Macroeconomic models in Japanese Government

Masanori Umeda

(Economic and Social Research Institute , Cabinet office, Japan)

ESCAP Workshop on Macroeconomic Modelling in Asia and the Pacific 8 December,2015

Overview of macroeconomic models in Japan

Two macroeconomic models are frequently used in Japanese Government.

1. Short-run Macroeconometric model of the Japanese economy To evaluate effects of the economic policies and external shocks. ( not

designed for forecasting.) Published by the Economic and Social Research Institute(ESRI), Cabinet

Office, Japan.

2. Economic and fiscal model To describe the path of fiscal reconstruction. To show clear macroeconomic condition for the future (GDP, prices etc.)

and the macroeconomic vision that we should aim for. Published by the Cabinet Office, Japan

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Summary of macroeconomic models in Japan

Short-run macroeconometricmodels in Japnese economy Economic and fiscal model

Simulation Term Short Medium to longFrequency Quarterly YearlyEquation 152 2,345

Output multipliers, and economic policy analyses

Economic and fiscal projections(mid-long term forecast)

Short-run macroeconometric model of the Japanese economy- this model is useful for understanding the economic basic structure and the impact of economic policy and external shock.

Economic and fiscal model- this model includes national accounting identities in detail, for example government budget, so this model is suitable for assessing process of fiscal consolidation, reviewing economic and fiscal developments.

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Historical background (１)

“Short-run macroeconometric model of the Japanese economy” is based on IS-LM-BP framework.

Traditional Keynesian macro model made a important role in the government and central bank for their policy making from 1940s.

In recent years, due to the progress of microfoundationof macroeconomics, the discussion of conventional macroeconometric models have declined in academia.

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Historical background (２)After seminal critics by Lucas (1976) and by Sims (1980) on

traditional macroeconometric models, DSGE and VAR models have been developed and widely used as substitutes for the traditional models.

However, those substitute models still have several problems to overcome for practical use in economic policy analyses.

ESRI has been developing and utilizing multiple types of models, including DSGE, as well as traditional models.

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Historical background (３)

Japanese government adopts hybrid-model which pursue short-run empirical coherence and long-run consistency,and DSGE models, which place greater emphasis on theory.

“Short-run macroeconometric model of the Japanese economy” and “Economic and fiscal model” is classified to Hybrid model.

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The structure of “the short-run macroeconometricmodel of the Japanese Economy”

This model is basically a demand-oriented, traditional Keynesian model with IS-LM-BP framework; however it adopts recent developments in econometrics such as co-integration and error correction to ensure long-run properties of models.

This model is composed of 152 equations (includes 47 estimated equation).

This model is mainly composed of 4 blocks.(1) Goods and Services market (2) Labor market (3) Money market (4) Foreign exchange market.

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(1) Goods and services ①Demand Side Y=C+I+G+X-M (IS Curve)

(Private Consumption) C = C(NW, YD, r)Based on permanent income hypothesis. In the short term, private consumption is affected by disposable

income. In the long term, private consumption is affected by lifetime

income.

(Investment) IP = IP(KP/KPeq, UC/P, PS, X)Based on the Capital Stock Adjustment Principle.Capital stock is gradually adjusted to the equilibrium capital stock

level.

In the short-run, GDP depends on demand side:thisrelation composes IS curve. 7

(1) Goods and services ②Supply Side

Yp=F(KP,Ls) dp/P=P((dP/P)-1, GAP) GAP=Y/Yp

Potential GDP is defined by the factors of production(labor supply, capital stock, etc)

In the long-run, operating ratio converges to equilibrium operating ratio by the adjustment mechanism,whereGDPGAP affects prices by modified Phillips curve.

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(2) Labor MarketLabor demand is determined by the long-run inverse

correlation between in the real GDP growth rate and the unemployment rate (Okun's law).

Wages are determined by the adjustment of the labor share of the economy.

Ld＝ Ld（１－UR）UR＝（(UR/Ureq)-1,CU,UR-1, (YW/NI)/(YW/NI)eq )

Labor supply depends on the real wages, population and aging rate.

