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The BNB Quarterly Projection Model Emilia Penkova and Svilen Pachedzhiev

The BNB Quarterly Projection Model Emilia Penkova and Svilen Pachedzhiev. The BNB Quarterly Projection Model. Twinning Project “Adjustment of the Bulgarian National Bank to operate as a full-fledged member of the European System of Central Banks and the Euro-system”

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The BNB Quarterly Projection Model Emilia Penkova and Svilen Pachedzhiev

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  1. The BNB Quarterly Projection ModelEmilia Penkova and Svilen Pachedzhiev

  2. The BNB Quarterly Projection Model Twinning Project “Adjustment of the Bulgarian National Bank to operate as a full-fledged member of the European System of Central Banks and the Euro-system” Component 2:Research and preparation for monetary policy operations in line with ECB best practices

  3. Introduction • The first version of the Bulgarian National Bank Quarterly Projection Model (BNBQM) which belongs to the group of traditional structural macroeconomic models. • The model is similar to the European System of Central Banks multi-country model country blocks. The guiding principle in designing the country blocks is that of close compatibility with the ECB Area-Wide Model. • The development of a model over the period 1998-2007 poses formidable challenges, given the short and volatile time series – we calibrate coefficients. • The model is continuously tested and simulated in order to improve it. It should be viewed as work in progress and an area for future empirical research within the BNB, rather than as a finished product.

  4. Introduction • The theoretical background – Neo-Classical Synthesis. The long-run equilibrium is determined by supply side factors (Neo-Classical theory) and short-run fluctuations are demand driven (Keynesian theory). • Backward looking -expectations are reflected via lagged variables, which is considered adequate for the purpose of generating short- to medium-term forecasts. • Behavioral equations – error correction form (Engle Granger two step procedure has been employed).

  5. The purpose of the BNBQM is twofold: • First, to produce macroeconomic forecasts for the Bulgarian economy. • Second, to assess the effects of economic shocks on the Bulgarian economy in simulated scenario analyses.

  6. Outline of Presentation • Theoretical background • Structure of the model and estimated equations • Simulations • Concluding remarks and extensions of research

  7. Supply side of the Economy • The standard theory of monopolistic competition is applied. • Profits of an individual firm are determined by returns from sale with costs of labour and capital subtracted. • The production process is represented by a Cobb Douglas function.

  8. Supply side of the Economy

  9. Supply side of the Economy where Π(Yi) are profits of the firm, Li is the labour force used by the firm, Kiis the capital stock of the firm, α’s are the income shares; ρ is the exogenous growth rate of technological progress, σ is the elasticity of the demand for goods produced by the firm i to their relative price; w is the nominal wage level, c is the nominal cost of capital with where r is the real rate of interest, δ is the physical depreciation rate of capital, PIis price of investment goods, Piis the price of goods produced by the firm, P is the price of generic goods, Yiis the output of the firm i, Y is the aggregate supply of generic goods.

  10. Supply side of the Economy

  11. Supply side of the Economy First order conditions are:

  12. Supply side of the Economy Using the assumption of symmetric equilibrium (Pi=P, Yi=Y, Li=L, Ki=K), we receive:

  13. Supply side of the Economy The aggregate output and the long-run demand for capital and labour are given by:

  14. Structure of the model and estimated equations • The simulation and projection features of the BNB Quarterly Projection Model are driven by twenty behavioural equations and additional forty three identities. Around one hundred and sixtyvariables enter the model. • The model is in Eviews 5.1 (a program file which imports the data, estimates equations, solves the model and produces forecasts output). • The model is structured into five blocks: production function and factor demand equations, aggregate demand, prices and wages, monetary, and fiscal sector.

  15. Model linkages

  16. Error correction form Most of the dynamic equations take the following general form: where log(yt-1)-log(y*t-1) is the error correction term; γ(.) and σ(.) – are polynomials; l - the lag operator

  17. Potential output R_YP_R = Potential output, prices of 2005 R_TFP_TD = Total factor productivity, trend (2005=100) L_EMPL_TD = Employment, trend R_K_R = Capital stock, prices of 2005

  18. Potential output • Total factor productivity is estimated as a residual from the production function for the estimated period then using Hodrick-Prescott filter we receive the trend. • The potential employment is received from a labour force forecast and estimated NAIRU. • NAIRU is assumed to be at around 7.7% level (slightly decreasing over the forecasting period) and is estimated using Elmeskov (1993) approach.

