An Introduction to

Australian Economy-Wide Modelling

Colin Hargreaves

No. 35 - February, 1989

ISSN 0157-0188

ISBN 0 85834 807

An Introduction to Australian Economy-Wide Modellinq

by

Colin P. Hargreaves

This paper was written for a conference on the macroeconomic

models of Australia, that I arranged at the University of New

England in December, 1988. The participants at the conference

were people from the private and public sector and as such

were not academic macroeconomists. This paper was thus meant

to be a broad introduction covering the main developments in

macroeconomic modelling since its beginnings with the work of

Jan Tinbergen in the late 1930’s. After discussing some of the

earliest ideas in mathematical modelling of the economy, the

first models and their problems will be discussed leading up

to the developments at the Brookings Institution. Then some of

the major theoretical events over the last 20 years in dynamic

macroeconometric modelling will be discussed followed by the

development of other types of models such as applied or

computable general equilibrium models. I will conclude with

some comments upon the value of these models.

2

i. Early__~inninqL~ up to the 1930’s

In his posthumous and monumental work, "History of Economic

Analysis", Joseph $chumpeter points out how, thousands of

years before Christ, the Egyptians were running a planned

economy and, hundreds of years before Christ, the Chinese were

running exchange controls. Although many people were clearly

thinking about economic subjects, it is only with the Ancient

Greeks that we begin to find economic analysis along the lines

that we know today. Here we find Aristotle wrestling with the

concepts of ’value’, ~money’ and ’interest’, and Plato

discussing the Division of Labour and basically originating

the Cartal theory of money whereby money is not just another

commodity used as a medium of exchange (usually metal for

practical reasons) but an intrinsically valueless ’token’

which is socially accepted as a medium of exchange.

It is amazing how little development of economic thought there

was from this time right up until the 1600’s. Here the warring

state of affairs between England and Spain and between England

and Holland caused much discussion of the best way to increase

the wealth of England. Many Englishmen feared the wealth of

Spain in particular and its ability to buy large Armadas. Then

with the Cromwellian revolution there arose a parliament

thirsting for information upon which to make decisions about

the nation and taxes in particular.

Ioi Sir William Petty_~23-87.

The 1600’s saw a large number of great talents but one

particularly striking character was Sir William Petty. And he

only arose as a great figure because he broke his leg while a

14 year old cabin boy on an English merchantman. After being

dumped ashore in France he explained his pitiful circumstances

so well in Latin to the Jesuits that they not only cared for

him but admitted him to their college and there started his

career as one of the Renaissance’s self-made ’Universal’ men

of enormous versatility - physician, surgeon, mathematician,

inventor, engineer, member of parliament, public servant and

businessman - who refused the peerage twice before finally

accepting a third offer° One idea that he spent much time upon

was the ’Double Bottom’, a sort of catamaran; on one trial,

one of these outstripped all the boats in Dublin Harbour but

Petty was never able to obtain such good results again.

With Sir William Petty one has possibly the beginnings of

today’s mathematical economics and econometrics, with his

"Political Arithmetik, the art of reasoning by figures upon

things related to government". In this treatise he writes -

"Instead of using only comparative and

superlative Words, and intellectual Arguments, I

have taken the course ... to express in Terms of

Number, Weight or Measure; to use only Arguments of

4

Sense, and to Consider only such Causes, as have

visible foundations in Nature."

Petty is most famous in economics for his discussion of money

and the velocity of money in particular, but possibly of

greater relevance here is his analysis of National Income.

5

Table I: Sir William Petty[s Analysis of National Income

in "Verbum Sapienti", 16~

(£m) (£m)

Land: 24m acres @ 6s/8d p.acre

Houses: London - 28,000 @£15p.a. = £420,000pa => 5.04

Outer London - as many but not worthso much each, so same => 5.04

Cities and Market towns = 2 x London => 10.08

Outside cities and towns, approx same => 10.08

Houses Total say 30

Shipping: 500,000 tuns at 6d per tun 3

Cattel Stock: 1/4 of land value 36

Coined Gold and Silver: 6

Wares, Merchandises, Utensils of Plate & Furn. 31

Total of non-land 106

TotalWorth Rent

144

106 =>5.89say 7

Wealth of the Nation 250

Annual Proceed of Wealth 15

Expenditure:- 6 million people @ £6/13/4d => 40m per annum

"Then the Labour of the People must furnish the other 25"

As 250=>15, the Value of the people => 25 and so Human value => 416.67m

i.e. 420/6 = £70 each

In Table I, an attempt is made at summarising the logic used

in Perry’s ’~Verbum Sapienti" of 1665. He starts by saying that

there are 24 million acres of land worth on average about

6s/Sd per acre (a third of a pound sterling), creating a total

worth of £144m which should provide a rental income of £8m. As

to the houses on the Land, he separates these into various

categories in and outside London. In London there are about

28,000 houses with an average rental of £15p.a. giving a total

rental of £420,000p.a., so they must be worth £5.04 million.

Houses in the outer London suburbs are at least as many as

those in London but not worth so much, so, say, another £5.04

million. Houses in the other cities and market towns must be

worth twice as much as London and hence £10.08 million, and

finally all other houses must be worth about the same again

and hence another £10.08 million. All in all this makes a

housing total of, say, £30 million.

To this we must add £3million worth of shipping (500,000 tuns

at 6d per tun, 6d=£0.025), £36million of ’cartel~ stock ( say

a quarter of the land value ), say £6 million worth of coined

gold and silver, and say £31 million worth of Wares,

Merchandise~ Utensils of Plate and Furniture. This creates a

total non-land wealth of £106 million, leading to a convenient

total wealth of the nation of £250 million. Then just as the

£144m land wealth led to a rental income of £8 million, the

non-land wealth leads to, let us say, £7 million creating an

annual total proceed of wealth of a nice round £15 million.

