. For the decision support matrix only
the Pareto-optimal value of Y1= 4 is of interest.

Suppose, the maximization of Y2<1987> yields the point of (3,4). Starting a new optimization
yields necessarily a Pareto-optimal point, since now the achievement scalarizing function (2) will
be minimized involving all (now two) of the objectives. The previous result of the objective variables
(3,4) is attained as reference-point. This optimization yields the Pareto-optimal point (4,4) which
is the maximal value of Y2 at the same time. In our example the NeIder-Mead method needed
many thousands of iterations, while the Turn-the-worst method required only 476 iterations for
this calculation.

The decision support matrix is as follows:

Y1<1987y1> Y2<1987yl>
maxzmlze Yl<1987yl> 6.750 1.500
maxImIze Y2<1987y1> 4.000 4.000

The vector which contains the worst element from each column of the decision support matrix is
called the nadir point. The vector which contains the best element from each column (Le. the
diagonal elements) is the utopia point. The utopia point is generally not a feasible solution. The
utopia point cannot be improved in any element while the nadir point can be improved in each
element.

The utopia point is (6.75,4) while the nadir point is (4,1.5). We know now that
- the solution cannot be better than 6.75 for Y1, and not better than 4 for Y2;
- the compromise solu tion for the vector optimizing problem will be better than 4 for Yl and
better than 1.5 for Y2. These were our first guesses about the available compromise region of the
objectives, if we didn't know it in advance from the exhibits in our artificial case.

2.3.4 Finding the optimum by changing the reference-point

The reference-point has two meanings (Olbrisch 1988):

1. represen tation of desi rable (goal) values, and
2. pure control parameter in order to move the solution towards the individual ("subjective")
optimum.
 142

You can choose the utopia point from the decision support matrix or another desirable value as the
first reference-point. Gl ,G2 are the elements of the reference-point, while Yl, Y2 are the objectives:

1st reference-point (RP)

Gl<1985y1> 6.750
G2<1985y1> 4.000
Solution for the 1st RP
Y1<1987yl> 5.833
Y2<1987y1> 3.083

Suppose that we are not satisfied with Y2 and want to improve it by 0.5 . Change G2 by 0.5 . It
is not obvious that Y2 will also move by 0.5 but we don't have any advance information about the
way how the reference-point controls the objectives:

2nd reference-point (RP)

G1<1985y1> 6.750
G2<1985y1> 4.500
Solution for the 2nd RP
Y1<1987y1> 5.500
Y2<1987yi> 3.250

Suppose that 5.5 for Yi is by our preferences too small. Let Y2 deteriorate by 0.1 . We could also
improve the reference-point element for Yi which is Gl but in changing G2 we have got already
some guesses.

3rd reference-point (RP)

G1<1985y1> 6.750
G2<1985y1> 4.400
Solution for the 3rd RP
Y1<1987y1> 5.567
Y2<1987y1> 3.217

Suppose that we accept the last result with values for Yl,Y2 of (5.567,3.217) as our "subjec-
tive" optimum. Then the hypothetical MCDM problem formulated in our sample model has been
successfully solved by the reference-point approach as implemented in LOS.

3 Case study with an econometric model of West Germany

First let us summarize briefly the econometric model used in the case study. The model is a
quarterly business cycle model of West Germany, built in the Institute for Economic Research
(RWI) in Essen 2 . It consists of more than 140 partly non-linear equations, 58 of which form an
interdependent block. The number of behavioral equations is 41.

The time horizon for the optimization in our case study is set from the 4th quarter of 1988 to the
4th quarter of 1990. These nine periods make a system of more than 1260 equations.

2 You find a more detailed description of the model in this volume: see the contribution of V. Heilemann.
 143

The computations have been made on an 80386-SX PC with coprocessor, clock rate 16 MHz. LOS
issue 1.32 has been used for the computations.

3.1 Selecting the objectives and the instruments

The objective variables should be chosen according to economic aspects. In the case study we use
the state deficit (DEFKK) and the number of unemployed (AL) as objectives.

Among the exogenous variables of the model those variables should be selected as instruments
which can be controlled by the decision maker. In the case study we use the value-added tax
(MWST) and the public investments (IBST).

DEFKK denotes the state deficit in billions of Deutsche Mark, cumulated from 1989q1 through
1990q4. If there is a deficit, DEFKK is negative, if there is a surplus, DEFKK is positive. We want to
maximize its value in 1990q4.

The cumulation is defined in the model file of LOS by the following equation:

DEFKK if(eq(period(0),198901» + then(DEF) +

if(gt(period(0),198901» + then(DEF+DEFKK<-l»

It means, DEFKK takes in 1989q1 the value of the deficit of the current quarter (DEF), later the
lagged value is added to the current period value.

AL denotes the number of unemployed people in thousands. We want to minimize this in each
quarter of 1989 and 1990, this makes eight objectives over the eight periods.

These are nine objectives alltogether.

MWST is the value-added-tax rate (V.A.T.). We use it as an instrument in the following way:

MWST= if(eq(subperiod(O),l» + then(MWSTI) + else(MWST<-l» ;

By this definition MWST takes the first quarter value of MWSTI in all four quarters of a year,
which assumes some stability in the V.A.T. The instruments are actually MWSTI<1989ql> and
MWSTI <1990q1>.

IBST is the public construction investment in billions of Deutsche Mark.

Explicit restrictions in the model have been defined for the instrument variables since economically
unrealistic values would otherwise be obtained for the optimum. IBST can assume values between
Sand 20 billions of DM, MWST between 10 and 20 per cent. The following equation defines these
restrictions added to the model file:

PENAL= Ibound(IBST, 5) + Ibound(MWST, 10) +

ubound(IBST,10) + ubound(MWST, 20)
 144

The exogenous base-line data of IBST were assumed here to take values between 7 and 14 billions
of Deutsche Mark, of MWST exactly 14 per cent, like in RWI research.

3.2 The achievement scalarizing function for the case study

The achievement scalarizing function (2) is coded and added to the model file in the following way:

ALMAX =if(eq(period(0).198901)) + then«AL-ALREF)/2000) +

if(gt(period(0).198901)) +
then(max«AL-ALREF)/2000. ALMAX<-l») ;
ALSUM =if(eq(period(0).198901)) + then«AL-ALREF)/2000) +
if(gt(period(0).198901)) +
then«AL-ALREF)/2000+ALSUM<-1»
S =max(ALMAX. (DEFREF-DEFKK)/35)+
0.0001*(ALSUM+(DEFREF-DEFKK)/35) ;

where ALMAX is the term maxf~l(wi) applied for the pI = 8 periods of AL;
ALSUH is the term L:f~l(Wi) applied for the pI = 8 periods of AL;
S is the achievement scalarizing function s(w), summarizing all of the objectives;
DEFREF and ALREF are the components of the reference-point. The weighting factor of AL is 2000, the
weighting factor of DEF is 35. These seem to be representative absolute values of the corresponding
time series.

It is important to present the control file parameters of LOS used later in this section in order to
facilitate a repetition of the calculations. You find the meaning of the parameters in the User's
Guide of LOS:

SIMU <1988Q4> <1990Q4>

KONV 1.000000e-004 MAXIT 40 DYNAM <1988Q4>;
MINIMIZE S <1990Q4> KONV 1.000000e-004 MAXIT 65535
ALFA 1.050000 BETA 0.450000 GAMMA 2.050000 Gradient 0.2000
INSTRUMENTS 0.5 MWSTI <1989Q1> MWSTI <1990Q1>
IBST <1989Q1> IBST <1989Q2> IBST <1989Q3> IBST <1989Q4>
IBST <1990Ql> IBST <1990Q2> IBST <1990Q3> IBST <1990Q4>;

3.3 The base-line forecast

The base-line forecast with the assumed values (RWl) of the exogenous variables MWST and IBST is
the following, reporting only the variables introduced in section 3.1:

base-line 1989 1990

variable ql q2 q3 q4 ql q2 q3 q4
AL 2290.5 2109.7 1945.3 2050.2 2156.6 2006.9 1838.6 1923.5
DEFKK -10.68 11.446 -3.713 3.28 -15.23 -10.57 -17 . 37 -16.71
IBST 8.760 11. 889 12.890 11.50 7.620 12.950 13.820 12.44
MWST 14.0 14.0 14.0 14.0 14.0 14.0 14.0 14.0
Runtime 1 mlllute (there IS no optImlzatlOn).
 145

You can compare later this table with the results of the reference-point approach.

3.4 Decision support matrix

The decision support matrix is gained from the partial optimization of the single objectives. Maxi-
mizing DEFKK<1990q4> yields the following result:

1989 1990
variable q1 q2 q3 q4 q1 q2 q3 q4
AL 2312.1 2186.5 2089.5 2271.4 2436.8 2325.6 2198.5 2334.9
DEFKK -2.085 19.427 25.979 37.466 27.537 42.875 46.858 56.854
IBST 5.0 5.0 5.0 5.0 5.0 5.0 5.0 5.0
KVST 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0
RuntIme 45 mmutes.

The solution minimizing AL<1990q4> is:

1989 1990
variable q1 q2 q3 q4 q1 q2 q3 q4
AL 2232.2 1967.5 1748.4 1770.6 1798.3 1622.4 1444.3 1495.8
DEFKK -23.13 -19.62 -30.40 -33.77 -61.19 -62.72 -75.13 -80.97
IBST 20.0 20.0 20.0 20.0 20.0 20.0 20.0 20.0
KVST 10.0 10.0 10.0 10.0 10.0 10.0 10.0 10.0
RuntIme 15 mlllutes, but IllItIal values of the Illstruments were suggested from previous calculations.

Observe that the instruments (IBST. MWST) take in the last two tables their explicitly restricted
values, however the opposite bounds in the two tables.

Minimizing AL in a period before <1990q4> yields the same value for the periods up to the period
chosen for minimization as minimizing AL<1990q4>. This means, the minimal values of the AL-s
are time invariant. Therefore we present only one row for AL in the decision support matrix:

AL in 1989 AL in 1990 DEFKK

q1 I q2 I q3 I q4 q1 I q2 I q3 I q4 1990q4
max. DEFKK 2312.1 12186.512089.512271.4 2436.812325.612198.512334.9 56.854
min. AL 2232.2 1967.5 1748.4 1770.6 1798.3 1622.4 1444.3 1495.8 -80.97

The utopia point consists of the first eight values minimizing AL<1990q4> and of the last column's
val ue maximizi ng DEFKK <1990q4>.

The decision support matrix shows that there is a big conflict between the optimal scenarios of
DEFKK and AL: For example, targeting a small state defici t we obtain a surplus of 56.854 billions
of DM, while targeting the low level unemployment the state deficit is 80.97 billions of DM. This
means that further calculations by an MCDM method are required to find a compromise solution.

3.5 Finding the optimum

This is the subsection where we actu;;.lly do calculations with the reference-point approach. Our
aim is a solution with a low level of the state deficit and a low number of unemployed, together
with low seasonal fluctuations of unemployment.
 146

The tables contain the results of each calculation. AL and DEFKK are the objective (target) variables
while IBST and MWST are the instrument variables. ALREF and DEFREF are the reference-point
elements corresponding to AL and DEFKK. S is the value of the achievement scalarizing function.
Other variables of the RWI model are not presented in the tables.

The runtime reported is sometimes very high. However, the manual preparation of a new run for
LOS, including the analysis of the results and thinking about what to do next, takes often only
some minutes.

The long computation-time raises also the question: Do you need to optimize the model at all?
Optimization is of advantage if the number of economically different alternatives (possible scenarios)
is high. On the other side if you can restrict the number of scenarios to a small number, making only
simulations is more effective. For example, if you want to investigate only the effects of 15, 16 and
17 per cent of MWST and of an increase of IBST by 20 per cent, making simulations is much quicker
than using an MCDM method. But let's continue with our topic, the reference-point approach.

The utopia point from the decision support matrix (rounded) is used as the first-reference point
(ALREF ,DEFREF):

1st RP 1989 1990

variable q1 q2 q3 q4 ql q2 q3 q4
AL 2312.1 2185.2 2086.2 2267.0 2376.6 2203.7 2068.9 2185.7
ALREF 2230.0 1960.0 1740.0 1770.0 1790.0 1620.0 1440.0 1490.0
DEFKK -2.087 19.215 25.588 37.100 17.095 30.226 35.704 47.825
DEFREF - - - - - - - 60.000
IEST 5.001 5.278 5.289 5.049 18.015 10.461 5.002 5.001
H1lST 19.999 19.999 19.999 19.999 19.975 19.975 19.975 19.975
S 0.060 0.113 0.173 0.248 0.293 0.293 0.315 0.348
Runtlme 170 mmutes.

The unemployment is too high in all periods, near to the nadir values in the decision support ma-
trix. Let's set the reference-point component DEFREF<1990q4> to the more realistic value of zero
in the next iteration while ALREF remains unchanged. We hope that a reduced surplus reduces the
unemployment.

2nd RP 1989 1990

variable ql q2 q3 q4 q1 q2 q3 q4
AL 2241. 0 2033.8 1863.4 1909.1 1980.5 1806.5 1626.3 1759.6
ALREF 2230.0 1960.0 1740.0 1770.0 1790.0 1620.0 1440.0 1490.0
DEFKK -16.79 -0.853 -6.939 -5.037 -24.70 -15.88 -19.41 -4.717
DEFREF - - - - - - - 0.00
IEST 19.659 11. 063 19.706 19.743 19.998 19.973 19.999 5.044
H1lST 16.482 16.482 16.482 16.482 19.997 19.997 19.997 19.997
S 0.480 0.037 0.198 0.144 0.706 0.454 0.555 0.135
Runtime 350 mlllutes.

The unemployment hasn't decreased in a satisfactory way. In <1989q4> and <1990ql> it increases
to a high level and in the last period it also jumps up. These three reference-point elements are
reduced in the 3rd iteration by the desired differences.
 147

3rd RP 1989 1990

variable q1 q2 q3 q4 q1 q2 q3 q4
AL 2246.2 2008.7 1815.6 1870.6 1931.1 1775.1 1615.2 1736.5
ALREF 2230.0 1960.0 1740.0 1720.0 1670.0 1620.0 1440.0 1430.0
DEFKK -14.91 -4.543 -8.458 -5.092 -23.62 -15.79 -18.81 -5.361
DEFREF - - - - - - - 0.00
IBST 18.809 19.777 19.961 19.992 19.996 19.997 19.992 7.518
Kl/ST 17.781 17.781 17.781 17.781 19.995 19.995 19.995 19.995
S 0.426 0.130 0.242 0.146 0.675 0.451 0.537 0.153
RuntIme 817 mlllutes.

Then we tried to reduce AL<1990ql> by 130 in the fourth iteration with the reference-point ap-
proach.

4th RP 1989 1990

variable ql q2 q3 q4 ql q2 q3 q4
AL 2238.9 1991.5 1792.6 1838.7 1894.9 1744.8 1635.4 1784.9
ALREF 2230.0 1960.0 1740.0 1720.0 1540.0 1620.0 1440.0 1430.0
DEFKK -17 .64 -8.988 -14.58 -12.79 -31.40 -23.13 -15.07 -6.208
DEFREF - - - - - - - 0.00
IBST 19.961 19.991 19.984 19.991 20.000 19.112 5.011 10.259
Kl/ST 15.830 15.830 15.830 15.830 19.882 19.882 19.882 19.882
S 0.504 0.257 0.417 0.365 0.897 0.661 0.431 0.178
RuntIme 480 mlllutes.

I accept this result as optimal. It seems that the seasonality of the unemployment is not avoidable
with the used instruments. The solution suggests a 15.8 per cent V.A.T. in 1989 and 19.9 per cent
in 1990. The public investments should be on a high level.

Enlarging the time horizon could be profitable in further analyses with the model, since lags in
the system could influence the optimal solution in another way through more periods. Maybe, the
remarkably low values of IBST<1990q3> and IBST<1990q4> would cause a deterioration for the
objectives in the future.

It should be also noted that a real analysis requires watching the changes of all endogenous variables,
not only of the here selected seven ones. Maybe, the deterioration of any other endogenous variable
would suggest a different compromise solution.

This concludes the brief presentation of selected results from our case study, in which we applied
the reference-point approach as implemented in LOS to the RWI business-cycle model of the West
German economy.

4 References

Barabas, G. (1990a): Users's Guide of LOS 1.32. University of Hagen.

Barabas, G. (1990b): Implementing No-Derivative Optimizing Procedures for Optimization of

Econometric Models. University of Hagen.

B6hm B., Brandner P. (1989): Interactive Optimization. Manual for the lAO-Program Package.
Institute for Advanced Studies, Vienna. Research Report No. 95.
 148

Chow, G.C. (1975): Analysis and Control of Dynamic Economic Systems. John Wiley and Sons,
New York, London.

Gruber, J. (1981): Uber Finf Typen okonometrischer Entscheidungsmodelle und einige Anwen-
dungsprobleme. In: Clever, P., Hefihaus, W., Liicke, M., Mus, G. (Hrsg.): Okonomische Theorie
und wirtschaftliche Praxis. Verlag Neue Wirtschafts-Briefe, Herne, Berlin, 177-197.

Gruber, J. (ed.) (1983): Econometric Decision Models. Proceedings of a Conference at the Uni-
versity of Hagen, June 19-20, 1981. Lecture Notes in Economics and Mathematical Systems, Vol.
208, Springer-Verlag, Berlin, Heidelberg, New York.

Gruber, J. (1987): Interactive vector optimization as a complement to optimal control in econo-

metric models. In: Carraro, C., and Sartore, D. (eds.) Developments of Control Theory for
Economic Analysis. Kluwer Academic Publishers, Dordrecht, Boston, Lancaster, 63-82.

Lewandowski, A., Wierzbicki, A. P. (1987): Theory, Software and Testing Examples for Decision
Support Systems. Working Paper WP-87-26 of the International Institute for Applied Systems
Analysis (IIASA), Laxenburg, Austria.

Olbrisch, M. (1988): Das interaktive Referenzpunktverfahren als Losungsmoglichkeit okonome-

trischer Entscheidungsmodelle. Studienverlag Dr. N. Brookmeyer, Bochum.

Wierzbicki, A. P. (1986): On the Completeness and Constructiveness of Parametric Characteriza-

tions to Vector Optimization Problems. OR Spektrum 8:73-87.
OPTIMAL ECONOMIC POLICY MAKING WITH AN ECONOMETRIC
MODEL USING INTERACTIVE METHODS OF VECTOR OPTIMIZATION
Practical Experiences for Austria

Bernhard B6hm
University of Technology
Argentinierstrasse 8, A-1040 Vienna, Austria

Peter Brandner
Austrian Institute of Economic Research
A-l103 Vienna, P.O.Box 91, Austria

Abstract
This paper presents an evaluation of an economic policy optimization experiment using
interactive methods of vector optimization. A medium sized nonlinear macroeconometric
model for Austria is transformed to yield a set of linear constraints for macroeconomic
policy optimization using a set of mainly fiscal and monetary instruments. To assess the
practical impact of different methods and their implementation to support macroeconomic
decision making, four techniques of vector optimization have been tested with participants
in an experimental economic planning problem for the year 1989. The techniques based on
linear programming are applied interactively and differ from each other in the information
requirements and the conduct of the interaction. We consider the Step-Method (Benayoun
et al. (1971)), Interactive Multiple Goal Programming (Spronk (1981)), a method proposed
by Zionts and Wallen ius (1976) - all contained in the optimization program lAO - together
with the reference point approach, implemented in DIDAS (developed and provided to us
by the International Institute of Applied Systems Analysis, Laxenburg). People involved
in practical economic policy decision making for Austria have been invited to participate
in the experiment. Among them were members of the chamber of commerce, the ministry
of finance, the national bank and members of the national council. A survey of the results
achieved and a critical comparative evaluation is presented.
Keywords: Interactive vector optimization; optimal economic policy making; macroeco-
nometric model.

Contents
1 Introduction
2 Economic policy making with multiple objectives
3 Interactive optimization with multiple objectives
4 The optimization problem and the econometric model constraints
5 The experimental setup for interactive economic policy optimization
6 Conclusions
References

We would like to thank M. Lupuicik and P. MillIer for discussion and J. Gruber for helpful comments to
improve the paper.
 150

1 INTRODUCTION

The problem of economic policy making is to search for the joint realization of economic
objectives which in most cases are in conflict with each other. There exist numerous
attempts by economists to provide solutions to such problems by formulating some kind
of decision models (Gruber (1983), Despontin et al. (1984), Hughes Hallett (1984». By
taking a normative approach of decision making the question of how to choose values
for the decision variables (instruments) arises. Most approaches use an a priori specified
preference function to derive an optimal policy. Considering the difficulty of formulating
explicit preference or goal functions we intend to draw attention to the potential benefits
of interactive optimization techniques for decision making with econometric models. \Ve,
therefore, shall not assume knowledge of an objective function but rather show the potential
merits of four interactive procedures between the policy maker and some optimization
algorithm to reach a subjectively optimal set of target values given the economic conditions
in the form of an econometric model. Even for this approach one is confronted with a great
number of potential techniques. We shall use a particular selection and provide evidence
with respect to their qualities when applied to a medium sized econometric model.
Most applications of multiple objective decision making (MODM) methods were in-
tended to demonstrate the use of a particular algorithm (e.g. Despontin (1982». Other
studies that compare the performance of MODM procedures use fictitious problems which
have to be solved by students, staff members of research departments or managers from
industry (Wallenius (1975), Brockhoff (1985), Buchanan and Daellenbach (1987». As far
as we know, a comparative evaluation of MODM methods with a real world problem and
active policy makers has not been reported.
The paper is organised as follows: Section two gives a short review of approaches to
optimize economic policy with multiple objectives. The third section discusses shortly
the interactive optimization techniques used and their implementation. Essentials of the
nonlinear econometric model and its properties are discussed in the fourth section together
with a statement of the optimization problem the participants in the experiment were
supposed to solve. Section five describes the experimental design, presents results and a
comparative evaluation. Section six reports some conclusions.

2 ECONOMIC POLICY MAKING WITH MULTIPLE OBJECTIVES

Facing real world economic policy problems, a well known approach is to simulate an
econometric model for alternative policies which means to select some values for the in-
struments and solve for the objectives ("fixed instruments approach"). Obviously, such
simulation exercises are a poor tool for finding the best policy. By considering only a small
number of a priori specified policies, it is an inefficient method. Simulation experiments
by trial and error do not exploit all information of the econometric decision model, trade-
offs between objectives can not be properly examined. A consequence of the unsystematic
search process is the possible consideration of alternatives which are not Pareto optimal.
Additionally, no operative framework guides the decision maker to select an optimal policy.
Tinbergen (1952, 1956) adopted the opposite view in order to reach an instrument/objec-
tive combination. He suggested to choose some values for the objectives and solve for the
instruments ("fixed targets approach"). Generalizations along this line were discussed in
Russel (1975), Preston (1974, 1977), and Preston and Sieper (1977).
 151

Theil (1964) introduced explicitly an objective function supposed to represent the de-
cision maker's preferences. He assumed that decision makers are able to express desired
values for objectives and instruments. Then a quadratic target function can be minimized
under the restrictions derived from a linear econometric model. Friedman (1975) analysed
piecewise quadratic preference functions within this "flexible targets" approach. Further
generalizations consider a dynamic objective function which leads to optimal control prob-
lems (Chow (1975), Pitchford and Turnovsky (1977), Holly et al. (1979), among others).
Preston and Pagan (1982) present a unified treatment of the Tinbergen/Theil approach
to the theory of economic policy. Restricted to the linear/quadratic model, the existence,
uniqueness and design of policy is analysed in a static as well as a dynamic framework.
Hughes Hallett and Rees (1983) give an integrated account of these methods of quantitative
economic planning in which decision makers play an explicit role through descriptions of
their preferences, information, and risk aversion by extending the (dynamic) optimization
framework to problems with qualitative properties.
Frisch (1961, 1976) (see also Johansen (1974)) proposed to construct an explicit pref-
erence function intended to express the preferences of the decision making authority via
interviews. Basically policy makers have to be asked three types of questions in order to
identify and to estimate parameters of the preference function and points of indifference.
The estimation of preference parameters rather than applying interview schemes has also
been considered as a tool for constructing an explicit preference function (Ancot et al.
(1982), Ancot and Hughes Hallett (1983), and others in Gruber (1983)).
'While the explicit knowledge of a preference function is not required for conducting
simulation studies, its specification is essential for the traditional optimizing framework
starting with Theil's approach. Regardless of how scalar valued preference functions (or
cost functions) have been constructed, a policy maker is no longer needed. Optimal policy
is the outcome of a mathematical optimization exercise, a decision making process does not
evolve. Such a solution to the economic policy problem may satisfy optimality conditions,
but aspects concerning the quality of the decision are not taken into account. No decision
process takes place. This is at variance with R. Frisch's (1976, p.92) ideas of economic
policy making:
"Only through such a cooperation with demonstration of alternatives will
it be possible to map out to the authorities the feasible alternatives and to
help them to understand which one - or which ones - amongst the feasible
alternatives are the most desirable from their own viewpoint. To develop a
technique of discussing feasible policy alternatives in such a scientific way is
one of the most burning needs in economic policy-making today."
It turns out that interactive methods for solving multiple objective decision models are
well suited for economic policy making as an additional tool to simulation and control
theoretical approaches (cf. Gruber (1987)).

3 INTERACTIVE OPTIMIZATION WITH MULTIPLE OBJECTIVES

3.1 General Remarks

Decision problems are characterized by the interaction of a decision maker, a model, and
an optimization technique. Solving decision problems with multiple objectives requires
methods which
 152

• help the decision maker to clarify the complex structure of the system and confront him
with trade-off choices
• pay attention to psychological and sociological aspects of decision making
• assist the decision maker to find his optimal solution
• take into account learning effects.
Obviously, methods that first collect all preference information and then solve the problem
are not the relevant ones. Decision makers often decide in a stepwise and iterative manner
because they are not always able or willing to express their preferences once and for all.
By the use of interactive optimization techniques the decision process is formalized: The
decision maker operates from one solution to another, guided by local preferences. Local
preferences are those which are formed with respect to a current solution. The decision
process is an interactive collection of preference information and iterative calculation of
compromise solutions. The nature of including preference information articulated in an
interaction differs between methods. The decision maker may determine or judge trade-
offs among objectives, define aspiration levels (minimum or maximum values) for one or
more objectives, or choose a most preferred solution from a set of (efficient) solutions.
There exists a great number of available techniques to solve multiple objective deci-
sion problems (see e.g. Hwang and Masud (1979), Despontin et al. (1983), Grauer and
Wierzbicki (1984». Here we concentrate on four interactive methods which seem to us to
possess just the right qualities in order to explain the basic ideas to policy makers!. We
shall use the Step-Method (STEM) developed by Benayoun et al. (1971), interactive mul-
tiple goal programming (IMGP) by Spronk (1981), the method of Zionts and Wallenius
(1976)(ZW) and the reference point approach as implemented in DIDAS by Rogowski,
Sobczyk, and Wierzbicki (1988). As detailed descriptions of these methods are readily
available in the relevant literature we shall only present the basic ideas and point out a
few amendments which have been made in our computer application.

3.2 Some Techniques of Interactive Optimization

One can distinguish two principles of interactive techniques. One is based on the as-
sumption of an implicitly available preference function to be optimized. However, details
like weights are not explicitly known and have to be retrieved by interacting with the
decision maker. The ZW-method belongs to this group. It assumes a linear preference
function with unknown weights (for a concave function, see Zionts and Wallenius (1983»).
By an iterative procedure which involves asking the decision maker questions concerning
his preferred trade-offs between the objectives the unknown weights can be determined.
The decision maker is not required to estimate his marginal rates of substitution numer-
ically. After showing a Pareto-optimal solution, the decision maker is only requested to
answer wether certain trade-offs presented to him are desirable, undesirable or neither.
In the case of an underlying concave preference function, the decision maker additionally
has to compare efficient solutions. Based on Brandner (1984), the lAO-program package
derives new weights for the composite preference function from the answers in a more
efficient way than suggested in the original ZW-method.
The second principle corresponds closely to the idea of satisficing. By stating bounds on
the values of objectives the decision maker may change the solution space in each iteration

lObviously other methods also possess such qualities (e. g. Rosinger's algorithm as applied by Streuff and
Gruber (1983». Our selection was determined by easily available PC-software.
 153

until it shrinks to a satisfactory point. Both STEM and IMGP belong to this group of
methods.
In STEM the decision maker is always confronted with a compromise solution which has
been derived from the ideal (and unfeasible) solution by applying the minimax criterion.
By comparing the Payoff-matrix of the initial stage with the compromise solution at each
iteration, the decision maker is asked which and how much of the target values may
deteriorate in order to improve at least one other objective. Using the minimax criterion
as a measure of distance, the efficiency of the compromise solution is not ensured. In the
lAO-program package a modified version of STEM has been implemented, so the decision
maker is always confronted with an efficient solution.
In the IMGP method the decision maker has to provide his preference information on the
basis of a proposed solution and a Potency-matrix which consists of a vector of ideal and
a vector of pessimistic (minimum requirement) objective values. It starts from the worst
possible point and enables the decision maker to indicate his wishes for improvements and
to state aspiration levels. At each iteration the decision maker has to indicate wether a
proposal solution is satisfactory or not and wether shifts in this solution are outweighed by
shifts in a new Potency-matrix which represents a reduced objective space. A number of
features already discussed in Spronk (1981) have been added to the basic lMGP algorithm
and are available in the lAO-program package. Based on Muller (1985), it is possible
to state aspiration levels at any iteration step. If targets are to be improved simultane-
ously the decision maker has the opportunity to state a weighting vector via improvement
qualifications. Furthermore, an efficient solution can be presented at each iteration step.
A combination of the above mentioned two principles of interactive techniques can be
found in the reference point approach as implemented in DIDAS (Rogowski, Sobczyk,
Wierzbicki (1988)). The decision maker is assumed to specify aspiration levels for all
objective outcomes (the reference point) in order to influence the selection of efficient
decisions. A parametric scalarization of the multiobjective problem is then obtained by
maximization of an order approximating achievement function where the reference point
enters as a parameter. As a result the user is confronted with an attainable efficient solution
that is uniformly as close to the aspirations as possible. Scanning several representative
efficient solutions and outcomes controlled by changing aspirations, the user should learn
enough to select either an actual (subjective) decision or an efficient solution proposed by
DIDAS as a basis for actual decisions. Further discussion concerning this approach can be
found in Olbrisch (1988).

4 THE OPTIMIZATION PROBLEM AND THE ECONOMETRIC MODEL

CONSTRAINTS

Optimization of economic policy is constrained by structural relations expressed in an

econometric model. 'vVe assume a constant structure of the original nonlinear macromodel
for Austria containing 72 equations and based on annual observations from 1964 until 1984.
Recent data revisions and additions until 1987 support this assumption. The 30 stochastic
equations of the model have been estimated by the ordinary least squares method where
careful attention has been paid to a proper dynamic specification (Hendry et al. (1986))2.

2 PC-GIVE (Hendry (1987)) was used to carry out the estimations. A listing of model equations and
variables is available from the authors on request.
 154

Thus most behavioural equations exhibit an error correction mechanism. This specification
approach captures both short run dynamics as well as long run information of the time
senes.
The basic long run economic theory underlying the model specification follows the Key-
nesian spirit but contains neoclassical elements as well. Aggregate demand is the driving
force of the economy, production is assumed to adjust. Disequilibrium unemployment may
occur in the labour market. As a main objective in model building was the explicit con-
sideration of government economic activity with a spectrum of possible instruments, em-
phasis is placed on a distinction between private and public sector variables. Components
of public consumption and public investment at current prices are treated as exogenous
instruments. Private sector behaviour is assumed to be governed by profit and utility
maximization. Prices are determined by the mark-up principle. Hourly wage formation is
based on an expectations augmented Phillips-curve with additional working time effects.
The latter are included to provide a wage compensation rule for a working time reduction
policy. Price expectations are derived from the estimated consumer price equation. Im-
port and export equations depend on relative prices and an activity variable. The small
monetary sector explains the money stock (M3) via the multiplier mechanism of money
creation transmitting the indirect effects of current and capital account on base money as
well as required reserve and savings policy of the central bank. Interest rate movements
reflect the policy of pegging the Austrian shilling to the German mark. Indirect taxation
and subsidies influence the gross price level and thus the nominal value of the income to
be distributed. Direct taxation of firms and households as well as the institution of social
insurance affect their disposable income. The public sector budget constraint determines
the changes in the stock of total public debt which in turn influences the budget via the
necessary debt service.
The policy maker has the following instruments at his disposal: government transfers
to private households (TRANSV), public investment (OIFS), the average rates of indirect
and direct wage taxation (FTIV, FLST), the level of subsidies (SUBV) and the employers'
share of social security contributions (FDBSS). These variables are in reality controlled
by the government alone or jointly with the "social partners" (i.e. firms and labour union
representatives). Further instrument variables are the legal working time per week (NAZ),
the rate of interest on savings deposits (RSP) and the (effective) required reserve ratio
(RRR). The exchange rate is derived from the DM/US$ relation and set to some level
expected by the policy maker before the optimization procedure is started. Table 1 presents
forecasts of the instrument values (made in March 1989) which were used for comparisons
with experimental solutions. Reasonable lower and upper bounds are added to the model
constraints in order to keep the solution bounded. These values could be changed in an
experimental session.
From the large number of endogenous variables we have chosen five target variables:
growth of real gross domestic product (GDP), the inflation rate of consumer prices (PC),
the unemployment rate (UR), the foreign balance of goods and services (HDLB) and the
net government deficit as a percentage of the nominal gross domestic product (DEFQ).
Real growth of GDP was to be maximized, all other targets were to be minimized (HDLB
in absolute terms). Table 2 contains forecast values for these objective variables which
served as guidelines for possible outcomes.
The set of linear model constraints is derived from the nonlinear model by using the
 155

reduced form multipliers in a first order linear approximation:

Yt = DoXt +R t
where Do is the matrix of relevant reduced form multipliers and R t contains all remaining
terms and errors. We use the values of Do given in Table 3.

TABLE 1
INSTRUMENTS LOWER FORECAST UPPER UNIT DESCRIPTION

TRANSV 320.0 350.0 360.0 Bill.A.S. gov't transfers to

(-4.5%) ( 4.5%) (7.5%) private households

OIFS 48.0 51.0 53.0 Bill.A.S. public investment

(-4.0%) (2.0%) (6.0%) at current prices

FTIV 15.0 15.8 16.5 Percent average rate of

(-5.1%) (0%) ( 4.4%) indirect taxes

FLST 14.5 15.0 16.0 Percent average rate of

(-9.4%) (-6.25%) (0.0%) direct wage tax

NAZ 38.0 40.0 40.0 hours/week legal working time

(-5.0%) (0%) (0%)

RSP 2.5 2.625 4.0 Percent interest rate on

saving deposits

EXRC 10.0 12.8 14.0 A.5./US $ Shilling/Dollar

exchange rate

OPAS 170.0 174.0 185.0 Bill.A.S. government wage bill

(2.4%) (4.8%) (11.4%)
SUBV 40.0 46.0 50.0 Bill.A.S. subsidies
(-13.0%) (0%) (8.7%)

FDBSS 0.52 0.53 0.54 share share of employers' contributions

(-1.9%) (0%) (1.9%) to social security
RRR 0.055 0.056 0.057 Percent effective required
(-2.1 %) (0%) (1.4%) reserve ratio

Numbers in parentheses refer to percentage changes with respect to the previous year.

TABLE 2
OBJECTIVES FORECAST U1'iIT DESCRIPTION

GDP 968.7 Bill. A.S. gross domestic product at constant

(3.0%) prices 1976
PC 169.1 Indexpoints deflator of private consumption
(2.8%)
UR 4.9 Percent unemployment rate

HDLB 8.0 Bill. A.S. balance of goods and services

DEFQ 3.9 Percent net deficit as percentage
of nominal GDP

Numbers in parentheses refer to percentage changes with respect to the previous year.
 156

TABLE 3
VALUES OF Do (TRANSPOSED)

GDP UR PC HDLB DEFQ

TRANSV 0.2597 0.0260 -0.0156 -0.3380 0.0743
OIFS 0.4595 -0.0065 -0.0140 -0.;)649 0.0612
FTIV 0.2333 0.0810 1.2383 0.4189 -1.4912
NAZ -0.1396 0.0918 -0.0269 0.0947 0.0253
FLST -1.4312 -0.1430 0.0865 1.8631 -0.4117
EXRC -3.2162 0.1321 2.2190 -11.6693 -0.4634
RSP -1.7804 0.0211 0.0552 2.1895 0.0860
OPAS 0.4486 -0.0063 -0.0136 -0.5514 0.0613
SUBV 0.0077 -0.0056 -0.0928 -0.0624 0.1113
FDBSS 0.1452 0.0751 0.0877 0.0452 -0.0358
RRR -1.6073 0.0191 0.0498 1.9768 0.0777

Since the grO\vth rates of CDP and PC are chosen as targets, whereas the respective
columns of Do in Table 3 refer to levels, the columns are transformed appropriately.
The planning horizon for the experimental problem has be~n deliberately restricted to
one period. It could easily be extended to cover more periods by using the linearized final
form of the model. However, this would have made the experimental problem much too
complicated for the majority of participants because of the increased numbers of objec-
tives. We have, therefore, kept the problem relatively simple and avoided the intertemporal
problem. It turned out that even this setup proved to be rather demanding for practition-
ers.

5 THE EXPERIMENTAL SETUP FOR INTERACTIVE ECONOMIC

POLICY OPTIMIZATION

5.1 The experimental design

During the first half year of 1989 we invited fifty persons involved in economic policy
making as well as students and academics to take part in an experiment. The task for the
participants was to achieve an optimal policy for the year 1989 given the model constraints
in its reduced form and reasonable bounds on instruments (d. Table 1). Each experimental
session covered the use of the four different optimization techniques mentioned above. As
our motivation was not only to compare these techniques but also to obtain response on
the usefulness of the interactive MCDM approach to economic planning we have attempted
to set up a more realistic problem of economic policy and not a purely fictitious one. This
stands in contrast to earlier comparative evaluations of interactive optimization techniques.
vVe also distinguish three groups of participants in the experiment:
• One group consisted of academics and students of economics, mathematics and opera-
tions research.
• Economists and members of economic research institutions involved in advisory activity
made up the second group.
• Actual economic policy makers in government and industry at the top and the advisory
level formed the third group.
 157

Together with a brief model description the forecast situation has been presented to the
participants in the experimental evaluation. They were asked to attempt a "best" solution
to the decision problem with the stated five economic objectives. A little assistance was
provided to handle the software but the de<:isions were taken without any guidance by the
operator. Each participant was presented with the same problem and only asked initially
if he agreed to the proposed set of objeccives and instnunents, and to the bounds applied.
Generally, the exchange rate was kept fix at a level of 12.5 A.S./US $. If some participants
did not agree they were free to choose their own set. The majority, however, accepted the
set-up without changes.
The order in which the techniques were applied was always the same: STEM was used
first, then followed IMGP and finally ZW. A part of the participants was further confronted
with an implementation of DIDAS by Rogowski, Sobczyk and Wierzbicki (1988) to have
an opportunity to experience a different software implementation of yet another approach
to multiobjective decision support. After experiments with all methods the participants
were asked to fill in a questionnaire.
We understand that an assessment of the methods is not independent of how they are
implemented. The questions should, therefore, reflect aspects which are relevant to the
user and also allow some discrimination among the methods.
The following criteria were chosen:
1. Ease of use of the method
2. Ease of understanding the logic of the method
3. Ease of providing information required by the method
4. Confidence in the final solution
5. Satisfaction with the implementation of the methods
6. Degree of learning-effect
7. Potential for use of interactive MCDM techniques in concrete practical work of the
participants.
Criteria 1 and 2 were assessed by ranking, 4, 5 and 6 on a point scale from 1 to 10 (with
higher numbers preferred to lower numbers). Criterion 3 was measured according to a
scale from 1 (easy) to 6 (difficult). Criteria 1, 2 and 4 are comparable to some of the
criteria used by vVallenius (1975) and Bucha..'lan and Daellenbach (1987).

5.2 An experimental session of interactive economic policy optimization

To permit the reader to follow the experimental situation and to convey the type of
decision making involved we present the main steps of a typical session, always referring
to one participant. Space considerations prevent us from following the computer output
more closely (cf. Brandner and Bohm (1989) for more details).
Starting with STEM the first important information is given by the pay-off matrix. Its
elements are found by row-wise arrangement of those values of the target variables which
are obtained when each individual objective is independently optimized:
PAY-OFF KATRIX
gdp-% ur pc-X I hdlb I detq
max: gdp-X 4.1161 5.2901 2.7513 4.8491 4.9529
min: ur 2.7463 3.9126 2.0840 10.8362 3.6009
min: pc-Yo 4.0490 5.3507 1.5927 5.2890 7.2410
min: Ihdlbl 3.6171 4.9438 1.7413 0.0000 6.0784
min: detq 1. 8158 4.2186 3.9411 23.1849 -0.9752
 158

The compromise solution is given by the vector of objective values (3.50, 4.78, 3.52, 3.18,
2.21). The decision maker is asked whether a deterioration of one of the objectives is
accepted in order to improve at least another one. Suppose the deficit ratio may deteriorate
by 0.8 percentage points. Then the proposed compromise solution is (3.61, 4.85, 3.22, 1.63,
3.01). Now suppose in the following step a deterioration of 0.3 in the inflation rate and of
8.0 bill. A.S. in the foreign balance is permitted, but the deficit ratio remains unchanged.
The result is (3.41, 4.62, 3.01, 3.86, 3.01). If no further deterioration is permitted a
(subjectively) optimal solution is found yielding the values of the instruments:
transv 334.30 :!lst 14.50 subv 49.67
oifs 53.00 exrc 12.50 fdbss 0.52
ftiv 16.50 rsp 2.50 rrr .055
naz 38.00 opas 185.00

Using IMGP in the next part of the session the decision maker is again confronted with
the same pay-off matrix from which the following potency matrix is generated:
POTENCY-MATRIX for PROPOSAL SOLUTION
gdp-r, ur pc-Yo Ihdlbl defq
Ideal sol. 4.1161 3.9126 1.5927 0.0000 -0.9752
Pess. sol. 1. 8158 5.3507 3.9411 23.1849 7.2410

Now the aspiration levels are set (e.g. we choose 3.4 percent for GDP growth and 3.5
percent for the deficit ratio) and wishes to improve target values are indicated. Suppose
we want to improve all objectives but we are willing to accept only a minor improvement for
the foreign balance target. The new potency matrix will reflect these additional constraints
(if a feasible solution exists) and a new iteration is entered. Further interaction, finally,
leads to
POTENCY-MATRIX for PROPOSAL SOLUTION
gdp-r, ur pc-r, Ihdlbl defq
Ideal sol. 3.4010 4.5970 2.7650 3.6820 3.4981
Pess. sol. 3.4000 4.5983 2.7660 13.9594 3.5000

The corresponding efficient solution is accepted and yields the following vectors of target
values: (3.4,4.6,2.8,3.7,3.5). The instruments are:
transv 342.61 :!lst 16.00 subv 50.00
oHs 53.00 exrc 12.50 fdbss 0.52
ftiv 16.19 rsp 2.50 rrr .055
naz 38.00 opas 185.00

We note that in this case we have achieved a lower unemployment and inflation rate than
in the previous run with STEM, though at the cost of a higher deficit ratio. The (optimal)
policy differs only in the values of three instruments (TRANSV, FLST and SUBV).
Proceeding to the third technique we can already assume that the decision maker has a
fairly good idea of the combination of target values which might be achievable. In the ZW-
method we start with the question on weights for the objective function. In case no specific
weights are given equal weights are assumed. The solution based on equal weights is in our
case: (3.76, 5.02, 3.43, 0.00, 2.91). The search for efficient nonbasis variables leads to the
presentation of the following three trade-off vectors (rows): (0.00267, -0.04872, 0.00720,
0.00000, -0.05991), (-0.00429, -0.01040, -0.05465, 0.00000, 0.09758), (0.01909, 0.07858,
0.05203, 0.00000, -0.02586). We accept the first vector and reject the third one, being
indifferent to the second one. The new solution after this choice is: (3.72, 4.92, 2.89,
 159

0.00, 3.89). Two further trade-off vectors are presented. Let us assume that both are not
accepted. Then the solution remains unchanged and is considered optimal, yielding the
following instrument values:
transv 345.65 flst 14.50 subv 50.00
oifs 53.00 exrc 12.50 fdbss 0.52
ftiv 16.50 rsp 2.50 rrr .055
naz 38.00 opas 185.00

The resulting optimal weighting vector is (0.52822, 0.40484,0.02231,0.02231,0.02231).

It is interesting that the result of this optimization yields an instrument vector which
apart from the value of transfers is almost the same as the one obtained with STEM. In
terms of objectives, however, higher output growth could be obtained only at the cost of
a higher deficit ratio. Higher unemployment comes along with lower price inflation and a
perfectly achieved current account balance.
A final glance at the reference point technique of DIDAS reveals a result which is close
to the first one obtained above. Choosing a reference point of (3.5,4.5,2.7,4.0,3.0) for
the objectives produces the outcome: (3.4, 4.59, 2.7, 3.62, 3.63). The instrument vector
differs from STEM only with respect to the role of indirect taxation.

5.3 Results of a comparative evaluation

Some fifty people in the categories mentioned above were confronted with the model
and the optimization methods as described. Only 23 of them replied to the request to fill
in the questionnaire. Even among those were some who did not answer all the questions.
Especially many of the participants belonging to the third category of test persons felt
rather uneasy about filling in the questionnaire. Therefore, only four questionnaires of that
latter group could be included in the sample, too few to draw significant conclusions. Most
of them were strongly interested in the properties of the model and were quite indifferent
concerning the optimization methods. Also, in view of the time needed to conduct one
experiment, it is obvious that participants in top positions afford less time for it than do
those in lower ranks. We concluded that we should stretch our experiment over a longer
period in order to obtain a larger sample of the third group.
Of the remaining 19 questionnaires 11 were filled in by members of the first group
and 8 by those of the second one. In view of the sample size we shall not evaluate the
results according to groups. vVe may, however, occasionally indicate if results are strikingly
different among groups.
As initial information about the relevance of and the acquaintance with multiple criteria
decision making among all responding participants we found that in their daily work more
than 80 % of the participants are facing problems with multiple criteria but only about 20 %
actually use appropriate optimization techniques. Approximately 86 % of the participants
think that interactive optimization techniques can sensibly be applied to their multicriteria
problems.
TABLE 4
CRITERIA 1 & 2 - AVERAGE RANKS

STEM IMGP ZW DIDAS

Criterion 1: Ease of use 1.8 2.4 3.0 2.2
Criterion 2: Understanding the logic 1.7 2.0 2.5 3.2
 160

Ranking the four methods under scrutiny produced Table 4. It contains the average of
the ranks achieved (lower figures preferred). STEM and DIDAS are the easiest to use -
probably the implementation in IAC-DIDAS-L is partially responsible for this good result
- but participants had problems to understand the logic of the reference point method. It
turned out that most of the participants did not see how their result varied with variations
in the reference point. In contrast the guiding principle of STEM was the easiest to
understand and also easy to use. The term "ease of use" was often misunderstood by the
participants as "user friendly implementation".
Providing the required information (criterion 3) was generally found relatively easy,
sometimes with some need to think. Most participants did not find much difference across
methods, but for STEM and IMGP answering deemed a little easier than for the other
two methods.
Considering aspects of the implementation Table 5 gives point averages from a scale of
1 to 10 (higher figures preferred to lower figures):

TABLE 5
CRITERION 5 - AVERAGE POINTS

STEM IMGP ZW DIDAS

understanding interaction 7.8 6.6 6.6 6.4
clarity of information 6.7 6.5 5.5 7.5
speed 7.9 7.6 6.7 8.3
flexibili ty 6.5 7.3 5.0 6.3
sum 29.0 28.1 23.9 28.4
Concerning the sum of points all methods except ZW seem to do equally well. This may be
due to the fact that we present the tradeoffs in terms of a tradeoff vector and not in terms
of adjacent efficient solutions. The marginal (but not significant) dominance of STEM
might be explained by the fact that each participant was confronted with this method
first.
Turning finally to criteria 4 and 6, the degree of confidence in the solution and the
degree of learning experienced, we find a higher point average for the learning effect (7.7)
than for the degree of confidence (5.9). Both criteria are measured on a scale of 1 (no
confidence or nothing learned from the experiment) to 10 points. It is interesting to note
that academic participants varied much more in their answers than did participants from
the other groups. This does not seem surprising because the number of available methods
itself and the varying results associated with them makes participants suspicious about the
relevance of the achieved results. In most cases, however, heated debates started about
the econometric model, its properties and the consequences traced in the optimization
experiments. Learning about the problem at issue was then straightforward.

6 CONCLUSIONS

Utilizing all advantages of an optimization framework for actual decision making but with-
out the requirement of a preference function, interactive methods for solving multiple ob-
jective decision models are well suited for economic policy making. The policy maker is
closely involved in the solution process. Consequently, the decision quality is considerably
 161

improved because interactive optimization methods allow to pay attention to psychological

and sociological aspects of decision making. Important learning effects may be induced.
Three of these optimization techniques based on linear programming are implemented
in the InterActive Optimization program package lAO (Brandner and Bohm (1989». To-
gether: with a PC-version of DIDAS they are applied to the econometric model of Austria
in the context of an experiment in economic policy optimization. An evaluation of ques-
tionnaires returned by the participants in the experiments permitted to draw comparisons
between the methods which differ from each other in the information requirements and
the conduct of the interaction. A brief outline of an experimental session demonstrates
how decision makers could gain insight into the restrictions of their problem implied by
the model structure and the trade-off choices to find an optimal solution. It is certainly
not easily possible to convey in written form the process of learning - experienced by the
decision maker and the model builder too - associated with real life-use of an interactive
software. Therefore, the second purpose of the experiment was to assess the practical
usefulness of interactive procedures for people involved in actual economic policy decision
making in Austria. A survey of the results achieved so far together with a critical com-
parative evaluation of the techniques has been presented. There is clear evidence for a
demand for easily accessible techniques to solve multicriteria decision problems.
A number of problems remain most of which are too complex to be considered here,
e.g. group decisions, model specification problems. Two problems seem to be immediately
relevant. First, applying a nonlinear model requires certain approximations which are not
always satisfactory. Nonlinear optimization techniques will doubtlessly help provided the
model possesses the appropriate curvature properties. Earlier experiments of the authors
indicated that this is quite often not the case (cf. Brandner 1985). Second, a dynamic
model demands intertemporal considerations in decision making. Even in simple cases this
amounts to a multiple of one-period-target-vectors with the consequence of a very large
number of targets and correspondingly a larger number of tradeoff possibilities. Aspects
of this question have been investigated e.g. by Deissenberg (1983) and Streuff and Gruber
(1983).

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 PART 4:

CONSTRUCTING SCALARVALUED OBJECTIVE FUNCTIONS FOR ECONO-

METRIC DECISION MODELS
PUBLIC PREFERENCES AND THEIR ROLE IN THE DESIGN OF ECONOMIC
POLICY

Andrew Hughes Hallett

Dept. of Economics and Centre for Economic Policy Research
Strathclyde University 6 Duke of York Street
Glasgow, Scotland London, England

Abstract
This paper surveys some recent attempts to estimate revealed preferences econometrically.
It concentrates on the underlying assumptions of these exercises such as the implied axioms
of choice; the conditions for the existence of a collective preference function; the local
nature of the estimates obtained; and the extent to which the results can be interpreted as
preferences built up from a policy search. We distinguish between policy searches with
preferences implicit and with preferences explicit - the former being appropriate for policy
selection, the latter for identifying a preference ordering. An alternative way of structuring
the preferences implicit approach (for policy selection) is to examine efficient policy
trade-Dffs.

Keywords: Optimal policy selections; axioms of choice; revealed preferences; efficient policy
trade-Dffs.

Contents
1 Introduction
2 Economic planning models and economic decisions
3 The policy search: preferences implicit and preferences explicit techniques
4 Can preferences be represented by a quadratic function?
5 Examples: parameters in the preference function
6 Preferences implicit again: policy choice and policy trade-offs
References
 168

1 Introduction

The reconstruction of the preferences and priorities which are implicit in certain economic
decisions - and, by implication, the desire to be able to use numerical values for planning
priorities which are based on the observed behaviour of the decision makers rather than
imposed by econometricians - has been an enduring theme of economic research. The
reality is that specifying numerical values for the relative priorities and ideal values
assigned to target variables is an unavoidable necessity if any numerical decision values or
quantitative policy choices are to be made on a rational basis. And that holds whether
decisions are to be optimised or chosen using conventional simulation techniques.

An axiomatic approach, such as underlies most decisions of consumer and producer

behaviour, is quite satisfactory for deriving the implicit relationships between certain
decision variables and their main determinants; for example, between quantities demanded
and incomes, prices and relative prices. But if one wants an evaluation of how much of a
certain good is demanded in different circumstances, one has either to estimate the implicit
demand function explicitly (assuming constancy of the underlying utility function and risk
factors, non satiation, a particular functional form and error correction dynamics, and
exogeneity and/or separability for the remaining explanatory variables); or one can to
compute explicit demands directly from the utility function and budget constraint. For
other decisions, and policy selection in particular, the corresponding choice is between
estimating average "policy reaction functions" over a period of time, or computing explicit
decision rules by optimising the objective function subject to the constraints on feasible
economic performance.

The trouble with estimating policy reaction functions is that the necessary assumptions on
the constancy of priorities, on risk aversion, of nonsatiation, for specifying error correction
dynamics, or on the exogeneity and separability of exogenous variables simply cannot be
made in most cases. That means a numerical speCification of the objective function will be
needed in order to get explicit policy decision rules. Policy preferences may change quite
sharply over time, not least because policy makers and governments change over time and
also because, for most policy makers, policy priorities tend to be rather sensitive to the
current state of the economy and its expected development. We might characterise the
latter problem by saying that policy makers have complicated (nonlinear) preference
functions which they cannot specify fully for all eventualities, and any approximation
which they might use has partial derivatives which are very sensitive to any potential
changes in the target variables. In any event, that fact, electoral calendars, and shifts in
the government itself, will imply priorities which vary over time. As a result estimated
 169

reaction functions will almost certainly suffer from parameter instability and poor
performance characteristics. The same may be said of variations in the degree of risk
aversion. Moreover nonsatiation is clearly an inappropriate assumption for many targets of
economic policy and priorities may vary depending on which side of equilibrium the
economy finds itself (as well as how far it may be from the equilibrium point). Finally any
policy feedback mechanism is likely to compromise the exogeneity assumptions
incorporated in the simple reaction function approach.

For all these reasons, it is going to be necessary to specify an explicit objective function
and compute policy decision rules from there. However this necessity for specifying
objective functions directly conflicts with the weakness of the theoretical case for using
such objective functions at all. There are problems of whether one may assume that public
or collective preferences even exist and, if they are estimated, whether they reflect social
welfare in any sense or whether they are just a device enabling policy makers to make
reasonable policy choices more easily. Much of that debate turns on what underlying
axioms of choice should be ascribed to the policy makers and what restrictions may
reasonably be placed on the functional form, structure and "freedom of choice" represented
in the objective function. This conflict explains why there has been a continuing interest in
reconstructing "actual" preference functions while, at the same time, this branch of the
literature has had rather little impact on the theory and practice of economic policy.

Over the years a number of techniques have been proposed for recovering the relative
priorities implicit in certain policy or decision values, given a model which describes the
limits of feasible economic performance. These techniques have been of increasing
generality, both in terms of the number of restriction which must be imposed on the
preference function in order for the technique to work, and in terms of the range of
problems where the technique can be used. These techniques and some typical economic
applications are discussed in van Ejck and Sandee (1959), Friedlaender (1974), Ancot et al
(1982), Streuff and Gruber (1983) and Hordijk et al (1976). These investigations have
generally restricted themselves to linear-quadratic problems; i.e. to the optimisation of
quadratic preference functions subject to linear constraints on economic performance,
which are either deterministic or certainty equivalent and which contain only one decision
maker. However further generalisations which pay greater attention to the risk and
uncertainty aspects, and which allow nonlinearities (especially inequali ty constraints) and
multiple players in a game theory setting, have been undertaken by Brandsma et al (1988),
Boehm et al (1989) and Dolado et al (1989). On the other hand, the numerical properties,
and more importantly the statistical properties, of the estimates of the relative priorities
obtained from these algorithms have not been investigated. This survey will make no
 170

attempt to deal with these very recent extensions. Instead it will review the role of revealed
preferences in empirical policy problems, and the information which those revealed
preferences can provide for the investigator.

2 Economic planning models and economic decisions

The main reason for wishing to analyse economic decisions within a formalised model
framework is that to do so ensures that all components involved in the prediction and
decision making process are made quite explicit. This will be necessary if the resulting
decisions are to be open and accountable to all parties concerned. If those decisions are not
understood, or at least capable of being criticised, by all interested parties, then it is most
unlikely that they will be able to command the support and agreement which is needed if
they are to be carried out effectively.

Hence accountability means that the assumptions, priorities, information which have been
incorporated must be open to examination and debate, and to make that possible we need
an explicit planning model. To create such a planning model is of course a more extensive
operation than just constructing an econometric model of the economy's feasible responses
to policy changes. It must in fact contain four components:
(a) A dynamic econometric model, which states the economic responses to given policy
interventions
(b) An objective function specification, which lists the target variables, their ideal values
and their relative priorities in each year (plus any restrictions on the use of the policy
instruments)
(c) The conditioning information set, which states the expected values of the exogenous
variables and possibly the actions expected from other (foreign) policy makers over
the planning period
(d) A measure of risk aversion, which states how policy makers plan to allow for the
unavoidable uncertainties of economic planning.

These components are needed to ensure a systematic and internally consistent set of
policies. Consistency requires that the planned output of different sectors (or the planned
expenditures of different categories) do not preempt all the resources so that the planned
expansion in another sector becomes impossible. It also requires that plans are consistent
over time; resources should not be used today in such a way as to make tomorrow's plans
impossible. Finally internal consistency means that a full examination of the policy options
 171

must be undertaken to check which option matches society's needs best and that the
maximum scope for intervention in that direction has been exploited. Naturally that choice
must make some allowance for risk because random events, unpredictable actions of others
and imperfect models all imply substantial uncertainties. That must be taken into account
in formulating plans, at least in the form of a mechanism for revising plans as new or better
information becomes available.

2.1 Axioms of choice, implicit preferences and the maintained hypothesis

We suppose that rational choices are made by planners when selecting the values for the
variables (instruments) under their control. The assumption of rational choices implies no
more than that a preference ordering exists over values of all the variables of interest to the
planners, and that this preference ordering should satisfy a minimal set of axioms of choice.
Self-interest maximising choices are made on this basis.

Consider a policy problem which involves a column vector of n instruments, x t ; a column

vector of m targets, yt; and m uncontrolled and uncertain variables, St. The planning
horizon contains the discrete decision intervals t=I, ... ,T. Let y' = (Yl.··yf),
x' = (x1 ... xf) and s' = (si ... sf). We write z' = (y/, x'). Suppose the planners have
selected ideal but infeasible trajectories for the policy variables z as
d d' d d' d - d
z ' = (y 1 ····yT ' ,xl ... xT ' ). Let z = z - z .

The constraints, as perceived by the planners, are represented by a dynamic, time-varying

and causal model:
(1)
or
y=Rx+s (2)

where R = [~ll.
. .
1· So Rtj = {OftlfJx j ~f t ~ ~_
0 otherWIse, t,] - L.T
are dynamic multipliers

RTl····RTT
evaluated numerically at some level of economic activity, x and s.

Now rewrite (2) as

Hz = b (3)
where H = [I:-R] and b s - Hzd. We define the feasible set, F, of z values as
 172

F:: {zfE(n+m)T I Hz - s = OJ.

(i) Individual preferences

If values are rationally chosen for z then some index of economic performance can be
associated with each z value. The ability to do no more than rank z values implies the
index is an ordinal preference function for z,
w = w(z) (4)
which satisfies the minimal set of axioms consistent with rational choices. These axioms are
reflexivity and completeness to yield a properly defined set of options; and transitivity so
that a consistent preference ordering exists, plus convexity so that an optimal choice for Z
can be represented by minimising (4).

Whether we consider w(z) for an individual or collectively, the criterion of success is

seldom clearly and simply defined. In macroeconomic planning the criterion is not just
maximising some variables, and the minimisation or stabilisation of others. Nor is it just
vote maximisation, vote share maximisation, the maximisation of the utility of politicians
and administrators, maximising the tenure of office, or extending one's power base, etc. It
is a combination of all these. It is important not to restrict the maintained hypothesis or
prejudice the model of planning behaviour by imputing any specific criteria when setting
the form, structure, or the relative priorities in (4). That is why it is necessary to relax the
maintained hypothesis as far as possible by assuming no more than rational choices by the
planners. So we impose the minimal set of axioms of choice on the implicit function
necessary to guarantee a consistent preference ordering. Then any results, either for policies
or for preferences, stand or fall with just those axioms rather than with any particular
assumed objective function, or with any particular imputed criteria of success.

(ii) Collective preferences

There is a second reason why we need to work with implicit preference functions. The
specification of a w(z) suitable for formulating collective decisions cannot be known a
priori. There may be uncertainty as to the existence of collective preferences, doubt as to
the precise specification of relative priorities in areas of economic performance different
from recent experience, or for larger subs paces of F, or uncertainty over the correct
 173

specification of preferences in a form acc<;!ptable to all contributors to the planning process.

There are also issues of qualitative design to be incorporated into w(z), (e.g. the degree of
risk aversion; measures of robustness, coordination, or contmuity in policies etc.) which do
not admit a precise mathematical or nunlerical specification. But, the basic difficulty in
specifying preference functions a priori is th?_t no one person can fully know the preference
sets of the o,her c)IFributors to the policy pncess; tra:, is before consideration of how they
should, or could, be aggregated. Since pLlnning involves several individual participants,
either within ODe planning agency or thr01!gh the interaction of bodies of decision makers,
policies will emerge from the deliberations of those planners as a negotiated solution.
Moreover, the relative influence of each participant may vary with events. Hence our
representation of preferences must prejudge neither the bargaining process nor the route by
which collective decisions are made.

These points are crucial in representing the behaviour of a self-managed system because
decisions are scarcely ever taken by a single dictator without the influence of advisors. At a
national level decisions are influenced by the individual interests of the government,
organised labour, the business community, and the administrators. It applies equally in a
micro-view of organisations. A government is composed of individual cabinet (or polit-
buro) members; trade unions have executive councils, and aggregate to a confederation.
Not only may these different decision makers have different variables and different
priorities in their own preferences, but they may also judge success by altogether different
cri teria. Therefore our preference structures must not restrict the criteria which different
agents might apply.

There may still be a question of how far any revealed preferences could be interpreted as
collective preferences, since there are situations where a social welfare function cannot exist
(e.g. where Arrow's "impossibility theorem" l.pplies) However their non-existence requires
certain stnct conditions to be met. These conditions have been reviewed in detail by
Johansen (1969, 1974) and Bailey (1979), and they require that the decision process must
not be the outcome of a (cooperative) game; that the dcmain of the choice set may not be
restricted; and that the choice set must be rtducible to no more than two options. By the
nature of economic planning these conditions cannot be met. For example, the fact that
prices, nomina.l interest rates, exchange rat'~s, government expenditures etc. cannot be
negative irr.plies that the domain of the choice set must, in practice, be restricted. Since
there are 5,~vcral variable values to be seleted for several time periods (where to do
nothing is cJways a possibility) there is little chance of rt~ducing the process to a series of
dichotomous options. Finally the preceding paragraph makes it clear that policies will
generally emerge from a (cooperative) bargaining game. Thu~ the nonexistence conditions
 174

will not normally be met in economic planning problems.

2.2 The policy decision rules

A second order approximation to (4) about some feasible z* is

w=1/2z'Qz+q'z (5)
where Q = [a~~ l]z* and q = -Qz* + [~Jz*. Thus Q is symmetric and positive
definite if (4) is strictly convex and twice differentiable, at least over F. The ordinality of
(4) ensures that of( 5); hence some normalisation should be imposed on Q. The point made
clear by (5) is that the relative priority assigned to each element of z must generally
depend on the actual z* values. These penalties may be sensitive to small changes in z*
values.

The optimal decision is now given by

z* = m~n{w(z)IHz - b = O} (6)
z
i.e.
(7)
Finally, in response to the uncertainties facing the agent, we replace b in (7) by its
conditional expectation at the moment of calculating x and y. This follows by the usual
multiperiod certainty equivalence theorem in which Et(w) and Et(b) replace wand b
respectively in (6). Thus by choice of the conditioning information, we can represent z* at
any stage of revision, from open loop to the actually implemented closed loop sequence of
decisions.

3 The policy search: preferences implicit and preferences explicit techniques

Consider how a single planner would actually select optimal policies as his proposal.
Suppose he takes some sequence of candidate policies z(s)fF; s = 0,1, .... His selection
process is to rank the candidates according to the Euclidean distances
IIz(s+l) - z II < IIz(s) - z II (8)
P 2 P 2
where z is any preferred IIsecond bestll but generally infeasible policy while zd remains the
p
ideal. We can allow z to be updated during these comparisons, where necessary, in order
p
 175

to maintain it as preferred to all the candidates considered so far. The policy finally
selected will be the final member of the z(s) sequence, z(p) say, introduced by (8).

Within each individual planner's scale of preferences we assume that some z exists
p
preferred to z(s), and that the intersection of F and the set of z values acceptable to the
planner is nonempty. If each member of the sequence {z(s)} is the constrained optimum of
(5), corresponding to each member of the possibility set {Q(s)} for Q, then zp is any point
such that w(zp) < w(z(i)), i=O, ... ,s.

We next suppose the policy maker picks a sequence of zp vectors in order to sample the

Pareto optimal frontier of F with respect to zd. Each zp is picked as one in a series of
experiments to locate which feasible positions are preferable to each z(s); and therefore
ultimately to locate the preferred feasible position (the policy proposal) while zd remains
the ideal. We define each z to ensure a systematic search of the frontier, but otherwise the
p
switch from one zp to another (when, and by how much) is unrestricted. Our scheme now
has an inner iteration in z(s), and an outer one in z ; but that in z(s) need not be fully
p
exploited. If the inner iteration is completed we obtain the solution, for a given z ,to
P
z(p) = m!n{llz - zpl12 s.t. Hz - b} (9)
i.e.
(10)
Evidently (10) is a special case of (7) with Q = I, z = zd and q = o. Consider any point
p
on the Pareto optimal frontier of F; say z(o) generated by (7) with Q = q(o). Now consider
any other arbitrary point on that frontier, say z* = z(o) + dz*. Since z* is also feasible,
Hdz* = O. The optimisation to give z* would, if appropriate Q were known, be (7), from
which
pz d = z* - Q-1[ H'(HQ -1 H' )-1( s + HQ -1 q) - q1 (11)

where P = 1- Q-IH , (HQ- 1H' )-1. If zd were altered, then

dz* = Pdi (12)
Now r(P) = nT < (n+m)T where r(.) denotes rank. Thus r(P, dz*) ~ r(P) ~ (n+m)T.
Hence at least one solution exists for dzd given such an arbitrary dz* since H(P, dz *) = 0
yet H f. 0 (having rank mT by construction). So every feasible policy, rationally chosen
with respect to zd and according to some admissible preferences, may be generated by
fixing Q = Q(o) and varying zd as necessary within (7). One particular case is given by
 176

Q(o) = I and zd replaced by the zp sequence (10). It is only necessary for the planner to

experiment with different z values in order to sample the entire Par·~to optimal frontier of
p
F.

On the other hand, every feasible z* can also be generated by varying Q over the set of
positive definite, symmetric, normalised matrices while zd remains fixed. One way of doing
that is the algorithm described in detail in Ancot et al (1982) and Hughes Hallett and
Ancot (1982). We therefore have two fully equivalent search proced'lres for policy
selection. One keeps preferences implicit in the z values (Le. Q is fixed, zd iterated); the
p
other makes the preferences explicit (Le. zd is fixed, Q iterated).

Hence policy selection and the "estimation" of preferences are tWG facds of the same
problem, and the same interactive planning mechanism therefore permits the analysis of
two interesting but separate problems. Given any policy selection z(p), where w(z( is
unknown, the preferences implicit in that choice (up to a quadratic approximation at z p))
may be recovered by running pseudo policy iterations from an arbitrary start to z(p),
through the "preferences explicit" algorithm. Alternatively, given any p'Jlicy (zp) preferred

to the current situation or choice (z( s )), where w(z) is imperfectly known, we can generate
an improved policy recommendation by running actual policy iterations either through the
"preferences implicit" algorithm, (10), or through the "preferences explicit", (7), ·)ne if the
preference structure is also of interest.

4 Can preferences be represented by a quadratic function'!

4.1 Homogeneity

w in (5) displays Euler's theorem for a function homogeneous of degree 2 in z "ince q=O.
The priorities over correcting the failures in z are linearly related to z itself. ':.nd to the
extent that the level of economic activity varies by scalar multiples of b - and this
contains all the uncertainty - the true preferences will select failures for e,,,:h policy
variable in constant ratios to all the other optimal failures. That is to say that, :1.long the
linear expansion path, the marginal rates of substitution of zi for 22 at tht'" optimal

solution are constant. If all the exogenous factors in b, such as world trade, imput prices,
agricultural conditions, etc., conspire to prod1lce boom conditions with, say, 2%' 'lemploy-
 177

ment and 2% lllilation, and if we also accept falling short of the unemployment target by
100.000 jobs is tradeable without penalty for 1% less inflation, then the same rate of trade
is desired in a situation of 20% unemployment and 20% inflation. Clearly this is absurd.
Every government would press somewhat harder on the inflation target in the former case
and very much harder on unemployment in the latter.

This example reminds us just how restricted the validity of a particular Q and zd
specification is even where no references are made to (5) being an approximation to
something more general. If we need to consider policies significantly removed from the
economic conditions for which a particular set of preference parameters apply then the new
ones must be supplied.

4.2 The local nature of the approximate preferences

The difficulty with (5) is the restricted validity of this preference function specification. A
large shock to the economy, a radical change in the political atmosphere, or just dis-
satisfaction with current recommendation may well lead policy makers to identify a
preferred trajectory. Could the original preference specification still be used? The examples
above suggest not. One result discussed by Hughes Hallett and Ancot (1982) is that for any
given zp the associated Q is unique only up to additive factors such that

6Qz =0 where 6Q = Q1 - Q2 (13)

If we take a set of vectors which form a basis spanning z space, we can regard each member
of that set as a notional basic policy component mutually uncorrelated with the others. The
observed zp is spanned by a subset of that basis. Then (13) shows we have no uniquely
estimated preferences over those components which do not enter a basis for zp itself. The
latter policy components are, of course, those not chosen by the planners. Thus we have no
estimate of preferences over subspaces orthogonal to that containing zp but a unique
estimate for that in which zp lies. This is as it should be. Working from one zp' it is
unreasonable to expect to be able to infer relative priorities over policies or components
that have been rejected.

There is no disadvantage in practical terms to have the estimated preferences only locally
valid: it is a special feature of particular significance in problems of social choice that the
relative penalties on the policy failures z are themselves heavily dependent on the values of
 178

those variables. In recognition of this we have specified w(z) as potentially nonquadratic

but have worked with a quadratic approximation.

Other studies in this field have attempted to obtain globally valid preference orderings by
imposing prior zero restrictions and time invariance on Q. We relax the maintained
hypothesis on Q, and trade global results for local ones since in any event, no more
generality is justified. Indeed our results suggest that these prior restrictions do not
generally hold. A series of tests by Hordijk et al (1976) in which these prior restrictions are
varied when the implicit preferences of a fixed problem are calculated show that varying
the restrictions will typically produce greater changes in the results than are seen within
the preference structure itself.

5 Examples: the parameters in the preference structure

Our preference structure may be decomposed with respect to time:

T T
w= ~ ~ z~Q .. z. (14)
i=l j=l 1 IJ J
and with respect to the choice variables:
T T n+m n+m ]
w=[ ~ E E ~ (Q. ·)kez.kz.e (15)
i=1 j=1 k= 1 e= 1 IJ 1 J
Thus we may examine the preference structure over variables within one planning period;
or over planning periods for one variable; or both.

(i) The diagonal elements of Q, (Qii)kk i =1...T, k=l...n+m, show the relative
penalties assigned to squared deviations of variables from their desired values in
each period. In particular we can look cross-sectionally to see how the implied
preference ranking alters over time and how the relative gaps in that ordering
increase or decrease. We may also look at the same time series behaviour of those
weights in order to rank preferences on anyone variable over the planning
exercise. These results will show which policy variables were treated as most
important at each stage; which were unimportant, whether those rankings
become inverted at (say) elections or mid-term elections compared to nominal
years, and whether policy targets become much more important in the run-up to
an election whereas policy instruments are the focus for the new administration.

(ii) The remaining elements of Q .. show penalties on joint failures, additional to

11
 179

penalties on the individual failures to reach desired values of two variables

simultaneously at a given moment. Thus, with taxation and government
expenditure for example, pressure to maintain a balanced budget follows from a
negative weight on their joint failures in each period. If taxation overshoots its
desired value then the penalties are reduced below the weighted sum of their
individual penalties whenever government expenditure also does so; but they are
increased if it does not. Negative off-diagonal elements encourage complementary
positions, and positive elements substitution between the policy variables.

(iii) Finally the remaining submatrices, Q .. i/:j, contain penalties which perform a
1J
similar function but for the joint failures at different points of time. Inter-
temporal penalties may be assigned so that accelerating penalties accrue to
persistent failures, to penalise the timing with which a unit failure occurs, or to
encourage substitutability over time. This is in addition to the basic pattern of
preferences in each time period as set up in the block diagonal components of Q.
Examples of this are, respectively, penalising units of a balance of payments
deficit proportionally more the longer they persist; penalising undershooting the
employment target proportionally more the closer to an election it occurs;
penalising consecutive consumption failures of the same sign; or rewarding a
failure in receipts and a consecutive expenditure failure of the same sign when a
balanced budget is desirable in the long run, but a deficit or surplus is
permissible in the short run.

For more detail on these points and empirical examples see Ancot et al (1982) which
examines the economic priorities underlying the New Deal policies and their manipulation
for President Roosevelt's reelection ambitions. Hughes Hallett and Ancot (1982) contrast
President Eisenhower'S concern with mid-term congressional elections with his lack of
concern for Nixon's campaign against Kennedy in 1960 and study the effect of that on US
policies of the 1956-62 period. Ancot and Hughes Hallett (1983) look at the preferences
underlying Soviet economic policies of the 1966-70 and 1971-75 five year plans and find
two strands of policy - there are "economic" variables which are used for steering the
internal economy and there are "strategic" variables which are used to reinforce the
independence of the Soviet economy, and the latter group comes to dominate in importance
by the 1970s. Ancot and Hughes Hallett (1984) estimate the preferences implicit in the
election manifestos of two Dutch political parties who subsequently formed a coalition
government, and compare those preferences with those revealed by the policies of the
subsequent coalition government. The party preferences appear to account for only about
10% of the resulting government's preferences; the remaining 90% are presumably supplied
 180

by the "reality of office", the civil service, t,he central planning bureau ',!LC.

Less provocative but typical examples will be found in the analysis r;1 :\llitrian economic
priorities obtained by Boehm et al (lSg9:, and of German priorities ''I'hich are calculated
within a game between different governments (D'Jlado et al (1989)). 01'~U '~xaiilples appear
in Friedlaender (1974) on US macroeconomic policies of the Kennedy-.3 ,iL.JV'l era, and van
Ejck and Sandee (1959) who discuss estlmates of Dutch planning p;:~\Jntil;s in the 1950s.
Few other empirical examples appear to ha.ve been published.

6 Preferences implicit again: policy choiee and policy trad~£fs

So far we have considered revealed preferences from some historical or constructed

situation, It is not obvious how one should apply these methods in a !or-:1Jard planning
exercise when the policy maker is not on hand to participate in the interactive search
process, or where policy makers cannot or will not (dare not?) cooperate III setting their zp
vector while selecting their future policies. Given the local nature of the results, it is also
not clear how to use any preference estimates obtained from recent history, or from
pseudo-iterations derived from recent political announcements, when the purpose of policy
is to engineer significant changes in economic activity.

Indeed it is not entirely clear how a policy maker would actually arrive at '/alues for his zp
vector when he does cooperate. If he experiments fully, he must inevita1:ly end up setting
those values in terms of the best trade-offs between target variables that he can get. For
example he might search for the minimum increase in the inflation rate which must be
accepted in order to get a given reduction in the unemployment rate; or the minimum
sacrifice in terms of output growth needed in order to achieve a given improvement in the
balance of trade? Starting from some z vector, the values should be changed to alternative
p
trade-off values which the policy maker would find acceptable. (That does not necessarily
mean they expect those trade-offs to be feasible.) Policy makers can make those changes
relatively easily since trade-offs are a currency they understand - the abstract penalties
specified in an artificial objective function like (5) is not a formulation which they can set
up for themselves or use themselves. In that case, why not trace out these efficient policy
frontiers (target trade-offs) explicitly and have the policy makers choose their own
preferred position on those trade-offs? That should, in principle, be an easier way of
getting policy makers to reveal their preferences (albeit implicitly) while choosing policies
for their future plans, It is also the "menu" approach recommended in Hughes Hallett and
 181

Rees (1983), in which the role of policy maker and advisor are separated but linked by
two-way information flows. Advisors are expected to provide technical advice to problems
specified by the policy makers, but not to take decisions; policy makers are expected to
choose a policy from the range of projected outcomes and commentary provided by the
advisors, but not to dictate the techniques of analysis. The simplest way of doing that is to
present the policy makers with a few representative options and their projected outcomes,
and allow them to make their choice from that "menu". If those options are presented in
the form of a set of optimised trade-offs between policy targets, then policy makers can
choose optimal policies independently of any particular (arbitrary) objective function
specification that might be introduced on their behalf and it does show the scope and
limitations of policy at best (i.e. independently of any particular relative priorities).

The curious thing is that, although economists are clearly aware of the importance of
examining policy trade-offs and of reducing the arbitrariness of introducing some guessed
at objective function for the policy makers, there are so few examples in a large empirical
literature on policy choice and policy evaluation. Inflation vs. unemployment or output
trade-offs are studied by Chow and Megdal (1978), Henry et al (1982) and Wallis et al
(1987). The Chow approach may be represented by taking a special case of (5):

T[ d2 d2 d2 d2] (16)
w = ~ (Ylt-YIt) +a(Y2t-Y2t) +,8(x It -x lt ) +1(x2CX2t)
t=l
subject to the constraints in (2), where Y1 = inflation and Y2 = unemployment are targets,
and Xl = public expenditures and x2 = money supply (say) are instruments. Optimal
combinations of target values (and corresponding policy instruments) can be generated by
evaluating (7) for a whole range of values of m(O,m), keeping the rest of (16) and (2)
constant. The results can be examined by sketching the average inflation-unemployment

trade-off (i.e. y1 = T-1~y It vs. Y2 = T-1~Y2t) or the corresponding stability trade-Dff

(i.e. 0"1 vs. 0"2' where O"i denotes the time series standard deviation of Yi); see Figure 1. By
simulating certain historical or other policy proposals - in particular simple policy rules
like Friedman'S fixed growth rate rule for the money supply - by simulating them through
the model (2) with all other components of (2) held at the values used in the calculations
for Figure 1. Those simulations will generate points like A and B (respectively), from
which we can see their degree of inefficiency and what position they correspond to in the
preference ranking. Chow and Megdal (1978) produce results of this kind from two US
models. But the main point is that these calculations yield efficient policy frontiers and an
estimate of the minimum sacrifice, in terms of one target (or its stability), which must be
made in order to achieve an improvement of a certain size in another; and they alIoN policy
makers to choose from the range of options independently of any arbitrary pre-:lssigned
preference functions.
 182

p
o
p

.
B

u (J

Figure la u
Figure lb

The inflation-unemployment (fig.1a) and stability (fig.lb) trade-{)ffs

Of course we are not obliged to study average trade-{)ffs over several periods. We could
construct Figure 1 from the outcomes at t=l (a short run trade-{)ff) or at t=T (the long
run trade-{)ff, with instruments either free to change or restricted after t=l). Standard
theory would predict a steeper (possibly vertical) trade-{)ff in the long run, although that
result does not always emerge in practice. (See Henry et aI, 1982 and Wallis et aI, 1987 for
results on a variety of British models.) This kind of trade-{)ff can be studied for any set of
target variables - most obviously between inflation and output growth, which will rotate
the frontier in Figure la clockwise to an upward sloping curve.

Finally, as Wallis et al (1987) poin' out, simply varying one of the objective function
parameters in a multivariate objen:,', :unction such as (16) does not generate a genuine
trad€-{)ff in a strict efficiency sen.)! ;: ;1(' ;; confuses a movement along the trad€-{)ff curve
(which is what we get by varying '.' Wh"L :)=,=0) with shifts in the trad€-{)ff curve itself
(which is what we get by varying c xi:.en ({3, 'Y) are nonzero) since the latter increases the
target weights relative to instrurnC:'l. weights and therefore shifts the frontier of what is
feasible towards the ideal values in Figure 1. This however can be corrected by adjusting
the weights which would otherwise be left constant to bear the same relation as a set to
those on the targets which are being traded off (Hughes Hallett and Petit, 1990).
 183

Another problem is that these policy trade-offs can become "reversed" from what we
would normally expect; i.e. Figure 1a rotates to an upward sloping curve. In those cases
there is no trade-off (at least in absolute terms, there may be a relative change along the
curve) since one end of the "frontier" is unambiguously better than the other. Investigating
the reasons for such trade-off reversals reveals something of the role that different
preferences or preference rankings play in policy choice; i.e. it tells us where different
priorities matter and where they do not, and why different policy makers perceive policy
problems differently, and why they have different ideas over which components,
disagreements or uncertainties, form serious constraints on successful policy design. These
are important factors in understanding how to construct policy packages which will best fit
the policy makers wishes, and they have been analysed in Hughes Hallett and Petit (1988,
1989 and 1990). Those papers show how the slope of the optimised trade-off depends on
the policy makers' preferences (Q, yd), on their expectations for exogenous events (Et(s)),

and on their perception of the economy's responses (R). One can in fact test whether
alterations in anyone of these factors would materially change that slope (in sign or
steepness) and hence identify which of the relative priorities, which expectation of the
future, or which component of the economic model is crucial to the choice of policies even
when we are not exactly sure what the preference structure should be. That also allows us
to say where disagreements or uncertainties over the correct specification of the
preferences, model or expectations would cause genuine difficulties or confusion in the
process of selecting a policy. Some empirical examples for the Italian economy are given,
and in Hughes Hallett and Petit (1989) they are extended for the case where two policy
makers (the Central Bank and the Treasury) cannot cooperate. The latter reveals that not
only does noncooperation imply inferior policy outcomes, but it may impose a policy
conflict (trade-off) which otherwise would not be present and it can also reduce the range
of policy options open to policy makers. There are therefore more reasons than just
efficiency gains for wanting to be able to specify (collecti ve) preferences correctly. If
revealed preference methods are not possible, or if they are thought to be too restrictive an
approximation for developing new policies, a study of the relevant policy trade-offs will
help in that endeavour.

References

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Preferences in Economics: an Empirical Study", Greek Economic Review, 4, 3-35.
Ancot, J.P. and A.J. Hughes Hallett (1983), "The Determination of Collective Preferences
in Economic Decision Models: with an Application to Soviet Economic Policy" in J.
Gruber (ed), Econometric Decision Models, Springer Verlag, Berlin and New York.
 184

Ancot, J.P. and A.J. Hughes Hallett (1984), "Establishing Public Preferences for Coalition
Government: an Empirical Study in Economic Planning Behaviour", De Economist,
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Ancot, J.P., A.J. Hughes Hallett and J.H.P. Paelinck (1982), "The Determination of
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Dolado, J., M. Griffiths and J. Vinals (1989), "Preference Revelation in International
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Least squares estimation of quadratic preference func-
tions for econometric decision models based on survey
datal

Hartmut Hiisges 2 and Josef Gruber

Fern U niversitat Hagen
Lehrgebiet Statistik und Okonometrie
Feithstr. 140, D-5800 Hagen I, FRG

Abstract
In an econometric decision model which is an optimization model in the usual sense, a scalar-
valued preference function is needed. In the frequently applied "linear-quadratic" control
theory approach a quadratic objective function is used. We deal mainly with estimating
such a function on the basis of survey data and with constructing the questionnaire for such
a survey.
After briefly discussing some utility theoretic aspects of estimating preference functions
in the framework of a regression model, methods are presented for generating D-optimal
questionnaire designs with hypothetical policy alternatives. Such optimal policy alterna-
tives can be used in a survey to obtain the required information about preferences. We
also report about a pilot study in which students of the University of Hagen were asked to
evaluate 28 "D-optimal alternatives" of economic policy. The method of least squares was
used to estimate five versions of preference functions of the persons who had filled in the
questionnaires.
The results obtained show that it is possible to estimate quadratic and other scalar-valued
preference functions on the basis of survey data. It is no longer justifiable to work with
hypothetical values of e.g. weights in quadratic objective functions. After having discussed
the most important results of the analysis, some lines of future research are briefly outlined.
Keywords: Econometric decision model; preference function; estimation; survey data;
multiple objectives; control theory approach; linear-quadratic model.

Contents
1 Introduction
1.1 Relevance of econometric decision models .
1.2 Contents . . . . . . . . . . . . . . . . . . .

2 Estimation of preference functions in a regression model

2.1 The regression function .
2.2 Utility theoretic aspects
2.3 Least squares estimation

3 Constructing optimal designs

3.1 Introductory remarks . . . . . . . . . . . . . . . . .
3.2 D-optimality in the classical linear regression model
1 Version of March 25, 1991, that has been accepted for presentation at ESEM 1991 in Cambridge.
2Since February 1989 Federal Ministry of Economic Affairs, Bonn.
 186

3.3 D-optimality in the generalized linear regression model

3.4 A variant of D-optimality . . . . . . . . . . . . . . . .

4 Empirical analysis
4.1 Data collection
4.2 Preference functions estimated .
4.3 Results . . . . . . . .

5 Summary and outlook

Appendix A: Questionnaire with 28 policy alternatives

Appendix B: Estimation Results

References

1 Introduction
1.1 Relevance of econometric decision models
In many cases economic policy makers are faced with decision problems characterized by
multiple and conflicting objectives. An example for this kind of decision problem is to
stabilize and regulate the economy in a way that the following objectives are achieved
simultaneously: Unemployment is minimized, inflation is under control, economic growth
is maximized and imbalances in the foreign trade of goods and services are minimized.
Such decision problems are well known as decision problems with multiple objectives. There
is a large group of interactive procedures for solving MCDM (Multiple Criteria Decision
Making) problems (see e.g. Changkong, Haimes (1983), Zeleny (1982); some research on
MCDM in relation to econometric models is presented e.g. in Gruber (1983, 1987), Gruber,
Streuff (1983) and Streuff (1983)). One major disadvantage of MCDM procedures is that
the solution obtained is "subjective".
An econometric decision model with a scalar-valued objective function avoids this
disadvantage. The different conflicting objectives are aggregated into one evaluation cri-
terion (i.e. in a scalar-valued objective function). The evaluation of alternatives can be done
by this criterion. The criterion chosen should reflect the decision-makers preferences and
can be interpreted as a utility function. An optimal decision can be found by optimizing the
objective function (utility function) subject to restrictions derived (mainly) from an econo-
metric model.
A special case is the so-called linear-quadmtic approach: The scalar-valued objective func-
tion is a quadratic function and the restrictions are linear equations in the instrument and
target variables.
In practice this approach has been used rather early to derive optimal economic policies, es-
pecially optimal stabilization policies (Theil (1964), Fox, Sengupta, Thorbecke (1966), Chow
(1975)).
Ragnar Frisch, who together with Jan Tinbergen pioneered this approach, was convinced of
the relevance of econometric decision models as a means to optimize (macro-) economic de-
cision problems. He suggested a new type of cooperation of poli ticians and econometricians
(Frisch (1976), p. 41):
 187

"The new type of cooperation consists in formalizing the preference

function which must underlie the very concept of an optimal eco-
nomic policy.... the function being such that the maximization of
it can be looked upon as the definition of the goal to be obtained
by the economic policy. ... It is my firm conviction that an ap-
proach to economic policy through a preference function contains
the key to a much needed reform of the methods of decision making
in society at large in the world of today."

In Frisch's opinion an important task of econometricians is to support decision makers when

determining an optimal economic policy. The econometrician's service consists of describing
the economy by a macro-econometric model, which contains instrument variables as well as
target variables, and in specifying a scalar-valued function representing the decision-maker's
preferences. The optimal economic policy can be calculated by optimizing the decision-
maker's preference function subject to appropriately formulated constraints.
The analysis of macro-economic problems and the improvement of economic policy decisions
is the main purpose of econometric decision models.

1.2 Contents
The purpose of this paper is to present one possible way of assessing scalar-valued preference
functions: regression analysis of preference functions on the basis of survey data. The pref-
erence information necessary for the analysis can be gained by directly interrogating those
persons (i.e. they fill in a questionnaire) whose preference function has to be estimated.
Having collected preference data there are two possibilities of estimating the regression
model: non-parametric estimation procedures (e.g. kernel estimation of regression func-
tions) and parametric estimation procedures (especially the method of least squares). Non-
parametric estimation procedures don't require a priori assumptions about the mathematical
form of the preference function to be estimated. In order to apply parametric methods as-
sumptions of that type are necessary. In this paper only results of parametric procedures
are presented.
In a pilot study Merkies and Nijman (1983) assumed a quadratic preference function. They
used the method of least squares to estimate the regression model. In this paper we are also
concerned with the method of least squares. Some theoretical difficulties are discussed and
empirical results from a small survey of students at the University of Hagen are presented
in this paper. In more detail, the paper is organized as follows:
First, the regression function showing the dependence of the utility index u on the values
of n target variables Yi (i = 1,2"", n) is presented (section 2.1). Then the random utility
model is taken as an appropriate utility theoretical basis for the analysis to follow (section
2.2). Finally, it is shown how the unknown parameters of a scalar-valued quadratic prefer-
ence function can be estimated in a linear regression model by OLS (section 2.3).
Section 3 of the paper deals with an important question concerning the development of the
questionnaire to be filled in by those persons (e.g. decision makers or others) whose pref-
erence function is to be estimated: How to formulate the hypothetical policy alternatives
(which form the rows of the data matrix) so that the utility index value for each alternative
can be stated with minimal strain on the person filling in the questionnaire and with a low
level of error? Statistical principles usually used in the experimental design literature are
applied here and adapted to answer the question stated above.
In section 4, a selection of empirical results is presented: For each of 13 persons who filled in
the questionnaire which contained 28 policy alternatives, the results of estimating 5 models
(out of a larger number of models) are gi\'en in tables and briefly discussed.
In section 5, after a short summary, some problems are indicated which could or should be
investigated next.
 188

2 Estimation of preference functions in a regression

model
2.1 The regression function
In order to apply econometric decision models which are optimization models with a single
criterion a scalar-valued objective (preference) function has to be specified numerically repre-
senting the decision maker's preferences. This preference function should contain all those
target variables characterizing the decision problem at hand. This section shows in which
way the preference function can be estimated by methods of regression analysis on the basis of
survey data. The utility index is denoted by u and the n target variables by (Y1 , Y2"" , Yn).
The utility index and the target variables can be interpreted as random variables. Then
(u,Yi,Y2,···,Yn ) is a random vector with a joint density function !(U,YbY2,"',Yn)' The
conditional expectation

r(Yi, Y2,"', Yn) = E(ulYl = Yl, Y2 = Y2,"', Yn = Yn) =

(1)
i~oo U!UIYI .... ,YJ UIYl, Y2, ... , Yn)d( u)
is represented as a regression of u on (Yi, Y2 , " ' , Yn ), for short u = g(.). This regression
function has to be determined. !UIYI .... ,YJuIYb Y2,"', Yn) is the conditional density function
of u given (Yl, Y2, ... , Yn). }i represents the target variable i as a random variable. Yi is
a realization of this random variable. In this paper we use the method of least squares to
estimate the regression function g(.). Before going into more details concerning special prob-
lems when applying the method of least squares some utility theoretic aspects of modelling
the decision maker's preferences by a regression model are discussed.

2.2 Utility theoretic aspects

The most important characteristic of modelling preferences by a regression model on the
basis of survey data is that the decision maker's utility is represented as a random variable.
The utility index and the target variables have a joint probability distribution. The reason
to interpret the utility index as a random variable is that preference statements cannot be
made without errors.
Errors may occur if the decision-maker isn't entirely sure about his preferences or about the
set of alternatives available to him. An important consequence is that some assumptions of
classical (normative) decision theory defining rationality of decision maker's behavior, e.g.
transitivity of preferences3 , no longer hold. Therefore one has to find another definition of
rationality. The concept of probabilistic consistency seems to be an appropriate approach.
The preference statements of the decision maker are interpreted as random variables. The
probability of a preference statement is denoted as follows:
Prob{y' >- y"} = Py'y",
where y' and y" are two vectors with values of the target variables. py'y" can be interpreted
as a measure of the extent to which the decision maker prefers Y' to y". X is the set of
alternatives (respectively the set of all vectors with values of the target variables). Then
X X X defines the set of all pairwise comparisons of these alternatives. p can now be defined
as follows:
P: X X X ~ [0,1].
We can now try to construct a utility function u so that the following equation holds:
Py'y" = Prob{y' >- y"} = Prob{u(y') ~ u(y")}.
3Transitivity: a >- " and b >- ~ ==> ;J >- c.
 189

Roberts (1979) shows the conditions for the existence of functions of this type.
This utility model is called the Random Utility lv/odel: It is taken here as a theoretical basis
for handling the problem of estimating scalar-valued preference functions based on survey
data in the framework of regression analysis.

2.3 Least squares estimation

In order to estimate the regression function g(.) information about the decision maker's pref-
erences has to be collected. To get the necessary information the decision maker is asked
to evaluate alternative policy programs, each consisting of particular values of the target
variables which characterize the decision problem. The decision maker has to assign to each
alternative a utility index representing the degree of preference or utility respectively. It's
worth mentioning that a cardinal utility concept is needed in order to apply the method of
least squares. This requires not only that the utility index values can be ranked. The range
of the utility index could e.g. be in the interval [0, 100J, 0 representing the worst alternative
and 100 being attached to the alternative satisfying most.
This kind of inquiry results in a suitable data set for the regression analysis. The data set
consists of n vectors with T values of the n target variables and one vector of corresponding
preference statements, i.e. one vector with T values of the utility index. The data matrix
then is as follows:

UI Yll Y12 YIn

Ut Ytl Yt2 Ytn

UT YTI YT2 YTn

The t-th row refers to the t-th policy alternative. The total number of alternatives to be
evaluated by the actual or hypothetical decision maker is T.
Before being able to estimate the parameters of the decision-maker's preference function on
the basis of this data set the mathematical form of the regression function g(.) must be
determined.
In a pilot study Merkies, Nijman (1983) have assumed that the preference function is
quadratic in the target variables. It can be written as follows:

U(Ytl, Yt2, ... , Ytn) =

n n n-l n

ao + LaiYti + LaiiYZi + 2 L L aijYtiYtj + t.t (2)

i=l i=l i=lj=i+1

t=l,···,T.

This function consists of a linear and a quadratic part and a term considering interactions 4
between the target variables. After redefinition we obtain the regression model for estimating

4
aij = dy,d'u h d I . ..
dYJ' t e un er ymg questiOn IS: How does the utility index change if target variable Yi is

infinitesimally changed, dependent on Yj?

 190

the parameters of such a quadratic preference function:

U(Ytl, ... , Ytn) =

n n tn (n-l)
bo + 2: bi Z ti +2: bn+i Z t.n+i + 2: b2n+i Z t,2n+i + Et
(3)
i=1 i=l ;=1
t = 1,···, T.

The linear part consists of n variables (regressors) Zti, with i = 1,2,···, n, and n being
the number of target variables. In the quadratic part there are n regressors Zti, with i =
n + 1,n + 2,··· ,2n. The interaction part contains ~n(n - 1) regressors Zti, with i = 2n +
1, 2n + 2, ... , 2n + tn( n -1). In matrix notation we write the regression model (3) as follows:

(4)
u is a T x I-vector, Z a T x K-regressor matrix, f3 a K x I-vector of regression coefficients,
and EaT x I-vector with error variables. The regression coefficients can be estimated by
the method of least squares.
It is important to point out that a utility function which is quadratic in the undesired
deviations of target variables from the corresponding desired values yti can always be trans-
formed into a quadratic function where undesired deviations no longer explicitly appear.
The following example shows this:

U(Ytl, Yt2) = + a2(Yt2 - yt2)2 + Et

al(Ytl - ytl)2
= +alYZl - 2alYtlytl + al(ytl)2 + a2Y;2 - 2a2Yt2yt2 + a2(yt2)2 + Et
= al(ytl)2 + a2(yt2)2 - 2alytlYtl - 2a2yt2Yt2 + alY;1 + a2Y;2 + Et
= bo + b1Ytl + b2Yt2 + b3YZI + b YZ2 + Et·
4

Y1i is the desired value of target variable i in alternative t. This simple example indicates that
the regression model ( 2) is a correct representation of a utility function which is quadratic
in the undesired deviations of the target variables.

3 Constructing optimal designs

3.1 Introductory remarks
In most applications the policy alternatives (vectors with hypothetical values of target values)
presented to the decision maker are determined more or less arbitrarily (see e.g. Merkies,
Nijman (1983)).
Nevertheless it is possible to generate alternatives subject to statistical criteria of optimality
in order to get an optimal questionnaire. It seems to be straightforward to use results
from the theory of optimal design. Criteria of optimality usually refer to properties of the
estimated parameters of the underlying regression model.
A survey of this problem can be found for example in Ash, Hedayat (1978) and Silvey (1980).

3.2 D-optimality in the classical linear regression model

A criterion frequently used to construct optimal designs is the concept of D-optimalitl.
This concept refers to the optimality of the estimated coefficients of the regression model.
50ther criteria are for example A- and G-optimality; see e.g. Silvey (1980).
 191

To illustrate this approach we consider the classical linear model of normal regression (see
e.g. Schonfeld (1969)) that can be written as follows:

y=Xf3+L (5)

y is a T X I-vector of endogenous variables and X a T X K-matrix with observations of the

explanatory variables (regressors). T is the number of observations and K the number of
regressors. f3 is a K X I-vector of regression coefficients. E is a T x I-vector of error variables.
We assume that the assumptions of the classical model of normal regression hold. Therefore
we assume that the vector of error variables E is normally distributed with the covariance
matrix
L:(,( = 1J,2 I and with E(E) = O.
Best linear and unbiased estimates of the coefficients can be calculated by the Ordinary
Least Squares method (OLS):
(6)
The idea of the concept of D-optimality is to fix the elements of the regressor matrix X such
that the quality of the estimates of the coefficients ffi is as great as possible.
A measure of quality of the estimated regression coefficients is the covariance matrix of the
random vector ffi:
(7)
The smaller the elements of the covariance matrix L:(P,P) ' the greater the quality of the
estimated regression coefficients ffi. Therefore a scalar-valued measure has to be found ag-
gregating the distribution properties of the vector ffi. This measure can simply be derived
from equation (7):

(XIX)-IIJ/ = det(~'X) Adj(X'X)IJ,2. (8)

Adj(XIX) is the adjunct of the matrix X'X.

It can immediately be seen that the elements of the covariance matrix L:(J,J) are ceteris
paribus the smaller the greater the determinant of (XIX) is. The determinant of (XIX) can
be interpreted as the generalized variance. It is a proper measure of dispersion.
The analyst should fix the elements in X such that the determinant of (XI X) takes its
maXImum.
The common sense behind this approach is that a large determinant of X'X guarantees that
very much "independent" information is used.
According to the terminology and the symbols introduced in section 2.3 the determinant of
(Z'Z) has to be maximized. The following optimization problem has to be solved:

maxdet(ZIZ). (9)
z

3.3 D-optimality in the generalized linear regression model

Tn section 3.2 the covariance matrix of the vector of estimated regression coefficients has
been appropriately transformed. This matrix depends on (apart from Adj (X' X)):

1. det(X'X) as a measure of the amount of information within the design matrix X and

2. 1J,2as a measure of the variability of the decision maker's preference statements

(evaluation errors) concerning the utility index Ut (see section 2.3).
 192

According to the literature available to us, until now only term 1 has been used in order
to construct an optimal design. The underlying assumption is that the variance of the
evaluation errors is independent of the design matrix X. This will often be an unrealistic
assumption.
A more realistic assumption is that the design of the questionnaire has a considerable influ-
ence upon the decision maker's evaluation errors. As a consequence we can no longer assume
a classical linear regression model because it has to be expected that the evaluation errors
are auto correlated as well as heteroscedastic.
Therefore the construction of an optimal design requires a generalized linear regression
model. It can be written as follows:

y=XP+f., (10)
where now the error variables f. are assumed to be normally distributed with covarIance
matrix
~(,( = % and with E(f.) = 0,
with 0 a positive definite TxT-matrix.
Best linear and unbiased estimates can under model assumptions be calculated by the
Generalized Least Squares Method (GLS):

~ = (X'O- I X) -I X'0-1y. (11 )

The covariance matrix of ~ is denoted by:

(12)

Since 0 IS a positive definite and symmetric matrix the following representation for 0- 1
holds:
0- 1 = p'P.
P is a non-singular matrix. Equation (12) can therefore be written as:

~ 00) = ((P X)'(P X»)-IO'/. ( 13)

({3,{3

Defining P X = X we obtain:
~(O""
(3,(3)
= (X X) -1 0'(.2
- I -
(14)
This formal representation corresponds to the case of the classical linear regression model.
If the matrix P were known an optimal design matrix X could be generated (section 3.2) by
maximizing the determinant of .X"' X.
However, another problem arises. The starting point of this section is the hypothesis that
the evaluation error is influenced by the design matrix X. As a consequence the matrix P
is influenced by the design matrix X. Referring to (13) and (14), the optimization problem
therefore has the following objective function:

max det((P(X) X)'(P(X) X», (15 )

X

where P(X) represents the influence of the design matrix X on matrix P.

In order to solve the optimization problem with the objective function (15) information about
the matrix P(X) is needed. It is obvious that there has to be a considerable amount of a
priori information about the decision maker's evaluation behaviour (or suitable assumptions
have to be made) in order to use the design-optimization methods described so far.
 193

3.4 A variant of D-optimality

In this section a variant of the method of D-optimality is applied, which was originally
presented in Hiisges (1990). The idea is to choose the design matrix X such that (in spite of
the dependencies between the evaluation errors and the design matrix X) the assumptions
of the classical linear regression model hold, first of all: L:<.< = (J'< 2 I. In particular, the D-
optimal design xopt has to be chosen from a subset j(k of 3{k. It is supposed that on ~k t.he
assumptions of the classical linear regression model hold, especially L:<.< = (J'< 2 I. The problem
of constructing a D-optimal design matrix xopt satisfying this condition can be written as
follows:
ma,x det(X' X) ( 16)
XERk

respectively
maxdet(X'X) subject to R(X) = O. (17)
X

R( X) is an equation system of restrictions describing the subset ~k of 3{k, where L:<.< = (J'< 2 I
holds.
Forming the restrictions R(X) = 0 requires a priori information about the relationship
between the decision maker's evaluation errors and the design matrix X. For illustration
purposes an example is presented. About the decision maker's evaluation behaviour we
assume the following:
The variance of the evaluation error is the larger the more different consecutive
alternatives are.
The evaluation of alternatives can be done the more easily the fewer target va-
riables are changed from one alternative to the next.
A design taking into account an evaluation behaviour like this can be written as follows
(compare with section 2.3):

Alternative 1
(Yl.l, Y1.2, Yl.3, YI.4) = ('flg.1 Yg.2 Yg.3 Yg.4)
Alternative 2
(Y2.1, Y2.2, Y2,3, Y2.4) = (Yg.l + 8 Yg.2 - 8 Yg.3 Yg.4)
Alternative 3
(Y3.1, Y3.2, Y3,3, Y3,.1) = (Yg,l + 8 Yg.2 Yg,3 - 8 Yg,4)
Alternative 4
(Y4.h Y4,2, Y4.3, Y4,4) = (Yg.1 + 8 Yg,2 Yg.3 Yg.4 - 8)
Alternative 5
(YS,1, YS.2, YS.3, YS.4) = (Yg,l Yg.2 + 8 Yg.3 - 8 Yg.4)
Alternative 6
(Ys,], YS.2, YS,3, YS.4) = (Yg,] Yg.2 + 8 Yg.3 Yg.4 - 8)
Alternative 7
(Y7.1, Y7.2, Y7.3, Y7.4) = (Y'J.] Yg.2 Yg.3 + 8 Yg,4 - 8)

Yt.i is the value of target variable i in a.lternative t and Yg.i is a specific level 9 of the target
variable i. We start from a fixed level Yo,; of the four target variables. Then the other
alternatives are generated by changing a( the same time two target variables by 8. The
design can be constructed for different levels of the four target variables.
 194

The resulting design structure is the basis for the empirical analysis presented in section 4
of this paper. The design was generated for four different levels of the four target variables
(Yg,i' 9 = 1,2,3,4, i = 1,2,3,4) so that with the 7 alternatives (given above) per level there
are 28 alternatives (number of levels x 7). The system of restrictions (denoted by R(X) in
(17)) that should guarantee this design-structure is as follows:

Y2,l = Yu + 5 Y2,2 = Yl,2 - 5 = YI,3Y2,3 Y2,4 = YI,4

Y3,I = YI,I + 5 Y3,2 = YI,2 = YI,3 - 5
Y3,3 Y3,4 = YI,4
Y4,l = Yu + 5 Y4,2 = YI,Z Y4,3 = YI,3 Y4,4 = Yu - 5 g=l
YS,I = YI,I YS,2 = Yl,2 + 5 YS,3 = YI,3 - 5 YS,4 = Yl,4
Y6,l = Yl,1 Y6,2 = YI,2 + 5 Y6,3 = Yl,3 Y6,4 = YI,4 - 8
Y7,1 = YI,1 Y7,2 = Yl,2 Y7,3 = YI,3 + 5 Y7,4 = YI,4 - 8

Y9,1 = YZ,1 + 8 Y9,2 = Y2,2 - 5 Y9,3 = Y2,3 = Y2,4

Y9,4

YI0,1 = Y2,l + 8 YI0,2 = Y2,2 YlO,3 = Y2,3 - 8 YI0,4 = Y2,4

YII,1 = Y2,1 + 8 Yll,2 = YZ,2 Yll,3 = Y2,3 Yll,4 = Y2,4 - 8
g=2
Y12,1 = Y2,1 Y12,2 = Y2,2 + 8 Yl2,3 = Y2,3 - 8 Y12,4 = Y2,4
Y13,1 = Y2,1 Y13,2 = Y2,2 + 8 Y13,3 = Y2,3 Y13,4 = Y2,4 - 8
Y14,1 = Y2,I Y14,2 = Y2,2 Y14,3 = Y2,3 + 5 Y14,4 = Y2,4 - 8

Y16,1 = Y3,1 + 8 Y16,2 = Y3,2 - 8 Y16,3 = Y3,3 Y16,4 = Y3,4

Y17,1 = Y3,l + 8 Y17,2 = Y3,2 Y17,3 = Y3,3 - 8 Y17,4 = Y3,4

Y18,1 = Y3,1 + 5 Y18,2 = Y3,2 Y18,3 = Y3,3 Y18,4 = Y3,4 - 8

g=3
Yl9,1 = Y3,1 Y19,2 = Ih2 + 8 Y19,3 = Y3,3 - 5 Y19,4 = Y3,4

Y20,1 = Y3,1 Y20,2 = Y3,2 + 5 Y20,3 = Y3,3 Y20,4 = Y3,4 - 8

Y21,1 = Y3,1 Y21,2 = Y3,2 Y21,3 = Y3,3 + 8 Y21,4 = Y3,4 - 5

Y23,1 = Y4,1 + 8 Y23,2 = Y4,2 - 8 Y23,3 = Y4,3 Y23,4 = Y4,4

Y24,1 = 114,1 + 5 Y24,2 = 114,2 Y24,3 = 114,3 - 5 Y24,4 = 114,4
Y2S,1 = 114,1 + 8 Y2S,2 = 114,2 Y25,3 = Y4.3 Y2S,4 = 114,4 - 5
g=4
Y26,1 = Y4,1 Y26,2 = 114,2 + 8 Y26,3 = 114,3 - 8 Y26,4 = Y4,4

Y27,1 = Y4,1 Y27,2 = Y4.2 + 8 Y27,3 = Y4,3 Y27,4 = Y4,4 - 5

Y28,1 = Y4,1 Y28,2 = Y4,2 Y28,3 = Y4,3 + 5 Y28,4 = Y4,4 - 8.

Besides this, lower and upper bounds of the target variables should be taken into account in
order to avoid "utopian" values of the target variables:

Y; :=::: Yt,i :=::: yi

i = 1,2,· .. ,4 and t = 1,2,· ··,28.
 195

Y; is the lower and Yi the upper bound of target variable i.

The D-optimization problem then is as follows:

!!lax det(X'X)
Yg,i'O
subject to
(18 )
R(Yt,i, Yg,i, 0) = 0, Y! ~ Yt,i ~ Y't,
Yt,i, Yg,i, 0 E ~.
i = 1, 2, 3, 4, 9 = 1, 2, 3, 4 an d t = 1, 2, ... , 28.
R(Yt,i,Yg,i'O) = 0, (i = 1,2,3,4, 9 = 1,2,3,4 and t = 1,2"" ,28) represents the system of
restrictions presented earlier.
The interpretation of this optimization problem is as follows: Working with four target
variables (i = 1,2,3,4) we are looking for those four levels Yg,i (g = 1,2,3,4) and the
"change parameter" 0 which maximize the objective function subject to the restrictions
presented.
We solved this optimization problem by the Simplex method 6.

4 Empirical analysis
4.1 Data collection
The procedure described in section 3.4 has been used to generate a questionnaire containing
28 policy alternatives. Students of the University of Hagen were presented this questionnaire
and asked to evaluate the 28 alternatives of that questionnaire by stating their utility index
for each alternative. Thus, for each student who filled in the questionnaire, a 28 X 5-data
matrix resulted. On the basis of these data, mainly quadratic scalar-valued preference func-
tions were estimated (section 2.3).
We selected the following four target variables:
Yl = yearly percentage increase in the cost of living index.
Y2 = registered unemployment as a percentage of the dependent working population.
Y3 = yearly percentage increase of GNP in real terms.
Y4 = yearly percentage increase of public debt.

In order to avoid implausible or utopian values of the target variables III the policy al-
ternatives to be evaluated, lower and upper bounds were fixed.
Lower bounds: y~ = l.0 Upper bounds: y~ = 6.0
y~ = 6.0 yz = 12.0
y~ = l.0 y~ = 7.0
y~ = 3.0 y~ = 10.0 .
The resulting questionnaire containing 28 policy alternatives to be evaluated IS shown III
Appendix A.

6We used a subroutine of the NAG Fortran pe50 Library (Release 1) which is a collection of Fortran
routines for solving problems that occur in numerical computation.
 196

4.2 Preference functions estimated

Various preference functions of the persons who had evaluated the alternatives in the ques-
tionnaire were estimated by the method of least squares. Our interest centered on estimating
quadratic preference functions; but some reiated forms were also investigated. The following
regression models were analyzed:

n
Modell 1 u(Ytl,"',Ytn) = ao + LaiYti + LaiiY;i
i=1 i=l
n-l n
+2L L aijYtiYtj + Et
i=1 j=i+1
n
Modell 2 u(Ytl,··· ,Ytn) = aO + LaiYti + Et
i=l
n
Modell 3 u(YtJ, ... ,Ytn) = ao + LaiY;i + Et
i=l
n
Modell 4 log u(Ytl, ... ,Ytn) = ao + Lai log
Yti + Et
i=1
n
Modell 5 log u(Ytl, ... ,Ytn) = ao + Lai[log Yti]2 + Et
i=1
t = 1"" ,T.
Model 1 is a quadratic utility function with a linear, a quadratic and an interaction term.
Model 2 is a linear utility function. The quadratic term and the interaction term of Model
1 were omitted.
Model 3 is also a special case of model 1: the interaction term and the linear part were
dropped.
Models 1 to 3 are very well suited for practical applications in econometric decision models
with a scalar-valued objective function because they are easy to handle from a mathematical
point of view (convexity, differentiation). rvloreover models 1 and 3 obey a fundamental law
in economics: the decreasing marginal rate of substitution. Using models 1 or 3 respectively
as the objective function in a decision model with a linear (or linearized) system of restric-
tions we obtain the so-called linear-quadratic decision model.
Model 4 is a logarithmic utility model. Model 5 is well known in demand theory as the
translog utility function 7 (e.g. Jorgensen, Lau (1975), Christensen, Jorgensen, Lau (1975),
Krelle, P allaschke (1981)). The advantage of this type of function is that it is flexible to
handle and consistent with utility maximization theory. Therefore translog functions are
very well suited to test hypotheses about the decision maker's evaluation behaviour.

4.3 Results
Tables 1 to 5 (see Appendix B) summarize the estimation results for 13 students who had
filled in the questionnaire. B1 to B15 denote the estimated regression coefficients. A star
marks statistically significant coefficients (significance level 5 % ). R2 and R2C denote the
coefficient of determination and the corrected coefficient of determination respectively. MAPE
is the mean absolute percentage error, DW is the value of the Durbin-Watson test-statistic and
RHO the estimated first-order autocorrelation coefficient of the regression residuals. (Strictly
speaking, DW is applicable only to time series.)
Several specification test statistics which are not presented in the tables usually indicate the

7Transcendental logarithmic utility function

 197

desired quality of the estimated models, especially of model 1.

It can be seen from the tables that all models fit the data very well. As far as goodness of fit
is concerned model 1 shows the most favourable results. In model 1 the coefficient of deter-
mination lies within a range of R2 = 0.90 (person 12) to R2 = 0.998 (person 6). The minimal
and maximal values of the corrected coefficient of determination are R2C = 0.793 (person
12) and R2C = 0.996 (person 6). For person 6 all regressors are statistically significant in all
5 models (except one regressor in model 4). Obviously the linear terms and the interaction
terms playa very important role for person 6. If these terms are omitted, the coefficients
of determination drop considerably. The lack of significance of some regressors in model 1
for the other persons can be explained by larger errors made in filling in the questionnaire,
i.e. in stating the utility index for each of the 28 policy alternatives. It can also be due to
collinearity of the regressors: Linear terms are correlated with their corresponding quadratic
terms and the interaction terms are highly correlated with the linear terms.
For model 2 the range of values of the coefficient of determination is [0.291,O.978J and
[0.168,O.974J for the corrected coefficient of determination. The results show that the re-
lationship between utility indices and alternatives obviously seems to be more complicated
(possibly non-linear). Model 2 fits the data sufficiently well for persons 11 and 3, for both
persons the coefficient of determination is larger than 90 %. With respect to the significance
of the regressors the results are very satisfactory.
This holds also for model 3 which is also a special case of model I, although model 3 fits
the data not as well as models 1 and 2.
Models 4 and 5 as well as models 2 and 3 are characterized by an unusually large fraction of
statistically significant regressors. Concerning goodness of fit models 4 and 5 both perform
less satisfactorily than model 1.
Our empirical analysis demonstrates that there is no need for incorporating only hypotheti-
cal information about the scalar-valued preference function of a decision maker to be used as
an objective function in an econometric decision model. It has been shown that it is possible
to estimate the decision maker's preference function on the basis of preference information
that can be obtained by an inquiry.

5 Summary and outlook

It has been shown in some kind of pilot study that it is possible to estimate preference func-
tions for use in macro-econometric decsion models on the basis of survey data. Therefore, in
practical applications of econometric decision models with scalar-valued preference functions
it is no longer necessary to work with hypothetical assumptions about the decision maker's
preference structure.
But there is a need for research to improve the methods for constructing scalar-valued pref-
erence functions based on survey data. Some of the most important problem areas are briefly
discussed below.
A. A major disadvantage of the regression-based least squares methods is that a priori infor-
mation about the mathematical type of the preference function (linear, quadratic, log-linear
etc.) has to be used. Non-parametric methods (Prakasa Rao (1983)) (e.g. method of kernels,
method of splines etc.) don't need such a priori information and should be tested empirically
with respect to their applicability. First steps in this direction were done by and are reported
in Hiisges (1990). Especially non-parametric methods should be regarded which could take
into account some fundamental properties of preference functions like monotonicity. Pos-
sibly results from the research area non-parametric estimation under order restrictions (see
e.g. Barlow, Bartholomew, Bremner, Brunk (1972), Friedman, Tibshirani (1984)) could be
helpful.
B. The questionnaire used in the empirical analysis presented in this paper has been gener-
ated by means of a variant of the D-optimality criterion. In order to analyze the evaluation
 198

behaviour of actual decision makers some improvements of the questionnaire should be made.
Results from psychology could be used.
C. Further empirical studies could employ optimal designs based on other models (i.e. not
on the "full" quadratic model 1 used in this paper). Moreover other hypotheses about the
decision maker's evaluation behaviour could be used.
D. An important further step would be to analyze preference structures of actual decision
makers in order to get more experience with respect to interview techniques.
£. Moreover, alternative ways of gathering information about the decision maker's prefer-
ences should be explored. Interactively interrogating the decision maker (dialogue between
the analyst and the decision maker) could perhaps improve the quality of the data. It seems
fruitful to look for possibilities to estimate a scalar-valued preference function in the frame-
work of interactive vector optimization procedures (or at least to obtain the information
required for estimating the preference function in a separate model).
F. Individual preferences and the parameter estimates derived therefrom show considerable
variability. To reduce the undesirable variability in the parameter estimates, a scalar-valued
preference function could be estimated on the basis of data about preferences of several
persons who together form a rather homogeneous group (like groups of consumers, members
of a labour union, members of a political party).
 199

Appendix A: Questionnaire with 28 policy

alternatives

Alternatives Yl I Y2 I Y3 I Y4 Utility
1. 2.00 8.50 2.50 4.70
2. 1.50 9.00 2.50 4.70
3. 1.50 8.50 3.00 4.70
4. 1.50 8.50 2.50 5.20 8 = 0.5
5. 2.00 8.00 3.00 4.70
6. 2.00 8.00 2.50 5.20
7. 2.00 8.50 2.00 5.20
8. 4.00 8.80 5.40 7.70
9. 3.10 9.70 5.40 7.70
10. 3.10 8.80 6.30 7.70
11. 3.10 8.80 5.40 8.60 8 = 0.9
12. 4.00 7.90 6.30 7.70
13. 4.00 7.90 5.40 8.60
14. 4.00 8.80 4.50 8.60
1.5. 5.90 8.70 4.70 5.40
16. 4.90 9.70 4.70 5.40
17. 4.90 8.70 5.70 5.40
18. 4.90 8.70 4.70 6.40 8 = 1.0
19. 5.90 7.70 5.70 5.40
20. 5.90 7.70 4.70 6.40
21. 5.90 8.70 3.70 6.40
22. 2.00 9.00 2.20 7.00
23. l.l0 9.90 2.20 7.00
24. l.l0 9.00 3.10 7.00
25. l.l0 9.00 2.20 7.90 8 = 0.9
26. 2.00 8.10 3.10 7.00
27. 2.00 8.10 2.20 7.90
28. 2.00 9.00 1.30 7.90

Utility index: 0 worst alternative, 100 best alternative.

 Person 1 Person 2 Pers'lD 3 Person I Person 5 Farson 6 Person 7 Person 8 Person 9 Person 10 l'orsoI: 11 Person 12 Person 13 >
~
--- "0
B1 -61.57173 -136.77983 -69.1Wl -17.68258 -58.47829 -154.05 l86 t 38.81543 -69.90658 86.83622 -53.49456 63.93722 47.85862 7.00299
"0
CD
B2 -93.97861 -347.29376- 46.39862 35.63904 -191.73634- -139.25 165 t -49.95327 -97.36640 -123.49083 -43.94445 114,32817 t 11.86936 -32.93822 =:s
G3 133.81378 _ 46.1047 66.11518- -2.47716 92.25381 _ -156.70 H5 t -50.34777 71.63173 -65.95598 H4.43355 t 2.85154 116.02885* 55.58082 0-
~.
B4 -106.07334 t 24.00790 -36.47423 -10.01665 -91.51435 t -152.54 mt -4.58266 30.14151 -36.87417 -8.81985 31.27071 38.86674* 12.78812
85 0.70026 1.23116 -0.5Ull -0.82818 1.31576 3.72 139 t -0.46802 2.m99 -4.57869 1.23532 -0.2l92( -1.37047 0.78410
X
B6 2.54685 20.30070 t -4.10319 -2.76337 8.53455 t 2.00 643 t :1.45996 3.92167 4.87319 1.65574 -4.69967 1.04136 0.42578 to
B7 -0.10825 1.79889 -1.17997 -0.53587 0.98776 3.39 lJ2t -0.02447 -1.13616 3.69806 -0.76384 0.60390 -1.83145 t -0.12691 ..
B8 2.37879 0.1002 0.25166 -0.21353 3.51214* 3.11 299 t 0.63970 -1.56547 0.97698 0.05148 -0.70779 -0.85067 0.12068
B9 7.27598 11.14818 5.85780* 0.75634 5.10301 6.60 109* -3.84644 7.16599 -3.69966 6.12289 -2.69128 -0.56391 -1.4102
M
Ul
B10 -4.31285 3.42562 4.57371 t 1. 71361 -6.22861 t 7.12 i58* 2.26740 -1.04645 -7.36472 -5.65080 -2.m86 -5.96775 t -4.33056 M-
~.

