Macroeconomic Models
Introduction
A macroeconomic model is an analytical tool designed to describe the operation of the problems of
economy of a country or a region. These models are usually designed to examine the comparative
statics and dynamics of aggregate quantities such as the total amount of goods and services
produced, total income earned, the level of employment of productive resources, and the level of
prices.
Macroeconomic models may be used to clarify and illustrate basic theoretical principles; they may be
used to test, compare, and quantify different macroeconomic theories; they may be used to produce
"what if" scenarios (usually to predict the effects of changes in monetary, fiscal, or other
macroeconomic policies) and they may be used to generate economic forecasts. Thus, macroeconomic
models are widely used in academia in teaching and research, and are also widely used by international
organizations, national governments and larger corporations, as well as by economic consultants and
think tanks.
Types of Macroeconomic models
Simple theoretical models
Simple textbook descriptions of the macroeconomy involving a small number of equations or diagrams
are often called ‘models’. Examples include the IS-LM model and Mundell–Fleming
model of Keynesian macroeconomics, and the Solow model of neoclassical growth theory. These models
share several features. They are based on a few equations involving a few variables, which can often be
explained with simple diagrams. Many of these models are static, but some are dynamic, describing the
economy over many time periods. The variables that appear in these models often represent
macroeconomic aggregates (such as GDP or total employment) rather than individual choice variables,
and while the equations relating these variables are intended to describe economic decisions, they are
not usually derived directly by aggregating models of individual choices. They are simple enough to be
used as illustrations of theoretical points in introductory explanations of macroeconomic ideas; but
therefore quantitative application to forecasting, testing, or policy evaluation is usually impossible
without substantially augmenting the structure of the model.
Empirical forecasting models
In the 1940s and 1950s, as governments began accumulating national income and product
accounting data, economists set out to construct quantitative models to describe the dynamics
observed in the data.[3] These models estimated the relations between different macroeconomic
variables using (mostly linear) time series analysis. Like the simpler theoretical models, these empirical
models described relations between aggregate quantities, but many addressed a much finer level of
detail (for example, studying the relations between output, employment, investment, and other
variables in many different industries). Thus, these models grew to include hundreds or thousands of
equations describing the evolution of hundreds or thousands of prices and quantities over time,
making computers essential for their solution. While the choice of which variables to include in each
equation was partly guided by economic theory (for example, including past income as a determinant of
consumption, as suggested by the theory of adaptive expectations), variable inclusion was mostly
determined on purely empirical grounds.
Dutch economist Jan Tinbergen developed the first comprehensive national model, which he built for
the Netherlands in 1936. He later applied the same modeling structure to the economies of the United
States and the United Kingdom. The first global macroeconomic model, Wharton Econometric
Forecasting Associates' LINK project, was initiated by Lawrence Klein. The model was cited in 1980 when
Klein, like Tinbergen before him, won the Nobel Prize. Large-scale empirical models of this type,
including the Wharton model, are still in use today, especially for forecasting purposes.
The Lucas critique of empirical forecasting models
Econometric studies in the first part of the 20th century showed a negative correlation between
inflation and unemployment called the Phillips curve. Empirical macroeconomic forecasting models,
being based on roughly the same data, had similar implications: they suggested that unemployment
could be permanently lowered by permanently increasing inflation. However, in 1968, Milton
Friedman[9] and Edmund Phelps[10] argued that this apparent tradeoff was illusory. They claimed that the
historical relation between inflation and unemployment was due to the fact that past inflationary
episodes had been largely unexpected. They argued that if monetary authorities permanently raised the
inflation rate, workers and firms would eventually come to understand this, at which point the economy
would return to its previous, higher level of unemployment, but now with higher inflation too.
The stagflation of the 1970s appeared to bear out their prediction.
In 1976, Robert Lucas, Jr., published an influential paper arguing that the failure of the Phillips curve in
the 1970s was just one example of a general problem with empirical forecasting models. He pointed out
that such models are derived from observed relationships between various macroeconomic quantities
over time, and that these relations differ depending on what macroeconomic policy regime is in place. In
the context of the Phillips curve, this means that the relation between inflation and unemployment
observed in an economy where inflation has usually been low in the past would differ from the relation
observed in an economy where inflation has been high. Furthermore, this means one cannot predict the
effects of a new policy regime using an empirical forecasting model based on data from previous periods
when that policy regime was not in place. Lucas argued that economists would remain unable to predict
the effects of new policies unless they built models based on economic
fundamentals (like preferences, technology, and budget constraints) that should be unaffected by policy
changes.
