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Dynamic Stochastic General Equilibrium Model Dynamic Stochastic General Equilibrium Model for the Philippine Economyfor the Philippine Economy
Center for Monetary and Financial Policy Center for Monetary and Financial Policy ‐‐ Bangko Sentral ng PilipinasBangko Sentral ng Pilipinas2010 Central Bank Macroeconomic Modeling Workshop2010 Central Bank Macroeconomic Modeling Workshop
The Peninsula Manila, 19The Peninsula Manila, 19‐‐20 October 201020 October 2010
Authors: Prof. Paul McNelis (Fordham University), Dr. Francisco G. Dakila , Jr., Eloisa T. Glindro and Ferdinand S. Co. The views expressed herein do not represent the views and opinions of the Bangko Sentral ng Pilipinas (BSP) nor the Fordham University.
2
Outline of PresentationOutline of Presentation
I. Structure of the BSP‐DSGE model for the Philippine economy
II. Policy simulation results
2.1 100 bps reduction in policy rate
2.2 Increase in fiscal expenditures equivalent to 1% of GDP
III. Further areas of improvement
3
I. Structure of the BSPI. Structure of the BSP‐‐DSGE Model for the DSGE Model for the Philippine EconomyPhilippine Economy
Schematic Diagram of the BSPSchematic Diagram of the BSP‐‐DSGEDSGEModel for the Philippine EconomyModel for the Philippine Economy
Banks
National Government
Households
Firms:• Local producers• Importers• Exporters
Central Bank
International Financial Centers Foreigners:
Firms and Consumers
Supply labor to firms and consume goods produced by firms
Pay taxes
Make deposits and receive interest incomeSupply home goods to NG
Make import and
export transactions with foreign firms and
consumers
Lend to NG
Lend working capital to firms
Providespublic goods
Sets policy rate and provides
liquidity to banks
Send reserves to
CB
Service debts to IFCs
Buys home goods from
firms
International Financial Centers
Lend to banks with risk premium
Supply consumption and investment goods 4
Risks confronting each sectorRisks confronting each sector
Banks
National Government
Households
Firms:• Local producers• Importers• Exporters
Central Bank
International Financial Centers Foreigners:
Firms and Consumers
Supply labor to firms and consume goods produced by firms
Supply consumption and investment goods (both home goods and imports) 5
Pay taxes
Make deposits and receive interest incomeSupply home goods to NG
Make import and
export transactions with foreign firms and
consumers
Lend to NG
Lend working capital to firms
Providespublic goods
Sets policy rate and provides
liquidity to banks
Send reserves to
CB
Service debts to IFCs
Lend to banks with risk premium
Buys home goods from
firms
Surprise policy change
World demand
Fiscal slippage
Increase consumption over savings
• Waves of optimism and pessimism
• Foreign interest rate changes
• Productivity shock• Terms of trade shock• Monopolistic markup
pricing in home goods
• Risk averse lending• High costs of
intermediation
6
BackgroundBackground
• Quarterly data for 16 observable variables for the inflation targeting period. – the choice of 2002 as the beginning period has an added benefit to the calibration exercise because it marks the change in monetary policy framework
• Estimation procedure:– Calibration : steady state parameters were kept at their calibrated values.
– Bayesian method : applied on parameters that do not affect the steady state such as the autoregressive and exogenous shock parameters.
