At a time when the Government is working on a new national budget for the 2011/12 financial year, the Energy Chamber believes it is crucial that the country builds and analysis macroeconomic models to help build scenarios and make informed policy decisions. While much of this work should take place in government agencies and the universities, it is also important for independent think tanks and lobby groups to build their capacity to analyse the economy and make credible policy recommendations.
To this end, the chamber has been developing an aggregated macroeconomic model of the T&T economy. Last year, the energy sector contributed 43 per cent to our gross domestic product. As a result of this continued dominance of this sector, the Energy Chamber's model will quantitatively measure the impact of how changes, in particular commodity prices, can affect the rest of the economy in terms of the key macroeconomic variables. This model will serve as a tool to help the chamber in its lobbying efforts by demonstrating to policy makers the impact of various policy scenarios on the rest of the economy.
Markets that impact the model
Our economy can be analysed by visualising four broad markets: the goods and services market, the labour market, the money/bond market, and the foreign exchange market. Supply and demand forces or competition in these markets determine our economy's important macroeconomic variables: inflation, unemployment, interest rates, and the exchange rate. The goods and services market determines the price level/inflation rate and the amount of output/input produced annually by our economy. The labour market determines the wage rate and the employment/unemployment level. The money market determines the interest rate and the price of bonds. And the exchange market determines the balance of payments and the exchange rate.
Overall equilibrium
Macroeconomic modelling seeks to simulate how these four markets interact and how quickly the automatic forces of supply and demand created serve to push our economy back to an overall equilibrium, and how government intervention (by means of macroeconomic policy) can influence equilibrium or speed up the process of adjustment to equilibrium. For example, unemployment reflects disequilibrium in the labour market. Market adjustment forces pushing the economy back to full employment may operate too slowly, so one might ask what government policy would speed up this adjustment? Because of the interconnections between the four markets, it is not obvious what government policy would be best. To influence the labour market, it is not necessary to intervene directly in this market. The government could intervene in one of the other markets, for example, by using fiscal policy to affect demand in the goods and services market, or monetary policy to affect supply in the money/bond market.
Model specification
The schematic (see diagram) provides an outline for the specification of the model currently being developed by the Energy Chamber. The model contains 11 behavioural equations and two identities: one for real disposable income and the accounting identity for real gross domestic product (GDP). Each equation in the model is estimated using annual data from 1970-2009.
Simulation of the model
The complete model system developed by the chamber was simulated using real data from T&T.
Two historical simulations and an ex-post forecast were performed to evaluate the model's ability to replicate the actual data. The first simulation covers the entire estimation period 1970-2009. The second covers the final 15 years of historical data in the sample. To perform the ex-post forecast each equation of the model was re-estimated using data from 1970-2004, truncating the sample period by five years. Then the model was simulated over the final five years, solving for values of the endogenous variables by using actual historical values for the exogenous variables. The early results generated by the model seem to indicate that this model may be a tool that could be used to understand aspects of the economy and test different policy decisions.
Forecasting the policy analysis
Standard forecasting and policy experiments were created to determine if the results of the model coincided with intuition. The first experiment was the baseline forecast. This assumes things will continue as they have in the recent past. Under a second scenario, constant real government spending is assumed to remain constant throughout the forecast horizon 2010-2014, equal to its value in the 2009. All the other exogenous variables follow the same paths that they are following in the baseline forecast. In the third scenario, a 20 per cent cut in exports is modelled, reflecting a fall in prices.
The result of these experiments is shown in Figure 1. Holding government spending constant in real terms reduces aggregate demand, thus decreasing GDP and its components.
A 20 per cent cut in exports due to significant commodity price declines will spell disaster for this economy according to this model. The early results from this model show that this could be an important tool to build understanding of our economy, however these are only preliminary results and further work is needed to validate and teak the model. As always, the Energy Chamber is committed to furthering the analysis of our economy and finding the right tools to help our planners implement the correct policy frameworks for national economic development.
For more information on the article,
contact Stein Trotman at: stein@energy.tt, or 6-ENERGY.
Visit: www.energy.tt