Macroeconomic Models for the PC+L862
Author: Mr. Willem Bier

This paper describes a computer program with which one can build macroeconomic models. It is possible to specify up to eighteen behavioral equations, each with between five and eleven independent variables. For certain variables, the user can decide whether they will be endogenous or exogenous. Many policy simulations dealing with adjustment and growth issues can be performed with this program by varying any of the exogenous variables, and these experiments can be repeated for different model specifications. This paper describes a number of experiments with a model of an open economy where output and prices are endogenous.

Abstract

This paper describes a computer program with which one can build macroeconomic models. It is possible to specify up to eighteen behavioral equations, each with between five and eleven independent variables. For certain variables, the user can decide whether they will be endogenous or exogenous. Many policy simulations dealing with adjustment and growth issues can be performed with this program by varying any of the exogenous variables, and these experiments can be repeated for different model specifications. This paper describes a number of experiments with a model of an open economy where output and prices are endogenous.

I. Introduction

This paper discusses a computer program that has been developed to build macroeconomic models and to experiment with different scenarios. 2/ The intent is to provide a tool that is easy to use to simulate the impact of changes in policy, in the environment, or in the structure of the economy. The program gives the user the opportunity to construct models that capture significant aspects of the macroeconomy. It includes eighteen behavioral equations and up to thirty-five exogenous variables.

Macroeconomic models are useful to study the interaction among assumptions about the behavior of an economy, but their use is subject to several limitations. First, these models omit a considerable amount of detail necessary for a full understanding of the functioning of an economy. Second, the Lucas critique raises fundamental issues about modeling that cannot be addressed in the context of this paper. Third, there is among economists no lack of disagreement about how exactly an economy works. Fourth, the available data often does not lend itself to estimating the coefficients of a model with a sufficiently high degree of confidence. With these limitations in mind, the aim of this paper is to discuss ways in which one can investigate the possible implications of alternative assumptions about the behavior of certain macroeconomic variables.

To create a program that is easy to use, the following elements have been combined. First, the program is menu-driven. Second, the program incorporates a set of mathematical equations needed for a complete model. It is not necessary to create the accounting framework for a model, write out the behavioral equations, or solve the model. Third, an example of a model is included so that one can immediately perform simulations. This illustrative model also can be used as a stepping stone for the construction of other models.

The following five elements are needed to construct a macroeconomic model:

  • (1) An accounting framework, which is described in Section II; except for two options for different closure rules (Section VI), the accounting framework cannot be changed.

  • (2) Data for the base year, which should be supplied by the user.

  • (3) Behavioral equations for the endogenous variables, which also should be specified by the user. Section III describes the options that exist within this program for the specification of the behavioral equations.

  • (4) Definitions of other variables, e.g., relative prices. These definitions are invariable and described in Section III and Appendix IV.

  • (5) A forecast of the course of exogenous and policy variables. The user should supply the projected changes in exogenous and policy variables for a five-year projection period.

Section IV explains how certain endogenous variables can be made exogenous, and vice versa. Section V discusses the feedback mechanisms that can be part of the models built with this program.

Section VI explains how some structural changes can be made in a model and which closure rules can be modified. Section VII presents the illustrative model that comes with the program. This is a model of an open economy operating under a fixed exchange rate regime that comprises, apart from an external sector, a real sector, a financial sector, and a public sector. Finally, Section VIII discusses several simulations with the illustrative model, and two simulations with a Mundell-Fleming model with capital mobility, under fixed and flexible exchange rate regimes.

II. The Accounting Framework

The program is built on an accounting framework comprised of four sectors: the national accounts, the balance of payments, the public sector, and the monetary sector. The framework also includes an account for foreign debt. In the first four sectoral accounts a balance equation states that the use of resources is equal to the resources that are available. For the balance of payments and the public sector, the balance equations contain real resources (goods and services) and financial resources (assets and liabilities). The national accounts in this program deal only with real resources, while the monetary accounts and the foreign debt accounts comprise only financial resources.

The user must supply base-year data for all variables of a specific country, which the program fits into the accounting framework. If the value of a variable is equal to zero, that variable plays no role in the model. Similarly, if all the variables in one account are equal to zero, the entire sector will be excluded from the model. Thus, it is possible to construct a model of a closed economy, or a model without a public sector. It is not possible to add variables to the accounting framework; the options provided in the program therefore limit the size of the models. The next subsections describe each account separately and discuss the interrelations among the accounts (Table 1).

Table 1.

Interrelations among the Accounts of the Program

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Notes:1. Variables with an asterisk: these variables are always exogenous.2. Variables underlined: these represent the residual variable in the specified sector.

1. National accounts

In the national accounts balance equation, total resources available equal total expenditure:

(1)Y+M+NFSd=Cp+Ip+Cg+Ig+X+NFSc

Total resources are equal to gross domestic product (Y) and imports of goods (M) and nonfactor services (NFSd). Expenditure on goods and services is composed of private consumption (Cp), private investment (Ip), government current expenditure (Cg), government investment (Ig), and exports of goods (X) and nonfactor services (NFSc). All variables are measured in monetary units; in principle, they are all endogenous and described by a behavioral equation (Section III), except private consumption, which is the residual in this balance equation. The endogenous variables described by a behavioral equation can be changed to exogenous variables (Section IV).

In the national accounts section of the program, the user needs to supply base-year data only for GDP and private investment. Because of the links that exist among the various accounts, all other data in the national accounts are automatically imported from the other accounts in the system, in particular from the balance of payments and the public sector accounts.

2. Public sector

The balance equation of the public sector can be written in a familiar way which says that the overall budget balance is equal to the financing available:

(2)Cg+Ig+INTgTiTgTmTs=Bfg+dCREDg+Bnb

The budget balance is equal to total expenditure minus total revenue. Total expenditure consists of current expenditure (Cg), investment expenditure (Ig), and interest on foreign public debt (INTg). Total revenue is the sum of taxes on income and profits (Ti), taxes on goods and services (Tg), taxes on imports (Tm), and stabilization revenue (Ts). Net foreign borrowing by the government (Bfg) equals disbursements plus debt relief, minus scheduled amortization (see the debt accounts). Domestic borrowing is net borrowing from the banking sector (dCREDg) and net borrowing from the nonbank private sector (Bnb).

The variables that are described by a behavioral equation are: current expenditure, investment expenditure, taxes on income, taxes on goods, and taxes on imports. Interest on foreign debt depends on the interest rate and the stock of foreign debt. Stabilization revenue, which is also endogenous, accrues to the public sector if a marketing board sets certain prices at a different level from world market prices (Section VI).

The exogenous variables in the public sector are: net foreign borrowing and domestic nonbank borrowing. Net borrowing from the banking system is the residual in the balance equation and endogenous.

3. Balance of payments

The accounts of the balance of payments state that the sum of the current account (the first term in parenthesis below) and the capital account (the second term) equals the change in net foreign assets (dNFA):

(3)(X+NFScMNFSdINTgINTp+TR)+(Bfg+Bfp)=dNFA

The current account is defined as exports of goods (X) and nonfactor services (NFSc) minus imports of goods (M) and nonfactor services (NFSd), minus interest on public (INTg) and private debt (INTp), plus unrequited transfers (TR). The program provides the signs as shown above. The user should input only positive numbers, unless the opposite sign is required. The assumption is that the country pays net interest on private and public foreign debt and receives net transfers from the rest of the world; if any of these assumptions do not apply, the base-year data should be preceded by a negative sign.

