Dr. Imtithal AL-Thumairi Webpage: An Overview of Policy Modelling

Outline of the Talk Need for applied Policy Modelling An overview of policy modelling Best strategy in modelling Future directions Issues and challenges Discussion

Why do we need models? Complex interactions Policy matters Policies have economy wide effects Policies change behaviour Policies may have international effects Long-run effects may be larger Monitoring and analyzing policies Forecasting their impacts Modelling helps us to understand complex issues and to take better decisions

Increasing Demand & Shortage Increasing demand for quantitive analysis E.g. Kyoto agreement, WTO negotiations, financial crisis,…have global implications and potentially affect all sectors of the economy Regional policies and governments gaining influence and power Shortage / lack of tools for quantitive economic analysis

What is a Model? A set of equations Embody the history of theoretical and empirical economic knowledge Macro or/and detailed structure Key bits Identities Behavioural equations Exogenous inputs

Desiderata for policy models Relevance Link policy variables to outcomes Linking policy variables to outcomes Aggregate and structural indicators: identifying winners and losers Transparency ‘Black- Box’ Syndrome Timeliness Validation & estimation Diversity of approaches

How to use Economics Models Very carefully! Can get both quantitive estimates and new insights on complex issues

What Features are Important? Does the model take into account the specifications of the country? Does the model explain anything we observe today or in the recent past (VALIDATION)? Do the model results pass the test of common sense?

What Features are important? Are the mechanisms in the model transparent to other trained economists? Is the model continually reviewed and updated by experts who actually use it; is it open to evaluation by others?

Types of Models Accounting & regression models Input/output models Computable general equilibrium models Overlapping generations models Macro-econometric models Intertemporal macro-econometric models Intertemporal general equilibrium models Micro-simulation models Optimization models Regional models

Types of Models Input/output models Trace the flow of resources between sectors Little role for relative price changes or substitution of inputs or consumption bundles Tend to be static No allowance for capital accumulation or international financial flows Ignore the role of money and asset prices Government behaviour not properly modelled Tax structure not properly modelled

Types of Models Computable General Equilibrium Models Derived from microeconomics optimization theory Considerable attention to individual behaviour Considerable detail in the tax structure Considerable disaggregation Relatively easy to understand and results given theoretical structure Inadequate macroeconomic behaviour Tend to be comparative static or recursive dynamic

Types of Models Computable General Equilibrium Models Inadequate treatment of intertemporal saving and investment decisions, capital accumulation, financial capital flows Ignore the role of money and asset prices Rarely validated with actual experience either econometrically or through forecasting or shock replication

Types of Models Macroeconometric models Rely on correlations in time series data based on aggregate economic theory Reasonably good for short term forecasting (tend to be quarterly) Difficult to understand results because of lack of theoretical structure Unclear long run properties Government behaviour not properly modelled Tax structure not properly modelled

Types of Models Intertemporal macroeconometric models More tightly specified theory Rational expectations in some markets Short run data consistency with long run theoretical properties Tend to be quarterly Government behaviour not properly modelled Tax structure not properly modelled

Types of Models Intertemporal GE models Integrates the key features of the other types of models Mix of econometric estimation and calibration Annual frequency Problem with large degree of disaggreagtion because of complexity of the numerical algorithms needs

Types of Models Micro simulation models Extremely detailed tax/benefit structure Lack macro-economic linkages No dynamics

Types of Models Overlapping generations models Very useful for pension reform studies Usually closed economy Often one or few sectors Not detailed tax structure

Integrated use of models CGE models can be used jointly with macro models for forecasting and projections Or CGE and macro models can be fully integrated

Best Strategy in Modelling Start small! Go from small to large Start simple! Go from simple to complex Develop several models Have always two versions of the model: One operational One in development

A Strategy for the Future Short-term forecasting model General equilibrium models Sectoral disaggregation Global model for trade, energy and environment Overlapping Generations Long term work (regular updating) Human resources

Step in Applied Modelling 1. specify dimensions of the model Number of agents Number of goods and factors Number of countries/regions Number of active markets 2. chose functional forms (behaviour on markets) 3.Construct micro-consistent data set (CGE) 4.Calibration & econometrics estimation 5. replication and debugging 6. testing and fine tuning 7. counter-factual experiments, scenario and impact analysis 8. regular updating

Agents, Markets, Key Features Agents Households Firms Government institutions Markets Goods & Services Factors of production Money Financial Assets Foreign Exchange

Agents’ Behaviour & Markets How do agents behave? Microeconomics Functional forms How do markets operate? Microeconomics Industrial economics

Model Use Policy, impact, scenario analysis Forecasting Projections planning

Issues & Challenges Data Parameter specification Systematic sensitivity analysis Maximum entropy econometrics Model preselection Functional forms Expectations Capital and labour mobility Alternative terminal conditions Expectations Market structure

Expectation Myopic Adaptive Limited forward-looking expectations Perfect foresight

Market Structure Empirical evidence: Scale economies and deviations from marginal cost pricing Models with IC allow to quantify industrial organization effects, which often dominate policy debates but are not captured by PC models Inclusion of industrial organization effects may significantly affect simulation results

Alternative Models of IC Firm Conduct Specifications differ along several dimensions: Conduct: Bertrand-Cournot-Conjectural Variations- Monopolistic Competition Market Regime: Segmentation VS integration across regions Product Substitutability: Homogeneity VS differentiation across firms Alternative demand nesting hierarchies

Alternative Models of IC Firm Conduct Specifications differ along several dimensions: Conduct: Bertrand-Cournot-Conjectural Variations- Monopolistic Competition Market Regime: Segmentation VS integration across regions Product Substitutability: Homogeneity VS differentiation across firms Alternative demand nesting hierarchies