The Macroeconomic Forecas Model (MFM) of he Bank of Guaemala Bank of Guaemala Sepember 27 Absrac This documen describes he so-called semi-srucural macroeconomic model (henceforh MMS, for Modelo Macroeconómico Semiesrucural ) ha he Bank of Guaemala has adoped o faciliae inerpreing he sae of he economy and o suppor is policymaking process in pursui of is fundamenal objecive. The model consiss of a sysem of equaions ha quanify he direcion and magniude of he correlaions among he principal macroeconomic variables, as well as foreseeable changes in he variables, aking ino accoun he reacion of economic agens o he Bank s moneary policy, which is organised around explici inflaion arges.
TABLE OF CONTENTS. Inroducion... 2 2. The Bank of Guaemala s moneary policy forecasing and analysis sysem (SPAPM)... 3 3. The semi-srucural macroeconomic model... 3 (a) Principal channels by which moneary policy is ransmied... 4 (b) Informaion supplemenary o he MMS... 5 (c) Risk assessmen and moneary policy recommendaions... 6 (d) Mechanism by which he Bank s moneary policy forecasing and analysis sysem (SPAPM) funcions... 7 4. Simulaions... 8 (a) Ineres rae shock simulaion covering a wo-year period... 8 (b) The exchange-rae channel... 9 (c) The expecaions channel... (d) Conclusions...
. Inroducion Moneary policy in Guaemala during he 98s and early 99s was organised around moneary arges. Objecives for moneary aggregaes were esablished, based on he judgmen ha changes in he aggregaes accouned, o a large exen, for he course of inflaion. Already in he lae 99s, however, and more markedly since hen, he demand for money has become less sable, making he money supply a less imporan shor-erm facor in inflaion. In ligh of his, and considering he experience of oher counries, he Bank of Guaemala decided o move o a scheme of explici inflaion arges, in which i publicly announces medium-erm inflaion arges and formally commis o achieving hem. According o he provisions of is new charer, daing from 22, he Bank s fundamenal objecive is o help creae and mainain he condiions mos conducive o he orderly developmen of he counry s economy by fosering moneary, exchange-rae and credi condiions ha promoe general price sabiliy. The insiuion s governing body, he Moneary Board, has ranslaed his mandae ino inflaion arges ha call for gradually reducing inflaion from 6% o 3% beween 26 and 2 (wih a +/- % margin of flucuaion). To achieve his, he Bank may change he leading moneary-policy ineres rae, namely, he ineres rae on 7-day cerificaes of deposi issued by he Bank. This rae is o be modified by he Moneary Board in he meeings i ordinarily holds according o a predeermined imeable in he hird week of each monh. The decisions i makes on hose occasions are based on a number of economic indicaors, including is semi-srucural macroeconomic model (MMS), which is a sysem of simulaneous equaions describing he macroeconomic dynamics of he principal mechanisms by which he Cenral Bank ransmis moneary policy o he real secor of he Guaemalan economy. Since he sysem of explici inflaion arges seeks o anchor he expecaions of economic agens by enunciaing inflaion arges, he Bank mus be able o forecas he behaviour of variables ha are vial o effecive moneary policy. The moneary policy rae and inflaion rae are paricularly imporan in his respec. The presen documen examines he semi-srucural macroeconomic model (MMS) ha he Bank of Guaemala has adoped o faciliae inerpreing he sae of he economy and o suppor is policymaking process in pursui of is fundamenal objecive. The model consiss of a sysem of equaions ha quanify he direcion and magniude of he relaionships among he principal macroeconomic variables, as well as foreseeable changes in he variables, aking ino accoun he reacion of economic agens o he moneary policy decisions ha he Bank makes in pursui of explici inflaion arges. The MMS is a neo-keynesian fixed-price model based on hree moneary ransmission mechanisms: (i) aggregae demand; (ii) exchange raes; and (iii) expecaions. Thus, he MMS provides an analyical framework for accurae and orderly policy o comba he various inflaionary pressures. I was consruced wih valuable cooperaion from expers specializing in he creaion of such models. The Inernaional Moneary Fund s echnical assisance missions on inflaion argeing were of paricular imporance o he Bank. The purpose here is o explain, in as much deail as possible, he model and how i funcions. 2
