Different parts
2004-06-23
The model is a general equilibrium model in the sense of an interdependent system in which all dependent variables affect each other. It is instructive to divide the model into a supply and a demand side. BASMOD could be described as an extended Mundell-Fleming model which uses forward-looking behaviour and endogenous economic policy in various places in the model. To some extent it therefore handles critique against older Keynesian models though it does not build consistently and throughout from optimizing microeconomic agents.
The long run equilibrium is determined in the aggregate supply side of the model. When aggregate demand is inconsistent with aggregate supply the price mechanism brings the economy back to equilibrium. A common way to think about this goes through the “output gap” which then is the difference between actual GDP (aggregate demand) and potential GDP (aggregate supply). As long as actual GDP exceeds potential GDP, the price level increases, which in turn lowers GDP and make the economy move back to equilibrium. Another way of thinking about this is in terms of marginal costs rather than the output gap. As aggregate demand increases firms move along an upward-sloping marginal cost curve and the general price level increases and likewise restore equilibrium in the model. The latter way of thinking about this is more general while the output gap analysis corresponds to a particular
– and restrictive – specification of production and costs, the Cobb-Douglas technology. Still, the output gap analysis dominates most central banks’ thinking about this. The marginal cost view with a less restrictive technology governs BASMOD.
Aggregate Supply
The aggregate supply side of the model is built up as a Wage Setting-Price Setting model. Wage determination is based on a bargaining model where the wage share is determined by the unemployment rate and structural factors like the replacement ratio. Price setting is marginal cost pricing taking account of the degree of competition. This determines the long run equilibrium of price and wages as well as the unemployment rate and GDP. The equilibrium unemployment rate is determined by the degree of competition the price elasticity of demand and structural factors in the labour market. The equilibrium output level is determined by these same factors as well as the productivity growth and the growth rate of the labour force.
Aggregate Demand and Short Run Equilibrium
In the short run aggregate demand deviates from the long run aggregate supply mainly due to the rigidity of prices and wages. The demand side of the model consists of the balance of resources and the financial markets as well as the endogenous stabilization policy.
The balance of resources – or output market – is the common one mainly defined from the national accounts. It consists of household and government consumption expenditure, gross fixed investments in housing, business and government, inventory investments and exports and imports of goods and services. All together it makes nine components. In addition, for the ambitious model user household consumption expenditure can be divided into seven items.
The financial markets are treated as a pseudo portfolio choice model. It is assumed that households own all assets. Household net wealth is comprised of housing wealth and financial wealth less liabilities. Financial wealth is net foreign assets plus bonds, money and equities including equities in funds. Asset values in bonds are affected by interest and exchange rates and equities by changes in equity prices. Housing wealth are affected by changes in housing prices. Therefore, changes in asset prices is an important link between financial and real markets, since changes in asset prices affect household wealth and therefore household consumption expenditure. In addition, changes in asset prices affect Tobin’s Q which in turn is a determinant of investment in the business sector. Changes in the exchange rate also affect household wealth since it affects the value of net foreign assets.
Finally, stabilization policy is endogenous in the model and works through aggregate demand. There are policy rules for monetary as well as fiscal policy. Monetary policy is conducted through a policy rule in which the central bank smoothly sets the short run (3 month) interest rate with respect to the deviations of expected future rate of inflation (UND1X) from the target 2 percent annual rate. This rule is easily altered with respect to smoothing, horizon, etc.
There is also a fiscal rule that adjust the direct tax rate with respect to the deviations of the budget deficit from the target set by the rules of the EU stabilization pact. There is also a smoother for the adjustment of tax rates.