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The Macroeconomic Model Briefing paper No. 5 The macroeconomic model October 2013 © Crown copyright 2013 You may re-use this information (excluding logos) free of charge in any format or medium, under the terms of the Open Government Licence. To view this licence, visit http://www.nationalarchives.gov.uk/doc/open- government-licence/ or write to the Information Policy Team, The National Archives, Kew, London TW9 4DU, or e-mail: [email protected]. Any queries regarding this publication should be sent to us at: [email protected] ISBN 978-1-909790-28-5 PU1558 Contents Chapter 1 Introduction.................................................................................. 1 Chapter 2 Expenditure components of GDP ................................................... 9 Chapter 3 The labour market ...................................................................... 63 Chapter 4 Prices, costs and earnings ........................................................... 71 Chapter 5 Balance sheets and income accounts ........................................... 95 Chapter 6 Public sector ............................................................................. 145 Chapter 7 Domestic financial sector........................................................... 183 Chapter 8 North Sea................................................................................. 187 Annex A Glossary of Winsolve notations.................................................. 193 Annex B Winsolve model code................................................................ 195 Introduction 1 Introduction 1.1 The Office for Budget Responsibility (OBR) was created to examine and report on the UK’s public finances. To that end, we publish five-year forecasts for the key components of the public finances twice a year, alongside each Budget and Autumn Statement. But the evolution of the public finances depends to a considerable degree on the evolution of the economy. So, to generate a forecast for the public finances, we also need to forecast the outlook for the economy. 1.2 The key features of each forecast reflect judgements made by the OBR’s Budget Responsibility Committee, working with our full-time staff. To help flesh out the details of the forecast, we use a large-scale macroeconomic model originally developed by the Treasury in 19701 and updated and improved subsequently on a continuing basis. Since June 2010, the model has been maintained and developed by the OBR and the Treasury jointly. A Memorandum of Understanding2 sets out the governance arrangements for this shared ownership. Co-ownership of the model in no way compromises the ability of the OBR to forecast independently of Government. We have complete freedom over the version of the model that we use and could adopt an alternative if we so wished. 1.3 It is also important to emphasise that the model is a computational tool and considerable human judgement must be applied to produce a coherent forecast. Two forecasters using exactly the same model could end up with very different forecasts because the judgements underpinning them differ.3 That said, using a model helps ensure that judgements are applied in a mutually consistent way. A model can also be used to generate consistent forecasts for a large range of variables from a smaller set of key judgements. 1 Chan, A., Savage, D., and Whittaker, R., The New Treasury Model, Government Economic Service Working Paper no. 128. 2 http://budgetresponsibility.independent.gov.uk/wordpress/docs/MoU_model.pdf. 3 For example, the ITEM club have used the 2008 version of the macroeconomic model to produce their forecasts, which have regularly differed from official forecasts produced using the same model. 1 The macroeconomic model Introduction 1.4 This paper describes the version of the model in use as of October 2013, but it will continue to be revised on an ongoing basis. The previous written description of the model was published by the Treasury in 2008.4 The model and the economic forecast 1.5 The macroeconomic model is a simplified representation of the economic activity described and recorded in the National Accounts published by the Office for National Statistics (ONS). The equations in the model represent a set of relationships between different economic variables. These relationships can be broken down into three broad groups: accounting identities: equations that specify the identities and definitions in the National Accounts. Examples include the identity that real Gross Domestic Product by definition equals the sum of consumption, investment, government spending and net trade, and that nominal consumption is the product of real consumption and the consumption deflator; behavioural (or econometric) equations: econometrically estimated equations based on economic theory and statistical analyses of how the economy has behaved in the past. For example, the behavioural equation for households’ spending assumes that it responds to changes in real incomes, interest rates and wealth as it has in the past. But no theory fits the data perfectly, and the forecaster is always free to make the judgement that it will now behave differently; and technical relationships: equations in the model that are neither identities nor econometrically estimated. This category includes calibrated relationships based on economic theory or broad historical trends and stylised forecasting assumptions – such as the assumption that employees’ contributions to pension schemes remain constant as a share of total wages and salaries. The role of judgement 1.6 All models are necessarily simplifications of reality. And forecasters are typically confronted with at least some behavioural equations that do not explain the recent past well, particularly if there have been significant structural changes in the economy. Under these circumstances, the ‘residuals’ of the equations – the elements of unexplained behaviour represented by the difference between outturns and the model’s output – will be relatively large. Accordingly the 4 http://data.parliament.uk/DepositedPapers/Files/DEP2009-2901/DEP2009-2901.pdf The macroeconomic model 2 Introduction forecaster has to attempt to interpret the path of residuals implied by the model and judge how the unexplained behaviour will evolve over the forecast period. In these cases it makes sense to use a range of approaches and models to inform the forecast, rather than to rely solely on the behavioural relationship implied by the model, which will reflect the behaviour of the economy over the specific time period over which the relationships were estimated.5,6 For example: the forecast path for a particular variable may be informed by historical evidence, including comparable episodes or long-run trends; the ‘residuals’ or unexplained errors in the behavioural equations in the macroeconomic model can also inform the forecast; in some cases, the appropriate judgement is captured by technical relationships or identities specified by the model; for other variables, the forecast judgement is based on auxiliary models outside the main macroeconomic model; and for certain variables, the judgement is to adopt an external conditioning variable, such as market expectations of interest rates and oil prices. Imposed variables 1.7 Some variables that appear in the model are actually determined outside it. For the purposes of this document, we refer to these as ‘imposed’ variables. In some cases they will be ‘exogenous’ variables, imposed by assumption. For example, we assume that oil prices and interest rates will move in line with the expectations embodied in financial market prices at the time of the forecast. 1.8 In other cases, the variables are ‘endogenous’ – determined by other variables – but imposed on the main macroeconomic model having been estimated using other models. Often, these variables are imposed because the methods used to forecast them cannot practically be contained within our main macroeconomic model. For example, the forecast for tax receipts is endogenous – it is determined 5 For more discussion of the use of judgement in forecasting, see OBR, 2011, Forecasting the economy; and Burgess et al, 2013, The Bank of England’s forecasting platform: COMPASS, MAPS, EASE and the suite of models. 6 Indeed, given that the model includes a number of imposed variables that are determined outside the forecast, it would not be possible to derive a considered and plausible result in the absence of alternative models and judgement. 3 The macroeconomic model Introduction by variables such as wages, profits and consumer spending. But tax receipts are imposed on the main macroeconomic model having been calculated using the models for individual taxes run for the OBR by HM Revenue & Customs.7 1.9 Potential output – the level of economic activity consistent with stable inflation – is another variable estimated outside the macroeconomic model and then imposed on it. In this instance there are a range of methods that we could use, many of which do not lend themselves well to inclusion in a large-scale macroeconomic model. 1.10 Our general approach to forecasting potential output is to begin by estimating the current output gap – the difference between potential and actual output. To this end, we use a range of methodological approaches, including evidence from cyclical indicators.8 We then estimate how potential output will evolve by splitting up growth in potential into several components that are analysed and projected separately: productivity growth (output
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