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The BNB Quarterly

Projection Model

Emilia Penkova and Svilen Pachedzhiev


The BNB Quarterly Projection Model

Twinning Project “Adjustment of the Bulgarian National


Bank to operate as a full-fledged member of the
European System of Central Banks and the Euro-
system”

Component 2: Research and preparation for monetary policy


operations in line with ECB best practices
Introduction
 The first version of the Bulgarian National Bank Quarterly Projection
Model (BNBQM) which belongs to the group of traditional structural
macroeconomic models.

 The model is similar to the European System of Central Banks multi-


country model country blocks. The guiding principle in designing the
country blocks is that of close compatibility with the ECB Area-Wide
Model.

 The development of a model over the period 1998-2007 poses


formidable challenges, given the short and volatile time series – we
calibrate coefficients.

 The model is continuously tested and simulated in order to improve it. It


should be viewed as work in progress and an area for future empirical
research within the BNB, rather than as a finished product.
Introduction
 The theoretical background – Neo-Classical Synthesis.
The long-run equilibrium is determined by supply side factors
(Neo-Classical theory) and short-run fluctuations are demand
driven (Keynesian theory).

 Backward looking -expectations are reflected via lagged


variables, which is considered adequate for the purpose of
generating short- to medium-term forecasts.

 Behavioral equations – error correction form (Engle


Granger two step procedure has been employed).
The purpose of the BNBQM is
twofold:

 First, to produce macroeconomic forecasts for the


Bulgarian economy.

 Second, to assess the effects of economic


shocks on the Bulgarian economy in simulated
scenario analyses.
Outline of Presentation

 Theoretical background
 Structure of the model and estimated equations

 Simulations

 Concluding remarks and extensions of research


Supply side of the Economy
 The standard theory of monopolistic competition is
applied.

 Profits of an individual firm are determined by


returns from sale with costs of labour and capital
subtracted.

 The production process is represented by a Cobb


Douglas function.
Supply side of the Economy

∏(Yi ) = PiYi − wLi − cKi


P σ
Yi =Y ( )
Pi
ρt 1−α
Yi = AK i (e Li )
α
Supply side of the Economy
where Π(Yi) are profits of the firm, Li is the labour force used by
the firm, Ki is the capital stock of the firm, α’s are the income
shares; ρ is the exogenous growth rate of technological
progress, σ is the elasticity of the demand for goods produced
by the firm i to their relative price; w is the nominal wage level,
c is the nominal cost of capital with
c = PI (r + δ )
where r is the real rate of interest, δ is the physical
depreciation rate of capital, PI is price of investment goods, Pi
is the price of goods produced by the firm, P is the price of
generic goods, Yi is the output of the firm i, Y is the aggregate
supply of generic goods.
Supply side of the Economy

∏ (Yi ) = PiYi − wLi − cKi =


1 1 σ −1
Y α ρt 1− α σ
P( ) Yi − wLi − cKi = PY ( AKi (e Li ) )
σ σ
Yi
− wLi − cKi
Supply side of the Economy
First order conditions are:

σ −1
∂∏
1
ρt 1−α σ σ − 1 α ( σσ−1 )−1
= PY ( A(e Li )
σ
) α( ) Ki −c = 0
∂ Ki σ
1 σ −1
∂∏ α ρ t (1− α ) σ σ − 1 (1−α )(σσ−1 )−1
= P Y ( A Ki e
σ
) (1 − α )( ) Li − w= 0
∂ Li σ
Supply side of the Economy
Using the assumption of symmetric equilibrium (Pi=P, Yi=Y, Li=L,
Ki=K), we receive:

α ρt 1−α
Y = AK (e L)
∂∏ ρt (1−α ) L 1−α σ −1
= PAe ( ) α( ) −c = 0
∂Ki K σ
∂∏ ρ t (1− α ) K α σ −1
= PAe ( ) (1 − α )( )− w = 0
∂ Li L σ
Supply side of the Economy
The aggregate output and the long-run demand for capital and
labour are given by:
α ρt 1−α
Y = AK (e L)
α (σ − 1)Y
K=
c
σ
P
(1 − α )(σ −1)Y
L=
w
σ
P
Structure of the model and
estimated equations
 The simulation and projection features of the BNB Quarterly
Projection Model are driven by twenty behavioural equations
and additional forty three identities. Around one hundred and
sixty variables enter the model.