Exports, imports, and NFS are endogenous and are described by a behavioral equation. Interest payments due are also endogenous, depending on the rate of interest and the stock of debt. Transfers are exogenous.

The financing consists of net foreign borrowing by the public sector (Bfg) and net foreign borrowing by the private sector (Bfp). Public sector borrowing from the rest of the world is exogenous, while private sector borrowing can be endogenous. The balancing item is the change in net foreign assets (dNFA).

4. Monetary sector

In the monetary sector total assets are equal to total liabilities:

(4)NFA+CREDg+CREDp=MQM+OIN

Total assets consist of net foreign assets (NFA), net credit to the public sector (CREDg), and credit to the private sector (CREDp). All these variables are endogenous, with net foreign assets depending on the outcome of the balance of payments and credit to the public sector depending on the outcome of the budget. Credit to the private sector is described by a behavioral equation.

The variable “Other Items Net” (OIN) is exogenous, leaving the supply of money and quasi-money (MQM) as the residual.

5. Foreign debt

The foreign debt accounts trace the level of public and private foreign debt, starting from the historical level in the base year:

(5)DEBTg(t)=DEBTg(t1)+Bfg

The stock of public debt at the end of the current year [DEBTg(t)] equals the stock at the end of the previous year [DEBTg (t - 1)], plus net foreign borrowing by the public sector (Bfg).

(6)Bfg=DfgAfg+DRfg

Net foreign borrowing is composed of disbursements (Dfg) minus amortization (Afg), plus debt relief (DRfg); all these variables are exogenous.

Private foreign borrowing (Bfp) is defined as the difference between the private debt stock at the end of the year [DEBTp(t)] and the stock at the end of the previous year [DEBTp(t - 1)]

(7)Bfp=DEBTp(t)DEBTp(t1)

The stock of debt is endogenous and described by a behavioral equation.

6. Interrelations among the accounts

The interrelations among the accounts are mostly conventional (Table 1). The model includes the national accounts, the public sector, the balance of payments, the monetary accounts, and a section on foreign debt. Accounts for the private sector are implicit.

Data for imports and exports of goods and nonfactor services are in principle identical in the balance of payments and in the national accounts, according to the Balance of Payments Manual and the System of National Accounts (SNA). The computer program treats them as such. The user supplies these data for the base year only in the balance of payments, and they are automatically transferred to the national accounts.

The computer program treats current expenditure of the public sector (exclusive of interest on foreign debt) as identical to the national accounts’ concepts of public consumption. Similarly, public investment in the public sector account and in the national accounts are treated as identical. While there are differences in the definitions of these variables in the SNA and the Government Finance Statistics Manual, this approach has been adopted to simplify the program. This choice has no implications for the functioning of the models built with this program. The data for current and investment expenditure should be entered in the public sector accounts; they are then automatically incorporated into the national accounts.

Interest on the public debt is identical in the government accounts and in the balance of payments. Net foreign borrowing by the government is identical in the public sector, the balance of payments, and in the debt accounts. Data for the base year are entered in the debt section. The change in net credit to the public sector, which is a residual in the public sector accounts, is transferred automatically to the monetary survey.

The change in net foreign assets is identical in the balance of payments and in the monetary accounts. The change in net foreign assets, dNFA, is calculated in the balance of payments and valued in SDR. This value, multiplied by the exchange rate, is used in the monetary accounts to calculate the end of year stock of net foreign assets. The program recognizes only one exchange rate so there is no distinction between period average and the end of period rate. Any changes in the stock of NFA in local currency due solely to changes in the exchange rate, in this program, are accounted for in other items net (OIN); this does not cause any change in OIN, however, because the counterpart of valuation changes is also recorded here. This approach differs from the standard treatment of valuation changes, by which valuation changes are reflected in the stock of NFA in local currency, with a counter-entry in OIN. The approach adopted here has no effect on the functioning of the system; changes in the value of NFA due to exchange rate changes do not impact on the money supply in either case, which is a crucial variable in the system. The level of net foreign assets in SDR can be calculated as the stock in the base year plus the outcome of the balance of payments during the projection period.

III. Behavioral Equations

There are eighteen behavioral equations in the program. The program offers several options for the specification of each equation. For each dependent variable, the user can choose the independent variables from a list of variables often used in the economic literature (Table 2). The worksheets for each equation also offer the possibility of specifying a lag structure and a constant term. The standard form of a behavioral equation is as follows:

(8)Y(t)=aX(t)+bZ(t)+c
Table 2.

Behavioral Equations: Options for Independent Variables

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In this equation, Y(t) is the dependent variable in year t, while X(t) and Z(t) are two independent variables, with parameters a and b. There could be more or fewer independent variables, as needed. The constant term c has no time subscript; it is constant for all years. To incorporate an independent variable into an equation, one has to assign a value (other than zero) to the parameter of that variable; if the parameter is zero, the independent variable plays no role in the model. If all parameters in an equation are zero, the entire equation is absent from the model.

In the interest of uniformity, most variables in the program are measured as the annual change in the referenced variable, in percent. This means that the parameters are partial elasticities, while the constant term in each equation is in percent of the dependent variable. The program automatically assigns a positive sign to each parameter. If a negative sign is required, it should be typed in with the value of the parameter.

There are a few exceptions to the rule that the variables are measured as the change in percent, although even then all are expressed in percent. The exceptions are the following:

  • a. Excess capacity is the difference between installed capacity and actual output, in percent of actual output.

  • b. Excess money supply is the difference between the supply of money and the demand for money, in percent of the demand for money.

  • c. The inflation rate variable in the money demand equation is the difference between the rate of change in the price index in the current year and in the previous year, both expressed in percent. 3/

  • d. The interest rate in the money demand equation is the difference between the interest rate in the current year and in the previous year. The interest rate is an exogenous variable in the program.

  • e. Domestic arrears are defined as the change in domestic arrears expressed in percent of GDP.

  • f. The ratio of reserves to imports in the import functions is the change in net foreign assets in percent of imports.

In the remainder of this section, we discuss the options available for the specification of the equations.

1. Equation for real GDP

Real GDP, or actual production, can be a function of both demand and supply factors. The demand could be described by a reduced form equation of a submodel of the economy that might have the following structure:

(9)Y=Cp+Ip+G+XM
(10)Cp=c(YT,EMS)
(11)M=m(Y)

In this model, GDP (Y) is the sum of total demand, with private consumption (Cp) depending on income after taxes (Y–T) and on excess money supply (EMS). 4/ Private investment (Ip), government expenditure (G), exports (X), and EMS are exogenous in this submodel.

The reduced form equation is:

(12)Y=y(Ip,G,X,EMS)

This equation is similar to an IS curve, and represents all combinations of Y and EMS for which production equals demand. It contains a link between the monetary sector and production.

