High capital inflows and rising vulnerabilities underscore the importance of a comprehensive approach to ensuring stability. Standard balance sheet indicators mask a substantial build-up of exposures to exchange rate, maturity, and rollover risks. Household balance sheet risks originate from currency mismatches owing to credit euroization. The fiscal balance has a strong and significant impact on the current account in Serbia. The model is broadly able to reproduce recent economic and policy developments in Serbia. The analysis indicates that privatization can result in sizable fiscal savings.


High capital inflows and rising vulnerabilities underscore the importance of a comprehensive approach to ensuring stability. Standard balance sheet indicators mask a substantial build-up of exposures to exchange rate, maturity, and rollover risks. Household balance sheet risks originate from currency mismatches owing to credit euroization. The fiscal balance has a strong and significant impact on the current account in Serbia. The model is broadly able to reproduce recent economic and policy developments in Serbia. The analysis indicates that privatization can result in sizable fiscal savings.

VI. A Forecasting and Monetary Policy Analysis Model for Serbia45

Objective: To implement and calibrate a simple macroeconomic model for Serbia—widely used by IMF staff—and use it for policy analysis.

Main results: The model is broadly able to reproduce recent economic and policy developments in Serbia. It can be used to forecast the reaction of inflation, growth, and the exchange rate to various exogenous shocks (e.g., exchange rate, interest rate, oil price, fiscal, and foreign demand shocks) given the endogenous reaction of monetary policy on interest rates.

Policy implications: The model helps central banks forecast the main macroeconomic variables and make interest rate decisions in an inflation targeting framework.

A. Introduction

88. The model—the so-called Forecasting and Policy Analysis System (FPAS) set up by IMF staff—is a simple macroeconomic framework that allows to forecast monetary variables and analyze monetary policy actions and shocks in an inflation targeting regime with a flexible exchange rate.46 It focuses on the short- and medium-term interaction between monetary policy and output, inflation, and the exchange rate. The model combines the New Keynesian synthesis, which emphasizes nominal and real rigidities and the role of aggregate demand in output determination, with methods of dynamic stochastic general equilibrium modeling with rational expectations. Specifically, it consists of an aggregate demand equation, a price-setting equation, an uncovered interest parity condition for the exchange rate, and a monetary policy reaction function relating the policy interest rate to output and inflation. Thus, the model embodies the principle that the role of monetary policy is to provide an anchor for inflation and inflation expectations.

89. The model, and variations thereof, has been used by IMF staff teams and by central banks in various advanced and emerging countries over the past few years.47 Here, the model is adapted to Serbia by calibrating the parameter values to the characteristics of the Serbian economy and monetary policy-making. Because of the numerous structural changes in the past years in Serbia and the short data series, parameters are not estimated econometrically. Instead, plausible parameter values, based on a variety of sources, are tried and adjusted in an iterative process until the model displays reasonable properties and appropriately replicates recent developments and forecasts.

90. Because it is simple enough to allow for full comprehension of the interactions between variables, the framework is useful to analyze and communicate monetary actions. Of course, simplicity has its drawbacks in that many issues (importantly, the current account) are outside the scope of the model. Moreover, the model essentially considers deviations from equilibrium values and, thus, does not explain those equilibrium values.

91. The model is used here for several purposes—forecasting, analysis of policy alternatives, and risk assessment. First, the model helps assess the consistency of baseline forecasts (e.g., those of the authorities or of IMF staff) and how much they deviate from the model-based forecast. Second, it is used to simulate alternative policy actions and assess their impact. And third, it can simulate exogenous shocks and analyze the effect of policy responses to those shocks. More generally, the model helps organize policy analysis by pointing to the essential linkages between economic variables and policy actions, and by providing quantitative projections of those variables and policies.

