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Macroeconomic models, forecasting, and policymaking.

"All models are false but sonic are useful"

--George Box

Periods of economic and social crisis can easily turn into periods of change for economics as a profession. The dramatic financial crisis we experienced recently has caused economists to question the prevailing assumptions and standard approaches of the field. It is not the first time--the problems of the 1970s and 1930s had a similar effect on economic theory--and it surely will not be the last.

As we come to terms with why the crisis happened and why economists could not prevent or predict it, it is important to understand what was wrong with mainstream doctrine and practice. It is likewise just as important to identify what was working fine. As the old saying goes, let's not throw the baby out with the bath water.

In this Commentary. We focus on one subset of economic theory and practice, the role of econometric models in the conduct of monetary policy. We review the development of different types of models commonly in use and highlight their successes and failures since the 1950s. In doing so we also describe some of the common approaches that central banks This is a list of central banks.

Contents A B C D E F G H I J K L M N O P Q R S T U V W Y Z
 use for forecasting and evaluating different policy scenarios.

Forecasting and Monetary Policy

Forecasting plays a vital role in the conduct of monetary7 policy. Policymakers need to predict the future direction of the economy before they can decide which policy to adopt. While, strictly speaking Adv. 1. strictly speaking - in actual fact; "properly speaking, they are not husband and wife"
properly speaking, to be precise
, they do not necessarily need an economic model to discuss where the economy is heading, the use of a model's forecast has the benefit of elevating that discussion to a scientific and systematic level. Models can be used to test different theories, for example, and they require forecasters to clearly spell out their underlying hypotheses.

But policymakers need forecasting tools that do more than project the likely path of important economic indicators like inflation, output, or unemployment. They need tools that can provide them with policy guidance--tools that help them determine the economic implications of monetary-policy changes. For example, what will the economy look like under the original monetary policy, and what will it look like after the change? For this reason, there has been an effort over the past 40-50 years to develop empirical forecasting models that are able to provide policymakers with this kind of guidance. Three broad categories of macroeconomic mac·ro·ec·o·nom·ics  
n. (used with a sing. verb)
The study of the overall aspects and workings of a national economy, such as income, output, and the interrelationship among diverse economic sectors.
 models have arisen during this time, each with its own strengths and weaknesses: structural, nonstructural, and large-scale models.

Structural models arc built using the fundamental principles of economic theory, often at the expense of the models ability to predict key macroeconomic variables like GDP GDP (guanosine diphosphate): see guanine.  prices, or employment. In other words Adv. 1. in other words - otherwise stated; "in other words, we are broke"
put differently
, economists who build structural models believe that they learn more about economic processes from exploring the intricacies of economic theory than from closely matching incoming data.

Nonstructural models are primarily statistical time-series models-that is, they represent correlations of historical data. They incorporate very little economic structure, and this fact gives them enough flexibility to capture the force of history in the forecasts they generate. They intentionally "fudge"' theory in an effort to more closely match economic data. The lack of economic structure makes them less useful in terms of interpreting the forecast, but at the same time, it makes them valuable in producing unconditional forecasts. That means that they generate the expected future paths of economic variables without imposing a path on any particular variable. These unconditional forecasts arc typically accurate if the overall monetary policy regime does not change. Since policy regimes change infrequently, most forecasts from nonstructural models are useful.

The third category, large-scale models, is a kind of middle ground between the structural and nonstructural models. Such models are a hybrid; they are like nonstructural models in that they are built from many equations which describe relationships derived from empirical data. They are like structural models in that they also use economic theory, namely to limit the complexity of the equations. They are large, and their size brings pros and cons. One advantage is that relationships can be selected from a huge variety of data series, making it possible to provide a thorough description of the economic condition of interest. For instance, structural models rarely feature variables such as "car sales," while large-scale models often do. The main disadvantage is their complexity which poses some limitations to their understanding and use.

Big Models Take Shape

The interest in developing large-scale forecasting models for policy purposes began in the 1960s at a time when Keynesian economic theory was very popular and advances in computer technology made their use feasible. Toward the end of the decade, the Federal Reserve Board developed its first version of a macro model for the U.S. economy called MPS (MIT MIT - Massachusetts Institute of Technology , University of Pennsylvania (body, education) University of Pennsylvania - The home of ENIAC and Machiavelli.

