The OECD Development Centre constructed the Medium-term Projection Framework for Growth and Development to provide medium-term growth and development scenarios for the regional Economic Outlook.
The Framework has two components:
i) Baseline models for medium-term projections
ii) Economic projection models
Baseline models determine potential output and the output gap, while the economic projection models provide the components of output and other variables. First, the baseline models derive the GDP series that are consistent with the output gap’s closing by 2015. Then these reference series are used as input to economic projection models to obtain a set of variables from the models.
i) Baseline Models: Estimation of potential outputs and output gaps
One of the key assumptions for the medium-term projections is related to potential output, which is estimated by baseline models.
In Southeast Asia, there is no comparable information on output gaps and potential output. Conventionally, potential output is measured either by applying a statistical filter to actual real output data, such as the Hodrick-Prescott filter, or by a production function approach in which potential output is related to labour and capital inputs. The filtering approach is relatively easy to produce results but there are drawbacks resulting from potential instability in the estimates and the need to specify a value for potential for one period (‘end-point’ problem); moreover the filtering approach lacks a theoretical base. The production function approach is widely used, but its application to Southeast Asian countries has its limits related to the lack of reliable data.
The estimates of potential output and output gaps used in the baseline models of MPF-SAEO 2010 are based on an alternative approach that has been recently developed, the dynamic stochastic general equilibrium (DSGE) method. The properties of potential output and output gap fluctuations derived from the DSGE approach can be different from those derived from the filtering or production function approaches. A clear advantage of this approach is that it can provide comparable information on potential output and potential output for Southeast Asian countries by using relatively easily available data (for instance, GDP, inflation, and interest rates). In addition, this approach has strong theoretical foundations which explicitly reflect the optimising behaviour of households and firms and this approach can take account of different types of shocks from both the supply and the demand side.
The model for each country is based on a new Keynesian framework that consists of a dynamic Investment-Savings (IS) equation, a Phillips curve (aggregate supply equation), and a monetary policy reaction function. Equilibrium dynamics are driven by four exogenous shocks: technology, price markup, external demand, and monetary policy shocks. The baseline models’ parameters are estimated using Bayesian methods. It is assumed that the shocks in the last sample period gradually converge to zero following the estimated stochastic processes. Under these assumptions, the output gap for each country converges to zero by 2015.
The measure of the potential output is the stochastic trend level of output expected to prevail in the long run without any other temporary shocks. The potential outputeveloves according to the following law of motion:where represents the long-run growth rate and is the permanent technology shock that affects the potential output growth rate. According to this definition, the output gap is defined as the deviation of output from its stochastic trend:, where is the actual output.
The baseline models are completed using relations to determine consumption, inflation, and the real interest rate. These relations are based on the optimising behaviour of households and monopolistically competitive firms that face price stickiness and on a monetary policy interest-rate feedback rule. The model features a stochastic trend for real variables and gradual adjustment in consumption, inflation and the interest rate.
The equations presented below are the linear approximation of the model, and the variables are denoted as deviations from the balanced growth path.
a) Households derive utility from consumption goods and disutility from labor supply. The optimality conditions for utility maximizationare are given by
,where is the subjective discount factor, b represents habit persistence in consumption preferences, measures the risk aversion. is the Lagrange multiplier interpreted as the marginal utility of consumption and is private consumption, is the nominal interest rate, and is inflation.
According to these equations, consumption increases (decreases) when the real interest declines (rises). Consumers adjust their actual consumption to desired consumption gradually rather than immediately ("habit persistance").
The market clearing condition for final-goods is , where and are the steady-state share of private consumption and the other demand components. is the external demand shock that captures government expenditure and net export. Combining these equations above, a dynamic IS equation is obtained which characterises the demand side of the economy.
b) Monopolistically competitive firms maximise their profits by setting the prices of their product.
It is assumed that not all firms adjust prices every period. In each period, a fraction of firms reoptimises prices, while the remaining fraction keeps prices unchanged or indexes prices to past inflation.
Profit maximisation gives a dynamic equation called the New Keynesian Phillips curve:
where is the weight of price indexation to past inflation and is the inverse of the labor supply elasticity in the households’ utility function. The term represents the real marginal cost that is equivalent to the real wage derived from households’ maximisation problem. is the marginal cost shock that captures an exogenous cost push to the firms’ price setting such as the changes in oil price and taxes.
This equation means that the current inflation rate is determined by past and expected future inflation, the real marginal cost, and the exogenous cost shock. The backward- and forward-lookig features of the equation enable the model to replicate realistic inflation dynamics.
c) The monetary authority follows the Taylor-type inflation targeting rule:
where determines the degree of policy smoothing, and and measure the responsiveness of the interest rate against inflation and the output gap respectively. is the monetary policy shock interpreted as an unsystematic component of the monetary policy.
This means that the monetary authority gradually adjusts the short-term nominal interest rate in response to the deviation of annual inflation from its target and the output gap.
The data used for estimation is the real GDP growth rate (), the CPI inflation rate
(), and the short term interest rate ().These data are related to model variables by the following measurement equations:
where , and are the GDP growth rate, inflation rate and nominal interest rate that prevail in the long-run respectively.
Baseline models of SAEO 2010 apply Bayesian methods to estimate model parameters. Given the estimated parameters, series of potential output and output gaps are estimated so that the estimates are consistent with both the model and data.
ii) Economic Projections Models
With reference to GDP projections conducted by baseline models, economic projection models are used to provide details of the projections for SAEO 2010. Economic projection models are medium-scale demand-driven economic forecasting models that comprise a set of equations describing the five sectors of the economy: real sector, monetary sector, fiscal sector, balance of payments sector and debt sector.
The results of projections are derived through iterations to identify a set of economic variables in all sectors including the current account, fiscal balance, investment and private consumption. The Economic Projection Models take into account national development plans considering their feasibility given the budgetary and other circumstances.
Supplementary data and insights into policy directions were provided during the OECD Development Centre’s medium-term outlook missions in July and August 2010. The preliminary results were also discussed with governments and central banks in Southeast Asia during the missions.
For more information, please contact Kensuke Tanaka (email@example.com), Asia and Pacific Desk, OECD Development Centre