B. The Model

92. The model consists essentially of four equations: (i) an aggregate demand or output gap equation (IS curve) relating real activity to expected and past real activity, the real interest rate, the real exchange rate, and foreign activity; (ii) a price-setting equation (Philips curve) relating inflation to past and expected inflation, the output gap, the real exchange rate, and the price of oil; (iii) an uncovered interest rate parity condition to determine the real exchange rate; and (iv) a monetary policy rule for setting the policy interest rate as a function of real activity and expected inflation. In addition, to allow for a different impact of oil prices on headline and core inflation, the model is augmented with a second price-setting equation for core inflation that does not depend directly on oil prices, but nevertheless incorporates a lagged effect of headline inflation on core inflation. There are two sets of equations, one for the home country (Serbia), the other for the foreign country (the euro area).

93. The output gap equation is as follows, with the gap terms measured as deviations of actual values from trend. All variables are quarterly (see Appendix I for a complete definition of variables):



RRgapEA = RREA (1 + ResReqSerbia) − RRSerbia*

where ygap is the output gap, RRgap the real interest rate gap, zgap the real exchange rate gap (expressed as a real depreciation), ygapEA the output gap in the euro area, β a series of parameters attached to those variables, and εygap is an error term. In words, this equation means that the output gap in time t is a function of its expected value in the next period, its lagged value in the previous period, the real interest rate (lagged, negatively), the real depreciation (lagged, positively), the foreign country’s output gap (external demand), the effective foreign real interest rate (augmented by the cost of reserve requirements, lagged, negatively), and a disturbance term.

94. The variable RRgapEA is added to the original BKL model to capture the fact that high euroization of credit activity in Serbia makes real activity depend not only on domestic real interest rates, but also, and perhaps mainly, on euro interest rates RREA. However, the euro interest rate is raised by the cost of foreign currency reserve requirements ResReqSerbia. It should be noted that this gap term is calculated relative to the long-term Serbian real interest rate, implying that similarly to the domestic real interest rate, the effective foreign real interest rate will have an expansionary effect on activity only if it is lower than the domestic long-term steady-state real interest rate.

95. The price-setting equations are as follows. For headline inflation:


where π4t+4 is the four-quarter ahead y-o-y inflation rate, π4t-4 the four-quarter lagged y-o-y inflation rate, ygap the output gap, zt – zt-1 the real depreciation, πrpoil,t the change in the relative price of oil, α are parameters, and επ is an error term. In words, this equation means that inflation is a function of expected inflation, lagged inflation, the lagged output gap, real depreciation, oil price changes, and a disturbance term.

96. For core inflation:


where πc stands for core inflation. The last term represents the difference between headline and core inflation, allowing, for example, some pass-through from oil prices into core inflation.

97. The real exchange rate equation is:


where z is the real exchange rate (in increase represents a depreciation), ze the expected real exchange rate, RR the real interest rate, RRUS the real interest rate in the euro area, ρ* the equilibrium risk premium on the domestic currency, δ are parameters, and εz is an error term. This equation is a traditional uncovered interest rate parity condition: the real exchange rate is a function of the expected real exchange rate and the real interest rate differential (corrected for the currency risk premium), and a disturbance term.

98. The expected real exchange rate is defined as:

zet+1 = δzzt+1 + (1δz)zt−1

where the first term is the future exchange rate rationally consistent with the model’s expectation, and the second term is a backward-looking component.

99. Finally, the monetary policy rule is:


where RS is the nominal interest rate, RR* the equilibrium real interest rate, π* the inflation target, γ are parameters, and εRS is an error term. This equation means that the nominal interest rate is set depending on its lagged value, the equilibrium real interest rate, current inflation, the deviation of four-quarter ahead y-o-y inflation from its four-quarter ahead target, the output gap, and a disturbance term. We assume that the central bank targets core inflation for 90 percent, and only 10 percent headline inflation.

100. The model is a two-country model where the home country is small and open whereas the foreign country—the home country’s main trading partner—is relatively large and closed, in effect exogenous to the home country. Thus, the foreign country enters the home country equations through (i) the impact of its activity on the home country demand and (ii) the impact of its real interest rate on the bilateral exchange rate. Conversely, the home country does not impact the foreign country, which implies that the output gap of the foreign country does not depend on the bilateral exchange rate or the home country activity; and foreign country inflation does not depend on the bilateral exchange rate. Hence, the uncovered interest rate parity condition is irrelevant for the foreign country model.