Other variables could affect demand and they could thus be included in the equation for GDP. These variables include the availability of credit to the private sector and autonomous tax changes. Autonomous tax changes are defined as the percentage change in tax receipts resulting from a change in policy. Changes in disposable income could affect output with a lag of one year. Disposable income of the private sector (DY) is defined as GDP (Y) plus transfers from the rest of the world (TR), minus the sum of all government revenue (T), private sector interest payments to the rest of the world (INTp), and the increase in public sector arrears during the current year (AR). The accumulation of arrears is forced lending, which may have similar effects as an increase in taxes. The definition is as follows:

(13)DY=Y+TRTINTpAR

On the supply side, three factors could cause a change in output: (1) an increase in productive capacity could stimulate actual production if the demand is not a binding constraint; (2) the existence of excess productive capacity might have the same effect; and (3) a change in the real exchange rate could affect the production of tradables. The equation also includes the dependent variable with a lag of one year, and a constant term, expressed in percent of the dependent variable; this will be the case for all the behavioral equations in the program.

2. Equation for real productive capacity

The productive capacity (Q) in this program can be a function of both public and private investment. A standard lag of one year is included.

Excess capacity (EC) is an argument in the equation for real GDP. It is the difference between the productive capacity (Q) and actual output (Y), expressed in percent of actual output.

(14)EC=QYY×100

The excess capacity can be either positive or negative; it is inversely related to unemployment.

3. Equation for real private investment

Independent variables that can be included in the investment function are real output, real exports, real bank credit to the private sector, and excess productive capacity. The elasticity for the last variable is expected to have a negative sign.

4. Equation for prices

The money supply and the cost of imported goods are most often used as independent variables in a price function, with or without a lag. The cost of imports depends on three factors: foreign prices of imports, the nominal exchange rate, and import taxes. Several studies mention an excess supply of money as a factor that can have an upward impact on prices, while excess productive capacity can have a downward impact on prices. Finally, changes in domestic arrears of the public sector to the private sector, which can be a problem in certain countries, could put upward pressure on prices.

5. Equations for taxes

The three tax equations in the program offer identical options for independent variables: nominal GDP, imports, and exports. The lag can be zero or one year. If both lags are selected simultaneously, the total lag is less than a full year. The government also may obtain revenue from price stabilization, which is described in Section VI.

6. Equations for government expenditure

Government expenditure is often treated as exogenous in macro models, although there are exceptions. The equations in the program, one for current expenditure and one for investment expenditure, may be interpreted as policy rules adopted by the authorities. Significant factors that may influence the level of government expenditure are the evolution of the economy, represented by GDP, and government revenue. The exchange rate may affect certain expenditure categories and price developments also can have an impact. In the definition used, current expenditure excludes interest on foreign debt, which is a separate item in the public sector accounts. It is possible to define government current and investment expenditure as exogenous variables (see Section IV).

7. Equations for real imports

There are two import categories in the program, and thus two equations for imports, which may be used together or singly. The traditional arguments in an import demand function are real GDP and relative prices of imports. The relative price of imports (PmREL) is the ratio of the local currency price of imports to the domestic price level. The elasticity for the relative price of imports is presumably negative, but the sign needs to be supplied with the value of the coefficients. Import prices in local currency depend on foreign prices, the nominal exchange rate, and import taxes. Each import category has its own foreign price in SDR (Pml, Pm2). The local currency price is obtained by multiplying these with the nominal exchange rate (NER, measured in local currency units per SDR). In addition, import taxes affect the local price of imports; “tm” is the import tax rate. The definition is as follows:

(15)PmREL=Pm×NER×(1+tm)P

The demand for imports also can be a positive function of excess money supply. Furthermore, it is sometimes assumed that import controls are tightened or relaxed depending on the level of reserves compared with imports; in the import functions used in the program, a change in the reserve ratio can cause a change in real imports. The change in the reserve ratio (RR) is the change in NFA (dNFA) over total imports in the previous year [M(t - 1)].

(16)RR=dNFAM(t1)×100

8. Equations for real exports

There are also two equations for exports. Using the small country assumption, the supply of exports depends on relative export prices (PxREL) and productive capacity. The relative price of exports is defined as the ratio of export prices over domestic prices (P), both in local currency. Lags of up to two years can be incorporated. Export prices in local currency depend on foreign prices (Px) and the nominal exchange rate (NER.) The definition is as follows:

(17)PxREL=Px×NERP

Changes in foreign demand can be incorporated in the equation either in the constant term, or as an exogenous change in exports.

9. Equation for nonfactor services

Nonfactor services (NFS) would normally depend on the volume and value of trade. The program differentiates between payments and receipts, in order to be able to calculate the debt service as a ratio of exports of goods and nonfactor services. Payments for services in the program can be a function of imports, while receipts can be a function of exports. Receipts and payments can also grow at separate and constant rates, using the constant terms in the equation. If necessary, NFS net can be exogenous. Then data on the rate of change would need to be supplied under “Instruments”; this rate would be the rate of change of NFS net, implying that receipts and payments change at the same rate.

10. Equation for private foreign debt

This equation describes the evolution of the stock of private foreign debt. Net private capital inflows or outflows during the year are calculated as the difference between the stock of debt at the end of the current year and the stock at the end of the previous year. The flows are shown in the capital account of the balance of payments. Private foreign debt can vary depending on the economic situation in the country as represented by GDP, imports, or private investment. It can also vary because of an excess supply of money, which impacts on interest rate differentials. Finally, changes in the exchange rate could play a role in determining private foreign debt, if they are viewed as foreshadowing future exchange rate developments.

11. Equation for nominal exchange rate

The nominal exchange rate (NER) is the number of local currency units per SDR.

(18)NER=UnitsoflocalcurrencySDR

There is only one exchange rate in the program; thus there is no distinction between the end of period and the period average exchange rate. A depreciation increases the nominal exchange rate.

The real exchange rate (RER) is the ratio of domestic prices (P) over world prices (WP), expressed in local currency.

(19)RER=P(WP×NER)×1000

The base year value is set at 1000. A depreciation of the real exchange rate reduces its value. The world price (WP) is an index of world prices in SDR, which is exogenous.

The nominal exchange rate can be determined in three different ways in the program:

  • 1. The exchange rate can be endogenous and determined by the equation in the program. In that case, the exchange rate depends on past changes in relative prices, domestic prices, and excess money supply. This equation may reflect a policy rule adopted by the authorities.

  • 2. The exchange rate can be exogenous.

  • 3. The exchange rate can also float, and thus be endogenous. In that case, the exchange rate is determined by a simulated auction described in Section VI.

12. Equation for credit to the private sector

This equation also defines the path of a stock variable while the program calculates the related flow variable, similar to private foreign debt. Credit from the banking sector, like foreign debt, is a source of financing for the private sector, which may depend on economic activity, and thus relate to GDP, investment, and imports. When domestic payment arrears from the public sector change, they can affect the demand for bank financing by the private sector, which banks may accommodate.

13. Equation for real demand for money

The real demand for money (also a stock variable) traditionally depends on real GDP and the rate of interest. Often, the opportunity cost of holding money is also represented by the rate of inflation. The real demand for money and real GDP are measured as the percentage change in these variables. The rates of interest and inflation are measured as the first difference.

Excess supply of money (EMS) is the difference between the supply of money (MQM) and the demand for money in the previous period [MD(t - 1)] in percent of the demand for money. The supply of money is equal to the sum of the assets of the banking sector (minus “Other items net”), while the demand for money follows from the behavioral equation.