 The model is in Eviews 5.1 (a program file which imports the data,
estimates equations, solves the model and produces forecasts
output).

 The model is structured into five blocks: production function and


factor demand equations, aggregate demand, prices and wages,
monetary, and fiscal sector.
Model linkages
Error correction form
Most of the dynamic equations take the following general form:

γ (l )∆ log( yt ) = σ (l )∆ log( yt ) −
− µ (log( yt − 1) − log( y * t − 1)) + εt
where log(yt-1 )-log(y*t-1 ) is the error correction term;
γ(.) and σ(.) – are polynomials;
l - the lag operator
Potential output
R _ YP _ R = R _ TFP _ TD * L _ EMPL _ TD 0.6 *
* R _ K _ R 0.4

R_YP_R = Potential output, prices of 2005


R_TFP_TD = Total factor productivity, trend (2005=100)
L_EMPL_TD = Employment, trend
R_K_R = Capital stock, prices of 2005
Potential output
 Total factor productivity is estimated as a residual from
the production function for the estimated period then
using Hodrick-Prescott filter we receive the trend.

 The potential employment is received from a labour force


forecast and estimated NAIRU.

 NAIRU is assumed to be at around 7.7% level (slightly


decreasing over the forecasting period) and is estimated
using Elmeskov (1993) approach.
Employment
Log(L_EMPL_STAR) = 3.278 + 0.600*log(R_Y_R) -
(5.607) (-)
- 0.400 *log(L_W/I_HICP_P)
(-)
Dlog(L_EMPL)= -0.089 - 0.296*(log(L_EMPL (-1)) –
(18.365) (5.138)
- log(L_EMPL_STAR(-1)))+ 0.001* Dlog(L_EMPL(-1))
(0.002)

L_EMPL = Employment (employees + self employed)


R_Y_R = GDP, prices of 2005
L_W = Nominal wage bill per worker
I_HICP_P = Harmonised index of consumer prices, 2005 = 100
Employment
Employment

3900
3800
3700
3600
3500 TRUE
3400 FORECAST
3300
3200
3100
3000
05

06

06

06

06
05

05

05
1'

3'

1'

2'

3'

4'
2'

4'
Q

Q
Gross fixed capital formation
Log(R_KF_R_STAR)= 1.942+ 0.700*log(R_Y_R)-
(4.338) (-)
- 0.108*M_LTIR_N - 0.007*I_I_P
(9.451) (2.516)

Dlog(R_KF_R) = 0.242 -0.003*(log(R_KF_R(-1))-


(6.285) (-)

- log(R_KF_R_STAR(-1))) - 0.363*Dlog(R_KF_R(-1))
(2.135)
R_KF_R = Gross fixed capital formation, 2005 prices
R_Y_R = GDP, 2005 prices
I_I_P = Inflation, in percentages
M_LTIR_N =Nominal long-term interest rate, in percentages
Gross fixed capital formation
Gross fixed capital formation

4500
4000
3500
TRUE
3000
FORECAST
2500
2000
1500
Q2

Q3

Q4

Q2

Q3

Q4
Q1

Q1
05

05

06
05

05

06

06

06
20

20

20

20

20

20

20

20
Private consumption
Log(R_C_R_STAR) = 2.365 + 0.800*log(R_DI_N/I_HICP_P) +
(21.979) (-)
+ 0.300*log(R_K_R)
(-)

Dlog(R_C_R) = 0.077 - 0.483*(log(R_C_R(-1)) –


(3.743) (2.200)
- log(R_C_R_STAR(-1))) -0.343*Dlog(R_C_R(-1))
(2.074)

R_C_R = Private consumption, prices of 2005


R_DI_N = Disposable income (wages and salaries+ pensions and social benefits +
imputed rent +compensation of employees(BOP) + current transfers (BOP))
I_HICP_P = Harmonised index of consumer prices, 2005 = 100
R_K_R = Capital stock, prices of 2005
Private consumption
Private consumption