101. The supply side of the model is extremely simplified. Potential output is given outside the model (either by inference from past data, or from other assumptions). The only complication introduced is that potential output growth is made to depend not only on long- run potential growth, but also on changes in oil prices. This allows to replicate the impact of oil shocks on potential output, assuming that oil is an input in the production of goods and services. The potential output equation is:


where y* is potential output, g* the long-term growth rate of potential output, π4rpoil,t the four- quarter change in the relative price of oil, ν a parameter, and εy* an error term. In words, the equation means that the current growth rate of potential output is equal to its long-term growth rate minus a function of the change in the relative price of oil, and a disturbance term.

C. Implementing the Model

102. The model is implemented using Serbia and Euro Area data and parameters. Historical data are quarterly from 1999q1 to 2007q4, and baseline forecasts run from 2008q1 to 2012q4. The model also requires choosing long-run steady-state values for the main variables. The euro area is Serbia’s main trading partner, and the dinar-euro exchange rate is, in effect, the main exchange rate used in Serbia. Euroization of deposits, loans (including through euro-indexation of loans) and, to some extent, transactions is high. Thus, the model parameters for Serbia are calibrated to capture the high pass-through of the exchange rate to domestic prices. In addition, the monetary policy reaction function takes into account that the NBS targets core inflation. For the euro area, parameter values were taken from IMF staff applications of the same model. Appendix II provides greater details on data.

103. There is little consensus on a measure of the output gap in Serbia. Given the short history of transition, potential output is difficult to estimate, both for the past and for the future, and actual output has fluctuated widely. For the purpose of the model, we calculate the output gap as the difference between the trend-cycle component of the seasonally adjusted GDP series and the Hodrick-Prescott filtered GDP series. This minimizes excessive fluctuations, and ensures that the output gap is positive during most of the recent quarters and the short-term projection period, thereby providing an inflationary impulse.

Parameter Values for Serbia

104. The parameter values are chosen based on the modeling experience of other similar country models, but adapted to our priors regarding the characteristics of the Serbian economy and policy-making (Table 1). We follow an iterative process whereby the parameter values are changed, one at a time, until the residuals in the model (i.e., the difference between the historical data series and those calculated by the model), which correspond to the “judgment” added to the model, are broadly minimized in recent years. However, we do not expect these residuals to be zero: first because the model is too simplified to capture all the idiosyncrasies and shocks of recent economic developments in Serbia; and second because a “regime change” occurred in mid-2006 with the beginning of the transition toward an inflation targeting framework.

Table 1:

FPAS Model Parameters 1/

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Source: IMF staff.

Indicative parameters of initial models. Current country models may differ.

105. The β parameters in the output gap equation depend to a large extent on the degree of inertia in the economy, the effectiveness of monetary policy transmission, and the openness of the economy.

  • Drawing on the experience of several applied country modeling efforts, Berg, Karam, and Laxton (2006b) suggest that the value of βlag will lie between 0.5 and 0.9, with a lower value for less mature economies more susceptible to volatility. For Serbia, we choose a low value of 0.5 (somewhat smaller than in the euro area) to take account of the emerging and volatile nature of the Serbian economy.

  • The lead of the output gap (βId) is typically small, between 0.05 and 0.15, and we choose a value at the mid-point of that range for Serbia.

  • The parameters βzgap and βygap depend mainly on the importance of the exchange rate channel and the degree of openness. We choose a high value for βzgap to reflect the importance of the exchange rate channel and a low value for βEAygap due to Serbia’s relatively modest openness.

  • The parameter βRRgap depends traditionally on the effectiveness of the monetary transmission mechanism. In the Serbian context, however, the two parameters βRRgap and βRRgapEA, which reflect the impact of dinar and foreign interest rates on domestic activity, respectively, depend largely on the degree of euroization. The βrst parameter is set relatively low and the second one relatively high to reflect the weak dinar interest rate channel and the predominance of foreign interest rates (augmented by the effect of reserve requirements) in the context of a highly euroized economy

106. The α parameters in the inflation equations depend on the role of expectations and aggregate demand on inflation, and the pass-through from the exchange rate to prices.

