Copyright 1998 R.H. Rasche
Economics 827
Conditional Forecasting and Macroeconomic Models
Copyright 1998 R.H. Rasche
Multiple Variable Forecasting Models
Forecasts conditional on specific future events
Copyright 1998 R.H. Rasche
Conditional Forecasts Forecasting frameworks discussed so far use only
historical data as inputs to forecasting process.
Suppose that you want to generate conditional forecasts:– e.g. What path will the economy follow from the the
slow recovery turns into a depression for Southeast Asian economies?
Copyright 1998 R.H. Rasche
Conditional Forecasts Forecasting approaches that we have discussed would
produce the same forecasts in either event, independent of whether such an event really would affect the economy.
Such a depression (or its absence) is a future event and not included in the history of the economy that is input into the forecasting process
You need to be able to form some idea as to what the current shock will be, and how its effects will spread through the system.
Copyright 1998 R.H. Rasche
Conditional Forecasts
To conduct such forecasting exercises you need a different type of framework
Such a framework is provided by Macroeconomic or Macroeconometric Models
Copyright 1998 R.H. Rasche
Macroeconomic Forecasting Models
Such models distinguish two types of variables:
– Exogenous or conditioning variables. The future values of such variables are not forecast by the macroeconomic model, but are used as inputs into the forecasting process
– Endogenous variables. Future values of these variables are the output of the forecasting process and are conditional upon the assumed values of the exogenous variables
Copyright 1998 R.H. Rasche
Examples of Exogenous Variables
Monetary Policy Variables:– how will economy behave if Fed keeps the Funds
rate target at present level (5.25) for rest of year vs. increasing it 50 basis points (5.75) this spring and holding at that for the rest of the year.
Fiscal Policy Variables:– what is the impact of a 15 % income tax reduction
vs, maintaining the current rates.
Copyright 1998 R.H. Rasche
Examples of Exogenous Variables II
World Economic Events
– Dollar is now trading at about 125 yen and 1.8 D-marks compared with 110 and 1.50 a two years ago. What are the consequences of major (permanent) changes in exchange rates for U.S. economy? for foreign economies?
– World Crude Oil Prices dropped substantially with reduced demand from SE Asia, then rebounded. What are the implications for the U.S. economy if such price decreases are repeated?
Copyright 1998 R.H. Rasche
Examples of Endogenous Variables
Real GDP or its Growth Rate– GDP components such as Consumption, Investment,
Exports, Imports
Inflation - determined by how “hot” the economy is running
Interest Rates– Short-term Interest Rates – Long-term Bond Rates
Employment and/or Unemployment Rate
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Sources of Economic Forecasts I
Building your own wheel
Borrowing someone else’s wheel
– lots of publicly available forecasts at present.
– Congressional Budget office prepares forecasts semi-annually (typically two year horizon)
– Council of Economic Advisers prepares annual forecast (two year horizon)
– FED publishes estimate of “central tendencies”
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Sources of Economic Forecasts II
Private Forecasts - publicly available– Wall Street Journal publishes forecasts from a sample of
economists semiannually.
– University of Michigan forecast summary available:» http://rsqe.econ.lsa.umich.edu/forecast/table.html
– Survey of Professional Forecasters (Philly FED)» http://www.phil.frb.org/econ/spf/spfpage.html
– “Livingston Survey” of Economists (Philly FED)» http://www.phil.frb.org/econ/liv/welcome.html
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Forecasts: Who to Believe? Faced with a large number of conflicting forecasts,
how to choose?
– remember, none of these forecasters is really exceptionally accurate - a lot of randomness in economic behavior that just isn’t predictable
– look at track records of particular forecasters
Copyright 1998 R.H. Rasche
Combining Forecasts Large technical literature on how to best combine forecasts to
minimize forecast error variance.
– problem is similar to constructing a minimum variance asset portfolio (except you can sell a forecaster who is consistently wrong short -- negative weight)
– difficulty is in getting long enough individual forecasting record to get any precision on the optimal weights of individual forecasters
– typically people just construct a simple average
Copyright 1998 R.H. Rasche
Macroeconomic Models
A. Basic Structure
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Prototype Macro Models Who Purchases the output that is produced (Real
GDP)?
