Building and Utilizing Macroeconomic Modelingfor Policy Purposes: An

Overviewby

Atchana WaiquamdeeDeputy GovernorBank of Thailand

Presented at the SEACEN-CCBS/BOE-BSP Workshop on

Dynamic Stochastic General Equilibrium Modeling and Econometric Techniques

November 23–27, 2009Manila, Philippines

22222

1.Introduction2.Macro models and DSGE

model3.Building DSGE model4.Challenges in macro

modeling 5.Conclusion

2

Outline of Presentation

33333

1. Introduction3

4The Long History of Economic Models

Analogies – clear your thinking– Adam Smith’s pin factory

Early analytical tools – simplify the issues– Alfred Marshall’s demand/supply,

Edgeworth’s box,Cournot’s model of competition, Hicks’ IS-LM analysis

Formal use of mathematics – retain the coherence– Micro: Game theory, General equilibrium – Macro: Dynamic models with optimizing and

rational agents– Empirical: Econometrics, Time-series

5Two macro revolutions

(1) Lucas critique

Role of monetary policy: anchoring inflation expectations

Expectations in previous macro models– Purely adaptive: based on what happened in the

past Rational expectations Agents do not make

systematic errorswhen predicting the future– Model parameters in fact depend on agents’

expectations of policy– Would be naive to evaluate policies based on past

aggregate data– To predict effects of policy experiment, we must

modeldeep parameters that govern individual behavior

6

Nevertheless, even in model with rational agents, role of monetary policy is limited– In reality, we do observe impacts of monetary

policy in short run Hence, emerging role of market

imperfections– Imperfect competition– Nominal frictions: price and wage rigidities

Rational expectations and New Keynesian framework– Give rise to crucial role of macroeconomic

stabilization policies– Form the basis for modern macroeconomic

models

Two macro revolutions(2) New Keynesian macroeconomics

777772. An overview of macro models

7

8

Generic uses of macro models

Examination of dynamics of macro variables– Output and its components,

employment, prices Macro models:

– Articulate and expound theoretical ideas

– Test different theories– Construct “what if” scenarios – Produce forecasts

9Using macro models in policymaking process

Policymaker must base decisions on limited understanding ofthe economy, a large and complex system

Models aim to simplify complex system but keep all salient features– Deep parameters capturing preferences, technology,

and institution factors

Good models, for policy making, should…– Be backed by a coherent and logical theory – Replicate the statistical properties of the actual time

series

Both criteria are necessary– Lack of a coherent theory leads to ‘Lucas critique’,

spurious relationships, data mining, over-fitting, and model misspecification for example

– Lack of statistical congruence leads to poor forecasting

10

Driven by theory

Driven by data

Portfolio of macro models in most central banks

DSGE model

Macroecono-metric model

VAR

Adapted from Pagan (2003), “Report on Modeling and Forecasting at the Bank of England,” Bank of England Quarterl

y Bulletin , (Spring), 60-88

■

■

■

Small New-Keynesian model■

10

Different models have different comparative advantage inwhat is required by policymakers•Those mainly

driven by data: forecasting

•Those mainly driven by theory: policy analysis

111111111111

VAR

Use econometric procedures to obtain model parameters

Emphasize fitting historical data Rely very little on theory

121212121212

Macroeconometric Model

Fit data to equations that are loosely based on theory

Typically use error correction mechanism, specifying– Long-run relationship: based on

theory– Short-run relationship: guided by

factors driving short-run dynamics While linked to theory, long-run

values– Do not depend on supply side– May not satisfy stock-flow consistency

Furthermore, model does not emphasize microeconomic agents and their expectations– Susceptible to Lucas critique

131313131313

Small New-Keynesian Model

This model borrows key results from New Keynesian economics that emphasizes market imperfections, especially, price rigidities

Model usually specified in terms of gaps—how much each variable is deviated from its long-run, equilibrium value

While model focuses on key aggregate relationships–IS relation, Phillips curve, Taylor rule, UIP condition

they lack structural features that underline aggregate dynamics

1414

DSGE Model

Neoclassical RBC models

New Keynesian imperfections

Optimizing agents

Perfect competition

Monopolistic competition

No rigidities Real and nominal rigidities

New Neoclassical Synthesis

DSGE Model = Sticky-Price RBC Model

Long runDriving forces = real factors

(e.g., technology shocks)

Short runMonetary policy does have real effects

because of price rigidities

14

1515

DSGE models characterize the workings of the economyRational expected utility-maximizing agentsand forward-looking central bankBoth demand and supply sides of the economyStock-flows consistency between various variablesin order to explainShort-run business cycle fluctuationsLong-run growth path of the economy

15

Why DSGE Models?

