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Lecture 5: Macroeconomic Model
Given to theGiven to theEMBA 8400 ClassEMBA 8400 ClassBuckhead CenterBuckhead Center
April 4, 2009April 4, 2009
Dr. Rajeev DhawanDr. Rajeev DhawanDirectorDirector
Important Macro Lessons To Be Learnt Today
GDP cannot grow beyond its potential in the long run
Loose Monetary Policy can create only a short-run stimulus in GDP. In long-run it only creates inflation! Net-Net money growth determines inflation
Government spending can create only a short-run stimulus in GDP. In the long-run it leads to a rise in the real interest rate with no gain in GDP but higher deficits
Balanced budget spending just redistributes the share of GDP attributed to consumption & government spending
world interest
rateworld GDP
IMPORTS
price level lag 1
worldprice
money
government
tax rate
capital stock lag 1
EXCHANGE RATE
INTEREST RATE
INVESTMENT
TAX REVENUES
investmentlag 1
EXPORTS
NETEXPORTS
REAL GDP
CONSUMPTION
DISPOSABLE INCOME
CAPITAL STOCK
inflationlag 1
PRICE LEVEL
INFLATION
EXPECTED INFLATION
UNEMPLOYMENT
POTENTIAL GDP
labor force
~~Typical Macro-ModelTypical Macro-Model~~
Macroeconomic Model
The Macroeconomic Model simulates the working of the US Economy using explicit equations to model consumption, investment, exports, imports, exchange rate, price level and inflation rate.
Classification and Listing of Equations
1. Accounting Identities: Real GDP (GDP); Tax Revenues (T) Disposable Income (YDP), Net Exports (NETEX) Price Level (P)
Example: Disposable Income (YDP) = GDP – Tax Revenues (T)
Accounting Identities have the following properties: As forecasting equations, they are PERFECT! Don’t have parameters to be fitted No error term No theoretical disputes about their truth, only about their
relevance
2. Behavioral Equations: Consumption (C), Real Interest Rate (R), Investment (I), Exchange Rate (EXCH), Exports (EX), Imports (IM), Inflation (P%)
Example: Consumption (C) = α0 * Disposable income (YDP)
(Where α0 = marginal propensity to consume = 0.9215686)
Behavioral Equations have the following properties:Estimated parameter values change as behavior changesSource of all forecasting errorsTheoretical disputes concerning these equations, e.g., are consumers myopic or forward looking?
Endogenous and Exogenous Variables
Define: A = B + C ……………………(1) Where B = A/2 ………………..…..(2) and C = 5 (given) Then equation (1) becomes A = B +5 which
using definition of B becomes the following: A = (A/2) + 5 Thus, A/2 = 5 or A = 10 and using (2) B=5 In the above example, A & B are endogenous
variables and C is an exogenous variable
Accounting Identity
Behavioral Equation
Macroeconomic Model
The Exogenous Factors in the model are:– GDP Potential (GDP@FULL) which is GDP value
at full employment level– Domestic Policy Variables:
Money Supply (M) Government Spending (G) Tax Policy (T%)
– Rest-of-the-World (ROW) factors such as Foreign Interest Rate (R@ROW) Foreign Price Level (P@ROW) ROW GDP Potential (GDP@ROW)
Model Simulation Approach 1. State macroeconomic theory as a complete set of algebraic
equations.
2. Estimate/postulate numerical values of all parameters.
3. Assume initial conditions for the history of all lagged variables.
4. Assume “base case” values over future time periods for all exogenous variables.
5. Solve the model under base case assumptions.
6. Change some of the exogenous variable assumptions.
7. Solve the model again under alternative assumptions.
8. Compare model solutions
1. Base Case and the alternative policy Simulation.
1. Integrates short run and long run analysis into one coherent story of the dynamic reactions of an economy to macroeconomic policy.
2. Traces the complete logic of the model, step-by-step, instead of trying to condense model into a two-dimensional diagram, such as IS-LM diagram.