7

Now there are 6 million people spending about £6/13/4d p.a.,

(£6o66), making £40 million p.a. Given the £15 million from

’rent’, "Then the Labour of the People must furnish the other

25". Probably for the first time, we have here none other than

an expression of the key national income-expenditure identity

that is at the core of all macroeconomic models.

He goes on to say that since £250 million of property wealth

led to £15 million worth of ’rents’, the value of the people

that creates £25 million of income must be £250,25/15 =

£416o67 million. Given that there are 6 million people, then

on average each person is worth just £70° This must also be

one of the first evaluations of the modern concept of human

wealth. He developed this argument as a reason for spending

the equivalent of a few pounds per person to save Londoners

from the ravishes of the plague; for his purposes, there was

no reason to be numerically more accurate°

Sir William Petty was the leader of a small group of

outstanding people including Gregory King, Charles Davenant

and John Graunt, the founder of demography. In Gregory King’s

"Natural and Political Observations and Conclusions upon the

State and Condition of England in 1696" we find the first

definite expression of demand equations that was not to be

improved on for over two hundred years. In discussing the

demand for wheat he comments that, if production fell by 10%

or 20% etcor be!ow normal, then the price will rise by some

8

30% and 80% above trend° This image of a demand curve was not

to be improved upon till the early 20th century with the work

of Moore. For an interesting re-appraisal of Petty, see the

book by Alessandro Roncaglia (1977, English text 1985) wherein

the author tries to escape from the linear development of

economic thought implied by Schumpeter’s historical analysis;

Roncaglia argues that the many aspects of Perry’s thought,

other than those developed by later economists, are now of

relevance today°

1.2 Adam SmithL 1723-90~ and David Ricardo~ 1772-1823o

While Petty had been a very dramatic figure of his age, a man

about whom there are many tales, not all apocryphal, the next

great watershed came with a very different type of man. In an

amazing indictment Schumpeter writes about Adam Smith, ’Few

facts and no details are needed about the man and his

sheltered and uneventful life (1723-90). It will suffice to

note: first that he was a Scotsman to the core, pure and

unadulterated; second, that his immediate family background

was the Scottish civil service .o. ; third, that he was a

professor, born and bred, ... by character indelebilis; fourth

oo. that no woman, excepting his mother, ever played a role in

his existence: in this as in other respects the glamours and

passions of life were just literature to him .... He was

conscientious, painstaking to a degree, methodical, well-

poised, honorable° He acknowledged obligation where honour

required it, but not generously° He never uncovered the

footprints of predecessors with Darwinian frankness. In

criticism he was narrow and ungenerous. He had the courage and

energy that exactly fit the scholar’s task and go well with a

good deal of circumspection°’ (op.cito p181-2).

Like many ’great’ works, Adam Smith’s Wealth of Nations,

published in 1776, was in no way innovative but rather it was

a detailed methodical statement of the ideas of the day put

into a logically consistent form. As such it publicised the

ideas, and economics became an established subject. ’But no

matter what he actually learned or failed to learn from his

predecessors, the fact is that the Wealth of Nations does not

contain a single analytic idea, principle or method that was

entirely new in 1776o~ (Samuelson p184) o

One of the major changes of this time was the relatively

important position given to the concept of labour. Value was

no longer a matter of exchange but of labour "conceived as

toil and time, the working day that divides up, and uses up,

men’s lives." (Sheridan, p66). Michel Foucault in his

magnificent analysis of human thought, ’Les mots et les

chosesW, marks this point as the move away from the Classical

Age of representation.

Foucault’s translator, Alan Sheridan, says "By making labour

the constant measure of exchange value" Adam Smith "laid the

i0

foundations for a political economy that could be based not on

exchange (representation) f but on production. But in Smith’s

analysis labour is still regarded as a commodity that can be

bought and soldo As long as representation retained its

precedence all commodities represented a certain labour and

all labour a certain quantity of commodities. The second stage

of the founding of political economy was the work of David

Ricardo .... Ricardo pointed out that labour could not be used

as a constant measure since it is ’subject to as many

fluctuations as the commodities compared with it’. This

insight led him to make the productive activity of labour

itself not the measure of value but the source of value. Value

is no longer a sign in the system of equivalences but a

product of labourf which is prior to any system of exchange.

The theory of production must now precede that of circulation.

Circular causality has been replaced by linear causality.

Ricardo has made possible the articulation of economics on

history." (Sheridan p68-9) o From here it was only a natural

progression in one respect to the historicological work of

Marx and the mathematical ’causal’ models of Popperian

positivism.

1o3 Leon Walra_~s 1834-1910.

The next major figure~ however~ of relevance to us, arising

from the organismic systemic thinking of the 19th century, is

the Frenchman, Leon Walras~ with his ’Elements d’economie

ii

politique pure’ in 1874; Schumpeter referred to his system as

’the Magna Carta of economic theory’ (op.cit. p242). Although

Isnard back in 1781 was possibly the first to try

mathematically to define and prove the concept of economic

equilibriums it is in Walras’s theory of general equilibrium

that we finally see a system that ’determines the equilibrium

values of all the economic variables, to wit: the prices of

all products and factors~ that would be bought in perfect

equilibrium and perfect competition by al! households and

firms.’ (Schumpeter~ p998-9).

Although this is the foundation of modern economics, Leon

Walras gained very little credit for it during his own

lifetime. As he himself once wrote in a letter to a friend,

"If one wants to harvest quickly, one must plant carrots and

salads; if one has the ambition to plant oaks, one must have

the sense to tell oneself: my grandchildren will owe me this

shade."

