Lecture 5: Macroeconomic Model

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Lecture 5 Macroeconomic Model
Dr. Rajeev Dhawan Director
Given to the EMBA 8400 Class Buckhead
Center April 4, 2009
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Important Macro Lessons To Be Learnt Today

• GDP cannot grow beyond its potential in the long
  run
• Loose Monetary Policy can create only a short-run
  stimulus in GDP. In long-run it only creates
  inflation! Net-Net money growth determines
  inflation
• Government spending can create only a short-run
  stimulus in GDP. In the long-run it leads to a
  rise in the real interest rate with no gain in
  GDP but higher deficits
• Balanced budget spending just redistributes the
  share of GDP attributed to consumption
  government spending

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Typical Macro-Model
price level lag 1
world interest rate
IMPORTS
world GDP
inflation lag 1
world price
EXPORTS
EXCHANGE RATE
PRICE LEVEL
NET EXPORTS
money
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
EXPECTED INFLATION
UNEMPLOYMENT
CONSUMPTION
DISPOSABLE INCOME
tax rate
TAX REVENUES
POTENTIAL GDP
capital stock lag 1
investment lag 1
CAPITAL STOCK
labor force
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Macroeconomic Model

• The Macroeconomic Model simulates the working
  of the US Economy using explicit equations to
  model consumption, investment, exports, imports,
  exchange rate, price level and inflation rate.

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Classification and Listing of Equations

• Accounting Identities
• Real GDP (GDP) Tax Revenues (T)
• Disposable Income (YDP), Net Exports (NETEX)
• Price Level (P)
• Example Disposable Income (YDP) GDP
  Tax Revenues (T)
• Accounting Identities have the following
  properties
• As forecasting equations, they are PERFECT!
• Dont have parameters to be fitted
• No error term
• No theoretical disputes about their truth, only
  about their relevance

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• 2. Behavioral Equations
• Consumption (C), Real Interest Rate (R),
• Investment (I), Exchange Rate (EXCH),
• Exports (EX), Imports (IM),
• Inflation (P)
• Example Consumption (C) a0 Disposable
  income (YDP)
• (Where a0 marginal propensity to consume
  0.9215686)
• Behavioral Equations have the following
  properties
• Estimated parameter values change as behavior
  changes
• Source of all forecasting errors
• Theoretical disputes concerning these equations,
  e.g., are consumers myopic or forward looking?

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Endogenous and Exogenous Variables
Accounting Identity

• Define A B C (1)
• Where B A/2 ....(2)
• and C 5 (given)
• Then equation (1) becomes A B 5 which using
  definition of B becomes the following
• A (A/2) 5
• Thus, A/2 5 or A 10 and using (2) B5
• In the above example, A B are endogenous
  variables and C is an exogenous variable

Behavioral Equation
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Macroeconomic Model

• The Exogenous Factors in the model are
• GDP Potential (GDP_at_FULL) which is GDP value at
  full employment level
• Domestic Policy Variables
• Money Supply (M)
• Government Spending (G)
• Tax Policy (T)
• Rest-of-the-World (ROW) factors such as
• Foreign Interest Rate (R_at_ROW)
• Foreign Price Level (P_at_ROW)
• ROW GDP Potential (GDP_at_ROW)

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Model Simulation Approach

• State macroeconomic theory as a complete set of
  algebraic equations.
• Estimate/postulate numerical values of all
  parameters.
• Assume initial conditions for the history of all
  lagged variables.
• Assume base case values over future time
  periods for all exogenous variables.
• Solve the model under base case assumptions.
• Change some of the exogenous variable
  assumptions.
• Solve the model again under alternative
  assumptions.
• Compare model solutions
• Base Case and the alternative policy Simulation.

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Advantages of the Model Simulation Approach

1. Integrates short run and long run analysis into
   one coherent story of the dynamic reactions of an
   economy to macroeconomic policy.
2. Traces the complete logic of the model,
   step-by-step, instead of trying to condense model
   into a two-dimensional diagram, such as IS-LM
   diagram.
3. Extends to real-world macroeconomic policy
   issues.
4. Same process applies to realistic models of
   actual economies, such as U.S. forecasting
   models, oil shocks, or world slowdown.

