Comparative Properties of Models of the UK Economy

By Fisher, P. G.; Turner, D. S. et al. | National Institute Economic Review, August 1990 | Go to article overview

Comparative Properties of Models of the UK Economy

Fisher, P. G., Turner, D. S., Wallis, K. F., Whitley, J. D., National Institute Economic Review

1. introduction

The nature of the association between inflation and the level of unemployment has been a persistent issue of controversy over the last three decades. initially, attention focussed on the statistical relationship between nominal wage inflation and unemployment-the Phillips curve-which could be seen equally as a relationship between price inflation and unemployment, if prices are a constant mark-up on wages. This was quickly adopted as a menu for policy choice, describing the trade-off between increases in unemployment and reductions in inflation. By the 1970s, however, the question was whether a long-run trade-off existed at all, the OECD economies having experienced rising unemployment and, simultaneously, rising inflation. The subsequent re-examination of labour market behaviour introduced the concept of an equilibrium rate (the natural rate) of unemployment which, in the monetarist view, was not amenable to demand management policies. More recent developments reflect a growing concern with the supply side of the economy, including the question of what determines the non accelerating inflation rate of unemployment (NAIRU).

The emerging framework uses bargaining models for the determination of wages: unionised employees set pay demands and employers respond according to their ability to meet these demands, depending in turn on their pricing decisions. In an influential analysis, Layard and Nickell (1985) develop a three equation model, determining wages, prices and employment, and emphasise the role of 'push' variables, which can affect firms' price mark-up on wage costs or wage bargainers' mark-up on prices, that is, the real wage. The push variables include taxes and benefits, import prices, and productivity. For given values of such variables there is a unique level of unemployment, the NAIRU, which leads bargainers to settle for a real wage which is consistent with that which firms are willing to accept in their pricing behaviour. Large-scale macroeconometric models differ substantially in size from the Layard-Nickell model, nevertheless this provides a useful starting point in studying their properties, given that they increasingly incorporate aggregate supply considerations. Extensions to the Layard-Nickell framework are necessary, however, most notably to take account of the endogeneity of the real exchange rate, which is an important adjustment mechanism in an open economy with floating exchange rates. Additional push factors, such as a deterioration in the current balance, can then act to produce higher relative prices of imports, in turn increasing the NAIRU. Recent NIESR research (Joyce and Wren-Lewis, 1989; Wren-Lewis, 1989) shows how the change in the NAIRU following any policy change on the NIESR model can be derived as a simple function of the long-run solutions to the model's wage and price equations, together with the response of the real exchange rate.

This paper describes six major macroeconometric models of the UK economy, using their wage-price-exchange-rate interaction as a core supply-side framework in which to interpret their properties, as revealed in standard simulation experiments. The wage, price, and exchange-rate equations provide considerable insight into the simulation results, and these are accordingly analysed next, in Section 2. Some general features of the simulations are noted in the course of this discussion, with detailed analysis presented in Section 3. The numerical results of the policy simulations for the major macroeconomic indicators-ready reckoners-are presented in Appendix tables A1-A5, and Section 4 contains concluding comments. The models considered are those of the London Business School (LBS), National institute of Economic and Social Research (NIESR), Her Majesty's Treasury (HMT), Bank of England (BE), Oxford Economic Forecasting (OEF) and the Liverpool University Research Group in Macroeconomics (LPL), as deposited with the Bureau in late 1989; the HMT model was also publicly released at this time. …

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