– Households -- consumption demand (C)– Firms -- Investment Demand (I)– Government -- Government Purchases (G)– Foreigners -- exports (X) - open economy case
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Measuring Investment Demand
Investment as used in should not be confused with Investments as used in finance– Investment here refers to purchases of newly
produced plants and equipment (including houses) plus changes in stocks of inventories (+/-) held by firms
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Investment Demand Simple Investment Function - Investment depends
negatively on real interest rates.– theory is that at lower real interest rates there are more
profitable opportunities for firms to exploit– Problems
» accurately measuring real interest rates = nominal interest rates - expected future inflation
» Investment a very volatile component of real GDP» Lags between initiation of project and completion
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Historical Evidence - Investment-GDP Ratio
Fixed Nonresidential Investment
29 37 45 53 61 69 77 85 930.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
0.10
0.11
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Estimated Annual Long-Term Real Rate
Estimated Real Interest Rate
30 37 44 51 58 65 72 79 86 93-15
-10
-5
0
5
10
15
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Investment and Real Interest Rates
Investment Ratio and Real Interest Rate
realrate-15 -10 -5 0 5 10 15
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
0.10
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Measuring Government Purchases
Only include government purchases of newly produced goods and services
Large portion of government expenditures are transfer payments - expenditures for which government does not get goods and services directly in return.
» examples: welfare payments, social security, Medicare payments
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Determinants of Private Demand
Consumption Demand– Real Disposable Income = Real GDP - Taxes +
Transfer Payments to persons (Yd)– Real GDP = Income Earned from current
production (compensation, profits, interest, rents)– Real Disposable Income = Income Received during
current period.» Earnings less appropriations by government
(taxes) + unearned receipts from government (transfers)
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Consumption Demand Simple Consumption Function
– C depends on Real Disposable Income (Yd=Y-T) in a linear fashion.
– Change in consumption with a one unit change in Yd is positive and less than one = marginal propensity to consume
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Historical Evidence: Consumption Function
Consumption-Disposable Income
Disposable Income0 1000 2000 3000 4000
400
800
1200
1600
2000
2400
2800
3200
3600
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Historical Evidence: Consumption- Yd Ratio
Consumption/Disposable Income Ratio
29 37 45 53 61 69 77 85 930.720
0.760
0.800
0.840
0.880
0.920
0.960
1.000
1.040
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Import Demand Demand for Imports usually specified to depend on
both real income (or real disposable income) and the real exchange rate (rer):
– M = M(Y, rer)
– sign of relationship between imports and real exchange rate depends on units of measurement of real exchange rate. When foreign goods get cheaper relative to domestic goods, import demand increases
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Commodity Market Equilibrium Condition:
– Output Produced must be purchased by someone (or end up as inventory accumulation)
– Y = real GDP– Y = C + I + G + (X-M)– M = imports are subtracted out because C and I are
measured as total not just domestic purchases– Macroeconomic Models typically take G and X as and
exogenous variables
Are we ever in equilibrium in the US?
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IS Curve: Definition and Construction
IS Curve: Those values of real output and real interest rates that are consistent with commodity market equilibrium; i.e agents are just willing to purchase the total amount of output that is being currently produced
Why output and interest rates? Because interest rates link both the real (goods, services) and monetary (banking, financial) sectors of the economy. Interest rates are what allow the abilities of the monetary sector to match the needs of the real sector.
Copyright 1998 R.H. Rasche
IS Curve The IS-curve (I.S.= Investment, Savings) assumes
fixed values of G,T, X, real exchange rate, in the short term.
IS Curve : Equation– Y = C(Y-T) + I(r) + G +X - M(Y, rer)
So Output should equal expenditure
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Slope of IS Curve IS curve is a negatively sloped relationship between real
output (Y) and real interest rate (r). Why?
– What happens if r is increased holding Y constant?
– Higher r means lower investment demand; so expenditures (including investment) are expected to be less than planned output.
– To equilibrate planned expenditures with production requires lower output. So, as r rises, Y falls.
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IS Curve
r
Y
IS
Along IS Curve, real output(Y) has to increase as realinterest rate declines to maintain equality between actual output and planned expenditures (C + I + G +[X-M])
Copyright 1998 R.H. Rasche
Shifts in IS Curve Either an increase in [government spending (G) or
exports (X)] or a decrease in [net taxes (T) or imports (M)] will increase planned expenditures on output.
To restore equilibrium between actual output and planned expenditures, either Y will have to increase, or r will have to increase, or some combination of the two. Why? Because expenditures are now greater than planned output, so either output must rise, or interest rates must rise (to choke off domestic investment, and keep expenditures in line with output)
The effect is to shift the IS curve to the right (or up)
Copyright 1998 R.H. Rasche
Shift in IS Curve: Example
r
Y
IS
Increases in G, X (or decreases in T, M) increase plannedexpenditure and shift the IS curve to the right (up)
IS’