Challenges for macroeconomic modelling

Economic model
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For example, artificial neural networks may find unknown interactions between different variables which can be used to build more accurate economic models. However, there are still large barriers to machine learning really changing economic models. Algorithms are still created by humans, so code is susceptible to our mistakes and biases.

While Stiglitz recommends taking a step back from micro-economic models, and researchers at the Bank of England suggest a deeper dive into detailed data, it could be that a combination of the two will produce more effective economic models than the ones that have performed so poorly in recent years. Skip to navigation Skip to content. The appeal of these lines of reasoning seems indisputable.

Economic growth in IOs’ models: A Mechanical Fantasy with Ideological Clout

Variants of neoclassical economics taught in most universities worldwide offer the allure of apparent rigour by elaborating models that incorporate this intuitive content. But for reasons detailed further below, outcomes are disappointing. Failure of these recipes for growth and high employment is the norm rather than the exception.

How, then, do modellers insist on the same assumptions and prognostications in each successive period and maintain good reputations? In the other camp, which disregards entirely the aggregate production function, models are informed by theories of economic growth developed by economists like Roy Harrod, Evsey Domar, Petrus Johannes Verdoorn, Nicholas Kaldor and others belonging to the so-called post-Keynesian tradition.


The United Nations uses an empirical global model along these lines to explore alternative policy scenarios. First, under the most general conditions, the main constraint faced by an economy national, and especially global is insufficient aggregate demand. This is observable in the resources—e. The low level of inflation in most economies during the last three decades is another indication. Second, as is evident from recent history, technical progress is usually a response to sustained increases in aggregate demand, especially if wage incomes are maintained over time and investment and innovation are supported by government programmes that promote research and the services and infrastructure required for widespread adoption of new products.

Here also, assumptions matter. The UN GPM model contemplates the risk that inflation could rise to levels that will eventually erode aggregate demand and cause instability. Demand could become stronger than the ability of an economy to produce at the desired pace. But this has not been the norm. Hence, productive potential is derived from a simple, path-dependent technical progress function of the type outlined by P. Verdoorn [14] , N. Kaldor and others [15] in which increases in current output adjust over time to aggregate demand pressures.

At their core, such narratives tend to stress that an effective role for government is the promotion of research, maintenance of social protection, income distribution, employment generation, and the coordination of demand stimuli at a global level. Far from acting as obstacles to rising aggregate productivity, these activities stimulate it.

How can macroeconomic models be used?

Related narratives include, for example, that research promoted by public universities and other public institutions has been, and should remain, at the core of major technological advances; research and development by private companies should be rewarded in ways that are conducive to its wider use and dissemination for future technological development, and regulated in accordance with social objectives; government expenditures on goods, services, infrastructure and social investment can effectively contribute to full employment; employment promotion policies and wage protection can help sustain stable growth of income and create incentives for adoption of new technologies; and patterns of global growth can be improved if imbalances are corrected by higher spending by surplus countries rather than reduced expenditure in deficit countries.

The final section of this essay expands on some of these issues, after laying out how models from the IOs disentangle problems of distribution and macroeconomic policy.

Modern Macroeconomic Models as Tools for Economic Policy

As a consequence, Basel II reduces default risk when leverage is low, but it magnifies it when leverage is high. Agent based model exploration and calibration using machine learning surrogates. Blanchard, Olivier, Which one should be used if one employs the model to deliver policy implications? That means that fiscal policy should be countercyclical over both expansion and contraction, creating room to use this anti-crisis tool without excessive deterioration of public accounts.

Income distribution is an essential aspect of macro and global models. This is because unlike micro-economic models, where wage payments are a cost that erodes the potential for profit accumulation, a macro model explores the impact of wages and profits on the aggregate macroeconomic structure. Crucial among those are the effects of wages, which represent both costs for firms and incomes for households on the decisions of firms to increase productivity by investments in different sectors and the decisions of households to spend their wage income.

Likewise, macro-economic models that contain a financial sector surprisingly, few macro models do , help trace the impact of distributional changes—e.

Economic Models That Reality Can No Longer Afford

However, in empirical models, particularly for the world economy, distributional issues have been hard to crack because of conceptual and data issues. Early frameworks in the tradition of models from the IOs discussed here were based on a simple dichotomy in which profits and savings push up investment and wage growth constrains it. Recent versions mentioned above are more sophisticated. Regarding investment, while firms continue to operate as profit-maximizing units in which wage costs and interest payments impose a constraint, they can also take advantage of the assumed effects of technological change and of stock market valuations.

The EUROGREEN Model of Job Creation in a Post-Growth Economy

While investment in these models is positively influenced by stock market valuations, with tight labour markets and high interest rates, stock markets may languish and investment will be less profitable. Regarding consumption, these models specify two kinds of households. Liquidity-constrained households, which obtain income only from wages and public sector transfers, will likely increase consumption following wage increases and social policies, provided that inflation remains subdued. Such wealth includes, most importantly, stock market assets. There are therefore a multitude of forces at work: wage increases, price pressures, technology-rich investment decisions, savings, acquisition of financial assets, interest rates and asset prices.

How these different forces interact is complex and generally involves considerable discretion and adaptability to specific circumstances. The general tenor, observed in detailed model results across many of the papers reviewed while preparing this essay, is to stress the advantages of promoting investments by keeping wage pressures low. Essential to these outcomes is a policy of maintaining low interest rates so long as wage inflation is tamed. Low interest rates benefit both investors and the bulk of consumers, who react positively to moderation of inflation and high asset prices.

This narrative is fully consistent with the preceding discussion of the role of aggregate production functions. In recent years, IOs have become increasingly aware of the limits to growth when the distribution of income worsens significantly. For example, the April issue of the World Economic Outlook IMF, a devotes a chapter to analysing the dynamics of income distribution using a version of the IMF model presented above.

