The problems involved in the construction of econometric macro-models are well known and have been discussed extensively in general terms, and also in relation to Irish data. One of the difficulties arises out of the nature of the model and the purposes which it is intended to serve. If the equations of the model are designed to explain the working of the economy, they may not be very suitable for short-term forecasting; if on the other hand they make considerable use of leading indicators and other forecasting devices, their theoretical content may be very limited

Leser, C. E. V.

Archive of European Integration

A new basic model of the Irish economyBy C. ~. V. LeserThe problems involved in the construction ofeconometric macro-models are well knownand have beendiscussed extensively in general terms, and also in relationto Irish data [~j 5] One of the difficulties arises outof the nature of the model and the purposes which it isintended to serve.     If the equations of the model aredesigned to explain the working of the economy, they maynot be very suitable for short-term forecasting;    if onthe other hand they make considerable use of leading indic-ators andother forecasting devices, their theoretical contentmay be very limited.Another antithesis is that between small-scaleand large-scale models, the relative merits of which wereextensively debated in the discussion on a paper by Friendand Jones [4].    A small-~cale model containing only afew equations is obviously less ambitious in scope thana very large and complex model, but on the other handpermits more intensive testing of various alternatives.This applies particularly to interdependent systems, inwhich the specification of any one equation affects theestimation of several or even all the other equations.In a recursive mo~.el which specifies that thereis no true cross-relationship between the endogenousvariables but only an influence in one direction, thedifficulties are not so great as it is possible to startfrom a small basic model and to enlarge it by addingfurther equations.     Since each equation of such a systemmay be individually estimated, alternative variants ofone equation may be Gonsidered without having to worryabout the remainderConfidential: Not to be quoteduntil the permission of the Authorand the Institut  he= .oAThese reasons of convenience do not by themselvesjustify the use of recursive systems if genuine inter-dependence is specified on theoretical grounds.    Recursivemodels have, howevery been used with advantage in thefield of demand and supply analysis on the micro-level,and their application in the macro-economic field maydeserve further consideration wherever the specificationof a causal Chain appears to be at least a reasonableworking hypothesis.The model introduced here is designed to explainshort-term movements, from one year to another, in someof the key national accounts variables.    The relationshipsare such as to allow theoretical interpeetation providedthe specification is correct; failing the latter, theymay still be used as prediction relationships.     Themodel may be used in connection with short-term fore-casting though it is not specifically designed for thatpurpose, as it does not explicitly introduce short-termindicators Such as quarterly or monthly data which couldbe used for forecasting purposes.The model is fully recursive, specifyingclearly the direction in which the relationships aresupposed to work.    It is a basic model with importsof goods and services, gross national product, personaldisposable income and personal expenditure as endogenousvariables, all of them in current prices.    It couldwell be further extended to cover price indices andconstant price terms, employment and other variablesof this kind.- 8 -The variables of the model are:M imports of goods and servicesY gross national product at market pricesYdper~ nal disposable incomeCGIXBaBnezpersonal expenditurepublic authorities’net current expendituregross domestic fixed capital formationexports of goods and servicesvalue of physical changes in agricultural stocksvalue of physical changes in non-agricultural stocksweekly earnings index in transportable goods industries!z dummy variablesAll variables are measured in ~ mill. in currentprices, except for the dummies which will be explainedlater and the annual earnings index numbers which haveOctober 1953 as base and which refer to October exceptthat the September index was used for 1965.     Importsand exports follow the old official definition,including all factor income flows.     Personal disposableincome is defined as personal income less direct taxeson personal income and thus represents personalexpenditure plus personal savings.After some experiments, the structural equationswere formulated as follows, apart from dummy variables:A ?,4 = c~1 + P 11 A I +p 19 ( AX + ABa )AY - AG = c~, + /3222 F21 ~X + ( AX + ABa)+ P23 AeAYd = c~ 3 + PZl (AY - AG)AC    = c¢ 4 + P41 AYd + p42to which may be added the identityABn = ( AM + AY) - ( AC + AG + AI + AX + AB )athe symbol L, indicating year-to-year chanses.- 4 -The first equation represents an import function,It tacitly assumes that a change in impoPts depends onchanges in fixed capital formation and exports as wellas on an expected change in personal expenditure~ whichin turn has a constant term and variable te~ms dependingon fixed investment and exports.     