Download lecture5_2009 - Dr. Rajeev Dhawan

Lecture 5: Macroeconomic Model
Dr. Rajeev Dhawan
Director
Given to the
EMBA 8400 Class
Buckhead Center
April 4, 2009
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
~Typical Macro-Model~
world
interest
rate
world
price
price
level lag 1
world
GDP
IMPORTS
inflation
lag 1
EXPORTS
EXCHANGE RATE
NET
EXPORTS
money
PRICE
LEVEL
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
CONSUMPTION
tax
rate
capital stock
lag 1
TAX REVENUES
investment
lag 1
DISPOSABLE INCOME
CAPITAL STOCK
EXPECTED
INFLATION
UNEMPLOYMENT
POTENTIAL GDP
labor force
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 changes
Source of all forecasting errors
Theoretical disputes concerning these equations, e.g., are
consumers myopic or forward looking?
Endogenous and Exogenous Variables
Accounting Identity
 Define: A = B + C ……………………(1)
 Where B = A/2
………………..…..(2)
 and C = 5 (given)
Behavioral Equation
 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
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.
2.
3.
4.
5.
6.
7.
8.
State macroeconomic theory as a complete set of algebraic
equations.
Estimate/postulate numerical values of all parameters.
Assume initial conditions for the history of all lagged
variables.
Assume “base case” values over future time periods for all
exogenous variables.
Solve the model under base case assumptions.
Change some of the exogenous variable assumptions.
Solve the model again under alternative assumptions.
Compare model solutions
 Base Case and the alternative policy Simulation.
Advantages of the Model Simulation Approach
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.
Listing Of Variables in the Model
 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 12 Equations in the Model
 12 Endogenous Variables
– One GDP Equation/Accounting Identity
Accounting Identity
– Three Consumption Related Equations
Accounting Identity
Accounting Identity
Behavioral Equation
– Two Interest Rate and Investment Equations
Behavioral Equation
Behavioral Equation
– Four Exchange Rate, Export, Import and Net Export Equations
Behavioral Equation
Behavioral Equation
Behavioral Equation
Accounting Identity
– Two Price Inflation Equations
Behavioral Equation
Accounting Identity
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
Index
World
Endogenous
R
Real Interest Rate
Percent
Exogenous
R@ROW
Real Interest Rate, Rest of
Percent
the World
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
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”.
ENDOGENOUS VARIABLES
ACCOUNTING IDENTITIES
Gross Domestic Product
Tax Revenues
Disposable Income
Net Exports
Price Level
BEHAVIORAL EQUATIONS
Consumption Expenditure
Real Interest Rate
Investment
Real Exchange Rate
Exports
Imports
Inflation
Nominal Exchange Rate
EXOGENOUS VARIABLES
POLICY VARIABLES
Money
Government Purchases
Tax Rate
GDP
T
YDP
NETEX
P
2008
$ 7,000.00
$ 1,050.00
$ 5,950.00
$ (248.25)
1.000
C
R
I
EXCH
EX
IM
P%
EXCH(N)
$ 5,483.33
4.00
$
999.99
1.000
$ 1,764.29
$ 2,012.53
0.000
1.000
M
$ 3,500.00
G
TAX%
REST-OF-WORLD VARIABLES
Price Level, ROW
P@ROW
Real Interest Rate, ROW
R@ROW
GDP@ROW
GDP @ Rest of World
OTHERS
Price Level % (t-1)
Price Level (t-1)
Potential GDP
$
764.92
0.15
1.00
4.00
$ 7,000.00
P%(t-1)
0.00
P(t-1)
1.00
GDP@FULL $ 7,000.00
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 Case
This means that GDP will be equal to its potential value for all the
years in the base case.