B11 -0.16124 2.53081 0.15795 1. 25364 3.JOm 7.03 123* -1.26754 0.10433 -0.14477 O.mOl -1.96249 -2.62887 t 1. 71025
B12 -11.57421 t -9.60134 -7.65545* -0.m45 -4.86271 7.64 555 t 4.27082 -3.42676 6.80714 -9.62625 t 0.42036 -6.67367 t -0.26529
S
P,
B13 8.25585 t -5.06616 3.12261 0.50503 umo 7.25 654 t -1.11656 0.78190 1.42837 1.94754 -1.32963 -1.59482 -0.31046 M-
~.
B14 -1.J8820 2.55001 1.08560 0.86319 -U5065 t 6.79 l59* 1.54086 -3.31791 0.09852 -3.18HJ -0.58639 -3.15994* -4.88637* 0
B15 733.06628 1686.92615 t 15.41185 13.53481 1165. 38477 t 1697.0 ;04 * 342.16904 360.08m 810.10559 173.56508 -762.08459 t -357.45508 195.73587 =:s
~= ------ ~---
- - = = . ===-== =---= =--==--== - - - - - - - - - - - - - ---- --=---== ===---=_.
===--== I\)
R2 0.949 0.919 0.980 0.937 0.945 O. 198 0.911 '1).912 0.919 0.939 0.991 0.900 0.944 ~ 0
CD 0
R2C 0.894 0.831 0.957 0.870 0.885 O. 196 0.815 0.942 o.m 0.874 0.983 0.793 0.88' Ul
~
MAPE 10.85 51.99 6.25 2.37 12.36 1.(8 11.06 42.00 20.03 6.77 12.04 4.78 6.16 M-
SE 6.14289 0.41588 4.179(8 2.9804 6.16385 1.44 397 U469S 7.16798 9.93467 6.52491 3.95374 3.50295 6.51700 Ul
-
- - r---- ----- ----
DW 2,555 2.705 2.656 2.515 3.008 2. 651 2.W 2.m 2.469 2.305 2.357 2.50 2.390
RHO(l) -o.n -0.39 -0.39 -0.26 -0.51 -0 .36 -0.24 -0.07 -0.26 -0.20 -0.19 -0.28 -0.23
'-----'--- - - - ---- - -- --
Table 1: Estimation results, model 1_
~ Person 1 Person 2 Person 3 Person 4 Person 5 Person 6 Person 7 Person 8 Person 9 Person 10 Person 11 Person 12 Person 13
(1) - - 1------1--- --- - - - - - - -
rou 81 -11.48396' -5,27169 -4021465' -3,73847' -8,9(516' -9,9WO' 2.17975 1 9,26970* -U,65885 1 -1.70567* 18,7H71* -1.81007 -0,31263
82 -17,1181(1 -33,07628' -23,37116 1 -10,39745' -13,91488* -15,71933 1 -10.56800* -10.03779 1 -lU96~7' -17.89550 1 18,83929 1 -3,80730 -30.05232*
t;? B3 10,036361 7,51703 1 12,77713 1 2.36902* 9.19358 1 11.m73* 5.01197* 8.22744* 1.22061* 13.01224* -1.33447 1.32663 2.m22
rt
84 -8,37428* -2,17953 -2,61056* -2.24310* -9,63727* -9.66897 1 -4.11381* 3,32786' -8,23763* -0.19955 4.13803* -2,48641* -0,29241
~' ------- ---- --
rt
1-" 85 236.53377' 313.62317* 231,57234* 168,50595* 201.95284 1 250,10538* 127 .06709* 58.24237 227,75444* tn.66168' -200,68018' 93,36122' 319,0286*
g - = -=--::= ===--::= =--==
R2 0.851 o,m 0,918 0.7J6 0,800 0.532 0,859 0,909 0,565 0.854 0.918 0,291 o.s88
R2C 0,825 0,621 0.903 0.737 0.766 0,451 0,834 0,893 0,489 0.829 0.974 0.168 0,869
~
f-' -- f - - - - -
it HAPE 19.65 15.70 1U6 U8 22052 26,59 11. 76 09.05 55.43 10.33 24.09 12.59 9.H
SE 7.88623 5.30466 6,75200 4.24004 8,79823 7,75317 6.00095 9,70878 7.31U0 7,61115 1.90201 7,0204 6.92372

~ DW 20611 1.838 1. 781 1. 730 2,366 0,956 2.062 1.032 1.194 2.815 1.674 1. 200 J.131
f-'
RBO(l) -0.32 0,07 0,08 0,13 -0,19 0.51 -0,05 0,45 0,38 -0,41 0,15 0, (0 -0.08
tv
, -- I\)
o
~
,..-------.....- - - --'--- -------- ------- --------- ------ --------- -------,

~ Person Person 2 Person 3 Person 4 Person 5 erson 6 I Person 7 Person 8 1 Person 9 Person 10 Person 11 Person 12 Person 13
--------- - - - - ---------- -----~--- - ---------- ------------ --------- ----------.
~
w B1 -1.392 -0,67750 -0,43853* -0,49761* -1.11182* -1.33580* 0,32161' 1. 35641' -1.84561* -0,81005' 2.10233* -0.16654 0,03865
82 -0,964 -1.85112* -1.32085* -0,60247* -0.79732* -0,93448' -0,60024* -0,56001 * -0,83153' -0,98983' 1.01724* -0,20404 -1.70868*
t;? 83 1.014 0,91456 1 1.49818' 0,23883* 0,95154' 1.24911* 0.65497' 1.08511* 0,84878* 1.38410 1 0.17129 0,08722 0,24998
rt 84 -D.680 -0,21280 -0,23428* -0,18392* -0.76151* -0,76096* -0,31623* 0,26957' -0,71400* -0,09822 0,36593* -0,19910* -0,02417
~. --------- ----- --------- ---- --------- --------- ------- ---------_.
[1 85 1 139,093 167,22688* 137 ,87245* 116,87622* 123,21904* 62,32034'1 78,88372* 1 48,58874* 1 142,84924 123,78547* -84,75568' 68,37716* 190,69485*
:.::::.===== ==::~=== ======- =========- ::: : =::::::=-==== =========
8 ========= =======:
R2 0,8 0,615 0,911 0,808 0,769 0,540 0,857 0,9081
I 0.665 0.195 0,970 0,276 0,883
R2C 0.7 0.618 0.903 0,775 0,128 0.460 0,832 0,892 0.601 0.759 0,965 0,150 0,863
[ - - - - --------- ------- . --------- ------- ------ --------
rt MAPE 22 11.23 14,16 4.61 22.21 26,981 13,53 11.71 32.68 12,61 9.45
til 11.22 I 48.36
S8 8,861 5,35888 6,16402 3.92282 9,47118 7,59962 6.04620 9,77105 5.18646 9.03016 5.63526 7,10138 7,07842
------ - . ------- ------ ----- --------
D1I 2, 1.838 1.446 1.852 U48 1.080 2.183 1.3061 1.195 2.111 1.554 1.238 2,125
~ RBO(l) -0 0,07 0,26 0,06 -0,23 0,45 -0,12 0.31 0,22 -0,22 0,20 0.37 -0,09
w ----- ------ --------- - ------ --------- - - - - - -------
 Person 1 Person 2 Person 3 Person 4 Person 5 Person 6 Person 7 Person 8 Person 9 Person 10 Person 11 Person 12 Person 13
~
(D r----- r---" ----
ol>o B1 -1.07350* -0.58836* -0.26023* -0.15374* -0.7988(t -0.29360 0.18022 0.38315 -0.53186 -0.38577* 1.90704 * -0.18380 -0.05639
B2 -4.63981* -13.56075 t -4.95938* -1.52517 t -4.10690 t -2.29270* -2.81166* -2.40559 -3.20886 -2.82105* 6.82309* -0.87957 -4.40775*
~ B3 1.16957* 1.37059* 0.99791* 0.11337 1.30865* 0.61289 t 0.65347* 1.09573* 0.28612 0.81372* -0.46764 0.17230 0.16178
rt -0.93424t -0.35021* -0.00019
B4 -1.14935* -1.82873 t -0.41094* -0.17903* -1.81013* -0.91868* 1.25412 -0.92605 0.00843 2.64784*
~. 1------1 - - - - - - -1------- ---- -- - - - - - --- - - ----- 1-------- -------
rt 6,270B1* 13.49514*
1-" 85 15.18314* 34.21077 t 14,21085- 7.73m* 14.663B1t 10.22827 t 10.23695 t 4.77979 12.28225 t 9.44245* -17.64310*
g F~-== F=--== - - = - - -=:=:===:=--
R2 0.848 0.854 0.872 0.690 0.867 o.m 0.881 0.573 0.244 0.865 0.802 0.337 0.867
R2C 0.822 0.829 0.850 0.636 0.844 0.382 0.860 0.499 0.113 0.842 0.767 o.m 0.844
[ ~- 1 - - - - --- 0 - - - -1 - - - - - - --- ----- ----- r------ --------
rt MAPE 5.U 13.44 U8 1.49 5.57 6.76 4.02 10.60 15.58 2.56 9.30 3.19 2.37
til
BE 0.23516 0.48376 0.20460 0.08308 0.23887 0.33340 0.18494 0.72609 0.65691 0.12909 0.60691 0.16627 0.12720
1----- - - - - ------ ---- -- ---- -----
~ DW 2.052 1.866 1.969 1.317 1.074 0.659 2.112 1.750 0.734 2.780 1.755 1.2481 2.408
f-' RHO(l) -0.04 0.01 -0.02 0.33 0.45 0.66 -0.09 0.12 0.63 -0.50 0.11 0.37 -0.20
~--- ----- ------- - - - - - --------- ----- - - - - - - - - - - -- - - - - - --------- ---------
.*'" ----- ------ I\)
0
I\)
- --- -------- - - -
Person 1 Person 2 Person 3 Person 4 Person 5 Person 6 Person 7 Person 8 Person 9 Person 10 Person 11 Person 12 Person 13
~ -----1-- 1--- -- ---- -----
V1 B1 -0.55912* -0.34927* -0.16415* -0.09356* -0.45269* -0.23837 0.03801 0.27724 -0.55471 * -0.19873* 0.97318 t -0.05629 -0.01669
B2 -0.99241* -3.13052* -1.15029* -0.34884t -0.91763* -0.55042 *I -0. 69556 t -0.57235 -0.79224* -0.62653* 1. 44599* -0.17479 -1.01822*
~ B3 0.51463* 0.60557* 0.44815* 0.06132* 0.58272* 0.33270 0.31216 t 0.36887 0.38464* 0.3U2Bt -0.19107 0.04010 0.05558
rt
B4 -0.39239* -0.56452* -0.16147* -0.05919* -0.56747* -0.29103 t I -0.28007* 0.32884 -0.33983 t -0.04031 0.77509 t -0.10260* -0.00441
~. - - - - 1------ ------- ------ - - - - ---- - - - - - - - - ------- ------ -----
rt
1-" 85 9,25214* 18.63669* 9.09001* 5.94793* 9.10787* 7.35668 7.06024 t l 4.18916 8.38718*1 6.nl79*1 -7.05972*1 4.93148*1 8.81540*
g --- --- == F==== ====--= f=-=== ===== ---=--==Io====*---=====:t========:t======
@ R2 0.895 0.854 0.889 0.777 0.903 0.561 0.857 1 0.567 0.842 0.271 0.867
o.m j0.859
R2C 0.876 o.m 0.870 0.738 0.886 0.485 0.832 0.492 0.404 0.834 0.814 0.145 0.843
~f-' ------- ------ -------- -------- 1 - - - - - - ----- ------- ------ -------- --------
fir MAPE 4.60 13.85 4.07 1.16 UB 5.86 4.58 1 10.05 11.61 2.37 7.44 3.36 2.46
BE 0.19592 D.48432 0.19019 0.07050 0.20430 0.30443 0.20284 0.73074 0.53841 0.13214 0.54245 0.17434 0.12726
- - - - - - - - 1------ - --- - - - ----- - - - ------
DW 1.887 2.136 2.106 1.820 2.054 1.094 2.235 1 1.870 2.594 2.106 1.206 2.352
~
f-' 0. 972 1
RHO(l 0.02 -0.21 -0.08 0.08 -0.19 0.44 -0.18 0.06 0.50 -0.31 -0.08 0.39 -0.19
. L - - - - - 1______ ~ _____ _
V1 - - - ------- ' - - - - - ----- '------ ----
.
 203

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OPERATIONALIZING A MACRO-ECONOMIC PREFERENCE FUNCTION

Arnold H.Q.M. Merkies and Marjan W. Hofkes

Department of Econometrics
Free University
De Boelelaan 1105, 1081 HV Amsterdam
The Netherlands

Abstract

For a preference function U (y) to be a proper representation of the com-

munity's well being, y should contain all relevant aspects of life and will
therefore be of high dimension. In any analysis to support policy proposals
this high dimensionality needs to be reduced to an operational setting. A
policy problem is therefore studied in a proj ection of U(y) into some
explicitly defined variables. In this paper it is shown how preference
functions can be based upon interviews of political parties. This helps to
highlight some consequences often ignored.

Keywords: Preference function; Policy variables; Interviewing

Contents

1 Introduction

2 Preferences and Possibilities

3 The Inquiry; Design and Results

4 The Estimated Functions

5 The Implications

6 Summary
 206

I INTRODUCTION

Many economic problems require the maximization of some preference function,

given a model which describes definitions, technical constraints and reaction
patterns of economic agents. Most studies concentrate on the improvement of
the models. However, interest in preference functions is increasing.
For U(y) to be a proper representation of the community's well being, y
should contain all relevant aspects of life and will therefore be of high
dimension. Without a projection of such a preference function into a small
number of crucial variables an operational model is hardly possible. Most
researchers are not aware that such a proj ection could affect our analysis
and our a priori ideas on functions and parameters. We will show this by
constructing preference functions from directly interviewing policy makers.
The construction of these empirical preference functions follows earlier work
in this field, e.g. Merkies and Nijman (1981, 1983), Van Daal and Merkies
(1984) and Merkies and Hofkes (1986). The present paper draws heavily on the
latter. The book by Van Daal and Merkies also gives references to the work
with Vermaat, where particularities and intricacies of the data collection
are described. The basic assumption is that macro-economic preferences can be
approximated by a quadratic function around the prevailing value of the argu-
ments.

The direct interviewing refers to evaluations for various conceivable values

of the arguments. Additional information is provided by the answers to ques-
tions about the optimal conditions as viewed by the interviewed. The mathema-
tical framework, more extensively described in Merkies and Hofkes (1986) is
sketched in section 2. The data, collected at the end of 1983, are described
for the present purpose in section 3. The resulting preference functions for
five Dutch political parties are described in section 4. This section also
gives information on the sensivity of these functions with respect to some of
the underlying assumptions. The implications of our findings are illustrated
by the implied Phillips curve in section 5. Finally, section 6 summarizes.

2 PREFERENCES AND POSSIBILITIES

2.1 The specification of the preference function and the sources of informa-
tion collected

A macro-economic policy problem can be formalized as:

max W(y,x)
(2.1)
s.t. G(y,x,z) - 0,

where y, x and z are vectors of targets, instruments (controls) and data re-
spectively. The projection of W(y,x) in targets alone is written as U(y) and
can be approximated by

U(y) - a o + a'y + ~y'Ay, (2.2)

where the constant ao' the row vector a' with n "linear" parameters a i and A,
the positive definite matrix of "quadratic" parameters a i j , may depend upon
the prevailing situation y •.
To estimate the parameters of (2.2) we need observations. We have for each
 207

policymaker two sources of information. Our first source consists of N

different (n+l)-tuples (UiJ,Yu, ... ,Yni) containing for i-l, ... ,N an
imaginary policy program (Y1i' ... 'Yni) and the evaluation Uij of policymaker
j of this program. The actual programs will be described in section 3 below.
To estimate the parameters of the quadratic function (2.2) with the given
information a regression equation for any j appears of the form

U - Y/3 + £, (2.3)

where U is a vector of N indices, Y is an Nx(K+l) matrix with typical row

[Yi1'YiZ' ... 'Yin,yf1, ... ,yfn'Yi1YiZ' ... 'Yi<n-1JY in l containing the policy
programs and transformations thereof, /3 is a columnvector of K+l parameters
and £ is an N-vector of errors, indicating improper introspection of the
evaluation. To save notation we dropped the index j, attached to U and /3.

The introduction of the matrix A without any restriction would imply too many
parameters to be estimated, viz. K-(n2 +3n)/2 «n2+n)/2 "quadratic" parameters
a ij and n "linear" ones at). In view of the reluctance of the enquirees to
answer questionnaires with much more than 25 programs the estimation is not
possible unless restrictions are introduced. Therefore the matrix A is re-
stricted to be diagonal. Hence K is taken as 2n. The vector /3 is estimated as

(2.4)

The variance-covariance matrix of £ is specified as

(2.5)

with Pi some weight. The diagonality of the matrix V reflects the plausible
assumption that each policy program is evaluated independently. The weights
express the idea that if a program is considered "odd" or its probability Pi
to occur low no serious attempt is made to quantify Ui ' leading to a large
variance of £i. This assumption on V will be discussed in more detail in
section 2.2.

A second source of information is obtained as follows. The optimal value of

U(y) is attained at
au(y)
ay - -a - Ay - °. (2.6)

The solution of this equation is indicated by y. Asking the enquirees to

indicate the optimal value of their targets provides the vector yo. The dif-
ference

(2.7)

substituted into (2.6), gives:

a + Ayo + v - 0, (2.8)

where v=AS is a vector of n elements. Equation (2.8) can be rewritten in

observational form

R/3+v-O, (2.9)
 208

where the first row of R equals R1-[l,1,0, ... ,O,y~ ,0, ... ,0] and so on and fi
is a column vector of 2n+l elements, being a constant, n "linear" parameters
a i and n "quadratic" ones a i i .
Equation (2.9) is added as a restriction to (2.3). Note that R is an
nx(2n+l)-matrix so that (2.9) puts n constraints on the estimation of the
parameters. The estimation problem is solved by combining (2.3) and (2.9)
into

(2.10)

and assuming for the errors zero expectation and a variance-covariance

matrix given by

(2.11)

where A is an indicator that relates the two sources of information.

The parameters are estimated by

i f A"'O, (2.12)

and by

i f A=O, (2.13)

with ~ the estimat~r from (2.4). ~

the c~mp~nents of fiA rearranged as a and A give the estimated optimum as
y = -A-1a (see (2.6», which for A"'O clearly differs from both the "true"
optimum y
and the revealed optimum yO .

The value of A is of special interest. If only information on the evaluation

of the programs is collected, yO does not exist and we may take A~ in which
case (2.12) reduces to (2.4) and therefore /JA->~' Such information is in
general shown to be insufficient to generate adequate preference functions.
On the other hand, if political parties are only willing and able to provide
their values of yO (strategies of revelation ignored) the measurement of a
preference function is not possible. Therefore, it is useful to persuade par-
ties to provide both sources of information. We may proceed by choosing A=O
to avoid that the measurement of the preference function affects the implied
value of the optimum 6=0, but a value of A from the open interval (0,00) is
usually more appropriate. The element of (2.12) still to be explained is the
variance-covariance matrix Vo' It is supposed to indicate the precisicn with
which the optimal values are provided. We assume:

diag (at, ... ,a; ) (2.14)

with a3 the variance of the variable Yj over the past, expressing the idea
that the more volatile a variable Yj has been in the past, the more difficult
it will be to specify its optimal value y~.

In the analysis given above it is tacitly assumed that the global preference
 209

function W(y,x) is differentiable in y •. This allowed us to work with symme-

tric approximation (2.2). (Differentiability in the entire domain of y was
assumed to obtain (2.6». As a consequence, asymmetric preference functions
fall outside the scope of this paper.

2.2 How real are the scenarios

Before we ask an enquiree to evaluate a policy program i, we attach a weight

Pi to it indicating its probability to occur. If such probabilities are too
low the enquirees are usually reluctant to answer. The probabilities are
derived from a forecasting model, described in more detail in Merkies and
Nijman (1981, 1983), and specified as:

(2.15)

Yt is a vector of n elements at time t; 0, ~ and a are vectors of parameters

of length n and ~t = IN(O,~) is a stochastic vector of n elements, which is
independent of time.
If we have a sample of length T, a simultaneous forecasting interval for some
T years ahead can be constructed according to
T-r-n+l
(2.16)
(T-r)n

e r is a vector with n forecasting errors in year T with variance-covariance

matrix
~

o - (~+qr)S , (2.17)

where S is an estimate of ~ and qr=X;(X'X)-lX r with X;-[l,T]. The parameter

~ which we will generally refer to as "the degree of uncertainty of the
future" is the ratio of the variance of the forecasting period to that of the
sample period. For given a, probability-contours can be constructed from
(2.16). Inversely, each scenario Yi can be considered as a realization in
year t+T, so that its forecasting error - its difference with the forecast
from (2.15) - can be computed and its a%-probability of excess - indicated by
Pi - can be derived from (2.16).

Apart from these "objective" probabilities Pi we use "subjective" probabili-

ties, i.e. we asked the enquirees to evaluate the realism of each policy pro-
gram. This can be done only after a set of programs is specified. The
computation of probabilities Pi helps to select a proper set of policy
programs in advance. The diagonal elements of the matrix S help to specify
the matrix Va in (2.11) if we assume that the accuracy with which the optima
yare evaluated is related to the variance of the variables in the past.

3 THE INQUIRY; DESIGN AND RESULTS

3.1 The enquirees

At the end of 1983 we held an inquiry among political parties, more specifi-
cally among their representations in the "Tweede Kamer der Staten-Generaal"
(Parliament). Those parties who provided answers that could be processed are
 210

mentioned in table 1 together with the number of seats they held in that
chamber.

Table 1. The political parties inquired*

Number of seats
CDA Christian Democrats 45
VVD Liberals 36
PvdA Labour Party 47
D'66 Democrats 6
GPV Reformed Political Association 1

Total number of seats of participating parties 135

Total number of seats in Lower Chamber 150

A coalition of CDA and VVD as in power during this period.

The ques tions concerned a set of 25 "policy programs" (N-25). Each program
refers only to the values of five policy variables (n-5). A set provides two
sources of information; firstly the evaluation Ui j of party j on each of the 25
programs and secondly the content of the optimal program of party j. We col-
lected information on two different sets of policy programs. A and B.

3.2 Policy variables; set A

The policy variables of set A are:

Yl registered unemployment of the dependent working population
according to the definition introduced in CEP 1983
yz growthrate of real NNP
Y3 percentage increase in the price-index of wage-earners'
family expenditure
Y4 borrowing requirements of the Government (as a percentage of
NNP)
Y5 balance of payments of current account (as a percentage of
NNP).

The 25 possible scenarios for 1987 of these variables are given in table 2.
The information asked for is indicated by dots. The first source of informa-
tion concerns the evaluations of the programs in the column indicated by U,
the second source is the specification of the optimal program in the first
row. Hence this row (= yO) differed among the parties.

Scenario number 18 represented more or less l ) the actual situation prevailing

at the time of the inquiry (fall of 1983). hence Yl8 = y*.
The last column of table 2 refers to the probabilities Pi as described in
section 2.2. To compute these probabilities we used time series covering the
period 1964-1983. so T=20 (years). In applying (2.15) we selected a quadratic
trend only for two variables (i=l and i=4). Hence for three out of five
variables a regression with a linear trend was run for the period 1964-1983;
for the variables Yl and Y4 a quadratic term of 0itZ was added. To compute

1) The measurement of the "actual" situation is not unambiguous. It depends upon the time of
measurement. It remains always possible that more recent information gives corrections on
earlier estimates. Moreover. measurement errors always remain.
 211

(2.16) we specified T=20, n=5 and r=3 (so ignoring that no quadratic term is
included in 3 equations).

Table 2. Scenarios for 1987: set A

i U Yl Yz Y3 Y4 Ys pl)

1 100
2 16 -1 7 13 2 100
3 12 2 8 9 2 78
4 16 2 7 14 2 99
5 16 -5 7 14 2 100
6 16 -2 9 14 2 100
7 16 -2 4 14 2 100
8 16 -2 7 14 -1 95
9 16 -2 7 14 5 94
10 12 -2 7 14 2 62
11 18 -2 7 14 2 98
12 16 -2 7 9 2 66
13 16 -2 7 17 2 82
14 14 -2 7 9 2 81
15 16 -2 8 9 2 64
16 12 1 5 8 2 61
17 18 -3 7 9 3 44
18 17 0 4 9 4 70
19 20 1 3 10 5 58
20 16 2 3 13 4 94
21 16 3 3 10 4 87
22 16 2 2 10 4 84
23 16 2 3 10 0 77
24 10 2 3 10 4 16
25 16 2 3 7 4 42

1 ) Probability of occurrence, see text.

The parameters of (2.17) selected for the present study are

~ - 10 (degree of uncertainty of the future)

(3.1)
T = 1 (horizon of the enquiree)

The first value was found in the previous studies to be a reasonable compro-
mise. It expresses the view that the degree of uncertainty of the future is
ten times as great as suggested by the variance of our regression. The para-
meter T, which we will refer to as the "horizon of the enquiree" , is given a
value of one to indicate that the enquirees considered these scenarios
implicitly as to refer to 1984 (1 year ahead from the time of the inquiry).
In other words, the horizon of the evaluators was taken to be one year and
not 4 years as suggested by the inquiry (see table 2). The probabilities Pi
were calculated, according to these rules, prior to the inquiry. Thus we
could compile a set of scenarios of different degree of attainability. For
instance, program 24 was thought to be so unrealistic that its probability to
appear (or rather the probability that this program or a more odd vector in
the same Cartesian direction would materialize in 1985) was thought to be
 212

only 16% and it seemed almost certain that situations 2, 5, 6 or 7 would

arise, indicating that an inflation of 9% (alt 6) was considered equally
likely as an inflation of 4% (alt 7); more or less the same view existed with
respect to a decreased growth of 1% (alt 2) or of 5% (alt 5).

There are some points worth noting concerning these probabilities:

1. The probabilities of table 2 are calculated with (2.16); they are there-
fore of a mechanical character. They were needed prior to the inquiry to
assure sufficient variety in the set of scenarios.

2. Parties' views on the reality of the scenarios were also asked for. They
were quite different, see table 3. Only the Democrats' views were posi-
tively correlated (r=.20) with the mechanically obtained probabilities.

3. Ex post comparison between the mechanical and the parties' views revealed
that changing the "degree of uncertainty of the future" }1 or the
"horizon" T would not have improved the correlation, see table 3.

4. It is of interest to see how the parties looked upon the reality of their
own preferred plans, see table 4.

5. The real situations for the years 1984-1987 have been added for compari-
son. We have:

Y1 Y2 Y3 Y4 Y5

1984 17 2 3 9 5
1985 16 2 3 7 5
1986 15 3 0 6 3
1987 14 1 0 8 2

Table 3. Correlation between parties' views and mechanical views on

scenarios: set A

Parties' estimates computed estimates

T~l T=2
CDA VVD PvdA D'66
}1=10 1'=15 1'=10 1'-15
---
CDA 1.00 0.80 0.68 0.33 -0.46 -0.40 -0.61 -0.57
VVD 0.80 1.00 0.78 0.13 -0.54 -0.52 -0.62 -0.63
PvdA 0.68 0.78 l.00 0.00 -0.36 -0.31 -0.41 -0.38
D'66 0.33 0.13 0.00 l.00 0.20 0.25 -0.07 0.02
 213

Table 4. Preferences of political parties and the chances to realize them:

set A

Programs yO Probabilities

parties J.I=lO J.I~15

Y1 Yz Ya Y4 Y5 own T= 1 T- 1

CDA 12.0 3.0 3.0 7.0 2.75 0.90 0.41 0.60

WD 5.0 2.5 3.0 2.5 2.0 0.00 0.02 0.06
PvdA 14.0 3.0 4.0 9.0 3.0 0.25 0.78 0.88
D'66 4.0 5.0 2.0 3.0 1.0 0.00 0.02 0.06
GPV 10.0 3.0 10.0 6.5 3.0 1) 0.14 0.29

1) No information given.

3.3 Policy variables; set B

The variables of the second set are:

Y1 registered unemployment of the dependent working population accord-
ing to the definition introduced in CEP 1983.
Ya percentage increase in the price-index of wage-earner's family
expenditure.
Ys Public share in net national income.
Y7 Labour share in net national income.
Ys (competitiveness) difference in percentage increase in real
unit labour costs (in guilders) between the Netherlands and
its competitors.

The scenarios of set B were designed similarly to those in table 2.

No one was near to the realized view on 1985. Probabilities were computed as
before, a quadratic term was selected only for variable Yl. Again we speci-
fied T-20, n=5 and r=3 (ignoring zero parameters of quadratic terms). Again
we chose J.I-lO and r=l.

Table 5. Correlation between parties' and mechanical views on scenarios:

set B

Parties'estimates Computed estimates

T=l T=2
CDA WD PvdA D'66 J.I=lO J.I=15 J.I-lO J.I=15
---
CDA 1.00 0.15 0.21 0.15 -0.46 -0.48 -0.53 -0.59
VVD 0.15 1. 00 0.83 -0.36 -0.39 -0.34 -0.53 -0.52
PvdA 0.21 0.83 1. 00 -0.13 -0.37 -0.35 -0.47 -0.47
D'66 0.15 -0.36 -0.13 l.00 0.51 0.49 0.42 0.43

Table 5 again shows mainly !l.egative correlations between the mechanically

computed probabilities and those the parties attached to the different
programs.
 214

The optimal vectors of the parties and their probabilities are given in table
6.

Table 6. Preferences of political parties and the chances to

realize them: set B

programs yO probabilities

parties 11=10 11=15

Y1 Y3 Y6 Y7 Ya own 1'=1 1'=1

CDA 12 3 57 85 2 0.90 0.25 0.44

VVD 5 3 50 80 0 0.00 0.00 0.01
PvdA 14 4 57 84 2 0.25 0.19 0.37
D'66 4 2 58 85 -1 0.00 0.09 0.21
GPV 10 0 56 85 2 1) 0.15 0.30

1) No information given.

4 THE ESTIMATED FUNCTIONS

4.1 The variables of set A and set B

Preference functions can be estimated if one is willing to accept parties'

evaluations of our programs as sensible information. As soon as some positive
value is attached to A the estimation of the preference functions can be im-
proved, but the optimal yO from table 4 (and table 6) is affected. The former
value yO will be replaced by estimate yO. The choice of A is a subjective
matter as indicated above, but there are some objective elements involved. If
A gradually increases from zero to larger positive values it may happen that
the estimation procedure fails to generate a negative semi-definite Hessian
matrix A. Then at least for one variable the vector yO does not indicate
maximum utility! This clearly sets a limit to the value of A. In Merkies and
Hofkes (1986) extensive results for various values of A are shown. Here we
give only results for A=O.OOl and parties' own weights (see tables 7 and 8).

Table 7. Estimates of preference functions with parties' own weights;

set A

party ao a1 az a3 a4 as ~all ~azz ~a3 3 ~a44 ~ass

CDA -11.14 -19.93 0.11 -4.55 -8.10 -3.25 -1. 99 -0.01 -2.26 -2.02 -1. 29
VVD 1. 66 -2.43 4.98 -1.94 -10.28 1. 22 -0.10 -1.00 -0.97 -0.79 0.30
PvdA 20.84 -4.90 8.84 0.03 0.03 -7.90 -0.80 -1.47 -1. 29 -5.84 -3.94
D'66 -6.83 -10.68 2.04 0.40 -0.97 -1.85 -0.41 -0.20 0.10 -0.08 -0.31
• 0 • 0 '0 • 0 • 0
Computed optima Yl Yz Y3 Y4 Ys U

CDA 12.0 10.70 2.99 7.00 2.74 91

VVD 5.01 2.50 3.00 2.50 1. 99 86
PvdA 13.95 3.01 4.01 9.00 3.00 46
D'66 3.98 4.98 1. 95 2.97 1.00 73
 215

Table 8. Estimates of preference functions with parties' own weights:

set B

party a o a1 a3 as a7 aa ~all ~a3 3 ~a66 ~a77 ~aa8

CDA 10.05 -3.15 -0.00 -1. 72 -5.71 18.62 -0.39 0.19 -0.41 -0.95 -3.10
VVD -0.04 -1. 52 -0.00 -1. 76 -7.26 2.75 -0.07 0.97 -0.10 -0.45 -1. 38
PvdA 0.0 -112.86 -10.0 -5.0 -0.0 -8.57 -28.21 5.00 -1. 25 -0.0 1.43
D'66 -0.03 -1. 95 0.04 -0.74 0.03 -0.00 -0.08 0.02 -0.36 0.01 0.04

-0 -0 - 0 -0 -0
Computed optima Y1 Y3 Ys Y7 Ya U

CDA 11.98 3.00 56.88 85.00 2.0 99.7

VVD 5.00 3.00 50.00 80.00 -0.0 106.7
PvdA 14.00 4.00 57.0 84.00 2.0 100
D'66 4.01 1. 98 57.98 84.84 -1. 0 11.98

4.2 Discussion of the results

The most striking feature of the above result is that the computed optima y
hardly differ from the revealed optima Yo in tables 4 and 6. This is not
surprising because the parties' own weights are in general rather close to
zero. This implies that such observations are more or less ignored in the
computations. With so many weights close to zero the content of the informa-
tion source 1 shrinks away leaving the conclusions to depend only on informa-
tion of source 2. This is also indicated by the U-values of the various
optima which are much closer to 100 than those with mechanical weights. It is
not surprising that the measured preference functions become rather
unreliable as they depend only upon a very mutilated set of observations. The
slight differences between computed and revealed optima must be handled with
prudence. We have verified whether our conclusions are depending upon the
weights. Table 9 shows for the variables of set A for each party and for
each variable whether the computed optimum was above (+) or below (-) the
revealed optimum if the mechanical weights were used. If the same feature was
found with the parties' own probabilities an asterisk (*) was attached to the
indicated sign.

Table 9. Estimated optima higher (+) or lower (-) than revealed optima;

set A; modelweights*

Y1 yz Y3 Y4 Y5
unemployment growth inflation govt. balance of
finance payments

CDA +*
VVD + +
PvdA +* +*
D'66
GPV + +

* does not change i f parties' weights are used.

 216

The hidden wish for higher growth rates and lower unemployment appears to be
independent of the set of weights.
For the second set of variables (set B) sufficient information is lacking to
construct a table.

4.3 Stability through time

Whether preferences are stable through time can be verified with the help of
the variables of set B. In Merkies and Nijman (1983) preference functions on
the same set of variables are discussed. They referred to 1977, the same
procedure was followed and optima were computed in the same way. The results
are reported in Merkies and Hofkes (1986). The remarkable point is that much
lower unemployment figures were strived for in 1977. A saying often heard is:
"Politics is the art to attain what is possible". The differences between
computed and revealed optima vanish against differences over time. But this
mainly concerns unemployment. Actual possibilities in the economy seem to be
more important than preferences.

5 THE IMPLICATIONS

5.1 The aggregate preference function and its projections

We now turn to the implications of our computations. In our operational sett-

ing the multidimensionality of the preference function is reduced to only
five dimensions. As it remains a difficult task to obtain a clear view on the
shape of a preference function in five dimensions, we simplify further by
looking to the projection on two variables only: the price-index and the rate
of unemployment. To be impartial we aggregated the functions of the political
parties into preferences of the community. It is common knowledge that the
construction of such a community preference function is not possible in
general, but it seems admissable for the restricted domain of the variables
with which we are dealing here. The construction of such a function has the
advantage that we can study the implications of preferences on economic de-
velopments. In reality power play among political parties decides over the
preferences that are favoured in a particular period. But as long as prefer-
ences are not too different, one may expect that a weighted average - with
weights reflecting Parliament representation - constitutes a reliable indica-
tion of the community's preferences. On these premises we have constructed
the preference function of the Dutch community with respect to the two sets
of variables discussed. The two functions are:

u -4.25 Y1 - 0.45 Y3 - 0.48 YI - 0.37 y~ (5.1)

u -2.0 Y1 - 0.01 Y3 - 0.23 Yt - 0.10 Y5 (5.2)

These two community preference functions can be handled in the same way as
before. The optimal values for the two sets are:

Tab 1 e 10. . :.O...

p-,t_i_m_a_l_v_a-,l=-u_e,-s,-:-::.f.:..o::.r--=t.::.:h-,e--=a:..sg~g~r,-,e:...!g",a::.t=-e_
set A set B
unemployment 12.57 11.65
inflation 3.39 2.95
 217

The indifference curves of the two quadratic preference functions are ellips-
oids. Their projections for U-95 and U-99 (or 95% resp. 99% of the optimal
value) are drawn in figure 1 (for set A) and figure 2 (for set B). The opti-
mal points of table 10 are represented in the figures by a +sign and referred
to by point A.
Comparison of both figures shows that the projection depends upon the varia-
bles in the preference function that are suppressed. In both figures the
symmetry axes of the ellipses are parallel to the main axes of the diagram.
This is not coincidental but follows from the diagonality of the matrix A in
(2.2). This was assumed to save degrees of freedom. Figure 1 and figure 2
suggest that it may not have been the most plausible assumption.
Apart from the indifference curves we have represented the possibilities in
the figures. The point estimate of 1984, made with model (2.15), i.e. 14%
unemployment and 6,5% inflation, is represented in both figures with a black
box and referred to by point B. We computed a 95% probability interval around
this point in the way we also computed our probabilities in section 3. These
intervals are ellipsoids in five dimensions. The projection is represented in
the figures 1 and 2. As the variables suppressed in both preference functions
are not the same the ellipses of the figures 1 and 2 differ. They are
projections from two different five-dimensional spaces. Note that these
projections depend upon the values adopted for the suppressed variables.

If the weighted preference functions (5.1) and (5.2) reflect indeed the pref-
erences of the society and the possibility-ellipses are indeed true represen-
tations of what the economy allows, an optimal policy in the line of Theil
(1964) can be constructed. The solution of the maximization of the preference
function (5.1) and (5.2) subject to the constraints described by our possi-
bility ellipses leaves one degree of freedom: the relation between ends and
means. For given means the possibilities-ellipse is fixed and the optimal
policy is obtained by varying the indifference ellipse such that the two
ellipses are tangent. The same solution can be obtained with a given
indifference curve and a varying possibilities-ellipse. The smaller we take
this given indifference curve, the closer the optimal point will be to the
society's optimum of table 10. It is clear that for different given indif-
ference curves the optimal points will be on a curve that goes through both
points A and B. A little geometry will indicate that this curve is only a
straight line if both ellipses degenerate into circles. But although in gen-
eral a variety of curves can appear, a glance at the figures shows that in
our example the path between A and B is not far from a straight line.

5.2 The Phillips curve

We have selected the two variables inflation and unemployment to throw some
light on the significance of the Phillips-curve. Although the original form
launched by Phillips (1958) connected money-wages with unemployment, the
literature on this subject, see e.g. Desai (1984) often selects other repre-
sentations of the concepts discussed. Whatever the actual choice of the
variables, the underlying significance remains somewhat obscure. Few authors
attempt to describe the true nature of the relation. Does it describe demand
or does it describe supply? Is it the locus of clearing points of the labour
market or is it the result of a disequilibrium solution? Whatever the true
nature, we would like to know what the scatter diagram originally studied by
Phillips reflects. Is it allowed, as for instance done by Reuber (1964), to
 218

interpret the graph through the scatter by the society's indifference curve?

To clarify the point we assume that usually the optimal policy, as given by
Theil's method, is more or less attained. This assumption is not as bold as
it seems. Authors who try to deduce community's preferences from revealed
preference theory, see e.g. Friedl~nder (1973) do in fact the same.
In our framework this assumption would imply that, if neither preferences nor
the economies' possibilities change, the scatter of historical points would
lie around the line-segment through A and B. The scatter of actual points in
figure 1 and figure 2 shows that this is not the case. The points may be on a
remote contour around A but they cannot be on a line-segment through A and B,
unless these points are also shifted.
We have no definite answers yet on the questions raised above. There are,
however, various features that are worth to draw attention to:

1) Any curve through the scatter is a projection of a locus in higher dimen-

sions. What differences this may cause is shown by the different posi-
tions of the possibilities ellipses in figure 1 and figure 2. The same
may hold for the indifference curves if we allow these to adopt skew
positions (allowing non-zero off-diagonal elements in the Hessian matrix
A) .
2) The community's optimum at the time of the inquiry was completely differ-
ent from what it had been before, when such high unemployment rates as
observed lately were considered unacceptable. The figures suggest that
preferences are rather influenced by short term opportunities of the
economy!
3) The locus drawn through the historical scatter cannot be interpreted as
an indifference curve. The indifference curve is neither a kind of
hyperbola indicating higher utility the closer it is to the origin. The
indifference curve is a rather unstable ellipse around a point determined
by the possibilities of the economy.
4) The historical scatter may be interpreted as an upward sloping curve
representing the A-B graph of optimal points. If this interpretation is
correct the fluctuation between ends and means decided over the actual
situation between 1964 and 1983.

6 SUMMARY

In this paper we have made another attempt to measure preferences of Dutch

political parties on economic issues. For this purpose we collected some
information from these parties at the end of 1983. Parties were inquired
about two sets of variables. The first referred to unemployment, growth, in-
flation, government financing and the balance of payments, the second to
unemployment, inflation, distribution of expenditures between public and
private, distribution between labour and other income and finally interna-
tional competitiveness. Parties were asked to indicate their target values on
these variables for the period 1983-1987 and also to evaluate various
alternative economic situations. The answers were analyzed within the
framework of a collective choice model.

The information on the first set allowed us to measure quadratic preference

functions for four political parties (Christian Democrats, Liberals, Socia-
lists and Reformed Political Association). The same holds for the second set
but for the Socialists. The answers of the fifth party - the Democrats - did
 219

not generate functions for either set.

This result as such indicates that it is at least formally possible to meas-
ure preference functions by inquiries. It appeared that evaluation of alter-
natives provides useful additional information on the indicated targets if
parties confess consistent long term options. This was most clearly shown by
the answers of the Liberals and somewhat less clear by the Reformed Political
Association. Nevertheless the dominating result was that revealed targets in
general heavily depend upon the actual state and the possibilities of the
economy. One may call this realism, modesty or myopia according to one's
attitude. It may also indicate a weakness of the inquiry to clarify the
difference between a long term goal and a partial achievement within a given
time period.
With the computed preference functions alternative target values were gener-
ated. Comparison with values that were revealed is compiled in table 9. This
shows that in general parties preferred higher growth rates, lower unem-
ployment and more stringent borrowing requirements for the government than
they were willing to admit.

The comparison of our results with earlier attempts supports the view
mentioned above that preferences shift with actual opportunities of the
economy. If this is true it affects the interpretation of certain relations
in economic theory, e.g. the Phillips-curve. The empirical relation between
price increases and unemployment ratios can no longer be interpreted as an
indifference-curve as e.g. done by Reuber (1964). The relation may indicate
the opportunities of the economy, but our sample period (1964-1983) is
probably too short to verify such a statement.

REFERENCES

C.E.P. (1983), Central Economic Plan, Centraal Planbureau, Staatsuitgeverij,

's Gravenhage.

Van Daal, J. and A.H.Q.M. Merkies (1984), "Aggregation in Economic Research:

from individual to macro relations", D. Reidel Publishing Company, Dord-
recht.

Desai, M. (1984), "Wages, Prices and Unemployment a Quarter Century after the
Phillips Curve" in: Hendry, D.F. and K.F. Wallis (eds.), "Econometrics
and Quantitative Economics", Basic Blackwell, Oxford, pp.342.

FriedHl.nder, A.F. (1973), "Macro Policy Goals in the Postwar Period: a Study
in Revealed Preference", Quarterly Journal of Economics, 87, pp.25-43.

Merkies, A.H.Q.M. and T.E. Nijman (1981), "Preference Functions of Dutch

political parties", Economie Appliquee, 4, pp. 785-818.

Merkies, A.H.Q.M. and T.E. Nijman (1983), "The Measurement of Quadratic Pref-
erence Functions with Small Samples" in: J. Gruber (ed.), "Econometric
Decision Models", (Proceedings, Hagen, West Germany, 1981), Lecture Notes
208, Springer-Verlag, Berlin, pp.364.
 220

Merkies, A.H.Q.M. en A.J. Vermaat (1981), "De Onmacht van een Kabinet. Een
Empirisch Onderzoek naar Sociaal-Economisch Preferentiefuncties en hun
Gebruik als Welvaartsindicator" , Maandschrift Economie, 45, pp.101-118.

Merkies, A.H.Q.M. and M.W. Hofkes (1986), "Preferences and Possibilities in

the Dutch Economy", Onderzoeksverslag 159, Free University, Amsterdam.

Phillips, A.W. (1958), "The Relation between Unemployment and the Rate of
change of Money Wage Rates in the United Kingdom, 1861-1957", Economica,
25, pp.283-299.

Reuber, G.L. (1964), "The Objectives of Canadian Monetary Policy, 1949-1961,

Empirical 'Trade-offs' and the Reaction Function of the Authorities",
Journal of Political Economy, vol.LXXII,2.

Theil, H. (1964), "Optimal Decision Rules for Government and Industry",

North-Holland, Amsterdam.

Figure Preferences and possibilities: set A

'75
0
a '7'b
a
'7)
0
'72
0 '7fa
'7'0
a
cD

'RI)
'6'b 0

0 '69 '77
0
.D 0
'66
0

'70 '78
0 '798
'65
~
0

'"6
'68 0
'sF
~
N

a
0i------r----~-----,r-----r_----~----_r----_,--,L_,r_--__,
o 2 6 8 18
UNmpLOYI1ENTRATE
 221

Figure 2 Preferences and possibilities: set B

a
N

'75
0
a '74
a 0

'73
'72 0
0 '760
, 71
a
(I)
. 0

'64 !80
0 0
, 81
0
z
a a
H
' 69 0 0
U)
E-<
<t:
,....l
~ '66 0
z
H

'70 '78
' 7cB
.,..
0
a '65 0

'67
0
'68 '84
0 0
a
N

a
a~------r------.------'---~--r------.~----,---f---r------+------'
o
On Constructing Objective Functions 1

A. S. Tanguiane and J. G~uber

Lehrgebiet Statistik und Okonometrie, FernUniversitat Hagen
Postfach 940, D-5800 Hagen I, Germany

Abstract

In this paper an algorithm for constructing a separable (=additive) objective function

f( Ul, ... , un) = 2::'=1 fi( ud is considered. We suggest a mathematical substantiation of
this algorithm, estimating its accuracy and proving its validity in different cases.

According to our results, the features of this algorithm are the following: It requires minimal
input information which may be obtained by interviewing an expert; the algorithm requires
only ordinal information about preferences, like preference, or indifference; the objective
function can be uniquely constructed from the obtained data; from incomplete data the
objective function can be constructed approximately, and this construction is stable with
respect to inaccuracies in the data; any input data are consistent with the formal assumptions
of the model; consequently, no contradiction will arise in applications.
In this paper we also discuss briefly how the algorithm considered can be adapted to construct
a quadratic objective function f(ul,' .. ,un) = 2::'=1 ai U ; + 2: i #J bijUiUj + 2::'=1 Ci1(i·

Keywords: Separable objective function; quadratic objective function, data from inter-
viewing experts, interactive procedures.

Contents

1 Introduction

2 Independent Preferences and Separable Objective Functions

3 Approximate Construction of a Separable Objective Function

4 Accuracy of the Approximation Obtained

5 Applicability of the Algorithm Considered

6 Conclusions and Further Problems

IThis paper, based on the results from Tanguiane (1991), was written while the first author was a visiting
professor in the Department of Economics, University of Hagen, in 1990/1991.
 223

7 Appendix: Proofs

References

1 Introduction

Recall that the statement of a choice problem presupposes determining a set of alternatives
which are commonly identified with the vectors of their characteristics, as in linear program-
ming. The preference structure is often formalized by a scalar-valued objective function
(called also utility function, or goal function) which adopts greater values at better alter-
natives. The physical, or economical constraints like budget, resources, technology, etc. are
taken into account as restrictions. The optimal choice is realized as finding the maximum of
the scalar-valued objective function under the given restrictions.
We can say that the desire is compared with reality-the objective function with the restric-
tions, and their interaction determines the optimal decision.

Thus rational decision making requires:

(1) the representation of each alternative by a vector of the characteristics (specifications)

of the alternative,

(2) the representation of goals by a scalar-valued objective function,

(3) the representation of the physical and economical constraints by restrictions,

(-1) finding the global maximum of the objective function under the given restrictions.

Although no item from the above four can be considered as quite simple, we think that the
weakest links are the first two. Indeed, solving an optimization problem is a technical task,
and although mathematical methods may differ in efficiency, in principle any optimization
problem is solvable by scanning. The physical and economical constraints are usually known,
and their representation by restrictions is not so difficult. However, the preference function,
or the objective function, is not so easy to reveal. It may depend on subjective intentions
and goals which are not realized clearly, or which are not commensurable. Finally, in most
cases we are not even capable to recognize possible alternatives. Even if they are given, they
may not be characterized by numbers, or be incomparable.
In the present paper we deal with the second item. The main assumption of our model is
therefore the existence of a set of alternatives characterizable by the same specifications, i.e.
representable by vectors of the same n-dimensional space. The main attention will be paid
to the commensuration of goals and the substantiation of the related procedure.

In section 2, "Independent Preferences and Separable Objective Functions", we introduce

the main definitions, illustrate them with examples, and refer to the literature.
 224

In section 3, "Approximate Construction of a Separable Objective Function", we consider a

heuristic algorithm for constructing a separable scalar-valued objective function and adduce
reasons in its favour.
In section 4, "Accuracy of the Approximation Obtained", we define the measure of accuracy
for approximations of objective functions and estimate the accuracy of the construction from
the previous section. We also formulate the conditions for the unique reconstruction of a
separable objective function and show that the data required are minimal in a certain sense.

In section 5, "Applicability of the Algorithm Considered", we prove that the algorithm is

consistent with any input data. This means that no contradiction will arise in applications.
We also suggest modifications of the algorithm which may be more convenient in practice.
In "Conclusions and Further Problems" we discuss the applicability of our algorithm to
constructing a quadratic objective function. Finally, we outline very briefly a possible im-
plementation of the algorithm in an interactive man-machine decision making system.
Thus the goal of our paper is to substantiate the algorithm considered with a series of strict
mathematical statements. After such a study this algorithm becomes ready for applications
and, in particular, can be adapted for some particular needs like constructing a quadratic
objective function.

2 Independent Preferences and Separable Objective

Functions

Let X be a set of alternatives. For example, X may consist of different models of cars to
be compared. Suppose that each alternative x E X is identified with the n-dimensional
real-valued vector of its characteristics or specifications

For example, each car x can be characterized by its power Uj(x), gas consumption U2(X),
number of doors U3(X), etc.

We shall consider only the characteristics Ui which may adopt all intermediate values from
certain segments [ai; bi]. Obviously, there are characteristics which don't meet this assump-
tion. For example, for cars the number of doors can be 2, 4, or 5, but never 2.5. However,
dimensions, power, maximal speed, gas consumption, etc. are continuous variables. There
are also specifications which are discrete but we can assume their continuity, as in the case
of price measured in dollars.

Thus we identify the set of possible alternatives (not actual!) with an n-dimensional paral-
lelepiped
v = VI X ... X Vn = {(UlJ ... ,u n ): ai:::; Ui:::; bi, i = 1, ... ,n},
where Vi = [ai; bi], ai < bi for all i, i = 1, ... ,n.
To formalize the idea of preference, we consider a scalar-valued objective function
 225

defined on U. By definition, the objective function adopts greater values at preferable

alternatives and adopts equal values at indifferent alternatives. Finding the best alternative
is equivalent to finding the maximum of the objective function. Note that any monotone
transform of the objective function represents the same preference. Therefore, an objective
function is defined up to a monotone transform. The order on U induced by an objective
function f(u) is called preference order and is denoted by .<,' (strict preference), or -:!C'
(preference or indifference).

We shall consider only continuous objective functions. The continuity implies that close
alternatives cannot differ dramatically in preference. This assumption is quite reasonable
in applications, since the distinguishability of alternatives is limited, in particular due to
inaccuracy of measurement.

We shall also assume that an increase in any specification Uj, while other specifications
remain constant, results in an increase in preference. For example, the more powerful a
car is, while gas consumption, price, tax, etc. remain the same, the more preferable it is.
To meet such an assumption, some specifications should be bounded (like the dimensions,
since bigger cars are preferable only within reasonable limits), others should be inversed (like
the price, since cheaper cars with other specifications being the same are preferable). Thus
objective functions are supposed to be increasing (monotone) with respect to all of their
arguments.
Note that, varying one specification Uj, we suppose that an increase in preference is under-
stood equally whatever the fixed values of the other specifications are. Such a preference
structure is called independent of the other specifications.

Let us illustrate the difference between "independent" and "dependent" specifications with
a simplified version of the example by Winterfeld & Fisher (1975).
Consider two specifications of a car: Length of the body, and steering type (mechanical, or
powered). If the car body is not very large-up to 4.5 meters long, then the larger car is
always preferable regardless of the steering type. Therefore, we can write down:

(4 ..j m, power steering) >- (4 m, power steering);

(4.5 m, mechanical steering) >- (4 m, mechanical steering).
In this case the specification "length of the body" is independent of "steering type". If we
consider cars differing in length greatly-up to 6 meters, then our preference with respect to
dimensions can depend on the steering type. Indeed, a large car with a mechanical steering
is not quite safe, and a smaller car is preferable if the steering is mechanical. However, if
the steering is powered, a larger car is still preferable. We can write down:

(6 m, power steering) >- (4 m, power steering);

(6 m, mechanical steering) .<, (4 m, mechanical steering).

In this case the specification "lengt h of the body" is not independent of the "steering type".

In the above example the assumption of independence is violated, because a new factor, the
safety, is taken into account. The violation of independence means a revision of preferences
with regard to specifications, which is natural under great changes in parameters, but is not
 226

typical for their small deviations. For close alternatives the independence of specifications
is more likely, since the alternatives are regarded from the same point of view and with
respect to the same criteria. Sometimes it is possible to classify alternatives and assume the
independence of preferences within these classes.
Now we generalize the idea of independent preferences from a single specification (charac-
teristic) to a pair of specifications (two characteristics). The idea of independent preferences
means that we can consider a group of characteristics of the alternatives separately from
the other characteristics. Such a consideration is meaningful, only if our preference on the
given characteristics is not influenced by the particular values of the other characteristics.
In particular, the pairwise independence implies that it is meaningful to speak of a global
improvement obtained by an improvement in a pair of specifications which is understood
equally for arbitrary fixed levels of others. For our purposes it suffices to define the pairwise
independence.

Let a preference order on the space V = VI x ... X Vn of n-dimensional vectors u = (Ul, ... , un)
be represented by the objective function

This preference order is called independent with respect to VI X V 2 (of V3 x ... x Vn) if

for certain u~, ... , u~ always implies

for arbitrary U3, •.. , Un. The independence of preferences with respect to other pairs of
specifications Vi X Vj is defined similarly.
The above definition is illustrated by Fig. 1 for the case n = 3. The pairwise independence
implies that the related preference cuts (the preferences in two-dimensional planes VI x V 2
shown by indifference curves) are the same at any level of the other specification U3 (in
the case n > 3 we would have n - 2-dimensional vectors (1l3, ... , lin) instead of 113). The
dependence means deviations in this preference, while shifting the cut plane U I x U2 up and
down the axis V3 .
It was established that under rather general assumptions the pairwise independence of pref-
erences with respect to all pairs of specifications is equivalent to that the associated objective
function is separable (=additiue), i.e. it has the form

The discussion of related questions goes back to Ramsey (1931). Later it has been contin-
ued in the context of econometric modelling (Leontief 1947; Samuelson 1948; Neumann &
Morgenstern 1947). A topological approach to independent preferences was formulated by
Debreu (1960) and Koopmans (1972). An algebraic approach based on Holder's theorem on
ordered groups was developed by Krantz, Luce , Suppes & Tversky (1971). One can find
more references in Fishburn & Keeney (1974).
 227

_ - - - - - - . (u'\. It; )
_-
_---- _ - - -.- -.
(II ".
U\. U~)
.,.
-------- ---
... -.-..-..--
-----------------
-.."..~ ~...

.... --_..--_.-
/
-...~-..-....
/
....,,. ..-

....
........ -
--------
. .'" ,.... .------ - - - - - - - - - - -----------
/ ../~.-.------ --------------
...-----_ ...--
'."

Fig. 1. Preference cuts in case of an independent preference order

The interest in justifying separable objective functions is explained by their common use in
econometric decision models. Besides, for them there are special methods to solve optimiza-
tion problems (Hadley 1964).

Considerable attention has been paid to the practical construction of separable objective
functions. Thus, Fishburn (1967) describes 24 heuristic methods for constructing separable
objective functions. However, all these methods have a common disadvantage, namely, the
lack of uniqueness in the determination of the objective function.

We therefore require that every procedure for constructing an objective function must be
backed by a uniqueness theorem, or, at least, by an estimate of the accuracy of the con-
structed objective function. These questions are discussed in the following sections.

3 Approximate Construction of a Separable Objec-

tive Function

We shall construct a separable objective function on the space of specifications which is an

n-dimensional (n ~ 2) parallelepiped

U = UI X ... x Un = {( U I, ... , Un) : Qi ~ Ui ~ bi , i = 1, ... , n},

where U, = [ai; bi], ai < bi for alii , i = 1. ... , n.
Assume t hat there exists a preference order ~f on U representable by a separable objective
 228

function

where 1;( Ui), i = 1, ... ,n, are continuous and increasing, but neither the order .:!/, nor the
objective function f( UI, ... , un) are known.
Assume that two compensation curves (indifference curves) Ml and M z , which are level
curves of the function fl(ud + fz(uz), are given in the coordinate plane U1 x Uz (see Fig. 2,
top). Let Ml correspond to a lower level of the objective function fl(Ul) + h(uz) than M z ,
implying Ml to be below M z .
Also assume that a compensation curve M i , which is a level curve of the function fl (Ul) +
fi(Ui), is given in each coordinate plane Ul x Ui , i = 3, ... , n (see Fig. 3, top).
Suppose that the curve Mi passes through the vertices (aI, bi ) and (b 1 , ai) of the rectangle
U1 x Ui for every i, i = 2, ... , n, as shown in Fig. 2 top and Fig. 3 top (otherwise, points ai
and bi can be chosen appropriately, diminishing, if necessary, the parallelepiped U).
By means of these n compensation curves we are going to construct an approximation
g( U}, • •• , un) of the separable objective function f( UI, ... , un) which corresponds to the pref-
erence order :5. 9 . This preference order approximates the unknown preference order :5.'. At
first we shall present the related algorithm, and then we shall explain its background.

1. In the plane U1 x Uz construct a "staircase" between the two curves Ml and Mz -

a polygonal line of horizontal and vertical segments with endpoints at MI and M 2 ,
beginning at the point (b l , az), as shown in Fig. 2 top. Let the coordinates of the
vertices of this polygonal line along the axis U1 be

2. Define an increasing piecewise linear function gl (ud on U1 such that

and
gl(s~)=t:+k
for every k, k = 0, ... , I<, where t: = 0 if s~ = aI, and 0 < t: < 1 if al < s~ (see Fig. 2
bottom), i.e. t: f. 0 if the upper "stair" in Fig. 2 top is incomplete.

3. Transfer the obtained segmentation from U1 to other axes Ui by "reflection" from the
curves A{. In other words, on each axis Ui , i = 2, ... , n, determine the sequence

o K
ai = Sj < Sj1 < ... < Sj ::; bj

such that
k K-k
(Sj,Sj )EMj
for all k, k = 0, ... , I<, as shown in Fig. 3 top.
 229

Fig. 2. The construction of gl (utJ which approximates it (Ul) by means of a "staircase"

 230

{ ,
(/,
.0
-'I

!i;(U,)

o
[/,

Fig. 3. Construction of gi( lli) which approximates ji( lli) for i = 2,3, ... , n
 231

4. For i = 2, ... ,n define an increasing piecewise linear function gi( Ui) on Ui , put ting

for every k, k = 0, ... ,1(, and

gi(b i ) = 1( + f,
where f is the same as in item 2 (see Fig. 3 bottom).

5. Define a preference order -:i g on U by the separable objective function

which is obviously continuous and increasing with respect to each variable.

The idea of the above algorithm is the following:

Assuming the existence of the unknown separable ob jective function I (UI' ... , un) = II (UI) +
... + In(u n ), we can normalize it so that its values at the compensation curves MI and 1'v12
will differ by 1. Then each horizontal segment of the polygonal line constructed in the first
item corresponds to the increment of 1 in function II(ud + I2(u2), with the increment in
II (UI) only, since U2 remains constant. This is reflected by the first and second items.
The third and fourth items are based on the observation that if the function II (ud increases
by 1 along a certain interval on the axis UI , then the function Ii( u;) decreases by 1 along the
corresponding interval on the axis Ui - in order to retain the sum II(uI) + Ii(u;) constant
along the compensation curve ]'vIi.

By the way note that the number 1( + 1 of points s?, s~, . .. ,sf' E UI is always finite;
otherwise, the continuous function II (uIl would be unbounded on the compactum [al; bl],
which is impossible.
A strict substantiation of the algorithm is given in the next section.

Note that, in fact, the compensation curves MI and M2 in Fig. 2 top and Mi in Fig. 3
top are not needed for our approximate construction. For each axis Ui we need only the
segmentation
sio < siI < ... < s,J\ ,
corresponding to an equal increase in I,( H,) by a certain conventional unit. Such segmenta-
tions can be obtained directly by interviewing an expert in the following way:
Suppose that two pairs of specifications are given (cf. Fig. 2 top): (b l , a2) and (st· - I , a2)
which is worse only in the first specification, since sf' - I < bl. This means that the points
(b l , a2) and (st· -I, a2) belong to different compensation curves (indifference curves) M2 and
:'vII, respectively. The expert has to answer the question: 'Which increase in the second
specification does compensate the difference in the first specification'? In other words, the
expert has to determine the point s~ on U2 such that (s{' -1, sD is equivalent to (b l , a2), i.e.
belongs to lvl2 • Now, with reference to the obtained point on /v12 , the expert has to answer
the question: Which decrease in the first specification does make this imaginary alternative
equivalent to the point (st'- I ,a2) on M 1 "? Thus the value s{'-2 on C1 is obtained. Next the
 232

expert has to answer again the question: Which increase in the second specification does
compensate the decrease in the first specification? That is, which value s~ on U2 brings the
interviewed expert back to Mz?
This way the "staircase" in Fig. 2 top, which determines the required segmentation of UI
and U2 , can be constructed. The upper corner points of the "staircase" are located on
indifference curve lv[2, the lower ones on indifference curve MI. The indifference curves may
be interpreted as the result of interpolating the related corner points of the "staircase".

The segmentation of the axes corresponds to an increase in the separable objective function
by the same conventional unit. That is, in a certain round of the interviewing process, one
specification value is always moving back and forth between the same imaginary indifference
curves, i.e. between All and /V[2 in Fig. 2 top. Therefore, in Fig. 2 bottom the segments of
the gl (Ul )-axis are always of equal length. The distances between the points s~, si, ... ,s{'
will, as a rule, vary, thus determining the shape of the function gi (ud in Fig. 2 bottom. Of
course, this function is also the result of interpolation.

The segmentation of every other axis Ui can be obtained by interviewing the expert in a
similar way. For that purpose, referring to the segmentation s~, si, ... ,sf of the axis U1 , the
expert has to determine the segmentation s?, s; , ... ,sf of the axis Ui such that the pairs
of specifications (s~, sf) are equivalent to a certain point (all bi ) (cf. Fig. 3 top). Here, only
one indifference curve Mi has been drawn. Since the objective function fl(ud + fi(ui) is
constant along Mi and it (Uj) increases by one on each segment on Uj , the component fi( Ui)
must also increase by one on each segment on Ui. Fig. 3 bottom illustrates the construction
of the functions 9i( Ui) for i = 3, ... ,n.
Since all of our construction activit.ies relate to certain points of indifference, one can see
that the knowledge of compensation curves in their entirety is not needed. Rather, the
compensation curves are the result of interpolation.

4 Accuracy of the Approximation Obtained

Since objective functions, representing preferences, are defined up to monotone transforms,

it is impossible to estimate the distance between objective functions in common functional
metrics. Therefore, we define the distance between objective functions as the distance be-
tween the associated preference orders.
In our case the preference orders ·::Y and -jg, as binary relations, are subsets of the com-
pactum U x U with common Euclidian metric p. Since the associated objective functions are
continuous, -j! and -jg are closed in U x U (Tanguiane 1991, chapter 2). Therefore, we can
use the Hausdorff distance d which for closed subsets A and B of a compactum is defined to
be
d(A, B) = max{sup inf p(a, b); sup inf p(a, b)}.
aEA bEB bEB aEA

To estimate the closeness of binary relations, we shall refer to the oscillation of a function
(Shilov 1973), with which we characterize the compensation curves M 2 , ..• , !lIn- For example,
consider an order on the rectangle Y x Z = [a; b] x [c; d] represented by a continuous increasing
 233

objective function f = f(y,z). Then each level curve of the function f(y, z) is a graph of
some decreasing continuous function
z = m(y)
which has the oscillation

Wm (p) = sup I m(y') - m(y") I.

y',y"EY:ly'-y"I:'Op

Recall that the oscillation is a continuous non decreasing function, defined for all P 2 0, and
equal to zero at p = 0.

Thus we can estimate the distance between the unknown objective function

and its approximation

g(UI, ... , un) = gl(ud + ... + gn(u n )
as the distance between the associated preference orders ~f and ~g.

Theorem 1 (Accuracy of the Approximation of a Separable Objective Function).

Under the assumptions of the previous section, the Hausdorff distance between the preference
orders ~f and ~g satisfies the inequality

where Wi, i = 2, ... , n, are the oscillations of the compensation curves NIi E UI X Ui, i =
2, ... ,n, considered as functions of UI, and p is the horizontal distance between NIl and M 2 ,
l. e.
p = sup I y' - y" I.
y' ,y" EUj :(y,z)EA'fJ,(y" ,z)EM2 ,ZEU2

The proof of the theorem is given in the appendix.

Note that if p -+ 0, then Wi(P) -+

d( ~f, ~g)
°
for all i, i = 2, ... , n. By theorem 1, consequently,
-+ 0, and we obtain arbitrarily accurate approximations of the unknown preference

order ~f. Since the Hausdorff distance is not a pseudometric but a metric, the unknown
preference order ~f can be uniquely reconstructed as the limit of its approximations. Thus
we obtain the following theorem.

Theorem 2 (Uniqueness Theorem). Consider an n-dimensional (n 2 2) parallelepiped

where ai < bi, i = 1, ... , n. Suppose that there exists an unknown preference order ~f on U
representable by a separable objective function f( UI, ... ,un) = fl (ud + ... + fn( un), where
the fi(ui) are continuous and increasing for all i, i = 1, ... , n. Suppose that compensation
curves 1vIi - the level curves of the functions h(ud + fi(ui) which pass through the points
(ai, bi ) and (6 1 , ai) - are given in the coordinate planes U, X Ui for every i, i = 2, ... ,n, and
that a sequence of compensation curves {;\1,k : k = 1,2, ... }, converging to the compensation
curve AI2 , is given in the coordinate plane U 1 x U2 . Then the preference o7'der ~j can be
uniquely reconstructed from these data.
 234

f( t)

.~- ... ------...

•....-.
{'
...
" .
o i"
o 2 .,
Fig. 4. The graph of the function f( t) from example 1

Note that to reconstruct a preference order uniquely, it is necessary to know an infinite

number of compensation curves (indifference curves) on at least one coordinate plane. A
finite number of compensation curves determines a finite segmentation of the coordinate
axes, fixing the indifference in certain points and restricting the deviation of compensation
curves to a certain extent, but not determining them uniquely. Let us show this with an
example.

Example 1 (No Uniqueness of a Separable Objective Function). Let m be a positive

integer. We define a continuous increasing function f( t) on the segment [0; 2m] by the rule:

f(t)=[t-(2p-lW+(2p-l) if 2p-2$.t$.2p, p=1,2, ... ,m.

The graph of the function f( t) for m = 2 is shown in Fig. 4.

Consider the parallelepiped

U = UI X ... X Un = [0; 2m] X ... X [0; 2m],

and define a preference order ~f on it by the objective function

 235

v ]

o
-I

Fig ..j. The indifference curves in two-dimensional preference cuts from example 1

We shall show that in each coordinate plane Vi x Vj the straight lines

{( Hi, Hj) : (Hi, Hj) E Vi X Vj , Ui + Uj = 2p}

for all p, p = 1, ... , m, are the level curves of the function f(ui) + f(u;), see Fig. 5_

Indeed, since f(t) on [0; 2m] is composed by reiterating the curve f(t) on [0;2]' the compen-
sation curves on [0; 2m] x [0; 2m] are also composed by reiterating the compensation curves
on the square [0; 2] X [0; 2]. Consequently, it suffices to show that the objective function
f(u;) + f(llj) is constant along the line tii + H] = 2. In fact,
f(Ui) + f(2 - 11,) = (Ui - 1)3 + 1 + (2 -lli - 1)3 +1= 2,

as required.

Consider another preference order ::5 9 on V induced by a continuous increasing separable

objective function
g(uJ, ... ,u n ) = til + ... + Un·
Obviously, the mentioned stright lines are also compensation curves of the preference order
-<9
Thus for any positive integer m there exist two different preference orders on an n-dimensional
parallelepiped associated with continuolls increasing separable objective functions which have
 236

m common compensation curves in each coordinate plane. Consequently, it is impossible to

reconstruct uniquely a separable objective function from these curves.

5 Applicability of the Algorithm Considered

Essential assumptions of theorem 1 are the existence of an unknown separable objective

function, and that the curves M; C UI X Ui, i = 2, ... , n, are level curves (indifference
curves, compensation curves) of such a function. In this connection the question emerges:
Are arbitrary curves, for example drawn by an expert, compatible with these assumptions?
The positive answer is given in the following theorem.

Theorem 3 (Admissibility of Arbitrary Compensation Curves). Let the curves

Mi C UI X Ui, i = 2, ... , n,

be the graphs of continuous decreasing functions

gi : UI -+ Ui , i = 2, ... , n,

and the curve

be the graph of a continuous decreasing function

where al < c < bi and gI(C) = g2(b I ), as in Fig. 2 top. Suppose that the curve MI lies below
M2! i.e.
gI(ud < g2(ud
for all UI E [aI; c). Then there exist continuous increasing functions II (UI), ... ,fn (un) on
UI , ... , Un! respectively! such that lvfI and 1'.12 are the level curves of the function fI(ud +
f2 (U2)! and Mi are the level curves of the functions fl (ud + Ii (u;) for all i, i = 3, ... , n.

The proof of this theorem is also given in the appendix.

Note that the algorithm described in section 3 can be modified in different ways. For example,
if it is not convenient to compare the first specification with others, the comparisons can
be carried out for other pairs of specifications. However, for our purposes it is necessary
to transfer the segmentation of UI and U2 obtained by means of the "staircase" to every
other axis. For that purpose it suffices to follow a certain tree of pairs of specifications,
transferring the obtained segmentation to all other axes by the corresponding compensation
curves. Estimating the accuracy of the approximation of the preference order may become
complicated, since to estimate h in the proof of theorem 1 we have to consider compositions
of oscillations.
 237

c = s~

1+t
o
.0
- I

Fig. 6. The construction of gl(u.) which approximates II(u.) by means of "saw teeth"

For example, if the compensation curves are given in the planes Ui - 1 x Ui, i = 2, ... , n, and
,,;)i(P) are the oscillations of !vIi as functions from Ui- I to Ui , i = 2, ... , n, then the estimate
of the accuracy of the constructed preference order looks like

Also note another modification of the algorithm for constructing separable objective func-
tions. Instead of constructing a "staircase" in the first step one can construct "saw teeth"
as follows .

lao Determine c = s1 E U2 and S~-I E UI to make (sf"-I,C) and (b"a2) indifferent with
respect to our preference. Then determine sf" -2 E U I to make (sf" -2, c) and (sf" -1, a2)
equivalent with respect to the preference, etc. (Fig. 6). In this way the segmentation

is determined so that the first component II (ut} of the unknown objective function
I( UI, ... ,un) = II (lld + ... + In (Un) increases by the same value along every segment
i. SIi+IJ ,Z. -- 1 , ••. , }'
[ SI' .. - 1.
 238

All other steps of the algorithm are the same as in section 3.

In designations of the proof of theorem 1, the Hausdorff distance between the preference
orders ~f and ~g is less than 3nh, where h is the length of the maximal segment [s~'; Sfi- 1]
and the maximum is taken over all ki and i. Since the separable objective function increases
by 1 along each of these segments, and since it is uniformly continuous on the parallelepiped
U, we obtain that h ~ 0 if s1 - sg ~ 0, i.e. if c ~ a2'
It is important that the convergence of the whole construction is determined by the conver-
gence of a single parameter which may be varied and measured with ease.

6 Conclusions and Further Problems

We have considered an algorithm for constructing approximations of a separable objective

function. According to our results, the features of this algorithm are the following:

• To approximate a separable objective function of n variables (characteristics, speci-

fications), only n indifference curves in n - 1 two-dimensional coordinate planes are
required. Moreover, it is not necessary to know these curves in their entirety; it suffices
to fix them in vertices of a "staircase" or of "saw teeth" and related points (theorem
1 and the remarks following theorem 3).

• A separable objective function of n variables can be uniquely reconstructed from a

converging sequence of indifference curves in one two-dimensional coordinate plane
and n - 2 indifference curves in the other n - 2 two-dimensional coordinate planes
(theorem 2). Since no finite number of compensation curves is sufficient for uniquely
reconstructing a separable objective function (example 1), the data required for the
uniquely reconstructing a separable objective function are minimal.

• Any input data are consistent with the formal assumptions of the model (theorem
3); consequently, no contradiction will arise in applications. Moreover, our approach
requires only ordinal information about preferences, so no cardinal information about
preferences is needed.

In conclusion let us discuss the applicability of our algorithm to constructing quadratic

objective functions
n n
J( Uj, ... ,un) = L ai u ; + L bijUiUj + L CiUi,
i=1 i'lj i=1

which are rather important in econometric studies (Chow 1981).

Firstly, note that a quadratic objective function without the terms biJUiUj, where i f= j, is
separable. Consequently, our procedure can be applied without adaptation to constructing
incomplete quadratic objective functions, i.e. quadratic objective functions without the terms
biJUiUJ' where i f= j.
 239

In the general case, such terms can be eliminated by a linear transform of the coordinates
which reduce the associated quadratic form to a simpler form involving square terms only,
see e.g. Rao (1973). However, the specifications of alternatives (old coordinates) may be
transformed into "factors" of their linear combinations. The main problem is therefore to
compare such factors with each other in order to construct compensation curves (indifference
curves).
According to our algorithm, an expert should answer questions whether he is indifferent
between certain combinations of specifications. In the case of a separable objective func-
tion these questions relate to pairs of specifications. In the case of a quadratic objective
function, more complex combinations of specifications should be considered. The role of the
computer is to help in determining these combinations for comparisons, and in constructing
an objective function from the obtained data.
The computer system may be provided with options for optimal decision making with respect
to the constructed objective [unction. Since our algorithm constructs a separable piecewise
linear objective function, some special optimization programs can be used (Jacquet-Lagreze,
Meziani & Slowinski 1987; Slowinski 1988). With regard to the obtained optimum, the
parameters of the model can be adjusted by recursive estimation in an interactive mode
to provide better consistency between the expert's intuition (subjective optimization) and
computed results. Finally, the objective function and the optimal solution can be determined.
The work with the comput.er can be organized as a series of questions to an expert about
his preferences (indifference) on certain possible combinations of specifications according to
our algorithm. After the expert has answered the questions, the computer can construct the
objective function and determine the optimal decision with respect to the objective function
constructed. If the expert is not satisfied with the computed optimal decision and can suggest
an alternative intuitive optimum, the computer might suggest necessary minor changes in
the expert's answers in order to make his rational answers consistent with his intuitive
judgement. After the expert has accepted certain changes, the objective function can be
constructed again, and the new optimal decision with respect to the corrected objective
function can be determined.

A decision making model can therefore consist of two interacting levels with a feedback.
At the upper level the data about the preferences of the expert are processed; at the lower
level the corresponding optimal decision is determined. The analysis of the optimal decision
can require preference adjustments at the upper level of the model. In turn the optimal
decision with respect to the adjusted preferences can be determined. To make the preferences
consistent with the decisions, several iterations may be needed.
Since the objective function is nothing but the formalization of goals, the decision model
can give a means to recognize and, if necessary, to revise real intentions of the expert, and
to find and to substantiate the optimal decision.
Certainly, to implement such an idea in a man-machine decision making system on a com-
puter, a lot of mathematical and programming work must be done.

The first step in future research could be an integrative review of the approach to constructing
scalar-valued objective functions presented in this paper and the one discussed in Husges &
Gruber (1991).
 240

7 Appendix: Proofs

PROOF OF THEOREM 1. Denote 5 11 = al and S~+1 = bi for every i, i = 2, ... , n. Put

and

for every i, i = 2, ... ,n. Let

S = Sl X ... X Sn,
i.e. S is the set of nodes of the network in the parallelepiped U, through which pass the
level hypersurfaces of the objective function f( Ul, . . . ,Un) = fl (ut} + ... + fn( Un) and of its
approximation g(Ul, ... , un) = gl(ud + ... + gn(u n ). The only uncertainty is inherent in the
boundary nodes of the network whose first coordinates equal to 5 11 , or the ith coordinates
equal to sF+1. When the upper stair constructed in the first item of the algorithm is in-
complete, the values of the objective functions at these boundary points are not determined
accurately, but estimated within 0 < ( < 1.
The idea of the following proof is based on the observation that S divides U into n(1( + 1)
small parallelepipeds, in vertices of which the values of the goal functions f and 9 are equal.
By strict monotonicity of the objective functions f and 9 the level hypersurfaces, passing
through the vertices of such a parallelepiped, cannot come out of it, which implies that
their difference is bounded by its size. All other level hypersurfaces are constrained by these
reference hypersurfaces, whence their deviations can be estimated. Finally, the distance
between the preference orders ~J and ~g is estimated from the maximal deviations of the
reference level hypersurfaces of the two preference orders.

Before we continue the proof, let us formulate an auxiliary proposition.

Lemma (Ordering Nodes of the Network). Let

S k -- S,
( 8 k) , ... , Sn
1
kn) E
sm = (s~l, ... ,s;;'n) E S.

PROOF OF LEMMA. Normalize the separable objective function f(u], ... ,u n ) = JI(ud +
... + fn (un) in order to make
fi(ai) = 0

for every i, i = 1, ... ,n, and

Then by our construction we have

 241

for all k, kl = 0, ... , K, where (= 0 if al = s?, and 0 < ( < 1 if al < s? Hence,

1,(s7') = kj

for k j = 0, ... , f{, and

1j(b;) = K +(
for i = 2, ... , K. Thus,

for any S~1 E 51, and

k - 1 < j·(sk i )
1 _ t I <k
_ t

for any s7 E 5 j , i = 2, ... , n. Therefore,

i

for any (s~', . .. , s~n) E 5.

Hence,

and

Since by assumption

we obtain

or sk ~f sm. The same is valid for ~9, hence sk ~9 sm, as required.

CONTINUATION OF THE PROOF OF THEOREM 1. For every i, i = 1, ... , n, denote

hj = max {I Siki -
ki-I
Sj
I} ,
3~1 ESj

and put

Let U = (Uh ... ' un) E U and v = (VI, ... , v n ) E U be such that U ~f v. We shall show that
there exist sk, sm E S such that

p(U,Sk):::; (n + y'n)h,
p(v, sm) :::; (n + y'n)h,

where p is the distance in n-dimensional Euclidian space En and sk -:5. 9 sm. For this purpose
we take Sk', Sm' E S such that U E [sk'; sk'+eJ and V E [sm'-e; sm'], where [sk'; sk'+eJ denotes
a small parallelepiped with the diagonal vertices indexed by k' = (k~, ... , k~) and k' + e =
(k~ + 1, ... ,k~ + 1), i.e.

k' k'+e]
[s;s ={
u=(UI, ... ,U n ) k' k'+1
:Sj':::;Uj:::;s' ,i=l, ... ,n }
 242

u
k'
S

sm

nt'
S

. m'-e
.S
a1 = s~
C
a I = ""I ,<? .5: >
~i .< .~

Fig. I. Illustration to the proof of theorem 1

(Fig. 7). The parallelepiped [sm'-o; sm'] is defined similarly. Since -:5. 1 is strictly monotone,

and

Note that Sk' -:5. 1 sm' (otherwise v -:5. 1 sm' ~1 Sk' -:5. 1 u, hence v ~1 u, against the assumption).
Therefore,
k~ + ... + k~ - n ::; m; + ... + m~

(otherwise, m~ + ... + m~ + n < k; + ... + k~ , consequently, by increase of f (U1, ..• , un)

with respect to every Ui, and by virtue of lemma we get sm' ~f sk', against the obtained
relation). Take a collection of indices

such that

and
k1 + ... + k n = k~ + ... + k~ - n.
If there is no such k, take
1.:=(-1,0, ... ,0) ,
 243

i.e. let

Similarly, take a collection of indices

such that
m~ :::; mi, i = 1, .. , n,

and
ml + ... + mn = m~ + ... + m~ + n.
If there is no such m, take
m = (J(,J( + 1, ... ,J( + 1),
i.e. let
Sm = b = (b l , ... , bn ) .
If Sk = a, or sm = b, then by increase of 9 we get sk -<.g sm; otherwise, taking into account
the above proof and the definition of k and m, we have

kl + ... + k
n = k; + ... + k~ - n :::; m~ + ... + m~ = nIl + ... + nI n - n,

whence, by the lemma we obtain sk :? sm.

According to our construction,

k
p(u,s) < p(u.s k' )+p(s k' ,s)
k

< (hi+ .. ·+h;)1/2+nh

< vnh + nh
(n + vn)h.
Similarly,

Con versely, for any u, v E U such that u ~g v there exist sk, sm E S such that

p(U,Sk):::; (n + .;n)h,
p(v,sm):::; (Il + vn)h,

and sk ~f sm. Therefore, the Hausdorff distance between ~f and ~g in E 2n is not greater
t.han

Finally, note that hi :::; p and hi :::; ""'i(hd for every i = 2, ... , n, whence

its required.
 244

<k+2
<2

U;+I [
Sk+1
2
~r;
:
[ Sk

Uf [
.2

S~ = a2

Fig. S. Illustration to the proof of theorem 3

PROOF OF THEOREM 3. Construct a "staircase" between the curves MI and M2 as shown

in Fig. 8, i.e. determine a positive integer J( and two collections of J( + 1 points each on U\
and U2 :

Such a construction is possible and unambiguous, since the functions gl(ud and g2(UI) are
continuous and decreasing. The number 1( is finite, because gl (u\) < g2( UI) for all u\ E [at; c]
implies
inf 1y' - y" 1= t > O.
y',y" EU,:(y' ,z)EM, ,(y" ,z)EIIf2 ,zEU2

Hence, the differences s~ - s~-\ > t for every k; consequently, J( cannot be infinite.

Define continuous increasing functions II (1(1) on U\ and h( 1(2) on U2 such that

II(ud + 12(U2) = 0 if (UI,U2) E M I ,

II(ud +/2(U2) = 1 if(uI,u2) E iV[2.
For every k, k = 0, .. ,,1(, denote
U \k -- [Sk-I'sk]
I '1

and
 245

The following construction we realize by induction on k.

1. Define a continuous increasing function it (ud on U{ such that

Since 92( ud E U~ for UI E U{, the continuous increasing function

is defined for all U2 E U~. Obviously,

and

2. Suppose that for a non-negative integer k < f{ the continuous increasing functions
fl(UI) on U{-k and !2(U2) on U;, satisfying the conditions

have already been constructed, and also

fl(Ud + !2(U2) = 0 if (UI,U2) E M I,

h(ud + !2(U2) = 1 if (UI' U2) E J'vI2.

3. Since 91(Ul) E U; for UI E U{'-k-I, by the previous item the continuous increasing
function
fl(ud = -f2(91(UI))
is defined for all UI E U{-k-I, and

Since 92( UI) E U;+I for HI E [:/" -k-I, the continuous increasing function
 246

is defined for all U2 E U;+ 1, and

f2(s~+1) =1- fl(g21(S~+1)) =1- fl(sr- k - 1 ) = 1 + k,

h(S~+2) =1- !t(g2 (S;+2))
1 = 1- h(sr- k- 2) = k + 2.

This way the continuous increasing functions fl(ud on UI and f2(u2) on U2 can be
constructed.

For every i, i = 3, ... ,n, define the continuous increasing function

on Ui . Obviously, if (UI' u;) E M i , then

as required.

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Optimal dictatorial and multi-dictatorial choice in
Arrow's model with applications to multicriteria deci-
sion making

Andranick S. Tanguiane
Computing Centre of the USSR Academy of Sciences,
40 Vavilov Street, 117333 Moscow, USSR

Abstract

The capability of a given individual to represent the preference of other individuals in a

collective choice model is characterized by two quantitative indicators of representativeness.
We prove that there always exists an individual who, on average, represents a majority, and
an individual who represents a majority in more than 50% of all possible cases.

We apply this result to Arrow's collective choice model and revise Arrow's paradox. It
follows that there always exists a dictator who is a representative of the collective rather
than a dictator in a proper sense. The refinement of the concept of a dictator leads to the
consistency of Arrow's axioms.
Besides single representatives, we consider the cabinet (named by analogy with a cabinet
of ministers) which consists of a few dictators with delimited domains of competence. We
show that the representativeness of optimal cabinets tends to 100%-values with the increase
in their size, not depending on the size of the collective. We suggest a geometric interpre-
tation of optimal dictators and cabinets. It is based on the approximation formulas for the
indicators of representativeness derived for the model with independent individuals. Finally,
for cabinets we establish the consistency of different concepts of optimality, resulting from
the use of different indicators of representativeness.

Our model has applications to multicriteria decision making. The appointment of a cabinet
corresponds to the selection of a few partial criteria. Therefore, our results can be used for
the reduction of the set of criteria to a certain sufficient minimum.

Keywords: Arrow's collective choice model; collective choice; multicriteria decision making;
dictator; representative; cabinet; mathematical theory of democracy.

Contents

1 Introduction

2 Definitions

3 Main Results
 249

4 Independent Individuals and Geometric Interpretation

5 Discussion of the Results

6 Conclusions

References

1 Introduction

In the present paper a possibility to overcome Arrow's paradox in social choice is discussed.
K.Arrow (1951) proved that under certain assumptions the collective choice is determined by
an individual, called a dictator. To overcome Arrow's paradox, two different approaches have
been suggested. Usually, Arrow's conditions are interpreted quite restrictively. Therefore, to
overcome the paradox, it is possible to omit one of the conditions, or weaken their formulation
(see Kelly (1978) for several variants of Arrow's theorem). Another approach was developed
for the model with an infinite set of individuals interpreted as a large collective. For such
a model Fishburn (1970) proved that the dictator may disappear. However, Kirman &
Sondermann (1972) showed that in the infinite model the dictatorial origin is still present
but in an indirect form, being realized by coalitions grouped around an "invisible" dictator.
In Schmitz (1977), Armstrong (1980, 1985), and Fishburn (1987) it is established that the
dictator makes decisions together with certain deciding coalitions. These coalitions form a
kind of deciding hierarchy (Tanguiane 1980).
The definition of a dictator doesn't specify whether the dictator compels other individuals
to bend to his will, or whether the collective preference is formed in the first turn, and
only afterwards an individual who shares this preference is found out. Nevertheless, the
interpretation of the concept of a dictator in Arrow's model depends on what we put first--
dictatorial or collective preferences. The former possibility corresponds to our understanding
of dictatorship in a common sense and the latter possibility meets the interpretation of a
dictator as a representative of the collecti ve.

The present paper and other publications (Tanguiane 1989a,b; 1991a-c) are devoted to the
analysis of the latter possibility, i.e. to the interpretation of a dictator as a representative.
As follows from the cited works, the dictator may be considered as a representative of the
deciding coalitions. The problem therefore is to estimate their weight and show whether the
dictator can be interpreted as a representative of the whole collective.
For this purpose we define probability measures on the elements of Arrow's model which are
interpreted as the weight of coalitions, and the probability of different cases in decision mak-
ing. For arbitrary measures we show that a dictator can be appointed to express a majority
preference in most cases. Owing to the interpretation of a dictator as a representative, we
can speak about overcoming Arrow's paradox. The paradox can be regarded as the result of
an excess of information in Arrow's model, which comes into contradiction with itself. An
excess of information can be caused either by an excess of rules with which the contradictive
 250

information is deduced, or by an extended treatment of basic concepts, as in "naive" set

theory. The former case is interpreted as the necessity to eliminate one of Arrow's axioms.
The latter case leads to the revision of the concept of a dictator .which, as we prove, is
understood in an extended way. In this connection it is recalled that paradoxes of the set
theory have been overcome by means of a refinement of the concept of a set itself.

To be more precise, we introduce quantitative indicators of representativeness, and prove

that with respect to these indicators there always exist dictator-representatives which we
don't consider as dictators in a proper sense and to whom we don't apply Arrow's axiom
about the prohibition of dictatorship. Thus we obtain the consistency of Arrow's axioms.

However, even for an optimal representative, the part of cases, when his preference contra-
dicts that of a majority, can be quite significant. In this connection the question emerges,
whether it is possible to take a few representatives and to delimit their competence in such
a way that the decisions of the resulting "cabinet" (named by analogy with the cabinet of
ministers) would meet the majority preference in all, or almost all situations.
In section 2, "Definitions", we introduce two quantitative indicators of representativeness of
individuals: The average representativeness (the mathematical expectation of the weight of
the coalition represented by the given individual), and the majority representativeness (the
probability of the event when the given individual represents a majority). Then we introduce
the concept of a cabinet which is a multi-dictatorial representation with delimited domains
of competence. This concept generalises the concept of a single dictator.
In section 3, "Main Results", we estimate the saturation of cabinets (understood as the
closeness of indicators of representativeness to their maximal possible values). In particular,
we show that for every positive integer k there exists a cabinet with k members such that
the part of the cases when it represents a majority is greater than 1 - 2- k . For example,
it is always possible to find a cabinet with 7 members, representing a majority in at least
(1- 2- 7 ) ·100% > 99% of all cases, and with 10 members, representing a majority in at least
99.9% of all cases. We also formulate corollaries for single individuals. It follows that there
always exist individuals who can be representatives of the collective rather than dictators in
a proper sense. Restricting the prohibition of dictators to dictators in a proper sense, we
obtain the consistency of Arrow's axioms and overcome Arrow's paradox.
In section 4, "Independent Individuals and Geometric Interpretation", we consider a model
with a large number of individuals with independent preferences. Owing to the indepen-
dence, we can use the law of large numbers to derive simple approximation formulas for the
indicators of representativeness. Using these formulas, we suggest a geometric interpretation
of our model. The individuals and cabinets are associated with the vectors of their chacter-
istics, and it is shown that the vectors associated with the optimal dictators and cabinets
provide maximal projections on certain characteristic vectors of the collective. We also prove
that cabinets which are optimal with respect to one indicator of representativeness are at
the same time almost optimal with respect to the other indicator. This way the ambiguity
in understanding optimal representation, inherent in single representatives, is overcome for
cabinets.

In section 5, "Discussion of the Results", some general remarks and observations concerning
the interpretation of our model are outlined. In the final section 6, "Conclusions", the
 251

contents of our study are summarized.

Note the applicability of our model to multicriteria choice. The appointment of a cabinet
corresponds to the selection of a few partial criteria out of a large number of criteria. In
other words, we speak of the reduction of the set of criteria to their sufficient minimum.
In particular, our results imply that for practical purposes, when the reliability of decisions
is limited by the reliability of the information to 99-99.9%, it is unnecessary to take into
account the totali ty of the data, since 7-10 properly selected factors can be qui te sufficient. It
also meets the experimentally established human capabilities to take into account not more
than 7-9 factors in decision making (Larichev 1979). In a sense, this property is analogous
to the situation in computing, when there is no need to perform 64-bit arithmetics, if the
accuracy of the data is within 8 digits.

2 Definitions

In the present section we define a collective choice model and introduce indicators of represen-
tativeness. We refer to such common basic concepts as individuals, coalitions, alternatives,
preferences, using the designations from (Fishburn 1970; Kirman & Sondermann 1972; Tan-
guiane 1980). In addition, we also consider three probability measures on the elements of
the model and introduce the concept of a cabinet.
By V we shall denote a finite set of individuals, called the collective. In the present paper
any subset of the collective A C V is said to be a coalition. For simplicity, we restrict our
consideration to the discrete finite case, although our results are also true for an infinite set
of individuals with a countable coalition Boolean algebra (Tanguiane 1991a).
To distinguish between majority and minority, we define a probability measure f.1 on V. By
f.1( v) we denote the weight of individual v E V; by p( A) we denote the weight of coalition
A C V. Since we refer to a probability measure, the weight of a coalition can be understood
as the percentage of the total number of individuals. Obviollsly, the collective V has the
weight 100%, and the weight of a non-strict majority is greater than or equal to .50%.
Let X be a finite set of alternatives. In social choice the alternatives may be candidates for
the president, different social programs, particular important decisions as "war", "peace",
"20% income tax", "2.5% income tax", etc. In multicriteria choice they may be competitive
projects, different models of cars to be bought, vectors of quantities of consumer products
delivered to certain regions, school-graduates entering the university, etc. Detailed examples
of alternatives and further references one can find in Gruber (1983) and Hwang & Lin (1987).
Let P = {P} be the class of weak orders P on X. A weak order P on X is defined to be an
asymmetric and negatively transitive binary relation on X, i.e. (.f, y) E P =} (y, x) tt. P and
(x,y) tt. P & (y,z) tt. P =} (x,z) tt. P. In this case the notation (x,y) E P means that x is
preferred to y. For example, the relation "x is cheaper than y" is a preference.
To specify the probability that a given pair of alternatives (x, y) will be considered in decision
making, i.e. it will be judged whether x should be preferred to y, deflne a probability measure
( on X x X. The measure ( can be also interpreted as the significance of decisions on the
 252

pairs of alternatives. If ~(x,y) > 0, the pair of alternatives (x,y) is said to be significant.
A situation, or profile, is defined to be a combination of individual preferences, i.e. a mapping
f: V -+ P, for each individual l' E V, putting into correspondence his preference f(v) E P.
By F we denote the set of all situations.
Since F is finite, we can define a probability measure v on F to characterize the forecasts
on individual preferences. We interpret the value v(J) as the probability of situation f.
Consider the sample space
n=XxXxF.
A simple event is therefore "a pair of alternatives and a situation":

w = (x,y,j).

The probability measure P on n is defined to be the product of the measures ~ and v:

P=~®v

which we interpret as the probability of different cases in decision making.

Each simple event w = (x, y, j) determines a division of the collective V into two coalitions
(one of which may be empty) by preferences on the pair (x, y) under the situation f. We
denote them by

Aw = Aryl = {v: v E V, (x,y) E f(v)}; (1)

A~ = A~YI = {v: V E V, (x,y) t/:. f(v)}.

The first coalition consists of the individuals who prefer x to y under the situation f. The
second coalition consists of the individuals who don't prefer x to y under the situation f.
Fix an individual v. Since he belongs to one of these coalitions, we can consider him as a
representative of the coalition to which he belongs and whose preference on the given pair
of alternatives under the given situation he shares. The measure of his representativeness is
the weight of the given coalition. We denote it by

( ) ( f) r(Aw) if v E A w ,
m v,w = m V,X,y, =
{ r(A~) = 1- r(Aw) if v E A~, (2)

and call it the representativeness of individual v for event w. Note that since {L(V) = 1, the
value m(v,w) is the part (percentage) of the individuals represented by v for event w.

Now suppose that simple events (pairs of alternatives and situations) are taken randomly.
In this case the individual v represents a certain coalition for each simple event, and for each
simple event he has a certain magnitude of representativeness, associated with the weight
of the represented coalition. This way we define a random variable on n. We call it the
representativeness of individual v and denote it by

m(v) = m(v,w) = m(v,x,y,f).

To characterize the representativeness of individuals, we introduce two indicators of repre-
sentativeness.
 253

The average representativeness of individual v is the mathematical expectation of his repre-

sen tativeness:
Em(v) = L P(w)m(v,w).
wEn

The majority representativeness of individual v IS the probability of the event when the
individual v represents a majority:

Mm(v) = P{w: wE n,m(v,w) ~ 1/2}.

An individual v is called a dictator-representative lEith resepect to the average representa-

tiveness if on average he represents a majority:

Em(v) ~ 1/2,

otherwise he is called a proper dictator with respect to the given indicator.

An individual v is called a dictator-representative with resepect to the majority representa-

tiveness if on average he represents a majority:

Mm(v) ~ 1/2,

otherwise he is called a proper dictator with respect to the given indicator.

A generalisation of a single dictator is a cabinet, i.e. a limited group of individuals who
make decisions on behalf of the whole collective. Each cabinet member, by analogy with the
cabinet of ministers, makes decisions in the prescribed cases. Entrusting certain decisions to
certain cabinet members, we mean that the sample space n of "decisions under situations"
is divided into "domains of competence" of the cabinet members, in which they make deci-
sions as dictators. We can say that a cabinet is a multi-dicatorial structure with delimited
competence. Obviously, the representativeness of a cabinet, i.e. its capability to represent
a majority preference, depends both on its members and the delimitation of competence
between them. The aim of the cabinet is to represent a majority preference in the best way.
Therefore, the delimitation of "competence" is always supposed to be the most rational for
the given cabinet, i.e. providing the maximal representativeness of the given cabinet as a
whole.

Bya cabinet with k members we understand a set of cabinet members ~V = {VI, ... , vd c V.
We suppose that for every simple event w = (x, y, 1) the cabinet VV accepts or rejects the
decision "x is preferred to y", entrusting it to the member with the highest representativeness
for the given event. Therefore, the representativeness of cabinet W is defined to be the
random variable
(3)

where m(v,w) is the individual representativeness of cabinet member v defined in (1)-(2).

The average representativeness of cabinet VV is the mathematical expectation of its repre-

sen tativeness:
Emk(W) = L P(w) mk(n",W).
wEn
 254

The majority representativeness of cabinet W is the probability of the event when the cabinet
W represents a majority:

Mmk(W) = P{w : wEn, mk(W,w,f) ~ 1/2}.

A cabinet ~V* = (v~, ... , vi;) E V k is called optimal with respect to the average representa-
tiveness if it has the greatest average representativeness among the cabinets with the same
number of members, i.e. for all WE V k it holds

Similarly, an individual v* E V who has the greatest average representativeness is called an

optimal dictator with respect to the average representativeness.

A cabinet W" = (v~·, ... , vZ*) E V k is called optimal with respect to the majority repre-
sentativeness if it has the greatest majority representativeness among the cabinets with the
same number of members, i.e. for all WE V k it holds

Similarly, an individual v** E V who has the greatest majority representativeness is called
an optimal dictator with respect to the majority representativeness.

From (3) it follows that the representativeness of cabinets increases while adjoining new
members. To characterize the saturation of cabinets, we shall compare their representa-
tiveness with the representativeness of the maximal possible cabinet which consists of the
whole collective V. Obviously, for every simple event w such a cabinet represents a majority.
Its average representativeness will be denoted by Em(V). One can see that its majority
representativeness Mm(V) is equal to 1.

3 Main Results

In the present section we show that the indicators of representativeness of optimal cabinets
with k members tend to their maximal values at the speed of the exponent 2- k • We shall
also formulate corollaries for single dictators with applications to Arrow's paradox.

Theorem 1 (Representativeness of Optimal Cabinets) Consider arbitrary measures

J-l on V and P on w, and let W* and ~V" be the cabinets with k members optimal with respect
to average and majority representativeness, respectively. Then th e saturation of optimal
cabinets is characterized by the following inequalities:

Emk(W*) ~ 1/2,
1
Emk(W*) ~ Em( V) - 2- kk- 1 (1 - k + 1 )k+l,
Mmk(W") > 1-2-k.
 255

In particular, an optimal cabinet with only k = 4 members has the average representativeness
greater than 99.5% of its maximal possible value. It means that already four members almost
saturate the cabinet with respect to the average representativeness. One can see that the
saturation of optimal cabinets with respect to the majority representativeness is somewhat
slower than with respect to the average representativeness. However, the interpretation of
the saturation estimate is more clear. We can say that an optimal cabinet with k = 7
members represents a majority more often than in 99% of all simple events.

Theorem 2 (Existence of Dictator-Representatives) Consider arbitrary measures If-

on V and P on w, and let v' and v" be the optimal dictators with respect to average and
majority representativeness, respectively. Then it holds:

Emk(V') ~ 1/2, (4)

Mmk(V") > 1/2.

Recall that Arrow's paradox (1951) is a theorem about the inconsistency of the following
five axioms.

Al (Number of alternatives) X contains three elements at least.

A2 (Universality) For any situation f E F there exists a collective preference aU) E P.

A3 (Unanimity) If all individuals prefer one alternative to another, then the first one is
also preferable for the collective, i.e. if under situation f E F it holds (x, y) E f( v) for
all v E V, then (x, y) E aU).

A4 (Independence of Irrelevant Alternatives) If two situations f,g E F coincide on

a pair of alternatives (x,y) E X x X, i.e.
f(v) n {(x,y)} = g(v) n {(x,y)}
for all individuals v E V, then the associated collective preferences coincide on this
pair of alternatives, i.e.

aU) n {(x,y)} = a(g) n {(x,y)}.

AS (Prohibition of Dictatorship) There must be no dictator who determines the col-

lective choice, i.e. there must be no individual v E V such that f( v) C aU) for all
situations f E F.

A mapping a : F ~ P which satisfies axioms A 1-A4 is called Arrow's social welfare function.

From the standpoint of our consideration a general prohibition of dictatorship turns out
to be rather rough. Indeed, the common meaning of the word "dictator" implies that his
decisions contradict interests of other individuals. If he expresses opinions of large coalitions,
he should be called a representative and shouldn't be prohibited. Owing to the indicators of
representati veness, we can distinguish between proper dictators and dictator-representatives
whose prohibition we cannot justify. In other words, we refine the concept of a dictator to
a proper dictator, not considering dictator-representatives as dictators. Taking into account
these arguments, we reformulate Arrow's axiom AS.
 256

A5a (Prohibition of Proper Dictators) There must be no proper dictator with respect
to the average representativeness, i.e. there must be no individual v E V such that
Em(v) < 1/2 and f(v) C O"(J) for all situations f E F.

Take an optimal dictator v· E V and determine Arrow's social welfare function by the rule

O"(J) = f(v·)

for all situations f E F. By (4) the dictator v· is a dictator-representative, consequently,

under 0" there is no proper dictator. Thus we obtain the following proposition.

Theorem 3 (Overcoming Arrow's Paradox) W7wtever the measures f.l on V and P on

n are, the axioms A1-A5a are consistent.

Note that we could overcome Arrow's paradox, referring not to average but to majority
representativeness.
Comparing Arrow's formulation with ours, one can notice that our model assumes the ex-
istence of certain probability measures, whereas Arrow's model doesn't. In particular, one
can ask whether theorem 3 really overcomes Arrow's paradox. \Ve can consider the measures
used as some additional information about the individuals and their preferences, always in-
herent in real situations. Theorem 2 is valid for arbitrary measures, implying the potential
existence of an appropriate representative, even if these measures are not known. This is
analogous to the theory of differential equations where the existence of the solution can be
proved, but its analytical expression may be not found. Similarly, theorem 3 implies the
potential existence of a non-dictatorial social welfare function, even if we cannot determine
it. Certainly, we overcome Arrow's paradox at the level of its interpretation, not revising
the mathematical result.

It is noteworthy that an assumption about the existence of an appropriate representative

(not evident at all) justifies entrusting the collective decisions to elected individuals. If there
were no appropriate representatives, or if they existed only under special conditions, the
very idea of elections would be doubtful. However, the elections are widely used with no
doubt in their justice. This means that in practice Arrow's paradox doesn't arise, and we
only suggest some formal explanations.

In the light of our consideration one can ask why our approach to overcoming Arrow's
paradox wasn't proposed earlier. Probably, the cause is the common understanding of de-
ciding coalitions as consisting of individuals sharing the dictatorial preference (Kirman &
Sondermann 1972; Schmitz 1977; Armstrong 1980, 1985; Tanguiane 1980). Identifying the
dictator's representativeness with the weight of such coalitions, we can see that it is too
small to interpret dictators as representatives. Our approach is much more refined, since we
consider the deciding coalitions with respect to each pair of alternatives, but not with respect
to preferences. To explain it in simple words, one can imagine a president who shares the
preference of all peasants with respect to one decision, of all workers with respect to another
decision, etc. Nevertheless, as a whole program, his decisions (described by his preference)
may meet no appreciation of these coalitions. Obviously, then he represents a large coalition
 257

with respect to each particular decision, and no coalition with respect to his preference as a
whole. Thus, defining deciding coalitions with respect to pairs of alternatives, we take into
account the individual representativeness in the most complete form.

4 Independent Individuals and Geometric Interpre-

tation

As in most probability models, the most interesting results can be obtained for independent
events. The assumption of independence implies the validity of the law of large numbers
which is useful for the description of sums of random variables. In our case we assume the
independence of individuals, meaning that they can choose their preferences independently.

Individuals Vb . •. ,Vn E V are said to be independent, if for arbitrary preferences PI,· .. , Pn

which are not necessarily pairwise different it holds
n
v{J: f E F, f(vI) = PI, ... , f(v n ) = Pn } = II v{J : f E F, f(Vi) = Pd·
i=1

For the model with independent individuals we use the following designations.
Fix a pair of alternatives (x,y). The preference probability of individual V on a pair of
alternatives (x,y) is defined as the probability that the individual v prefers x to y. This
probability is denoted by

Pry(V) = v{J: f E F, (x,y) E f(v)}. (5)

The mean probability that a "typical" individual prefers x to y is denoted by

Pry = "L p,(v) Pry(v). (6)

vEV

To simplify the formulation of further results, define the characteristic of individual v to be

( )={ Pxy(v) -1/2 if Pry -I- 1/2, (7)

Cxy V 0 if Pxy = 1/2.

Denote the probability that all members of cabinet W prefer x to y, and that they don't
prefer x to y, respectively, by

II PXy(v),
vEW

II (1 - PXy(v)).
vEW

The characteristic of cabinet W is defined to be

PXy(W) - 1/2 if Pxy < 1/2,

cxy(W) = { 1/2 - Pxy(W)/2 - qxy(~V)/2 if Pxy = 1/2, (8)
1/2 - qxy(W) if Pry> 1/2.
 258

It is easy to verify that the characteristic vector of a cabinet W with a single member v
coincides with the characteristic vector of the individual v.

The mean characteristic and its sign are denoted, respectively, by

Pry - 1/2, (9)

{ -II if Cxy < 0, (10)

if Cxy 2': o.

To introduce vector designations, enumerate significant pairs of alternatives (such that

~(x,y) > 0) by the numbers k = 1, ... , J(. Below we shall use the index k instead of writing
a pair of alternatives. For example, if (x, y) has the number k, we shall write ~k = ~(x, y).

Define c( v) to be the characteristic vector of individual v E V, with its coordinates being

Ck(V)= cxy(v) defined in (7), i.e. put
(11 )
Therefore, c( v) is a vector of Euclidean space of dimension J(, where J( is the number of
significant pairs of alternatives.

Similarly, define the vectors of the same dimension:

c(W) = {Ck(W)} = {CXy(W)} the characteristic vector of cabinet W, (12)

C = {cd = {Cxy} the mean characteristic vector, (13)
S = {sd = {sry} the sign vector. (14)

By E denote a diagonal matrix of size J( x [{, with the diagonal elements being ~k
> 0:
~(x,y)

E = ( ;' .~, ~ ~.
. .. : : : .. ) (15)
o 0 0 ... ~K

Finally, denote the scalar product of vectors of the considered vector space by

( , ).

Theorem 4 (Representativeness of Cabinets for Independent Individuals) Con-

sider a model with a sufficiently large number n of individuals, each with a sufficiently small
weight. Suppose that all the individuals are independent and Pry =1= 0.5 for all significant
pairs of alternatives (x, y) E X x X. Then for all cabinets W C V with k members we have
in the designations (8)-(15):

Emk(W) ~ 1/2 +2 L ~(x, y) Cxy cxy(W) = 1/2 + 2(Ec, c(W)), (16)

(x,y)EXxX
L ~(x, y) Sxy cxy(W) = 1/2 + (E s, c(W)). ( 17)
(x,y)EXxX
where the accuracy of approximation increases with n regardless of the choice of cabinet W
in (16) and (17).
 259

Theorem 5 (Representativeness of Dictators for Independent Individuals) Con-

sider a model with a sufficiently large number n of individuals, each with a sufficiently small
weight. Suppose that all the individuals are independent and Pxy =I- 0.5 for all significant
pairs of alternatives (x,y) E X x X. Then for all individuals v E V we have

Emk(v) ~ 1/2 + 2 L ~(x,y) Cxy Cxy(v) = 1/2 + 2(3c, c(v)), (18)

(x,y)EXXX
Mmk(V) ~ 1/2 + L ~(x, y) Sxy cxy(v) = 1/2 + (3s, c(v)). (19)
(x,y)EXXX

where the accuracy of approximation increases with n regardless of the choice of individual
v in (18) and (19).

The above approximation formulas result from the application of the law of large numbers
to our model, and the larger the collective is, the more accurate is the approximation. The
formula (16) implies that, within the accuracy of approximation, the cabinet W whose vector
c(W) provides the maximal projection onto the vector e under the linear transform 3 is
the optimal cabinet with respect to the average representativeness. Similarly, from formula
(17) it follows that the optimal cabinet with respect to the majority representativeness is
the cabinet W whose vector c(W) provides the maximal projection onto the vector sunder
the linear transform 3. The same relates to dictators.
Note that each coordinate of the vector s has the same sign as the corresponding coordinate
of the vector c. Therefore, sand e belong to the same multidimensional angle, bounded by
the coordinate hyperplanes (quadrant if these vectors are two-dimensional). Since all the
elements of the diagonal matrix 3 are positive, the vectors 3e and 3s are also located in
the same multidimensional angle as e and s. Therefore, the angles between all these vectors
cannot exceed 90°. Consequently, the posi ti ve half-spaces determined by the hyperplanes
passing through a with normals 3c and 3s have a non-empty intersection, containing the
whole multidimensional angle mentioned. Since these hyperplanes, within the accuracy of
approximation, separate the characteristic vectors c( v) of dictator-representatives from that
of proper dictators, we obtain the following proposition.

Theorem 6 (Condition of Consistency of Two Definitions of Optimal Dictator

and Dictator-Representative) Under the assumptions of theorem 5 the following state-
ments are valid within the accuracy of approximations (18) and (19):

(a) A n individual v is a dictator-representative with respect to average and majority rep-

resentativeness simultaneously if and only if

(3c,c(v)) 2: 0, (20)
(3s,c(v)) 2: O. (21)

(b) If vectors 3e and 3s are collinear, then the optimal dictator with respect to one
indicator of representativeness is also optimal with respect to the other indicatcr.
 260

Let us show that the collinearity of the vectors Bc and Bs in the formulation of theorem 6
is essential.

Example 1 (Inconsistency of Two Definitions of Dictator-Representative) Consider

a set V of n independent individuals, having equal weights J.l( v) = lin, where n is sufficiently
large. Let V = VI U V2 , where J.l(V!) = J.l(~) = 1. Suppose that X = {x,y,z} and
~(x,y) = ~(x,z) = 1. Fix four preferences

PI = 0, P2 = {( x , y)} , P3 = {( x , z)} , P4 = {( x, y), (x, z)}.

For every VI E V!, V2 E V2 we put

PI(VI) = 0.02, P2(Vl) = 0, P3(vd = 0.68, P4(Vl) = 0.30

PI(V2) = 0.06, P2(V2) = 0.90, P3(V2) = 0, P4(V2) = 0.04.

Referring to designations (5)-( 14), we obtain

Pry(Vl) = 0.30, Prz(vd = 0.98, i.e. C(Vl) = (-0.20,0.48),

Pry( V2) 0.94, pxz( V2) = 0.04, i.e. c( V2) = (0.44, -0.46),
Pry = 0.62, Pxz = 0.51, I.e. C = (0.12,0.01), s=(I,I).

The vector space for our example is shown in fig. 1. Since only two pairs of alternatives
are significant, the dimension of our vector space is f{ = 2. Since these two pairs are
equisignificant, the matrix

~
=,=(10 1 0)=~(1
201 0) '
2

In fig. lone can see the characteristic vectors c( vd and c( V2) of individuals VI E VI and
V2 E V2 , the mean characteristic vector 2c, and the sign vector !s.
Since all the assumptions of theorem 5 are satisfied, by (18)-(19) we have

Em( VI) ~ 1/2 + CXyCxy ( vd + cxzcxz ( vd = 0.4808,

1 1
Mm(vd ~ 1/2 + 2sXycXy(vl) + 2sxzcxz(vd = 0.6400,

and, similarly,

Em(V2) ~ 0.5482,
Mm(v2) ~ 0.4900.

Comparing the obtained values Em(vd, Mm(vl), Em(v2)' and Mm(v2), we see that in our
example every individual is an optimal dictator with respect to one indicator of represen-
tativeness, but not a dictator-representative with respect to the other indicator, which is
even weaker than an optimal dictator. To show this graphically, two dotted lines, passing
through 0, with the normals C and s, respectively, are drawn in fig. 1. These lines sepa-
rate the space of characteristic vectors c( v) into the half-planes of that of proper dictators,
and dictator-representatives with respect to each indicator (cf. with (20)-(21)). The dotted
domains correspond to the vectors C(Vl), C(V2) which are inconsistent with the system of
 261

Fig. 1. Geometric interpretation of dictators from example 1

inequalities (20)-(21) for the given vector c, binding C(VI), C(V2) by virtue of (6) and (9) as
follows:

which is equivalent to

We can conclude that our two definitions of dictator-representatives (with respect to the
two indicators) are inconsistent in rather specific cases, when the following conditions hold
simultaneously:

(a) The angle between the vectors C and s is close to 45° (since s is the bisectrix of the
multidimentional angle to which belongs the vector c).

(b) The absolute value of the vector C is small , otherwise the dotted domain is outside the
domain of admissible characteristic vectors restricted by the inequalities I cxy ( v) I::; 0.5
(by virtue of (9) and the property of probabilities 0 :::: Pry:::: 1).

(c) The individual preferences are antipodal: Pxy(vtl is small for VI E VI, whereas Pry(V2)
 262

is great for V2 E V2, and, conversely, Pxz( vI) is great for VI E VI, whereas Pxz( V2) IS

small for V2 E V;.

To satisfy the above conditions, the characteristic vectors c(v) must have a quite special
localization. When the characteristic vectors c( v) are widely scattered, we can expect the
existence of the desired dictator-representative with respect to both indicators. In any case,
an individual v with the characteristic vector c(v) from the same multidimensional angle as
c, is the dictator-representative with respect to both indicators of representativeness.
As seen from example 1, our two indicators of representativeness may result in the ambiguity
of an optimal representative (with respect to average and majority representativeness). In
theorem 6 we have formulated the conditions for the consistency of the two definitions of
optimality, which are not inherent in the general case. As shown below, the problem can be
solved for large cabinets.
It follows from theorem 6 and example 1 that for single dictators the consistency of our two
definitions of optimality is true only for the one-dimensional space of preference probability
vectors p = {PXy(v)} which arises when only one pair of alternatives is significant. The
consideration of cabinets, in other words, the increase in the dimension of the space of
representation allows us to extend this result to the multidimensional space of preference
probabili ty vectors.

Theorem 7 (Consistency of Two Definitions of Optimal Cabinets) Consider a

model with a sufficiently large number n of individuals, each with a sufficiently small weight.
Suppose that all the individuals are independent and Pxy -I- 1/2 for all significant pairs of
alternatives (x, y). Let W', W" C V be the cabinets with k members optimal with respect to
average and majority representativeness, respectively. Then

(x,y)EXxX

< rk+Ic + t(n),

C1 '"
~ ((x, y) I cxy I (1/2- I cxy I) k + t(n)
- (x,y)EXXX
< 2- k - I k-- 1e- I Q-I + t(n),

lI:here

C= max
(x,y)EX xx :~(x,y) >0
I cxy I,
Q= min
(x,y)EX x X~(x,y»o
I cxy I,
and t(n) ~ 0 has the same exponent as the accuracy of approximations (18) and (19).

Thus the concepts of optimality of cabinets wj;J.-: 'espect to different indicators of represen-
tativeness tend to become equivalent with the enlargement of thE' cabinets.
 263

5 Discussion of the Results

In section 2 we have introduced a quantitative indicator of representativeness-the average

representativeness, with which we have proved the existence of dictator-representatives and
overcome Arrow's paradox. However, as shown in example 1, there are cases when the
optimal dictator with respect to the average representativeness represents a minority in
most cases. To analyze these possibilities we have introduced the second indicator-the
majority representativeness. Its properties are similar to that of average representativeness,
and it also allows distinguishing between dictator-representatives and dictators in a proper
sense.
Generally speaking, to choose an approach to the definition of dictator-representative, one
needs additional reasons. For example, if a dictator is to be appointed for a long period of
time, when he is supposed to express varying preferences of other individuals, the average
representativeness seems to meet the problem better. The majority representativeness can
be used for a single decision, because the optimal dictator expresses the majority preference
with higher probability.
The desired equivalence of the two approaches to the appointment of optimal representatives
is obtained for two alternatives and a large number of independent individuals. As mentioned
after example 1, in ordinary cases the two approaches are likely consistent.
In the case of a large number of independent individuals some remarkable peculiarities of
the interaction of the optimal dictator with the collective are revealed. By virtue of the
law of large numbers, the weight of coalition of the individuals who prefer one alternative to
another, as a random variable, is concentrated within a small neighborhood of its mathemat-
ical expectation, being practically constant. These weights for different pairs of alternatives
are characterized by the mean vector c. By (18) the maximum average representativeness is
attained for the individual v whose preference is "close" to the preference of the "average"
individual, providing the scalar product (Sc,c(v)) with maximum. A similar situation is
observed for the majority representativeness. The majority preference is also nearly deter-
mined by general tendencies in the individual preferences described by the sign vector s,
showing whether an "average" individual is inclined to prefer one alternative to another, or
not. By (19) the maximum majority representativeness is attained for the individual v whose
preference is "close" to the majority preference, maximizing the scalar product (Sc, s(v)).
The matrix E (15) in the scalar products mentioned introduces corrections caused by taking
into account the significance of decisions.
The interaction of the optimal dictator with the collective is influenced by the degree of
definiteness of forecasts for individual preferences. By (18)-(19) if the forecast is indefinite,
i.e. the probabilities Pry are close to 1/2, then the representativeness of optimal dictators
is lowest, being close to 1/2. The representativeness of optimal dictators increases with
the definiteness of the forecast, i.e. with Pxy deviating from 1/2. Therefore, the definiteness
(reliability) of the forecast for individual preferences turns the optimal dictator to be an ac-
ceptable representative, or, on the contrary, to meet the common use of the word "dictator".
That is of prime importance in applications, where dictatorial rules of decision making caD
be used to replace a set of criteria by a single representative.
 264

The probabilities PXy( v) can be interpreted as indicators of the individual interest, expressing
the degree of preference. Such an interpretation is similar to that of lotteries in Neumann-
Morgenstern utility theory. Therefore, the methods of revealed preferences can help in the
numerical determination of the probabilities Pxy( v) and, indirectly, the measure v on the
set of situations. Furthermore, if the probabilities Pxy( v) are interpreted as indicators of
the individual interest, then the mean probabilities Pxy can be interpreted as the average
collective interest. In this case, according to (18)-(19), the optimal dictator is the individual
whose interest is "closest" to the interest of the collective. In the interaction of collective
and individual interests we see parallels with the theory of economic equilibrium, cooperative
games, etc.
In comparison with the results concerning optimal dictators, we can draw conclusions about
the advantages and the disadvantages of the collective representation in the form of cabinets.
The advantages are:

(a) The possibility to attain high representativeness by means of limited groups of indi-
viduals (theorem 1).

(b) Overcoming the ambiguity in understanding the optimal representation, inherent in

single representatives (theorem 7).

The disadvantages of the cabinet in comparison with the dictators are caused by some general
principles. Since Condorcet (1743-1794) it is known that the part of the situations when
a majority rule leads to intransitive orderings increases rapidly with the increase in the
number of alternatives and individuals. The same disadvantage, consequently, is inherent
in preferences of cabinets which represent a majority preference. Therefore, we come to a
principal methodological alternative:

• Either eliminate the "inconsistency" in the cabinet preferences in prejudice of democ-

racy (decrease the size of the cabinet, thus decreasing its representativeness),

• or allow the inconsistency in the cabinet preferences in favour of democracy (enlarge

the cabinet, thereby increasing its representativeness).

This alternative cannot be avoided, and the choice of one of these possibilities should be
made, taking into account many factors outside the model.

6 Conel usions

1. The common approach to overcoming Arrow's paradox suggests to reject the least
evident of Arrow's axioms-the universality condition, or independence of irrelevant
alternatives. We suggest to refine the concept of dictator, implying the refinement
of the related axiom. This approach is analogous to overcoming paradoxes in the set
theory. (Recall that its paradoxes were overcome by a refinement of the concept of a
set itself.) Such an approach was never before applied to collective choice.
 265

2. We consider the dictator as a representative of deciding coalitions. To elaborate this

idea, we define quantitative indicators, characterizing the capabilities of single individ-
uals to represent the collective preference. Owing to the formalization of the idea of
representativeness, we pose and solve a series of new problems. In particular, we dis-
tinguish between dictator-representatives and dictators in a proper sense and prove the
existence of a dictator-representative, who, on average, represents the majority. Re-
stricting the prohibition of dictators to dictators in a proper sense, we revise Arrow's
paradox, and after this refinement Arrow's axioms become consistent.

3. The further study of the concept of representativeness is undertaken for cabinets,

understood as limited groups of individuals, making decisions on behalf of the whole
collective. We prove that cabinets can be as representative as desired, and that for
large cabinets different definitions of optimal representation are almost equivalent.

4. This way we prove that the collective choice can be entrusted to single representatives,
or several representatives organized in certain structures. Their interaction with the
represented collective has many common properties which allows considering cabinets
as a kind of "agents". The cabinet can provide high representativeness, but its pref-
erences may lack "consistency", being intransitive. A dictator is not as representative
as a cabinet, but has an evident advantage in the "consistency" of his preference and
the simplicity of its presentation.

5. Another important conclusion relates to the applications of our model to multicriteria

decision making. The appointment of a cabinet corresponds to the selection of a few
partial criteria out of a larger number of criteria. As we have proved, the indicators of
representativeness of the optimal cabinet with k members are not less than (1 - 2- k ) •
100% of their maximal possible values. This implies that k appropriately chosen partial
criteria can represent the general quality of the alternatives with the reliability (fiducial
probability) not less than (1- 2- k )·100%. Note that the reliability of decisions is limited
by the reliability of the information required, which is conventionally estimated usually
as not better than 99-99.9%. According to the result obtained, to provide a reliability
of 99-99.9% in representing the quality of alternatives, 7-10 properly selected criteria
are quite sufficient. Therefore, the totality of data is usually redundant for decision
making, and instead of processing the available data for all partial criteria it suffices
to consider a few partial criteria, or specifications of the alternatives.

References

Armstrong T.E. (1980). Arrow's Theorem with Restricted Coalition Algebras. Journal
of l'vlathematical Economics, vol. 7, No. 1: 55-75.

Armstrong T.E. (1985). Precisely Dictatorial Social Welfare Functions. Erratum and
Addendum to 'Arrow's Theorem with Restricted Coalition Algebras'. Journal of Math-
ematical Economics, vol. 14, No.1: 57-59.

Arrow K.J. (1951). Social Choice and Individual Values. Wiley, New York.
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Fishburn P.C. (1970). Arrow's Impossibility Theorem: Concise Proof and Infinite Voters.
Journal of Economic Theory, vo!' 2, No. 1: lO3-106.

Fishburn P.C. (1987). Interprofile Conditions and Impossibility. Harwood Academic Pub-
lishers, Chur.