7
Optimization Problem for HouseholdsOptimization Problem for Households
;11
)/~(),/~(
11
ϖγ
σβ
ϖσ
+−
−=
+−ttt
ttttLHC
LHCUMaximize
habit stock
[ ]ηηη µµ1
1)1(~ −−−
− −+= ttt GCC
ρ1
~−
=t
CHt
Government consumption is included
Subject to two constraints,
xt
xt
xt IKK +−= −11 )1( δ
(1) =+Π+++ −−− 111)1( tktttdttt KRMRLW Sources of income 2
2(
)1( ⎟⎟⎠
⎞⎜⎜⎝
⎛ −+++++
t
ssf
tft
xt
fttttctt K
KIPIPLWMCP
δφττ
equal
Uses of income
Adjustment cost in investment
(2)
Optimization Problem for HouseholdsOptimization Problem for Households
Consumption at time t is a CES bundle of both domestically‐produced and imported consumption goods
11/1
1
1/1
1
1
1
1
1
11
1
1 )()()()1(−−−
⎥⎥⎦
⎤
⎢⎢⎣
⎡−=
θθ
θθ
θθθ
θ λλ ft
dtt CCC
λ1 = share of imports in the consumption basket (1‐λ1) = share of domestically‐produced goods in the consumption basketθ = price elasticity of demand for each consumption component
dtC
ftC
111
2
11
2
2
2
2
2
22
2
2 )()()1(−−−
⎥⎥⎦
⎤
⎢⎢⎣
⎡+−=
θθ
θθ
θθ
θθ λλ x
tht
d CCCt
Domestically‐produced goods consist of goods for home consumption and exports
htC
xtC
8
9
Optimization Problem for FirmsOptimization Problem for Firms
Three types of firms: ft
ht
xtt YYYY ++=
• Export firms: [ ] 111
1
11 )())(1( κκκ αα−−− +−= x
txt
xxt
xt KLAZY
• Home goods firms: 21)( α−= ht
ht
ht LZY
xfft ICY +=• Importing firms:
10
Optimization Problem for FirmsOptimization Problem for Firms
Firms face liquidity constraint and borrow a fraction of the wage bill from banks at prevailing loan rate l
tR
xtt
xt LWN 1φ=• Export firms:
xt
kt
xtt
lt
xt
xt
xt YPLWRYP −+−=Π )1( 1φ
Revenues Costs
htt
ht LWN 2φ=• Home goods firms:
xtt
lt
ht
ht
ht LWRYP )1( 2φ+−=Π
Revenues Costs
)*( *3
ft
ftt
ft YPSN φ=• Importing firms:
[ ][ ] f
ttlt
f
ftt
lt
f
PSRP
PSRP*
3
*33
1
))(1()1(
φ
φφ
+=
−++= Importers do not produce any good but incur cost of bringing imported goods into the domestic market
11
PricingPricing
**
2*12
* )1(tp
xt
xt
xt PPP ερρ +−+= −World export price:World export price:
*xtt
x PSP ∗=Export price in domestic currency:Export price in domestic currency:
*3 ]1[ f
ttlt
ft PSRP φ+=Import price in domestic currency:Import price in domestic currency:
Price of domestically produced goods:Price of domestically produced goods:
[ ] 221
2 11
21
2 )())(1( θθ θ
λλ −− −
+−= xt
ht
d PPPt
Price of export goods
Price of home‐produced goods
12
CalvoCalvo Pricing for Home GoodsPricing for Home Goods
• Sticky monopolistically competitive firms in the home‐goods market. The firms consist of backward‐looking price setters
and forward‐looking price setters
bhtP ,
otP
[ ] ζζζ ξξ −−− −+= 11
11, ))(1()( ot
bht
ht PPP
• Overall price index is a CES function of the price indices of domestic consumption goods and foreign goods.
[ ] 111
11
11
11 )())(1( θθθ λλ −−− +−= ft
dtt PPP
13
Optimization Problem for BanksOptimization Problem for Banks
• Banks earn by lending to government and firms, realizing FX gains from foreign bond holdings and taking in deposits from households.
• Banks incur costs by paying out interest to deposits, holding reservesagainst deposit, investing in government bonds, taking out new loans,setting aside capital against losses from private lending and realizingvaluation losses from foreign bond holdings.
tf
ttttlgttb
B MBSNRBRt
+++++=Π −−−− 11,11, )1()1(
tf
ttt
ttltgtttdttd
SBR
NRNBMRMR
11*
1
11,511,411,
)1(
)1(
−−−
−−−−−−
Φ++−
−−−−+− φφ
Earnings
Costs
14
Fiscal PolicyFiscal Policy
Government spending is considered procyclical, exhibits smoothing and has stochastic component.
TGTGYGtGGt YYGGG ,11 )()1()1( ερρρρ +−−++−= −−
Tax revenues are sourced from labor and consumption.
ttCttt CPLWTAX ττ +=
Fiscal balance determines the fiscal borrowing requirement.
tth
tgtt
gt TAXGPBRB −++= −− 11)1(
15
Monetary PolicyMonetary Policy
The monetary policy rule is a function of lagged policy rate, steady state policy rate, inflation gap and output gap:
ptRt
tpp
t
tpppsspptppt
YY
PP
RRR
ερρ
πρρρρ
+⎟⎟⎠
⎞⎜⎜⎝
⎛−−+
⎟⎟⎠
⎞⎜⎜⎝
⎛−−−+−+=
+
+−
1)1(
1)1()1(
131
*121111
The policy rate then feeds into bond rate, lending rate, and deposit rate
16
Monetary PolicyMonetary Policy
Once the policy rate adjustment by the central bank gets transmitted to the market interest rates, the CB provides liquidity support to the banking system.