  • The απld parameter in the headline inflation equation determines the forward component of inflation (while its inverse 1 - απld determines the backward component). This can be interpreted as depending in part on the credibility of the central bank, and in part on institutional arrangements regarding wage indexation and other price-setting mechanisms. A higher value of απld close to 1 involves a “speedboat” economy where small changes in monetary policy cause large changes in price expectations, while a low value involves an “aircraft carrier” economy where inertia and backward-looking expectations cause prices to respond with greater delays to changes in monetary policy. In this context, BKL propose values of απld significantly lower than 0.5. We choose a relatively high value of 0.3 (slightly higher than in the euro area), involving a rather low inflation inertia, to reflect the fact that indexation is not complete in Serbia (in the recent past, public and private sector wages have generally been set with respect to the authorities’ announced inflation objectives) and the assumption that the new inflation targeting regime is somewhat credible.

  • The αygap parameter depends on the extent to which output responds to price changes and, conversely, how much inflation is influenced by real demand pressures, and is typically between 0.25–0.50. This parameter ultimately depends on the “sacrifice ratio,” i.e., the loss of output necessary to bring down inflation. We set it at a low value of 0.25 to suggest that inflation is not primarily driven by real demand pressures. Nevertheless, the nonzero value insures that the model will consider some inflationary impact of expansionary fiscal policies.

  • The αz parameter represents the short-term pass-through of (real) exchange rate movements into prices, and depends on trade openness, price competition, and monetary policy credibility. In the case of Serbia, the high degree of euroization and the high exchange rate pass-through (at least historically) lead us to choose a relatively high value of 0.3 for that parameter.

  • Finally, the parameters related to the responsiveness of inflation to oil prices depend on the share of oil and oil-related products in the CPI, which is high in Serbia relative to other countries.

107. The α parameters are the same for the core inflation equation, except that we set αc,πld and αc,z slightly higher to reflect a stronger forward-looking component for core inflation (since the central bank is targeting core inflation) and a greater exchange rate pass-through into core inflation, respectively. The parameter αc,3 relating core to headline inflation is set at 0.25, in line with other country models.

108. The δ parameter in the real exchange rate equation determines the relative importance of forward- and backward-looking real exchange rate expectations. If δ is equal to 1, the equation behaves as in the Dornbusch overshooting model, i.e., the real exchange rate is a function of the future sum of all real interest rate differentials. This makes monetary policy a very effective tool. BKL, however, note that it may be imprudent to rely on such effective forward-looking linkages in the face of considerable uncertainty, and recommend choosing a parameter value lower than 0.5, which is what we do (we choose 0.4). Finally, note that the coefficient relating the real exchange rate and the real interest rate differential (adjusted for the risk premium) is unity, which assumes that rational arbitrage makes the uncovered interest parity condition hold.

109. The γ parameters in the monetary policy rule equation depend on the speed and aggressiveness with which the monetary authorities adjust the nominal interest rate, and the relative importance of the inflation target versus the real activity target.

  • Usually, the central bank cannot abstract from paying some attention to real activity even in a “pure” inflation targeting framework and, thus, the γygap will be greater than zero (we choose a value of 0.5, in line with other countries).48

  • We choose a value of 2.0 for γπ (in line with other country models with values between 2.0–2.7), which ensures relatively large interest rate interventions to achieve the inflation target in a relatively new and untested framework with shallow financial markets. In other words, we assume that the central bank reacts relatively aggressively to small deviations from the target.

  • However, we also assume that the central bank smoothes out interest rates by choosing a γRSlag parameter value of 0.5, in line with other country models. This means that the central bank also incorporates considerations about policy stability when moving its interest rate.