Name of Experiment:
Table 1: BASE CASE
History
2008
E NDOGENOUS VARIABLES
ACCOUNTING IDENTITIES
Gross Domestic Product (GDP)
* ***
2009
Short Run
2010
2011
* ** *
2012
* ** *
2019
Long Run
2024
2029
* ** *
2034
New Sim
Base Case
Diff
$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
$7,000.0
$0.0
$7,000.0
$0.0
$7,000.0
$0.0
$7,000.0
$0.0
$7,000.0
$0.0
$7,000.0
$0.0
$7,000.0
$0.0
$7,000.0
$0.0
$7,000.0
$0.0
New Sim
Base Case
Diff
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
OTHERS
Potential GDP (GDP@FULL)
Inflation will be equal to ZERO percent
Name of Experiment:
Table 1: BASE CASE
History
2008
ENDOGENOUS VARIABLES
ACCOUNTING IDENTITIES
Inflation (P%)
New Sim
Base Case
Diff
****
2009
Short Run
2010
2011
****
2012
****
2019
Long Run
2024
2029
****
2034
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
And the exchange rate will be at one for all the years
Name of Experiment:
Table 1: BASE CASE
History
2008
ENDOGENOUS VARIABLES
ACCOUNTING IDENTITIES
Real Exchange Rate (EXCH)
New Sim
Base Case
Diff
****
2009
Short Run
2010
2011
****
2012
****
2019
Long Run
2024
2029
****
2034
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
1.00
0.00
1.00
0.00
1.00
0.00
1.00
0.00
1.00
0.00
1.00
0.00
1.00
0.00
1.00
0.00
1.00
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.
Name of Experiment:
Table 1: BASE CASE
History
2008
E NDOGENOUS VARIABLES
ACCOUNTING IDENTITIES
Data Table
1
* ***
2009
Short Run
2010
2011
* ** *
2012
* ** *
2019
Long Run
2024
2029
* ** *
2034
Gross Domestic Product (GDP)
New Sim
Base Case
Diff
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
Taxes (T)
New Sim
Base Case
Diff
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
$1,050.0
$1,050.0
$0.0
Disposable Income (YDP)
New Sim
Base Case
Diff
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
$5,950.0
$5,950.0
$0.0
Net Exports (NETEX)
New Sim
Base Case
Diff
($248.2)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
($248.2)
($248.2)
$0.0
P rice Level (P)
New Sim
Base Case
Diff
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
Consumption E xpenditure ( C)
New Sim
Base Case
Diff
$5,483.3
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
$5,483.3
$5,483.3
$0.0
Real Interest Rate ( R)
New Sim
Base Case
Diff
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
Investment (I)
New Sim
Base Case
Diff
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
$1,000.0
$1,000.0
$0.0
Real Exchange Rate (EXCH)
New Sim
Base Case
Diff
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
1.00
1.00
0.00
E xports (EX)
New Sim
Base Case
Diff
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
$1,764.3
$1,764.3
$0.0
Imports (IM)
New Sim
Base Case
Diff
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
$2,012.5
$2,012.5
$0.0
Inflation (P%)
New Sim
Base Case
Diff
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
BEHAVIORAL EQUATIONS
Second half of the data Table 1
E XOGENOUS V ARIABLES
P OLICY VARIABLES
Money Supply (M)
New Sim
Base Case
Diff
$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
$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
$0.0
$0.0
$0.0
$0.0
$0.0
$0.0
$0.0
$0.0
$0.0
Government Purcha ses (G)
New Sim
Base Case
Diff
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
$764.9
$764.9
$0.0
Tax Rate (TAX%)
New Sim
Base Case
Diff
15%
15%
15%
15%
15%
15%
15%
15%
15%
15%
0%
15%
0%
15%
0%
15%
0%
15%
0%
15%
0%
15%
0%
15%
0%
15%
0%
P rice Level, ROW
New Sim
Base Case
Diff
1.0
1.0
0.0
1.0
1.0
0.0
1.0
1.0
0.0
1.0
1.0
0.0
1.0
1.0
0.0
1.0
1.0
0.0
1.0
1.0
0.0
1.0
1.0
0.0
1.0
1.0
0.0
Real Interest Rate, ROW
New Sim
Base Case
Diff
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
4.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
New Sim
Base Case
Diff
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
New Sim
Base Case
Diff
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
$7,000.0
$7,000.0
$0.0
REST-OF-WORLD VARIABLES
GDP @ Rest of World
OTHERS
P otential GDP (GDP@FULL)
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.