1616

Why DSGE Models?

DSGE models provide coherent framework

for policy analysis and forecastingProvide counterfactual experiments/simulationsAnswer questions relating to structural changesIdentify sources of shocks in the economyForecast and predict the effects of policy changesEvaluate alternative policies

16

17What can DSGE offer the policymaker?

It aims at ‘understanding’ rather than just ‘forecasting’– A rigorous structural model is required to uncover

the underlying driving forces of economic development

It imposes logical discipline on the policymaker– Effects of monetary policy works in complex ways

especially for small open economies; Interdependence of economic variables must be acknowledged

It is conceptually a natural tool for policy experiments– The framework is free from ‘Lucas critique’, and is

therefore more stable for alternative policy experiments

18

Traditional process

Policymaking process

Assumptions &risk assessment

Standard Macro-

econometric model

Inputs

Balance of risk &policy decision

Tunings Forecasts

Judgments

With DSGE

Assumptions &risk assessment

DSGE model

Inputs

Balance of risk & optimal policy

Tunings Forecasts

Judgments

Priors

Scenarios evaluation

Policy experiments

Transmissionlinkages

1919191919DSGE models at policy institutions

19

Institution/Model

Key applications

Federal Reserve Board SIGMA

Increased government spending, rising home consumption demand, falling currency risk premiums, changes in foreign demand, permanent productivity growth, reductions in labor and capital tax rates

IMFGEM & GIMF

Multi-country open economy;Fiscal analysis (GIMF)

Central Bank of ChileMAS

Contribution of shocks to business cycle,Effects of copper price shocks under different fiscal rules

RiksbankRAMSES

Scenario analysisgiven alternative interest rate paths

Bank of ThailandBOTDSGE

Macro-financial linkage:financial accelerators

2020202020Applications of DSGE Models at policy institutions

Examples of policy analysisA.E ffectiveness of alternative

monetary policy rules (Laxto n and Pesenti, 2 0 0 3 )

B.E ffects of structural reform p olicies

(Bayoumi, Laxton, and Pesenti, 2 0 04 )

C.Natural rates of output and interest(Edge, Kiley, and Laforte, 2008)

20

2121

Two-country DSGE model used to assess effectiveness

of Taylor rules in Czech Republic Key findingsRules that perform well in closed economy also perform well in another closed economy

Yet, maybe inefficient when applied to small open economies

Such rules respond too weakly to forecasts of inflation andtoo strongly to movements in output gapIn small, open, emerging economies, a modified rule that responds strongly to inflation produces better macroeconomic performance

21A. E ffectiveness of A lternativeM onetary P olicy Rules

2222

Two-country DSGE model where price and wage markup parameters of euro

area are lowered to U.S. levelsto simulate impact of increasing

product & labor market competition

Key findingsEuro area output and welfare rises significantlyThere are positive spillovers to the rest of the worldStructural reforms ease the task of monetary policymakers in euro area

Increased competition reduces nominal rigidities in euro area

Costs of stabilizing output reduced, thereby making it easierto use monetary policy in a counter-cyclical manner

22B. E ffects of structural reformpolicies

2323

A disaggregated DSGE model for U.S. economy studying

historical evolution of natural rates of output and interest

Potential output Output that would prevail absent wage and price rigidities and abstracting from shocks to markups

– Different from a more traditional view of potential outputas a smoothly evolving series

23C. Natural rates of output and interest

2424242424In short, DSGE models facilitate assessing how structural

features of the economy affect its responses to shocks

Reduced-form models If someone disagrees with predicted dynamics, it may be difficult to discuss why VARs impose very little restrictions

(just regressing on past data), making it difficult to identify what is behind model dynamics

Structural models are superior as they offer precise and coherent framework of where restrictions come from If policymakers disagree with the

results, it is possible for staffto identify what is behind them and fix them

Two-way interaction between policymakers and staff

24

2525252525

3. Building models for policy purposes

25

2626262626General Approach and Objective

Identify key features/stylized facts of economy Balanced growth path, steady-state

ratios Slow adjustments in prices and

wages Slow adjustments in GDP

components, e.g. consumption, investment

Mimic those features by incorporating in models: Calibrate key stylized facts, e.g. C/Y