(20)EMS=MQM(t)MD(t1)MD(t1)×100

This is the standard definition found in the literature, where the lag of one period is usually one year. This definition has been adapted to the particular solution technique of the program (Appendix III), where a lag of one period can be less than one year, depending on the number of iterations. With twelve iterations, the lag is one month. The advantage of the shorter lag is that both supply and demand factors can affect EMS during the year. The excess supply of money can be positive or negative.

IV. Exogenous and Endogenous Variables

There are thirty-five exogenous variables in the program. The user defines the course of these variables for all five years of the projection period. This is done by selecting “Instruments” from the main menu. Approximately half of these variables will always be exogenous in this program, but for eighteen of them, the user must decide whether they are exogenous or endogenous. These are the eighteen variables described by the behavioral equations. Even if these variables are endogenous, it is still possible to steer them exogenously.

Recall that the form of a behavioral equation is as follows:

(21)Y(t)=aX(t)+bZ(t)+c+d(t)

This is the form discussed in Section III, to which we have now added a final term d(t). The term d(t), which is similar to a constant term except that it may vary over time, represents an exogenous change in the dependent variable. With the addition of this term to the equations, the following options exist:

1. The variable is exogenous if all parameters (a and b) are zero. An exogenous variable is controlled in the section “Instruments.” Here one can set a rate of change for that variable for all five years of the projection period by assigning a value to d(t). The rate of change can be different in each year, but it can also be the same for all years.

2. A variable described by a behavioral equation is endogenous if one or more of the parameters (a or b) in the equation is different from zero. If the variable is endogenous, a constant term (c) may be added to the equation, and it is possible to influence its course exogenously by assigning a value to the term d(t). This is done by supplying data for an exogenous change in the variable in the section “Instruments”. These exogenous changes are in addition to the endogenous changes that are calculated by the equation. This feature can be important, for example, if there is an exogenous change in taxes when tax revenue is otherwise endogenous.

Like the endogenous variables, the exogenous variables are defined as the annual change in percent of the variable. There are a few exceptions to this rule:

  • a. Data relating to foreign debt are defined as flows measured in SDR.

  • b. The interest rate on foreign debt is the rate of interest in percent, not a change in the rate of interest.

  • c. The domestic interest rate that appears in the worksheet for the monetary sector is the first difference in the domestic interest rate. This variable is intended only for the demand for money function.

It should be noted that private foreign debt follows the rules and is measured as the percentage change in the stock of private foreign debt.

The term “old debt” is used for the stock of foreign debt of the public sector at the end of the base year, measured in SDR. The stock of old debt decreases over time as the debt is amortized, but it does not increase; amortization is an exogenous variable. “New debt” is the public foreign debt accumulated during the projection period. It is equal to the sum of disbursements minus the sum of amortization payments scheduled on new debt. Both are exogenous variables. The “consolidated debt” is the stock of debt that results from rescheduling of debt service falling due, minus any amortization projected on the rescheduled amount. Both debt rescheduling and amortization of the consolidated debt are exogenous.

V. Feedback Mechanisms

Models built with this program can have four different feedback mechanisms, which are often found in macro models in one form or another. A feedback mechanism takes information that originates in a part of the system and passes it back, changing the original situation. In some cases, feedback destabilizes the system by amplifying the original disturbance, but in other cases it has a stabilizing function. While feedback mechanisms involve several variables of the system, certain variables play a key role. For expositional purposes, the mechanisms may be associated with the following four variables:

  • - income

  • - excess money supply

  • - prices of home goods

  • - excess capacity

To include a specific feedback mechanism as part of a model, it is necessary to make sure that the key variable is endogenous and impacts other variables in the model.

1. Income

The variable income plays an important role in almost any macroeconomic model, since it controls tax revenue, spending, imports, and other variables. Those variables in turn can determine income. In Keynesian models, the multiplier captures the feedback from income, which often magnifies an initial disturbance. The feedback through income also plays a role in determining the budget deficit and the balance of payments, where it usually mitigates an original disturbance. For example, an increase in government expenditure causes an increase in income, and thus in taxes, limiting the initial increase in the budget deficit. Similarly, an increase in exports improves the current account and raises income, which raises imports, partly reversing the initial improvement in the current account.

In the models built with this program, the feedback stems from the direct link that can be created between income and private spending, public spending, and exports in the equation for GDP. Since the equation for GDP is a reduced form equation, its coefficients capture the multiplier effects. There is a feedback from changes in demand if one of the following variables is included in the equation for GDP: government expenditure, private investment, credit to the private sector, excess money supply, disposable income, and exports.

2. Excess money supply

The role of the excess money supply variable is analogous to that of the interest rate in economic models in that it helps achieve equilibrium in the money market. It is defined as the difference between the supply of money, determined by credit policy and the outcome of the balance of payments, and the demand for money, determined by a demand for money function. The demand and supply of money in this program are not necessarily equal, but excess money supply (or a shortage of money) can set in motion changes throughout the economy that may reduce the excess money supply and thus restore money market equilibrium. An increase in the supply of money can stimulate domestic demand for goods and services and the demand for foreign assets, depending on whether the demand for goods and assets is sensitive to what has been called the “curb” rate of interest. 5/ If an increase in excess money supply results in an increase in production, the demand for money will increase, thus reducing the original excess supply. If the demand for foreign assets is sensitive to the “curb” rate of interest, an increase in excess money would provoke an outflow of capital, thus also reducing the excess money supply. It is also possible that the excess money supply stimulates inflation, which would reduce the real demand for money and the real money supply, with an uncertain impact on excess money. Finally, excess money could cause imports to increase, which would reduce net foreign assets and thus the money supply.

3. Domestic prices

Domestic prices in many models are a function of the money supply and they play a role in the determination of the balance of payments and the budget. A change in the balance of payments or in the budget can feed back into the money supply, and thus affect prices again. Prices could either stabilize the economic situation following an expansion in the money supply or destabilize it, depending in particular on the budget parameters.

Higher inflation, due, for example, to an increase in the stock of money, can increase the balance of payments’ deficit, which stabilizes the system by reducing the initial expansion in money. Inflation could also increase the budget deficit, particularly if taxes are collected with a lag while expenditures are indexed to current prices. If the increased deficit is financed by bank credit, the feedback will be destabilizing with prices rising out of control.

4. Excess capacity

Excess capacity is the difference between productive capacity and actual production. Excess productive capacity can negatively impact on prices and on private investment, which in both cases can reduce the initial disequilibrium. A reduction in prices can stimulate exports and domestic demand and raise actual production, changing the allocation of resources in the process. A reduction in investment, due to excess capacity, will gradually reduce the excess by limiting the creation of new productive capacity. 6/

VI. Options

The item “Options” in the main menu provides choices regarding the structure of the economy and closure rules.

1. Fixed producer prices for exports

In some countries, a marketing board fixes the producer prices of certain export products. The marketing board is considered part of the public sector. If export prices in local currency, which depend on foreign prices of exports and the nominal exchange rate, exceed producer prices paid by the marketing board to producers, the public sector receives the difference as stabilization revenue. If the price difference is reversed, the board pays producers a subsidy, which is accounted for in the program as negative revenue.