1A: Monetary-Stimulus (Inflation) Experiment
Money Growth Stops in 2012
 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.
Money Supply
$4,500
$4,000
$3,500
$2,500
$2,000
$1,500
$1,000
$500
Years
Money Supply (Simulation)
Money Supply (Base)
2034
2033
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
$-
2007
$ Billions
$3,000
• Money supply growth rate is a constant 5% for four
years from 2009 – 2012
Money Supply Growth
(in Percentage %)
6.0
5.0
4.0
3.0
2.0
1.0
0.0
2034
Money Supply Growth (Simulation)
2033
Money Supply Growth (Base)
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
Years
GDP versus Potential
GDP
$7,150
$7,100
$ Billions
$7,050
$7,000
$6,950
$6,900
$6,850
$6,800
Same as
GDP Potential in Long Run
$6,750
$6,700
2034
2033
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
Years
GDP (Simulation)
GDP (Base)
Q&A
Q: Why does GDP values fluctuate around the potential?
A: Interest Rate becomes cyclic which makes Investment
cyclical
Q: 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 overshooting on the way down. Inflation, however, is equal to the growth rate of
money supply in the long-run
Money Supply Growth Vs. Inflation
7.0
6.0
5.0
(in Percentage %)
•
4.0
3.0
2.0
1.0
0.0
2034
2033
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
-1.0
-2.0
-3.0
Years
Inflation
Money Supply Growth
•The real interest rate becomes cyclic. At first it drops
and then rises as P overshoots M!
Real Interest Rate
(In Percentage %)
4.6
4.4
4.2
4.0
3.8
3.6
3.4
3.2
2033
Real Interest Rate (Base)
2031
Real Interest Rate (Simulation)
2029
2027
2025
2023
2021
2019
2017
2015
2013
2011
2009
2007
Years
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
Investment
$1,040
$1,020
$1,000
$ Billions
•
$980
$960
$940
$920
2034
2033
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
Years
Investment (Simulation)
Investment (Base)
Comparison of Inflation and Nominal Interest Rates
Nominal = Real + Inflation Rate
Inflation vs. Nominal Interest Rate
12.0
10.0
(In Percentage %)
8.0
6.0
4.0
2.0
0.0
2034
2033
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
-2.0
-4.0
Years
Inflation
Nominal Interest Rate
Comparison of Real Interest Rate and Nominal
Interest Rate
Real Vs Nominal Interest Rate
12.0
(In Percentage %)
10.0
8.0
6.0
4.0
2.0
0.0
2034
2033
2032
2031
Nominal Interest Rate
2030
Real Interest Rate
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
Years
•As R drops it pulls down the real exchange rate
Real Exchange Rate
1.200
(In Percentage %)
1.000
0.800
0.600
0.400
0.200
0.000
Real Exchange Rate (Simulation)
Real Exchange Rate (Base)
2033
2031
2029
2027
2025
2023
2021
2019
2017
2015
2013
2011
2009
2007
Years
•Exports increase in the short-run due to a drop in the real exchange rate
α9 < 0
Exports ($ Billions)
Billions
$1,790
4.6
$1,780
4.4
$1,770
4.2
$1,760
4.0
$1,750
3.8
$1,740
3.6
$1,730
3.4
$1,720
3.2
2034
2033
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
Years
Exports
Real Interest Rate
Real Interest Rate (in %)
Exports Vs. Real Interest Rate
$1,790
$1,780
($ Billions)
$1,770
$1,760
$1,750
$1,740
$1,730
$1,720
Years
Exports (Simulation)
Exports (Base)
2034
2033
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
Exports
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
Billions
2007
•Exports increase in the short-run due to a drop in the
real exchange rate
•Imports also increase in the short-run even despite a drop in the
real exchange rate. Why? GDP has increased!