  19. Employment Log(L_EMPL_STAR) = 3.278 + 0.600*log(R_Y_R) - (5.607) (-) - 0.400 *log(L_W/I_HICP_P) (-) Dlog(L_EMPL)= -0.089 - 0.296*(log(L_EMPL (-1)) – (18.365) (5.138) - log(L_EMPL_STAR(-1)))+ 0.001* Dlog(L_EMPL(-1)) (0.002) L_EMPL = Employment (employees + self employed) R_Y_R = GDP, prices of 2005 L_W = Nominal wage bill per worker I_HICP_P = Harmonised index of consumer prices, 2005 = 100

  20. Employment

  21. Gross fixed capital formation Log(R_KF_R_STAR)= 1.942+ 0.700*log(R_Y_R)- (4.338) (-) • 0.108*M_LTIR_N - 0.007*I_I_P (9.451) (2.516) Dlog(R_KF_R) = 0.242 -0.003*(log(R_KF_R(-1))- (6.285) (-) - log(R_KF_R_STAR(-1))) - 0.363*Dlog(R_KF_R(-1)) (2.135) R_KF_R = Gross fixed capital formation, 2005 prices R_Y_R = GDP, 2005 prices I_I_P = Inflation, in percentages M_LTIR_N =Nominal long-term interest rate, in percentages

  22. Gross fixed capital formation

  23. Private consumption Log(R_C_R_STAR) = 2.365 + 0.800*log(R_DI_N/I_HICP_P) + (21.979) (-) + 0.300*log(R_K_R) (-) Dlog(R_C_R) = 0.077 - 0.483*(log(R_C_R(-1)) – (3.743) (2.200) - log(R_C_R_STAR(-1))) -0.343*Dlog(R_C_R(-1)) (2.074) R_C_R = Private consumption, prices of 2005 R_DI_N = Disposable income (wages and salaries+ pensions and social benefits + imputed rent +compensation of employees(BOP) + current transfers (BOP)) I_HICP_P = Harmonised index of consumer prices, 2005 = 100 R_K_R = Capital stock, prices of 2005

  24. Private consumption

  25. Exports Log(E_EX_R_STAR) = 6.108 + log(A_WTV_R)- (2.024) (-) - 0.451*log(E_EX_P/(A_MEPAE_P*E_ER_PI)) (4.758) Dlog(E_EX_R) = -0.265 -0.206*(log(E_EX_R(-1))- (8.268) (1.448) -log(E_EX_R_STAR(-1))) + 0.020*Dlog(E_EX_R(-1)) (0.151) E_EX_R = Exports,prices of 2005 A_WTV_R = Volume of world trade (weighted average), 2005 = 100 E_EX_P = Export deflator, 2005 = 100 A_MEPAE_P = Manufacturing export price for advanced economies, 2005=100 E_ER_PI = Exchange rate BGUSD, 2005=100

  26. Exports

  27. Imports Log(E_MP_R_STAR) = -2.473 + log(R_DD_R) – (13.023) (-) - 0.305*log(E_MP_P/R_GDP_P) (3.821) Dlog(E_MP_R) = 0.072 – 0.052*(log(E_MP_R(-1)) – (4.811) (0.645) -log((E_MP_R_STAR(-1))) E_MP_R = Imports, prices of 2005 R_DD_R = Real domestic demand, prices of 2005 (private consumption expenditure + government consumption expenditure + gross fixed capital formation) E_MP_P = Import deflator, 2005 = 100 R_GDP_P= GDP deflator, 2005 = 100

  28. Imports

  29. GDP deflator Log (R_GDP_P_STAR) = -0.011 + log(L_ULC) (0.482) (-) Dlog(R_GDP_P)=0.017-0.030*(log(R_GDP_P(-1))- (2.202) (1.002) log(R_GDP_P_STAR(-1)))-0.071*dlog(R_GDP_P(- (0.397) -1))+0.100*R_YG_R (-) R_GDP_P = GDP deflator, 2005=100 L_ULC = Unit labour cost, 2005=100 R_YG_R = Output gap (% potential GDP)