1.4 John Maynard Keynes, 1883-1946.

The thrust of development in economic thought turned from

comparative statics to analysis over time, and the business

cycle in particular° On the econometric side we have the path-

breaking work of Henry Moore and his ’Economic Cycles: Their

Law and Cause’ (1914) and ’Generating Economic Cycles’ (1923).

Joseph Schumpeter wrote his own two-volume historical book on

12

’Business Cycles’, (1939)o On the economic side we have John

Maynard Keynes and ’The General Theory of Employment, Interest

and Money~, (1936) o Although this may be in part a synthesis

of the work of Joan Robinson, RoG.Hawtrey, RoFoHarrod and

RoFoKahn, and at the same moment~ contemporaries in Sweden,

EoRoLindahl and CoFOhl~ were in the process of writing down

the same ideasr Keynes had a startling analytical flair.

Although nobody seems to read the original Keynes any more, I

would at least highly recommend reading such works as ’The

Economic Consequences of the Peace’ (1919)~ ’The Economic

Consequences of Mr Churchill’ (1925) ~ ’Can Lloyd George Do

It?’ (1929) and ’How to pay for the War’ (1940) o

Keynes~ major economic innovation was possibly what Schumpeter

beautifully describes as his stagnationist image of "an

arteriosclerotic economy whose opportunities for rejuvenating

venture decline while the old habits of saving formed in times

of plentiful opportunity persist" (op.cit. p 1171). As far as

today is concerned~ however, one must remember that Keynes’

concept of unemployment was that of cyclical unemployment, not

the Marxian structural unemployment which may seem more

relevant today.

13

2. The Development of National Macroeconomic Models.

2.1 Jan Tinbergen’s Early Models

While Henry Moore’s analysis of cycles and his estimation of

elasticities possibly led to the partial equilibrium analysis

of Allen, Wold and Stone, the general interest in cycles also

led to the pioneering work of Jan Tinbergen who may well be

called the forefather of macroeconomic models of today. As

early as 1935 he published a model of the Dutch economy, but

more famous is his 1939 model of the US economy. Though his

structures owe more possibly to common-sense considerations

than pure economic theory, they are no mean feats. The US

model has 32 stochastic equations and 18 identities with 14

exogenous variables. There are three consumption, three

investment and three liquidity preference functions and it

even includes the stockmarket. In his 1951 model of the UK

economy there are 45 equations with 9 exogenous variables. The

gold stock is modelled endogenously thus linking the monetary

sector to international trade and share prices are also

modelled endogenously.

A major aspect of Tinbergen’s work is that the statistical

analysis was used to estimate parameters and test hypotheses

resulting from theory, not the other way around. In

particular, it was not like the more statistical analysis of

Wesley Mitchell and the NBER, whose analysis aimed more at

14

establishing the facts so that the theory could be based on a

firm foundation° While Tinbergen’s approach has held sway, the

other methodology has reappeared recently with the VAR

modelling started by Christopher Sims (1980, "Macroeconomics

and Reality", Econometrica,48,1-48) who was worried about the

inaccuracies arising from imposing unproven theoretical

constrictions on the data~ We will return to this approach

later°

A major factor in the late 1930’s and the 1940’s was the

quality of the data. Firstly, for the major time series, only

annual data was available. Secondly, what with two world wars

and a depression, the economies had not been going through a

stable period from which stable statistical results could be

derived. For lack of other information, it is not~surprising

that many economists, during World War II, predicted another

depression after this war. Note also how, when estimating a

model in 1950 to analyse business cycles, Tinbergen used 44

observations from 1871 to 1914. Nobody now would use

observations over thirty years old to estimate a model to be

of relevance to today. Klein used 20 pre-war observations to

estimate his 1950 model and the Klein-Goldberger (1955) model

was estimated with 13 pre-war and 7 post-war observations!

2.2 The Age of Klein.

The post-war period saw a great explosion of macrodynamic

modelling led by the work of Lawrence Klein. One might almost

15

call this jubilant confidently optimistic period, the ’Age of

Klein’. People had such high hopes for economics; the world’s

problems would soon be solved. These grandiose claims were not

the fault of economic theory but rather forced upon it by the

social attitudes of the time. When scepticism started to creep

in, economics, and macroeconomic modelling research in

particular, were criticised more than they deserved. Now

people are beginning to be more realistic in their attitudes

and are realising that, while macroeconomic models do not

represent the economy perfectly, they are a valuable source of

information needed to make reasonable business and policy

decisions.

The first Klein model was an extraordinarily simple demand-

driven model of expenditure; note how many things are missing.

There is

i. n_~o explicit production function and so no analysis of

the supply side and technological effects,

2. n~o price or wage equations and so no analysis of

inflation,

3. n__Qo labour market and so no analysis of unemployment,

4. n_9o financial sector and so no analysis of interest

rates,

5. n__go international linkages are modelled and so no

analysis of the balance of trade, the exchange

rate etco

And so the list could go on. This is not meant as a criticism

16

of this early model, but, when you think of all the questions

attacked by modern modelsr it shows just how far such models

have developed over only thirty years.

One could say that model development really got under way with

a rush of new models when quarterly data became available.

Most models were fairly small with some 28-37 equations -

Duesenberry et al’s recursive model (1960), Klein-Popkin

(1961), Fromm (1962) and Liu (1963). On the other side one had

the idea that greater detail would lead to greater accuracy

and one has the Brookings model developed over 1961-4. This

had some 272 equationsr of which 125 were stochastic, 51 a

priori and 96 definitional. The debate over whether models

need to be highly disaggregated or not still continues today

and may never be decided; rather than asking this in general,

it may be more useful to ask such a question only in the

context of a specific planned use of the model.