= 0.60 Nominal rigidities: contractual

price/wage setting processes Real rigidities: habit persistence,

investment adjustment costs

26

27

Households

Consume and invest

Hire inputs and produce

Model environment of a baseline DSGE model

Agents

What they do

Features

Firms

GovernmentCentral

Bank

Supply labor to firms and set wage

Consumption habit persistence;

Monopolistic competitive labor market; wage rigidities

Monopolistic competitive market

Spend according to fiscal rule

Set interest rate according to monetary policy rule

Fixed proportion of nominal GDPInflation targeting

27

Invest Investment adjustment costs

price rigidity

2828

Model consists ofa)First-order conditions

and policy rulesb)Exogenous processesc)Market clearing conditionsd)Steady-state conditions

TransitiondynamicsN equationsin N unknowns

Transitiondynamics &terminalconditions

Fully/partially micro-founded behavior

Dynamic path ofmodel variablescan be solved (Think of solving a system of differential equations)

3.1. Model structure28

29

1. Firm’s input demand problem

29

Optimal inputs demanded

a) First-order conditions

micro-founded behavior

3.1. Model structure

3030

2. Firm’s pricing problem

Optimal price setting micro-founded behavior

Price rigidity parameterMarkup

parameter

characterize underlyingstructure of economy

Price in long run = markup over marginal cost

Price in short run depends on how difficult it is for firms to change prices

3.1. Model structure

32323232323.2. Model parameterization

Two broad methods Calibration Select parameters based

on empirical findingsthat result in model that best characterizes Thai economy

Estimation Potential difficulties with likelihood– limited data– structural breaks– multiple local maxima

32

33333333334. Challenges and New Directions

33

343434343434

Reliance on individual rationality Near-absence of heterogeneity Simplifying assumptions:

– Assuming perfect financial market: missing macro-financial linkage

– Assuming Ricardian equivalence: no role of fiscal policy

Approximate model solution– Missing nonlinearities originally built

in model

Potential weaknesses in DSGE models

353535353535

Not enough emphasis on financial market imperfections – Standard models focus on real

economy exclusively– Probably missing real-financial

linkage in the economy While some models study liquidity

problems in financial markets– They do not explain why some

assets that previouslywere very liquid suddenly stop being traded

Possible improvement Integrate financial imperfections in

addition to standard nominal and real rigidities in macro models—recent study by Bank of Thailand

More on last day of Workshop

4.1. Models need to strike balancebetween simplicity and complexity

36363636364.2. Model solutions need to incorporate

risks and uncertainty

36

Although DSGE models themselves admit nonlinearities,model solution relies on linearizing the model– We focus on small shocks in the neig

bourhood of steady state– Buiter (2009): We took these

models “into the basement and beat them with a rubber hose until they behaved”

In such linear quadratic framework equations describing economy are linear and objective function specifying policy goals is quadratic– Minimizing inflation and output

volatility subject to linear model

373737373737

Under these assumptions, monetary policy is certainty equivalent

– Policy responses do not depend on variances or any other aspect of probability distribution of shocks

– Mishkin (2008): In such an environment, monetary policy “does not focus on risk management”

Possible improvement Solving model using higher-order

approximation methods that retain information discarded by linearization (first-order approximation)

4.2. Model solutions need to incorporate

risks and uncertainty

38383838384.3. DSGE models need to have

good forecast performance

38

It was only until recently that DSGE models can

Track/forecast time series as well as VAR (Smets and Wouters, 2003)

Incorporate extraneous predictions and judgments consistent with underlying structure of the model (Benes et al., 2009)

Predict future path of nonmodeled variables (Schorfheide and Sills, 2009)

These improvements will help Utilize information on high-frequency

(monthly) indicators in (quarterly) DSGE models

Gain more accuracy of initial condition of forecast

More on last day of Workshop

393939393939We need macro models for policymaking process

Success of central banks rests in appropriate and timely response of monetary policy to disturbances to anchor inflation expectation

Role of modelers and forecasters is to provide clear framework of the working of economy and monetary policy transmission

Models help policymakers take appropriate action and communicate their decisions to public– Provide consistent framework to

think about forecast andto evaluate alternative monetary policy