3. Extends to real-world macroeconomic policy issues.
4. Same process applies to realistic models of actual economies, such as U.S. forecasting models, oil shocks, or world slowdown.
Advantages of the Model Simulation Approach
12 Endogenous Variables – GDP, C, I, EX, IM, NETEX, R, P, YDP, T, EXCH, P% (requires 12 equations in 12 unknowns)
7 Exogenous Variables– 3 Policy Variables: M, G, TAX%– 3 ROW Variables: P@ROW, R@ROW, GDP@ROW– 1 Other Variable: GDP@FULL
Listing Of Variables in the Model
Listing of 12 Equations in the Model 12 Endogenous Variables
– One GDP Equation/Accounting Identity
– Three Consumption Related Equations
– Two Interest Rate and Investment Equations
Accounting Identity
Accounting Identity
Behavioral Equation
Behavioral Equation
Behavioral Equation
Accounting Identity
– Four Exchange Rate, Export, Import and Net Export Equations
– Two Price Inflation Equations
Accounting Identity
Accounting Identity
Behavioral Equation
Behavioral Equation
Behavioral Equation
Behavioral Equation
Glossary of Variables Type Variable Meaning Units
Endogenous C Consumption Billions of $
Endogenous EX Exports Billions of $
Endogenous EXCH Exchange Rate Index
Exogenous G Government Purchases Billions of $
Endogenous GDP Gross Domestic Product Billions of $
Exogenous GDP@FULL GDP @ Full Employment Billions of $
Exogenous GDP@ROW GDP in Rest of the World Billions of $
Endogenous I Investment Billions of $
Endogenous IM Imports Billions of $
Exogenous M Money supply Billions of $
Endogenous NETEX Net Exports Billions of $
Endogenous P Price Level Index
Endogenous P% Inflation Percent
Exogenous P@ROW Price Level, Rest of the
World
Index
Endogenous R Real Interest Rate Percent
Exogenous R@ROW Real Interest Rate, Rest of
the World
Percent
Endogenous T Tax Revenues Billions of $
Exogenous TAX% Tax Rate Fraction
Endogenous YDP Disposable Income Billions of $
Additional Definitions
The model variables are in real terms (except of course the price variable). We need three other variables in nominal terms to complete our understanding. These are like “derived” accounting identities.
Econ 101 Rule
ENDOGENOUS VARIABLES
2008Gross Domestic Product GDP 7,000.00$ Tax Revenues T 1,050.00$ Disposable Income YDP 5,950.00$ Net Exports NETEX (248.25)$ Price Level P 1.000
BEHAVIORAL EQUATIONSConsumption Expenditure C 5,483.33$ Real Interest Rate R 4.00Investment I 999.99$ Real Exchange Rate EXCH 1.000Exports EX 1,764.29$ Imports IM 2,012.53$ Inflation P% 0.000Nominal Exchange Rate EXCH(N) 1.000EXOGENOUS VARIABLES
POLICY VARIABLES
Money M 3,500.00$
Government Purchases G 764.92$
Tax Rate TAX% 0.15
REST-OF-WORLD VARIABLESPrice Level, ROW P@ROW 1.00Real Interest Rate, ROW R@ROW 4.00GDP @ Rest of World GDP@ROW 7,000.00$
OTHERSPrice Level % (t-1) P%(t-1) 0.00Price Level (t-1) P(t-1) 1.00Potential GDP GDP@FULL 7,000.00$
ACCOUNTING IDENTITIES
Optimize Values of One Year, to obtain:
P = 1.000P% = 0.000Exch(N) =1.000
Econ 101 Rule
“Given the values of exogenous variables for a given economy, if the values of inflation (P%) = 0.00% & nominal exchange rate (EXCH) = 1.00, then the economy is in equilibrium or steady state in such a way that actual GDP is exactly equal to potential GDP”.