tf
tttbt
ttltltf
ttf
t
ttdtdttt
SBBRM
NRRSBR
MRRBNLIQ
−+−−
−+−Φ+++
−+++=
−−
−−−−−−−
−−−
11,
11,51,1111
11,41,
)1(
)1()1(
)1(
φ
φ
Reserves against deposit (φ4) and capital‐asset ratio (φ5)
17
Risk Premium and Foreign Debt AccumulationRisk Premium and Foreign Debt Accumulation
The accumulation of foreign debt is determined by the difference between existing foreign debt stock and net exports.
xt
xt
xt
ft
ft
tf
ttf
tf
tt
CPICP
SBRBS
−++
Φ++= −−−−
)(
)1( 1111 Foreign debt stock
Net Exports
Foreign interest rate follows an autoregressive process.
ftr
ff
ftf
ft RRR ,1 )1( ερρ +−+= −
The model is closed by the risk premium (Φ) embedded in accumulation of foreign debt.
18
Solution of Steady StateSolution of Steady State
• The system is highly non‐linear and non‐recursive; Hence, there is no analytical solution for the steady state.
• Used computational algorithms to solve for steady state values based on calibration of structural parameters of the model.
– Hybrid approach to mitigate the problem of “local minimum” trap
• Local gradient‐based algorithm, simulated annealing, and genetic algorithm.
CE Conditions: CE Conditions: CE CE Conditions.pdfConditions.pdf
19
Convergence and Relative Stability of Parameter MomentsConvergence and Relative Stability of Parameter Moments‘‘Multivariate DiagnosticMultivariate Diagnostic’’
Convergence and Relative Stability of Parameter MomentsConvergence and Relative Stability of Parameter Moments‘‘UnivariateUnivariate DiagnosticDiagnostic’’
20
21
II. Policy SimulationsII. Policy Simulations
(the usual disclaimer applies)(the usual disclaimer applies)
Monetary Stimulus Equivalent to 100 bpsMonetary Stimulus Equivalent to 100 bps
All results are expressed in terms of percentage deviation from All results are expressed in terms of percentage deviation from steady state values. steady state values.
22
23
Comparative simulation results Comparative simulation results 1/1/
from various Philippine models from various Philippine models
Model Impact on Inflation Impact on Domestic Demand
BSP‐DSGE 0.17 0.12
BSP‐MEM 2/ 0.06 0.01
NEDA‐QMM 3/ 0.05 0.01
1/ Impact on the first year of 100 bps reduction in policy rate.2/ BSP‐MEM sensitivity table, as of 31 August 2010.3/ The NEDA Quarterly Macroeconometric Model of the Philippines: Final Report, May 2004.
Fiscal Stimulus Equivalent to 1% of GDPFiscal Stimulus Equivalent to 1% of GDP
All results are expressed in terms of percentage deviation from steady state values .
24
25
Future DirectionsFuture Directions
• Further parameter re‐calibrations to test the robustness of the model.
• Introduce matching frictions and nominal wage rigidities would enhance our study of the transmission mechanism and the implications of wage dynamics on inflation.
• Include more market‐based financial stress indicator in the model.
• Finetune inflation forecasts generated by the model.
Dynamic Stochastic General Equilibrium Model Dynamic Stochastic General Equilibrium Model for the Philippine Economyfor the Philippine Economy
Center for Monetary and Financial Policy Center for Monetary and Financial Policy ‐‐ Bangko Sentral ng PilipinasBangko Sentral ng Pilipinas2010 Central Bank Macroeconomic Modeling Workshop2010 Central Bank Macroeconomic Modeling Workshop
The Peninsula Manila, 19The Peninsula Manila, 19‐‐20 October 201020 October 2010
Authors: Prof. Paul McNelis (Fordham University), Dr. Francisco G. Dakila , Jr., Eloisa T. Glindro and Ferdinand S. Co. The views expressed herein do not represent the views and opinions of the Bangko Sentral ng Pilipinas (BSP) nor the Fordham University.