Steady-State Values

110. The long-term steady-state values for key parameters—the inflation target, potential output growth, and the real interest rate—have an impact on the direction and speed of convergence of the model, particularly in the outer years. However, these values are not essential for the short- and medium-term forecasting exercise. We set the long-term inflation target at 4 percent and the long-term interest rate at 4 percent. We set the long-term potential output growth at 5½ percent, a relatively high value in the very long run, but close to the current average rate of growth. This assumes that in the long run, structural reforms to enhance productivity and EU integration will sustain high growth rates after the initial catching up effect from the economic collapse of the 1990s has faded.

Model Historical Robustness

111. Overall, the relatively small “Model residuals and judgment” in Table 2 for the period 2005q1 to 2007q4 suggest that the model is broadly able to replicate the recent historical data series. However, it is far from perfect, suggesting that more work is needed in adjusting parameter values. The notable deviations are the jump in inflation in 2005q1, which is due the introduction of the VAT—an exogenous shock that the model cannot anticipate; the maintenance of high inflation in 2006q2 despite a strong real appreciation; the more-rapid-than-predicted disinflation in the second half of 2006 and in 2007q1; and the spike in inflation in the second half of 2007 despite real appreciation—in part due to supply shocks.

Table 2:

Baseline Forecast in December 2007

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D. Using the Model

112. In the first instance, we use the forecasts of the Serbian authorities or the IMF staff, not those produced by the model itself. Judgmental forecasts, which take into account a large amount of information and specific knowledge about the economy, should perform better in the short run than purely model-based forecasts, especially in the context of a model as simple as this one. However, the model can be used to assess the consistency of the forecasts. We then use the model to simulate a series of plausible shocks, with a view to assessing the risks to the baseline forecasts and analyze the impact of the endogenous policy reaction.

Baseline Analysis and Model Forecast

113. The (judgmental) baseline assumes an unwinding in 2008–09 of the tight monetary stance of 2006–07 which, through high interest rates that contributed to significant real exchange rate appreciation, succeeded in bringing inflation down from double-digit rates. The lagged effect of real appreciation on growth, which will slow down to or below potential, will also remove inflationary pressures stemming from excess demand. At the same time, gradually lower interest rates will generate a slight nominal and real depreciation which, while consistent with achieving low inflation, will sustain growth in the medium term (Table 3, baseline).

Table 3:

Baseline and Model-Based Forecast, 2007-08

(Annual average in percent, unless otherwise indicated)

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Source: IMF staff projections.

114. Comparing the judgmental baseline forecast with the purely model-based forecast suggests the need for monetary tightening in the face of rising inflation (Table 3, last two columns). The model projects somewhat higher interest rates in the short term to maintain a real interest rate differential with the euro area, thereby supporting the more appreciated exchange rate needed to reduce both headline and core inflation, which tend to converge. However, this comes at the cost of lower growth than in the baseline due to the real appreciation and the high real interest rates.

Risk Analysis

115. Real exchange rate appreciation (Table 4). This shock is modeled as a temporary and exogenous decline in the currency risk premium, resulting in a one-quarter nominal exchange rate appreciation of 10 percent. This could be due to a favorable but temporary event affecting Serbia and giving rise to a positive change in expectations. Given the high pass-through, the appreciation reduces headline and core inflation significantly, leading the central bank to react by lowering interest rates. The real appreciation has a negative impact on growth in the short run and creates a persistently negative output gap. Since the real appreciation helps the central bank achieve its disinflation target, and the reaction function does not put a large weight on the output gap, the model does not call for an aggressive reduction in the interest rate to boost growth and close the output gap. The real appreciation, thus, persists for some time.

Table 4:

Risk Analysis, 2008-09

(Deviation from baseline, in percentage points or in percent)

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Source: IMF staff projections.

116. Real exchange rate depreciation (Table 4). This shock has opposite effects from the previous one. An exogenous increase in the risk premium (causing the nominal exchange rate to depreciate by 10 percent for one quarter) and the associated real depreciation cause inflation to rise in the short run, triggering a monetary response via higher interest rates. The real depreciation also provides a short-term boost to growth. After a few quarters, the shock unwinds. Through the monetary response, first the nominal and then the real exchange rates both appreciate, slowing inflation and growth down and back to the baseline. The monetary response needs to be relatively vigorous to undo the inflationary impact of the shock and return to the disinflation path. Nevertheless, the temporary shock generates a lasting positive output gap due to the one-time increase in output.