Equal
Base Case
The Base Case is the state of the economy where for the given values of exogenous variables, the ECON 101 rule applies and the values of endogenous variables solved in the first year remain constant for all subsequent years
Base CaseThis means that GDP will be equal to its potential value for all the years in the base case.
Inflation will be equal to ZERO percent
And the exchange rate will be at one for all the years
Name of Experiment:
History * * * * * * * * * * * * * * * *2008 2009 2010 2011 2012 2019 2024 2029 2034
Gross Domestic Product (GDP) New Sim $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0
Base Case $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0Diff $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
ACCOUNTING IDENTITIES
Table 1: BASE CASE
Long RunShort RunENDOGENOUS VARIABLES
OTHERS
Potential GDP (GDP@FULL) New Sim $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0
Base Case $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0Diff $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
Name of Experiment:
History * * * * * * * * * * * * * * * *2008 2009 2010 2011 2012 2019 2024 2029 2034ACCOUNTING IDENTITIES
Table 1: BASE CASE
Long RunShort RunENDOGENOUS VARIABLES
Inflation (P%) New Sim 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Base Case 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Diff 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Name of Experiment:
History * * * * * * * * * * * * * * * *2008 2009 2010 2011 2012 2019 2024 2029 2034ACCOUNTING IDENTITIES
Table 1: BASE CASE
Long RunShort RunENDOGENOUS VARIABLES
Real Exchange Rate (EXCH) New Sim 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
Base Case 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00Diff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Cont…
This also implies that values of all other endogenous variables will also be constant for the subsequent years.Why? Endogenous variables P and P% from today become the exogenous variables for subsequent years’ endogenous value calculations as seen from equations 11 and 12.
Data Table 1
Name of Experiment:
History * * * * * * * * * * * * * * * *2008 2009 2010 2011 2012 2019 2024 2029 2034
Gross Domestic Product (GDP) New Sim $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0
Base Case $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0Diff $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
Taxes (T) New Sim $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0
Base Case $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0Diff $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
Disposable Income (YDP) New Sim $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0Base Case $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0
Diff $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
Net Exports (NETEX) New Sim ($248.2) ($248.2) ($248.2) ($248.2) ($248.2) ($248.2) ($248.2) ($248.2) ($248.2)
Base Case ($248.2) ($248.2) ($248.2) ($248.2) ($248.2) ($248.2) ($248.2) ($248.2) ($248.2)Diff $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
Price Level (P) New Sim 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
Base Case 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00Diff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
BEHAVIORAL EQUATIONS
Consumption Expenditure ( C) New Sim $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3
Base Case $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3Diff $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
Real Interest Rate ( R) New Sim 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0
Base Case 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0
Diff 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Investment (I) New Sim $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0Base Case $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0
Diff $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
Real Exchange Rate (EXCH) New Sim 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
Base Case 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00Diff 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Exports (EX) New Sim $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3
Base Case $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3Diff $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
Imports (IM) New Sim $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5Base Case $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5
Diff $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
Inflation (P%) New Sim 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Base Case 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Diff 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
ACCOUNTING IDENTITIES
Table 1: BASE CASE
Long RunShort RunENDOGENOUS VARIABLES
Second half of the data Table 1EXOGENOUS VARIABLES
POLICY VARIABLES
Money Supply (M) New Sim $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0Base Case $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0 $3,500.0
Diff $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
Government Purchases (G) New Sim $764.9 $764.9 $764.9 $764.9 $764.9 $764.9 $764.9 $764.9 $764.9
Base Case $764.9 $764.9 $764.9 $764.9 $764.9 $764.9 $764.9 $764.9 $764.9Diff $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
Tax Rate (TAX%) New Sim 15% 15% 15% 15% 15% 15% 15% 15% 15%
Base Case 15% 15% 15% 15% 15% 15% 15% 15% 15%Diff 0% 0% 0% 0% 0% 0% 0% 0% 0%
REST-OF-WORLD VARIABLES
Price Level, ROW New Sim 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0
Base Case 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0 1.0Diff 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Real Interest Rate, ROW New Sim 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0
Base Case 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0
Diff 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
GDP @ Rest of World New Sim $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0Base Case $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0
Diff $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
OTHERS
Potential GDP (GDP@FULL) New Sim $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0Base Case $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0
Diff $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0 $0.0
4 Important Guidelines to Use the Model
1. Tools/Options/Calculations/Iterations=100
2. Use Graph Button to Generate New Graphs for the experiment performed
3. Use Print Button for Printing the Results
4. To Reset the Model, Press the Base Case Button, and run the model once using the Calculations Button
Policy Experiments With The Integrated Macro Model
Policy Experiments are comparisons of simulated time paths of all endogenous variables to changes in the values of some of the exogenous variables representing macroeconomic policy, such as government spending, taxes, or money supply.
