Dr. Stefan Kooths DIW Berlin – Macro Analysis and Forecasting

1. Consultancy to Develop and Implement a Macroeconomic Model for Lesotho (DIMMoL)Macro-Econom(etr)ic ModellingPart 1 Dr. Stefan KoothsDIW Berlin – Macro Analysis and Forecasting

2. Course program • Introduction • Outline of macroeconom(etr)ic models • Macroeconomic framework • Econometric methodology • Applied econometrics with EViews • Lesotho case studies

3. Course program • Introduction • Outline of macroeconom(etr)ic models • Macroeconomic framework • Econometric methodology • Applied econometrics with EViews • Lesotho case studies

4. Fields of interest • Macroeconomics(model building) • Econometrics(applied mathematical statistics) • National accounting(data sources) • Country-specific knowledge(institutions, industries, policy regimes)

5. Recommended literature • Blanchard, O.: Macroeconomics, 3rd ed., 2003. • Wooldridge, J. M.: Introductory Econometrics – A Modern Approach, 3rd ed., 2006. • Enders, W.: Applied Economic Time Series, 2nd ed., 2004. • Matlanyane, R. A.: A Macroeconometric Model for the Economy of Lesotho: Policy analysis and Implications, 2004. (http://upetd.up.ac.za/thesis/available/etd-04182005-091509/)

6. My contact data • here in Maseru cell: 5847.0578 email: skooths@diw.de • in Berlin DIW Berlin, German Institute for Economic Research Koenigin-Luise-Strasse 5 14195 Berlin fon: +49 30 89789-248 fax: +49 30 89789-102 email: skooths@diw.de

7. Introduction of participants • Who are you? • Where are you from? • What are your specific questions and modelling needs?

8. Course program • Introduction • Outline of macroeconom(etr)ic models • Macroeconomic framework • Econometric methodology • Applied econometrics with EViews • Lesotho case studies

9. Scope of macroeconometric models • Forecasting • short-term behaviour of key macroeconomic variables • long-term trends • Policy analysis • simulating the potential impact of alternative policy measures • basis for long-term planning • Note: • both aims are not allways harmonic • “one size fits all” doesn’t apply (different questions, different models) • generally: „small is beautiful“(robustness more important than detailed precision)

10. Building blocks, fundamental characteristics • Institutional sectors (actors, agents) • Markets (intermediaries) and regulations • Time horizon and dynamics • Equilibrium • Adjustment processes • Expectation formation

11. Institutional sectors • Private households • including non-profit organizations • Enterprises • independent of ownership • Public sector • government • social security systems • Rest of the world (external sector) • Financial sector

12. Markets and regulations • production = primary income • price formation(inflation rate) • (nominal) wage setting • (nominal) interest rates • (nominal) exchange rates,foreign reserves • disposable income • Goods market(s) • sectoral disaggregation • Labor market(s) • disaggregation by skills • Financial markets • capital market (implicit) • money market • foreign exchange market • Income Redistribution interconnection of markets:direct vs. indirect effects

13. Sector interactions via markets:circular sectoral flow chart

14. Consultancy to Develop and Implement a Macroeconomic Model for Lesotho (DIMMoL)Macro-Econom(etr)ic ModellingPart 2 Dr. Stefan KoothsDIW Berlin – Macro Analysis and Forecasting

15. Course program • Introduction • Outline of macroeconom(etr)ic models (cont.) • Macroeconomic framework • Econometric methodology • Applied econometrics with EViews • Lesotho case studies

16. The IS-identity:goods and capital market intertwined

17. Time frames • The short run (a few years) • output driven primarily by demand • no significant price/wage movements • analytical framework: IS-LM • The medium run (up to a decade) • output determined by supply factors • adjustment via price and wage movements • fixed stock of capital, labor, technology • analytical framework: AD-AS • The long run (more than a decade) • accumulation effects of (physical and human) capital, technological progress • analytical framework: growth-models

18. Types of variables • By status • endogenous • exogenous • third-party sources • autoregressive forecasts (outside the model) • Most important/interesting variables • output • income • (un)employment • inflation

19. Types of equations • Assumption-based equations • Behavioural (e.g. consumption function) • Technological (e.g. production function) • Institutional (e.g. tax revenues) • Simple identities • e.g. disposable income • Equilibrium conditions • e.g. market clearing condition • Closed system of equations for capturing interactions and feed-backs

20. Supply, demand and market prices • What drives demand and supply? • components/inputs of both market sides • behavioural equations (assumptions) for all involved sectors • What happens when demand and supply don’t match? • (temporal) disequilibriums • adjustment process (quantities, prices) • short run • medium run

21. Goods market (income and price block) • Final demand meets production • Price formation • Short-run vs. long-run • long-run: income creation (economic growth) is supply-side-driven • short-run: level of final demand comes into play • output gaps: actual GDP vs. potential GDP (changing capacity utilization, business cylces) • Potential GDP • filter-approach (HP-filter) • production function + input factor stock approach

22. finaldomestic demand Goods market: demand side • Final demand: C + I + G + NX • Private consumption (C) • Private Investment (I) • Government expenditure (G) • Foreigen trade: Net exports (NX) • Exports (X) • minus: Imports (IM)

23. Private consumption • Important factors • real disposable income: current or permanent? • wealth • real interest rates • Sub-components • durables • non-durables • services

24. Private investment • Private non-residential investment • [expected] output or output-gap (rate of capacity utilization) • user cost of capital (influenced by real interest rate) • Private residential investment • real disposable income (again: current or permanent) • real interest rate

25. Government expenditure • Consumption • Investment • Expenditure for goods and services only! • Both usually (but not necessarily) exogenous • bound by budgetary rules • counter-cyclical use of fiscal policy • Distinction between consumption and investment matters in the long run!