α12 > 0
Imports Vs. Real Exchange Rate
1.2
Imports ($ Billions)
$2,030
1.0
$2,020
0.8
$2,010
$2,000
0.6
$1,990
0.4
$1,980
0.2
$1,970
$1,960
0.0
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
Years
Imports
Real Exchange Rate
Real Exchange Rate
(in %)
$2,040
•Imports increase in the short-run due to a rise in GDP which
overpowers the negative effect of a weak exchange rate on imports
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
Imports
$2,040
$2,030
$ Billions
$2,020
$2,010
$2,000
$1,990
$1,980
$1,970
$1,960
Years
Imports (Simulation)
Imports (Base)
•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!)
Trade Deficit Vs. Real Exchange Rate
$(230)
1.2
$(235)
1.0
$(240)
0.8
$(245)
0.6
$(250)
0.4
$(255)
0.2
Years
$(260)
0.0
Trade Deficit
Real Exchange Rate
RealExchange Rate
Trade Deficit
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
Billions
• 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
GDP
$7,150
$7,100
Unemployment Drops
$ Billions
$7,050
$7,000
$6,950
$6,900
$6,850
Unemployment Rises
$6,800
$6,750
$6,700
2034
2033
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
Years
GDP (Simulation)
GDP (Base)
•Government surplus increases because GDP increases result in
increased tax collections, and government spending is assumed to be
constant.
Surplus / Deficit
$310
$300
$ Billions
$290
$280
$270
$260
$250
$240
2034
2033
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
Years
Surplus / Deficit (Simulation)
Surplus / Deficit (Base)
•Consumption rises as GDP has risen!
Consumption
$5,600
$5,550
$ Billions
$5,500
$5,450
$5,400
$5,350
$5,300
$5,250
2034
2033
2032
Consumption (Base)
2031
Consumption (Simulation)
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
Years
Comparison of Government Surplus and Nominal
Interest Rate
$310
12.0
$300
10.0
Surplus
$290
8.0
$280
6.0
$270
4.0
$260
$250
2.0
$240
0.0
2034
2033
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
Years
Surplus
Nominal Interest Rate
Nominal Interest Rate (in%)
Surplus Vs. Nominal Interest Rate
Cont…
Comparison of Government Surplus and Real Interest
Rate
Surplus Vs. Real Interest Rate
$310
4.0
4.0
Surplus
$290
4.0
$280
4.0
$270
4.0
4.0
$260
4.0
$250
4.0
$240
4.0
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
Years
Surplus
Real Interest Rate
Real Interest Rate (in%)
4.0
$300
Name of Experiment:
Money Supply Growth
History
2008
ENDOGENOUS VARIABLES
ACCOUNTING IDENTITIES
****
2009
Short Run
2010
2011
****
2012
****
2019
Long Run
2024
2029
****
2034
Gross Domestic Product (GDP)
New Sim
Base Case
Diff
$7,000.0
$7,000.0
$0.0
$7,101.3
$7,000.0
$101.3
$7,114.6
$7,000.0
$114.6
$7,072.9
$7,000.0
$72.9
$7,017.9
$7,000.0
$17.9
$7,033.5
$7,000.0
$33.5
$6,994.3
$7,000.0
-$5.7
$7,000.5
$7,000.0
$0.5
$7,000.1
$7,000.0
