Economic policy works through two policy rules – one for fiscal and one for monetary policy. Apart from imposing chocks to these policies it is possible to introduce exogenous chocks to other parts of the model such as government expenditure, unemployment benefits, various taxes, etc. The main focus, however, is on changes in the policy rules.

 

 Fiscal policy

 

Fiscal policy is governed by the long run solvency criterion as implemented by the EU stabilization pact. The target for the Swedish government budget surplus is set to 1.5 percent of GDP and the policy governed by the equation

 

 

which states that the changes in taxes relative to income should be equal to the lagged difference between target and actual budget surpluses valued at nominal GDP. In equilibrium at SEGBR=1.5 taxes will grow at the same rate as personal incomes, SEPI. If the budget surplus is lower than the target, taxes will be raised faster than personal income. In this particular case the adjustment is done through changes in direct taxes and not by SEWT, wage taxes, or SECOLL, payroll taxes[1].

 

Of course, the fiscal policy rule can be altered in line with the model users’ preferences. I have run the model with adjustments in multiple tax rates and it would also be possible to change government expenditure or transfer payments.

 

Monetary policy

 

The same goes for monetary policy where it has been an intense discussion in recent years about the specifications of the policy rule. In Sweden there is the inflation target for CPI at

 

 

where SEKPI80 is the consumer price index with 1980=100 and here defined for the quarterly data[2].

 

It has been argued that the monetary transmission mechanism implies that it takes approximately two years for a change in the policy interest rate to achieve its maximum effect on inflation. Hence, the CB should change the policy rate in response to the two year ahead expected deviation of the actual from the target inflation rate. A smoother that makes the policy rate persistent is most often included and a possible rule then could be

 

 

This simple rule shows that the interest rate is rather persistent, that the response to deviations is fairly large and aims at increasing the real interest rate and that the long run equilibrium interest rate is five percent (hence a three percent real rate). A large number of experiments with this and other types of rules have been done. It is very easy to try out different variants in the model. Presently the following rule rules:

 

 

with policy weights increasing linearly with the 2,5 year’s horizon. The equilibrium rate is about 4.6 percent.