Economic Models and Economic Policies

Nico van der Windt

5 December 2005

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Content of the presentation

1. Economic Policies
2. Economic Models
3. Use of Economic Models in Economic Policies
4. Usefulness of Economic Models in Economic
Policies
5. Czech example
6. Some Conclusions

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1. Economic Policies
Welfare Function:

W = W(Y,X,p)

 Objectives (Y)
 Instruments (X)
 Preferences (p)

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Economic Policy Problem
Max W = W(Y*,X,p)
Subject to
Y = f(Y, X, Z)

in which:
Y* is a subset of Y
Z is vector of other variables

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Objectives (Y*)
 Economic growth
 Employment
 Inflation
 Balance of Payments
 Distribution of income
---------------------------
 Government Deficit

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Instruments (X)
Quantitative instruments:
 Fiscal instruments
 Monetary instruments
Non-quantitative instruments:
 Legal instruments
 Institutional instruments

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Fiscal instruments
 Taxes: tax base; tax rates and
various types of taxes
 Government expenditures:
consumption and investment
expenditure
 Below the line: different modalities
to finance the deficit

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Monetary instruments
 Interest rates
 Money supply
 Quantitative restriction in for
example credit provision by banks

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Legal instruments
 Articles in the law about for example
competiton and regulation of
markets
 Bankruptcy law
 Law and regulations related to
private sector activities

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Institutional instruments
 Public Institutions for support to
private sector activities
 Examples: Competition Agency;
Energy agency; Chambers of
Commerce; Foreign Investment
agencies, etc.
 Reduction of “red tape”

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Problems with welfare function
W = W(Y*,X,p)

 Quantitative only
 Preferences not known
 Preferences not stable over time
 Mathematical function not known
(Theil’s Certainty Equivalence
require quadratic function)
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2. Economic Models
Y = f(Y, X, Z, e)
Large variety of different models
Different models for different purposes:

 Long run models, focus on supply

 Short term models, focus on demand
 Hybrid models
 Macro & Sector models
 General Equilibrium Models
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Long-term models
 Focus on supply
• Production function
• Volume and quality of Capital and labour
 Important role of prices on adjustments
 (Stable) long-term growth path
 Functioning of markets
 Short term aberrations do not have an
impact on long term growth path

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Short-term models, main features

 Focus on various components of

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

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

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Macro versus sector models
 Macro models focus on aggregate,
assuming that the sector
composition does not matter for
total
 Sector models focus on industrial
structure of the economy, assuming
that sector composition is important
for the aggregate
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General Equilibrium Models
 Main assumption: prices generate
equilibrium between supply and demand
 Often static, describing one state of
equilibrium and compares this with an
equilibrium under different assumption of
exogenous variables
 Recently also dynamic, describing the
path from one equilibrium to another
state of equilibrium

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Problems with models - 1
Y = f(Y, X, Z, e)

Models give only a simplified and

stylised view of a complex real world

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Problems with Models - 2
 Models are always incomplete
 Uncertainty in behavioural equations
 Instability of parameters:
• Instability over time
• Parameters not invariant under policy
change (Lucas critique)
• Local validity

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Advantages of Models
 Structure and focus the discussion
 Coping with complexity
 Consistency
 Accountability

Yet, always question the validity of

the model for the problem at hand

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Sensitivity of results
Results are in particular sensitive for
specification of:
 Wage equation
 Investment
 Exports and imports

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Example Wage Equation
WPRPC =
+ 1.00 * (0.66*PCNPC + 0.34*PYPC)
+ 1.00 * LABPROD
+ 1.00 * WEDGE1
+ 0.75 * WEDGE2(-1)
- 0.36 * (UR(-4) – 10.00)

R-squared = 0.92

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Implications wage equation -1
 Terms of trade effect through (PC/PY)
 Shifting indirect taxes to employers (PC)
 Shifting burden of taxes and social
security premiums to employers (WEDGE)
 Additional real wage increases if
unemployment rate is above 10% (UR)

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Implications wage equation -2
 Taxes and contributions to social
security affects cost per unit of
output
 Balanced budget multiplier (that is
expenditure increase financed
through additional taxes) negative

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Example Imports and Exports
Observations Czech economy:
 both export and import GDP ratios
have increased considerably over
past decade;
 Difficult to find satisfactory
econometric fit
 Both demand and supply approach
not satisfactory

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3. Use of Economic Models in
Economic Policies

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

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Forecasting
Y = A * Y + Σ (B(i) * Y(t-i)) +
Σ(C(i) * X(t-i+1)) +
Σ (D(i) * XROW(t-i+1)) i = 1,…,n
 Parameter uncertainties (A, B(i),
C(i), D(i))
 Uncertainty policy reactions (X)
 Uncertainty outside world (XROW)

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

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4. Use of Models in Economic Policy
W = W(Y*,X,p)

Example quadratic loss function:

L = a(i) * (Y*(i) – Y*(i))2 +

b(j) * (X(j) – X(j))2

With model Y = F(Y,X) as constraint

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

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Trial and Error
 Discussion between model builder
and experts
 Discussion between model builder
and policy maker

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Trial and error procedure
1. Policy maker suggests particular set of
instrument values
2. Analysis and translation into model
input by model builder
3. Model results supplemented with expert
knowledge
4. Overall results translated for policy
maker
5. Discussion between model builder,
expert and policy maker
6. Revised set of instrument values 32
Preferences through trial
and error process
Policy makers unlikely to provide
well-defined welfare function,
because they:
 Do not have the technical skills
 They don’t know the consequences
of their preferences
 They are not willing to reveal their
preferences

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Preferences through trial
and error
Confrontation with likely outcome of
concrete policy proposal forces them
to
 Formulate better set of instrument
values
 Define additional targets
 Think about additional conditions

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Requirements model builder
 Be clear and comprehensive in his
reporting
 Show trade offs between objectives
 Show trade offs between instrument
values
 Show feasibility of various policy
packages

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5. Usefulness of Economic Models in
Economic Policy making

Structuring of discussion through

 Focusing of the discussion
 Quantification of the problems
 Clarification of the relative
importance of the problems
 Clarification of feasibility of policy
options

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Usefulness of Economic Models in
Economic Policy making

Although they simplify reality

models can cope with complexity:
 Models indicate 2nd and higher order
effects through feed backs
 Models cope with simultaneity
 Models calculate accurately
 Models have a good memory

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Usefulness of Economic Models in
Economic Policy making

Models are consistent if specified

correctly within the national
accounting system

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Usefulness of Economic Models in
Economic Policy making

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

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5. Czech example
Current situation:
 Quarterly (econometric) model
 Sector model for MIT
 Sector model for MoF

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

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Similarities and Differences
Differences:
 Macro <-> sector
 Quarter <-> annual
 Calibration/estimation <->
calibration

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Use of Models in Czech
Republic
Quarterly model:
 Short- to Medium-Term forecasting
 Fiscal policies (aggregate)
 Sensitivity analysis exogenous
variables
 Sensitivity analysis policy options

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Use of Models in Czech
Republic
Sector Model:
 Long-term forecasting
 Fiscal policies -> sector impact
 Sector policies
 Sensitivity analysis -> sector impact

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

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6. Some Conclusions - 1
 Models useful for understanding
main economic mechanisms
 Models useful in discussion on
economic policy packages

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Some Conclusions - 2
 Models as basis for economic policy
preparation available
 Modelling continuous activity
 Continuous re-estimation of parameters
required
 More discussions between model builders
and experts
 More discussions between model
builders/experts and policy makers

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Some Conclusions - 3
 Strengthening model building
departments
 Procedures for use of models in
policy discussions
 Further research

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