$0.1
Taxes (T)
New Sim
Base Case
Diff
$1,050.0
$1,050.0
$0.0
$1,065.2
$1,050.0
$15.2
$1,067.2
$1,050.0
$17.2
$1,060.9
$1,050.0
$10.9
$1,052.7
$1,050.0
$2.7
$1,055.0
$1,050.0
$5.0
$1,049.2
$1,050.0
-$0.8
$1,050.1
$1,050.0
$0.1
$1,050.0
$1,050.0
$0.0
Disposable Income (YDP)
New Sim
Base Case
Diff
$5,950.0
$5,950.0
$0.0
$6,036.1
$5,950.0
$86.1
$6,047.3
$5,950.0
$97.3
$6,012.0
$5,950.0
$62.0
$5,965.2
$5,950.0
$15.2
$5,978.4
$5,950.0
$28.4
$5,945.2
$5,950.0
-$4.8
$5,950.4
$5,950.0
$0.4
$5,950.1
$5,950.0
$0.1
Net Exports (NETEX)
New Sim
Base Case
Diff
($248.2)
($248.2)
$0.0
($254.0)
($248.2)
-$5.7
($254.7)
($248.2)
-$6.5
($252.3)
($248.2)
-$4.0
($249.2)
($248.2)
-$1.0
($250.1)
($248.2)
-$1.8
($247.9)
($248.2)
$0.3
($248.3)
($248.2)
$0.0
($248.3)
($248.2)
$0.0
Price Level (P)
New Sim
Base Case
Diff
1.00
1.00
0.00
1.02
1.00
0.02
1.07
1.00
0.07
1.14
1.00
0.14
1.21
1.00
0.21
1.20
1.00
0.20
1.22
1.00
0.22
1.22
1.00
0.22
1.22
1.00
0.22
Consumption Expenditure ( C)
New Sim
Base Case
Diff
$5,483.3
$5,483.3
$0.0
$5,562.7
$5,483.3
$79.3
$5,573.0
$5,483.3
$89.7
$5,540.4
$5,483.3
$57.1
$5,497.4
$5,483.3
$14.0
$5,509.5
$5,483.3
$26.2
$5,478.9
$5,483.3
-$4.4
$5,483.7
$5,483.3
$0.4
$5,483.4
$5,483.3
$0.1
Real Interest Rate ( R)
New Sim
Base Case
Diff
4.0
4.0
0.0
3.7
4.0
-0.3
3.7
4.0
-0.3
3.8
4.0
-0.2
4.0
4.0
0.0
3.9
4.0
-0.1
4.0
4.0
0.0
4.0
4.0
0.0
4.0
4.0
0.0
Investment (I)
New Sim
Base Case
Diff
$1,000.0
$1,000.0
$0.0
$1,027.7
$1,000.0
$27.7
$1,031.4
$1,000.0
$31.4
$1,019.9
$1,000.0
$19.9
$1,004.8
$1,000.0
$4.9
$1,003.6
$1,000.0
$3.6
$998.5
$1,000.0
-$1.5
$1,000.1
$1,000.0
$0.1
$1,000.0
$1,000.0
$0.0
Real Exchange Rate (EXCH)
New Sim
Base Case
Diff
1.00
1.00
0.00
0.97
1.00
-0.03
0.93
1.00
-0.07
0.88
1.00
-0.12
0.83
1.00
-0.17
0.83
1.00
-0.17
0.82
1.00
-0.18
0.82
1.00
-0.18
0.82
1.00
-0.18
Exports (EX)
New Sim
Base Case
Diff
$1,764.3
$1,764.3
$0.0
$1,773.3
$1,764.3
$9.1
$1,766.5
$1,764.3
$2.2
$1,748.4
$1,764.3
-$15.9
$1,745.0
$1,764.3
-$19.3
$1,768.5
$1,764.3
$4.2
$1,763.6
$1,764.3
-$0.7
$1,764.3
$1,764.3
$0.1
$1,764.3
$1,764.3
$0.0
Imports (IM)
New Sim
Base Case
Diff
$2,012.5
$2,012.5
$0.0
$2,030.8
$2,012.5
$18.2
$2,033.1
$2,012.5
$20.6
$2,025.6
$2,012.5
$13.1
$2,015.7
$2,012.5
$3.2
$2,018.5
$2,012.5
$6.0
$2,011.5
$2,012.5
-$1.0
$2,012.6
$2,012.5
$0.1
$2,012.5
$2,012.5
$0.0
Inflation (P%)
New Sim
Base Case
Diff
0.0
0.0
0.0
2.2
0.0
2.2
4.6
0.0
4.6
6.2
0.0
6.2
6.6
0.0
6.6
0.3
0.0
0.3
-0.1
0.0
-0.1
0.0
0.0
0.0
0.0
0.0
0.0
BEHAVIORAL EQUATIONS
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 neteffect 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!!
Summary of Reactions









Inflation follows the money growth path, lagging behind at first but then overshooting 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!