A New Macroeconomic Model Of The UK Economy

Researchers at the Universities of Cambridge, Edinburgh and Leicester have developed a new small macroeconomic model of the UK economy, which is capable of explaining the main short-term (business cycle) features of the UK economy over the past four decades while at the same time taking account of the longer-run relationships between the key domestic and foreign macroeconomic variables, such as the interest rate, the foreign exchange rate, inflation, money and output. Details of the model are published in the latest issue of the Economic Journal.

The research team behind the model – Anthony Garratt, Kevin LeeHashem Pesaran and Yongcheol Shin – note that increased globalisation of the world economy has important consequences for the conduct of monetary policy by central banks and risk management by commercial banks. In setting interest rates, more than ever before, central bankers need to allow for the short- and long-term relationships between domestic and global macroeconomic variables. The main difficulty has been how best to reconcile often volatile, short-term (business cycle) deviations in these relationships with the more durable and stable long-run nature of the macro economy.

Using their new model, the researchers show that although market forces tend to operate reasonably well in the long run, this tendency is often punctuated by prolonged periods of ''disequilibria'' in the product and financial markets. The extent to which macroeconomic variables deviate from their long-run values varies considerably across markets. The most important deviations are seen in the relationships between domestic and foreign output,
and the extent to which the exchange rate deviates from its equilibrium PPP (purchasing power parity) value. By comparison, domestic and foreign interest rates adjust much more quickly.

The model also generates sensible short-term predictions. For example, a rise in oil prices by $3 per barrel is predicted to reduce output by 0.25% after one year, an effect that remains in the system unless the oil price rise is reversed. As far as the effect of the monetary policy is concerned, a policy intervention that lowers the interest rate by 50 basis points has very little immediate impact on output. The full impact of the interest rate on output is felt only after two to three years, with output rising by 0.46% above its level prevailing in the absence of the monetary policy intervention. The inflation effect of the fall in interest rate is also perverse in the short run, and gets only partly reversed after two to three years.

The model can also be used to investigate the type of monetary policy interventions required for redressing the adverse effects of a hike in oil prices. For example, a sustained rise in oil prices of $12 per barrel relative to the
reference price of $20 will require a reduction of 200 basis points in the interest rate if the adverse effects of the oil price rise on output is to be avoided. Such large interest rate reductions can prove difficult considering the very low interest rates that are currently prevailing.

The new model is also an extremely useful tool in forecasting. Given the model's size and relatively simple structure, it is relatively easy to use it to compute probability event forecasts. In a related paper, the authors provide probability forecasts of recession, the probability of inflation falling within the government''s target range of 1.5% to 3.5%, or the probability that the exchange rate will depreciate by 5% over a quarter. These are the types of event that are typically relevant to decision-makers looking into the future.

The model was built using a new statistical approach that emphasises the role of the long-run relationships between the variables in influencing what happens today. Economic theories underlying these relationships are relatively well accepted, are common to most models and reflect common sense. So, for example, UK output cannot grow out of line with the rest of the developed world over long periods; differences in domestic and foreign price inflation are ultimately reflected in exchange rate movements; and domestic and foreign rates of interest cannot diverge indefinitely.

These long-run relationships are built into the new model and provide the model with a transparent and theoretically coherent foundation. More shortrun phenomena, about which there is more disagreement and which give rise to the variety of conflicting models, are captured in the new model by simply looking at patterns in the data over the last four decades. This more statistical approach allows the new model to perform very well in explaining the shortrun fluctuations in the economy and in forecasting short- and medium-term outcomes.

''A Long-run Structural Macroeconometric Model of the UK'' by Anthony Garratt, Kevin Lee, Hashem Pesaran and Yongcheol Shin is published in the April 2003 issue of the Economic Journal. Pesaran is at the Faculty of Economics and Politics, University of Cambridge, Sidgwick Avenue, Cambridge CB3 9DD; Garratt and Lee are at the University of Leicester; Shin is at the University of Edinburgh. Further information on the work is available at: http://www.econ.cam.ac.uk/dae/research/svar/