For this purpose,agricultural stock changes are treated as potentialexports and are therefore separated from non-agriculturalst6ck changes and added on to actual exports.DThe second equation which may be described asa production decision function is similarly specified.Government expenditure is assumed to be fully translatedinto home production but without any multiplier effect.The price element in th~ valuation of national productis taken care of by industrial earnings as a costindicator.The very simple form of the income formativeequation which follows implies that only that part ofgross national product which is not induced by governmentspending influences personal disposable income.    Thismay not apply An a country which makes extensive useof budget surpluses and deficits to influence consumerspending p but appears valid in the Irish context wherebalanced budgets have hitherto been the rule and there-fore an increase in government expenditure was fullymatched by increased taxation.In the consumption function given by the fourthequation, F41 represents the short-term propensity toconsume and in addition there is an adjustment from theexisting ratio C/Yd towards a long-term equilibrium v~luec "~ = I + ~4           P42 >0~4;. e 2 c~4 <0- 5 -This would be in accordance with the permanent incomehypothesis, and would still comply with it if thespecification was less restrictive.Finally, non-agricultural stock changes areneither taken as exogenous nor directly estimated bythe model equations but obtained by difference,     Thestructure of the model is considerably simplified by thisprocedure.The latest availablQ . figures for the variablesfrom 1953 to 1965 were taken from official publications[1,3 ] and converted into first differences, thus giving12 observations.     Furthermore, dummy variables wereused for the import and consumption functions.     In theimport function .z indicates the anticipation of importlevies in 1955, their introduction in 1956 and removalor reduction in 1958: thusZThere appeared to be a similar but lagged effect in the!consumption function, the dummy variable z for whichwas taken asz’t = z + zI_thusz’ I=             ’ : for 1954-5, 1957-8, 1958-9 )_ for 1955-6,for 1956-70 otherwise                         jLeast-square estimation then yielded the followingresults:LM = 1.200 + 0.8238 LI + 0.5574 (LX + LB ) + ii.416 Za(0.1717)    (0.1216) (2.242)AY- AG = 1.623 + O.5491 AI + 0.9214 (AX +# B ) + 1.7976 ~.e(0.2761)     (0.1629) a (0.6776)AYd =- 3.980 + 0.9762 (LY- AG)(o .o81 )AC 32.520 + 0.6469 /Yd + 508 81 Yd~+(0.0685)     (100.58) YdI I2.071)- 6 -All regression coefficients are significant atthe I0% level, and all except those of ,’ I in the secondand z in the fourth equation at the 5% level at least.The coefficients of determination and standard errorsof estimate (in ~ mill) are as follows:R2       Se’k~ . 948 5 . 30/¥ _ A G.944 7.09/Yd .9~5 6.91/C ,937 5.84The coefficients of determination are high forequations in terms of first differences,    This issatisfactory though it does not prove the specificationto be correct as there is a fair degree of correlationbetween most national accounts data even in terms offirst differences.     There remain moderately highunexplained elements in the endogenous variables asevidenced by the standard errors of estimate,     If thedummy variable was ommittedfrom the consumptionwe wou~Id obtain R2 = .90~ therein.The first two equations show that fixed investmenthas alarger effect upon imports than have expo~ts~ whilst theopposite applies to domestic production.    This is whatwe should expect to find.    The sum of the coefficientsof {,I in the two equations is greater than !~ as isalso the sum of coefficients ell X + t~Ba; thus theincrease in imports and home production which is meetingincreased personal expenditure seems to vary very largelyin ste~ with the increase in exogenous demand.The consumption function shows that in theshort run about two-thirds of any addition to personaldisposable income tends to be spent.     In the long run,however~ the proportion of disposable income spent- 7 -appears to adjust itself to about .93652. 5201 - = .9561508.81since:Personal disposable income, personal expenditureand non-agricultural stock changes could be expressedin terms of predetermined variables if desired.    Itshould be noted that government expenditure does thendisappear from these equations.The model may be applied to 1965-6 and to1966-7~ though conditions in 1966 have shown so manyabnormal features that this does not constitute a fairprediction ~est; it rather shows what might have beenexpected to happen in more normal circumstances.Using official and N.I.E.C. estimates and forecasts[3,6] , estimating Yd as 816 in 1966 for the purpose oft~e 1967 consumption forecast and assuming a 1966-7earnings increase of ~ or 6.5 index points, weobtain for the exogenous variables/,IAXa/.    