In the program it is possible to create a situation where a marketing board fixes producer prices of the first export category (Exports 1). The user will be prompted to indicate the level of producer prices in the base year and the changes in those prices during the projection period. The producer price is defined as the total cost to domestic agents of production, transportation, storage, transformation, taxes etc., so that the difference from the export price, which accrues the government, is net of any costs. Foreign prices of exports are exogenous. Stabilization revenue is calculated as the difference between export prices and producer prices (both in local currency) times the volume of exports.

If producer prices are controlled by the marketing board, relative prices of exports, in the equation for Exports 1, refer to the ratio of producer prices in local currency over domestic prices of all goods and services. Thus, the supply of exports depends on the relative producer prices. However, when producer prices are not controlled by the marketing board, the supply of exports depends on relative export prices.

2. Fixed consumer prices for imports

Sometimes, the government, or one of its agencies, also controls consumer prices of certain imports. In the program it is possible to create a situation in which local consumer prices of Imports 1 are controlled by the government. If there is any difference between local currency prices of imports paid by the government and the prices it charges the public, revenue accrues to the government’s budget, or it pays a subsidy.

If local prices are controlled, relative import prices in the equation for Imports 1 refer to the ratio of controlled prices to domestic prices. Thus, the demand for imports depends on the prices fixed by the government. In case prices of imports are not controlled, the demand for imports will depend on market-determined import prices.

3. Floating exchange rate

It is possible to choose between a fixed and a floating exchange rate regime. If a fixed exchange rate regime is chosen, the exchange rate is exogenous or it is determined by certain policy rules. When a floating exchange rate regime is chosen, the program emulates a foreign exchange auction, which takes place at the end of each subperiod. 7/ At the time of the auction, the supply and demand for foreign currency during the past period are compared with each other, and the program calculates the nominal rate at which there would have been equilibrium, given the demand and supply elasticities provided by the user. This nominal exchange rate is then fixed for the next period and used for all transactions during that period, until the next auction. In a freely floating system, the balance of payments is in equilibrium; however the auction does not result in perfect equilibrium in the balance of payments for the year as a whole, because of the one-period lag. For each subperiod a fixed regime exists in the program; the rate is automatically adjusted at the beginning of every subperiod. In most situations, the annual change in net foreign assets will be small.

The supply and demand elasticities that play a role in this process are the elasticities for relative prices in the import and export equations, without a lag. They are weighted for the relative importance of each category of imports and exports. In addition, the elasticity of the exchange rate in the function for private foreign debt is also taken into account. If all these elasticities are zero, it is impossible for the market (auction) to bring demand and supply into equilibrium and find the equilibrium exchange rate. In that case, the program reverts to a fixed exchange rate regime. If the elasticities are very small, although different from zero, the program also may not be able to find an appropriate solution for the exchange rate.

4. Balance of payments gap

The closure rules in a model govern which endogenous variables are determined by behavioral equations, and which variable is the residual in the balance equations. In the models built with this program, the residual variables are private consumption (in the national accounts), net bank borrowing by the government (in the fiscal sector), the change in net foreign assets (in the balance of payments), and the money supply (in the monetary sector.)

In this section of the program, it is possible to choose a different closure rule for the BOP by which the change in net foreign assets is exogenous, reflecting the fact that this is a target of economic policy. The user will be prompted to enter the target for the projected change in NFA. As the change in NFA, which used to be the residual, now becomes exogenous, another residual variable needs to be defined, because the model would otherwise be overdetermined. The new residual variable is the BOP gap, which reflects a shortage in BOP financing given the current account deficit, the capital account, and the constraint on reserves.

When there is a BOP constraint there is an implied limit on government bank borrowing, because, with a given demand for money and credit to the private sector, credit to the government needs to be in line with the BOP constraint. The program has been designed to ensure that in this case the BOP gap is equal to the fiscal gap. This results in net bank borrowing by the government being reduced by the amount of the gap. There is no impact on the money supply from selecting the closure rule, and the BOP and the public sector accounts each include an unidentified and equal financing gap.

5. Fiscal gap

A different closure rule should be adopted when the government, has limited access to the banking system so that net bank borrowing is exogenous. The new residual variable is the accumulation of domestic payment arrears of the public sector, the counterpart entry of which is in the private sector accounts. The user is prompted to specify the maximum access of the government to bank credit for the projection period. When there is a fiscal constraint because of a statutory limit on government bank borrowing, this may result in containing the BOP deficit, but it does not mean that there is necessarily a BOP constraint; the country could very well have plenty of reserves. In the program, once a limit on credit to the government has been defined, it is not possible to define a separate limit on the change in NFA.

VII. An Illustrative Model

The illustrative model in the program may be summarized as follows (Table 3). Output is demand determined and private investment depends on income. The evolution of domestic prices depends on monetary factors and import prices, although prices adjust slowly. In the public sector, taxes depend on output and imports, both in nominal terms, and expenditures are related to nominal GDP with a lag of one year. The balance of payments section shows traditional equations for imports and exports; imports depend on domestic demand and on relative import prices, while exports depend on relative export prices. Credit to the private sector depends on GDP, while the demand for real money depends on real GDP and the rate of inflation. For this illustrative model, values for the elasticities were chosen that are also purely illustrative. Some of these values come from among the values reported in the literature. Others were chosen to ensure adequate feedback in the system as a whole. The user can customize all these elasticities and select values that are deemed more appropriate for the simulations that are desired. Appendix VI shows the baseline scenario with the illustrative model; this table has been prepared using the print facility included in the program. The results of any simulation can be printed and viewed on the screen; see Appendix I. They can also be imported into a Lotus file; see Appendix II.

Table 3.

The Illustrative Model

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VIII. Simulations with the Illustrative Model

In the experiments discussed below, the illustrative model is used, first, to generate a baseline scenario, and second, to simulate the impact of changes in policy or in exogenous variables. Each table below shows the difference between the simulation and the baseline scenario for selected variables. A positive sign means that the variable in the simulation has a higher value than in the baseline scenario.

1. An increase in credit to the private sector

In the first simulation, there is an exogenous increase in credit to the private sector of 20 percent in 1992. This increase is in addition to the increase that occurs in the baseline scenario.

The experiment shows that an increase in credit causes inflation, has a positive effect on GDP in the first year, and worsens the current account of the balance of payments (Table 4). The increase in credit raises the rate of inflation through its effect on the money supply and excess money. An excess supply of money stimulates demand and GDP rises as a result, but not for very long, because the two following factors work in the opposite direction: (1) inflation lowers the competitiveness of exports, which has a negative effect on domestic production; and (2) inflation reduces real government expenditure. In the current example, nominal government expenditure depends on nominal GDP with a lag of one year. This implies that cash limits are in effect, so that higher inflation reduces real expenditures.

Table 4.

Simulation: Increase in Credit to the Private Sector (Difference from Baseline)

(Annual percentage change or ratio)

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Due to the loss of competitiveness, imports increase in real terms while exports decrease, thus worsening the balance of payments. This feeds back into the money supply which now contracts compared to the baseline, reversing the initial increase in money and, consequently, in the rate of inflation.

2. An increase in the price of the main export product

In this simulation, the foreign price of the main export product increases by an additional 20 percent in 1992. The increase in the price of the main export product improves the balance of payments and initially stimulates domestic demand and thus production. However, inflation accelerates and crowds out other exports (Table 5).

Table 5.