9500.00000
9000.00000
8500.00000
TRUE
8000.00000
FORECAST
7500.00000
7000.00000
6500.00000
5

'05

'06

6
'0

'0

'0

'0
'0

'0
Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4
Exports
Log(E_EX_R_STAR) = 6.108 + log(A_WTV_R)-
(2.024) (-)

- 0.451*log(E_EX_P/(A_MEPAE_P*E_ER_PI))
(4.758)

Dlog(E_EX_R) = -0.265 -0.206*(log(E_EX_R(-1))-


(8.268) (1.448)

-log(E_EX_R_STAR(-1))) + 0.020*Dlog(E_EX_R(-1))
(0.151)

E_EX_R = Exports, prices of 2005


A_WTV_R = Volume of world trade (weighted average), 2005 = 100
E_EX_P = Export deflator, 2005 = 100
A_MEPAE_P = Manufacturing export price for advanced economies, 2005=100
E_ER_PI = Exchange rate BGUSD, 2005=100
Exports
Exports

11000
10000
9000
8000 TRUE
7000 FORECAST
6000
5000
4000
1

3
3

4
Q

Q
05

05

05

05

06

06

06

06
20

20

20

20

20

20

20

20
Imports
Log(E_MP_R_STAR) = -2.473 + log(R_DD_R) –
(13.023) (-)

- 0.305*log(E_MP_P/R_GDP_P)
(3.821)

Dlog(E_MP_R) = 0.072 – 0.052*(log(E_MP_R(-1)) –


(4.811) (0.645)

-log((E_MP_R_STAR(-1)))

E_MP_R = Imports, prices of 2005


R_DD_R = Real domestic demand, prices of 2005 (private consumption expenditure +
government consumption expenditure + gross fixed capital formation)
E_MP_P = Import deflator, 2005 = 100
R_GDP_P= GDP deflator, 2005 = 100
Imports
Imports

11000

10000

9000
TRUE
8000 FORECAST
7000

6000

'0 5 '0 5 '0 5 '0 5 '0 6 '0 6 '0 6 '0 6


Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
GDP deflator
Log (R_GDP_P_STAR) = -0.011 + log(L_ULC)
(0.482) (-)

Dlog(R_GDP_P)=0.017-0.030*(log(R_GDP_P(-1))-
(2.202) (1.002)
log(R_GDP_P_STAR(-1)))-0.071*dlog(R_GDP_P(-
(0.397)
-1))+0.100*R_YG_R
(-)

R_GDP_P = GDP deflator, 2005=100


L_ULC = Unit labour cost, 2005=100
R_YG_R = Output gap (% potential GDP)
GDP deflator
GDP deflator

1.05
1.04
1.03
TRUE
1.02
FORECAST
1.01
1
0.99
05

05

05

05

06

06

06

06
1'

2'

3'

4'

1'

2'

3'

4'
Q

Q
HICP without administered prices
Log(I_HICPEXA_P_STAR) = 0.007 + 0.488*log(R_GDP_P) +
(0. 588) (4.155)
+0.512*log(E_MP_P)
(-)
Dlog(I_HICPEXA_P) = 0.029 - 0.381*(log(I_HICPEXA_P(-1))
(5.701) (3.891)
-log(I_HICPEXA_P_STAR(-1))) +

+0.220*Dlog(I_HICPEXA_P(-1))
(1.526)

I_HICPEXA_P = Harmonized Index of Consumer Prices without administered prices, 2005


= 100
L_ULC = Unit labour cost, 2005=100
E_MP_P = Import deflator, 2005 = 100
HICP without administered prices
H IC P without administe re d price s

1 .1 2
1 .1
1 .0 8
1 .0 6 TR U E
1 .0 4 FOR E C AS T
1 .0 2
1
0 .9 8
5

6
5

6
'0

'0

'0

'0

'0

'0

'0

'0
Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4
Export deflator
Log(E_EX_P_STAR) = -2.313 + 0.592*log(R_GDP_P) +
(5.052) (3.376)

+ 0.408*log(A_MEPAE_P*E_ER_PI)
(-)