Address: Philadelphia, PA, USA.
, and Social Science Research Council). The Board began to use the model for forecasting and policy analysis in 1970. In the initial version, MPS contained about 60 behavioral equations (equations that describe the behavior of economic variables). At the time, economists thought they had built a structural model. Soon they would find otherwise.

The initial optimism and momentum for building practical economic models was abruptly interrupted in the 1970s, a decade of great inflation and macroeconomic turbulence. The failure of economists to forecast high inflation and unemployment and to successfully address the economic troubles of the period produced a loss of faith in mainstream Keynesian theory and in the models that were the operative arm of that theory.

Disappointment came from realizing that the models that had been developed were not as structural as previously thought. Several flaws were identified, including assumptions about the behavior of prices and the overall modeling approach.

The models' greatest weakness was dial they ignored the role that expectations play in influencing future economic events. The Fed's and other large-scale models were often used for conditional forecasting exercises, in which variables of interest are forecasted for a chosen monetary policy stance. Comparing scenarios shows the economic implications of different monetary policy stances. But since the models did not incorporate expectations, in particular about monetary and fiscal policies, they did not produce reliable conditional forecasts.

These weaknesses were clearly a drawback when turbulence hit the economy. In fact, when people arc making decisions in periods of high uncertainty, they put a lot emphasis on anticipating what policymakers will do. They can behave differently than they did in the past, which policymakers won't be able to predict if they're relying on models that merely capture historical behavior patterns and don't incorporate expectations.

The Nobel Prize Nobel Prize, award given for outstanding achievement in physics, chemistry, physiology or medicine, peace, or literature. The awards were established by the will of Alfred Nobel, who left a fund to provide annual prizes in the five areas listed above.  winner Robert Lucas
This article is about the Ohio governor. For the economist, see Robert Lucas, Jr.

For the English cricketer, see .

Robert Lucas (April 1, 1781–February 7, 1853) was the 12th governor of the U.S. state of Ohio, serving from 1832 to 1836.
 was one of the first economists to point out the pitfalls of underplaying die role of expectations, especially in relation to policy recommendations. He pointed out that the underlying parameters of the prevailing models--the numerical constants embedded in the models that drove the forecasts--were not constant at all. They would change as policy changed or as expectations about policy changed, leaving policy conclusions based on these models completely unreliable, (lire argument came to be called the Lucas critique The Lucas Critique, named for Robert Lucas's work on macroeconomic policymaking, says that it's naive to try to predict the effect of a policy experiment based purely on correlations in historical data, especially high-level aggregated historical data. .) The policy failures of the 1970s seemed to bear him out. Lucas called for models with deeper theoretical structures, and the economics profession heard him.

Development led next in two directions, one toward improving the existing large-scale models and the other toward further developing nonstructural forecasting models. The latter effort has led to the widespread use and success of vector auto-regression models (VARs).

The Fed continued to work on its large-scale models. It developed a multicountry model (MCM (MultiChip Module or MicroChip Module) A chip package that contains several bare chips mounted close together on a substrate (base) of some kind. ) to complement the MPS, and in the 1990s it developed a new set of models--FRB/US, FRB/MCM and FRB/World. These new models still kept most of the underlying structural framework and the equilibrium relationships of the MPS and the MCM. But they also contained explicit specifications of forward-looking expectations and a more sophisticated representation of agents' decision making. Though they are not truly structural, they are still nevertheless the prime large-scale macro models (with over 250 behavioral equations) currently in use at the Fed. FRB/US is the most comprehensive model of the U.S. economy available anywhere.

The Dawn of DSGE DSGE Dynamic Stochastic General Equilibrium  Models

The rational expectations revolution of the 1970s created a temporary disconnect between academia and central banks. Economists at universities started working on developing a modeling framework that did not violate the Lucas critique. Monetary policymakers meanwhile continued to work with existing large-scale models since they were the only available framework for policy analysis. At the same time, they worked on improving those models by incorporating features advocated by Lucas and others, such as forward-looking expectations.