117. Negative interest rate shock in Serbia (Table 4). This shock involves a temporarily higher nominal interest rate than in the baseline due, for example, to a misjudged monetary policy tightening. The nominal interest rate increases by 3 percentage points in one quarter, then reacts again according to the model reaction function. As a result, the exchange rate appreciates in both nominal and real terms and inflation drops, but at the cost of slower growth. With inflation below target and growth slowing down, the central bank reduces interest rates below the baseline after three quarters, but it takes two years for growth to return to the baseline and for the output gap to close. It should be noted, however, that in this rational expectations model, economic agents know that the central bank will ultimately return to its model reaction function and they anticipate such action. This moderates somewhat the impact of the excessive tightening.

118. Oil price shock (Table 5). In this shock, the price of oil rises by 50 percent relative to the baseline during 2 quarters, and then returns to the baseline over the next year and a half. The shock raises headline inflation, but with a small pass-through to core inflation (by assumption, see Section C). But because the central bank is assumed to take some account of headline inflation, it reacts by raising interest rates during 6 quarters. The exchange rate depreciates on impact because of the drop in real interest rates (as inflation rises more than nominal interest rates) but, as inflation is contained and real interest rates rise, it appreciates back to and above the baseline after two quarters. Potential output growth drops due to the direct oil price effect, and this in turn reduces output for about two years. In response to lower growth, the monetary policy response is unwound during the second year through significantly lower interest rates than in the baseline. This, and the subsequent drop in oil prices back to the baseline, provides a boost to actual (and potential) output to close the output gap.

Table 5:

Risk Analysis, 2008-09

(Deviation from baseline, in percentage points or in percent)

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Source: IMF staff projections.

119. Fiscal or domestic demand shock (Table 5). This shock simulates a temporary increase in domestic demand, brought about for example by expansionary fiscal policies. The output gap increases by 2 percentage points for one quarter, and is then phased out only gradually (by 85 percent per quarter). Because of the low parameters assumed regarding the impact of the output gap on inflation and the low weight attributed to it in the monetary policy reaction function, the effect of the shock is relatively benign on inflation and nominal interest rates. Growth increases temporarily along with higher demand. The central bank reacts by raising nominal interest rates above the baseline. This causes the exchange rate to appreciate, keeping inflation down and, in turn, leads to a sharp slowdown in growth to below potential after about a year already. This scenario illustrates how the sharp real appreciation brought about by a surge in domestic demand can, after the initial boost has passed, choke off growth.

120. Foreign demand shock (Table 5). This shock, where the euro area output gap increases by 1 percentage point for one quarter and is then gradually phased out (by 85 percent per quarter), could reflect, for example, a strong rise in demand from the euro area for Serbian exports following positive steps toward EU integration. The temporary increase in foreign demand raises domestic growth (and the output gap) mildly in the short term. However, in the absence of an increase in potential output, this raises inflationary pressures, which the central bank addresses by increasing interest rates. Interestingly, most of the impact of this shock runs through the response of the euro area. To dampen the demand shock in the euro area, the ECB raises interest rates, causing the dinar to depreciate because of the drop in the real interest rate differential. The exchange rate channel is the channel through which inflationary and demand pressures are passed on to Serbia, thereby prompting significant monetary tightening over the projection period.

121. Reduction in the inflation target (Table 6). A permanent reduction in the numerical value of targeted inflation can, in this forward-looking model, achieve rapid results in terms of disinflation within a few quarters. However, the rapid disinflation leads to an increase in the real interest rate and to nominal and real exchange rate appreciation, which in turn result in a drop in growth. The central bank reacts only gradually by reducing nominal interest rates. Thus, growth returns to the baseline rate after three years, but the cumulative output loss is significant.

Table 6:

Risk Analysis, 2008-09

(Deviation from baseline, in percentage points or in percent)

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Source: IMF staff projections.