Three policy experiments are discussed in this Guide:
1. A Monetary-Stimulus (Inflation) Policy Experiment: Simulated response to an increase in the growth of money supply from zero to a chosen rate of inflation (1 to 20 percent range).
2. A Fiscal-Stimulus Policy Experiment: Simulated response to an increase in real government spending by $50 billion increments without any change in taxes.
3. A Neutral-Budget Policy Experiment: Simulated response to two coordinated fiscal policy changes:
a. An increase in real government spending, (the same as in the second experiment).
b. An increase in tax rates high enough to “crowd out” an exactly offsetting amount of consumption.
Rate of growth of the money supply is increased from 0% to 5% in 2007. This is done for 4 years from 2009 to 2012, and then money supply
growth drops to 0% in 2013 and thereafter.
1A: Monetary-Stimulus (Inflation) Experiment Money Growth Stops in 2012
$-
$500
$1,000
$1,500
$2,000
$2,500
$3,000
$3,500
$4,000
$4,500
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
$ B
illi
on
s
Years
Money Supply
Money Supply (Simulation) Money Supply (Base)
• Money supply growth rate is a constant 5% for four years from 2009 – 2012
0.0
1.0
2.0
3.0
4.0
5.0
6.0
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034(i
n P
erce
nta
ge
%)
Years
Money Supply Growth
Money Supply Growth (Base) Money Supply Growth (Simulation)
$6,700
$6,750
$6,800
$6,850
$6,900
$6,950
$7,000
$7,050
$7,100
$7,150
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034$
Bill
ion
s
Years
GDP
GDP (Simulation) GDP (Base)
GDP versus Potential
Same asGDP Potential in Long Run
Q & AQ: Why does GDP values fluctuate around the potential?A: Interest Rate becomes cyclic which makes Investment
cyclicalQ: So?A: Interest rate is cyclical because inflation rate in the model
at first is smaller than or lags the money supply growth rate, and then later overshoots it. The important thing to note is that if the inflation rate is equal to the money growth rate, then there will be no dynamics!
Q: Why does Inflation lag the money growth rate initially?A: By construction, based upon historical evidence, there is a
lag or slowness in people’s adjustment of their inflation expectations. However, this adjustment is complete i.e. expectations are equal to actual inflation rate in the long run, which is equal to the growth rate of money supply. Inflation is always a monetary phenomenon.
• Inflation follows the money growth path, lagging behind at first but then over-shooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
(in
Per
cen
tag
e %
)
Years
Money Supply Growth Vs. Inflation
Inflation Money Supply Growth
•The real interest rate becomes cyclic. At first it drops and then rises as P overshoots M!