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Listing Of Variables in the Model

• 12 Endogenous Variables
• GDP, C, I, EX, IM, NETEX, R, P, YDP, T, EXCH, P
• (requires 12 equations in 12 unknowns)
• 7 Exogenous Variables
• 3 Policy Variables M, G, TAX
• 3 ROW Variables P_at_ROW, R_at_ROW, GDP_at_ROW
• 1 Other Variable GDP_at_FULL

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Listing of 12 Equations in the Model

• 12 Endogenous Variables
• One GDP Equation/Accounting Identity
• Three Consumption Related Equations
• Two Interest Rate and Investment Equations

Accounting Identity
Accounting Identity
Accounting Identity
Behavioral Equation
Behavioral Equation
Behavioral Equation
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• Four Exchange Rate, Export, Import and Net Export
  Equations
• Two Price Inflation Equations

Behavioral Equation
Behavioral Equation
Behavioral Equation
Accounting Identity
Behavioral Equation
Accounting Identity
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Glossary of Variables
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Additional Definitions
The model variables are in real terms (except of
course the price variable). We need three other
variables in nominal terms to complete our
understanding. These are like derived
accounting identities.
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Econ 101 Rule
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Econ 101 Rule

• Given the values of exogenous variables for a
  given economy, if the values of inflation (P)
  0.00 nominal exchange rate (EXCH) 1.00, then
  the economy is in equilibrium or steady state in
  such a way that actual GDP is exactly equal to
  potential GDP.

Equal
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Base Case

• The Base Case is the state of the economy where
  for the given values of exogenous variables, the
  ECON 101 rule applies and the values of
  endogenous variables solved in the first year
  remain constant for all subsequent years

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Base Case

• This means that GDP will be equal to its
  potential value for all the years in the base
  case.

• Inflation will be equal to ZERO percent

And the exchange rate will be at one for all the
years
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Cont
This also implies that values of all other
endogenous variables will also be constant for
the subsequent years. Why? Endogenous variables P
and P from today become the exogenous variables
for subsequent years endogenous value
calculations as seen from equations 11 and 12.
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Data Table 1
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Second half of the data Table 1
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4 Important Guidelines to Use the Model

1. Tools/Options/Calculations/Iterations100
2. Use Graph Button to Generate New Graphs for the
   experiment performed
3. Use Print Button for Printing the Results
4. To Reset the Model, Press the Base Case Button,
   and run the model once using the Calculations
   Button

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Policy Experiments With The Integrated Macro
Model

• Policy Experiments are comparisons of simulated
  time paths of all endogenous variables to changes
  in the values of some of the exogenous variables
  representing macroeconomic policy, such as
  government spending, taxes, or money supply.
• Three policy experiments are discussed in this
  Guide
• A Monetary-Stimulus (Inflation) Policy
  Experiment Simulated response to an increase in
  the growth of money supply from zero to a chosen
  rate of inflation (1 to 20 percent range).
• A Fiscal-Stimulus Policy Experiment Simulated
  response to an increase in real government
  spending by 50 billion increments without any
  change in taxes.
• A Neutral-Budget Policy Experiment Simulated
  response to two coordinated fiscal policy
  changes
• An increase in real government spending, (the
  same as in the second experiment).
• b. An increase in tax rates high enough to
  crowd out an exactly offsetting amount of
  consumption.

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1A Monetary-Stimulus (Inflation) Experiment
Money Growth Stops in 2012

• Rate of growth of the money supply is increased
  from 0 to 5 in 2007.
• This is done for 4 years from 2009 to 2012, and
  then money supply growth drops to 0 in 2013 and
  thereafter.

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• Money supply growth rate is a constant 5 for
  four years from 2009 2012

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GDP versus Potential
Same as
GDP Potential in Long Run
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Q A

• Q Why does GDP values fluctuate around the
  potential?
• A Interest Rate becomes cyclic which makes
  Investment cyclical
• Q So?
• A Interest rate is cyclical because inflation
  rate in the model at first is smaller than or
  lags the money supply growth rate, and then later
  overshoots it. The important thing to note is
  that if the inflation rate is equal to the money
  growth rate, then there will be no dynamics!
• Q Why does Inflation lag the money growth rate
  initially?
• A By construction, based upon historical
  evidence, there is a lag or slowness in peoples
  adjustment of their inflation expectations.
  However, this adjustment is complete i.e.
  expectations are equal to actual inflation rate
  in the long run, which is equal to the growth
  rate of money supply. Inflation is always a
  monetary phenomenon.