122. Domestic inflation shock (Table 6). This shock simulates a temporary increase in non-core prices—for example a one-off increase in energy or utility tariffs. 49 In response, the central bank gradually raises interest rates because its reaction function includes headline inflation and because it anticipates some feedback from headline into core inflation. This raises real interest rates and leads to real exchange rate appreciation, causing GDP growth to slow. Growth only recovers to the baseline after three years, leaving a significant and persistent negative output gap.

123. Euro area interest rate shock (Table 6). A temporary increase in euro area interest rates (by 2 percentage points for two quarters) leads—through the exchange rate depreciation brought about by the lower real interest rate differential—to a slight rise in Serbian inflation. This requires some monetary tightening in the short run. The impact of euro area interest rates on the euroized domestic environment also lead to lower growth.

124. Increase in reserve requirements (Table 6). The model suggests some slowdown in growth resulting from a permanent increase in reserve requirements above the baseline. The central bank does not react significantly with interest rates, and the slowdown in real growth is partially compensated by exchange rate depreciation.

125. Productivity shock or positive supply shock. In this model, as expected, an increase in potential output translates into an increase in growth, and nothing else is affected as there are no imbalances.

Appendix I: Definition of Variables


output gap (yt – yt*), percentage points


log of real GDP


log of potential real GDP


growth rate of potential GDP, quarter/quarter at annual rate, percentage point


steady state growth rate of potential GDP, Q/Q at annual rate, percentage point


CPI inflation, quarterly at annualized rate, percentage points


target inflation rate, annualized rate, percentage points

π 4t

four-quarter change in the CPI, annualized rate, percentage points


Steady state inflation target, annualized rate, percentage points


change in the relative price of oil, quarterly at annualized rate, percentage points


four-quarter (moving average) change in the relative price of oil, percentage points


level of the domestic consumer price index

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level of the Euro Area consumer price index


nominal interest rate, in percentage points


real interest rate, in percentage points


equilibrium real interest rate, in percentage points


real interest rate gap (RR – RR*), in percentage points


steady state equilibrium interest rate, in percentage points


Euro Area real interest rate, in percentage points


equilibrium euro area real interest rate, in percentage points


equilibrium risk premium on the domestic currency


log of the real exchange (an increase implies a depreciation)


log of the equilibrium real exchange rate (an increase implies a depreciation)


real exchange rate gap (z – z*), percentage points


nominal exchange rate, value of foreign currency in local currency


log of the steady state equilibrium exchange rate

Appendix II: Data

For both Serbia and the euro area, quarterly historical data are from 1999q1 to 2007q4. Forecasts run from 2008q1 to 2012q4 and are IMF staff projections prepared in the context of the biannual World Economic Outlook (WEO). For Serbia, the relevant definitions and sources are provided below.

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Euro area data come from IMF staff, based on Eurostat and WEO forecasts. Potential GDP is calculated using an enhanced HP filter that allows to impose prior views on the output gap. The euro area nominal interest rate is the ECB’s main refinancing rate.


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Prepared by Eric Mottu (EUR). The author is grateful to Douglas Laxton, Philippe Karam, and Andrew Berg in the IMF for providing the necessary codes and assistance to run the model. Useful comments were received from participants in a March 2007 National Bank of Serbia (NBS) seminar and in an IMF seminar, as well as from Peter Doyle, Tokhir Mirzoev, and David Vàvra.


The FPAS model was developed by Berg, Karam, and Laxton (2006a, 2006b), hereafter referred to as BKL. See also Beneš and al. (2003). On theoretical foundations, see the references in the above-mentioned papers, and Clarida, Galí, and Gertler (1999, 2001). Published applications by IMF staff include Harjes and Ricci (2005) and Epstein and al. (2006).


A simplified version, excluding the output gap equation, has been developed by the National Bank of Serbia (NBS, 2007, Appendix 2).


The original Taylor rule would imply a weight on the lagged interest rate of zero and the weights on inflation and the output gap each equal to 0.5.


Headline inflation increases by 3 percentage points (year-on-year) above the baseline for one quarter.