This documen describes he principal feaures of he model, which are essenially designed o creae and calibrae each of he main equaions needed o model he macroeconomic effecs of he various ypes of shocks he model is capable of simulaing. Secion 2, below, describes he moneary policy forecasing and analysis sysem (Sisema de Pronósicos y Análisis de Políica Monearia, or SPAPM) adoped by he Bank of Guaemala, which uses his model. Secion 3 analyses he medium- and long-erm economic effecs of various shocks ha could affec he long-erm equilibrium of he Guaemalan economy. Lasly, Secion 4 provides a brief conclusion o he repor. 2. The Bank of Guaemala s moneary policy forecasing and analysis sysem (SPAPM) As one elemen of a moneary regime based on explici inflaion arges, he Bank of Guaemala s moneary policy forecasing and analysis sysem consiss of a se of echnical ools (economeric models, relevan informaion from analyss, economic indicaors, daabases, ec.) ha are used o forecas he behaviour of economic variables imporan o he Cenral Bank (principally, inflaion and economic variables), plus he various aciviies involved in making moneary policy decisions once he projecions and possible macroeconomic oucomes of differen policy measures are aken ino accoun. The sysem is par of a series of operaional changes ha he Bank of Guaemala is implemening as i makes he ransiion o an inflaion argeing scheme. The sysem conains hree principal elemens: (i) a semi-srucural forecasing model for he Guaemalan economy (he MMS); (ii) informaion supplemenary o he MMS; and (iii) risk assessmen and moneary policy recommendaions. These componens of he sysem are explained in he individual secions below. 3. The semi-srucural macroeconomic model The role of macroeconomic models in an explici inflaion argeing regime are principally: (i) o describe he ineracions among key macroeconomic variables in he medium erm; (ii) o provide consisency in he opinions used as a basis for formulaing he projecions; (iii) o faciliae sysemaic analysis of he risks associaed wih prediced scenarios, including sensiiviy o hypoheical facors and shocks, as well as policy responses; (iv) o aid in coherenly and sysemaically considering and developing major moneary policy issues; and (v) o provide a useful and coheren framework for analysis, discussion and decisionmaking regarding moneary policy, in addiion o mere quaniaive precision in projecions and forecasing. The MMS is a sysem of equaions ha quanifies he magniude and direcion of he relaionships among he principal macroeconomic variables, as well as foreseeable changes in hese, facoring in economic agens reacions o moneary policy. The sysem s purpose is o assis he Bank of Guaemala in inerpreing he sae of he economy, and in making policy decisions in pursui of is fundamenal objecives. Thus, he model is designed o reflec a consensus of he Bank s governing bodies and echnical saff regarding he mechanism by which policy measures, hrough various ransmission channels, affec general 3
price levels. The MMS is an analyical framework ha promoes accurae and orderly deliberaion on measures o comba he various inflaionary pressures. The MMS reflecs hree channels of moneary policy ransmission: (i) aggregae demand; (ii) exchange raes; and (iii) expecaions. (a) Principal channels by which moneary policy is ransmied The aggregae demand channel consiss of he effecs of policy on he oal oupu gap and on inflaion, when he Cenral Bank s nominal moneary-policy ineres rae is changed. An increase in his rae will produce an increase in nominal and real long-erm ineres raes. An increase in he real long-erm ineres rae produces a decline in planned invesmen, durable goods consumpion and, herefore, in he oupu gap and domesic inflaion. Furhermore, an increase in he moneary-policy ineres rae produces a rise in he long-erm ineres rae spread. This encourages capial flows ino he counry from invesors seeking beer reurns on heir capial. Capial inflows increase he supply of foreign currency in he counry, raising nominal and real exchange raes, hus reducing expors, wih a negaive effec on