Gruber J. (Ed.) (1983). Econometric Decision Models. Proceedings of a Conference Held

at the University of Hagen, West Germany, June 19-20,1981. Springer-Verlag, Berlin,
Heidelberg.

Hwang Ch.-L. &. Lin H.J. (1987). Group Decision Making Under Multiple Criteria.
Methods and Applications. Springer-Verlag, Berlin.

Kelly J.S. (1978). Arrow Impossibility Theorems. Academic Press, New York.

Kirman A. &. Sondermann D. (1972). Arrow's Theorem, Many Agents, and Invisible
Dictators. Journal of Economic Theory, vol. 5, No.2: 267-277.

Lariehev 0.1. (1979). The Science and the Art of Decision Making. Nauka, Moscow.
(Russian).

Schmitz N. (1977). A Further Note on Arrow' Impossibility Theorem. Journal of Math-

ematical Economics, vo!' 4, No.3: 189-196.

Tanguiane A.S. (1980). Hierarchical Model of Group Choice. Ekonomika i matematich-

eskiye metody, vo!' 16, No.3: 519-534. (Russian).

Tanguiane A.S. (1989a). Interpretation of Dictator in Arrow's Model as a Representative

of the Collective. Matematicheskoe modelirovanie, vo!' 1, No.7: 51-92. (Russian).

Tanguiane A.S. (1989b). A Model of Collective Representation Under Democracy. Ma-

tematicheskoe modelirovanie, vo!' 1, No. lO: 80-125. (Russian).

Tanguiane A.S. (1991a). Aggregation and Representation of Preferences. Introduction to

Mathematical Theory of Democracy. Springer-Verlag, Berlin, Heidelberg.

Tanguiane A.S. (1991b). Overcoming Arrow's Paradox and Development of the Mathe-
matical Theory of Democracy. The University of Hagen: Discussion Paper No. 160.

Tanguiane A.S. CI991e). Optimal Appointment of Vice-President and Recurrent Con-

struction of Cabinets and Councils. The University of Hagen: Discussion Paper No.
161.
 PART 5:

RATIONAL AND ADAPTIVE EXPECTATIONS MODELS

RATIONAL VERSUS ADAPTIVE EXPECTATIONS IN PRESENT VALUE MODELS

Gregory C. Chow
Department of Economics
Princeton University
Princeton, NJ 08544-1017

Abstract
Using data on stock price and dividends, and on long-term and short-term
interest rates, we test an important implication of present value models, that
current value is a linear function of the conditional expectations of the
next-period value and the current determining variable. This implication,
combined with rational expectations RE, is strongly rejected. Combined with
adaptive expectations AE, it is accepted. The latter model can also explain
the observed negative relation between the rate of return and stock price.
Thus the RE assumption should be used with caution; the AE assumption may be
useful in econometric practice.

Keywords: Adaptive expectations; rational expectations; present-value models;

current value, next-period value; conditional expectations; rate of return;
stock price.

Contents
1 Introduction
2 Models and method
3 Statistical evidence
4 Adaptive or rational expectations?
5 Stock price model in logarithmic form
6 Conclusion
References

*I would like to thank Ben Bernanke. John Campbell. Angus Deaton. Mark
Gertler. Dwight Jaffee. Guy Laroque. Jianping Mei. Robert Shiller. Kenneth
West. three referees. and especially Whitney Newey for advice and comments.
Xu Zheng for able research assistance. and the National Science Foundation
for financial support.
Editor's note: Reprinted with the permission of Elsevier Science Publishers
from The Review of Economics and Statistics. Vol. 71. August 1989.
pp. 376-384.
 270

1 Introduction
The hypothesis of rational expectations (RE) has stimulated much interesting
research in economics for over a decade, although many economists remain
skeptical of its empirical validity. Lovell (1986) provides a survey of some
evidence bearing on this issue. This paper presents further evidence on the
validity of the RE hypothesis by applying it to present value models. A number
of studies have attempted to estimate and test present value models under the
RE assumption, including the recent studies of Campbell and Shiller (1987),
Fama and French (1988), Poterba and Summers (1987), West (1988), and the lit-
erature cited. Many of these studies have found the restrictions imposed by
the RE hypothesis on present value models inconsistent with the data, but the
authors usually prefer to reject the models tested while maintaining the RE
hypothesis. In this paper, I employ a different method of estimation and
testing from those employed in previous studies, and find one implication of
the present value model under RE to be strongly rejected by the data. However,
rather than searching for more complicated models and maintaining RE, I find
that the simple model under adaptive expectations (AE) can explain the data
very well. Such results might persuade some readers to reconsider the possible
validity of the AE hypothesis as compared with the RE hypothesis in some econo-
metric applications.

Section I describes the models and the method used for estimation under the RE
assumption. In section II empirical results on present value models for stock
price and long-term interest rate will be presented. Since the models are
strongly rejected, I will examine in section III the alternative AE hypo-
thesis and show that it explains the data much better than RE. Section IV
tests the model in logarithmic form and shows that the AE version is not only
preferable, but helps to explain the phenomenon of mean reversion in stock
prices.

2 Models and method

This paper is concerned with two present value models of the form

[1]

where Et denotes conditional expectation given the information It available to

the economic agents at time t. In the stock price example, Yt denotes the
price of a stock (or the total value of a number of stocks) at the beginning of
period t while Zt denotes the dividend derived from the above stock(s) during
 271

period tj 0 is the discount factor. assumed to be time invariant. c = a and a =

o. In the interest rate example. Yt denotes a long-term rate at time t while
Zt is a short-term rate at time t; c is the risk premium and a = 1 - o.

I will concentrate on testing the following implication of [1]. Using [1] to

evaluate EtYt+1, and subtracting oEtYt+1 from [1] give
[2]

In the case of stock price. [2] becomes

[2a]

In the case of interest rates. [2] becomes

[2b]

Assumption [1] implies [2] but not conversely; [2] is much weaker than [1]. In
the stock price example. [2a] asserts only that the price of a stock (or a
group of stocks) at the beginning of period t is equal to the discounted value
of the expected sum of money. from selling the stock and keeping the dividend.
to which the owner of the stock is entitled at the beginning of period t+1.
As it allows for the effects of speculation. this arbitrage relation for any
one period is much weaker than the assumption that the price of a stock is the
discounted value of all future dividends. It is well known [see Sargent.
(1987. p. 95)] that the solution to the difference equation [2a] is [1] plus a
speculative term At(l/o)t. where yt is a martingale. with EtYt+1 = At. This
paper is concerned mainly with hypothesis [2] under rational or adaptive ex-
pectations.

To estimate [2] under RE of Muth (1961). we equate the subjective expectation

Et in the minds of the economic agents with the mathematical expectations
generated by the econometric model used by the econometrician. Denote the
information available to the econometrician at time t by Ht. which includes at
least the values of the variables of the selected model up to time t. Ht is
usually assumed to be a subset of It. the information available to the economic
agents. If Et in [2] originally refers to E(.IIt). by applying E(.IHt) to [2].
we find that [2] is valid also for Et interpreted as E(.IHt) since
E(E[.IIt]IHt) = Et(.IHt). I will estimate and test [2], with Et interpreted as
E(.IHt)·

Assume that under RE Yt+1 can be written as

 272

Yt+1 - Et Yt+1 = ut +1 [3]

where Ut is serially independent. Using [3] to replace EtYt+1 in [2]. we obtain
[4]

By the method of Chow (1983. Chapter 11) we solve [4] for Yt+1 and reduce the
time subscripts of the resulting equation by one to give
-1 -1 -1
Yt = 0 Yt-1 - 0 eE t _1zt _1 + c(l - 0 ) + ut [5]

which is the model to be estimated. Taking expectation of [4] given Ht yields

the original model [2].

To estimate equation [5] for stock price. I assume the following model for Zt
Zt = a 1z t _1 + ••• + apz t _p + YOYt + ••• YpY t - p + b + vt [6]

where Vt is also assumed to be serially independent. Thus Et-1Zt-1 is a linear

function of Zt-2 ••••• Zt-p-1.Yt-1 ••••• Yt-p-1. If Et-1Zt-1 in [5] is replaced by
Zt-1 - Vt-1. equation [5] becomes. for e = 0
-1
Yt = 0 Yt - 1 - Zt-1 + Ut + vt-1 [7]

Since Zt-1 is correlated with the residual Ut + Vt-1. I will estimate [7] by
using as instrumental variable the least squares estimate Zt-1 of Et-1Zt-1.
For long-term interest rate. since Zt has the same timing as Yt. Et-1Zt-1 =
Zt-1 and equation [5] can be estimated by least squares.

3 Statistical evidence
Thanks to Campbell and Shiller (1987). I have been able to use their data for
studying the relations between stock price and dividends, and between long-
term and short-term interest rates. The stock price and dividend series are
deflated beginning-of-year price and dividends paid during the year for the
Standard and Poor's 500 stocks from 1871 to 1986 used by Shi11er (1984) and
updated to 1987. The interest rate series are U.S. Treasury 20-year yields
from Solomon Brothers' Analytical Record of Yields and Yield Spreads and the
1-month Treasury bill rate from the U.S. Treasury Bulletin. These series are
monthly from 1959.2 to 1983,11.

3.1 Stock price

I first apply OLS to estimate equation [6] for dividends using annual data from
1874 to 1986, obtaining
 273

.0979 + 1.129 Zt-1 - .493 Zt-2 + .217 Zt-3 R2 = .9534 [8]

(.0432) (.097) (.137) (.095) s = .1433
OW = 1.999
+ .0129 Yt - .0072 Yt-1 + .0011 Yt-2 - .0030 Yt-3
(.0021) (.0031) (.0032) (.0025)
where the standard errors of the coefficients are in parentheses, s is the
standard error of the regression and OW is the Durbin-Watson statistic (used
only as a descriptive statistic, the first-order autocorrelation being 1 -
DW/2). Introducing Zt-4 and Yt-4 as additional explanatory variables in [8]
yields insignificant t statistics, suggesting that these variables be omitted.
Using the estimated Zt-1 from [8] as the instrumental variable for Zt-1. I
estimate [7] for stock price using the sample period 1875-1987:

Yt = .868 Yt-1 + 3.569 Zt-1 s = 6.873 [9]

(.065) (1.642) OW = 1.685

The estimates of both coefficients of [9] strongly contradict the theory. The
coefficient of Yt-1 should be 6- 1 > 1. but is about two standard errors small-
er. If we assume asymptotic normal distribution for this coefficient when 6- 1
> 1, the hypothesis that 6- 1 = 1.02, say. would be rejected at about the 2.1
percent level using a one tail test. The coefficient of Zt-1 should be -1, but
is over two and a half standard errors larger. The F(2, 111) statistic for
testing the joint hypothesis that the coefficient of Yt-1 is 1.02, say, and the
coefficient of Zt-1 is -1 turns out to be 5.453, leading to rejection at the
.82 percent level.

To check whether the above asymptotic theory is applicable to the distribution

of the two coefficients of equation [9] estimated by using an instrumental
variable for Zt-1. a Monte Carlo experiment using 1000 replications has been
performed. In each replication, 112 observations for Zt beginning in 1874 are
generated by equation [8], with the estimated coefficients as the true values
and the estimated s as the residual standard deviation. using the observed data
for dividend Zt from 1871 to 1873 and for stock price Yt from 1871 to 1874 as
initial values. (After the Monte Carlo experiment, one more observation, for
1987, was added to estimate equation [9]. accounting for one more degree of
freedom in the above F statistic.) Data for Yt, beginning from 1875, are
generated by Yt = 1.02 Yt-1 - Etzt-1 plus a residual with a standard deviation
equal to s from [9]. The method of IV is applied to estimate the two coef-
ficients of equation [9]. The following distributions are found for the two
standard "t" statistics and the "F(2,110)" statistic.
 274

Theoretical one-tail probability .010 .050 .100

Monte Carlo relative frequency:
"to statistic for the 1st coefficient being 1.02 .021 .068 .131
"to statistic for the 2nd coefficient being -1 .014 .060 .122
F(2,110) statistic for both coefficients .020 .070 .110

In particular, the t statistic for testing the first coefficient of [9] being
1.02 has theoretical left-tail probability of .025 and Monte Carlo relative
frequency of .041. The F(2,110) statistic for testing the joint hypothesis of
the two coefficients being 1.02 and -1 respectively has theoretical right-tail
probability of .022 and Monte Carlo relative frequency of .032. Thus the above
Monte Carlo experiment has demonstrated that the rejection probabilities re-
ported by the standard t and F tests applied to the coefficients of equation
[7] estimated by IV, with 0- 1 as low as 1.02, are reasonably accurate. In the
rest of this paper, when I apply t and F tests in similar situations, I will
assume the standard distribution theory to hold.

One possible shortcoming of the estimates given by equations [8] and [9] is the
assumption of homoskedasticity. Since both dividends and stock price have in-
creased substantially from 1875 to 1986, the standard deviations of the resi-
duals of equations [8] and [9] might be expected to increase proportionally. I
will assume that the variance of the residual of [8] is proportional to (Zt-1)2
and the variance of the residual of [9] is proportional to (Yt-1)2. Indeed, a
regression of log of the square of the residual of [9] on the log of (Yt-1)2
has a coefficient of 1.075 with a standard error of .166. Using weighted least
squares, I have obtained an equation [8a] very similar to equation [8]. Using
[8a] to form the instrument ~t and applying weighted IV, I have modified equa-
tion [9]:
Yt = .919 Yt-1 + 2.358 Zt-1 [9a]
(.077) (1.534)
The F(2,111) statistic for testing the joint hypothesis for the coefficients to
be 1.02 and -1.0 respectively is 9.930, leading to rejection at the .000108
level, much stronger than the evidence from equation [9]. Since the method of
weighted least squares is equivalent to ordinary least squares applied to re-
scaled data, the Monte Carlo experiment reported above is relevant here also.

Another useful way to look at equation [7] is to regress Yt + Zt-1 on Yt-1 and
other variables in Ht-1. Hypothesis [2a] implies that Et-l(Yt+Zt-1) equals
0-l Yt -1 and that variables other than Yt-1 are not important in explaining
Yt+Zt-1. If we regress Yt+Zt-1 on Yt-1 alone, using data from 1875 to 1987,
 275

and again assuming the residual variance to be proportional to (Yt-1)2. the

result is
(Y t + Zt-1) = 1.084 Yt - 1 (10]
(.017)
The estimate 1.084 for 0- 1 appears high but is not unreasonable. An inter-
esting regressor to add to equation (10]. suggested by (7] and (9a]. is 2t-1
estimated from (8a]. For the period 1875 to 1987. weighted least squares gives

(Y t + Zt-1) = .937 Yt-1 + 2.986 2t - 1 [11]

(.070) (1.381)
The result contradicts (2a] strongly since the F(2.111) statistic for testing
the two coefficients to equal 1.02 and zero respectively is 9.685. leading to
rejection at the .000133 level. (11] is a variation of the test performed in
(9a] by adding Zt-1 to both sides and by using (weighted) least squares instead
of (weighted) IV for Zt-1 as in [9a].

To check whether the rejection of [2a] under RE might be due to a time-varying

discount factor Ot. I have replaced the variable Yt-1 in equation [9a] by
OE!lYt-1' According to the hypothesis (2a] with a discount factor Ot. the
coefficient of this variable should be unity. oE 1 is estimated by l+rt. where
rt is the six-month commercial paper rate used by Campbell and Shiller (1988)
minus the inflation rate based on the producer price index also used by Camp-
bell and Shiller (1988)plus a constant .057008 (risk premium) to make the mean
of rt equal to .084 as suggested by equations [10]. The weighted regression
modifying equation [9a] for the sample period 1875-1987. again using 2t-1 from
(8a] as instrument. is
-1
Yt = .835 (Ot-1Yt-1) + 2.588 Zt-1 (12]
(.070) (1.522)
Both coefficients are far from the hypothesized values 1 and -1 respectively.
The Fe2.11l) statistic for testing the joint hypothesis for both coefficients
is 2.806. leading to rejection at the 6.48 percent level. Thus introducing a
time-varying discount factor results in a somewhat weaker rejection of hypo-
thesis (2a] under rational expectations.

3.2 Interest rates

To test hypothesis (2b] under RE for long-term interest rate Yt. I apply un-
weighted least squares to estimate equation (5] with Etzt = Zt and e = (1-0)
using monthly data from 1959.2 to 1983.10:
 276

Yt = .0790 + .9602 Yt-1 + .0385 Zt-1 R2 = .9887 [13]

(.0481) (.0145) (.0137) s = .3069
OW = 1.825
The coefficients of Yt-l and Zt-1 should be 6- 1 and (1-6- 1) respectively, but
their estimates are very different. A positive risk premium c implies a ne-
gative intercept in [14] but it turns out to be positive. To test the joint
hypothesis that the coefficients of Yt-l and Zt-1 sum to one and the intercept
is zero, we regress Yt-Zt-l on Yt-l-Zt-l omitting the intercept:

(Yt - Zt-l) = .988 (Yt-l - Zt-l) R2 = .9426 [14]

(.014) s = .3105
OW = 1.768
The F(2, 298) statistic for testing this joint hypothesis is 4.491, leading to
rejection at about the one percent level. Furthermore the pOint estimate of
6- 1 is .988, although it is not significantly below one. If we allow a non-
zero risk premium by introducing an intercept to [15], the result is

(Yt - Zt-1) = .0706 + .9612 (Yt-l - Zt-l) R2 = .9443 [15]

(.0236) (.0136) s = .3063
OW = 1.827
suggesting a significantly negative risk premium and a discount factor 0
significantly above one, 6- 1 being estimated to be .961 with a standard error
of .0136. Thus model [2b] for long-term interest rate is strongly rejected.

4 Adaptive or rational expectations?

Are equations [2a] and [2b] under adaptive expectations (AE) consistent with
the data? We now interpret the symbol Et(.) as a subjective expectation in the
minds of economic agents and not as a mathematical expectation given the infor-
mation used by the econometrician. I will combine [2a] and [2b] with AE and
compare the results with RE.

4.1 Stock price

For stock price, denote (Yt+l + Zt) by Xt+l. Hypothesis [2a] asserts that Yt =
6Etxt+l. Specify the AE hypothesis as
Et xt +l - Et _l xt = a(x t - Et _1xt ) + Et [16]
where Et summarizes other factors than (Xt-Et-lXt) which may affect the change
in expectations. Et is orthogonal to variables in Ht; otherwise these vari-
ables should be included in [16]. If [2a] is correct, Yt is a measure of the
subjective 6Etxt+l. Multiplying [16] by 6 and using this measure of expecta-
tion, we obtain
 277

[17]
or
[18]

When equation [18] is estimated by the stock-dividend data from 1875 to 1987,
again assuming the residual variance to be proportional to (Yt-1)2, the result
is
Yt = .899 Yt-1 + 2.767 Zt-1 [19]
(.069) (1.357)
If an intercept is added to [19], its t statistic is only .059. Solving the
coefficients of [19] for 0 and a, we get
o = .965 a = .761 [20]
(.008) (.104)
which are very reasonable. The standard errors in [20] are obtained by apply-
ing weighted nonlinear least squares to [18]. [19] is consistent with AE, but
not with RE.

To see this, let us assume [19] to be correct and try to force a RE interpre-
tation into it. We advance its time subscript by one and take expectations
given Ht to yield
[21]

[21] contradicts [2a], as equation [9a] did, in giving a discount factor 0 lar-
ger than one and a coefficient for Etzt very different from -1. Note the simi-
larity between [19] and [9a]. The coefficients of both make good sense under
AE, but not under RE. Under RE, the coefficient of [19] would be 0- 1 and -1
respectively. Given the restrictions on 0 and a, the coefficient for Yt-1 in
[18] should be less than one and the coefficient for Zt-1 should be positive
under AE. Obtaining a coefficient for Yt-1 close to 0- 1 > 1 and a coefficient
for Zt-1 close to -1 in [19] would contradict AE and support RE. The fact that
[21J, with Etzt added on both sides, is consistent with the regression [11J
also confirms AE, for under AE we can take conditional expectation Et of [18]
for Yt+1 and obtain [21] by using EtEt=O. Hence [11] supports AE while reject-
ing RE.

4.2 Interest rates

For long-term interest Yt, assume hypothesis [2b] and AE:
Et Yt+1 - Et - 1Yt = a(Yt - Et - 1y t ) + Et [22]
 278

where Et has the same properties as in [16]. If hypothesis [2b] is true,

aEtYt+l can be measured by
aEtY t +1 = Yt - (l-a)zt - c(l-a) [23]

Multiplying [22] by a and using the right-hand side of [23] to measure aEtYt+1
and aEt-1Yt in the resulting equation, we obtain

Yt = (1-a)(1-aa)-l Yt _1 + (l-a)(l-oe)-l Zt - (1-a)(1-o)(1-aa)-l Zt _1 [24]

+ ca(1-a)(1-oa)-1 + a(l-aa)-lEt
This equation will be compared with equation [5] under RE.

Equation [24] is estimated by (unweighted) least squares using monthly interest

rates data from 1959,7 to 1983,10:
Yt = .0661 + .9441 Yt -1 + .1956 Zt - .1364 Zt-1 R2 = .9913 [25]
(.0428) (.0128) (.0202) (.0217) s = .2692
OW = 2.160
According to [24], the three coefficients of [25] provide estimates of a and
a. 1-0 can be estimated by .1364/.9441 or .1445, giving 0 = .8555. I-a can be
estimated by .1364/.1956 or .6972, giving a = .3028. When these estimates of 0
and a are used to estimate the coefficient of Zt-l, the result is -.1359, very
close to the estimate -.1364, supporting the hypothesis that the three coeffi-
cients are the functions of the only two parameters a and a according to [24].
Estimation of (24] by nonlinear least squares yields

o = .8554 a = .3003 c = 1.514 R2 = .9913 (26]

(.0224) (.0647) (.2810) s = .2689
OW = 2.150
The data are consistent with the adaptive expectations hypothesis with 0 < I,
a = .30 and a positive risk premium. Testing the nonlinear restrictions on the
coefficients by computing the ratio of the additional sum of squared residuals
of (26] as compared with [25], to the s2 of [25], we obtain an approximate
F(I,288) statistic of only .361, strongly supporting the restrictions. How-
ever, the estimate .8554 for 0 is lower than expected.

Is equation [24] or [25] consistent with the RE formulation [5]? If we take

conditional expectation of [24] given Ht-1 assuming [24] to be a correct model,
we get an equation for Et-1Yt having the same explanatory variables as [5J and
an additional variable Et-lZt. An equation for Yt results from adding a resid-
ual to the above equation for Et-lYt. In this equation for Yt, if the formula-
tion [5] is correct, the coefficient of Et-lZt should be zero and the remaining
 279

three coefficients (including the intercept) should be as specified in [5]. To

estimate this regression equation of Yt on Yt-l. Zt-1 and Et-lZt. the method of
instrumental variables is used. with Et-lZt replaced by Zt-Vt and the instru-
mental variable Zt being the estimated regression of Zt on Zt-1 ••••• Zt-6.
Yt-l ••••• Yt-6'

The estimated equation for the sample period 1959.7 to 1983.10 is

Yt = .0682 + .9472 Yt-1 + .1581 Et _1zt - .1028 Zt-l s = .2708 [27]
(.0431) (.0136) (.0538) (.0496) OW = 2.090

[27] is similar to [25] and is consistent with the AE model [24]. However.
[27] is inconsistent with the RE model [5] in having a significantly positive
coefficient for Et-1Zt and an estimate of the coefficient of Yt-l very signi-
ficantly below any reasonable value of 0- 1• The F(2. 288) statistic for test-
ing the jOint hypothesis under RE that the coefficient of Et-lZt is zero and
the coefficients of Yt-l and Zt-l sum to one is 5.491. leading to rejection at
the 0.46 percent level.

Campbell and Shiller (1987) suggest using a shorter sample 1959-1978 because of
a possible structural shift after 1978. and estimating Zt by 11 instead of 6
own lags and 11 lagged y's. Equation [24] for the AE hypothesis is so reesti-
mated using monthly data from 1959.12 to 1978.12 to yield
Yt = .0324 + .9729 Yt - l + .1263 Zt - .0959 Zt-1 R2 = .9878 [28]
(.0451) (.0124) (.0264) (.0272) s = .1769
OW = 2.161
An estimate of 1-0 is .0959/.9729. giving 0 = .901. An estimate of 1-e is
.0959/.1263. giving e = .241. Using the third coefficient of [24] these esti-
mates imply a coefficient of .0956 for Zt-1. very close to the estimate .0959
in [28]. Applying nonlinear least squares to estimate [24] yields
a = .9006 e = .2342 c = 1.710 R 2= .9878 [29]
(.0276) (.0949) (.455) s = .1765
OW = 2.154
The data are consistent with the AE hypothesis with a < 1. e = .234 and a po-
sitive risk premium. Again. to examine the RE hypothesis in the framework of
[24] we estimate. for the short sample 1959.12-1978.12. a regression equation
of Yt on Yt-1. Zt-1 and Et-1Zt. using Zt as instrumental variable. The result
is similar to [25] and is consistent with the AE model [24]. The coefficient
of Yt-1 is about two standard errors below any reasonable value of 0-1 > 1.
Hence the evidence suggests rejection of [5]. as before.
 280

To reexamine our rejection of equation [5] as presented in Section II.B using

the full sample, we have reestimated equations [13] and [15] using the shorter
sample from 1959,2 to 1978,12. From the revised equation [13], the joint hypo-
thesis that the coefficients of Yt-l and Zt-l sum to one and the intercept is
zero is rejected at the 3.79 percent level by an F(2,236) sta- tistic. If the
intercept is dropped, the hypothesis that the coefficients of Yt-l and Zt-1 sum
to one is rejected at the 1.56 percent level by an F(I,237).statistic. The
revised equation [15] suggests a significantly negative risk premium and a
discount factor 0 significantly above one. Hence the model [2b] under RE is
rejected as before.

5 Stock price model in logarithmic form

Under RE, the hypothesis Et(Yt+1+Zt) = o-I Yt for stock price can be tested by
assuming (Yt+1+Zt) to equal o-I Yt plus a residual with conditional mean zero,
or times a residual nt+l with conditional mean unity. The former assumption
was adopted in sections I and II. We now explore the latter assumption. By
taking logarithm of the model with a multiplicative residual nt+1' one obtains
-1 -1
In(Yt+l + Zt) - ln Yt = 1n 0 + ln nt+1 ln 0 + c + ut +1 (30]

where Etnt+l = I, Etut+l = 0, Etlnnt+l = c, and Ut is assumed to be serially

independent and identically distributed with finite variance. Denoting lnYt
and lnzt by Pt and dt respectively, one can approximate In(Yt+l+Zt), as in
Campbell and Shiller (1988), by a linear function of Pt+l and dt assuming the
variable 0t+l = dt-Pt+l is near its mean 0:
In(exp(Pt+l)+exp(d t )) = 1n(exp(Pt+l)(1+exp(ot+l»
-1
~ Pt+1 + In(l+exp(o)) + (1+exp(o» exp(o)(Ot+1-0)

PPt+1 + (1-p)d t + k [31]

where P = 1/(1+exp(0» and k = 1n(1+exp(0» - oexp(o)/(l+exp(o». By this

approximation, equation [30] can be approximated by
-1 (32]
PPt+1 + (l-p)d t + k - Pt = 1n 0 + c + ut +1

which corresponds to equation [5], and can therefore be estimated and tested by
equations corresponding to [6] and [7].

Equation [32] implies

Pt+l = P-1 Pt - P-1 (l-p)d t + p -1 (In 0-1 + c - k)+- p1 ut +1 [33]

 281

which corresponds to [7]. Since dt is correlated with Ut+1. we apply IV to

estimate [33]. Using an estimated regression of dt on dt-1 ••••• dt-3.Pt •••••
Pt-3 as instrument for dt (if added. dt-4 and Pt-4 having t ratios of .57 and
.20). I have estimated. for the period 1875 to 1986.
Pt+1 = .893 Pt + .092 dt + .279 [34]
(.091) (.128) (.444)
For this sample p is found to be .936. as in Campbell and Shiller (1988). The
F(2.110) statistic for testing the hypothesis that the two coefficients of [34]
are respectively p-1 = 1.0684 and _p-1(1-p) = -.0684 is 3.525. significant at
the 3.28 percent level.

To examine how well the AE hypothesis can explain the data. we assume
Etln(Yt+1+Zt) to be formed adaptively as in [16]:

By hypothesis. Etln(Yt+1+Zt) = lnYt+(lno- 1+c) = Pt+h. On substituting Pt+h for

Etln(Yt+1+Zt). and the linear approximation [31] for In(Yt+Zt-1). [35] becomes

Pt - Pt-l = e[PPt+(1-p)d t _1+k- pt_1-h] + Et

= .l:fL p + .lli..!=cl d + .fli..k::!!l + _t_ [36]

Pt l-Sp t-1 l-Sp t-1 1-ep l-Sp

Estimation of [36] by least squares for the period 1875 to 1987 yields

Pt = .850 Pt-1 + .155 dt - 1 + .497 R2 = .9080 [37]

(.074) (.102) (.353) s = .1780
OW = 1.738

implying p = .947 and S = .768, which are reasonable results. Furthermore, the
two coefficients of [37] sum to one. as the AE theory implies.

Equation [37), as equation [19], is inconsistent with RE. If we assume the AE

model [36] to be correct. and take expectation of [37] given Ht-1. we find

[38]

Equation [38]. just like [34]. is inconsistent with RE given by [33]. for the
two coefficients should be p-1 = 1.0684 and _p-1(1-p) = -.0684 respectively.
The fact that [37] estimated by LS is very similar to [34] estimated by IV for
dt-1 supports the assumption of [35] and [36] that Et-1Et = O. Hence the evi-
dence confirms AE while it rejects RE.
 282

Furthermore. equation [36] or [37] is capable of explaining the negative rela-

tion between the log of one-period return In((Yt+Zt-l)/Yt-l) and log price Pt-l
found in recent studies including Fama and French (1988). Poterba and Summers
(1988). and Campbell and Shiller (1988). Multiplying [36] by p and adding
(l-p)dt-l-Pt-l+k to both sides of the resulting equation. we obtain an equation
for log one-period return
~ ~ ~P£t
PPt+(l-p)dt-l+k-pt-l = - l-Sp Pt-l + l-Sp dt-l + 1-ap + l-Sp [39]

Hence. the log of one-period return is related negatively to Pt-l and posi-
tively to dt-l. with coefficients of the same absolute value. Assuming [39]
to be the true model and taking expectation given Ht-l. we derive

Et-l (PPt+ (1-p

) dt - l +k- pt-l ) = - ~ ~ ~
1-ap Pt-l + 1-6p Et-l dt-l + l-Sp [40]

[40] contradicts hypothesis [2a] or [32] under RE. for the latter hypothesis
implies zero coefficients for both Pt-l and Et-ldt-l. Estimating [39] by least
squares for the period 1875 to 1987. with the dependent variable denoted by
~l.t-l as in Campbell and Shiller (1988). yields

~1.t-l = -.204 Pt-l + .209 dt - 1 + .703 [41]

(.070) (.095) (.330)
The result supports the AE hypothesis. with the two coefficients having the
correct signs and almost equal in absolute value. Replacing the two regressors
by the difference dt-l-Pt-l yields a coefficient .201 with a standard error of
.062. implying S = .778 if p = .947 as estimated by [37]. Estimating [40] by
LS with the regressor Et-ldt-l replaced by dt-l. the instrumental variable used
in [34]. for the same period 1875 to 1987 gives
~1,t-1 = -.165 Pt-1 + .150 Et - 1dt - 1 + .499 [42]
(.085) (.120) (.415)
[42] is not very different from [41] and supports the AE assumption of Et-1£t
= 0 in [39] while it rejects the RE assumption of two zero coefficients, the
F(2,110) statistic being 3.524. significant at the 3.28 percent level.

It is of interest to note that the model (40] is consistent with. and provides
an explanation for. the regression equation for ~1.t-l reported in Campbell and
Shiller (1988. Table 3):
30 R2 = .086
~l.t-l = .008 0t-l + .137 6d t _2 + .126 £t-l + constant
(.125) (.155) (.085)
where £tQl = «et-2 + •.. + et-31)/30)-Pt-l. et being real earnings. In this
 283

regression, the main explanatory variable is EtQ1, with coefficient .126. If

we interpret the 30-year average of earnings as a good estimate of expected
dividend Et-1dt-1, equation [40] or [42] provides an explanation of the above
regression. It is also of interest to compare hypothesis [40] with the hypo-
theses of Fama and French (1988), and Poterba and Summers (1988) which also
imply a negative effect of Pt~l on log one-period return, but this topic is
beyond the scope of the present paper.

6 Conclusion
Using data on stock price and dividends, and on long and short-term interest
rates, I have tested hypothesis [2], which is an important implication of the
present value model [1]. Combined with RE, hypothesis [2] is strongly reject-
ed. Combined with AE, it is accepted. The AE formulation, if accepted, im-
plies a model which is inconsistent with the RE formulation. The data support
the former and reject the latter. The former model is also capable of explain-
ing the observed negative relation between the rate of return and stock price,
but how well it does, as compared with alternative models which maintain ra-
tional expectations, remains to be studied. The acceptance of hypothesis [2]
under AE does not imply the acceptance of the present-value model [1]. Hence
the finding that stock price is too volatile to be consistent with [1] under RE
does not affect the validity of hypothesis [2] under AE. How the latter hypo-
thesis explains the volatility of stock price is another topic deserving fur-
ther study.

This paper has illustrated a well-known fact, that incorrectly imposing the
assumption of rational expectations on an otherwise correct model can lead to
unreasonable estimates of important parameters. Assuming hypothesis [2] under
adaptive expectations to be correct, we have seen that taking conditional ex-
pectations of equations [19], [25] and [36] would lead to models which, if a
rational expectations assumption is forced on them, will yield unreasonable
parameter estimates. Hence the assumption of rational expectations should be
used with caution. This paper also suggests that the assumption of adaptive
expectations can sometimes be a useful working hypothesis in econometric
practice.

References

Campbell, John Y. and Shiller, Robert J., "Cointegration and Tests of

Present Value Models," Journal of Political Economy, 95 (October 1987),
1062-1088.
 284

_--::-:-__~.' "Stock Prices. Earnings and Expected Dividends." Journal of

Finance. 43 (July 1988). 661-676.
Chow. Gregory C•• Econometrics (New York: McGraw-Hill. 1983).
Economic Report of the President 1986 (Washington. DC: United States
Government Printing Office. 1986).
Fama, Eugene F. and French. Kenneth R•• "Permanent and Temporary Components
of Stock Prices." Journal of Political Economy. 96 (April 1988), 246-273.
Historical Statistics of the United States: Colonial Times to 1957
(Washington, DC: Bureau of Census. 1960).
lovell, Michael C., "Tests of the Rational Expectations Hypothesis," The
American Economic Review, 76 (March 1986), 110-124.
Muth, John F., "Optimal Properties of Exponentially Weighted Forecasts of
Time Series with Permanent and Transitory Components," Journal of the
American Statistical Association, 55 (June 1960), 299-306.
_--;::_ _ ' "Rational Expectations and the Theory of Price Movements,"
Econometrica, 29 (July 1961) 315-35.
Poterba, James M. and Summers, lawrence H., "Mean Reversion in Stock Prices:
Evidence and Implications," NBER Working Paper (1987).
Sargent, Thomas J., Dynamic Macroeconomic Theory (Cambridge: Harvard
University Press, 1987).
Shiller, Robert J., "Stock Prices and Social Dynamics," Brookings Papers on
Economic Activity, X (1984), 457-98.
West, Kenneth D., "Dividend Innovations and Stock Price Volatility."
Econometrica, 56 (January 1988), 37-62.
THE FINNISH RATIONAL EXPECTATIONS QMED MODEL: ESTI~~TION, DYNAMIC PROPERTIES
AND POLICY RESULTS l

Ari Lahti
The Finnish Bankers' Association
P.O. Box 1009
SF-OOlOl Helsinki
FINLAND
and
Matti Viren
Bank of Finland
Research Department
P.O. Box 160
SF-OOlOl Helsinki
FINLAND

Abstract

This paper reports some policy experiments carried out with the Quarterly
Model of the Economics Department of the Bank of Finland (QMED). These
experiments illustrate the dynamic and long-run properties of the model. Thus,
it is investigated how different temporary and permanent, random and nonrandom
shocks affect the cyclical path and the long-run growth rate of total output.
The main issue is, however, the role of expectations. We compare a static
expectations version with two rational expectations versions of the model.
These two versions differ in terms of the time horizon of expectations. When
various policy simulations are carried out with these different versions
- both in terms of anticipated and unanticipated shocks - it turns out that
the whole short-run dynamics is crucially affected by the way in which
expectations are modelled. In particular, we find that advance effects can be
of considerable magnitude in the case of the rational expectations versions.

Keywords: Macromodels, rational expectations; dynamic simulation; business

cycles.

1 We are indebted to Anneli Majava and Pekka Sulamaa for research assistance
and the Yrjd Jahnsson Foundation for financial support. Thanks are due to Paul
Fisher, Josef Gruber and Kenneth Wallis as well as to the other participants
of the Second International Conference on Econometric Decision Models, in
Hagen, and the European Meeting of the Econometric Society, in Munich, for
useful comments.
 286

Contents

1 Introduction
2 A short description of the QMED model
3 Some simulation results of the QMED model
4 Examining the dynamic properties of the model
5 Examining the role of expectations
6 Concluding remarks
Reference~

1 Introduction

This paper reports some policy experiments carried out with the Quarterly
Model of the Economics Department of the Bank of Finland (QMED). In designing
these experiments we have paid particular attention to the dynamic and
long-run properties of the model, and, even more, to the role of expectations.
Thus, in essence we have two model specifications to be compared: a model
version in which expectations - to be more precise, inflation, wage and income
expectations - are modelled using a simple static scheme and a model version
in which these expectations are modelled using the rational expectations
hypothesis. Obviously, the rational expectations version is of special
interest because it allows us to examine the difference between anticipated
and unanticipated policy changes and the importance of the time horizon of
expectations. In addition, it is of some interest to investigate how various
computational aspects affect the simulation results.

The paper is organized as follows: in Section 2 we present a short summary of

the current version of our model and discuss some problems connected with
estimating and simulating the model. Section 3 contains some basic simulation
results and Section 4 deals with the dynamic properties of the model, i.e.
long-run effects of temporary (once-for-all) shocks and cyclical responses of
various random (unautocorrelated) and autocorrelated shocks. Section 5, in
turn, contains the simulation results with alternative expectation
specifications; at the end there is a brief concluding section.

2 A short description of the QMED model

QMED model is a small, aggregative quarterly model of the Finnish economy. The
current version consists of 35 equations and of 79 endogenous and exogenous
variables. The number of stochastic equations is 21. However, 6 of these
equations are some sort of auxiliary equations for income accounting, the
structure of private consumption expenditure, and for employment and the
labour fource. The remaining 15 main equations are reported in Table 1. In
order to save space, only the coefficient estimates and the basic equation
statistics are reported here. (The corresponding diagnostic statistics, which
rather well pass muster, are reported in Appendix 1, however.) The estimates
are OLS estimates; Hatanaka's iterative IV estimates are presented in Lahti
and Viren (1989). The model uses seasonally adjusted data which are almost
entirely derived from the Finnish National Accounts. A novel feature of the
current version of the model is the treatment of expectations. It is assumed
that expectations concerning the rate of inflation, the rate of change of real
wages, and real income are formed rationally, given information of the current
period. Inflation expectations, in turn, determine the expected real interest
rate, and all these variables together affect, in the first place, private
 287

consumption, investment in residental construction, manufacturing investment

and employment 2

Table 1: OLS Estimates of the Main Behavioural Equations of the QMED Model

(1 ) - .346*~x(-4) - .669*~pxf(-2) - .369*(x-f)(-1) + .363*(x-f)(-2)

(3.45) (2.56) (3.62) (3.57)

+ .800*~f + .638*~f(-2) + .360*cap(-2)

(3.09) (2.50) (2.77)

R2 = .553 D-W = 2.181 SE = .052

(2) ~m 1.184*~z + .704*~pzm - .484*(m-z)(-1) + .263*(m-z)(-2)

(3.93) (4.12) (4.42) (2.07)

+ .204*(m-z)(-3) - .250*cap(-1)
(1.72) (1.92)

R2 = .569 D-W = 2.342 SE = .055

(3) c = .595*c(-1) + .4l0*yhr(+1) - .002*(r-(400*~pc(+1») - .685*~pc(+1)

(7.38) (5.15) (1.45) (1.54)

+ .023*d1 + 1.800
(2.57) (4.73)

R2 = .992 D-W = 2.474 SE = .012

(4) ih .594*ih(-1) + .166*yhr(+1) - 1.992*hk(-1) + 14.062*n

(5.18) (0.65) (3.12) (3.27)

- .001*(r-(400*~pc(+1») - 0.450*pcih(-4) - 87.509

(0.75) (2.22) (3.22)

R2 = .733 D-W 2.264 SE = .045

(5 ) Hf ~ye - .412*(if-y)(-1) .064*d13*(if-y)(-1)

(4.68) (4.22)

- .001*~(r-(400*~pi»(-1) - .250*~wr(+1) + .1l4*d14

(1.46) (3.12)

+ .111*d15 + .113*d16 - .926

(3.35) (3.44) (4.72)

R2 = .552 D-W = 2.239 SE .046

2 Households' disposable income is endogenous in the model in the sense that it

is determined by the income tax rate, employment (a distinction is made
between wage earners and self-employed persons), the wage rate and other
income (which is modelled using an auxiliary equation in terms of the wage
rate, the price level, the self-employed persons' employment and the time
trend) .
 288

(6) A1 = .198*A1(-4) + 1.344*Ayi - .053*Awr(+1) - .224*(1-n)(-1)

(2.15) (3.12) (1.12) (4.81)

- .049*eap(-1) - .005*d2 + .024*d3 + .008*d4 - .329

(3.16) (1.33) (7.30) (4.38) (4.81)

R2 = .646 D-W 1.524 SE = .004

(7) Aw .109*A4(pe(+1» + .894*Awe - .011*eap(-1)

(7.93) (1.13) (18.50)

R2 = .886 D-W = 1. 915 SE = .005

(8) Ape .305*Awn + .127*Aw(-1) + .232*Awn(-2) + .078*Apm + .058*Apm(-1)

(5.91) (2.51) (4.57) (3.14) (2.30)

+ .053*pm(-2)
(2.10)

R2 = .695 D-W= 1.975 SE = .007

(9) Api .591*Awn + .043*Apmo + .043*Apm(-2) + .182*Api(-1) + .012*d5

(5.69) (3.43) (0.79) (1.56) (0.97)

+ .013*d6
(1. 21)

R2 = .437 D-W = 2.173 SE = .015

(10) Apg .595*Awn + .218*Awn(-3) + .099*Apm + .008*d7 .053*d8 + .028*d9

(7.84) (3.03) (2.75) (1.04) (7.19) (3.87)

R2 = .725 D-W = 1.963 SE .010

(11) Apx .156*A2(Apx(-2» + .300*Awn + .503*Apf + .192*Aer(-4) + .060*dl0

(2.82) (3.85) (1.39) (2.27) (4.45)

+ .057*dll
(5.96 )

R2 = .705 D-W 2.047 SE = .019

(12) r = .732*r(-1) + 9.444Ape + .240*rd + 3.332*Adr

(9.17) (2.94) (1. 38) (1.82)

R2 = .892 D-W = 1. 750 SE = .546

(13 ) q .440*q(-1) + .552*z + .084*ig .108*d12 - 1. 547

(5.40) (5.85) (1.71) (5.17) (4.22)

R2 = .998 D-W = 1. 369 SE .020

(14) cap = .006*t - 2.066 + .7*k(-1) + .3*n - q + mr

(17.22) (137.80)
 289

(15) Awc gp(-3) + .611*Apc(-3) + .404*A(w-wc)(-3) + .052*d17 - .006

(2.66) (2.78) (2.55) (0.95)

R2 = .242 D-W = 2.285 SE = .020

All variables, except r, are expressed in logs, and all expenditures are
defined in real terms. The number of lags in quarters is shown in parentheses
after each lagged variable (i.e. (-1) refers to period t-1 and (+1) to period
t+l). /:,. denotes the first backwards differencing operator and A4 denotes the
fourth backwards differencing operator. The numbers in parentheses below
parameter estimates are t-ratios. R2 = coefficient of determination, D-W
Durbin-Watson statistic and SE = standard error of estimate. The list of
variables is the following (exogenous variables are underlined):

c private consumption
ca current account
cap capacity utilization rate in manufacturing
d1-dl7 dummy variables
er exchange rate
i foreign import demand
R public consumption
gp rate of change in labour productivity (five-year moving average)
hk stock of housing capital
1.& public consumption and investment
if manufacturing investment
ih housing investment
k stock of capital, manufacturing sector
1 wage and salary earners' employment
m imports (excluding oil)
mr scale parameter for capacity utilization
.!l working-age population
pc private consumption prices
pcih pc - pih
.£i foreign producer prices, manufacturing
pg public consumption prices
pi investment prices
pih housing investment prices
.P!!l import prices
pmo import prices of oil
pq GDP deflator
Q£ prices of raw materials
prz pr - pz
px export prices of goods (excluding bilateral exports)
pxf px - pf
pz domestic demand prices
pzm pz - pm
q manufacturing production
r interest rate (government bond yield)
rd discount rate
~ employers' social security contributions
~ linear trend
w wage rate
wc contract wage rate
wn w*(l+s)
wr w*(l+s) - pq
x exports of goods (excluding bilateral exports)
 290

xe bilateral exports
y gross domestic product at constant 1985 market prices (GDP)
~ instrumental variable for output (determined by f and g)
yh households' disposable income
yhr yh - pc
Yi instrumental variable for output (determined by xe, f, (px-pq) and ig)
z domestic demand

Obviously, this kind of specification creates problems both in terms of

estimation and simulation. As far as the estimation problems are concerned, we
tried to solve them by using the Iterative Instrumental Variable technique
proposed by Hatanaka (1978). Thus, we first estimated the whole model using
OLS, the period of estimation being 1971.1-1986.4. We then formed the
Gauss-Seidel solution for the whole model and used the solution as the
instrument for both the expected inflation rate and the current-period
endogenous variables. The solution of the model was carried out using the
Extended Path Method developed by Fair and Taylor (1983). In order to improve
the small-sample properties of the estimators the whole procedure was iterated
several times.

As a rule, no serious computational problems were encountered in estimation

and simulation. This is obviously due to the small size of the model, and also
to the fact that only one period-ahead predictions are used in the basic
version of the model. 3

We are not able to discuss all features of (the rational expectations version)
of the QMED model here. May it suffice to say that it is basically a Keynesian
macromodel in which effective demand plays a crucial role. There are, however,
some features which abstract from this standard Keynesian framework: First,
prices, wages and interest rates are not (completely) rigid; second, the

3 Various values for the path extension parameter k and different tolerance
levels were used in solving the model. Thus, k was taken to be between 2 and
10, and the tolerance levels were varied between .01 and .000001 for the three
iteration types which were used in solving the model for the estimation period
(see Fair and Taylor (1983) and Fisher et al. (1985) for details of the
procedure). Different values for k did not make any noticeable difference.
Also, the tolerance level turned out to be of little importance. For instance,
as regards GDP, we could detect an average quarterly difference of a magnitude
of .01 % between two successive simulations, which differed by .10 in terms of
the tolerance level (with k, this difference was of the magnitude of .0005 %).
The average total number of passes through the model for the overall solution
was about 13 000. However, when the time horizon of expectations was extended
to two periods (see the discussion in Section 4), about 30 000 passes were
required. The corresponding average amount of CPU time with a Burroughs A12
computer was about 6 minutes (in the case of the static expectations version
of the model, only about 20 seconds were needed). Most of the computation work
was carried out using the lAS-SYSTEM software (see Sonnberger (1985) for
details). In the present study, the tolerance level was set at .005 for all
three types of iteration; k, in turn, was set at 3. The model was estimated
with three iterations of Hatanaka's IV estimation procedure. On another
occasion, we experimented by continuing the iterations until ten, but the
further iterations did not produce any noticeable difference in results.
 291

capacity variable is endogenous, allowing for supply side effects; third, the
demand for labour and capital depends on relative prices and some demand shift
variables - not on actual output; and, finally, expectations with respect to
some key variables are modelled using the rational expectations framework.

We cannot describe the functioning of the model in any detail here. Thus, we
limit reporting to the presentation of the mean absolute percent errors (MAPE)
for some key variables (see Table 2). These statistics are derived from a
dynamic simulation which makes use of data for the estimation period
1971.1-1986.4. As pointed out by e.g. Fisher and Wallis (1988) and Pagan
(1989), these dynamic simulation results should not, however, be used as a
proof for model validation. Rather, the diagnostic statistics reported in
Appendix 1 could serve this purpose. Although we accepted this point. the
dynamic simulation results may still be worth presenting because they show the
relative tracking performance of different equations. In addition, we report
some standard policy simulations using changes in interest rates, contract
wages, public consumption and investment as well as taxes, and, finally, oil
prices as 'policy variables,.4

Clearly, the MAPE values in Table 2 indicate that the model generates the
actual data rather well. This is true particularly if one takes into account
the relatively (in a cross-country sense) high volatility of Finnish exports
and price movements during the sample period. Moreover, there do not appear to
be any noticeable problems in terms of the long-run properties of the model.

Table 2: MAPE Values for the Estimation Period 1971.1-1986.4, %

OL5 H25

Gross domestic product (v) 1.41 1. 47

Private consumption (v) 2.27 2.22
Private investment (v) 2.30 2.33
Exports (v) 3.59 3.66
Imports (v) 3.28 3.40
Implicit GDP deflator (p) 1.89 1. 21
Consumption prices (p) 1.88 1.19
Export prices (p) 4.55 3.63
Wage rate (p) 1.77 1.71
Employment (h) .94 .90

v refers to volumes, p to implicit price deflators and h to working hours. OL5

indicates the MAPE values obtained using the OL5 version of the model (with
exogenous contract wages). H25 indicates the MAPE values obtained with
Hatanaka's iterative IV version of the model.

4 In order to help in understanding the logic of these simulations, it is

pointed out that Finland is a highly unionized country (the overall
unionization rate being about 80 %) and thus collective wage agreements
covering the whole economy are (or at least seem to be) of crucial importance.
As far as the determination of interest rates is concerned, they are (o~ have
b2en, until very recently) effectively controlled by the Bank of Finland via
the discount rate.
 292

3 Some simulation results of the QMED model

We now turn to the simulation results presented in Table 3. The effects of the
following sustained policy changes on gross domestic product (y). consumption
prices (pc). the interest rate (r) and current account balance (ca) are
tabulated for an increase in: a) the discount rate. b) the contract wage rate,
c) public consumption. d) public consumption and taxes, e) public investment
and taxes, and f) oil prices. All these changes take place at the beginning of
the first quarter of 1972, the model being solved, however. from the first
quarter of 1971. Thus, the changes are already known in advance. We do not
discuss here the time paths of these policy effects in detail. Rather. we hope
that it suffices to point out that these time paths are - at least in our
op~n~on - fairly standard (cf. e.g. Taylor (1985». An increase in interest
rates has a persistent - albeit declining - effect on GDP and a persistent -
albeit very small - negative effect on prices. In the oil price simulation,
the GDP effect is similar but the price effect is - as one might expect - much
stronger. An increase in contract wages has only a temporary positive effect
on GDP. which becomes negative after just two years (this is due to the
deterioration in competitiveness; notice that the exchange rate index is kept
unchanged in this simulation). Finally. expansive fiscal policy has a positive
effect on output.

There is a multiplier effect of the magnitude of 1.5, the long-run effect

being about 0.5. (Obviously, these values depend very much on the way the
deficit is financed: for instance in alternative c it is assumed that foreign
borrowing is used).5 The public investment simulation indicates that if one is
able to change the structure of demand so that consumption is decreased and
(productive) investment is increased, this has a significant positive effect
on output. This is due to a positive capacity effect, which. in turn. affects
wages, prices and net exports. Thus. the model suggests that the public sector
could achieve some favourable growth effects with a well-designed structural
policy.

4 Examining the dynamic properties of the model

Before focusing on the role of expectations we shortly analyze the dynamic

properties of the QMED model. This is done in two different ways. First.
temporary policy shocks are introduced to the model. Six exogenous variables
are increased temporarily (one at a time) in the first quarter of 1972 (only)
and, after this shock, model simulation is continued until 1997.2. The purpose
of this simulation is to find out whether the model returns to the original
(control) solution path. Secondly. unautocorrelated random shocks and.
alternatively. autocorrelated shocks are fed to either endogenous or exogenous
variables and alternative time paths of GDP are generated by dynamic

5 The contract wage, public demand and tax rate simulations are based on the
assumptions that the central bank pegs the discount rate. Moreover. the
exchange rate index is treated as exogenous. Thus. the resulting real interest
rate and real exchange rate effects do to some extent affect the long-run
adjustment paths, which. however. are not of the main interest here.
 293

Table 3 : Policy Simulation Results l }

72.1 73.1 74.1 75.1 76.1

a) Interest rate simulation 2 }

y -.02 -.10 - .11 -.09 -.05
pc .00 -.00 -.02 -.05 -.09
ca 1 S 22 37 52
r .24 .71 .S4 .S8 .89

b) Contract wage simulation 3 }

y .09 -.01 -.01 -.03 -.06
pc .30 .79 .S4 .85 .S5
ca -2 -12 -21 -33 -42
r .02 .02 .01 .00 .00

c) Public consumption simulation 4 }

y 1.71 1. 02 .SO .72 .60
pc .00 .OS .33 .61 .91
ca -31 -51 -100 -144 -178
r .00 .00 .01 .02 .02

d) Balanced budget simulationS}

y 1.12 .31 .26 .39 .47
pc -.00 .00 -.01 -.04 -.08
ca -4 34 90 147 202
r -.00 .00 .00 -.00 -.00

e) Public investment simulation 6 }

y .46 .46 .77 1.15 1. 65
pc -.00 -.03 -.10 -.21 -.36
ca 27 S4 214 369 524
r -.00 -.00 -.00 -.01 -.01

f) Oil price simulation7}

y -.01 -.04 -.07 -.OS -.OS
pc .OS .22 .48 .75 .90
ca -36 -39 -130 -125 -137
r .01 .01 .01 .01 .01

1) Effects are given as cumulative percentage differences between base and

variant for GDP, y, and consumer prices, pc, and as absolute differences
for the interest rate, r (I), and the current account, ca (millions of
FIM). All changes in shocked variables are permanent. Except for simulation
b), the contract wage rate is endogenous in the model.
2) A one percentage point increase in the central bank's discount rate.
3) A one per cent increase in the contract wage rate.
4) An increase in public consumption by an amount equal to one per cent of
GDP.
5) An increase in public consumption by one per cent of GDP and financed by an
equal j~crease in income tax revenue.
6) An inc: 2ase in public enterprises' investment by one per cent of GDP and
financ j by an equal increase in income tax revenue.
7) A ten 2r cent increase in oil prices.
 294

simulation. The eventual cyclical behaviour of GDP is then analyzed in the

frequency domain. 6

Let us first turn to the exercise with temporary policy shocks. The exogenous
(policy) variables which are analyzed here include public consumption (g),
contract wages (wc), discount rate (rd), income tax rate (tax), foreign import
demand (m) and import prices of oil (pmo). A 10 per cent shock is introduced
to each of these variables and the time path of GDP for each particular
variant is derived by means of dynamic simulation. Then the cumulative
percentage differences between the base and the variant solutions are
computed; these differences are presented in Figure 1. The sample period is
1971.1-1997.2. The data for the exogenous variable covering the period
1987.1-1999.4 are based on the extrapolated values of these variables. 7

Clearly, the effects of the temporary shocks on GDP die out rather quickly and
the long-run cumulative effect is zero. The discount rate represents some sort
of exception. The effect of the one-quarter shock on GDP lasts several
quarters and dies out rather slowly (notice, however, that the magnitude of
the whole effect is very small). Towards the end of the sample period, the
time path of GDP clearly deviates from the corresponding control solution
path. (A similar effect can be discerned with other policy shocks as well).
The obvious reason for this is that the model is here solved without any
terminal constraints, which can be of cPlcial importance given the rational
expectations form of the model. 8 Anyway, these simulations suggest that the
stability properties of the model are not far from satisfactory.

After this, we seek to analyze the cyclical properties of the model. This is
done by introducing, in the first place, purely random shocks to both the
endogenous and the exogenous variables of the model and by solving the model,
and then scrutinizing the cyclical pattern of the resulting time paths of GDP.
This exercise is carried out in the following way. First, we generate data for
the exogenous variables for a sample period of 150 quarters. In the case of
the control solution, these variables obtain constant values for all quarters,
the values being equal to the actual val'les of the last quarter of 1985. Then,
in the first experiment we introduce random shocks to ten exogenous variables:
public consumption (g), foreign import demand (f), discount rate (rd), foreign
producer prices (pf), working age population (n), bilateral exports (xe),
import prices excluding oil (pme), import prices of oil (pmo), income tax rate
(tax) and contract wage rate (wc).9

G See Howrey and Klein (1972), Naylor et al. (1969) and Bianchi et al. (1978)
fer earlier examples of this kind of 2.:\ l",is. See also Hm.ney (1980) for a
:pvi€~ of basic methodology.

To be more precise, it is assumed that the growth rates of the exogenous

variables are the same as in the period 1980.1-1985.4.

9 It also turned out that the time pat!, cf the dynamic S01ution for the last
observations in the data sample was rather sensitive in terms of computationa:
u,--:;uracy (cf. fn. 2). In general, this cer1sitiveness ceald be decreased by
ipcreasing accuracy from, say, the conventional .01 to .0001. As far as the
role of terminal conditions is concerne~. see e.g. Fisher (1987) and Minford
et a1. (1979).

9 In the case of the discount rate (rd; .ru~ the tax pa~ameter (tax), the
~ tandard dev ia tion is computed around t.~i2 :nean.
 295

Figure 1: Effects of Temporary Policy Actions on GDp 1 )

Publ i c consu mpti on Contract wages

3 1.0

I
I ! !
!I I
:
2 0.5
! -+~
i 0 .0
i
i i j i.
~T"'" I

a
I - 0 .5
I II
V
=- I
- 1 1975
=t I I I I I II
ao
I II I
85
III
90
i II
95 2000 - 1.0
-1 1/ 1 111 1
197 5 80 85 90 95 2000

Discount rate Income Tax rate

0 . 04 0 .5

- (' r--
0 .0
0 . 02

-
( I'- ./
il - 0 .5
0.00

~I
-1.0

- 0 . 02
-1.5
- I I -I I II I :1 I II I! /I I 1111 1 1 11 1 111 1 11 1
- 0 . 04 1975 I " /I -2 .0
80 85 90 95 2000 1975 80 85 90 95 2000

Foreign demand Oi l prices

1.5 0 . 01

1.0 0 . 00
rr- r-... . . . . '1.

0.5 - 0 .01

0.0 - 0 .02

- 0 .5 f - 0 .03
I

- 1.0 - 0 . 04 II I II I I Il l!
1975 80 85 90 95 2000 1975 80 85 90 95 2000

1) All effects are given as cumulative percentage differences

between base and variant for GOP given a 10 percent increase
in exogenous variables
 296

The random shocks are generated by using the normal distribution so that the
standard deviations correspond to those obtained from the computed deviations
between the actual values and the time trend. Thus, random shocks occur in all
of these ten variables in each one of the 150 periods. The model is solved
using these shocked exogenous variables, and spectral densities are computed
for the corresponding log difference of GDP. The exercise is repeated ten
times and the resulting average value of the spectral densities of ~log(GDP)
is presented in Figure 2. 10

In the same way, stochastic shocks are introduced to endogenous variables (cf.
equations (1) - (13) in Table 1). Thus, a nonzero error term (with the
standard deviation corresponding to the standard error of the estimate) is
introduced to all structural equations and the model is solved by means of
dynamic simulation for the same sample of 150 observations but now using
constant values of exogenous variables. Again, spectral densities of ~log(GDP)
are computed for the resulting 149 observations and the exercise is repeated
ten times. The average value of these densities is also presented in Figure 2.

Now, what can be said of the cyclical properties of the QMED model? As far as
shocks in exogenous variables are concerned, it is immediately obvious that
the resulting cyclical behaviour is characterized by short-term movements with
a duration of less than one year, so it is really more a question of some sort
of seasonal cycle. There is a weak cyclical component representing a two-year
cycle but this is really overshadowed by the short-term cyclical behaviour.
Finally, there are no signs of long swings (lasting more than, say, ten
years). Given the earlier results with temporary policy shocks presented in
Figure 1 these long-run properties are not really very surprising.

However, shocks in endogenous variables create a completely different cyclical

behaviour of GDP. As can be seen from Figure 2, these shocks do not produce
any clear cyclical pattern. There are some signs of short cycles and of a long
cycle lasting over ten years. But, after all, we find that completely random
shocks in endogenous variables of the model do not generate clearly
distinguishable business cycles, nor other well-behaving cycles. The fact that
shocks in exogenous and endogenous variables have different cyclical effects
was discovered already in the classic study of Adelman and Adelman (1959),
although they found that white noise disturbances generated cycles at business
cycle frequencies, while innovations in exogenous variables did not. 11 Even
though shocks in exogenous variables might do better in this respect, it
remains clear that the shocks which are fed in may not be completely random
but some degree of autocorrelation must be assumed.

This is why we carried out another simulation experiment in which we

introduced autocorrelated shocks in both endogenous and exogenous variables.
The idea that shocks are indeed autocorrelated instead of being purely random
can be justified by various arguments which have been put forward in the real
business cycle literature. Among others, one can refer to the Kydland and
Prescott (1982) approach, which emphasizes the importance of relatively long

10 The Tukey-Hanning window is used, the lag length being 40. Notice that
because of the rational expectations specification of the model the random
shocks are not genuinely random but they are in a sense expected. Thus our
results cannot be directly compared with some earlier results from models
which use backward-looking expectations or have no expectations at all.

II See also Salmon and Wallis (1982) for a review of earlier results.
 297

Figure Z: Averages of Spectral Densities for GDP

Random shacks in exogenous variables

0.1

0.0

Random shocks in endogenous variables

0.1

0.0 L L - - - - - - - - - L - - - - - -__~__________
L __ _ _ _ _ _~0.5

Autocorrelated shocks in exogenous variables

0.1

0.0

Autocorrelated shocks in endogenous variables

0.1

0.0 LL--------~----------~--------~--------~O.5
 298

gestation periods in investment and production and. in addition. various

(persistent) technology shocks. Moreover. one can refer i.a. to the
possibility of indivisibilities in labour supply. sectoral shifts. oil shocks
and preference shocks (although preference shocks are not very popular in this
literature). Shocks to government purchases or tax rates are typically not
introduced to real business cycle models. but this is mainly due to the simple
structure of these models. Anyway. the important thing is that all these
shocks can hardly be considered as purely random but rather more or less
persistent. (See e.g. Eichenbaum and Singleton (1986) for an overview of these
models.)

In order to have persistent shocks' we applied the following moving average

transformation to the random shocks Uit which were used in the previous
exercise:

(1) urit = Uit + . 45uit_l + .30Uit_2 + .15uit_3 + .08Uit_4.

where i = 1. 2 • . . . , 10 for exogenous variable shocks and i = 11. 12 •...• 23

for endogenous variable shocks. Given these processes, the generated shocks
ur it are. of course, autocorrelated and. moreover, in a way which is not much
different from an AR(l) case. On the other hand, the AR(l) structure seems to
be a rather good approximation for the time series properties of the key
variables of the model (see Lahti and Vir~n (1989), which also contains the
estimated autocorrelation functions of first log differences of these series).

The dynamic simulation experiment with these autocorrelated shocks was carried
out in the same way as the above-presented experiment with the purely random
shocks. The resulting spectral density functions are presented in Figure 2.
Clearly, the GDP series display some cyclical behaviour. When exogenous
variables are shocked, the GDP cycles are still rather short. although a clear
cyclical peak at the frequency of 2.2 years can also be discerned. In the case
of shocks to endogenous variables, the corresponding cycle length is about 3
years. Obviously. these cycle lengths are too short compared with conventional
business cycles, although with Finnish data for the 19703 and 1980s business
cycles are not easily found. Only a rather weak 4-year-cycle can be discerned
but that does not represent an important point of reference. This is not.
however, important. It is obvious that the cycle length of the generated
series can be increased by increasing the persistence of shocks. In this
context. the important thing is to know that reasonably persistent shocks do
generate medium-term cycles while purely random shocks only generate
short-term cycles (or no cycles at all).

5 Examining the role of expectations

Next. we deal with the question of how expectations functi.·:)n in this model. To
do so. we consider four alternative versions of the model. or ways of
performing the policy simulation. The policy simulation on which we
concentrate here is the contract wage simulation. in which the contract wage
rate is increased by one per cent at the beginning of the first quarter of
1972. The alternatives are:

1) We use the Rational Expectations (RE) version ot the model (see

Table 1) and assume that the change in contract wages is already known
at the beginning of the first quarter of 1971.
 299

2) We change the model by extending the time horizon for expectations to

two periods and assume again that the change in contract wages is known
in advance.

3) We repeat simulation 1 (explained above) but assume now that the policy
change is not known in advance.

4) We change the model by using static expectations for the rate of change
in consumption prices, wages and households' disposable income,
respectively.

The results of these simulations are reported in Figure 3. When the results
are scrutinized, it turns out that there is at least one important difference
in the results. Namely, simulations 1 and 2, on the one hand, and simulations
3 and 4, on the other hand, differ considerably in terms of the advance
effect. Thus, if we use a rational expectations specification and allow
economic agents to know the policy change in advance this change already has
significant (real) effects before the policy change actually takes place.

In this model, the advance effects are mainly due to the income effect:
households' real disposable income will increase and households react to this
increase in advance by increasing consumption and investment in residential
construction. In addition to this "income effect", the model reacts to
inflationary expectations. A change in inflationary expectations operates
through the direct inflation effect (which affects consumption negatively) and
the real interest rate effect (which tends to increase consumption) (see
equations 3 and 4 in Table 1).12

It is not only in terms of the adva~ce effects that these four simulations are
different. The whole short-run dynamics are very different. In the case of
simulations 1 and especially 2, the advance effect dominates the whole
short-run dynamics. This effect is of considerable magnitude. If the time
horizon of expectations is two periods, a one per cent increase in contract
wages increases GDP by .06 per cent during the previous year. If the time
horizon is only one period - as in the basic version of our model - the effect
en an annual basis is a little less than one half of this. By contrast, in the
case of simulation 3 (the "surprise case") the positive short-run effect is
strikingly small. The positive consumption (real wage) effect is nearly offset
by the simultaneous negative net exports effect. Finally, in the case of
simulation 4 (with static inflation and income expectations) the simulated
time paths are very close to those of the "surprise" simulation 3 (the
positive output effect being, however, slightly larger). Thus, in a sense one
can say that old-fashioned static-expectations macromodels assume that all
policy changes are, in fact, unanticipated.

Even though the simulations differ considerably in terms of short-run effects,

the medium- and long-run effects are very similar. In the medium run, the
effect is either nil or slight':'y negative, '"hile in the long run the effect is
clearly negative .13

i2 '..men evaluating these results one should keep in mind that prices and wages
,,1:':not completely flexib12 ire Lhe short run. Hence, the results may be more
consistent with models .;£ tee 'Teary cL:.l Stiglitz (1983) type than with
:'t'~;'eotype market-clc:a~ c.:-q, .:u:r rational e1q:ectations models.

13 The results seem to be analogous to those obtained by Fair (1979).

 300

Figure 3: Effect of an Increase in Contract Wages on GDP and Consumption

Prices under Different Forms of Expectations' Formation*

GOP Consumption Prices

~~! ~-~
-0.05 "-_ _ _ _..L_ _ _ _- '_ _ _ _---'

,.0012)FlE;~'WO
lead'
~.~i --.p:.~~2)
E-- FIE:-+-;
IwO I"_ad' -----1d ::: E-----
====~
0.25 E-_-----f7%?1:~~~:>-jo7;lt7.:~:::>l
0.00 t:...._ _ _"'"'~::.L.:::.dLL1L.o""""O>:::LoI:.Go~
-0.05 1 : . - ---
- ' --
- --
-----
'-------'