  30. GDP deflator

  31. HICP without administered prices Log(I_HICPEXA_P_STAR) = 0.007 + 0.488*log(R_GDP_P) + (0. 588) (4.155) +0.512*log(E_MP_P) (-) Dlog(I_HICPEXA_P) = 0.029 - 0.381*(log(I_HICPEXA_P(-1)) (5.701) (3.891) • log(I_HICPEXA_P_STAR(-1))) + +0.220*Dlog(I_HICPEXA_P(-1)) (1.526) I_HICPEXA_P = Harmonized Index of Consumer Priceswithout administered prices, 2005 = 100 L_ULC = Unit labour cost, 2005=100 E_MP_P = Import deflator, 2005 = 100

  32. HICP without administered prices

  33. Export deflator Log(E_EX_P_STAR) = -2.313 + 0.592*log(R_GDP_P) + (5.052) (3.376) + 0.408*log(A_MEPAE_P*E_ER_PI) (-) Dlog(E_EX_P) = 0.010 – 0.853*(log(E_EX_P(-1))- (2.110) (4.548) • log(E_EX_P_STAR(-1))) -0.071*Dlog(E_EX_P(-1))- (0.697) • 0.058*Dlog(E_EX_P(-2)) +0.381*Dlog(E_EX_P(-3))- (0.580) (3.798) • 0.264*Dlog(E_EX_P(-4))) (2.590) E_EX_P = Export deflator, 2005 = 100 A_MEPAE_P = Manufacturing export price for advanced economies, 2005=100 R_GDP_P = GDP deflator, 2005 = 100 E_ER_PI = Exchange rate BGUSD, 2005=100

  34. Export deflator

  35. Import deflator Log(E_MP_P_STAR)=-2.284 + 0.360*log(A_EU15MP_P*E_ER_PI) (2.810) (4.710) + 0.640*log(R_GDP_P) (-) Dlog(E_MP_P) = 0.025 -0.116*(log(E_MP_P(-1)) – (2.400) (0.827) -log(E_MP_P_STAR(-1)))- 0.381*Dlog(E_MP_P(-1)) (2.530) E_MP_P = Import deflator, 2005 = 100 A_EU15MP_P = EU 15 Import deflator,2005 = 100 E_ER_PI = Exchange rate BGUSD, 2005=100 R_GDP_P = GDP deflator, 2005 = 100

  36. Import deflator

  37. Wages Log(L_W_STAR) = -5.822+ log(L_LPR) – 0.001*L_UR + (3.087) (-) (0.712) + log(I_HICP_P) (-) Dlog(L_W) = 0.131 -0.207*(log(L_W(-1)) – (10.598) (1.138) - log(L_W_STAR(-1))) - 0.352*Dlog(L_W(-1)) (1.739) L_W = Nominal wage bill per worker L_LPR = Labour productivity: GDP in prices of 2005/Number of employees L_UR = Unemployment, in percentages I_HICP_P = Harmonised index of consumer prices

  38. Wages

  39. Fiscal sector Government expenditures and government revenues are modelled separately: • The government expenditures are disaggregated into five parts: government consumption, government investment, government transfers, government interest payments and other expenditure. • The government revenues consist of five components: revenues from personal income tax, social security contribution, revenues from corporate income tax, revenues from indirect taxes and other revenue items.

  40. Personal income taxes G_PIT = G_PIT_TR*R_CE_N G_PIT = Personal income taxes (million leva) G_PIT_TR =Personal income effective tax rate R_CE_N = Compensation of employees (million leva)

  41. Social security contribution G_SSC=G_SSC_TR*R_CE_N G_SSC = Social security contribution (incl. employers’ and employees’ contribution in million leva) G_SSC_TR = Social security effective tax rate R_CE_N = Compensation of employees (million leva)

  42. Indirect taxes G_IND=G_IND_TR*R_C_N G_IND = Indirect taxes (incl. VAT, customs revenue, excise duties) G_IND_TR = Indirect effective tax rate R_C_N = Private consumption, in current prices

  43. Corporate income tax G_CIT = G_CIT_TR*R_GOS_N G_CIT = Corporate income tax G_CIT_TR = Corporate income effective tax rate R_GOS_N = Gross operating surplus and mixed income