2°3 ’Brookin~

The Brookings Bureau was an unparalleled phenomenon. For many

years it seemed to tower over macrodynamic theory° It showed

clearly how collecting a group of researchers together into a

Bureau can be so productive, especially in its early exciting

formative years ( two books and forty-three papers in four

years). The Bureau is probably more famous for its innovative

research than any one model°

To list just a few of the Bureau’s earliest ideas -

17

a) Detection of Structural Chanqe - they found

significant changes across 1953 and so omitted the 1948-1953Q2

data and used just 1953Q3 to 1962,

b) Use of an Input-Output Core, relating final demand

categories to industrial sectors - 7 price equations, 9 price

conversion equations relating industrial sector prices to

final demand prices, 7 equations relating industrial sector

outputs to components of GNP,

c) Use of Demographic Information with separate labour

participation rates for men and women of different ages and

even a marriages equation,

d) Modelling ’intentions’ to invest separately from

’realisations’,

e) Use of a Highly Disagqreqated Government Sector to

model federal expenditures separately from state expenditures,

and so the list could go on and on. But let us not imply that

the USA had total hegemony over this new modelling enterprise.

Many models were being developed in countries all over the

world, especially Canada, England, Holland, Japan and also

Australia (see Nerlove, 1966).

18

2~4 The Neo-Classical Input

Early Brookings and Klein were part of this optimistic period

of the 1950~s and early 1960’s, the glowing age of the welfare

state° By the late 1960’s a dramatic social change had set in.

For many people this is marked by the dramatic events in

France in May 1968, especially on the streets of the Latin

Quarter in Paris. This was possibly more a social

emanation/release of something that had been brewing for a

while, a disaffection with the state, a fear of the state and

disbelief in its benevolence and even its ability to ’do good’

if it tried. So many people at the time wanted to express

their dissatisfaction with ’the powers that be’, whatever they

might be.

Within this atmosphere arose a shift of opinion against

government interference, what one might call the ’keep your

hands off’ revolution, the so-called neo-classical revolution

in economics and the rise of monetarismo The word ’revolution’

over-emphasises the number of new innovative ideas and

probably reflects more of a social phenomenon amongst

economists° Although Milton Friedman had written his "Studies

in the Quantity Theory of Money" as early as 1956, his ideas

only really gained public notice in the late 1960’s at which

time he published ’The Optimum Quantity of Money’ (1969)o

There are three major effects upon modelling that are still

being felt today - longer time horizons, supply side modelling

and greater financial modelling. With the concept of

’permanent income’ and the longer time horizon also came the

analysis of technical change.

19

Now we automatically distinguish between models that have

shorter or longer horizons, as what you can assume to be fixed

depends on your time horizon. In the short-run the labour-

supply is fixed and there is no resolution of disequilibria.

In the long-run ’all’ can vary and so there must be a method

of resolving disequilibria. Because of the extra effort needed

to do this, long-run models tend to be smaller. Also it may

not be sensible to model the immense detail of some models in

the long run as the structure of the economy is probably not

stable enough. A difficulty with long-run models is that of

testing, in that we never experience an economy settling down

to a long-run stable equilibrium. Thus these models have to be

assessed more by consistency with theory rather than data,

raising many methodological questions.

Long-run models tend to be Classical as what we term

’Keynesian’ economics is more interested in the short run.

With the revived classical use of production functions also

came the introduction of the supply side, and with the

discussion of the velocity and supply of money came much

greater financial modelling. In the so-called ’Keynesian’

model, supply was fixed and so output was demand driven; there

was no real production function. This meant, for instance,

that one could not study the effects of short-run capacity

2O

constraints and disequilibria. Above all, these models are

useful as logically consistent expressions of a body of theory

and its implications; I will return later to the use of models

to express theory concisely and consistently.

21

3. Major Post-War Developments in Macroeconomic Theory.

A few of the major developments are probably worth mentioning

as they feature in most macroeconometric models in one way or

another. I will relate them in particular to four Australian

models -

a) the Treasury model called NIF88 (see $imes, 1988),

b) the MURPHY model (see Murphy, 1988),

c) the McKibbin and Sachs Global Mode! called MSG (see

McKibbin, 1988)

d) the computable general equilibrium model called ORANI

(see Dixon et al, 1982).

3.1 Wealth and the Consumption Function

Firstly there is the analysis of wealth and in particular the

Modigliani/Ando consumption function. A typical expression of

this function, used in both the NIF model and the Murphy model

of Australia, would be -

$Con = f(current labour income, non-human wealth (lags of),NPOPxPI ..

The left-hand-side is real per-capita consumption (consumption

divided by the population and a relevant price index). Note

that the current labour income is seen as arising from human

wealth; this distinction reminds one of Petty’s original work.

22

With wealth comes the introduction of a new stock variable,

that we still find very hard to measure° This also led to the

demand for stock-flow consistent models such as Warwick

McKibbin and Sach’s MSG model of the world that includes a

specific Australian subBmodel. With the lengthening of the

time-horizon and the emergence of new, better data, one can

now deal with stock-flow effects and, in particular, see the

work of EoPoDavis of the Bank of England.

3.2 Investment and Interest Rates°

An example of a stock effect is Tobin’s Q, the valuation

ratio. This is the ratio of the market valuation of equity to

the replacement cost of the capital stock. The market

valuation of equity should equal the discounted net present

value of all future profits. If the present and future profits

of the capital are worth more than the cost of that capital,

then it is sensible to invest in more capital. This approach

is used in Murphy, NIF and MSG. However it leads to serious

problems in deriving the ’market value of equity’

The first solution was to use Portfolio Demand Equations, a

large set of equations for different types of assets demanded

by different sectors - foreign, public, private and household.