;.u'P';=..::1
~.~ :=t=:::~:::3lRE:: j3)RE;SU,P.';se
1.00

::: ~-----~~---+~~~~~
~~~
_o.ost= ___--'______ ...1..._ _ _ _- - ' .
0.25 E-=-----~;:y:$i?::F7~~~~ii7;~
0.00 t:....~ _ _ _c.::::..:lG=a:::L.I.~~~O:::\':;.:l

0.15 c------r------------, 1.00 c---- - - -- ----,r------,

4) static expectat ions 4l s.tat ie expectatIo ns
0 .10 b - - - - - - t - - - -- - - . - - -- - - l 0.75 F--..:...---;----=:d.,...,~;e;:~~

0.05 E-----+-f53I----t----- j 0 .50 1:------+---I7~?:I~7j':t:~7j!

0.00

-0.05 L---'--,9~7:-,-'-.L.J.-:-::'=-'--'-..L.:-:::::-1--'

*) Percentage difference between bue and variant

 301

One could of course discuss the proper ways of specifying the transmission
mechanisms of price and income expectations, for instance in the context of
the present model. It is clear that the present specification is deficient in
many respects. But perhaps the most important thing is, after all, the fact
that rational expectations do matter when evaluating the policy effects. That
is, the short-run effects of various "policy" changes are extremely sensitive
with respect to the way expectations are allowed to have an influence in the
model.

6 Concluding remarks

Our model is by no means complete. This is particularly true as regards the

way expectations are modelled. Even so, some interesting new results can be
obtained by making use of rational expectations (and by allowing for flexible
wages and prices as well as supply-side effects). Without attempting to
summarize our results in full, we would like to stress two points. First, the
estimation and simulation of (small-scale) models which make use of some form
of rational expectations do not represent a computational nightmare - as was
generally assumed in the 1970s (cf. e.g. Poole (1976)). Second, we can no
longer carry out policy simulations without specifying whether the change is
anticipated or unanticipated. This would seem to suggest that treating policy
variables as exogenous should be considered with great caution. Clearly, it is
not only the question of whether some variables are endogenous or exogenous
which becomes delicate with the rational expectations macromodels. Such things
as "the existence of policy regimes" and "the credibility of economic policy"
also start to be real problems. If the advance effects are really of crucial
importance then it is, of course, of crucial importance how different signals
from policymakers are interpreted. That, in turn, has something to do with the
past record of policy actions. 14

14 Unfortunately, we cannot continue this discussion here. The interested

reader is referred to Barro and Gordon (1983) and Friedman (1979).
 302

Appendix 1 : Diagnostic Test Statistics for the Main Behavioural Equations

Equation rl rz r3 r4 CHOW J-B ARCH(4)

No.

1 -.764 -.277 1.258 -1. 088 .749 .416 11.904

2 -1.374 -.317 -1. 568 .380 2.717 .112 6.016
3 -2.081 .126 .860 -.670 4.433 .768
4 -1.115 .255 .291 -1. 560 2.844 .188 1.152
5 -1.046 .461 1. 494 -2.679 .756 8.064
6 1.506 .700 .438 .061 4.154 2.432
7 - .113 1.662 -1.294 1.780 2.783 1.163 5.440
8 .066 -.264 -1.047 2.762 .501 6.980 1.920
9 -1.150 -1.633 -.859 3.635 2.099 26.048
10 -.094 -3.851 -1. 231 3.206 .917 11.520
11 -.190 -.383 -1. 316 - .171 1.072 1.984
12 .906 -.696 1.447 1.232 3.521 10.805 7.936
13 2.516 .840 1. 327 -.157 23.808 1.152
Critical
values 1.645 1. 645 1. 645 1. 645 2.370 5.991 9.488

Equation numbers are the same as in Table 1. The ri's refer to Godfrey's
autocorrelation test statistics for lags of 1, 2, 3 and 4 quarters, CHOW to
the Chow stability test statistic for the period 1977.2 (due to dummy
variables this statistic could not be computed for all equations), J-B to the
Jarque-Bera test statistic for normality, and ARCH(4) to Engle's
autoregressive conditional heteroscedasticity test statistic for four lags.
For other details, see Kramer and Sonnberger (1986). In this context we can
mention that the OLS residuals are typically not contemporaneously correlated.
Thus, only 4 out of 78 coefficients of correlation exceed the 5 per cent
critical value. In the case of squared residuals, however, the corresponding
number is 12. Moreover, if principal components are computed for these (13)
squared residuals, the first two account for about 80 Z of total variation.
Quite clearly the variability of the price and volume series is affected by
some common source(s) of variation.

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Means of Ensuring Unique Solutions for Rational Expectations Models with
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Neary, R. and J.E. Stiglitz (1983): "Towards a Reconstruction of Keynesian

Economics: Expectations and Constrained Equilibria", Quarterly Journal of
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Econometric Models", Journal of Econometrics, 40: 125-139.

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Macroeconomic Policy Rules", European Economic Review, 28: 53-81.
Qualms About the Linearized Expectations Hypothesis and
Variance-Bounds Studies of the Interest Rate Term Structure

Gary S. Shea
The Pennsylvania State University
Department of Finance
609 Business Administration Building
University Park, P A 16802, USA

Abstract
Campbell (1986) has shown that the linearized term structure hypothesis can reconcile the
conflicting objections to traditional term structure hypotheses raised by Cox, Ingersoll, and
Ross (1981). We build a cOintegrated model of the nonstationary zero-coupon term
structure which imposes the constraints of the Local Expectations Hypothesis (LEH).
When we simulate coupon-bearing bond term structure data, we find the linearized excess
volatility tests specified by Shiller (1979) and Singleton (1980) are nearly always
unreliable. Current practice is to linearize models around 'duration' points which result in
accurate approximations to yield data, but which also result in unreliable volatility tests.

Keywords: Expectations hypothesis; interest rates; term structure; cointegration; linearized

test statistics; nonstationary time series

Contents
1 Introduction

2 The Qualms Heuristically Explained

3 A Cointegration Model of the Local Expectations HypothesiS

4 The Simulations

5 Conclusions
Acknowledgemen ts
Appendix
References
 306

1 Introduction
In this paper we examine a recently developed method for testing simple present-value
models of the interest rate term structure. The linearized expectations hypothesis and its
associated test statistics were introduced by Shiller (1979), a means of attaching standard
errors to the statistics were presented by Singleton (1980), and since that time the
theoretical underpinnings of the model have been laid down by Campbell, Shiller, and
Schoenholtz (1983), Campbell and Shiller (1984), and Campbell (1986). Linearization is
common practice among econometricians to simplify an intrinsically nonlinear model, to
translate nonlinear constraints into a set of equivalent linear ones in a transformed model,
or even to approximate otherwise unobservable data. Each of these respective applications
of linearization technique has appeared in the papers cited above and in an additional
paper by Campbell and Shiller (1987). The intent of this paper is not to cast doubt on the
linearized term structure hypothesis itself, nor on all its results that have appeared so far in
the literature. We do intend to demonstrate however that the linearized hypothesis cannot
be uniformly successful in solving problems to which it has been applied in the study of the
term structure. In particular, we focus upon the reliability of linearized variance-bounds
tests whose results are widely cited as unfavorable to the simple expectations hypothesis
and bond market rationality and whose results are consistent with anomalous pricing
bubbles in fixed term securities.
The literature on excess volatility implied by inefficient market expectations has focused
primarily upon equilibrium relationships in the stock market (between prices and
dividends) and the term structure (long-term and short-term yields) as cases for study. In
the second round of papers in this literature, wide-ranging criticisms were leveled at the
empirical technique of the first papers. These cri ticisms are all well surveyed by Gilles and
LeRoy (1987), but we will summarize a few of these points here to distinguish them from
the criticisms presented in this paper. The criticisms primarily concern stock market
applications of excess-volatility tests and among these we can discern two broad themes.
First, test statistics based upon ex-post rational (perfect foresight) prices will, by
construction, contain finite sample biases; this point was first raised by Flavin (1983).
Related to this was a second critical argument, advanced by Kleidon (1986), that the
smoothing implications of present-value models cannot be reliably inferred from but one
time-series sample (even of very large size) of actual prices and approximated ex-post
rational prices. Such criticisms are not pertinent to the term structure literature, however,
since the use of ex-post rational prices or yields has been quite limited in that context. In
Shiller's (1979) paper, for example, comparable time series plots oflong-term yields and ex-
post rational long-term yields are subject to this criticism, but are offered only as
preliminary evidence of variance bounds violations.
Test statistics for excess volatility within a linearized framework, however, have been a
primary means used to study the term structure. When introduced, it was intended that
linearized term structure tests for excess volatility could substitute for methods based upon
multivariate stochastic models which are the approach taken by LeRoy and Porter (1981).
To date, there has been no examination of the empirical reliability of these techniques as
there has been for the stock market tests. In this paper we examine whether the linearized
framework is an adequate approach to studying excess volatility in the term structure.
The paper proceeds as follows. In the following section we briefly explain the linearized
term structure model, its motivation, and its variance-bounds implications. In a very
heuristic fashion we explain our qualms with the variance-bounds tests used to date. In the
next two sections, we develop and simulate a term structure model which conforms to a
simple expectations model and see whether in that model our qualms are justified. Then
we conclude with a summary of the results, lessons, and speculations on further research.
 307

2 The Qualms Heuristically Explained

A traditional expression of the expectations hypothesis of the term structure is that long-
term yields are arithmetic averages of expected future short-term yields. This expression
applies precisely to continuously-compounded yields on zero-coupon bonds, but is widely
used as an approximate expression of the equilibrium relation between long-term and short-
term yields of coupon-bearing bonds too. The variously cited implications of this model of
the term structure are that short-term spot yields equal expected short-term
holding-period yields on long-term bonds and forward yields equal expected future spot
yields. Cox, Ingersoll, and Ross (1981) have shown that in a very general stochastic
description of the term structure it is impossible to simultaneously impose all the
traditionally implied constraints on expectations; the equivalence of expected
holding-period returns and the current spot short-term rate (what Cox, Ingersoll, and Ross
call the Local Expectations Hypothesis, or LEH) cannot hold along with the equivalence of
forward yields and future expected spot yields (what they call the Return-to-Maturity
Expectations Hypothesis). In an interpretation of Cox, Ingersoll, and Ross's work,
however, Campbell (1986) showed that a broader view of the traditional expectations
hypothesis which allows for constant, but nonzero, premiums in the Local Expectations
Hypothesis or the Return-to-Maturity Expectations Hypothesis or both, can be
accommodated in a linearized version of the traditional model. The linearization
techniques presented in that paper were extended to the coupon-bearing term structure and
thus provided formal justification of the technique as it was applied in the earlier papers by
Shiller (1979), Campbell, Shiller, and Schoenholtz (1983) and Campbell and Shiller (1984).

The linearized term structure equation as it appeared, for instance, in the originating
Shiller (1979) paper was

(1)

where {3 is a constant between 0 and 1 and 1> is a constant premium. The long-term yields
(R) refer to yields of coupon-bearing bonds, of course, and the truncated exponential sum
of expected future short-term yields (r) puts greater weight on near-term expectations than
on far-term expectations. The linearization point commonly chosen is (3 = l/(l+C), where
C is the coupon rate of long-term bonds at issue, although in empirical practice, the sample
average yield on long-term bonds is used instead of C. We mi~ht call this 'duration
linearization' since Equation (1) "may be described as setting the (n)-period rate equal to a
duration-weighted average of expected future interest rates of any maturities that cover the
period from t to (t+n)." [
It is at this point that our first qualms about the linearized term structure hypothesis arise.
It is often asserted that the usefulness of the linearized hypothesis lies in its accuracy, but
this has usually connoted the accuracy with which linearized expressions of yields, for
example holding-period yields, approximate the exact yields on coupon-bearing bonds. As
long as we consider only long-term bonds near issue so that yields cannot be far from the
original coupon rates, these approximations can be very good and much evidence has been
marshaled in this direction (cf. footnote 9, Shiller, 1979, Table 1, Shiller, Campbell, and
Schoenholtz, 1983, and Tables I and II, Campbell, 1986). One such approximation used in
this paper is for holding-period yields,

(2)

[Shiller, Campbell, and Schoenholtz (1983, page 179).

 308

. 1
with fJ. = fJ(l-&-) .
J (1-&)
If Equation (2) is a good approximation for exact holding-period yields, does that imply·
that its subsequent use in variance-bounds tests is reliable? The question has not been
addressed, but it seems a doubtful proposition. Yield is, in general, a nonlinear function of
coupon and price, and duration linearization is designed to eliminate the nonlinear coupon-
related terms of the function in circumstances when they are likely to be small, that is,
when long-term bonds are selling near par. But in a variance-bounds test we try to infer
the relative variances of zero-coupon yields from the sample variances of coupon-bearing
yields or their approximations. The two objectives of accurately approximating yield data
in levels and accurately measuring the relative variances of yields seem to be quite
dissimilar. Could it be possible that duration linearization defeats the construction of
reliable variance-bounds tests even though it results in accurate yield approximations?
This is our basic qualm and to give it more substance, we now examine the linearized
variance-bounds tests themselves.

The linearized statistics that test the LEH were derived by Shiller (1979) as follows. If
short-term and long-term yields are stationary, the standard deviation of holding-period
yields in the linearized framework is bounded so that a(H) $ aa(r), for large j (thUS fJj~ fJ)
and a = (1_;)-1/2. If yields require differencing in order to render them stationary, the
bounds are a(H-r) $ ba(6.r) and, further, if the covariance between R-r and 6.r is
-
negative, the bounds are a(H-r) $ ca(6.r), where b
2 1/2 /(l-fJ)
= fJ(1-fJ)- and c = fJ/(l-fJ).
Shiller claims an advantage for these variance-bounds inequalities because in them "we
make no assumption, it should be emphasized, about the nature of the random processes or
the information used in forecasting." 2 But, to the contrary, such assumptions are clearly
being made since the relative variances of holding-period yields and short-term yields are
being directly related to interest rate levels; empirical evidence and modelling practice for
the term structure does not treat such a restriction between relative variances and interest
rate levels as relevant. We acknowledge that a linearized variance bound must be some
function of interest rate levels to properly account for duration effects in coupon-bearing
bonds' yields, but is it likely that, only because of linearization, the relative variances of
holding-period yields and short-term yields in the underlying zero-coupon term structure
can be summarized in one parameter and that this parameter is nothing but the simple
function of interest rate levels used in current practice?
We have other qualms. A linearization point is properly a function of an exoiSenously
supplied model parameter or population datum. In this respect, treating fJ as l/l1+C) is
proper, but when the sample average R (Rsa) is used so that fJ itself becomes a random
variable (l/(l+Rsa) whose sampling variation is not accounted for in linearized test statis-
tics. Finally, if we acknowledge that interest rates might be nonstationary, Rsa itself will
be undefined in the population, so it is doubly problematic what the sampling reliability is
of test statistics that depend upon Rsa. With respect to these two latter qualms we note
there is a presumption in this literature that linearization must be around an interest rate
level and a, b, and c are therefore not sensitive to Rsa since Rsa will generally be small and
"( = l/(1+Rsa) will therefore not vary much as a function of interest rate levels.

Shiller confirms (1979, page 1203) that the elastici ty of a with respect to Rsa for his data
appears to be -.5, but for band c it can similarly be calculated that they respectively are
-1.4 and -1. There is also tacit acknowledgement (cf. footnote 16, page 1204) that with

2Shiller (1979, pages 178-79).

 309

nonstationary interest rates, duration linearization may be inappropriate, but it was

concluded that nonstationarity did not characterize his data and was thus not a problem.
No formal tests for nonstationary behavior were conducted although in a later paper
(Campbell and Shiller, 1987) unit-root restrictions were imposed upon a modelled term
structure.
To answer these qualms we construct a simulation model for the interest rate term
structure. To make the answers appealing, the structure of the model must conform to
some established modelling practice and, of course, conform to an equilibrium expression of
the expectations theory. Parameters of the model must also result in simulations that have
some empirical verisimilitude. We fulfill these requirements in the next section in which
we develop a cointegration model of the term structure.

3 A Cointegration Model of the Local Expectations Hypothesis

In light of the revealed difficulties in deriving a time-consistent and theoretically consistent
expectations model of the term structure, in this section we use a simple local expectations
model of the interest rate term structure. 3 We first build a discrete time series model of
the zero-coupon term structure in which we impose the constraints implied by the Local
Expectations Hypothesis. In doing this we must restrict our attention to the
variance-bounds implications of the Local Expectations Hypothesis. This term structure
model will be repeatedly simulated and the resulting data will be used to construct term
structure data for coupon-bearing bonds. Then the variance-bounds tests for short-term
yields and holding-period yields developed by Shiller (1979) and Singleton (1980) will be
applied to this data. If the Local Expectations Hypothesis is rejected too frequently or too
infrequently, we shall look for the source of the problem. A second feature of the
simulations is that our cointegration model will contain a unit root. There is empirical
evidence that interest rates and the term structure are nonstationary in the sense that a
discrete stochastic difference equation representation contains a unit-root; results of unit-
root tests have been provided by Nelson and Plosser (1982) and by Campbell and Shiller
(1987), who have also applied unit-root cointegration models in their work.

The Local Expectations Hypothesis for nonstationary term structures implies that Hand r
are unit-root processes, but that the difference, H- r, is a stationary forecast error process.
Cointegrated time series models developed by Granger and Engle (1987) define equilibrium
between series of this type in terms of their low frequency coherence. We shall build a
model for Hand r that is cointegrated of order (1,1) and in this way we can treat H- r as
the forecast error that the Local Expectations Hypothesis requires it to be and also flexibly
model the short-term dynamics of Hand r. We adopt the notation of Granger and Engle
and employ a number of the results of the Granger Representation Theorem. Let

r t
H( 1)
t
x t -- H( 21 , where r t denotes the short-term spot yield at time t and Hi j 1 is the short-
t

term holding-p(Oriod yield realized at time t from the sale of a j-period term-to-maturity

3Gilles and LeRo.v (1986) extend Cox, Ingersoll, and Ross' work in exploring the
circumstances Ir, wrllc~ the LF.H '.vc"11:1 re true in a discrete time framework.
 310

bond. Further, let

H(ll-r
t t
be a vector of equilibrium errors we have chosen to be of length 9

H( 9)_ r
t t
in our simulations. We put these elements together in a ditIerence equation,

A*(B)(l-B)x t = -fZt-l + <'t' (3)

where B is the backshift operator, <' is a vector of multi variate-gaussian errors, A *(0 )=1,
A*(l) has all elements finite and ,*0. This is the so called error correction representation
of a cointegrated system. The Local Expectations Hypothesis implies that rt equals the
expected short-term holding period lield for any long-term bond and this constraint is
easily imposed on the system. Part (5) of the Granger Representation Theorem justifies a
stationary representation of Zt that can be wri t ten,

(l-B)Zt = -0' fZt-l + J(B)Et . (4)

The Local Expectations Hypothesis merely requires that 0' {-I and J(O)=J(B). We have
chosen a structural form for our simulation models, described in detail in an Appendix,
which conforms to the LEH and also lets us control the relative variances of .0.r and H- r
so that var[H-r]/var[.0.r] smoothly increases with j which is a hallmark of short-term
holding-period yield data. We can also control for the sign of the correlation coefficient
between .0.r and R- r, a matter of some importance in judging the reliability of linearized
volatili ty statistics studied in the next section.

4 The Simulations
The simulations are designed to answer several questions. First, what can we say about
the influence of the relative variances of the zero-coupon holding-period yields and short-
term spot yields upon the linearized variance-bounds tests? Is it possible that the tests
perform adequately if interest rates in some sense are not too variable as has been
frequently asserted in the literature? We have chosen two models in which the relative
variances are quite different. The ratio of standard deviation of H( 9)_ r to that of.0.r is at
a minimum of 2 in one model and at a maximum of 9 in the other. This wide range
encompasses the relative standard deviations observed in most samples of the zero-coupon
interest rate term structure that we have. 4 Moreover, in Shiller'S (1979) paper, similar
ratios of standard deviations for annual series of yields for coupon-bearing bonds are 7.5,
5.6, and 4.1 and are also well wi thin this range. We emphasize that our model imposes
only the LEH constraint, E t -1(H t ) = rt, and so while our simulations will always produce
smooth .0.r relative to H-r, restrictions on the relative variances of long-term yields and
short-term yields (Cox, Ingersoll, and Ross' Return-to-Maturity restrictions) are not
imposed.

4The difference between one-week holding period yields on la-week Treasury Bills and one-
week yields to maturity has a standard deviation 5 times the size of the standard deviation
of differenced one-week yields in Roll's (1970) long series of Treasury Bill yield curves
Remarkably, the ratio is about the same for the difference between one-year holding period
yields on la-year NTT bonds and one-year yields to maturity and differenced one-year
yields. The data set is described by Shea (1984).
 311

The second question we wish to address concerns the reliability of the linearized variance-
bounds tests as a function of the sample level of interest rates. Our simulation models are
zero-mean models for f:.r , 6.H, and H- r. By adding constants and drift to simulated data,
we can generate a term structure at any level we desire, but we should also ideally expect
that the rejection rates for the LEH would not be affected by the levels or the drift
characteristics of the models. The linearized variance-bounds test statistics, however,
have interest rate levels as their only parameter and we might therefore expect that the
rejection rates of the linearized variance-bounds tests would vary with the sample level of
interest rates. This would seem to be an undes~rable character of these statistics, but
perhaps the reliability of the statistics at realistic mean simulated sample levels for interest
rates does not suffer. We perform several sets of simulations normalized at different levels
of the term structure to study this matter.
The third question we address concerns the small sample reliability of the test statistics
themselves. There has been no study for such effects even though the only formula for
standard errors for linearized variance-bounds statistics is admittedly asymptotic
(Singleton (1980)). The simulations are therefore performed with two sample sizes and the
linearized statistics are compared to the performance of benchmark statistics pertaining to
the zero-coupon term structure. Since we drive our cointegrated models with simulated
gaussian errors, we know that the simulated variances of 6.r, f:.H, and H- r will be multi-
normally distributed around their population variances. The asymptotic variances and
covariances of the simulated variances are descri bed by

2 , _ 41f
a O"6.r [y 6.r,f:.r Y f:.r,H-r ]
vr [ 2 ----r- ' (5)
O"H_r y 6.r, H-r y H-r,H-r

where Y wr,wr
A A, for example, is the cumulated squared spectral density of 6.r over all
frequencies and YAH
wr, -r is the cumulated squared cospectrum plus the cumulated squared
quadrature spectrum of f:.r and H- r over all frequencies. (See page 465, T.W. Anderson,
1971.) When sample spectral estimates are used in Equation (5), a test statistic for excess
volatility in the zero-coupon term structure can be formed as

0" 2
6.r
1sample - r 2
0"-0"
r
2
f:.r 1actual
SD [ a 2 - 0" 2 ]
H-r 6.r sampl e

which is asymptotically distributed N(O,l). We designate this statistic ZSTAT and we

note that it depends upon knowledge of actual a H and a A . The extent to which ZSTAT
-r wr
differs from a standard normal statistic in finite samples is our ideal performance
benchmark. Against this benchmark the statistics for excess volatility in the linearized,
coupon-bearing term structure will be compared. These statistics are, for nonstationary
term structures,
 312

We designate these statistics respectively BSTAT and CSTAT and note that they are
hypothesized (Singleton (1980)) to be asymptotically normally distributed with positive
means and unit standard deviations. 5 Such linearized statistics may perform better or
worse in finite samples than the equivalent statistics (ZSTAT) we could use if we could
directly observe the zero-coupon interest rate term structure.

In Table 1 we report the performance of the statistics for 100 simulations of length 200
each. The levels and the drift for each model have been set so that the average short-term
yields for 100 simulations are the same across rows of the table. In this way we know that
the difference in performance between the models is due solely to different population
SD[H(j}-r]/SD[t.r]. We have run simulations of longer length (500) and the results are
not materially changed. The 'low-level' simulations produce short-term yields of
approximately 4% and the 'high-level' simulations produce an average level of 12%. The
low-variance simulations are for models which set SD[H( 9>-r]/SD[t.r] to 2 and the high-
variance simulations have the same ratio set to 9. Finally, all the simulation models have
a positive population correlation between R( 10)_ rand t.r. The details of the simulation
procedures are explained in the Appendix.

Simulations of length 200 seem to be sufficiently long to make ZSTAT behave as the
asymptotic N(O,l) variable it is and the bad behavior of BSTAT and CSTAT does not
appear to be improved by increasing sample size. The major qualms we have previously
stated do seem to be largely justified by our tabled results. First, the sizes of BSTAT and
CSTAT, as opposed to that of ZSTAT, are affected by the volatility built into the models;
as the volatility is increased, the linearized statistics become smaller and therefore more
likely to reject the LEH. Within the realistic ranges of volatility presented, however, we
see that BST AT is not capable of rejecting the LEH and at some point CST A T cannot help
but reject the hypothesis. 6 Clearly, realistic volatility in the term structure introduces
terms into an ideal statistic (ZSTAT) which are fatally ignored in linearized statistics such
as BST AT and CST AT. Second, our qualm that the linearized statistics will be more or
less reliable as a function of interest rate levels is also justified by the results. The high-
level simulations of the term structure are more likely to result in rejection of the LEH
even though the volatility of the simulations remains the same as it was when performed at
a lower level.

We emphasize that linearized procedures fail in this fashion not because they do not
approximate holding-period yields well. The exact holding-period yields on long-term
coupon-bearing bonds are almost perfectly approximated in our simulations. The test
statistics fail because the points around which the term structure model is linearized bear
little resemblance to the linearization point which is optimal for testing variance bounds.

5Calculation of BSTAT and CSTAT employ Hlj) as specified in Equation (2). The
empirical standard deviations are based on the same spectral approach embodied in
Equation (5). BSTAT and CSTAT are not calculated to have a zero expected value as is
ZST AT because, without knowledge of the model, we cannot expect the investigator to
know what the true positive means of BSTAT and CSTAT to be. Therefore, the fact that
BSTAT rarely rejects the null hypothesis does not cast as much doubt on the reliability of
the linearized test statistics as does the nearly uniform rejection of the null hypothesis of
which CST AT is capable. I thank an anonymous referee for pointing this out.
6Population correlation between R-r and t.r is positive for these models and so the
objection might be raised that the tighter bound tested by CST AT should not be used to
pillory the linearized test methodology. But the typical investigator would not know the
sign of the true correlation and so in a certain portion of cases would mistakenly apply
CSTAT. In any case, neither BSTAT nor CSTAT behaves like ZSTAT to give normally
specified rejection rates. Secondly, in simulation models in which the correlation is
rejection (refer to the Appendix for details), practically the same results are obtained; in
hightvolatility models CSTAT cannot fail to reject the true null hypothe is.
 Table 1
The Summary of 100 SiJDulated Excess Volatility Statistics, N per simulat ion =200
Low-Level Simulations

Low-Variance Simulations High-Variance Simulations

Rejection Rates Rejection Rates
ZSTAT BSTAT CSTAT ZSTAT BSTAT CSTAT

Significance .01 0 0 0 0 0 14
Levels for .05 5 0 0 2 0 31
N(O,l) .10 7 0 0 7 0 44
.25 17 0 0 25 0 67
Excess-Volat ili ty Statistics
Mean 0.2 220.0 41.2 0.2 34.0 -1.2
Std. Dev. 1.1 84.3 11.2 1.2 8.1 1.0
Minimum -2.3 69.0 17.6 -2.1 16.9 -3.5
Maximum 3.8 573.4 82.8 3.4 59.9 1.1
0J
......
High-Level Simulations 0J

LOll-Variance Simulations High--Variance Simulations

Re j ect ion Rates Rejection Rates
ZSTAT BSTAT CSTAT ZSTAT BSTAT CSTAT

Significance .01 0 0 0 1 0 75
Levels for .05 2 0 0 6 0 92
N(O,l) .10 5 0 0 9 0 96
.25 26 0 0 26 0 99
Excess-Volatility Statistics
Mean 0.0 90.9 21.7 0.1 17.5 -3.2
Std. Dev. 1.0 29.3 5.2 1.0 6.9 1.1
Minimum -1.9 39.8 11.4 -2.3 2.1 -5.7
Maximum 2.6 191.5 38.0 3.5 35.5 -0.6

The normalization in the' LOll-Level Simulations' is a level of 4 percent. The models in the' High-
Level Simulat ions' panel were normalized to simulate short-term interest rates at a mean level of
12 percent over 100 simulations.
 314

5 Conclusions
The linearized system has been called a 'well-tempered' one by analogy to a tuned musical
instrument in which the playable notes are separated by a fixed frequency. Campbell and
Shiller (1984) state that 'well-tempered' refers to the ability to tune a musical instrument
lito more than one key at a time." Well-tempered as precisely used by Bach referred to a
piano in which the octaves and fifths are mean-tempered (have fixed frequency differences)
but the thirds vary in their frequency span (Sloane, 1988). The linearized system of the
term structure is well-tempered in the sense that all of the traditional expressions of the
expectations hypothesis are consistent, whereas they are dissonant when applied to a
nonlinearized, zero-coupon term structure. The musical analogy is apt except that
composers will at times compose a piece containing certain intended effects that can be
achieved only if the musical instrument is tuned to a particular key. Not all pieces will
sound as the composer intended if played on an instrument tuned to the usual reference
key. By the same token the term structure model may be linearized around different
points (keys), but will perform adequately in one key for one purpose (approximating
holding-period yields) and inadequately for other purposes (testing variance-bounds).
There is evidence in this paper that variance-bounds tests 'play poorly' in a linearized
system tuned to the particular keys used by previous researchers, even though their
holding-period yield approximations play very well indeed. Even if we acknowledge that
the 'duration' keys are alright for variance-bounds tests as long as interest rates do not
vary too much, the results of our simulations suggest that this variation threshold is very
low indeed and too far below empirical volatilities for linearized variance-bounds tests to be
practical.
In summary, the linearized system of studying the interest rate term structure is an
important disciplinary step in that it forces our attention onto a model that is time
consistent and does not contain contradictory testable implications. In doing this,
however, not all practical econometric problems are solved or even made simpler. Our
qualms about the variance-bounds test methodology in a linearized framework first arose
because it seemed almost too good to be true; it promised a means for testing for excess
volatility without having to explicitly model the term structure. But the smoothing
properties of expectations theories of the term structure cannot, unfortunately, be
summarized in one parameter that is a function of nothing more than the sample level of
interest rates. It is the selection of a linearization scheme, not linearization itself, which we
question in this paper. The role played by linearization in other variance-bounds studies
and in the closely related asset price bubble studies may similarly reveal Significant effects.
Our small simulation study suggests that the choice of a linearization scheme is not
secondary to such an empirical study, but is one of the primary empirical problems to be
solved.

ACKNOWLEDGEMENTS
This paper has benefited from comments given by John Y. Campbell, Eric Renault, S0ren
Johansen, Katarina Juselius, an anonymous referee and seminar participants at Penn State
University, The Board of Governors of the Federal Reserve System, the European Meetings
qf the Econometric SOciety, the Ecole Nationale de la Statistique et de l' Administration
Economique, and the Second International Conference on Econometric Decision Models.
Any remaining shortcomings are, of course, solely the author's responsibility.
 315

REFERENCES
Anderson, T.W. (1971). The Statistical Analysis of Time Series. Wiley, New York.

Campbell, J. Y. (1986). A defense of traditional hypotheses about the term structure of

interest rates. Journal of Finance 41, pp. 183-193.

Campbell, J. Y. and R. J. Shiller (1984). A simple account of the behavior of long-term

interest rates. American Economic Review 74, pp. 44-48.

Campbell, J. Y. and R. J. Shiller (1987). Cointegration and tests of present value models.
Journal of Political Economy 95, pp. 1063-1088.
Cox, J. C., J. E. Ingersoll, and S. A. Ross (1981). A re-examination of traditional
hypotheses about the term structure of interest rates. Journal of Finance 36, pp. 769-799.

Engle, R. F. and C.W.J. Granger (1987). Co-integration and error correction:

representation, estimation and testing. Econometrica 55, pp. 251-276.

Flavin, M. A. (1983). Excess volatility in the financial markets: a reassessment of the

empirical evidence. Journal of Political Economy 91, pp. 929-956.

Gilles, C. and S. F. LeRoy (1986). A note on the local expectations hypothesis: a discrete-
time exposition. Journal of Finance 41, pp. 975-979.

Gilles, C. and S. F. LeRoy (1987). The variance-bounds tests: a critical survey, Working
Paper, University of California, Santa Barbara, August.

Kleidon, A. W. (1986). Variance bounds tests and stock price valuation models. Journal of
Political Economy 94, pp. 953-1001.
LeRoy, S. F. and R. D. Porter (1981). The present-value relation: tests based on implied
variance bounds. Econometrica 49, pp. 555-574.

Nelson, C. R. and C. 1. Plosser (1982). Trends and random walks in macroeconomic time
series: some evidence and implications. Journal of lvJonetary Economics 10, pp. 139-162.

Roll, R. (1970). The Behavior of Interest Rates. Basic Books, New York.

Shea, G. S. (1984). Pitfalls in smoothing interest rate term structure data: equilibrium
models and spline approximations. Journal of Financial and Quantitative Analysis 19, pp.
253-269.
Shiller, R. J. (1979). The volatility of long-term interest rates and expectations models of
the term structure. Journal of Political Economy 87, pp. 1190-1219.

Shiller, R. J., J. Y. Campbell, and K. L. Schoenholtz (1983). Forward rates and future
policy: interpreting the term structure of interest rates. Brookings Papers on Economic
Activity, no. 1, pp. 173-217.
Singleton, K. J. (1980). Expectations models of the term structure and implied variance
bounds. Journal of Political Economy 88, pp. 1159-1176.

Sloane, C. (1988). A brief survey of keyboard temperaments. Continuo 12, pp. 11-12.
 316

APPENDIX How The Simulations Were Performed

The construction of a nonstationary, dynamic cointegration model of the interest rate term
structure is nontrivial. In general it will describe the stochastic behavior of an array
containing a short-term yield, some long-term yields, and some holding-period yields. It
will, of course, have to be a realistic description and it will have to embody all the
constraints implied by the equilibrium term structure hypotheses. We write 'hypotheses'
in the plural to remind the reader that, in its linearized form, a full expectations model
would have to simultaneously impose the constraints of the Return-to-Maturity hypothesis
as well as the Local Expectations Hypothesis. In this paper we cannot afford to be so
ambitious and it will be shown in this appendix that a correct model of the LEH for a
nonstationary term structure by itself is complex enough to make its behavior difficult to
control in our simulations.

As elsewhere in the paper we use the notation of Engle and Granger (1987). The LEH
strictly requires a' 7=1 and J(O)=J(l) in Equation (4)'s representation of the model. By
the definition of Zt as a' Xt, a' is defined as
-1 10 . . . . 0
-1 0 1 0 . . . 0
-1 0 0 1 0 . . 0
a'
9x 10

. 0
-1 0 0 0 0 .. 1

Under the LEH, 7 will be the pseudo-inverse of a'. The choice of J(B) so that J(O)=J(l) is
important in that it determines the dynamics of the term structure model. From Engle
and Granger, we take

J(B) = a'd(B) + a'(A*(B) - I)C(B),

where deB) comes from the vector ARMA representation of the model, A(B)Xt = d(B)ft
and where C(B) comes from the Wold representation, (l-B)Xt = C(B)ft. If we simplify
matters by assuming that d(B)=I, we are left with two choices for the dynamics of the
model: i) by assuming A*(B)=I, the error-correction representation (Equation (3)) will
have no autoregressive dynamics, J(O)=J(1)=a' and the LEH constraint is satisfied, or ii)
we may assume, more generally, A*( 0)=A *(1 )=1, which would allow for some
autoregressive dynamics and would also guarantee J(O)=J(l)=a'.
In this paper we make the first assumption because the resulting model's dynamic behavior
is simple and it also results in a model for which Var(z) is more easily controlled. Consider
the implications of making assumption ii). In a previous version of this paper this was
done by assuming that A*(B) was a matrix of only second-degree polynomials in B. By
let ting A*(B) = 1 + Al*B + A2*B 2, where Al* and A2* are matrices, we satisfied the LEH
constraint J(O)=J(l), by letting Al*+A2*=O. This would not have raised any great
difficulties if we were not also trying to satisfy the constraints

Var(H(nLr) ~ Var(H(m)-r) ~ Var(6r),

for all m and n such that n>m and to also control for the correlation between 6rt and
R tn) - r t-[. Following Engle and Granger,

Var(z) = E [ a C*(B)a' C*(B)' a] ,

l
 317

where C(B) is C(l) + (l-B)C*(B). But under the LEH constraints, A(B) equals
1+ (Al* + la' - I)B - A2*B3 and, since C-l(B)(l-B) equals A(B), it is readily seen that
Var(z) is a complex function of the choices made for Al*' A2*, and E = E[ff']. This
approach led to a tedious trial and error process in choosing A*(B) and E to satisfy all the
constraints we wished to impose upon Var(z) and Var(Hl n) - r)/Var(!:::..r).

By making assumption i) instead, many of these problems were reduced and the
replicability of our simulations by other investigators was enhanced. Letting A*(B )=1 not
only guarantees J(B)=a', but (along with the other LEH condition 0'7=1) also makes
Zt = a' ft. Therefore, Var(z) becomes a'Ea. We also note that

!:::"xt = -1Zt-l + ft = -la' ft - l + f t and, therefore,

Var(!:::..x) = la'Ea1' +E= 1Var(z){' + E.

From this we see that Var(!:::..r) is -y(l,.)Var(zth'(·,l) + E(l,l) where -y(1,.) denotes the
first row of 1 and I' ( .,1) denotes the first column ot its transpose. Controlling for the
relative variances of !:::..r and H (n) - r is simply a matter of choosing an appropriate E and in
no way involves the dynamics of the model as it would under assumption ii).

Letting O'ij denote an element of E, we have constructed E's such that 0'11<0'22<' •••• <O'nn.
The off-diagonal elements of E were also made nonzero. In constructing E it was possible to
guarantee that SD[H(j)-r]/SD[!:::..r] increased with j, but it was not Simultaneously
possible to guarantee that that ratio be greater than 1 for any j, which is generally
observed in term structure data even for fairly small j. We emphasize, however, that this
feature in no way vitiates the model as an equilibrium model of term structure volatility.
To show how this feature arises we present the following mathematics. " being the pseudo-
inverse of a', makes la' = 1- (l/n)u', where L is an n-length vector of ones. Thus
Var(fl.r) is

where ~j denotes summation over i=l, ... ,n and ~i~jO'ij denotes the sum of all elements in E.
Since the variance of Zt is a'Ea, it is easily seen that, for example, Var(H( 1)_ r) is
0'11+ 0'22- 20'12 and Var(H ( n) - r) is 0'11+ 0'22- 20'1n. It is possible therefore in our
simulations that E is chosen so that SD[H (j) - rll SD [fl.r] is less than 1 for some j.

Another result of making assumption i) is that our term structure model imposes a positive
correlation between !:::..r and R( n) - r. This is in contrast to the negative correlation we
were able to impose in our models used in the previous version of this paper. The negative
correlation was obtained by manipulating the autoregressive structure (under assumption
ii) of A*(B). The results in the two versions are about the same, especially with respect to
the overly large rejection rates displayed by CST AT, which suggests that the reliability, or
the unreliability rather, of the linearized volatility statistics is not a function of this
particular feature of the underlying term structure model. We demonstrate the positive
correlation in the present model as follows. It is by definition that

R(n) = (l/n)~H(n~j) + r In.

t J t+J t+n
Let I(j,') denote the jth row of the identity matrix, so that
 318

But since
m

xHj = xHj-C 'Y a ' f Hj = fH/ (I-'Ya'\~1 fHj-k'

it follows that the covariance of R~nL r t - 1 and ,0,r t equals

It is not immediately obvious that, for any positive definite };, Cov[R~nL r t _ 1,,0,r t J is
positive. But if we consider the positive quadratic form [I(I")-+L']};[I(.,I)-+LJ,

which equals 0'11 - + EjO'lj+ ~2 bibkO'ij > 0, we can see that

n n
Now for b O'lj $ 0, it is clear that the covariance is positive and for E O'lj > 0 it is simi-
j=2 j=2
n-l 1 n I l 1
larly clear that ---O'll - - - b O'lj > - n bj O'lj- ---;:;2n Eibj O'ij >- ---;:;2n Eibj O'ij· By add-
n n . 2
J=
ing ~2 EibjO'ij to all sides of these inequalities we obtain Cov[R~nL r t _ 1,,0,r t ] > O.
Two versions of}; were constructed: Version 1 gave rise to a simulation model in which the
population ratio, SD[H( 9) -r]/SD[,0,rl, was 2 and in Version 2 the same ratio was set to 9.
In the simulations, }; was used to de1ine the multi-normal distribution from f'S which were
then used to drive Equation (3). Equation (3), along with the appropriate identities, was
simulated repeatedly to generate time series of zero-coupon term struct ure data. This basic
term structure data was then used to generate term structure data for coupon-bearing
bonds. We assumed that coupon-bearing bonds were issued at par with 10 periods term to
maturity and that they bore a coupon for each period. After forming this data in each
simulation, we calculated the one-period yields from holding a coupon bond from issue until
it was a nine-period bond. Since the bonds were issued at par, we found that the exact
holding-period yield and its linearized version (Equation (2)) were nearly identical so, as
emphasized in the text, the failure of the linearized variance-bounds tests is not related to
any inaccuracies in the linearized yields that might be used in the tests.

The simulations are distinguished not only by the version of}; employed, but also by their
length (lengths of 200 and 500 were used), their average sample level, and the
nonstationary drift imparted to Xt. We found that 200 and 500 were sufficient so that
small sample effects were not evident in our simulations. Likewise, in experiments with
drift, we found no appreciable effects on our simulations. We varied the drift from 0.0 to
0.03 percent per period and found, in no circumstance, are the rejection rates by ZSTAT,
BSTAT) and CST AT affected. The 'low-level' simulations in the tables have a 0.03
percent per period drift and the 'high-level' simulations have none. Finally, the
 319

simulations are also di vided into high and low level groups. The low-level simulations have
a mean level of short-term interest rates set at 4 percent. By this we mean that the
average level of rt over all 100 simulations was 4 percent after checking that the mean level
of the term structure in anyone simulation was never negative. (Imparting a positive drift
to these simulations aided us in this task.) The high-level simulations were normalized
around an average level of rt at 12 percent.
 PART 6:

COINTEGRATION: ESTIMATORS, TESTS AND APPLICATIONS

THE POWER FUNCTION OF THE LIKELIHOOD RATIO TEST FOR
COINTEGRA TION

S0ren Johansen
Institute of Mathematical Statistics
University of Copenhagen
5 Universitetsparken
DK-2100 Copenhagen 0, Denmark

Abstract

The distribution of the likelihood ratio test for cointegration under local alternatives is
found to be given by a suitable functional of a p-r dimensional Ornstein-Uhlenbeck
process. The results are related to those of Phillips (1988), who considered
near-integrated processes and derived the power function of a test for unit roots based
on a regression estimate. The power function is investigated numerically for a
one-dimensional alternative.

Keywords: Cointegration; likelihood ratio test; power; Ornstein-Uhlenbeck process.

Contents

1 Introduction
2 Asymptotic properties of the process X and the power function under
local alternatives
3 Numerical investigation of the power function under the alternative
of one extra cointegration vector
4 Appendix
5 Acknowledgement
References

1 Introduction

The concept of cointegration was introduced by Granger (1981) in order to define the
notion of a stable economic relation among non-stable economic variables. He
considered non-stationary economic variables, i.e. a non-stationary vector process,
and defined a cointegrating relation as a linear combination of the components with
the property that it determined a stationary stochastic process. This makes precise
one of the many meanings of the notion of stability and as such it can be investigated
and tested by statistical techniques, see Engle and Granger (1987), Park and Phillips
(1986) and Phillips and Ouliaris (1990). Many papers have since then been devoted to
finding properties of various regression and eigenvector estimators for cointegration
vectors.

This paper deals with vector autoregressive processes with Gaussian errors where
maximum likelihood estimators and likelihood ratio tests can be found, see Johansen
(1988b). There are now a number of papers that describe this method in detail and
apply it to economic problems, see Johansen and Juselius (1990), Ju~elius (1991),
Kunst (1988), (1989), Kunst and Neusser (1990), Liitkepohl and ReImers (1989),
Hoffman and Rasche (1989), and Garbers (1989). The method will be described briefly
below.

Consider the p-dimensional vector autoregressive process X t , t= l, ... ,T, defined by the
equations:
 324

X t = II 1X t _ 1 + ... + IIkX t _ k + f t , t = 1, ... ,T, (1.1)

where fF .. ,f T are independent Gaussian variables with mean zero and covariance
matrix A, and XO"",X_k + 1 are fixed. The parameters are the pxp matrices IIF .. ,II k ,
and A. Let II = - I + III + ... + IIk be the total impact matrix, and consider the
hypothesis of the existence of (at most) r cointegration vectors formulated as
H: II = Ct(3', (1.2)
where Ct and (3 are pxr matrices.

The max.imum likelihood estimation and likelihood ratio test of this model were
investigated in Johansen (1988b), and can be described as follows. First the model
(1.1) is rewritten as
k-1
~Xt = L:1 ri~Xt_i + Ct(3'X t _ k + f t , t = 1, ... ,T, (1.3)
where r.1 = - I + III + ... + II.,
1
i = 1, ... ,k-1. One can also rewrite the
model with the error correction term as Ct(3'X t _ 1 and a suitable transformation of the
other parameters, but the analysis remains the same. In model (1.3) the parameter
matrices r F .. ,r k_1,Ct,(3, and A are variation independent and one can easily maximize
the likelihood function with respect to the parameters r F··,r k-1 by regressing ~Xt
and X t _ k on the lagged differences, and obtain residuals ROt and R kt . We define

Sij = T -1 L: T1 RitR jt , i,j = O,k,

and find ~((3) = SOk(3((3'Skk(3)-l. Finally (3 is found as the eigenvectors corresponding
to the r largest eigenvalues of the equation

I),Skk - o5
Sko S S0k I = 0, (1.4)
giving the maximized likelihood function
-2/T -_
Lmax ISao I IIIr( 1 -).- ..)
1

The likelihood ratio test statistic for the hypothesis H of (at most) r cointegrating
relations is given by
-2 In(Q) = - T Ei+1In(1 -~) (1.5)
The limiting distribution of this statistic is non-standard and has been tabulated by
simulation in Johansen (1988b).
The theory for the model which also allows a constant term is more involved, and is
given in Johansen (1991).

It is the purpose of this paper to derive the power function of the above likelihood ratio
test, applying the results of Phillips (1988).

The alternative we are interested in is clearly that there are one or more extra
cointegrating relations than assumed under H. If we investigate the power of the test
under the assumption that there is in fact another cointegration relation with some
non-zero loadings, then it is not difficult to see that the power tends to one. More
interesting is it to consider local alternatives of the form
HT : IIT = Ct(3' + Ct 1(3i/T,
 325

where a 1 and {J1 are pxs matrices. Under the alternative HT we are thus allowing s
extra cointegration vectors to enter the model with small weight aliT. These extra
linear components of X t are "near-integrated" in the terminology of Phillips (1988),
and the basic mathematical results are directly taken from that paper and adopted to
this slightly different framework of analyzing the multivariate Gaussian distribution.

In the next section we describe the asymptotic properties of near-integrated series, and
apply these to find an asymptotic expression for the power function. In section 3 we
investigate by simulation the power function for the local alternative of one extra
cointegration vector with a small loading. The appendix contains the proofs of the
mathematical results.

2 Asymptotic properties of the process X and the power function under local
alternatives

In order to discuss the asymptotic properties we recall some of the properties of the
process X t as given in Theorem 4.1 (Granger's representation theorem) in Johansen
(1991). We assume that rank(a) = rank({J) = r and let a .I. and (J.I. denote px(p-r)
matrices orthogonal to a and (J and of full rank. The condition for the process X t in

(1.1) to be 1(1) is expressed as a relation between the impact matrix II = -I + I;tIIi =

a{J' and the mean lag matrix III = I;fiII i , and is given by
rank(a'llI{J ) = p-r.
.I. .I.
(2.1)
Under this condition we have the moving average representation of the differenced
process D.X t = C(L)c t and the expression

C(l) = {JJa~IlI{J)-la~ = C, (2.2)

say. From this it is seen that D.X t is stationary, (J'X t is stationary and Xt is
non-stationary.

Under model HT we denote the process by X~T). In order to separate the

stationary part of the process from the near-integrated and integrated components we
introduce the r-dimensional process y~T) = (,B',B)-l,B'X~T) and the (p-r)-dimensional

process Z(T) = ({J' (J )-1{J' X(T) so that

t .1..1..1. t '
X~T) = pyF) + (J.l. z(~). (2.3)

THEOREM 1. Under the local alternative H T .' II T = a,B' + a 1{J ;/T, and under the
condition (2.1) and
rank{(a,al)~IlI({J,{Jl)) = p-r-s (2.4)
the process X~T) converges weakly to the process X t' and the process T-~ z(VtJ
converges weakly to the (p -r) -dimensional process Gt' which satisfies the stochastic
 326

differential equation

- a:a1f31f3) bGu du + a:if!f3j. Gt = Wf (2.5)

Here W t is a {p-r)-dimensional Brownian motion on the unit interval with variance
a'Aa.
1. 1.
The (p-r)x(p-r) matrix a:ailf3j. has rank s and the solution to (2.5) is the
Ornstein- Uhlenbeck process in p - r dimensions which can be expressed as

G t = {a'if!f3 )-1 Jotexp{a ' a 1f3 1'f3 (a'if!(3 )-l(t-u)}dW.

1. 1. 1. 1. 1. 1.
(2.6)

The proof of this result will be given in the appendix. The main result about the
power function is given in the next Theorem:

THEOREM 2. The asymptotic distribution of the likelihood ratio test statistic - 2lnQ
for the hypothesis H: II = a(3' is, under the local alternative H T : II = a(3' + a lf3 liT,
given by

tr{J(dK)K'(J KK'du)-l J K{dK) 1, (2.7)

where K is the {p - r)-dimensional Ornstein-Uhlenbeck process given by

-ab'J bKudu + K t = B t, (2.8)

and where B t is a Brownian motion with covariance matrix I, and
a = {a'Aa )-ta'a
1. 1. 1. l'
and b = {a'Aa )tff3 'if!'a )-1f3'f3 .
1. 1. (, 1. 1. 1. 1

The proof is given in the appendix. If the (p-r)-dimensional process K t has

coordinates {K/t), i = 1, ... p-r}, then the notation JK(dK)' stands for a (p-r)x(p-r)
matrix of stochastic integrals with elements JR-dK .. The matrix JKK'du has elements
1 J
JKj(u)K}u)du, where all integrals are on the unit interval.

This result is closely related to the result by Phillips (1988), p.1031, on the power
function for a certain test statistic for the hypothesis II = 0 based on a normalization
of a regression estimate of II. In this situation, where we want to test the hypothesis
that II = 0, the present test which exploits the Gaussian distribution can not be
distinguished by its asymptotic properties for local alternatives from the test given by
Phillips.

It is seen that the asymptotic power function for local alternatives depends on the
parameters only through a and b. Thus it depends on how the extra loadings (a l ) and
cointegrating relations (f3 1 ) are related to the a and f3 assumed under H. A tabulation
of the power function thus involves 2(p-r)xs parameters. It turns out, however, that
fewer parameters will do. In order to see this, we shall exploit the invariance of the
multivariate Brownian motion under rotation and the invariance of the test statistic.
 327

Let 0 denote a (p-r)x(p-r) orthonormal matrix. Clearly B t and OB t have the same
distribution and hence after multiplying (2.8) by 0 we see that OK t solves the
equation (2.8) for the Brownian motion OB t with the pxs matrices Oa and Ob. The
test statistic is invariant under this transformation and thus the power function is the
same for any alternatives ab' and a 1bi such that Oab'O' = a 1bi. We can simplify still
further by choosing new coordinates using the orthonormal vectors

e 1 = b(b'b)-t

e2 = (a - b(b'b)-lb 'a)(a'a - a'b(b'b)-l b'a)-t

and finally e 3 such that (e 1 ,e 2 ,e3 ) are orthonormal. We define Kit = e;Kt and Bit =
e;Bt, i = 1,2,3. The equation (2.8) is then equivalent to
l I t
- (b'b)-'b'a(b'b)'
oJK lu du + K 1t = B
It'
(2.9)

- (a'a - a'b(b'b)-l b 'a)!(b'b)t

ojK lu du + K 2t = B
2t'
(2.10)
K3t = B 3t · (2.11)
This shows that the power function only depends on a 1 and /3 1 through the matrices
a'a, b'b and a'b. For s = 1 this result simplifies still further.

CO RO LLAR Y. Under the local alternative II = a/3' + a 1/3 liT, where a land /3 1 are
px 1 vectors, the power function for the likelihood ratio test for cointegration depends on
a 1 and /3 1 only through the quantities f and g given by
f= a'b = /3jCa 1 < 0, (2.12)
and

l = a'ab'b - (a'bl
= (aja/a;Aa)-la;a l )(/3jCAC'/31) - (/3jCa l l , (2.13)

where C=/3.L (a'\fJ/3

.L.L
rla',
.L
see (2.2) .

Note that the expressions above for C as well as a (a' Aa )-1 a' do not depend on the
.L .L.L .L
particular choice for a and /3. Note also that for p - r = 1 the power function
.L .L
depends only on f, since (2.9) above describes the process K t . The proof of the
Corollary is given in the appendix.

In order to interpret these results we consider the hypothesis HT for the simple
example we get from (1.3) by setting k = I, that is we consider the system

t;xF)= T-lal/3ix~~i + Ct·

Thus we have left out the short term dynamics and assumed that a = /3 = O. In this
 328

case we have taken A = I, IT = 0, a1. = (31. = I and'll = 1. Thus C = I, a = a 1 and b

2 2
= (31' so that f = ai(31 and g = ai a 1,6'i,6'1 - (ai(31) .

We can express the results as follows: The power for finding a stationary relation (31

with weights T-1 a 1 depends on the position of the vectors a 1 and (31 through the
angle between them (fig) and the area spanned by them (g), as well as the dimension
of the space in which we are looking for them (p-r).

3 Nu.merical investigation of the power function under the alternative of one extra
cointegration vector

For s = 1 the equations (2.9), (2.10) and (2.11) are of the form
t
- f f OKlu du + Kit = Bit, (3.1)
t
- g f OKlu du + K2t = B2t , (3.2)
K3t = B 3t . (3.3)
The distribution of the functional (2.7) is too complicated to find analytically but it
can be found by simulation. In order to simulate the processes we shall apply the
discrete version of these equations

Kit = (1 + f/T)K It _ 1 + cit' (3.4)

K2t = K 2t - 1 + (g/T)K It _ 1 + C2t' (3.5)

(3.6)

t = l, ... ,T, starting with KO = O.

Note that the actual expression for the limit distribution is not so important. What is
being used here is only the fact that the parameters of the original model (1.3) with
ITT = a,6" + a 1(3i/T only enters through the dimension p-r and through the
parameters f and g. Thus the system we simulate consists of the last p-r equations of
model (1.3) with k = I, a = ,6' = (1,0)' and
a 1 = (O, ... ,O,f,g,O, ... ,O)',,6'l = (0, ... ,0,1,0,0, ... ,0)',
where both vectors start with r zeros. Thus in order to simulate the system we choose
the simplest possible system compatible with the given f and g.

We then easily solve the equations (3.4), (3.5) and (3.6) recursively and form the
Tx(p-r) matrix j\l with elements Mti = Kit. Then we calculate .0.M and M_ 1 , i.e. the
differences and lagged variables respectively and find the test statistic
Test = tr{ .0.M'M_1(M~l M_l)-lM~l.0.M}.
The number of observations T has to be chosen so large that the approximation of the
random walk to the Brownian motion is sufficiently good. We have chosen T = 400.
 329

We find the results for stationary alternatives and p-r = 1,2, and 3 in Table I and
Figures 1 and 2 based. It is seen that, not surprisingly, the power decreases as the
dimension increases, i.e. if there are many dimensions to hide in. This means that it is
difficult to find the cointegrating vector, if it has a small loading. It was found that
the non-stationary alternatives (not shown) are readily picked up by the test with
large power. The test appears unbiased as f and g move away from O.

The table gives the limit distribution for the process defined by (3.1)-(3.3). If we
apply the results for the approximation defined by (3.4)-(3.6) one can for a large value
of T interpret the coefficient 1 + f/T = 1 + ai.81/T as the autoregressive parameter,
see (3.4), in the stationary (or near-integrated) relation we are trying to find. Hence
we can apply Table I as follows: Assume we have T = 100 observations and an
autoregressive coefficient of .79 say. Then the relation .79 = 1-21/100 = 1 + f/T
shows that we can use Table I with f = -21. Now the power of finding such a process
depends on the relation between the loadings and the cointegration vector. If a1 and
.81 are proportional, so that g = 0, then, if the number of non-stationary components
is p-r = I, we have a probability of .998 of rejecting the hypothesis of
non-stationarity, and hence of finding a stationary relation. If, however, the system
has p-r = 3 non-stationary components, then the probability of rejecting the
non-stationarity hypothesis is only .346. For a given angle, that is for fixed f/ g, it is
seen from the table that the larger the vectors the easier it is to find them.

Table I
The asymptotic power of the likelihood ratio test at 5% for r co integration vectors
among p variables under the local alternative of one extra cointegration vector. The
quantities f and 9 are defined in {2.12} and {2.13}. The number of simulations is 5000
for p-r = 1 and 2000 for p-r = 2,3, and T = 400.

p -r = 1
f 0 -3 -6 -9 -12 -15 -18 -21
.052 .141 .350 .620 .820 .945 .987 .998

g P -r = 2

0 .060 .069 .105 .175 .272 .416 .565 .714

6 .615 .335 .269 .298 .390 .513 .642 .772
12 .944 .850 .760 .716 .717 .760 .830 .874

g p-r=3
0 .054 .059 .073 .105 .136 .187 .266 .346
6 .510 .211 .143 .142 .188 .233 .305 .383
12 .834 .694 .536 .424 .407 .429 .476 .543

4 Appendix

We have here collected the proofs of Theorem 1, Theorem 2 and the Corollary. We
first define the variance and covariance matrices conditional on the lagged differences
by
 330

Power
p-r

1.00

.as ~::::::--.:::::;.--
o -18 -21 f

Fig. 1:
The power function of the LikeLihood ratio test for cointegration, as a
function of f, see (2.12), for g = 0, see (2.13), and different vaLues of
the dimension p - r.

Power

100

0.67

0.33

-7

-11.

Fig. 2:
f e p~wer function for the LikeLihood ratio test for cointegration
Th as a
unctton of f and g, see (2.12) and (2.13) and p-r = 2.
 331

,B'~kk,B = Var(,B'Xt_kl6.Xt_1, .. ·,6.Xt_k+1)'

~Ok,B = Cov(6.Xt,,B'Xt_kl6.Xt_F··,6.Xt_k+1)·
It follows from the representation (1.3) that, since £t is independent of the past values
of the process X t ' one can find the relations
~OO = a,B'~kk,Ba' + A, (4.1)
and
~Oki1 = ai1'~kk,B, ( 4.2)
which can be solved for a

a = ~Oki1(,B'~kk,B)-l. (4.3)
One can apply these identities to prove

LEMMA 1. The following relations hold:

A -1 _ A -1 a (a'A -lar 1a'A -1 = a (a'Aa r 1a' ( 4.4)
.I. .1..1. .I.

( '
= a.!. a.!. ~ OOa.l.
)-1,
a.!.
-1 -1
= ~ 0 0 - ~ 0 Oa (a 'r; OOa
-1 )-1 -1
a 'r; 0 O·

PROOF. The second equality sign holds by the relation (4.1) and the two others can
be proved by multiplying by (a,Aa ) .
.I.

We now give the proof of Theorem 1. The result follows from the results in Phillips
(1988), and we here only sketch the calculations involved in the proof.

We wri te the model (1.1) under HT in the form

- (a,B' + a ,B'/T)X(T)
1 1 t
+ W6.X(T)
t
+ IT (L)6. 2X(T) = E
2 t t·
(4.5)
The basic idea is to go to the limit in this stochastic difference equation and derive
either another stochastic difference equation or a limiting stochastic differential
equation. It turns out that only IT and W will be relevant in this last approximation,
so that near-integrated processes can be approximated by AR(l) processes, see (3.4).

If we let T -; CD, in (4.5) we get the equation

- a;J'X t + W6.X t + IT 2(L)6. 2X t = £t'

which shows that X~T) converges weakly to Xc If we multiply (4.5) by a'.L we get
instead
-T- 1a'a ;J'X(T) + a''lI6.X(T) + a'IT (L)6. 2X(T) = a'£ .
.LIlt .L t .L2 t .Lt
1
Summing over t = 1, ... ,[Tt], and dividing by T' we obtain, apart from some initial
values,
- a' a T-l~[Tt],B'X(T)/T! + a''lIX(T) IT! + a'IT (L)6.X(T)]/T! (4.6)
.L 1 lIt .L [Tt] .L 2 [Tt
= ~Ftla~ Et/T!.
 332

Now apply the decomposition (2.3) and use the result that

tJYf~~ ITt = tJ(tJ'l3)-ltJ'Xt~~l/Tt ~ 0

since tJ'x~Tl
is stationary. Hence we can replace X~T) by tJl. Zt. For T -I rn we define
the Brownian motion W by

EFtla~ <t/Tt : W(t)

so that W has variance a' Aa. The first term in (4.6) is, apart from terms that are
1. 1.
opel), given by

- a~ altJitJl. T-lEFtlz~T) ITt

i.e. a Riemann sum of the process zF) ITt, which converges weakly to the integral

a'altJl'tJ
1. 1.
fotG U duo The second term converges to a'1J!tJ
1.1.
Gt .

It is easily checked that the solution of (2.5) is given by (2.6). In order to see that the
matrix a~ altJitJl. has rank s we have to apply the conditions (2.1) and (2.4) which
guarantee that the process X t is at most 1(1) both under Hand HT · Let b l =

tJl. (tJ~tJ)-ltJ~tJl and let b 2 be orthogonal to (tJ,b 1) such that (tJ,b 1,b 2) has full rank.
Then tJl. = (b 1 ,b 2) and (tJ,tJ1)1. = b 2. Similarly we define a l and a 2 from a1 and al.'
The condition (2.1) can now be expressed as

[ a i 1J!b 1 ai1J!b2]
rank a' 1J!b a' 1J!b = p-r,
2 1 2 2
whereas the condition (2.4) can be expressed as
2
rank(a 1J!b 2) = p-r-s.
These conditions clearly imply that
2 2
ai 1J!b 1 - ai 1J!b 2 ( a 1J!b 2)-1 a 1J!b l
is offull rank S. This therefore also holds for ai1J!b l and hence for a l and b l . Now

tJ~tJlaial. = jJ~bIaial. = [~~]blai(ala2) = [bib1~ia1 ~]

which has rank S.

Next we turn to the proof of Theorem 2. This follows closely the proof given in
Johansen (1988b) for the asymptotic distribution under H, and it will therefore not be
given in full technical detail. The likelihood ratio test is calculated from (1.5) solving
the eigenvalue problem (1.4). The basic idea in the proof is to study what happens as
T -I rn in equation (1.4) under different normalizations, and then apply the continuity of
the ordered eigenvalues as a function of the coefficients.

1
First multiply the matrix in equation (1.4) by (/3,T-'/31. ), and its transposed

(/3, T-t jJ jPS kk -SkoSo6S0k)(/3, T-1 /3)

and apply the stationarity of /3'X t to see that /3'Skk/3 and /3'Skk/3l. are Op(1). By
 333

Theorem 1, /3'.L Skk/3.L IT converges weakly to /3'.I. /3.I. fGG'd/3'.I. /3.I. = 4>, say, and this shows
that in the limit). has to satisfy the equation

/3'Ekk/3 0] _ [/3'EkO] Eo6 [/3' EkO] , _

I). [ 0 4> 0 0 1-0
or

0
I ),/3'E kk/3 - /3'E ko E 6 E ok/3II),4> I = 0,
which has r positive solutions and p-r null solutions. Thus the r largest eigenvalues of
(1.4) converge to those of

I ),/3'E kk/3 - /3'E ko E 6 E ok/31 = 0, 0

and the p-r smallest tend to zero. The r largest eigenvalues correspond to the
stationary components /3'X t , whereas the p-r smallest correspond to the
near-integrated as well as the non-stationary components.

Now normalize ).. by T and define p. = T)'.. We multiply the matrix in (1.4) by
1 1 1

(/3,/3 ), and (/3,/3 ), and let T .... ill. We then get that the limiting value of p will satisfy
.I. .I.
the equation

0] _ [/3'E kO] Eo6 [/3'E kO]' _

0
I[ 0
p4> F' F I - 0,
where F' is the weak limit of /3~ SkO. This can be written

0
I/3'EkOEoOIEok/311 p4> - F'(E 6 - Eo6EOk/3(/3'EkoEOOIEOkf3)-1 /3' Eko E o6)F 1=0.
Since a = E ok /3(/3'E kk /3)-l one can express the matrix between F' and F as
-1 -1 ( -1 )-1 -1
EOO - EOOa a'E OO a a'E OO '
which by Lemma 1 equals
a (a' Aa )-l a , .
.I. .1..1. .I.

Thus p is the solution to the equation

Ip4> -F'a.I. (a'Aa
.1..1.
)-la'FI
.I.
= O. (4.7)
The equation (1.3) gives the following relation between the residuals and the residual
sum of squares after the preliminary regressions,

SkO - Skk(/3a'+ /31 ai T - 1) = T-1 E'fRktCi·

It follows that /3'SkOa
.I. .I.
= F'a.I. has the same limit as

/3~Skk/31aia.l.T-l+ T-1 E'f/3~Rktcta.L'

which by Theorem 1 converges to

/3'.I. /3.I. (jGG'du /3'.I. /31 a'1 a .I. + fG(dW)') = /3'.I. /3.I. fG(dG)'/3'. 1Il!'a
..1.
.

Inserting this result into (4.7) we find that the limiting values of p are the roots of the
 334

equation
1(,8',8
.L.L
){pjGG'du-jG(dG)',8'w'a
.L
(a'Aa )-l a.,w,8
.L.L.L L.L
j(dG)G'}(,8',8)1 =0 .
.L.L

For K t = (a' Aa )-1 a' w,8 G t this can be expressed as

.L.L .L.L
1pjKK'du - jK( dK)' j(dK)K' 1= o.
Hence the result (2.7) holds, since
- 2lnQ = - T E~+lln(l-\) ~ E~+l T ~i = E~+l;i
w
--j tr{J(dK)K'(jKK'du)-l jK(dK)'}.

Finally we ~ive the proof of the Corollary. This result follows from the equations (2.9),
(2.10) and (2.11), and the expressions for the coefficients f and g are easily deduced by
applying the expressions for a and b. We find
f= b'a = ,8',8 (a'w,8 )-l a 'a = ,8'Ca
1.L .L.L .L 1 1 I'
which is non-zero by the result of Theorem 1. Since we are interested in stationary
alternatives only, it follows from (2.9) that b'a < o. Furthermore
a'a = a'a (a'Aa )-l a 'a
1.L.L.L .L1
and

5 Acknowledgement

The author thanks Neil Ericsson for some interesting discussions on the topic at an
early stage of the work, and a referee for suggestions on how to improve the
presentation.

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Long-run relations in a well-defined statistical model for the data generating
process. Cointegration analysis of the PPP and the UIP relations for Denmark and
Germany

Katarina Juselius
Institute of Economics
University of Copenhagen
Studiestrade 6
DK 1455 Copenhagen K
Denmark

Abstract
The concept of a well-defined statistical model for the data generating process is given an
empirical formulation in the vector autoregressive model under the assumption of
cointegration in an analysis of prices, interest rates and exchange rates between Denmark
and Germany. The long-run relations are estimated as stationary linear combinations
between the non-stationary variables. Comparative analyses of the long-run relations
based on the single equation error-correction model as well as the Engle-Granger two-step
procedure are performed. The full system versus the partial system analysis approach is
discussed in terms of optimal inference on the long-run parameters. By testing hypotheses
about the weight coefficients it is empirically demonstrated that the full five-dimensional
system cannot be reduced without loosing some efficiency.
Keywords: Non-stationary time-series; cointegration; long-run relations; VAR models;
purchasing power parity; uncovered interest rate parity.

Contents
1 Introduction
2 The dynamic linear regression model
3 The maximum likelihood estimation of the general cointegration model
4 The long-run purchasing power parity and the uncovered interest rate parity
relation between Denmark and Germany
5 Comparison with other methods
6 Concluding remarks
Appendices
References

1 Introduction

It is a well-known fact that economic time series are typically non-stationary. Never-
theless, the effect of non-stationarity on model specification and estimation had not
received much attention among econometricians before the discussion of cointegration in
Granger (1983). Most empirical models based on time-series data are of the following
categories:
i) Models using differences instead of levels. Since economic variables usually are
integrated of order one the differences do not have unit roots and standard distributional
results apply to the model estimates. However, all long-run information is removed by
differencing unless the difference operator is applied to the error process as well. When
 337

short-run effects are equal to long-run effects, this procedure gives satisfactory results, but
empirical evidence seems to indicate that these are often fundamentally
different (see for instance Juselius, 1989).
ii) Partial adjustment and rational expectations models. These models assume a
long-run steady-state relation between the levels of the variables and a simple adjustment
mechanism when the process is out of equilibrium. Thus the long-run information in the
data is preserved and some dynamics are allowed for, but it is often too restrictive for the
model to be a satisfactory statistical description of the complicated data generation process
of economic time-series.
iii) Error-correction-mechanism (ecm) models. These models which originate from
Sargan (1964) and were further developed in Hendry (1987), Davidson et al. (1978),
explicitly postulate the possibility of different short-run and long-run dynamics. The
long-run information is accounted for by including so called error-correction mechanisms
(equilibrium errors) defined as Yt-Yt* where Yt* = f(x t ) is an assumed steady-state relation
between the levels of y and the levels of the explanatory variables in the model. The
short-run information is described by differences of the explanatory variables, the dynamic
specification of which is usually data determined. Most empirical ecm-models have been
estimated as single equation models. The concept can easily be extended to the
multivariate case, but the estimation becomes more complicated due to non-linear
cross~quation restrictions. An example of a multivariate ecm-model is given in Davidson
(1983).
The mathematical formulation of the multivariate error-correction model was first given
by Granger (1983). In this paper, he defined the concept of cointegration and demonstrated
the connection with error-correction mechanisms using the moving average representation
of a vector time series model. In Johansen (1988a) the results were generalized to the
autoregressive representation which greatly facilitated estimation. The statistical analysis
then developed along two lines, on one hand the full information maximum likelihood
procedure developed in Johansen (1988b), Johansen (1991a) and Johansen & Juselius
(1990) and on the other hand the two step procedure in Engle & Granger (1987), Stock
(1987), Phillips (1987), Phillips & Durlauf (1986), Park & Phillips (1988) and Park &
Phillips (1989). In t.he latter procedure the cointegration relation is first estimated by a
static regression analysis, the estimates of which have been shown to be super consistent
(Stock, 1987) when the variables are non-stationary. In the second step the residuals from
the first step are tested for stationarity and, if accepted, included as ecm-mechanisms in
the final model analysis. Thus the final model is similar to the traditional ecm-model but
estimation and testing of the steady-state relations are di fferen t.
In this paper we analyze the hypothetical long-run relations in a simultaneous model
approach by applying the Johansen method of multivariate cointegration. The main
difference to the methods discussed above is that the long-run relations are estimated
jointly with the short-run effects thus using all information in the data. The concepts are
illustrated by an empirical analysis of the uncovered interest rate parity versus the
purchasing power parity relation between Denmark and Germany. Graphs of the data are
given in Appendix A.
In section 2 we attempt to demonstrate empirically the close connection between the vector
autoregressive model and the concept of a well-defined statistical model for the data
generating process (DGP) following mainly Hendry & Richard (1983) and Spanos (1986),
and then show that non-stationarity can easily be incorporated in this general framework
such that the presence of cointegration vectors can be statistically estimated and tested. In
section 3 some of the basic concepts and some important results on estimation and
inference on maximum likelihood cointegration are discussed. In section 4 the estimated
cOintegration vectors and their corresponding weights are presented. The adjustment
 338

coefficients in the full simultaneous model framework are analyzed to gain insight into how
deviations from equilibrium states interact with the rest of the system. Comparative
analyses of the long-run relations based on the single equation ecm-model as well as the
Engle-Granger two-step procedure are presented in section 5 and the relative importance
of a full system analysis is discussed.

2 The dynamic linear regression model

In this section some important principles developed by the "British school" of econometric
methodology (see for instance Hendry & Richard, 1983, Hendry, 1987 and Spanos,1986) are
discussed in the context of the dynamic linear regression model. This school explicitly
stresses the distinction between a theory model and an estimable empirical model on one
hand, and the reality that has generated the data and the statistical generating model on
the other. The statistical properties of the latter are then used to investigate the appro-
priateness of the former.
When the data are realizations of time series neither the sampling model nor the proba-
bility model for the actual data is usually known to the investigator. This means that many
economic hypotheses may not be testable or possibly only indirectly testable based on the
available data set. On the other hand, if a general well-defined statistical model can be
found that describes the data satisfactorily, this can be used as a framework in which the
economically interesting questions can be asked and statistically tested. Moving from "the
general to the specific" will ensure that the restrictions imposed on the final model are
consistent with the information in the data. This is in contrast to the experimental design
case where the sampling and probability model are designed first and then the data
collected accordingly, such that the theoretical questions can be answered in some optimal
way.
In the following, we will analyze a general vector autoregressive (V AR) model and
demonstrate that it can be reparameterized such that questions about short-run and
long-run economic phenomena can be given a statistical answer. This is made possible by
exploiting the information inherent in the stationary and the non-stationary part of the
process using the concept of cointegration.
Consider the p-dimensional vector Zt = [zlt, ... ,Zpt l ' where the elements Zit' t = 1, ... ,T, are
realizations of stochastic variables. Let us further assume that Zt and Zt_i are time
dependent. The joint probability of all the sample data has then to be given conditional on
the initial values, i.e.: D(Zt IZO;8) or in the form of the factorized density function:
T
II D(zt IZt_l' ZO;O),
t=l

where Zt-l = {Zt_l,Zt_2,···,zl} and ZO= {zO,z_F"}'

Let us further assume that the conditional process {Zt:Zt_l;O} N NIID(ll't'~) and that Il t
has an autoregressive representation of order k, i.e.

where Al'" .. ,A k are pxp matrices of autoregressive parameters. Under these assumptions
 339

we can now define a statistical model for the data generating process:
k
Zt = E A.z t _· + Ct· (2.1)
i=l 1 1
In an economic sense equation system (2.1) corresponds to the so-called reduced form and
can be efficiently estimated by the ordinary least squares method applied to each equation
in turn. This means that estimation and testing are straightforward using any computer
package. If the residuals <t pass misspecification tests for normality, independence and
homoscedasticity it is concluded that the statistical model (2.1) is an approximate
description of the data generating process.

As an approximate description of the non-experimental sampling situation of econometric

time series data, this model seems intuitively plausible. It would be consistent with an
economy where agents make contingent plans based on the relevant past information set,
such that the deviations between actual and planned outcome are a normal innovation
proce;;s (Hendry, 1987). This does not exclude the possibility that agents make plans based
on future expectations, only that the expectations are formed conditional on past
experience. In a practical situation, it is hardly possible to condition on all relevant
information, and the investigator chooses the information set he/she believes most rele-
vant. The implications of selecting only a subset are probably less serious in the context of
a dynamic regression model than of a static regression model. This is because the condi-
tioning is done on past values of the included variables, which are likely to be strongly
correlated with other omitted variables. It seems reasonable to assume that there is a
trade--off between conditioning on many variables with few lags or on few variables with
many lags. In this sense the error ct should be interpreted as a residual process, measuring
what is left unexplained when all systematic variation is measured by the conditional mean
of the model, instead of being interpreted as an autonomous error process added to the
theoretically specified model (see for instance Hendry, 1987).

Up to this point we have only assumed that the conditional process is stationary but not
considered explicitly that the data are non-stationary. We will now discuss the statistical
implications of Zt being a non-stationary process and begin with a formal definition of the
order of integration and cointegration (see for instance Johansen, 19S5a) .

Definition 1. Zt is integrated of order d if Zt has the representation (l-L)d Zt

*
C(L)c t , where C(l) 0, and ct is a white noise process.

Definition 2. Let Zt be integrated of order d, then Zt is cointegrated of order s

with cointegrating vector !3 if !3'Zt is integrated of order d-s.

Thus the notion of cointegration implies that certain linear combinations of the compo-
nents of the vector process are integrated of lower order than the process itself. The impli-
cation of cointegration is that the non-stationarity in one variable corresponds to the
non-stationarity in a companion variable such that a linear combination of them becomes
stationary. Another way of expressing this is that when two or several variables have
common stochastic (or deterministic) trends they will tend to move together in the
long-run, since they are driven by the same persistent shocks. Such a linear combination
!3'Zt is of considerable interest for the decision maker since it can often be interpreted as an
adjustment process for a long-run economic relation. This makes the association with the
error-correcting mechanisms straightforward.
 340

To begin with, we will demonstrate the association between the data generating mechanism
as given in (2.1) and the general cointegration model. For notational simplicity we assume
that k = 2 and add an intercept to each equation of the model. The implications of a
constant term in the model will be discussed subsequently in section 3. Using the lag
operator L, where Liz t = Zt_i the model is formulated as:
,
2
(I - AIL - A2L )Zt = /.L + ct ' ft ,.., NIIDp(O,E). (2.2)

Assuming that Zt is 1(1) and noting that L = l-(l-L) = 1-t:.., where t:.. is the difference
operator, (2.2) can be rewritten as
(2.3)

The system of equations (2.3) is a reparameterized version of (2.2) which is now more
appropriate for the analysis at a first order non-stationary process. Note that there is no
loss of long-run information in (2.3), a phenomenon usually associated with models for
differenced data. All long-run information is contained in the levels component IIz t _ 2.
Since Zt is 1(1) and f t is stationary it follows that the matrix II cannot be offull rank, since
this would mean inconsistent interpretation of the model. On the other hand if II = 0 the
model is statistically consistent but there would be no long-run information in the data,
and (2.3) would be reduced to the standard V AR model in first differences. Finally when
the rank is greater than zero, say r, the model implies the existence of r linear cointegration
vectors, defining the number of long-run relations in the data. If these can be given an
economic interpretation they can be considered the equivalents of the error-correcting
mechanisms.
In the next section model (2.3) will be discussed and estimated under the assumption of
reduced rank.

3 The maximum likelihood estimation of the general cointegration model

3.1. The general case with the rank r known.
We shall now examine the component IIz t _ 2 in (2.3) somewhat closer and start by
investigating the rank of the matrix II, based on the hypothesis that II = a{3' where a is a
(pxr) matrix and {3 is a (pxr) matrix with r $ p. Model (2.3) is now written as:
(3.1 )

To simplify the derivation of the ML estimates for a and (3, all short-run dynamics are
conditioned out by regressing t:..Zt and Zt-2 respectively on t:..Zt_l and the constant term /.L,
giving rise two (px1) vectors of residuals, the "difference" residuals called ROt and the
II levels II residuals called R
2t . Model (3.1) can now be written as:

(3.2)
 341

The non-linear estimation problem is solved by first keeping /3 fixed, which gives the esti-
. -1 .
mate a(/3) = 5 02 /3(/3'5 22 /3) and the residuals sum of squares function ~(/3) =

SOO-a(/3)(/3'S22/3)a(/3)', where 500 , 522 and 5 20 are defined as the product moment
matrices based on the residuals ROt and R 2t . Minimizing the determinant of this function
for /3 gives the maximum likelihood estimator. It has been shown that the estimates are
found by first solving the eigenvalue problem:

(3.3)

which gives the eigenvalues Al > ... > Ap ~nd the corresponding matrices of eigenvectors V

= (v 1 ,... ,v p ) normalized such that V'S22V = L For further details, se.e Johansen (1988b),

Johans,en (1991a) and Johansen & Juselius (1990). The eigenvalues \ correspond to the
squared canonical correlations between the ~'levels" residuals and the "difference" !esiduals
as defined above. The r first eigenvectors v·1 determine the linear combinations v!Zt
1
(i =
1,,,.,r) which are most correlated with the conditional process {tlZtl tlZt_i' i = 1,,,.,m-l}.

Thus the magnitude of A.1 is a measure of how strongly the cointegration relation v!Zt
1
is
correlated with a linear combination of the stationary process tlZt. The last (p-r)

combinations ViZt (i = r+ 1,,,.,p) define the directions in which the process is

non-stationary,. and are therefore uncorrelated with the stationary part of the process.
Consequently, A. = 0 for = r+1,.",p. For known r the maximum of the likelihood
1
function is given by:
-2/T _ r
L -15001IT (I-A.), (3.4)
max i=l 1

leading to the choice of /3 = (v1"",v r ), corresponding to the r largest eigenvalues. To each

column vector /3.1 (i = 1,,,.,r) there is a corresponding column vector a·1 of dimension pxl for
which at least one element is nonzero. The elements of a· can be interpreted as the weights
I
with which the cointegration relation /3iZt_2 enters each of the p equations in the system.
For a given estimate f3 the matrix a is estimated as

(3.5)

Note that the parameters a and /3 are not identified in the sense that given any choice of a
and /3, then for any non-singular matrix ~(rxr), the choice a~ and /3(0-1 will give the
same matrix IT = a/3', and hence determine the same probability distribution for the varia-
bles (Johansen & Juselius, 1990). It is, however, not unusual that the /3. vectors, deter-
I
mined by the normalization /3'S22/3 = I, can be interpreted directly in terms of interesting

economic relationships. In these cases the estimated /3/Zt are the relations of interest and
not linear combinations of them, but to make interpretation easier it is often
 342

recommendable to normalize 13·I individually by setting one of the coefficients to unity.

3.2. Rank r unknown.

The exposition above was based on the assumption of known cointegration rank. In
practical situations the rank r is not known but has to be inferred from the data. The
corresponding statistical problem is to discriminate between non-zero and zero eigenvalues
and the likelihood solution is given by the likelihood ratio test procedure, two versions of
which are presented below:

The first is a test procedure for the hypothesis r ~ q against the general unrestricted model
r = p and is given by:
p
-2In(Q;qlp)=-T ~ In(l-'x.) (3.6)
. =q+ 1
I
I

where Q is the likelihood ratio test statistic.

The second test procedure is for testing the hypothesis r < q against the previous
hypothesis r ~ q+1:
,

-2ln(Q; ql q+1) = -Tln(1-\+l)' (3.7)

These tests will be described in more detail in connection with the empirical application.
For a mathematical derivation, see Johansen (19SSb).
3.3. Two interesting cases in a hypothetical example.

Below we shall investigate in some detail two cases where we first assume one cointegrating
vector and then two cOintegrating vectors in order to illustrate the potential use of this new
concept in econometric modelling. In both cases we will assume that Zt is a four-dimensio-
nal vector described by the AR(2) model:

Case 1. Analysis of II = afj' when r= 1:

It would often be natural to normalize by the coefficient of one of the variables, say zl' by
multiplying 13 by 1/131 and a by 131 to facilitate the interpretation of the cointegrating
 343

*
vector as the long-run equilibrium error, zlt - zlt:

where zlt* = - {(.82/.81)z2t + (.8 31.81)z3t + (.841.81)z4t} is the long-run steady-state

relation.

Case 2. Analysis of II = O!.8' for r=2:

O!ll 0!12 O!ll 0!12

0!21 0!22 0!21 0!22 [.811Z1+.821Z2+.831Z3+.841Z4]
0!31 0!32 0!31 0!32 .812 z1+.822z2+.832z3+.842z4 .
0!41 0!42 0!41 0!42

If we denote :
.811 z1 + .821 z2 + .831 z 3 + .841 z4 ci 1
and

then

O!ll 0!12 0!1lci 1 + 0!12 ci 2

0!21 0!22
0!31 0!32
[ c~l 1 =
C1 2
0!21 ci 1 + 0!22 ci 2
0!31 ci 1 + 0!32 ci 2
0!41 0!42 0!41 ci 1 + 0!42 ci 2

In this case we have two cointegrating relations (cil and ci 2) and the interpretation of
these need not always be straightforward, due to the non-uniqueness discussed above. For
instance, assume that {.811 = .82l f 0 and .831 = .841 = O} in the first relation, and {.812 =
.822 = 0 , .832 = .842 f O} in the second. This would imply that zl and z2 are cointegrated,
i.e. that they have a common stochastic trend, and also that z3 and z4 are cointegrated,
possibly with a different common trend. In most applications the structure is not so
clear-cut as in this hypothetical example; instead, all f]. . will typically differ from zero. By
IJ
taking linear combinations of the estimated vectors structurally simpler cointegration
vectors could be found.

Cointegration analysis has frequently been concerned with the analysis of the ,B-vectors
without paying much attention to the corresponding a-coefficients. However, the analysis
of the O!ij-coefficients provides additional insight into the complicated functioning of the
economic system which can be of great importance. Consider for instance the first two rows
of O! in case 2 and assume that ci 1 and ci 2 describe a long-run demand and supply relation,
respectively, such that O! and .8 can be assumed to be well-defined. Assume then that {O!ll
f 0, 0!12 =O} and {0!21 =0, 0!22fO}. This would imply that the DGP of zl has been affected
 344

by the equilibrium error ci 1 but not by ci 2, whereas the opposite is true for the DGP of z2.
Clearly, such a result would be stron~ evidence that a demand relation and a supply
relation have actually been identified. (An illustration of this is given in Juselius, 1989).
Thus the a· .--<:oefficients are the weights of each cointegration relation in each of the four
IJ
equations of the system. Note that some of the coefficients might be statistically significant
from zero whereas others will not. From an economic point of view these hypotheses are
often of considerable interest, as will be shown later.
The inclusion of a constant term in the model turns out to have strong implications both
on the probability theory (Johansen (1991b)) and the economic interpretation (Johansen
and Juselius (1990)). This is a consequence of the dual role the constant plays in a model
with stationary and non-stationary components, namely as the intercept in a long-run
relation in levels and as the slope of possible linear trends in the non-stationary part of the
model. This can be stated more generally by expressing fL as the sum of the a and a
.L
projection:
fL = a{30 + a.L '0' (3.9)
where {30 = (a'a)-l a 'fL is a vector of (rx1) intercepts, '0 = (a .L.L
'a )-l a .L 'fL is a «(p-r)x1)
vector of linear slope parameters and a is a px(p-r) matrix of full rank, the columns of
.L
which are orthogonal to the columns of a, Johansen (1991a) and Johansen & Juselius
(1990).

The hypothesis that there are no linear deterministic trends in the data can be tested by
applying the likelihood ratio test procedure described in Johansen & Juselius (1990). The
procedure consists of comparing the restricted model
~Zt = r 1~Zt_1 + a{3' *Zt_2
* + tt' (3.10)
where {3*= *
[{3',{301',
Zt= [zt',11' and {30 is from (3.9), with the unrestricted model (3.1).
Model (3.10) is chosen if the restriction a .L 'fL = 0 is accepted. However, it should be pointed
out that the distributions of the likelihood ratio test, (3.6) and (3.7) respectively, are not
the same under these alternatives. In fact three different distributions are needed, one for
model (3.10) and two for model (3.1). All three are non-standard but their asymptotic
distributions have been estimated by simulation and are reported in Johansen & Juselius
(1990) as Table D.1, Table D.2 and Table D.3. The latter table corresponds to model (3.10)
whereas Tables D.1 and D.2 correspond to model (3.1), i.e. the model where we allow for
the possibility of a linear trend. In this model we are in the unfortunate case of having two
limiting distributions under the null: Table D.1 corresponds to the case where deterministic
trends are correctly included in the model, whereas Table D.2 corresponds to the case when
deterministic trends are allowed for but there are actually no trends in the data. Since one
does not usually know which case is true it is advisable to use Table D.2 since it has fatter
tails, or alternatively simulate a distribution which corresponds as closely as possible to the
actual problem being investigated.

4 The long-run purchasing power parity and the uncovered interest parity relation
between Denmark and Germany

In this section we will investigate two popular theories for the international transmission
effects between two trading countries. The first is based on the purchasing power parity
(PPP) relation, Pd = Pg + ed / g , and the second on the uncovered interest rate parity
 345

(UIP) relation, id = ig + 6ee , where Pd is the natural logarithm of the Danish consumer
price index, id is the Danish bond rate, p and i are the corresponding German variables,
g g
ed / g is the logarithm of the exchange rate measured as Dkr/Dmk and the superscript e
denotes the expected exchange rate. For a general review of theories and evidence in the
foreign exchange market see Baillie and McMahon (1989).
The link between the two relations is obtained by assuming that 6e~+1= (ed/g-Pd+Pg)t.
Given that expectations are unbiased this would lead to E(id-i g-€d/g +Pd-Pg)t = 0 where
E(x t ) denotes the mean value of the process x t . The two parity concepts are fundamentally
different. The PPP is a long-run relation and the adjustment towards it can be expected to
be backward looking and probably very slow, if at all present, whereas the UIP is basically
a forward looking market clearing relation. The interaction between them is clearly an
interesting empirical question for which the full information maximum likelihood
cOintegration methods should be ideal to provide an answer.

We will here give an illustration of the full information maximum likelihood method
applied to the vector zi
= [Pd,Pg,ed/g,id,iglt, t =1973.1-1987.3. The sample period
coincides with the post Bretton Woods period, which for Denmark has been characterized
by pegged exchange rates within certain ranges specified by the snake and later on by the
EMS. Graphs of the data are given in Appendix A.

The first step of the empirical analysis is concerned wi th the unrestricted estimation of the
long-run parameters in the full cointegration model. If the data support the existence of
long-run relations and these can be interpreted in terms of the purchasing power parity
relation and/or the uncovered interest rate parity relation, the next step is to analyze the
effect of these disequilibria by testing restrictions on the matrix a of adjustment
coefficients. This is likely to give valuable information about the complicated interactions
of the system. The ML method estimates model (2.3) under the restriction that II=a,B'.
Thus the estimation is non-linear in the parameters and requires an eigenvalue routine
and a computer program that can handle matrices. A program written in RATS is
available and can be obtained from the author on request. The estimated coefficients of
model (2.4) are given in Appendix B.

In the upper part of Appendix B we have reported the estimates of the unrestricted
VAR-model and in the lower part some misspecification test statistics. The independence
assumption is tested by the Box-Pierce Q-statistic which is asymptotically distributed as
X2(12). As a complement to this the individual residual autocorrelations are reported. It
can be noticed that the Box-Pierce test statistic is quite high for the first equation,
whereas for the other equations it is more satisfactory. There also seems to be excess kurto-
sis both in the Danish price equation and the German interest rate equation. This could
indicate either that the second order autoregressive model is not sufficiently general to
describe all the systematic variation in the data or that the information set we have used is
not sufficiently large. The estimated coefficients of the short-run dynamics r l' also
reported in Appendix B, are not of particular interest in the context of this empirical
investigation. They correspond to the reduced form of the system and, due to the general
model formulation, are not effiCiently estimated. The simultaneous structure of this system
is described by the error covariance matrix. To facilitate interpretation, it is given in
correlation form in Appendix B.

In the following we will concentrate on the investigation of the long-run impact matrix II
given in Appendix B. The rank is determined by the two test procedures described in
 346

section 3. The first is based on the test statistics '\race (3.6) and the second on Amax
(3.7). The following six hypotheses are being tested by each test:

H5: r $ 5, i.e. {A 1 )2)3)4)5 ~ O}

H4: r $ 4, i.e. { at least A5=0}

H3: r $ 3, i.e. { at least A5 ,A 4=0}
H2: r $ 2, i.e. { at least A5,A 4 )3=0}
HI: r $ 1, i.e. { at least A5 ,A 4 )3,A 2=0}
HO: r = 0, i.e. { A5 )4)3)2)1 =O}

The trace test is based on the likelihood ratio:

i.e. each hypothesis H. is tested against the unrestricted general model H5. The A test
1 max
is performed conditional on the previous model, i.e.:

Amax= Hi_ 1/H i for i= 5,4, .. ,1.

There is no obvious rule for which of the test statistics to choose. The trace statistics will
usu~y have more power to detect the r-th stationary relation when several of the estima-
ted A., i=r+l, ... ,p, are quite close to being significant, whereas A has more power when
1 max
the estimated \ are either large or close to zero. Consequently Amax is usually preferable
when the estimates discriminate effecti::ely between small and large eigenvalues, whereas
Atrace is preferable when the estimated Ai values are rather evenly distributed.

In Table 4.1, the eigenvalues and both of the test statistics are given for models (3.1) which
allows for deterministic trends in the non-stationary part of the model. The choice of
model (3.1) instead of (3.10) is motivated by the obvious linear trend in the Danish price
variable.
Table 4.1 The likelihood ratio tests for the rank of IT in the model with linear trends.
Critical values are from Table D.2 in Johansen & Juselius (1990).

A. -Tln(l-A.) A . 90 A . 95 -~Tln(I-A.) A· 9O A· 95
1 1 max max 1 trace trace
1 .469 36.13 30.81 33.26 78.12 65.96 69.98
2 .229 14.80 24.92 27.34 41.99 45.25 48.41
3 .224 14.44 18.96 21.28 27.19 28.44 31.26
4 .127 7.73 12.78 14.60 12.75 15.58 17.84
5 .084 5.02 6.61 8.08 5.02 6.69 8.08

Based on the test results of Table 4.1. it would be natural to accept r = 2, but the third
eigenvector (see Table 4.2 below) seems to measure exactly what we are looking for,
 347

namely the PPP and the interest differential. Therefore it does not seem reasonable to omit
the third cointegration vector from further analysis and we choose r = 3 although the
p-value is above 0.10. In this context it can be pointed out that the power of the tests is
quite poor for small values of \' Johansen (l991b), which in some situations can motivate
the choice of larger significance values than the standard ones. In this sense the decision to
include the r-th cointegration vector in the stationary set is a question of whether it can be
interpreted as a reasonable economic relation or not.
,
The decomposition of II into eigenvectors and weights, based on model (3.1) are given in
Table 4.2. The three stationary vectors are denoted by {J. and the two non-stationary ones
1

by v1.. Correspondingly the first three weights vectors are denoted by a·1 and the last two by
Wi· In Appendix C, the graphs of the ;1i'Zt relations are given. The first three ;1j'zt relations
determine the stationary relations, whereas the last two determine the common trends.

Table 4.2 The eigenvectors and the weights of II in model (3.1)

The e~genvectors:,

;11 ;12 ;13 v4 v5

-.051 -.604 1.000 1.000 1.000
-.096 .265 -1.182 -1.913 -2.482
-.221 1.000 -.931 .268 .223
1.000 1.830 .347 .855 -.383
r 2.635 -1.895 -.330 1.215 -.117

The w,eights:
a1 a2 a3 w4 w5

.066 -.029 -.006 -.017 -.036

.034 .004 .003 -.001 .021
-.028 -.022 .208 -.004 -.052
.006 -.054 .020 -.019 .021
-.033 .042 .027 -.013 .036

We will now try to give an interpretation of the first three /1-vectors. It might seem
surprising that we find strong evidence on the PP P relation in the third vector and not as
one might expect in the first one. However, if the adjustment to the long-run steady-sta!e
is very slow, one should expect the corresponding cointegration relation to have a small A.
I

value. Since the first three coefficients of ;13 seem to determine the PPP relation quite
accurately we have normalized ;13 by the Danish price level. The last two coefficients seem
!o determine the nominal interest rate differential between Denmark and GermanJ- The
;12-vector seems primarily to be a relation for the interest rate differential whereas ;11 does
not seem to have an intuitive interpretation. It will be shown b,elow that the role of the
first one will become clear after the analysis of the corresponding a-vector.
 348

We will now demonstrate how the investigation of the ai-vectors facilitates a full
understanding of the complicated functioning of the system, by evaluating the relative
A

importance of each a ij for i=l, ... ,5 and j=l,2,3. This is done by testing the
hypotheses a·1. =0 for i= 1, ... ,5, which gives us the relative importance of each
cointegrating vector rvzin each equation. The test results are presented in Table 4.3
together with the new estimates of /3.1 under the restriction that a·1. =0.
Since the third cointegration vector, /33'z, can be considered to be the most interesting from
an economic point of view we will look at the third column of test values in table 4.3. They
indicate that the third cointegration vector is most important for the exchange rate
equation, has some significance for both interest rate equations, but has no significance for
the German price equation and only a minor impact on the Danish price equation. This
result tells us that the information about the PPP is mainly in the exchange rate equation
and that prices hardly adapt at all, an empirical result which is consistent with the notion
of sticky nominal prices.

Table 4.3 The test results of the hypothesis a· = 0

1.

A A

-Tln(1-A 1) -Tln(1-A 2)
Full model 36.13 14.80

Reduction in test values by imposing a.=O

1

a 1=0 9.36 .36 1.14

a2=0 17.31 .27 .47

a 3=0 .51 .01 6.60

a 4 =0 .08 .35 2.80
a 5=0 2.95 .31 2.88

The estimates of /3.1 under the restriction a.=O.

1

i
/31 {32 /33 {31 {32 /33 /31 /32 /33 /31 /32 {33 /31 /32 /33

.1 -1.1 .-.3 -.2 -1.0 .0 .0 -.5 2.8 -.0 -1.2 -.8 .0 -1.0 -.0
-.3 1.4 -.1 .4 1.0 -.0 -.0 -.0 -4.9 -.0 1.5 .6 -.1 1.0 -.0
-.1 1.0 .7 -.1 1.0 -.1 -.1 1.0 -.5 -.0 1.0 1.0 -.1 1.0 .1
.1 -.6 1.0 .1 .5 1.0 .4 2.5 1.0 .4 -.9 1.0 .6 1.0 1.0
1.0 .6 -.6 1.0 -.3 -.4 1.0 -2.6 1.2 1.0 .9 -1.6 1.0 -.2 -.9
 349

The first cointegration vector is strongly significant in the German price equation as well
as in the Danish price equation. It also has some impact on the German interest rate. This
can actually provide us with an interpretation of the first cointegration vector: namely that
it measures the positive association between the inflation rate t:.Pt and the nominal interest
rate.

It is interesting to notice the effect on /32 and /33' when the information from the DGP of
the German price ~nd the Ge~man interest rate equations, respectively, is suppressed.
Firstly, notice that /33 becomes /32 and vice versa. This can econometrically be explained by
the fact that the estimates of ).2 and ).3 are very close to each other and therefore the
ordering is non-informative. Secondly, and more interestingly, the relation between devia-
tions in the PPP and the interest rate differential seems to be very sensitive to these impo-
sed restrictions.
This illustrates how sensitive the cointegration results can be for small changes in the
information set. One way of circumventing this indeterminacy is to specify the structural
hypotheses of interest and then test whether they are contained in the space spanned by (3.
These test procedures are described in Johansen & Juselius (1990).

As a final step in the cointegration analysis the estimates of IT = a/3' for r = 3 are calcu-
lated and given in Table 4.4. The rows indicate the combined effect of the three cointegra-
ting relations on each of the Zit processes. The empirical results can be summarized for:

1) the Danish price equation: No effect from the PPP, positive effects from the
German and the Danish interest rates.
2) the German price equation: No effect from the PPP, some positive effects from the
interest rates (own country interest rate).
3) the exchange rate equation: Strong PPP effects, no effect from the Danish interest
rate, some effects from the German interest rates.
4) the Danish interest rate equation: Indication of a long-run real interest rate
relation.
5) the German interest rate equation: No effects except from own interest rate.

Table 4.4 The IT -matrix for r = 3 (IT = a(3')

dk price eq. .026 -.008 .019 .117 .121
ge price eq. -.001 -.006 -.006 .042 .081
exchange eq. .222 -.248 -.209 .004 -.102
dk inte. eq. .052 -.039 .074 -.085 .112
ge inte. eq. .004 -.018 .024 .052 -.175

5 Comparison with other methods

The most widely used method for estimating long-run relations is the Engle-Granger
two-step procedure (Engle & Granger,l987). The first step is simply to estimate the coeffi-
cients of the suggested long-run relation with a simple linear regression model:
 350

(5.1)

where Yt' xlt,··,x kt are one-dimensional time-series and Dit are seasonal dummies. The
second step is then to test the hypothesis that the residuals ut are a stationary process. If
the stationarity hypothesis is accepted the estimated linear relation is assumed to be an
estimate of the long-run steady-state relation. In the second step the full dynamic model
is specified so that the changes in the variable y t are explained by present and lagged
~hanges of the explanatory variables and by the estimated error-1:orrecting mechanism

u t- 1. For instance:

A(L)6.Yt = BO(L)6.xlt + B1 (L)6.x2t + ... +B k(L)6.x kt + fU t -1 + Ekpjt + tt' (5.2)

where A(L), Bi(L), i = 1, ... ,k are lag polynomials.

The second method estimates the steady-state relation as the static long-run solution of a
dynamic linear regression model, given for instance by:

A(L)6.Yt = B1 (L)6.xlt + ... + Bk (L)6.x kt _ 1 + cYt-1 + c 1x lt _ 1 + ... + ckx kt - 1 +

+ Co + Ekpjt + tt' (5.3)

where ct is a white noise process. The long-run steady-state relation is then derived as:

*
y = fO + f1 x 1 + f2 x 2 + ... + fkxk' (5.4)

where fi = -1:/c, i = 1, ... ,k. The estimates in (5.4) are shown to be equivalent to the
maximum likelihood estimates of model (3.1) for the special case when there is just one
cointegration vector and just one a i f- 0 , i.e. the one corresponding to the equation for y
(Johansen & Juselius, 1990).

To allow for full comparability, each of the models is estimated with Pd' e d / g and id
respectively as regressands. The estimates are presented in Table 5.1, where a regress and is
indicated by -l.0, and a coefficient with a significant t-value (> 121) is indicated by an *.
For each model the Durbin-Watson and the Box-Pierce test statistic is calculated as a
measure of residual autocorrelation. The D-W test statistic is used to test the null hypo-
thesis that ut in (5.1) has a unit root, whereas the Wald test statistic is used to test the
overall significance of the long-run steady-state relation (5.4). Based on the reported
D-W statistics the estimated long-run relations would be considered stationary though
most of them are close to non-stationarity. The striking exception is the exchange rate
equation of model (5.3).

It is, however, not straightforward to compare the results from a single equation analysis
with the results of a system analysis. We have chosen to compare the results in Table 5.1
with the corresponding estimates of II = af3' given in Table 4.4, since we believe that the
combined estimates are likely to correspond most closely to the single equation estimates.
 351

Table 5.1 Estimation of the long-run real interest parity relation by the static regression
model (5.1) and the dynamic linear regression model (5.3)
The static linear regression estimates

Pd Pg ed / g id i DW Q(21)
g
-1.0 1.75* .44* .08 -.18 .25 264.11
.70 -.48 -1.0 -.20 .45* .34 122.70
.10 -.10 -.15 -1.0 .72* .18 180.40
The dynamic linear regression estimates

Pd Pg ed / g id i DW Q(21) Wald(8)
g
-1.0 1.68* .23 .96 .75 2.08 40.92 853
.94 -1.00 -1.0 .54 .04 2.10 6.39 48250
.11 .05 .29 -1.0 .45 2.15 19.95 30

The Danish price equation: Both the static and dynamic regression methods find cointegra-
tion between prices and the exchange rate, though the coefficients are not consistent with
the PPP-hypothesis. In the static regression case the interest rates enter with very small
and insignificant coefficients, whereas in the dynamic regression case the interest rates
seem to have an effect similar to the one found in the ML case.
The exchange rate equation: In the dynamic regression case the PPP seems to have the
expected coefficients, whereas the result is less satisfactory in the static regression case.
The interest rate equation: In the static regression case the relation between nominal
interest rates dominates though the coefficient of the German interest is quite different
form the ML estimate. In addition the PPP-relation comes out very nicely but with small
and insignificant coefficients. In the dynamic regression case the estimates are completely
different from the ML estimates.

6 Concluding remarks

In this paper we have demonstrated empirically the potential use of cointegration analysis
based on a second order VAR model. Based on the assumption that the VAR model is a
satisfactory statistical description of the non-stationary vector process Zt it is possible to
derive procedures for likelihood inference on long-run relations. This is done under the
assumption of reduced rank r<p of the long-run impact matrix II which then can be parti-
tioned into the (pxr) matrices a and {J with IT = a{J'. These matrices summarize all data
information about the long-run relations of interest and a variety of structural hypotheses
can be tested against the general model formulation.
The full system maximum likelihood approach is compared to two single equation proce-
dures. We conclude by noting that when there is more than one cointegrating relation in
the data any single equation method would usually be unsatisfactory since one would not
be able to discriminate between the different relations by such a method. On the other
hand, one would usually expect the economic structure to be quite complicated in those
cases when the data suggest several long-run relations. This clearly motivates the use of all
information in the data as effiCiently as possi ble.
 352

APPENDIX. A. Graphs of the data

LEVELS DIFFERENCES
DANISH PRICE

I.-r------------------------------------__
.~
..
•• 4-----------------~~----------------_1 l.
-. z
I.
-.1

_ I I o.4------4--------------------------~

-.1 ·1
13 1. 15 11 11 IS n 10 II IZ ., s. 15 U 81 73 1~ 15 11 11 IS 1~. ao. S1 52 n a. 85 18 81

GERMAN PRICE

·,
1.-r----------------------------~--~~_,
z '-r--~------------------------------~

, .,
••
• .3

13 1~ 15 11 7T 18 71 eo II IZ 13 S. l5 el 81
13 n 15 71 17 I. n. 10 II 12 13 I_ 15 9S 87

EXCHANGE RATES

I·°lr--------------------______________-, 7· l r----------------------__________
5. ,

s .• s.

I .7
l.

5 .1
I.
5.5

""
-I .

73 T. 15 71 11 18 l' eo II IZ 13 8~ 85 sa 87
 353

APPENDIX A. cont.

LEVELS DIFFERENCES
INTEREST RATE IN DENMARK

~~.,--------------------------------------, 1.,----------------------------------,
20. z.
II.

II.
O.-r~_+~+_~~~~~~~~~~~--+_~~

I~ .
·1.
12 .
·a.
10.
.J .

. ~

71 15 TS 77 7S I'. 10 51 !Z Il 55 'I 81
7~ 8~
71 1~ 15 TJ 17 re l' eo 51 ez 11 8~ 85 n 81

INTEREST RATE IN GERMANY

Il.-r--------------------~--------------, ,,------------------------------------,
II.

2 .

..
• L

1.

1·~r-_r_r~--~~_r~--r_~_r_r_.--~~~·1

11 1~ 15 18 n 18 l' 10 II 12 !l 8' 85 II il 11 1~ 15 7! 11 18 Il 10 II 52 !1 8' 85 es 81

 354

APPENDIX B. The unrestricted V AR model ~Zt = r 1~Zt-1 + IIz t _ 2 + Jl. + ~D t + "t '
"t niid(O,E) where z' = [Pd,Pg,ed/g,id,igJ and If>Dtaccounts for fixed seasonal effects.
OJ

The short-run dynamics:

-.281 -.144 .047 .227 .477

-.057 .244 .034 -.063 .156
.142 .946 .134 -.324 .334 = r1
-.055 -.119 .127 .166 .347
.061 .220 .034 .066 .478

The long-run impact matrix:

-.080 .131 .007 .116 .105

.019 -.056 -.002 .032 -.077 A
.166 -.111 -.222 .020 -.102 =II
-.054 -.054 -.075 -.110 .086
.026 -.081 .028 .027 -.196

The standardized error covariance matrix:

1.00 .21 .64 .15 .14

1.00 -.30 .24 .26 "-
1.00 .19 .04 = RE
1.00 .21
1.00

The residual autocorrelations:

Lag 1 2 3 4 5 6 7 8
eq.1 -.03 -.34 -.07 -.22 -.10 .36 .23 -.20
eq.2 .04 -.24 -.02 .11 -.06 -.10 -.19 -.13
eq.3 -.10 .01 -.06 -.14 -.03 -.15 -.13 -.04
eq.4 -.04 -.07 -.10 -.18 .09 -.10 .01 -.05
eq.5 .10 -.28 -.13 .14 .14 -.06 -.10 -.17

Some misspecification test statistics:

skewness excess B.P Q(12)
kurtosis
.172 2.063 23.620
.258 .321 10.534
.330 .923 9.082
-.125 .123 7.533
1.113 3.966 12.803
 355

APPENDIX C. Graphs of the cointegrating relations

The cointegration relations The driving trends

... ., ,----------------------------------------~

... ., 0
,/
·10 ., I

·H
.,

:j
."
· 51 .,
·n
·e 0 .1

73 I~ H 78 1 H 7 ~ '0 ,. az " " es IS 73 7, S 78 71 n 7' 10 a. • 2 !3 " es I.

v 5 'Zt

J t~ i · 10 :I

:: h
\
·10 Ie

'10
'0
A
'n~1
'10 n

u
\}V '10 /,

II I
I
'10
"\
I~ ·10
111
1 '2~----~--~~--------~~--------------- ·10 10
as II
IS " 75 7S 77 18 7' 10 II 52 I' "

t33Z t
·1. I I

·1. 10

·10 I I

·11 7~

·1. I.
'1 ~
,.
·10 10

·IO . 1l

·10 I"
71 I, 1 S re 77 11
7' lO II n !3 ,- 'I Ie
 356

REFERENCES

Baillie, R. & McMahon, P. (1989): "The foreign exchange market. Theory and econometric
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Davidson, J.(1983): IIMoney disequilibrium: an approach to modelling monetary pheno-

mena in the U.K. II International Center for Economics and Related Disciplines. London
School of Economics.

Davidson,J.,Hendry,D.,Srba,F. & Yeo,Y. (1978): IIEconometric modelling of the aggregated

time series relationship between consumers' expenditure and income in the United
Kingdom." Economic Journal, Vol.88, pp.661-92.

Engle, R.F. and Granger, C.W.J. (1987): "Co-integration and error correction: representa-
tion, estimation, and testing."Econometrica, Vol. 55, pp. 251-276.
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Hendry, D.F. (1987): "Econometric methodology: A personal perspective". Ch. 10 in

Advances in Econometrics. T. Bewley (ed.): Econometric Society Fifth World Congress.

Hendry, D.F. and J-F. Richard (1983): "The econometric analysis of economic time series,
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rary Mathematics, American Mathematical Society, Vol.80, pp. 359-386.

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Dynamics and Control, Vo1.12, pp. 231-254.

Johansen, S. (1991a): "Estimation and hypothesis testing of cointegration vectors in

Gaussian vector autoregressive models." To appear in Econometrica.

Johansen, S.(1991 b): "The power function of the likelihood ratio test for cointegration." In
this volume.

Johansen, S. & Juselius, K. (1990): "Maximum likelihood estimation and inference on

cointegration - with applications to the demand for money." Oxford Bulletin of Economics
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Johansen, S. & Juselius, K. (1991): "Some structural hypotheses in a multivariate cointe-

gration analysis of the PPP relation and the UIP relation for the UK." To appear in
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Juselius, K. (1989): "Stationary disequilibrium processes in the Danish money market. An

application of ML cointegration." Institute of Economics, University of Copenhagen.
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Park, J.Y. & P.C. Phillips (1989): "Statistical inference in regressions with integrated
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vectors." Econometrica, Vol.55, pp. 1035-1056.
INTEREST RATE LINKAGES BETWEEN EC COUNTRIES PARTICIPATING IN THE
EUROPEAN MONETARY SYSTEM: AN APPLICATION OF COINTEGRATION

Wilhelm FritzI
Bank for International Settlements
Monetary and Economic Department
Centralbahnplatz
CH-4002 Basle, Switzerland

Abstract

The purpose of this study is to analyse the linkages between

one-month Euro-market interest rates of the EC member countries
participating in the European Monetary System (EMS) on the basis
of the recently developed concept of cointegration. The data are
split into two sub-samples, the first of which covers the founda-
tion of the EMS and the initial turbulences and the second the
more steady development in recent years. The level of integration
is determined and the cointegrating relations are computed. A
bivariate error correction model is specified to identify short-
term adjustment patterns to long-run equilibrium paths.
Keywords: European Monetary System; Euro-market interest rates;
integration/cointegration; error correction model.

Contents

I Introduction
2 Interest rate linkages in the EMS
3 The concept of cointegration
4 Econometric specification
5 The order of integration
6 Testing for cointegration
7 The error correction representation
8 Conclusions
References
Appendix

I Introduction

Most research on international interest rate linkages focuses on

the interest rate development of major economies like Japan or

IViews expressed in this paper are those of the author and are
not necessarily shared by the BIS.
 359

Germany vis-a-vis the United States. Less attention has been paid
to the interest rate linkages of other countries which also main-
tain close international economic relations. The EC countries are
no exception.

The European Community represents a group of countries closely

related by international trade and a monetary system. Moreover,
growing integration and deregulation of the money and financial
markets of the EC member countries have taken place in recent
years. Capital movements will be fully liberalised between eight
member countries by mid-1990, with the others to follow suit
after a transition period. Recent statements about the future
development of the EMS go beyond this full liberalisation to
envisage a uniform European currency (see the Report on Economic
and Monetary Union in the European Community, Committee for the
Study of Economic and Monetary Union, Basel (1989». Parallel
movements of nominal long-term and, to a lesser extent,
short-term interest rates are now markedly higher than they used
to be in the mid-1970s. This can be taken as an indication that,
in some EC countries at least, the long-run determinants of
interest rates have changed noticeably.

The purpose of this study is to analyse the linkages between

interest rates of the EC member states participating in the
European Monetary System (EMS) using the recently developed
concept of cointegration. The level of integration of nominal and
real short-term interest rates in the EMS countries is first
estimated. Tests are then conducted to see whether the long-term
behaviour of the interest rates and the interdependences between
them changed after the creation of the European Monetary System.
Furthermore, the effect of inflation on nominal interest rates is
analysed.

2 Interest rate linkages in the EMS

The European Monetary System has gradually evolved towards a

system with full capital mobility. For open economies with full
capital mobility, the interest rates of financial assets are
determined on the common market, where savers and investors from
all the participating countries meet. The economic agents know
the nominal interest rates of these assets, but uncertainty about
the development of domestic and foreign inflation rates and the
exchange rates prevails. Unfortunately, the interaction between
interest rates, exchange rates and inflation is far from clear in
spite of the huge amount of literature devoted to this topic. For
the purposes of this study some basic linkages between these
economic variables are reviewed to explain the occurrence of
parallel interest rate movements.
Under full capital mobility it is possible, but not mandatory,
that investors regard financial assets denominated in different
currencies but otherwise identical as perfect substitutes. If the
uncovered interest parity condition holds, the returns on
comparable domestic and foreign assets (id and if respectively)
 360

should differ only by the expected change in the exchange rate

exp (de) :

i
d
= if+exp(de). (1)

To explain interest rate linkages, assumptions about the forma-

tion of exchange rate expectations are necessary. The formation
of such expectations can depend on differences between inflation
rates. When the purchasing power parity condition holds and nomi-
nal exchange rate changes fully offset inflation differentials,
the real exchange rates do not change. In terms of expectations,
ex ante real exchange rate changes are assumed to be zero, which
implies that the expected nominal exchange rate changes (exp(de))
are equal to the expected differential between the domestic and
foreign inflation rates (exp(dp)d and exp(dp)f respectively):

exp(de) = exp(dp)d - exp(dp)f' (2)

Using (2), equation (1) can be transformed into:

(3)

which states that the equalisation occurs between the anticipated

interest rates in real terms. If the agents have perfect fore-
sight, the assets are perfect substitutes and purchasing power
pari ty holds, then observable real interest rate differentials
should disappear.
These quite restrictive conditions have to be postulated to ex-
plain one-for-one linkages between the interest rates of differ-
ent economies. Especially in the short run, perfect capital mo-
bility and asset substitutability alone are not sufficient to
bring interest rates together.
For the European Monetary System, the assumption of perfect capi-
tal mobility itself does not hold in spite of the strong finan-
cial and real linkages between its member countries. Regulations
governing intra-system movements of capital were quite important
when the EMS was founded and have only gradually been liberalised
since.
Under an irrevocably fixed exchange rate regime, expected ex-
change rate changes are zero. This condition does not hold either
for the European Monetary System, which should be seen as a re-
gion where "exchange rate stability is a consequence of the inte-
grating role of the institutionalised co-operation between the
member countries". Each currency is allowed upward and downward
flexibility of 2.25% (Italian lira: 6% until January 1990)
against every other currency, and realignments may be undertaken
to avoid pronounced disequilibria caused by different inflation
rates. Investors in foreign member currencies thus face a degree
of exchange rate risk and should - if the expected exchange rate

2Since June 1989 the Spanish peseta has participated in the EMS
(Footnote Continued)
 361

changes are determined by inflation differentials - base their

decisions on real interest rates.

For these reasons it cannot be expected that comparable interest

rates in different countries will level out completely, even un-
der equilibrium conditions. Differences between nominal interest
rates should persist at least as long as inflation differentials
exist. Real interest rates should show a stronger tendency than
nominal interest rates to level out in the long run. An appropri-
ate model specification for the analysis of nominal and real in-
terest rates must allow for long-term differences. In addition,
any such model should provide insight into the short-term dynamic
movements which are difficult to explain by economic theory.

3 The concept of cOintegration

3.1 Theoretical foundation of cointegration

Under specific conditions, the class of error correction models

can be used for the analysis of dynamic adjustments of economic
variables to long-run development paths. Engle and Granger (1987)
proved that error correction models represent an appropriate
econometric specification if the economic time series are
cointegrated. This in turn implies that the behaviour of the time
series is non-stationary.
The concept of cointegration represents a new approach to
econometric modelling in the presence of non-stationarity. The
majority of time series observations which are of interest to
econometricians are not stationary; interest rates are no excep-
tion. Ignoring the non-stationarity of variables in estimation
can lead to "spurious regressions". One modelling approach which
avoids this problem is to difference the time series until they
are stationary, but this differencing removes the long-term prop-
erties from the data. Non-stationarity of an economic variable is
itself not a problem, but the way in which variables with dif-
ferent time series properties are combined in estimation is cru-
cial. Actually, the researcher can use the fact that economic
variables are non-stationary to identify long-term linkages be-
tween them.
Only a brief description of the integration/cointegration concept
is given here. A time series is defined as integrated of order n
p(n)) if it can be transformed into a stationary, invertible,
non-deterministic ARMA representation by differencing it n times.
Generally, a linear combination of I(n)-time series yields a
variable that is also integrated of order n. However, it is pos-
sible that a constant c exists, so that the linear combination z:

(Footnote Continued)
exchange rate mechanism; the margin for fluctuation is 6%. Since
September 1989 the peseta and the Portugese escudo have been
included in the ECU basket.
 362

(4)

is integrated of order n-m with m>O. The variables x and yare

then said to be co integrated of order m. If n-m=O, it is unlikely
that the I(n)-variables drift far apart in spite of the fact that
they are non-stationary. Particularly sui table for economic in-
terpretations are time series integrated of order 1 with a
co integrating relation so that the difference between them is
stationary. It is possible to combine the differenced I(l) series
and the linear combination (z) in the same regression without
creating the spurious regression problem since all variables are
stationary.

For the estimation of cointegrated systems there are a number of

observationally equivalent alternative parametrisations to chose
from (see Hylleberg and Mizon (1988»; the error correction rep-
resentation is just one of them. The class of error correction
models, which was developed in the 1960s (see Sargan (1964)),
provides a framework for modelling a long-run equilibrium while
allowing for short-term dynamics at the same time. Where the er-
ror correction representation is appropriate for modelling the
behaviour of interest rates, the equilibrium path is represented
by their joint movements in the long run which can be explained
by economic theory. By separating this long-term component from
the actual values, it becomes possible to analyse their short-
term adjustment processes, although these may be difficult to
explain theoretically.
The interest rate linkages between the EMS countries are possibly
of multivariate nature, but a bivariate approach was chosen. This
decision can be justified as providing a means of revealing the
basic interdependences in a multi-country comparison and thus
smoothing the way for a more selective analysis, which might then
exploi t multivariate techniques. Estimation techniques such as
"Maximum Likelihood Cointegration" have been developed recently
to solve multivariate models with cointegrated variables (see
Juselius (1989) for an application of "ML Cointegration").
Engle and Granger (1987) proposed a two-step estimation procedure
for the estimation of bivariate models which requires only
least-squares regressions of single equations. Referring to equa-
tion (4), firstly, x is regressed on y:

xt = c Yt + ct (5 )

ignoring any dynamics. It has been shown by Engle and Granger

(1987) that this regression provides "super-consistent" esti-
mates. From this regression, the series z can be derived which,
in a second stage, is used in an error correction representation.
The estimated residuals i from equation (5) represent the esti-
mate ~ for z. This second-stage equation can also be estimated by
OLS provided that any further explanatory variables in addition
to the error correction term are stationary. It is in this equa-
tion that the appropriate specification of the dynamics is to be
found. The error correction specification thus enables the long-
run equilibrium constraints to be separated from the short-run
dynamics. The Simplest error correction representation is given
by:
 363

dX t a 2t _ 1 + ~t (6 )

with:

2t = x t - C Yt = 6 t
which implies that the change in the dependent variable x from
one period to the next is determined by the lagged deviation be-
tween the two variables x and y - taking a scaling factor into
account - and a random component ~. It is possible to combine the
differenced 1(1) series and the error correction term in the same
regression without creating the spurious regression problem since
all variables are stationary.

Applied to interest rates, the scaling factor measures the aver-

age distance between two series in the long run, while the coef-
ficient (a) measures the speed with which the system adjusts to
this equilibrium position.

3.2 Estimation technique

The first step in the empirical analysis is to estimate the un-

known order of integration. This is accomplished by determining
the unit roots which I(l)-variables must have. Several tests for
the order of integration have been proposed in the literature (a
survey is given in Hendry (1986)). These try to discriminate be-
tween random walk and autoregressive time series processes. This
can be demonstrated by a simple time series model:

(7 )

where F: is a normally distributed error term with a zero mean

and a cSnstant variance. A random walk requires that a=l whereas
abs (a) <1 gives a stationary first-order autoregressive process.
(An absolute value of a>l implies an explosive data-generating
process.) To reject the hypothesis that the time series is non-
stationary, the coefficient a must be significantly smaller than
I, thus, the null hypothesis to be rejected is a=l.

Usually the test is performed by subtracting the lagged term from

both sides of equation (7) and estimating the coefficient b=(a-l)
in:

(8 )

The test based on this model is known as the Dickey-Fuller test.

Here, the Dickey-Fuller (OF) and augmented Dickey-Fuller (ADF)

test statistics have been chosen with the latter providing a unit
root test for a higher-order autoregressive model. The estimated
t-statistics on (a-I) are the OF and ADF statistics respectively.
The tests are only valid if x t is 1(1), but in cases of higher
orders of integration the obvlous solution would be to compute
 364

the ~east-squares regression with all terms differenced once

more.
Once the order of the processes x and y has been determined, it
is appropriate to evaluate whether a cointegrating relationship
exists. For 1(1) variables, the same unit root tests can be ap-
plied by subjecting the variables to the error correction trans-
formation (equation 4) and showing that this transformed series
is stationary. However, the cointegrating coefficient c is usual-
ly unknown and has to be estimated from the data. Step one of the
two-step estimator described above provides an estimate ~ for c,
and the residuals ~ from this regression form the appropriate
variable for the unit root test. If these residuals are station-
ary, they can be used in step two as the error correction term.

4 Econometric specification

In an empirical analysis it is not surprising to find linkages

between interest rates in the EMS countries but the strength and
time pattern of these linkages are less certain. For the present
analysis, it has been decided to focus on the one-month Euro-mar-
ket interest rates of the EC countries participating in the EMS
system. Compared with domestic market interest rates of the same
maturity, the Euro-market rates should be influenced less by
country-specific conditions such as tax laws or capital controls
and, thus, show a stronger tendency to level out. Month-end ob-
servations of the interest rates were available for all EMS coun-
tries except Ireland from the end of 1977 to the beginning of
1989. The time series for Germany and the Netherlands start in
January 1977 while that for Ireland starts in November 1981. Us-
ing a rather simplistic model of backward-looking expectations,
percentage changes over twelve months in the consumer price indi-
ces were applied as deflators in calculating real interest rates.
The sample covers the full period of existence of the European
Monetary System which was founded in March 1979. The observations
are, somewhat arbitrarily, split into two sub-samples half-way
through the year 1983. The first period is marked by large infla-
tion differentials between the EMS countries and by strong fluc-
tuations in both nominal and real interest rates (see graph 1 in
the appendix). In the second period, the inflation rates of the
EMS countries converged and interest rate volatility decreased.
Seven of the ten realignments of the currencies in the EMS during
the observation period took place during the first sub-period.

3Monte-Carlo experiments show that the OF and ADF tests have good
power properties and their critical values are quite robust
compared with alternative unit root tests (Engle and Granger
1987); however, it has been shown recently that specific
conditions in the data-generating process (like moving-average
components) can have considerable influence on the distribution
reported by Dickey and Fuller (Schwert 1989).
 365

The concepts of integration and cointegration are applied to the

data in each sub-sample separately. Firstly, the level of inte-
gration of the nominal and real interest rates is determined by
use of the Dickey-Fuller unit root tests for non-sta tionari ty.
Secondly, the co integrating regression is computed for all pairs
of interest rate series included in both sub-samples. The Dickey-
Fuller tests are applied to the residuals from this regression.
Finally, an error correction model based on these residuals is
estimated to provide further insight into the linkages between
the interest rates of the EMS countries.

5 The order of integration

The auxiliary regressions for the Dickey-Fuller test were comput-

ed for the nominal interest rates in the periods 1977 to June
1983 and July 1983 to early 1989 (Table 1a in the appendix). If
the coefficient of the lagged exogenous variable is significantly
different from zero it is unlikely that the time series is non-
stationary. Critical values have been reported by Dickey and
Fuller (Hylleberg and Mizon (1989)):

obs. 99% 95% 90%

48 -3.34 -2.81 -2.52
100 -3.39 -2.85 -2.56

The hypothesis of non-stationarity cannot be rejected for the

nominal interest rates. All coefficients (a-I) are close to zero,
nearly all show a negative sign and their OF statistics are far
below the critical values. This implies that the interest rates
behaved in both sample periods like a random walk. The decrease
in interest rate volatility from the first to the second sample
period has no bearing on the outcome of the Dickey-Fuller tests.

In addition, the augmented Dickey-Fuller test, which allows for

more complicated dynamics at the expense of a probable over-
parametrisation, was applied to the interest rates. The regres-
sions were repeated with - arbitrarily chosen - six lags of the
endogenous variable included on the right-hand side of the equa-
tions; this produced nearly the same coefficients and OF values.
(These results are not shown in the tables.)

The Dickey-Fuller test assumes that the first-order integration

model is correct, which means that differencing once is suffi-
cient to remove the non-stationarity from the data. To verify
whether the interest rates follow an 1(1) process, the difference
between consecutive observations was computed and the unit root
tests (subsequently referred to as I (2) test) were applied to
these transformed series in the same way as described above (Ta-
ble Ib in the appendix).

The estimated OF values are actually very high and the non-
stationarity hypothesis can be rejected for all equations without
lagged endogenous variables. Including the lagged endogenous
 366

variables on the right-hand side of the equations lowers the DF

values but nearly all remain highly significant. (Since not
enough observations were available for the Irish interest rate
series in the first sample period, results involving the Irish
series are not taken into consideration.) Only the DF value for
the German series in both samples and for the Netherlands in the
second sample are below (but still close to) the critical values.
It can be concluded from these results that the nominal interest
rate series for the EMS member countries during both sample peri-
ods behaved like random walks.
The unit root testing was repeated after removing the inflation-
ary component from the data by subtracting the yearly percentage
changes in prices from the interest rates. The DF values for the
real interest rates in the first sample period are higher than
those for the nominal interest rates, but nearly all remain in-
significant (Table 1a). France satisfies the 99% requirement and
Denmark the 90% requirement. When the augmented DF test statis-
tics are computed, all DF values are insignificant. All test sta-
tistics for the second sample period are very close to their nom-
inal counterparts. The non-stationary behaviour of the real in-
terest rates seems to be less pronounced during the first obser-
vation period when compared with the behaviour of the nominal
interest rate series and with the deflated series during the sec-
ond sample period.
The I (2) tests for the real interest rates produce practically
the same results as for the nominal interest rate series. There
is strong evidence that the real interest rates also followed an
I(l) process.

6 Testing for cointegration

6.1 Requirements

The non-stationarity of time series is a necessary prerequisite

for the existence of cointegrating relations between them. The
1(1) behaviour of the individual interest rate series makes pos-
sible an I(O) connection between pairs of rates. The two-step es-
timation technique for cointegration can be applied to all pairs
of I (1) interest rates. Firstly, the cointegration equation is
estimated, which provides an estimate for the cointegrating coef-
ficient (c) if the residuals from this regression are integrated
of order zero. Secondly, these residuals are used as the determi-
nant in an error correction representation.

If two time series are cointegrated, it should not matter which

series is used on the right and which on the left-hand side of
the co integrating equation. Ideally, in this bivariate case, the
coefficient of an estimation in one direction should be identical
to the reciprocal of the coefficient of the estimation in the
other direction. This holds true for an R*2 of 1, as the product
of both coefficients measures the share of the explained vari-
ance. It implies, at the same time, that the bias of the estimat-
ed cointegrating coefficient depends on R*2. The two-step
 367

technique is only appropriate if the bias is small; therefore,

the share of the explained variance (R*2) from the cointegration
regression needs to be high. (Problems arising from modelling
with co integrated series are reviewed in Hendry (1986); he sug-
gests a critical value of R*2>.95.)

A low Durbin-Watson statistic has to be expected from this re-

gression owing to its static nature. However, the closer this
figure to zero, the more likely it is that the behaviour of the
residuals will be non-stationary, which implies that no long-term
relation exists between the time series. If the cointegrating
regression provides a high R*2, the residuals will need to be
investigated for non-stationary behaviour and this can be done
with the test techniques used above. Only if the residuals show
stationary behaviour mayan error correction model be specified.
Here, only the simplest error correction model was estimated in
the second step: the once-differenced interest rate series were
regressed on the error correction term as the only exogenous
variable.

6.2 Testing for cointegration between pairs of nominal interest

rates

The estimated cointegration equations for the nominal interest

rates are presented in Table 2a for the period 1977 to June 1983
and Table 2b for the period July 1983 to 1989. The lowest R*2 in
the first sample is 83%, and in the second not less than 94%. All
R*2s were higher in the second sub-period than in the first. The
Durbin-Watson statistics are low, ranging from .28 to 1.89 and
.22 to 1.31 in the first and second sub-period respectively.
These results already suggest that the nominal interest rates are
cointegrated in pairs. More evidence on the long-term relation-
ships between the interest rate series can be obtained by apply-
ing the unit root test to the residuals from the cointegration
equation, assuming that the R*2s are sufficiently high to prevent
large biases in the estimated cointegration coefficients.
For nearly all residual series derived from the cointegration
equations the hypothesis of non-stationarity can be rejected in
the first sample period at the 95% level. Only the equations for
the interest rates of Denmark vis-a-vis those for Germany and
Belgium produced DF statistics slightly below the critical values
(Table 2a). (Once again, no interpretation is given for the re-
sults where Ireland is involved.)
For the second sample the results are very similar (Table 2b).
This time the combinations Belgium/Germany and Belgium/the Neth-
erlands produced estimates which were insignificant even at the
90% level. Insignificant DF statistics were obtained for most of
the residuals from the equations where Ireland was involved in
this latter period. For both periods, the R*2s proved to be suf-
ficiently high, so that reversing the endogenous and exogenous
variables did not produce ambiguous DF values.
 368

6.3 Testing for cointegration between pairs of real interest

rates

The cointegration regressions were also computed for the real

interest rates (Table 3). The R*2s obtained for the first sample
period diverge markedly from their nominal counterparts and vary
considerably between the equations. Without Ireland, the lowest
R*2 is now 7% and the highest 87%. In the second sample they are
much higher and closer to those obtained for the nominal interest
rates. The lowest R*2 is 85%.
The low R*2s for the first sample period suggest that the corre-
sponding pairs of real interest rates are not cointegrated. In
applying the non-stationarity test to the residuals from these
estimates one would, therefore, expect rather low OF statistics.
This is also what may be observed for Germany, Belgium and the
Netherlands (Table 3a), whereas for Italy and France rather high
and significant statistics are found. The series for Denmark lies
somewhere between these two groups. Thus, for France, Italy and
partly for Denmark the hypothesis of stationarity cannot be re-
jected as for the first group - but given the low R*2s obtained
for the cointegration equations this does not imply that the in-
terest rate series are cointegrated, but rather that they were
already almost stationary before being linked (see Table 1a).
For the second sample period the R*2s were sufficiently high to
pas s the unit root test (Table 3b). Apart from the pairs the
Netherlands/Germany and the Netherlands/Belgium, and Ireland with
most others, the OF statistics are significant at the 95% level.
Hence, for this period, the residuals are stationary in spite of
the 1(1) behaviour of the real interest rates themselves.

7 The error correction representation

The residuals from the first-stage least-squares estimation which

did not show non-stationary behaviour can be used as an exogenous
variable in an error correction representation. The error correc-
tion model assumes that the endogenous variable reacts to devia-
tions from the equilibrium position, defined here as the
cointegrating relationship, but that this adjustment does not
occur instantaneously. It is, therefore, necessary to find an
appropriate dynamic specification to model the movements of the
endogenous variable in response to deviations from the equilibri-
um position, as represented by the residuals from the first-stage
estimation.

The simple error correction model presented above was used to

evaluate the linkages between the interest rates:
( 3' )

But before looking at the estimation results a few observations

are required with respect to the likely sign and significance of
the error correction parameter (a).
 369

As regards the sign, it may be seen from (3') that when the
endogenous interest rate x is above its long-run average position
vis-a-vis the other country's interest rate y, the error correc-
tion term is positive. A downward movement of the endogenous in-
terest rate towards the long-run equilibrium path is required to
reduce the disequilibrium, thus the coefficient (a) should be
negative. By contrast, when the endogenous interest rate (x) is
below its long-run average, the error correction term is negative
and the change (dx) should be positive, which again requires that
the coefficient be negative. A negative coefficient is therefore
to be expected, should a linkage between the interest rates ex-
ist. (These movements towards the long-run equilibrium should not
be confused with movements of the two interest rates towards each
other. Whenever the endogenous series is located between the
equilibrium path and the other series, the likely movement is
away from the latter.)

Secondly, it is important to note that the error correction equa-

tion implicitly assumes a causal relationship and not merely
collinearity as the cointegration equation. Thus, in three cases
co integration may be accepted but (a) is likely to be insignifi-
cant: (i) when the left-hand variable is a series which sets the
path for the other series in the system to follow; (ii) when the
adjustment delay is shorter than the frequency of the observa-
tions; and (iii) when the two series being linked in the error
correction equation are dominated by the same external factors,
such as a "world" interest rate or economic fundamentals in the
two economies.

Given the I(l) nature of the interest rates, the endogenous vari-
able is stationary, and, therefore, ordinary least-squares re-
gression is appropriate at this second stage to find an estimate
for the coefficient (a), which measures the speed at which the
endogenous interest rates adjust to the long-run equilibrium. The
error correction model has been estimated for both sample periods
separately. For interest rate pairs which failed to pass the unit
root tests the error correction model should not be estimated
(nevertheless such results are presented in the interest of com-
pleteness; see Table 4b).
Nearly all estimated coefficients of the error correction term
are negative and none of those with the "wrong" sign is signifi-
cant (Table 4). The interest rates of one country are markedly
different from all others: viz. those of Germany. Nearly all co-
efficients from the sub-samples - for both nominal and real in-
terest rates - where the German series entered the equation on
the left-hand side are insignificant. Conversely, the coeffi-
cients for the other interest rates vis-a-vis the German series
are practically all significant. Ignoring Ireland in the first
sub-sample, the smallest t-value was computed for the Netherlands
(-1.776; Table 4a).

A closer look at the nominal interest rates reveals the remark-

able behaviour of the smaller countries' interest rates. In the
first sample, the Netherlands' interest rates are only loosely
associated with the others, including the German series. During
the second period, they are strongly linked to the German series
and completely independent of all the others. The value of -0.235
 370

means that within one month a disequilibrium of 100 basis points

is reduced by 23.5 basis points. The Belgian series was only
linked to the series for Germany and the Netherlands in the first
sample, and to those of Germany and Italy in the second sample.
The linkage between the Danish series and the German rates
strengthened from -0.127 to -0.194, but this series was, at the
same time, closely associated with the series of the other larger
countries.
The French interest rate series is also noteworthy, as it has
maintained strong linkages with all other series, particularly
that for Italy. This coefficient rose in absolute terms from
-.567 in the first sample to -.796 in the second (Table 4b),
while the Italian series did not adjust at all to the French se-
ries. However, practically all other estimates for the Italian
series were significant. There is no apparent reason for this
very strong one-sided dependency of the French on the Italian
series. Foreign exchange controls played an important role in
both countries during most of the period and the trading volume
on the Euro-market was quite small. The French and Italian au-
thorities intervened on the money market to counteract specula-
tion. Between 1980 and 1983, the two-day money market interest
rates occasionally reached 50%, and once even 400% and 200% re-
spectively. Spill-over effects on the one-month interest rates
might explain the peaks but not the one-sided dependency, as
these interventions occurred virtually simultaneously in both
countries. As far as the extremely low estimate for the second
sample is concerned, this is obviously caused by the interest
rate peaks which occurred during the fir~t quarter of 1986 imme-
diately before the ninth EMS realignment.

4To complement the results for this particular case, the

cointegration method was also applied to the one-month domestic
interest rates (see the table below).
Domestic one-month nominal interest rates
for France and Italy
(monthly data; January 1977 - May 1989)
coeff. t-values R*2 DW obs.
Dickey-Fuller test:
IFR I ( 1 ) -.015 -.943 0.01 2.01 124
I ( 2) -1.014 -11.204 0.51 2.00 123
IIT I ( 1 ) -.000 -.109 0.00 1. 80 124
I (2) -.900 -9.994 0.45 2.01 123
Cointegration equation:
IFR<IIT .649 0.93 0.50 125
IIT<IFR 1. 423 0.93 0.47 125
Error correction equation:
IFR<IIT -.226 -4.027 0.12 1. 81 124
IIT<IFR -.027 -1.926 0.03 1.73 124

(Footnote Continued)
 371

In spite of the simple dynamic structure of the error correction

model, the Durbin-Watson statistics are - with the exception of
Ireland in the second sample - quite close to 2. However, the
R*2s are low, implying that the specification is somewhat inc om-
plete. This suggests that the error correction term should be
included in a more complete model specification.

For the real interest rates, the error correction model is also
presented for both sample periods (Table 4b). "Good" results were
obtained for the first sub-sample, but no attempt has been made
to interpret them owing to the ambiguous results of the
cointegration test. The estimates for the second sub-sample are
very similar to those found for the nominal interest rates. This
is not surprising, given the diminished inflation differentials.
The Durbin-Watson statistics for the Netherlands, Belgium and,
particularly, Ireland are low, suggesting that the dynamic speci-
fication is not appropriate.

All in all, the results clearly identify the German series as the
dominant interest rate in the EMS throughout the whole period.
Given the weight of the Deutsche Mark in the EMS currency basket
and its importance in world financial markets, some influence
would be expected. Nevertheless, the strength of this influence
could not have been predicted. In the early part of the decade
the German interest rate was closely followed by the rates in all
other EMS countries, with the sole exception of the Netherlands.
However, by the end of the observation period, the Netherlands'
series was also closely linked with the German series.

8 Conclusions

In recent years, the EMS countries' short-term Euro-market inter-

est rates have moved more symmetrically than during the period
immediately following the creation of the EMS system. This change
has coincided with a liberalisation of the financial markets and,
crucially, with the convergence of the inflation rates in the EMS
countries which has helped to avoid realignments of the curren-
cies in the EMS and has reduced risk premiums.
Our analysis has revealed the dominant role of the German inter-
est rate in determining the paths of the other EMS countries'
interest rates. No inherent predictive power can be attributed to
the German interest rate; it showed random walk behaviour inde-
pendent of the other interest rates included in the analysis. The
German series could probably be linked to a "world" interest
rate, but no tests were made for this. It was shown that parallel
movements in the EMS interest rates are predictable to a certain
degree as they adjust to each other and particularly to the Ger-
man series.

(Footnote Continued)
The domestic one-month interest rates show the same one-sided
relationship as the Euro-market rates, though clearly less
pronounced.
 372

The dependences between given pairs of interest rates have shift-

ed only slightly during the last decade. The linkage of the Neth-
erlands' interest rate to the German rate became stronger. A spe-
cific linkage between the French and Italian interest rates ex-
ists but is exaggerated by outliers in the data.
Assuming that exchange rate expectations are determined by the
development of price level differentials and that the open inter-
est parity condition holds, real interest rates should always
move together while joint movements of nominal interest rates
should be prevalent when inflation rate differentials are low and
less volatile.
However, movements in real interest rates turned out to be sur-
prisingly independent during the period of high and volatile
prices at the beginning of this decade. Assuming that partici-
pants in the one-month Euro-markets are not casual investors with
"money illusion", they have been rather unsuccessful in predict-
ing inflation differentials. Even during the more recent years
with low inflation nominal interest rates were still more closely
connected than the deflated interest rates.

If, as suggested by the purchasing power parity assumption, real

interest rates are an appropriate criterion for efficient deci-
sion-making by investors in the international financial market,
the joint movements of real interest rates should be stronger
than those of nominal interest rates. For the period of high in-
flation differentials this hypothesis can clearly be rejected.
The closer linkages between movements in real interest rates in
the second sample period probably have to be attributed to the
improved real and monetary stability.

Acknowledgement

The author would like to thank his colleagues at the BIS and es-
pecially P. Andersen for suggestions and support.
 373

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 374

A ~ ~e n d l x

Graph One-m on t h Euro - ma rk et i nterest ra t es

( month-e nd val ues)
Germany France

J
40 40 '0
I
l
n~t'''Ilnal
__ rea~

30 3C JO 30

20 t 2J 20 20

10 10 10 10

0 0 0 0

- 10 - ,0 - 10 ·10
78 BO 82 8. 86 88 78 80 82 84 86 dS

Nether l an ds Italy
40 40 .0 .0

30 30 30 30

20 20 20 20

10 10 ,0 ,0

0 0 0 0

·10 . '0 . '0 · 10

78 80 a2 a. 86 aa 78 80 82 8. 86 88

Belgium Denmark
40 .0 .0 4C

30 30 30 30

20 20 20 2C

'0 ,0 ,0 ,e

0 0 a 0

- 10 - 10 . a . Ie
73 BO 82 8. as a8 78 ao 82 8. 86 88
 375

Table 1. Dickey-Fuller test of one-month Euro-market interest rates

lao Levels: dx = (a-I) x t _ 1 - E
t t
Sub-sample 1: 1977 to June 1983
Nominal interest rates Real interest rates
Country (a-I) DF DW R*2 (a-I) DF DW R*2 obs.

Germany -0.006 -0.473 2.37 0.00 -0.042 -1. 229 2.55 0.02 77
France -0.040 -1.146 2.65 0.02 -0.291 -3.385 2.34 0.14 69
Netherlands -0.012 -0.739 2.35 0.01 -0.058 -1.477 2.25 0.03 77
Italy -0.018 -0.751 2.36 0.01 -0.338 -3.782 2.05 0.17 69
Belgiwn -0.003 -0.221 1.86 0.00 -0.018 -0.779 1.88 0.01 69
Denmark -0.021 -0.943 2.24 0.01 -0.174 -2.568 2.17 0.09 69
(Ireland -0.017 -0.888 2.36 0.04 (-0.152 -1.138 1. 70 0.07 19)

Sub-sample 2: July 1983 to 1989

Nominal interest rates Real interest rates
Country (a-I) DF DW R*2 (a-I) DF DW R*2 obs.

Germany 0.002 0.216 2.06 0.00 -0.005 -0.320 1. 94 0.00 70

France -0.016 -0.923 2.07 0.01 -0.036 -1. 061 2.05 0.02 69
Netherlands 0.003 0.363 1. 81 0.00 0.005 0.479 1.55 0.00 70
Italy -0.012 -0.947 2.27 0.01 -0.028 -0.923 2.32 0.01 70
Belgium -0.003 -0.476 1. 83 0.00 -0.001 -0.044 1.58 0.00 70
Denmark -0.004 -0.303 2.81 0.00 -0.028 -0.906 2.65 0.01 69
Ireland -0.010 -0.962 1. 36 0.01 -0.013 -0.684 1.22 0.01 69

lb. First differences: d(dx)t = (a-I) dx

t-1
- Et

Sub-sample 1 : 1977 to June 1983

Nominal interest rates Real interest rates
Country (a-I) DF DW R*2 (a-I) DF DW R*2 obs.

Germany -1.093 -10.669 2.03 0.60 -1.309 -11.890 2.13 0.65 76

France -1. 352 -11.828 2.05 0.68 -1. 355 -11.880 2.07 0.68 68
Netherlands -1.182 -10.571 1. 97 0.59 -1.166 -10.221 1. 98 0.58 76
Italy -1.194 -9.952 2.01 0.60 -1.196 -9.984 2.01 0.60 68
Belgium -0.934 -7.630 1. 99 0.67 -0.949 -7.759 2.00 0.47 68
Denmark -1.132 -9.307 1.96 0.56 -1.194 -10.036 1. 97 0.60 68
(Ireland -1.160 -4.808 1. 97 0.58 (-0.939 -3.925 1.91 0.48 18)

Sub-sample 2: July 1983 to 1989

Nominal interest rates Real interest rates
Country (a-I) DF DW R*2 (a-I) DF DW R*2 obs.

Germany -1. 028 -8.532 1. 99 0.51 -0.988 -8.335 1. 97 0.50 70

France -1. 038 -8.632 2.00 0.52 -1. 050 -8.637 1. 99 0.52 69
Netherlands -0.957 -8.148 1. 87 0.49 -0.831 -7.212 1. 85 0.43 70
Italy -1.152 -9.810 1. 91 0.58 -1.185 -10.204 1. 93 0.60 70
Belgium -0.898 -7.700 2.04 0.46 -0.781 -6.728 1. 99 0.40 70
Denmark -1.379 -12.779 2.33 0.70 -1. 344 -11. 952 2.18 0.68 69
Ireland -0.680 -5.928 1.89 0.34 -0.622 -5.538 1. 89 0.31 69
 376

Table 2. Cointegrating regression (nominal Euro-market interest rates)

2a. Sub-sample 1 : 1977 to June 1983
x t = c Yt - E
t
dE t = (a-I) E
t-1
+ J.L t
Country c R*2 DW (a-I) DF R*2 DW obs.

Germany 0.4875 * IFR 0.87 0.63 -.316 -3.563 0.16 2.32 69

0.8722 * INL 0.94 0.39 -.195 -2.886 0.10 2.23 77
0.3953 * IIT 0.91 0.59 -.299 -3.453 0.15 2.22 69
0.6329 * IBE 0.95 0.49 -.246 -3.080 0.12 2.20 69
0.4821 * IDK 0.83 0.28 -.144 -2.320 0.07 2.18 69
0.4534 * IIE 0.97 0.38 (-.235 -1.716 0.14 2.03 19)

France 1. 7769 * IDE 0.87 0.70 -.351 -3.793 0.17 2.29 69

1. 5863 * INL 0.85 0.68 -.339 -3.702 0.17 2.39 69
0.7719 * lIT 0.95 loll -.557 -5.142 0.28 2.11 69
1.1757 * IBE 0.90 0.95 -.473 -4.588 0.24 2.21 69
0.9400 * IDK 0.87 0.74 -.370 -3.904 0.18 2.44 69
1. 0332 * IIE 0.94 1.89 (-.966 -4.149 0.49 2.04 19)

Netherlands 1.0741 * IDE 0.94 0.40 -.202 -2.956 0.10 2.23 77

0.5382 * IFR 0.85 0.61 -.307 -3.498 0.15 2.43 69
0.4412 * IIT 0.91 0.67 -.338 -3.693 0.17 2.28 69
0.7066 * IBE 0.96 0.62 -.309 -3.497 0.15 2.36 69
0.5567 * IDK 0.90 0.47 -.243 -3.121 0.13 2.26 69
0.4391 * lIE 0.95 0.56 (-.362 -2.303 0.23 2.21 19)

Italy 2.2965 * IDE 0.91 0.62 -.313 -3.545 0.16 2.20 69

1. 2301 * IFR 0.95 1. 06 -.536 -5.012 0.27 2.12 69
2.0726 * INL 0.91 0.69 -.349 -3.757 0.17 2.26 69
1. 5188 * IBE 0.94 0.82 -.418 -4.265 0.21 1.93 69
1.2191 * IDK 0.91 0.79 -.395 -3.999 0.19 2.15 69
1. 2179 * IIE 0.96 1. 29 (-.657 -2.999 0.33 2.05 19)

Belgium 1.5015 * IDE 0.95 0.49 -.244 -3.056 0.12 2.19 69

0.7653 * IFR 0.90 0.87 -.435 -4.348 0.22 2.24 69
1. 3556 * INL 0.96 0.61 -.303 -3.446 0.15 2.36 69
0.6203 * lIT 0.94 0.79 -.401 -4.155 0.20 1. 94 69
0.7821 * IDK 0.92 0.33 -.170 -2.548 0.09 2.02 69
0.7676 * lIE 0.99 0.92 (-.457 -2.191 0.21 1. 70 19)

Denmark 1.7238 * IDE 0.83 0.30 -.159 -2.490 0.08 2.16 69

0.9221 * IFR 0.87 0.68 -.348 -3.805 0.18 2.47 69
1. 6097 * INL 0.90 0.48 -.254 -3.233 0.13 2.24 69
0.7504 * lIT 0.91 0.79 -.395 -4.034 0.19 2.15 69
1.1787 * IBE 0.92 0.35 -.188 -2.737 0.10 2.03 69
0.8230 * IIE 0.95 0.57 (-.276 -1.576 0.12 1. 30 19)

Ireland 2.1325 * IDE 0.97 0.38 (-.216 -1. 542 0.12 2.02 19)
0.9056 * IFR 0.94 1. 79 (-.931 -4.035 0.47 2.08 19)
2.1729 * INL 0.95 0.56 (-.333 -2.071 0.19 2.18 19)
0.7904 * lIT 0.96 1.26 (-.645 -2.983 0.33 2.07 19)
1. 2902 * IBE 0.99 0.92 (-.459 -2.183 0.21 1. 70 19)
1.1553 * IDK 0.95 0.55 (-.270 -1. 548 0.12 1. 30 19)

IDE. IFR. INL. lIT, IBE. IDK and lIE denote the nominal interest rates
for Germany, France, the Netherlands. Italy, Belgium. Denmark and Ireland
respectively.
 377

Table 2. Cointegrating regression (nominal Euro-market interest rates)

2b. Sub-sample 2: July 1983 to 1989
xt c Yt - E
~

t
de
t
(a-I) e ~

t-1
+ fL t

Country c R*2 DW (a-I) DF R*2 DW obs.

Germany 0.4713 * IFR 0.95 0.48 -.230 -2.824 0.10 1.77 70

0.8602 * INL 0.99 0.32 - .170 -2.620 0.09 1. 95 70
0.3640 * lIT 0.96 0.40 -.193 -2.548 0.09 2.18 70
0.5579 * IBE 0.98 0.27 -.107 -1.669 0.04 1.87 70
0.5018 * IDK 0.96 0.39 -.193 -2.641 0.09 2.41 70
0.4176 * lIE 0.95 0.22 -.086 -1. 485 0.03 1. 61 70

France 2.0195 * IDE 0.95 0.50 -.245 -3.003 0.12 1.77 70

1. 7465 * INL 0.95 0.47 -.246 -3.139 0.12 1. 76 70
0.7634 * lIT 0.99 1. 31 -.656 -5.816 0.33 1.97 70
1.1543 * IBE 0.98 0.67 -.343 -3.837 0.18 1.93 70
1. 0295 * IDK 0.94 0.49 -.279 -3.590 0.16 1. 94 70
0.8713 * lIE 0.96 0.44 -.222 -2.924 o .ll 2.12 70

Netherlands 1.1496 * IDE 0.99 0.32 -.169 -2.602 0.09 1. 95 70

0.5448 * IFR 0.95 0.45 -.230 -2.940 O.ll 1. 75 70
0.4203 * lIT 0.96 0.36 -.192 -2.721 0.10 2.01 70
0.6432 * IBE 0.97 0.23 -.102 -1. 790 0.04 1. 57 70
0.5830 * IDK 0.97 0.52 -.256 -3.061 0.12 2.29 70
0.4858 * lIE 0.96 0.28 -.129 -2.035 0.06 1.43 70

Italy 2.6428 * IDE 0.96 0.41 -.205 -2.716 0.10 2.18 70

1. 2937 * IFR 0.99 1. 30 -.653 -5.797 0.33 1. 98 70
2.2837 * INL 0.96 0.37 -.205 -2.916 o.ll 2.02 70
1.5037 * IBE 0.98 0.49 -.263 -3.374 0.14 2.20 70
1.3466 * IDK 0.95 0.36 -.229 -3.415 0.14 2.12 70
1.1323 * lIE 0.96 0.33 -.166 -2.494 0.08 1. 91 70

Belgium 1.7529 * IDE 0.98 0.27 - .111 -1. 749 0.04 1. 86 70

0.8464 * IFR 0.98 0.65 -.330 -3.730 0.17 1.94 70
1. 5121 * INL 0.97 0.23 -.108 -1.898 0.05 1.57 70
0.6507 * lIT 0.98 0.48 -.255 -3.279 0.13 2.20 70
0.8923 * IDK 0.97 0.39 -.215 -3.066 0.12 2.44 70
0.7489 * lIE 0.97 0.26 -.129 -2.168 0.06 1. 86 70

Denmark 1. 9165 * IDE 0.96 0.39 -.197 -2.685 0.09 2.42 70

0.9176 * IFR 0.94 0.48 -.267 -3.450 0.15 1.96 70
1.6658 * INL 0.97 0.53 -.261 -3.114 0.12 2.30 70
0.7082 * lIT 0.95 0.36 -.222 -3.276 0.13 2.13 70
1. 0845 * IBE 0.97 0.40 -.216 -3.039 0.12 2.44 70
0.8238 * IIE 0.96 0.47 -.273 -3.592 0.16 1. 99 70

Ireland 2.2658 * IDE 0.95 0.22 -.097 -1. 686 0.04 1. 59 70

1.1033 * IFR 0.96 0.43 -.215 -2.882 o .ll2.12 70
1. 9720 * INL 0.96 0.28 -.141 -2.233 0.07 1.42 70
0.8461 * IIT 0.96 0.33 -.164 -2.474 0.08 1.89 70
1.2932 * IBE 0.97 0.26 - .135 -2.267 0.07 1.85 70
1.1704 * IDK 0.96 0.46 -.278 -3.701 0.17 1. 98 70

IDE, IFR, INL, lIT, IBE, IDK and lIE denote the nominal interest rates
for Germany, France, the Netherlands, Italy, Belgium, Denmark and Ireland
respectively.
 378

Table 3. Cointegrating regression (real Euro-market interest rates)

3a. Sub-sample 1 : 1977 to June 1983
x
t
= c
Yt - E t de = (a-I) e
t t-1
+ f.L t
Country c R*2 DW (a-I) DF R*2 DW obs.

Germany 0.2673 * RFR 0.22 0.26 -.128 -2.147 0.06 2.63 69

0.6573 * RNL 0.62 0.33 -.167 -2.642 0.08 2.28 77
0.2248 * RIT 0.11 0.20 -.100 -1.870 0.05 2.64 69
0.4975 * RBE 0.78 0.62 -.308 -3.481 0.15 2.23 69
0.4276 * RDK 0.38 0.41 -.204 -2.751 0.10 2.25 69
-0.1750 * RIE 0.03 0.03 (-.012 -0.276 0.00 1.87 19)

France 0.8219 * RDE 0.22 0.75 -.376 -3.969 0.19 2.29 69

0.6350 * RNL 0.17 0.72 -.359 -3.850 0.18 2.34 69
0.8892 * RIT 0.56 0.97 -.493 -4.737 0.25 2.16 69
0.4051 * RBE 0.17 0.71 -.355 -3.818 0.18 2.30 69
0.6378 * RDK 0.27 0.84 -.423 -4.272 0.21 2.36 69
0.4917 * RIE 0.04 0.62 (-.316 -1.848 0.16 2.77 19)

Netherlands 0.9358 * RDE 0.62 0.36 -.183 -2.783 0.09 2.19 77

0.2667 * RFR 0.17 0.25 -.125 -2.124 0.06 2.67 69
0.2011 * RIT 0.07 0.18 -.088 -1.741 0.04 2.54 69
0.5979 * RBE 0.87 1. 01 -.516 -4.866 0.26 2.11 69
0.5639 * RDK 0.51 0.59 -.307 -3.552 0.16 2.22 69
-0.0679 * RIE 0.01 0.11 (-.085 -1.070 0.06 2.50 19)

Italy 0.4890 * RDE 0.11 0.77 -.396 -4.167 0.20 2.06 69

0.6292 * RFR 0.56 1. 05 -.540 -5.108 0.28 2.01 69
0.3389 * RNL 0.07 0.72 -.370 -3.983 0.19 2.07 69
0.2308 * RBE 0.08 0.71 -.363 -3.949 0.19 2.02 69
0.3703 * RDK 0.13 0.78 -.405 -4.262 0.21 2.08 69
0.0191 * RIE 0.00 0.55 (-.280 -1.721 0.14 2.20 19)

Belgium 1.5687 * RDE 0.78 0.57 -.283 -3.330 0.14 2.22 69

0.4154 * RFR 0.17 0.16 -.082 -1. 710 0.04 2.54 69
1.4603 * RNL 0.87 0.94 -.476 -4.617 0.24 2.14 69
0.3345 * RIT 0.08 0.09 - .043 -1.228 0.02 2.10 69
0.9598 * RDK 0.60 0.46 -.233 -3.031 0.12 2.01 69
-0.2734 * RIE 0.03 0.03 (-.037 -0.929 0.05 1. 76 19)

Denmark 0.8826 * RDE 0.38 0.66 -.336 -3.722 0.17 2.06 69

0.4281 * RFR 0.27 0.60 -.306 -3.537 0.16 2.42 69
0.9015 * RNL 0.51 0.82 -.424 -4.348 0.22 2.06 69
0.3513 * RIT 0.13 0.46 -.241 -3.123 0.13 2.28 69
0.6282 * RBE 0.60 0.76 -.389 -4.105 0.20 1. 94 69
0.2780 * RIE 0.03 0.18 (-.091 -0.939 0.05 1. 46 19)

Ireland -0.1990 * RDE 0.03 0.31 (-.128 -0.932 0.05 1. 69 19)

0.0759 * RFR 0.04 0.33 (-.174 -1. 265 0.08 1. 91 19)
-0.1105 * RNL 0.01 0.29 (-.129 -0.972 0.05 1. 70 19)
0.0047 * RIT 0.00 0.30 (-.150 -1.133 0.07 1.71 19)
-0.1063 * RBE 0.03 0.31 (-.138 -1.005 0.05 1.71 19)
0.0950 * RDK 0.03 0.29 (-.147 -1.123 0.07 1. 69 19)

RDE, RFR, RNL, RIT, RBE, RDK and RIE denote the real interest rates for
Germany, France, the Netherlands, Italy, Belgium, Denmark and Ireland
respectively.
 379

Table 3. Cointegrating regression (real Euro-market interest rates)

3b. Sub-sample 2: July 1983 to 1989
x t = c Yt - E t dE t = (a-l) E t _ l + ~t

country c R*2 DW (a-l) DF R*2 DW obs.

Germany 0.6109 * RFR 0.85 0.52 -.262 -3.222 0.13 1.76 70

0.7547 * RNL 0.95 0.28 -.128 -2.040 0.06 1.67 70
0.5876 * RIT 0.86 0.58 -.306 -3.622 0.16 2.12 70
0.6588 * RBE 0.96 0.37 -.201 -2.919 0.11 1.76 70
0.6870 * RDK 0.90 0.69 -.377 -4.186 0.20 2.18 69
0.5213 * RIE 0.90 0.33 -.161 -2.389 0.08 1.53 69

France 1.3960 * RDE 0.85 0.59 -.292 -3.434 0.15 1.75 70

1.0812 * RNL 0.85 0.54 -.271 -3.276 0.13 1.70 70
0.9243 * RIT 0.93 1.11 -.585 -5.524 0.31 2.06 70
0.9748 * RBE 0.92 0.71 -.366 -3.999 0.19 1.89 70
1.0107 * RDK 0.85 0.66 -.351 -3.937 0.19 1.91 69
0.7722 * RIE 0.87 0.46 -.229 -2.927 0.11 2.11 69

Netherlands 1.2561 * RDE 0.95 0.27 -.119 -1.903 0.05 1.65 70

0.7876 * RFR 0.85 0.47 -.233 -2.958 0.11 1. 68 70
0.7600 * RIT 0.87 0.50 -.253 -3.130 0.12 1. 98 70
0.8370 * RBE 0.93 0.21 -.101 -1. 852 0.05 1.21 70
0.8798 * RDK 0.90 0.59 -.311 -3.563 0.16 2.31 69
0.6719 * RIE 0.91 0.36 -.160 -2.218 0.07 1.19 69

Italy 1.4680 * RDE 0.86 0.64 -.329 -3.761 0.17 2.10 70

1.0106 * RFR 0.93 1.10 -.577 -5.458 0.30 2.08 70
1.1407 * RNL 0.87 0.56 -.284 -3.379 0.14 1.98 70
1.0207 * RBE 0.92 0.83 -.420 -4.292 0.21 2.03 70
1.0890 * RDK 0.91 0.83 -.415 -4.222 0.21 2.00 69
0.8079 * RIE 0.87 0.50 -.265 -3.307 0.14 2.03 69

Belgium 1.4536 * RDE 0.96 0.36 -.196 -2.855 0.11 1.75 70

0.9412 * RFR 0.92 0.65 -.331 -3.747 0.17 1.91 70
1.1095 * RNL 0.93 0.21 -.105 -1.924 0.05 1.21 70
0.9014 * RIT 0.92 0.78 -.392 -4.107 0.20 2.05 70
1.0244 * RDK 0.91 0.68 -.350 -3.831 0.18 2.17 69
0.7764 * RIE 0.91 0.26 - .134 -2.208 0.07 1.63 69

Denmark 1.3121 * RDE 0.90 0.74 -.399 -4.315 0.21 2.17 69

0.8457 * RFR 0.85 0.64 -.341 -3.868 0.18 1.96 69
1.0217 * RNL 0.90 0.65 -.339 -3.785 0.17 2.30 69
0.8312 * RIT 0.91 0.82 -.413 -4.218 0.21 2.02 69
0.8885 * RBE 0.91 0.74 -.377 -4.016 0.19 2.17 69
0.7061 * RIE 0.87 0.54 -.296 -3.615 0.16 2.04 69

Ireland 1.7318 * RDE 0.90 0.34 -.169 -2.484 0.08 1.49 69

1.1241 * RFR 0.87 0.41 -.206 -2.778 0.10 2.12 69
1.3574 * RNL 0.91 0.37 -.176 -2.420 0.08 1.18 69
1.0727 * RIT 0.87 0.46 -.249 -3.240 0.13 1.99 69
1.1715 * RBE 0.91 0.28 -.147 -2.382 0.08 1.59 69
1.2283 * RDK 0.87 0.51 -.282 -3.555 0.16 1.97 69

RDE, RFR, RNL, RIT, RBE, RDK and RIE denote the real interest rates for
Germany, France, the Netherlands, Italy, Belgium, Denmark and Ireland
respectively.
 380

Table 4. Error Correction Model (nominal Euro-market interest rates)

4a. Sub-sample 1: 1977 to June 1983 and 2: July 1983 to 1989

Sub-sample 1 Sub-sample 2
Country vs. a t-value R*2 DW obs. a t-value R*2 DW obs.

Germany IFR .013 .351 0.00 2.42 69 .007 .178 0.00 2.04 69
INL -.090 -1. 775 0.04 2.35 77 .079 1. 029 0.02 2.13 69
lIT -.031 -.682 0.01 2.31 69 -.040 -.922 0.01 1. 96 69
IBE -.107 -1. 745 0.04 2.21 69 .013 .226 0.00 2.05 69
IDK -.038 -1.120 0.02 2.33 69 -.009 -.215 0.00 2.01 69
(lIE -.106 -1. 422 0.10 1. 37 19) .012 .334 0.00 2.06 69

France IDE -.370 -4.315 0.21 2.34 69 -.254 -3.318 0.14 1.89 69
INL -.313 -3.697 0.17 2.31 69 -.239 -3.086 0.12 1.88 69
lIT -.567 -4.007 0.19 2.36 69 -.796 -6.323 0.37 2.04 69
IBE -.430 -4.359 0.22 2.22 69 -.324 -2.925 0.11 1.83 69
IDK -.284 -3.110 0.12 2.38 69 -.199 -2.711 0.10 1. 97 69
(lIE -.849 -3.653 0.43 2.09 19) -.131 -1.480 0.03 1. 94 69

Netherlands IDE - .118 -1.776 0.04 2.23 77 -.235 -3.510 0.15 1. 94 69

IFR -.035 -.800 0.01 2.40 69 -.006 -.173 0.00 1. 83 69
lIT -.071 -1. 226 0.02 2.31 69 -.036 -.915 0.01 1.80 69
IBE -.142 -1. 748 0.04 2.22 69 -.059 -1. 261 0.02 1. 79 69
IDK -.090 -1. 742 0.04 2.33 69 -.024 -.529 0.00 1.80 69
(lIE -.297 -2.827 0.31 1. 91 19) -.035 -.916 0.01 1. 79 69

Italy IDE -.287 -3.995 0.19 2.13 69 -.161 -2.462 0.08 2.06 69
IFR -.008 -.076 0.00 2.38 69 .132 1.153 0.02 2.42 69
INL -.287 -3.797 0.17 2.09 69 -.154 -2.386 0.08 2.08 69
IBE -.354 -3.904 0.18 2.10 69 -.156 -1.797 0.05 2.05 69
IDK -.245 -3.130 0.13 2.13 69 -.101 -1.642 0.04 2.19 69
(lIE -.473 -2.039 0.19 2.12 19) -.004 -.064 0.00 2.24 69

Belgium IDE -.142 -2.836 0.11 1. 70 69 -.120 -2.746 0.10 1.82 69

IFR -.045 -1. 224 0.02 1. 76 69 -.034 -.779 0.01 1.84 69
INL -.170 -3.146 0.13 1.72. 69 -.037 -.893 0.01 1. 79 69
lIT -.067 -1. 372 0.03 1. 79 69 - .115 -2.615 0.09 1.89 69
IDK -.041 -.975 0.01 1. 85 69 -.042 -1.127 0.02 1.80 69
(lIE -.203 -1.308 0.09 1. 57 19) .025 .653 0.01 1.87 69

Denmark IDE -.127 -2.456 0.08 2.12 69 -.194 -2.950 0.11 2.12 69
IFR -.106 -1. 787 0.04 2.10 69 -.106 -1.880 0.05 2.27 69
INL -.174 -2.662 0.09 2.08 69 -.245 -3.319 0.14 2.04 69
lIT -.170 -2.302 0.07 2.04 69 -.145 -2.361 0.08 2.25 69
IBE -.149 -1.930 0.05 2.14 69 -.183 -2.560 0.09 2.09 69
(lIE -.186 -1.076 0.06 1. 37 19) -.199 -2.889 0.11 2.11 69

Ireland (IDE -.148 -1.416 0.10 2.16 19) -.108 -2.392 0.08 1. 33 69
(IFR - .135 -1.910 0.17 2.05 19) -.101 -1. 927 0.05 1. 34 69
(INL -.083 -.917 0.04 2.17 19) -.100 -1.890 0.05 1. 30 69
(lIT -.200 -2.243 0.22 2.39 19) -.169 -3.569 0.16 1. 37 69
(IBE -.275 -1.402 0.10 2.04 19) -.168 -2.969 0.11 1. 28 69
(IDK - .111 -1.239 0.08 2.34 19) - .117 -2.056 0.06 1. 36 69

IDE, IFR, INL, lIT, IBE, IDK and lIE denote the nominal interest rates for
Germany, France, the Netherlands, Italy, Belgium, Denmark and Ireland
respectively.
 381

Table 4. Error Correction Model (real Euro-market interest rates)

4b. Sub-sample 1: 1977 to June 1983 and 2: July 1983 to 1989

Sub-sample 1 Sub-sample 2
Country vs. a t-value R*2 DW obs. a t-value R*2 DW obs.

Germany RFR -.015 -.366 0.00 2.59 69 -.074 -2.015 0.06 1. 99 69

RNL -.083 -1.525 0.03 2.53 77 .012 .182 0.00 1. 97 69
RIT -.035 -.910 0.01 2.54 69 -.100 -2.641 0.09 1.84 69
RBE -.218 -2.978 0.12 2.31 69 -.122 -1. 740 0.04 1.89 69
RDK -.068 -1. 505 0.03 2.51 69 - .071 -1.503 0.03 1.89 69
(RIE -.033 -.800 0.03 2.14 19) -.036 -.775 0.01 1.89 69

France RDE -.403 -4.340 0.22 2.26 69 -.222 -2.670 0.09 1.87 69
RNL -.349 -3.778 0.17 2.25 69 -.221 -2.664 0.09 1.88 69
RIT -.366 -2.755 0.10 2.45 69 -.599 -5.282 0.29 2.15 69
RBE -.356 -3.873 0.18 2.28 69 -.291 -2.590 0.09 1.83 69
RDK -.358 -3.584 0.16 2.28 69 -.248 -2.906 0.11 2.00 69
(RIE -.291 -1.683 0.14 2.70 19) -.148 -1. 621 0.04 1. 93 69

Netherlands RDE -.141 -2.279 0.06 2.20 77 - .133 -2.845 0.11 1.65 69
RFR -.065 -1.474 0.03 2.35 69 -.043 -1. 542 0.03 1. 62 69
RIT -.058 -1.396 0.03 2.34 69 -.048 -1.572 0.04 1. 57 69
RBE -.369 -3.453 0.15 2.02 69 -.097 -2.421 0.08 1. 61 69
RDK -.136 -2.420 0.08 2.28 69 -.006 -.180 0.00 1.56 69
(RIE -.097 -1.149 0.07 2.47 19) -.086 -2.381 0.08 1. 58 69

Italy RDE -.402 -4.370 0.22 2.00 69 -.244 -3.065 0.12 1. 98 69

RFR -.466 -3.397 0.15 2.22 69 -.046 -.368 0.00 2.23 69
RNL -.367 -4.009 0.19 2.01 69 -.247 -3.046 0.12 2.01 69
RBE -.368 -3.998 0.19 2.03 69 -.284 -2.712 0.10 1. 91 69
RDK -.377 -3.975 0.19 2.00 69 -.260 -2.690 0.10 2.21 69
(RIE -.279 -1.711 0.14 2.19 19) - .114 -1.333 0.03 2.14 69

Belgium RDE -.108 -2.226 0.07 1. 74 69 -.093 -1.562 0.03 1. 56 69

RFR -.016 -.642 0.01 1. 87 69 -.082 -1. 949 0.05 1. 69 69
RNL -.165 -2.607 0.09 1. 73 69 -.017 -.369 0.00 1. 58 69
RIT -.013 -.536 0.00 1.88 69 - .136 -3.355 0.14 1.71 69
RDK -.021 -.560 0.00 1. 89 69 - .114 -2.903 0.11 1. 65 69
(RIE -.055 -1.674 0.13 1.81 19) .024 .571 0.00 1. 64 69

Denmark RDE -.309 -3.785 0.17 2.03 69 -.343 -3.774 0.17 1. 98 69

RFR -.239 -3.069 0.12 2.07 69 -.130 -1.624 0.04 2.26 69
RNL -.344 -3.726 0.17 1. 99 69 -.336 -3.779 0.17 1. 97 69
RIT -.201 -2.802 0.10 2.15 69 -.179 -1. 852 0.05 2.22 69
RBE -.386 -3.774 0.17 2.06 69 -.255 -2.610 0.09 2.00 69
(RIE -.075 -.735 0.03 1. 50 19) -.218 -2.675 0.10 2.09 69

Ireland (RDE - .134 -.962 0.05 1. 70 19) -.138 -2.262 0.07 1. 22 69

(RFR -.178 -1. 335 0.09 1. 69 19) -.093 -1. 755 0.04 1. 24 69
(RNL -.142 -1. 046 0.06 1. 71 19) -.076 -1.135 0.02 1.18 69
(RIT -.152 -1.143 0.07 1. 70 19) -.175 -3.463 0.15 1. 28 69
CRBE - .134 -.975 0.05 1. 70 19) -.179 -2.857 0.11 1. 20 69
CRDK -.170 -1.268 0.08 1. 72 19) -.097 -1.779 0.05 1. 27 69

RDE, RFR, RNL, RIT, RBE, RDK and RIE denote the real interest rates for Germany,
France, the Netherlands, Italy, Belgium, Denmark and Ireland respectively.
 PART 7:

ECONOMETRIC ESTIMATORS AND TESTS FOR VARIOUS MODELS AND THEIR

PROPERTIES
Estimating the Second Moments of Random Coefficients

Karsten-Dietmar Freimann
Institut fUr Angewandte Wirtschaftsforschung
Ob dem Himmelreich 1
D-7 400 Tiibingen, Germany

Abstract

In this paper the small and large-sample properties of six estimators of the variances
and covariances of random coefficients are compared. The criteria chosen for the
evaluation in small samples were bias, mean-squared error, the fraction of negative
variance estimates, and consistency for large samples. It turns out that five of these
estimators are consistent, but that only two of them always show moderate or small
mean-squared error values, even in the presence of data generated by a linear trend
and a random walk process.

Keywords: Random coefficient models; Hildreth/Houck estimators; covariances of ran-

dom coefficients; maximum likelihood estimation

Contents

Introduction

2 The Model

3 Hildreth/Houck and Related Estimators

3.1 The Original Hildreth/Houck Estimator (HH)
3.2 Generalization of the HH Estimator
3.3 Modification of the Generalized HH Estimator (MGHH)
3.4 The Corrected MGHH Estimator

4 Unrestricted Estimation of the Positive Definite Covariance Matrix

4.1 The PDM Estimator
4.2 A Mixed Estimator (ME)
4.3 The Maximum Likelihood Estimator

5 Monte Carlo Study

5.1 Data Generation
5.2 Results of the Monte Carlo Study

6 Summary

References
 386

1 Introduction

A large number of authors have discussed the problem of estimating the expected
values and the variances of random coefficients since the well-known article by
Hildreth and Houck appeared in 1968. This paper is a further contribution to this
topic; it also generalizes the problem to the estimation of covariances.

If the researcher believes that a random coefficient model is suitable for his empirical
problem he must interpret the regression coefficients very carefully: The values of the
variances and covariances of the random coefficients have also to be taken into
account. The elements of the covariance matrix are important because
their size indicates changes in the behaviour of the people or the severity of the
specification error the researcher may have committed,
they can be used for a GLS estimation of the parameter vector, i. e. for im-
proved least squares estimation. (In a maximum likelihood procedure estimates of
the variances and covariances are always computed.)

In this paper the small and large-sample properties of various estimators of the
covariance matrix of random coefficients are compared with the corresponding
maximum likelihood estimator, namely some variants of a generalization of the
Hildreth/Houck procedure and two estimators which are based on a decomposition of
the covariance matrix, an idea by Schwallie (1981).

In section 2 of this paper the random coefficient model and its transformation into a
fixed coefficient model is described. Section 3 deals with some variants of a
generalization of the Hildreth/Houck procedure, and in section 4 the maximum
likelihood estimator as well al) two other estimators are introduced which make use of
the positive definiteness of the true covariance matrix. In order to investigate the
small-sample properties of these estimators the results of a Monte Carlo study are
presented in section 5. Section 6 contains a summary of the results.

2 The Model

The estimation problems discussed in this paper are connected with the following
random coefficient model:

Yt = Xt'b t, t = 1, 2, ... , T. (2/1 )

The symbols used in this equation mean:

Yt: dependent variable of the regression equation,

Xt: a column vector of nonstochastic, exogenous variables with K components,
bt : a random column vector with K elements, interpreted as coefficients,
t: an integer variable, interpreted as an index referring to time periods or to cross-
sectional units.

The following assumptions are important:

 387

(AI) - b t is distributed as N(/3, 1:),

- 1: is a positive definite KxK matrix independent of t,

- E«b s - /3)(b t - /3)') = 0, s '* t, s, t = 1, 2, ... , T.

°
(A2) - The elements Xtk of the vector Xt are nonstochastic and satisfy
< IXtkl < 00 for k = 1, 2, ... , K and t = 1, 2, ... , T.

- The TxK matrix X defined by X': = (Xl, Xz, ... , xT) has full column rank K
for T ~ K.

- The matrix

T
Mx:= lim 1 L XtXt'
T~oo T t=1

exists and is positive definite.

- The T x K(K + 1)/2 matrix X" defined by

[ x: ,2 2x, ~ x12 2x'.' x13 ... 2xllxI K X12 2 2X12X13 ... XIK 2
X** -
XTl 2 2XT1 xT2 2XTlxT3 ... 2xTl xTK XT2 2 2xT2 xT3 ... XTK 2
I,
has full column rank for T ~ K(K + 1)/2, where Xtk 2 := (Xtk)2,
t = 1, 2, ... , T and k = 1, 2, ... , K.

- The matrix

Mx**:= lim 1 X**'X**

T~oo T

exists and is positive definite.

If 1: is diagonal we have the Hildreth/Houck (1968) model. (2/1) can be easily

reformulated in terms of fixed coefficients:

Yt = Xt'/3 + Ut, t = 1, 2, ... , T, with (2/2)

(2/3)

By (AI) the vector Vt is distributed as N(O, 1:) and serially independent. The random
variable Ut is distributed as N(O, 0/) where O"t 2 XtTxt. Hence Ut is also serially
independent but heteroscedastic.

The problem we are interested in is to estimate the elements of the covariance matrix
1: = E(vtv t'), i. e. the variances and covariances of the random coefficients.
 388

3 Hildreth/Houck and Related Estimators

3.1 The Origi nal Hildreth/Houck Estimator (HH)

The most familiar approach to the problem of estimating L can be found in

Hildreth/Houck (1968) which inspired several contributions in the literature. Hildreth
and Houck assume that L is diagonal and obtain from (2/3):

(3.1/1)

where crkk is the kth diagonal element of L The vector u·'

of OLS residuals satisfies the well-known relationship
( UI ..
, U2 , ... , UT .)

u· = (I - X(X'X)-l X')u =: Mu, (3.1/2)

with u' := (UI, ... , uT)' X' := (Xl, ... , XT) and with I being the identity matrix. Hence
the relation E(u·u·') = M4»M' holds with E(uu') =: 4», and we find that

E(u· *) = M*X*cr. (3.1/3)

In this equation we defined u·" = (UI· 2, U2· 2, ... , UT· 2), M* M*M, where "."
denotes the Hadamard product of two matrices, X· is given by

X* [ X~12 Xl.22 ::: Xl~21

XT1 2 XT2 2 ... XTK 2

and cr' : = (crll, cr2Z, ••. , crKK)' Now, adding u·· and subtracting E(u h) on both
sides of (3.1/3) yields

u·· = M*X*cr + e, (3.1/4)

e '. = u·' - E(u· *), e' .. -- (e 1, e 2, ... , eT·

)

The parameter vector cr in (3.1/4) can now be estimated by means of OLS yielding
an estimator cr· (also denoted by HH for Hildreth/Houck in the sequel) which is un-
biased and consistent under (A 1) and (A2), but not (asymptotically) efficient.

The main problem connected with this estimator is, however, that it very often
produces negative estimates for the variances crkk, k = 1, 2, ... , K In order to
overcome this problem some authors suggest a GLS-like estimation of the parameter
vector cr (see e.g. Hildreth/Houck (1968) or Raj/Ullah (1981»; others propose in-
strumental variable techniques (see Raj/SrivastavajUpadhyaya (1976», but none of
these estimators provides an entirely satisfying solution. Another way to overcome the
problem would be inequality restricted estimation, e.g. by means of maximum
likelihood methods. Such estimators are not considered in this paper. The most
convincing solution to the problem of negative variance estimates was provided by
 389

Schwallie (1982) who proposed the decomposition of L into the product of two
nonsingular triangular matrices tJ.:

L = tJ.'tJ. (3.1/5)

and to estimate the elements of tJ. by means of maximum likelihood procedures.

3.2 Generalization of the HH Estimator

The Hildreth/Houck procedure outlined so far only estimates variances. The off-
diagonal elements of L, however, the covariances of the random coefficients, will in
practice not be restricted to zero and may give valuable information about the model
to be specified. Therefore, the HH method was generalized (see for instance
Raj/Ullah (1981» to the estimation of covariances, based on a regression equation
which is very similar to (3.1/4):

u· * = M*X**cr* + e*, (3.2/1)

where u· *, M* and e* have the same meaning as in (3.1/4), but now

X** : = [ X~ 12 2Xll.X12 2Xll~13 ::: 2Xll~lK X1.22 2Xl.2X13 ... XIK2j

XTl 2 2xTlXT2 2XTlXT3 ... 2XnXTK XT2 2 2XT2XT3 ... XTK 2

That is, X** contains products of the exogenous variables, and the vector cr* consists
of the elements of the upper triangle and the main diagonal of the matrix L Again,
we consider the OLS estimation of the vector cr* proposed in Raj/Ullah (1981):
The OLS estimator cr*· of <r* is unbiased and consistent, but
not (asymptotically) efficient, and
it can produce negative estimates of variances (and very often does).

This estimator will be denoted by GHH in the sequel.

3.3 Modification of the Generalized HH Estimator (MGHH)

Since the GHH estimator often shows large mean-squared error values, usually caused
by large variances of the elements of cr*·, it was tried to improve its small-sample
performance by dropping the matrix M* in (3.2/1). This modified estimator (denoted
by MGHH) has the following properties:
MGHH is consistent if (A 1) and (A2) hold (see Freimann (1988) for a more
general case), but
not unbiased and
not (asymptotically) efficient.
MGHH can also yield negative variance estimates.
 390

3.4 The Corrected MGHH Estimator

As MGHH can still produce negative variance estimates or at least an estimated

covariance matrix which is not positive definite, the following corrections are made:
negative estimates of the variances O"kk, k = 1, 2, ... , K, are set to the value of
10- 5 ,
covariance estimates which correspond to a negative variance estimate are set to
the value of 10- 1 °,
if the resulting estimated covariance matrix is not positive definite it is corrected
to a diagonal matrix.

The corrected estimator (denoted by CMGHH) has the following properties under
(A 1) and (A2):
The estimator is consistent (see Freimann (1988) for a more general model), but
not unbiased and
not (asymptotically) efficient.
It always yields a positive definite estimate of L

4 Unrestricted Estimation of the Positive Definite Covariance Matrix

4.1 The PDM Estimator

As an alternative to the variants of the Hildreth/Houck estimator considered so far a

procedure is now presented (see Freimann (1988» which is based on an idea by
Schwallie (1982) who decomposes the covariance matrix L of the random coefficients
into the product L = fl' fl, where fl is, for instance, a nonsingular, upper triangular
KxK matrix. This estimator (denoted by PDM (for Positive Definite Matrix) in the
sequel) is derived from the equations (2/2), (2/3) and from the identity

(4.1/1)

The first step in the derivation of the PDM estimator is to define the Kx1 vector

(4.1/2)

where fl is a nonsingular, upper triangular matrix, and to set

O"t/t!R k = 1, 2, ... , K, (4.1/3)

such that

(4.1/4)

holds with rt·' = (rn·, rt2·, ... , rtK·)' Since the vector rt • is not known, its ele-
ments are estimated by

r tk •• 1, 2 .... , K, (4.1/5)
 391

where the symbol "I . I" denotes the absolute value and where Ut - is the OLS resi-
dual. Now we have the following system of regression equations:

(4.1/6)

where rt - -, = (rn - -, rt2 - -, ... , rtK - -), I':t'

I':tk : = IUt -I/V"K - rtk,

for k = 1, 2, ... , K Equation (4.1/6) reads in greater detail:

IUt-I/V"K

IUt-I/V"K

(4.1/7)

The coefficients 0ij are the elements of the upper triangular matrix fl. They are
estimated by OLS applied to each equation of the system (4.1/7). The resulting
estimator E - = /l -, /l- of the covariance matrix of the random coefficients has the
following properties if (A 1) and (A2) hold (compare Freimann (1988)):
It is biased and
not consistent, but as we shall see later,
has small variances in finite samples,
small mean-squared errors in finite samples, and
always yields a positive definite matrix E-.

The estimator of the elements of E derived from the OLS estimates of the Oij' PDM,
is in general not consistent because the disturbances I':tk of the equation system
( 4.1/7) need not have zero expectations, not even asymptotically.

The POM estimator has the advantage that it can be calculated without any restnctlOn
on the coefficients to be estimated: One can always order the elements of Xt in such
a way that the element 011 - of the upper triangular matrix /l -, which corresponds to
the standard deviation of the random variable vtl in (2/3), is positive.

The matrix E - may be approximately positive semidefinite since the estimates of the
variances can approach zero very closely.

Unfortunately we cannot specify the asymptotic distribution of this estimator because

the size of its inconsistency is not known.
 392

4.2 A Mixed Estimator (ME)

In order to make use of both the satisfactory small-sample properties of the POM
estimator and of the consistency of the Hildreth/Houck-related estimators, POM is
combined with the CMGHH estimator (compare Freimann (1988». The resulting
mixed estimator (denoted by ME in the sequel) is a weighted average:

(4.2/1)

where cr*PDM and cr*CMGHH denote the POM and CMGHH estimators of the vector
cr* in (3.2/1). and where 0 :0:; cT :0:; 1 is the weighing function, defined by

CT : = MSE(MGHH) / (MSE(POM) + MSE(MGHH» (4.2/2)

The symbol "MSE" denotes here the trace of the mean-squared error matrix of the
corresponding estimator (in brackets). As MGHH is consistent and POM is not, the
weighing function cT converges to 0 if T approaches infinity, and hence (1 - CT)
converges to 1.

Although CMGHH is a consistent estimator, its mean-squared error matrix is un-

known in small samples and is replaced in (4.2/2) by MSE(MGHH) which is known.
The mean-squared error matrix of POM is estimated by:

(4.2/3)

using the consistency of CMGHH. This choice of weights makes the mixed estimator
converge to the true covariance matrix L in probability, i.e. ME is consistent under
(AI) and (A2).

4.3 The Maximum Likelihood Estimator

Since a comparison of the estimators considered so far would be incomplete without a

maximum likelihood procedure, such a method was included in the simulation study.
The log-likelihood function reads in our model (2/1):

T T
LL - T In(21T) - L I In (Xt'!1' !1Xt) - L I (Yt - Xt'(3)2 (4.3/1)
2 2 t= 1 2 t= 1 Xt'!1' !1Xt

where "In" denotes the natural logarithm.

In order to find the unconstrained maximum of this function, several procedures were
tested, among them variants of the Gauss and Newton-Raphson methods, e.g. the
Marquardt algorithm. Most of them showed good convergence results for one
replication of the simulation experiment; the 200 replications this study is based upon
took however too much time on the AT-compatible personal computer used for the
simulation. Therefore a variant of the direct search method by Ludeke, Hummel and
Rudel (1988) was used for the calculations.
 393

The original procedure operates on a standardized parameter space and uses a lattice
which is refined in subsequent iterations. The ML version investigated in the present
Monte Carlo study takes the estimates of the mixed estimator (ME) outlined above
as starting values and establishes a lattice in the neighborhood of the starting point
and refined ones in subsequent iterations. As the reader will see below, this procedure
often improves the already good results of the ME and PDM estimators. It usually
finds a local maximum of the likelihood in the neighborhood of the starting point in
at most three iterations, often already during the first iteration. Its advantage for
simulation experiments is that the number of calculations necessary to reach the local
maximum is nearly the same for each replication and that only the calculation of the
likelihood has to be done. First or second derivatives are not needed.

The ML estimator used here

is consistent under (A 1) and (A2),
asymptotically efficient and
always estimates L as a positive (semi)definite matrix.

5 Monte Carlo Study

5.1 Data Generation

The small-sample properties of the above estimators were investigated by means of

simulation experiments based on the following simple regression model:

(5.1/1)

where btl - N(/31' 0'11)' bt2 - N(/32' 0'22), Cov(b tl , b t2 ) = 0'12, i. e. the random
coefficients were generated from a bivariate normal distribution. Also, the data for XI>
the exogenous variable, were chosen as realizations of normally distributed random
variables and produced by the random number generator of RATS. Three different
processes were taken into account for the generation of the exogenous variable Xt:

Xt 5.0 + Zt, where Zt - N(O, 1.0), Zt serially independent,

Xt 5.0 + alt + Zt, where Zt - N(O, 1.0), Zt serially independent, al 0.1,

0.5, 0.9,

Xt = 5.0 + Zt, where Zt = Zt-l + Et and Et - N(O, 1.0), Et serially independent.

The last two data generating processes are nonstationary (a linear trend and a random
walk process). They proved to be important for the small-sample properties of the
estimators. The numbers of observations available for each variable in the simulation
experiments were T = 20, 40, 80.

In each experiment the expectations (31 and (32 of the random coefficients were held
constant at 1.0, and, unless otherwise stated, the parameter values 0'11 = 0'22 = 0.05
and 0'12 = 0.01 were used. Each experiment was repeated 200 times.
 394

5.2 Results of the Monte Carlo Study

5.2.1 Variation of the Variances and Covariances of the Random

Coefficients

The first series of experiments consists of a variation of the variances and covariances
of the random coefficients and was done for untrended data. Table 5.2.1 shows the
results for the mean-squared errors (MSE, now interpreted as the mean-squared
errors of the estimated elements). In order to save place, only typical outcomes are
reported here. 1 It turns out that the mean-squared errors
rise independently of T with increasing variances of the random coefficients,
may rise or fall if the covariances increase,
fall if the number of observations, T, increases,
of POM, ME and ML never exceed 0.5 for 0"11 = 0"22 = 0.05 and never exceed
1.5 for 0"11 = 0"22 = 0.1 while the MSEs of the other estimators sometimes take
very large values, especially in the case of 0"11·.
- The results show the following order:
MSE(ML) < MSE(POM) < MSE(ME) < MSE(CMGHH) as well as
MSE(CMGHH) < MSE(MGHH) < MSE(GHH).
No exception to this ordering occurred among the simulation results.

For a deeper analysis of these results it is useful to look at table 5.2.2: The biases
corresponding to the above MSE values
increase in absolute value, apart from only few exceptions, if the variances of the
random coefficients rise,
rise or fall, depending on the estimator, on the coefficient to be estimated and
on the number T of observations, if the covariances between the random
coefficients increase,
of PDM, ME and ML never exceed 0.5 for 0"11 = 0"22 = 0.05 and never exceed
1.0 for 0"11 = 0"22 = 0.1 in absolute value while the biases of the other esti-
mators often exceed 1.0 in absolute value, expecially the biases calculated for the
estimates of 0"11 at T = 20,
of GHH do not indicate that this estimator is unbiased.

This outcome reveals that the fall of the mean-squared errors caused by an increase
in the number of observations T (see table 5.2.1 above) is due to the performance of
the variances. A clear ordering of the estimators with respect to the absolute value of
the bias is difficult to find.

The fraction of negative variance estimates which occurred in each experiment was
very large for GHH and MGHH. The minimum fraction was 181/400 (calculated for
2 variances in all 200 replications) found for GHH at 0"12 = 0.04 and T = 80, the
maximum fraction was 269/400 computed for MGHH at 0"11 = 0.05 and 0"12 =
0.01 as well as at 0"11 = 0.1 and 0"12 = 0.02, in both cases at T = 20. The fraction
of negative variance estimates was always larger for MGHH than for GHH although
this relation does not hold for the absolute bias.

1The interested reader can get the complete set of simulation results from the author.
 395

Table 5.2.1: MSE values dependent on 0"11. 0"12. 0"22 and T for untrended Xl

O"ll 0"22 0.05

G H H MGHH C MGH H
0"12 T 0"11 • 0"12 • 0"22 • O"ll • 0"12 • 0"22 • O"ll • 0"12 • 0"22 •

20 164.5862 8.4318 0.4039 79.3014 4.2440 0.2113 28.1350 0.9863 0.0828

0.0 40 77.9015 3.9423 0.1891 52.7613 2.7401 0.1344 25.8863 1.3386 0.0671
80 28.4866 1.4408 0.0677 23.7262 1.2032 0.0566 13.5004 0.7082 0.0354

20 197.0216 10.0330 0.4780 95.2867 5.0582 0.2502 37.3068 1.6454 0.1057

0.02 40 103.6297 5.2505 0.2523 69.9367 3.6340 0.1784 35.3130 1.5197 0.0934
80 38.3413 1.9182 0.0888 31.7262 1.5932 0.0739 19.0583 0.9914 0.0482

20 228.0463 11.3512 0.5279 112.4134 5.7848 0.2771 45.0717 2.0535 0.1154

0.04 40 114.5615 5.8089 0.2798 77.4114 4.0199 0.1977 35.6402 1.8854 0.0958
80 47.6497 2.3705 0.1093 39.1105 1.9562 0.0905 23.6971 1.2226 0.0586

I I

~1
P D M ME ML
0"11 • 0"12 • 0"22 • O"ll • 0"12 • 0"22 • O"ll • 0"12 • 0"22 •

20 0.2450 0.0176 0.0020 0.3567 0.0189 0.0025 0.1692 0.0120 0.0013

0.0 40 0.0913 0.0040 0.0008 0.1126 0.0059 0.0009 0.0695 0.0027 0.0006
80 0.0101 0.0019 0.0005 0.0289 0.0036 0.0006 0.0062 0.0014 0.0005

20 0.3070 0.0215 0.0020 0.3678 0.0245 0.0023 0.2072 0.0109 0.0009

0.02 40 0.1239 0.0074 0.0009 0.1538 0.0099 0.0010 0.0523 0.0056 0.0007
80 0.0135 0.0028 0.0005 0.0314 0.0046 0.0005 0.0067 0.0029 0.0005

20 0.3690 0.0222 0.0016 0.3951 0.0243 0.0016 0.2968 0.0179 0.0013

0.04 40 0.1440 0.0118 0.0011 0.1702 0.0143 0.0012 0.0817 0.0074 0.0007
80 0.0173 0.0042 0.0005 0.0301 0.0061 0.0005 0.0184 0.0056 0.0007
 396

Table 5.2.1 (continued)

O"ll = 0"22 0.1

I I
GHH MGHH CMGH H

~J O"ll • 0"12 • 0"22 • O"ll • 0"12 • 0"22 • O"ll • 0"12 • 0"22 •

20 658.3447 33.7273 1.6156 317.2057 16.9762 0.8452 112.5399 3.9454 0.3311

0.0 40 311.6059 15.7690 0.7563 211.0453 10.9606 0.5376 103.5453 5.3544 0.2686
80 113.9465 5.7634 0.2706 94.9047 4.8129 0.2262 54.0016 2.8327 0.1418

20 727.7841 37.2664 1.7849 350.7674 18.7499 0.9331 131.7380 5.2402 0.3856

0.02 40 362.8145 18.3624 0.8809 245.0799 12.7257 0.6240 123.8813 6.4450 0.3234
80 133.1337 6.7003 0.3124 110.4808 5.5777 0.2604 65.2748 3.4091 0.1682

20 788.0863 40.1320 1.9120 381.1466 20.2326 1.0007 149.2274 6.5815 0.4230

0.04 40 414.5190 21.0020 1.0092 279.7467 14.5362 0.7137 141.2517 6.0788 0.3735
80 153.3650 7.6726 0.3552 126.9049 6.3729 0.2955 76.2330 3.9656 0.1929

0"12

-
j 0"11 •
P DM
0"12 • 0"22 • 0"11 •
ME
0"12 • 0"22 • O"ll •
ML
0"12 • 0"22 •

20 0.9802 0.0705 0.0079 1.4270 0.0756 0.0099 0.7109 0.0461 0.0044

0.0 40 0.3652 0.0161 0.0031 0.4506 0.0236 0.0034 0.1995 0.0127 0.0023
80 0.0403 0.0076 0.0020 0.1155 0.0144 0.0022 0.0406 0.0041 0.0015

20 1.0624 0.0791 0.0083 1.4578 0.0864 0.0101 0.8253 0.0572 0.0046

0.02 40 0.4483 0.0221 0.0032 0.5510 0.0313 0.0037 0.2498 0.0240 0.0026
80 0.0426 0.0089 0.0019 0.1158 0.0160 0.0021 0.0489 0.0064 0.0017

20 1.2280 0.0859 0.0081 1.4714 0.0978 0.0092 0.8134 0.0752 0.0059

0.04 40 0.4954 0.0296 0.0035 0.6153 0.0395 0.0041 0.1980 0.0270 0.0024
80 0.0541 0.0111 0.0019 0.1255 0.0185 0.0021 0.0488 0.0099 0.0018
 397

Table 5.2.2: Bias values dependent on 0"11. 0"12. 0"22 and on T for untrended XI

0.05

GHH MGH H CMGH H

0"l2 T 0" 11 • 0" 12 • 0"22 • O"ll • 0" 12 • 0" 22 • 0" 11 • 0"12 • 0'22 •

20 -1.6026 0.3650 -0.0804 -2.3891 0.5538 -0.1281 2.2964 -0.4350 0.0850

0.0 40 -0.0494 0.0321 -0.0112 -0.9022 0.2239 -0.0553 2.3094 -0.5195 0.0833
80 0.0851 -0.0389 0.0117 -0.4567 0.0858 -0.0168 1.6013 -0.3721 0.0533

20 -1.4255 0.3134 -0.0679 -2.4567 0.5576 -0.1284 2.6366 -0.5358 0.1040

0.02 40 0.2727 -0.0412 0.0049 -0.8137 0.2007 -0.0500 2.7168 -0.5773 0.1015
80 0.5070 -0.1329 0.0307 -0.1243 0.0106 -0.0018 2.1001 -0.4934 0.0766

20 -0.7511 0.1583 -0.0341 -2.2053 0.4954 -0.1150 3.0431 -0.6537 0.1204

0.04 40 0.0900 -0.0140 0.0014 -1.0992 0.2516 -0.0591 2.9040 -0.6824 0.1157
80 0.8415 -0.2045 0.0450 0.1428 -0.0472 0.0095 2.5151 -0.5910 0.0974

P DM ME ML
0"12 T 0"11 • 0"12 • 0" 22 • 0"11 • 0"12 • 0" 22 • 0"11 • 0"12 • 0"22 •

20 0.2172 -0.0469 -0.0116 0.2538 -0.0517 0.0098 0.1475 -0.0445 -0.0060

0.0 40 0.1263 -0.0242 -0.0155 0.1528 -0.0304 -0.0142 0.0789 -0.0250 -0.0135
80 0.0271 -0.0166 -0.0143 0.0566 -0.0234 -0.0129 0.0144 -0.0172 -0.0173

20 0.2791 -0.0771 -0.0057 0.3207 -0.0840 -0.0037 0.1796 -0.0667 -0.0063

0.02 40 0.1778 -0.0490 -Om08 0.2065 -0.0553 -0.0095 0.0760 -0.0550 -0.0051
80 0.3174 -0.0327 -0.0119 0.0670 -0.0407 -0.0103 0.0159 -0.0399 -0.0100

20 0.3132 -0.1022 -0.0006 0.3514 -0.1103 0.0012 0.2111 -0.0936 0.0005

0.04 40 0.1933 -0.0703 -0.0063 0.2177 -0.0760 -0.0052 0.0834 -0.0700 -0.0031
80 0.0497 -0.0494 -0.0088 0.0827 -0.0569 -0.0074 0.0252 -0.0644 -0.0017
 398

Table 5.2.2 (continued)

0"22 0.1

G H H MGH H CMGH H
0" 12 T 0"11 • 0"12 • 0"22 • a II • a12 • a22 • all • a l2 • a22 •

20 -3.2052 0.7300 -0.1608 -4.7782 1.1076 -0.2563 4.5928 -0.8700 0.1699

0.0 40 -0.0988 0.0643 -0.0224 -1.8045 0.4478 -0.1105 4.6188 -1.0391 0.1666
80 0.1702 -0.0778 0.0234 -0.9133 0.1716 -0.3367 3.2024 -0.7441 0.1066

20 -3.1482 0.7048 -0.1539 -4.9248 1.1288 -0.2603 4.9290 -0.9726 0.1871

0.02 40 0.2945 -0.0225 -0.0038 -1.6625 0.4147 -0.1035 4.9852 -1.1315 0.1836
80 0.5803 -0.1698 0.0421 -0.5956 0.0990 -0.0191 3.6146 -0.8440 0.1274

20 -2.8510 0.6268 -0.1358 -4.9134 1.1151 -0.2568 5.2731 -1.0717 0.2080

0.04 40 0.5454 -0.0825 0.0098 -1.6274 0.4014 -0.1001 5.4335 -1.1545 0.2029
80 1.0139 -0.2657 0.0614 -0.2486 0.0213 -0.0037 4.2000 -0.9867 0.1532

dJ
0.0
20
40
all •
PDM
a l2 •

0.4344 -0.0938 -0.0233

0.2526 -0.0484 -0.0310
a22 • all •
ME
al2 •

0.5077 -0.1033 -0.0196

0.3055 -0.0608 -0.0285
a22 • all •
ML
0" 12 •

0.2689 -0.0957 -0.0225

0.1315 -0.0604 -0.0278
a22 •

80 0.0542 -0.0331 -0.0286 0.1133 -0.0468 -0.0258 0.0134 -0.0408 -0.0275

20 0.4911 -0.1222 -0.0179 0.5738 -0.1342 -0.0138 0.3140 -0.1275 -0.0153

0.02 40 0.3068 -0.0737 -0.0262 0.3635 -0.0869 -0.0235 0.1498 -0.0931 -0.0224
80 0.0555 -0.0483 -0.0265 0.1198 -0.0630 -0.0236 0.0172 -0.0624 -0.0277

20 0.5583 -0.1542 -0.0114 0.6414 -0.1680 -0.0073 0.3549 -0.1601 -0.0122

0.04 40 0.3557 -0.0979 -0.0217 0.4130 -0.1106 -0.0190 0.1407 -0.1176 -0.0182
80 0.6348 -0.0655 -0.0238 0.1340 -0.0814 -0.0206 0.0200 -0.0808 -0.0260
 399

5.2.2 Influence of a Linear Trend

Table 5.2.3 shows the mean-squared errors obtained for different versions of a linear
trend in the exogenous variable Xt. The results reveal that the MSEs
rise or fall if the slope of the linear trend increases, they usually rise for er11·,
usually fall for small values of the slope if the number T of observations increa-
ses,
rise or fall for moderate and large values of the slope if T increases,
of ML never exceed 1.0 and those of POM and ME never exceed 1.5 while the
MSE values of the other estimators often become very large, especially for er11·.

An ordering of the estimators with respect to their mean-squared errors is difficult,

but the following one holds for the majority of cases:
MSE(ML) < MSE(POM) < MSE(ME) < MSE(CMGHH) as well as
MSE(CMGHH) < MSE(MGHH) < MSE(GHH).
This order is exactly the one obtained above for the variations of the variances and
covariances of the random coefficients when the data were untrended.

An analysis of the bias values corresponding to table 5.2.3 is even more difficult and
is therefore omitted here. The only fact to note is that the absolute values of the
biases of ML, POM and ME never exceed 1.0 while the absolute biases of the
Hildreth/Houck-related estimators often exceed this margin in the case of eru •.

Again, the fraction of negative variance estimates was large for GHH and MGHH,
but not as large as the one found in the last section. As before, GHH produced
fewer negative variance estimates than its modification. All these fractions lie in the
interval between 149/400 and 231/400.

5.2.3 Influence of a Random Walk Process

As an alternative to the linear trend, the exogenous variable Xt was generated as the
realization of a random walk process. Table 5.2.4 shows the mean-squared error
values calculated for different values of the variance of Et. It turns out that the MSEs
for er11· first fall and then rise and those for er12· and er22· monotonously fall
in the case of the HH-related estimators if the variance of E t increases,
for er11· monotonously decrease, for er12· first fall and then rise and for er22·
remain (nearly) constant in the case of POM and ME if the variance of Et in-
creases,
monotonously fall in the case of ML if the variance of Et rises,
for er 11· rise and for er 12· and er 22· fall if the number T of observations in-
creases, independently of the estimator,
of POM and ME never exceed 0.01 and those of ML never exceed 0.03 while
the MSE values of the HH-related estimators do.

An ordering of the estimators with respect to the size of their mean-squared error
values yields:
MSE(POM) < > MSE(ME) < MSE(CMGHH) < MSE(ML) as well as
MSE(ML) < MSE(MGHH) < MSE(GHH)
 400

Table 5.2.3: MSE values dependent on the slope a 1 of the linear trend of XI and on T

GHH MGHH CMGH H

at T all • au • a22 • all • a12 • a22 • all • a12 • a22 •

20 238.8826 8.8580 0.2987 121.0470 4.6934 0.1640 52.8489 0.8784 0.0784

0.1 40 133.3222 4.0212 0.1079 88.4848 2.7964 0.0772 67.1542 1.0225 0.0593
80 61.6807 1.0778 0.0159 52.5990 0.9348 0.0139 27.3016 0.4890 0.0084

20 459.4638 7.0517 0.0857 286.8801 4.5870 0.0571 155.7893 0.5464 0.0343

0.5 40 429.0099 3.6718 0.0219 325.6672 2.8903 0.0175 224.6418 0.4280 0.0132
80 693.7116 2.5730 0.0056 605.4113 2.3045 0.0051 304.9619 0.6365 0.0034

20 1117.9850 9.8434 0.0620 714.1560 6.5970 0.0424 436.4484 0.4521 0.0286

0.9 40 1389.6900 5.8836 0.0153 1059.3840 4.6809 0.0123 712.5652 0.5502 0.0094
80 3396.9910 5.5488 0.0046 2958.1220 4.9844 0.0042 1480.7790 1.2350 0.0029

P DM ME M L
at T all • a 12 • a22 • erll • erl2 • er 22 • erll • a12 • er 22 •

20 0.1806 0.0112 0.0012 0.2209 0.0120 0.0013 0.1234 0.0045 0.0008

0.1 40 0.1209 0.0059 0.0006 0.1401 0.0062 0.0006 0.0662 0.0021 0.0008
80 0.0293 0.0021 0.0004 0.0303 0.0022 0.0004 0.0212 0.0016 0.0010

20 0.3168 0.0094 0.0008 0.3268 0.0094 0.0008 0.2309 0.0063 0.0011

0.5 40 0.1917 0.0053 0.0005 0.1942 0.0053 0.0005 0.2118 0.0037 0.0012
80 0.2671 0.0047 0.0005 0.2675 0.0047 0.0005 0.2235 0.0027 0.0014

20 0.7943 0.0133 0.0008 0.8070 0.0133 0.0008 0.9879 0.0136 0.0013

0.9 40 0.6034 0.0086 0.0005 0.6049 0.0086 0.0005 0.6203 0.0057 0.0014
80 1.3849 0.0100 0.0005 1.3852 0.0100 0.0005 0.8970 0.0028 0.0017
 401

Table 5.2.4: MSE values dependent on the variance (1f-2 and on T

GHH M G H H eM GHH
(1 2
f- T (111 • (112 • (122 • erll • (112 • (122 • (111 • (112 • (122 •

20 0.0259 0.0275 0.0126 0.0210 0.Ql71 0.0059 0.0054 0.0021 0.0028

0.8 40 0.0733 0.0423 0.0119 0.0562 0.0333 0.0092 0.0304 0.0050 0.0064
80 0.0186 0.0005 0.0005 0.0182 0.0005 0.0005 0.0092 0.0003 0.0005

20 0.0021 0.0089 0.0080 0.0018 0.0063 0.0038 0.0014 0.0004 0.0023

1.0 40 0.0083 0.0178 0.0077 0.0061 0.0143 0.0060 0.0044 0.0007 0.0046
80 0.0204 0.0008 0.0005 0.0200 0.0008 0.0005 0.Ql08 0.0004 0.0005

20 0.0050 0.0028 0.0056 0.0031 0.0026 0.0028 0.0030 0.0002 0.0020

1.2 40 0.0021 0.0078 0.0054 0.0018 0.0064 0.0043 0.0016 0.0003 0.0036
80 0.0259 0.0011 0.0005 0.0251 0.0010 0.0005 0.0137 0.0006 0.0005

PDM ME M L
er 2
f- T (111 • er 12 • (122 • erll • (112 • (122 • (111 • (112 • er 22 •

20 0.0011 0.0000 0.0011 0.0018 0.0007 0.0017 0.0028 0.0114 0.0247

0.8 40 0.0014 0.0000 0.0006 0.0065 0.0009 0.0020 0.0035 0.0081 0.0134
80 0.0059 0.0002 0.0025 0.0045 0.0002 0.0012 0.0042 0.0008 0.0026

20 0.0009 0.0000 0.0012 0.0007 0.0001 0.0017 0.0009 0.0062 0.0191

1.0 40 0.0012 0.0000 0.0006 0.0020 0.0002 0.0023 0.0014 0.0077 0.0158
80 0.0078 0.0004 0.0022 0.0056 0.0003 0.0012 0.0080 0.0009 0.0036

20 0.0006 0.0001 0.0013 0.0005 0.0001 0.0016 0.0006 0.0031 0.0119

1.2 40 0.0008 0.0000 0.0007 0.0008 0.0001 0.0022 0.0010 0.0043 0.0105
80 0.0082 0.0006 0.0019 0.0063 0.0005 0.0012 0.0160 0.0014 0.0033
 402

where "< >" denotes that there is no clear ordering between PDM and ME. It is sur-
prising that the random walk process of XI worsens the small-sample properties of the
maximum-likelihood estimator in such a manner that its MSE values are even worse
than those of CMGHH.

The bias values (which are not tabulated here) reveal that the influence of the
random walk process of XI is different for each estimator and for each coefficient. The
size of the biases of all estimators is however much smaller than in the case of a
linear trend. Surprisingly, GHH now shows the smallest absolute bias values which
increase with T.

The fraction of negative variance estimates found in the experiments of this section is
much smaller than before for both GHH and MGHH. Now, there is no clear
ordering with respect to this criterion, the fraction of negative variance estimates
found for GHH and MGHH always lies in the interval between 46/400 and
231/400.

6 Summary

The results of the investigation described in this paper show that although five of the
six estimators of the variances and covariances of random coefficients are consistent
their small-sample properties need not be satisfactory. Only two estimators always
show moderate or small mean-squared error values, namely PDM and ME, even in
the presence of a linear trend and a random walk process of the exogenous variable.
While PDM is not consistent, the estimator ME, which is consistent, turns out to be
the most robust method. The maximum likelihood estimator ML shows small mean-
squared errors in the case of untrended data and in the presence of a linear trend, its
behaviour worsens, however, when the data are generated by a random walk process.
Four of the estimators, namely ML, PDM, ME and CMGHH, always yield positive
variance estimates while the Hildreth/Houck-related estimators GHH and MGHH
often produce negative ones in combination with large mean-squared errors.

References

Freimann, K.-D. (1988): Simultaneous Equations Models with Random Coefficients:

Estimation Procedures for a Special Case, discussion paper by the Institut fUr Ange-
wandte Wirtschaftsforschung, Tiibingen.
Hildreth, C./Houck, J.P. (1968): Some Estimators for a Linear Model with Random
Coefficients, Journal of the American Statistical Association, 63, 584 - 595.
Judge, G.G./Griffiths, W.E./Hill, R.C.jLiitkepohl, H./Lee, T. (1985): The Theory and
Practice of Econometrics, New York/Chichester/Brisbane/Toronto/Singapore.
Liideke, D.jHummel, W./Riidel, Th. (1988): Das Freiburger Modell. Ein mittelfristi-
ges okonometrisches Vierteljahresmodell fUr die Bundesrepublik Deutschland mit
Simulationen zur Arbeitszeitverkiirzung und Steuerreform, Berlin/Heidelberg/New
York/London/Paris/Tokyo/Hong Kong.
Raj, B./Srivastava, V.K./Upadhyaya, S. (1976): The Efficiency of Estimating a Ran-
dom Coefficient Model, Journal of Econometrics, 12, 285 - 299.
 403

Raj, B./UIlah, A. (1981): Econometrics. A Val)'ing Coefficient Approach, New York.

Schwallie, D.P. (1982): Unconstrained Maximum Likelihood Estimation of Contempo-
raneous Covariances, Economics Letters, 9, 359 - 364.
 TIGHTER BOUNDS FOR THE EFFECTS OF ARM A DISTURBANCES
ON TESTS FOR REGRESSION COEFFICIENTS

Jan F. Kiviet
University of Amsterdam
Department of Actuarial Science & Econometrics
23 Jodenbreestraat, 1011 NH Amsterdam, The Netherlands

Abstract
The usual t- and F-tests for linear constraints on regression coefficients
involve an unambiguous assumption on the distribution of the disturbances,
whereas in most practical applications the correlations of the disturbances
are unknown. However, it is possible to use the same test statistics in a
bounds test under a composite assumption on these correlations. In this paper
such bounds for critical values and also for actual significance levels are
derived which take into account that particular regressors (such as the
constant or a time trend) occur in the regression. These bounds are
calculated for tests on restrictions in multiple regressions with a constant
term and with AR(l) or ARMA(l,l) disturbances. They are presented in such a
way that the bounds test is easily applicable, as is illustrated.

Keywords Regression; t-Test; F-test; Autocorrelation; Bounds Tests;

Actual Significance Level; Critical Values; Robustness.

Contents
1 Introduction
2 Bounds on t- and F-Tests
3 Boundary Levels and Critical Values
4 Illustrations and Conclusions
Acknowledgements
References

1 INTRODUCTION

It is certain that regression analysis will often be made using a wrong

correlation matrix of the disturbances. This statement is borrowed from
Watson (1955, p.327) where it is tried to assess the maximal injury that a
postulated correlation matrix can do to a linear regression analysis when in
fact the true correlation matrix is different. Watson derives inequalities on
the bias in the estimates of the variance of the regression coefficients, on
the efficiency of the estimates of the regression coefficients and on the
significance points of various t- and F-tests. The bounds on these
statistical variables are expressions in terms of eigenvalues of a matrix
that depends both on the true and on the mistaken correlation matrix. Some of
these bounds hold for arbitrary regression matrices, but in most results it
 405

is supposed that the regressor vectors are orthogonal, or that some of the
regressors are similar to particular eigenvectors corresponding to the above
mentioned eigenvalues.
Less restrictive results on the bias of the variance estimates are
presented by Sathe and Vinod (1974), and as far as the variance of the
disturbances is conerned - by Neudecker (1977). In Neudecker (1978) one
constraint is put on the regressor matrix; it is supposed that the regression
contains a constant term, and now quite definite results on the direction and
possible magnitude of the bias in the residual variance are obtained. Vinod
(1976) calculates bounds on the significance points for the F-test of the
complete coefficient vector for arbitrary regressor matrices and he indicates
how the practitioner can use these bounds to infer from an Ordinary
Least-Squares (OLS) statistic in what in fact is a Generalized Least-Squares
(GLS) model. In Kiviet (1980) some critical comments on Vinod (1976) are made
and in addition attainable bounds are derived and calculated for the
significance points of the test statistic for an arbitrary set of linear
constraints on regression coefficients. These bounds, which generalize
Watson's results, also apply to the significance test of a subvector of the
coefficients, hence they include the usual t-test. The above mentioned
contributions are reviewed in Vinod and Ullah (1981, pp.97-l02); a more
sophisticated but computationally much morn complex procedure has
recently been developed by Dufour (1990).
In this paper we try to make the results on the t- and F-test of more
particular interest to the practitioner. This is pursued by presenting the
bounds in convenient diagrams, and also by tightening the bounds through
exploiting the presence of particular regression variables in the regression,
along the same lines as Neudecker (1978) did with respect to bounds on the
bias of the disturbance variance estimate. The assumptions made here with
respect to the presence of particular regressors have practical relevance,
contrary to the assumptions made by Watson concerning the correspondence of
regressors with particular eigenvectors. In the figures presented here, we
assume and exploit that a constant term is present. The diagrams enable to
interpret - without any further calculations the standard statistical
results of a regression analysis embodied in t-ratios and F-statistics, when
the assumption is dropped that the disturbances are independent. Some of the
diagrams can also be used when it is recognized that - in an (unsuccessful)
attempt to make Ordinary Least Squares applicable - an incorrect assessment
of the correlation matrix may have been employed in the transformation of the
model. Doubts about a regression analysis originating from a fallacy in the
adopted correlation matrix can thus be removed, because the bounds permit an
appeal to the robustness of t- and F-tests with respect to departures from
the assumption of independent disturbances.

2 BOUNDS ON t- AND F-TESTS

We consider the linear regression model

(1)

where we have n observations on the dependent variable y and on the k

linearly independent exogenous regressor variables X, whereas the disturbance
vector u is n-variatt normally distributed with zero mean and non-singular
covariance matrix '2 O. Possibly the variables y and X, as well as the
covariance matrix a 0, are already the outcome of some transformation of a
basic model, when an attempt has been made already to remove serial
dependence of the disturbances.
 406

We investigate the classical t- and F-test procedures for the general

linear hypothesis on the coefficient values expressed by

(2)

where R is an hxk matrix of rank h~k and r is an h-element vector of

constants. When the (remaining) correlation of the disturbances is ignored,
the test statistic is

n-k (Rb-r)'[R(X'X)-lR' j-l(Rb_r) n-k e'e - e'e

(3)
Qh,n-k = ~ e'e - ~ e'e

where b=(X'X)-lx'y and e=y-Xb are the ~tS coeffic:\ent_rnd residual

vector, respectively, whereas b - b - (X'X) R' [R(X'X) R'j (Rb-r) and
e-y-Xb are the constrained least-squares estimator and corresponding
residual vector, respectively, see Maddala (1977, p.458). When HO is true and
0-1 statistic (3) follows the F-distribution, with hand n-k degrees of
n
freedom. Under HO the test statistic can be written as

n-k u'Mu - u'Mu n-k u'Nu

Qh n-k = ~ u'Mu (4)
~ u'Mu '

where M=1-X(X'X)-lX' and M=M+N with

N = X(X'X)-lR' [R(X'X)-lR'j-1R(X'X)-lX'

This is easily seen, since e=Mu, and upon substituting r=Rp it is found
that

e = y - Xb

e + Nu (M+N)u

whereas MN=O and M and N are symmetric idempotent.

Attainable bounds for statistic (4) for arbitrary X and fixed 0 are
given in:

THEOREM 1: If y~Xf3+u with u-N(O,a 2 0) whereas the constraints ~Rp=r

are valid, then the statistic Qh ' is bounded by the statistics
,n-K
r.h ,n- k
and F~,n_k (which do not depend OJ: X and R) so that

~
h,n-k
< Q
- h,n-k
where
h
2
2: >.
n-h+i 'Ii
n-k i=l n-k
~
h,n-k 11 n-k and FU
11
h,n-k
2
2: >.. '1 +
~ k i
i~l

, 2 -1/2
with >'l~" ·~>'n the eigenvalues of 0 and ('11"" ,'In) =(a 0) u-N(O,I)
 407

PROOF: See Kiviet (1980), but note that here the eigenvalues are arranged
in decreasing order.

From this Theorem bounds on the actual critical values of this test
statistic follow, and also bounds on the actual significance level of the
standard test procedure when the a-level F significance points are
(erroneously) employed. In Kiviet (1980) tables of calculated boundary

percent significance level for particular °

cri tical values are presented for various values l::sh:sk<n at the nominal 5
matrices of the ARMA(l,l) type.
It was found that these bounds are rather wide; for substantial departures
from independent disturbances they enclose a fairly large region where no
definite inferences can be made. On the one side this is indicative of the
vulnerability of OLS statistical inference with respect to dependence of the
disturbances, but on the other hand it is the consequence of the generality
of these bounds with respect to the regressor matrix (the bounds do depend on
nand k, but not on X itself). Therefore we shall here derive tighter bounds
for regressor matrices with some specific regressor vectors.
Suppose that h<k, then - without loss of generality - we may assume that
the model has been rearranged or reparametrized in such a way that the h
linear restrictions do not affect the kl::Sk-h coefficients which correspond to
the regressors Xl' where X and ~ are partitioned according to

(5)

with Xl (nxk l ) and X2 (nxk 2 ) of full column rank, whereas R~=[0:R21~=R2~2=r

with R2 an hxk 2 matrix of rank h. Now we can prove

2
THEOREM 2: If y = X~+u ~ Xl~1+X2~2+u wHh u-N(O,o 0) whereas the
constraints are such that R~=R2~2-r is valid (and hence they do not concern
the coefficients ~l)' then the statistic Qh -k is bounded by the statistics
~* ~ ,n
h,n-k and Fh,n_k (which do not depend on X2 and R2 ) so that

where
h h

~* ~ n-k i=l
l;
"
*
n-kl-h+i 'Ii
*2

and F
u* =
n-k
l;
i=l
".
* *2
.1 'Ii
h,n-k 11 n-k h,n-k 11 n-k
l;
i=l
".
*
.1
*2
'I k +i
2
2:
i=l
*
"k2+.1.
*2
'I k +i
2

Here *
"I?:" *
'?:"n-k are the possibly non-zero eigenvalues of 1'11 °, and
* * l 2 -1/2
C'u - N(O,I) , where C is the nx(n-k 1 ) matrix
('11'··· n k )' = (0 C'OC)
,'I _
1
of eigenvectors corresponding to the unit eigenvalues of 1'11 =I-X1 (Xi Xl)-lXi
 408

PROOF: For the idempotent matrix Xl we have Ml-CC', whereas C'C-I k'
n- 1
Upon premultiplying model (5) by C' we obtain

and since C'Xl-C'CC'Xl-C'MlXl-O this transformed model reduces to

y * (6)

where y *-C'y and u *-C'u are n *xl vectors and

X*2 -C'X 2 is a n *xk*
regressor matrix. The number of observations is n *-n-k there are k *~k2
coefficients, and for the disturbance we*find u -N(O,a 0 ) with 0 *-C'OC .
* 2 1*'

If it is assumed that O-In this yields 0 -I and then the appropriate test
n-k l
statistic for the hypothesis R2fi2=r is

* * *
n -k
Qh,n* -k* = - h -
e *' e *
Since R=[O:R 2 ] this statistic is equivalent to Qh,n-k of (3), as is seen as
follows. From a standard result on partitioned regression we obtain Rb=R 2b 2 =
1 * *'*-1*'* -1
R2 (X 2 Ml X2 )- X2M)Y and since b 2=(X 2 X2 ) X2 y =(X 2 CC'X 2 ) X2 CC'y=b 2 we
find Rb=R 2 b 2 Also R(X'X)-lR'-[O:R ](X'X)-l[O:R ]'~R (X'M X )-lR'=
*' * -1 * * * * 2 2 2 2 1 2 2
R2 (X 2 X2 ) R2 And finally e -y -X2b2=C'(y-X2b2)=C'(y-Xlbl-X2b2)=C'e, so
the residual sum of squares is e *' e *=e'CC'e=e'M 1 e-e'e.
Q* * *=Q
Since they have equivalent boundary critical values.
h,n -k h,n-k *
Upon application of Theorem 1 to model (6) - hence replacing n by n =n-k l and
k by k2 etc. these bounds are easily found, and they involve now
expressions in the n-k l eigenvalues of C'OC, which conform to the n-k l
possibly non-zero roots of CC'O=MlO. o

L*
Like the boundary statistics of Theorem 1, the statistics Qh,n-k and
u*
Qh,n-k of Theorem 2 imply on the one hand bounds on the actual significance
level of the test procedure when the dependence of the disturbances is
ignored, i.e. the test statistic Qh,n-k is naively used in combination with
the a-level F significance points. On the other hand they imply bounds on the
exact critical values of Qh,n-k in the presence of serial correlation.
The actual significance level (probability of a type I error) of the
Qh,n-k test statistic when employed at the nominal size a is defined as

a = (7)
h,n-k

where is the a-level significance point of the central F

 409

distribution with h degrees of freedom in the numerator and n-k in the

denominator. From Theorem 2 it follows that ~ is bounded by
n,n-k
L* U*
::5 ::5 , (8)
~,n-k ~,n-k ~,n-k
where
L* L*
~,n-k - P(Fh,n_k
~ Fh,n_k(a) I HO)
and
U* U*
ah,n_k P(Fh,n_k ~ Fh,n_k(a) I HO)

These values can be calculated numerically.

If Qh n_k(a) denotes the exact 100a percent upper critical value of
Qh,n-k ' then P(Qh,n-k ~ Qh,n_k(a) I HO) - a . Obviously Qh,n_k(a) depends
on R2 , Xl' X2 , 0 and a. However, Theorem 2 yields the bounds

(9)

on the actual critical value; these boundary critical values are defined by
L* L*) u* u* )
P ( Fh,n_k ~ Fh,n_k(a) = a = P(Fh,n_k ~ Fh,n_k(a) (10)

The bounds of (8) and (9) are attainable, and in contrast with ah,n_k and
Qh,n-k(a), they do no depend on X2 . Notwithstanding the multitude of their
determining factors, such bounds can be tabulated. The bounds on ah,n-k in
(8) indicate the maximal deviation of the actual from the nominal
significance level which is possible, given 0 and Xl' due to X2 .
The bounds on Qh,n_k(a) permit a bounds test which is immune to serial
dependence of the disturbances. This test procedure is employed as follows.
From Theorem 2 we find

(11)
and
a . (12)

Now let q be the realisation of the test statistic Qh,n-k in some model.
U*
Consequently, if q ~ Fh n_k(a) then the null-hypothesis should be rejected,
L*
and if q ::5 Fh,n_k(a) then the null-hypothesis should not be rejected; in the
L*
event that one obtains Fh,n_k(a) u*
< q < Fh,n_k(a) the test is inconclusive.

3 BOUNDARY LEVELS AND CRITICAL VALUES

The bounds given in (8) and (9) depend on n,k,h,O,X l and a. The boundary
values can be calculated numerically, since the boundary statistics are
ratios of simple quadratic forms in normal variates. In all calculations that
 410

follow the significance level a is set at the 5 percent level, and Xl is an

nxl vector referring to the constant term. The formulas can also be used, of
course, for other values; notably one could incorporate the linear time trend
or seasonal dummies in Xl.
Two types of 0 matrices are considered. First, the effects of
disturbances generated by an AR(l) process with positive serial correlation
are examined. Second, we consider the case where the starting point is that
in a basic model the disturbances follow an AR(l) process with first-order
serial correlation coefficient p; however, this basic model has been
transformed with the intention to remove the dependence of the disturbances.
As in practice p is unknown the coefficient r, used for the transformation,
will generally differ from p. When we neglect the possibly stochastic nature
of r then the disturbances conform to the ARMA(l, 1) characteristics, apart
from the first disturbance. The first observation is, as all standard
textbooks mention, best treated in a special way. However, when r~p then it
will have a different variance and covariance. Nevertheless we will denote
this type of 0 matrix as ARMA(l,l) and it has autoregressive coefficient p
and moving average coefficient -r, see Kiviet (1980, p.355). In the AR(l)
case Xl is simply a column of ones, but in the ARMA(l,l) case only the first
element of X is one and all others are equal to (l-r) (1_r2) -112 This
affects Ml and therefore the eigenvalues of MIO.
With respect to sample size n the range 10 ~ n ~ 50 is investigated,
and concerning the number of regressors we examine k - 2, ... ,5 . Regarding
h, the number of restrictions tested, we focus on the case h-l, but for AR(l)
disturbances we also make calculations for 2 ~ h < k Throughout we present
results for p - 0.3, 0.5, 0.7 and 0.9 . L*
Over our grid of p, n, k and h values we found 0 < ah,n_k < 0.017 .
Hence we see that in the presence of (moderate or serious) positive serial
correlation the actual significance of the standard test procedures can be
very low for particular X2 matrices. One can prove that

(13)

so the actual probability of a type I error may depart from a in both

directions, depending on particular characterics of the X2 matrix in
connection with o. Some striking results on a~~n_k are presented in Table 1.

TABLE 1 Upper Bounds on Actual Type I Errors at the Nominal 5 Percent

Level for Regressions with a Constant Term and AR(l) Errors

k=2 k=3 k=4 k=5

p n
h=l h=l h=2 h=l h=2 h=3 h=l h=2 h=3 h=4

0.3 15 0.15 0.16 0.19 0.17 0.20 0.21 0.18 0.21 0.23 0.23
50 0.15 0.16 0.20 0.16 0.21 0.25 0.16 0.22 0.26 0.29

0.9 15 0.56 0.63 0.73 0.66 0.78 0.80 0.69 0.80 0.83 0.83
50 0.67 0.71 0.87 0.74 0.89 0.94 0.76 0.91 0.96 0.97
 411

Notice that when the serial correlation coefficient is only 0.3, the type I
errors may already have tripled, and - irrespective of the size of the sample
- they may be a tenfold of a, or even larger when p-0.9 . Upon comparison of
these results with those for general X matrices, we see that the
incorporation of only a constant term does not lead to bounds which are
considerably tighter.

Values of the upper bounds for ARMA(l,l) disturbances are presented in

Table 2. When r differs from p by 0.3 or more, again pretty substantial type
I error probabilities may occur. The Tables 1 and 2 illustrate how vulnerable
the standard significance tests are. Therefore it is desirable to know when
the value of a calculated test statistic can (or can not) be affected by
serial correlation in such a dramatic way that wrong inferences could be
made; the bounds on the true critical values make this possible.

TABLE 2 Upper Bounds on Actual Type I Errors at the Nominal 5

Percent Level for t-Tests in Regressions with a Constant
Term and ARHA(l,l) Disturbances

k-2 k=3 k=4 k=5

p r
n-15 n=50 n-15 n=50 n=15 n=50 n=15 n=50

0.0 0.3 0.11 0.11 0.12 0.12 0.12 0.12 0.13 0.12
0.6 0.15 0.15 0.17 0.16 0.18 0.16 0.20 0.17
0.9 0.17 0.17 0.19 0.17 0.21 0.18 0.24 0.18

0.3 0.6 0.09 0.09 0.10 0.10 0.10 0.10 0.11 0.10
0.9 0.11 0.11 0.12 0.12 0.13 0.12 0.14 0.12

0.6 0.3 0.20 0.23 0.21 0.24 0.22 0.25 0.23 0.26
0.9 0.08 0.08 0.08 0.08 0.08 0.08 0.09 0.08

0.9 0.3 0.47 0.63 0.52 0.66 0.54 0.69 0.56 0.54
0.6 0.29 0.50 0.31 0.52 0.32 0.53 0.32 0.54

The boundary critical values are presented here in diagrams; these

facilitate the application of the bounds test considerably. In the Figures I,
2, 3.1 and 3.2 we present results for different types of 0 matrices and for
various values of k and h. Each diagram presents the bounds on the actual
critical values of the test statistic for particular values of p and for n =
10, ... ,50 . Actually the bounds ~gve only been calculated for n=10,12,15,25
and 50 with a tolerance of 10 ; next a spline interpolation has been
employed to construct the plotted curves.
If just one linear restriction is tested (h=l) , usually not the F-test,
but the t-test is applied; then the test statistic is the positive or
negative square root of Qh,n-k' The bounds for the right-tail significance
prJnts of thisulest statistic are given by the positive square roots of
Qh,n_k(a) and Qh,n-k(a).
Figure 1 presents the boundary critical values for the t-test in the
presence of ARCl) disturbances. In each diagram the dashed line marks the 5
percent critical t-values, which, under the assumption p=O, are to be applied
when one linear constraint is tested. The various diagrams clearly show that
 412

when k increases, the critical t-values increase too, because of the decrease
in the number of degrees of freedom n-k. One can derive (and observe from the
diagrams) that

(14)

and a comparable inequality holds for h-l concerning the bounds for the
critical t-values.
In comparison with the unrestricted bounds tabulated in Kiviet (1980) we
find that the incorporation of a constant term of course leads to tighter
bounds, but that this gain is impressive only for high values of p and for
small or moderate sample sizes.

4 ILLUSTRATIONS AND CONCLUSIONS

In order to clarify the practical usefulness of the theoretical results

presented above, we shall now apply the diagrams and perform the t and F
bounds test procedure to a few simple examples borrowed from the textbook
literature.

ILLUSTRATION 1: Huang (1970, p. 19) presents an es timated relationship

based on 11 observations, viz.

Y.
~
11.60 + 0.789 Xi +
(1.53) (4.41)

where figures in parentheses are t-ratios. Under standard assumptions the

slope coefficient is strongly significant. How about its significance if the
errors are positively serially correlated? The upperleft diagram of Figure 1
shows that for n-ll a t-value of 4.41 just exceeds the p-O.5 upper bound. So
the coefficient is significantly different from zero under the composite
assumption O~p~0.5 as well. For values of p higher than say 0.55 the bounds
test is inconclusive and then the zero slope hypothesis can neither be
accepted nor rejected.

Note that these diagrams cannot be used to test the constant term,
because we restricted ourselves in the derivations to tests involving the
coefficients corresponding to X2 only.
Figure 2 presents bounds on F-values, where the dashed lines mark the
Fh,n_k(a) critical values.

ILLUSTRATION 2: For the regression of model (5.23a) in Huang (1970, p.96)

we find (n=3l):

R = -924.3 + 0.91 S + 683.5 E2 + 496.9 E3 + 2226.2 E4 + e .

(9.7) (4.5) (3.2) (14.1)

The joint significance of the coefficients corresponding to E 2 , E3 and E4 is

tested, and the test statistic appears to be 72.4. The diagram of Figure 2
where k=5 and h=3 shows that at sample size 31 this value is just below the
p=0.9 upper bound. So even under the assumption 0~p~0.85 we can reject the
null-hypothesis; this involves a type I error not exceeding 5 percent!
 413

F~gure I. Hounds on t-Values at 5 Percent Level jor RegressLOns

wtth n Con~lant Term and AR(J) Dtsturbances, k= 2 ..... 5 .

IG k - 2 I. lG k - 3 I.. :.
12 12 : p_ 0.9
101i-------~~~~·
----------~--~
IOIf-----~------~-=~~----~----~p- 0 9 -
...... L .... :.. .. ,
8 8 .......
- - - - -~ . . ..... : . . . . _. . i . , .. : ...•• .•• . j.,"

6 ~~~~~~~~'~~~~'~~~.
~ ......... . .................. . ........ :: .. :.:: ... : p-07 ' .. '::::::::::::::.. .. . " . : : :: ::: ::: :: ::: IT" 0.7"
.... ... .. --........ .. ....... ,,; . . . . . . . . : p - O.~ ..

....... .. >--,.......~.....:.:-:-:-:..:.:.:..~....:.:.;..~.:..:... :. :... :.:.. :. :; p- 0J

.,... ........ ........ .., ........ .. . . ... .. , , . .
. -- .
..

2 ~
...
... ... .. ........ ......... _ ~........ , _. _ .~'
:. 7 . ~ . ~ . ":"' . : . ":'" p. O

1.6 :------:
.... ~::- : ~
..::- .."" ..~~-----.:: p- OJ .
..""
1.6 :------...:
.. .... ~-::
. :""
...,..,
...,.,
..,..,.....:- -...:.....- ---..:: IT" O.J ..

12 - ---;-- - . . . . ; . . . . - -...:: p- O ~ I.;! -:----.:.....--~. p- O.~

l.0J~~"'S~~-~=======- p . ••• ,.1. ••••• . 0.7 1.0't-:-:~~~;;:::~7'~~':.~..:=:.:;:..:::.::::::::;::;:;:;:;:;:=:-. p- 0.7..

0.8 O.B

0." .............. . ....................... ,; . . ....... ; p . 0.9 06 .... . . .•• , ...... ~ ~ ~: ',:::'.'. ~:.: .......... : . •. ~ ::'.::',::'.: .~. 09
...... .. ..... .... . ' ., .... ........ .
o,' ~--~~--±-------~~~~~~ 0~-----1~0----~20~----JO
------4~0-----5-0----~
10 20 30 ~o ~o
n ( , umpl . su o) n ( ~amph .t l2: f' )

16 .1 t - 4 IG k - :;
~ P- 09
Il I~
. : . . .
10 IOI+-----7-----~--~----~----~
---_ ... : ' .. " .... ! .... ..... :' .. . -_ ... ........... \
8 ......... .. ....... . .. . ........................ .

.
:- ... ,- .:'.: .- ."':'.7 ; , ~ , ~ ,,,:,, ,,,,, , ,,, , ,,! __ __ __ ._ "~ p. O

1.6 16

1.2

o o
10 20 30 40 ~O 10 ZO 30 40 50
n (lo.mp' " loU . ) n (samph J'Uf')
 414

Ftgure 2 . Hound~ on F-Values at .5 PerCf'nt Level for Regresswns

wdh a Cons lant Term and AR(7) Dtsturbnn(:f's, k= 3,4,5
and the Number oj Reslnclions TesleeL h = Z,.. ,k-I.

I k - ~ ; h - JL''''
loof::====.:==~~~~--~-~--I
w /~ '-O.' .
........... . . .
--\'······_-·-········ 1·
. "; p- 07 "
20 ·········;· · ·······j·········:·····,,··I·········
. . ...... .:... ..... . p .. 07
.
~o

. ---- - .... : . . ....... ~" ~

p - O.J ••

.\ ., : p- o, ~ :-:
,.,', ;::::: ....... :
0.6
O. ~ ... _........ ......... .. : .... : : : ~ f ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ p . 0.7 ..

: : ::: :~ ~: :: : :::: :::'" ... : : -. :::: :',... .... , .. .

" " " "
p- 09

0~:tlrk==_;5=.h==_=J'I-:·-··-··-·.-..~f.-..-..-..-..-:.-..-..-..-..:~.-..-..-..1.

. . ... - . - . . ... : - ....... .: . . .. . . , .. ~

~IOJ-~~~~~-:::::==~====~==~~p-o~
"':: :: :.:::::. :::::::::::
~
~ b .... . .......... .. ............. .
.::::.:~;~ ~~ :.~::~~:~ ~ :~::~~':~;.: ~ :::::.::. : :::.: : ' : . ; p- o.J :.

,: K- ~ct~,J,~:YH : ~ •
I

O.!>
04
... , : : : : : ~: : : : : : : . . : : . ~ ~ ~ ~ ~ " ~ : '. .'. : '. .".~: ~ . -. .-. .....'"'::~
. .:- . ~ p- 0.9 .:

......... .......... .. ... . ........ ... .

f~ 1I--..i-----i- -@,:~-
.. ...
20 ......... :'""-...c_.......
' :-;'-:7:-:-'t:;
, '-:-':":
".........
c.,';';''-:-:.::
' '.,.:.;
' .....
':'":';''':''':.;.'
. .';'":.;.;..:.:..:..:.:.:..;
,.. -: p. 07

.. : . . . . . : p-O.J ··

......... :::~~ p- Ol) .-:

O.!>
0.4
p - 0.9 ..
o Oc
· +-----1~0----~20~--~~~O-----~~0-----5~O~--~
10 20 :JO 40 50
" ( . ampl • .... ) I stunple UZ f )
 415

F ~gure 3.1 Bounds on I-Values al 5 P e rcenl Level jor Regresswns

wtth a Con:;/anl Term. and ARMA(1, 1) Di:; lurbances, k= 2,3 .

.j k • 3 : r • 0 .3 1- ..
. .
101~----~------~----~----~------~---- 1 10+-. .-.-..-.-.-:
. :~ ..-.-...".."...".=..,;.: p_ 0.9
. .-.-..-.-.~.:-.-..-.-..-.-T.---~
'-.- ~

:·: ~: ~~~~~U<H«TT~/l//U .:
I! • . ::: :: : :;~; P.0.9 "
G : ~ ;;; ; ;;r;;;; : :: c; ;; ;;ri :: ::iLi;;; ;) .
: .' .' .' .' .' ::.' :.' .' .' .' .' .' .' .' .' :.' .' :::.- ...:....:::: .- :.- .' .' .' .' .' .' .' .' ~ ..... ..... .... . , ........... ...... ....... ... ...... .
. : : -: . . .. - . .. . : p . 0 ,(" . ,
3 • • p- 0.0 ~_H:-:':--,'-c'·cT:.,.
· ',.,'.,. ' ._._.'.;.:~
' ", ' .~._._.._. _..~:_
.._._. _••_. .....
..:
; -.. ... -
:::" ..
- _. - - - -

22.".~·. ~'. ~~' " ~ - --.~.t.~. ~.-.~.\

~

!
. ( .

2 p. 0.0

---.:::::==:
H

) :::.' ::: ::: : :: .':: :: : :~ : : : ,- ::: :::: .'.' .'.' .' .' :!: : .'.'.' .'.'.'.' ~ .'.':'.~? - .- .- :::::::i::: ::~; .- :~ : ::::::::~ :~ :::::::::: ::::::~ ~ :~: :~.!: :-.

; mmn.:.u····:··
0 .6 ... ... .......
. ...... ................ ... ... ..... .............
.
O.I!
..... . : .... ..... : , . . .. . . .. : .. .. .... . : .. ....... .. ... ... "

O.~ ~~ ~ ~ ~ ~ ~ ~!~ ~ ~~ (: ~: ~ j~ ~: ~ ~ ~ ~ ~ ~l~~ ~ ~:~:: ~ j~~: ~ ~ ~ ~~ ~~ ~~;~: ~ ~: ~

0.6 . ... .. ....... ...... ; . ..... . .. . ... . ..... ; ..•. . .. •. . . •.... ...

:
0.3 .. . ...... ; ......... ! .. . .. . ... ~ ......... : .. . ...... ; ...... .
... ......... .. .. ..: .... .... ... .... .. .: ..... .. ....... .
, . .... ... ... ..... .... ...... .. .... ...... .. .
O' 0'

101i-----~----~----;-----~----;----- 1
6 . ... . . . ::; :.':: ::: : :; ::: : : -. :::; :: : ::::::~ :: : : ::::: ; : :: :: : :'.
. ... ............ ... ... .... ... ... ....... .
10~-----~----~.----~----~:------:----- 1
6 ........ . ; .. . .. . . .. , ......... ; .... .. ... , .. . ...... ; .. ... .. .

a /:iii;~'~~'~<; ;:::~~;;;;
3 :::~ ~"';" " ": : :~::.::::.:::!::.::.: .: :: :;
~r~···~· ~~~t-~·~·~· ~· r~·~· ~-l :::9 ..
; . .• . • . . . ., 1 . .. ... ... ;