3.2
3.4
3.6
3.8
4.0
4.2
4.4
4.6
2007
2009
2011
2013
2015
2017
2019
2021
2023
2025
2027
2029
2031
2033
(In
Pe
rce
nta
ge
%)
Years
Real Interest Rate
Real Interest Rate (Simulation) Real Interest Rate (Base)
$920
$940
$960
$980
$1,000
$1,020
$1,040
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
$ B
illi
on
s
Years
Investment
Investment (Simulation) Investment (Base)
• Investment follows a cyclic path, increases in the short-run due to a drop in the real interest rate, then drops as real interest rate rises. In the long-run it comes back to its steady state value
Comparison of Inflation and Nominal Interest RatesNominal = Real + Inflation Rate
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034(I
n P
erce
nta
ge
%)
Years
Inflation vs. Nominal Interest Rate
Inflation Nominal Interest Rate
0.0
2.0
4.0
6.0
8.0
10.0
12.0
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034(I
n P
erce
nta
ge
%)
Years
Real Vs Nominal Interest Rate
Real Interest Rate Nominal Interest Rate
Comparison of Real Interest Rate and Nominal Interest Rate
0.000
0.200
0.400
0.600
0.800
1.000
1.200
2007
2009
2011
2013
2015
2017
2019
2021
2023
2025
2027
2029
2031
2033
(In
Per
cen
tag
e %
)
Years
Real Exchange Rate
Real Exchange Rate (Simulation) Real Exchange Rate (Base)
•As R drops it pulls down the real exchange rate
3.2
3.4
3.6
3.8
4.0
4.2
4.4
4.6
$1,720
$1,730
$1,740
$1,750
$1,760
$1,770
$1,780
$1,790
2007200820092010201120122013201420152016201720182019202020212022202320242025202620272028202920302031203220332034
Rea
l In
tere
st R
ate
(in
%)
Exp
ort
s ($
Bil
lio
ns)
Years
Exports Vs. Real Interest Rate
Exports Real Interest Rate
Billions
•Exports increase in the short-run due to a drop in the real exchange rate
α9 < 0
Billions
•Exports increase in the short-run due to a drop in the real exchange rate
$1,720
$1,730
$1,740
$1,750
$1,760
$1,770
$1,780
$1,790
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
($ B
illi
on
s)
Years
Exports
Exports (Simulation) Exports (Base)
Imports Vs. Real Exchange Rate
$1,960
$1,970
$1,980
$1,990
$2,000
$2,010
$2,020
$2,030
$2,040
2005200620072008200920102011201220132014201520162017201820192020202120222023202420252026202720282029203020312032
Years
Imp
ort
s ($
Bil
lio
ns)
0.0
0.2
0.4
0.6
0.8
1.0
1.2
Rea
l E
xch
ang
e R
ate
(in
%)
Imports Real Exchange Rate
•Imports also increase in the short-run even despite a drop in the real exchange rate. Why? GDP has increased!
α12 > 0
$1,960
$1,970
$1,980
$1,990
$2,000
$2,010
$2,020
$2,030
$2,040
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
$ B
illi
on
s
Years
Imports
Imports (Simulation) Imports (Base)
•Imports increase in the short-run due to a rise in GDP which overpowers the negative effect of a weak exchange rate on imports
Billions
•Trade deficit increases in the short-run because the increase in real exports is less than the increase in real imports (based upon values of alphas!)
0.0
0.2
0.4
0.6
0.8
1.0
1.2
$(260)
$(255)
$(250)
$(245)
$(240)
$(235)
$(230)
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Rea
lExc
han
ge
Rat
e
Tra
de
Def
icit
Years
Trade Deficit Vs. Real Exchange Rate
Trade Deficit Real Exchange Rate
$6,700
$6,750
$6,800
$6,850
$6,900
$6,950
$7,000
$7,050
$7,100
$7,150
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
$ B
illio
ns
Years
GDP
GDP (Simulation) GDP (Base)
• Real GDP shoots above the base case value, so that there is a boom in the economy in the short-run. In the long-run, once the prices adjust completely, the economy is back to its potential GDP value
Unemployment Drops
Unemployment Rises
•Government surplus increases because GDP increases result in increased tax collections, and government spending is assumed to be constant.