Dlog(E_EX_P) = 0.010 – 0.853*(log(E_EX_P(-1))-


(2.110) (4.548)
- log(E_EX_P_STAR(-1))) -0.071*Dlog(E_EX_P(-1))-
(0.697)
- 0.058*Dlog(E_EX_P(-2)) +0.381*Dlog(E_EX_P(-3))-
(0.580) (3.798)
- 0.264*Dlog(E_EX_P(-4)))
(2.590)
E_EX_P = Export deflator, 2005 = 100
A_MEPAE_P = Manufacturing export price for advanced economies, 2005=100
R_GDP_P = GDP deflator, 2005 = 100
E_ER_PI = Exchange rate BGUSD, 2005=100
Export deflator
Export deflator

1.16
1.14
1.12
1.1 TRUE
1.08
1.06 FORECAST
1.04
1.02
1
05

06

06
05

05

05

06

06
1'

2'

3'

4'

1'

2'

3'

4'
Q

Q
Import deflator
Log(E_MP_P_STAR)=-2.284 + 0.360*log(A_EU15MP_P*E_ER_PI)
(2.810) (4.710)
+ 0.640*log(R_GDP_P)
(-)
Dlog(E_MP_P) = 0.025 -0.116*(log(E_MP_P(-1)) –
(2.400) (0.827)

-log(E_MP_P_STAR(-1)))- 0.381*Dlog(E_MP_P(-1))
(2.530)

E_MP_P = Import deflator, 2005 = 100


A_EU15MP_P = EU 15 Import deflator, 2005 = 100
E_ER_PI = Exchange rate BGUSD, 2005=100
R_GDP_P = GDP deflator, 2005 = 100
Import deflator
Import deflator

1.11
1.1
1.09
1.08 TRUE
1.07 FORECAST
1.06
1.05
1.04
05

06

06

06
05

05

05

06
2'

4'

1'

3'

4'
1'

3'

2'
Q

Q
Wages
Log(L_W_STAR) = -5.822+ log(L_LPR) – 0.001*L_UR +
(3.087) (-) (0.712)
+ log(I_HICP_P)
(-)
Dlog(L_W) = 0.131 -0.207*(log(L_W(-1)) –
(10.598) (1.138)

- log(L_W_STAR(-1))) - 0.352*Dlog(L_W(-1))
(1.739)

L_W = Nominal wage bill per worker


L_LPR = Labour productivity: GDP in prices of 2005/Number of employees
L_UR = Unemployment, in percentages
I_HICP_P = Harmonised index of consumer prices
Wages
Nominal wage bill per worker

500
450
400
TRUE
350
FORECAST
300
250
200
05

05

05

05

06

06

06

06
1'

2'

3'

4'

1'

2'

3'

4'
Q

Q
Fiscal sector
Government expenditures and government revenues
are modelled separately:

 The government expenditures are disaggregated into five


parts: government consumption, government investment,
government transfers, government interest payments and
other expenditure.

 The government revenues consist of five components:


revenues from personal income tax, social security
contribution, revenues from corporate income tax,
revenues from indirect taxes and other revenue items.
Personal income taxes
G_PIT = G_PIT_TR*R_CE_N

G_PIT = Personal income taxes (million leva)


G_PIT_TR =Personal income effective tax rate
R_CE_N = Compensation of employees (million leva)
Social security contribution
G_SSC=G_SSC_TR*R_CE_N

G_SSC = Social security contribution (incl. employers’ and employees’


contribution in million leva)
G_SSC_TR = Social security effective tax rate
R_CE_N = Compensation of employees (million leva)
Indirect taxes
G_IND=G_IND_TR*R_C_N

G_IND = Indirect taxes (incl. VAT, customs revenue, excise duties)


G_IND_TR = Indirect effective tax rate
R_C_N = Private consumption, in current prices
Corporate income tax
G_CIT = G_CIT_TR*R_GOS_N

G_CIT = Corporate income tax


G_CIT_TR = Corporate income effective tax rate
R_GOS_N = Gross operating surplus and mixed income
Simulations
To illustrate the simulation properties of the BNBQM, we assess
the response of the model’s main variables to the following
standard shocks:

 an increase in government consumption by 1% of GDP

 an increase in volume of world trade by 1%

 a depreciation of the lev against the US dollar by 1%

 an increase in the price of oil by 10%

 an increase in EURIBOR by 100 basis points


Simulation of an increase in government consumption by 1%
of GDP (Q1’2002 – Q4’2008)
Levels, percentage deviations from baseline