~~~~~~~ ---- ~ ---- ~ ,-r

P-OJ ~-"""' ~ """ "' i " "" '- ~ "..09 , - p- 0.3

II- -0.0 · : . . .
o.e · : :~::·:::~?S+:::·::::;: : :::: ::: i : ::::: :::~ : ::::::::
M ::.::::
004
~~ : ~~ L: ~ ~ ~ ~ ~ ~ ~ j~ ~::::: ~~~ E~ ~ ~ ~ ~ ~:: ~ i: ~ ~ ~~: ::J~: ~:::::
·· .. · i ·· .. ..... ,· .... . . . . ; .. .. . . . ··; .. ··· .... ;· · ···· ..

.. .... ...., ... ...... ...... .... ... .. ... ... ..... .
0,3 ~ : : : : :: : .. ~: .-: : : .- : .. : ~ : : : : : .- : :: ~ ~ ~ : :: : : : : ~ .. : : : : .. :: :
. .... ....... .. ... ..... . .. ..... ..... ... .. .
t: ::. :::. .
02:t;======~--:---~--:--1 02t;::=====::;---~--:--~--1
·1k - 2: r - 0.9 I·.. ····; ........ ·: .. .. .. .. ·~. . , Ie - 3 : r • 09 , . .. .... ....... ............ . . .
.. ........... .... ... ...... ...... . ,., . ..... , , ..
104-----~----~----~----~~----~---- .. 10' .
. .... ..... .... ..... ... ...... .... ..... ..... ... ...... .. . .
: ;::;;;;:; i;;;;;;;: :i;;;;: ::; ;t; :;;;;;;; 1;;;;;;:;;1;;;;:; ;;.: : :::::: : : r::::~ ~ ~ ~ r~ ~ ~;~:;;;;:::;:::::;;::::::::r:::::::;
.. .... ... ... ..... ..... , .............. .... ... ... ......... . .

. :: . . . :.:i~~ ::~:: .::

• . .. : . . • . . . • . .: • • • . • • •.• : • • . • • .••• •. ... ••. . r . . • • • . • • .

J: •~~~-~LL~I~~j'-.
~

3 :~ g:~ S?::~ : : : .:: .:~::::: :: : ~'. : ~

~ 2 •. ~ .",::-::: .",:~. :-. ~,.",." ~ ........ - -:- - - - - ~ p. r

2. 2. ' . ,

:: ~ :~:G~uuu
0.4 : ~'. :, ~ :.~r:::·:
:. ::, ·: ~:: i:::.~:. ~ ~ ': ~ ~ ':':'::. ~:::;:::. ~~'::: ~;: ~ ~ ~ ~~: ~:
OJ
j:.:....:.\ . ...:. :::~ ........::.j:::·:3:::::::·.·.
0.:1 : :. : : .••.....
O'
10 20 30 ~o 0;0 O.~
· ~--~----~--------~~~----~
10 ZO 30 40 50
" (.remp" $''') n (."mph .... )
 416

Figure 3.2. Bounds on t-Values at 5 Perrent Level for Regresstons

with a Constant Term and ARMA{t, 1) Disturbances. k= 4,5.

..;-.-..-.-. -. .-."C
10-1--..- .-.-. .-. ...; ..'=.=
" ,"".---:.=.::i ..~.-.-..-."C.."'.-..-.-. -..-. -;'
. ~ ,- 0.9 -
e .. :: . : . ::~ . ':.:: .. :. ;':::::.: ':. ~'.: : .::: ':.:':::.:'.::::
6· : ~::. :.: ::: ~:::::: '. ',:. i:·:· :-:.:::::. ~:.t • :.•.:.:• :.. :..:.:.:.
• , •• • ••• 1: •• •• • , ••• ~ ........ . •• . :
L:·:·:::·::: ~
04 · . .. . ..... ........... . ..... . .... ... . . . . . .. • • • • • • •• , •• • •
, - 00 :~. ; .. . : . :: .. . ; : ... . . .. . ; . . ...... . ~ ,-0.6 '
3
... ... ... .: .. .... .. . ... .. : .... •.• .
.. ::
~ , ;

~ 2
I
~_ 0.0 ~ . ~:;:~:~:~.~.T.~.- -.~.-.-.-.-.~ 06 ..

1 ·> ~ . 09.:-: ..=

i--.-..-..':.,-..-.-.. -,,":.. .=
=, . =..=. ,=..=..==i.._ ..-..-...:., p_ 0.9 :-:
=.
o.C ............ . ...... .. ............. .... .... ............. ..
~
0 .8 . :.: .:.:::.:: : : : : : : .: .: ~ r·:·:·:',', :"": ~ ', """""'. ', : ~', :: .""',:":', ::::": ", .. ... .....
. , ...... ; ....... .. .......... .: .... .. ... .: ." ..... .
O.G •... . .. . :: .. ::: .... .. .. : •... :: ....'.'.'..• : : ; . .. •. : '. '.'.'.'. : •. •. •. : ......• : ; ::::: : : . . 0 .6 .... . .... •. ... .. . .• •. .. • • •. .• . .. . ...... . . . ... .. ... . .... . .
:.::::: : :~::.'::.-:::
. .... ... ~: :.-:: .'.'.': ;:::: ::::: ~: : :.- '-: ::: i:::::::::
.... , ,, .. .... . ,, ... ...... ... ...... ... ... ...... .. ..
O..c ~ .. . ~ : : : :. : ~ : : : :. : : :. ~. :.J:. :. :. ~. :. :. :.:.:~ :.::::.~. :::~ ~. :. ::~. :. ::. :1:.:~ :.' :.' -" . 0.4 ..... .... ;: ..... .. .. ~ ..........: ......... ~ ... . .. .. . , .... . .. .

0.3 ~ ~::. ~ ~.: ~.: {~~ ~.~ ~ ~ ~ ~.: ~.~.:.: .: .:.:.: .: ~~~~ ~ :~.:.:.: ~ j.: .: ~ ~.:.: .:.: .:!.:.~.:.:.:.: ~.:: 0.3 '.:: , :'::::C ::::::L:: ::::::L::':':':: :.'!.'.'.'.'.'.'.'.' .' i:.'.'::::::
0"
I J: - 4: - 0.(; I · .. <. · . . ·. . :........ ·
·· ~ ·
02
... .... ... ... ........... ...... .. ...

10 .. . ... : ...... . ... .. .... ... : .............. ... .. lo~----~----~----~----~----~----

.. ....... ... .......... .. , ............. ..... ...... . .I
B . . . . . .. • . ;: .... . .. , ..:. • . ••...• , . ...... . . ~ . • ....... ~. 6 ..... .... ; ......... ~ .......... . ... . ... , . . .. . .. ; . .... .. .
.' .'.'.'.'.'::i:::::::: :::::: ·... ~ ..~ j:>: .. ~.'; p-09 .' .'

~;~::m! ; ;:
G •
....... ~
........ . ' . .. H ...... ; ...... . ...
.. p- 00 : ... : .. ... ; ~::::: .... :::: '.:: ' : ' ;::::::::: ;
4 .. '. . .. . ............ . .. ... .. ... ..

o~· :. . ~~. 0:0 ~~::: :::.:;::::: :::. ;: : : : ::::: ~ : :: ::: :

, ....... ....... .., ..... .. .
~.: _.~ .;~··.·--:-I··:--l.: .~' •
:: '··j: 'Y::/:..n.j
0.<> . ••.•. .• . •...... ' •. "' " ••••••.
. .. ::::::.'~:::::::::~::·::::::i:::::::::~ : :::::: .;. ,., . ....
M ::::::::: i:: :::::::;::::::::.'i.'::::::::;:::;:::::i::::::::.
······ i········· :··· ·· ····:····· ·· ··:· ····· ···:· ······ ...
0.3 ... . .. . .. ~ ......... ; ' . .. . ' ... \ . ........ ~ ......... !......
.... .. .... .. . . , .... .. ..... ...... ... ... ... ..... . .
' ~====~--:-~---:--1
01
·1k - 5: r
.
~ 0.9 I·" .. .. .f.... .. ·.. ;····· .. .. f· ........
10· .. ..... .... ..
; .... .. , . ,....... .. . .. . .
6 ......... ; ......... , ......... ; ..... .. . . , ...... ... ; ...... " .
····· ···· : ·· ··· ··· ·:····· ·· ·· l··· ·· ·· ·· :········· :· ··· .... .

i! . :~: ~'_ /
':::.:::~~ . :::::
'-'"~

~., 2+~_ :~ _:~_>~

•• ~._ ·~._ ~._·.
10
~
••·_...... ••..;i_•• .·_
20
... ...' _._••.•_••..;.;;;1;:;.;........_••_-_1_••_••_••_••_••-1.
:10
n ('(I ,n1'l . . . . .)
~o 50
O, ~
OJ
O'
. ::: :. :~~~2tilil}>:::::::·;:
~~:·.:::.':i.':::::~~:·::·. :·::·::;·:::::::: :
10 20 30
n ('(lmph .... )
40 50
 417

Figures 3.1 and 3.2 concern ARMA( 1,1) disturbances for simple tests
(h=l). For models subject to an autoregressive transformation with r-0.3, 0.6
and 0.9 the bounding significance points for p=O, 0.3, 0.6 and 0.9 are
mapped. We see that the bounds for overcorrection (r>p) are interlaced with
those for undercorrection (r<p). Application of the bounds test is now
handicapped because interpolation is required with respect to both p and r,
as is seen in the following example.

ILLUSTRATION 3: In Maddala (1977, p.195) Cobb-Douglas production

functions are estimated and the hypothesis of constant returns to scale is
tested. The analysis is based on 39 annual data on U.S. gross product and
labor- and capital-input. For one particular specification we find (note that
there are some misprints in Maddala's book):

In X -2.532 + 1. 519 In L2 + 0.292 In K2 + 0.014 t + e ,

(10.86) (3.61) (4.86)

w1tere t is a linear trend and figures in parenthesis are again t-ratios;

R and for the test of HO:.8 2 +.8 3- l a t-value of 4.48 is found. So, under
~0.99

the assumption p~O the hypothesis is rejected. Figure 1 shows that for
0~p~0.5 the hypothesis of constant returns can still be rejected. But, as we
are cautious with respect to serial correlation, we of course should also
test the hypothesis HO: p=O The Durbin-Watson statistic turns out to be
0.839, which is significant at the 5 percent level. Although this may as well
be an indication of some other form of misspecification, we will here assume
that an autoregressive transformation of the model is the correct remedy. We
choose r=0.58 (since the Durbin-Watson statistic is used to estimate p)
which leads to the (conditional) GLS estimates

In X -1.774 + 1.325 In L2 + 0.285 In K2 + 0.016 t + e

(8.42) (2.27) (4.85)

and the test statistic for .8 2 +.8 3=1 is now 2.96 . With some trouble Figure
3.2 indicates that now even for 0~p~0.6 the hypothesis that the returns to
scale are constant must be rej ected. When r-O. 3 is used, the t-value is
3.95 and now the diagram clearly shows that rejection of the null hypothesis
is indisputable for 0~p~0.6 . Apparently as a result of the transformation
of the model the estimates and tests are a bit more efficient and the
robustness has improved.

From the above we may conclude that straightforward tests on the values
of (functions of) regression coefficients may acquire more reliability with
respect to unknown serial correlation by making reference to the boundary
critical values. The ensuing test procedure guarantees Type I errors not
exceeding 5 percent under a composite assumption concerning serial
correlation. The bounds for actual type I errors given in the Tables 1 and 2
show that the significance level of the ordinary t- and F test procedures is
completely out of control when the disturbance terms are dependent. This
problem is extremely serious when the first-order autocorrelation coefficient
is close to unity, as is also shown in Kramer et al. (1991). From our
diagrams it is obvious that the probability of inconclusiveness of the bounds
test procedure approaches unity when very high values of the correlation
coefficient are not excluded. So, in cases where very serious serial
correlation may be relevant, inferences are better not based on the usual t-
and F-statistics; then also the hounds procedure falls short, and the more
 418

elaborate approaches suggested in Dufour (1990) seem a promising alternative.

Acknowledgements
This is a revised version of an unpublished paper presented at the European
Meeting of the Econometric Society in Athens, 1979. Helpful discussions over
the years with many people, notably Jean-Marie Dufour and Walter KrAmer, are
gratefully acknowledged, as well as the comments by a referee and the editor
of this volume.

References
Dufour, J-M. (1990), "Exact Tests and Confidence Sets in Linear Regressions
with Autocorrelated Errors", Econometrica, 58, 475-494.
Huang, D.S. (1970), Regression and Econometric Methods, New York: John Wiley.
Kiviet, J.F. (1980), "Effects of ARMA Errors on Tests for Regression
Coefficients: Comments on Vinod's Article; Improved and Additional
Results", Journal of the American Statistical Association, 75, 353-358.
KrAmer, W., J.F. Kiviet and J. Breitung (1991), "True vs. Nominal Size of the
F-Test in the Linear Regression Model with Autocorrelated Errors", this
volume.
Maddala, G.S. (1977), Econometrics, Tokyo: McGraw-Hill Kogakusha. 2. the
Neudecker, H. (1977), "Bounds for the Bias of the LS Estimator of a l.n
Case of a First-Order Autoregressive Process (Positive utocorrelation)"
Econometrica, 45, 1257-1262. 2
Neudecker, H. (1978), "Bounds for the Bias of the LS Estimator of a in the
Case of a First-Order (Positive) Autoregressive Process when the
Regression contains a Constant Term", Econometrica, 46, 1223-1226.
Sathe, S.T. and H.D. Vinod (1974), "Bounds on the Variance of Regression
Coefficients due to Heteroscedastic or Autoregressive Errors",
Econometrica, 42, 333-340.
Vinod, H.D. (1976), "Effects of ARMA Errors on the Significance Tests for
Regression Coefficients", Journal of the American Statistical
Association, 71, 929-933.
Vinod, H.D. and A. Ullah (1981), Recent Advances in Regression Models, New
York: Marcel Dekker.
Watson, G.S. (1955), "Serial Correlation in Regression Analysis In,
Biometrika, 42, 327-341.
TRUE VS. :;OYlINAL SIZE OF THE F-TEST IN THE LINEAR REGRESSION MODEL

WITH AUTOCORRELATED DISTURBANCES *

Walter Kramer
Universitat Dortmund, Fachbereich Statistik
Lehrstuhl Wirtschafts- und Sozialstatistik
Vogelpothsweg, D-4600 Dortmund 50, FRG

Jan Kivi et
University of Amsterdam
Faculty of Economics and Econometrics
23 Jodenbreestraat, 1011 NH Amsterdam, Netherlands

Jorg Brei :ung

Universitat Hannover
Fachbereich Wirtschaftswissenschaften
Wunstorfer Str. 18, D-3000 Hannover 91, FRG

Abstract

We demonstrate the extreme non-robustness of the F-test to autocorrelation

among the disturbances in the linear regression model, and characterize
design-matrices such that the true size equals unity.

Keywords: F-Test, autocorrelation, null distribution.

Contents

1 The problem
2 Non-robustness to autocorrelation
3 Empirical examples
4 Conclusion

1 The prob I em

This note is concerned with the null distribution of the well-known F-test of
a general linear restriction in the standard linear regression model, when the
disturbances are ill-behaved. More formally, we consider the model

y ="
VJ X(1)3(l)
+ u =, I +
X(2)(3(2) + u , (1)

where y and u are Tx1, X is TxK, nonstochastic and of rank K < T and
the design matrix has been partitioned into X(l)(Txq), 1 < q < K, and
X (2) (Tx (K-q) ) .

* Research presented at the Second International Conference on Econometric

Decision Models and supported by the Deutsche Forschungsgemeinschaft (DFGl.
AI I computations were done wi th the I/\S-SYSTEM econometric software package.
 420

The null hypothesis under test is

(2 )

for some fixed (q;.;l)-vector bel) This particular way of putting the null
hyphothesis involves no loss of generality, since any linear hypothesis about
the unknown regression coefficients can always be cast in the form (2) by
appropriate reparameterization.

The familiar F-test of the null hypothesis (2) is based on the statistic

1\ 1\
u'(M(2)_
rv '"
(u'u - u'u)/q M)u/q
F A A
(3)
u'u I(T-K) u'Mu/(T-K)

A A
where u y X~ is the vector of the residuals from the unrestricted

estimator p (X'X)-lX'y, and u = y - X(1)b(1)_ X(2)~(2) is the vector of the

residuals from the restricted estimator ~(2)= (X(2)'X(2»-lX(2),(y -
X(1)b(1»). Under HO' these vectors of residuals can also be expressed as ~
Mu and u = M(2)u , where M = I - X(X'X)-1 X' and M(2)= I -
2
X(2)(X(2)'X(2»-1 X(2),. The test assumes that u N(O, a ul) and rejects HO
for

F > Fa (4)
- q,T-K

where Fa is the (l-a)-quantile of the central F-distribution with q and

q,T-K
T-K degrees of freedom, and a is the significance level of the test.

It is well known (see e.g. Lehmann, 1986, p. 369) that (4) is uniformly
most powerful among all invariant tests, if the disturbances are indeed
n.i.d.(O,(J"2 l , as has been required in the derivation of the test. Much less
u
is known about the test if this crucial condition fails. One can then either
think of completely different tests or check the robustness of the standard
test in nonstandard situations. In particular, statisticians have long been
concerned with the size of the test, i.e. with the true probability of the
event (4), under conditions of (i) nonnormality, (ii) heteroskedasticity, and
(iii) autocorrelation of the disturbances in the regression model.

Below we focus on the latter case (autocorrelation), i.e. on the linear

regression model with cov(u) = (J"2V , where V is the correlation matrix of the
u
disturbances, retaining the assumptions of normality and homoskedasticity. Our
problem is: How far can the true size of the test differ from the nominal
a-level if V;t'. I ?

This issue has been addressed bv various authors from different view-
points. ~euwirth (1982) and Tranquil\i and Baldessari (1988) derive conditions
on X and V such that the true size equals the nominal size. Watson (1955) and
Watson and Hannan (1956), among others, show that these can differ markedly.
 421

Vinod (1976) and Kiviet (1980) derive explicit and attainable bounds for the
size of the test, given some specific V, and arbitrary X. Kramer (1989 a,b)
and Kramer et al. (1989) on the other hand fix the design matrix X and
consider the size of the test as a function of the correlation matrix V, with
the main result that the true size can be as large as unity.

Below we expand upon this latter theme. We characterize design matrices

where this can happen, and demonstrate the relevance of this result with
examples from the empirical literature.

2 Non-robustness to autocorrelation

Following Kramer (1989 a,b) and Kramer et al. (1989), we confine

ourselves to stationary AR(l)-disturbances

ut p u t _1 + c t (lpl< 1, t = 1, ... ,T), (5 )

where

T-l
1 p
PT-2
P 1 P
2
P P
V ( 6)

T-l T-2
P P 1

The rationale is: If the null distribution of the F-test is quite erratic in
this simple case, the same applies a fortiori to more general error models
which comprise AR(1}-disturbances as a special case.

Given (5) and (6), the null hypothesis under test can be rephrased as

(7 )

2
where we take explicit notice of the nuisance parameters ~u

p. The true size of the test is

true
a P(F (8 )
< 1

which is always greater than the nominal a. The only question is, how much?

Kramer (1989 a,b) and Kramer et al. (1989) show that a true = 1 is
possible. Below we characterize design matrices where this happens. To this
purpose, let j 11,1, . . ,11' and e 11,_1,1,.,(_I)T-1 1, Let <X> and
(2) denote the column spaces of X and X(2), respectively
<X >
 422

Theorem: The true size of the F-test equals unity if and only if one
or more of the following conditions hold:

i'(M(2)_ M)i/q > Fa

(i ) i ftc <x> and
i'Mi/(T-K) q,T-K

e'(M(2)_ M)e/q > Fa

(i i ) e rt <X> and
e'Me/(T-K) q,T-K

(iii) i E <X> and i rt <X(2»

(iv) e E <x> and e ftc <X(2»

Comment: The condition i ftc <x> implies that there must be no intercept in the
regression (since i itself would then appear as a column of X). For all
practical purposes, case (i) therefore applies to regressions without an
intercept. By the same token, (iii) applies to regressions with an intercept,
where the intercept is excluded under HO'

Conditions (i) and (ii) involve the nominal a-level of the test. They
mayor may not hold in a given application, depending on a. In fact, they can
always be made to hold by choosing a large enough. Conditions (iii) and (iv)
on the other hand do not depend on a, i.e. they induce a true size of unity no
matter how small the nominal significance level is.

Proof of the Theorem: The rejection probability of the test can be expressed
as

u'(M(2)_ Mlu/q
P ( ~ Fa
u'Mu/(T-K) q,T-K

q
Fa u'M u ~ 0 1
q,T-K
T-K

q a
P (u'lM(2) - dM)u ~ 0 ) (where d 1 - - F
T-K q,T-K

(where f. V- 1 / 2u ~N(O,I))
(J

T 2
PC I Tt t ~t ~ 0 ) , (9 )
t=l
 423

c 2 are 11
.. d 2 . 1/2 (2) 1/2
where ~t XI 1 I and ~t are the eIgenvalues of V (M - dM)V ,and
therefore also of

(10 )

The probability (9) is strictly less than one for all correlation
matrices V of the form (6), where Ipl< 1. This follows from the fact that
M(2 )_ dM has at least two non-zero eigenvalues of different sign, so by
Sylvester's law of inertia (see result 5.7.3 in Marcus and Minc, 1964) the
same is true for V1/2 (M(2)_ dM)V 1/2 . Since in addition the probability (9) is
a continuous function of p, a supremum of one can only occur as the limit of
(9) as p ~ 1 or as p ~ -1.

The limiting rejection probabilities as Ipl ~ 1 are determined by the

limiting eigenvalues of (10), where

1 i m VU/ 2 ) - dM) = Y+CM(2)_ dM) , (11)

{HI

1 i m VCM(2)- dM) Y-CM(2)_ dM), C 12)

{H-1

wi th

1 1 1
1 1
y+ ii' ( 13)

1 1
and

1 -1 (_1)T-1
-1 1 (-1) T-2
V ee' (14)

Since both y+ and V have rank one, at most one of these limiting eigenvalues
is different from zero. It can be obtained as

(15 )

and

(16 )
 424

respectively, where (15) is easily seen to be positive under conditions (i)

and (iii), and (16) is positive under conditions (ii) and (iv). For the size
of the test to be equal to unity, it is therefore sufficient that at least one
of these conditions holds.

For the proof of the necessity, assume that all conditions fail. The
expressions (15) and (16) are then either zero or negative. If they are
negative, the limiting rejection probability tends to zero as ipi 4 1. If they
are zero, the situation is more complicated, because this implies that (11)
and (12) are zero, so all the 7r'S from (9) will also tend to zero, and their
limit can no longer be obtained from the limit of the 7r s. t
Consider first the case where p 4 1, and rewrite (9) as

p (17)

where 7r t /(1-p) , t = 1, ... ,T, are the eigenvalues of l~P V(M(2)_ dM). These
eigenvalues have limits equal to the eigenvalues of

lim _1_ V(M(2)_ dM) = lim _1_ (V _ ;;;+)(M(2)_ dM)

p41 1-p p41 1-p
(18)

where by I'Hopital 's rule,

0 1 T-1
0 T-2
2 T-3
W+ lim (V - ;;;+) (19)
1-p
p41
T-1 T-2 0

Since W+ has full rank, we infer that W+(M(2 1- dM) ~ 0, with eigenvalues not
all equal to zero. Again by Sylvester's law of inertia, we see that at least
two nonzero eigenvalues must have opposite signs, so the limit as p41 of (17)
must be strictly less than one.

Along the same lines, we see that

T 7r t 2
(20)
lim P ~ l+p Et ;;: 0 ) < 1
p4-1 t=l
 425

Here, the limiting probability is obtained from the eigenvalues of

lim 1 V(M(2)_ dM)

~-1 +p

where

o 1 (T_l)(_I)T-l
1 o (T_2)(_I)T-2
-2 (T_3)(_I)T-3
w 1
(22)

(T-l) (_I)T-l o

is likewise nonsingular, so W-(M(2)_ dM) has at least two nonzero eigenvalues

of opposite sign. We have therefore shown that the size of the test must have
a limit strictly less than one both as ~1 and as p ~ -1, if V+(M(2)_ dM) = 0
or V (M(2)_ dM) = 0, so the conditions (i)-(iv) exhaust all cases where the
size of the test can be equal to one. 0

3 Empirical examples

Next we illustrate the seriousness of the problem by computing the size

of the F-test for some design matrices from the empirial literature, using
expression (9) and Koerts' and Abrahamse's (1969) FQUAD subroutine. The data
are the same as in Kiviet (1980), i.e. models (3.17E) and (5.23a) from Huang
(1970) .

We consider first the simple linear model with two regressors

(23)

where K = 2, T = 11, and the x 's are from Huang (1970, p. 21, table 3.3). If
we test HO ~2 = 0, neither of the conditions (i) - (iv) in the theorem

appl ies, so the size of the test is less than unity. Table 1 reports the
exact rejection probabilities, given a nominal significance level of Q = 5%.
for various values of p (The entries under p = -1 and p = 1 are the limiting
values as p ~ -1 and as p ~ +1). The table also gives the exact rejection
probabilities of the test of HO ~1 = O. For p ~ +1, condition (iii) applies,

so the size of the test equals one.

Table 1 shows that the test is conservative for both null hypotheses for
negative p, even producing a limiting rejection probability of zero as p ~ -1.
As expected from the proof of the theorem, the true size of unity of the test
of HO : ~1 = 0 is attained as the limiting rejection probability as p ~ 1.
 426

Table 1 True size of the F-test in a simple regression model with two
regressors (percent)

absolute value of rho

hypothesis
0 o.1 0.2 0.3 0.4 0.5 0.6 0 .7 0.8 0.9 0.99

a) positive rho

/3 2 0 5 5 .2 5.3 5 .4 5 .5 5. 4 5.3 5.0 4.6 4.1 3. 6 3.5

.8 1 0 5 5 .3 5.7 6. 1 6. 5 7. 1 8 .0 9. 6 13.4 24 .5 69 .0 100

b) negative rho

.8 2 0 5 4 .8 4 .6 4 .4 4.2 3 .9 3. 6 3. 1 2.4 1.4 o. 3 0

.8 1 0 5 4 .7 4 .4 4. 3.8 3. 5 3. 1 2. 6 2.0 1.2 o. 3 0

Table 2 gives the analogous results for the model

(24)

where T = 20, K = 5, x t3 ' x t4 and x t5 are quarterly seasonal dummies, and x t2

is from Huang (1970, p97, table 5.1). The null hypotheses under test are HO
(33 = (34 = (35 = 0 (no seasonal effects) and HO : /31= 0, respectively. In the
latter case, condition (iii) produces a size of one for the test.

Tabl e 2 True size of F-test in a multiple regression model (percent; T=20)

absolute value of rho

hypothesis
0 .1 .2 .3 .4 .5 .6 .7 .8 .9 .99 1

a) positive rho

/33=(34=/3 5 =0 5 4 .3 3. 6 2 .9 2. 2 .7 1.3 .0 0.8 O. 7 O. 7 0.7

(31 = 0 5 6. 6 8. 7 11 .4 14 .7 19. 1 24 .6 31 .7 40.7 52. 1 68. 3 100

b) negative rho

/33=(34=3 5 =0 5 5 .7 6. 6 7 .8 9. 7 12 .6 17. 1 24. 3 35. 5 53. 7 85. 6 100

/3 1 = 0 5 3 8 2 .8 2. .6 .2 0.9 O. 8 .0 2 .8 37 .5 100
 427

For p --) +1, the size of the test equals one, like in table 1.

Contrary to table 1, we now have limiting rejection probabilities of one

a 1 so asp --) -1, for bo t h nu 11 hypo the s e s .

Table 3 shows the same as table 2, but now for T 31. The results in
table 3 are essentially the same as those in table 2.

Table 3: True size of F-Test in a mUltiple regression model (percent; T=31)

absolute value of rho

hypothesis
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 0.99 1

a) positive rho

(33=(34=(35=0 5 4.1 3. 3 2.4 1.7 1.1 0.7 0 .4 0.2 0.2 0.1 0.1
(31 = 0 5 6.8 9. 1 12.0 15.8 20.6 26.8 34. 7 45.1 58.5 76.3 100

b) negative rho
(33=(34=(35=0 5 5.8 6 .8 8.2 10.2 13.3 18.0 25.3 36.5 54.7 86.4 100
(31 = 0 5 3.6 2 .5 1.8 1.2 0.9 0.7 0.7 1.2 4.8 50.0 100

4 Conclusion

The conventional F-Test is extremly non-robust to autocorrelation of the

disturbances of the model, in the sense that a significant value of the test
statistic can equally well be due to autocorrelation rather than a violation
of the linear restrictions under test

References

Kiviet . .J.F. (1980), "Effects of AR'<lA Errors on Tests of Regression

Coefficients: Comments on Vinod's Article, Improved and Additional Results",
Journal oJ Ihe American Slalis[lcal Assocla[ion 75, 353-358.

Koerts, J. and Abrahamse, A. P. J. (1969), On [h~ Theory and Application of

[he Ceneral Linear Model, Rotterdam: Rotterdam University Press.

Kramer, W. (1989a), "On the Robustness of the F-Test to Autocorrelation among

Disturbances". Econunllcs Le{{crs 30, 37-40.

Kramer IV (1989b), "The Robustness of the Chow-test to Autocorrelation among

Disturbances", in: P. Hackl led.), SI([[llIical Analysl.1 alld Foreca.lling of
Economic Siruciural Change, Berlin: Springer, 45-52.
 428

Kramer, W., Kiviet, J. and Breitung, J. (1989), "The Null DiSlrihution of the
f-Test in Ihe Linear Regression Model wilh Autocorrelated Dislurhances·,
to appear in Statistica.

Lehmann, E., (1986), Tesling Sialislical Hypolheses (2nd ed.) New York: Wiley.

Marcus, M. and Minc, H. (1964), A Survey of Matrix Theorv and Matrix

Inequalilies, Boston: Allen and Unwin.

Neuwirth, E., 1982), "Parametric Deviations in Linear Models", in: IV.Grossman

et al .(eds.): Probahility and Sialistieai Inference, Dordrecht: P. Reidel,
257-264.

Tranquilli, G.B. and Baldessari, B.,(1988), "Regression Analysis with

Dependent Observations: Condition for Invariance of the Distribution of an
F-Statistic", Statistiea 48,49-57.

Vinod, H. D. (1976), "Effects of ARMA Errors on the Significance Tests for

Regression Coefficients", Journal of the American Statistical Association 71,
929-933.

Watson, G. S. (1955), "Serial Correlation in Regression Analysis I",

Biometrika 43, 436-448.

Watson, G.S. and Hannan, E.J. (1956), "Serial Correlation in Regression

Analysis II", Biometrika 43, 436-448.
ASYMPTOTIC AND SHALL-SAMPLE PROPERTIES OF THE FIXPOINT-ESTIHATOR
FOR RATIONAL EXPECTATIONS MODELS

Manfred Losch
Ruhr-Universitat Bochum
Faculty of Economics
P.O.Box 10 21 48
D-4630 Bochum 1, FRG

Abstract
The extension of WOLD's distribution free fixpoint-(FP-)
estimation principle to simultaneous systems, which contain
rational expectations variables, has been shown to be a very
powerful estimation technique especially with respect to
econometric system predictions. The FP-estimator is introduced
and its asymptotic properties (consistency, asymptotic
distribution) are presented. Furthermore, EFRON's bootstrap and
TUKEY's jackknife are available to assess the variability of the
estimates. A brief review of the bootstrap and jackknife idea in
the context of the considered rational expectations model will be
given. An application of the presented techniques is illustrated
in an example.
Keywords: Rational expectations; identification; fixpoint-
estimator; bootstrap; jackknife.

Contents
o Introduction and summary
1 The RE-model
2 Identification
3 The fixpoint-(FP-)estimation principle
4 Asymptotic properties of the FP-estimator
5 Alternatives to the conventional asymptotics: TUKEY's
jackknife and EFRON's bootstrap
6 Application
References

o Introduction and summary

In recent years models containing unobservable rational
expectations (RE-models) gained increasing importance even in
applied econometrics. In the following the term 'rational
expectation' is used in accordance with the definition given by
MUTH (1961), which, for instance, can be summarized in the
sentence that economic units' predictions are as correct as those
of the relevant economic model.

The first main part of the paper deals with the problem of
identification of simultaneous RE-models. As PESARAN (1981)
pointed out, it is important to distinguish between exogenous
variables, say Xl , which cannot be anticipated precisely, and
 430

between those, say X2, like dummies, time trends etc. which are
perfectly predictable. With respect to the not perfectly
predictable variables Xl a further distinction can be considered:
(i) The predictions Xl+ are given or (ii) the predictions Xl+ are
generated by a process which is not completely known. For case
(i) identification criteria have been derived by WALLIS (1980),
PESARAN (1981) and WEGGE and FELDMAN (1983a). Furthermore WEGGE
and FELDMAN (1983b) have shown that PESARAN's result is not
correct to some extent. The present paper is restricted to case
(ii) and, following PESARAN (1981), an autoregressive process of
known order is assumed to generate Xl. The actual structural
model is given by a linear simultaneous system containing current
expectations and lagged endogenous and exogenous variables. Under
linear identifying restrictions on structural coefficients within
the same equation an order and rank condition is presented which
contrasts with PESARAN (1981). As a simple counter-example
SARGENT's (1976) two equations model is adduced.
In the third chapter the extension to the above RE-model of
WOLD's (1965, 1980) distribution free fixpoint-(FP-)estimation
principle is introduced. This extension is not new at all. It has
already been treated in detail by LOSCH (1984) even for models
containing future rational expectations variables. It has been
shown to be a very powerful estimation technique especially with
respect to econometric system predictions; see SCHIPS (1988).
Chapter 4 deals with the asymptotic properties of the FP-
estimator. Under the given assumptions the strong consistency of
the estimator can be stated. Furthermore the asymptotic
distribution of the FP-estimator is given, generalizing
LYTTKENS' (1973) result for classical models, i.e. models without
rational expectations. The derivation of the asymptotic
distribution makes use of the presented identifiability
criterion. Since the asymptotic distribution is explicitly given,
it is possible to get estimates for the standard errors of the
FP-estimator by using the asymptotic variance-covariance matrix.
Therefore an objection to the FP-estimation of RE-models is
removed, which arose from the fact that it was up to now
impossible to assess the standard errors on the basis of
conventional asymptotics.
Since the computation of the standard errors has to be done
simultaneously and requires the inversion of large matrices this
computation is almost impossible for large models. Thus it is of
great importance that two further methods, TUKEY's jackknife and
EFRON's bootstrap, are available to assess the variability of
estimates; see TUKEY (1958), MILLER (1974) and EFRON (1979).
Chapter 5 gives a brief review of the jackknife and the bootstrap
idea in the context of the considered RE-model and the FP-
estimates. The result is presented that the bootstrap is
asymptotically as correct as the conventional asymptotics. But in
general there is good empirical evidence that the bootstrap
outperforms the conventional asymptotics; see EFRON (1979, 1982),
or FREEDMAN and PETERS (1984a,b).
The objective of chapter 6 is to illustrate the performance of
the three competing procedures in a real example. The
 431

application seizes upon a small RE-model which was presented

originally by NEUMANN (1981) and which has been slightly modified
by the author.

1 The RE-Model

Consider the following linear multivariate model

yet) = ~h=O,H Bhy(t-h) + Ay+(tlt-1) ( 1. 1 )
+ ~r=O,R Drx(t-r) + U(t)
with diag BO=ONxN for every t E Z. The parameter matrices En, A
and Dr are of dimension NxN, NxN and NxM, respectively, and
the vectors yet-h), y+(tlt-1), x(t-r) and u(t) have N, N, M and
N elements, respectively. The endogenous variables yet-h) and the
exogenous variables x(t-r) are observable, whereas y+(tlt-1)
represent unobservable expectations, formed in period t-1 about
the values of the endogenous variables yet).
In accordance with the rational expectations (RE) hypothesis,
y+(tlt-l) is given as the expectation of yet) implied by the
model, conditional on information +Qt-l available at time t-1,
i.e

y+ (t I t-1) : = E (y (t) I + Qt - 1) , (1. 2)

where
zQt:= {z(t),z(t-1),oo. } ,
( 1. 3)
+Qt : = z Qt v {y ( t ) }
and

z(t):=[y(t-1)', ... ,yet-H)' ,x(t)', .. ,x(t-max(R,S)']' (1.4)

denotes the vector of predetermined variables containing
K:=NH+(max(R,S)+l)M elements.
We postulate the following assumptions:
IN-Bo and IN-Bo-A are nonsingular. (Al)
E(u(t) IzQt )=ONxl (A2)

From (A2) we immediately get E(u(t»=ONxl and

y+ (t I t-l) = (Eo +A) y+ (t I t-1) + ~h =1 ,H En Y (t- h) (1. 5)
+ Dox+(tlt-1) + ~r=l,R Drx(t-r)
where
x+(tlt-l):= E(x(t)I+Qt-l) . (1. 6)

Therefore the unobservable rational expectations y+(tlt-1) depend

on the formation of expectations for the exogenous variables and
will necessarily be conditional upon the process generating x(t).
Let x(t) be partitioned into Xl (t) with M1 elements that cannot
be anticipated exactly and into an (M2x1)-vector X2(t) (M2:=M-M1)
 432

containing variables like dummies, time trends etc. which are

perfectly predictable, i.e.

xl+(tlt-1);:XI (t) and xz+(tlt-1)=xz(t)

Furthermore we parti tion Dr = [Or. 1 ,Dr. 2] conformably to

x(t)'=[Xl(t)',X2(t)'] , i.e. Drx(t)=Dr,IXl(t)+Or,2x2(t) and
00 x+ (t I t-l ) =Do , 1 Xl + (t I t-l ) +00, 2 X2 (t) .

Following PESARAN (1981) we postulate the following assumptions

with respect to the exogeneity of Xl (t) and to the linearity of
the process generating Xl (t):

Xl (t) follows a multivariate stationary S-th order (A3)

autoregressive process

Xl (t) = ~s" 1 ,S 1{sX ( t - s) + e ( t ) (1.7)

= ~S" 1 • S [11:s. 1 Xl (t - s) + 7ts, 2 X2 (t - s )] + e ( t )

E(e(t) IzQt - {Xl (t)})=OMlal . (A4)

Assumption (A4) implies E(e(t»=OMlxl

E(e(t)u(t)')=OMlxN (A5)

(xz(t),u(t),e(t» are i.i.d. and E{lxz(t),u(t),e(t)14} (A6)

< m for t E Z, where i I denotes the Euclidian norm.

The predetermined variables z(t) follow an ergodic and (A7)

stationary process with: E(z(t)z(t)')=:~zz is
nonsingular.

Without loss of generality we can assume H=R=S=l. Setting B:=Bo

and 1£:=7tl we consider the following model:

yet) = By(t) + Ay+(tlt-l) + Bly(t-1) + DO,lxl (t) (1. 8a)

+ Do, 2 X2 (t ) + 01 X ( t -1) + u ( t )

and

Xl (t) = 11:x(t-1) + e(t) (1. 8b)

= KIXI (t-1) + K2X2(t-1) + e(t)

where

7t =: [Kl ,K2 ] . (1. 9)

We get

y+(tlt-l) = (B+A)y+(tit-1) + Bly(t-l) + DO,lXl+(tlt-1) (1.10)

+ Do, 2XZ(t) + DIX(t-l)

with

xl+(tlt-1) = 1Ix(t-1) (1.11)

 433

The use of (1.10) gives the following 'empirically observable

reduced form' of (1.8):

yet) = TIly(t-1) + TI2Xl(t) + TI3X2(t) + TI4x(t-1) + vet), (1.12)

where

TIl :=(IN-B-A)-lBl (1.13a)

(1.13b)

TI3:=(IN-B-A)-lDO,2 , (1.13c)

TI4 :=(IN-B-A)-lDl + (IN-B)-lA(lN-B-A)-lDo,17[ (1.13d)

and

V(t):=(IN-B)-lU(t) (1.14)

Sometimes it is favourable to put the two models (1.8a) and

(1.8b) together. For that reason the following definitions are
introduced:

(1.15)

y(t):= rX1(t)] y+(tlt-1):= [Xl+(tlt-1)]

Ly(t) y+(tlt-1)

u(t):= [
e(t)]
u(t)
X2 (t) : =
[ X2 (t)
X2 (t-l)
]

B .· -- [
OHlllHl
Do, 1
~H1I1N ] Bl : = [
1(1
Dl, 1
OHlll N ]
Bl

G ·. -
[ OHlll H2
DO,2 Dl,2 ] .
A· -
[ OHlll Hl
ONII Hl
~Mlll N ]

Now (1.8a) and (1.8b) can be written in the following way:

yet) = By(t) + Ay+(tlt-l) + Bly(t-l) + GX2(t) + u(t) (1.16)

Furthermore we get

y+(tlt-l) = (B+A)y+(tlt-l) + Bly(t-l) + GX2(t) (1.17)

Therefore

yet) = (IH1+N-B-A)-lBIY(t-1) + (IMl+N-B-A)-lGx2(t) (1.18 )

+ (IM1+N-B)-lu(t)

and, by (Al), the matrices (IHl+N-B-A) and (IHl+N-B) are

invertible.
 434

Define
(1. 19)

nl := [ Kl OHlxN Jl
(IN-B-A)-l (Dl, l+Do, lKl) ( IN - B-A) - 1 Bl

- [
n2 :=
OHl J[ Hl
(IN-B-A)-lDo,2
1[2
(IN-B-A)-l (Dl, 2+Do, 11[2)
] and

=[ e(t)]
(IN - B) -1 Do, 1 e (t) + v (t)

Then we get the following empirically observable reduced form

(1. 20)

Furthermore, we assume
11Th II < 1, where II II is the operator norm (AB)
11Th U=sup{lfhyl; IYI~l } .
If ~(C) denotes the spectral radius for any (nxn)-matrix C, we
get max(n:n )'nnl »= ~(i'h )S;IITI111<1 and the final form
(1. 21)

of (1.20) and the final forms

yet) = }:-r=o, "" (ITl)1: [n2Xl (t--r.:)+n3X2 (t--r.:)+n4x(t-1--r.:)] (1.22 )
+ }:-r=o,"" (TIl )-rv(t--r.:)

and
( 1. 23)

of (1.8) exist.
If we admit that the first Nb equations of (1.8a) are behavioural
equations and that the last Ni:=N-Nb equations are identities, we
introduce the following partitions:

B = lBll
r

B2l
B12]
B2Z
, A = [All
AZl
A12]
Azz
Nb
Hi
( 1. 24 )

Nb Hi Nb Hi
with a priori known matrices B12, BZ2, AZl and Azz,
(1.25 )

yet) = rlyiyb (t)]

(t)
, u(t) = rUb (t)]
Lui (t)
, vet) = [ Vb (t)]
vi (t)
Nb
Ni

with u i (t)=ONixl
 435

Completing (A1) and (A7) we assume

INi -B22 , INi -B22-A22 and E(u b (t)u b (t)' )=:2:u, bare (A9)
nonsingular.

Similarly, it can be assumed that only the first M1b equations of

the AR-process (1.8b) are not completely known whereas all
coefficients of the last M1i:=M1-Mlb equations are given. Then we
introduce the partition

e(t) =
i
(t)]
rebe (t) MIb
Mli
( 1. 26)

We add the assumptions:

E(eb(t)eb(t)' )=:2:e, b is nonsingular. (A10)

Model (1.8) contains at least one behavioural equation (All)
with a constant term.

Finally we shall consider restrictions on the elements of the

coefficient vectors of the Nb behavioural equations of (1.8a).
Since in the context of full-information methods nonhomogeneous
linear restrictions on coefficients within the same equation can
be reduced to point restrictions ai=Ci (ai coefficient, Ci ERa
priori known), we shall only admit point restrictions. For
further details see chapter 2.

2 Identification

We choose a concept of identification which follows the one given

by SCHONFELD (1971) for nonstochastic exogenous variables and
which has been treated in detail for classic linear models
(A=ONxN) with stochastic exogenous variables by LOSCH (1980).

Starting-point is the conception that model (1.8) can be

considered to be a set H of all structures

S= (B , (X2, U, e; Z) ) (2.1)

where

<X2,u,e;Z}:= { <x2,u,e;J> ; ,t.:l:J=Z , J finite} (2.2)

<X2,u,e;J):= distribution of the process (2.3)

{(X2(t),u(t),e(t»; t E J}
and

0:= aggregate of all model parameters. (2.4)

If e is any subaggregat of B with parameter space e define th n
mapping

fa H -> e
 436

by
fa(5):=8 for every 5 E M (2.6)
and assume 8=fe(M).
Furthermore we write
JT:= {1, ... ,T} for any TEN (2.7)

and
(2.8)
<S>T:= <y,z;JT>
distribution of the process {(y(t),z(t»;t E JT}
which can be generated by using the final forms (1.22) and (1.23)
and which depends on 5 E M.
Then we introduce the following definitions:
Definition 2.1: For 5 E M and TEN 5* is said
T-observationally equivalent to S in H
in M ) iff 5* E Hand <S>T=<S*>T.
Write
KT(5):= {5* E H; 5-T5* in M} (2.9)
Definition 2.2: Call e T-identifiable in M for 5 E H iff
faIKT(5) is constant.
Call 8 T-identifiable in H iff e is T-
identifiable in M for every 5 E M.
Definition 2.3: For 5 E M 5* is said to be observationally
equivalent to 5 in M (5-S* in M) iff S-TS*
in M for every TEN.
Write
K(5):= {S* EM; S*-S in M} = n TEM KT(S). (2.10)
Definition 2.4: e is called identifiable in M for S E H iff
faIK(5) is constant.
e is called identifiable in M iff e is
identifiable in H for every S E M

This identification concept coincides with the one considered by

WEGGE and FELDMAN (1983a) and PESARAN (1981) for normally
distributed variables and with ROTHENBERG's (1971) concept for
parametric distribution assumptions. Furthermore the following
statement holds (LOSCH, 1980).
 437

Proposition 2.5: H model with parameter a.

(a) a is identifiable in H if an unbiased

estimator for 8 exists.

(b) 9 is identifiable in H if a consistent

estimator aCT), TEN, for 8 exists.

Thus the matrix x of the AR-Modells (1.8b) and the reduced form
matrices TIl, TI2, TI3 and TI4 are identifiable under the given
assumptions, since they can consistently be estimated by ordinary
least-squares.

In the following this identification concept will be used to

identify the structural form matrices of RE-model (1.8a).

Write

<z,u,e;N}:= { <z,u,e;J> ·H:J -= N , J f ini te } (2.11)

where

<z,u,e;J}:= distribution of the process

{(z(t),u(t),e(t»; t E J } .

Then the following result is obtained which is a generalization

of the corresponding statement for classic simultaneous systems
(see SCHONFELD (1971) and LOSCH (1980». For a detailed proof of
theorem 2.6 and all the following results of chapter 2 see LOSCH
(1987, chapter 2).

Theorem 2.6: Let M be model (1.8) and assume (A1)-(A8) and

S, S* E H. Then it is equivalent:

(a) S~S* in H .

(b) There exist nonsingular (NxN)-matrices r1 and

r2 such that

(i ) rl [Bl ,Do. 2 , Dl + Do. 1 x]

=[B1*,Do, 2*,Dl*+Do, l*X*]
(ii ) r2 Do , 1 =Do , 1 *
(iii) r1 (IN-B-A)=IN-B*-A*
(iv) r2 (IN-B)=IN-B*
(v) <z,r2u,e;N>=<z*,u*,e*;N>

and x=x*.

The next theorem again is a generalization of a corresponding

statement for classic simultaneous systems (see SCHONFELD (1971)
and LOSCH (1980».
 438

Theorem2.7: Let H be model (1.8) and assume (Al)-(Al0). H

contains identities in the structural model (1.8a).
But suppose that with the exception of diag B=ONxN
there are no a priori restrictions on the
coefficients of the behavioural equations of (1.8a).
Furthermore with the exception of u i (t)=ONixl and
(A10) there are no restrictions on the distribution
system <x2,u,e;Z>, which are not invariant under
transformations fu(t) with any nonsingular (NxN)-
matrix f.

Then it is equivalent for any subaggregate 8 of

[B,A,Bl ,Do, 1 ,DO,2,Dl] and for any structure S E H:

(a) 8 is identifiable in H for S E H.

(b) Let S* E H. If there exist nonsingular (NxN)-

matrices f1 and f2 such that (i)-(iv) of theorem
2.6 hold with respect to Sand S* and if n=n*
then fe(S)=fe(S*).

In the following we concentrate on the identification of the n-th

equation (n=l, ... ,Nb) of model (1.8a) under point restrictions on
the coefficients. Let [C]n be the n-th row of any matrix C. Then
without loss of generality we can assume the following
partitioning of the n-th row of the coefficient matrices:

[B]n=[bB, n , b*, n, 0 , QA, n , .12+, n ] (2.12)

[A]n=[gB,n , a*,n , an,n , aA,n , g+,n ]

Nn B, B Nn* 1 Nn A , A Nn+

[Do, 1 ] n = [do, 1, n , go, 1 , n J

[Do, 2 ] n = [do, 2, n , go, 2, n

M2 nO M2 nO

[Bl]n=[b1,n , Ql,n ]
Nn 1 H.n.l

[Dl ] n = [dl ,n , 9,1, n ]

Mn 1 Mn 1

where the subscript ' denotes a priori known parts of the

above vectors. From (l.13a-d) we get
 439

[IN-B-A]nTIl = [Bl ]n (2.13)

[IN-B]nTI2 = [Do, 1 ]n
[IN - B-A]n TI3 = [Do, 2 ]n and
[ IN - B- A] n P4 = [01 In + [Do,l]nx
where

P4 : = TI4 + TI2X = (IN-B-A)-l (01 +00, IX) (2.14)

Starting from (2.13) we partition the matrices TIl , TI2 , TI3,

P4 and X conformably to (2.12):

(2.15)

QIB ~lB Q2B g,,] NnB,B

Ql * ~l * Q2* ~2* Nn *
TIl Qln ~ln TI2 Q2 n ~2n 1
QlA Q2A NnA, A
~lA
~2AJ
Ql+ ~l+ Q2 + ~2+ Nn+

Nn l !i.!:l..l I'll nO t!.l...n. 0

1
~23B ~3B P4 B £4 B 1 NnB,B

TI3 r
I
Q3*
Q3 n
Q3 A
~3*
~3n

il3 A J
P4
rL
P4 *
P4 n
P4 A
i::j
f4 A
Nn*
1
NnA,A
I Q3+ Q3+ P4+ £4+ Nn+
L

M2n O ~O Mnl Mn.l

and

X rL Xll
X2l
21
'J{l

X22J
Mln O
l:U.ll. 0

Mnl Mnl

Define

~lB QzB Q3 B f4 B -Q2 BXlZ

j
ill * Q2* il3* £4 *-Q2 *Xl2
p( n)
r
I
ill *
I ill A
0
0
Q3*
Q3 A
£4*
£4 A
(2.16)

L
 440

P( n) [ ~ln 0 ~3n

and

{
p( n) an, n a priori known
n(n) [ p( n)
P( n)
1 otherwise
(2.18)

The matrix P(n) is of dimension (NnB.B+Nn*+Nn*+NnA,A)

x (M1n O +Nn 1 +M2n o +Mnl ) .

Furthermore, we define
(2.19)
Nn B := number of all a priori not known elements of [B]n
= NnB. B + Nn*

Nn A := number of all a priori not known elements of [A]n

Nn* + NnA,A an, n a priori known

= {
l+Nn* + NnA, A otherwise
and
Kn:= number of all a priori known elements of
[ Bl , Do. 1, Do. 2, Dl] n

Since p(n) is a (lxKn)-vector, the matrix n(n) is of

dimension (NnB+NnA)xKn.

Now it is possible to give the generalization of the familiar

rank condition of identification of simultaneous systems
originally derived by KOOPMANS et al. (1950) (Also see
SCHONFELD (1971) and LOSCH (1980».
Theorem 2.8: Rank Condition
Let H be the model of theorem 2.7. Then under
identifying point restrictions on the coefficients
of the n-th behavioural equation of (1.8a) it is
equivalent:
(a) The coefficients of the n-th structural
equation of (1.8a) are identifiable for S E H.

(b) rank TI(n) = Nn B + Nn A

From theorem 2.8 we get

 441

Corollary 2.9: Order Condition

Let M be model (1.8) with the assumptions of
theorem 2.8.
A necessary condition for the identification of
the coefficients of the n-th behavioural equation
of (1.8a) in M for a structure S E H is that the
number of all unknown coefficients of this
equation is less than or equal to the number K of
all predetermined variables.

Theorem 2.9 contradicts PESARAN's conditions (1981, prop.2,

p.384). PESARAN requires as a necessary condition for
identification that the order S of the AR(S)-process is greater
than the order R of the distributed lag relation specified
between the exogenous and the endogenous variables of model
(1.1). But this condition is only necessary for his way of
deducing identifiability criteria! As a simple counter-example
take SARGENT's (1976) two equations model
p(t)=b12y(t)+m(t)+c12 r(t-1 )+C13 (m(t-1 )-p(t-1) )+Ul (t)
y(t)=b21 (p(t-1)-p+(tlt-1»+C2~t+c25Un(t-1)+c26Un(t-2)+C27+U2(t).

All exogenous variables with the exception of met) are assumed to

be perfectly predictable.

If we specify m(t)=xlm(t-1)+x2m(t-2)+e(t), i.e. S=R=2, we get

rank IT( 1) = rank [b21 I( 1-b12b21 ), C27, C2~, C25, C26]

= 1 = Nl B+Nl A
and
rank IT(2) = rank [1] = 1 = N2B+N2A.
Thus the rank condition of theorem 2.8 holds for both equations.
If we assume that met) is perfectly predictable, too, we get

i.e. the second equation is not identified. Both results are in

accordance with those given by WEGGE and FELDMAN (1983a) for the
case of given expectations xl+(tlt-1). Furthermore, if the first
equation is altered to
p(t)=b12y(t)+am(t)+c12r(t-l)+c13(m(t-l)-p(t-l»+Ul (t) ,

with a priori unknown coefficient a and not perfectly predictable

m(t)=xlm(t-1)+x2m(t-2)+e(t), we get

showing that the second equation is not identified.

3 The Flxpoint-(FP-)Estlmation Principle

In the context of model (1.8) the starting-point of WOLD's FP-
estimation principle (WOLD (1965), (1980» is given by the
following statements (see LOSCH (1984»:
 442

yz (t It) : = E (y (t) I z Qt) = y (t) -v (t) and (3.1)

yet) = Byz(tlt)+Ay+(tlt-1)+Bly(t-1)+Dox(t) (3.2)

+ DI x ( t -1 ) +v ( t) .

Furthermore it can be shown that the reduced form disturbances

v(t)=(IN-B)-lu(t) of the so called 'reformulated structural form'
(3.2) are not correlated with the right-hand variables of (3.2):

E(v(t)lyz (tlt),y+(tlt-1),y(t-1),x(t),x(t-1» = ONxl . (3.3)

Therefore (3.2) can be considered to be a regression model if

the problem of the unobservability of yz (tit) and y+(tlt-1) can
be solved by way of (1.10)

y+(tlt-1) = (B+A)y+(tlt-1)+Bly(t-1)+Do.IXI+(tlt-1)+Do.2X2(t)
+DI x( t-l)
and

yz(tlt) = Byz(tlt)+Ay+(tlt-1)+Bly(t-1)+Dox(t)+DIX(t-l). (3.4)

Equation (3.4) is a direct consequence of (3.1) and (3.2). Since

Xl (t)=xx(t-1)+e(t) can be treated as a regression model in the
usual way, the above considerations lead to the following
preliminary definition of the FP-estimator:

Definition 3.1: Given a sample of size T for all observable

variables the FP-estimator x(T), B(T), ACT),
BI (T), Do(T) and Dl (T) for x, B , A, BI, Do and DI
is defined as the solution of the following
nonlinear equation system:
(3.5)
Lt =I ,T Xl (t) x ( t -1 )' = x ( T ){ L t = I , T X ( t -1 ) x Ct -1 ) , },
Lt =1 • T Y( t ) rT (t)' = [B ( T ) , A ( T) ,BI (T) , Do (T) ,DI (T) ]
• Ut =I, T rT (t) rT (t) , }
with
yz, T (t It)
y+ , T ( t I t - 1 )
rT (t) : = y(t-l)
x(t)
x(t-l)

yz , T (t It) = [B ( T ) , A ( T) , BI (T) , Do (T) , Dl (T)] rT (t)

y+,T(tit-l)=yz,T(tlt)+B(T)[y+,T(tlt-l)-yz,T(tlt)]
+ Do, I (T) [Xl +, T (t I t -1 ) - Xl (t)]
XI+,T(tlt-l)=x(T)x(t-l)
for every t=l, ... ,T.