e/Yd- £~"~Yd :/-1~196 5-6 1966-7-9 1731 33-14 -29 92~.0 6.5.0949 .0964The predicted changes in the endogenousvariables then are as follows :- 8 -1965- 6~,~o d el Of fi ci al K~o delor NIEC/. ~ 9 5 39.A Y 67 47 60/’ Yd 5 3 46A C 50 24 45B         2          4             -1on1966- 7Officialor NIBC4067d46Thus the model gives an estimate of how muchsharper gross national product and personal expenditurewould have risen in 1955-6 in the absence of strikes andcredit restrictions other than those holding back capitalformation¯     On the other hand, a pure model predictionwould give a smaller rise in imports and gross nationalproduct than the N I B C forecast, and with Bnfor 1966, this would imply a fall in non-agriculturalstocks in 1967 by ~4 mill.     In an actual prediction onewould be inclined to make allowance for the deficienciesin LM and A Y for 1965-6, though it is difficult to seeto what extent.A number of questions remain unanswered.     Towhat extent do the equations formulated and estimatedhere have real structural content, and alternativelyhow useful are they for prediction ; or else has themodel fallen between two stools?    If using it forshort-term forecasting, should one make use of independentinformation about the endogenous variables, particularlyabout non-agricultural stock changes, and if so, inwhat way?    There is no simple answer to these questions.What seems to have been established is the possibilityof building a reasonably satisfactory recursive macro-economic model which includes a consumption function asan integral part, and which permits fur.tker elaborationby both improving the existing and a~ding on furtherrelationships.[I][2][3][43[s][6]- 9 -RHFHRHNCHSCentral Statistics Office, National income andexpenditure 1962~ 1964t 1965.gconomic Research Institute, Staff of~ The Irish~conomy in 1966a    H.S.R.I. Paper No. 33.~inance, Department of,for 1967.Review of 1966 and OutlookFriend, l.and Jones) R: C., Short-run forecastingmodels incorporating anticipatory data" Modelsof income de-termination,    Princeton 1964.Leser, C: F~. V. ,1966, E. S. R. !.The Irish F~conomy in 1964 andPaper No. 2’2.National Industrial gconomic Council, Comments onDepartment of Finance Report. ’Review of 1966 andOutlook for 1967," Report No. 2U.

A New Basic Model of the Irish Economy. ESRI Memorandum Series No. 41 1966(?)

A new basic model of the Irish economy
By C. ~. V. Leser
The problems involved in the construction of
econometric macro-models are well knownand have been
discussed extensively in general terms, and also in relation
to Irish data [~j 5] One of the difficulties arises out
of the nature of the model and the purposes which it is
intended to serve.     If the equations of the model are
designed to explain the working of the economy, they may
not be very suitable for short-term forecasting;    if on
the other hand they make considerable use of leading indic-
ators andother forecasting devices, their theoretical content
may be very limited.
Another antithesis is that between small-scale
and large-scale models, the relative merits of which were
extensively debated in the discussion on a paper by Friend
and Jones [4].    A small-~cale model containing only a
few equations is obviously less ambitious in scope than
a very large and complex model, but on the other hand
permits more intensive testing of various alternatives.
This applies particularly to interdependent systems, in
which the specification of any one equation affects the
estimation of several or even all the other equations.
In a recursive mo~.el which specifies that there
is no true cross-relationship between the endogenous
variables but only an influence in one direction, the
difficulties are not so great as it is possible to start
from a small basic model and to enlarge it by adding
further equations.     Since each equation of such a system
may be individually estimated, alternative variants of
one equation may be Gonsidered without having to worry
about the remainderConfidential: Not to be quoted
until the permission of the Author
and the Institut  he= .oA
These reasons of convenience do not by themselves
justify the use of recursive systems if genuine inter-
dependence is specified on theoretical grounds.    Recursive
models have, howevery been used with advantage in the
field of demand and supply analysis on the micro-level,
and their application in the macro-economic field may
deserve further consideration wherever the specification
of a causal Chain appears to be at least a reasonable
working hypothesis.
The model introduced here is designed to explain
short-term movements, from one year to another, in some
of the key national accounts variables.    The relationships
are such as to allow theoretical interpeetation provided
the specification is correct; failing the latter, they
may still be used as prediction relationships.     The
model may be used in connection with short-term fore-
casting though it is not specifically designed for that
purpose, as it does not explicitly introduce short-term
indicators Such as quarterly or monthly data which could
be used for forecasting purposes.
The model is fully recursive, specifying
clearly the direction in which the relationships are
supposed to work.    It is a basic model with imports
of goods and services, gross national product, personal
disposable income and personal expenditure as endogenous
variables, all of them in current prices.    It could
well be further extended to cover price indices and
constant price terms, employment and other variables
of this kind.
