Lecture 5: Macroeconomic Model Given to the EMBA 8400 Class South Class Room #600 February 2, 2007 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

Article: The Fed’s Thermostat WSJ: by: Milton Friedman  To keep prices stable, the Fed must see to it that the quantity of money changes in such a way as to offset movements in velocity and output  Keynes had taught them that the quantity of money did not matter, that what mattered was autonomous spending and the multiplier, that the role of monetary policy was to keep interest rates as low to promote investment and thereby full employment  Inflation, according to this vision was produced primarily by pressures on cost that could best be restrained by direct controls on prices and wages  MV = PY key a good thermostat was there all along