Furthermore the matrices IN-B(T) and IN-B(T)-A(T)

are nonsingular and the estimator satisfies all
restrictions given by a priori point restrictions
or identities.
 443

There exist adequate numerical procedures to solve the above

equation system. They are given by standard extensions of WOLD's
FP-method for classical simultaneous systems (WOLD (1965),(1980),
LOSCH (1984». In practice no difficulties at all have been met
with the calculation of FP-estimates.
Starting from definition 3.1 a stronger definition of the FP-
estimator will be introduced which guarantees the existence and
uniqueness of the estimator and which allows the examination of
asymptotic properties. First we present the following composed
matrix
TTl TIz TI3 P4 -TIz 7r ( 3.6)
TIl 0 TI3 P4
IN 0 0 0
=
r
[z :
0 1Ml 0 0
0 0 1M2 0
l 0 0 0 1M
Now consider the n-th behavioural equation of system (3.2). With
respect to the partitioning introduced in (2.12) we can write
yn (t) = an [( n) ,v Z (t ) + gn I( n) ,v Z ( t ) + Vn ( t ) , (3.7)
where an respectively gn denotes the row vector of all a priori
not known respectively known coefficients and r(n),v and I(n),v
are conformable submatrices of fz. Notice that f(n),v has rank
equal to the number of its row vectors if the same is true for
TI(n). Furthermore we define
( 3 .8)
a'. - Cal , ... ,aNb] a'- [gl , ... ,gNb]

f( 1) , v 0 0
0 f( 2) , v 0
fv:=

0 0 [( Nb) ,v

I( 1) , v 0 0
0 I( 2) , v 0
£v:=
r
l 0 0 I< Nb) , v

and the full system of all Nb behavioural equations (3.8) can be

given in stacked form below.
(3.9)
(yb(t»' - g Iv[INb 00 z(t)] = a fv [INb (}) z(t)] + (vb(t»'.
 444

Notice that fv has rank equal to the number of its row vectors
if the same is true for TI(n) for every n=l, ... Nb. Postmultiplying
(3.9) by [INb !Xi z(t)]'fv' and summing up leads to
(3.10)
(l/T)~t=l,T{[yb(t) 00 z(t)]'fv' -~ [v[INb 00 z(t)z(t)']fv'}

=(l/T)~t=l,T{a fv[INb ~ z(t)z(t)']fv' + [vb(t) ~ z(t»)'fv'}

or
Syb.z fv' - g [v[INb ® Szz]fv' (3.11)
= a fv[INb ~ Szz]fv' + Svb,z fv'
with
Szz: = (1/T)~t=l, T z(t)z(t)' (3.12)
Syb,z:= (l/T)~t=l,T [yl(t)Z(t)' .... ,yNb(t)Z(t)'] and
Sv b • z : = (1 / T ) ~ t =1 • T [VI (t) z ( t) , , . .. ,VN b (t) z ( t ) , ]
Similarly to (3.7) we find for the m-th equation of AR-model
( 1. 8b)

Xl • m (t) = ~m f ( m) . e Z (t ) + im [( m) . e Z (t ) + em (t ) (3.13)
= ~m f ( m) ,i X ( t -1) + im [( m) , i X( t -1) + em ( t )
where
~m respectively 1m denotes the vector which contains the
unknown respectively known elements of [~]m ,
f(m),e respectively [(m},e denotes the matrix containing the
rows of [OMxN,OMxMl ,OMxM2 ,1M] which correspond to ~m
respectively to 1m,
f(m), i respectively [(m},i denotes the matrix containing the
rows of 1M which correspond to ~m respectively to 1m.
Furthermore define
~: = [~l, ... , ~Ml b ] and i: = [11, ... , IMI b ] (3.14)
and take f(m},e, t(m),e, f(m) , i and t(m),i. respectively, to
construct the blockdiagonal matrices reo [e. fi and [i.
respectively, analogously with fv and [v in (3.8). Now the full
system of the first M1b equations (3.13) can equivalently be
given in the two stacked forms below.
(3.15)
(Xlb(t»' - I te[IMlb !Xi z(t)]= ~ fe[IMlb IX' z(t)] + (eb(t»'
and
(Xlb(t»' - i Ii[IMlb 00 x(t-l)] = ~ fi[IMlb !Xi x(t-l)] (3.16)
+ (e b (t) ) ,

Note that by construction the matrices f(m).e, fe and f(m),i and

fi have rank equal to the number of their row vectors.
Postmultiplying (3.16) by [IMlb 00 x(t-1)]'fi' and summing up
leads to
 445

Sxlb, xi ri' - 1 .ri [IMlb w Sxx, i Jri' (3.17)

= ~ ri [1Mlb 00 SXll ,i Jri' + Seb, lIi[i'
with
(3.18)
Sxlb,xi:= (l/T):l:t=l,t [Xl,1(t)X(t-1)', ... ,Xl,Mlb(t)X(t-1)'J,
Su,i:= (l/T):l:t=l,T x(t-1)x(t-1)' and
Se b, xi: = (1 IT) :l:t =1 ,T [el (t) x ( t -1 ) , , ... , eMl b ( t ) x ( t -1 ) , J .

Taking the definitions given above we find that equation system

(3.5) is equivalent to
Sy b, z [v ( T)' - g .rv ( T )[ IN b IZi Sz z J f v ( T) , ( 3 . 19 )
= aCT) [v(T)[1Nb 00 SzzJ[v(T)'
and
Sx I b , II i [i' -1.ri [IMI b 00 SlIlI, i J [i '
= ~(T) [i [1Mlb 00 Su. i Jfi'
where aCT), ~(T), [veT) and .rv(T) denote the corresponding FP-
estimators. Notice that [veT) and .rv(T) depend on aCT) and ~(T)
and that ri and .ri are constant. Assuming (A1)-(A10) the
following expectations exist:
:l: y b, z : = E ( [Yl (t) z ( t) , , ... ,YN b (t) z ( t) , J ) (3.20)
:l:z z : = E( z (t ) z (t ) , )
:l:x I b, II i : = E ( [Xl. 1 (t) x ( t -1 ) , , ... ,Xl, M1 b (t) X( t -1 ) , J) and
:l:u, i: = E(x(t-1)x(t-1)' )=E(x(t)x(t)') =::l:u
and the following assertion holds.
Proposition 3.2: Assume (A1)-(A10). Then
(i ) (3.21)

~ [i[1Mlb 00 :l:uJfi'
= :l:x I b, xi [i' - 1 .ri ' [1MI b 00 :l:lIlI J[i '

(ii) (3.22)
a [v[INb 00 :l:zzJfv'
= :l:yb,z fv' - g .rv[1Nb 00 :l:zzJfv'
By (A4), E(Seb,xi)=Olx(Nb.M) and, by (A2), E(Svb,z)=Olx(Nb.K)
Thus (i) and (ii) follow from (3.11) and (3.18).
Let ~2 be the vector which contains the elements of the matrices
:l:zz and :l:yz. Then we can write (3.21) and (3.23) in the following
way:
 446

and
where
Fl ~~,a X ~K+N)K --) ~~ and
F2 .Q~, a X R< K+N) K --) ~a
with
~~x ~a: ~ .Q~, a
.Q~,a:= {(~,a) (~,!,a,Q) satisfies (A1) and (AB)}
N~:= length of vector ~ and Na:= length of vector a.
With respect to (3.23) and (3.24) there exists an open subset
C~,a of .Q~,a such that
Fl C~, a X R( K + N ) K - - ) ~~
and
F2 C~, a: X R( N+K) K --) ~a:

are continuously differentiable. Let

Then we get

aF/Cl(~,a) = [ fi [IMlb \Xi i:zz]fi'

ClF2 /a~

Hence aF/a(~,a) is nonsingular at the point (~,a,M2) if and only

if aF2/aa is nonsingular at the point (~,a,M2). Let (~,a,M2) E
C~,a x R(N+K)K such that aF/a(~,a) is nonsingular at the point
(~,a,M2). Then, by the implicit function theorem (DIEUDONNE
(1960», there is an open neighbourhood U(M2) of M2 in R( K+N) K
and a continuous function f uniquely determined by U(M2) such
that
(3.23)
f (,Ll2) = ( ~ , a) ,

f(g2) E C~,a and F(f(g2),g2)=01z(N~+Na) for any g2 E U(M2).

Corresponding to M2 let m2 be the vector which contains the
elements of the empirical second order moment matrices Syz and
Szz By (3.19), we get F(~(T),a(T),m2)=01z(N~+Na). If
m2 E U(M2), then, by (3.23), (~(T),a(T»=f(m2). Furthermore, ~(T)
and aCT) are uniquely determined. Assuming (A1)-(A10), we get
E{lz(t)z(t)'12} < CD and E{ly(t)z(t)'12} < CD and limT-)oo m2=M2
a.e. from BIRKHOFF's ergodic theorem (see GANNSLER and STUTE
(1977». Hence at least in an asymptotic sense it can be
neglected wether m2 E U(M2) does or does not hold. With respect
to these considerations we postulate the following assumption to
guarantee the unique existence of a solution of equation system
(3.5) in definition 3.1.
 447

The true but unknown parameters ~, a and ~2 satisfy (AFP)

the condition: aF2/da is nonsingular at the
po int (~, a ,~2 ) .
Furthermore m2 E U(~2).

Now the following stronger definition of the FP-estimator is

introduced:

Definition 3.2: Assume (A1)-(A10) and (AFP).

Then (~(T),a(T» = f(m2)
is called FP-estimator for (~,a) in model (1.8).
It should be emphasized that the FP-estimator of definition 3.2
satisfies equation system (3.5) of the preliminary definition
3.1.

4 Asymptotic Properties of the FP-Estimator

At first the well-known result is presented that the FP-estimator
is consistent (LOSCH (1984». Here we can state the strong
consistency according to the ergodicity of the process
{z(t); t E Z }.
Theorem 4.1: Let M be model (1.8). Assume (A1)-(A10) and (AFP).
Then the FP-estimator is strongly consistent, i.e.
limT->m (~(T),a(T» = (~,a) a.e.
For a proof of theorem 4.1 see LOSCH (1987, p.57)
To present the asymptotic distribution of the FP-estimator the
following notations are introduced:
(4.1)
r: = [ ~e
He, v: = -[INb,ONbxNi ](IN-B-A)-lA(IN-B)-lDo, 1 [IMlb
OMl i x Ml b
1
Hv:= [bb ,ONbxNi ] (IN-B-A)-l [INb
ONixNb
1
[ IMlb 0 1
Hb: =
He, v Hv
J
LV,b:= E (vb (t) vb (t ) , )

Lb:= [ ~e, b ~V, 1 b

 448

and
(4.2)

Q:= (f(Hb \XI };zZ)f']-1[f(};b \XI };zz)f'][f(Hb;XI };zz)f']'-1.

With these notations the asymptotic distribution of the FP-

estimator (~(T),a(T» can be stated and we get a generalization
of LYTTKENS' (1973) result for classic simultaneous systems
(A=ONxN) .

Theorem 4.2: Let M be the model of theorem 2.8 and assume (AFP).
Then

(i) (T)1/2(~(T),a(T»-(~,a)] converges in

distribution to N(O,Q) with Q defined in (4.2).

(ii )

If [ ~ ~'<xl
Qa. ~ Qa
is the partitioning of Q

corresponding to (~,a). then

Q~ = (Qe ) - 1 Se (Qe ' ) - 1

Q<x = (Qv ) - 1 (Qv, e ~Qv, e ' +Sv ] (Qv ' ) - 1
and
Qa, ~=- (Qv ) -1 Qv, e ~

with
Se: =fe (};e, b ® };z z ) fe'
Sv: =fv (};v, b \XI };zz )fv'
Qe : =fe (1M1 b \XI };z z ) fe'
Qv: =fv (Hv \XI };zz )fv' and
Qv, e: =fv (He, v \XI };z z ) f e
,

For a detailed proof see LOSCH (1987, p.60-73).

Remarks:

(a) Of course, taking into account the estimation of the AR-model

(l.8b) the variance of the estimator of the really
interesting RE-model (1.8a) is increased.

(b) The computation of the covariance matrix Qa requires the

inversion of the nonsymmetric matrix Qv. But Qv has as many
rows and columns as unknown structural form coefficients are
contained in model (l.8a). In the case of large models this
will lead to considerable practical problems. But the FP-
estimator shares these problems with other full-information
estimators.
 449

(c) Note that Qe is blockdiagonal. Hence, computing ~, we do not

meet with the difficulties which have been noted in (b).
Furthermore, the matrices on the diagonal of Qe are positiv
definite and their dimension is equal to the number of the
unknown coefficients of the corresponding equation of model
(1. 8b) .

(d) Often ~e,b is assumed to be diagonal, i.e. E(ei (t)ej (t»=O

for i~j. In this case the resulting covariance matrix of the
coefficient vector ~i of the i-th equation of (1.8b)
coincides with the one which is deduced for ordinary least-
squares estimators in the context of linear regression models
with stochastic explanatory variables (see SCHONFELD (1971».
Furthermore the estimators ~i (T) and ~j(T) are not correlated
for Hj.

5 Alternatives to the Conventional Asymptotics: TQKEY's

Jackknife and EFRON's Bootstrap
Since the computation of the asymptotic variance-covariance
matrix Qa of aCT) requires the inversion of large matrices, it is
often impossible in practical situations to get estimates for the
standard error of aCT) especially if systems are large. TUKEY's
jackknife and EFRON's bootstrap provide distribution free
assessments of the standard errors of parameter estimates even in
situations, where the assumptions underlying the standard formula
are not fulfilled.
The jackknife was introduced by QUENOUILLE (1956) to reduce the
bias of parameter estimators. TUKEY (1958) proposed to use the
jackknife to get a distribution free assessment of the standard
errors of parameter estimates. MILLER (1974) gave an excellent
review of the jackknife technique. Furthermore, the distribution-
robustness of the jackknife was pointed out by subsequent
researchers, who proposed weighted jackknife variance estimators
in the context of regression models; related papers are HINKLEY
(1977), WU (1986), SHAO and WU (1987) and SHAO (1989). WOLD and
BERGSTROM (1983) used the jackknife for the first time in the
context of econometric models to assess the standard errors of
the parameter estimates.
In the following a brief description of the ordinary jackknife
method is given:
Given a sample of size T let o(T) be the estimate of a
certain parameter O. If observation t is deleted denote the
corresponding estimate by O-t. Assume that o(T) as well as
the T estimates 0-1, ... ,O-T are available. Then TUKEY
proposed to consider the so-called pseudo values
O(t):= To(T) - (T-1)o-t (5. 1)

The jackknife estimator is defined as

OJK(T):= (l/T)~t=l,T oCt) ( 5 . 2)
= To(T) - «T-1)/T)~t=1,T O-t
 450

and an estimator of the variance of 6JK(T) is obtained as

O"JK2 = (1/T)(1/(T-1»~t=1.T (6(t)-6JK(T»2 . (5.3)

As has been pointed out by some authors (see EFRON (1979) and
BERAN (1984» there is a close theoretical relationship between
the jackknife and the bootstrap.
The basic bootstrap is described by EFRON (1979, 1982), related
papers are BICKEL and FREEDMAN (1981. 1983), FREEDMAN
(1981, 1984) and SHORACK (1982). Later on, various modifications
of the basic bootstrap approach have been considered by several
authors (BERAN (1987). RUBIN (1981), HALL (1986), EFRON (1987).
SILVERMAN and YOUNG (1988) and BANKS (1988». In essence. the
bootstrap is a procedure for estimating standard errors by
resampling the data in a suitable way, so the model is tested
against its own assumptions. The objective of this chapter is to
show how the bootstrap can be applied to the considered RE-model
(1.8).

Following FREEDMAN (1984) two kinds of evidence are needed to

make the bootstrap appealing:
(i) A showing that the bootstrap gives the right answer
with large samples, so it is at least as sound as the
conventional asymptotics given by theorem 4.2.
(ii) A showing that in finite samples, the bootstrap
actually outperforms the conventional asymptotics.
The present chapter focuses on (i). Empirical results are given
for classical models (A=ONxN) and for RE-models in chapter 6.
With respect to (ii) there is further empirical evidence in EFRON
(1979. 1982) and FREEDMAN and PETERS (1984a.b).
Coming back to model (1.8), data are available for t=l, ... ,T and
the coefficients are estimated as ~(T), B(T), A(T), BI (T), Do(T)
and Dl (T) by the FP-procedure. Furthermore we get conformable
estimates y+,T(tlt-l) for y+(tlt-l). Due to the randomness in
X2(t). u(t) and e(t) there is random error in the above
estimates. To get an idea of the size of these errors EFRON's
basic bootstrap procedure is applied in the following way:
Define the residuals
e T (t): =Xl (t)-n:(T)x(t-1)
and
u T (t): =y(t)-[B(T)y(t)+A(T)y+. T (tl t-l)+Bl (T)y(t-1)
+Do (T)x(t)+D1 (T)x(t-1)]
for every t. t=l, ... ,T.
By normalization and orthogonalization these residuals can be
transformed to new residuals e(t) and u(t), t=l, ... ,T, such that
 451

(5.4)
(l/T)L:t=l,T e(t) = OHlxl
(l/T)L:t=l, T U(t) = ONxl
( 1 /T ) L:t =1 , T e(t)u(t) , = OMlxN
(l/T)L:t=l,T e (t )X2 (t) , = OHlxH2
(l/T)L:t=l,T U(t)X2 (t)' = ONxH2
Now consider a model like (1.8), but where all the ingredients
are known:
Set the coefficients at the FP-estimates.
Make (X2(t),u(t),e(t», t=l, ... ,T, independent, with
common distribution equal to the empirical distribution,
which puts mass l/T at each of the triplets
(X2(t),u(t),e(t», t=l, ... T.
Using this simulation model, pseudo-data can be generated
for periods t=l, ... ,T. This pseudo-data will be denoted by
stars: (Xl * (t) ,y* (t», t= 1, ... ,T .
For theoretical considerations the pseudo-data will be
successively calculated using the final forms (1.22) and (1.23),
where the (X2*(t),u*(t),e*(t»'s are independent with the common
empirical distribution specified above:
(5.5)

Xl*(t):= L:s =0 ,CD (]rl (T) ) S]r2 (T) X2 * (t - s )

+ L:s=o,ao (]rI(T»se*(t-s)

X* (t) : = [Xl * (t) , ,X2 * (t) , ] ,

y* (t) : = L:. =0, CD (TIl (T) ). [TI2 (T) , TIs (T) ] X* (t-<;)
+ L:.=O,CD (TIl (T».TI4(T)x*(t-<;-1)
+ 2:.=0," (TIl (T».(IN-B(T»-lu*(t--r::)

where conformable to (1.13)

TIl (T) : = (IN - B ( T ) - A ( T) ) - I Bl (T)
TI2 (T) : = (IN - B (T) ) - 1 Do , 1 (T)
TIs(T):= (IN-B(T)-A(T»-lDo,2(T) and
TI4 (T) : = ( IN - B (T) - A (T) ) - 1 Dl (T)
+ (IN - B (T) ) - 1 A(T) (IN - B (T) - A ( T» - 1 Do, 1 (T) 1[ (T )
 452

In practice the construction is iterative, putting y*(O):=y(O),

Xl * (0) : =Xl (0) and X2 * (0) : =X2 (0) :

Xl * (t) : = ~l (T) Xl * (t-1 ) +~2 (T) X2 * (t-1 ) +e* (t)

XI*, +(tlt-1):= Xl*(t)-e*(t)

y*, + (t I t-1 ) : = (IN - B (T ) -A (T) ) - I

[ Bl (T)y*(t-1)+Do, I (T)Xl*, +(tlt-1)
+Do , 2 (T) X2 * (t ) + Dl (T) x* ( t -1) ]

y*,z(tlt):= (IN-B(T»-l[ A(T)y*,+(tlt-1)+BI(T)y*(t-1)

+Do (T) X* (t ) + Dl (T) X* (t -1) ]

y* ( t) : = y*, z (t It) + ( IN - B ( T) ) - 1 U* (t )

Then by construction of the pseudo-data (5.5) assumptions (A1)-

(A10) hold for the simulation model presuming the FP-estimates
comply with (A1) and (A8).

Now pretend the pseudo-data (5.5) come from a model like (1.8)
with unknown coefficient matrices. Using the FP-estimation
principle we get new estimates ~*(T) and a*(T). The distribution
of the pseudo-errors ~*(T)-~(T) and a*(T)-a(T) can be computed
and used to approximate the distribution of the real errors
~(T)-~ and a(T)-a. This approximation is the bootstrap. The
distribution of the pseudo-errors ~*(T)-~(T) and a*(T)-a(T) can
be computed by Monte Carlo.

The following result shows that in an asymptotic sense this

approximation is just as correct as the one which is given by the
asymptotic normal distribution of theorem 4.2.

Theorem 5.1: Let H be the model of theorem 2.8 and assume (All)
and (AFP). Then along almost all sample sequences,
as T-)m, conditionally on the data, the conditional
law of Tl/2[(~*(T),a*(T»-(~(T),a(T»]
has the same limit as the unconditional law of
Tl /2 [ ( ~ ( T) ,a ( T) ) - ( ~ , a ) ] .

The proof of theorem 5.1 is extensive and not straightforward. It

claims some new techniques like Mallow's metrik (see BICKEL and
FREEDMAN (1981». A proof for the special case A=ONxN, i.e. for
classical econometric models, has been given by BLUMEL (1987).
For the general case of the RE-model (1.8) see LOSCH (1990).

6 Application

The objective of this section is to illustrate the performance

of the three procedures in a real example. The application
seizes upon a model which was presented originally by NEUMANN
 453

(1981) and which has been slightly modified by the author. The
model tries to explain the movements in the real gross national
product and in the consumer price level for West Germany. Since
monetary variables have been taken into account the RE-hypothesis
is involved owing to the FISHER-equation which explains the
nominal rate of interest as a function of the real rate of
interest and of the difference between the expected and the
observed consumer price level. The model consists of the
following equations:

LNPV(t) = ao + alLNBS(t) + a2 LNPV(t-1)

+ a3[TETA(t)-TETA+(tlt-1)] + Ul (t)

LNBS(t) = ~o + ~l [LNM1(t)-LNPV(t)] + ~2[LNST(t)-LNPV(t)]

+ ~3[LNPV+(tlt-1)-LNPV(t)] + ~4LNAF(t)

+ ~5TETA(t) + U2(t)

TETA(t):= LNPV(t) - LNPI(t)

The variables are defined as

LNPV: In of the consumer price level

LNBS: In of the gross national product
LNM1: In of money supply
LNST: In of nominal government expenditure
LNAF: In of export
LNPI: In of import price level
Ul, U2: latent variables
It is assumed that the four exogenous variables LNM1, LNST, LNAF
and LNPI follow a 4-th order autoregressive process. Thus we have
only one exogenous variable, the dummy variable 1 for the
constant terms, which can be anticipated exactly.
Table 1: Bootstrap experiment for the RE-Model.
=================================================================
FP Bootstrap
( 1) (2 ) (3 ) (4) (5 ) (6) (7)
Est. Nom.SE JK SE Mean SD t RMS Nom.SE
-0.1659 0.0434 0.0429 -0.1536 0.0563 -2.18 0.0517
0.0684 0.0188 0.0243 0.0622 0.0301 2.06 0.0290
0.9547 0.0170 0.0181 0.9597 0.0301 -1. 66 0.0306
-0.1309 0.0442 0.0670 -0.1393 0.0529 1. 59 0.0305
5.1787 0.2457 0.3229 4.764 0.4259 9.74 0.3065
0.0336 0.0846 0.1975 -0.0629 0.1060 9.10 0.0877
0.3503 0.0558 0.1843 0.3293 0.0554 3.79 0.0515
-0.6054 1.239 3.932 -0.5959 1.861 -0.05 1.348
0.1766 0.0539 0.0650 0.2766 0.1013 -9.87 0.0718
0.3196 0.1016 0.1623 0.3419 0.1033 -2.16 0.0824

Estimation is by FP. There are 100 bootstrap replications.

The t-Test is for the difference between the mean and the
assumed value shown in the estimate column.
 454

The estimation has been performed by using a data set of 35

semi-annual values which span the period 1962 II (t=l) to 1979 II
(t=T=35). The FP-method converges after 11 iteration steps where
the coefficients of two successive iteration steps do not differ
in their first 5 leading figures.
Column 2 of Table 1 displays the standard errors (SE's) of the
FP-estimates 1. The SE's are obtained from the conventional
formula of theorem 4.2 and are called 'nominal' SE's. Column 3
gives the standard error OJK based on jackknifing, see (5.3).
Columns 4 and 5 in Table 1 show, for each parameter in the
original model, the sample mean and sample standard deviation
(SD) for the 100 estimates, which have been calculated using the
100 sets of bootstrap pseudo-data.
Comparing Columns 1 and 4 in Table 1 indicates the presence of a
significant small-sample bias in the coefficient estimates for
some parameters. For example, in our simulation, ~4 is set at
0.1766; the FP-estimate averages 0.2766. This difference is very
unlikely to be due to variability in the Monte Carlo, as shown by
the t statistic in Column 6. With 100 replications the standard
error of the mean is
0.1013/(100)1/2 = 0.01013,
so
t = (0.1766-0.2766)/0.01013 = -9.87.
The difference between the true value of ~4 and the mean of the
estimated values is very hard to explain by sampling error
(p < 0.005). The other entries in Column 6 may be interpreted in
a similar way. The small-sample bias is statistically significant
in four of the estimates.
Comparing Columns 2 and 3 and Columns 2 and 5 in Table 1 shows
that the jackknife SE's and the bootstrap SD's are uniformly
larger than the nominal SE's, with one exception (~2) for the
bootstrap SD. It will now be shown that the nominal SE's
underestimate the true variability of the FP-estimates for some
parameters. Take, for example, the coefficient ~4. In the
simulation world of the bootstrap experiment, the "real"
variability of the FP-estimate for this parameter is known to be
0.1013, from Column 5. In the same world, how good is the nomina.l
SE? The answer is that it is too small, as is shown in Column 7.
This column may be explained as follows. At each of the 100
repetitions, the nominal SE for each of the FP-estimates is
computed using the conventional formula of theorem 4.2 on the
starred data set. The root mean square of these SE's is shown in
Column 7. Thus the apparent variability of the FP-estimate for
~4, from the conventional asymptotics, is in a typical run only
0.0718: this is 0.0718 "" «1/100)~i=1, 100 SEi 2 )1/2, where SEi
denotes the nominal SE of the i-th FP-estimate for ~4. Therefore,
the nominal SE for ~4 is too small by 30%. This finding cannot be
explained by ··specification error", since the specification is
built into the simulation procedure. One reasonable explanation
is: There are not enough data to use an asymptotic formula in a
finite-sample situation with sufficient accuracy.
 455

Now, using theorem 5.1, in an inductive step we believe the

comparison between Columns 5 and 7 shows that Column 2 is too
small by 10% to 30% for almost all coefficients. For ~4 the
corrected nominal SE is 0.077. But, even if 0.077 gives the
"true" variability of the FP-estimate for ~4, this coefficient is
still significant.
As a whole, it can be stated that the three procedures (nominal
SE, jackknife SE, bootstrap SD) coincide in the assessment that
in the first equation all parameters are highly significant and
that in the second equation the variables [LNM1(t)-LNPV(t)] and
[LNPV+(tlt-1)-LNPV(t)] are highly non-significant.
It must be mentioned that, in general, this typical relation
between the size of the estimates using the three competing
procedures cannot be expected. Thus a general rule of thumb for
deciding which one should be preferred cannot be deduced from
this example. But the availability of the three procedures may
essentially decrease the uncertainty in the assessment of
parameter estimates. Thus the combined application of the three
competing assessment procedures seems to give a fairly reliable
guide to the standard errors.
Table 2: Bootstrap SD due to the number of bootstrap replications
=================================================================
Coefficient Number of replications
10 20 40 50 60 80 100
00 0.0290 0.0384 0.0487 0.0511 0.0568 0.0562 0.0563
a1 0.0224 0.0241 0.0293 0.0278 0.0305 0.0294 0.0301
a2 0.0239 0.0254 0.0316 0.0293 0.0308 0.0291 0.0301
a3 0.0425 0.0515 0.0448 0.0449 0.0435 0.0507 0.0529
~o 0.3451 0.4265 0.4186 0.4031 0.3832 0.4254 0.4259
~l 0.0955 0.1231 0.1068 0.1007 0.1059 0.1084 0.1060
~2 0.0433 0.0595 0.0592 0.0562 0.0543 0.0541 0.0554
~3 1.854 1.718 2.017 1.945 1.866 1.953 1. 861
~4 0.0802 0.0984 0.0985 0.0952 0.0906 0.1010 0.1013
~5 0.0664 0.0968 0.0897 0.0951 0.1031 0.1047 0.1033

At least, Table 2 shows that for testing the significance of

variables even 50 replications are sufficient to approximate the
bootstrap distribution.

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The analysis of non-metric endogenous variables in
latent variable models: The MECOSA approach 1

Andreas Schepers
Gerhard Arminger
Ulrich L. Kiisters
Bergische Uniyersibit Wuppertal
Fachbereich 6: Wirtschaftswissenschaft
CauJ3-Str. 20 ~U4.2S
D-·'i600 Wnppcrtal-Elberfeld 1
Federal Republic of Germany

Abstract

In this paper we present models for the analysis of microeconomic data that can
handle limited dependent variables (metric, censored metric, dichotomous, ordinal)
simultaneously. In these models the dependent variables are indicators of latent variables
that are the endogenous variables in a simultaneous equation system. Such models may
be considered as generalizations of models with errors in the variables. \Ve also introduce
a new computer program (MECOSA: MEan and COvariance Structure Analysis) for
estimating the model paramet.ers. Unlike the LISCO~IP program (Muthen 1988), ?vlECOSA
can treat the case where the latent yariables are hierarchically structured. and ,'vIECOSA
can also handle more general restrictions on th.' parameters, subject only to the condition
that each parameter can be expressed as a continuously differentiable function of the set
of fundanwnt"l parameters. The program itself is implemented in GAUSS (Version 2.0)
for IB!\I-PC's and compatibles.
Keywords: Factor analysis, hierarchical structures, L1S8.EL, L1SCO!lIP, polychoric
correlcttion coefficient, probit model, tobit model.
Contents
1 Introduction
:2 The gelleral MECOSA model
:3 Estimation and implementatioll in the ~IECOSA program
4 Example
References

1 Introduction

III tltis section tbe building blocks of the general \IECOSA (MEan and COvariance
Structure clnalysis) model - simultanpol1s equation systems, factor analysis and limited
dcpPllfjellt variablr:' models - aT" brieflv rc\·ip\\'f,d. In section :2 the gelleral lVIECOSA
model (including nested Sil1111ltancolls equation models ane! factor analytic models yielding
the hicrarchical model structure) j" described. Section:} introduces the concept of

I For b,'lpftil COlllltlCnts on a previolls dnft of the p3per tbe alltllors are indebted to M. E. Sobel,
Ulli\'ersity uf Ariwll;) at TUCSOll, all 1illkllUII'Il referee ai"! to G. ROllning;, Cniwl'sity of [(onstanz. FRG.
who also ;Slll'i_-djt_~d tile d~lt<-t set .Jl1alyzcd ill this P;\PCl'.
 460

fundamental parameters, the marginal maximum likelihood estimation strategy and its
implementation in the MECOSA program. In section 4, an empirical example wi th business
test data is given.
The building blocks of the general model are the following:

• simuitaneo1Ls equation systems (cf. Schmidt 1976) to formulate linear relations

between metric latent traits collected in the vector T) and exogenous variables that
include dummy variables collected in the vector x:

BT) = rx + ( (1)

The matrices Band r of structural coefficients as well as the covariance matrix of

the disturbance vector ( are of substantive interest and are to be estimated.
• factor analysis (cf. Arminger 1979) to express metric variables in terms of one or
more latent traits. Assume the observed metric variables are collected in the vector
y* and serve as indicators for the unobserved latent variables T). A factor analytic
model is given by:

y* = AT) +8 (2)

The matrix A is usually called the matrix of factor loadings, and 8 is the vector of
error terms. The factor loading matrix and the covariance matrix of the vector 8
are the parameters of interest. Note that setting A to the identity matrix I yields
an errors in variables model.

• threshold measurement relations (Maddala 1983) to connect censored, dichotomous

and ordered categorical dependent variables collected in the vector y of observed
outcomes with underlying metric variables y*. Each of the observed y variables
is then modelled as a tobit, dichotomous or ordered probit model in which the
corresponding underlying variable y* is the dependent variable, depending on
exogenous variables x. The parameters of interest in such a model are the threshold
values, the structural coefficients and the elements of the variance-covariance matrix
of the errors.

A graphical representation of a simple MECOSA model by a path diagram is shown

in figure L where the unobservable disturbance and error terms are omitted to avoid
unnecessary conceptual complications. Figure 1 should be read from the bottom to the
top. The exogellous variables in the vector x are related to the metric latent traits
collected in T) through the parameter matrices Band r. The latent traits are connected
to the indicators y* through the factor analytic model parameterized in A. The indicators
Y~ can sometimes only be observed as non-metric variables y. The relationship between
y* and y is represented as a threshold model with thresholds collected in the vector T.

All the parameters of interest in the three building blocks are combined in a parameter
vector 13 which must be estimated from a random sample of observations {Yt, Xt }t=l .....T
where T is the sample size. N" ote that the combination of thesE' building blocks allows one
to estimate latent variable models with endogenous variables that have only been observed
on a censored, dichotomous and/or ordinal level. ]\loclels depicted above have been
considerE'd by Muthen (1979, 1984). However, the MECOSA model is more general because
it can handle hierarchical structures and more general types of parameter restrictions
(Ki.isters 1987).
 461

Figure 1: A simple MECOSA-model

x- variables

2 The general MECOSA model

2.1 The unrestricted model and distributional assumptions

The observation Vt is an n-dimensional vector of endogenous variables, with components

that may be metric, censored or ordered categorical. The analysis of VI is performed
conditionally on an m-dimensional vector Xt with components that are either metric or
dummy-coded. Each component Vti, i = 1, ... ,n, of Vt is connected with an unobservable
random variable V;; by a threshold relation described below. The latent endogenous vector
V; is conditioned on Xt by the distributional assumption
(:3)

where N'" denotes an n-variate normal distribution. Here ~f(li) + I1(v)· Xt is the mean
structure of V; and 2::(19) is the covariance structure. Note that in contrast to the
hierarchical structures below the mean and the covariance structures are unrestricted, i.e.
not yet parameterized in a factor analytical or simultaneous equation framework. Hence,
the mean structure depends on exogenous variables x but the covariance structure does
not. The assumption of multivariate normality of (v7lxd implies that each component
(Y7ilxt) is univariate normal. If the obsenoed variable Yti is censored or ordered categorical,
the threshold models connecting Vti and Y~i discussed in section 2.4 and the assumption
of univariate normality imply that the reduced form coefficients for Y~i can be estimated
by using a tobit model for censored and an or'dinal probit model for ordered categorica.l
dependent variableso The assumption of multi\Oariate normality also allows a meaningful
specification of correlations between equations and of autocorrelated terms that is difficult
 462

to formulate for other models such as the logit model (Arminger & Eiisters 1991). The
mean and the covariance structure of y;
are generated by the mixture of factor analytic
submoclels and simultaneous equation models described below.

2.2 Hierarchical structures

In this subsection the unrestricted mean and covariance structures are restricted by factor
analytic and simultaneous equation parametrizations. The idea of a hierarchical structure
goes back to McDonald (1978, 1980). It is most simply explained by the concept of
second order factor analysis (Thurstone 1947). Let y* = 1)0 be a vector of observed metric
variables which are reduced to first order factors 1)1 in the model

(4)

where 171 and El are independent, and E( El) = o. Now the first order factors themselves
are reduced to second order factors 1)2 in the equation

171 = A2'1)2 + C2 (5)

where '1)2 and E2 are independent, and E( '1)2) = E( E2) = o. The hierarchical structure for
is given by 112, the two error terms El and
'1)0 E2 and the two level multiplicative structure
1\11\2, i.e.,

(6)

The covariance struct ure is

(7)

The expectecl value of rio is o. This idea may be extended from two to H hierarchical
levels, with nonzero mean values, and exogenous variables x (I(iisters 1987). In genera.!,
we assnme II + 1 hierarchical levels of latent endogenous variables '1)h of dimension nh x 1
conditional on exogenous variables Xh:

(8)

for gi\·en Ilh+l ~ nh+1 x 1 and Xh+1 rv 171h+1 x 1. The latent variable 1)0 is equal to the vector
y* = '10 whose components are connected with the obsen·ationo by threshold models. 1)h+l
is the latent endogenous vector on the level of the hierarchy. The \·ector x h+1 contains
elements of Xt, while Eh+1 rv nh X 1 is an error term. Each level is parameterized in the
matrices B"+1 rv nh xn,,, /lh+1 rv nil x 1, Ah + 1 rv TIh X Ilh+1 and f h + 1 rv 71h X mh+l· B h + 1
is a nonsingular matrix that either represents relations between the components of Tlh in
a simultaneolls equation system or serves as a scaling matrix in a variance components
model. The vector Ph+1 is the general mean of the vector 1)h. The matrix f h + 1 consists of
the coefficients of the linear regression of '1)h on Xh+l, while Ah+J is usually either a matrix
of factor loadings or a design matrix in a variance component model. :-lany special cases
of this model arc gi\·en in IGisters (1987).
 463

2.3 The mean and covanance structure

Successive substitution of level h + 1 in level h yields the reduced form of the system for
y~,

H-1 H-1 H
y* = T)o = ( IT (FhC h))FHi1(II) + (IT (FhCh))FHKHx(H) + (IT (FhCh))T)(H+l)' (0)
h=l h=l h=l

In this formulation the substitution is achieved by using the following structured matrices:

Ir
0 0

(I
In! 0
Fh = ( 10)
0 I nh _ 2
0 0 Bh

n
0 0 0
In! 0 0

[1
Cit = (11 )
0 I nh _ 2 0
0 0 Tflh _!

n
0
( f,
K, ~ 1 f2
( 12)
0

The \'ectors il(h), Cr(h) and 17(h) are defined by:

P(It) = T
( Ill"" ,Ph
T)T
(13)

T
,7:(h)= ( X 1 "",X"T)T (1·1 )

T T T)T (1,5)
11th) = ( c1"'" c"_l' IIh-l

By using obvious substitutions for ;, IT and C the reduced form may be written as:

y~ = ~( + ITx + E* (16)

To achieve multivariate normality of v;lx t we assume that 17H+1 is multi\'ariate normal

with expected value EiI(IIH+llxt) = 0 and covariance matrix \'d(T)(H+dlxd = n(v), With
this assumption

) + fI(u) , xll~(d)) ( 1/)

 464

The multiplicative structure of the reduced form coefficients is given by:

H-l
,(v) = (IT (FhGh))FHJ-i(H) (18)
h=l

H-l
IT(19) = (IT (FhGh))FHJ(H (19)
h=l

and

H H
~(19) = (IT (FhG h))f2(V)( IT (FhGh))T (20)
h=1 h=l

In the last equation the covariance matrix f2( 19) is block diagonal

(21 )

(22)

To achieve a simple notation which can more easily be implemented in a computer

program we set Li = FiG i for i = 1, ... , H - 1, Iv1j = FjG j for j = 1, ... , H - 1,
and Nk = FkGk, k = 1, ... , H, as multiplicative structures for the mean and covariance
structure equations (18)-(20). Additionally we set LJ = FHJ-i(H) and M J = FHJ{H as
the multiplicative structures for the mean structure in equations (18) and (19). These
structures are implemented in the MECOSA program as follows:

J
,(v) = IT Li(19) (23)
i=l

J
IT ( v) = IT M j (() ) (24)
J=1

J\ J\
~(D) = (IT N k(D))f2(v)(IT Nk(v)f (2.5 )
k=! k=l

Another \\'ay of looking at the last three equations is to consider the multiplicative
structure as a completely general structure for ,(v), IT(v) and L:(v) parameterized in v,
rather than a consequence of the model fOIllulated in equation (8). This is the approach
taken in the ~vIECOSA program. In the third step of the estimation procedure the user
has to specify the number of levels and the matrices L i , il1j , f2 and Nk as functions of !?
 465

2.4 The threshold relations

Depending on the measurement level each component 1J1l is connected with 1Jri by one of the
following measurement relations. For convenience of notation the case index t = 1, ... , T
is omitted.

• V, is metric (identity relation).

Vi == yt (26)

• Viis ordered categorical wi th unknown thresholds Ti,l < Ti,2 < ... < T,,I\',
and categories Yi = 1, ... , !{i -'- 1 (ordinal probit relation, McI<:elvey and Za-
voina 197.5).

Vi =k ¢:=} vi E [r;,k-l,Ti,d (27)

Note that for reasons of identification the threshold Ti 1 is set to 0 and the variance
of the reduced form error term 0-;( 0) is set to 1. '

• Classified metric variables may be treated analogously to the ordinal probit case with
the difference that the class limits are now used as known thresholds (Stewart 1983).

• Vi is one-sided censored with a threshold value Ti,l known a priori (tobit relation,
To bin 19,58).

if vi > Ti,l }
(28)
if vi :::; Ti,l
• V, is double-sided censored with threshold values Ti,l < T,,2 known a pnorl (two-
limit-probit relation, Rosett and :\elson 197.5).

Ti,l if v7 :::; Ti,l }

Vi = { 1J7 if Ti.l < v7 < Ti2 (:29)
T;,2 if Ti,2 ::; vi
For the case where !Ji is dichotomous, the probit relation also arises as a specia.l case of
the random utility maximization principle (Nelson 1'JIG, Daganzo 1(79).

2.5 A note on identifiability

For the identifiability of the structural parameters contained in the ll1ultiplicati\'e

struct ure certain restrictions like normalization and the exclusion of vaTiables must be
imposed. Unfortunately, conditions like the rank and order conditions are not applicable
t.o the lVIECOSA model (see also Dupacova and \Vold 1982). Hence, researchers must
apply rank checks which reveal at most the state of local identifiability UdcDonald and
Krane 1977).
 466

3 Estimation and implementation in the MECOSA

program
The estimation of the parameter vector () in a general mean- and covariance structure
with endogenous non-metric variables is done in three stages.

1. In the first stage the threshold parameters T, the reduced form coefficients I and
II of the regression equation, and the reduced form error variance 0-; of the i-th
equation are estimated using marginal maximum likelihood. Note that this first
stage is the estimation of the mean structure without restrictions as in equation (3).
The parameters to be estimated in the i-th equation are the thresholds denoted by
the vector Ti, the regression constant denoted by Ii, the regression coefficients, i.e.
the i-th row of II denoted by IIi. and the variance denoted by 0-;' The loglikelihood
function that is maximized with respect to {Ti, Ii, IIi., o-?} of the i-th equation is
given by

T
fi(Ti,I;,II;.,oD = LlnP(Yt;!Xt) (30)
t=1

The formulation of P(Vt; IXt) depends on the measurement level of the observed
variable Vi. If Yi is metric then P(YtilXt) is the univariate normal density with
expected value Ii + IIi.Xt and variance 0-;,
i.e.,

(31)

in which <p(vlp, 0- 2 ) denotes the univariate normal density. Another example is the
ordinal probit model that is applied if Vi is an ordinal variable. In this case the
probability that Vti = /.., must be computed as:

(32)

The probability of the last equation is the basis of the likelihood used in the ordinal
probit model (McKeh'ey and Za\'oina 1975). If other models are used such as the
tobit model (Tobin 1%8) for dependent variables censored on one side only or the
two limit probit model (Rosett &; Nelson 1975) for dependent \'ariables censored on
two sides then the probabilities P(YtiIXt) have to modified accordingly.
A solution to the likelihood equations obtained by setting the first derivatives
of C(Ti.I"IIi.,o-1) to 0 is computed in I\IECOSA by applying a Quasi-Newton
algorit hm proposed by Polak (1971) using analytical first deri\'ati yes. The second
order derivatives are approximated by computing the crossproduct of the first
order derivatives. The first estimation stage yields strongly consistent estimates
of Ti, Ii, IIi and o-f for each equation i. Regularity conditions and the proof of
strong consistency are given in Ktisters (1987).
2. In the second stage the problem is to estimate the covariances of the error terms in
the reduced form equations. Note that in this stage the covariances are estimated
wi thout parametric restrictions. Since the eITors are assumed to be normally
distributed (lnd strongly consistent estimators of the reduced form coefficients
 467

have already been obtained in the first stage the estimation problem reduces to
maximizing the loglikelihood function

T
£ij(aij) = L InP(Vti,Vtjlxt, 7i,1i, It, 0-;, 7j,';fj, TI j , o-],aij) (33)
t=l

in which P( Vti, Yt; Ixt, 7;, ';/i, TIi.' 0-;' Tj,';(j, TI j., 0-], ai)) is the bivariate probability of Vti
and Vtj given Xt and the reduced form coefficients. A typical example of this bivariate
probability is the case when Vi and Vj are both ordinal. Then the probability that
. Vti = k and Vtj = I is given by:

(31 )

in which {tti = ';fi + flixt,ittj 1j + tIp:t and cp(vi,yjlfl;,a;,pj,a],aij) is the

bi variate normal densi ty function. Note that in the ordinal case 0-; = 0-] = 1. Hence,
ai) is a correlation coefficient which is called the polychoric correlation coefficient
(Olsson 1979). The loglikelihood function fij(aij) has to be modified accordingly if
variables with other measurement levels are used.
The objective function (aij) is maximized using the regula falsi algorithm wi th
analytical first derivatives. The resulting estimates 2ij are strongly consistent
estimators of aij. Note that these covariances are the covariances of the error terms
in the equations conditional on Xt. In contrast to LrSREL 7 , we do not assume that
the variables V7i and V;j, which depend on X t , are normal. vVe only assume that the
errors are normal.
The estimated thresholclsTi, the reduced form coefficients ';ii and IT,., the variances
2; and the covariances o-i) from all equations are then collected in a vector K.T
which depends on the sample size T. For the final estimation stage, a strongly
consistent estimate of the asymptotic covariance matrix TF of h:T is computed.
This estimate is denoted by lilT. The asymptotic covariance matrix TV is difficult
to derive since the estimates of o-i) of the second stage depend on the estimated
coefficients Tf, 1f' TI f·, 2J, f = i, j of the first stage. The various elements of the
asymptotic covariance matrix TV are given in K listers (1987). The est imate It'T is
computed in MECOSA by using analytical first order and numerical second order
derivatives of the first and second stage loglikelihooc! function.

:3. In the third stage the vector K of thresholds, and the reducecl form regression
coefTicients ane! the reduced form covariance matrix are written as a function of
t he structural parameters of interest, collected ill the pa rameter vectorl? The
parameter \·ector () is thell estimated by minimizing the quadratic form

(:3.5)

\\"hich corresponds to a weighted least squares approach. The \·ector K.T IS

asymptotically normal with expected value K(J) and covariance matrix IV. Since
TTIT is a strongly consistent estimate of TF the quadratic form CJT(lJ) is centrally X2
distributed with j! - q degrees of freedom if the model i:o specified correctly ane! the
sample size is sufficiently large. The llUl1lbf'J" Jl i[lClicatt's the !lumber of Clelllf'nts ill
h:T while q is the number of elf'ments i!l U.
 468

In the MECOSA program the function QT( 1J) is minimized using the Davidon-
Fletcher-Powell algorithm (Luenberger 1984) with numerical first derivatives. The
MECOSA program offers two features that are available neither in LrSREL 7 nor in
LrSCOMP. First, the general multiplicative structure of equations (23) - (25) can be
used, with up to 10 levels. The individual matrices Li(1J), M;('r'J) , Ni(1J) and n(1J)
are specified by the user. Second, the parameter vector 1J itself may be thought of
as a continuously differentiable function of a vector ~ of fundamental parameters.
Hence, the 1J's may be restricted in a very general way. Typical examples are the
restriction that 1J k must be positive, that the 1J's are ordered or that the 1J's lie
within given intervals. All of these restrictions are easily formulated in terms of the
ts and are easily implemented in MECOSA.

4 Example
The MECOSA approach is demonstrated by analyzing business test data that have
previously been considered by Ronning and Kukuk (1988) using a model of Nerlove
(1988). Nerlove models future changes in the demand for the goods of a firm t with
the adaptive expectations hypothesis:

(36)
D;,s is the expected demand for the time period s + 1 for the goods of firm t, the
expectations being formed at time period s. D; 3-1 is the same variable lagged one
period. Dt,s is the demand observed at time s. ~t,s is an error term. The coefficient
(3 describes how quickly the firms adapt to discrepancies between expected and
observed demand.
For the estimation of (3 we use the data of the German business test conducted by
the IFO Institute for the third quarter of 1980 collected from T = 5389 German
firms. Since only one time point is observed, s is set to 1. The time index is
equal for all cases and hence is eliminated for the sake of simplicity. The observed
demand for the third quarter of 1980 of firm t, t = 1, ... ,T, is denoted by D t . The
expected demand for the fourth quarter of 1980 of firm t is denoted by D;. The
lagged expected demand for the third quarter of 1980 of firm t is denoted by D;(_I)'
Hence, the model for the t-th firm is given by

(37)

If D;, D;(_l) and D t were known, a simple regression analysis would have to be
performed. However, we have only ordinal measurements Vt3, Ytl and Yt2 of these
variables with the categories negative change (1), no change (2) and positive change
(3). Additionally, we have the restriction that in the equivalent regression equation
for firm t, t = 1, ... ,T,

(38)

the coefficient 0:1 is equal to (1 - 0:2)' To put the equations (37) and (38) into the
1IECOSA program we consider the three variable simultaneous equation system for
each firm t

(39)
 469

(40)

(41 )

with ordinal threshold models for the observed variables Ytl as an indicator for
D~( -I)' YtZ for D t and Yt3 for Dr The possible combinations of these three variables
and their observed frequencies are given in table 1.

Table 1:
Observed frequencies of lagged expected demand (YI), observed demand (yz)
and expected demand (Y3) for the third quarter 1980 of T = 5389 firms.

YI Y2 Y3 f YI Y2 Y3 f
1 1 1 24 2 3 2 456
1 2 1 52 2 1 3 43
1 3 1 29 2 2 3 437
1 1 2 43 2 3 3 588
1 2 2 97 3 1 1 11
1 3 2 39 3 2 1 20
1 1 3 19 3 3 1 33
1 2 :3 46 3 1 2 51
1 3 3 56 3 2 2 'Y,)
~o~

2 1 1 45 3 3 2 173
2 2 1 71 3 1 3 59
2 3 1 43 3 2 3 393
2 1 2 162 3 3 3 914
2 2 2 1233

In the first step we estimate the parameters of the reduced form equation system

(42)

with V( E) = 2: under the restrictions Tjl = 0, o-'j = 1, j = 1,2,3. Note that

regression constants are estimated in equation (42) although they have not been
formulated in equations (39) - (41). This is a consequence of ordinal probi t models
in which either regression constants or threshold values must be restricted to ensure
identification. Since MECOSA restricts the thresholds T J l = 0, regression constants
~/j are estimated. In this model - without exogenous variables - the negative of
each regression constant may be interpreted as the lower threshold Tjl,j = 1,2,3. If
this interpretation is chosen the threshold values reported in table 2 must be shifted
by subtracting the corresponding regression constant. The results given in table
2 agree exactly with the results of the two step procedure given by Ronning and
Kukuk.
 470

I
Table ~: Results from the first estimation stage

I Thresholds
!
Tl~ T22 TJ2
loS 1cl 1.5.Jc:3 1.G1~

Regression Constants

[I "'/2 ~i3

1. :1:3S 1.:37:3 1.5e1S

I
PolycllOric Correla bon ~Iatrix

VI Y2 !/3
1
.2SS 1
.451 .407 1

Unlike Ronning and Kukuk however, we are also able to compute the weight matrix
TV which is an estimate of the asymptotic cO\'ariance matrix of the reduced form
parameters. This covariance matrix is given in table :3.

Table :3: The estimated asymptotic covariance matrix

from the second estimation st i1ge (multiplied by 1000)

TI2 122 T32 11 ~(2 "'/3 <721 <731 <732

0.761.Jc
0.09e15 0.668;)
0.lS62 0.11.56 0.799j
o.,'ieiS 1 0.Oc19~ O.l1Si O.CUi
0.056:) 0.185 cl O.ln28 0.080:' 0 ..5968
0.1~20 0.0(j~)2 0.6193 0.1(;20 0.0960 0.i:30!J
0.07:jcl 0.0807 0.02H 0.0618 0.0713 0.OE1S 0.~elS6
0.10i~ O.O~lli 0.10!)! 0.09U 0.0 I !):) O.mlO:2 0.0:513 0.lS16
0.0442 0.0938 0.1:3131 0.0:381 0.0151 0.1 ~69 (i.0118 0.01-+:3 0.21:33

In the third estimation stage tbis covariance matrix is used to calculate the weighted
least squares estimates of Ctl and Ct2 if the coefficient:' of equation (:38) ,l1'C not
restricted and the estilllillt' of J of (''Illatioll (:37). The results arc giW'll in table -1.
 471

Table 4: Results from the third estimation stage

Unrestricted model Restricted model

Parameter 001 002 Parameter (3

Estimate 0.3637 0.3029 Estimate 0.4 797

Standard error 0.014:3 0.0150 Standard error 0.0106
t-value 25.4797 20.1399 t-value 45.2547

Wald statistic for Ho : 001 + 002 = 1 against HI : 001 + 002 i- 1, W = 429.0187

The estimates of 001 and 002 agree with the estimates of Ronning and Kukuk (1988).
However our standard errors are larger and the t-values are accordingly smaller since
the MECOSA approach takes explicitly the fact into account that the estimates from
the first estimation stage are stochastic and not fixed. Our final result is the estimate
~ = 0.4797 for f3 which is quite different from the unrestricted value pointing to a
possible misspecification of the model.
To check for misspecification we have included a yVald test for Ho : 001 + 002 = 1
against HI : 001 + 002 i- 1. The Wald statistic equals 429.0187 wich is significant on
the 0.05 test level. Hence, Ho has to be rejected.
The present - very simple - model will be extended to deal with multiple periods
and exogenous variables such as seasonal dummy variables in the future.

References
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Econometric Modelling with Interval Coefficients -
A Non-Stochastic Approach

Max Christoph Wewel

Deutsche Bundesbank, Research Department
Wilhelm-Epstein-StraJ3e 14, 0-6000 Frankfurt 50, FRG
Views expressed in this paper are those of the author and are not necessarily shared by
the Deutsche Bundesbank.

Abstract

Starting with critical remarks on the compatibility of the probability approach adopted
in econometrics with the widely accepted requirements of Popperian epistemology, a
new, non-stochastic approach to macroeconomic modelling is presented. This new
methodology is based on the assumption that coefficients in a structural relationship
vary erratically within numerically fixed interval boundaries. Within this framework,
allowance for observational errors can easily be made by extending the interval concept
to the variables. Thus, the stochastic foundations of the traditional econometric
approach are replaced by elements of interval mathematics. Since conditional
predictions of the endogenous variable derived from such a model are fixed intervals
as well, econometric interval hypotheses can be tested effectively even in situations of
scarce empirical data, as is typically the case in the macroeconomic field. From the
falsificationist point of view, this constitutes a clear advantage of the interval model,
compared to the stochastic model. The issue of "estimation" of the interval coefficients
is also attempted by using epistemological instead of statistical criteria. The suggestion
is to select from all a priori feasible and hitherto corroborated structures of a given
econometric interval model, the one with the highest empirical content. It is shown that
this decision rule results in a linear programming task, if the economic relationship is
linear. Finally, some implications of the interval model are indicated.
Keywords: Econometric methodology, Non-stochastic modelling, Interval mathematics,
Linear programming, Errors in variables, Selection of structures.

Contents

I Epistemological Aspects of Stochastic Econometric Modelling

2 Elements of Interval Mathematics
3 The Econometric Interval Model (ElM)
4 Testability of Econometric Interval Hypotheses
5 Empirical Content and the Issue of "Estimation" in the EI M
6 Concluding Remarks
 474

1 Epistemological Aspects of Stochastic Econometric Modelling

Almost fifty years ago, Haavelmo wrote his famous monograph on "The Probability
Approach in Econometrics", in which he pleaded for the acceptance of a stochastic
framework in econometric models. He argued that, if one wants to apply mathematical
methods of statistical inference such as parameter estimation and hypothesis testing,
economic theories necessarily have to be formulated in a probabilistic way. In the
meantime, the stochastic approach has become the fundamental, mandatory paradigm
of econometric theory formulation. However, there has been more and more criticism
of this paradigm from the epistemological side. According to the Critical Rationalism
of Popper, the probabilistic formulation of hypotheses entails the risk of immunizing
these hypotheses against experience. This applies particularly to those scientific fields
where the empirical basis for hypothesis testing is small.
Unfortunately, the analysis of relationships bet\veen macroeconomic time series
constitutes to a large extent such a field, since the data occur only at yearly, quarterly
or, at best, monthly intervals. Moreover, these data are usually subject to considerable
observational errors. For this reason, Blaug characterized the working philosophy of
science of modern economics as "innocuous falsificationism" [I]. In his words, the
diagnosis of the crisis in modern economics is this: "Unfortunately, we lack both reliable
data and powerful techniques for distinguishing sharply between valid and invalid
propositions in positive economics ... These weaknesses, not so much of theoretical
econometrics as of the actual procedures followed by applied econometricians, go a long
way toward explaining why economists are frequently reluctant to follow their avowed
falsificationist precepts. In many areas of economics, different econometric studies reach
conflicting conclusions and, given the available data, there are frequently no effective
methods for deciding which conclusion is correct. In consequence, contradictory
hypotheses continue to coexist sometimes for decades or more." [2J
What kind of conclusion has to be drawn from this diagnosis? Of course, dismissing
stochastic methods from macroeconomics cannot qualify as a reasonable research
strategy, as long as no substitute with a better epistemological foundation is available,
which allows as refined investigations of macroeconomic relationships as do the existing
macroeconometric models based on probability theory. Also, the obvious discrepancy
between the requirements of Popperian epistemology and traditional econometric
methodology cannot serve as a pretext to reject Critical Rationalism as an inappropriate
epistemological basis of economic theories. Instead, this diagnosis should be a motiva-
tion to search seriously for alternatives to the probability approach in econometrics.
Although there has been little discussion of non-stochastic approaches to empirical
macroeconomic modelling in the past, few authors have addressed this issue. In a
comprehensive article on the statistical methodology in economics, Grohmann presents,
apart from deterministic hypotheses (which obviously cannot give a perfect explanation
of human behaviour) and stochastic hypotheses, a third type of hypotheses described
as a conjectural approach [3]. In line with the requirements of Critical Rationalism,
conjectural statements are characterized by a logical structure which emphasizes the
aspect of testability rather than the aspect of hypothesis formation, the latter playing a
decisiw role in the traditional stochastic concept. To state it briefly, the degree of
testability of an economic hypothesis is a decreasing function of the amount of data
necessary for its potential falsification. Therefore, econometric models, while taking into
account the imperfections of economic explanations by allowing a certain variability in
the mathematical relationships, must set well-defined boundaries to the extent of
variability to be tolerated.
 475

These seemingly irreconcilable requirements provide the background of the interval

arithmetic approach to econometric modelling explained below. This new approach can
be regarded as a concrete formulation of Grohmann's conjectural concept in terms of
mathematics. The idea of the interval approach is fairly simple: It is assumed that the
coefficients in a structural relationship vary erratically within numerically fixed
intervals according to (limited) f1uctuations in economic behaviour. Thus, each vector
of explanatory variables also implies a well-defined interval for the value of the
endogenous variable [4]. An economic hypothesis formulated in this \vay has, like a
stochastic hypothesis, a good chance of withstanding any number of empirical tests in
principle; however, in contrast to its stochastic counterpart, such a hypothesis can also
be refuted by a single contradictory observation.

2 Elements of Interval Mathematics

Interval mathematics [5] has evolved as a special field of numerical mathematics.

Originally, it was applied to the automatic control of rounding errors in numerical al-
gorithms implemented in mainframe computers [6]. In the meantime, however,
applications of interval mathematics have occurred in numerous scientific fields [7],
including economics [8]. Interval arithmetic, which constitutes the core of interval
mathematics, deals with the computation of arithmetic expressions of closed intervals
in the set of real numbers (JR). Interval arithmetic operations are defined on the set of
closed real intervals,

as an extension of real arithmetic operations:

(2) [ a] w [b I := {x € .ffi. I x =a w b where a E [a], b E rb J \ .

Substituting +,-,*,/ for w yields the following formulae for computation:

+ b- , a
+
(3) tal + [bl [a + b+J

(4) raj [bl [a

- b+ , a + b-]

[min {a-b , a b , a b , a b }, max [a-b - , a b , a b , a +b +} 1

[a] * - - + + - + + - + + -
(5) [bl

[a , a +] * [lib +, lib - I
-
(6) [ a] / [b 1 (0 rj [b I)
The interval arithmetic operations + and * are both commutative and associative.
However, the distributive law is only valid in the weaker form of subdistributivity:

(7) [ a I * ([ b I + [e]) e [a] * [b I + r a] * [e I and

a * ([b] + [el) a * [bJ + a * [eJ (a E lR) .

MoreO\er, the interval arithmetic operations have the inclusion property:

(8) tal e [bj, [e] e [d] ~ tal w [el e [b] ,,] ld].
 476

The neutral elements of interval addition and multiplication are [0,0] and [1,1 J,
respectively, but the inverse elements generally do not exist.
Interval addition and subtraction can easily be generalized for interval vectors
[a] E In(lR) and interval matrices [AJ E Inxm(IR) by application of the respective operation
to each component. Similarly, an interval matrix is multiplied by a scalar interval
[k] E I(lR):

(9) (k] * (A]:= ((k] * (a ij ] ) ,

and the matrix product of two interval matrices [A] E Inxm(lR) and [B] E ruxh(lR) is defined
by:

m
(10) [A) * [B] (I [a iJ·] * [b J· k ]) E rnxh (lR)
j =1

Again, matrix mUltiplication is only subdistributive and inclusive, but it is neither

commutative nor associative.
Now, let f: [d] ~ lR be a continuous function defined for real arguments x E [d] and
[F] : 0 ~ I(JR) another function defined for interval arguments [x] c [dJ. Then [FJ is
called an (inclusive) interval extension of function f, if [F] satisfies the two following
conditions [9]:

(II) [F] (x) = f(x) for real x E [d] and

(12) [x] c [y] ~ [Fl([x]) c [F]([y]) for [x], [y] E D

where D:= l[z] E In(JR) I [z] c [d]) .

The most important interval extensions are the joint range extension [F] defined by

(13) [F]( [xl) u {fex)} = (min fex) ,max fex)]

x E [x] xdx] xdx]

and the natural extension [F] of a rational function f, which results from the substitution
of interval arguments [xi) for real arguments xi in the function term [10]. Both these
interval extensions are continuous functions [II], and, if f is a rational function, the
following relation holds:

(14) [F] ([xl) c [F] ([xJ) for [xl ED.

However, if_each variable x i occurs only once in the function term of f, the interval
extensions [F] and [F] are identical [12].

3 The Econometric Interval Model (ElM)

As described above, the interval approach is based on the assumption that a coefficient
b i in an econometric relationship generally varies between the boundaries of a specified
 477

interval [bi]. As a result, the exact value of the endogenous variable (conditional on the
values of the explanatory variables) remains undetermined, but captured in a well-
defined interval, providing continuity of the underlying function. Mathematically, the
interval model is expressed by the general equation

(IS) [y] =
-
[F](x,[b]) =
-
[F](x" ... ,xj,[b,l, ... ,[b k ]) ,

which is obtained from the according deterministic relationship y = f(x 1, ... ,Xj>b, , ... ,~)
by a joint range extension with regard to the coefficients bi .
If the underlying function f is rational with each coefficient b i occurring only once in
the term, the joint range extension is equivalent to the natural extension, which makes
the formal treatment of the interval model much easier. Specifically, this applies to the
linear interval model:

k
(16) [y] = I y=x'blb db]} = [min x'b, max x'b] = x' [b] = I [b.] x.
b€[b] b£[b] i=l 1 1

The interval model can easily be generalized by introducing a second joint range
extension with regard to the explanatory variables, thereby allowing for (bounded)
observational errors in the empirical data:

(17) [y] =
-
[F] ([x], [b]) resp [y] [x]' [b] .

Figure I:
Predictions with a linear interval model using exact versus interval explanatory data

y y

x x
 478

Equation (l S) represents an empirical econometric interval model (ElM), if the factual

meaning of the economic variables x und y is determined, the intended scope S is
specified in terms of space and time, and the feasible range of the coefficient vector [b]
is well defined as a subset M C lk (IR) according to theoretical a priori restrictions.
Furthermore, any numerical setting of a particular [b * 1 E M stands for a feasible
structure of the ElM.

4 Testability of Econometric Interval Hypotheses

From the epistemological point of view, it is very important to explain clearly what the
econometric hypothesis associated with a certain structure of an econometric model
states about reality. Though this is rarely discussed in traditional stochastic
econometrics [13], an exact definition of econometric hypotheses is absolutely necessary
as a precondition for effective empirical testability, because an empirical statement must
explicitly state what is permitted and what is prohibited [14]. For this reason, we define
an econometric interval hypothesis (EIH) as a statement of the logical form:

(18) for t E S .
Translated into words, this statement declares for all empirical situations t within the
scope S of the model that the numerical value of the endogenous variable y t is
contained in a prediction interval which is mathematically determined by the vector of
explanatory variables Xt and the fixed structure [b*]. The logical form of this statement
ensures a high degree of testability, since the compatibility of an EIH with economic
reality can be judged on the basis of single observations, which is very important in view
of the rare opportunities to obtain suitable data for testing macroeconomic theories.
Now, suppose an EIH is confronted with a set of exactly observed test data
{ (x t,Yt) I t ET } defined by the index set T c S. Then the logical form of statement (18)
implies the test rule that the EIH is ultimately refuted, if

(19)

holds for at least one observation t E T. Otherwise. the EIH is tenable further on as a
tentative (or conjectural) statement. Only by withstanding extensive and rigorous
testing of this kind docs an EIH gradually corroborate.
However, it might be argued that the above rule of falsification is too strict compared
to the inaccuracy of the basic statements in economics, especially in view of highly
aggregated macroeconomic data. To avoid the refutation of an EI H by mistake,
researchers should therefore allow for an appropriate error margin, which depends on
the specific data employed in the test. Consequently. the test decision has to be
modified for the case of interval data {([x ],[y D I tET }. This is done by requiring for
the falsification of an EIH that even t t

has to be true for at least one observation t E T. ThIS means that, taking into account
the error margin of the data, an EIH is not refuted until statement (18) is proven to be
false for any possible combination of values (x t ,y t ) E ([x t l.[Y t D. This conservati\e
 479

formulation of the test rule is necessary because of the asymmetry of ultimate rejection
and temporary retention. So, as a consequence of using flawed data, it has to be
accepted that sometimes falsifying facts are not detected.

5 Empirical Content and the Issue of "Estimation" in the ElM

The demarcation criterion of falsifiability in Critical Rationalism is closely connected

with the concept of empirical content. Defined as "the class of potential falsifiers", the
empirical content of a hypothesis is determined by its level of universality and its degree
of precision [15]. In the context of the EIH, the level of universality depends on both its
scope S and its complexity reflected in the number of explanatory variables, whereas the
degree of precision is clearly given by the width of the prediction interval,
w([y*]) := yH_y*-.

Obviously, the size of w([y*]) in its turn is determined by the specification of the EI M,
the selected structure [b*], and the numerical values of vector x. Since the latter factor
does not refer to the EIH itself, the relative empirical content of an EIH is defined in
terms of average prediction intervals using some weighting function g(x) [16]. Let HI
and H2 be two EIHs corresponding to the structures [hI] and [bz] of the same EI M [17],
then the empirical content of H I is equal to or higher than that of H2, if the following
inequality holds:

(21) f w([F](x,[b 1 ]))g(x)d.x;; f W([F](x,[bZJ))g(x) d.x .

k k
JR IR

According to this definition, the borderline case of the deterministic hypothesis where
w([y *]) = 0 has the maximum empirical content; however, high empirical content by
itself is not a criterion for the appraisal of a scientific hypothesis unless coupled with
corroboration. Essentially, scientific theories qualify by withstanding rigorous
falsification attemps despite a high risk of failure (reflecting high empirical content).

This consideration provides a good starting point for tackling the issue of structure
selection (or "estimation") in the ElM. For the formal treatment of this problem, assume
an EI M specified by function [F] representing an economic relationship between varia-
bles x and y, certain a priori restrictions defining M, and the scope S. Moreover, the
empirical evidence E C S is defined as the set of all relevant empirical data available at
the present time [18]. Given this basis, the selection of the "best" structure of the EI:-"1
is attempted from the epistemological point of view, leaving aside statistical
optimization criteria used in traditional econometric estimation.

First, all a priori structures which are inconsistent with the empirical evidence are
eliminated in the selection process. Hence, fundamentally, only those structures
[b] EM are eligible, which satisfy, for all tEE, the following condition of consistency (for
both exact and in terval da ta, respectively):

[ 19].
 480

In the following, these structures are called corroborated in view of empirical

evidence E, and C(E) c M denotes the set of all these structures. Second, structure [b *]
which implies the maximum empirical content of the corresponding EIH is selected.
Thus, the "estimation" of the coefficients in an ElM results from the following
optimization problem in interval space I k(lR):

Minimize objective function

!j>([b]) = J w([F](x,[bJ))g(x) dx
JRk
(23)

subject to the constraint

[b] E C(E)

Since the objective function takes no negative values, this optimization problem is
always solvable, provided C(E) is not empty. However, the optimal solution is not
always easy to obtain. Difficulties of an especially· serious nature arise if [F] is not
equivalent to a natural extension of a rational function, because in this case the above
optimization problem cannot be expressed in terms of the interval bound.aries
b- and b+; i.e., it does not reduce to an optimization problem in the real space JR Zk.
Structure selection becomes comparatively simple in case of a linear ElM based on (16),
with a finite number of linear a priori restrictions on the coefficients,

r ,

and a multiplicative weighting function:

k
(25) g(x) II g. (x.) .
1 1
i=l

Then, the resulting optimization problem (23) takes the form of a linear programming
task. In particular, the objective function becomes

- + + -
k\ +-
(26) !j>(b,b) c'(b -b ) = L c.(b.-b.)
i=l 1 1 1

where c· J Ix·lg·(x.) dx. (i=l, ... ,k) ,

1 III 1
-",

and the entirety of constrain ts consists of theoretical constraints ensuring [b * ] E: M and

empirical constraints ensuring [b*] E: C(E). The former group includes, apart from the
a priori restrictions (24), the interval restrictions
 481

<
o ,

whereas the latter group comprises constraints refering to the available observations
(for both exact and interval data, respectively):

(28) y E X[b] resp

- +
[y] E X[b] for all X E [X] [X ,X ] .
It can be shown that these empirical constraints can also be written in the form of linear
inequalities, making use of
[20 ]
(29) X[b] (Xl+Xz) (b] Xl [b] + Xz[b]

where the matrix X is expressed as the sum of non-negative matrix X 1 and non-positive
matrix X Z defined by

(30) X, = (xl,ti) := (max (xti,Ol) and Xz = (xZ,ti) := (min (xti,Ql)

Thereby, the empirical constraints are expressed by the inequalities:

(31) Xlb- + Xzb+ ~ Y ~ Xzb- + Xlb+ .

Thus, the coefficients of a linear ElM can be obtained as the solution of the linear
programming task composed of items (26), (27), (24), (31):

Minimize objective function

¢(b-,b+) = c' (b+ - b- )

subj ect to the constraints

(32) b- b+ <
0

<
Rlb + Rzb+ r
- +
Xlb + XZb ~
Y
-x2b- Xlb
+ ~ -y

Allowance for interval data is easily made by substituting the appropriate boundaries
Xl' X;, y- and X~, X;, y+ for the exact data Xl' X Z' Y [21].
 482

6 Concluding Remarks

As can be seen from this representation, the shift from well established statistical
methods of inference to empirical methods guided by epistemological criteria is not only
desirable in order to improve the testability of econometric hypotheses: It is also
practicable from the mathematical point of view. However, it must be granted that the
"estimation procedure" loses some elegance. Moreover, the technique developed in the
previous section is not intended to provide an ideal method for determining the
numerical values of the coefficients in the ElM. It is simply a rationale to obtain those
numerical \"alues which produce the most informative hypothesis, i.e. the statement with
the highest risk of falsification among all possible hypotheses not yet defeated.
Therefore, the solution of optimization problem (23) should be interpreted merely as a
useful guideline for the numerical setting of an EIH. After all - irrespective of the
"estimation" method - an EIH, like any other hypothesis, remains a more or less vague
conjecture, which only corroborates through repeated and rigorous empirical testing.

Finally, two implications of the ElM seem worth mentioning [22]. First, an EIH may
be used not only in macroeconomic forecasting, but also in policy decision making. Then
eq uation (15), with a fixed target interval [y], has to be solved for some policy instru-
ment variable xi. Again, the solution is an interval [x i], unless the target interval is
inadequately narrow compared to the forecast precision of the EIH. In the latter case,
no setting of the instrument variable exists which guarantees the realization of the
target. This result ref1ects the almost evident rule that the precision of policy target
formulation has to correspond to the stringency of the supposed inf1uence of the in-
strument variable on the target variable.

Likewise, another implication of the ElM seems to be self-understood: In a dynamic

ElM where at least one of the explanatory variables is the endogenous variable with
some lag, iterative predictions automatically take into account the forecast uncertainty
of previous prediction periods. So, generally (but not necessarily), prediction intervals
widen as the forecast horizon is extended. In the final analysis, these characteristics of
the ElM make it clear that "soft hypotheses inevitably entail "soft" conclusions -
U

a point sometimes neglected in traditional econometric reasoning.

References

Alefeld, G. Herzberger, J. [1974]: Einfuhrung in die Intervallrechnung,

Bibliographisches Institut: Mannheim i Wien / Zurich

Blaug, M. [1980]: The Methodology of Economics - Or How Economists Explain,

Cambridge University Press: Cambridge

Garloff, J. [1985]: Interval Mathematics, A Bibliography, Institute for Applied

Mathematics. Uni\"ersity of Freiburg (West Germany)

Garloff, J. [1987]: Bibliography on Interval Mathematics, Continuation, Institute for

Applied rVlathematics, University of Freiburg (West Germany)
 483

Grohmann, H. [1976]: Statistics in Economic Sciences and Economic Policy - Some

Methodological Reflections upon Objectives and Approaches (in German), Allgemeines
Statistisches Archiv, Vol. 60, pp. 320-356

Haavelmo, T. [1944]: The Probability Approach in Econometrics, Supplement to

Econometrica, Vol. 12

Lorenzen, G. / Maas, C [1989]: On Input-Output Analysis with Interval Data (in

German), Jahrbucher fUr Nationalokonomie und Statistik, Vol. 206, pp. 257-263

Maier, T. [1985]: Intervall-Input-Output-Rechnung, Hain Verlag: Konigstein (West

Germany)

Maier, T. [1987]: Interval Input-Output Analysis as the Basis of a Price System with
Inexact Data Material (in German), Jahrbucher fur Nationalokonomie und Statistik,
Vol. 203, pp. 274-294

Moore, R.A. [1966]: Interval Analysis, Prentice Hall: Englewood Cliffs (New Jersey)

Nickel, K. [1978]: Intervallmathematik, Parts I and II, Unpublished script of lectures

held at the University of Freiburg (F.R.G.)

Popper, K.R. [1959]: The Logic of Scientific Discovery, Basic Books: New York

Rohn, J. [1980]: Input-Output Model with Interval Data, Econometrica, Vol. 48,
pp.767-769

We\\'el, M.C [1987]: Intervallarithmetische Dependenzanalyse in der Okonometrie -

Ein konjekturaler Ansatz, Verlag Peter Lang: Frankfurt I Bern I New York I Paris

Footnotes

[I] See Blaug [1980], p. 259.

[2] Blaug [1980], pp. 260-261.

[3] See Grohmann [1976], pp. 347-351.

[4] For convenience, the discussion of the interval approach is restricted to the case of
a single economic relationship, in which the endogenous variable is a continuous
function of several explanatory variables.

[5] For this section see textbooks of interval mathematics by Moore [1966], Alcfeld
Herzberger [1974] and Nickel [1978].

[6] See Preface to Moore [1966].

[7] A comprehensive bibliography of interval mathematics and its applications is

provided by Garloff [1985] and [1987].
 484

[8] There are, e.g., applications of interval mathematics to input-output analysis; see
Rohn [1980], Maier [1985] and [1987], Lorenzen! Maas [1989].

[9] See Nickel [1978], Part I, p. 14.

[10] See Moore [1966], p.18, and Nickel [1978], Part I, p. 13. Note that the natural
extension is not unique, because [F] depends on the specific representation of term f.

[11] In this context, continuity refers to the metric defined by

q([a],[b]) := m?-xmin {Iai -bil,lai -bi!}

1
in interval space In(m); see Moore [1966], pp. 15-18.

[12] See Alefeld / Herzberger [1974], pp. 32-33.

[13] An attempt to define the stochastic econometric hypothesis associated with a

traditional econometric model is made by Wewel [1987], pp. 78-82.

[14] See Popper [1959], p. 86.

[15] See Popper [1959], pp. 119-126.

[16] g(x) has to fulfill the same requirements as a density function in probability theory
(non-negativity, unit integral).

[17] This means that both EIHs must be commensurable in the sense that they refer to
the same endogenous variable; see Wewel [1987], pp. 130-131.

[18] The necessary condition for obtaining unique estimation results in the stochastic
model, namely that the number of available observations, i.e. the cardinality of E, has
to equal or exceed the- number of coefficients, applies to the interval model as well.

[19] Note that, in order to be on the conservative side in case of interval data, all
structures which are possibly refuted by the empirical evidence have to be excluded
from the selection (which is asymmetric to test rule (20)).

[20] Here the distributive law holds, because at least one of any two corresponding
components of matrices Xl and Xz equals zero.

[21] See Wewel [1987], pp. 187-193.

[22] For mathematical details see Wewel [1987], pp. 177-186.

 PART 8:

ANALYZING THE STRUCTURE AND SENSITIVITY OF ECONOMETRIC

MODELS
Optimal triangulation of a matrix and a measure of interdependence for a linear eco-
nometric equation system

Jiirgen Bartnick
FernUniversitat Hagen
Lehrgebiet Statistik und Okonometrie
Feithstr. 140, D-5800 Hagen 1, FRG

Abstract
A measure of interdependence of a system of equations facilitates e.g. Monte Carlo studies of small
sample properties of estimators and tests.
To find such a measure we reorder the equation system such that the sum of the absolute values
above the the main diagonal of the coefficient matrix is maximal. If in the reordered system there
are only zeroes below the main diagonal, the system is recursive and the degree of interdependence
is zero. We use the 'degree of linearity' proposed by Helmstiidter 1965 for an equivalent problem
(triangulation of an input-output matrix) to measure the degree of interdependence. The measure
is refined later: First the classes of interdependence are constructed (using the transitive closure
operation) and then the measures of interdependence are computed within these classes. This
means block-triangulation of the coefficient matrix and corresponds to reordering the equation
system so as to achieve a blockrecursive system of equations.
Keywords: reordering of equations; optimal ranking; linear ordering problem; measure of inter-
dependence; degree of linearity; triangulation; block-triangulation, blockrecursive system.

Contents
1 Linear econometric equation systems
2 The position matrix of an equation system
3 Construction of the transitive closure of the position matrix
4 Classes of interdependence
.5 The optimization problem
6 Construction of a ranking for the classes of interdependence
7 Measure of interdependence within a class of interdependence
8 Critical remarks on the method
9 Appendix: Some short programs in PASCAL
References

1 Linear econometric equation systems

vVe consider a linear econometric equation system of the form

where
C is a real matrix of type m X m, nonsingular, and all its elements on the main diagonal are equal
to -1 (the coefficient matrix of the system),
Yt is a vector with m real components, containing the unlagged endogenous variables of the model.
B is a real matrix of type m X k,
 488

Xt is a vector with k real components, containing the predetermined variables of the model: exo-
genous and lagged endogenous variables,
Ut is a vector with m real components, containing the error terms,

t is time.
Two variables Yi and Yj are called interdependent if Yi depends on Yj and vice versa. They are
directly interdependent if the elements eij and eji of the coefficient matrix C are both different
from zero. But it can happen that interdependence is not recognized at once from the coefficient
matrix, because the interdependence is indirect. Therefore, we construct the transitive closure
of the position matrix (section 3). In a first approach we reorder the equation system such that
the sum of all absolute values of the coefficients above the main diagonal is maximal. If one gets
only zeros below the main diagonal, the system is (with respect to the form of C) recursive and
the degree of interdependence should be zero. The "degree of linearity" defined by Helmstadter
as the measure of success for triangulating input-output matrices corresponds to the "degree of
recursivity" for econometric equation systems. Therefore, we can use this degree to formulate our
measure of interdependence.
But this first approach is very hard to compute for large equation systems. Therefore we refine our
method. \Ve first compute classes of interdependence by taking the transitive closure of the position
matrix. \Vithin these interdependence classes we use our first approach. Thus the problem is to
block-triangulate the econometric equation system. Triangulation does not mean transformation
into an exact triangular matrix (that is not possible in general) but it means transformation into a
matrix, where the sum of absolute values of the elements below the main diagonal of the coefficient
matrix C is minimal. This definition was given by Korte and Oberhofer (1969).

2 The position matrix of an equation system

The coefficient matrix C contains the essential information concerning interdependence of our
equation system. For the elements on the main diagonal of C it is customary to choose the
coefficient -1. \Ve define a matrix P of the same type by

Pij 0 if ei) = 0

pi) else.

This matrix is called relation matrix by Krupp (1976) and position matrix by Bodin (1974). There
is another situation, if P is chosen before C is estimated. Then eij = 0 a priori, if Pij = O.
If one considers the position matrix P instead of the coefficient matrix C some information is lost.
We will later return to the coefficient matrix C. But for the moment using the position matrix has
some advantages: Numerical values are ignored, only direct dependences are indicated. Variable
Yi is directly dependent on variable Yj iff Pi; = 1. (This follows from equation number i because
of Pii = 1.) \Ve could even use Boolean values (false and true) as components of P, but for later
computations it is simpler to use the integer values zero and one.
Example:
\Ve consider the example from Gruber (1968), pp.38-41. There are m 5 endogenous variables.
The coefficient matrix is

C = (~ ~ 0 0 *
1 1 -1
~ ~:~~ ~)
0.13 0
* 0
o 0 0 *
(we use * as a neutral symbol for -lor 1 in the main diagonal).
 489

id)
The position matrix in this example is

p~(H
Dependence should be a transitive relation, therefore we build the transitive closure. In the example
Y2 depends directly on Y4 and Y4 depends directly on Y3, therefore (by transitivity) Y2 depends on
Y3. General definition: The transitive closure is the smallest transitive extension (of a relation or,
in our case, a matrix with elements 0,1).

3 Construction of the transitive closure of the position matrix

The algorithm for a computer program for constructing the transitive closure of the position matrix
P is not trivial. We choose the formulation of Reingold, Nievergelt, Deo (1977), p. 341. As we
do not use Boolean values in the position matrix we need a function "vel" (or function) with the
property

vel(O,O) == 0, vel(O, 1) == 1, vel(l,O) == 0, vel(l, 1) == 1.

The formulation in PASCAL for the function "vel" and for procedure "transc" IS given III the
appendix. In the example we get the following transitive closure:

4 Classes of interdependence
Two variables Yi and Yj are interdependent if tij == 1 and tji == 1. The relation of interdependence
is an equivalence relation and we are interested in equivalence classes for this relation, see Krupp
(1976).
In the example the classes of interdependent elements are obvious. The first class is formed by 1,
2, 3, 4, i.e. the first four structural equations of the .5-equation-model taken as an example, and
the second class consists only of the element 5, i.e. of the 5th structural equation.
In the appendix we give a PASCAL procedure giving all classes of interdependent elements for a
given transitive closure T of a position matrix P.
For the example the output is:
1 234
5
The elements of the classes of interdependence are ordered by their numerical value in the computer
output (of course, each class of interdependence is a set and there is no order of the elements). In
the computer output the classes are ordered by the numerical value of the first element. But we
are interested in an optimal linear ordering. We will consider the internal order of the classes of
interdependence later. We first have to define an optimality criterion resp. an objective function.
As we now consider classes as elements, it is adequate to take a more abstract point of view. Up
to now we only considered econometric equation systems.
 490

5 The optimization problem

There are several problems which have the same structure:

a) aggregation of preference relations

b) triangulation of an input-output matrix

c) optimal reordering of a linear econometric (or other) equation system.

The considered elements are

a) alternatives

b) production sectors

c) endogenous variables.

Relations between the considered elements are

a) alternative A is better than alternative B

b) sector Si supports sector Sj

c) variable Yi depends on variable Yj.

In all three cases the problem can be extended to weak relations (search for optimal preference-
indifference-relations, block- triangulation of an input-ou tput matrix, block- triangulation of an equa-
tion system). These problems are reconsidered later (section 8). We used the transitive closure of
the position matrix and the classes of interdependence to reduce the problem to strong relations.
In all three problems a typical quadratic matrix is used:

a) voting matrix

b) input-output matrix

c) coefficient matrix of endogenous variables.

The voting matrix contains in row i and column j the number of votes for" ai is better than ai".
The input-output matrix contains in row i and column j the transactions from sector i to sector j.
The coefficient matrix contains in row i and column j the factor (oy;j aYj) measuring how strong
variable Yi depends on variable YJ. For the following optimization problem only non-negative values
make sense (otherwise positive and negative values could sum up to zero). Therefore in the case of
econometric equation systems we take the absolute value of the coefficients. This is also reasonable
for the transformation of problem c) into problem a) - there is no negative number of votes.
We now have the fourth problem of optimally reordering classes of interdependent elements. The
matrix to be triangulated has as elements only zero or one and the number of rows is equal to
the number of different classes of interdependence. We get the matrix to be triangulated from the
transitive closure: For every class we choose a representative variable (e.g. the first variable of
the class in the numerical ordering). Then we remove all other variables which are not chosen as
representative variables and the corresponding rows and columns of the transitive closure.
In the example we have a matrix with 2 rows. vVe choose YI and Ys as representative variables and
remove rows and columns no. 2,3, 4. Result:

1: o
5:
 491

We look for an optimal ranking of these elements (alternatives, production sectors, endogenous
variables, classes of interdependence).
Optimality criterion: A ranking is called optimal, if the sum of the absolute values above the main
diagonal of the matrix is maximal.
Objective function: The sum of the absolute values above the main diagonal of the matrix.
Equivalently we could minimize the sum of the absolute values below the main diagonal. In the
special case when the sum of the values below the main diagonal is zero, we have an upper triangular
matrix. Therefore in the case of input-output matrices the name "triangulation" is usual, though
in general it is not a precise triangulation in the sense of linear algebra (Korte/ Oberhofer, 1968,
1969) .. Methods of linear algebra for block-triangulation cannot be used for our problem. The
optimization problem is not trivial, it is NP-hard (it is equivalent to the minimal feedback arc
set problem, see Garey/Johnson 1979, problem GT8). This optimization problem is solved in
Korte/Oberhofer (1968,1969), BartMlemy/Monjardet (1981), Bartnick (1983,1989), Reinelt (1985).
The problem has different names: triangulation of input-output matrices, construction of a median
relation, aggregation of preference relations, linear ordering problem. Applications are described in
Gruber (1978) and Wessels (1981). Methods of artificial intelligence are used to improve computing-
time (Bartnick 1989). Another question is the number of optimal solutions. For the problem of
econometric equation systems one optimal ordering is sufficient, but there are several solutions in
general, which is not only of theoretical interest. Already Korte and Oberhofer remarked that the
number of optimal solutions is a structural measure for the considered matrix (Korte/Oberhofer,
1969, p.429: "This fact ... shows that the number of essential different optima can be interpreted
as a further structural indicator (Strukturkennzahl)." Bounds for the number of optimal solutions
are given in Bartnick (1990). The number of optimal solutions seems to be closely connected with
the computing time for the A * algorithm (Bartnick 1989).

6 Construction of a ranking for the classes of interdependence

The general methods described in section 5 can be applied for the ranking of the classes of in-
terdependence. But of course this application is a rather special case. The transitive closure is
by definition a transitive relation. What is needed is only an extension of an ordering to a linear
ordering. This is always possible (Szpilrajn, 1930). We used the PASCAL program "measure"
(described in section 7) which can handle this special problem, of course, too (the computing time
is very short compared to the general case, because methods of artificial intelligence can recognize
this special case). We do not have to use the special algorithm described in Krupp (1976).
For the example the result is trivial:
.5: 1
1: a 1.
Ys depends on Yl and therefore Ys depends on all other Yi (but no Yi depends on Ys).
The program "measure" not only gives a ranking, but also a measure of interdependence (as its
name indicates). In the case of classes of interdependence the measure is zero, of course.

7 Measure of interdependence within a class of interdependence

We now use the coefficient matrix C instead of the position matrix P. The position matrix is
given a priori before the coefficients are estimated from empirical data. The optimal ranking was
computed to simplify the estimation of coefficients. But after the coefficients have been estimated
it is reasonable to ask for the degree of interdependence using all information contained in the
coefficient matrix C. As already mentioned we have to take the absolute values of the coefficients.
For practical reasons, we use integer values and therefore we multiply the coefficients by a constant
factor, e.g. 100.
 492

For each class of interdependence we look for an internal measure of interdependence.

For problem b) (the triangulation of input-output matrices) we have a measure for the success of
triangulation: the degree of linearity (Helmstadter, 1965). This degree of linearity is a measure for
the dependence of production sectors. It is widely accepted and used (e.g. in Wessels, 1981).
As problems a), b), c) have the same structure we can use this measure in all three types of
problems.
For econometric equation systems it would be more common to call this degree "the degree of
recursivity" (but that would confuse mathematicians and computer scientists because they would
think of complexity of recursive functions).
The degree of linearity for a matrix C = (Cij) is defined as

A= Li<j I Cij I,
Liofj I Cij I
where it is assumed that the matrix C is already ordered optimally.
The degree of interdependence is now defined as

8:=2·(1-A).
As A is the degree of "recursivity", we have to take the complementary value (1 - A). The factor
2 is chosen because the minimal value of A is 0.5.
If we have only zeroes below the main diagonal, then

A = 1 and 8 = O.
If lambda has its minimal value then

A = 0.5 and 8 = 1.
In the example of GRUBER (1968) we get for the interdependence class of the first four variables
(the fifth variable forms a separate interdependence class):

(~o
100
0
~ ~* ~~)
100
13
100 *
We now look for an optimal reordering of this system, which maximizes the sum of values above
the main diagonal.
The program "measure" (written in PASCAL) is available in Bartnick (1991). It computes an
optimal ranking with the algorithm of Bartnick (1989) and uses the formula above. We get as a
measure of interdependence

Ii = 0.56.
Optimal rankings for this problem are not of interest. There may be several rankings, but all must
give the same value for the measure of interdependence.

8 Critical remarks on the method

In the general case (preference-indifference relations) we cannot use the method of sections 5, 6
and 7. The problem corresponds to blork triangulation of input-output matrices. Wessels wrote:
"Fiir die Blocktriangulation gibt es heute !loch keine mit der Triangulation vergleichbare exakte
Berechnungsmethode" (Wessels, 1981, p. 38).
 493

One could use the method of sections 5, 6 and 7 and get the indifference classes via the elements
remaining below the main diagonal in the optimal solution. But as econometric equation systems
are very large and the optimization problem is NP-hard, this is quite impractical.
And there are theoretical reasons for not doing this: The objective function used in section 5 is not
adequate for preference-indifference relations.
Remember that the general formulation of "optimal fit" is a minimum (least sum of distances,
Barthelemy /Monjardet 1981) and this minimum can be transformed in a maximum in the case of
preference relations without indifferences (Bartnick, 1983, p.131).
In the case of a general preference-indifference relation resp. in the case of block triangulation this
minimum cannot be transformed into a maximum in the same way (consider the special case of
total indifference).
Tiishaus (1983) proposes a general method for all types of relations (order, preorder, equi valence, ... ).
An example for preference-indifference relations (complete preorders) is given on p.95.
This algorithm is too slow for large econometric equation systems. Transitive closure is simpler and
very fast in computation, but there is no clear optimization criterion. Which objective function is
to be maximized or minimized, if we build the transitive closure?
For this question it is interesting to compare results of voting theory with econometric equation
systems.
If we take for example the coefficient matrix

c = (~~ ~~ ~:~)
0.6 0.3 -1
there is nothing remarkable: The equation system is totally interdependent, if we use the transitive
closure of the position matrix. But for the analogous voting matrix

C = (
*
10
20* 50)
40
60 30 *
the famous voting paradox arises. Solving the voting paradox by declaring all three alternatives as
indifferent, is obviously too simple.
Final remark: In this paper only discrete methods were used. There are approaches which use con-
tinuous methods (GauB-Seidel and Newton-type algorithms), e.g. Garbely/Gilli (1984), Don/Gallo
( 1987).
 494

9 Appendix: Some short programs III PASCAL

Declarations for sections 1-4:
const m =5
type imat: array [Lm, Lm] of integer;
These declarations have to be adapted to the problem.

function vel(i,j:integer): integer;

begin
if (i=O) and (j=O) then vel:=O
else vel:=l;
end;

procedure transc(p:imat;var t:imat)

var i,j,k: integer;
begin
for i:=l to m do for j:=l to m do t[i,j]:=p[i,j];
for k:=l to m do
for i:=l to m do
if t[i,k]=l then
for j:=l to m do t[i,j]:=vel(t[i,j],t[k,j]);
end;

procedure interdep(t:imat);
var i, j: integer;
ok: array [l .. m] of boolean;
begin
for i:=l to m do ok[i] :=false;
for i:=l to m do
if not ok[i] then
begin
Ilrite(i:3);
for j:=l to m do
i f (t[i,j]=1) and (t[j ,i]=1) then
begin
Ilrite(j:3);
ok[j] :=true;
end;
Ilriteln;
end;
end.
 495

References
BARTHELEMY, J.P. ; MONJARDET,B.: The Median Procedure in Cluster Analysis and Social
Choice Theory, Mathematical Social Sciences 1 (1981), pp. 235 - 267
BARTNICK, J.: Bewertung und Kompromifibildung, Eine Weiterentwicklung der Nutzwertanalyse
mit Beispielen aus der Raumplanung, Baden-Baden 1983
BARTNICK, J.: An A * Algorithm for the Aggregation of Preference Relations, Methods of Ope-
rations Research 59 (1989), pp. 311 -322
BARTNICK, J.: On the Number of Optimal Solutions of the Linear Ordering Problem, Extended
Abstract, Methods of Operations Research 63 (1990), pp. 425-426
BARTNICK, J: Ein Mail fUr die Interdependenz okonometrischer Gleichungssysteme und Ver-
fahren zur Ermittlung blockrekursiver Strukturen. Diskussionsbeitrag Nr. 166 des Fachbereichs
Wirtschaftswissenschaft, FernUniversitat Hagen 1991
BARTNICK, J: Aggregation of individual preference relations to a collective cardinal evaluation
(to appear in Methods of Operations Research)
BODIN, L.: Recursive Fix-Point Estimation. Theory and Applications, University of Uppsala,
Department of Statistics, Selected Publications, vol. 32, 1974
DON, F.J.H.; GALLO, G.M.: Solving Large Sparse Systems of Equations in Econometric Models,
Journal of Forecasting 6 (1987), pp. 167 - 180
GAREY, M.R.; JOHNSON, D.S.: Computers and Intractability - A Guide to the Theory of NP-
Completeness, San Francisco 1979
GARBELY, M.; GILLI, M.: Two approaches in reading model interdependencies, in: ANCOT,
J.P. (ed.), Analysing the Structure of Econometric Models, The Hague, Boston, Lancaster 1984,
chapter 2
GRUBER, J.: Okonometrische Madelle des Cowles-Commission- Typs: Bau und Interpretation,
Hamburg-Berlin 1968
GRUBER, J.: Zur Interdependenz iikonometrischer Gleichungssysteme, in: FROHN, J. (ed.), Ma-
kroi:ikonometrische Modelle fUr die Bundesrepublik Deutschland, Gottingen 1978, pp. 185 - 213
HELMSTADTER, E.: Ein Mail fiir das Ergebnis der Triangulation von Input-Output-Matrizen,
Jahrbiicher fiir Nationaliikonomie und Statistik 177 (1965), pp. 456 - 463
KORTE, B.; OBERIIOFER, W.: Zwei Algorithmen zur Losung eines komplexen Reihenfolgepro-
blems, Unternehmensforschung 12 (1968), pp. 217 - 231
KORTE, B.; OBERHOFER, W.: Zur Triangulation von Input-Output-Matrizen, Jahrbiicher fUr
Nationaliikonomie und Statistik 182 (1969), pp. 398 - 433
KRUPP, R.: Interdependenz und Zerlegbarkeit iikonometrischer Madelle, Jahrbiicher fUr Natio-
nalokonomie und Statistik 190 (1976), pp. 105 - 120
REINELT, G.: The Linear Ordering Problem: Algorithms and Applications, Berlin 1985
REINGOLD, E.M., NIEVERGELT,J. ; DEO, N.: Combinatorial algorithms: Theory and Practice,
Englewood Cliffs, New Jersey 1977
ROD DING, W.: Aggregation of Individual Preferences, Gottingen 1975
SZPILRAJN, E.: Sur l'extension de l'ordre partiel, Fundamenta Mathematicae 16 (1930), pp. 386
·389
TUSHA US, U.: Aggregation binarer Relationen in der qualitativen Datenanalyse, Kiinigstein/Ts.
1983
WESSELS, n.: Triangulation und Blocktriangulation von Inpu t-Output- Tabellen und ihre Bedeu-
tung, Deutsches Institut fiir \Virtschaftsforschung, Beitrage zur Strukturforschung, Heft 63, Berlin
1981
Evaluating the number of zero eigenvalues in a
dynamic model

Myriam Garbely and Manfred Gilli

Department of Econometrics
University of Geneva
1211 Geneva 4, Switzerland

Abstract

If a sparse matrix can be put into a block triangular form its eigenvalues can simply be
computed from the submatrices on the diagonal and most zero eigenvalues are recognized
without numerical computations. It is shown how to find the block triangular form of a
dynamic multiplier matrix based only upon the causal content of the coefficient matrices.
For the indecomposable matrices on the diagonal additional zero eigenvalues may also be
identified on a qualitative basis. Moreover the approach provides insight on which coefficients
are relevant for the existence of eigenvalues and which coefficients are not.
Keywords: Structural properties of econometric models; graph theory; sparsity.

Contents

1 The problem
2 Case with decomposable matrix D
3 Maximum matching and minimum cover
4 Illustration
5 Comments
References

1 The problem

The investigation of the dynamic properties in a model consists, among others, in evaluating
the eigenvalues of a particular matrix. Let us consider a deterministic linear model in its
structural form
(1 )
where Yt is the (n xl) vector of endogenous variables and Zt is the (m xl) vector of exogenous
variables. D, E and F are coefficient matrices. If D is nonsingular the reduced form of (1)
will be
(2)
and it is well known that the steady-state solution of (1) depends on the eigenvalues of
D- 1 E. From a numerical point of view, the identification of zero eigenvalues is a delicate
matter, e~pecially if the dimension of D- 1 E becomes large. However. for applications where
D and E Me large, but sparse, as it is the case for almost all econometric models, D- 1 E
 497

might be put into a block triangular form by appropriate column and row permutations and
the eigenvalues are those of the submatrices on the diagonal.
If E has p nonempty columns, i.e. there are p lagged endogenous variables, it is straightfor-
ward that D- l E can be put into the following block triangular form

_ D-l E _ _ D- l [ Epp 0 ] _ [ Spp ] (3)

- E(n_p)p 0 - S(n-p)p O(n-p)(n-p)

with n - p single zero blocks corresponding to n - p zero eigenvalues l .

Our purpose is to investigate, relying only upon the structure of the matrices D and E,
whether the p X P submatrix Spp of D-lE contains additional zero eigenvalues.

2 Case with decomposable matrix D

If matrix D is indecomposable, i.e. if all n equations form one interdependent model, the
submatrix Spp in (3) will also be indecomposable and we will show in section 3 how zero
eigenvalues may be identified in such a case.
If D is decomposable it can be put into a block triangular form and D- l will have the same
block triangular pattern. In such a case the submatrix Spp in (3) might also be decomposable,
but of course with a different pattern. We can take advantage of such a decomposition to
identify additional zero eigenvalues.
A nonzero eigenvalue corresponds to a feedback in the model, i.e. a loop which goes over
the same variable from period t - 1 to period t.
If the matrix D is indecomposable every entry in matrix E creates a feedback. To identify,
whether in the case of a decomposable matrix D the lagged variables create feedback, we
drop all the lags, so that all lagged variables become current variables. This leads to a new
model with a matrix D*, corresponding to D + E, for which we seek the block triangular
form 2 •
If we now partition the original matrices D and E according to the q blocks of D* as shown
in (4), they will be block triangular, however, the diagonal blocks may be decomposable. In
such a case we partition the zero and nonzero columns of each matrix Ei as described in (3).

S1

[D": Di :
1
[E'.: E2. . S2 (4)

... ... D;l ......... Eq ......... Sq

v '-------.----"
D-l E D-IE

A diagonal block Si in matrix D- l E is given by D-;l E i . The eigenvalues of matrix D- l E

are given by the eigenvalues of the blocks 5 i , which can then be investigated separately.
The discussion which follows applies indifferently either to a block D,-l Ei in case of a de-
composable matrix D*, or to the full matrix D- l E in case D* is indecomposable.
lSuch a decomposition has been used for example in [4].
"For more details about block ordering see [1].
 498

3 Maximum matching and mInImum cover

As D is assumed regular, the rank of D-l E is determined by the rank of E. In order to

determine an upper bound for the rank of E we will use the following bipartite graph

(5)

which corresponds to the matrix E. The set of vertices H represents the rows of E, which
are the equations, and the set of vertices y(-I) represents the columns of E. The set of edges
AE corresponds to the nonzero elements in matrix E, i.e. for a given element eij which is
nonzero there will be an edge [hi,y)-I)] in G E •
Let us now consider a matching ~VE of G E , i.e. a set of edges none of which being adjacent,
thus defining a one to one correspondence between some vertices belonging to H and some
vertices belonging to y-I. For matrix E a matching corresponds to a set of elements such
that each row and each column contains at most one of these elements. We then have

rank(E) S card(Wi) (6)

where rVE is a matching with the maximum possible cardinality in G E. To show this, let us
consider the determinant 3 of matrix E:
n
I E 1= L s(p) II eip(i) , (7)
pEPin) i=1

where P( n) is the set of n! permutations of set I = (1,2, ... , n) and p( i) is the i- th component
of permutation p. The function s takes the value +1 if the permutation is even and -1 if it
is odd. We conclude that a necessary condition for I E 1# 0 is that there exists at least one
permutation p, such that the product in (7) becomes nonzero. The set of elements of matrix
E satisfying
eip(i)#O for i=1,2, ... ,n (8)
corresponds in G E to a set of edges which define a matching. Hence it comes that a matching
with maximum cardinality WE will define the largest submatrix of E for which (7) is nonzero.
If the maximum cardinality of the matchings of matrix E is r < p, matrix Epp in (3) can
be partitioned in a way to show which columns or rows of Epp are linearly dependent. To
do so, we consider a minimum cover C' in G E, i.e. the smallest set of vertices which meets
every edge. According to the theorem of Konig-Egervary4 we have

card(Wi) = card(CE), (9)

I.e. the maximum number of edges in a matching equals the minimum number of vertices in
a cover.
Let VI be the number of vertices of the cover belonging to 1I and V2 the number of vertices
of the cover belonging to y(-l), VI + V2 = r. We then partition matrix Epp as follows:

(10)

3See for instance [2].

4 A proof of the theorem can be found in [3] and [.')].
 499

where the dimension of the zero matrix satisfies p - VI + p - V2 > p, which characterizes
a singular matrix. If V2 > VI matrix E V ,(P- V 2) contains the V2 - VI dependent columns, if
VI > V2 it is matrix E(P-VJ) V 2 which has VI - V2 dependent rows.

4 Illustration

All the computations of the following illustration have been carried out with the program
CAUSOR, see [1], for which mainframe and PC versions can be obtained from the authors.
The matrices given hereafter are incidence matrices S of D and E of a thirteen equation
model, such as defined in (1).

It;
I
2 2
3 . 1 I 3
4 1 1 4 1
5 I 1 1 5
6 I I 6
7 7
D= S 1 1 E= 8 1 1
9 I I 9
10 10 1 I
11 11 1 1
12 I .~
.. I 12
13 I . . I 1 13 I
Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y Y
2 I S I I 4 3 6 978 I 1 2 1 5 1 1 4 3 6 9 7 8 1 1
0 I 2 3 0 1 2 3

Matrix D is supposed to be nonsingular and matrix E has one zero column corresponding
to variable Ys, which makes matrix Spp in (:3) be of rank less than or equal to twelve.
Matrix D is decomposable and therefore we compute D* which happens to be decomposable,
too. Indeed we verify that D + E can be put into a block triangular pattern and we give
hereafter matrix D and matrix E partitioned according to the block triangular pattern of
matrix D*:

7 1 7
6 1 I 6
4 1 I 4 1
I I 1 5
13 1 I 13
3 3
D= 8 1 I E= 8
10 I I 10
9 1 1 9
2 I 2
12 I
1l
Y Y Y Y Y Y Y Y Y Y Y Y Y
'l4-n
. . I
12
11 I
Y Y Y Y Y Y Y Y Y Y Y Y Y
I :4-h
2 3 4 I I I 6 7 9 1 I 8 2 3 ·1 I I I 5 6 7 9 I I 8
I 2 o 3 I 2 o 3

We immediately recognize an additional zero eigenvalue corresponding to the zero on the

diagonal of E corresponding to variable Y13'
For the first block corresponding to variables Y2, Y3, Y4, Yll and YI2 we verify that the
maximum cardinality of all matchings is two, which gives three more zero eigenvalues.
SAn incidence matrix of a given matrix consists of ['s for nonzero elements and zero otherwise. For better
readability zeros are represented by dots. The same symbols are llsed for a matrix and its incidence matrix.
 500

Finally we have to seek a maximum matching in the block corresponding to variables Yl, Ys,
Y6, Y7, Y9 and YlO. The bipartite graph as defined in (5) is:

equations
@
o
o
@-

The edges drawn with solid lines form a matching with maximum cardinality which is five.
The vertices in the boxes form a minimum cover and we partition the block according to
(10):

8[0"
9
10
3
.1.
. . 1 1 . 1
1 . . . . .
. . 1 . . .
13 1 . . . . .
2 . 1 . . . .
y y y y y y
691157
o

which shows that the equations 2, 13,3 and 10 are linearly dependent in the subspace defined
by the variables Y6, Y9, YlO, Y1, Ys and Y7·
We conclude that the thirteen equation model has at most seven nonzero eigenvalues.

5 Comments

If D or D* is indecomposable, it is a maximum matching of the complete matrix E which

determines the lower bound for the number of nonzero eigenvalues.
If D* is decomposable the number of nonzero eigenvalues depends on the maximum matching
of the matrices E;, i = 1, ... , q, on the diagonal of E only.
The block triangular partitioning of E in (4) shows that any entry below the diagonal block
does neither affect the number of eigenvalues nor their numerical values. For the partitioning
of matrix Epp given in (10), only entries in the submatrix 0(p-V.)(P- V2) will increase the number
of nonzero eigenvalues, other entries will not modify the number of nonzero eigenvalues.
Finally from a computational point of view, the method presented is very operational as
the algorithm for putting the matrices D and D* into a block triangular form as well as the
algorithm for seeking a maximum cardinality matching of matrix E operate within linear
time.
 501

References

[1] Gilli, M., 1984, CAUSOR - A Program for the Analysis of Recursive and Interdepen-
dent Causal Structures, Cahiers du Departement d 'Econometrie, No 84.03, U niversite
de Geneve.
[2] Murata, Y., 1977, Mathematics for Stability and Optimization of Economic Systems,
Academic Press, New York.
[3] Roy, B., 1969, Algebre modeme et tMorie des graphes, tome I, Dunod, Paris.
[4] Schoonbeek, L., 1983, On the Number of Non-Zero Eigenvalues of a Dynamic Linear
Econometric Model, Empirical Economics, Vol. 8, pages 119-123.
[5] Strang, G., 1986, Introduction to Applied Mathematics, Wellesley-Cambridge Press,
Massachusetts.
Forecast and multiplier sensitivity analysis with respect to chan-
ges of structural equations and submodels in dynamic systems

Johann Elker
Fern U niversitiit Hagen
Lehrgebiet Statistik und Okonometrie
Feithstr. 140, D-5800 Hagen 1, FRG

Abstract
In this paper improved methods are presented for computerized automatic analysis of the sensiti-
vity of forecasts and multipliers in interdependent dynamic models. These methods facilitate the
diagnostic checking of the effects of structural coefficients on point forecasts and multipliers. The
effects of changes of all coefficients in one or more structural equations (i.e. in a sub model) on
point forecasts and multipliers are quantified. In addition, measures are constructed for measu-
ring the sensitivity to be investigated. The presented results may not only be helpful instruments
for sensitivity analysis of point forecasts and multipliers in the "finished" model. They may also
be useful tools for comparison of distinct submodels and variants of equations already during the
construction of econometric models.
Keywords: Sensitivity analysis in nonlinear and linear models; computing inverse matrices with·
out repeated inversion; measures of sensitivity; diagnostic checking.
Editor's Note:
Johann Elker, a blind mathematician, was a staff member of the Chair of Statistics and Econome-
trics, University of Hagen, and a doctoral student from June, 1985,till August, 1987. At that time
he suffered a severe stroke from which he never recuperated. He died on ~Iarch 13, 1989, at the
age of 4l.
In honor of Johann Elker, this paper is included in this proceedings volume. It was written as Dis-
cussion Paper No. 112 in 1986. the present revised version was finished on July 17, 1987. It briefly
summarizes several papers listed at the end of this paper (there, also various proofs and derivations
can be found). An earlier version of this paper was presented at the VlIIth International Confe-
rence on Problems of Building and Estimation of Large Econometric Models. Macromodels '86, in
Szczyrk-Bila, Poland. December 3-5, 1986, organized by the Committee of Statistics and Econo-
metrics, Polish Academy of Sciences, and the Institute of Econometrics and Statistics, University
of Lodz.
The methods of sensitivity analysis developed by Johann Elker can also be applied to nonlinear
models: In a Taylor series expansion. only the linear terms are used. For the linearization the
solution of the nonlinear system is used which is generally computed iteratively only once.
The methods for sensitivity analysis developed by Johann Elker are also available in a FORTRAN
computer program. It has been written in 1987 by Paul Chr. Gruber in close cooperation with
Johann Elker. It is available on request from the editor.
This program has been extended by parts for computing sensitivity measures (which J. Elker and
P. Chr. Gruber could not finish because of J. Elker suffering a stroke on August 29, 1987) by
Wiltrud Terlau. She also adapted the program to particular problems arising during the sensitivity
analysis of a 49-equation quarterly model of the "Vest German textile and apparel industry (see
paper by W. Terlau in this section).
 503

Contents
1 Introduction

2 Derivation of the final form and of multipliers

3 Sensitivity analysis of the reduced coefficients

3.1 Computation of the matrices of increments of the reduced coefficients in
the general case. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.2 Computation of matrices of increments of the reduced coefficients after
changing a submodel . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.3 Computation of the matrices of increments of the reduced form coeffi-
cients after changing one equation

4 SensHivity analysis of multipliers

4.1 Computing the matrices of increments of the multipliers in the general
case . . . . . . . . . . . . . . . . . . . .
4.2 Simplified computation of the matrices of multiplier increments after
changing a submodel . . . . . . . . . . .
4.3 Simplified computation of the matrices of multiplier increments after
changing one equation . . . . . . . . .

5 Sensitivity analysis of point forecasts

5.1 Calculating the forecast increments in the general case . . . . . . . . . .
5.2 Simplified computation of forecast increments after changing a submodel
5.3 Simplified computation of the forecast increments after changing onE'
equation . . . . . .

6 Sensitivity measures

7 Outlook
 504

1 Introduction
In this paper, instruments for automatically analyzing the sensitivity of point forecasts
and multipliers in large interdependent dynamic models are developed. In many cases
of forecasting by econometric models and calculating multipliers, considerable errors
occur, which may be due to the particular structure of the underlying model. Even small
changes of the structure may cause relatively large increments of forecasts. The forecast
sensitivity analysis serves for localizing strong influences on the forecasts, caused by
one or several structural coefficients. Like incorrect forecasts, erroneously estimated
multipliers can lead to disadvantageous decisions in economic policy. The structure of
the model may be a reason for the errors. It may be localized by sensitivity analysis of
the multipliers. Sensitivity analysis of forecasts and multipliers helps in diagnosing the
dependencies of multipliers and forecasts on the structural coefficients. Thereby, the
increments of multipliers and forecasts caused by a change in one or several structural
coefficients are calculated (under the ceteris paribus condition that all other coefficients
are not changed and interdependencies of coefficients are not taken into account). The
sensitivity analysis of forecasts and multipliers in nonlinear interdependent dynamic
systems with regard to influences of one or all coefficients of an equation is described
in detail by Elker (1986a,b,c,d).
In the present paper these results are developed further for analyzing the effect of
changing the structural coefficients of a submodel of a linear model. The changes of the
structural coefficients in the sensitivity analysis usually being small, the instruments
described can be transferred for use with nonlinear systems without severe loss of accu-
racy (using in a Taylor series expansion only the linear term and using for linearization
the solution of the nonlinear system which is generally computed iteratively only once).
In the linear case the presented algorithms permit the investigation of structural
changes of any size. So they arc suitable for diagnosing in the "finished" model and
for comparing the quality of various equations and su bmodels in the pbase of model
construction. Meanwhile, the author of this paper is transferring the techniques for
sensitivity analysis for use with nonlinear models.
The described methods may be of considerable importance not only in the "finished"
model, they may even be of help in the phase of construction. So they might improve
the accuracy of multipliers and forecasts, because the constructor of a model can easily
investigate the structural changes of several variants of equations or submodels, the
estimated coefficients and explanatory variables of which differ from those of the other
ones. Judging the quality of a variant by statistical and other criteria often does not
lead to a clear decision.
The classical method for sensitivity analysis requires the inversion of a matrix and
(in dynamic models) frequently a considerable number of matrix multiplications. It
always requires also considerable manpower input. Therefore it is rather expensive and
hardly applied. The techniques presented in this paper are, so to.speak, automatized
and, by and large, cheaper. Thus they facilitate simplified computerized sensitivity
 505

analysis especially of large systems. The proofs are neglected, since they are given In
Biker (1986a,b,c,d) or can be derived in similar ways.
The paper is organized as follows: In section 2, we present the structural form of
a dynamic linear system of (difference) equations. We also derive the corresponding
reduced form, the final form, impact multipliers and delay multipliers. Then we are
concerned with the sensitivity analysis of the reduced coefficients (section 3), of the
multipliers (section 4) and of the point forecasts (section 5). In the first subsection of
these three sections, we deal with the general case in which changes are made in all
equations. In the second subsection, changes are restricted to a submodel consisting of
one or more (h) equations. In the third subsection, a special case is treated: changes
of structural coefficients are made in only one equation. In section 6, measures of
the sensitivity of point forecasts with respect to changes of structural coefficients are
presented and briefly discussed.
I

2 Derivation of the final form and of multipliers

Our further considerations are based on the dynamic linear econometric equation sy-
stem in the structural form:

COY, + C1Yt-l + ... + CSYt-S + BoXt + B1Xt-1 + ... + BRXt-1? + tit = 0,

t = 1, ... , T, (1)

where

1. Yt,Yt-I, ... ,Yt-S are the g x 1 - random vectors of the endogenous variables in
the periods t, t - 1, ... , t - S,

2. Xt, Xt-l, ... ,Xt-R are the p x 1 - vectors of exogenous variables III the periods
t, t - 1, ... , t - R,

3. tit is the g x 1 - random vector of disturbances in the period t,

4. Co, C I , ... ,Cs are the g x g - matrices of the corresponding structural coefficients
of the endogenous variables and

5. Bo, B I , ... , BR are the g x p - matrices of the corresponding structural coefficients

of the exogenous variables.

Assuming that Co is nonsingular, the reduced form can be derived by solving (1) for
Yt:
Yt = F1Yt-1 + ... + FSYt-s + DoXt + D1Xt-l + ... + DRXt-R + Vt. (2)
In this equation, F., Dr and Vt are given by

(3)
 506

(4)
Vt = - C-1 0 Ut· (5)
The coefficients of the reduced form conLained in Lhe matrices F.• , s = 1, ... , S, and
Dr) r = 1, ... , R, are called reduced coefficients.
Appropriately lagged versions of (2) are substituted aL first for Yt-l in (2), then for
Yt-2 in the resulting equation etc. In this way, one obtains after K substitutions:

Yt + ... + pK
= PK+IYt-K-l
K ](+sYt-K-S + QK
0 Xt + 1 Xt-l + ...
QK

+ KXt-K + K+IXt-K-l + ... + K+RXt-K-R + W tK

Q K QK QK (6)

The equation (6) is called the final form with fixed starting conditions.
The matrices p!!and Qt; may be calculated using the recursively defined auxiliary
matrices <Pn:
n n-l
<Po =I and <Pn = L F~CJ>n-~ = L i1>k Fn-K (7)
.• =1 k=O

In all equations of this paper, it holds by definition: F3 = 0 for s < 1 or s > Sand
Dr = 0 for r < 0 or r > R. In (6), the coefficient matrices can be constructed as
follows:

n= K+1,K+2, ... ,K+S (8)

J(

Q~ = L <PkDn-k n = 0,1, ... , J{ + R (9)

k=O

Furthermore we have:

wr
K
= L <PkVt-k (10)
k=O

If the coefficients of the lagged endogenous variables approach zero for K -> 00, (if
and only if the modulus of the equation det(>.s 1+ >.S-1 Fl + ... + Fs) = 0 is less than
one; I denotes the unit matrix of rank g) (6) takes the form

Yi = QoXt + QIXt-l + ... + Wt· (11 )

Equation (11) is named final form under stochastic starting conditions.

The elements of the matrix Qo are called impact multipliers and those of the matrix
Qn (for n 2' 1) indirect, delay or lagged multipliers. The multiplier matrices can be
computed as follows:
n n

Qn = L i1>rDn-r =L i1>n-rDr 11.=1,:2, ... (12)

r=O r=O
 507

In the following the matrices C .• , s = 0,1, ... , S, and B r , r = 0,1, ... , fl, are replaced by
the matrices C,. and 13r of the estimated structural coefficients. The reduced coefficient
matrices F .• , s = 1,2, ... , S, and Dr, r = 0, 1, ... , R, are replaced by Fs and Dr, which
can be constructed corresponding to (3) and (4). The matrix <Pn and the matrix Qn,
n = 0, 1, ... , of the lagged multipliers are replaced by ell n and Q", which can be derived
according to (7) and (12).

3 Sensitivity analysis of the reduced coefficients

3.1 Computation of the matrices of increments of the reduced coef-
ficients in the general case
In this section the impact of changes of structural coefficients in all equations on the
coefficients of the reduced form of a dynamic system is investigated. This is possible
by quantifying the effect of the structural coefficients in equation (1) on the reduced
coefficients in equation (2).
For this purpose the matrices C.. of the endogenous variables and Dr of the exoge-
nous variables are varied by additive change matrices 6.C.• , s = 0, 1, ... , S, and 6.E r ,
r = 0,1, ... , R, where Co + 6.Co is assumed to be nonsingular. If the correction matri-
ces can be written as products 6.C, = XY! and 6.E r = XY~ of the 9 x It - matrix X
c, B,
and the h x 9 - matrices Yc! and the h x p - matrices y! , respectively, where h ::; g,
'. Ii,
then the matrices of increments 6.ft's and 6.D r of the corresponding coefficients of the
reduced form (2) obey the equations

6.F tl
= _C-0 1 XlI -l-
' Cn
y~ (;-1
0
X)-I(y!C ~ + y~C
lI
F)
$
( 13)

(14 )

The change matrices 6.C, and 6.E r can always be decomposed in products of the men-
tioned form. Thus, for example, for X the unit matrix I and for Y!, and Y! the change
c. B,
matrices 6.C.• and 6.E r themselves can be chosen. In this case, It = 9 holds, However,
the methods for sensitivity analysis derived from (13) and (14) provide advantages in
comparison to traditional procedures (i.e, recomputing by (3) and (4)) only if h is
substantially smaller than g, because in the other case the effort for computation may
not decrease sufficiently.

3.2 Computation of matrices of increments of the reduced coeffi-

cients after changing a su bmodcl
Varying the structural coefficients of a submodel which consists of 1 ::; h ::; 9 equa-
tions, i.e. changing the rows i l , ... , i h of the matrices (;", s = 0,1" .. , S, by the
 508

vectors !lei.. J • , ... , !lei.. It· and of t!Je matrices E r

~"'It ~'It
, r = 0, 1, ... , R, by the vectors
" , ... , !lb'r,t".
!lb'r11. · ,respectively, the matrices of increments can be written as:

!lC, = Ei!lC3 ,i
!lEr = E;!l Br,;

where i = (i l , ... , i h ) and E, denotes the 9 X h - matrix, the columns of which are the
unit vectors C;I" .. , CiJ, (Cikj = 1 for j = ik, 1 ::; k ::; h, else Cikj = 0). The h X 9 -
matrix !lC."j and the h X P - matrix !lEr ,;, respectively, arc identical with the vectors
of changes as their rows.
With X = Ei 'Yc! = !lC 3 ,i and Y! = !lEr,i, the following relations, which are
',. Br
fundamental for sensitivity analysis of the reduced form coefficients, may be derived
from (13) and (14):
(IS)
and
(16)
where
(17)
Furthermore, (COI)i denotes the matrix consisting of the columns i 1 , ... , i h of the
matrix COl.
When h is substantially smaller than g, the sensitivity of the reduced form coeffi-
cients can be computed without much effort, using (15) and (16). So it is not necessary
to compuLe repeatedly the changed system (1) of sLructural equations in Lhe usual way
(e.g. by inverting the 9 x 9 - matrix Co cLc.). These formulas may be applied for
sensitivity analysis separately to one structural coefficient or to more than one structu-
ral coefficient. Thus, the foundations for the simply feasible, computerized sensitivity
analysis of the reduced form coefficients with respect to all structural coefficients are
available.
The results in (15) and (16) may be transferred to changes of coefficients of several
variables in all structural equations (changing columns) In a similar way. But in the
present paper this case is not dealt with.

3.3 Computation of the matrices of increments of the reduced form

coefficients after changing one equation
When h = 1, which is an important special case for empirical economic research (one
variant of an equation is substituted by another one or all structural coefficients of one
equat.ion are changed), Lhe advantages of the new techniques become obvious. Formulas
(15) and (16) simplify to

(18)
 509

and
(19)
where
1

In these equations, cO,.i is the i-th column vector of COl, the 1 X 9 - vector 6.c 3 ,;. is the
change of the i-th row of the matrix C. and the 1 x p - vector 6.b r ,;. denotes the change
of the i-th row of the matrix 13r .

4 Sensitivity analysis of multipliers

4.1 Computing the matrices of increments of the multipliers in the
general case
We look at the general case in which the coefficients of all structural equations may be
changed at the same time. For this case, the relations between changes of the structural
coefficients and the resulting increments of multipliers are now given.
Let the matrices C., s = 0,1, ... ,5, and 13 r , r = 0, I, ... , R, in the structural form
(1) be changed by 6. C.• and 6.13 r , respectively, at the same time (6.C. = 0, =0 Yb.
for s > 5 and 6.13 r = 0, Y};, = 0 for r > R). CO + 6.Co and Co are assumed to be
nonsingular.
Furthermore let 6.C. and 6.13 r be decomposed into products of the 9 x h- matrix X,
the h X 9 - matrices Y~ and the h x p - matrices Y! like in section 3. Then the matrices
l.~ Br
of multiplier changes are given by
n n-k 1
6.Qn = L L ci>kCol X8 n- k- 1 r(L Yl.. QI-. + y~), for n = 0, 1,... (20)
k=O 1=0 3=0

where
r = -(I + y!Gil C-0 1X)-l. (21 )
The matrices en are recursively defined by
n
eo = 1 , en = L nme m - n n = 1,2, ... , (22)
m=l

where
m
nm- r "\~vl
L-,lC,.~m-3
~ c--lx
0 . (23)

In (20) <hc- l X represents an h x h - matrix, en-k-I and r h x h - matrices and

Yc: QI-s + Y B
: an h X P - matrix.
'. I
 510

The explanation in section 3.1 about simplified sensitivity analysis of reduced coef-
ficients holds also true for the simplified sensitivity analysis of multipliers: The techni-
ques based on (20) are only favourable if h is very much smaller than g.

