Transcript EC827_B1 - Michigan State University

Economics 827
Conditional Forecasting and Macroeconomic
Models
Copyright 1998 R.H. Rasche
Multiple Variable
Forecasting Models
Forecasts conditional on specific
future events
Copyright 1998 R.H. Rasche
Conditional Forecasts

Forecasting frameworks discussed so far use only
historical data as inputs to forecasting process.

Suppose that you want to generate conditional forecasts:
– e.g. What path will the economy follow from the the
slow recovery turns into a depression for Southeast
Asian economies?
Copyright 1998 R.H. Rasche
Conditional Forecasts

Forecasting approaches that we have discussed would
produce the same forecasts in either event, independent
of whether such an event really would affect the
economy.

Such a depression (or its absence) is a future event and
not included in the history of the economy that is input
into the forecasting process

You need to be able to form some idea as to what the
current shock will be, and how its effects will spread
through the system.
Copyright 1998 R.H. Rasche
Conditional Forecasts

To conduct such forecasting exercises you need a
different type of framework

Such a framework is provided by Macroeconomic or
Macroeconometric Models
Copyright 1998 R.H. Rasche
Macroeconomic Forecasting
Models

Such models distinguish two types of variables:
–
Exogenous or conditioning variables. The future
values of such variables are not forecast by the
macroeconomic model, but are used as inputs into
the forecasting process
–
Endogenous variables. Future values of these
variables are the output of the forecasting process
and are conditional upon the assumed values of the
exogenous variables
Copyright 1998 R.H. Rasche
Examples of Exogenous
Variables

Monetary Policy Variables:
– how will economy behave if Fed keeps the Funds
rate target at present level (5.25) for rest of year vs.
increasing it 50 basis points (5.75) this spring and
holding at that for the rest of the year.

Fiscal Policy Variables:
– what is the impact of a 15 % income tax reduction
vs, maintaining the current rates.
Copyright 1998 R.H. Rasche
Examples of Exogenous
Variables II

World Economic Events
–
Dollar is now trading at about 125 yen and 1.8 Dmarks compared with 110 and 1.50 a two years ago.
What are the consequences of major (permanent)
changes in exchange rates for U.S. economy? for
foreign economies?
–
World Crude Oil Prices dropped substantially with
reduced demand from SE Asia, then rebounded.
What are the implications for the U.S. economy if
such price decreases are repeated?
Copyright 1998 R.H. Rasche
Examples of Endogenous
Variables

Real GDP or its Growth Rate
– GDP components such as Consumption,
Investment, Exports, Imports

Inflation - determined by how “hot” the economy is
running

Interest Rates
– Short-term Interest Rates
– Long-term Bond Rates

Employment and/or Unemployment Rate
Copyright 1998 R.H. Rasche
Sources of Economic
Forecasts I

Building your own wheel

Borrowing someone else’s wheel
–
lots of publicly available forecasts at present.
–
Congressional Budget office prepares forecasts semiannually (typically two year horizon)
–
Council of Economic Advisers prepares annual
forecast (two year horizon)
–
FED publishes estimate of “central tendencies”
Copyright 1998 R.H. Rasche
Sources of Economic
Forecasts II

Private Forecasts - publicly available
– Wall Street Journal publishes forecasts from a sample
of economists semiannually.
–
University of Michigan forecast summary available:
» http://rsqe.econ.lsa.umich.edu/forecast/table.html
–
Survey of Professional Forecasters (Philly FED)
» http://www.phil.frb.org/econ/spf/spfpage.html
–
“Livingston Survey” of Economists (Philly FED)
» http://www.phil.frb.org/econ/liv/welcome.html
Copyright 1998 R.H. Rasche
Forecasts: Who to Believe?

Faced with a large number of conflicting forecasts,
how to choose?
–
remember, none of these forecasters is really
exceptionally accurate - a lot of randomness in
economic behavior that just isn’t predictable
–
look at track records of particular forecasters
Copyright 1998 R.H. Rasche
Combining Forecasts

Large technical literature on how to best combine
forecasts to minimize forecast error variance.
–
problem is similar to constructing a minimum variance
asset portfolio (except you can sell a forecaster who is
consistently wrong short -- negative weight)
–
difficulty is in getting long enough individual
forecasting record to get any precision on the optimal
weights of individual forecasters
–
typically people just construct a simple average
Copyright 1998 R.H. Rasche
Macroeconomic Models
A. Basic Structure
Copyright 1998 R.H. Rasche
Prototype Macro Models

Who Purchases the output that is produced (Real
GDP)?
–
–
–
–
Households -- consumption demand (C)
Firms -- Investment Demand (I)
Government -- Government Purchases (G)
Foreigners -- exports (X) - open economy case
Copyright 1998 R.H. Rasche
Measuring Investment
Demand

Investment as used in should not be confused with
Investments as used in finance
– Investment here refers to purchases of newly
produced plants and equipment (including houses)
plus changes in stocks of inventories (+/-) held by
firms
Copyright 1998 R.H. Rasche
Investment Demand