Year 1 Year 2 Year 3 Year 4 Year 5 Year 7


HICP 0.031 0.162 0.319 0.476 0.607 0.666
ULC -0.506 0.040 0.316 0.538 0.670 0.709
Comp. per employee 0.385 0.794 0.917 0.933 0.840 0.450
Productivity 0.896 0.753 0.599 0.393 0.168 -0.256

GDP 1.012 1.058 0.973 1.053 0.498 -0.119


Private consumption 0.060 0.333 0.517 0.575 0.534 0.257
Investment 0.003 0.009 0.014 0.017 0.020 0.020
Exports -0.009 -0.086 -0.198 -0.300 -0.387 -0.427
Imports 0.042 0.196 0.386 0.595 0.781 1.099
Government consumption
shock
 An increase in the government consumption boosts domestic
demand and raises GDP by 1.01% as a primary effect. This effect
remains for 5 years, after which it gradually dies out due to secondary
effects.

 The fiscal expansion stimulates production and investment.

 Nominal wages and prices go up. Higher employment and wages


lead to higher personal incomes and to an increase in consumption.

 Larger investment and stronger private and government consumption


leads to increasing imports.

 Expanding economic activity translates into widening of the output


gap that pushes up the price level.
Simulation of an increase in world demand by 1% (Q1’2002 –
Q4’2008)
Levels, percentage deviations from baseline

Year 1 Year 2 Year 3 Year 4 Year 5 Year7


HICP 0.005 0.071 0.204 0.379 0.564 0.807
ULC -0.255 -0.205 0.077 0.366 0.551 0.788
Comp. per employee 0.101 0.554 0.884 1.076 1.144 1.010
Productivity 0.357 0.760 0.807 0.708 0.589 0.220

GDP 0.395 0.971 1.175 1.173 1.100 0.545


Private consumption 0.007 0.158 0.397 0.576 0.662 0.571
Investment 0.001 0.005 0.011 0.016 0.021 0.027
Exports 0.725 1.546 1.583 1.497 1.426 1.320
Imports 0.001 0.029 0.106 0.235 0.390 0.728
An increase in world demand
 This simulation is particularly important because of the openness of
the Bulgarian economy. The external demand shock leads to a
stronger domestic demand. The external shock directly drives up
the volume of exports by 1.55% (second year), which in turn also
increases imports.

 Employment and nominal wages increase which leads to higher


private consumption (0.57%-seventh year).

 Higher aggregate demand widens the output gap that pushes up


the aggregate price level.
Simulation of a depreciation of the lev against the US dollar
by 1%(Q1’2002 – Q4’2008)
Levels, percentage deviations from baseline

Year 1 Year 2 Year 3 Year 4 Year 5 Year 7


HICP 0.008 0.065 0.129 0.190 0.250 0.310
Import deflator 0.067 0.190 0.279 0.337 0.390 0.005
Export deflator 0.336 0.565 0.493 0.511 0.572 0.006
ULC -0.067 -0.009 0.056 0.137 0.203 0.003
Comp. per employee 0.032 0.145 0.236 0.328 0.387 0.004
Productivity 0.099 0.154 0.180 0.191 0.184 0.001

GDP 0.110 0.205 0.266 0.308 0.325 0.288


Private consumption 0.003 0.044 0.090 0.118 0.133 0.011
Investment 0.000 0.001 0.002 0.003 0.004 0.001
Exports 0.198 0.289 0.294 0.308 0.295 0.002
Imports -0.003 -0.028 -0.066 -0.098 -0.110 -0.098
An exchange rate shock
 The decrease in the value of the lev against the US dollar has an
immediate impact on both the import and export deflators – they both
increase.

 HICP increases by 0.25% in the fifth year. Compensation per employee


adjusts and income increases which drives the consumption up.