4.2 Simplified computation of the matrices of multiplier increments

after changing a submodel
Changing simultanously all coefficients of the h equations, i l , ... , i h , 1 :S h :S g, i.e. by
changing the matrices of structural coefficients Cs by 6.C. and 13r by 6.13 r, respectively
,where 6.C., and 6.13 r can be decomposed like in section 3.2, the matrices of multiplier
increments may be written as:
n n-k 1
6.Qn = LL <I>dCo1)i8n_k_lr(L 6.C."iQI-. + 6.131,;), (24)
k=O 1=0

where rand (Colr are defined like in section 3.2 and 8 n -k-1 is defined 1Il (22), with
the exception that
m

TIm = r I: 6.C.,i<I>m-.(Co f· l (25)

.,=0
In the linear case, these algorithms handle any given magnitude of coefficient chan-
ges. Thus they are applicable not only for sensitivity analysis of structural coefficients
in several equations (the coefficient changes are relatively small), but they are even
useful for comparing different variants of equations and submodels with each other,
respecti vely.

4.3 Simplified computation of the matrices of multiplier increments

after changing one equation
Analogously to section 3.3, for h = 1 equation (24) implies the variation of the coeffi-
cients of one structural equation to be a special case. The formula for the simplified
computation of the matrices of multiplier increments resulting from a change in the
structural coefficients of the i-til equation is:
n n-k 1
6.Qn = :L L IOn-k-l<I>kc~,i(:L 6.C~,iQI-s + 6.6;,i), (26)
k=O k=O .• =0

where the i-th row of the matrix C., is changed by 6.c' . , s

~q ,1.
= 0,1, .. . ,5, and the i-th
row of the matrix 13r is changed by 6.b~,i' r = 0, 1, ... , R, respectively. cO,.i denotes
the i-th column of the matrix COl. The inverse of an h x h - matrix appearing in r in
(24) simplifies to calculating the reciprocal value of a scalar:
1
"'( = (27)
 511

In this special case, the matrices 8 n - k- 1 also reduce to a scalar, which can be computed
by
n

00 = 1 On = L lfmO n - m n = 1,2, ... , (28)

m=l

where

(29)

One might presume that the compuLa\,ion of the matrices of increments D.Qn) which
result from changing several equations at a time, may be simplified and accelerated
by stepwise changes using the less complicated formula (26). However) this procedure
requires the inversion of Co after each step before calculating the next one (in reality,
repeatedly calculating the col umns iI, i"l., ... ) i h is sufficient). Especially it can happen
that one s\,ep produces a (nearly) singular matrix of coefficients Co (in the worst case
even independent of the order of the changes), although the matrix is nonsingular after
changing all rows at a time. This problem can only be avoided by special precautions,
which are not discussed in this paper.

5 Sensitivity analysis of point forecasts

5.1 Calculating the forecast increments in the general case
After changing the matrices of structural coefficients C" by D.Cs, s = 0,1, ... ,5, and
13r by D.B r, r = 0,1, ... , R, and decomposing the matrices of changes D.C, and D.Br
into products of thc matrices X and Y! and Y! ,respectively, like in section 3.1, thc
c. B,
forecast values of fit grow by

(30)

where

K-k 1 5 R
ak = L 'CL 1";.)1t-](+I-"
8K-k-I I + L Yf.Yt-K+I-,o + LYb,Xt-K+l-r) (31)
1=0 ,,,,.(1 s=l+l r=O

In these equations, Y! = 0 for s > 5 and Y! = 0 for r > R. Furthermore, r is defined

c. B,
by (21) and 8 by (22).
In equation (31), the second sum is defined to be equal to 0, if the lower bound of
the summation exceeds the upper one. In (30), <l>kCo I X u;-;:: 9 x h- matrices and ak
are h X 1 - vectors, k = 0, 1, ... , ]{, which can be compu ted with small effort.
 512

5.2 Simplified computation of forecast increments after changing a

submodel
For changing the coefficients of the equations i I , ... , i h , formulas (30) and (31) with
the notation like in section 3.2 have the following forms:
K
~Yt = L <h(Colrak,i (32)
k=O

where
K-k l S R
ak,i = L 8K-k-lr(L ~C.,dJt-K+l-., + L ~Cs,iYt-K+l-. + L ~Br,iXt-K+l-r)
1=0 .=0 3=l+ I r=O
(33)
In these equations (COl)i is defined like in section 3.2, 8K-k-1 is defined by (22), with
TIm like in (23) and r being defined by (17).

5.3 Simplified computation of the forecast increments after chan-

ging one equation
Varying the structural coefficients of one equation (e.g. the i-th one), i.e. the i-th
row of the matrices Cs by ~i:~,i' S = 0, 1, ... , S, and of the matrices Br by ~b~,i.,
r = 0, 1, ... , R, the vector of forecasts Yt is changed by:
K
6.Yt = L ~k £hC~,.i (34)
k=O

where
K-k 1 S R
G:k = L ,8K - k- l (L 6.c~,i.Yt-K+l-s + L 6.i:~".Yt-K+l-., + L 6.b~,i Xt-K+l-r)'
l=O .• =0 ~=I+ I r=O
(35)
These formulas clearly show the advantages of the simplified techniques for forecast
sensitivity analsis developed in this paper. The 9 x 1- vectors 4>kcO,.i , k = 0, 1, ... , K ,
i = 0,1, ... , (<1>0 = I) and the vectors of forecasts Yt-K +1 , l = 0,1, ... , K, have to be
computed only once, independent of the actual change. Then every change only requires
the computation of the scalars G:k, k = 0,1, ... , K, by (35) and 6.Yt by (34), which is
rather simple.

6 Sensitivity measures
In this section measures for the sensitivity of point forecasts are presented. Here a
denotes the vector which contains all structural coefficients to be varied; is the 6.a.
 513

corresponding change vector. The effects of these changes on the point forecasts of the
jointly dependent variables can be measured by t,he following terms:

II (~Yt'l , ~Yt,2 , ... , ~Yt'9 )'11 (36)

Yt,l Yt,2 Yt,g
IIfl.Yt II Iiall (37)
11:1£11 IIfl.iill
Ifl.Yt,il
max { - - - (38)
IYt,il

where II . II denotes the Euclidian norm.

The measures (1 and Coo were proposed for changes of only single coefficients by
Gruber and Rosemeyer (1982, 1983). But they may signal high sensitivity, although a
defect does not occur (if e.g. the forecasts naturally take values near zero, as is most
likely in the case of growth rates and interest rates). The measure C2, which may be
seen as a generalized elasticity measure (of Yt with respect to a), in general does not
have this disadvantage. But in some cases it does not discover strong influences of
structural coefficients on the forecasts because smaller components of fl.Yt and Yt do
not contribute to the norm, although the corresponding relative change may be large.
Therefore, it is recommended to apply both (2 and Coo. With (2 one can gain a survey
over the sensitivity of the forecasts with respect to changes of the structural coefficients
&. by fl.&.. On the other hand, (00 indicates potential defects of the system as a whole.

7 Outlook
in the past sensitivity analysis of forecasts and multipliers was made only in rare cases,
probably because of the large inputs of manpower and computer time. In contrast to this"
the presented simply and fastly executable analysis procedures may find widespread
applications. For especially in large equation systems their advantages are very conspi-
cuous in relation to traditional techniques. In the phase of model construction they may
serve as a diagnostic instrument and may therefore promote the quality of forecasts
The efficiency of the simplified sensitivity analysis procedures presented in this paper
still has to be demonstrated in practice. An application to large equation systems of
the FRG is in preparation.
The generalization of the presented techniques to sensitivity analysis of interval
forecasts (forecast ellipsoids) is as desirable as the sensitivity analysis of forecasts with
respect to changes of data.
 514

References
Diick, W. (1970)
Numerische Methoden der WirtschafLsmaLhematik 1. Akadcmie- Verlag, Berlin.
Elker, J. (1986a)
SensiLivitaLsanalyse der Multiplikatoren in dynamischen okonometrischen Modellen.
Diskussionspapier Nr. 105, Fachbereich Wirtschaftswissenschaft, Fern Universitat
Hagen.
Elker, J. (1986b)
Sensitivitatsanalysc der Punktprognosen in dynamischen okonometrischcn Modellen.
Diskussionspapier Nr. 106, Fachbereich Wirtschaftswissenschaft, Fern Universitat
Hagen.
Elker, J. (1986c)
Sensitivity analysis of multipliers in dynamic econometric models. Discussion paper
No. 110, Fachbereich Wirtschaftswissenschaft, Fern Universitat Hagen.
Elker, J. (1986d)
Sensitivity analysis of point forecasts ill dynamic econometric models. Discussion
paper No. Ill, Fachbereich Wirtschaftswissenschaft, Fern Universitat Hagen.
Goldberger, A.S. (1966)
Econometric Theory. John VViley & Sons, New York.
Goldberger, A.S. (1959)
Impact Multipliers and Dynamic Properties of the Klein-Goldberger-Model.
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einige Ergebnisse fiir das RWI-Konjunturmodell. In: I\:rallmann, H. (Ed.) ] 982.
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Sensitivitiitsanalyse der Prognosen in okonometrischen Mehrgleichungsmodellen. In:
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Structural Sensitivity in Economctric Models. Wiley & Sons, New York.
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Scnsitivitatsanalysen im statischcn offenen Leontief-Modell. DIW-Beitrage zur
Strukturforschung, Heft 42. Duncker & }-IumbloL, Berlin.
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General Sensitivity Theorie. American Elsevier Publishing Company, New York.
 STRUCTIJRAL SENSITIVITY ANALYSIS IN ECONOMETRIC MODELS:
AN APPUCATION TO TIlE MODEL OF TIlE WEST GERMAN TEXTILE
AND APPAREL INDUSTRY

Wiltrud Terlau
University of Munster
Forschungsstelle fur allgemeine und textile Marktwirtschaft (FATM)
Alter Fischmarkt 21, D-4400 Munster, Germany
Since March 1, 1991:
Rheinisch-Westfalisches Institut fur Wirtschaftsforschung (R WI)
Hohenzollernstr. 1-3, D-4300 Essen, Germany

ABSTRACT

Structural sensitivity analysis is a useful tool for better understanding of econometric

models. We investigate the sensitivity of changes in forecasts of endogenous variables to
changes in structural coefficients.
Improved methods have been applied to a 49-equation quarterly model of the West
German textile and apparel industry. The model considers the various stages of the
textile pipeline: It yields point forecasts starting from the final demand of textile
products to production, turnover and foreign trade.
Results of an application of specialized software to the model of the textile and apparel
industry are presented. They illuminate the model structure and its incorporated
interactions of the variables and identify strengths and weaknesses of the model.

Keywords: Structural sensitivity; dynamic econometric forecasting models; textile and

apparel industry; sensitivity of point forecasts

CONfENfS

1 Introduction
2 The Structure of the Forecasting Model for the Textile Pipeline (Qualitative Ana-
lysis)
3 Structural Sensitivity Analysis of Forecasts
4 Selected Empirical Results for the Model of the West German Textile and Apparel
Industry
5 Conclusions
Appendix
References
 517

1 INTRODUCTION

This paper reports on a methodological study of procedures for examining some basic
behavioral properties of dynamic equation systems, applied to the quarterly model of
the West German textile and apparel industry. Until now, questions of the structure of
econometric models, which illuminate the properties of the observed system, have
received relatively little attention.

The traditional multiplier analysis gives indicators of the reactions of the endogenous
variables caused by variations of the exogenous variables. The computed multipliers
measure the direct and indirect effects of such variations. As parameters of the reduced
form equations, each multiplier consists of a conglomeration of many structural
coefficients. When an understanding of the relations between economic theory and
economic behavior through the model is of main interest, the structural equations have
to be analyzed.

Structural sensitivity analysis studies the structure of a model by investigating the sensi-
tivity of point forecasts to changes in structural coefficients. It detects those structural
parameters to which model "outputs" (endogenous variables) are most sensitive. High
sensitivity to certain structural coefficients indicates their importance in the model. If
statistically poor values are estimated for the endogenous variables, it may signal a
defect of the model [Kuh, Neese (1982a), 120, Gruber, Rosemeyer (1982), 3].

In the context of a forecasting model, the computed point forecasts are of main interest.
Even small changes of the structure may cause relatively large increments of point
forecasts. The influence of an individual parameter in a given equation is revealed by
structural coefficient variations. The results of such an investigation help to illuminate
the interactions of the model elements. Furthermore structural sensitivity analysis can be
used to assess the robustness and the reliability of the model [Kuh, Neese (1986a), 126].

Investigations of the structural sensitivity have so far, to the best of my knowledge, been
carried out for models of the economy as a whole. The transfer to sector-specific models
will be of significant interest.

The object of this study is the disaggregated forecasting model of the economic
development of the West German textile and apparel industry. The applied structural
analysis is divided into two parts: a qualitative and a quantitative one. With regard to a
modified incidence matrix the qualitative analysis gives a first overview of the
interactions of the variables. The intensity of these links is quantified by the structural
sensitiviy analysis. Improved sensitivity analysis methods and several sensitivity measures,
to scale the reactions of point forecasts of the endogenous variables caused by changes
in structural coefficients, are applied to the forecasting model. The software program
used is briefly described. Selected empirical results are presented in the last section of
this paper.
 518

2 THE STRUCfURE OF THE FORECASTING MODEL FOR THE TEXTILE

PIPELINE (QUALITATIVE ANALYSIS)

21 The Model

For more than 20 years the Forschungsstel1e fUr allgemeine und textile Marktwirtschaft
(FATM) at the University of Munster has been working on and with a quarterly
econometric forecasting model of the West German textile and apparel industry
[Helmstiidter, Krupp, Meyer (1976), Kleine, Thiele (1982)]. Its purpose is to make every
year forecasts of 5 - 9 quarters ahead. The results are presented to interested parties in
associations and business.

The most recent version of the forecasting model considers the various stages of the
textile pipeline [Terlau (1991)]. It is based on the demand-side approach: Basic
assumption of the model is the dependency of the development of production on the
domestic and foreign demand for textile goods. The model yields point forecasts starting
from the final demand for textile products up to production, turnover and foreign trade.

In the textile pipeline there are reaction lags of the economic units. This makes it
necessary to formulate a dynamic equation system. The structural form of the linear
dynamic equation system is as follows:

where

yp Yt-l' ... , Yt-S are the gx1-random vectors of the endogenous variables in the
periods t, t-1, ... , t-S,
are the px1-vectors of exogenous variables in the periods t, t-1, ... , t-
R,
is the gx1-random vector of disturbances in period t,
are the gxg-matrices of the corresponding structural coefficients of
the endogenous variables and
are the gxp-matrices of the corresponding structural coefficients of
the exogenous variables.

In our case, g=49, p=25 (including the intercept), S=4 and R=4.

The model is in real terms. The estimation period is from 1970,1 to 1987,4, using
quarterly, seasonally unadjusted data. The sources are statistics of the Bureau of
Statistics (Statistisches Bundesamt) and from the lio-Institute for Economic Research.
Seasonal components are taken into account by means of dummy variables. The list of
variables is given in the appendix.

The parameters of the 49 behavioral equations have been estimated by ordinary least
squares. The software package SAS has been used for model construction.
 519

2.2 Qualitative Analysis of Causal Structure

One major goal of qualitative analysis of causal structures in dynamic forecasting models
is to obtain a first overview of the interactions of the variables.

The incidence matrix is a conventional tool to describe the structure of a model [Krupp
(1971), 203 ff, Helmstadter (1973), 123 ff]. Variable links (structural coefficients
different from zero) are usually characterized by "1" and their absence by a dot. For a
dynamic model containing lagged variables, one incidence matrix for each lag can be
formed. A hierarchical ordering of the matrices makes it possible to reveal the structure
of the system [Simon (1953), Gruber (1978)].

But the disadvantage of this form of structural analysis is that it only considers the direct
interactions between the economic magnitudes [Heile mann (1989), 258 ff]. The indirect
links, which are also important, have also to be taken into account.

In the graph-theoretic approach to the structural analysis, a modified incidence matrix

has been developed [Gilll (1984)].1 Causal links of a model can be described by arrow
schemes, which are called "graphs". Sets of interdependent variables are condensed to
blocks. Causal links between the blocks build the "reduced" or "minimal graphs". A
hierarchical ordering of the blocks makes it possible to analyze the dependencies
between the blocks. Present as well as lagged causal links, which are referred to as a
temporal aggregation over a given period, are considered simultanously. The
interactions between the variables are described by direct links ("B" and "D"), which is
equivalent to the existence of an explanatory variable in an equation and indirect links
("I"), which appear if a variable has an effect on another variable through the inter-
actions of a set of equations.

The modified incidence matrix of the forecasting model of the textile and apparel
industry is given in Figure 1. Its rows contain the explained variables and its columns
contain explanatory variables. Only a few coments are possible here:

The modified incidence matrix, reproducing the minimal (reduced) graphs, contains
all 49 endogenous variables. This means, there are no interdependent subblocks of
equations. The endogenous variables form so-called trivial blocks, each containing
just one variable. The demand-side approach to the textile forecasting model leads
to a recursive formulation; the structure of the model is triangular [HelmsHidter
(1962)].

48% of the entire 462 links (structural coefficients) are direct links (B, D) and 52%
indirect links (I). The greatest part (71 %) is composed of the structural coefficients
of the 24 exogenous variables (columns AEBA to ZEIT).

IThe program CAUSOR is used for the follOwing computations; it is implemented in the software
program TROLL of M.LT., USA
 520

Fig. 1: Triangulated Structure of the Forecasting Model for the Textile Pipeline
- Qualitative Analysis of Causal Links -

""...
UIXIU
. . . 8 II . ..
' • • • el • • • •
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• • .
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.
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.,
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,
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OHUO • . 1D . . . . . . . II . . I!!I . .1

...
OITIl . . 111.0.1. l- . e. I I . . I- 1
OlIn · .110.1. . . . . . . . .1. . 11 • . 1. · 1
10..,.. •. .. 1011.1. . • 111 . . I . I . .. · . 1
WI. . . • . 1111 . . . . . •. I .• . • B · I ••• 1
IIIGGVU, . • • • 10.1 • . . . • 181 . · I . I.
Imll • • • 1 . . . 1. . . . • 1.1. .... I • I 1 . I- .1

.
CIIe(I( 11. • • • • 1. . • . . 1.1. .11 •. 1 • • •• • • 1. .1

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..... 11 • • • 1.1. . . . . 1.1. II .. I . I ..... I. . . 1
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·
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JJN,ua 1 1 I 1 1 I 1 I • . • 1 • I I 1 I I 1 1 . I . I' . I . . . . Ii . 1
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~Iil C[OHHHT[ ('G'~O\lT IOCi"U[tilIiIGK"(llE AKXBKOllE AISSl tsoT GEE'O~ ; E t l • • 1A
CQAJ[EC OE1"11 IIIIIIIWESICSICXII:1IAII. 1111:. [['TIIII I ' UXKAIA SI K l lll KI
OIICUIJO '':ISVW[ I. AllaT .... 1 • N 1t5 .0 .AI IE t • • • • AM
I 1S"I. "T~( O. I I.
E 0 II ~

Symbols: (B) = Basic (Direct) Link, (D) = Direct Link, (I) = Indirect Link
 521

The temporal disaggregation of the direct links shows that 69% of them operate
without lag.

Periods t-O t-l t-2 t-3 t-4

Number 190 45 15 o 27
of Links

- The set of variables affected by a variation of a structural coefficient in an equation of

a dependent variable is given by the set of variables defined by the non-zero entries in
the corresponding column (qualitative structural sensitivity analysis). The first block
(columns EHEIMR - VKLEIR) is above all indirectly very influential, whereas the
middle part (EXGARNR - EWAER) shows more direct effects. The last part of the
matrix appears only slightly linked with the rest of the system.

3 STRUCfURAL SENSITIVITY ANALYSIS OF FORECASTS

3.1 PRELIMINARY REMARKS

The qualitative structural analysis, which is presented in Figure 1, only describes the
causal links of the variables, but no statements about the important economic question
of the intensity of the links are possible.

Structural sensitivity analysis investigates quantitatively the dependence of the jointly

dependent variables on the structural coefficients. It quantifies the structural increments
of forecasts caused by the variation of structural coefficients, always under the ceteris-
paribus condition that all other coefficients (and exogenous variables) are held constant
and always without regard to the mutual dependence of the structural parameters. An
important assumption is that even though most coefficients are statistical estimates, they
are viewed as the "true" parameters, which most accurately reflect economic theory and
reality. It is then reasonable to vary the coefficients [Kuh, Neese (1982), 122].

In the last years, improved methods have been developed to quantitatively analyze the
structure of large equation systems. Traditional sensitivity analysis may, especially in
large models, be extremely laborious. Every change in the structure requires the
inversion of a matrix and the multiplication of a large number of matrices. But recent
research has made it possible to quantify the structural sensitivity of point forecasts with
respect to structural parameters by using algorithms for calculating inverse matrices
without repeated inversions [Gruber, Rosemeyer (1982), (1983); Elker (1986), (1986a),
(1986b)]. On the basis of a given structural equation system and the derived final form,
a simplified computation of the vector of forecast changes !l.y is possible.
 522

3.2 METI-lODS OF SlRUCfURAL SENSITIVITY ANALYSIS OF FORECASTS

At the University of Hagen a corresponding software package has also been developed
[for the most recent version see EIker, Gruber (1987)] . This computerized structural
sensitivity analysis has been applied by Gruber and Rosemeyer (1982, 1983) to the
nonlinear RWI-model. The effects of parameter perturbations are computed for one
period (static structural sensitivity analysis).

These methods have been extended by EIker (1986, 1986a, 1986b), to dynamic equation
systems, considering also the effects over time (dynamic structural sensitivity analysis).
They refer to linear systems, but they can be transferred to nonlinear models by using
only linear terms in a Taylor series expansion and using for linerarization the solution of
the nonlinear system which is generally computed iteratively only once.

Following Elker (1986a, 1986b), we start with the structural form of a linear dynamic
equation system, like in equation 1. Assuming Co to be nonsingular, the corresponding
reduced form is derivable:

(2)

where

Fs = _C~l Cs' s= 1,2, ... ,S

Dr = -C~ 1 Br, r = O,l, ...,R

v = _C- 1 u .
tot
This reduced form and the structural form (eq.I) contain all inputs needed for analyzing
the sensitivity of point forecasts and of multipliers with respect to structural coefficients.
In our analysis we follow exactly the improved methods presented in the paper by Elker
(1986b), which is also contained in this proceedings volume.

3.3 SENSITIVITY MEASURES

The .sensitivity of the changes in the forecasts of the endogenous variables caused by
variations in structural coefficients may be difficult to interpret, because the units of
measurement of the variables involved have to be taken into account, and these units of
measurement usually differ widely.

To facilitate the interpretation of the results of the study, various sensitivity measures
are used. Elasticities, i.e. the relative change of the forecast with respect to a small
percentage change of a structural coefficient (aij)' are widely used and serve
substantive/theoretical goals. From the statistical point of view a measure considering,
for example, the variable's standard deviation may be preferable. Choosing a scale
 523

depends mostly on the immediate purposes of the investigation [Kuh, Neese, Hollinger
(1985),30].

Several sensitivity measures are used in this study.1 As a measure for the sensitivity of
the individual forecasts with respect to changes of individual structural coefficients, we
use the following:

1. The unscaled difference D tg in the point forecast of the g-th endogenous variable,
caused by a change in the structural model:

(3)

2. The percentage change P tg is computed as

* 100. (4)

3. The arc elasticity Eltg,ij of the point forecast of the g-th endogenous variable with
respect to the structural coefficient aij

JiYtg aij
Eltg,ij= * (5)
Ytg Jia ij

These scalings provide sensitivity measures for single parameter changes.

4. The following elasticity which uses the Euclidian norm II-II is a useful tool to
measure the responsiveness of a single endogenous variable with respect to
simultaneous changes of several structural coefficients [Schintke (1976), 65, 155 ff):

Iiall
*--- (6)
II Mill

where a denotes the vector which contains all structural coefficients to be varied and
.11ft is the corresponding vector of changes.

5. When the sensitivity of the point forecasts of all endogenous variables y of the
model with respect to changes in the vector a of structural coefficients as a whole is
of main interest, then the following generalized elasticity is a suitable measure:

For further scaling possibilities see Kuh, Neese, Hollinger (1985), 24, Elker (1986a), 16 f, Gruber,
Rosemeyer (1983), Terlau (1991). The question, which sensitivity measure is best suited or whether
there are better scaling possibilities, is of interest for further research.
 524

/I AYtg /I /I a II
Nt = - - - - * (7)
II Ytg I /I Aajl
The measures (eq.6) and (eq.7) may be seen as generalized elasticity measures [Gruber
(1978),204, Elker (1986a), (1986b)].

3.4 SOFIWARE

Specialized software is needed to apply the previously described methods of structural

sensitivity analysis. Elker and Gruber (1987) at the University of Hagen have developed
such a program.

This program is divided into two parts:

(1) The initial program produces four files containing the inverse of Co' the multipliers
Q, the forecast Yand the matrices (~ * inverse of Co (named "auxvec")). This part
needs to be run only once .
(2) The main program calculates the unscaled changes of the multipliers (AQ) and of
the point forecasts Ay, resulting from various changes of the structural coefficients.
It is run as often as needed.

The following data are needed as an input:

- the vectors of endogenous variables, y (size gx1, periods 0 to S, i.e. t to t-S);

- the vectors of exogenous variables, x (size px1, periods 0 to R, i.e. t to t-R);
- the matrices of structural coefficients of the endogenous variables, C (size gxg,
periods 0 to S, i.e. t to t-S), with the diagonal elements cii = -1 (i=1, ... ,g);
- the matrices of structural coefficients of the exogenous variables, B (size gxp, periods
o to R, i.e., t to t-R);
- the forecast of x (size px1, periods 0 to K, i.e. t to t + K).

The output consists of point forecasts of the endogenous variable vectors Yt of the size
gx1 for the periods 0 to K, i.e. t to t+ K..

As sensitivity measures only the unscaled differences (eq.3) are used in Elker and
Gruber (1987). Therefore an extended version of the program of Elker and Gruber
(1987) has been developed by Terlau (1989). It calculates also other forms of structural
sensitivity measures. Variations of the point forecasts are scaled as percentage changes
(eq.4), arc elasticities (eq.S) and, when the sensitivity of all point forecasts as a whole is
of main interest, elasticities expressed in Euclidian norm (generalized elasticity, eq.7)
are computed. A sensitivity measure for simultaneous changes (eq.6) is also
considered. 1

1 Caused by the great dimensions of the matrices the program of Elker and Gruber (1987) had to be
converted from the eMS-System to the MVS-System. Furthermore it is possible now to insert the
desired coefficient perturbations in different periods as percentage changes.
 525

4 SELECfED EMPIRICAL RESULTS FOR TIlE MODEL OF TIlE WEST

GERMAN TEXTILE AND APPAREL INDUSTRY

The structural sensitivity analysis methods presented in the previous section have been
applied to the model of the textile and apparel industry. For variations of all structural
coefficients of the system a tremendous amount of output has been produced.ln
selecting results here, we focus our attention to the interactions among turnover,
production and foreign trade in order to serve the dual purpose of learning more about
a matter of substantive/economic interest and understanding how the structural
sensitivity methods apply to a meaningful problem. 1

4.1 Specification

Structural sensitivity analysis will be described by quantifying the effects of perturbations

of turnover to production and foreign trade, illustrated by the equation of domestic
turnover of apparel (UBEKI).

This equation is:

UBEKI = -32.0979 + 0.20886 AEBI + 0.19324 G03TEXBEK

(4.43539) (3.85801) (5.57465)

+ 0.68449 UBEKI(-4) + 6.27070 D1

(10.4693) (3.45251)

2.57492 D2 + 8.6904 D3
(1.69785) ( 4.27624) (8)

R2= 0.9549 RMSE= 4.0849

D.W.(I)= 1.8566 D.W.( 4)= 1.7998

The t-values are given in parentheses.

The domestic turnover of apparel depends mostly on the domestic order intakes (AEBI)
and on the business climate index for retailing of textiles and apparel (G03TEXBEK),
which quantifies the opinions of the firms about the state and the expectations of the
corresponding trade-sector (final demand). The lagged endogenous variable UBEKI(-4)
is responsible for the economic dynamics. Saisonal effects are considered by the dummy-
variables Dl, D2 and D3.

Table 1 summarizes basic information about structural coefficient vanatIOns in the

UBEKI-equation. All of the changes are one percent of the estimated coefficient values
in the UBEKI-equation (see columns 1,2,3 and 4 of Table 1). These variations, except
C4.21, are small percentages of the corresponding standard errors (see columns 5 and
6) and can be viewed as statistically "small". The change of C4.21 is however nearly 10
percent of its standard error.

1 The present paper is a condensed version of an extensive study to be published later [Terlau (1991)).
 526

Table 1: Basic information about structural coefficient variations for equation UBEKI

Varied Associated Est imated Coefficient Estimated Variation in X

coeff i c ient variable coeff i cent change standard error of standard
value of coeff i c i ent error
(1) (2) (3) (4) (5) (6)

BO. 25 Intercept '32.09795 '0.3209759 7.23678 4.44

BO. 2 AEBI 0.20886 0.0020886 0.05414 3.86
BO. 10 G03TEXBEIC 0.19324 0.0019324 0.03466 5.58
C4. 21 UBEICI (·4J 0.68449 0.0068449 0.06538 10.47
BO. 22 o1 6.27071 0.0627071 1.81628 3.45
BO. 23 o 2 '2.57492 '0.0257492 1.51657 1.70
Bo. 24 o 3 8.69604 0.0869604 2.03357 4.28

4.2 Empirical Results

The qualitative structure analysis (Fig. 1 in section 2.2) provides a first overview of the
interrelations of the economic variables. The set of variables affected by a variation of a
parameter in equation UBEKI is given by the set of variables with the non-zero entries
in the UBEKI column (qualitative structural sensitivity):

A change in equation UBEKI will affect the point forecasts of production (ONBEK,
KDOBR, KHAKAR, KMWAE), imports (IMBEKR, IMHAKAR, IMWAER), the
entire revenues of apparel (UBEK) and UBEKI itself. Most of the links are of indirect
nature, whereas UBEK and IMBEKR are characterized by direct links. 1

Applied structural sensitivity analysis can be viewed as a comparison of a baseline

dynamic ex post-simulation of the model in which no coefficient is varied to a series of
simulations in which the parameters of the UBEKI equation are changed over the
whole reference period (step perturbation) by one percent. 2

Tables 2 - 5 describe the responses of production, turnover and imports to a variation of

single structural coefficients in the UBEKI-equation. Only one single structural
coefficient is changed at a time which is shown in the columns of these Tables. The nine
endogenous variables listed in the Tables 2-5 are affected by structural changes. The
impact sensitivity measures (Le. unlagged reactions) are given in Table 2. Five quarters
are the typical short forecast horizon, nine quarters are the usual upper limit of short-
run forecasts and the twenty-five quarter dynamic reactions refer to long-term aspects
[Kuh, Neese (1982), 139 ffJ. The corresponding sensitivity measures are presented in
Tables 3, 4 and 5. The reactions of the individual forecasts of these 9 variables are
measured by the unscaled differences "D" (eq.3) and the arc elasticities "EL" (eq.5). The
sensitivity of the forecasts of all endogenous variables of the model as a whole is given
as a generalized elasticity measure (eq.7) called "Norm".

1 For the list of variables, see the appendix.

2 For a deeper discussion of alternative perturbation procedures see Kuh, Neese, Hollinger (1985). 25 f,
60 ft.
 527

Table 2: Impact sensitivity measures for single-coefficient variations

Varied coefficient
Endogenous variable 80.25 BO.2 BO.l0 C4.21
0 EL 0 EL 0 EL 0 EL
UBEK[ ·0.32 ·0.27 0.22 0.19 0.45 0.38 0.77 0.65
UBEK ·0.28 ·0.25 0.19 0.18 0.39 0.36 0.66 0.61
ONBEK ·0.15 ·0.12 0.10 0.08 0.21 0.17 0.35 0.29
KOOBR ·2.48 ·0.13 1.71 0.09 3.46 0.18 5.91 0.31
KHAKAR ·1.07 ·0.11 0.74 0.07 1.49 0.15 2.55 0.25
KM\lAE ·0.1 ·0.03 0.07 0.02 1.44 0.04 0.24 0.07
[MBEKR ·2.29 ·0.46 1.58 0.32 3.20 0.64 5.46 1. 10
[MHAKAR 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
[MIIAER 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Norm 0.07 0.05 0.09 0.16

Table 3: Five quarter interim sensitivity measures for single-coefficient vanations

Varied coefficient

Endogenous variable BO.25 80.2 BO.l0 C4.21

D EL D EL D EL D EL
UBEKI ·0.54 ·0.44 0.41 0.33 0.75 0.60 1.33 1.08
UBEK ·0.47 ·0.41 0.35 0.30 0.64 0.56 1.15 1.00
ONBEK ·0.54 ·0.42 0.41 0.32 0.74 0.57 1.29 1.00
KOOBR ·7.06 ·0.35 5.40 0.27 9.68 0.48 17.12 0.84
KHAKAR ·5.05 ·0.48 3.85 0.36 6.93 0.66 12.02 1. 14
KMIIAE ·0.52 ·0.17 0.39 0.13 0.71 0.23 1.22 0.39
IMBEKR ·4.03 ·0.69 3.01 0.52 5.55 0.95 10.09 1.73
IMHAKAR 0.66 0.25 ·0.46 ·0.18 ·0.92 ·0.36 ·1.51 ·0.58
[MIIAER 0.02 0.01 ·0.01 ·0.01 ·0.02 ·0.01 -0.04 ·0.02

Norm 0.17 0.13 0.23 0.41

Table 4: Nine quarter interim sensitivity measures for single-coefficient variations

Varied coefficient
Endogenous variable BO.25 BO.2 BO.l0 C4.21
0 EL 0 EL 0 EL D EL
UBEKI ·0.69 ·0.55 0.52 0.42 0.93 0.74 1.78 1.42
UBEK ·0.59 ·0.51 0.45 0.39 0.80 0.69 1.52 1.31
OHBEK ·0.88 ·0.69 0.69 0.54 1.19 0.93 2.17 1.69
KOOBR -10.50 -0.49 8.20 0.39 14.08 0.66 26.17 1.23
KHAKAR ·8.80 -0.82 6.87 0.64 11.88 1. 11 21.44 2.00
KMIIAE .1. 06 -0.37 0.82 0.29 1.44 0.50 2.55 0.89
IMBEKR ·4.65 -0.69 3.56 0.53 6.21 0.93 12.38 1.85
IMHAKAR 1.76 0.62 -1.31 ·0.46 ·2.43 0.86 -4.16 -1.47
IMIIAER 0.11 0.05 ·0.09 ·0.04 ·0.16 ·0.07 -0.27 -0.12
Norm 0.24 0.19 0.32 0.60
'---.
 528

Table 5: Tw~nty-five quarter long-term sensitivity measures for single-coefficient

vanatlons

Varied coefficient
Endogenous variable 80.25 80.2 BO.l0 C4.21
0 EL 0 EL 0 EL D EL
UBEKI ·0.95 ·0.86 0.64 0.58 1.14 1.04 2.35 2.15
UBEK ·0.81 ·0.78 0.55 0.52 0.98 0.93 2.02 1.93
ONBEK ·1.55 ·1.47 1.08 1.03 1.85 1.75 3.68 3.49
KDOBR ·16.39 ·0.87 11.46 0.61 19.52 1.04 39.25 2.08
KHAKAR ·16.09 ·1.92 11.28 1.35 19.19 2.30 38.08 4.55
KMIIAE ·3.03 -1.55 2.16 1.11 3.69 1.89 7.24 3.71
IHBEKR -2.80 ·0.31 2.02 0.22 3.44 0.38 8.90 0.97
IHHAKAR 4.52 0.84 ·3.09 -0.58 ·5.43 -1.01 -10.76 ·2.01
IMIIAER 0.74 0.32 ·0.54 -0.23 ·0.92 ·0.39 ·1.80 ·0.76

Norm 0.38 0.26 0.45 0.91

To summarize the results reported in Tables 2-5, the following major points emerge:

1. A decrease of domestic turnover of apparel (UBEKI), reflected by perturbation of

the intercept (BO.25), caused a decrease in production (ONBEK, KDOBR,
KHAKAR, KMWAE) and one import variable (IMBEKR) and an increase in two
other import variables (IMHAKAR, IMWAER).

2. Increasing the structural parameter of domestic order intakes (BO.2) by the amount
shown in Table 1, has positive effects on 7 and negative effects on 2 endogenous
variables (only in Table 2 are the corresponding effects zero).

3. Similar results are obtained by varying the structural coefficient of the business
climate index of retailing on a higher level: A one percent increase of BO.1O causes
an increase in point forecasts nearly twice as large as a corresponding change of
BO.2.

4. The autoregressive term (C4.21) has the greatest influence on the 9 endogenous
variables: both on impact (Table 2) and in the longer run (Tables 3-5). An increasing
parameter produces a strong increase in production and imports. The great sensitivity
of endogenous variables to "own-dynamics" parameter perturbations, apparent also
for the other endogenous variables in Tables 3, 4 and 5, indicates its importance in
the context of this model. This is a result appearing also in corresponding
investigations of other models [Kuh, Neese, Hollinger (1985), 210, 229].

The dynamic analysis (Tables 3-5) shows an amplification of structural sensitivity, mostly
at a factor of five from impact to twenty-five quarter computations. In the short-run, the
greatest structural sensitivity with respect to variations of the parameters of the equation
explaining domestic turnover of apparel appears for imports of apparel (IMBEKR). In
the long-run this effect will be weakened and the response of the production of men's
outer garments (KHAKAR) is largest.

IMHAKAR and IMWAER show in comparison to the other variables different

reactions. A decrease of domestic turnover of apparel causes expansive effects on
imports of under garments and men's outer garments. This means that the observerd
domestic products are continuously substituted by foreign goods.
 529

Furthermore it is obvious, that in the short-run the interactions of the economic

magnitudes are only weak, a phenomenon already described by Simon (1981, 193ff.).
Most complex systems can in a simplified way be described as hierarchical systems. A
structural analysis of this form of complex systems leads to a theory of "nearly
decomposable systems", in which the interactions among the elements in the short-run
are weak, but not negligible. In a hierarchical, nearly decomposable system the magni-
tudes are in the short-run approximately independent of each other. A result, which is
reflected in rather large local influences of economic variables. I.e. in the short-run the
greatest sensitivity effects are obvious for those endogenous variables which contain the
varied coefficient as an equation element ("own" coefficient changes). Furthermore the
"own-dynamics" coefficients, which are the structural parameters of the autoregressive
variables, have a great influence on the endogenous variables of the model of the West
German textile and apparel industry. For comparable model studies similar results have
been obtained by Kuh, Neese, Hollinger (1985, 209, 229) and Heilemann (1989, 258ff.).

The results of the structural sensitivity analysis of the model of the West German textile
and apparel industry give also information about the forecast quality of this model. For
the prediction of the endogenous variables possible structural changes have to be taken
into consideration. The empirical analysis of the responses of the point forecasts of the
endogenous variables with regard to structural parameter variations shows at the
impact and in the long-run relatively small sensitivity effects. The point forecasts of the
model of the West German textile and apparel industry are relatively robust against
structural changes.

A graphical summary is given in Figures 2 - 10. The time paths of several elasticities
with respect to each coefficient are scaled so that their individual largest magnitude will
be + 1. For example, the scale factor of the elasticities series of the endogenous
variable ONBEK with regard to the coefficient C4.21 is 3.59 (see Table 6).

Constructing corresponding overlay graphs for each endogenous variable facilitates the
comparison of the individual time paths [Kuh, Neese (1982), 149 ff, Kuh, Neese (1982a),
128]. The reactions of point forecasts of an endogenous variable to each coefficient
change are nearly identical in course of time. The variables show more or less damped
oscillations. The fluctuations of elasticities are influenced by the time path of the
associated variable of the parameter (see Table 1) and by the fluctuations of the point
forecast itself. The maximum values in Table 6 complete the summary.

Table 6: Maximum elasticities of point forecasts with respect to several coefficients

Po int forecasts
Varied coefficients
UBEKI UBEK CHBEK KOCBR KHAKAR KMIIAE IMBEKR IMHAKAR IMIIAER

BO. 25 ·1.01 -0.94 -1.53 -1.08 -2_04 -1.63 -0_84 1.1 0.38

BO. 2 0.78 0.72 1. 11 0.79 1.41 1. 16 0.69 -0.79 -0.28

BO. 10 1.21 1.12 1.85 1.29 2.44 2 1. 14 -1.33 -0.47

C4. 21 2.15 1.94 3.59 2.45 4.78 3.89 1.85 -2.62 -0.92
 Fig.2: Scaled elasticity response~ tor UBEKI to Fig.3: Scaled elasticity responses tor UBEK
variations 01 the tour coefficients to variations ot the tour coefficients
1,00 , A •. _ _ • 1,00 I A ,· jL .' " 1

0.75 I 1/ \\..;;1"(4 / \' "l l 0.75 I I ~ :pA l , I ~

:x.-~ \ \ r QI
r \(V"J\ '1
O.!O I / J\' .;tV II
MO I !f\«:'V V

0.25 r ¥ 0.25 r V

0.00 +1-ii"""T....,....-r-.-r-,--r-r-T.....,..-.-,...........,....-r-i"""T....,....-r-r-T~ 0.00 +1_ii"""T....,...........,i"""T....,....-r-..............,....,.....r-T.....,....,.--r""T.....,..-.-r-T~

,a71 "73 1911 '977 1171 '913 li75 li11

[ - ~O~'5 - 80. 2 - 80.tO - C4 .21 - BO.25 - BO.2 - BO.l0 .... C4.21

FATM FATM

U1
W
o

Fig. 4: SC<lled elasticity responses tor ONBEK to Fig. 5: Scaled elasticity responses tor KDOBR to
variations ot the tour coefficients variations 01 the tour coerticients

'.00 I }< ~ 1.00 I A

0.75 I ,:=--= 0.75 1 ./\ N \,' "S$ V

0.50 I zf/ 0 .50 I #;<;. /1 .....[/

0.25 I --,7

0.00 1i i i 0.00 +1_ir-T""",,""-'-'i"""T-'--'-'-'r-T......-"'-'-'r-T......-....-..-.--.-....---l

It71 d13 lliIrl 1111 1111 IlUl 1975 li71

[ - BO.25 - BO. 2 - BO.IO . ••• C4. 21 [- BO.25- ~ --=B;.,0 ·· ·· CUI

FATM FATM
 Fig. 6: Scaled elasticity responses for KHAKAR Fig. 7: Scaled elasticity responses for KMWAE to
to variations of the four coeffic ients variations of the four coefficients

'.00 I i 7 ........ 1.00 I x..

0,76 1 tf7= 0,75 , }+ .....

o,SO I }S '" 0,50 I /

0,25 1 # 0,25 I xY"

0,00 .fr;=,-
, .,-.,..-,-,--,-.,-.,..-,--r-,-.,-.,..-,--.--,-.,-,.....,.-.--,--,-""""
..73 1176 ,err IIU, 1Ii~13 liU linT

- 80.25 - 80.2 - 80.'0 • . .. C4 .2' r= 80.25 - 80.2 - 80.10 .. .. C'. 21 I

FATM FATM

U1
W
~

Fig. 8: Scaled elasticity responses for IMBEKR Fig. 9: Scal ed elaslicity responses lor IMHAKAR
to variations of the four coefficients to varialions 01 the four coefficients
1,00 I .~ j 1,00 I X

0,75 I . Y 1 f , 0,7&
" I I '~ V ,
£f14 I IIV;S' V""

0,50 II \ 1 \'dl !.l' IN ~',-- iN ·.Ift ' A'\ 0,50 I ./7/

0.25 I 'tt" "-'1 ..' - ?tT/1 0,25 1 #

0,00 I 'i 0,00 -j-.,.<.£- - - - -- - - - - - -- --------i

IITS 1~77 1;71 1915 U)71

HI" .." .."
- 80. 25 - 80.2 - BO.l0 ... C4.21 - 80. 25 - 80.2 - 80.10 ... C4 .21
FATM FATM
 532

Fig. 10: Scaled elasticity responses for IMWAER

to variations of the four coefficients

1,00 ,..---- - - - - - - - - - - - - , ,"Al

0,75 +-____________ ~~r......>\v------j

0 ,50 .J----------""dt~f------j

0 ,25 + - - - - - -- -....~-----------i

0 ,00 +--....-.-.,.-? ...,-,.....--,--,.-...,-,.-,.-.,..-.-...--.--r-,-...,--r-,.......,.-,--I

1911 1013 lirs ,g11

- 80.25 - 80.2 - BO.l0 ••.• C4.21 I

FATM

5 CONCLUSIONS

This paper illustrates an approach to the structural sensitivity analysis of point forecasts
with respect to structural coefficients in linear dynamic equation systems. Improved
methods have been developed by Elker (1986a, 1986b), using e. g. algorithms for
calculating inverse matrices without repeated inversions. The corresponding software
package which was written at the University of Hagen has been further developed and
been applied to the econometric forecasting model for the textile pipeline of West
Germany. Empirical results illustrate the structure of the forecasting model and give
information about its forecast sensitivity. The available space made it necessary to limit
the presentation to a few examples. A much greater volume of results will be published
in Terlau (1991).

Structural sensitivity analysis of econometric models to understand the working of the

models is of great interest for further research. This study will be a reference possibility
for corresponding investigations of other models.
 533

APPENDIX
List of Variables of the Model of the West German Textile and Apparel Industry

The quarterly data are measured in real terms (prices of 1980)

Endogenous Variables

VKLElR Private consumption - textiles

EWAER Retail Sales - under garments, knitted garments

EHAKAR - outer garments, men's and boys', woven
EDOBR - outer garments, women's and girls', woven
EOBER - outer garments
EHEIMR - home textiles
EHTOAS - textiles and apparels, without any point of main effort
EMETR - fabrics
ETWR - textiles and apparels
EHAUSR - household textiles

EXWEBR Export - woven fabrics

EXGARNR - yam
EXGGSTOR - knitted fabrics
EXGGWAER - under garments, knitted
EXWAER - under garments, woven
EXGGR - outer garments, knitted
EXHAKAR - outer garments, men's and boys', woven
EXDOBR - outer garments, women's and girls', woven
EXBEKR - apparels
EXTEXR - textiles

UBEKI Turnover domestic apparels

UBEKA - foreign apparels
UBEK - apparels
UTEXI - domestic textiles
UTEXA - foreign textiles
UTEX - textiles

KHAKAR Ready-man-made -outer garments, men's and boys', woven

KDOBR - outer garments, women's and girls', woven
KMWAE - under garments, woven
KHABER - household textiles

OWEB Production -fabrics, woven

OGGSTO -'
fabrics, knitted
OGGWAE -under garments, knitted
OGARN -yam
OGESP -yam processing
OGGOBR outer garments, knitted
OHEIM - home textiles
ONBEK - Index of net production of apparels
ONTEX - Index of net production of textiles

IMWEBR Imports - fabrics, woven

IMGARNR - yam
IMGGSTOR - fabrics, knitted
 534

IMGGWAER - under garments, knitted

IMWAER - under garments, woven
IMGGR - outer garments, knitted
IMHAKAR outer garments, men's and boys', woven
IMDOBR outer garments, women's and girls', woven
IMBEKR - apparels
IMlEXR - textiles

Exogenous Variables

AEBA Order intake - foreign apparels

AEBI - domestic apparels
AETA foreign textiles
AETI - domestic textiles

INC Disposable income of private consumers

G03TEXBEK Business climate -textiles and apparels

index of retailing
G03HAKA - outer garments, men's and boys', woven
G03DOB - outer garments, women's and girls', woven
G03HAUS - household textiles
G03HEIM - home textiles

EXOECDI Index of exports, OECD-countries

IMOECDI Index of imports, OECD-countries

POECD4 Index of net production, OECD-countries

TOTOBWEB Terms of Trade - outer garments, woven

TOTWEB - fabrics, woven
TOTGGSTO - fabrics, knitted
TOTWAE - under garments. woven
TOTGG - outer garments, knitted
TOTGGWAE - under garments, knitted
TOTBEK - apparels
TOTTEX - textiles
TOTGARN - yam

RAUTO Production - motor cars

ROPOL - upholstered furniture

RAUSB Construction

Dl Dummy Variable -firs t quarter

D2 - second quarter
D3 - third quarter

ZEIT Trend Variable

 535

REFERENCES
Belsley, D.A, Kuh, E., Welsch, R.E. (1980): Regression Diagnostics - Identifying Influential Data and
Sources of Collinearity, Wiley Series in Probability and Mathematical Statistics, New York,
Chichester, Brisbane, Toronto, Singapur.

Elker, J. (1986): Sensitivitlitsanalysen der Punktprognosen in dynamischen Okonometrischen Modellen,

Diskussionsbeitrlige des Fachbereichs Wirtschaftswissenschaft der Fernuniversitat Hagen, No.
106.

Elker, J. (1986a): Sensitivity Analysis of Point Forecasts in Dynamic Econometric Models, Discussion
Papers of the Department of Economics, University of Hagen, No. 111.

Elker, J. (1986b): Forecast and Multiplier Sensitivity Analysis with Respect to Changes of Equations and
Submodels in Dynamic Systetns (revised version of July 17, 1987, is published in this volume).

Elker. J .. Gruber, P. (1987): Program for Sensitivity Analysis of Multipliers and of Point Forecasts in
DynamiC Econometric Models, University of Hagen.

Gilli, M. (1984): CAUSOR, A Program for the Analysis of Recursive and Interdependent Causal
Structures, Version 3.10, Cahiers du d~partement d'~conom~trie, Universit~ de Geneve,
Cahier 84.03.
Gruber, J. (1978): Zur Interdependenz i:ikonometrischer Gleichungssysteme, in: J. Frohn (Ed.),
Makroi:ikonomische Modelle fUr die Bundesrepublik Deutschland, Sonderhefte zum
Allgemeinen Statistischen Archiv, No. 12, GOttingen, 185-213.

Gruber, J., Rosemeyer (1982): Prognose-Sensitivitiitsanalyse in grol3en rucht-linearen okonometrischen

Modellen - einige Ergebnisse fUr das RWI-Konjunkturmodell, in: H. Krallmann (Ed.),
Sozioi:ikonomische Anwendungen der Kybernetik und der Systemtheorie, Betriebliche
Kommunikationssysteme 2, Berlin, 173-195.

Gruber, J .. Rosemeyer, B. (1983): Sensitivitiitsanalyse der Prognosen in i:ikonometrischen Mehrglei-

chungsmodellen, in: W. Buhler u.a. (Eds.), OperatiOns Research Proceedings 1982, DGOR,
Beitriige der 11. Jabrestagung, Berlin, Heidelberg, New York, 531-541.

Heilemann, U. (1989): "Was leisten Prognosemodelle?" Eine empirische Untersuchung am Beispiel des
RWI-Konjunkturmodells, in: B. Gahlen u.a.(Eds.), Wirtschaftswachstum, Strukturwandel und
dynamischer Wettbewerb, Festschrift fUr Ernst Heltnstiidter, Berlin, Heidelberg, New York,
253-272.

Helmstadter. E. (1962): Die geordnete Input-Output-Struktur, in: Jahrbucher fur Nationali:ikonomie und
Statistik 174, 322-361.

He1mstiidter, E. (1973): Was leisten Prognosemodelle?, in: Zeitschrift fur allgemeine und textile Markt-
wirtschaft, Tagungsband Textilwirtschaftlicher Prognosen, No. 2/3, 118-150.

Helmstadter, E., Krupp, R., Meyer, B. (1976): Ein i:ikonometrisches Prognosemodell fur die Textilwirt-
schaft der Bundesrepublik Deutschland, Schriften zur Textilwirtschaft 19, FATM (Ed.),
Miinster.

Kleine, E., Thiele, W. (1982): Ein disaggregiertes Prognosemodell fUr die Textilwirtschaft der Bundesre-
publik Deutschland, Schriften zur Textilwirtschaft 27, E. Helmstadter (Ed.), Frankfurt a.M.,
Bern.

Kuh, E., Neese, L. (1982): Parameter Sensitivity, Dynamic Behavior and Model Reliability: An Initial
Exploration with the MQEM Monetary Sector, in: E.G. Charatsis (Ed.), Proceedings of the
Econometric Society European Meeting 1979, in Memory of Stefan Valavanis, Athens, 121-
168.
 536

Kuh, E., Neese, L. (l982a): Econometric Model Diagnostics, in: G.e. Chow, P. Corsi (Eds.), Evaluating
the Reliability of Macro-Econometric Models, Chichester, New York, 119-146.

Kuh, E .. Neese, J.W., Hollinger, P. (1985): Structural Sensitivity in Econometric Models, Wiley Series in
Probability and Mathematical Statistics, New York, Chichester, Brisbane, Toronto, Singapore.

Schintke, J. (1976): Sensitivitiitsanalysen im statischen offenen Leontief-Modell, DIW-Beitrlige zur Struk-

turforschung, Heft 42, Berlin.

Simon, H.A (1953): Causal Ordering and Identifiability, in: W.C. Hood, T.e. Koopmans (Eds.), Studies
in Econometric Methods, New York, 49-74.

Simon, H.A (1981): The Sciences of the Artificial, Cambridge, London.

Terlau. W. (1989): Program of Structural Sensitivity Analysis in Dynamic Econometric Models, A Modi-
fied Version of Elker, J., Gruber, P. (1987), Munster.

Terlau. W.: Strukturelle Sensitivitlitsanalyse dynamischer Okometrischer Prognosemodelle - dargestellt am

Beispiel der westdeutschen Textilwirtschaft, Dissertation Munster, 1991 (to be published).
 PART 9:

ECONOMETRIC MODELING OF ENVIRONMENTAL AND ENERGY PROBLEMS

THE OPTIMUM PRICE OF ENERGY:
A THERMOECONOMIC ANALYSIS *

Helmuth-M. Groscurth and Reiner Kiimmel

Physikalisches Institut der Universitiit Wiirzburg
D-S700 Wiirzburg, Federal Republic of Germany

Abstract

A program for Linear Energy Optimization (LEO) which was used to investigate ther-
modynamical and technical options of reducing the energy consumption of industrialized
countries is extended to handle the cost associated with the realization of the calculated sa-
vings. We do vector optimization a) by parameterizing the cost function and b) by forming
a scalarizing function from the individual objective functions. As a result, we are able to
show the dependence of the possible energy savings on the energy price and determine the
trade-off between energy conservation and cost.

Keywords

Energy and cost optimization of industrial systems, vector optimization.

Contents

1 Introduction
2 Definitions and Assumptions in the Energy Optimization Model
3 The Cost Function
4 Vector Optimization
5 Conclusions

1 Introduction

Energy conservation may be an efficient instrument of pollution abatement, if it is done

with proper consideration of the energy's quantity and quality. Energy quantities are usually
measured by their heating value (enthalpy) H. The quality Q of an enthalpy H is defined
to be the ratio of the exergy (i.e., the potential of performing mechanical or electrical work)
contained in H to the amount of enthalpy H itself [1,2]. Though no energy is lost (first

·'Work supported, in part, by the Deutsche Forschungsgemeinschaft

 540

law of thermodynamics), its quality decreases in any real process of work performance and
information processing (second law of thermodynamics). Excess heat of industrial processes
is often emitted into the environment (e.g., by cooling towers), even if its temperature T
is still higher than the temperature of the environment and its quality is therefore still
greater than zero. Based on energy demand profiles that indicate the process heat demand
of industrialized countries at various quality levels, we present an optimization model that
determines strategies to make the best possible use of this excess heat before its quality
finally reaches zero. The model has been described in detail in Refs. 3 and 4. We repeat
some important definitions and assumptions in Sec.2. It is the purpose of this paper to
develop a vector optimization procedure that may be helpful in determining the conditions
under which market forces will drive the development of industrial systems towards greater
energy efficiency. The guiding principles are those of thermoeconomics [5].

2 Definitions and Assumptions in the Energy Optimization Mo-

del

The principle energy saving technologies considered in thermoeconomics are heat-

cascading via heat exchangers from high quality levels to lower quality levels, heat pumps
(which require extra exergy input) and cogeneration of electricity and heat. Energy that
- after having served a certain process - would be discharged to the environment, if the
saving technologies listed are not applied, is called secondary energy throughout this paper.
Using an amplified quality scale q := 10Q, the demand and supply levels are characterized
by integer qualities running from zero to ten. We define as primary conversion efficiency
T/( q, F) the fraction of one unit of demand enthalpy q generated from one unit of fuel F
and as secondary conversion efficiency TJ:(q, ql) the fraction of one unit of demand enthalpy
q generated from one unit of secondary energy ql, where the index i = ex, c, p refers to heat
exchangers (ex), heat pumps (p) and cogeneration (c), respectively. The numerical values of
all technical parameters (T/, TJI) used in the optimization procedure are given in Ref.4.
The energy amounts handled in the system are: n( q) = number of annually demanded
enthalpy units of quality q (q = 1, ... ,9); n(ql) = number of available secondary energy units
of quality ql; n(lO) = fixed demand of enthalpy units of electricity (q = 10); N(F) = total
number of enthalpy units of primary energy F (fuel, q = 10); x;(q,ql)n(ql) = fraction of
the total amount of available secondary energy ql supplied to demand level q via technology
i (i = ex,p); x e(q)n e(10) = amount of electricity cogenerated with heat of quality q; the
sum of xe(q) over all q is equal to 1, ne(10) therefore gives the total amount of cogenerated
electricity. Optimization variables are the 45 X ex , the 6 xene(lO) and up to 45 Xp.
The outmost limits to energy conservation are calculated on the basis of the following
idealizing assumptions: (a) All processes are treated as if they were taking place at the same
location and at the same time. (b) All energy delivered to a certain quality level is available
as secondary energy of the same quality. The second law of thermodynamics is observed by
prohibiting reuse on that quality level itself.
Performing optimization under 20 restrictions, which are mostly due to the first law
of thermodynamics (conservation of energy) with the Revised Simplex-Algorithm using the
newly developed Linear Energy Optimization program LEO leads to industrial energy saving
potentials of 30% in the case of West Germany, 55% in Japan, 5170 in the Netherlands and
 541

34% in the United States. For this result it was assumed that waste heat from the use of
electricity cannot be reused as secondary energy.
In a more realistic scenario energy losses during heat transportation are included [4]. If
all heat from heat exchangers has to be transported over 50km and heat from cogeneration
plants over 25km and if at the same time the efficiency of heat pumps is reduced to 0.6 of
the Carnot efficiency, the remaining industrial saving potentials are 25% for West Germany,
30% for the United States and about 45% for the Netherlands and Japan.

3 The Cost Function

The definitions for the cost function given in Ref.6 are C = total annual cost for complete
satisfaction of process-heat-demand of the considered industrial system; Co = total cost
before optimization and b(F) = price of one unit of fuel F at the location where it is used,
including all cost like buying price, transportation etc.
All following cost factors are defined to include investment, capital cost and operation
(e.g., maintenance) cost as long as they are not fuel cost: c(q, F) = cost of producing one
enthalpy unit q from fuel F; « q, q') = cost of providing one enthalpy unit q from secondary
energy q' via technology i (i = ex, p); cc( 10) = cost of producing one uni t of electrical energy
in a cogeneration plant. The cost of producing one enthalpy unit q via cogeneration is set
equal to zero because all cost for cogeneration will be charged to electricity production.
With the assumptions of Sec.2 still valid, we can write down the function for the total
cost C per year:

The first row of Eq.(3.1) contains the cost of process-heat-supply on levels q = 1, ... ,9
before optimization. The demanded amount of energy, n( q), is multiplied by the specific
cost, which consists of the cost factor derived from investment, capital cost and operation
cost, c(q, F), and the fuel price b(F). While the cost factors are given with respect to a
produced enthalpy unit q, the fuel price is based on one unit of fuel F. The latter must
therefore be divided by the efficiency 7]. The next three rows contain saved and added cost
by heat exchangers (ex), cogeneration (c) and heat pumps (p). The specific cost factors
 542

for conventional energy supply multiplied by the amount of energy supplied by the new
technologies (e.g., .,,~x( q, q')xex( q, q')n( q') in the second row) yield the saved amount of money.
On the other hand there will be new costs for the installation and operation of the new
technology, i.e., <Aq, q')"'~x(q, q')xex(q, q')n(q') for each pair of levels q, q' in the second row.
The cost of cogenerated electricity is indicated in the fifth row. The last row gives the cost of
electricity production in all-electric power plants. It includes the electricity demand of heat
pumps and the respective cost. e is the Heavyside function and Pp is a function that has
positive values if a heat pump works efficiently and negative values otherwise [4]. The two
underlined terms indicate the cost without optimization, Co. Using an adequately defined
specific transportation-cost factor, it is possible to include the (considerably high) cost of
heat transportation into the model.

4 Vector Optimization

The mathematical optimization problem consists of two objective functions, namely the
amount of primary energy, N(F), needed to satisfy the electricity and process-heat demand
of an industrial system and the total cost C of the energy system. While environmental
protection and cost are often considered as examples of usually conflicting objectives of
vector optimization, energy conservation may lead to a reduction of cost and pollution, if
only energy prices are high enough.
Since for conflicting objective functions there is no single optimal solution to the mini-
mization problem, a possible solution is called functional efficient or pareto optimal if none
of the objective functions can be reduced further without increasing the other one.
It is the goal of this investigation to determine under what circumstances the minimiza-
tion of energy consumption and minimization of the cost of energy services may be parallel
objectives, which means that pursuing one objective will at the same time optimize the other
one. In our case there are two ways of tackling the problem: (a) parameterization of one
objective function [6] or (b) the linear combination of the two weighted objective functions
[7]. In the following sections we summarize the results of both methods.
The cost factors used in this paper were obtained by van Gool and Kummel for an earlier
investigation [2]. 'While, in Ref.2, they were given in dollars, we now prefer to use arbitrary
currency units (ACU) in order to avoid problems with exchange rates and inflation. For
orientation, the reader may note that a primary energy price of 4 ACU jGJ corresponds to
an oil price of 24$/ barrel before 1986. The cost factors include an annuity factor of 0.175 / a.
They are c(q, F) = 0.39 ACUjGJ·a, c(10, F) = 3.33 ACUjGJ·a, c:x(q, q') = 1.40 ACU/GJ·a,
c~(q, q') = 3.50 ACUjGJ·a, cc(IO) = 3.85 ACUjGJ·a. The cost factor for transportation-cost
has been chosen to be 1.0 ACUjGJ [8].

4.1 Introducing an Upper Cost Limit

The cost function of Eq.(3.1) is used to introduce an upper cost limit, which serves
as an external parameter and which is defined as a function of the cost without saving
technologies, Co. An energy conserving technology is called cost efficient, if its employment
is less expensive than using primary energy directly [at a given primary energy price, b(F)].
If the cost restriction implies that energy savings must be realized without allowing for
additional cost, a saving potential can only be found, if at least one of the considered
 543

N(F) [1000 PJ/a] C, Co [10 9 ACU]

3.2~------------------------------------------~r40

Co
3.0 32
'-
~

2.8 " 24

2.6 16
N(F)

2.4 8
~ - -<>- - -<>- -

2.2+----.---.----,---.----.----.---.----.---.----+0
2.0 4.0 6.0 8.0 10.0 12.0
b( F) [ACU /GJ]
Fig.I. Optimization results for West Germany; upper cost limit at 1.0 . Co (solid
curves) and 1.1 . Co (dashed curve); displayed are the requi red primary energy
N(F) (for both scenarios) and the cost with (C) and without (Co) energy
saving technologies (for the first scenario) vs. the fuel price b(F). The optimi-
zation value without cost restriction is 2321 P J / a. Nate the suppressed zero
point on the N(F)-scale on the !.h.s. [6].

technologies is cost efficient. Taking into account the additional energy needed for heat
transportation, all technologies considered in this paper need extra exergy input for their
operation.
In Fig.1, optimization results for vVest Germany are shown at fuel prices rising from 2 to
12 ACU/GJ. The first scenario (solid curves) allows for no extra cost, while the second one
(dashed curve) tolerates cost which are 10% higher than Co. At the current very low energy
prices, which lie somewhere on the left edge of Fig.1, none of the discussed technologies is
cost efficient. With rising energy prices. heat pumps would be the first technology to become
cost efficient between 4 and.5 ACU/GJ. This is the point, where the solid N(F)-curve, which
represents the amount of primary energy needed to satisfy all energy demand, starts to
decrease. It keeps decreasing with rising fuel prices until it reaches its minimum value of
2321 PJ/a, which is about 74% of the amount of primary energy without energy savings.
The minimum is identical with the value one gets for optimization without cost restriction.
For fuel prices higher than 10 ACU /GJ, all energy saving technologies are cost efficient.
The cost without energy saving measures, Co, is linearly rising with increasing fuel price.
Due to the restriction of the first scenario, the actual cost, C, has to be smaller than or
at most equal to Co- For fuel prices up to 10 ACU /GJ the allowed cost is fully used, the
curves for Co and C are identical. For prices higher than 10 ACU/GJ it will be increasingly
cheaper to use saving technologies, the curve C is now running below Co. For the energy
 544

demand-profiles of the ."l"etherlands, the United States and Japan one finds analogous results
which lead to similar conclusions.
The dashed curve in Fig.1 shows the results of optimization if the cost C of energy supply
may be 10% higher than Co. Now, even for the lowest fuel price of 2 ACU /GJ, savings are
possible. They continue to increase until they reach their maximum at 7 ACU/GJ.

N(F) [1000 PJ/a]

3.2~--------------------------------------------------------'
o
o
o +
3.0 o +
o
o +
2.8
o
2.6
+
o +
2.4 o +
o +
2.2+--.-.--.--.-.--.--.-.--.--.-.--.--.-.--.-~
14 16 18 20 22 24 26 28 30
C [10 9 ACU]

Fig.2. Trade-off between primary energy consumption N( F) and the total cost C for
West Germany at fuel prices b(F)=4 ACU/GJ (0) and 8 ACU/GJ (+) [7].

4.2 Linearly Weighted Objective Functions

A new scalar-valued objective function Z is formed as a convex combination of two

'individual' objective functions:

Z = (3. [N(F)/No(F)] + (1 - (3) . [CICo] , (4.1 )

where (3 is the weighing factor. The index '0' indicates the magnitude of N(F) and C when
no saving technologies are applied. The weighing factor is neither a physical nor an economic
quantity but an external parameter expressing preferences of the decision-maker.
Optimization was performed for values of (3 between 0.2 and 0.7. Each value of (3 leads to
a pareto-optimal solution that can be viewed as a compromise between the two conflicting
objectives. For a given value of (3, the amount of primary energy needed to satisfy the
demand for process heat and electrical energy, N( F), was determined together with the
respective cost, C. In Fig.2 we plot N(F) versus C, which means that every point in the
figure represents a destinct value of (3. One can now directly determine the trade-off, i.e.
evalutate how much money each unit of additionally saved primary energy will cost. For the
considered low energy price scenario [b( F) = 4 ACU /GJ] there is an increase of nearly 30%
 545

in total cost between the maximum and minimum primary energy use. For higher fuel prices
[b(F) = 8 ACU/GJ], this increase is reduced to about 6%, but the whole curve is shifted
towards higher total cost.
There is a second advantage of the new objective function in Eq.(4.1): For values of
j3 > 0.7 the program LEO selects from the possibly very many energy optimal solutions
the one that requires the least cost. On the other hand, for values of j3 < 0.2, among the
solutions without cost increase the one which uses the smallest amount of energy is selected.

5 Conclusions

Using a highly aggregated model of the industrial energy demand in West Germany, we
have demonstrated the dependence of energy saving potentials on the energy price. As a
result of vector optimization, we may say that, at current energy prices, the realization of
the maximum savings potential will lead to more than 30% higher cost. If, however, energy
prices are increased, the relative increase in cost is reduced, while, at the same time, the total
cost at minimum energy use is higher. Therefore, if we want to stimulate energy conservation
and thus pollution abatement we have two choices: Either double or triple the energy price,
e.g. by high energy taxes, so that energy saving and cost minimization become parallel
objectives on a high total cost level, or accept a moderate cost increase on a much lower
level. The latter could be achieved by appropriate subsidies, the funds for which might be
raised by a relatively low energy tax.

References

1. W. van Gool, "The Value of Energy Carriers", Energy 12, 509 (1987).
2. W. van Gool and R. Kiimmel, "Limits for Cost and Energy Optimization in Macrosystems",
in: Miyata, Matsui eds., Energy Decisions for the Future, VoU, Tokyo (1986), pp. 90-106.
3. R. Kiimmel, H.-M. Groscurth and W. van Gool, "Energy Optimization in Industrial Models",
in: M. Iri, K. Yajima eds., Proceedings of the 13th IFIP-Conference on System Modelling and
Optimization, Springer, Tokyo (1988), pp. 518-529.
4. H.-M. Groscurth, R. Kiimmel and W. van Gool, "Thermodynamic Limits to Energy Optimi-
zation", Energy 14, 241 (1989).
5. VV. F. Kenney, Energy Conservation in the Process Industries, Academic Press, Orlando, FL
(1984).
6. H.-M. Groscurth, R. Kiimmel and W. van Gool, "Cost Aspects of Energy Optimization", in:
W.W. Koczkodaj, R. Janicki eds., Proceedings of the International Conference on Computing
and Information (ICCI '89), Elsevier, Amsterdam (1989), pp. 481-486.
7. H.-:"1. Groscurth, R. Kiimmel, "Energy and Cost Optimization in Industrial Models", in:
N.N. (eds.), Proceedings of the 14th IFIP-Conference on System Modelling and Optimization,
Springer, Berlin, Heidelberg (1989), in print.
8. A. Tautz et al., "Fernwarmeschiene Niederrhein", BMFT research report T 84-167, University
of Dortmund, FRG (1984).
ENERGY RESOURCES DEPLETION AND ECONOMIC GROWTH

01 eg A. Eismon t
Institute for Systems Studies
USSR Academy of Sciences
9, Prospect 60 Let Octyabrya
117312, Moscow, USSR

For a one-sector economy, a production fu~wtil)n that t~kes

into accOlmt non-zero extractIon eosts of an exhaustIble
natural resour(~e ( which is essential Jar the eeonomy) has been
used. The long-term eonmunption of this exhaustible natLtral
reSOLtrCe is analysed. It is shown tl1a t Lmder c(?rtain i~i)ncli tiuns
the economy whiell uses this exhaus tible na tl_u'al resottrce (Oan
grow indefinitely long.
After the first ener?::..'! crisis of 1973-1974 two Cllternatives
have been widely discussed. The firs t one is called a "hard"
path and 1s associated wi tll t11e fLU~ther development (If the coal
industry, the nllio,lear enE:rgy and, in the more distant futLtre,
the Jusion energy. TIle sec,ond one i8 eallecl a "sof t" pa th. It
is based on energy saving, introduction of nontraditional
renewable energy SOLtrees (solar, wind, geothermal) and
presupposes at first the stabllizati,)n I-If enel~gy ':onsumption
and then its deeline. The "hard" path 1s aecompanied by
inevitable environmental problems while the "SI]I't" paUl gives
some hopes to solve theSE: problems.
Technically the "soH" path may look real1stie since it is
possible to decrease the average energy intensity in developed
cotmtries nearly tenfold and to cover a considerable share 01'
energy demand by renewabl e energy sources ([ 1 J ). However, the
question of w11ether the "soft" path is feasible eeonomically is
worth JLtrther considera !ion. In what follows an attempt is made
to answer this question from the macroeconomic point of view.
In macroeconomic modelling, production l'tmctions play an
important role. The most widely k.l1own production JLmctiom: are
of the Go bb-Douglas and the CES type. The main produc t ion
Jactors which are included in these produetion ftmctions are
laboLtr, capital and, in some cases, na tm~al reSOLu~ces (mainly
energy). The in troduet ion of na tLtral reSOLtrCeS in the usual
way, Similar to that of labour and eapital, can be justHied
only 11' there are no extraction costs (see l'or example [2 j ).
 547

Thus, the problem of constructing a production flmction which

includes, among other production factors, a natural resource
with nonzero extraction costs arises. To solve this problem let
us consider an economy comprising two sectors: the one which
produces energy and the second one which represents the rest of
the economy. Each sector has a certain amolmt of capital K and
labour L. The final product, GDP= Y, is produced only in t11e
second sector which uses the energy produced in the first
sector, the energy flow being R. Then asslUning the existence
of a neoclassical production function we have
y = F.-,c.. ( K",
c..
Lr"c.. R, U), (1 )

where U is the technical level, assumed to be identical in

both sectors, and where the indices mark t11e corresponding
sectors of the economy. Expanding the function F"c.. in a Taylor
series in the vicinity of the point (K, L, R, U) we 'have
8F2 8F2
Y Fr,(K, L, R, U) - I K1 : L1 + (2 )
c.. oK 2 : K.-,=K 8L2 : K.,=K
I c.. I L

: L,,=L
c..
: Lr,=L
c:.

Taking into account that in a real economy the inequalities

K1/K « 1, L1/L « I hold, only linear terms can be retained
in the corresponding Taylor expansion.
Assuming that in the energy sector current expenditures for
raw materials coming from the rest of t11e economy are
negligible in comparison with labour and capital expenditures
the corresponding production flmction will be as follows:
R = F1 (K 1 , L 1 , U, Q), (3)
where Q is the cumulative amolmt of the natural resource
extracted.
AssLUning that production functions (1) and (3) are linear
homogeneous in labour and capital and using profit maximization
condi tions we get the following expression for the production
function corresponding to the economy as a whole:
Y = F2 {K, L, R, U) - cRR, (4)
wnere CR 1s the specific extraction cost defined as the
expendi tures for labom' and capital for the extraction of a
lmit amOtmt of natural resource.
 548

It should be noted that in the case of a limited natural

resource its market price is defined as follows:
PR = cR + P, (5)
where P is the scarcity rent which in the case of constant
extraction costs rises exponentially ([3]):
P = de rt (6)
where r is the discount rate and d=const.
It should be stressed that in general the extraction costs
depend no t only on the geological, teclmical (and,
consequently, economic) conditions of the resource deposit but
also on the other economic variables. Thus, it is generally
wrong to asswne the constancy of the extraction costs only on
the basis of tIle uniformity of the geological conditions of the
resource deposi t. However, it can be Sl10wn that for tIle case of
a Cobb-Douglas production function with reasonable labour and
capital elasticities the extraction costs depend on the
capital-labour ratio with nearly zero elasticity. Thus, in this
particular case it can be asswned that the extraction costs
depend only on the depletion of the natural resource.
Let us discuss ft~ther the problem of long term tendencies
in the conswnption of the limited natt~al resource (a
similar problem is considered in [4] for the case of zero
extraction costs). The demand for the limited natural resot~ce
is defined from the profit maximization condition by the
equation
Q[ = p. (7 )
oR
We asswne for simplicity that F""- is a Cobb-Douglas
production ftffiction, linear homogeneous in K, L and R:

F2 (K,L,R,U) = A IfJ- L~ RJ-a-~ U. (8)

From (5)-(8) we can easily get the expressions for natt~al
resource const@ption and for GDP:

(9 )
 549

From (9) it follows that for the natural resource not to be

depleted in finite time, the growth rate of the teclmical
progress should be not too hig,h. On the other hand, from (10)
it follows that for GDP growth rates to be positive the growth
rate of the teclmical progress should be high enough. If the
growth rate of the technical progress is denoted by v then,
asst@ing equilibrium growth of the economy and the
stabilization of the labour force, from the aforementioned it
follows: The economy which uses the limited natural resource
can grow indefinitely long provided the following inequalities
hold:
'v ,
(1 - a - ~) r (1 - a) r. (11)
It is readily seen that the statistically observed values of
the corresponding parameters (v co< .02 to .05, r co<.1, a "" .2,
~ "" . 7) provide the validity of the inequalities (11) .
Thus, from the macroeconomic point of view the "soft" path
is feasible.
As an illustration we consider the possible energy
const@ption pattern in the economy which has three energy
sources: 1) an exhaustible energy resource with relatively low
extraction costs, 2) an unlimited substitute energy source with
high production costs, and 3) a renewable energy source which
can be supplied only at a limited rate. At firs t, when the
cumulative extracted amount of the exhaustible resource is
still low and scarcity rent is much less than the extraction
costs, the energy consumption is growing exponentially. This
stage may be called a "hard" path. The renewable energy source
is supplied at a constant rate. As the exhaustible resource
gets more and more depleted, the scarei ty rent becomes the
major part of energy price. Energy const@ption first stabilizes
and then falls. This stage may be called a "soft" path. From
the very beginning the energy price is rising monotonously.
When it reaches the production costs of the tmlimi ted
substi tute energy source, the economy switches to its
 550

consumption ami the latter will rise again. Thus the

economy may retLU~n to the "hard" path again. This process is
shown in fig.1: R is the annual energy consumption; the dashed
line corresponds to the rate at whic,h the renewabh~ energy
SOUTce can be supplied: point A marks the moment when t11e
economy 8wi tches to the consumption of lmlimi ted substitute
energy SOLU~ce.

,.1'
.'
I

.'~
--- , ... ,
1"·'-- -....... I'
.' "- .......
It I "
,.It II,. .........

.... . ....
~ ',~
,.",
t' -:,~

............ H'·' \_.•..•.

. -.,
...... --...
/ "
.. -......... ---.._-
---,

t
Fig.1
REFERENCES
1. A.Lc,vins, L.H.Lovins, F.Krause, W.Bac11, "Energy Strategy
for Low Climatic Rl sks" , Report for the German Federal
Environmental Agency, 1981.
~. SJ'!Tlposium 011, th~ EcoTlOmics of Exhaustible ResoLU'ces,
ReVIew of ~conomic ~tudles, 1974 vol.41.
3. H.Hotelling, "The Economics of Exhaustible Resolu~ces",
Journal of politf{~al Economy, 1931, vo1.39, pp. 137-175.
4. W.Krelle, "Theorie des Wirtscl1at"tIicl1en Wachstul11s",
Springer Verlag, Heidelberg, 1985.
Econometric methods as an instrument for estimating external
costs per unit of emission: the case of a groundwater model
Monika Vorreyer
Fern U niversitat Hagen
Lehrgebiet Statistik und Okonometrie
Feithstr. 140, D-5800 Hagen 1, FRG

Abstract

Econometric methods are used in this study to analyze the cause-effect relationships of the sulfur
dioxide and nitrate emissions on the damage costs of groundwater pollution (purification costs)
and on the nitrate induced avoidance costs. A simultaneous 4-equation groundwater model was
constructed for this purpose. By means of the reduced form coefficients the results provide
estimates of the external costs per unit of emission which are caused by power economical and
agricultural activities and which are imposed on the water-supply enterprises (68.2 DM/t sulfur
dioxide and 327 DM/t nitrate).
Keywords: Ecological modeling; external costs; damage costs of groundwater pollution;
emission-multipliers.

Contents
1 Introduction
2 Emissions, immissions and environmental damages
3 External costs of groundwater pollution
4 Econometric groundwater model
5 Concluding remarks
Appendix
References

1 Introduction
Econometric methods have been applied mainly in the field of modeling macroeconomic theories
and relationships. More recently, they have also been used in health-care economics, social,
natural and technical sciences. A number of studies l have linked different variables (among
other things environmental factors like specific air pollution levels) to health damage (the damage
indicators being mortality and morbidity).
The aim of this paper is to outline some major results of an econometric ~roundwater mo-
del. This model was especially constructed to show that the cause-effect relatIOnships between
emissions, immissions and monetarized environmental damages can be modeled.

2 Emissions, immissions and environmental damages

Emissions are produced e.g. by the energy sector and by agriculture. The main pollutants
emitted from the transformation processes of fossil energy are sulfur dioxide, nitrogen oxides,
dust, carbon oxides and hydrocarbons. By fertilizing activities of the agricultural sector the pol-
lutants nitrate and plant protection products (atrazin) are carried into the soil and subsequently
into the groundwater. The pollutants are transported and cause as immissions environmental
damages, in this case groundwater damages.
The exact determination of significant polluter-damage relationships is very difficult. Since
adequate damage functions are not available and since the regress from immissions to emissions
lSee e.g. RIDKER (1971), LAVE, SESKIN (1970), CHRISTAINSEN, DEG EN (1980), OSTRO (1983), LEU
et aI. (1984), GYSIN (1985).
 552

implies knowledge of various factors, it is presently impossible to derive polluter-damage cost

curves. Therefore statistic/econometric methods are taken as instruments for the estimation
of damage cost curves, which can describe the additional purification costs and monetarized
avoidance effort (e.g. water import) due to groundwater pollution.

3 External costs of groundwater pollution

External costs are the monetarized negative external effects (external diseconomies) caused by
the power economical and agricultural activities; they are not internalized by the polluters
but Impose utility losses on the affected water-supply enterprises. Using environmental policy
instruments, e.g. the polluter-pay principle, the external diseconomies are passed on to the
polluter. An appropriate instrument could be a tax system.
Referring to the econometric groundwater model, the respective negative external effects are
the deterioration of the groundwater quality, which results from using the groundwater as a
waste-disposal medium for the emissions of the energy sector and of agriculture. The utility
losses are expressed by two categories of costs: These are the costs for purifying the polluted
groundwater due to not-avoided sulfur dioxide emissions of the energy sector and the costs for
avoiding nitrate pollutants of agriculture. To internalize these costs, there is a lack of knowledge
about the amount of the monetarized negative external effects per unit of emission. These values
can be quantified by the reduced form coefficients of the econometric groundwater model. The
estimates can be interpreted as the slope of the relevant monetarized polluter-damage curve.

4 Econometric groundwater model

4.1 General remarks
The emissions, immissions and monetarized groundwater damages are combined in an econo-
metric groundwater model. This model consists of four behavioral equations. The relations-
hips between emissions and immissions on the one hand and those between immissions and
monetarized groundwater damages on the other hand are modeled. Together, they build an
interdependent model.
In the econometric analysis least squares and two-sta~e least squares estimation methods
are applied to cross-section data of 44 cities and rural distncts in Baden- Wiirttemberg for 1987.
For the most part the data consist of official statistics. At present, especially the data for the
quality of the groundwater are only available for this federal state ("Land") of the FRG.
In our econometric groundwater modeling, we mainly concentrate on three aspects:
1. Specifying the relevant equations.
2. Estimating the structural coefficients and deriving therefrom the reduced form coefficients.
3. Evaluating the validity of the groundwater model, especially by means of
• statistically significant effects of the regressors on the regressand (t-statistic and beta-
coefficien ts),
• scientific plausibility of the partial regression coefficients and
• the goodness of fit of a specific equation (R 2 ).

4.2 Specification
The model specification stands at the beginning of building an econometric model (see e.g.
GRUBER 1968, 1981). One task is the determination of the explanatory variables of the ground-
water model. By expert considerations and by the availability of data the explanatory variables
are given for three equations, the WGS-, KB3- and KANNEU-equations listed below. For
the WGN2-equation, which explains the effect of variations in agricultural p{)llution on the
groundwater Immission by nitrate, there exists a broader spectrum of potential explanatory
 553

variables. The proced ure to select the explanatory variables of this equation involved stepwise
regression.
The specified interdependent groundwater model has the following structural form 2 :

WGS Bl * EMS + B2 * DG + B3 * AL + B4 * W F + B5 * WSGB

+B6 * CONST + WGS'I
WGN2 Bl * EMN + B2 * AL + B3 * W F + B4 * SOKU
+B5 * CON ST + WGN2'1
KB3 Bl * WGS + B2 * K AN N EU + B3 * LH KW2 + B4 * ABI +
B5 * WBGES + B6 * WA+ B7 * AT + B8 * CONST + KB3'1
KANNEU Bl * WGN2 + B2 * K B3 + B3 * W BGES + B4 * WAN
+B5 * GWU E + B6 * CONST + KANNEU'l.
The variables WGS'I, WGN2'1, KB3'1 and KANNEU'1 denote in the lAS (Inter-Active Simu-
lation) system the disturbances in the equations. The lAS system (SONNBERGER et at. 1986)
is an econometric software package providing a spectrum of standard estimation routines such as
least squares (OLS) or two-stage least squares (TSLS) estimators and many testing procedures.
The empirical regressions results are shown below.

4.3 Estimation
The second phase of the construction of the econometric groundwater model is the parameter
estimation. The four equations of the groundwater model are linear in the parameters and
there are no lagged endogenous variables. The first and second equations are estImated by OLS,
the third and fourth ones, which above all describe the effect of the variations in groundwater
immissions on the additional purification and avoidance costs, are estimated by TSLS. Table 1
reproduces the regresssion results for some interesting relationships, that means for the struc-
tural and reduced form coefficients of the explanatory variables EMS (sulfur dioxide emissions),
EMN (nitrate emissions), WGS (sulfur dioxide induced immissions) and WGN2 (nitrate induced
immissions ).

Tabelle 1: Regression results

dep.var. WG::i WG~:! Ktl:.J KA~Nt;U

mdep.var. J:;MS' _J:;H JY' t;M~" r.;MJV WliY r.;1\;1 ~ ,. r.; MlV WlilV:!
RJ. 0.550 0.613 0.640 0.638
j3 0.00277 0.03311 0.068"17 -0.00636 24.5676 -0.00059 0.00523 0.15649
(J" 0.00059 0.02434 8.35131 0.04585
I t I-value 4.71 1.36 2.94 3.41
beta-coefL 28.9 9.8 17.4 28.7

* structural form coefficients

* calculated reduced form coefficients
4.4 Testing
Testing is the third phase of model construction. The four equations are subjected to various
tests (see e.g. KRAMER, SONNBERGER 1986):
• Durbin- \Vatson test (cross-correlation; strictly speaking not applicable in case of cross-
section data)
2 For the explanation of the four endogenous and 15 exogenous variables of the ground water model see the
appendix.
 554

• Goldfeld-Quandt test (heteroskedasticity)

• J arque- Bera test (nonnormality)

• Rainbow, Ramsey's Reset and Harvey-Collier Psi tests (functional form and misspecifica-
tion)
• Plosser-Schwert-vVhite Differencing and vVhite's Information MatrLx tests (general mlS-
specification).
None of these tests leads to the rejection of the respective null hypothesis.

4.5 Emission-multipliers
The estimated structural coefficients quantify the external costs per unit ofimmission. By means
of the relevant calculated reduced form coefficients, it is possible to attribute the external costs
to the polluters energy and agriculture.
The marginal external costs, which are caused by the sulfur dioxide emissions from the
combustion of fossil energy and imposed on the water-supply enterprises are estimated at 68.2
DM/t S02 (sulfur dioxide emission-multiplier with respect to the additional purification costs).
The marginal external costs which result from fertilizing activities of agriculture and which
the water-supply enterprises have to bear are estimated at 327 DM/t Noi (nitrate emission-
multiplier with respect to the nitrate induced avoidance costs).

5 Concluding remarks
The econometric groundwater model provides the basis for causal-analytically quantifying partial
effects of the emissions on the additional costs of the water-supply enterprises (purification costs
and nitrate induced avoidance costs). The estimated structural regression coefficients and the
reduced form coefficients derived therefrom indicate the order of magnitude for the marginal
external costs per unit of emission to be internalized.

Appendix
List of endogenous and exogenous variables of the econometric groundwater model
Endogenous variables:
WGS - fraction of the output of raw water with a sulphate content 2: 60 mg/I, in %
WGN2 - output of raw water with a nitrate content 2: 40 mg/l, in 1000 m 3
KB3 - by groundwater pollution induced damage/abatement costs, in 1000 DM
KANNEU - nitrate induced avoidance costs, in 1000 DM.

Exogenous variables:
EMS - sulfur dioxide emissions, in tons
DG - meadows, in ha
AL - arable land, in ha
WF - forest, in ha
WSGB - water protection areas, in ha
SOKU - special cultures, in ha
EMN - nitrogen oxide emissions, in tons
LHKW2 - raw water with a content of volatile halogenized hydrocarbons 2: 0.013 mg/I, in 1000 m 3
ABI - raw water-supply plants with chemical-physical purification, number

3 As there are no data available for the groundwater pollution by nitrates arising from agricultural activities,
the external costs per unit of (nitrate) emission are calculated by means of the external costs per ha arable land
and the degree of the losses by washing out and denitrification.
 555

WBGES - water import, in 1000 m3

WA - water consumption, in 1000 m3
AT - output of raw water with an atrazin content ~ 0.0001 mg/I, in 1000 m3
WAN - fraction of supplied drinking water with a nitrate content ~ 25 mg/I, in %
GWUE - crossing the limit for the output of raw water with nitrate concentrations ~ 50 mg/I, in %
CONST - auxiliary variable for the intercept coefficient.

References
1. CHRISTAINSEN, G.B., DEGEN, C.G. (1980)
Air Pollution and Mortality Rates: A Note on Lave and Seskin's Pooling of Cross-Section
and Time-Series Data. Journal of Environmental Economics and Management 7, 149-155.

2. GRUBER, J. (1968)
Okonometrische Modelle des Cowles-Commission- Typs: Bau und Interpretation. Verlag
Paul Parey, Hamburg - Berlin.
3. GRUBER, J. (1981)
Okonometrie 2: Formen. Typen und Spezifikation iikonometrischer Modelle. Kurse 0860-
3-01-S1 und 0860-4-02-S I, Fernuniversitat - Gesamthochschule - in Hagen, Fachbereich
vVirtschaftswissenschaft, Hagen.
4. GYSIN, Ch.H. (1985)
Externe Kosten der Energie in der Schweiz. Reihe Okologie Band 5, Verlag Rliegger,
Grusch.
5. KRAMER, W., SONNBERGER, H. (1986)
The Linear Regression ~Iodel Under Test. Physica-Verlag, Heidelberg - \Vien.
6. LAVE, L.B., SESKIN, E.P. (1970)
Air Pollution and Human Health. Science Vo!' 169, 723-733.
7. LEU, R.E., GYSIN, Ch.H., FREY, R.L., SCHMASSMANN, N. (1984)
Externe Kosten der Energie am Beispiel von !"[ortalitiit und Morbiditat. Schweiz. Zeit-
schrift fUr Volkswirtschaft und Statistik Heft 3.
8. OSTRO, B.B. (1983)
The Effects of Air Pollution on Work Loss and Morbidity. Journal of Environmental
Economics and Management 10,371-382.
9. RIDKER, R.G. (1971)
Economic Costs of Air Pollution: Studies in Measurement. Praeger Publishers, New York
- Washington - London.

10. SONNBERGER, fJ.. KR)i.~IER, W .. SCHRAICK, W., RESCHENHOFER, E., WASI-

LEWSKI, Z., ZEISEL, H. (1986)
lAS-System: User Reference ~Ianual. Part Two: Econometric Methods. Institutsarbeit
Nr. 234, Institute for Advanced Studies. Vienna.
11. VORREYER. ;"1. (1991)
Okonometrische Analyse cler U rsache- \Virkungs-Zusammenhange in einem Grundwasser-
model!. (Doctoral dissertation submitted in April, 1991, to the Faculty of Economics,
University of Hagen).
 PART 10:

ECONOMETRIC MODELS OF COUNTRIES, MARKETS ETC., BASED ON

MICRO DATA AND MACRODATA, AND THEIR PERFORMANCE IN POLICY
ANALYSES
Microeconometric research at the Sonderforschungsbereich 3

Heinz P. Galler
F achbereich Wirtschaftswissenschaften
Johann Wolfgang Goethe-UniversiUit
Senckenberganlage 31, D-6000 Frankfurt 11, FRG

Abstract

The Sonderforschungsbereich 3 is one of the places in the FRG where microeconometric

models and methods have been developed and applied for a comparatively long time. In
the meantime, micro analyses have become more frequently used in the FRG. At least to
some extent this is a response to improved data, better methods and cheaper computing
facilities. But microanalytic models also have some advantages as compared to the tradi-
tional macroeconometric approach. Especially, microeconometric models are less affected
by structural changes in the economy. In addition, more precise estimates can be obtained
on the micro level due to the large number of observations in micro data sets. However,
also some new problems arise like unobserved heterogeneity of observations and sample
selectivity that have no direct counterpart on the macro level. But experiences at the Son-
derforschungsbereich 3 demonstrate the large opportunities for detailed analyses that can
be conducted using micro data.

Keywords: Microeconometric models; hazard rate models; microsimulation; policy analy-

sis; micro data; panel data; labor force participation; employment; unemployment; occupa-
tional mobility; earnings; transfer analysis; Weibull hazard rate to leave unemployment.

Contents

1 Why microeconometric models?

2 Microeconometric analyses at the Sfb 3
3 Policy analyses by microsimulation
4 Conclusions
5 Bibliography
 560

1 Why microeconometric models?

The Sonderforschungsbereich 3 (Sfb 3) has been a large interdisciplinary research project

that was started in 1979 by a group of economists, sociologists, statisticians, econometri-
cians and researchers in informatics at the universities of Frankfurt and Mannheim 1. It has
been funded by the German Science Foundation (Deutsche Forschungsgemeinschaft) till
its end in 1990. A major goal of the research work was the development of quantitative
models which can be used for policy analyses. The basic idea was that such models provide
valuable information on economic and social structures. The design of efficient policies
requires information on the consequences of alternative policy measures. On such a basis
policy measures can be selected which result in an efficient solution, in the sense of an at
least approximate conditional optimum of public welfare, given the resources available.

In this approach, a quantitative model is used to describe the processes relevant for politics
as well as to assess the effects of different policy measures on these processes. Traditio-
nally, macroeconometric models have been used in economics for this purpose based on
aggregated data derived from the national accounts. However, there are some short-
comings in such an approach related to the level of aggregation.

First of all, policy makers are usually not only interested in broad aggregates like national
income, total consumption or investment, but they also have to consider distributional and
structural aspects of the economic process. This implies that aggregated models cannot
provide all information needed. In addition, models are required which allow to assess the
distributional and structural impact of policy measures. This can only be achieved by more
disaggregated approaches.

Secondly, at least some of the instruments of economic policy have a rather complex design
and depend strongly on structural characteristics of the economy. An example is income
taxation with its set of complex regulations, depending on individual income and other cha-
racteristics of the tax payer. In most cases, such a tax schedule cannot be modelled appro-
priately on an aggregated level since the impact of taxation depends strongly on the struc-
ture of the tax base. Structural aspects must be considered in great detail in order to assess
the effects of changes in the tax law appropriately. This requires disaggregated models
allowing to analyse such structures.

In addition, models based on aggregated data also suffer from some methodological defi-
ciencies 2. One problem is that the reliability of econometric forecasts depends strongly on
the stability of the underlying structural relations. Only if the basic structure remains
unchanged, valid forecasts can be derived from a model. But since the parameters of
macroeconometric models represent weighted means of the corresponding parameters on
the micro level of individual economic agents, structural change on the micro level will
result in parameter shifts on the macro level, even if the individual micro relations remain
unchanged. As a consequence, aggregated models may be unreliable in periods of structu-
ral change. However, since structural effects are considered explicitly, models on a lower
aggregation level are less affected by this problem.

1 A general overview on the Sonderforschungsbereich 3 can be found in Hauser and Hochmuth (1989).
Cf. Orcutt (1986).
 561

Another problem concerns the efficiency of parameter estimates. Since usually only a
comparatively small number of observations is available for time series data on the macro
level, estimates based on macro data are of limited statistical efficiency. In micro data sets
on the other hand, a comparatively large number of practically independent observations
with detailed information on structural characteristics is available. This allows not only
more detailed analyses, but also more efficient parameter estimates. Thus, behavioral rela-
tions on the micro level do not only tend to be more stable but the parameters can be esti-
mated more efficiently than in macro relations.

However, in the past the lack of suitable micro data, the predominance of cross sectional
data not allowing dynamic analyses and comparatively large computational requirements
have been an obstacle for a vast application of microeconometric approaches. But since
sample surveys have become a standard source of information, an increasing number of
micro data sets has become available to researchers not only in the USA but also in Euro-
pean countries. Additionally, the limitations of cross sectional data have been overcome by
the availability of panel surveys containing longitudinal information on micro units 3. In
parallel, the costs of computing have been reduced dramatically. Thus, even dynamic
microeconometric analyses have become feasible which could not be conducted a few years
ago.

2 Microeconometric analyses at the Sfb 3

As a response to these developments, microeconometric approaches have been adopted in

addition to traditional macroeconometric models at the Sfb 3 4. Models of this type have
been used to analyse the behavior of private households and to estimate the impact of
policy measures on the household sector. Especially, labor force participation, employ-
ment, unemployment and occupational mobility, earnings and income, positive and nega-
tive transfers, and consumption and savings have been investigated on the micro level 5.
Analyses of this kind provide valuable insights into the relationships which govern the
socio-economic process on the micro level. Besides, it is much easier to test hypotheses
concerning economic behavior on the micro level because the behavior of economic agents
is observed directly and no information is lost due to aggregation.

An example is an analysis of the duration of unemployment of men in West Germany by

Hujer and Schneider (1989). It was based on longitudinal micro data from the first three
waves of the German Socio-economic Panel Study with information on individual spells of
unemployment, measured up to single months. For the analysis a Weibull hazard rate

3 One of the major projects at the Sib 3 was the German Socio-economic Panel Study which is now continued
by the Deutsches Institut fUr Wirtschaftsforschung, Berlin. In this panel, a sample of about 6000 households
in the Federal Republic of Germany has been followed up since 1984 in annual interviews. Besides other
information, the panel contains detailed longitudinal information on the the socio-demographic structure of
the households, on education, labor force participation, employment and unemployment, on earnings and
other income, on taxes and transfers on the level of individual persons. Cf. Autorengemeinschaft Panel 1990.
4 At the Sib 3, a medium sized macroeconometric model of the business cycle has been developed. Cf.
Hujer/Hansen/K1ein 1988.
5 Selected references are given in the bibliography at the end of this contribution.
 562

model for the individual propensity to leave unemployment was used with individual cha-
racteristics like nationality, education and age as explanatory variables. In addition, the
impact of unemployment compensation was controlled for as well as seasonal factors.
Duration dependence of the hazard rate is modelled in the Weibull specification by an
exponential time trend.

In table 1 parameter estimates are given for a specification without unobserved heteroge-
neity of the micro units as well as a specification with unobserved heterogeneity, using the
semiparametric approach of Heckman and Singer (1982). Except for the Weibull parame-
ter for duration dependence, the estimates for the two specifications do not differ signifi-
cantly. German nationals show a higher propensity to leave unemployment than foreigners.
Better education also reduces the duration of unemployment. The chances to leave unem-
ployment are reduced in the higher age brackets. There is a bigger chance to become
unemployed during spring and summer 6. The results also indicate that the entitlement to
unemployment benefits, granted in the first months of unemployment (Arbeitslosengeld),
does not affect the exit rate significantly whereas subsidiary benefits (Arbeitslosenhilfe),
granted after unemployment benefits have expired, seem to reduce the exit rate.

The two different specifications for unobserved heterogeneity result in significantly diffe-
rent estimates for duration dependence. While the specification without unobserved hete-
rogeneity shows no significant duration dependence, the estimates based on the semipara-
metric Heckman/Singer specification imply a significant positive duration dependence, i.e.
the exit rate increases with prolonged duration of unemployment. This result is in accor-
dance with the results of search theory. However, analyses by Galler and Potter (1990) cast
some doubt on such estimates. Their research shows that the Heckman/Singer estimator
seems to be rather sensitive with regard to deficiencies of the data. Therefore peculiarities
of the data may result in an estimate of negative duration dependence, even if it is not the
true relationship.

This points to a problem of microeconometric analyses which has no direct counterpart on

the macro level. Since there exist systematic differences between different micro units not
fully explained by the models due to an imperfect specification, the error terms for diffe-
rent individuals will contain a component specific to the individual. If this unobserved
heterogeneity is not taken into account, biased estimators may result. Another problem on
the micro level is that of sample selectivity. In some cases the selection of the sample is not
independent of the process modelled. For example, if persons being unemployed for a lon-
ger time tend to drop out of the sample with a higher probability, the mechanism of sample
selection would be related to the observed process. If this is true, but the selection mecha-
nism is not taken into account explicitly, biased parameter estimates may result. Thus, on
the micro level additional methodological problems arise. Some solutions to these
problems are already available, but still additional research is required to improve the
microeconometric methods.

6 The large coefficient for December results at least partially from a methodological artefact. Information on
the unem ployment spells is collected annually by retrospective interviews. Since some respondents forget to
report the continuation of unemployment in the next interview, transitions out of unemployment are
overestimated for December.
 563

Table 1: Weibull Model for the Transition of Men from Unemployment to Employment

without unobserved with unobserved

heterogeneity heterogeneity
Variable name exp(9) 9 SignJev. exp(9) a Sign.Lev.

A! 1.0000 0.0665
A2 (State Probabilities) 0.4219

A3 0.5116
-2.4302 0.2822 -1.2652
'\ 0.0880 0.0000 0.0000
02 (Support Points) 0.1073 -2.2320 0.0000

°3 0.0528 -2.9407 0.0000

1> (Weibull Parameter) 1.0649 0.0629 0.1217 1.1551 0.1442 0.0002

Nationality 1.2157 0.1954 0.0903 1.1895 0.1735 0.1215
Realschule 1.0273 0.0269 0.8585 1.0204 0.0202 0.8912
(Fach-)Abitur 1.7808 0.5771 0.0001 1.7522 0.5609 0.0001
A"e hetween 10 and 40 0.8390 -0.1756 0.1888 0.8556 -0.1560 0.2313
 564

3 Policy analyses by microsimulation

A certain disadvantage of the micro approach is that no direct conclusions can be drawn
from micro relations with regard to variables and structures on the macro level. But on the
other hand the ultimate interest, at least of policy orientated research, is to infer about the
implications of given processes or of policy measures on a more aggregated level. In order
to derive such aggregated results, the structure of the population must be considered in
addition to the micro relations. For this purpose, microanalytic simulation techniques have
been developed at the Sonderforschungsbereich 3 allowing to derive aggregated estimates
from micro relations 7.

In these simulation models, the micro relations are applied to a representative sample
from the population considered. Based on the results for the individual micro units, the
corresponding aggregates are estimated for the total population or subgroups of interest.
Thus, the micro simulation approach provides an instrument for inferences about the
aggregated consequences of policy measures, using micro relations for individual units.
Detailed structural properties of the economy can be taken into account explicitly in esti-
mates derived from microsimulation models.

An example is an analysis of the distributional effects of the German reform of direct taxa-
tion in 1990, conducted by van Essen et al. (1988,1988a) using a static microsimulation
model. While the effects of changes in the tax schedule on individual income can be asses-
sed easily, the net effect for different groups is much more difficult to estimate. Depending
on the individual characteristics of the tax payer, the different measures imply reductions
and eventual increases in the tax burden which may compensate each other. Therefore the
joint distribution of taxable income and other characteristics of the tax payers must be
taken into account when estimating the net effect of the tax reform. This cannot be done in
a macroeconomic model.

For this simulation study, the micro data of the first wave of the German Socio-economic
Panel study of 1984 have been used. This data set contains rich information on family and
household structures, on taxable income and its components as well as on other variables
required for computing the income tax. However, since some pieces of information like
costs of maintaining houses are missing, some imputations had to be applied to the data.
Monetary variables have been adjusted to the levels of 1988 and 1990 by adjustment fac-
tors. However, the basic socio-demographic structure of the sample was not changed by re-
weighting since no significant changes occur in such a short period of time. Besides, no
provisions have been made to account for behavioral responses to changing tax rates. Thus,
the simulation represents the formal incidence of the tax reform.

The effects of the different tax schedules have been estimated by computing first taxes for
the individual micro units in the sample according to their characteristics and to the regula-
tions of the tax law. Afterwards, these micro results have been aggregated into estimates of
the effects for different groups as for example households in given income brackets or for
the total population. They represent the net effect of the reform, given the distribution of
the characteristics in the sample. Some basic results concerning the distribution of benefits
are presented in figure 2. In terms of the percentage of the taxes paid according to the pre-

7 An overview is given by Galler (1991) and Galler/Wagner (1986).

 565

vious schedule, low income households benefit most since a larger part of income remains
untaxed or is taxed at lower rates. Tax reductions become relatively smaller for the middle
income groups, up to about an annual income of about DM 75000, but rise again for high
incomes.

Figure 2
Formal Inoldeno. 01 I". 111110 I n r.form
(S Imulation r.eulle)

" Ta .... " Inoom.

80'' ,-------~======~------------------------------------__r'e"

14"
eo" 12"

10"

40" 8S

es

20" .___ ,- --,------r.~~. .r····l ....r····

'''''''1'1.''''''''''''''''''
J ------r. . . .. . .. . ,··· ··,. . . 1
...•..........
2"

2 20 200
I ncome (1000 0 1.4)

.--- N.I Inoom. ....... Or o .. Income - Ta .... 11183

Source: van Essen at al. (11188)

This is mainly a consequence of the reduction of the maximum marginal tax rate. However.
if the tax reduction is compared to income, the effects are smallest for low income groups
and increase with rising income. This effect is strongest for households with an annual
income of more than DM 60000.

When the effects are broken down by income brackets as well as the number of dependent
ch ildren, it becomes evident that households with no children benefit less than the average.
In general the absolute tax reduction increases with the number of children and with rising
income. However, in the income bracket between DM 50000 and DM 100000 the reduc-
tion for families with up to two or three children is smaller than for households without
children. This is a consequence of the reduction of tax exemptions depending on the num-
ber of children, especially for contributions to retirement funds and to thrift institutions,
that had benefitted most the middle income groups in the past. This shows that in a com-
plex set of policy measures compensating effects may occur which cannot be detected
easily unless very detailed analyses are performed. As it is possible to take into account all
relevant variables, microsimulation models are a superior instrument for such analyses.
 566

4 Conclusions

In the last decade, the availability and the quality of micro data as well as the computatio-
nal facilities have been improved substantially. Besides, new methods have been developed
allowing to analyse especially longitudinal micro data appropriately. As a result, microeco-
nometric analyses have become an important tool for applied economic research. As the
example of research conducted at the Sonderforschungsbereich 3 shows, analyses based on
micro data are not only feasible but moreover can provide additional insights that cannot
be achieved by traditional macroeconomic approaches.

The micro approach has even become more important in the last years due to the structu-
ral changes taking place. Changes in society in general and in particular in politics affect
economic behavior. As a consequence, economic relations have become less stable. The
impact of structural change is probably stronger for macro relations, since the parameters
of such relations depend implicitly on structural aspects of the economy. Behavioral
models on the micro level on the other hand should show more stability since the indivi-
dual preferences governing individual behavior in general show a strong latency. Thus, one
may expect that micro relations describing individual behavior will be more stable than
macro relations in such a situation. If this is true, microeconometric analyses can give use-
ful information on the economic process even in a period of substantial structural change.

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 567

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 568

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INCOME AND PRICE POLICY MAKING WITH AN ECONOMETRIC MODEL OF
FINANCIAL INCOMES AND EXPENDITURES OF POLAND'S POPULATION

Wieslaw Debski
University of Lodz
Institute of Econometrics
and Statistics
41 Rewolucji 1905r.
PL-902l4 Lodz

Abstract

The main purpose of this article is to present the simulation

analysis of the components of financial incomes and expenditures
of the population in Poland. The analysis is done on the basis of
an econometric model (consisting of 104 equations) which has been
constructed by using the balance of incomes and expenditures
prepared by the Ministry of Finance each year. The model, the
parameters of which were estimated by OLS using annual data from
the period of 1972 1987, consists of two main blocks of
equations. The first block is constituted by the equations
describing the components of the financial incomes of the
population. The equations of the second block describe the
components of expenditures and savings of the population. These
two blocks are supported by the block of equations explaining the
price indices in order to take into account the inflation
feedback in our economy.

Keywords: model of financial incomes and expenditures;

multipliers; simulation analysis; tax policy; subsidy policy;
labour productivity and inflation.

Contents

1 Introduction
2 Structure of the model
3 Income and price policy in the light of the simulation analysis

References
 571

1 Introduction

In the socialist countries there is some research devoted to a

model of financial incomes and expenditures of the population,
elaborated on the basis of a balance of incomes and expenditures
on the macroscale. We can quote, for example, publications by
Hajnovic(1981, 1983) or W. Welfe(1989) and A. Welfe(l98B) (see
also A. Welfe, W. Welfe,19B6). In the case of Poland the balance
of incomes and expenditures is rather highly aggregated
because,up till now, it has been considered in the context of a
model of the national economy (W. Welfe) or a model of the market
(A. Welfe). Our model of financial incomes and expenditures of
the population (see Debski, 19BB, 19B9) is constructed on the
basis of the balance of incomes and expenditures made by the
Ministry of Finance. It also has a slightly higher (especially on
the side of incomes) disaggregation than the last two models
mentioned above. It can be connected, of course, with a model of
the national economy in order to check its behaviour in the
context of more feedbacks and to do some special simulation
exercises.
The main purpose of this article is to present simulation
analyses of the components of financial incomes and expenditures
of the population, done on the basis of the model presented by
Debski (1990).

2 Structure of the model

2.1 Personal incomes block

Our model of financial incomes and expenditures of the population

consists of two main blocks of equations, i. e. the block of
personal incomes and the block of expenditures of households.
Personal incomes (Fig. 1 presents the scheme of the main
connections) are cons idered in the disaggregation on (average)
wages in particular sectors of the economy and other components
of incomes because of different mechanisms of growth of both of
these quantities. Wages, in turn, are considered separately for
production and nonproduction sectors of the economy since there
is some difference in the set of explanatory factors of these
variables.
In the production sectors of the economy we distinguish the
following four main determinants of average wages:
a) changes in the structure of the qualification of the
employees represented in our model by the lagged endogenous
variable (mainly for the explanation of the growth of wages
caused by so-called institutional changes) or the index of
qualification of the employees - measured by the ratio of the
number of employees having higher education to the total number
of employees having more than primary education;
b) rules of payment for work represented by labour
 fig. 1: structure of the block "Personal incomes )) Price index ot
Net procurement ot
Inde'lC ot Situation output ClgricuLtural goOd5
Cost ot hCj,.UQlifiCCJtion on labour L
of emplo~ee5 mClr\<;et
Profits
living I I Income or I-
index I Emplovmen~ private farmers
Additional fated
r ---- ----, ---! wages due to tinanciaH--
Averaqe wage Wage bill employment personal
Other personal I-
Labour in production j n production f- Income
produc ~eC+ors income
sectors
-tivit~ r--
I
I
t
I Wage bill Total earnings ~rotal
t I+l in 5oc"Ialized in socialized I - personal Total (J1
Average wage Wage bill in ---J
econom'j economy income ~dispo~ble N

in nonproduc nonprocluctionr- personal

-tion sectors sectors Income
Employment in
non50cia lized Income due to
A'Jerage number econol11~ exce p employment in
of pen ion5 agriculture n0f150cialized I -
1 Hard
economye)Ccept
GroS5 output
J CI riculture currenc'j'
realized
Averaqe Pen5ions Demografic tactor5
1 pension
h on bu,:/it1
L
goods
L ______ ...1 --- ,,50c.ial weltare"~
I
. payments
5tlpen '!>

Endogenou5 yariable~ are in rectanqleC) Other variables have exoqenous character.

------ laq ot one year.
 573

productivity which is measured by the ratio of net production (in

constant prices) to the number of employees;
c) the price level of goods and services;
d) the situation on the labour market - represented by the
difference between the number of vacant jobs (demand for labour)
and the number of registered people looking for jobs (supply of
labour) related to the total employment in the socialized economy
(this variable explicitly appears only in the equation explaining
the average wage for the whole economy).
When constructing models of average wages in the nonproduction
sectors, we assume that their wages should increase in some
proportion to the growth of labour productivity of the whole
economy. In our further investigations this quantity is replaced
by the labour productivity of the two main sectors of the economy
which are decisive for its growth, i.e. construction and
manufacturing. However, since the labour productivity determines
the level of the average wage in the models for the production
sectors, we decided to explain the average wage in the
nonproduction sectors by the average wage in the two construction
and manufacturing sectors, treating this quantity as the factor
defining this part of the growth of average wage which comes from
the rise of labour productivity of the whole economy (both
spheres). The second assumption which was made here is that the
wage changes in the nonproduction sectors tend to follow wage
changes in the production sectors. This phenomenon is connected
with the policy of the government which tries to avoid great
disproportions between the increment of wages in both spheres
because it could negatively affect the development of services.

The other part of the growth of the average wages in the

nonproduction sectors (the so-called autonomous growth) depends
mainly on the changes in the structure of qualification of the
employees or on institutional changes. This growth of wages is
explained I ike in the production sectors, i. e. by the lagged
endogenous variable or the qualification index.

Incomes from the activities in the nonsocialized sector of the

economy constitute the second main component of the personal
~ncome. They are considered in disaggregation into incomes due to
employment in the nonsocialized sector apart from agriculture
(depending on the number of employees in this sector or,
alternatively, on the originating production) and incomes of
individual farmers. With regard to the last category we assume
that it is mainly determined by the output of agriculture and by
the financial policy within the sphere of procurement prices.
"Social welfare" payments constitute the third component of
personal income. It is investigated in disaggregation in stipends
(treated exogenously), sickness benefits and pensions. Regarding
the average pension we assumed that the mechanisms explaining its
growth rate are similar to the mechanisms determining the rise of
the average wages in the nonproduction sectors of economy. In
other wordsI we sapply the hypothesis that the level of the
average pens Lon follows the level of the average wage in the
socialized ecsnomy.
 574

2.2 Expenditures of population

The side of expenditures is represented in our model by two main

groups (see Fig. 2). The first one is constituted by the realized
household expenditures for goods and services. They are treated
as the consumption demand of the population (households) being
realized on the level of selling. Functions describing both
categories are the classical functions of consumption demand,
where the expenditures depend on the personal income ( in our
model represented by the disposable income of the population), on
the price index (or its relation to the prices of other goods)
and eventually on the lagged endogenous variable for taking into
account consumers' behaviour, or on the indicator of
disequilibrium.
The expenditures of financial nature constitute the second main
group of the population's expenditures. They consist of
expenditures for residential investment realized by the
population, repayment of credits, taxes and other payments. We
consider them in dependence on the total sum of disposable
income.
As an output from our model of financial incomes and expenditures
of the population we obtain the increment of financial means of
the population. This quantity is understood as the population's
savings which remain after satisfying the current consumption
(and after paying taxes and making other payments). It is further
divided into the increment of means put into savings institutions
(depending on the cost of living index) and into the increment of
cash which enlarges with a one-period lag the total disposable
personal income.

2.3 Inflation spiral

The blocks of financial processes described so far are connected

with creating and distributing incomes. They are additionally
supported by and connected with a mechanism commonly known as the
inflation loop (see Fig.3). It is based on the current
functioning in our economy of the cost model of inflation.
In our model the inflation feedback is simplified in such a way
that we explain the price deflator of net production (of the
socialized sector) by determining its growth rate by the growth
rate of the average wage in this sector and financial
accumulation. This last quantity is considered as the sum of
three separately explained components, namely profit, turnover
tax and subsidies. Introducing the financial accumulation into
that price equation has the following aspects. First, we want to
take into account the tendency to raise taxes of enterprises in
order to ensure means for financing activities (like wages) of
the nonmaterial sphere of production. Second, this can be
connected with the tendency to equilibrate the market by setting
proper rates of the turnover tax. Finally, it can also reflect
 Fig.2: structure ot the block II Expenditures ot the population»
Indicator ot
Price index r---------- ___ -, di5e~itibrium
or material I I
L., r-J C05t at
g ooels Expenditures J 'fate (
n on material f-
living index
inkres t
good?
I
Price index oj
rJonrrlCltericll servicesjl Increment of
~ tinCincial mea~5
Expenditures on
at population In
1- nonmoteria I t- sovlng<o
Toto I '5erVICecs Increment l- i n5titution5 U1
disposable of "finanCial -..J
U1
personal means ot the
Re5idential inve';)tmerrt
Income 1-, I population
...a outlay':! tl ncmced
I-- t-
by populaiion Increment
I'
+I fL. ot cash
I
Taxe'O and other
I --'" I
pa~n1eI'11S
at pop~ilCI- r- I
I tlOn
I I
I I
I I
I IOther expenditures I
I I
IL _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ JI

Endogenou':> voriCibles are in rectangles. Other voriables have exogenous character.

----lag one 'lear.
or
 Fiq,3: Structure at tile block J) Inflation 5p'/ral I)

Indicator at
Index of. d ise9vuilibrium
Labour q,ualificClhon !
produchvity or employee5 state l
[ Profit sUboidies
L J
I I

,- -- -. - - f - - - I
1
financial
accumulation
:-~ /r'.e.raqe U
L-1 wage in the ~
'production h IA veraqe wage Prfce deflator Price i nclex
'------~~I of N M P i t'l h I c.~~t or U1
5ector~ I I-----l in socialiud h t- ---J
OJ
I or material I f-.l 1,Iving
socia lized I ~ qoods
I economy economY Index
I
I
., Price index ot
nomonst,..lmer Price index ot 'Price i nctex ot
Averuge wage commodltle5 procurement ~
nonmateria 1 t--
in the or agricu Lturol services
nonproduction Capita 1 u5i n oods
sectors i c05r
I
•
I I I
L _________ J
Price il1c1e~ at Price detlCltor 01"
material qoods consumption of
buyinq on free nondurable goods
marKet

Enclogenou5 variable5 are in recrangles, other variables have exogenous chamcter,

- - - - - lag or one yeo'(',
 577

the tendency to maintain price stability (e.g. by increasing

state subsidies). Further, the price deflator of net production
together with the endogenously treated price index of procurement
of agricultural goods in connection with the prices on the free
market influence the growth rate of retail prices of material
goods. This variable and the price index of nonmaterial services
determine the cost of living index, which in turn appears without
lag in the explanatory set of average wages.

3 Income and price policy in the light of the simulation analysis

As an objective of further considerations we propose, broadly

understood, simulation analysis done on the basis of our model of
the financial incomes and expenditures of the population in
Poland described above. Such an analysis can be useful for
preparing some economic decisions concerning the whole economy or
some particular sectors. In our article we will present the
results of both multiplier analysis (with respect of changes in
the level of economic instruments or structural parameters) and
scenario analysis of the chosen variants of wage and price policy
according to changes in the tax policy announced by the
government, forming profits, subsidies and so on.

3.1 Multiplier analysis and scenario analysis

From the rather big set of results of our simulation analysis

(all of which are described in Debski, 1989), we present here
only the most interesting ones. They are important from the point
of view of Polish economic policy in the near future. Thus the
presented results are connected with the changes of labour
productivity and of the components of financial accumulation.

3.1.1 Effects of changes of the labour productivity

Labour productivity plays, from an economic point of view, an

important role in our model. It ensures the link between the
financial processes explained by the model and real economic
quantities. There is no explicit feedback between those two
categories because of a gradual decline of the stimulating role
of wages on labour productivity in our economy. That is why the
effects of changes of real processes in the model can be only
observed through the changes of labour productivity. Though the
postulated changes have hypothetical character it does not mean
that they can not occur in reality. We only want to estimate the
effects of such changes (since we are conviced that our economy
has to go this direction) in the short and in the long term in
order to create a helpful tool for making decisions.
 578

Fig. 4: Effects of a 5% increase of the labour productivity

in 1989 - 1994

a) average Ud9E.', C()1Slrtx:1JOO

d) average Ud9E.', soc iallzed
O.~%r-------------------------------' E?Ccrul':J
;-
O·~r'----------------------------,
0.4

0.3 -
0.50
0.2

0.1 - I 0.25

O.O~~----~--~----~--~----~-J
1909 1'J'Xl 1991 19'J2 UJJ 19')<1 O.CJJ'-~----~--~----~--~----~--'
1909 1'J'Xl 1991 19')2 1993 1994

b) aver,)ge ua<)e, ~jacluring

;- e) ua<;e bi 11
O.~r'-----------------------------,
0.6 %

0.5
0.50 -
0.4 -

0.3 -
0.25 -
0.2 -

0.1
O.CJJL-~----~-- __----~--______~~
lWJ J9'.-Q 19')1 1m lW 19'.)01 0.0
1989 1m 19') 1 1992· 1993 1994

c) ave r 9JE.' ua<)e, rx:n> r ocU: 1100

sec lor f) lOla] f'(?rsooa] ireene

o. ~%r-------------------------------, 0.6 %

O.~

0.:Al 0.4

0.3
0.25 - 0.2

o. J -
1989 1m 1991 1992 1993 1994 O.U
1989 1m 1991 1992 1993 1994
 579

Taking into account the above remarks, we propose to analyse the

responses to the following (in the relation to the base-line
solution) changes:
1) a 5% annual increase of labour productivity in the socialized
sectors of the economy in 1989 - 1994,
2) a 30% increase of the parameters standing at the labour
productivity in the wage equations of the socialized sectors of
the economy in 1989 - 1994.

Ad 1: a) In the first case the change has been made in relation

to the baseline solution (it is also shown in Oebski, 1989). The
rise of labour productivity starts in 1989 and it is maintained
till 1994 (last period of our simulation analysis). We think that
it can happen especially through additional savings of raw
materials, energy or some changes in the structure of employment
in our economy. I f the assumption about the above increase of
labour productivity is fulfilled, the average wages in particular
sectors of the economy rise very slowly because their growth
rates oscillate between 0.08% and 0.22% in 1989 and between 0.44%
and 0.83% in 1994 (see e.g. Fig. 4a,b). The average wage in the
whole economy (Fig. 4d) goes up from 0.14% (1989) to 0.62%
(1994), whereas the average pension grows by 0.03% (1989) and
0.53% (1994). The total nominal personal income (Fig. 4f) rises
by about 0.09% (1989) and 0.52% (1994). As we see the results of
our multiplier analysis support the common opinion that an
increase of the labour productivity is rather loosely connected
with the wages. In our model this fact results from rather small
elasticity coefficients which take values between 0.16
(construction) and 0.29 (transportation).

b) Now let us look at the distribution in time of the effects of

a 5% increase of labour productivity made only in 1989. The
change is the same as in case a) but it lasts only one year. The
resul ts of such an analysis (for the variables shown in Fig. 4)
are presented in Table 1.

Table 1: Effects of a 5% increase of labour productivity only in

1989 in the socialized sectors of the economy (in %)

1989 1990 1991 1992 1993

Average wage, construction 0.082 0.041 0.017 0.005 0.0

Average wage, manufacturing 0.152 0.053 0.015 0.001 0.0
Average wage, nonproduction 0.135 0.053 0.017 0.002 0.0
sector
Average wage, the whole 0.142 0.053 0.017 0.002 0.0
economy
Wage bill 0.124 0.047 0.015 0.002 0.0
Total personal income 0.094 0.039 0.015 0.005 0.001

All effects of the described disturbance are very short in time.

