Dynamic Stochastic General Equilibrium Model for the Philippine Economy Center for Monetary and Financial Policy ‐ Bangko Sentral ng Pilipinas 2010 Central Bank Macroeconomic Modeling Workshop The Peninsula Manila, 19‐20 October 2010 Authors: Prof. Paul McNelis (Fordham University), Dr. Francisco G. Dakila , Jr., Eloisa T. Glindro and Ferdinand S. Co. The views expressed herein do not represent the views and opinions of the Bangko Sentral ng Pilipinas (BSP) nor the Fordham University. Outline of Presentation I. Structure of the BSP‐DSGE model for the Philippine economy II. Policy simulation results 2.1 100 bps reduction in policy rate 2.2 Increase in fiscal expenditures equivalent to 1% of GDP III. Further areas of improvement 2 I. Structure of the BSP‐DSGE Model for the Philippine Economy 3 Schematic Diagram of the BSP‐DSGE Model for the Philippine Economy Central Bank Sets policy rate and provides liquidity to banks Service debts to IFCs International Financial Centers Send reserves to CB Banks Foreigners: Firms and Consumers Lend working capital to firms Lend to banks with risk premium Make deposits and receive interest income Lend to NG Supply home goods to NG Pay taxes National Government Provides public goods Households Buys home goods from firms Supply labor to firms and consume goods produced by firms Supply consumption and investment goods Make import and export transactions with foreign firms and consumers Firms: • Local producers • Importers • Exporters 4 Risks confronting each sector • Waves of optimism and pessimism • Foreign interest rate changes Central Bank Sets policy rate and provides liquidity to banks Service debts to IFCs International Financial Centers Surprise policy change Send reserves to • Risk CB averse lending • High costs of Lend working intermediation capital to firms Banks Lend to banks with risk premium Make deposits and receive interest income Fiscal slippage Pay taxes Increase consumption over savings Supply home goods to NG National Government Buys home goods from firms • Productivity shock • Terms of trade shock Supply labor to firms and • Monopolistic markup consume goods produced by firms pricing in home goods Provides public goods Households Lend to NG Foreigners: Firms and Consumers World demand Make import and export transactions with foreign firms and consumers Firms: • Local producers • Importers • Exporters Supply consumption and investment goods (both home goods and imports) 5 Background • Quarterly data for 16 observable variables for the inflation targeting period. – the choice of 2002 as the beginning period has an added benefit to the calibration exercise because it marks the change in monetary policy framework • Estimation procedure: – Calibration : steady state parameters were kept at their calibrated values. – Bayesian method : applied on parameters that do not affect the steady state such as the autoregressive and exogenous shock parameters. 