26. real effective exchange rate Exports (= final foreign demand) • GDP of main trading partners • Relative export prices(international competitiveness) • domestic production costs • foreign prices (in main trading partners) • nominal exchange rates • Trade agreements, tariffs

27. Imports (= foreign production) • Domestic final demand or production • Relative import prices (see previous slide) • domestic production costs • foreign prices • nominal exchange rates • Trade agreements, tariffs • Special case: non-substitutional goods (oil, raw materials)

28. Consultancy to Develop and Implement a Macroeconomic Model for Lesotho (DIMMoL)Macro-Econom(etr)ic ModellingPart 3 Dr. Stefan KoothsDIW Berlin – Macro Analysis and Forecasting

29. Course program • Introduction • Outline of macroeconom(etr)ic models (cont.) • Macroeconomic framework • Econometric methodology • Applied econometrics with EViews • Lesotho case studies

30. Goods market: supply side • Production of goods (and services) and generation of (domestic) income = use of (domestic) input factors • Production function for capturing production possibilities • Input factors • labor • (physical) capital stock • land usage • [Technology] • Most common: Cobb-Douglas production function and time trend for technological progress • Extensions: human capital, role of health, etc. • Disaggregation by industries

31. Goods market: inflation • Cost-push inflation • unit labor cost: wages and productivity • exchange rate/external prices (oil, etc.) • Regulatory influences • taxes • administrated prices • Import regulations • Demand-driven inflation • output-gap • What inflation? • GDP-deflator • Consumer price index (CPI) example: oil price increase

32. Labor market (wage block) • Supply of labor • fix or real-wage dependent • long-run: population-dependent(aging, health, behavior (e.g., participation rates)) • Demand for labor • derived from production function • Disaggregation by skills • Nominal wage setting • unemployment rate (relative bargaining power) • inflation expectations • minimum • expectation-augmented Phillips-curve

33. Money market 1 (interest block) • Demand for money • income-dependent via velocity of circulation(income as a proxy for transaction volume) • interest-sensitive • Money supply • monetary base controlled by central-bank • money creation via lending of commercial banks • BUT: special case of Lesotho!

34. Money market 2 (The Lesotho case) • Common Monetary Area: fixed exchange rate with CMA partners • Small country within the CMA: exogenous exchange rate fluctuations (independent of domestic current account balance) • Money supply no longer exogenous • Interest rate no longer endogenous • Adjustment via current account and real exchange rate channel

35. Foreign exchange market (external block) • Demand-side • imports of goods and services • exports of capital (portfolio or direct foreign investment) • Supply-side • exports of goods and services • special treatment of income transfers from SA • imports of capital (portfolio or direct foreign investment) • Central bank interventions • Linkages with monetary block • Sterilization policy?

36. Terminology: Exchange rates • Exchange rate = price of foreign currency(foreign currency in terms of domestic currency)example: Euro-exchange rate: 9 [M/€] • Appreciation= decrease of exchange rate (example: 8 [M/€]) • Depreciation= increase of exchange rate (example: 10 [M/€]) • Case of fixed exchange rates appreciation = revaluation depreciation = devaluation

37. Government activities (fiscal block) • Public revenue • taxes (including customs receipts) • social contributions • interest payments from public assets • Public expenditure • goods and services • social transfers • interest payments on public debt • Budget surplus/deficit • Just a model add-on in the short run • except for existence of budgetary rules • debt/asset dynamics relevant in the medium and long run

38. Putting it all together

39. A walk through the model

40. Course program • Introduction • Outline of macroeconom(etr)ic models • Macroeconomic framework • Econometric methodology • Applied econometrics with EViews • Lesotho case studies

41. The IS-LM/AD-AS framework: Overview • Income-expenditure model (Keynesian multiplier) • IS-curve • LM-curve • IS-LM model • IS-LM mechanics within a monetary union • AD-curve • AS-curve • AD-AS model • AD-AS dynamics • Inflation: DAD-DAS

42. Income-expenditure model:Closed economy

43. Income-expenditure model:Open economy

44. Consultancy to Develop and Implement a Macroeconomic Model for Lesotho (DIMMoL)Macro-Econom(etr)ic ModellingPart 4 Dr. Stefan KoothsDIW Berlin – Macro Analysis and Forecasting

45. Course program • Introduction • Outline of macroeconom(etr)ic models • Macroeconomic framework (cont.) • Econometric methodology • Applied econometrics with EViews • Lesotho case studies

46. Income-expenditure model:Main points • Production follows demand(no limiting supply-side factors) • Exogenous prices • goods market • interest rate • wage rate • exchange rate • Multiplier effect depends on • marginal propensity to consume (+) • marginal tax rate (-) • marginal import rate (-) • Income expansion reduces trade surplus

47. IS-curve:Construction

48. IS-curve:Response to fiscal policy

49. IS-curve:Response to price movements

50. LM-curve:Discussion