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It points out that relative wage compression is significant in low- and middle-skill sectors, while in high-skill sectors wage incomes have grown faster than productivity. The central policy recommendation is instructive: Considering that technological advances and globalization are exogenous—i. That is, with the expectation of higher rewards for labour, it seems persuasive to aim at supporting labour-upgrading. Whether all this would lead to the increased availability of labour, labour market flexibility, the erosion of collective bargaining and reduced earnings is not spelled out.

In this model, fiscal profligacy is the main explanation for balance-of-payments problems and uncontrolled inflation. As the fiscal deficit rises, the ensuing monetary expansion leads to inflation, making exports less competitive, raising imports, encouraging capital flight and worsening the external balance. As explained by Patnaik and many other observers, the same view prevailed throughout the 20th century, and still permeates the latest incarnations of IMF models as well as those of the OECD and the EC considered here.

A proactive fiscal policy and enhanced government expenditure are seen to offer benefits under some circumstances—as reflected in the emphasis in recent times on public investments in infrastructure after all, good infrastructure increases the profitability of businesses at no direct cost for them. But fear of public sector debt is paramount. The models in question tend to establish an a priori ceiling for the public debt-to-GDP ratio, to which the government deficit is connected by stock-flow arithmetic.

The reader may be familiar with the traditional mainstream view that deficits crowd out private sector expenditure, at least to a certain extent. The argument assumes that debt financing leads to inflationary pressures and interest rate rises that adversely affect real consumption and investment. By this logic, each dollar of public expenditure sacrifices a defined amount of private expenditure. The net result of the public expenditure increase and the private sector contraction will be less than the dollar spent, while the increase in the debt will be one dollar.

Fiscal deficits must shrink. Modern versions of these models invoke all sorts of devices to create this basic effect. On the other hand, transfers to the poor in the form of subsidies and government current expenditure in various areas often excluding the military are suggested targets for downward adjustment.

The government can reinforce fiscal consolidation by raising the rate of value added tax also known as sales tax.

Keynesian economics - Aggregate demand and aggregate supply - Macroeconomics - Khan Academy

These all are obviously regressive measures. But they are justified in the pursuit of financial stability and improving long-term growth prospects. In contrast to advice related to fiscal policy, it has become commonplace to espouse expansionary monetary policy. To stimulate demand, central banks can use a transparent, market-friendly policy rule that allows for lowering the interest rate in presence of sluggish demand. This will surely stimulate investment, it is assumed, and will not pander to vested interests of policy officials or overt corruption.

Though the models of IOs allow for a rich interplay between policy choices, expansionary policy scenarios proposed by these models show a bias against fiscal relaxation in favour of monetary expansion.

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In the aftermath of the global financial crisis of , governments and central banks tried various combinations of fiscal and monetary policy responses. Monetary policy reactions came first, as they always do. Although policymakers remained fearful of the unambiguous position of IOs during the last many decades— condemning deficit spending—the gravity of the crisis was such that most countries resorted to fiscal stimuli. Despite the initial success of the relaxation in containing a freefall, the tables turned in less than two years.

Public debt ratios were high, but the fact that these were for the most part induced by the crisis and emergency assistance programmes was disregarded. In most countries, with the exception of some of the larger emerging economies, the government brought on fiscal austerity, while major economies adopted more aggressive monetary policy in successively larger amounts in the form of quantitative easing.

Therein lies the wisdom of policy-propositions in the models of dominant IOs: Policies that encourage private sector activity and risk-taking are naturally optimal, but policies that increase the size or the influence of the public sector amount to interference with the efficient market mechanism and should be avoided.

Again, the narrative is powerfully intuitive: The private sector can take care of itself, since failures are punished with losses. But experiences during the s, the s and most recently the global financial crisis of , have demonstrated repeatedly that the most traumatic macro-financial crises occur in the wake of private sector excesses. A useful way to explore model properties is by assessing how a model resolves the many aggregation issues in the process of finding a global solution.

In modelling terms, this is not as simple as it seems because the whole is not necessarily a sum of its parts. Modelling parts are not fixed bricks; rather, they represent organic components reacting to changes in other parts of the model. To complicate matters further, for similar reasons, aggregation over time is not always as simple as assuming that long-run outcomes are the cumulative result of short-run episodes.

Two examples could help highlight this issue. First, from the perspective of a single firm, it seems advantageous to increase activity when labour costs are reduced. Thus, if the model simply aggregates the expected results out of the profit-maximizing premises of all firms, one can assume that wage cuts will trigger greater activity and aggregate investment. But the additive properties of the model have to take into account whether other feedbacks—from wages to demand—matter, and by how much. Second, if the public sector deficit rises, its immediate effect would be an increase in the stock of public debt.

But if the effect of the deficit is to both accelerate GDP growth and increase government revenues, public debt could after one or two years shrink or rise less than the sum of deficits in the previous years. There are innumerable techniques that can help and are most often used.

The importance of macroeconomic modelling

The Human Dimension of Economic Models (H.R.H. Prince Claus of The Netherlands). A Research Agenda: Panel Discussion on Macroeconomic Models . Challenges for Macroeconomic Modelling (Contributions to Economic Analysis) [ W. Driehuis, Martin M. G. Fase, H. Den Hartog] on *FREE*.

Furthermore, in testing a model, some degree of judgement is required. Time dynamics can also be complex. Most models of the IOs reviewed here, as well as many other global and macroeconomic models, are estimated empirically using large amounts of data. But because many of the features of the models themselves defy measurement—e. The most critical empirical relation in models reviewed in this essay is the aggregate production function.