$240
$250
$260
$270
$280
$290
$300
$310
20
07
20
08
20
09
20
10
20
11
20
12
20
13
20
14
20
15
20
16
20
17
20
18
20
19
20
20
20
21
20
22
20
23
20
24
20
25
20
26
20
27
20
28
20
29
20
30
20
31
20
32
20
33
20
34
$ B
illi
on
s
Years
Surplus / Deficit
Surplus / Deficit (Simulation) Surplus / Deficit (Base)
•Consumption rises as GDP has risen!
$5,250
$5,300
$5,350
$5,400
$5,450
$5,500
$5,550
$5,600
20
07
20
08
20
09
20
10
20
11
20
12
20
13
20
14
20
15
20
16
20
17
20
18
20
19
20
20
20
21
20
22
20
23
20
24
20
25
20
26
20
27
20
28
20
29
20
30
20
31
20
32
20
33
20
34
$ B
illi
on
s
Years
Consumption
Consumption (Simulation) Consumption (Base)
Comparison of Government Surplus and Nominal Interest Rate
0.0
2.0
4.0
6.0
8.0
10.0
12.0
$240
$250
$260
$270
$280
$290
$300
$310
2007200820092010201120122013201420152016201720182019202020212022202320242025202620272028202920302031203220332034
No
min
al In
tere
st R
ate
(in
%)
Su
rplu
s
Years
Surplus Vs. Nominal Interest Rate
Surplus Nominal Interest Rate
Cont… Comparison of Government Surplus and Real Interest
Rate
Surplus Vs. Real Interest Rate
$240
$250
$260
$270
$280
$290
$300
$310
2005
20062007
20082009
201020112012
20132014
20152016
20172018
20192020
20212022
20232024
202520262027
20282029
20302031
2032
Years
Su
rplu
s
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
Rea
l In
tere
st R
ate
(in
%)
Surplus Real Interest Rate
Name of Experiment:
History * * * * * * * * * * * * * * * *2008 2009 2010 2011 2012 2019 2024 2029 2034
Gross Domestic Product (GDP) New Sim $7,000.0 $7,101.3 $7,114.6 $7,072.9 $7,017.9 $7,033.5 $6,994.3 $7,000.5 $7,000.1
Base Case $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0 $7,000.0
Diff $0.0 $101.3 $114.6 $72.9 $17.9 $33.5 -$5.7 $0.5 $0.1
Taxes (T) New Sim $1,050.0 $1,065.2 $1,067.2 $1,060.9 $1,052.7 $1,055.0 $1,049.2 $1,050.1 $1,050.0
Base Case $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0 $1,050.0
Diff $0.0 $15.2 $17.2 $10.9 $2.7 $5.0 -$0.8 $0.1 $0.0
Disposable Income (YDP) New Sim $5,950.0 $6,036.1 $6,047.3 $6,012.0 $5,965.2 $5,978.4 $5,945.2 $5,950.4 $5,950.1
Base Case $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0 $5,950.0
Diff $0.0 $86.1 $97.3 $62.0 $15.2 $28.4 -$4.8 $0.4 $0.1
Net Exports (NETEX) New Sim ($248.2) ($254.0) ($254.7) ($252.3) ($249.2) ($250.1) ($247.9) ($248.3) ($248.3)
Base Case ($248.2) ($248.2) ($248.2) ($248.2) ($248.2) ($248.2) ($248.2) ($248.2) ($248.2)
Diff $0.0 -$5.7 -$6.5 -$4.0 -$1.0 -$1.8 $0.3 $0.0 $0.0
Price Level (P) New Sim 1.00 1.02 1.07 1.14 1.21 1.20 1.22 1.22 1.22
Base Case 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00Diff 0.00 0.02 0.07 0.14 0.21 0.20 0.22 0.22 0.22
BEHAVIORAL EQUATIONS
Consumption Expenditure ( C) New Sim $5,483.3 $5,562.7 $5,573.0 $5,540.4 $5,497.4 $5,509.5 $5,478.9 $5,483.7 $5,483.4
Base Case $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3 $5,483.3
Diff $0.0 $79.3 $89.7 $57.1 $14.0 $26.2 -$4.4 $0.4 $0.1
Real Interest Rate ( R) New Sim 4.0 3.7 3.7 3.8 4.0 3.9 4.0 4.0 4.0
Base Case 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0 4.0
Diff 0.0 -0.3 -0.3 -0.2 0.0 -0.1 0.0 0.0 0.0
Investment (I) New Sim $1,000.0 $1,027.7 $1,031.4 $1,019.9 $1,004.8 $1,003.6 $998.5 $1,000.1 $1,000.0
Base Case $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0 $1,000.0