This approach was used in an earlier version of NIF called

NIFI0o Through these equations one can determine the interest

rate, the price of equity, the exchange rate and many other

23

things. This approach has since been found to be unduly

complicated and may lead to unstable equations. A method used

now is to determine a key interest rate and from this

determine others by arbitrage conditions as is done in NIF88

(see Simes, 1988). Also in MSG, "Exchange rates, long-term

interest rates and equity prices are determined according to

intertemporal arbitrage conditions based on rational

expectations of the future path of the global economy."

(McKibbin, 1988)

3.3 Unemployment, Inflation and the NAIRU.

Another major theme has been the Phillips curve, originated in

1958. The trade-off between unemployment and inflation was not

new. The shock was the level of unemployment at which

inflation started, over 5%! This implied that if you wanted

unemployment below 5% you had to accept some degree of wage

inflation. Initially this was treated as a constraint and it

was a political nightmare; the aim of policy soon became to

shift the whole curve rather than just move along it.

This Phillips curve development was in fact a dubious one in

the first place for it was purely a statistical result. In the

late 1960’s new data led to the derivation of families of

curves and so the idea proliferated. In many if not by far the

majority of models, the rate of unemployment was used in the

causal determination of the rate of inflation whereas this

24

apparent causality was partly just a spurious effect of the

simultaneous forces in the economy. For this reason, and

partly the difficult political problems raised by the idea, it

is pleasing to see that the rate of unemployment is used less

now in determining inflation. For instance, in Ray Fair’s

Model (Fair, 1984), the labour supply is an intermediary

function of much else such as taxes, real wages, interest

rates and transfer payments, and so there is no clearly stable

Phillips curve°

With the debate upon the Phillips curve, there arose the idea

of the ’Natural Rate of Unemployment’ (NRUI in possibly the

most influential paper since Keynes, "The Role of Monetary

Policy", given by Milton Friedman in his Presidential Address

to the American Economic Association in 1968. The NRU is the

rate at which the average real wage rate is held constant and

any expansionary policy will just cause inflation in the long

run. This led to the notorious vertical long-run Phillips

curve. The form of this concept used today is the ’Non-

Accelerating-Inflation-Rate-of-Unemployment’. This is known as

the NAIRU, a name which is not much of an improvement. MSG,

NIF and Murphy all make use of this concept though the effect

is mollified by allowing some hysterisis; hysterisis is when

the particular path taken towards the long-run solution

affects that long-run solution.

3.4 Expectations

25

Friedman’s paper talked of people’s expectations of inflation.

This led to the idea that the government had to reduce

people’s inflationary expectations to shift the curve. To do

this they had publicly to espouse a long-term deflationary

policy. Friedman assured the policy-makers that this would not

take long and one could soon get back to a more publicly

acceptable policy° Out of this arose the grand experiment,

Margaret Thatcher~s "Medium term financial strategy" in which

her government announced a five-year slow reduction in the

rate of growth of money and in the PSBRo The result?

Unmitigated disaster. Not only did unemployment rise to

incredibly high levels but so did inflation! It will be many

years before Great Britain recovers from the scars (for

further comments on this tregime’, see Buiter and Miller,

1983). The more recent reduction in inflation was a result of

the reduction in global inflation levels and there are

disturbing signs of galloping inflation again in Britain. One

doubts whether the British government had read Friedman’s

later 1976 Noble Memorial lecture, in which he talks of

slumpflation, positively sloped Phillips curves and much

longer time periods.

People’s expectations were not only discussed in Friedman’s

theory but had been a standard part of the debate for years,

even in Keynest work. However, in 1960, J.F. Muth laid the

theoretica! foundations of a new development, known as

26

’rational expectations’. The name is rather misleading for in

at least one sense expectations had always been rational. The

distinguishing idea is that the expectations are forward-

looking, not adaptive and backward-looking. By this I mean

that the expected values are the actual values predicted by

the model, given all the information it has at this present

point of time. Given this, a much better name would be ’model

consistent expectations’ There is still much evidence for and

against the hypothesis but, above all, it is a very

parsimonious modelling strategy. The modeller does not have to

explain how people derive their expected values; he simply

equates them with the models expected values.

Early rational expectations models go back to Lucas (1973 and

1975), Sargent (1976), Sargent and Wallace (1976) and Barro

(1976). In England, Patrick Minford has used rational

expectations extensively in his Liverpool Model. In

Australia, they are used in both Murphy and MSG but not in

NIFo The debate for and against is at times surprisingly

heated and vitriolic. The popular middle line is to use

rational expectations not across the board but in specific

areas such as in financial markets. The expectations debate

goes on to discuss the different effects of anticipated and

unanticipated changes in government policy and even the

effectiveness altogether of government policy.

27

4. Developments in Statistical Estimations

There is not time or space in this paper to describe the many

other developments in macroeconomic theory, for developments

in other ways in modelling must be mentioned. Here I can pay

little more than lip-service to the dramatic developments in

econometrics, starting with the work of Trygve Haavelmo (for

example 1940, 1943 and 1947) and the Cowles Commission in the

1940’s and 50’s. Most estimation techniques were developed

some while ago now and it is possibly surprising to see the

lack of use today of instrumental variable methods and LIML

(if not FIML) techniques. A major criticism of econometrics is

possibly that too much effort has been put into hypothesis

testing rather than estimation. Economics is not without its

own major debates such as the procedural differences between

David Hendry, Christopher Sims and Edward Leamer (see Pagan

1987). Curiously such issues, while vitally important, are

commonly omitted from econometrics courses which concentrate

on technique. For instance, it is rarely mentioned in student

texts; it is not discussed at all in Gujarati’s popular basic

text (1988).

