Few industrial economies have been as much analyzed and commented upon in recent years as that of the United Kingdom. For much of the period since 1945, Britain has had rather slow economic growth, low investment, and recurrent balance of payments problems. Furthermore, after the introduction of a more flexible exchange rate in 1972 the U. K. economy experienced a period of rapid monetary expansion and inflation. In recommending policies for stabilizing the economy, some economists have emphasized the causal linkages running from the rate of domestic monetary expansion to price inflation, while others have stressed the effects of wage demands on the domestic price level. Each of these approaches, at least in its extreme form, emphasizes one part of the inflationary process to the exclusion of others and tends to obscure crucial elements of an advanced industrial economy. Although inflation cannot continue without monetary expansion, the money supply itself is not necessarily determined independently of the behavior of the private sector, because the authorities respond to market developments in determining the stance of their policies. A most important case in point occurs if, over time, the authorities want to maintain a target level of unemployment. In this case, attempts by workers to push the real wage above its equilibrium level may induce policymakers to raise government spending in order to maintain employment. If the monetary authorities are attempting to stabilize nominal interest rates, however, the increased fiscal deficit of the public sector will induce monetary expansion and inflation.
To understand more fully how the government and the private sector interact during the inflationary process, it is necessary to construct models that have two features. In the first place, they must include both the real and financial sectors of the economy and explain how they are linked with each other and with markets in the rest of the world. Second, these models must try to explain how the actions of the private sector lead to predictable reactions by the authorities. Only when such reactions are specified as an integral part of the system can structural parameters, even of the private sector’s behavior, be estimated consistently. Furthermore, only when the dynamic properties of a system with given reaction functions have been analyzed is it possible to suggest changes in the behavior of policymakers that would enhance the achievement of major economic goals.
The econometric model that is presented in this paper attempts to meet these requirements. Its structural equations describe the interactions between domestic residents and foreigners in markets for goods and financial assets. The real sector consists of the markets for output and labor services, and these markets are linked by an explicit production function that both constrains the long-run relation between domestic output and the supply of inputs of labor and capital, and influences the short-run behavior of wages, prices, and investment in fixed capital. A detailed financial sector that specifies the behavior of home and foreign residents in the markets for domestic money balances, advances, government and private sector securities, and net Eurocurrency liabilities of banks resident in the United Kingdom is also specified.
In the model, the excess demands that arise in real and financial markets may lead to disequilibrium in the balance of payments at the current exchange rate. If the domestic currency is not floating freely, these changes will induce accommodating movements of international reserves that feed back into the domestic economy in many ways, particularly via changes in the domestic money supply. The model takes explicit account of the financial implications of changes in the government borrowing requirement, and it includes reaction functions for four policy instruments: taxes, government spending, Bank rate, and base money. In the United Kingdom, where it is convenient for certain purposes to aggregate the Treasury and the Bank of England into a single official sector, the latter policy instrument is best specified as the rate of acceleration in nonofficial holdings of U. K. Government debt.
While the behavior of real and financial markets has been studied intensively in previous empirical work, the last two relationships—the budget constraint of the authorities and their reaction functions—have received less attention in macroeconometric models. Yet, it is important to emphasize at the outset that these relationships are fundamental to a thorough understanding of recent developments in the U. K. economy.
While the model described in this paper is not wedded to either the neo-Keynesian or monetarist schools of economic analysis, it is grounded on extensive previous theoretical and empirical research. In particular, it builds on the work of Bergstrom (1966), Bergstrom and Wymer (1976), and Knight and Wymer (1975). Section I sets out the equations of the model and provides a condensed discussion of its basic structure. The analytical properties of the model are considered in Section II, where the steady-state solution of the model is discussed. Section III describes the estimation of the model and presents the empirical results, including point estimates of the behavioral parameters and in-sample forecasts. The stability of the model is considered in Section IV, and the implications for the authorities’ policy reaction functions are analyzed. Some conclusions of the study are summarized in Section V.
Bergstrom, A. R., “Nonrecursive Models as Discrete Approximations to Systems of Stochastic Differential Equations,” Econometrica, Vol. 34 (January 1966), pp. 173–82.
Bergstrom, A. R., and C. R Wymer, “A Model of Disequilibrium Neoclassical Growth and Its Application to the United Kingdom,” in Statistical Inference in Continuous Time Economic Models, ed. by Abram R. Bergstrom (Amsterdam, 1976), 267–327.
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Knight, M. D., and C. R Wymer, “A Monetary Model of an Open Economy with Particular Reference to the United Kingdom,” Ch. 8 in Essays in Economic Analysis: The Proceedings of the Association of University Teachers of Economics, Sheffield 1975, ed. by M. J. Artis and A. R Nobay (Cambridge University Press, 1976), 153–71.
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)| false Knight, M. D., and C. R Wymer, “A Monetary Model of an Open Economy with Particular Reference to the United Kingdom,”Ch. 8 in Essays in Economic Analysis: The Proceedings of the Association of University Teachers of Economics, Sheffield 1975, ed. by ( M. J. Artisand A. R Nobay Cambridge University Press, 1976), 153– 71.
