Lecture 5: Macroeconomic Model Given to the EMBA 8400 Class Buckhead Center April 4, 2009 Dr. Rajeev Dhawan Director

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

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

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.

Classification and Listing of Equations 1.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!  Don’t have parameters to be fitted  No error term  No theoretical disputes about their truth, only about their relevance

2. Behavioral Equations: Consumption (C), Real Interest Rate (R), Investment (I), Exchange Rate (EXCH), Exports (EX), Imports (IM), Inflation (P%) Example: Consumption (C) = α 0 * Disposable income (YDP) (Where α 0 = marginal propensity to consume = ) 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?

Endogenous and Exogenous Variables  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) B=5  In the above example, A & B are endogenous variables and C is an exogenous variable Accounting Identity Behavioral Equation

Macroeconomic Model The Exogenous Factors in the model are: – GDP Potential 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  Foreign Price Level  ROW GDP Potential

Model Simulation Approach 1.State macroeconomic theory as a complete set of algebraic equations. 2.Estimate/postulate numerical values of all parameters. 3.Assume initial conditions for the history of all lagged variables. 4.Assume “base case” values over future time periods for all exogenous variables. 5.Solve the model under base case assumptions. 6.Change some of the exogenous variable assumptions. 7.Solve the model again under alternative assumptions. 8.Compare model solutions  Base Case and the alternative policy Simulation.

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. Advantages of the Model Simulation Approach

 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: –1 Other Variable: Listing Of Variables in the Model

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 Behavioral Equation Accounting Identity

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

Glossary of Variables

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.

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

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

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

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.

Data Table 1

Second half of the data Table 1

4 Important Guidelines to Use the Model 1.Tools/Options/Calculations/Iterations=100 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

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: 1.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). 2.A Fiscal-Stimulus Policy Experiment: Simulated response to an increase in real government spending by $50 billion increments without any change in taxes. 3.A Neutral-Budget Policy Experiment: Simulated response to two coordinated fiscal policy changes: a.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.

 Rate of growth of the money supply is increased from 0% to 5% in  This is done for 4 years from 2009 to 2012, and then money supply growth drops to 0% in 2013 and thereafter. 1A: Monetary-Stimulus (Inflation) Experiment Money Growth Stops in 2012

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

GDP versus Potential Same as GDP Potential in Long Run

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 people’s 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.

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

Comparison of Inflation and Nominal Interest Rates Nominal = Real + Inflation Rate

Comparison of Real Interest Rate and Nominal Interest Rate

As R drops it pulls down the real exchange rate

Billions Exports increase in the short-run due to a drop in the real exchange rate α 9 < 0

Billions 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! α 12 > 0

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

Billions 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 Unemployment Drops Unemployment Rises

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!

Comparison of Government Surplus and Nominal Interest Rate

Cont… Comparison of Government Surplus and Real Interest Rate

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.

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!!

 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! Summary of Reactions