he domesic oupu gap and on inflaion. The exchange rae channel consiss of he direc effec ha changes in he exchange rae exer on domesic prices. The effec on he consumer price index is direc, because impored producs play a very significan role in he index. Finally, he expecaions of economic agens are imporan in deermining prices. Inflaion expecaions, in paricular, are a funcion of ineria and raional expecaions. Exchange-rae expecaions shif wih changes in he spread beween foreign and domesic ineres raes, and as a resul of changes in he counry s credi risk. Figure Canal de Demanda Agregada Inflación Canal del Tipo de Cambio Inflación Canal de Expecaivas Inflación 4
The MMS is a mahemaical formulaion of he ransmission mechanisms illusraed in Figure. The principal equaions making up he model are described below. Domesic aggregae demand DD d = A d + (.9 A d + + A R + ε () Exernal aggregae demand x ) 2 * x =.99( x+ x ) + A3 ( A4 z + y x ) + ε (2) XD Toal demand y ) = A5 x + ( A5 d (3) Aggregae supply (Phillips curve) oil PC ( B2 + B3 ) z + B3 q + ( B2 B y ) ε π + (4) e, π =.99( π + π ) + B 3) Moneary policy rule i = D i + ( D ) i + D ( π π + 6 + D y + ε (5) ( ) PM 2 + 6 ) 3 Uncovered ineres rae pariy * e, I I = 4( s + s ) + ρ + ε MD (6) Yield curve I CR (( i + i + i + i ) / + erm ) + ε = F I + ( F ) + + 2 + 3 4 (7) Long-erm Fisher equaion e, R = I π + (8) Inflaion expecaions π (9) e, + = Wπ + + ( W ) π Exchange-rae expecaions e, s = W2s+ + W2 ) s + ( z 2 + ( ss ) + π π () (b) Informaion supplemenary o he MMS The supplemenary informaion needed for he MMS o formulae projecions includes (i) a daa managemen sysem; (ii) shor-erm inflaion projecions; (iii) saellie models; and (iv) oher relevan informaion. We now urn o each of hese. Daa managemen sysem 5
The MMS daa managemen sysem consiss of a daabase wih curren values for he principal variables in he MMS, as well as repors from hose responsible for monioring he relevan informaion and managing he daabase. The repors indicae possible effecs on he MMS and on shor-erm projecions ha could resul from he recenly published informaion. The daabase provides easy access o informaion for hose working wih he MMS and for hose responsible for producing shor-erm projecions. I consiues official informaion available o all personnel in he Cenral Bank s economic division. Shor-erm inflaion projecions Shor-erm inflaion projecions are based on daa provided by he marke analysis secion, which is a uni wihin he Cenral Bank responsible for monioring inflaion. Projecions are based on exper knowledge of facors such as seasonal paerns and rends in componens of he price index, as well as on experienced judgmen. Proposed projecions are presened o he forecasing eam, which is responsible for monioring all maers relaed o he MMS. I makes he final decision on wheher o accep he shor-erm projecion and anchor i in he model as an iniial condiion. Oher relevan informaion In addiion o he above, he MMS draws on informaion from members of he forecasing eam responsible for assessing he possible effecs ha various domesic and foreign variables could have on domesic prices. Their opinions are also imporan inpu for he forecas. In addiion, he MMS incorporaes he houghs and analysis of he Implemenaion Commiee, which are based on he behaviour of he variables considered indicaive of moneary policy, as well as on oher crieria ha he commiee deems perinen. Ineracion beween he forecasing eam and he Implemenaion Commiee is essenial, since he MMS mus incorporae he opinions of he commiee; oherwise, he MMS forecass would be of lile relevance in he commiee s moneary policy decisionmaking. (c) Risk assessmen and moneary policy recommendaions The risk assessmen is based on simulaed scenarios for he endogenous variables, principally he inflaion and moneary-policy ineres rae figures ha can be expeced from developmens in he MMS s exogenous variables. On he basis of he risk assessmen, a moneary policy recommendaion is made o he Implemenaion Commiee, which considers i in he conex of he moneary, exchange-rae and credi policy se by he Moneary Board, as one elemen in deermining wheher o change he moneary-policy ineres rae. MMS endogenous variables are: inflaion, he oupu gap, he moneary-policy ineres rae, he long-erm marke ineres rae, he nominal exchange rae and he real exchange rae. Is exogenous variables are: foreign inflaion, he foreign ineres rae, he exernal oupu gap, inernaional oil prices, counry risk, and he spread beween shor-erm and long-erm ineres raes. Noe ha for he purpose of he model, he foreign variables essenially reflec condiions in he Unied Saes. 6