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• Inflation follows the money growth path, lagging
  behind at first but then over-shooting on the way
  down. Inflation, however, is equal to the growth
  rate of money supply in the long-run

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• The real interest rate becomes cyclic. At first
  it drops and then rises as P overshoots M!

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• Investment follows a cyclic path, increases in
  the short-run due to a drop in the real interest
  rate, then drops as real interest rate rises. In
  the long-run it comes back to its steady state
  value

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Comparison of Inflation and Nominal Interest
Rates Nominal Real Inflation Rate
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• Comparison of Real Interest Rate and Nominal
  Interest Rate

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• As R drops it pulls down the real exchange rate

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• Exports increase in the short-run due to a drop
  in the real exchange rate

a9 lt 0
Billions
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• Exports increase in the short-run due to a drop
  in the real exchange rate

Billions
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• Imports also increase in the short-run even
  despite a drop in the real exchange rate. Why?
  GDP has increased!

a12 gt 0
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• Imports increase in the short-run due to a rise
  in GDP which
• overpowers the negative effect of a weak exchange
  rate on imports

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• Trade deficit increases in the short-run because
  the increase in real exports is less than the
  increase in real imports (based upon values of
  alphas!)

Billions
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• Real GDP shoots above the base case value, so
  that there is a boom in the economy in the
  short-run. In the long-run, once the prices
  adjust completely, the economy is back to its
  potential GDP value

Unemployment Drops
Unemployment Rises
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• Government surplus increases because GDP
  increases result in increased tax collections,
  and government spending is assumed to be constant.

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• Consumption rises as GDP has risen!

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• Comparison of Government Surplus and Nominal
  Interest Rate

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Cont

• Comparison of Government Surplus and Real
  Interest Rate

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(No Transcript)
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A Somewhat Sequential Working of the Model
(Monetary Policy)

• As Money Supply goes up (M?), Inflation goes up
  (P?), but not as much which implies that Real
  Interest Rate falls (R?) which stimulates the
  Investment (I?).
• Also as Real Interest Rate falls (R?), the Real
  Exchange Rate falls (EXCH?) which boost Exports
  (EX?) but hurts Imports (IM?)
• Rise in Investment and Exports by GDPO identity
  means GDP increases (GDP?). Consumption also
  rises (C?) as GDP rises.
• However a rise in GDP also stimulates Imports and
  the net-effect is that Imports rise overall
  (IM?).
• Trade Deficit (NETEX?) increases because the rise
  in Imports is greater than the rise in Exports.
• Government surplus increases because GDP
  increases result in increased tax collections,
  and government spending is assumed to be constant.

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In the Long Run

• Inflation rate is exactly equal to the money
  growth rate. This means there is no change in the
  value of real interest rate which in turn implies
  no change in the other variables of the model,
  and hence no change in GDP!!

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Summary of Reactions

• Inflation follows the money growth path, lagging
  behind at first but then over-shooting on the way
  down. Inflation, however, is equal to the growth
  rate of money supply in the long-run
• The real interest rate becomes cyclic. At first
  it drops and then rises as P overshoots M!
  Investment follows a cyclic path, increases in
  the short-run due to a drop in the real interest
  rate, then drops as real interest rate rises. In
  the long-run it comes back to its steady state
  value
• As R drops it pulls down the real exchange rate
• Exports increase in the short-run due to a drop
  in the real exchange rate
• Imports also increase in the short-run even
  despite a drop in the real exchange rate. Why?
  GDP has increased!
• Trade deficit increases in the short-run because
  the increase in real exports is less than the
  increase in real imports (based upon values of
  alphas!)
• Real GDP shoots above the base case value, so
  that there is a boom in the economy in the
  short-run. In the long-run, once the prices
  adjust completely, the economy is back to its
  potential GDP value.
• Government surplus increases because GDP
  increases result in increased tax collections,
  and government spending is assumed to be
  constant.
• Consumption rises as GDP has risen!