CONTRIBUTIONS TO ECONOMIC ANALYSIS 178 Honorary Editor: J.TINBERGEN Editors: D.W.JORGENSON J.WAELBROECK NH TU ÖS NORTH-HOLLAND AMSTERDAM NEW YORK OXFORD TOKYO CHALLENGES FOR MACROECONOMIC MODELLING Edited by: W. DRIEHUIS University of Amsterdam Amsterdam,The Netherlands M.M.G.FASE De Nederlandsche Bank, N.V. and the University of Amsterdam The Netherlands H. DEN HARTOG Central Planning Bureau The Hague,The Netherlands andTechnical University Eindhoven,The Netherlands NORTH-HOLLAND AMSTERDAM NEW YORK OXFORD TOKYO ©ELSEVIER SCIENCE PUBLISHERS B.V., 1988 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical photocopying, recording or otherwise, without the prior written permission of the publishers, Elsevier Science Publishers B.V. (Physical Sciences and Engineering Division), P.O. Box 1991,1000 BZ Amsterdam,The Netherlands. 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Box 1991 1000 BZ Amsterdam The Netherlands Sole distributors for the U.S.A. and Canada: ELSEVIER SCIENCE PUBLISHING COMPANY, INC. 52 Vanderbilt Avenue é- New York, N.Y. 10017 U.S.A. LIBRARY OF CONGRESS Library of Congress Catalog1ng-1n-PublIcatlon Data Challenges for macroeconomlc modelling / edited by W. DMehuis, M.M.G. Fase, H. den Hartog. p. cm. — (Contributions to economic analysis ; 178) Papers from a conference held 1n Amsterdam, Oct. 21-23, 1987 and organised by the University of Amsterdam, the Nederlandsche Bank, and the Central Planning Bureau. Includes Index. ISBN 0-444-70529-5 1. Macroeconomics—Mathematical models—Congresses. I. DMehuis, W. II. Fase, M. M. G., 1937- . III. Hartog, H. den. IV. Universitelt van Amsterdam. V. Nederlandsche Bank (Amsterdam, Netherlands) VI. Netherlands. Centraal Planbureau. VII. Series. HB172.5.C445 1988 339' .0724—dc19 88-25214 CIP PRINTED IN THE NETHERLANDS V Introduction to the series This series consists of a number of hitherto unpublished studies, which are introduced by the editors in the belief that they represent fresh contributions to economic science. The term 'economic analysis' as used in the title of the series has been adopted because it covers both the activities of the theoretical economist and the research worker. Although the analytical methods used by the various contributors are not the same, they are nevertheless conditioned by the common origin of their studies, namely theoretical problems encountered in practical research. Since for this reason, business cycle research and national accounting, research work on behalf of economic policy, and problems of planning are the main sources of the subjects dealt with, they necessarily determine the manner of approach adopted by the authors. Their methods tend to be 'practical' in the sense of not being too far remote from application to actual economic conditions. In addition they are quanti- tative. It is the hope of the editors that the publication of these studies will help to stimulate the exchange of scientific information and to reinforce international cooperation in the field of economics. The Editors VII EDITORS' INTRODUCTION W. Driehuis, M.M.G. Fase, H. den Hartog In 1985 we realized that the year ahead was one of celebration. In October 1936 Jan Tinbergen presented the first econometric model ever made, which was of the Netherlands economy, to an audience of Dutch economists. The year 1986 was therefore the fiftieth anniversary of macroeconomic model- building and there were many reasons to commemmorate its birthday. First of all there were reasons to look back. What was this first model all about? How has macroeconomic modelbuilding in the Netherlands and other countries developed since then and where does it stand now? There were also reasons to look ahead. Since the monetarist-new classical revolution, macroeconomic modelbuilding has come under heavy fire. These schools in economics consider empirical macro-economic modelbuilding a fairly useless activity devoid of all intellectual challenge. The reason- ing is based on assumptions about the way people absorb information about economic events and economic policy. Economic agents are supposed to beha- ve rationally no matter what economic policy looks like, that is if they are not taken aback by it. We recognize the importance of the rational expectations school for bring- ing back expectations, particularly in the forward looking variant, in macroeconomic modelling, but we remain sceptical about the rational ex- pectations revolution and have doubts on its meaning for practical model- building so far. We decided to organize an international conference with a theme which reflected some doubt and uncertainty about the future of macroeconomic modelbuilding. We asked all participants to contemplate the question: will macroeconomic modelbuilding remain an intellectual chal- lenge for the future? The conference was held in Amsterdam on October 21-23, 1987 and organised by the three institutions with which we are affiliated: the University of VIII Introduction Amsterdam, the Nederlandsche Bank and the Central Planning Bureau. We were lucky to have His Royal Highness Prince Claus of the Netherlands to hold the opening speech honouring Jan Tinbergen. He emphasized the human factor in Tinbergen's work and asked the audience to continue their activities in the field of macroeconomic modelbuilding in Tinbergen's spirit. The audience, made up of about 330 economists from all over the world, was then able to listen to the presentation of