February 1987 93 Structure and Uses of the MPS Quarterly Econometric Model of the United States Flint Brayton and Eileen Mauskopf of the Since 1970, when the first working version was Board's Division of Research and Statistics pre- completed, the Board's Division of Research and pared this article. Statistics has used the model for forecasting, for analyzing the consequences of exogenous eco- In the late 1960s, staff members of the Board of nomic shocks and alternative monetary or fiscal Governors of the Federal Reserve System, along policies, and for various research projects. Al- with several university economists, undertook to though many key elements of the original model build a quarterly model of the U.S. economy. remain intact, considerable effort has been de- Their goal was to develop a model that focused voted over the years to maintaining and improv- more intensively than did existing models on the ing the model. These efforts stem from new channels through which monetary policy affected insights provided by theoretical and applied eco- the real sectors of the economy. The model has nomic research, from revisions in data, and from generally become known by the abbreviation institutional and technological developments that MPS, which reflects the academic affiliations of have caused the performance of some equations two of its key developers, Franco Modigliani to deteriorate. This article provides a general (Massachusetts Institute of Technology) and Al- description of the current structure and uses of bert Ando (University of Pennsylvania), and the the model.2 organization (Social Science Research Council) through which Federal Reserve support for the 1 project was channeled. SUMMARY OF MODEL STRUCTURE As of late 1986, the MPS model consists of 334 1. Papers describing early versions of the model and citing equations, of which 128 are stochastic and 206 contributors to the development of the model include Frank are identities. In addition, it has 188 exogenous de Leeuw and Edward Gramlich, "The Federal Reserve- MIT Econometric Model," FEDERAL RESERVE BULLETIN, variables. The theoretical core of the model is vol. 54 (January 1968), pp. 11-40; Frank de Leeuw and based on the behavior of cost-minimizing pro- Edward Gramlich, "The Channels of Monetary Policy: A ducers and utility-maximizing consumers. Further Report on the Federal Reserve-MIT Econometric Model," FEDERAL RESERVE BULLETIN, vol. 55 (June 1969), In the long run, when markets clear and expec- pp. 472-91; Robert H. Rasche and Harold T. Shapiro, "The tations are fulfilled, the model behaves like a F.R.B.-M.I.T. Econometric Model: Its Special Features," neoclassical growth model. The long-run growth American Economic Review, vol. 58 (May 1968, Papers and Proceedings, 1967), pp. 123-49; and Albert Ando and Franco rate of the economy is determined by the rate of Modigliani, "Econometric Evaluation of Stabilization Poli- population growth and the rate of technological cies," American Economic Review, vol. 59 (May 1969, progress, both of which are exogenous to this Papers and Proceedings, 1968), pp. 296-314. Jared Enzler. Associate Director of the Division of Re- model. The level of per capita output depends on search and Statistics, was involved in the model development the capital-output ratio and the characteristics of work, managed the model through much of its first decade of operation, and continues to maintain an active interest in and oversight of model developments. Other current and former Board staff who have worked with the model in its operation- 2. A more detailed description of the model, containing a al phase include Robert Anderson, Douglas Battenberg, complete list of the equations (as of 1985), is presented in Richard Berner, Flint Brayton, Tim Grunwald, William Lee, Flint Brayton and Eileen Mauskopf, "The Federal Reserve Eileen Mauskopf, Stephan Thurman, David Wilcox, Anne Board MPS Quarterly Econometric Model of the U.S. Econ- Williams, and David Wyss. omy, "Economic Modelling, vol. 2 (July 1985), pp. 170-292. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis February 1987 94 Federal Reserve Bulletin • February 1987 the production function.3 Although an optimal affects real output directly through the contribu- capital-output ratio exists at which the sustain- tion of government spending to aggregate de- able level of per capita consumption is highest, mand and less directly through the impact of tax there is no guarantee that the actual path to policy on disposable income and investment in- which the model converges is this "golden rule" centives; changes in the supply of money affect path. The capital-output ratio that prevails in the both nominal and real interest rates, and the long run will be affected by fiscal policy, among latter influence investment and consumption. other things. The long-run unemployment rate The transition from the short-run responses of will be consistent with nonaccelerating infla- the model to the long-run state after either a tion—which, in the model, depends both on the change in policy or some other disturbance is pace of productivity growth and the ratio of often lengthy. As shown in simulation results unemployment benefits to take-home pay. In the described below, however, after about one year long run, the rate of inflation will equal the wages and prices are sufficiently flexible that the excess of the rate of growth of money over that short-run effects of fiscal and monetary policy on needed to support the growth rate of real activi- demand begin to be offset by supply responses ty; inflation also will depend on any exogenous reflected in movements in wages, prices, and trend in the ratio of income to money. Money is interest rates. neutral in the long run in the sense that a A crucial issue in building economic models is permanent change in the amount of money in the the appropriate way to model expectations. The economy will cause a proportionate change in use in the MPS model of autoregressive (AR) the price level, leaving all real magnitudes un- expectations contrasts to the approach using changed. A permanent change in the rate of rational expectations (RE) that has prevailed in growth of money, however, will not be neutral in theoretical macroeconomic analysis during the the long run. The consequent changes in the rate past decade. The rational expectations hypothe- of inflation and the nominal rate of interest will sis is based on the assumption that economic have real effects because the demand for money agents use all available information in forming depends on the nominal rate of interest and expectations. In its strong form (SRE), this hy- because some provisions of the tax code are pothesis requires that expectations appearing in defined with respect to nominal, rather than real, a model be consistent with the forecasts of that magnitudes. model.4 For several reasons, the MPS model has In the short run, the properties of the model not adopted this constraint on modeling expecta- are quite different. Because wages and prices are tions. One is practical: the computational diffi- estimated to adjust slowly, neither labor nor culties in estimating and simulating a large-scale goods markets are continuously in equilibrium. model incorporating SRE are formidable; conse- This disequilibrium reflects the presence of ad- quently, most of the empirical models that have justment costs and the assumption that expecta- incorporated this approach have been small. tions are formed autoregressively (for example, Another reason is our belief that the SRE ap- expected inflation depends on past inflation). proach is extreme. The economy is sufficiently Thus, in the short run, the model has properties complex that economic agents are likely to un- that may be characterized as Keynesian: aggre- gate demand largely determines the level of 4. A weaker definition of rational expectations postulates output, and the unemployment rate of labor (and that expectations are optimal forecasts based on available the utilization rate of capital) may be either information. Costs of acquiring and evaluating information could cause economic agents to make use solely of past below or above the natural rate; fiscal policy observations of a variable in forming their expectations of its future values. In this restricted case, the AR model would be rational, but its parameters need not be constant over time: they could vary with changes in policy rules. The distinction 3. The level of per capita output also depends upon the between strong and weak rational expectations is made by level of technology embodied in the existing capital stock and P. A. V. B. Swamy, J. R. Barth, and P. A. Tinsley, "The on the relative price of energy. The latter determines the Rational Expectations Approach to Economic Modelling," energy intensity of production. Energy prices are exogenous Journal of Economic Dynamics and Control, vol. 4 (May in the model. 1982), pp. 125-47. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis February 1987 Structure and Uses of the MPS Quarterly Econometric Model of the United States 95 derstand it only imperfectly. Moreover, once To describe the structure of the model in more sluggish adjustments owing to sources other than detail, we split it into aggregate demand, aggre- expectational lags (such as long-term contracts) gate supply, and financial components, although are introduced into economic behavior, SRE a precise division between the demand