6 Optimization Problem for Households Maximize ~ βU t (Ct / H t , Lt ) = ~ (Ct / H t )1−σ 1−σ ~ρ H t = C habit stock ~ C t = µC t−η + (1 − µ )Gt−−η1 [ t −1 ] −1 η L1t +ϖ ; −γ 1 +ϖ Government consumption is included Subject to two constraints, (1) Wt Lt + (1 + Rdt −1 ) M t −1+ Π t + Rkt K t −1 = ⎛ ⎞ f x f φ(I t −δKss ⎜ ⎟ Pt Ct (1+τ c ) + Mt +τWt Lt + Pt I t + Pt ⎜ ⎟ 2 K t ⎝ ⎠ f (2) K tx = (1 − δ 1 ) K tx−1 + I tx Sources of income 2 equal Uses of income Adjustment cost in investment 7 Optimization Problem for Households d C Consumption at time t is a CES bundle of both domestically‐produced t f C and imported consumption goods t θ −1 θ −1 ⎡ = ⎢ (1 − λ 1 ) 1 / θ ( C td ) θ ( λ 1 ) 1 / θ ( C t f ) θ ⎢⎣ 1 Ct 1 1 1 1 1 ⎤θ ⎥ ⎥⎦ θ1 1 −1 λ1 = share of imports in the consumption basket (1‐λ1) = share of domestically‐produced goods in the consumption basket θ = price elasticity of demand for each consumption component h Ct Domestically‐produced goods consist of goods for home consumption and exports Ctx θ −1 θ −1 θ 1 ⎡ ⎤ 1 θ θ θ h x ⎥ = ⎢ (1 − λ 2 ) ( C t ) + λ 2 θ (C t ) ⎢⎣ ⎥⎦ 2 C d t 2 2 2 θ2 2 −1 2 2 8 Optimization Problem for Firms Three types of firms: Yt = Yt x + Yt h + Yt f [ • Export firms: Yt x = Z tx A x (1 − α 1 )( Ltx ) −κ1 + α 1 ( K tx ) −κ1 ] − 1 κ1 h h h 1− α • Home goods firms: Yt = Z t ( Lt ) 2 • Importing firms: Yt f = C f + I x 9 Optimization Problem for Firms Firms face liquidity constraint and borrow a fraction of the wage bill from banks at prevailing loan rate Rtl • Export firms: N tx = φ1Wt Ltx Π tx = Pt xY xt−(1 + φ1 Rtl )Wt Ltx − Pt k Y xt Revenues Costs • Home goods firms: N th = φ 2Wt Lht Π th = Pt hY ht−(1 + φ2 Rtl )Wt Ltx Revenues Costs • Importing firms: N t f = φ3 ( S t Pt* f * Yt f ) [ = [1 + φ R ]S P P f = φ 3 (1 + Rtl ) + (1 − φ 3 )( S t Pt* f ) Pf 3 l t t t *f ] Importers do not produce any good but incur cost of bringing imported goods into the domestic market 10 Pricing World export price: Pt = ρ2 Pt−1 + (1− ρ2 )Pt +ε p* t x* x* x* Export price in domestic currency: P = S t ∗ Pt x Import price in domestic currency: x* Pt f = [1 + φ3 Rtl ]S t Pt f * Price of domestically produced goods: [ Pt d = (1 − λ2 )( Pt h )1−θ 2 + λ2 ( Pt x ) Price of home‐ produced goods 1−θ 2 ] 1 1−θ 2 Price of export goods 11 Calvo Pricing for Home Goods • Sticky monopolistically competitive firms in the home‐goods market. The firms consist of backward‐looking price setters Pt h ,b o and forward‐looking price setters Pt [ Pt = ξ ( Pt h h ,b 1− ζ ) o 1− ζ + (1 − ξ )( Pt ) ] 1 1− ζ • Overall price index is a CES function of the price indices of domestic consumption goods and foreign goods. [ ] 1 f 1−θ1 1−θ 1 Pt = (1 − λ1 )( Pt d )1−θ1 + λ1 ( Pt ) 12 Optimization Problem for Banks • Banks earn by lending to government and firms, realizing FX gains from foreign bond holdings and taking in deposits from households. • Banks incur costs by paying out interest to deposits, holding reserves against deposit, investing in government bonds, taking out new loans, setting aside capital against losses from private lending and realizing valuation losses from foreign bond holdings. Π B = (1 + Rb ,t −1 ) Btg−1 + (1 + Rl ,t −1 ) N t −1 + S t Bt f + M t t − (1 + Rd ,t −1 ) M t −1 − φ 4 Rd ,t −1 M t −1 − B gt − N t − φ5 Rl ,t −1 N t −1 − (1 + Rt*−1 + Φ t −1 ) Bt f−1 S t Earnings Costs 13 Fiscal Policy Government spending is considered procyclical, exhibits smoothing and has stochastic component. Gt = (1 − ρG )G + ρGGt −1 + (1 − ρG )ρGY (YT −1 − Y ) + εG,T Tax revenues are sourced from labor and consumption. TAX t = τWt Lt + τ C Pt Ct Fiscal balance determines the fiscal borrowing requirement. Btg = (1 + Rt −1 ) Btg−1 + Pt h Gt − TAX t 14 Monetary Policy The monetary policy rule is a function of lagged policy