Dynamic stochastic general equilibrium models
Partly as a response to the Lucas critique, economists of the 1980s and 1990s began to
construct microfounded[15] macroeconomic models based on rational choice, which have come to be
called dynamic stochastic general equilibrium (DSGE) models. These models begin by specifying the set
of agents active in the economy, such as households, firms, and governments in one or more countries,
as well as the preferences, technology, and budget constraint of each one. Each agent is assumed to
make an optimal choice, taking into account prices and the strategies of other agents, both in the
current period and in the future. Summing up the decisions of the different types of agents, it is possible
to find the prices that equate supply with demand in every market. Thus these models embody a type
of equilibrium self-consistency: agents choose optimally given the prices, while prices must be
consistent with agents’ supplies and demands.
DSGE models often assume that all agents of a given type are identical (i.e. there is a
‘representative household’ and a ‘representative firm’) and can perform perfect calculations that
forecast the future correctly on average (which is called rational expectations). However, these are only
simplifying assumptions, and are not essential for the DSGE methodology; many DSGE studies aim for
greater realism by considering heterogeneous agents or various types of adaptive
expectations.] Compared with empirical forecasting models, DSGE models typically have fewer variables
and equations, mainly because DSGE models are harder to solve, even with the help of computers.
Simple theoretical DSGE models, involving only a few variables, have been used to analyze the forces
that drive business cycles; this empirical work has given rise to two main competing frameworks called
the real business cycle model and the New Keynesian DSGE model. More elaborate DSGE models are
used to predict the effects of changes in economic policy and evaluate their impact on social welfare.
However, economic forecasting is still largely based on more traditional empirical models, which are still
widely believed to achieve greater accuracy in predicting the impact of economic disturbances over
time.
DSGE versus CGE models
A closely related methodology that pre-dates DSGE modeling is computable general equilibrium
(CGE) modeling. Like DSGE models, CGE models are often microfounded on assumptions about
preferences, technology, and budget constraints. However, CGE models focus mostly on long-run
relationships, making them most suited to studying the long-run impact of permanent policies like the
tax system or the openness of the economy to international trade. DSGE models instead emphasize the
dynamics of the economy over time (often at a quarterly frequency), making them suited for studying
business cycles and the cyclical effects of monetary and fiscal policy.
Agent-based computational macroeconomic models
Another modeling methodology that has developed at the same time as DSGE models is Agent-based
computational economics (ACE), which is a variety of Agent-basedmodeling. Like the DSGE
methodology, ACE seeks to break down aggregate macroeconomic relationships into microeconomic
decisions of individual agents. ACE models also begin by defining the set of agents that make up the
economy, and specify the types of interactions individual agents can have with each other or with the
market as a whole. Instead of defining the preferences of those agents, ACE models often jump directly
to specifying their strategies. Or sometimes, preferences are specified, together with an initial strategy
and a learning rule whereby the strategy is adjusted according to its past success. Given these strategies,
the interaction of large numbers of individual agents (who may be very heterogeneous) can be
simulated on a computer, and then the aggregate, macroeconomic relationships that arise from those
individual actions can be studied.
Strengths and weaknesses of DSGE and ACE models
DSGE and ACE models have different advantages and disadvantages due to their different underlying
structures. DSGE models may exaggerate individual rationality and foresight, and understate the
importance of heterogeneity, since the rational expectations, representative agent case remains the
simplest and thus the most common type of DSGE model to solve. Also, unlike ACE models, it may be
difficult to study local interactions between individual agents in DSGE models, which instead focus
mostly on the way agents interact through aggregate prices. On the other hand, ACE models may
exaggerate errors in individual decision-making, since the strategies assumed in ACE models may be very
far from optimal choices unless the modeler is very careful. A related issue is that ACE models which
start from strategies instead of preferences may remain vulnerable to the Lucas critique: a changed
policy regime should generally give rise to changed strategies.
Other Types of Maccroeconomics Model
Three types of macroeconomic models were developed for India since the early 1950s. They
are: input-output (I-O); computable general equilibrium; and econometric models. The objective
of all models is structural analysis, forecasting and policy evaluation.
Input-Output Models
With the advent of planning in the early 1950s, focus was on models of plan-variety concerning
growth and investment allocation. One aspect central to planning models is the sectoral
interdependence and sectoral balance for a given macroeconomic growth rate. Input-output
models form a core element of planning exercises. The economy is viewed as consisting
of n producing sectors, each producing ideally a single homogeneous output. The intersectoral
flow matrix charts the flow of output of a sector to each of the sectors and to final demand over
a specified period, generally one year. The final demand relates to consumers, government,
investment, and the foreign sector. It is a two-way table (each sector appearing in a row and in a
column) describing the production structure of the economy. The ratio of output of i-th sector
used as input by j-thsector, divided by output of j-th sector, represents input-output coefficient.