Diff $0.0 $27.7 $31.4 $19.9 $4.9 $3.6 -$1.5 $0.1 $0.0
Real Exchange Rate (EXCH) New Sim 1.00 0.97 0.93 0.88 0.83 0.83 0.82 0.82 0.82
Base Case 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
Diff 0.00 -0.03 -0.07 -0.12 -0.17 -0.17 -0.18 -0.18 -0.18
Exports (EX) New Sim $1,764.3 $1,773.3 $1,766.5 $1,748.4 $1,745.0 $1,768.5 $1,763.6 $1,764.3 $1,764.3
Base Case $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3 $1,764.3
Diff $0.0 $9.1 $2.2 -$15.9 -$19.3 $4.2 -$0.7 $0.1 $0.0
Imports (IM) New Sim $2,012.5 $2,030.8 $2,033.1 $2,025.6 $2,015.7 $2,018.5 $2,011.5 $2,012.6 $2,012.5
Base Case $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5 $2,012.5
Diff $0.0 $18.2 $20.6 $13.1 $3.2 $6.0 -$1.0 $0.1 $0.0
Inflation (P%) New Sim 0.0 2.2 4.6 6.2 6.6 0.3 -0.1 0.0 0.0
Base Case 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0Diff 0.0 2.2 4.6 6.2 6.6 0.3 -0.1 0.0 0.0
ACCOUNTING IDENTITIES
Money Supply Growth
Long RunShort RunENDOGENOUS VARIABLES
A Somewhat “Sequential” Working of the Model (Monetary Policy)
As Money Supply goes up (M↑), Inflation goes up (P↑), but not as much which implies that Real Interest Rate falls (R↓) which stimulates the Investment (I↑).
Also as Real Interest Rate falls (R↓), the Real Exchange Rate falls (EXCH↓) which boost Exports (EX↑) but hurts Imports (IM↓)
Rise in Investment and Exports by GDPO identity means GDP increases (GDP↑). Consumption also rises (C↑) as GDP rises.
However a rise in GDP also stimulates Imports and the net-effect is that Imports rise overall (IM↑).
Trade Deficit (NETEX↑) increases because the rise in Imports is greater than the rise in Exports.
Government surplus increases because GDP increases result in increased tax collections, and government spending is assumed to be constant.
In the Long Run…
Inflation rate is exactly equal to the money growth rate. This means there is no change in the value of real interest rate which in turn implies no change in the other variables of the model, and hence no change in GDP!!
Inflation follows the money growth path, lagging behind at first but then over-shooting on the way down. Inflation, however, is equal to the growth rate of money supply in the long-run
The real interest rate becomes cyclic. At first it drops and then rises as P overshoots M! Investment follows a cyclic path, increases in the short-run due to a drop in the real interest rate, then drops as real interest rate rises. In the long-run it comes back to its steady state value
As R drops it pulls down the real exchange rate Exports increase in the short-run due to a drop in the real exchange rate Imports also increase in the short-run even despite a drop in the real
exchange rate. Why? GDP has increased! Trade deficit increases in the short-run because the increase in real exports is less
than the increase in real imports (based upon values of alphas!) Real GDP shoots above the base case value, so that there is a boom in the economy
in the short-run. In the long-run, once the prices adjust completely, the economy is back to its potential GDP value.
Government surplus increases because GDP increases result in increased tax collections, and government spending is assumed to be constant.
Consumption rises as GDP has risen!
Summary of Reactions