rate, steady state policy rate, inflation gap and output gap: ⎛ Pt +1 *⎞ R pt = ρ p1 R pt −1 + (1 − ρ p1 ) R pss + (1 − ρ p1 ) ρ p 2 ⎜⎜ − 1 − π ⎟⎟ ⎠ ⎝ Pt ⎛ Yt +1 ⎞ + (1 − ρ p1 ) ρ p 3 ⎜⎜ − 1⎟⎟ + ε R pt ⎠ ⎝ Yt The policy rate then feeds into bond rate, lending rate, and deposit rate 15 Monetary Policy Once the policy rate adjustment by the central bank gets transmitted to the market interest rates, the CB provides liquidity support to the banking system. LIQt = N t + Bt + (1 + Rd ,t −1 − φ4 Rd ,t −1 )M t −1 + (1 + Rt f−1 + Φ t −1 ) Bt f−1St −1 − (1 + Rl ,t −1 − φ5 Rl ,t −1 ) N t −1 − M t − (1 + Rb,t −1 ) Bt −1 − Bt f St Reserves against deposit (φ4) and capital‐asset ratio (φ5) 16 Risk Premium and Foreign Debt Accumulation The accumulation of foreign debt is determined by the difference between existing foreign debt stock and net exports. S t B t f = (1 + R t f− 1 + Φ f ) B t −1 t −1 S t −1 + P t f ( C t f + I tx ) − P t x C tx Foreign debt stock Net Exports Foreign interest rate follows an autoregressive process. R t f = ρ f R t f−1 + (1 − ρ f ) R f + ε rf, t The model is closed by the risk premium (Φ) embedded in accumulation of foreign debt. 17 Solution of Steady State • The system is highly non‐linear and non‐recursive; Hence, there is no analytical solution for the steady state. • Used computational algorithms to solve for steady state values based on calibration of structural parameters of the model. – Hybrid approach to mitigate the problem of “local minimum” trap • Local gradient‐based algorithm, simulated annealing, and genetic algorithm. CE Conditions: CE Conditions.pdf 18 Convergence and Relative Stability of Parameter Moments ‘Multivariate Diagnostic’ 19 Convergence and Relative Stability of Parameter Moments ‘Univariate Diagnostic’ 20 II. Policy Simulations (the usual disclaimer applies) 21 Monetary Stimulus Equivalent to 100 bps All results are expressed in terms of percentage deviation from steady state values. 22 Comparative simulation results 1/ from various Philippine models Model Impact on Inflation Impact on Domestic Demand BSP‐DSGE 0.17 0.12 BSP‐MEM 2/ 0.06 0.01 NEDA‐QMM 3/ 0.05 0.01 1/ Impact on the first year of 100 bps reduction in policy rate. 2/ BSP‐MEM sensitivity table, as of 31 August 2010. 3/ The NEDA Quarterly Macroeconometric Model of the Philippines: Final Report, May 2004. 23 Fiscal Stimulus Equivalent to 1% of GDP All results are expressed in terms of percentage deviation from steady state values . 24 Future Directions • Further parameter re‐calibrations to test the robustness of the model. • Introduce matching frictions and nominal wage rigidities would enhance our study of the transmission mechanism and the implications of wage dynamics on inflation. • Include more market‐based financial stress indicator in the model. • Finetune inflation forecasts generated by the model. 25 Dynamic Stochastic General Equilibrium Model for the Philippine Economy Center for Monetary and Financial Policy ‐ Bangko Sentral ng Pilipinas 2010 Central Bank Macroeconomic Modeling Workshop The Peninsula Manila, 19‐20 October 2010 Authors: Prof. Paul McNelis (Fordham University), Dr. Francisco G. Dakila , Jr., Eloisa T. Glindro and Ferdinand S. Co. The views expressed herein do not represent the views and opinions of the Bangko Sentral ng Pilipinas (BSP) nor the Fordham University.