Simulation: Increase in Price of Main Exports (Difference from Baseline)

(Annual percentage change or ratio)

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The increase in export earnings in the first year raises the money supply and excess money, which increases prices and real GDP, just as in the first experiment. Unlike in the first experiment, the balance of payments now improves. The main export product has become more attractive and, after a one-year lag, output in this sector increases, stimulating GDP further. The second export sector, however, will at some point begin to lose its competitive position due to higher inflation, which reduces production in that sector, with a dampening effect on GDP. This experiment illustrates a case of “Dutch disease,” in which the success of one large export sector can be detrimental for other exports due to an appreciation of the real exchange rate.

3. An increase in the price of exports while the producer price is controlled

In this simulation, a government marketing board purchases the main export product from producers for a fixed price and sells this product abroad for the world market price. The marketing board receives revenue from its stabilization activity if the world market price exceeds the producer price; in the opposite case it subsidizes producers. 8/

Here, an increase in the world market price of exports does not affect the economy other than by increasing the stock of net foreign assets (Table 6). As in the previous case, the balance of payments improves, but now the additional income is not passed on to producers. Instead, it accrues to the marketing board, which improves public sector finances. Since net credit to the public sector is a residual, the increase in revenue leads to a reduction in net credit. That reduction in domestic assets of the banking sector is equal in size to the increase in its net foreign assets, so that the additional export receipts are sterilized entirely. Prices, demand, and money are the same as in the baseline scenario.

Table 6.

Simulation: Increase in Price of Exports while Producer Price is Controlled (Difference from Baseline)

(Annual percentage change or ratio)

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4. Devaluation

In this simulation, a one-time devaluation of 20 percent in 1992, accompanied by no other measures, improves the balance of payments, raises the level of prices, and initially reduces the rate of growth of GDP (Table 7). Through its effect on relative prices, the devaluation reduces the demand for imports and increases the supply of exports, thus improving the current account of the balance of payments. Given the lag structure, the improvement occurs immediately in year One but continues into year Two.

Table 7.

Devaluation (Difference from Baseline)

(Annual percentage change or ratio)

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Domestic prices rise as the cost of imports go up. This rise is sustained by the increases in net foreign assets and money that result from the improvement in the balance of payments. The increase in inflation has a negative effect on real domestic absorption and thus on production. Absorption is reduced in this model since nominal government expenditure does not adjust to the new inflation rate until the next year. Real government expenditure therefore falls in year One. However, this reduction in real demand is cushioned by the increase in exports and the emergence of an excess supply of money. In year Two, because of a delayed supply response to the improvement in relative prices, exports grow faster and the rate of growth of GDP increases again.

The higher rate of inflation limits the improvement in the real exchange rate and over time the real exchange rate returns to the level in the baseline scenario. However, if the devaluation is accompanied by a more restrictive monetary policy that aims at limiting the increase in money, the rise in domestic prices can be contained. This will have a more positive effect on the real exchange rate and the growth of exports.

5. A fiscal expansion

In this simulation, total government expenditure—excluding interest on foreign debt—increases by an additional 10 percent over the baseline scenario, which is financed by domestic nonbank borrowing. This has a limited effect on GDP as private spending is crowded out (Table 8).

Table 8.

Simulation: Fiscal Expansion (Difference from Baseline)

(Annual percentage change or ratio)

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The increase in real government expenditure increases demand for goods and services produced at home and abroad. Given the parameters, production should have increased by 2 percent due to the increase in government expenditure. However, the demand for money increases while the money supply has not changed, which depresses demand. The deterioration in the balance of payments reinforces this, since it reduces net foreign assets and thus the supply of money. Because of these developments, production only increases by 1.4 percent. The model emulates an IS/LM model where a pure fiscal expansion increases the interest rate, which crowds out private spending. As the fiscal expansion is financed by borrowing from the nonbank sector, and not by creating money, there is no inflationary effect of this policy.

6. An increase in the foreign price of imports

This simulation shows that an increase in import prices of 20 percent worsens the balance of payments and can cause a depression and perhaps simultaneously higher prices, although the latter outcome is uncertain (Table 9).

Table 9.

Simulation: Increase in Foreign Price of Imports (Difference from Baseline)

(Annual percentage change or ratio)

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The model confirms that an increase in import prices can cause a depression as demand falls. This comes about because of a decrease in the money supply. Given that the price elasticity of imports is less then one, nominal imports rise, although real imports fall, which increases the overall balance of payments deficit and reduces the money supply. As the tax base of import taxes rises, revenue increases and credit to the government falls, which leads to a further reduction in the money supply. Essentially due to the fall in the money supply, the rate of growth of production is lower in the first two years compared to the baseline; afterwards it returns to the baseline because of the reduction in the inflation rate.

This simulation shows that domestic prices do not necessarily rise when import prices rise, depending especially on the reduction in the money supply and its effect on the rate of inflation. In the first year, the rate of inflation is practically the same as in the baseline, since the two opposing forces, higher foreign inflation and a lower money supply, are of equal strength. In subsequent years the rate of inflation is lower than in the baseline scenario because of the continuing decline in the supply of money.

7. An increase in taxes on imports

Increasing taxes on imports improves the balance of payments, causes higher inflation in the first year, and depresses domestic production (Table 10). The immediate impact of this change in policy is to raise revenue per unit of imports and to raise the domestic price of imports, causing an increase in the domestic price level. Import demand is price elastic and demand for imports falls, but the reduction in the tax base for import taxes is less than the increase in the tax rate, and government receipts increase. The balance of payments and the budget improve, each with an opposite effect on the money supply. The improvement in the balance of payments increases the money supply, while the improvement in the budget reduces the money supply. Given the parameters of the model, the improvement in the budget happens to be stronger, and therefore the net result is contractionary. This works against the initial rise in prices that resulted from the increase in taxes. Because of the conflicting forces that impact on prices, the rate of inflation is higher in the first year compared to the baseline scenario, and then lower.

Table 10.

Simulation: Increase in Taxes on Imports (Difference from Baseline)

(Annual percentage change or ratio)

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The rate of growth of production is below the baseline in the first two years and then returns to the baseline values. The reason for the decline in production is the increase in inflation, which negatively affects real government expenditure and real exports.

8. A credit expansion with fixed exchange rate and capital mobility

If capital is free to move and responds to changes in the “curb” rate of interest, monetary policy becomes ineffective. The model emulates a Mundell-Fleming model with a fixed exchange rate regime and capital mobility.

To perform this experiment, the model needs to be changed by adding an equation for private foreign debt. The equation has the form: 9/

(22)Privateforeigndebt=12×Excessmoneysupply

The assumption is that the demand for foreign debt decreases as excess money supply emerges because the “curb” rate of interest falls. Thus, the elasticity of excess money with respect to foreign debt is negative. Once this new equation has been added, a new baseline scenario has to be created by running the new model; this baseline will be different from the original baseline since the model has changed. Subsequently, the experiment, by which credit increases by 20 percent, can now be conducted and should be compared with the second baseline scenario.

When domestic credit increases there is an excess supply of money, causing an outflow of capital as agents rearrange their portfolio. This reduces the supply of money immediately, reducing the impact of the original increase in credit on production, prices, and the balance of payments (compare the results with the first simulation: Tables 11 and 4).

Table 11.