Simple Investment Function - Investment depends
negatively on real interest rates.
– theory is that at lower real interest rates there are
more profitable opportunities for firms to exploit
– Problems
» accurately measuring real interest rates =
nominal interest rates - expected future inflation
» Investment a very volatile component of real
GDP
» Lags between initiation of project and
completion
Copyright 1998 R.H. Rasche
Historical Evidence Investment-GDP Ratio
Fixed Nonresidential Investment
0.11
0.10
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
29
37
45
53
61
69
77
85
93
Copyright 1998 R.H. Rasche
Estimated Annual Long-Term
Real Rate
Estimated Real Interest Rate
15
10
5
0
-5
-10
-15
30
37
44
51
58
65
72
79
86
93
Copyright 1998 R.H. Rasche
Investment and Real Interest
Rates
Investment Ratio and Real Interest Rate
0.10
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
-15
-10
-5
0
5
10
15
realrate
Copyright 1998 R.H. Rasche
Measuring Government
Purchases

Only include government purchases of newly produced
goods and services

Large portion of government expenditures are transfer
payments - expenditures for which government does
not get goods and services directly in return.
» examples: welfare payments, social security,
Medicare payments
Copyright 1998 R.H. Rasche
Determinants of Private
Demand

Consumption Demand
– Real Disposable Income = Real GDP - Taxes +
Transfer Payments to persons (Yd)
– Real GDP = Income Earned from current
production (compensation, profits, interest, rents)
– Real Disposable Income = Income Received during
current period.
» Earnings less appropriations by government
(taxes) + unearned receipts from government
(transfers)
Copyright 1998 R.H. Rasche
Consumption Demand

Simple Consumption Function
– C depends on Real Disposable Income
(Yd=Y-T)
in a linear fashion.
– Change in consumption with a one unit change in
Yd is positive and less than one = marginal
propensity to consume
Copyright 1998 R.H. Rasche
Historical Evidence:
Consumption Function
Consumption-Disposable Income
3600
3200
2800
2400
2000
1600
1200
800
400
0
1000
2000
3000
4000
Disposable Income
Copyright 1998 R.H. Rasche
Historical Evidence:
Consumption- Yd Ratio
Consumption/Disposable Income Ratio
1.040
1.000
0.960
0.920
0.880
0.840
0.800
0.760
0.720
29
37
45
53
61
69
77
85
93
Copyright 1998 R.H. Rasche
Import Demand

Demand for Imports usually specified to depend on
both real income (or real disposable income) and the
real exchange rate (rer):
– M = M(Y, rer)
– sign of relationship between imports and real
exchange rate depends on units of measurement of
real exchange rate. When foreign goods get
cheaper relative to domestic goods, import demand
increases
Copyright 1998 R.H. Rasche
Commodity Market

Equilibrium Condition:
– Output Produced must be purchased by someone (or
end up as inventory accumulation)
– Y = real GDP
– Y = C + I + G + (X-M)
– M = imports are subtracted out because C and I are
measured as total not just domestic purchases
– Macroeconomic Models typically take G and X as
and exogenous variables

Are we ever in equilibrium in the US?
Copyright 1998 R.H. Rasche
IS Curve: Definition and
Construction

IS Curve: Those values of real output and real interest
rates that are consistent with commodity market
equilibrium; i.e agents are just willing to purchase the
total amount of output that is being currently produced

Why output and interest rates? Because interest rates
link both the real (goods, services) and monetary
(banking, financial) sectors of the economy. Interest
rates are what allow the abilities of the monetary sector
to match the needs of the real sector.
Copyright 1998 R.H. Rasche
IS Curve

The IS-curve (I.S.= Investment, Savings) assumes
fixed values of G,T, X, real exchange rate, in the short
term.

IS Curve : Equation
– Y = C(Y-T) + I(r) + G +X - M(Y, rer)

So Output should equal expenditure
Copyright 1998 R.H. Rasche
Slope of IS Curve

IS curve is a negatively sloped relationship between real
output (Y) and real interest rate (r). Why?
–
What happens if r is increased holding Y constant?
–
Higher r means lower investment demand; so
expenditures (including investment) are expected to
be less than planned output.
–
To equilibrate planned expenditures with production
requires lower output. So, as r rises, Y falls.
Copyright 1998 R.H. Rasche
IS Curve
r
Along IS Curve, real output
(Y) has to increase as real
interest rate declines to
maintain equality between
actual output and planned
expenditures
(C + I + G +[X-M])
IS
Y
Copyright 1998 R.H. Rasche
Shifts in IS Curve

Either an increase in [government spending (G) or
exports (X)] or a decrease in [net taxes (T) or imports
(M)] will increase planned expenditures on output.

To restore equilibrium between actual output and
planned expenditures, either Y will have to increase, or
r will have to increase, or some combination of the
two. Why? Because expenditures are now greater than
planned output, so either output must rise, or interest
rates must rise (to choke off domestic investment, and
keep expenditures in line with output)

The effect is to shift the IS curve to the right (or up)
Copyright 1998 R.H. Rasche
Shift in IS Curve: Example
r
Increases in G, X (or
decreases in T, M)
increase planned
expenditure and shift
the IS curve to the
right (up)
IS’
IS
Y
Copyright 1998 R.H. Rasche