Ls＝ Ls（W/P, POP65／POP, UR）9

(3) Money Market Short-term interest rates is based on Taylor rule(adjustment

by GDPGAP and Inflation).is= is(dP/p,GAP,Yp) If Taylor rule suggests negative value, interest-rate would be fixed to 0.01%.

Money Supply is endogenously determined by the function of money demand.MS=MD(is,Y,P)

Long-term interest rates is determined by period structure of short-term interest rates.

il= is(L)r= il -dP/p

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(4) Foreign exchange Market Foreign exchange rate is determined based on “Asset Approach”. Foreign exchange rates is determined by equilibrium rate, interest

rate gap between Japan and the U.S and risk premium. Import price, net export and net factor income is effected by

exchange rate. Current account balance is determined by these factor.

Capital account balance is defined by BP Curve(balance of payments curve) .

E=E(il-il*, P/P*, ρ）ρ=Σ BC/(P・Y)BC=P・X – E・P*・MBC ＋ BK＝０ (BP Curve) 11

The cases of Simulation1. Government investments

Effect of real government investments (1% of real GDP)

Effect of real government investments (1% of real GDP) 【fixed short-term interest rate】 Effect of nominal government investmets（1% of nominal GDP）

2. Income-tax reduction Effect of income-tax reduction (1％ of nominal GDP)

3. Consumption-tax increase Effect of the consumption-tax rate rise (1％point)

4. Monetary policy Effect of short-term interest rates rise(1%pt)

Effect of 1% of Money supply increase

5. External shocks Effect of 10% devaluation in exchange rate

Effect of oil price hike by 20%

Effect of world demand increase by 1%12

Main result(Short-run macroeconometric model)

Effect of Government Investments

(１% of Real GDP)

Effect of Income-TaxReduction

(１% of Nominal GDP)

Effects of Short-termInterest Rate Rise

(１% point)

Effects ofDepreciation of the

exchange rate(10% )

1st Year2nd Year3rd Year

1.141.020.97

0.300.370.45

-0.32-0.26-0.29

0.080.440.41

Effects of Macroeconomic Policies in Japan on Real GDP(% deviation)

Here are some of the multipliers of policy simulations. The fiscalmultiplier, i.e., the effect of government investments on GDP, is1.14 in the first year.

The effect of income tax reduction is smaller than that of thefiscal expenditures due to its leak to household savings. 1%point rise of short-term interest rate reduces real GDP by 0.32%in the first year.

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Dataset and Software Platform

(Dataset)Quarterly data. Estimation period is FY1980 to FY2012. The dataset is composed of macroeconomic time series

data such as SNA(System of National Account).

(Software Platform) Software is “Portable Troll Release2.6”

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The characteristics of “Economic and Fiscal model”

“Economic and fiscal model” interacts macroeconomy and public finance and social security synthetically.

The projection based on this model is published twice a year. To describe the path of fiscal reconstruction. To show clear macroeconomic condition for the future(GDP,

prices etc.) and the macroeconomic vision that we should aim for.

The latest projection (“Economic and Fiscal Projections for Medium to Long Term Analysis”) was published in July ,2015.

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1. Halving the rate of the fiscal deficit against GDP by FY2015 (▲6.6%→▲3.3％）

2. Turning the fiscal deficit to a surplus by 2020.3. Reduce the debt-to-GDP ratio in a stable manner.

The target of the fiscal consolidation

Around 3％ nominal gross domestic product (GDP) growth and around 2％ real GDP growth, on average, over the next ten years.

The aiming for the macroeconomic perspectives (Medium to long term)

Macroeconomic vision in Japan

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Main result (1)(economic and fiscal model) The target of halving the ratio of deficit to GDP from the FY2010 rate

by FY2015(3.3% to GDP) is expected to be achieved. In the Economic Revitalization Case, the primary deficit is projected to

be approximately 1.7% in FY 2018 and 1.0% in FY2020.

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Main result (2)(economic and fiscal model) In the Baseline Case, the ratio of outstanding debt to GDP in FY2020

(excluding the reconstruction bonds) is projected to be approximately198.8% and to increase afterwards.

In the Economic Revitalization case, the ratio of debt to GDP is projected to be approximately 184.2% and to decline afterwards.

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