 Because of the relative increase in foreign prices, imports decrease


and exports increase slightly. The reaction of real GDP to an
exchange rate shock achieves its maximum in the fifth year (0.32%).
Simulation of an increase in the price of oil by 10%(Q1’2002
– Q4’2008)
Levels, percentage deviations from baseline

Year 1 Year 2 Year 3 Year 4 Year 5 Year7


HICP 0.016 0.110 0.177 0.227 0.296 0.413
Import deflator 0.160 0.468 0.656 0.851 1.052 1.299
Export deflator 0.481 0.814 0.618 0.886 1.031 1.103
ULC 0.032 0.110 0.084 0.117 0.185 0.204
Comp. per employee -0.005 -0.055 -0.048 0.028 0.088 0.352
Productivity -0.037 -0.164 -0.132 -0.089 -0.097 0.148

GDP -0.041 -0.194 -0.186 -0.140 -0.146 0.220


Priv. consumption 0.000 -0.012 -0.067 -0.125 -0.171 -0.231
Investment 0.000 -0.001 -0.003 -0.004 -0.005 -0.006
Exports -0.081 -0.394 -0.413 -0.432 -0.593 -0.621
Imports -0.005 -0.057 -0.154 -0.280 -0.424 -0.774
An oil price shock
 An oil price shock leads to increasing domestic prices through direct
channels - rising import prices. The response grows gradually and
achieves its maximum - 0.41% for HICP in the seventh year.

 The rise in prices causes a reduction in the demand for domestic and
foreign goods and the consequent fall in household consumption,
imports and exports. As a result, GDP and real disposable income are
below baseline till year six.

 Higher oil price has a negative impact on output and domestic


demand (private consumption declines by 0.17% and GDP falls by
0.15% in the fifth year).

 Reduced economic activity leads to a lower demand for imports, real


exports are also decreasing due to an increase in domestic prices.
Simulation of an increase in EURIBOR by 100 basis points
(Q1’2002 – Q4’2003)
Levels, percentage deviations from baseline

Year 1 Year 2 Year 3 Year 4 Year 5 Year7


HICP -0.001 -0.007 -0.017 -0.021 -0.015 0.015
ULC 0.026 0.011 -0.049 -0.054 -0.031 -0.010
Comp. per employee -0.010 - 0.051 -0.054 -0.001 0.041 0.082
Productivity -0.086 -0.195 -0.156 -0.052 0.037 0.220

GDP -0.096 -0.269 -0.291 -0.182 -0.059 0.239


Private consumption -0.066 -0.182 -0.243 -0.289 -0.342 -0.359
Investment -0.283 -0.933 -1.256 -1.118 -1.038 -0.890
Exports 0.000 0.000 0.001 0.001 0.000 0.001
Imports -0.006 -0.071 -0.214 -0.396 -0.571 -0.865
Interest rate shock
 Because of the fixed exchange rate regime the exchange rate does not
react to domestic interest rate changes. The main effect is through
investment- raising costs of capital and reducing output. Investment
decreases by 1.12% and GDP is reduced by 0.18% in the fourth year.

 The effect on domestic prices is negative due to a weaker domestic


demand.

 Due to lower internal aggregate demand, employment and wages fall.


Concluding remarks and
extensions
 A first step towards building a structural
macroeconomic model.

 This practical work gives valuable information for the


future development of the model which needs to be
continuously developed and could be improved in a
number of respects:

 Availability of new data will require re-estimation and re-


calibration of the model;
Concluding remarks and
extensions
 Developing a long-run baseline that reflects a fully theory-
consistent long-run steady state;

 To consider policy rules in the simulations;

 Developing a more detailed representation of the trade


block by including services on the one hand and different
regions on the other hand;

 An extension of forward-looking behaviour. Expectations


should be incorporated, particularly to allow for a specific
role in price and wage formation.
Baseline (work in progress)
Real exports to GDP
70

65

60

55

50

45

40

35
2000 2025 2050 2075 2100 2125 2150 2175 2200
Baseline (work in progress)
Real imports to GDP
100

90

80

70

60

50

40

30
2000 2025 2050 2075 2100 2125 2150 2175 2200
Baseline (work in progress)
Real private consumption to GDP

80

75

70

65

60

55

50

45
2000 2025 2050 2075 2100 2125 2150 2175 2200
Baseline (work in progress)
Real capital formation to GDP
35

30

25

20

15

10

5
2000 2025 2050 2075 2100 2125 2150 2175 2200