After going through a rather dry period full of asymptotic

theory, there have been a number of exciting developments in

econometrics in the last few years, notable amongst which are

the specification tests which have been written about by a

number of Australasians, such as David Giles, Max King, Mike

28

McAleer and Adrian Pagan (see references below). Also there

has been the development of the methodologically more dubious

diagnostic tests for heteroscedasticity, autocorrelation, non-

normality, etc. Hardly a model is estimated without extensive

use being made of these tests° Many models are still estimated

with single equation techniques, and have to be for lack of

data; this raises the risk of simultaneity bias and here the

Hausman tests are very useful~

Finally the increased computing power available has permitted

the development of computer-hungry techniques such as Jack-

knife and Bootstrap methods (see Miller 1974, Efron 1982 and

Hinckley 1988), and the movement of computer-aided design

(CAD) techniques into statistics with the development of

exciting new graphical techniques. Further information on the

development of econometrics can be gained from Epstein’s

(1987) ’History of Econometrics’, which is particularly

relevant to modelling as it concentrates especially upon

structural estimation, the question of exogeneity, rational

expectations and vector autoregressions.

29

Extensions of the Macroeconometric Model.

5.1 VAR Modellinq.

One econometric technique deserves greater mention as it has

led to a whole new field of macroeconometric modelling. The

new models are ~ector ~uto-~egressive ( ~oving-~verage )

models known as VAR(MA) models. They are essentially just

multivariate Box-Jenkins ~uto-~egressive/~oving-~verage

(AR!4A) models. As mentioned earlier, they arose because of

fears that theoretical restrictions were too constrictive on

the data, not allowing the data to ’speak’ The comments in

Christopher Sims’ critique of standard methods remind one of

the work of Wesley Mitchell.

Since his tAutoregressive index model for the U.So, 1948-75’,

published in 1981, many VAR models have been estimated

including Sims own world model, and, here in Australia, one

estimated by Trevor and Thorp of the Reserve Bank (1988). The

main trouble with these models is that in the end they need as

many arbitrary restrictions as the normal macroeconometric

models and I prefer the normal model’s theoretical rather than

the VAR modelts statistical justifications for these

restrictions (see Doan et al, 1984, and Trevor & Thorpe).

Although data-oriented, these models do not produce any better

predictions although they may improve with the development of

cointegration. A major use of VAR models might be to use them

30

as benchmarks for other theoretical models.

5°2 International Models.

Aside from the econometric developments, mention must be made

of the development of other new types of model. In the early

1600’s it was forbidden to export gold from England as it was

thought that this would reduce the wealth of England and hence

its strength to fight Spain and Holland. When an East India

Company boat sank with a large cargo of gold bullion soon

after leaving an English port, it raised a furor of public

consternation. The director of the East India Company, Thomas

Mun, sprang to its defence with his tract "England’s Treasure

by Forraign Trade" in 1630. Possibly from this arose the

mercantilist theories in economics. Given this and England’s

large entrepot trade~ it is surprising that there are few

British international models°

Now there are many types of international model with different

geographical coverage and country groupings. Another

distinction is whether they use a common model structure for

each country or combine differing sub-models of each country.

The Project Link uses 79 different models developed in their

original countries (Waelbroeck, 1976) o The Japanese EPA world

econometric model uses different models for each country,

constructed however by the EPA itself (Yoshitomi et al, 1984).

MSG uses similarly structured models for each sector of the

31

world but the Japanese labour market in particular has to be

modelled differently. These models are now used extensively by

the IMF and others to help devise international policy. This

is possibly the greatest area of development in modelling

today (for exampler see Bryant et alr 1988).

5.3 Multi-Reqional Modellinq~.

Of a similar nature in a way to international models are the

multi-regional models of a single country. Here two distinct

approaches abound. Firstly there is the top-down approach (TD)

where some national model is used to create some aggregate

forecasts which are then broken down into regional forecasts

in some consistent fashion. An example is the model of Milne,

Adams and Glickman (1980) which uses the Wharton model’s

aggregate forecasts. The alternative approach is of course the

bottom-up approach (BU) which builds up from individual sets

of equations for each region, adding the results together in

some consistent manner to obtain national aggregates. An

example is the National Regional Impact Evaluation System

(NRIES) of Ballard, Glickman and Gustely (1980). Here there

are 51 state models with approximately 230 equations each plus

a 50 equation national model; there are some 4000 behavioural

equations in some ii,000 equations all told! Given the lack of

good state-based statistical data, the TD approach is probably

more suitable to Australia.

32

6o General Equilibrium Modellinq~

6.1 The ’Tableau Economique’o

The final development that I will discuss is General

Equilibrium Modelling° Schumpeter writes "few sequences in the

history of economic analysis are so important for us to see,

to understand, and to fix in our minds, as is the sequence:

Petty-Canti!lon-Quesnay’~ (p218) o While Richard Cantillon

(1680-1734), a Parisian banker of Irish extraction, was

clearly inspired by the work of Petty, his achievement stands

out clearly in its own right. Most outstanding of all was his

understanding of the circular flow of the economic process as

the payments of each sector of society become the incomes of

other sectors. In a!l its bare essentials, Cantillon really

created the ~Tableau economique’ that was developed by the

surgeon-physician to Madame Pompadour, Francois Quesnay (1694-

1774) o

Quesnay was a member of the physiocrats who tried to find

valid criteria for judging particular policy proposals. While

the mercantilists had aimed at increasing wealth by ’forraign’

trade, the physiocrats aimed at increasing wealth by

increasing production, particularly agriculture. Quesnay’s

work lies directly in the tradition, since Petty, of

’describing the facts’o Amongst his many treatises on economic

theory, the most famous is the ’Tableau Economique’ of 1758.

He followed Cantillon’s categorisation of people into three

classes, the landowners (classe proprietaire), the farmers

(classe productive), and anyone not involved in agriculture,

the merchantmen, which he called the ’classe sterile’. The

Tableau depicts the flows through the economy of funds from

one sector (classe) to another.