Simulation: Credit Expansion With Fixed Exchange Rate and Capital Mobility (Difference from Baseline)

(Annual percentage change or ratio)

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9. A credit expansion with flexible exchange rate and capital mobility

The model used for this simulation is another version of a Munde11-Fleming model with flexible exchange rates and capital mobility. The results of a monetary expansion in this model are, not surprisingly, a depreciation of the exchange rate with a positive impact on output.

In this new model, prices are exogenous (rising at 5 percent per year) while output is still demand determined. Foreign private debt, as before, depends negatively on excess money supply (with an elasticity of -3). Government tax revenue depends on GDP with a one year lag (the elasticity is 0.9), while government expenditure depends on revenue (the elasticity is 1.1). These elasticities have been chosen to ensure that money creation by the budget is virtually constant in terms of GDP, to contain the possible feedback from monetary financing of the deficit, which can otherwise cause an explosion in the model.

In the baseline simulation of this model, the supply and demand for money are almost identical throughout the projection period, the exchange rate is stable after an initial appreciation, and the overall balance of payments is in equilibrium.

In the policy simulation, credit to the private sector increases by an additional 20 percent in the first year. Initially, the money supply increases because of the credit expansion which causes excess money supply. As the “curb” rate of interest falls, net foreign debt is reduced as agents move capital abroad to take advantage of the interest rate differential. The nominal and real exchange rates depreciate sharply with a very strong effect on exports and GDP. As the current account improves, the exchange rate appreciates again, implying some initial overshooting of the exchange rate.

Table 12.

Simulation: Credit Expansion with Flexible Exchange Rate and Capital Mobility (Difference from Baseline)

(Annual percentage change or ratio)

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Appendix I: How to Use M2

1. Starting the program and using the menus

The program is contained on a diskette and can be run from an external disk drive. The program runs much faster, however, if it is installed on the hard disk. It is recommended that you copy all the files from the diskette to a new directory and call this new directory “M2”.

A. To start the program
  • - Start the computer and go to DOS

  • - Put the diskette in drive A

  • - Type a: to move to drive A; press ENTER

  • - Type the letter “m” and press ENTER.

B. To select an item from the main menu
  • - Use the left and right ARROW keys to point to a menu item

  • - Press ENTER to make the selection

    or:

  • - Type the highlighted letter.

C. To select an item from the pulldown menus
  • - Use the up and down ARROW keys to point to the menu item

  • - Press ENTER to make a selection

    or:

  • - Type the number of the menu item.

D. To change data in the work sheets
  • - Use the up and down ARROW keys to point to the data item

  • - Press F2

  • - Type in the new data

  • - Press ENTER.

2. Options available for printing

The Print menu can be found under “Simulation”. It is necessary to select “Run the model” before you can access the Print menu. The Print menu offers the possibility of making a few changes in the output table:

A. A one-line header can be supplied with up to 75 characters, which might be useful for typing in the table number and the country.

B. A one-line footnote can also be supplied.

C. It is possible to indicate the units for SDR and local currency.

D. It is possible to change the labels for imports and exports in the tables that are printed; in the screen tables these are simply called imports 1 and 2 and exports 1 and 2, and there they cannot be changed.

To access these facilities: select the relevant menu item from the Print menu, then press F2 if a change is to be made; if no change is desired, press any other key to continue.

3. Options available when displaying charts

The charts can be displayed in two basic ways:

A. They can show the difference between the latest simulation and the baseline scenario. In this case, it is necessary to define the baseline scenario beforehand; this has already been done for the illustrative model, but the user may wish to define a different baseline scenario.

The procedure for defining a different baseline scenario is as follows:

  • - Experiment with the program until a baseline scenario has been found

  • - Run the model

  • - Select Charts from the “Simulation” menu

  • - The chart menu will pop up

  • - Select “Save baseline”; the baseline data are now saved for later use in the comparison. These saved data will not change until “Save baseline” is selected again.

  • - Select “Quit”

Once a policy change has been simulated, select “Charts” again and then “Show chart”. The charts will show the result of this last simulation compared to the baseline scenario.

B. The charts can also show the actual results of the latest simulation without comparing them to the latest baseline. To choose this option, select “No baseline” from the pop-up chart menu.

Appendix II: Link with Lotus 1-2-3

The data generated by the program are saved in files that can be accessed by Lotus 1-2-3. The advantage of having the data available in Lotus is that they can be manipulated easily. To access these files from within Lotus, you should perform the following key strokes:

/Files Import Numbers

The user will then be prompted to type in the names of the files to be imported, which are:

yr0.txt, yr1.txt, yr2.txt, yr3.txt, yr4.txt, yr5.txt.

These files are on the diskette with the M2 program, meaning that the drive or the directory needs to be supplied as well. This is a somewhat cumbersome procedure, so we have created Lotus macros to perform these tasks.

The diskette with M2 includes a Lotus 1-2-3 file called “M2.wk1” which includes these macros. When this file is “Retrieved” in Lotus, the top panel explains the macros that are available. For example, if the program M2 is in drive A, you can press simultaneously “Alt” and “a” which will automatically import the data from the program files into the Lotus 1-2-3 file.

In case the program M2 has been installed on the hard disk in a directory called “M2”, there is an other macro to perform the same task. The data can now be loaded by pressing “Alt” and “m”.

A third macro allows you to print the output by pressing “Alt” and “p”.

Appendix III: Solution Technique of the Program

The program calculates the annual value of the variables with a series of nonrecursive models, each of which covers a subperiod of the year. There are between one and 36 subperiods in the year, to be decided by the user. There is no feedback within the subperiod, but there is feedback within the year since the output is passed on from one subperiod to the next, leading to a recalculation of the endogenous variables.

At the beginning of the first subperiod, all exogenous and predetermined variables are taken into account in calculating their impact on the endogenous variables. At the beginning of the next subperiod, the changes calculated in the previous subperiod are now taken into account, and so on. Thus, changes in a variable affect other variables with a lag of one period. As an example, an exogenous increase in government expenditure in period One impacts on GDP in period Two, while tax revenue, if it depends on GDP, is affected in the third period.

The program calculates the flow variables for each period and adds these over all periods to yield the annual value of that variable. A stock variable at the end of the year is defined as the value at the beginning of the year plus the related flow variable for that year.

This solution technique provides for greater stability of the models by building in a lag of at least one period; that stability is sometimes lost if a simultaneous solution is sought through iterations.

In the program it is possible to specify the number of subperiods by selecting “Iterations” under “Data”. The number of subperiods or iterations can vary between one and 36. There is very little difference in the outcome of the model with 36 or 12 subperiods, whereas the program runs faster with only 12 subperiods.

One implication of this solution technique is that the actual elasticities on an annual basis are not exactly equal to the elasticities supplied by the user, as the program introduces a lag of one sub-period between the change in the independent variable and the dependent variable. The larger the number of iterations, the smaller this lag and the differences between the actual and supplied elasticities will be.

Appendix IV: Definitions

1. National accounts

Disposable income of the private sector (DY) equals GDP (Y) plus transfers from the rest of the world (TR) minus the sum of all government revenue (T), minus private sector interest payments on foreign debt (INTp), minus the increase in public sector arrears during the current year (AR).

DY = Y + TR - T - INTp - AR

Excess productive capacity (EC) is the difference between capacity output (Q) and actual output (Y), expressed in percent of actual output.