seven papers written by eminent scholars in the field of (macro)economic theory and econometrics and four- teen discussants as well as a panel discussion on a research agenda. Dis- tinguished policy advisers took part in the discussions and chaired the sessions. Although with different emphases, all authors, some of the panellists and other participants were of the opinion that the world cannot do without macroeconomic models. However, despite their fifty years of existence and increasing degree of sophistication, the present models are still far from satisfactory, whether for forecasting purposes or for economic policy evaluation. Much work needs to be done to make further progress in these respects. The main result of the conference was in fact that it provided a research agenda. The answer to the question contained in the theme of the conferen- ce is clearly: yes, macroeconomic modelbuilding remains an intellectual challenge. From the conference papers and the reports of the discussions, which have been collected in this book, the reader may learn about the research agen- da which the leading scholars in the field of macroeconomic modelbuilding have in mind. Without weighing the arguments it seems clear that at least ten items will be of importance for the future. These are: the modelling of international linkages, the functioning of the financial sector with special emphasis on asset-pricing behaviour, quantity rationing, stock- flow consistency, the improvement of the micro underpining of macro models, the testing of a particular theory for different countries, the modelling of dynamics, both of a backward-looking and of a forward-looking type, improvement of the forecasting performance of models, the combined use of cross-section and time series data, the inclusion of micro-simula- Introduction ιχ tion blocks in macro models and the modelling of the heterogeneity of labour. It is furthermore clear that a major insight can be obtained from general equilibrium models and models that enable an interactive optimisa- tion procedure. There can be no doubt that appropriate and partly new econometric methods are required to fulfil the tasks before us. And last but not least, the job cannot be done without new and better statistical data. The editors hope that the present volume will help to raise the standard of macroeconomic modelbuilding, both for analytical and forecasting pur- poses, in the spirit of Jan Tinbergen, the aim being to improve the quali- ty of life. We gratefully acknowledge the financial support of - the Ministry of Economic Affairs - the Nederlandsche Bank - the Central Planning Bureau - the Amsterdamse Universiteits Vereniging - the Social and Economic Council - the Universiteitsvereniging Rotterdam Without the help of these institutions, the conference would not have been held. Furthermore we owe a great deal to the Nederlandsche Bank which provided an enormous amount of organizational and secretarial assistence. We are also thankful to Alexander van Voorst Vader of the Nederlandsche Bank and his 'Golden Girls' Marianne Jonker, Marja Kooijman, Astrid Rijff and Mar- tine de Wilde, and Hans Haan assisted by Gerrie van der Geest and Kathy Schuitemaker of the Central Planning Bureau for their competent help. Last but not least our special thanks are for Marianne Brouwer of the Neder- landsche Bank, for her excellent secretarial and logistic efforts to plan the conference at its initial stage and to edit this volume. Without so much help by so many persons there would have been no conference and no book! Challenges for Macroeconomic Modelling W. Driehuis, M.M.G. Fase, H. den Hartog, (Editors) Elsevier Science Publishers B.V. (North-Holland), 1988 1 THE HUMAN DIMENSION OF ECONOMIC MODELS His Royal Highness Prince Claus of the Netherlands Opening speech held at the conference on Macroeconomic Modelling: Still an Intellectual Challenge? in Amsterdam on 21 October 1987. When on last Monday night - the 19th of October 1987 - at around 10.30 pm local time at The Hague - after the closing hour of the New York Stock Exchange - it became apparent to me that we were not passing through a technical adjustment process but were witnessing a real fully fledged crash whose consequences for the US and indeed the world economy - at least to me - seem difficult to predict as of today - I felt very much in doubt as to the relevance of what I had prepared as a short introduction for this morning. Nobody would listen anyway; all the eminent economists supposed to be gathering here in Amsterdam - if they would show up at all - would be very absent-minded, trying to figure out how the events in Tokyo, New York, London and Amsterdam - to name just a few financial centers - should be assessed and made plausible in terms of economic theory. Well, I decided not to panic and went to Amsterdam in a 'wait and see' mood. I am happy to find that my eminent audience has not panicked either. So I propose to call it Business As Usual - for today. Manana is another day. Although I myself am no modelbuilder, I was very pleased and indeed honoured at being invited to open this international conference on macroeconomic modelling. The organizers have given the conference a theme in the form of a question: Does macroeconomic modelling still constitute an intellectual challenge? My inclination is to answer this question in the affirmative. I for one have always regarded my attempts to fathom the