33

Apart from the great simplification provided by the Tableau it

lays the way open for statistical analysis; Quesnay was fully

aware of the possibilities here° Like Petty he also tried to

estimate the national income. Schumpeter wrote "the Cantillon-

Quesnay tableau was the first method ever devised in order to

convey an explicit conception of the nature of general

equilibrium° It would seem impossible to exaggerate the

importance of this achievement if admiring disciples had not

actually succeeded in doing so". (op.cit. p242)o However this

approach has led a checkered history. It lay essentially

undeveloped until Walras took it up over a hundred years later

and even then, because of the mathematical complexity, it was

not further developed until the 1930’s and 50’s.

6.2 Input-Output Analysis°

The essential concept of interchanging flows was developed by

Wassily Leontief in his Input-Output analysis (Leontief, 1941

and 1964). This led in particular to Richard Stone’s Input-

Output model of the UK economy, which has developed into the

34

massive present-day Cambridge Growth Project model. In

Australia the first I-O tables were produced by Cameron in the

late 1950~so In 1964 the Australian Bureau of Statistics (ABS)

under Cameron produced its first table for 1958-9. While

initially such tables were infrequent, dependent on censuses,

more recently the ABS has produced tables for consecutive

years in the early 1980’s and even a state breakdown for 1985-

6o For further information on Australian Input-Output Tables,

see the article by Barbetti (1987) in the new Australian

Journal of Regional Studies; for a computer package to use

these tables~ there is the GRIMP package, described in Jensen

and West (1986) and distributed by the Department of

Immigration~ Local Government and Ethnic Affairs~

6°3 The Johnasen and Scarer A roacheso

If you add some neo-classical production functions and some

price-sensitive demand equations to the basic I-O table, you

have the essence of a highly non-linear Walrasian general

equilibrium model° This was developed by two different groups.

One group stems from the mathematical developments of

Scarf(1967~ 1973)o Scarf’s mathematical solution produced a

whole stream of Applied General Equilibrium models° In the

U.K., one has the models of Whalley (1975), Miller and Spencer

(1977) and Piggott and Whalley (1977). In the US, one has

Fullerton et al (1978) and in Australia, Piggott (1980). Much

of this work is described in the book ’New Developments in AGE

analysis’, edited by John Piggott (1985) o Note that Warwick

McKibbin describes his MSG model as Wa dynamic general

equilibrium model of a multi-regional world economyWo

35

Most general equilibrium Scarf-type models were developed to

study particular policy changes. The other group to develop

the Walrasian scheme have tended to develop more long-lasting

models of the whole economy. These stem from the pioneering

work of L. Johansen with his 1960 model of Norway° Essentially

this is based on the idea of taking logs and differentiating

to create a linear model. Strangely the Scarf and Johansen

groups appeared initially to be totally unaware of each

other’s work°

The Australian example of a Johansen type model is ORANI

developed mainly by Peter Dixon in the IMPACT Project directed

by Alan Powell. Now it is developed by Peter Dixon and Brian

Parmenter at the Institute of Applied Economic and Social

Research in Melbourne (see Dixon et al, 1982). This approach

has developed greatly over the last ten years, partly through

the mathematical expertise of Ken Pearson and the development

of the GEMPACK set of computer programs for running models°

Peter Dixon and Brian Parmenter have also now produced a

forecasting version of ORANI simply called ORANI-F. These lie

directly in the tradition stemming from Quesnay of a

macroanalytic description of the economy based on a

microanalytic theory of exchange and, as such, they are often

called, rather confusingly, microeconomic models of the

36

economy.

Such models should be contrasted with models that use a

microeconomic input-output core as a foundation for a

macroeconomic model. An Australian example of this is the

Institute Multi-Purpose model (IMP), developed largely by

Peter Brain of the National Institute for Economic and

Industrial Research. This is a highly detailed, largely

Keynesian, demand-driven econometric model containing some

6000 equations in ten modules; apart from the main module,

other modules cover demography, finance, energy transport,

industrial activity, agriculture, international trade and

telecommunications° There are two further modules, a linear

programming module to determine patterns of demand for new

energy types and a module splitting key aggregates by state.

For further information see Peter Brain (1986).

37

7. The Value of Models.

Let me conclude quickly with some brief comments on the value

of these various types of models. Firstly, modelling forces an

open expression of theory in a logically consistent way. Great

analysts may have magnificent subconscious models in their

heads but they are of little use to other people and die with

them. Models also help the analysis of the economy and the

effects of policies. And, however much criticism they have

received, they are also helpful in understanding the future.

As Samuelson wrote ’However good is the qualitative judgment

..o our judgment is kept tuned up by looking at computer

forecasts.’ One should not believe one model’s forecast

wholeheartedlyo Rather the analysis of many different models’

forecasts, and other people’s personal judgements, help create

better judgements in the on-going decision-making processes of

government and private industry.

Different models reveal different aspects of the economic

system. The aim of conferences on the models, and of modelling

Bureaux, is not to produce one grand supermodelo It would

probably be as bland as the well-known cartoon and now film

super-heroo Different models implicitly summarise the

implications of different theories and hence comparative

analysis leads to greater understanding of these theories and

inevitably to their development. One should not think of it as

the ’War of the Models’ but rather construe it as the

38

construction of a well-informed debate. And it is precisely

this debate which I hope to enhance by the establishment of an

economy-wide modelling Bureau to be called the Economic

Modelling Bureau of Australia (EMBA).

39

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WORKING PAPERS IN ECONOMETRICS AND APPLIED STATISTICS

The Prior Likelihood and Best Linear Unbiased Prediction in StochasticCoefficient Linear Models, Lung-Fei Lee and William Eo Griffiths,No. 1 - March 1979.