Practically they are close to zero after the third period of
time. It is worth to note that the ratio of the direct effect in
case b) to the total effect of the considered above change of
labour productivity for the variables mentioned in Table 1
 580

oscillates between 0.47 (construction) and 0.61 (manufacturing).

Ad 2: The results of the changes of the parameters standing at
labour productivity in the wage equations seem to be more
interesting, from the economic point of view, for the decision
process than the observation of the effects of a change in the
level of this variable. An increase of such parameters is
interpreted as an increment of the elasticity coefficient, which
means that for each additional unit of labour productivity one
must pay the larger wage. Thus the relations between labour
productivity and average wage in particular sectors of the
economy have been changed. In our case we increase those
parameters by 30%, which is equivalent to a rise of the
elasticity coefficients to the level of 0.21 (construction) and
0.38 (transportation). The results of such an analysis are
presented in Fig. 5. These results are 8 to 10 times larger than
the effects of a 5% increase of the labour productivity discussed
in the previous case. For instance, the average wage in
manufacturing (Fig. 5b) rises by 1.42% (1989) to 0.72% (1994).
The rises of the average wage in the whole economy (Fig. 5d) are
almost the same. Average pension grows by between 0.46% and 1.16%
in the whole period of time examined, whereas the total personal
income (Fig. Sf) increases by between 0.91% (1989) and 0.65%
(1994) .

3.1.2 Effects of changes of components of financial accumulation

The three next simulation experiments are connected with the

financial accumulation and its role in the process of creating
prices. This variable is dis aggregated into three main
components, i.e.: 1. turnover tax, 2. subsidies and 3. profit,
which play a different role as instruments of economic policy.
Having explained each component of accumulation separately, we
get the possibility to investigate the effects of decisions
changing an intensity of reaction of the steering parameters
mentioned above. Those effects can be observed by the following
feedback in our model:

turnover tax subsidies profit

I I I
I
financial accumulation

prrces ~ cost of living ~ wages ~ incomes ~ labour1costs

In our analysis we carried out the following experiments:

1) a 20% decrease of the turnover tax rate in 1989 - 1994,
2) a 20% decrease of the subsidy rate in 1989 - 1994,
3) a 30% decrease of profit rate in 1989 - 1994.
 581

Fig. 5: Effects of a 30% increase of the parameters standing

at the labour productivity

a) average uage, ccnstruc llon

~
d) average 1Ja9(', S(Xialized
1.OO~'---------------------------, econcny
~
1.5~'--------------------------__,
0.75

1.0
0.50

0.25 0.5

0.00 L __- -__----~--__--~--__~....

U.OL_-_--~-~-_-~---'
1989 1m 1991 1992 1993 1994
1989 1990 1991 1992 1993 1994

b) average uage, ra.:nJlactunn<J

e) uage bi 11
:.-
1.5;:'"- - - - - - - - - - - - - - , ;,
1.5~'--------------,

1.0
1.0

0.5
0.5

U.UL~-~-~--~-~-_._--'
1909 1m 19')1 1992 1993 1994 O.uL~---~-~--_-~-I
1989 1m 1991 1992 1993 1994

c) average uage, raprcd.x: lim

sector j) total per5a'oal ircooe

1.5%;:------------------, 1.00%:':.--------------,

O.r,)
1.0

0.50
0.5
0.25

O.OL_-~-_- _ _ _~-~--'
1989 1990 1991 1992 1993 1994 U.WL------~-~-----i
1~ 1990 1991 1992 1993 1994
 582

Ad 1: It is well known that the turnover tax is mainly used as an

instrument of financial policy in socialist countries which
serves to equilibrate the market through the respective tax rates
(and thus prices) for different goods. It can be also used for
gathering means to finance the nonmaterial sphere of production
or to stabilize prices through defining respective relations
among these rates. In our present economic situation (deep
disequilibrium on the consumer goods' market) the government's
policy should rather tend to increase the rates of the turnover
tax in order not to deepen the disequilibrium. However, it is a
common view that these rates of many goods are too high now. And
we know that higher rates of the turnover tax cause higher prices
and then larger wages. Consequently, we analyze the effects of a
20% decrease of the turnover tax rate. The results of such an
experiment are presented in Fig. 6.
A 20% drop of the turnover tax rate causes in the first turn a
cut in prices of material goods (2.3% to 1.9%) and of nonmaterial
services (1. 4% to 1. 2%) in 1989 1994 (Fig. 6e, f). Prices
influence the cost of living index and also wages which go down
around 1.6% (Fig. 6a,b). The total personal income (Fig. 6c)
falls from 1.0% (1989) to 1.3% (1994) and its diminution is
smaller than the decrease of the expenditures on material goods
since the last quantity drops by between 2.5% (1989) and 1. 8%
(1994) (Fig. 6d). As a result of such a policy we get an
increment of the financial means of the population by 11% (1989)
to 18% (1994) which denotes the growth of the share of this
increment in disposable income. This suggests that the gap
between demand and supply can become greater and greater.
Ad 2: Subsidies are chiefly used in the economy as an instrument
which can stabilize prices. They exist in each economic system
but they should not be too large since they can become a reason
for a deformation of the price system. Holding prices of some
goods at a relatively low level one has to increase (often by the
turnover tax rates) the prices of other commodities (even
significantly higher than production costs) if we do not want to
extend the budget deficit. At present we have such an economic
situation in which the longer maintenance of stable prices of
food causes an unreasonable increase of the subsidies in the
relation to the total sum of budget expenditures. The government
wants to change this situation through the gradual reduction of
the budget deficit and making prices of all goods constant in
real terms. That is why we postulate to decline by 20% the rate
of subsidies in our present experiment. This exercise is similar
to the previous one with the turnover tax, however, the way of
reaction should be opposite (empirical results are shown in Fig.
7) .

The decrease of the rate of subsidies by 20% causes first of all

an increase of the financial accumulation from 6.3% (1989) to
7.9% (1994). This rise affects the deflator of net production of
the socialized sector by about 3.8% which in turn influences the
prices of material goods (1.6%) and of nonmaterial services
(1.2%) (Fig. 7e,f). The rises of the average wages in particular
sectors of the economy (Fig. 7a,b) oscillate between 1.0% (1989)
and 1.4% (1994). Taking into account the balance of financial
 583

Fig. 6: Effects of a 20% decrease of the turnover tax rate

in 1989 - 1994

a) aver~ uage, rknJlacturing d) expenditures on ~teriaJ

9OQ(.Is
%

-0.5 -
-0.51--
-1.0 -
-1.0 -1.5 -
-2.0
-1.5 -
-2.5·
-J.OL..·_ _-_-~-_-_--~.J
-2.0 '-~-~-~--~-~-~-- 1989 1990 19'Jl 1992 1:J93 1994
1S@ 1990 1:J91 1992 199J 19')4

e) price JrYlex, ~lerial

b) aver~ uage, s<xiallZl'd 9OQ(.Is
E.'(X)()(I<j
/,

-0.:5 -
-0.5
-1.0
-1.0
-1.5 -

-1.5 -2.0 - -
-2.0 '--~-~----~-~--~ 1m 19'.AJ 1991 1992 199J 1994
1989 1990 1991 I9'JZ 1m 1994

j) price incJc>x. ra'naleriaJ

c) total perscoal ]ncCJne
servICes
% %

-0.5 '0.5

-1.0 '1.0

·1.5'-_ _ _--~_ _ _~--_...J

-1.::i'-~-~-~-~--_ _~...J
1989 1990 j 931 19')2 1993 1994
198'J 19'.AJ 1')') 1 1932 1933 1m
 584

Fig. 7: Effects of a 20% decrease of the rate of subsidies

in 1989 - 1994

a) avera<}e U<lge. r><n..Jlacluring d) exPend] turt>S m Ilalerial

~
Z.O%r-------------------------------- ;-
2.5~"-------------------------------,

1.5 Z.ll -

1.5 -
1.0
1.0
0.5 0.5 -

O.O'--~----~--~--~----~--~-
O.O'-~----~-~-~-_~-
1989 19s() J991 1992 1993 1994 1909 1990 1991 1992 1993 1994

b) ave r<lge LJd9('. S()Cl a llZed e) POC!? lr(](>x. Ilalenal

eccn:oy 9:JQds
;-
1.5 r%-----=::::====:.::::=:-----, Z.O t"--:=::======---------,

1.5
-
1.0
1.0

0.5 -
0.5 f-

O.O~~----~--~----~--~----~~ 0.0 '------~-~--~----~--~---I

1989 19S() 1991 J~92 1993 1994 1909 1m 1991 19')2 1993 1994

c) lolal perscnal m:cne I) price ] nd(>x , nanalenal

sernces
1.2 %
"
1.5 r " - - - - - - - - - - - - - - - - .
J .0

O.B ~ 1.0
--------------------
0.6

0.4 - 0.5 -

0.2

0.0 0.0 '------~----~----~--~-

1989 19S() J9'JI 1992 1993 19')4 l5€9 1'r.JJ 1991 19')2 1993 1994
 585

incomes and expenditures of the population one can note the

higher growth rate of total expenditures (1 .. 9% to 1.5%) in
comparison with such a growth rate of total l.ncomes (0.3% to
0.02%). It causes a decline of the increment of the financial
means of the population (11% to 16%) in 1989 1994 being a
reason for a slightly smaller drop of the growth rate of cash.

Ad 3: Profit is the third main instrument of economic policy.

Being calculated as a definite percentage ratio of production
cost it can be a reason for increasing prices. Enterprises will
accept higher costs (even sometimes unreasonable from the
production point of view) in order to get more profit and divide
it among workers and management (profit constitutes a source of
an additional wage as bonus or premium). Such a statement results
from the fact that the cost formula, on the basis of which the
prices are defined, encourages the enterprises to raise profit.
Thus, it is an opinion that profit constitutes an additional
factor intensifying inflation. Of course, the economic authority
has a possibility to limit the level of profit. First of all it
can be done by a respective taxation system that counteracts high
profits. However, there are a lot of reductions and exemptions
from the profit tax done by the government. The quantity and sum
of these reductions end exemptions are a subject of negotiations
between government and enterprises. Thus as we see they can be
also used as policy instruments to steer the economy.
In our present simulation analysis we investigate the effects of
a 30% decrease of the profit rate in 1989 - 1994. This decline
(the sample average profit rate is 5%) causes in the first turn a
drop of additional wages (like bonus and premium) in the economy
from 1.7% (1989) to 6.8% (1994) and of the financial accumulation
by 6.9% to 9.3%. This last variable affects the deflator of the
net production of the socialized sector (the yearly fall is
around 4%) which next causes a decrease of prices of material
goods (2%) and of nonmaterial services (1.3%) (Fig. 8e,f). The
slop of prices influences wages in particular sectors (Fig. 8a,b)
that go down by about 1.0% (1989) to 1.6% (1994) and taking into
account the drop of additional wages in the whole economy we got
the decline of personal incomes (Fig. 8c) by between 0.8% and
1.7%. As a final result of such a policy we obtain the greater
decrease of the total expenditures of the population (yearly
around 2%) in cumparison with the slop of total incomes (0.4%).
It causes an increment of financial means of the population
(yearly 15%) which are located in saving institutions (more than
a half), and the remaining increases cash. One conclusion is that
such a decrease of the profit rate extends the excess demand on
the consumer goods' market.

4 References

1. Debski W. (1988), Zarys ekonometrycznego modelu pienieznych

dochodow i wydatkow ludnosci (An Example of An Econometric Model
of Financial Means and Expenditures of population), Studia Prawno
 586

Fig. 8: Effects of a 30% decrease of the profit rate

in 1989 - 1994

a) average uage, raanJlacturing d) exPenditures on ~terial

% 9XXIs
%

-0.5 -0.5

-1.0
-1.0

-1.5

-2.0 '--~-~-~-~-~--~-I
1969 1990 19:11 19:12 I9:lJ 1994 1989 1990 19:11 1992 1m 1994

b) average uage, socialized e) price iro:lex, ~terial

ecm::ny 9XXIs
% %

-0.5
-0.5
-1.0
-1.0
-1.5
-1.5
-2.0

-2.0l-_--~-~-_--~- _ ___' -Z.5'--_ _ _--~-~-~--~..J

1969 1990 19:11 1992 1m 1994 1969 1'HJ 1991 1992 1m 1994

c> total perscoal inccne o price iro:lex, ncrnaterial

% servlCes
%

-0.5
-0.5
-1.0

-1.0
-1.5

-2.0L-~-_--~-~-_--~-l -1.5 ' -_ _ _ _ _~-~-~--~-l

1969 1990 19:11 19:12 I9:lJ 1994 1989 199] 19:11 19:12 1m 1994
 587

- Ekonomiczne, forthcoming.
2. Debski W.(1990), Model pienieznych dochodow i wydatkow
ludnosci Polski - ekonometryczna analiza, symulacje (A Model of
Financial Incomes and Expenditures of Poland's population - An
Econometric Analysis, Simulations), Lodz.
3. Hajnovic F.(1981), Prijmovo spotrebny model v systeme
modelov (Model of Incomes and Expenditures in the Systems of
Models), Informacne Systemy, No.3.
4. Hajnovic F.(1983),Zobrazenie penaznych priJmov a vydatkov
obyvatelstva v systeme modelov (An Outline of the Financial
Incomes and Expenditures of Population in the System of Models),
Informacne Systemy, No.6.
5. Welfe A. (1988), Prognoza rynku dobr konsumpcyjnych do roku
1992 (pazdziernik 1987) (The Forecast of the Consumer Goods'
Market up till 1992) (October 1987), Prace Instytutu Ekonometrii
i Statystyki UL, Seria F, No. 61, Lodz.
6. Welfe A., Welfe W.(1986), Modele i prognozy rynku w warunkach
nierownowagi (Models and Forecasts of Market under
Diseqilibrium),Ekonomista, No.2.
7. Welfe W.(1989), The Outlook for the Polish Economy 1988 - 1993
and the Plan of Economic Consolidation, Prace Instytutu
Ekonometrii i Statystyki UL, No. 68, Lodz.
Keynesian or Classical Unemployment in West Germany?
- An Empirical Analysis with a Disequilibrium Model -*)
Hermann-Josef Hansen
Sonderforschungsbereich 3
Johann Wolfgang Goethe-Universitat
Senckenberganlage 31
D-6000 Frankfurt am Main, FRG

Since the mid-seventies the labour market of the Federal Republic of Germany is marked
by persistently high unemployment. Macroeconomicaliy, the most prominent candidates
competing for the explanation of unemployment are insufficient demand for domestic
goods (Keynesian unemployment) and too high wage costs (classical unemployment). The
significance of these two approaches can be tested with econometric disequilibrium
models.

A further developed Sneessens/Dn!ze (1986) model, which was originally conceived for
Belgium, serves as the basis for the empirical analysis. The essential assumption in this
model refers to the structure of production: While in the long run the possibility of
substitution between the factors of production, labour and capital, exists. the short-term
production function is limitational. If we designate the ratio of output to labour input as A
and the ratio of output to capital input as B, then A· LS and B· K are the upper production
limits, with LS for labour supply and K for disposable total capital. If producers consider
possible rationings on output markets, employment L results - considering the
heterogeneity of the economy - from the equation

(1)

with
LP = potential employment (LP = A-I . B . K)
LK= Keynesian labour demand (LK = A-I . yd)
LS = available labour supply.

The parameter ql measures the capital mismatch, q2 the labour mismatch.

The model is thus composed of submodels for production, the goods market and the labour
market.

In the goods-market submodel the level of planned goods demand yd is determined.

Possible rationings in the demand for domestic products are considered within foreign
trade equations.

*) This paper was prepared within the project 'Macroeconomic Simulation' of the SonderfLlrschungsbereich
3 'Microanalytical Foundations of Social Policy'. I would like to thank the German Science Foundation
(DFG) for financial support.
 589

In the production sector submodel the technical coefficients A and B as well as total capital
are explained. Given the assumption that producers are risk neutral, producers select the
technical coefficients and the capital stock so that their expected profits are maximized.
Possible output-market restrictions are considered. The resulting optimum technical
coefficients are a function of relative prices and technical progress. The optimum capital
stock is a function of relative prices, expected goods demand and expected profits at full
capacity [Lambert/Mulkay (1987)]. The process of adjustment of the present production
structure to the optimum structure is represented by an error-correction model.

The model has been estimated for the Federal Republic of Germany for the period 1961-
1988 using annual data. For estimating the parameters we used a sequential block-by-block
limited information procedure. In the first block the planned goods demand yd is
determined. It is needed for the determination of the capital stock as an explanatory
variable, which is jointly estimated with the technical coefficients in the second block.
Finally, the employment equation (1) is estimated by inserting for yd, A and B the
estimates from the first two blocks.

Figure 1 presents the components of employment over time. Figure 2 shows the share of
firms in each regime. The shares can be calculated from the elasticities of employment with
respect to LP, LK, and LS [For a detailed description of the model and the estimation
results see Hansen (1991)].

The results show that the two recessions of 1974/75 and 1981/1982, which were mainly set
off by supply shocks on the world markets, carried the West German economy each time
into a state of Keynesian unemployment. During recent years, the share of firms in the
regime of classical unemployment has increased. This development is to be explained by
insufficient investment activities in the first half of the eighties.

25.0
- - employment
24-.5 potential employment
24.0 Keynesian labour demand
23.5 _.- labour supply

23.0

22.5

22.0

21.5

21.0

Figure 1: Components of Employment over Time

 590

1.0

0.9

0.8

0.7

0.6

0.5 Keynesian
0.4 unemployment

0.3 repressed
0.2 inflation

0.1

0.0
61 65 70 75 80 85 88

Figure 2: Shares of 3 Regimes over Time

The results are comparable to those of other empirical analyses concerned with this
complex of questions. One advantage of the approach used here is that it can be integrated
into a larger macroeconometric model. This makes it possible to study alternative policy
scenarios and make a contribution to well-founded policy counseling.

References
Hansen, H.-J., 1991, Keynesianische oder Klassische Arbeitslosigkeit in der Bundesrepublik
Deutschland - Empirische Analysen mit einem okonometrischen Ungleich-
gewichtsmodell (Schulz-Kirchner, Idstein).
Sneessens, H.R. and J.H. Dreze, 1986, A Discussion of Belgian Unemployment, Combining
Traditional Concepts and Disequilibrium Econometrics, Economica 53, S89-
S 119.

Lambert, J .-P. and B. Mulkay, 1987, Investment in a Disequilibrium Context or Does

Profitability Really Matter? (Working Paper No. 87()l, Cahier du Cerec,
Bruxelles ).
A MACROECONOMETRIC DISEQUILIBRIUM MODEL FOR POLAND

Jerzy RomaCIski
University of Toru~
Chair of Econometrics and Statistics
Armii Czerwonej 25, Toru~, Poland
and
Wlaclyslaw Welfe
Uni ver'si ty of l:..6dz
Institute of Econometrics and Statistics
Rewolucji 1905 r, 41, 90-214 t.6dz, Poland

Abstract
The paper presents the structure of a new mini-model W-6 of the
Polish economy. It combines the long-term relationships with the
short-term adaptation mechanisms. It also assumes that the growth
of the economy was in the past unbalanced. Hence, i t defines
demand, supply and excess demand for commodities and labour, being
(partly or fully) unobservables. To deal with this problem excess
demand indicators were developed and used in the estimation
process after suitable respecification of the initial equations.
The paper discusses the results obtained for the simulation
version of the model which is composed of initially specified
equations, including accounting identities.

Keywords: Macromodel; structure of model; disequilibria; demand

and supply functions; excess demand indicators

Contents
1 Intr-oduction
2 The structure of the W-6 model
3 Specification of the equations of the W-6-85 simulation mini-
model
4 The changes in the structure of the Polish economy 1961-1985 and
the adjustments of the model structure
References
Appendix; List of W-6 minimodel variables

1 Introduction

Minimad~ls of ~conomic systems play an important role in the pro-

cess of economic research and education. They help to summarize
and analyze the main properties of complex economic systems, which
have recently been built as a result of the aggregation of large
econometric models. They serve as convenient tools for comparing
alternative approaches and estimation methods, and can easily de-
monstrate the relationships and feedbacks, characteristic for com-
plex systems. Hence they are used by bath researchers and teachers
to explain these characteristics.
By the mid 1980's a new minimodel W-6 of the Palish economy had
been built, to same extent, as a result of the aggregation process
 592

applied to the macromodel W-5 of the Polish economy. Its main

characteristic is the tendency to combine the long-term relation-
ships with the short-term and medium-term adaptation mectlanisms.
It assumes - relying on the Polish experience of the last decade
that the growth of the economy is unbalanced. The disequilibria,
however, are treated more in favour of Kalecki [2] than Kornai
[3], disregarding the explicit short-term plan realization adap-
tation rules by Charemza and Quandt [1].
The model contains unobservables - demand and supply. To deal with
this problem several excess demand indicators were developed.
Firstly, the initial model was respecified in order to substitute
observable realizations for unobservables, then standard estima-
tion techniques were used. Secondly, the estimates uf the regres-
S10n coefficient were transformed in order to determine the va-
lues of the parameters of the initial model.
The previous version of the W-6 model was presented in 1986. It
used the time series until 1982, thus, allowing only for a study
of the immediate impact of the shocks which led to the economic
crisis. Later, we updated the time series up to the year 1985 and
the revised version of the model was elaborated.
Tile respecification of particular equations of the model proved
indispensable as the economic crisis of 1981-1982 brought about
several distortions in the economic mechanism, which could be ob-
served in the next few years. They had to be reflected in respec-
tive parameter changes, and in the addition of new variables. We
also improved the construction of the disequilibrium indicator for
the labour market. Our paper [4] gave an account of the above
changes, presenting the results of reestimation with special
emphasis on those blocks of equations, where the disequilibria had
to be explicitly emphasized.
This paper shows the complete structure of the model W-6. It inc-
ludes all identities linking the behavioural equations into a com-
prehensive simulation system. It puts the emphasis on the feed-
backs between and within different blocks of the model, allowing
for shifting economic regimes.

2 The structure of the W-6 model

A survey of the W-6 model is supplied in Table 1. The model

cons1sts of 111 structural equations, 46 of which are stochastic.
9 blocks of equations have been distinguished. These blocks are
discussed in some detail in section 3 of this paper.
The structural coefficients presented here are either OLS
estimates or their suitable transformations based on annual data
for the years 1961-1985. Detailed results of estimation of the
parameters of the equations explaining the observable realizations
of variables (including all standard statistics) are shown in
an Appendix which may be obtained from the authors on request.
The model is two-sectoral; it focuses on the material product sec-
tor (MP) and non-material services sector (NMS). It describes the
process of the reproduction of production factors: labour force
and fixed assets (fixed capital). The production process itself
is represented by a production function, generating net material
product and the gross material product. The distribution of the
national income is then described, including its final compo-
 593

Table 1: The Str-u..:ture of the W-6 Model (simulation versiord

I~n d 09 ~.!Il f.JU '.;;; Tu I~al St_ochast i c

variables

Total til 46
1. Employment 15 6
Ill'..n:!sf.ifler'!':' uutlr3.y'=' ):J
3. Fi ;·~ed assets 20 6
4.
3.
Production
Consump t i on and i rlv',·ntc.... i. t:!S
18
9 .,.
6

6. Foreign trade 20 8
7. Personal income, wages ~
.,,1

8. Personal savings 1
9.. Pr- i C}:!s 6

Estimation
Per-i od: 1961 - 1985
Mel. hod",; OLS <)_nd TSI_S
Hildreth-Lu for serial correlation

nenls: consumption (individual and social), dcculnulation (invest-

ments, 'J.nd inv~nL(Jr'y chdngesi. For··eign tr·ade equ<:lt:ior;" clr]s(~ lh,:!
real side of tMe system. The financial processes are represented
by components of the money balance of household receipts and ex-
penditures and a c<JfTlpr-ellerlsivf~ price system.
For each of the real flows described above, demand and supply fun-
ctions were built for- the sample period. L·Je as-:;urned that it WdS
mai nl y the suppl y, not cfelll,.,md, that has bE'en real i .:ed ovur· t.he
sample period, as the price changes were not elastic erluufJh Lo el1-
~jure Ot' rl:"-,tur'e equili.ur·-i.,-".. In urdt~r- to eslimatE' Lhe pc.\r·""meter-~; of
the rJefTIdnc.l (and e;{cess demand) fUflctiofl", we hdve Lluilt specific
e;{ces''; de,n~1nd indic<"d~Gr·5. The." "H:!re '=oflsl:r·ucted primdr-ily dS ir,di-
cators of the second type i.e. as standardized relations of fac-
t or- 5 deb'_'r'ln i. n i n 'J dl"',n<~n d v pr' SI..I-'; tr lo~,e "pi-. I,?r-· III i n l n'] 'o.upp 1 'I (·,j'2e [i~]).
In general, defining excess dem2nJ
""t Dt - St (1 )

wher~ D - demand,S - ~upply,

we can write for reali.:ation (transacted value) Q

Dt for Et I)

Q, - {D j --E f-. fDr E 1; I)

(2 ;

i .. e" C't (i-Lit J lJ L + Ut COl. - Et ) whJ:!re

0 i-F Et (I
:J t { 1 if E ..' i)
t
 594

Dt = d( * ) (3 )

and the disequilibrium indicator IE, we can write

(4)

and use the identity (2) to obtain the equation explaining the ob-
servable realization Q from the demand side:

for (5)

This was the procedure generally applied in the estimation of

single equations used to generate demand function and excess de-
mand. On the assumption that supply was equal to realization (St=
=Qt) for the sample period, the parameters of the supply functions
were estimated directly from the data. If there were technical re-
lationships (identities or their stochastic approximations) we as-
sumed that they can be used to determine both demand and supply,
unless the existence of disequilibria did not affect the coeffi-
cients of these relationships. Thus, in the first case the estima-
b~s wer·e based directly on realized values of val~iables (for· in-
stance in the equation linking net and gross investment outlays).
In the second case we had to look for· disequilibria indicators.
At the initial stage OLS was used to experiment among alternative
specifications. Next TSLS and ML were tried. As the results did
not differ significantly especially between OLS and TSLS
estimates - only the first will be shown.
The simulation minimodel W-6 contains 9 blocks covering the ac-
tivities outlined above. It is decomposed into two sectors of the
economy: material product (MP) and non-material services (NMS)
sector. For some activities it also distinguishes agriculture. Ex-
port and import functions were specified separately for socialist
and nonsocialist countries. For the following macrovariables the
demand, supply and excess demand functions were specified: em-
ployment (N), investment outlays rJ), net material product (X),
gross product (Q), personal consumption (eX), exports (E) and im-
ports (M). The demand functions were obtained after decomposing
(5), i.e. by dropping the estimate of excess demand E = e(IE t ).
"'-
This estimate IE) has been independently used either as an expla-
natory (r.h.s.) variable to study the spillover effects or to
arrive at an estimate of supply using (1). This happened if we had
demand but not supply functions defined for a particular activity
(i.e. for governement expenditures G or for employment decomposed
by sectors - the supply function was defined for total supply on-
I y) •

The specification of the particular blocks of the model is briefly

discussed below. The links between them, the dynamic properties
of the system, can be summarized as follows. The model generates
the final demand, which simultaneously determines the demand for
domestic output and employment, as well as for imports. As the de-
mand for output affects the demand for investment outlays a feed-
back of the dccelerator type was defined. Personal consumption
depends on wages, which, however, are related to re~lized employ-
ment. Thus the multiplier· is observed only for fully demand deter·-
mined regimes (see [7J for the explanation of this notion), when
the demand for employment is redlized. The final demand is exter-
ndoll y dri ven ei thel~ by e:·:por·ts or by gover·nment interventions (in
 595

the form of parameter changes). The final and intermediate demand

depends alsD on past values of endogenous variables, i.e. their
realizations. Thus it keeps up with the supply side, if this de-
termined the ~~haviour in the past.
The model carefully specifies Lhe supply side, especially with re-
gard to the production process. It generalizes: the labour supply
and labour input; the fixed capital formation, which after allo-
wing for lags depends on investment outlays, linked to the domes-
tic total output and imports; production and imports of interme-
diate commodities, the latter being one of the constraints in the
production process; the production itself by means of an extended
Cobb-Douglas production function. The allocation process follows
some stable rules.
The supplies to the consumer goods markets depend on gross output
adjusted for foreign trade and investments. The supplies of in-
vestment goods are dependent on the NMP and imports of machinery
equipment. They enter the feedback called supply type accelerator.
They materialize in investment put into operation (after years of
completion), extend and/or replace capacities, extend the total
output and thus investment outlays. Also in generating supplies,
the lagged endogenous variables as well as financial variables are
assumed to rely on the realized values.
In general, the realized values of the variables in the real sec-
tor are obtained from the minimum condition. This, especially in
the case of switching from one regime to another, raises serious
computational problems.
The model generates wages, being dependent on the one hand on
labour productivity and on the other hand prices which depend on
labour costs. Thus the inflationary spiral has been defined in the
model.
The exports mostly depend on total output. As they determine
(given E.';{traneous net fureign financi.ng) imports, then in the
short run they determine imports of material inputs, thus domestic
output and again exports - we have the feedback called foreign
trade bottleneck mUltiplier. In the long-term - investment imports
may grow, thus adding to general rates of growth and further in-
crease exports - this is a feedback of an exports-imports lead
growth type. Of cour~~, r-esulls of an increase of foreign lending
can be shown as well Cimpor-ts lead gr-owth).

3 Specificat.ion of the equat.ions of t.he W-6-85 simulat.ion

minimodel

BLOCK I. EMPLOYMENT (15 equations)

1.1. NXD - employment in the MP sector, demand

Labour demand function: the demand for labour NXD depends on the
lagged output X(-1) and lagged productivity of labour to allow for
the impact of technical progress and capital-labour substitution.

NXD=13.332+0.00324*X(-1)-0.0429*X(-1)/NX(-l'- O.6334*U6164+
-0. 3391*U7679

I.2. NOD - employment in the NMS sector, demand

In the s~r-vices sector' a new specification was intr-uduced. Because
 596

of the lack of ~ata on output, the fixed capital KO was used as a

proxy for the number of total available jobs. The rate of social
consumption G to the fixed capital, serves as a proxy for the rate
of fixed capital utilization due to changes of demand for servi-
ces. Both of these factors generate the effective demand for la-
bour NOD.

NOD=O.1662+0.000103*KO+40.554*GD/KO+O.2375*U6769

I.3. NS - Loted emplc.yment., supply

Labour supply (NS) fluctuations depend mainly on the changes in
the labour- par-tici.pdticm of \~omen. Therefor'e despite the number- of
the population in the productive age LP, the ratio of the average
wage ZUP to the averaue income YP was introduced as an explanatory
variable. The intensity of this factor (representing the economic
pressur-es 'for-cing wurnell 1_0 look for jobs) incr-eased over time,
which is reflected in the changes of the parameter standing with
(ZUP*L/YP). Tbt~ par-clmetE"!r standing with LP shuws the mar(dinal
participation rate; it is about 65% .

NS=8. 832+0. 6522*LP-3. 708*ZUP*L/YP+O.5539*ZUP*L/YP*U617 6+

-O.7141*ZUP*L/YP*U8285

1.4. NE - total employment, excess demand

NE ~ (NXD + NOD) - NS

As the attempts to specify separate labour- supply functions to the

MP and NMS se~tor~ were not. successful, the supplies were genera-
ted by means of subtracting from resp. demand the estimated excess
demdnd. It was aS5ur,,,~r! that: toli'l c!·:cess der. •.:::nd NE can be alloca-
ted between two sectors in the same proportions as observed in the
sampl e peri od. The AN - v<".l ue says that 58% of total e:{cess demand
-for labour- \rJa~i pr-esenl in the j'1P sectur.

1.5. NXS - e-~mploymenl 111 t.he t1P sector-, ::A'pply

NXS=NXD-~N*NE , where ~N = O.575~181

1.6. NOS - employment in the NMS sector, supply

1.7. N - tutal employment, realization

N min { ND,NS }

1.8. NX - employment in the MP sector, realization

NX = min { NXD.NXS }

1.9. ND - total employment, demand

NDcoNOD+NXD

1.10. NO - employment in the NMS sector, realization

f'IO=N-NX

1.11. NXE - employment in the MP sector, excess demand

NXE=NXD-NX5
 597

The next equations link th~ tolal employment with employment in

the socialized sector, in ol~der to -Facilitate computatinns of tile
wage bill. Similarly for employment in agriculture.

1.12. NUX - employment in lhe socialized MP sector

NUX=-11.560+1.4972*NX-0. 4177*U6775+0. 4376*U79

1.13. NUO - employment in the socialized NMS sector

NUO=-O.0188+0.9491*NO

I. 14-. NU - total empluyment i.1l sClcialized sector

NU-,NU;< +NUO

1.15. NR - employment i n agl~i cul ture

NR=-O.9563+1.1117*NR(-1)+0.3785*YRP/NR(-1)/ZUP+O.3933*U80

BLOCK It. INVESTMENT OUTLAYS (13 equati ons)

11.1. JXO - investment outlays in the MP sector, demand

The investment uutlays - the demand equation - reflects the acce-
leration rule. After rearranging the original equation, the in-
vestmerl t demand depends on e:{pected output and 1 aggeu investment
outlays. As this relationship was disturbed in the periods when
the investment policy of rapid acceleration (1973-1975) and of de-
celeration (1980-1982) of investment growth prevailed - respective
changes in pa~ameters were introduced for these two periods. Thus
the marginal productive investment-output ratio which was on the
average equal to 0.11 increased to 0.14 in the period of accelera-
ted growth and was depresse~ to 0.08 in the period of crises.
Its long term level remained rather high (0.28).

JXD=-120.93+0.5961*JX(-1)+O.tt33*XD+O.0294*XD*U7375+
-O.0348*XD*U8082
II.2. JOD - investment outlays i.l the NMS sector, demand
Inves~ment outlays in the NMS sector are composed of residential
and communal structures. They depend on the e~pected increase of
urban population DLe and social consumption G. To allow for the
lags in response the lagged investment outlays were introduced.

JOD=-25.173+0.7892*JO(-1)+74.523*DLC+O.3563*GD+74.002*U74+
-95.037*U80

11.3. JS - investment outlays total, supply

The supplies of investment goods are determined as a fraction of
the total sLlppl ies of conllliodi ties from domestic output XG and a
function of imports of machinery equipment M7. The marginal in-
vestment-output ratio, being on average close to 0.15, had to be
adjusted downwards because of the investment policy changes in the
early 70-ties, after a rapid increase of imports of machinery
equipment took plclc~. The same had to be done for the eighties,
both becal.he L1f th.~ decline in the clctivitie,; of tile building in-
dustry and the increase of the exports of machinery equipment .
 598

II.4. JD - investment outldys total, demand

JD=JXD-I-JOD

11.5. JE - investment outlays total, excess demand

JE=JD-JS

11.6. JOS - investment outlays in the NMS sector, supply

The suppl ies of investment goods for the NMS sector are gen.?rated
in an indirect way, by means of subtracting from the demand the
estimated excess demand assumed to be equal to ca. 1/3 of tutal
excess demand for consumer goods.

JOS=JOD-A_JO*CXE , where "-JO 0.333023

11.7. JXS - investment outlays in MP sector, supply

JXS=JS-JOS

11.8. J - investment outlays total, realization

J = min { JD,JS }

11.9. JX - investment outlays in the MP sector, realization

JX = min { JXD,JXS }

11.10. JAD - net investment outlays, demand

This is a bridge equation showlng that the marginal net investment
is equal to 86% of the total investment. It had to be adjusted
downwards in the eighti~s as the decline of investment activities
during the crisis was accompanied by steadily growing deprecia-
tion. All this applies both to demcmd and supply equations as it
can be assumed that there are always enough investment goods to
ensure the full replacement of used fixed capital at the macro-
level (in the global terms).

JAD=37.796+0.8643*JD-O.1327*JD*U8285-114.87*U76

11.11. JA - net investment outlays, realization

JA~37.796+0.8643*J-O.1327*J*U8285-114.87*U76

11.12. JO - investment uutldys in the NMS sector, realization

11.13. JR - investment outlays in agriculture

BLOCK III. FIXED ASSETS (20 equations)

The slowdown in financing investment outlays during the period of

economi c cr- i si s h.:{s e:-:tendecJ the d.verage per i ad uf investment
projects completion. Hence, two lag distributions were introduced.
IIT.l. I1<X - investments put illlo opE,r-dtion jn the MP sector
- selected lag distribution for the period 1961-1979:
 599

-';1::'?1,~::t~cj ldlJ ctistr-iLlutitJl! fur'- tl1~~ p ___ r-'iud t98()-198:;:;

,]X80;F::.(1" ::~*""J~:+O .. 2·it\.;X (-; ) +0" l*JX (-2) +0 .. 25*t-1X (-3) +

+O.1*JX(-4)+O.I*JXI-51

rVX~-82.17S+0.9U91*(JX79D*U6179+JX80A*U8085)+

III",2 .. IKO - in\lP5r::mE~:li_::. I!U.t intu upt_"'f"6.tion if"' titEI Nt-,S st=\r:.L(lr~

sel~c:t:.2d 1,0<9 distr'i/Jlxtiun for' t.he per'icld 1961-1979;

J079S~O.1*JO+O"5*JO(-11+0.2S*JO(-~)+O.1*JO(-3)+O.05*JO(-4)

",.elecb"d la,] di.stril:J1...d:.lr.'r, for L!,~., pC"'iod 1980-1985:

.]080A-::.O .. 1 *,]0+0. 4*t-iO (-1 :. +t: _ :::3*;iO (-·2) +0". :.. 5*,JO (-:]) +0 .. t *.10 (-4)

Tf:·S-'2S. 06,-S+ 1. .. 1278* (,]079S'+U,:, 1 '''7+,J080!~.;.:·U8(85) +

+O.6507·J079S~U6179-83.831*UR~

111.3. IV - total investments put into opt>t'dLiun

TK"'-II<X+H::O

111.4. iKR - investments put jrJt.. o op2r'dtiDn in agriculture

selected las distribution for the period 1961-1979:
JR79A-O.6*JR+O.3*JR(-1)+O.1*JR(-21

c~eJ ec ted 10llJ oJ i·., tr' .ll:JUt L '.J!l f ,~,,,. the per· i Del 1980-1985:
JR80S=0.096*JR+O.774*JR(-1)+O.13*JR(-2)

I~~~H::::;-6 7" .. 763+1. 3273* (,TRf'9?,,·;.n.Jt.179+JR80S-ifU3085) ~:­

+0. 3495*JR79A*U6179-80.922*U82

SCt"i:4ppirl!J:;> a,'e usudlly c,,~.=-UIlO2d to d'=PfHlci on the i n i t i a l s!. uLI, f,f

fixed ~sseLs. tt has been observed, however, that in periods when
investment e;~pect-::l.tion~ dr-~=' IJptimi·.;tic'J th(~ :::.. c:r·dPpirIlJ~:> f-dte i..rl-
C(·ed·=;e~, dncJ ",'hen they becume p;_:·~~~~"t mi sl.i c., Lhe f i l"'m~ tend to e!,-
tend the:! 1 ifesp.:m of POSSE-c,s.cd equi pment. In th~ NMS sector i t was
additiunally ds':,umed tllat. UII? l(w" b=nslClfl ill U\e ldbuur market .in-
dUt:,=:Sadd.i.ti;::)l--Ir..~l '.-:lj.:t·-::\p~lj.n'J"::l; t~e- r-~pl<:.-t"_::2m(~nt of 2Ql.iiplllenf:..

KOX~-3.4792+0.003;9*~X~(-1)+O.1~95*IKX(-1)+121.36*U82

II1.6. t·:·OO - scr'appings of fi;:ed assets in the NMS sector'

f~DO~-"34. 078+0. 0067{JI!YDf< (-1) +0. 0::79* (IKO+If<O (-1) 1*0.5+
+18. 714*U7172+20. 807*LJ83-A f;OO*NE (-1) 'lI-U8085 ,
whore ~K~O ~ 9~ . 615

TII.7. 1;'DR - scr'dppings uF fi::ed assets in a'Jf-icultufl"!

IIL8. f;XK - fi':ed assets in the MF' ;:,ector' (end c:f ye.~r)
 600

lII.9. KOK - +ixed assets in the NMS sector (end 0+ year)

KOK~(OK(-t) l·rKO-KDn

111.10. f·:RK - fi:-:ed a'5sets in dgl~icultLll'e (end of year)

!::R~::""f·::Rf( ( - 1 ) -I- I kR-f::DR

111.11. KX - fixed assets in the MP sector (av~rage value)

KX=0.5*(KXK(-1)+KXKl

111.12. KO - +lx~d assets ifl the NMS sector (average value)

KO=O. 5* (f.:'OK (-1) +KOK,

111.1.3. ,::R - fi:<ed assets in agriculture (avel'age value)

III.14. Ie:: - fi;,ed asset'~, total (a.vel'a'Je value)

K=f:'):+f':O

BLOCK IV. PRODUCTION (18 equation~)

IV.i. XS - net material product, supply

It is a Cobb-Douglastwo-factar' production +unction with constanL
returns to scale. It consequently allows for constraints in the
availability of labour input (i.e. fixed capital is adjusted by
the number of shifts worked in irldustry WZNQ). The embodied
technical progress is I~epresented by a special variable (WKXIl cle-
,pending on the increase of the rate of growth of fixed capital.
The changes in the utilization of the production capacities (de-
termined by loeans of previoLlsly defineJ variables) are additional-
ly explained; they depend mainly on the shor·tages in supplies of
imported materials and energy MNQ. Its impact was e::tr'emely seve-
re during the period of deep economic cr·ises (1982-1985) the
elasticity of net output with regard to the indicator of material
shortage, increased from 0.27 to 0.67. The attempt to explain the
decline of the capacity utilization rate by the increasing excess
demand in the consumer goods markets (1981 and after) was not
successful.
XS=(KX*WZNQ)O.4*(NXSIO.6*CMNQ/XI-I:;O.06l (O.2694+0.3963*U828S)*
*CWKXI)O.2875 * e(2.7738-0.0925*U83)

IV.2. WZNQ - dverclge flu,niJer' of 'Cihifts for industr'Y

WZNQ=(-11310.7+1.0S02*KX+O.0906*I(X*U7680+1112.1*NX)/KX

I V" :-;. W~<X I - coef f j c i. en t of e(llbod i ed l ':0'':'': hn i Cod ~wogress

~·w:X I~-'Wf;:X J (-1 j + n:x /1;;0:: C-1 )

IV.4. XGD - distriLut~d national income, demand
Total final domestic dPflklllcJ is obt.:,ined by adding up it~:; compo-
nents: demand for consumer gocds for household',_ CXD, government
GD, demdnd for investments JAD dnd increasE' of inv~ntori~s DRD.
XGD=CXD+GD+JAD+DRD
 601

IV.5. xn - net material product, demand

In Clr-del~ to ar-rive at the i~otdl fined demand for domestic pro-
ducts XD, the net e:-:por-ts must be ',ubLr'dcted from Lhe !Jr ..~viClus fi-
gure. However, a stochastic equation was defined in order to allow
also for the losses and discrepancies. It can also be used in or-
der to evaluate the total supplies of the domestic final users
given the net output.
XD-=XGD+XNXGD

IV.6. XNXGD - excess of produced over distributed national income,

demand
XNXGD=74.091+0.6834*(ED-MD'+46.985*U7172+56.520*U76-129. 39*U8081

IV.7. XNXG - e:;cess of produced over distributed national income

XNXG=74. 091+0. 6834* (E-M' +46.985*U7172+56.520*U76-129.3 9*U8081

IV.8. X - net material product (produced national income),

realization
x = min < XD,XS }
IV.9. XE - net material prodLlct J e:;cess demand
XE=XD-XS
Gross material product Q was obtained on the assumptiun that mar-
ginal use coefficients were stable up to the late 1970·s. In the
1980's they have shown an upward tendency.

IV.IO. Q - gross materj~l product

Q=-715.33+2.3989*X+1490.1*U6065

IV.ll. QS - gr'uss maLer'ial pr-oduct, ,;upply

QS~-715.33+2.3969*XS+1490.1*U8085

IV.12. QD - gross material product, demand

QD=-715.33+2.3989*XD+1490.1*U8085

IV.13. XGS - distributed fldl:ional income, supply

XGS=XS-XNXG

IV.14. XG - distributed national income, realization

XG'--X-XNXG

IV.15. AFOP - other nonmaterial costs of enterprises

They were mainly related to the wage bill (payments to social
security funds, taxes on wages etc.).
,~FOP=-95. 767+1. 1178*ZUP*NU-l 66. 88-l(-U82

IV.16. AFP - financial accumulation

Financial accumUlation is assumed residual, despite the fact that
some of its components (turnover tax) could be endogenized.
AFP=XP-ZUXP*NUX-AFOP-YRP
 602

IV.17. XP - net material product (current prices)

XP,,-,X-;r-PX

IV.IS. XR - net material product originated in agriculture

XR=(-B.S701+0.03797*KR/NR+129.47*IOWA-17.306*U6163-16.554*U69+
+21.298*U7779+-14.219*U81)*NR

BLOCK Y. CONSUMPTION AND INVENTORIES (9 equations)

V.I. CXS - supplies of consumer goads to the households

The suppl y of cr:Jnsumer goods d~pends on the toted domesl.:i c supp-
lies XGS adjusted for net investments JA. The marginal coeffi-
cient of allocation of the total supplies to the households was
pretty high (62'%). During the early period of economic crises
(1980-81) the supplies lo the hou5eholds were maintained at the
expense of deterioration of inventory investments which is reflec-
ted by a ciu",my var-i db] e.
CXS=-61.301+0.8203*(XGS-JAI-O.0377*(XGS-JA)*U7376+218.34*U8081

V.2. CXD - per-solldl consumption, demand

Consumer demand is related to the purchasing fund being equal to
the sum of real personal income Y and of real forced savings
DlEP(-l)/PY, the mdrgindl propensity to consume is close to 86%.
It also depends on the real interest rate on deposits (ODS) for
the last period, when the interest rate has shown a remarkable
i nCr-ed.:5.E'.

CXD=44.717+0.8595*(Y+OlEP(-1)/PY)+
-3.6781*[oO%/(PY-PY(-1»*100)]*U80S5

V.3. CXE - person~I consumption, excess demand

CXE =, CXD - CXS

V.4. CX - personal consumption, realization

ex = min { CXD,eXS }

V.5. GD - other consu,nptiol1, demand

Social consulTIpr~:iu'l io:., char-a,.~terized by i.ner-tia, hence lagged endo-
genous variable was introduced. Cledrly its chdnges depend also on
the changes in populatiol1 numbf~r· L.
GD=-621.75+0.8035*G(-1)+21.296*L

V.6. GS - other- consumpti on, suppl y

It is generated indirectly by adjusting (downwards) the demand. An
estimate of excess demdnd CXE is used, being equal to 11% of total
excess demand for consumer goods generated from V.3.
GS=GD-~G*CXE , where ~G = 0.1128837

V.7. G - other consumption, realizdtion

G min { GD,GS }
 603

V.B. ORO - increase of inventories, demand

The inventory increase DR naturally depends on the increa~~ of
total output Q. Its changes also reflect changes in the intensity
of disequilibria, represented by shortages in supplies of imported
fuels and raw materials MND. The impact of growing disequilibria
is such that the inventor-ies of consumer 'Joods decline; however,
the inventories of raw materials increase because of the tendency
to hoard them and of gr-owing buttIE!necio:s.
DRD=289.53+0.08233*IQD-Q(-1»+1.0B44*(MNQ/XI-l)-O.06)*X(-l)+
-174.40*U80-170.24*U83B5

V.9. DR - increase of inventories, realization

DR=XG-CX-JA-G

BLOCK VI. EXPORTS AND IMPORTS (20 equations)

VI.I. END - exports to nonsocialist countries, demand

For-eign demand depends Or! the pr-oxy fOI"' total potential demand uf
nonsocialist countries, represented by total exports of this group
of count.r-i es.
END=-26.122+0.4t57*ENHS

VI.2. ERD - exports to socialist countries, demand

The e:{planatory variable is her-2 tile intra CMEA countries e:{por-ts.
ERD=-59.212+4.6098*ERWPG-87.952*U81

VI.3. ED - total ~xrorts, demand

ED '" END + ERD

VI.4. MND - imports from nonsocialist countries, demand

It dep~ndson the 'Jc!neral dctivi ty level. Bel~.ecn 197::J and 1.976
i t considerably increased due to new loans. However we were not
able to e;{prEO'ss e;-;plicitly the impact of til •.! changes in import po-
llcies; therefore we used dummies to adjust respectively the mar-
ginal inputs from imports. The hypothe~is was alsu test~d whelh~r
the growing shortages in consumer goods markets have had any
impact on the increa",e of illlpor-ts. However·, in no case \~EO'r-e
the estimates significant (see [4J).
MND=-204.42+0.1426*XD+O.0253*XD*U7376-0.0252*XD*U8285

VI.5. MRD - imports fr-om soclalist countr-ies, demand

Imports from socialist countries depend on the dctivity level, the
r-elalive prices PMR/PX; they also compensated the chan']es of i<n-
ports fr-om otller- cOLtntrie:; t1N (the <jign is n"·';Jative).
MRD=202.37+0.04454*QD-153.15*PMR/PX-O.1692*IMN-MN(-1))*U77B2

VI.b. t1D - total Lmpcw-ts, d'~r.land

MD=t1ND+MRD

VI.? ENS - exports to nonsucialist countries, supply

ENS=--31. (}1.1.5+0. 04187-l1-G!S-O. 00116*QS*U81G5
 604

VI.B. ERS - exports to socialist countries, supply

ERS=-70. 367+0. ()<1-600-)(- (QS-ENS) +0. 00787* (QS-ENS) *U8285

VI.9. ENE - exports to nonsocialist countries, excess demand

ENE='END-ENS

VI.IO. ERE - expurts to socialist countries, excess demand

ERE=ERD-ERS

VI.II. EN - exports to nonsocialist countries, realization

EN = min { END,ENS }

VI.12. ER - exports to socialist countries, realization

ER = min { ERD,ERS }

VI.13. E - total exports, realization

E=EN+ER

To allow for balance of payments constraints, we assumed that the

imports realize at the level, which conforms to the availability
of its financing, which depends on current receipts from exports
and net available loans.

VI.14. MN - imports from nonsocialist countries, realization

MN == flIi n { j'1ND, (r:::r,p,PEN+SNEI'1P-j(-) /Pt'IN }

VI. IS. MR - imports from ~ocidlist countries, realization

MR = min { MRD,(ER-l!-PER+SREMP*)/PMR }

VI. lb. M - total imports, realization

M'=I'1N+MR

VI.17. SNEMP - balance of trade with nonsocialist countries

(current l-W ices)

SNEMF'=EN*FEN-MN*F'~1N

'JL18. SREMP - balance of trade with socialist C:OUrltriE'S

(cur-rent pr-i ces)
SREMP=ER*PER-MR*P~1R

The imports of par-ticul"w com;Il[J,.. ~ity gruups depend un the total

i rnpor-ts; tho: flktr'o] i n-31 dlloLd!..:ion c.u~f-Fi.ciel1ts changing,
however-.

VI.19. MNQ - imports of ~uels, rclW materials and other commodities

·r-r-om nonsoci.dl is! c.cl.ln1.r-i"'.'
MNQ=-7.8626+0.5563*MN+O.I013*MN*U8385

VI.20. 1".'7 - imports of ffid,.:liiner-y equiprnellt

M7==-42.804+0. 3587*M-O. 03b3*M*U8085
 605

BLOCK VII. PERSONAL INCOMES, WAGES (7 equations)

Nominal average wages in the MP sector depend on the productivity
of labour ane! til~2 r'al~(~ of inflaLion PY. Whereas thOSE~ in the NMS
sector follow them.
VII.I. ZUXP - nominal averaue annual wages in the MP socialized
secl:ul'-

ZUXP=-38.155+0.0335*(X-XR)/(NX-NR)+230.47*PY-66.256*PY*U8285

VII.2. ZUOP - nominal average annual wages in the NMS socialized

sec tor-
ZUOP=O.0279+0.9135*7UXP-O.0607*ZUXP*U8385

VII.3. FUP - nominal wage bill, ~ocialized sector total

VII.1. ZUP - nominal average annual wages in socialized sector

ZUP-,-,FUP/NU

VII.5. YRP - nominal personal income of private farmers from

agr- i cu] Lure
It depends on net output XR dnJ procurement prices PVYAA (bei ng
exogenous; they in fact dre rel~ted to input prices).
YRP=-78.131+0.07402*XR+613.28*PVYAA-32.573*UBl

VII.6. YP - total nominal personal income

YP=-238.90+1.2039*YRP+t.9437.FUP+l.3603*YRP*U6172-213.65*UBl

Y=YP/py

BLOCK VIII. ;:-EFSONAL SA')INGS (3 .:,:quaU ons)

VIII.i. DaZDP - increase of nominal voluntary personal savings

(increase of a~s~t~)
It depends on the increase of nominal personal income.
DOZDP=6. 0441.+0. 4-129*DYP-'Z57. 54*U8Z

VIII.2. OZEP - nominal farced personal savings

The i 11cr-ea~,e Df -Fcwcc'd ~_>avi rlg~, depends on the incr-ease of the
value of total e~cess demand in the consumer goads mar-kets CXE,
adjusted for d rate showing the ~rupensity of the huuseholds to
spend the remainders in the next period.
OZEP~OZEP(-l)+~O*(CXE*PY-CXE(-l)*PY(-l»

where ~O = 0.48077 .

VITI.3. DOZP - Total saving (increase of assets)

DOZP=DDZDP+(DZEP-DZEP(-l))

BLOCK IX. PRICES [6 equations)

 606

Producers prices depend en labour costs, partly on lagged mark-up

('Financial accumulat.iunl and import prices Pt'1. The demand
pressur'es clr'e introuuced to the eqLlation e:'plClining consumer pri-
ces PCX.
IX.!. PX - deflator of net material pro~uct

PX=c).001214+1).6039*(YF'+AFOPl/X+!.1059*O.5*(AFP+AFP(-I) l/X(-l)+
+O.04927*PM+O.1767*U82

IX.2. F'CX - deflator of personal consumptiun

PCX=O.01073+0.9346*PX-O.C)5011*U82+~PCX*CXE ,
where ~ PCX ~ 0.0001239
-, . , .

IX.3. PY - deflator of personal income

PY=O.00217+1.0030*PCX
Import deflators for both groups of countries (PMN, PMR) are
e:{ogenous. E::porl deflators were mdd.? dependent (In wo,..·Id pl'ices
PENHS cldjusted for changes in the doll ar e,{change rate WZLD. It
remains exogenous; however, it is our intention to explain its
movements taking illto account the domestic rate of inflation ver-
sus the world rate.

IX.4. PM - deflcltor of import~

PM=(MN*PMN+MR*PMRJ/M

IX.5. PEN - deflator of exports to nonsocialist countries

PEN=O.08640+0.9031*PEM~S*WZLD!WZLD82

IX.6. PER - deflator of exports to socialist countries

PER=O.1531+0.8342*PENHS*WZLD/WZLD82

4 The chanqes in t.he st.ruct.ure of t.he Pc,lish economy 1961 - 1985

and t.he adjustment.s of t.he model stl-ucture

of ttle g ...·DWt!l dnd d,~cJ. i ne of tile Pol i 5h r~conomy

The anal Y',,; s over'
the sample period by means of the model W-6 gives a comprehensive
insi.]ht into thE,' sour'cas of the initial successe!o, dnd the failures
of the economic policies.
The analysis of the post-crises development in the 80-ti~5 in
Poland, characterized by deep, slowly declining disequilibria, has
revealed specific features in the behaviour of producers and
households that had to (){! incol"porated into the equations of the
model mainly in the form of parameter changes.
The balance of payments shock in 1980-81 lead to a dramatic
decline in imports from hard currency areas, including imports of
material inputs. Low levels uf imfJorts prevailed in the ne:<t
years too which was reflected in a decrease of the marginal im-
ports coefficient (fr'om 0.14 to 0.12). It seriously affected
the industrial activities. This was demonstrated by an increase
by more than twice of the elasticity of output with respect to
material (imported) inputs indicator. The policy response to the
decline of economic activities was to constrain the financinu uf
investment outlays (demand) I.lp t,o 1980 and to p""otect the
 607

consumption by means of preventina a decline in commodity supplies

(p~,p('cia1Jy in 1980-19811, which was r-eflect,~d in changes of the
respective parameters.
The constraints in material inputs, especially of building mate-
r-ial!--, r'lsin'] IJr-(~s-.sur-,~,,; ill the labour- market limiting Llle utiIL:a-
tion of capacities, brought about shortages both in investment and
consumer goods. mar-h-?ts" Thei.r impact has been nll~~\sured using
disequilibria indicators. The gelleral picture is such that the
tensiolls i.n the 1 dunur- mar-h~t inLt·-edsed Ult'uulJ/.nut the ei ghties.
This lS l'"-eflt::ct",J flat only in investment goods mdl'"-kets, but also
in e:<por-ts constt'ai_.,ts. The fluctu,_xL.i_Cllls in cOllsum'O!r- ']lJods mal~kets
(especially its d2termination in the last years) reflect rdther
the outcome of income and price polici~s, and nol the supply con-
straints. Households reacted to the crisis in a non-trivial way.
They becam(,! f"f.lr-~' sensiti_ve Lo the impact of addi.ti_olldJ. eat--ni.nt]s
(fl-om the s.,?cond econolny) dnd incomes fr-om social s~..!curi ty in
terms of witlldr'cn-"'IIs from tIl>:! labour- for--ce (or- soci.,\lized sector
only). This WdS reflected irl the change of a parameter in the
1 <,.bcIl_"- supply ,,"qLkILi.on. After- l.:h..,. illtr-oduclioll of -fur-ced savings
as an additioncll source of financing consumer· e:,penditur-es, and
allo",ing for disequi l.i_bt-i<l --- l:.ll,~ lfIe.r-'Jinal propensity to consume
appeared unaffected by the crisis. After the savings deposits
interest rates b~cclme elastic, their incurporation seemed indis-
pensable.
The ne~t step will be to use thE simulation model for simulation
analyses, inl_:ludinIJ (3150 -the pu':!)ts.:.l.fople period, and taking into
account the coming transition toward a market economy.
The methodologi.cal problem which the authors still have to solve
is how to ensure a stepwise trclnsmission from one to the other
economi.c regina_~. Olher-wise, the ShDC:~S may make t.he solutions
._tnstable or- indefinite.

Ref<:>ro;>nc85

[lJ W.Charemza, R.Quandt [1982J Models and ~stimdtion of disequi-

lif:wium -for- centr-dlly planned economi~~s. Revie~~ (]f Ecunomic
Studies, Vol. 49.
[2J M.Kalecki [1973J Zarys t~orii w~rostu gospodarki socjalisty-
c;:nej (011 the l.heor-y o-f -y-'w~th of Ule socialisl economy).
FWN, Wdr-szawd.
[3] J.Korndi [1982J Growth, shortage and efficiency. A macrodyna-
OIic: model. uf th'1 ':'OCidl.isl_ '2':ur'ClfIl'l. Basic Bl.ackwell, O::for·-c!.
[4] J.Roma~ski, W.Welfe [lq89J New Minimodel of the Polish Econo-
10)' under Disequilibr·itHn. Ri-::'v-is~c.J., UluJdtJ2d Vt=r·"ji.un" Paper pre-
sl~n1.~ed dt tt")e r-::1.tl··I,p~dn t'1ee'l_in~J uf tl'Ie ECUI-\C!IH'2tr'i.c Society
ESEM'8 9 , Munich, mim~o.
[5J A.Welfe [1985J Analiza popytu w warunkach nieruwnowagi (De-
'''dnd analysis in .....:Jndi.tiu:1s uf disequilibrium). Ekonomista,
No .. 5 ..
(6J W.Welfe [1983J Econometric Mdcromadels of Unbalanced Growth.
Prace Instytutu Ekonometrii i Statystyki U.L., No.52, Lodz.
(7] ~<J.Welfe [1989] Macr-oecono,netr"-ic Disequilib,..-iufII ~1udels of Po-
IJnd, In: C.M.Davis ~nd W.Chd~emzd (eds.) Models of Disequi-
libri .. "n "n.d Si)uri_d'Jc' in Centrdlly Fldnned Econo,nies, Chc<pm",n
~ Hall, London, pp.205-246.
 608

APPENDIX: LIST OF W-6 MINIMOOEL VARIABLES

MF' material product sector'"

i-IMS nonmaterial services ~ectw
last l,=tter D demand
last letter'"- E e}:cess def11dfH.l
last 1.8ttf.?r-" S supply
last lel~ter ? curr-ent pl·_j C'.''oi
first letler D i.rlc"·ease

.':tFOP othf'T nur""i')l.£.>t-j •• 1Ct.sl __ " £.Ii ~r1 Lerpr-i '-'I':S

AFP financial accumulation
CX personal cunsumption expenditures
DR increase of invenlories
E e::por ts total
EN exports to nonsocidlist countries
ENHS world ~xports
ER exports to sucialist countries
ERWPG _. e~ports of CMEA lo CMEA countries (US dollars)
FUOP - nominal wage bill, NMS sociali~ed sectur
FliP -- nominal Wd'JI: lJi_II, "ocialized sector' total
FUXP nominal wage bill, MP socialized sector
G other (social) consumption
IK investments put into operation total
IKO invesltl1ents put into ofJer'atioll til NMS sectol"
IKR investments put into operation in agriculture
n-;.: investment -", P'_' t i n to operat i 0.-, i n ~iF' sector'
IOWA wC!dther i nde;~
r 11_06 l,3i.JuU.r- IIlcwh~t di=.;equiliurium indicator-
12 consu,II>-'r- gouds mar"k~t disequilibr-ium indicator
I3 furei']11 tr-ade dlsequilibr-·iLlITl indicator-
14 CMEA counlries exports-imports disequilibrium indicator
J jnve~tment outlays total
JA Ilet investment outlays
.70 investment outldys in NMS ~'E'ctO/'
JR investment outlays in ~~riculture
eTX inVf~5tmi;ent ()u!:1..]y~, in MP secto..:Jr
K fi:;ed d5sets tolal (mean value)
1(00 scr-appi nIJs 'Jf .f.i;-:ed .:o_ssets in NMS sector
feDR scrclppings of fixed assets in agriculture
I(OX scrappings of fixed assets in MP sector
KK fi ::ed assets total (end of year-)
KG fi"ed asset':5 in NM3 sector (mean value)
KOf;: f i ;(ed aS5ets in NMS sector (end of year)
I<R i'i :, ed as:.;ets in agriculture (m@dn value)
KR;~ fi;;ed assets in agriculture (end of year»
KX fi;;ed assets in MP sector (mean value)
KXI< fi:<ed assets in MP sector (end of year)
L papulation lotal
L8 vacancie5 (offered jobs)
LC urban papUlation
LP populaliun in ~roductive age
LZ registered looking for jubs
M i mpor-ts total
;·1N i.mpur-t'j -fr-LltlJ ponsl]ci iiI:i st countr ies
MNI imparts from nonsocidlisl countries (ather groups)
MNR imports of ftHel''', /-dW IIIclter-idls and other' CUIIlIilUditl.2'o'
from nonsocidllst countries
MR imports ff~'OIlI socictlisf. CQllntl'-jt.::lS
 609

M7 imparts uf machin€ry equipment

N c;::p1 l.JYI"":"! d tl:~!_ aT
NNR emplo'l,,,ent in MP sector outside:: d1Jr-iculture
NO ef:lp 1 nymen t .i n N~:S c_.PC!_ or-
NR employment in agricultw'e
i\HJ t::..-mploymel)t jrl s(lc.i,,31i."!ed sec tor-
Nun employment in NMS socialized sector
NUX employment i.11 t·W 5{.). __ ia.li.ced s,,=,,;I_or
NX emp 10 ymen t: ill MP -".-,!C tor-
NXV potential emploY"lent in MP sec\:or'
interest rate on the sdvings deposits
OZDP nominal voluntary (normal) personal savings
OZEP nominal forced persDnal savings
GZP nominal per-sonal savin']s t\J!:al
PCX deflator of CX
F'EN deflatcJr' of EN
PENDOL- deflator- of EN (US dollar's)
F'ENHS - deflator of ENHS
PER def 13. tor- of ER
PERDOL- defl ator of ER (US dolldl-s)
PM def lator- of M
PMN defJ.:::tor of t1N
P~1R deflator of MR
PI) dlo.'·Fl ,,-Ii: 01" j J.f Q
PVYAA dp-flator' of procurement sales of agriculture products
PX d~.?f 1 d·. L( )1-· of X
py deflator of y
Q gross md~erjal product
RNR inventories (except for government reserves)
SNEMP balance of trade with nl)nsf)cial ist countries (cur-r-eld_
pl-i:=~s)
SREMP balance of trade with socialist countries (current prices)
U •• - err g . .
dU.IPW/,

, f Ct- 1980-1 '7'82 lr~4 "- { 1 for- 1974

USGS: 'co { (A)
(1thEo'I--I"i se . I 0 ather-wi se
ItW_-XT -- cue-f-ficient of t:embodit=:d i:echnical pr-ogress
WRD e,;change rate ('--oubl,cc'/c!ollar)
"IXI': ctJeffici.t::nt uf th~ 1.-:1fJdCiLy utiliz.dt:ion
WZLD e;{Chdnge rat." (;::lot)'/dolJc.r)
\lJZLR e;< c i1 an IJ ~~::' t d:: f..? ( ~ 1 \) 1: 'y' /:'" (Ju!:J 1 e)
WZNQ dverage number of shifLs For industry
X net P1ater-i-31 i,,-odu,~t (n«t:iona_l income pr-oduced)
national income distributed
x f,: producLive lapacily
XNXG difference between NMP produced and distributed
XNXR rll"j matel~ial pr-oduct originating outo.ide ,:oIgr-icu; Lur-e
XF' net Inaterial pr-oduct originating in agr-icL,l !-_Llr~~
'( I-eal per-sunal J 1'1(' !1I"t-'
YRP no'ni nd 1 per-soflal income of pr- i vate farmers from
dgr i cuI· i:ur-e
ZUOP nominal average dnnual wdges in ~ms sociali~ed sector
ZUP nr:)ult.f1al ~ve""·i}ge c..~nnual w,~,';]es in socialized secLor'
ZUXP nominal average dnnudl wages in MP socialized sector
Evaluating econometric models: The 1988 forecast of the RWI-business cycle model
in retrospect

Ullrich Heilemann1
Rheinisch-Westfalisches Institut fur Wirtschaftsforschung
Hohenzollernstr. 1/3, D-4300 Essen 1, FRG

Abstract

The paper analyzes the causes of the large errors in the 1988 FRG macroeconomic
forecasts. The study is based on a forecast and various simulations with the RWI-business
cycle model, a medium-sized macroeconomic short-term model. It is shown that the most
important causes were errors in the assumptions of government construction outlays and -
more important - of world trade. As to endogenous errors, the forecasts of changes in stocks
and the distributed profits proved to be most damaging. By extending the error analyses on
such endogenous variates, the paper explores possibilities of model analysis only rarely
employed up to now. However, it should be clear that only such an extensive analysis gives a
true picture of a model's strengths and weaknesses.
Keywords: macroeconomic models; forecasting with macroeconomic models; forecast
analysis

Contents

1 Introduction
2 The RWI-business cycle model - an overview
3 The forecast for 1988
4 The accuracy of the forecast: exogenous and endogenous errors
5 Summary and conclusions
References

1 Introduction

The year 1988 might be remembered in the FRG's economic history for two reasons: its
comparatively strong economic growth and the fact that this growth was not foreseen by any
of the major forecasters. Both aspects provide a reason to take another look at the 1988
forecast of the RWI business-cycle model, focusing on three questions. First, do the
forecast errors lie in or outside the range expected from previous experience? Second, are

I am indebted to David Belsley, Josef Gruber and Kenneth Wallis for helpful comments.
 611

the errors attributable to certain aggregates? And third, since scientific forecasts rely on
both assumptions and hypotheses (Hempel-Oppenheim forecast deduction scheme) what
are their contributions to the forecast errors?

Of course, it might well be argued that the last question is primarily of interest to the
producer and not to the consumer of a forecast - indeed, most evaluations do not distin-
guish between assumptions and hypotheses. But a failure to do so here, in the context of an
econometric model, means to give up an opportunity to learn and to ignore some of the
models' truly unique features.

In addition, one might also ask for an evaluation of the forecast errors in utility terms - we
are, after all, economists! But, whereas the specification of a forecast utility function may
seem possible for the "truth-seeking" scientist, typically, we do not have the information to
determine utility functions of other forecast consumers (Menges 1975, p. 5f.). Faute de
mieux, one might speculate on how the economic policy of the federal government might
have differed, if there had been no forecast errors. But, since in 1988 the government
tended to be much more optimistic than most forecasters, it is unlikely that economic policy
would have differed much. Things might have looked somewhat different for the policy of
the Deutsche Bundesbank (Deutsche Bundesbank 1989).

The paper tries to answer the three questions in the context of the RWI business-cycle
model. Analyzing the predictive quality of econometric models has a long tradition (Evans,
Haitovsky, Treyz, Su 1972), but it has only been since the beginning of the 80s that this is
made on a regular and systematic base (Wallis (ed.) 1986; McNees 1989, p. 43). As to the
R WI business-cycle model, such analyses form a central part of every forecast production
and have been the subject of various studies before (Heile mann 1985; 1989). The current
study differs methodologically from previous studies primarily by examining not only the
influence of errors in exogenous variables (assumptions) but also the role of "endogenous"
errors.

This paper is organized as follows. The next section gives a synopsis of the model and an
overview of its ex post forecasting performance. Section 3 presents the 1988 forecasts, both
from the R WI-model and from other sources. Section 4 analyzes the forecast accuracy, and
section S is devoted to a summary and conclusions.

2 The RWl-business cycle model - an overview

The RWI business-cycle model is a medium-sized, short-term (quarterly) model which has
been used for forecasting and simulation for more than 10 years. It consists of roughly 40
stochastic equations and 75 identities, which together form an interdependent, weakly
 612

Exhibit 1

Ex post forecasting accuracy of the RWI-model

Dynamic simulation
1978-3 to 1987-2

MAEI RMSPE 2

GDP, origin, volume

GDP 3.4 1.0 0.2
Employed (x 1000) 72.8 0.4 0.3

GDP, demand, volume

Private consumption 3.0 1.7 0.6
Government consumption 0.8 1.4 0.5
Investment 1.4 2.2 0.4
Investment in machinery 1.0 3.9 0.6
Construction 0.7 2.0 0.4
Stocks,changes 2.5 71.0 1.1
Exports 1.7 1.9 0.3
Imports 1.9 2.1 0.4
GNP 2.7 0.9 0.3

Prices
Consumer prices, % change 0.5 71.7 0.8
GNP prices, % change

GDP, income distribution

Gross-wage income 3.0 1.6 0.3
G ross profits 3.5 4.8 0.5
National income 3.2 1.2 0.2
Net-wage income 1.5 1.4 0.3
Net profits 3.5 5.9 0.6

Government budget
Deficit 2.9 182.9 0.8

Author's computations. - 1) Mean absolute error, bill. of DM. - 2) Root-mean-square-percentage-error. - 3)

Theil's inequality coefficient.

nonlinear model (Heile mann, Mi.inch 1984a). It can be segmented into five sectors:
demand (30 equations), distribution (21 equations), production (16 equations), price (12
equations), and government (36 equations). The exogenous variables consist of "politically-
determined" variates, such as the social-security contribution rate, government construction
outlays, short-term and long-term interest rates, on the one hand, and internationally
determined ones, such as world trade and import prices, on the other. The theoretical
 613

Exhibit 2

The 1988-forecast of the RWI-model and its assumptions

% changes from previous year
1987-3 to 1988-4

1986 1987 1988 1987 1988

quarters
1 2 3 4 1 2 3 4

Assumptions
Public investm. 9.2 2.2 1.0 -2.2 1.4 3.5 3.9 10.4 2.6 -2.1 -1.8
Social sec. contrib. 17.7 17.7 17.9 17.6 17.6 17.8 17.9 17.9 17.9 17.9 17.9
World exports 4.2 3.2 3.4 2.7 1.8 3.4 4.7 4.5 3.7 2.6 2.7
Price index of imports -10.7 -4.4 1.2 -11.0 -4.8 -0.4 -0.8 0.8 0.8 1.2 2.1
Interest rate, short term 4.6 4.0 4.0 4.1 3.8 3.9 4.2 3.8 3.9 4.0 4.2
Interest rate, long term 6.1 5.9 6.1 5.9 5.6 6.1 6.1 5.7 6.0 6.2 6.5
Negotiated wages 4.2 3.8 3.7 4.0 3.7 3.8 3.8 3.4 3.8 3.8 3.8

Forecast
GDP, origin, volume
GDP, volume 2.6 1.4 1.8 2.2 0.8 1.4 1.1 2.6 2.0 1.3 1.4
Employed (x 1000) 1.0 0.6 0.8 0.9 0.7 0.5 0.5 0.7 0.6 0.8 0.9

GNP, demand, volume

Private consumption 4.3 2.8 3.3 2.6 2.3 3.2 3.1 5.0 3.4 2.9 1.9
Government consumption 2.3 1.7 1.6 2.4 1.2 1.3 1.8 1.4 2.0 1.8 1.1
Investment 3.1 1.1 3.2 1.1 -0.5 2.5 1.3 6.0 3.3 3.0 1.5
Investment in machinery 4.1 3.9 3.7 6.4 0.5 6.9 2.5 2.5 4.3 5.5 2.6
Construction 2.4 -0.9 2.8 -3.4 -1.2 -0.1 0.4 9.4 2.5 1.4 0.6
Stocks, changes 0.4 8.2 -4.1 20.8 -1.0 10.6 -22.2 16.1 -3.5 7.3 -23.9
Exports -0.2 -0.7 3.2 0.2 -2.6 0.6 -1.0 3.8 3.0 2.7 3.4
Imports 3.5 3.2 4.3 6.5 0.0 4.0 2.7 4.8 4.4 4.6 3.3
GNP 2.5 1.4 1.8 2.3 0.8 1.4 1.1 2.6 2.0 1.3 1.4

Prices
Consumer prices, % change -0.5 0.6 1.5 -0.5 0.8 0.8 1.1 1.8 1.3 1.4 1.6
GNP prices, % change 3.1 2.2 2.0 3.1 2.6 1.4 1.8 2.2 2.0 2.2 1.7

GNP, income distribution

Gross-wage income 5.0 3.7 3.5 3.3 4.4 3.4 3.6 3.4 3.7 3.6 3.5
Gross profits 9.8 4.0 4.2 11.9 1.7 1.9 1.2 8.9 4.9 2.4 0.6
National income 6.5 3.7 3.6 6.1 3.5 2.9 2.7 5.0 3.8 3.0 2.6
Net-wage income 5.3 2.2 4.0 2.4 2.9 2.1 1.3 4.1 4.4 3.6 3.9
Net profits 11.3 5.1 3.7 15.7 4.1 1.9 0.1 8.8 2.7 2.6 0.6

Govemment budget
Deficit -23.5 -38.4 -43.9 -16.2 -2.6 -11.1 -8.6 -19.7 -4.6 -11.0 -8.5

Source: Rheinisch-Westfalischcs Institut fUr Wirtschaftsforschung (Hrsg.), Vierteljahrliche Prognose mit dem
R WI-KonjunkturmodellI987-3 bis 1988-4, Nr.26 v. 20.12.1987 bearbeitet von T. Weil3. Essen 1987,3.
 614

Exhibit 3

Model-adjustments
1988 - forecast of the RWI-model
BiII_ DM

measure / 1987 1988

variable in the model

quarters
3 4 1 2 3 4

"Various social policies'

Government transfers to
private households 1.0 1.0 1.0 1.0 1.0
"Tax reform 1988"
Taxes on wage and salary income -2.5 -2.5 -2.5 -2.5
Taxes on profits and wealth -0.5 -0.5 -0.5 -0.5
"Transfer of profits ofthe
Deutsche Bundesbank"
Profit income of the government
sector 5.0
"Other adjustments"
Wage and salary income per
employee, % change -0.8 -1.1 -1.1 -1.1 -1.1
Distributed profits -5.0 -4.0 -4.0 -4.0 -4.0
Price indices
Private consumption, % change 0.5 0.5 0.5 0.5
Government consumption, % change -1.5 -1.5 -1.5 -1.5 -1.5
Exports, % change 1.4 2.0 2.0 2.0 2.0

Source: Rheinisch-Westfillisches Institut fUr Wirtschaftsforschung (Hrsg.), 2.

foundations of the equations are, as for most applied econometric models, somewhat
eclectic, including neoclassical, Keynesian, and monetarist elements. The architecture of
the model, however, is Keynesian, in the Keynes-Klein tradition. With respect to the roles
played by demand and money and the stability of the private sectors, the model may rather
generally be labelled as post-Keynesian (Davidson 1980; Chick 1983). Expectations are, in
most cases, adaptive or "weakly rational" (Eckstein 1983, p. 41).

The model is re-estimated twice a year; the sample period is the same for all equations and
covers the last 40 quarters of the data available ("moving window"). For the current study it
is 1977-3 to 1987-2. The parameters are estimated by ordinary least squares (OLS). Exhib-
it 1 presents the values for various forecast-error summaries of a full dynamic simulation of
the model over the sample period. In general, they do not differ from previous results
(Heilemann, Munch 1984a, p. 360f.; Heilemann 1989, p. 256f.), except that the tracking of
private consumption, and, as a consequence, of GNP, has deteriorated somewhat.
 615

3 The forecast for 1988

The forecast for 1988 (and the last two quarters of 1987) was made and published in De-
cember 1987 (Rheinisch-Westfalisches Institut fur Wirtschaftsforschung (Hrsg.) 1987). The
main assumptions and results are given in Exhibit 2. Additional assumptions, introduced by
add-factoring, are shown in Exhibit 3. While most of these seem quite clear, the "Other
adjustments" items deserve some comment.

The reduction in ''wage and salary income" has been made to account for the reductions in
the hours of the working week which became effective in 1988 (reflecting the fact that the
negotiated wage rate used here is a kind of gross rate, representing only the cost effects).
(The model has since been expanded to cope with such problems in a more straightforward
manner (WeiJ3 1989).) The reduction in "distributed profits" is a complementary change
reflecting the fact that this variate is supposed to follow not only gross profits but also wage
and salary income. The reduction in the "price index of government consumption" is meant
to represent the more restrictive wage policy in the public sector. The other changes reflect
the effects of the revaluation of the OM, which is not captured explicitly in the model.
Finally, because the increase in many of the negotiated wages had been fixed in the 1987
wage round, negotiated wages have been exogenized for the present forecast.

It should be noted that the main assumptions are very similar to those of the forecast made
by the Joint Diagnosis in October 1987 (Die Lage der Weltwirtschaft und der
westdeutschen Wirtschaft im Herbst 1987 (1987) (hence: Joint Diagnosis) with their model
so that both the RWI-model's and the Joint Diagnosis' forecast seem in accord with their
major assumptions 2.

Under these assumptions, the model predicts a (real) GNP growth of 1.8%, a O.4%-point
more than 1987. Prices at the consumer level increase 1.5%, while those for GNP remain
near 2.0% - results of the expected end of a phase of OM revaluation and of a reversal of
the price developments on world markets. Given a productivity growth of roughly 1.1 %, the
GNP growth leads to a growth in employment of about 0.8%, or of about 195,000 workers,
an increase of roughly 30,000 workers more than in 1987. The government deficit rises to
43.9 bill. OM, 5.3 bill. OM more than in 1987, mainly a consequence of the 1988 tax
reduction of roughly 12 bill. OM (gross, cf. Exhibit 2), although, in part because of the "self-
financing" nature of this measure, it is likely to accomplish only about 70% of the original
"expenditure."

2 World trade in the RWI model forecast was assumed to be about 0.5 %-point, price index of imports about
1.3 %-point lower than previously assumed by the Joint Diagnosis. The reductions of the interest rate were
about 1.0 %-point (short-term) and 0.6 %-point (long term).
 616

Exhibit 4

Selection of 1988-forecasts
% change from previous year

Actual RWI-model 1 Joint Council Deutsche

Diagnosis of Bundes-
Economic bank
Experts
II

GDP, origin, volume

GDP, volume 3.5 1.8 3.8 2.0 1.5
Employed (x 1000) 0.6 0.8 1.4 0.3 0.5

GNP, demand, volume

Private consumption 2.5 3.3 4.2 3.0 2.5 2.7
Government consumption 1.8 1.6 1.8 1.5 1.5 1.1
Investment 5.8 3.2 6.4 2.0 1.5 1.6
Investment in machinery 7.5 3.7 8.1 3.5 2.0
Construction 4.5 2.8 5.1 1.0 1.0
Stocks, changes, Bill. DM 13.9 -4.1 0.6 8.0
Exports 5.5 3.2 7.1 3.5 2.5 2.4
Imports 5.9 4.3 6.9 5.0 4.0 3.4
GNP 3.4 1.8 3.8 2.0 1.5 1.9

Prices
Consumer prices, % change 1.3 1.5 1.3 2.0 1.5 1.3
GNP prices, % change 1.5 2.0 1.9 2.0 1.5 1.5

GNP, income distribution

Gross-wage income 3.8 3.5 4.4 4.0 4.0 3.3
G ross profits 8.5 4.2 9.3 3.5 2.0 3.1
National income 5.3 3.6 5.8 4.0 3.5
Net-wage income 4.0 4.0 4.4 4.0 4.0
Net profits 8.5 3.7 9.6 4.0 1.5

Government budget
Deficit, bill. OM -42.2 -43.9 -38.0 -45.0 -49.5

Sources: Statistisches Bundesamt; Rheinisch-Westfiilisches Institut fUr Wirtschaftsforschung (Hrsg.) (1987),

Vierteljahrliche Prognose mit dem RWI-Konjunkturmodell 1987-3 bis 1988-4, a.a.O., 3; Die Lage der
Weltwirtschaft und der westdeutschen Wirtschaft im Herbst 1987. Beurteilung der Wirtschaftslage durch
folgende Mitglieder der Arbeitsgemeinschaft deutscher wirtschaftswissenschaftlicher Forschungsinstitute e.V.,
Essen: Deutsches Institut fUr Wirtschaftsforschung, Berlin; HWWA-Institut fUr Wirtschaftsforschung, Hamburg;
Ifo-Institut, Munchen; Institut fUr Weltwirtschaft an der Universitat Kiel; Rheinisch-Westfalisches Institut fUr
Wirtschaftsforschung, Essen. 0.0., 18f.; Sachverstandigenrat zur Begutachtung der gesamtwirtschaftlichen Ent-
wicklung, Vorrang fUr die Wachstumspolitik. Jahresgutachten 1987/88. Stuttgart u.a. 1987, 120f.; Deutsche
Bundesbank (Hrsg.) (1989), Die Verwendung des iikonometrischen ModeIIs der Deutschen Bundesbank zu
gesamtwirtschaftlichen Vorausschatzungen. "Monatsberichte der Deutschen Bundesbank", Jg. 41, Nr. 5, 33. - 1)
I: Published forecast; II: forccast with actual values of the exogenous variables (April 1989).
 617

In short: the model led us to expect a continuation of the recovery, although it was mainly
the effect of the tax reduction that produced the increase in the growth rate. The rising
inflation rate mainly reflected a turn in world inflation and in the exchange-rate
developments of the OM. It should be noted that no other consequences of the crash of
October 19, 1987, were expected than those incorporated in the (reduced) assumptions of
world-trade. The RWI model forecast was numerically well in line with that of the Joint
Diagnosis (1987, p. 18f), which shared much of its assumptions, and of the Council of
Economic Experts (Sachverstandigenrat zur Begutachtung der gesarntwirtschaftlichen Ent-
wicklung 1987, p. 120), at least within the published figures (rounded), as seen from
Exhibit 4.

4 The accuracy of the forecast

Before examining the forecast numbers, some methodological clarification seems advisable.
Econometric models like the RWI-businesscyc1e model may be written formally in period t
as:

(1) 0,

with
y vector of endogenous variates,
x vector of exogenous variates,
B matrix of parameters,
e vector of disturbance terms, and
order of lags, 1, ... , n.

If such a system is estimated, it can be used to produce statements of future events as

(where hats indicate forecasts or assumed future values):

(2) Yt+j = G(Yt+j' Yt-i+j,xt+j, Xt-i+j; B), j = I, ... ,k,

with}
k number of forecast periods.

For various reasons, (2) might be modified (elements in B might be altered) or com-

3 The presence of Yt +' on both sides of the equality here reflects the fact that a closed-form
solution for Yt +' may Jot exist in the general, ronlinear context. The form of (2) is intended to
convey the idea hat the Yt +' are the implicit solutions of this set of equations conditional upon
the values of the other vari!tes. The equations (2) can also be normalized with respect to the
individual endogenous variate so that the current value of the endogenous variate that occurs on
the left-hand-side does not also occur on the right-hand-side. It is assumed that a unique solution
for (2) exists within some appropriate region of the space of endogenous variates.
 618

plemented (additions might be made to some xH j)' In the R WI business-cycle model,

only additions (add-factors) to the constant terms are used, that is:

where
xa vector of additions to the constant terms.

The reasons for such additions may be of either an a priori economic or a statistical nature -
or they may just stand for a feeling that the outcome of an equation appears implausible. In
the RWI model, corrections are usually not made for statistical reasons (see, for example,
WeiB 1987 for some experience with Cochrane-Orcutt corrections). Thus, the model's
forecast may be presented as:

where
xe :vector of additions to the constant terms made for a priori economic reasons,
xP :vector of additions to the constant terms made for reasons of plausibility.

This short representation illustrates not only the way some econometric model forecasts are
made, but also the way their predictive accuracy should be ascertained. The simplest way, of
course, is just to compare forecast and actual values:

(5) Yt+jlx - Yt+j = et+jlx,

where
et + j Ix : vector of forecasting errors.

Further, since the forecasts developed here are conditional forecasts, the error e can be
cleansed of the effects of any errors that are subsequently observed to occur in all or part of
the assumptions by repeating the forecast with meanwhile available observations of x:

(6) Yt+ j Ix - Yt+j = et+j lx,

where
e t +j Ix vector of forecasting errors, corrected for observed errors in the assump-
tions.

The process lying behind (6) can be used to examine the effects of various types of
corrections. For example, the forecasts may be repeated after exogenizing some of the
endogenous variates, or after different assumptions have been made with respect to some
 619

Exhibit 5

Errors in exogenous variables of the 1988-forecast with the RWI-model

% changes from previous years

1987 1988
quarters
1987 1988 3 4 1 2 3 4

Public investment -0.2 -3.2 -3.1 2.2 -20.3 -1.8 0.4 0

Social sec. contributions 0 0 0 0 0 0 0 0
World exports -1.4 -3.3 -1.8 -3.8 -4.1 -5.2 -5.2 -3.1
Price index of imports -0.2 -0.1 -0.1 -0.9 -0.1 -0.1 -0.5 0.4
Interest rate, short term 0 -0.3 0 0.1 0.4 0.3 -1.1 -0.9
Interest rate, long term 0 0.1 0 -0.1 0 0.1 -0.2 0.3
Negotiated wages 0 0.4 0.1 0.2 0.6 0.3 0.3 0.3

Author's computations.

of the add-factors, etc., all of which need not be shown here.

The present analysis of forecast accuracy will follow the lines described in the introduction.
It will concentrate on the forecasts for 1988, ignoring the small errors in the base-year
(1987). The same holds for the effects of the mean while National Accounts-revisions which
the Deutsche Bundesbank (1989, p. 34) has calculated to be about 0.3% of GNP for their
model forecast.

We begin with the errors that have occurred in the main assumptions on the exogenous
variates X. These are seen in Exhibit 5 to be rather small, falling, for the most part, well
within the bounds experienced by the RWI model to date (Heilemann 1989, p. 269). Two
exceptions, however, are noteworthy: public investment and world trade. The error
relevant to public investment is twice its usual size and is due mainly to the very mild winter
(first quarter 1988) whose effects were not compensated during the rest of the year because
of the favorable finance position of the government sector. Of a more serious nature are
the errors that materialized in the assumptions relevant to world-trade development. The
usual 6-quarter forecast error in world exports (made outside the RWI-model) is 0.4 %-
points, but the figures for 1988 are approximately eight times as large. A detailed analysis
of the causes of this error is beyond the scope and possibilities of the present study. It seems
clear, however, that it was a consequence of an underestimation of the general trend of
 620

Exhibit 6

Errors of 1988-forecasts
% changes from previous year

Actual Errors

Joint Council
RWI-model1 Diagnosis of
Economic
Experts
II III IV V VI

GDP, origin, volume

GDP 3.5 -1.7 0.3 0.2 -0.4 0.5 0.1 -1.5 -2.0
Employed (x 10(0) 0.6 0.2 0.8 0.1 0.7 0.8 0 -0.3 -0.1

GNP, demand, volume

Private consumption 2.5 0.8 1.7 1.4 -0.1 2.0 0.3 0.5 0
Government consumption 1.8 -0.2 0 0 0 0 0.1 -0.3 -0.3
Investment 5.8 -2.6 0.6 0.5 -0.3 0.7 -1.5 -3.8 -3.3
Investment in machinery 7.5 -3.8 0.6 0.4 -1.1 0.7 -2.4 -4.0 -5.5
Construction 4.5 -1.7 0.6 0.6 0.3 0.7 -0.5 -3.5 -3.5
Stocks, changes, bill. DM 13.9 -18.0 -13.3 -13.5 -12.1 -12.8 -3.9 -5.9
Exports 5.5 -2.3 1.6 1.6 2.1 1.9 1.1 -2.0 -3.0
Imports 5.9 -1.6 1.0 0.8 -0.3 1.3 -0.4 -0.9 -1.9
GNP 3.4 -1.6 0.4 0.3 -0.3 0.6 0.2 -1.4 -1.9

Prices
Consumer prices, % change 1.3 0.2 0 0 0 -0.5 0.2 0.7 0.2
GNP prices, % change 1.5 0.5 0.4 0.3 0.4 -0.3 0 0.5 0

GNP, income distribution

Gross-wage income 3.8 -0.3 0.6 -0.2 0.4 0.7 0.6 0.2 0.2
G ross profits 8.5 -4.3 0.8 2.0 -1.2 -1.4 -1.0 -5.0 -6.5
National income 5.3 -1.7 0.5 0.3 -0.3 -0.1 0.1 -1.3 -1.8
Net-wage income 4.0 0 0.4 -0.1 0.3 0.5 -0.9 0 0
Net profits 8.5 -4.8 1.1 2.4 -1.4 -5.2 -0.7 -4.5 -7.0

Government budget
Deficit, bill. DM -42.2 1.7 4.2 -1.3 0.5 16.0 4.0 -2.8 -7.3

Sources: s. Exhibit 4 and author's computations.- 1) I: Original forecast; II: forecast with actual values of
exogenous variables; III: forecast II with employment exogenized; IV: II with "Distributed profits" exogenized;
V: II without parts of "other adjustments" (Exhibit 3); VI: ex post forecast with a 1979-1 to 1988-4 based model
verSIOn.

world exports as well as of an overestimation of the October 19-effects. Indeed, at least as

far as the perspective of the forecast is concerned, the reactions of the world markets to this
event seem relatively neutral, since prices (here, import prices) remained unaffected by the
 621

actual events. Otherwise, it is interesting to note that the interest-rate assumptions did
surprisingly well. With minor exceptions in the first two quarters - the monetary authorities
were likely too busy to prevent a slump in consequence of October 19 -, the interest-rate
assumptions proved nearly correct.

All of the 1988 forecast errors, both those of the RWI model and of the other forecasts
mentioned above, are brought together in Exhibit 6. Neglecting for the moment the role of
the assumptions, it is clear that the RWI model (column RWI-model I) performs poorly.
Ignoring the interdependencies, this is especially true relative to private consumption and
the changes in stocks, whereas the RWI-model proves superior with respect to the dynamics
of investment activity4.

Now, while such a comparison may reveal things about the forecaster's general under-
standing of the economic process, it can say nothing about the validity of the hypotheses
employed and little about the usefulness of the model as an instrument for scientific
forecasting. To gain insight into these issues, the entire 1988 forecast was repeated using
the actual values for the exogenous variates. It is seen from the column labelled RWI-
model II in Exhibit 6, that, in this case, the situation is very much changed. The 1.6 %-point
underestimation for real GNP becomes a 0.4 %-point overestimation, and the figure for
investment growth is reduced to only 0.6 %-points. Unfortunately, the forecast error with
respect to private consumption more than doubles, and the forecast of the changes in stocks
is only slightly improved. In assessing the other figures, given the uncertainty that prevailed
in late 1988, it is less surprising that their errors tend to lie outside the usual limits than that
the differences are rather small (cf. Heilemann 1989, p. 256).

Referring to the model's link matrix (Gilli 1984; Heilemann 1989, p. 260), the error in
private consumption might be linked via wage and salary income to employment which is
central for private consumption. To illustrate the role of employment for the model's
forecast, a further simulation was conducted in which employment (the number of wage and
salary earners) was exogenized. The results are presented in the column labelled RWI-
model III of Exhibit 6.

The forecast errors of nearly all demand categories are reduced, but perhaps not by as
much as expected. This, again, is mainly due to offsetting effects: The smaller prediction
errors for private consumption are balanced by the increased errors for imports. While this
finding could give cause to think of a structural change in the consumption function - a
previous study has cast some doubts upon its inter-temporal stability (Heilemann, Munch

4 Though these kinds of comparisons and statements are often made, they are basically inadequate since they
ignore the links (at least by definition) between the various parts of the forecast.
 622

1984b, p. 117f.) - a comparison of the present regression results with those of the 1979-1 to
1988-4 sample showed rather similar explanatory power and reaction-coefficients. A closer
examination of the forecasting accuracy of the explanatory variables proved more
successful. In fact, an analysis of the various income components revealed that the model
much overestimated "distributed profits". A comparison of the present regression results
and of the 1979-1 to 1988-4 sample reveals that the large overestimation in the forecast
period is mainly explained by the reduction of the gross profits-elasticity from 0.44 to 0.34
(the wage-elasticity changed from 1.11 to 1.18). Though the introduction of the Add-factors
corrected the variate in the right direction, the correction was too small. Whether the
unexpected slight increase in the savings rate that occurred during this period is due to the
"fallout" of October 19 or to specific attitudes held by consumers towards the "windfall
income" of the tax reduction ("tax fall"), or to a mixture of both, is difficult to judge.

The RWI-model forecasts are those of an econometric model and not those of eco-
nometricians (Evans, Haitovsky, Treyz, Su 1972, p. 952): Add-factors are set primarily to
account for special events (xe ) which the model is unable to capture explicitly. To illustrate
the role played by the "pure" add-factors (x P) in the 1988 forecasts, the forecast was redone
after eliminating the corrections for the three price indices (Exhibit 3). The effects of this
are seen in Exhibit 6 (RWI-model V). Comparing these results with those using the actual
exogenous variates (RWI-model II) reveals at least three characteristics of the model.
First, such corrections are primarily of local importance, as is illustrated by the effects on
consumer prices as well as those on private consumption and exports. Second, in both these
instances, the real responses are much smaller than the price-adds, especially with respect
to export prices. And third, the effects on nominal GNP and its distribution are more
substantial, although more difficult to detect because of various offsetting effects (cf. gross-
wage income, gross profits, and national income).

To complete the analysis, the current version of the model (Spring 1988, sample period
1979-1 to 1988-4) was used to forecast the period under study (i.e. an ex post forecast within
the sample period) was made. Although some of the equations of the model have since
been respecified (independently of the forecasting experience reported here), a comparison
with the previous results seems to be meaningful. In general, these forecast errors are
smaller (RWI-model VI) than those of the ex ante forecast with actual values for the
exogenous variates (RWI-model II). However, it is interesting to note some important
shifts in the hierarchy of the forecasting quality. While the errors for private consumption
and for the changes in stocks are much reduced, that for investment in machinery has
substantially increased. These are normalizations which can be attributed to the well-known
levelling-off effects of OLS.
 623

5 Summary and conclusions

1. Examining the 1988 forecasts of the RWI model in retrospect has shown that the
1.6 %-point underestimation of the FRG's economic growth has mainly been due to a large
underestimation of the 1988 expansion of world trade. While usually the errors in the va-
lues assumed for this variate have not tended to exceed greatly the 0.4 %-point margin, in
1988 it jumped to 3.3 %-points.

2. A model can, of course, hardly be blamed for having to operate with the wrong as-
sumptions, so it is interesting to note that once corrected for the preceding and all other
errors in the assumptions, the speed-up in the 1988 growth rate is well explained, and the
accuracy of the forecast does not differ from previous experience. This outcome is not
quite as obvious as one might expect, since models operating with wrong assumptions often
produce better forecasts than do those using correct ones (e.g. McNees 1989, p. 54) - a re-
sult caused by a tendency of some forecasters to orient their prediction at some "Star of
Bethlehem" (Waelbroeck, De Roo 1983, p. 400), technically achieved by extensive mas-
saging (exogenous variates as well as add-factors). At the same time, these results suggest
that the 1988 forecast errors do not stem from a shift in the short-term behaviour of the
FRG-economy. If some analysts see the growth of the FRG-economy in 1988 as a long
overdue result of a successful supply-side policy the present analysis hardly backs such a
view.

3. Private consumption and changes of stocks provide an exception to some of the previous
conclusions, as they show errors outside their usual margins. While the poor results for the
changes in stocks simply indicate that the explanation has to be revised, for private
consumption things look different. Judging from the empirical quality of the estimation of
the private consumption function used here (and in most other approaches), it is difficult to
blame this result on it. Rather, it is mainly due to the model's large errors in explaining
distributed profits. First of all it is the much-reduced reaction to gross profits which
accounts for most of the underestimation of this variate. The problems with the explanation
of the comparatively large withholdings of profits, however, do not seem to be restricted to
the RWI model. It also besets the forecasts by the Joint Diagnosis and by the Council of
Economic Experts - although both had additional difficulties in matching the dynamics of
private investment. Indeed, there is much evidence that this misperception has not been
restricted to the FRG. In 1988 the under-estimation of GNP growth has been of the same
magnitude (0.6 %-points) for the world as for the FRG, and there is some evidence that it is
mainly investment and exports that lie behind this drive, while private consumption lags
behind. This result once again raises the questions (1) whether expectations are an
important force for transmitting business cycles among countries (Waelbroeck, De Roo
 624

1983, p. 400), and (2) if so, how models should take them into account.

References
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P. Davidson (1980), Post Keynesian Economics. "Public Interest", Special Issue 'The Crisis
in Economic Theory'. New York, vol.20, pp.151-173
Deutsche Bundesbank (Hrsg.) (1989), Die Verwendung des okonometrischen Modells der
Deutschen Bundesbank zu gesamtwirtschaftlichen Vorausschatzungen. "Monatsberichte der
Deutschen Bundesbank", 4l.Jg., Nr.5, pp.29-36
Die Lage der Weltwirtschaft und der westdeutschen Wirtschaft im Herbst 1987 (1987). Be-
urteilung der Wirtschaftslage durch folgende Mitglieder der Arbeitsgemeinschaft deutscher
wirtschaftswissenschaftlicher Forschungsinstitute e.V., Essen: Deutsches Institut rur Wirt-
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Munchen; Institut fur Weltwirtschaft an der Universitat Kiel; Rheinisch-Westfalisches Insti-
tut fur Wirtschaftsforschung, Essen. 0.0.
O. Eckstein (1983), The DRI-Model of the U.S. Economy. New York
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Properties of U.S. Econometric Models. In: B.G. Hickmann (ed.), Econometric Models of
Cyclical Behavior. (Studies in Income and Wealth, 36) vol.2, New York u.a., pp.949-1139
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Causal Structures. (Cahiers du Departement d'Econometrie, 84.03) Universite de Geneve
U. Heilemann (1985), Zur Prognosegenauigkeit okonometrischer Modelle. "Zeitschrift fur
Wirtschafts- und Sozialwissenschaften", 105.Jg., pp.683-708
U. Heilemann (1989), "Was leisten Prognosemodelle?" Eine empirische Untersuchung am
Beispiel des RWI-Konjunkturmodells. In: B. Gahlen, B. Meyer, J. Schumann (Hrsg.), Wirt-
schaftswachstum, Strukturwandel und dynamischer Wettbewerb. Festschrift fur Ernst
Helmstadter zum 65. Geburtstag. Berlin, Heidelberg, New York, pp.253-272
U. Heilemann und H. J. Munch (1984a), Einige Bemerkungen zum RWI-Konjunktur-
model!. In: G. Langer, J. Martiensen und A. Quinke (Hrsg.), Simulationsrechnungen mit
dkonometrischen Makromodellen. Munchen, pp.355-385
U. Heilemann and H. J. Munch (1984b), The Great Recession: A Crisis in Parameters? In:
P. Thoft-Christensen (ed.), Proceedings of the 11th IFIP Conference on System Modeling
and Optimization, Copenhagen, Denmark, July 1983. (Lecture Notes in Control and
Information Sciences, 59.) Berlin, Heidelberg, New York, pp.117-228
S.K. McNees (1989), Why Do Forecasts Differ? "New England Economic Review",
January IFebruary, pp.42-54
G. Menges (1975), The Scientist and the Policy Maker as Forecaster. Paper presented at
the 3rd World Congress of the Econometric Society. Toronto
Rheinisch-Westfalisches Institut fur Wirtschaftsforschung (Hrsg.) (1987), Vierteljahrliche
Prognose mit dem RWI-Konjunkturmodell 1987-3 bis 1988-4. Nr. 26, Essen, 20.12.1987,
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Sachverstandigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung (1987),

Vorrang fUr die Wachstumspolitik. Jahresgutachten 1987/88. Stuttgart u.a.
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Models of the UK Economy. A Third Review by the ESRC Macroeconomic Modelling
Bureau. Oxford
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and ex ante Results. In: Polish Academy of Sciences - University of Lodz (eds.), Problems
of Building and Estimation of Large Econometric Models. Warsaw and Lodz, forthcoming
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Polish Academy 0 Sciences - University of Lodz (eds.), Problems of Building and
Estimation of Large Econometric Models. Warsaw and Lodz, forthcoming
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The Macroeconometric Nlodel of the Deutsche Bundesbank -
A Brief Review

Max Christoph Wewel

Deutsche Bundesbank, Research Department
Wilhelm-Epstein-Stra13e 14,0-6000 Frankfurt 50, FRG
Views expressed in this paper are those of the author and do not necessarily represent
the position of the Deutsche Bundesbank.

Abstract

This short review presents the main characteristics of the macroeconometric model of
the Deutsche Bundesbank. This medium-size quarterly model describing the West
German economy is regularly used in macroeconomic forecasting and policy evaluation.
It is divided into seven interdependent blocks dealing with (1) the demand side and
(2) the supply side of the economy, with (3) costs and prices, (4) the public sector,
(5) foreign trade and payments, and (6-7) the financing of the economy. The latter two
blocks were respecified recently, when a portfolio selection model was incorporated to
explain private demand for financial assets. This portfolio block is described in more
detail. Moreover, estimation results obtained by application of Zellner's restricted joint
generalized least squares (RJGLS) method are presented.
Keywords: Macroeconometric modelling, Portfolio theory.

Contents

1 Main Characteristics of the Bundesbank Model

2 Block Structure of the Bundesbank Model
3 The Portfolio Block of the Bundesbank Model

1 Main Characteristics of the Bundesbank Model

The macroeconometric model of the Deutsche Bundesbank is a quarterly model

describing the economy of the Federal Republic of Germany. The development of the
Bundesbank Model started almost twenty years ago, and its first version was presented
to the public in 1975 [4]. In the meantime, the Bundesbank Model has seen a lot of
changes in various respects [5] [7]. The present version of the Bundesbank Model
consists of 216 equations, 84 of them stochastic equations, and 132 definitions. The
model is divided into seven interdependent blocks referring to different sectors or
aspects of the economy (see section 2). Using about 70 exogenous variables (including
dummies), the model operates with a total of nearly 290 variables. The main data
 627

sources are the national accounts of the Federal Statistical Office (Statistischcs Bun-
dcsamt), and the banking statistics of the Deutsche Bundesbank.

The coefficient estimates in the stochastic equations are regularly updated as soon as
the national accounts data of a new quarter are available. In most equations, the esti-
mation period starts with the first quarter of 197I; thus, current estimations, for the
most, draw on more than 70 observations. The estimation method is 0 LS in linear
equations, NLS in non-linear equations, and restricted least squares (RLS) in equations
involving Almon lag distributions. The newly specified portfolio selection model (see
section 3) is estimated by Zellner's restricted joint generalized least squares (RJG LS)
method ([ II], pp. 295-317).
The Bundesbank Model is used on a regular basis to set up short-term macroeconomic
forecasts for the Central Bank Council; for the most part, these forecasts cover the
current year and the following one. Moreover, the Bundesbank Model is applied to
analyse the impact of exogenous shocks on the German economy by means of
simulation. Of course, the consequences of monetary policy measures are of specific
in terest, but in the past there were also studies dealing with oil price and other external
shocks, with a reduction of working time, or with fiscal policy changes like the recent
tax reforms. Although these studies; like the short-term forecasts, serve mainly internal
purposes, the Deutsche Bundesbank occasionally reported on these simulation results
[6) [8J (9). Recently, there was also an article on the performance of internal forecasts
using the Bundesbank Model [I OJ.

2 Block Structure of the Bundesbank Model

As mentioned above, the new version of the Bundesbank Model consists of seven
interdependent blocks dealing with the following aspects of the West German economy:
(A) the demand side, (B) the supply side, (C) costs and prices, (D) the public sector,
(E) the foreign sector, (F) financial assets and liabilities, and (G) interest and exchange
rates.
The first five blocks (A) to (E) form the real part of the Bundesbank Model, whereas
the last two blocks (F) and (G) refer to the financial sphere. Since the model is
structured from the theoretical point of view, the market behaviour of the different
economic agents is subsumed under separate blocks. Thus, block A represents private
households, block B refers to private firms, and blocks D and E obviously represent the
public and the foreign sectors. Each of these four blocks results in the definition of the
respective sector's financial surplus or deflcit, which then enters the financial part of the
model. However, the sectoral disaggregation is somewhat different in the financial part;
there, one finds the division: central bank, commercial banks, private sector (households
and production firms), government, and foreign sector.
Economic activities of private households explained in the demand block (A) are private
consumption and labour supply. The consumption function is specified in real per
capita terms, using an error correction form. In the long run, private consumption is
determined by real disposable income, net financial wealth of private households, the
functional distribution of income, and the real rate of return of the private portfolio.
The specification of labour supply is based on a utility maximization approach
comparing the benefits of working and leisure time. Thus, the labour force participation
 628

rate depends on real per capita wages, the comparative real non-wage income per
capita, and the age structure of the population. Moreover, the demand block contains
the definition of final demand and GNP, both in real and in nominal terms. Thereby,
in a technical sense, this block becomes the central part of the Bundesbank Model, since
there are direct links to all other blocks.

The core of the supply block (B) is the definition of potential output, which is derived
from the estimation of a CES production function relating final demand to total hours
worked. capital stock actually used, and imports. However, potential output is defined
only on the basis of standard working time of the total labour force and fully utilized
capital stock, not taking into account imported inputs. Apart from the determination
of aggregate supply, the second block contains the factor demand equations. According
to the assumption of profit maximizing firms, the demand for capital (i.e. net invest-
ment), labour, and imported inputs positively depends on final demand and the ratio
of product prices (after taxes) and the respective factor costs. The definitions of the rate
of capacity utilization, the unemployment rate, and the capital stock are also included
in the supply block, which is closely connected to the other real blocks, but has no direct
link to the financial part of the model.

In the third block (C), costs and prices are determined. Wages are explained by a
Phillips curve specification using the unemployment rate, consumer prices, and the
standard working time as explanatory variables. Together with the user costs of capital
(determined by real interest rates, depreciation rates, capital taxation and related
allowances) and import prices, they make up the costs of production index. To avoid
problems caused by multicollinearity of the cost components, this index is used to
explain prices. Also, capacity utilization and indirect tax rates enter the price equations.
Price deOators are defined by the ratio of the respective nominal and real aggregates.
Thus, the price block interacts closely with the other real blocks and also with the
financial part via interest rates.

The public sector block (D) deals with direct and indirect taxes, contributions to the
social security system, and transfer payments. The revenues of the various taxes are
determined by the respective bases of \'aluation and the corresponding tax rates.
Contributions of employees and employers to the social security system and tranfer
payments (unemployment benefits and pension payments) are specified in a similar
way. Thus, the variables explained in this block largely depend on those of the demand
block and the supply block. Conversely, there are several repercussions on these two
blocks. As noted above, taxes also affect costs and prices in manifold ways.
The foreign sector block (E) completes the real part of the Bundesbank Model. In this
comparatively small block, real exports and import prices are essentially explained by
external factors, whereas real imports (explained in block B) as well as export prices
(explained in block C) largely depend on domestic economic conditions. So, real exports
of goods and services are specified as a function of foreign demand expressed in terms
of production output and the real exchange rate based on deOators of final demand.
The explanatory variables of import prices are world prices of energy and of other raw
materials as well as foreign deOators of final demand, all these prices being converted
into O-marks. The definitions of this block serve to compute total exports and imports
both in real and in nominal terms, and the surplus or deficit in the current account. The
foreign sector block has mutual direct links to the other real blocks except the public
sector block, and there is of course an influence from the financial sphere through
exchange rates.
 629

Figure 1: Block Structure of the Bundesbank Model

D: Public sector C: Costs & Prices

• taxes
• contrib. to
~----------~r~ wages •
• user costs of
soc. sec. syst. capital
• transfer paym. ~ ~ • costs of prod.
• fin. balance of • prices and
public sector deflators
17 S 15 D 14 S 21 D

r
A: Demand Side B: Supply Side
(Priv. Househ.) (Private Firms)
• pro consumption • potent. output
• labour supply • factor demand
• GNP (= demand) • capacity util-
• fin. balance of • fin. balance of
priv. househ. +-- private firms
5 S 26 D 13 S 32 D

E: Foreign Sector
• exports
• import prices
• current account
7 S 19 D

REAL PART
FIN. PART

I
F: Financing I G: Financing II
(Portf. Modell
• fin. assets and • short and
liabilities long-term
• money stock interest rates
• fin. wealth • exchange rates
• fin. accounts
1& S 16 D 12 S 3 D

BUN DES BAN K MOD E L

84 S 132 D
 630

The financial part of the Bundesbank Model was respecified recently; it is now divided
into two blocks. The first block (F) contains the newly specified portfolio model
explaining private demand for several financial assets as described in the next section.
Moreover, it includes equations for financial assets of the public sector and bank
lending to the private and public sectors, definitions of monetary aggregates and
financial wealth of the sectors as well as accounting identities. In the second financial
block (G), interest and exchange rates are explained. The pivotal variable in interest
rate determination is the three-months money market rate, which hinges on the
Bundesbank rates, the equivalent Euro-dollar rate, the inflation rate, and a pressure
variable reflecting a liquidity surplus or deficit. The other interest rates, especially those
corresponding to the assets in the portfolio model, are appended to the money market
rate using term structure equations. The external value of the O-mark against the U.S.
dollar and other non-EMS currencies is explained by the respective price and interest
rate differentials and a risk premium, which depends on the net foreign position of West
Germany. Consistent with the view that realignments within the EMS are an instru-
ment of discretionary exchange rate policy, the external value of the O-mark against
other EMS currencies is assumed to be exogenous.

Obviously, exchange rate movements have multiple effects on the current account. In
this context, it is interesting to note a result from simulations carried out using the
foreign sector block. An appreciation of the D-mark against the U.S. dollar leads to a
slight improvement of the current account due to the pronounced reduction of import
prices, whereas an appreciation of the O-mark against other currencies produces the
normal reaction: the current account clearly deteriorates as a consequence of the
prevailing negative effect on exports. There arc also direct influences of interest rates
on the real sphere, since real interest rates play an important role in the determination
of private investment (block B) and consumption (block A). On the other hand, the
structure of the private portfolio depends on the volume of transactions.

3 The Portfolio Block of the Bundesbank Model

The core of the new financial part of the Bundesbank Model consists in an integrated
system of asset demand equations describing the portfolio selection of the private sector.
This system, built in the tradition of the Brainard-Tobin model [3], can be derived from
the maximization of the expected utility of the portfolio, subject to the constraint that
portfolio shares must add up to one (see [2] for mathematical details). The utility of the
portfolio is assumed to be a function of both the vector of individ ual rates of return of
the considered assets and their variance-covariance matrix representing the risk
structure of the assets. Additional explanatory variables, e.g., the volume of
transactions, can be included in the utility function. By choosing a suitable
mathematical form of the utility function, the maximization results in a system of linear
asset demand equations:

n m
(1 ) + L b ..
lJ
r.
J
+ L c ..
lJ
X.
J
(i=l, ... ,n).
j=l j=l

Thus, the optimal portfolio share yI of asset i depends on the rates of return
r i (i = I, ... ,n) of all assets of the system, apart from additional explanatory \'ariables
 631

x j (j = I, ... ,m). To allow for temporary deviations of the actual from the optimal
portfolio, usually a multivariate model of partial adjustment is used:

n
(2 ) y.(-l) +
1
L d ..
1J
( y.
J
- y'~ (-1)
J
} (i=l, ... ,n).
j=l

Consequently, asset demand equations explaining the actual portfolio structure always
contain the whole set of lagged endogenous variables. However, the coefficients of these
asset demand equations must satisfy various linear restrictions implied by the
adding-up constraint.

Strong multicollinearity of the numerous explanatory variables, especially among int-

erest rates, and the existence of cross-equation constraints cause serious estimation pro-
blems, especially if the portfolio system contains a larger range of assets. On the whole,
attempts at establishing asset demand systems based on empirical data have so far not
been very successful on these grounds [1) [2). Perhaps the simplest way to meet these
problems is to eliminate from each asset demand equation all explanatory variables
which have insignificant coefficients or coefficients with wrong sign. Then one equation
has to be omitted, since the demand for the last asset is already determined by the
adding-up constraint. However, the arbitrariness of this procedure often leads to
implausible estimates. Therefore, a different approach is adopted in the Bundesbank
iVIodel. To reduce the number of coefficients, additional linear constraints are imposed.
First, a portfolio yield is defined as a weighted average of the individual interest rates:

n
(3 ) r L y.(-l) r . .
i=l 1 1

In each asset demand equation, this portfolio yield is substituted for all interest rates
of competing assets so that only two interest rates remain in each equation. Moreover,
by imposing dij = 0 for i F j, the adjustment process (2) is assumed to be univariate,
which implies (due to the adding-up constraint) that the remaining coefficients
d ii (i = 1, ... ,n) are of the same size. According to these assumptions the asset demand
eq uations are specified in the form:

(4) Yi

+ c i3 ql + c i 4 q2 + CiS q3 + d Yi (-1) (i=l, ... ,n),

where the variables have the following meaning:

v·1
o
portfolio share of asset i (per cent)
r i interest rate of asset i (per cent p.a.)
r portfolio yield (per cent p.a.)
x GNP divided by total private portfolio
t dummy variable for withholding tax
q I ,q2,q3 : seasonal dummies.

In the portfolio block of the Bundesbank Model, nine financial assets are included, the
selection being made with reference to the available banking statistics. Table I shows
the list of assets as well as their respective shares and their yields a\eraged over the
years 1971 to 1988.
 632

Table I: Structure of the private portfolio in the Bundesbank Model

No. Financial assets Share Yield

1 Currency ~n circulation 6.04 % 0 %

2 Sight deposits of private sector 11. 26 % 0 %
3 Short-term time deposits of pro sector 10.40 % 5.43 %
4 Savings deposits at statutory notice 21.76 % 3.69 %
5 Savings deposits at agreed notice 14.26 % 4.88 %
6 Bank savings bonds 5.52 % 6.89 %
7 Bearer bonds and long-term deposits 23.12 % 7.95 %
8 Indebtedness of government to pro sector 6.21 % 7.74 %
9 Foreign assets of priv. sector 1. 42 % 9.53 %

Sum Total private portfolio 100 % 4.91 %

It should be noted that the yield on foreign assets is calculated as an average yield on
long-term government bonds in selected countries, corrected by changes in the effective
D-mark exchange rate in the past. Thus, the volatility of the yield on foreign assets
exceeds that of domestic assets by far.
In order to take into account the various constraints on the coefficients, the portfolio
system is estimated simultaneously using Zellner's RJG LS method. The resulting
estimates are presented in table 2.

Table 2: Estimation results of the portfolio block

Coefficient estimate of ...

Asset own portfolio GNP / dummy var. lagged
No. interest yield total pro for with- endogenous
rate 1) portfolio hold. tax variable

1 (0.0365) -0.0305 0.0236 0.1257 0.8491

2 (0.0680) -0.0933 0.0448 0.0942 0.8491
3 0.0627 0.0473 0.0070 0.0208 0.8491
4 0.1313 -0.2271 0.0394 -0.1748 0.8491
5 0.0861 -0.1363 0.0796 -0.1701 0.8491
6 0.0333 0.0015 -0.0416 -0.2812 0.8491
7 0.1395 -0.0385 -0.0604 -0.3678 0.8491
8 0.0375 -0.0945 -0.0139 -0.1754 0.8491
9 0.0086 -0.0319 -0.0785 0.9286 0.8491

Sum 0.6034 -0.6034 0 0 -

1) estimated coefficient (0.6034) multiplied by average portfolio shares

 633

To summarize, the main conclusions to be drawn from this table are:

I. The coefficients of the own interest rates are positive, because higher returns
constitute an incentive to expand the portfolio share of the respective asset. As indicated
in the footnote of table 2, these coefficients are proportional to the corresponding
portfolio shares.
2. The coefficients of the portfolio yield are mostly negative, since the portfolio yield
represents the interest rates of competing assets. The sum of portfolio yield coefficients
equals the sum of own rate coefficients in absolute value.
3. The effect of the transaction variable is positive in case of liquid assets (including
savings deposits) and is negative in case of long-term assets. Considering the portfolio
as a whole, these influences cancel each other out.
4. The announcement of the introduction of a withholding tax on capital income has led
to a shift from interest-bearing domestic assets to foreign assets (which are exempt from
the withholding tax) and to interest-free domestic assets, but to a lesser extent.
5. The coefficients of the lagged endogenous variable are identical in all equations,
indicating the interdependency of portfolio adjustments.

References

[I] Backus, D. / Brainard, W.e. I Smith, G. / Tobin, J. [1980]: A Model of U.S.

Financial and Nonfinancial Economic Beha\'ior, Journal of Money, Credit, and
Banking, Vo1.l2, pp. 259-293
[2] Bordes, e. [1988]: Modelisation des comportements financiers. Cadre theorique et
bilan des travaux empiriques, Cahiers economiques et monetaires, Vol. 29, pp. 141-175
[3J Brainard, W.e. ! Tobin, J. [1968]: Econometric Models: Their Problems and
Usefulness. Pitfalls in Financial Model Building, American Economic Review, Papers
and Proceedings, Vol. 58, pp. 99-122
[4] Deutsche Bundesbank [1975]: Structure and Results of the Econometric Model of
the Deutsche Bundesbank, Monthly Report, Vol. 27, No.5
[5J Deutsche Bundesbank [1978]: Further Development of the Econometric Model of
the Deutsche Bundesbank, Monthly Report, Vol. 30, No.4
[6J Deutsche Bundesbank [1981]: The Impact of the Second Oil Price Shock on the
Economy of the Federal Republic of Germany (An Econometric Analysis), Monthly
Report, Vol. 33, No.4
[7J Deutsche Bundesbank [1982]: Structure and Properties of a New Version of the
Econometric Model of the Deutsche Bundesbank, Monthly Report, Vol. 34, No.8
(8J Deutsche Bundesbank [1986J: External Influences on the Current Account and
Domestic Trends in the Econometric Model of the Deutsche Bundesbank, Monthly
Report, Vol. 38, No.7
[9] Deutsche Bundesbank [1988]: Determinants of the German Current Account 1984
to 1987. Results of an Econometric Analysis, Monthly Report, Vol. 40, No.5
[10] Deutsche Bundesbank [1989J: Macro- Economic Forecasting with the Econometric
Model of the Deutsche Bundesbank, Monthly Report, Vol. 41, NO.5
[I I] Theil, H. [1971]: Principles of Econometrics, John Wiley: New York
Alphabetical list of authors
1. Arminger, Gerhard ................................................................... 459

2. Bagdy, Ga.bor .......................................................................... 39

3. Barabas, Gyorgy ...................................................................... 131

4. Bartnick, Jiirgen ...................................................................... 487

5. Bohm, Bernhard ...................................................................... 149

6. Brandner, Peter ...................................................................... 149

7. Breitung, Jorg ........................................................................ 419

8. Chow, Gregory C. . ................................................................... 269

9. Debski, Wieslaw ...................................................................... 570

10. Eismont, Oleg A. . .................................................................... 546

11. Elker , Johann ......................................................................... 502

12. Freimann, Karsten-Dietmar ........................................................... 385

13. Fritz, vVilhelm ........................................................................ 358

14. Galler, Heinz P ........................................................................ 559

15. Garbely, Myriam ..................................................................... 496

16. Gilli, Manfred ........................................................................ 496

17. Groscurth, Helmuth-M ................................................................ 539

18. Gruber, Josef .................................................................. 3,185,222

19. Hansen, Hermann-Josef .... '" ........................................................ 588

20. Heilemann, Ullrich .................................................................... 610

2l. Hofkes, Marjan W ..................................................................... 205

22. Hiisges, Hartmut ..................................................................... 185

23. Hughes Hallett, Andrew .............................................................. 167

24. Johansen, Soren ...................................................................... 323

25. Juselius, Katarina .................................................................... 336

26. Kiviet, Jan F ..................................................................... 404,419

27. Kramer, Walter ....................................................................... 419

28. Kiimmel, Reiner ...................................................................... 539

29. Kiisters, Ulrich 1. ..................................................................... 459

30. Lahti, Ari ............................................................................ 285

 636

31. Leserer, tlichael ....................................................................... 51

32. Losch, Manfred ....................................................................... 429

33. Matulka, Josef ......................................................................... 57

34. Merkies, Arnold H.Q.M ............................................................... 205

35. Neck, Reinhard ........................................................................ 57

36. Romanski, Jerzy ...................................................................... 591

37. Schepers, Andreas .................................................................... 459

38. Shea, Gary S.......................................................................... 305

39. Strzala, Krystyna ...................................................................... 79

40. Sujan, Ivan ............................................................................ 94

41. Tanguiane, Andranick S .......................................................... 222,248

42. Terlau, Wiltrud ....................................................................... 516

43. Vasicek, Osvald ........................................................................ 94

44. Vasiliev, Vladimir ..................................................................... 119

45. Viren, Matti .......................................................................... 285

46. Vorreyer, Monika ..................................................................... 551

47. Wallis, Kenneth F ...................................................................... 15

48. Welfe, Wladyslaw ..................................................................... 591

49. Wewel, Max Christoph ........................................................... 473,626