In a curious twist of fate, the disconnect was resolved by the rise of a new set of models, commonly known as DSGE (dynamic stochastic general equilibrium Dynamic stochastic general equilibrium modeling (abbreviated DSGE or sometimes DGE) is a branch of applied general equilibrium theory that is increasingly influential in contemporary macroeconomics. ) models. The roots of DSGE models can be traced back to real business cycle theory--a theory that left very little room for monetary policy actions.

Harvard's Gregory Mankiw explains what DSGE models arc in his popular textbook. Paraphrasing, dynamic means the models "trace the path of variables over time" (since the decisions by households and businesses affect not only the current period but future periods as well): stochastic means they incorporate techniques that account for the possibility of random economic events; and general equilibrium General equilibrium theory is a branch of theoretical microeconomics. It seeks to explain production, consumption and prices in a whole economy.

General equilibrium tries to give an understanding of the whole economy using a bottom-up approach, starting with individual
 means that each model is built as a whole system and everything within the system depends on everything else (prices determine what people do. but what people do also determines prices).

Research on DSGE models has been going on at a significant pace since the 1980s, but only in the past few years have the models been used seriously for forecasting. While similar to large-scale models. DSGE models arc different in that the latter have better microeconomic mi·cro·ec·o·nom·ics  
n. (used with a sing. verb)
The study of the operations of the components of a national economy, such as individual firms, households, and consumers.
 foundations: Household and firm behavior is modeled from first principles, while equations that relate macroeconomic variables (such as output, consumption, and investment) to each other are determined from the aggregation of the micro-economic equations.

The aggregation follows a strict bottom-up approach that goes from the micro to the macro level. This approach makes DSGE models better-suited to constructing conditional forecasts and comparing different policy scenarios.

DSGE models have a number of other advantages over large-scale models. They avoid the expectations problem that Lucas alerted everyone to. They incorporate a role for monetary policy, making them appealing to central banks. And finally, a technical advantage is that they can make use of the powerful solution methods of nonstructural models, given that their decision rules arc usually well approximated by linear rules. The economist Francis Diebold described this aspect of DSGE models as "a marvelous union of modern macroeconomic theory and nonstructural times-series econometrics."

Model Shortfalls and the Future

Since DSGE models arc technically very difficult to solve and analyze, they are much smaller in scale--usually featuring less than a hundred variables. They cannot easily incorporate the large array of high-frequency data usually available to policymakers.

Unfortunately, leaving some variables out may often lead to serious misspecification. For this reason. Princeton economist Christopher Sims characterizes DSGE models as useful story-telling devices that cannot yet replace large-scale models for forecasting purposes. On the other hand, Ben Bernanke, chairman of the Board of Governors of the Federal Reserve System, noted that DSGE models are "increasingly useful for policy analysis" and "likely to play a more significant role in the forecasting process over time ..."

Economic forecasting economic forecasting

Prediction of future economic activity and developments. Economic forecasts, which range from a few weeks to many years, are widely used in business and government to help formulate policy and strategy.
 models have come a long way since the 1970s, both the structural and nonstructural varieties. Most models, however, failed to predict the recent financial crisis. This failure may be partly attributed to the models' failure to fully incorporate the growing role of the financial sector or the worldwide financial and trade linkages that globalization globalization

Process by which the experience of everyday life, marked by the diffusion of commodities and ideas, is becoming standardized around the world. Factors that have contributed to globalization include increasingly sophisticated communications and transportation
 has generated.

However, while the economics profession is currently trying to address those deficiencies, there is something intrinsic to economics that makes forecasting difficult. Contrary to the natural sciences, the social sciences do not have true invariants that can be used as scientific foundations. There is nothing like a "constant of gravity" in economics, which we can claim is really constant. This happens because the object that is studied and the observer are in continuous interaction, and those sorts of relationships have no easily predictable consequences.

It is unlikely drat drat  
Used to express annoyance.

[Short for God rot.]