They are technological parameters. The configuration of such n-by-n coefficient matrix
represents the I-O table. It is a linear production structure. Inputs bear a fixed proportion to
output, constant returns to scale prevail, and no substitution possibilities exist between inputs.
The model is static.
In the intersectoral flow matrix, final demands appear as a column. Imports appear with a
negative sign. They balance supply and demand. Imports, which enter as inputs in the
production process, appear in a separate row. Rewards for primary inputs, wages, and profits,
as well as indirect taxes and subsidies can also be shown as additional rows. If the intersectoral
flows are represented at producer prices, the column sums represent the total cost of producing
that sector's output. This should be equal to the corresponding row sum, suitably adjusted for
taxes and subsidies. The total of row sums should be equal to the total of column sums, and the
grand total represents the gross value of goods and services produced in the economy. This
represents not only intersectoral flows but also final demand and disposition of total output as
inputs and rewards for primary factors. This can be viewed as a social accounting matrix.
The Indian Statistical Institute built an input-output table for 1950–1951 with thirty-six sectors.
The Gokhale Institute of Politics and Economics published an input-output model for 1963. The
Planning Commission and the Central Statistical Organization constructed the tables for 1968–
1969 and subsequently published a new one every five years. The latest table refers to 1993–
1994. The various tables differ in the extent of aggregation.
The analytical problem in the solution of the I-O model is one of solving linear simultaneous
equations. Planning exercise involves setting an economy-wide growth target, calculating
associated final demands, and solving the I-O model to yield sectoral output targets. These
output targets aid in calculating sectoral investment requirements, employment, and other
related dimensions. In each of the Five-Year Plan exercises in India, these calculations have
been made in much detail.
The calculation of forward and backward linkages in an economy is crucial to evaluate
alternative strategies of development. Backward linkages reflect the impact of a sectoral output
change on all other sectors that supply inputs to it, while forward linkages measure consequent
increase in demand for other sectors' output. Key sectors in development are those that have
strong backward and forward linkages. These exercises have been made for India with the help
of I-O tables. Another application relates to measuring the impact of price changes of primary
factors or any other inputs on sectoral prices and overall price level. The estimates represent
accounting exercise and do not reflect the effect of many other important factors that underlie
price behavior.
Computable General Equilibrium Models
Computable general equilibrium (CGE) models have two facets. First, general equilibrium
connotes viewing the economy as a complete system of interdependent economic activities by
different agents, for example, producers, households, investors, the government, importers and
exporters. The interrelationships are through a web of intersectoral output flows and price
connections. The second term, "computable," signifies an empirical system that can be
implemented. Rules for the functioning of individual markets and the behavior of agents in the
markets, that is, causal links that determine equilibrium mechanisms, are specified. The
underlying production structure is the I-O model. CGE models have a close interface both with
the I-O and econometric models.
In the early 1980s substantive research on CGE models for India was initiated at the National
Council of Applied Economic Research. The model is maintained, frequently updated, and
improved over the years. Particularly notable is the recent effort to integrate segments of
behavioral macroeconometirc models with the CGE model. The model originally comprised
eight sectors, including infrastructure, services, three in agriculture (food, other crops, and
livestock), and three in industry (consumer, intermediate, and capital goods). Three income
classes (agriculture income recipients, nonagricultural wage income earners, and
nonagricultural nonwage income earners) were distinguished. Public finance and money were
also later brought into the system. In recent versions, sectoral decomposition has widened.
Agricultural output is determined outside the CGE model through an agricultural submodel,
treated as exogenous to CGE solutions.
Since the early 1980s, the model is used regularly for making annual forecasts of important
macroeconomic indicators, including output, prices, trade, and fiscal and external deficits.
Forecasts are made for only one year ahead, and sequential forecast over time do not generally
include dynamic interlinks. Many policy simulations have also been made over the years. Policy
simulations relevant to the 1990s, which witnessed far-reaching structural adjustments and
macroeconomic policy reforms, to name a few, relate to reduction in tariff and nontariff barriers
to trade, lower domestic indirect taxes, changes in the exchange rate, reduction in government
investment expenditures, and changes in interest rates.
Macroeconometric Models
India has had a history of macroeconometric modeling dating back to the 1950s, unparalleled
among developing countries. Many models were constructed, and to date about fifty models,
covering different time periods and focusing on issues relevant to those times, have been
constructed.