Ec=QYY×100

2. Public sector

The public sector surplus/deficit (DEF) is defined as the difference between total government revenue (T) [consisting of taxes on income and profits(Ti), taxes on goods and services (Tg), taxes on imports (Tm), and stabilization revenue (Ts)], and the sum of current expenditure (Cg), investment expenditure (Ig), and interest on foreign public debt (INTg):

DEF = (Ti + Tg + Tm + Ts) - (Cg + Ig + INTg)

Stabilization revenue (Ts) for exports 1 is equal to the price differential per unit of exports, times the volume of exports 1 (VX). The price differential is equal to the local currency price of exports (P1x), minus the producer price (PP).

Ts = (P1x - PP) x VX

The program sets the local currency price of exports 1 (Plx), equal to one in the base year, which at the same time defines the volume of exports.

Stabilization revenue (Ts) from imports 1 is the price differential per unit of imports times the volume of imports 1 (VM). The price differential is equal to the price charged consumers (PC) minus the local currency price of imports 1 (P1m).

Ts = (PC - P1m) x VM

Stabilization revenue can be either positive or negative.

There is a financing gap in the public sector if bank credit to the government is constrained. The gap is equal to the financing requirement, which is the overall deficit (DEF) with the opposite sign, minus available net foreign financing, net nonbank borrowing, and net credit from the banking system. As long as the financing gap is not financed by a reduction in the deficit and/or an increase in financing it leads to an accumulation of domestic payment arrears.

3. Balance of payments

The current account (CA) of the balance of payments is defined as exports of goods (X) and nonfactor services (NFSc) minus imports of goods (M) and nonfactor services (NFSd), minus interest on public debt (INTg) and interest on private debt (INTp), plus unrequited transfers (TR).

CA = X + NFSc - M - NFSd - INTg - INTp + TR

There are two import and export categories, each with its own foreign price in SDR (Pm1, Pm2, Px1, Px2). The local currency price is obtained by multiplying these with the nominal exchange rate (NER). The relative price of each export category (PxREL) is the ratio of the local currency price of exports (Px) and the domestic price level (P).

PxREL=Px×NERP

The relative import price (PmREL) is the ratio of the local currency price of imports (Pm x NER) and the domestic price level. In addition, import taxes affect the local price of imports; “tm” is the import tax rate.

PmREL=Pm×NER×(1+tm)P

The price of total imports is a weighted. average of the price of the two import categories (Pm1, Pm2). The price of total exports is calculated, in a similar way. The terms of trade (TOT) are defined as the ratio of total export prices over total import prices; the base year value of the terms of trade is set to 1000.

TOT=PxPm×1000

The nominal exchange rate (NER) is defined as the number of local currency units per SDR. There is only one exchange rate in the program, and there is thus no distinction between the end of period and period average exchange rate. A devaluation increases the nominal exchange rate.

NER=UnitsoflocalcurrencySDR

The real exchange rate (RER) is defined as the ratio of domestic prices (P) over world prices (WP), expressed in local currency. The world price (WP) is an index of world prices in SDR, which is exogenous.

RER=P(WP×NER)×1000

The base year value of RER is set to 1000. A depreciation of the real exchange rate reduces its value.

The reserve ratio is the ratio of net foreign assets (NFA) to total imports in the previous year [M(t-1)]; the change in the reserve ratio (RR) is defined as the change in NFA (dNFA) over imports.

RR=dNFAM(t1)×100

There is a financing gap in the balance of payments if the change in net foreign assets (dNFA) is constrained. The gap is equal to the financing requirement, which is the current account (CA), minus available net foreign financing and the maximum change in net foreign assets.

4. Monetary sector

Excess supply of money (EMS) is the difference between the supply of money (MQM) and the demand for money of the previous period (MD) in percent of the demand for money:

EMS=MQM(t)MD(t1)MD(t1)×100

5. Foreign debt

Old debt is the stock of foreign debt, in SDR, of the public sector at the end of the base year. The stock of old debt decreases over time as the debt is amortized, but it does not increase. New debt is the public foreign debt, in SDR, accumulated during the projection period. It is equal to the sum of disbursements minus the sum of amortization payments scheduled on new debt. Both are exogenous variables. The consolidated debt is the stock of debt that results from rescheduling of debt service falling due, minus any amortization projected on the rescheduled amount.

The debt service ratio (DSR) is the ratio of the total debt service due on public debt (interest and amortization = DS) over exports of goods (X) and exports of nonfactor services (NFSc).

DSR=DSX+NFSc×100

Appendix V: Combinations of Coefficients That Have Been Excluded

It is possible, in theory, to assign values to a certain combination of coefficients in such a way that the feedback may be so strong as to lead to an explosion of the model. These combinations” have been excluded from the computer program. An example would be a model in which GDP is determined in part by private investment, while private investment is in part a function of GDP; a change in one of these variables could set in motion a very strong multiplier process that would result in unrealistic figures for GDP and investment, particularly if the model goes through a large number of iterations. The combinations of parameters indicated in Table 4 have been excluded.

If non-zero values are accidentally supplied for both parameters in the table below, so that for example investment plays a role in the determination of GDP, while GDP plays a role in the determination of investment, the program will reset the parameter in the right-hand column (the elasticity for GDP in the investment function) to zero, to avoid an explosion of the model.

Table 13.

Combinations of Parameters that have been Excluded

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Appendix VI: Baseline Scenario with Illustrative Model

National Accounts

(In millions of local currency units)

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Exchange Rates and Terms of Trade

(1991=1000)

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Balance of Payments

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Public Sector

(In millions of local currency units)

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Monetary Survey

(In millions of local currency units)

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Appendix VII: List of symbols

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References

  • Barth, Richard C., and Bankim Chadha, A Simulation Model of Financial Programming,” (mimeographed, Washington, International Monetary Fund Working Paper WP/89/24, March 1989).

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  • Blejer, Mario I., and Nissan Liviatan, Fighting Hyperinflation: Stabilization Strategies in Argentina and Israel,” Staff Papers, International Monetary Fund (Washington), Vol. 34 (September 1987), pp. 409438.

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  • Blejer, Mario I., and Adrienne Cheasty, High Inflation, Heterodox Stabilization, and Fiscal Policy,” World Development, (Great Britain, Pergamon Press), Vol. 16, No. 8 (1988), pp. 867881.

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1/

I am grateful to Christos Androvitsaneas, Michel Dessart, Mohammed Hosny, Anthony Lanyi, Mohan Narasimhan, and Segura Ortega for their encouragement and detailed suggestions.

2/

For additional information about this program, please contact the author. Information on how to use this program is provided in Appendix I.

3/

It should be noted that whenever the variable “Prices” appears in an equation, the rule applies and the variable is expressed as the percentage change in the price index.

4/

Excess money supply is the gap between the supply of money and money demand, compare page 30. Excess money supply is inversely related to the free market rate of interest.

5/

M.S. Kahn (June 1990).

6/

Certain other feedback mechanisms that may lead to an explosion of the models built with this program have been excluded; see Appendix V.

7/

The program divides the year into a number of subperiods; compare Appendix III.

8/

The standard model needs to be changed to run this experiment. Select “Producer prices” from the “Options” menu.

9/

As before, the variables are measured as the annual percentage change.

Macroeconomic Models for the PC+L862
Author: Mr. Willem Bier