  44. Simulations To illustrate the simulation properties of the BNBQM, we assess the response of the model’s main variables to the following standard shocks: • an increase in government consumption by 1% of GDP • an increase in volume of world trade by 1% • a depreciation of the lev against the US dollarby 1% • an increase in the price of oil by 10% • an increase in EURIBOR by 100 basis points

  45. Simulation of an increase in government consumption by 1% of GDP (Q1’2002 – Q4’2008)Levels, percentage deviations from baseline Year 1 Year 2 Year 3 Year 4 Year 5 Year 7 HICP 0.0310.162 0.319 0.476 0.607 0.666 ULC -0.506 0.040 0.316 0.538 0.670 0.709 Comp. per employee 0.385 0.794 0.917 0.933 0.840 0.450 Productivity 0.896 0.753 0.599 0.393 0.168-0.256 GDP 1.012 1.058 0.973 1.053 0.498 -0.119 Private consumption 0.060 0.333 0.517 0.575 0.534 0.257 Investment 0.003 0.009 0.014 0.017 0.020 0.020 Exports -0.009 -0.086 -0.198 -0.300 -0.387 -0.427 Imports 0.042 0.196 0.386 0.595 0.781 1.099

  46. Government consumption shock • An increase in the government consumption boosts domestic demand and raises GDP by 1.01% as a primary effect. This effect remains for 5 years, after which it gradually dies out due to secondary effects. • The fiscal expansion stimulates production and investment. • Nominal wages and prices go up. Higher employment and wages lead to higher personal incomes and to an increase in consumption. • Larger investment and stronger private and government consumption leads to increasing imports. • Expanding economic activity translates into widening of the output gap that pushes up the price level.

  47. Simulation of an increase in world demand by 1% (Q1’2002 – Q4’2008)Levels, percentage deviations from baseline Year 1 Year 2 Year 3 Year 4 Year 5 Year7 HICP 0.005 0.071 0.204 0.379 0.564 0.807 ULC -0.255 -0.205 0.077 0.366 0.551 0.788 Comp. per employee 0.101 0.5540.884 1.076 1.144 1.010 Productivity 0.357 0.760 0.807 0.708 0.589 0.220 GDP0.395 0.971 1.175 1.173 1.100 0.545 Private consumption0.0070.1580.397 0.576 0.662 0.571 Investment0.001 0.005 0.011 0.016 0.021 0.027 Exports0.725 1.546 1.583 1.497 1.426 1.320 Imports0.001 0.029 0.106 0.235 0.390 0.728

  48. An increase in world demand • This simulation is particularly important because of the openness of the Bulgarian economy. The external demand shock leads to a stronger domestic demand. The external shock directly drives up the volume of exports by 1.55% (second year), which in turn also increases imports. • Employment and nominal wages increase which leads to higher private consumption (0.57%-seventh year). • Higher aggregate demand widens the output gap that pushes up the aggregate price level.

  49. Simulation of a depreciation of the lev against the US dollar by 1%(Q1’2002 – Q4’2008)Levels, percentage deviations from baseline Year 1 Year 2 Year 3 Year 4 Year 5 Year 7 HICP 0.008 0.065 0.129 0.190 0.250 0.310 Import deflator 0.067 0.190 0.279 0.337 0.390 0.005 Export deflator 0.336 0.565 0.493 0.511 0.572 0.006 ULC -0.067 -0.009 0.056 0.137 0.203 0.003 Comp. per employee 0.032 0.145 0.236 0.328 0.387 0.004 Productivity 0.099 0.154 0.180 0.191 0.184 0.001 GDP 0.110 0.205 0.266 0.308 0.325 0.288 Private consumption 0.003 0.044 0.0900.1180.133 0.011 Investment 0.000 0.001 0.002 0.003 0.004 0.001 Exports 0.198 0.289 0.294 0.308 0.295 0.002 Imports -0.003-0.028-0.066-0.098-0.110 -0.098

  50. An exchange rate shock • The decrease in the value of the lev against the US dollar has an immediate impact on both the import and export deflators – they both increase. • HICP increases by 0.25% in the fifth year. Compensation per employee adjusts and income increases which drives the consumption up. • Because of the relative increase in foreign prices, imports decrease and exports increase slightly. The reaction of real GDP to an exchange rate shock achieves its maximum in the fifth year (0.32%).

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