Academic journal article National Institute Economic Review

Comparative Properties of Models of the UK Economy

Academic journal article National Institute Economic Review

Comparative Properties of Models of the UK Economy

Article excerpt

This article describes the current versions of six leading macroeconometric models, focusing on their treatment of several current policy issues, namely the role of the housing market, the implications of ERM membership and, more generally, the relative effectiveness of fiscal and monetary policy. Differences in the modelling of the housing sector and the exchange rate are important in explaining differences in overall model properties which are revealed in standard policy simulations. Monetary policy is more potent than in previous versions of the models, which has important implications for the conduct of macroeconomic policy under ERM membership.

1. introduction

The housing market and the exchange-rate mechanism (ERM) of the European monetary system dominate the current policy debate. In his Budget speech the Chancellor warned that 'we need to do all we can to ensure that when recovery comes it is not accompanied by another bout of house price inflation, with the unwelcome consequences that would have'. And the speed at which inflation rates and interest rates converge across the member countries of the ERM will determine how quickly the UK will be able to combine low inflation with a satisfactory rate of growth of output. Quantitative assessments of economic policy rely on macroeconometric models, and this review of the properties of the current UK models focuses on their treatment of these two issues.

The strong growth in consumers' expenditure in the mid-to-late 1980s took most macroeconomic forecasters by surprise. Several explanations of this forecast failure have been developed, building on the observation that it occurred during a period of rapid house price inflation and a continuing process of financial deregulation and liberalisation. One explanation is that financial deregulation has increased the degree of liquidity of physical assets held by the personal sector, enabling consumers more easily to translate increases in physical wealth into current spending. Consumption functions in the UK models have typically included net financial wealth among their explanatory variables, although this is less common in models of other European economies, and the increased liquidity of physical wealth implies that this variable too might help to explain consumer spending. Given that housing represents a large part of the personal sector's holdings of physical wealth, the treatment of the housing sector then assumes greater importance in the models. Furthermore, since changes in housing wealth in the short run depend primarily on changes in real house prices, the determination of house prices in the models is of key importance. An alternative view, although one that is not represented in current models, is that the links between consumption and the housing market arise from equity withdrawal, which implies that it is the volume of house sales that is relevant rather than house price inflation. A further explanation of the failure to predict consumer spending, which is not inconsistent with the argument above, is that the relaxation of borrowing constraints on the personal sector has led to increased indebtedness, which is seen more as a general portfolio shift, not necessarily relevant to the housing market. In this article we examine the different ways in which the UK models have responded to these issues and assess the sensitivity of their policy simulations to the treatment of the housing sector.

The impact of interest rates on expenditure is now more powerful than in the past, which a recent study by the Bank of England (1990) partly attributes to financial deregulation and innovation. This is particularly relevant to the conduct of macroeconomic policy under ERM membership, since in practice this is equivalent to using monetary policy to target the required exchange rate, at least in the short run. We therefore consider the effects of interest rates in the various UK models, and assess their role in maintaining an exchange-rate target in the face of a fiscal shock. …

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