Macroeconometric models for India are based on annual time series data. They are estimated
by econometric methods and are subject to statistical inference. They are also subject to in-
sample validation, in terms of their ability to replicate historical series. Almost all of them have
had a policy focus. Most of the models have had only a short- to medium-run character. They
are dynamic in nature. Models have been concerned with the level of economic activity,
aggregate and sectoral, price behavior, fiscal and monetary phenomena, intersectoral linkages,
private investment and its linkages with public investment, consumption and savings, public
sector resource mobilization, current and investment expenditures and their composition,
budgetary deficits and pattern of financing, trade flows, balance of payments, exchange rate
and nexus between the twin deficits, budgetary and external, among others.
The theoretical approach to macroeconometric modeling in India has been eclectic in character.
Specification of components of final demand is Keynesian. Unlike in the simple Keynesian
approach, the economy is not entirely driven by effective demand. Supply constraints are well
jeweled in the models. Agriculture activity is determined by land, a limiting factor and natural
resources. Harnessing these resources is facilitated by capital. In the nonagricultural sectors,
output is viewed as constrained by stock of capital, the scarce factor and its utilization. Capital
utilization is conditioned by effective demand, which, in turn, is influenced by level of overall
economic activity in general, and agriculture in particular, and availability of critical inputs, such
as agricultural raw materials, infrastructure and imported materials.
Level of activity in most of the recent models is disaggregated into agriculture, manufacturing,
economic infrastructure, and services. Price determination in agriculture is governed by a flex
price (supply-demand balance) mechanism, subject to public intervention through procurement
and support prices. Price formation in other sectors is based on markup over costs, including
wage rate, administered prices of critical intermediates, and imported inputs. Markup is viewed
as being influenced by excess demand/liquidity in the economy, proxied by money stock to
overall output. This variable is also factored in the agricultural price determination. Money
supply is modeled as the outcome of public desire to hold money, government operations,
external factors, and monetary policy. Interest rate and exchange rate are also broadly
influenced by a similar set of factors. Turning to foreign trade, imports are determined by
domestic activity and relative prices, exports by world economic activity, relative prices, and
domestic availabilities.
In most of the models large parts of public activity is given. External economic environment is a
datum. Most of the recent models are driven by public investment-quantum and composition,
current expenditures and their composition, monetary-fiscal policies and external economic
environment, among others. In the short run, weather (rainfall) is a decisive factor.
One disappointing aspect of macroeconometric modeling in India has been that each model has
turned out to be a one-time exercise. It is only since the early 1990s that sustained ongoing
work on a structural macroeconometric model began jointly at the Institute of Economic Growth
and the Delhi School of Economics. That model is the single largest macroeconometric model
for India. The system has 347 equations. The model has five production sectors: agriculture,
manufacturing, economic infrastructure, services, and public administration and defense.
Agriculture is further subdivided into food and nonfood segments. Besides output, capital
formation, and price behavior relating to each of the sectors, the model includes separate
subsystems, dealing with trade and balance of payments, money and banking, public finance,
private consumption and savings. The model is a constituent of the Global LINK Model, being
operated under the auspices of the United Nations. Biannual (September and March) forecasts
for LINK are made regularly, and several policy simulations have been carried out. The
forecasts incorporate the dynamics of the model and are made for more than a year ahead. The
India model is constantly undergoing revisions to incorporate policy changes, taking advantage
of the latest data. The project is now housed at the Centre for Development Economics at the
Delhi School of Economics.
Most of the models were subject to policy simulations. They mostly relate to increase in
administered prices, enhanced public investment and change in its composition, pattern of
financing public deficits, fiscal—monetary policy stances, exchange rate changes, and world
economic scenario—world output, trade volume, and international prices. Normal rainfall
assumption is invariably a part of counter factual or "what if" simulations for almost all the
models.
Conclusion
The trilogy of models—I-O, CGE, and econometric—are complementary to each other.
Common to all the three models is the estimation of final demand. Econometric models do not
emphasize intermediate demands, as they deal with a net value-added output concept.
Behavioral characteristics that underlie consumption, investment, prices, public sector, money,
and trade receive more emphasis in macroeconometric models. Sectoral output
interdependence is at the core of I-O and CGE models. The data requirements for each of the
models are demanding, particularly in the case of developing countries. Whatever model is
used, it is essential to maintain it, with refinements in specification, use of the latest data, and
use of improved econometric methodologies to keep it relevant for policy analysis and
forecasting.