potential of macroeconomic models to lay bare economic relationships as a challenge. Although I realize that it would be improper to try to steer this conference in a certain direction, I would like to say that I hope that the debates in which you will take part over the next few days will also yield an affirmative answer to this question. Models are abstractions of reality, they help us to come to a greater 2 Prince Claus of the Netherlands understanding of reality and thus to be able to exert an influence. The comprehensive and technical nature of models sometimes makes us forget that their ultimate goal is to provide people with a better life, today - in this short introduction - I would like to go into this human dimension of economic models and the special significance which they may consequent- ly have for developing countries. It is notably in attempting to improve the fate of people in the developing countries that we have found a major source of inspiration in the work of professor Jan Tinbergen, which centres on man and his plight. After all, the aim of this conference is to draw the attention of the academic world once again to the trailblazing work done by Tinbergen in the 1930s. It was in 1936, more than fifty years ago, that he published the world's first empirical macroeconomic model. The model described the Netherlands economy and served to ascertain which policy instruments could be employed to influence cyclical conditions. All this took place against the background of the 1930s, when so many became redundant through no fault of their own, at the depth of the cyclical trough. This unexpected economic depression, which confronted policy makers with entirely new problems, formed an intellectual challenge for Tinbergen's social conscience. Partly as a result of his study of physics, Tinbergen was aware of the great advantages of a quantitive macroeconomic approach. After all, a model permits comparison of alternative solutions, and gives a concrete form to differences of opinion on economic policy. Models bring consisten- cy to our thinking about economic problems. They show us how various eco- nomic factors interact and present us with options from which to choose. In brief, models are a means of communication between people apd a way to arrive at a well-founded judgement. No more and no less. A model is not a cristal ball. It cannot predict events which are not contained in its vocabulary. Such as political and social cultural upheavels. Revolutions, coups d'état, and spiritual reorientations are not parameters on which economic models can be based. Yet, as I pointed out, Tinbergen was led by his intense personal involve- ment in social issues in choosing which problems to analyse by means of a model. In his view, a problem is never abstract, it is always part of rea- lity. Initially he turned his attention to the unemployment of the 1930s, with its disastrous impact on the self-confidence and self-respect of The Human Dimension of Economic Models 3 those affected. Later he concentrated on income distribution models, out of the conviction that the economic development of all human beings is inconceivable without an equitable income distribution. Tinbergen was especially interested in developments beyond the influence of the individual. He set himself the task of analysing these very de- velopments and indicating how they might be influenced. In doing so, he became increasingly preoccupied with the national and international dimen- sions and particularly the position of the poor countries. In 1945 Tinbergen published his 'International Economic Cooperation1, which deals with the interaction between the policies of individual coun- tries, a theme which has lost none of its poignancy today. He is opposed to barriers in international trade, especially those directed against what we so conveniently call the developing countries. A major theme of this work is worth repeating here: 'It is especially the fear of competition by countries with a low standard of living that must be considered as unfoun- ded1 . His message is: no protectionism, neither through tariffs nor other- wise, but the necessity to open up our markets to Third World products, a view which he was to reiterate on numerous occasions. The issue is topical because the developing countries are again expected to make enormous ad- justment efforts, while the industrialized world is increasingly calling for protectionst measures. In the effort to find an answer to the question what effect this will have on the world economy as a whole, an important role could be played by modelbuilders, especially when it comes to calcu- lating the price which the South and the North will have to pay fo rpro- tectionism. Models are, of course, directed at policy makers, and hence often stress the role of governments in the economic process. However, the past two decades have taught us to be more modest as regards our ability to control the economic process - despite the wide range of models available to us. We have come to realize that the role played by governments is subject to limits and that much depends on the freedom with which people can pursue their economic activities. This also applies to the developing countries. Even though they, too, cannot dispense with government, I am convinced that economic growth in the developing countries would benefit from a full-grown private sector. Examples of this abound.