Phillips, P. C. B. (1973), “A Sampling Experiment with a Dynamic Model of the Product Market,” University of Essex Discussion Paper in Economics.
Phillips, P. C. B. (1978), “Edgeworth and Saddlepoint Approximations in the First-Order Noncircular Autoregression,” Biometrika, Vol. 65 (April 1978), 91–98.
Wymer, Clifford R., “Continuous Time Models in Macro-Economics: Specification and Estimation,” paper presented at SSRC-Ford Foundation Conference on Macroeconomic Policy and Adjustment in Open Economies, Ware, England (April 28— May 01, 1976).
Mr. Knight, economist in the Financial Studies Division of the Research Department, holds degrees from the University of Toronto and from the London School of Economics and Political Science, where he also served as a member of the Economics Department from 1972 to 1975. He is the author of articles in the fields of macroeconomics and international finance.
Mr. Wymer, Senior Economist in the Financial Studies Division of the Research Department, is a graduate of the University of Auckland and of the London School of Economics and Political Science, where he taught from 1966 to 1976. During the last three years of that period, he directed the U. K. Social Science Research Council’s International Monetary Research Program.
This paper developed from work begun within the International Monetary Research Program at the London School of Economics, financed by the U. K. Social Science Research Council.
Actually, the sample period extends from the first quarter of 1955 to the fourth quarter of 1972, so that it includes two quarters of managed floating.
Such estimation is feasible, but it was considered preferable to obtain a satisfactory theoretical and empirical specification of the major relationships within the model using data from the fixed rate period before extending the model.
The production function is
The elasticity of substitution is 1/(1 + β4), and the elasticity of output with respect to capital is
The labor supply function in the model differs slightly from that given by Knight and Wymer (1975) because of a misspecification in the earlier model that was brought to the attention of the authors by Professor John Williamson. In the earlier model the demand for labor was expressed in efficiency units, while the supply was in actual units. This led to the conclusion (p. 164) that a consistent set of long-run growth rates could exist only if the supply of labor was inelastic with respect to the real wage. In the current version, this error in the dimensionality of the excess demand for labor has been corrected by adjusting the real wage rate for changes in the efficiency of the labor force. The new specification allows price changes to have an immediate effect on nominal wages through their impact on real earnings and on labor supply. Nevertheless, while the conclusion as stated in Knight and Wymer (1975) is incorrect, a similar restriction on the elasticity of the supply of labor still seems necessary in order that a steady state should exist.
The banking system in the model is highly aggregated and includes the clearing banks, overseas and foreign banks, and the accepting houses.
A policy of strict sterilization of the monetary consequences of payments flows would imply α21, α22 > 0, but such a reaction would tend to destabilize the system.
However, the estimation results that are reported in the next section do not incorporate the restrictive assumption that the model was near to its steady state during the particular sample period.
The most important assumptions are that wealth and income elasticities equal unity.
This solution was derived on the assumption that the steady-state paths of the exogenous variables are
Moreover, for a full international steady state, the rates of growth of domestic and foreign output must be equal, that is, Al λ1 λ2 = λ3.
The steady-state solution of the system is not presented in this paper but is available upon request from the authors, whose address is Research Department, International Monetary Fund, Washington, D. C. 20431.
That is, it is independent of those government policies that are incorporated in the model; it would not be independent of structural labor market policies.
The estimation results in the next section make use of the assumptions β8 = 0 and β4 = 1, but these restrictions were imposed only after research indicated that the estimates did not differ significantly from these values.
In the discussion of the results, the term “t-ratio” simply denotes the ratio of a parameter estimate to the estimate of its asymptotic standard error, and does not imply that this ratio has a Student’s t-distribution. In a sufficiently large sample, this ratio is significantly different from zero at the 5 per cent level if it lies outside the interval ± 1.96 and significantly different from zero at the 1 per cent level if it is outside the interval ± 2.58.
In the initial stages of estimation, 3 adjustment parameters in the full theoretical model were found to be insignificant and to have a sign different from that expected a priori. These parameters were set to zero.
These restrictions have the additional advantage that they eliminate the estimation problems that would result from multicollinearity between the different interest rates in the model.
That is, the authors have been unable to find a steady-state solution of a model that does not include this ratio.
The use of dynamic simulation, even through the sample period, provides a reasonable test of the dynamic structure of the model and of the feedbacks within the system. It is, of course, preferable to produce ex post forecasts for a postmodel-building period. Ex ante forecasts are less useful because of their dependence on some forecast of the values of the exogenous variables.
A copy of this model may be obtained upon request from the authors, whose address is Research Department, International Monetary Fund, Washington, D. C. 20431.
In this model, the introduction of the excess demand for money into the consumption function will increase the stability of the model. This result is consistent with the model of the Australian economy described in Jonson, Moses, and Wymer (1976), which incorporates an interest rate policy function and assumes a flexible exchange rate. In that model, the effect of the excess demand for money balances on consumption has a stabilizing influence.