Economics 827

Copyright 1998 R.H. Rasche

Economics 827

Conditional Forecasting and Macroeconomic Models


Multiple Variable Forecasting Models

Forecasts conditional on specific future events


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?


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.


Conditional Forecasts

To conduct such forecasting exercises you need a different type of framework

Such a framework is provided by Macroeconomic or Macroeconometric Models


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


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.


Examples of Exogenous Variables II

World Economic Events

– Dollar is now trading at about 125 yen and 1.8 D-marks 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?


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


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 semi-annually (typically two year horizon)

– Council of Economic Advisers prepares annual forecast (two year horizon)

– FED publishes estimate of “central tendencies”


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


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


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


Macroeconomic Models

A. Basic Structure


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


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


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


Historical Evidence - Investment-GDP Ratio

Fixed Nonresidential Investment

29 37 45 53 61 69 77 85 930.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.10

0.11


Estimated Annual Long-Term Real Rate

Estimated Real Interest Rate

30 37 44 51 58 65 72 79 86 93-15

-10

-5

0

5

10

15


Investment and Real Interest Rates

Investment Ratio and Real Interest Rate

realrate-15 -10 -5 0 5 10 15

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.10


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


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)


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


Historical Evidence: Consumption Function

Consumption-Disposable Income

Disposable Income0 1000 2000 3000 4000

400

800

1200

1600

2000

2400

2800

3200

3600


Historical Evidence: Consumption- Yd Ratio

Consumption/Disposable Income Ratio

29 37 45 53 61 69 77 85 930.720

0.760

0.800

0.840

0.880

0.920

0.960

1.000

1.040


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


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?


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.


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


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.


IS Curve

r

Y

IS

Along IS Curve, real output(Y) has to increase as realinterest rate declines to maintain equality between actual output and planned expenditures (C + I + G +[X-M])


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)


Shift in IS Curve: Example

r

Y

IS

Increases in G, X (or decreases in T, M) increase plannedexpenditure and shift the IS curve to the right (up)

IS’

Documents

Economics 827