(d) Mechanism by which he Bank s moneary policy forecasing and analysis sysem (SPAPM) funcions The SPAPM is a quarerly process ha akes place in various sages, and involves he Cenral Bank s enire economic division. Table shows he chronology of aciviies involved in he SPAPM. No. Subjec Oucome of he aciviy Paricipans Siuaional analysis meeing ( Sigues meeing ) Lis of issues ha deserve special aenion for he shor-erm inflaion projecion 2 Forecasing echniques meeing Lis of changes o models for use in shor-erm projecions 3 Iniial saus meeing Economic explanaion of iniial condiions for MMS. In addiion, values will be esablished for proposal o he Implemenaion Commiee (IC) 4 Meeing on iniial saus of he Values o be used, as iniial economy condiions in he semisrucural model, o creae he forecas. These include long-erm projecions for exogenous variables obained from exernal sources. 5 Firs version of forecas Economic explanaion of he forecas, and lis of adjusmens o he forecas 6 Official announcemen of inflaion forecas 7 Implemenaion Commiee meeing The coordinaor of he FT submis repor on inflaion o IC IC mees o analyse changes in he moneary-policy ineres rae 8 Pos-morem analysis Lis of changes o SPAPM for he nex quarer Economic Head (EH) and Forecasing Team (FT) Forecasing Team (PT) FT EH and FT Implemenaion Commiee (IC) GE and FT IC IC EH and FT 7
4. Simulaions (a) Ineres rae shock simulaion covering a wo-year period Based on he curren calibraion of he MMS, an increase in he moneary-policy ineres rae produces increases in he nominal long-erm ineres rae, he real long-erm ineres rae, and he spread in real long-erm ineres raes. The rise in real long-erm ineres raes causes a reducion in he domesic-based oupu gap and also, herefore, in he overall oupu gap, hus ending o lower he inflaion rae. These effecs are indicaed in he following chars, which show he rigger-response funcions for a shock of basis poins in he leading ineres rae. 6.4 Policy Ineres Rae Nominal Long-erm Ineres Rae 3.9.9 Real Long-erm Ineres Rae 6.2 3.8.8 6 3.7.7 5.8 3.6.6 5.6 3.5.5 5.4 3.4.4.4 Long-erm Ineres Rae Gap Domesic Demand Gap Oupu Gap.3 -. -.5 -..2 -.2 -.5. -.3 -.2 -.4 -.25 -.3 -. -.5 -.35 3.5 Inflaion 3 2.95 2.9 2.85 8
(b) The exchange-rae channel In he MMS, he exchange-rae channel operaes in wo ways. Firs, an increase in he monearypolicy ineres rae causes iniial real appreciaion, which in urn reduces he exernal-demand oupu gap. This narrows he oupu gap and, herefore, reduces inflaion. The chars below show he rigger-response funcions ha reflec hese effecs in he case of a shock of 25 basis poins in he leading moneary-policy ineres rae. A he same ime, he real iniial appreciaion has a direc moderaing effec on inflaion (since producion coss decline as he prices of impored inpus fall). 5.95 Policy Ineres Rae Rae of Variaion in Nominal Exchange Rae.8.4 Gap in RER 5.9.7.2 5.85.6. 5.8.5.8 5.75 5.7 5.65.4.3.6.4.2 5.6.2 5.55. -.2 5.5 -.4 5.45 -. -.6.7 Exernal Demand Gap Oupu gap 3. Inflaion.6 -.2 3.5.4 -.4 2.99.3 -.6 2.98.2. -.8 2.97 -. 2.96 -. -.2 -.2 2.95 -.3 -.4 2.94 9
(c) The expecaions channel An increase in he moneary-policy ineres rae firs operaes hrough he expecaions channel, causing a reducion ha anicipaes he reducion in observed inflaion.
(d) Conclusions The purpose of he semi-srucural macroeconomic model (Modelo Macroeconómico Semiesrucural, or MMS) is o assis he Bank of Guaemala in inerpreing he sae of he economy and making policy decisions in pursui of is fundamenal objecive. I provides an analyical framework ha faciliaes more accurae and orderly consideraion of policy measures o comba he various inflaionary pressures. The rigger-response funcions illusrae he principal channels for he ransmission of moneary policy and heir repercussions wihin he economy. Beyond being a mechanism for forecasing, he MMS is a ool ha provides a heoreical framework for moneary policy discussion and decisionmaking.