Basic structure

Bengt Assarsson

2003-10-13

 

BASMOD is a macroeconomic model based on an extended Mundell-Fleming approach with price and wage setting similar to Layard-Nickell. Macroeconomic policy is endogenous in the model, i.e. fiscal and monetary policy reacts to shocks, using model consistent expectations. The entire model is not forward-looking. Rather, forward-looking and model consistent expectations are imposed for variables for which this is considered particularly important, such as exchange rates.

 

Macroeconomic models can be divided into aggregate supply and aggregate demand. The demand side is often not a matter of controversy but still can be modelled very differently. Here, demand can be seen as consisting of product markets and financial markets. The product market is simply the balance of resources defined by the identity: , where notations are obvious and  is the real exchange rate and hence  the value of imports in constant domestic prices, i.e. real imports. In the simple IS-LM model financial markets are represented by a portfolio model in which agents choose between bonds and money. The rate of interest is determined by the supply and demand for money. Here, consumers are assumed to own all asset and choose among a broader range of assets: money, bonds, equities and real estate, i.e. financial as well as real assets. Also, there is a division between domestic and foreign assets. An increase in output tends to increase the demand for assets and hence to drive up asset prices. Similarly, an increase in interest rates tends to lower asset prices. Asset prices affect the balance of resources in several ways. Consumption expenditure is affected since it depends on household net wealth. Private investments depend on Tobin’s Q, here approximated by the ratio between a stock price index and the implicit price deflator of private investments. Net exports are also indirectly affected by financial markets since interest rate changes affect exchange rates through the open interest rate parity condition.

 

In the long run aggregate demand equals aggregate supply. Let aggregate supply be denoted . The model then can be closed by using a model for how prices are determined. For instance, the equation used by Taylor (1980) is  is a possibility, where  is the rate of inflation and z is a supply shock variable. This model obeys the non-accelerationist hypothesis, i.e. in the absence of shocks the rate of inflation should not change. If  is taken for the expected rate of inflation and it is assumed that the actual equals the expected rate in the long run the model also implies , i.e. actual GDP equals potential GDP. In the simple IS-LM model excess demand implies increasing prices which affect demand in two ways. First, the real money supply decreases and raises interest rates. Secondly, increased prices raise the real exchange rate and hence lower net exports. The appreciating real exchange rate is enhanced through an appreciating nominal exchange rate through the interest rate parity condition.

 

In BASMOD, different but similar mechanisms apply. Aggregate supply can be determined by the production function , where K is the capital stock, A is the rate of technical change and  the number of efficient hours worked. Potential output is produced when both capital and labour is in equilibrium. However, from the theory of duality we know that the technical conditions of the firm can be represented by the dual, i.e. instead of profit maximisation the same solution can be reached by cost minimisation. Hence, consider instead the cost function , where  is a vector of shadow input prices and  is a vector of efficient inputs and otherwise obvious notation. This cost function is consistent with the profit function , where P(Y) is the product demand curve. As is well-known input demand equations and marginal cost equation can be derived from the cost function, here as  and  respectively. From the profit function the price equation  may be derived for a monopolistic firm. Since some firms are monopolistic and others competitive a more general specification is , where  is a competition index. Note that all variables in this equation may be time varying. In equilibrium we have  where  is the output level consistent with the target rate of inflation, in the Swedish case two percent annual rate, here defined as the policy-consistent output level, . If  marginal costs increase and price inflation increases above its target.  This induces the central bank to increase its target interest rate which reduces aggregate demand through the channels mentioned above and the economy moves towards its equilibrium path. Note also that in BASMOD this equilibrium path endogenously determine the rate of technical progress, measured in the a-factor. The a-factor can be measured in various ways. In BASMOD it is determined by the level of education of the employed, so that the number of efficient hours worked increase with the level of education while the shadow wage simultaneously decrease (the cost of an hour worked).

 

Economic policy is endogenous in the model. Fiscal policy is governed by the European Union fiscal stability pact. In BASMOD this is implemented such that the (long run) budget deficit – through variations in taxes – is kept at a small surplus (2 percent at the moment) and only is allowed to deviate in the short run. Monetary policy is governed by the inflation target, which at the moment is 2 percent with a margin of +/- 1 percentage point. In the model the central bank reacts with respect to the expected future inflation rate, to be consistent with the view that the monetary transmission mechanism entails certain rigidities. Different policy rules can easily be implemented in the model according to the users’ preferences.