Stability Conditions in the Use of Fixed Requirement Approach to ManpowerPlanning Models. Howard E. Doran and Rozany Ro Deen, No. 2 - March1979.

A Note on A Bayesian Estimator Zn an Autocorrelated Error Model.William Griffiths and Dan Dao~ No. 3 - April 1979.

On R2-Statistics for the General Linear Model with Nonscalar CovarianceMatrix~ GoE. Battese and WoE. Griffiths, No. 4 - April 1979.

Construction of Cost-Of-Living Index Numbers - A Unified Approach°D.S. Prasada Rao, No. 5 - April 1979o

Omission of the Weighted First Observation in an Autocorrelated RegressionModel: A Discussion of Loss of Efficiency. Howard Eo Doran, No. 6 -June 1979.

Estimation of Household Expenditure Functions: An Application of a Classof Heteroscedastic Regresston Mode~s. George E o Battese andBruce P. Bonyhady, No. 7 - Septe~Joer 1979.

The Demand for Sawn Timber: An Application of the Diewert Cost Function.Howard Eo Doran and David F~ Williams~ No. 8 - September 1979.

A New System of Log-Change Index Numbers for Multilateral Comparisons.D.S. Prasada Rao, No. 9 - October 1980.

A Comparison of Purchasing Power Parity Between the Pound Sterling andthe Australian Dollar - 1979. W.F. Shepherd and D.S. Prasada Rao,Noo i0 - October 1980.

Using Time-Series and Cross-Section Data to Estimate a Production Functionwith Positive and Negative Marginal Risks, W.E. Griffiths andJ.R. Anderson, No. ii - December 1980o

A Lack-Of-Fit Test in the Presence of Heteroscedasticity. Howard E. Doranand Jan Kmenta, No. 12 - April 1981o

On the Relative Efficiency of Estimators Which Include the InitialObservations in the Estimation of Seemingly Unrelated Regressionswith First Order Autoregressive Disturbances° H.Eo Doran andW.E. Griffiths, No. 13 - June 1981.

An Analysis of the Linkages Between the Consumer Price Index and theAverage Minimum Weekly Wage Rate. Pauline Beesley, Noo 14 - July 1981.

An Error Components Model for Prediction of County Crop Areas Using Surveyand Satellite Data. George Eo Battese and Wayne A. Fuller, No. 15 -February 1982.

Networking or Transhipment? Optimisation Alternatives for Plant Lot;atDecisions~ H.Io Tort and P.A. Cassidy, No. 16 - February 1985.

{~ht~imm!.ic Tc,~I;s fo~, the Partial Adjustment and Adal,tioeModels. HoE. Doran, No. 17 - February 1985.

A F~rther Consideration of Causal Relationships Between Wages and Prices.

JoWoB. Guiss and PoA.Ao Beesley~ No. 18 - February 1985.

A Monte Carlo Evaluation of the Power of Some Test& For Heteroscedasticity.

WoE. Griffiths and Ko Surekha, No. 19 - August 1985.

A Walrasian Exchange Equilibrium Interpretation of the Geary-KhamisInternational Prices. DoS. Prasada Rao, No. 20 - October 1985.

Using D~rbin~s h-Test to Validate the Partial-Adjustment Model.H~E~ Doran, No. 21 - November 1985.

An Investigation into the Small Sample Properties of Covariance Matrixand Pre-Test Estimators for the Probit Model. William ~. Gr±~fiths,R. Carter Hill and Peter J. Pope, No. 22 - November 1985.

A Bayesian Framework for Optimal Input Allocation with an UncertainStochastic Production Function. William Eo Griffiths, No. 23 -February 1986,

A Frontier Production Function for Panel Data: With Application to theAustralian Dairy Industry. ToJ. Coelli and G.E. Battese, No. 24 -February 1986.

Identification and Estimation of Elasticities of Substitution for Firm-Level Production Functions Using Aggregative Data. George E. Batteseand Sohail J~ Malik~ No. 25 - April 1986.

Estimation of Elasticities of Substitution for CES Production FunctionsUsing Aggregative Data on Selected Manufacturing Industries in Pakistan.George Eo Battese and Sohail J. Malik~ No.26 - April 1986o

Estimation of Elasticities of Substitution for CES and VES ProductionFunctions Using Firm-Level Data for Food-Processing Industries inPakistan. George E. Battese and Sohail J. Malik, No.27 - May 1986.

On the Prediction of Technical Efficiencies~ Given the Specifications of aGeneralized Frontier Production Function and Panel Data on Sample Firms.George Eo Battese, Noo28 - June 1986.

A General Equilibrium Approach to the Construction of Multilateral IndexNmmberso DoS. Prasada Rao and J. Salazar-Carrillo, No.29 - August1986o

Further Results on Interval Estimation in an AR(1) Error Model.W.E0 Griffiths and PoA. Beesle~ No.30 - August 1987.

Bayesian Econometrics and How to Get Rid of Those Wrong Signs.Griffiths, Noo31 - November 1987.

H.E. Doran,

William E.

Confidence Intervals for the Expected Average Marginal Products ofCobb-Douglas Factors With Applications of Estimating Shadow Pricesand Testing for Risk Aversion. Chris M. Alaouze, No. 32 -September, 1988.

Estimation of Frontier Production Functions and the Efficiencies ofIndian Farms Using Panel Data from ICRISAT’s Village Level Studies.G.E. Battese, T.Jo Coelli and ToC. Colby, No. 33 - January, 1989.

Estimation of Frontier Production Functions: A Guide to the ComputerProgram, FRONTIER. Tim J. Coelli, No. 34 - February, 1989.

An Introduction to Austratian Economy-Wide ModeZling. Colin Pc Hargreaves,No. 35 - February, 1989.