Slang an exclamation of annoyance [probably alteration of God rot]
 models will ever provide perfectly accurate forecasts. That is because forecasts arc ultimately just another variable in the system, and it is impossible to restrain them from influencing other variables in the system. Once a forecast is revealed, the forecast itself can actually change people's behavior. In fact, the people who attend most closely to forecasts are the people whose behavior is most likely to affect the future course of the variables forecasted. In the end. while policymakers would prefer better forecasts, policymakers' ultimate objective is better policy. And the lack of forecasting ability does not prevent models from being useful devices that can help policymakers in making decisions.

In this respect, the contribution that DSGE models have provided is mainly methodological, making them a useful complement to, but not a substitute for. large-scale macro-economic models or nonstructural VARs. At the same time, they have given academic economists and central bank staff a base for a common language. In this respect, we believe DSGE models have had a success that cannot be judged by their inability to forecast the recent crisis.

Cited Works

"Inflation Expectations and Inflation Forecasting," remarks by Chairman Ben S. Bernanke at the Monetary Economics Workshop of the National Bureau of Economic Research Summer Institute, Cambridge, Massachusetts This article is about the city of Cambridge in Massachusetts. For the English university town, see Cambridge, England. For other places, see Cambridge (disambiguation).
Cambridge, Massachusetts is a city in the Greater Boston area of Massachusetts, United States.
, July 10, 2007.

"Robustness in the Strategy of Scientific Model Building." George E.R Box. 1979. hi Robustness in Statistics: Proceedings of a Workshop. New York New York, state, United States
New York, Middle Atlantic state of the United States. It is bordered by Vermont, Massachusetts, Connecticut, and the Atlantic Ocean (E), New Jersey and Pennsylvania (S), Lakes Erie and Ontario and the Canadian province of
: Academic Press.

"The Evolution of Macro Models at the Federal Reserve Board," by Flint Brayton, Andrew Levin. Ralph Tryon, John C. Williams. Carnegie-Rochester Conference Series on Public Policy.

"The Past. Present and Future of Macroeconomic Forecasting." by Francis X. Diebold, 1998. Journal of Economic Perspectives.

"The Econometrics of DSGE Models," J. Fernandez-Villaverde. 2009. NBER NBER National Bureau of Economic Research (Cambridge, MA)
NBER Nittany and Bald Eagle Railroad Company
 working paper no. 14677.

"Computing Power and the Power of Econometrics." J. Hamilton, 2006.

Macroeconomics, Seventh Edition. Gregory Mankiw, 2009. Worth Publishers.

"Theory Ahead of Business Cycle Measurement." Edward C. Prescott Edward Christian "Ed" Prescott (born December 26, 1940) is an American economist. He received the Nobel Memorial Prize in Economics in 2004, sharing the award with Finn E. , 1986. Federal Reserve Bank of Minneapolis The Federal Reserve Bank of Minneapolis covers the 9th District of the Federal Reserve, including Minnesota, Montana, North and South Dakota, northwestern Wisconsin, and the Upper Peninsula of Michigan. , Quarterly Review.

"Expectations and the Neutrality of Money In economics, neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages and exchange rates, having no effect on real variables like GDP, employment, and consumption. ." Rober E. Lucas, 1972. Journal of Economic Theory, vol. 4.

"Comment on Del Negro, Schorfheide. Smets and Wouters," Christopher Sims. 2006. Journal of Business and Economic Stataistics.

"DSGE Models and Central Banks." Camillo Tovar, 2008. BIS, working paper no. 258.

Economic Commentary is published by the Research Department of the Federal Reserve Bank of Cleveland The Federal Reserve Bank of Cleveland is the Cleveland-based headquarters of the U.S. Federal Reserve System's Fourth District. The district is composed of Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia. . To receive copies or be placed on the mailing list, e-mail your request to or fax it to 216.579.3050. Economic Commentary is also available on the Cleveland Fed's Web site at.

Andrea Pescatori is a fomer research economist at the Federal Reserve Bank of Cleveland. Saeed Zaman is a senior economic analyst at the Bank. The views they express here are theirs and not necessarily those of the Federal Reserve Bank of Cleveland, the Board of Governors of the Federal Reserve System, or Board staff.
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Author:Pescatori, Andrea; Zaman, Saeed
Publication:Economic Commentary (Cleveland)
Date:Oct 4, 2011
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