- 8 -
The variables of the model are:
M imports of goods and services
Y gross national product at market prices
Yd
per~ nal disposable income
C
G
I
X
B
a
B
n
e
z
personal expenditure
public authorities’net current expenditure
gross domestic fixed capital formation
exports of goods and services
value of physical changes in agricultural stocks
value of physical changes in non-agricultural stocks
weekly earnings index in transportable goods industries
!
z dummy variables
All variables are measured in ~ mill. in current
prices, except for the dummies which will be explained
later and the annual earnings index numbers which have
October 1953 as base and which refer to October except
that the September index was used for 1965.     Imports
and exports follow the old official definition,
including all factor income flows.     Personal disposable
income is defined as personal income less direct taxes
on personal income and thus represents personal
expenditure plus personal savings.
After some experiments, the structural equations
were formulated as follows, apart from dummy variables:
A ?,4 = c~1 + P 11 A I +p 19 ( AX + ABa )
AY - AG = c~, + /3222 F21 ~X + ( AX + ABa)+ P23 Ae
AYd = c~ 3 
+ PZl (AY - AG)
AC    = c¢ 4 + P41 AYd + p42
to which may be added the identity
ABn = ( AM + AY) - ( AC + AG + AI + AX + AB )
a
the symbol L, indicating year-to-year chanses.
- 4 -
The first equation represents an import function,
It tacitly assumes that a change in impoPts depends on
changes in fixed capital formation and exports as well
as on an expected change in personal expenditure~ which
in turn has a constant term and variable te~ms depending
on fixed investment and exports.     For this purpose,
agricultural stock changes are treated as potential
exports and are therefore separated from non-agricultural
st6ck changes and added on to actual exports.
D
The second equation which may be described as
a production decision function is similarly specified.
Government expenditure is assumed to be fully translated
into home production but without any multiplier effect.
The price element in th~ valuation of national product
is taken care of by industrial earnings as a cost
indicator.
The very simple form of the income formative
equation which follows implies that only that part of
gross national product which is not induced by government
spending influences personal disposable income.    This
may not apply An a country which makes extensive use
of budget surpluses and deficits to influence consumer
spending p but appears valid in the Irish context where
balanced budgets have hitherto been the rule and there-
fore an increase in government expenditure was fully
matched by increased taxation.
In the consumption function given by the fourth
equation, F41 represents the short-term propensity to
consume and in addition there is an adjustment from the
existing ratio C/Yd towards a long-term equilibrium v~lue
c "~ = I + ~4           P42 >0
~4;. e 2 c~4 <0
- 5 -
This would be in accordance with the permanent income
hypothesis, and would still comply with it if the
specification was less restrictive.
Finally, non-agricultural stock changes are
neither taken as exogenous nor directly estimated by
the model equations but obtained by difference,     The
structure of the model is considerably simplified by this
procedure.
The latest availablQ . figures for the variables
from 1953 to 1965 were taken from official publications
[1,3 ] and converted into first differences, thus giving
12 observations.     Furthermore, dummy variables were
used for the import and consumption functions.     In the
import function .z indicates the anticipation of import
levies in 1955, their introduction in 1956 and removal
or reduction in 1958: thus
Z
There appeared to be a similar but lagged effect in the
!
consumption function, the dummy variable z for which
was taken as
z’t = z + zI_
thus
z’ I=             ’ : for 1954-5, 1957-8, 1958-9 )_ for 1955-6,
for 1956-7
0 otherwise                         j
Least-square estimation then yielded the following
results:
LM = 1.200 + 0.8238 LI + 0.5574 (LX + LB ) + ii.416 Z
a(0.1717)    (0.1216) (2.242)
AY- AG = 1.623 + O.5491 AI + 0.9214 (AX +# B ) + 1.7976 ~.e
(0.2761)     (0.1629) a (0.6776)
AYd =- 3.980 + 0.9762 (LY- AG)(o .o81 )
AC 32.520 + 0.6469 /Yd + 508 81 Yd
~+(0.0685)     (100.58) Yd
I I
2.071)
- 6 -
All regression coefficients are significant at
the I0% level, and all except those of ,’ I in the second
and z in the fourth equation at the 5% level at least.
The coefficients of determination and standard errors
of estimate (in ~ mill) are as follows:
R2       Se
’k~ . 948 5 . 30
/¥ _ A G
.944 7.09
/Yd .9~5 6.91
/C ,937 5.84
The coefficients of determination are high for
equations in terms of first differences,    This is
satisfactory though it does not prove the specification
to be correct as there is a fair degree of correlation
between most national accounts data even in terms of
first differences.     There remain moderately high
unexplained elements in the endogenous variables as
evidenced by the standard errors of estimate,     If the
dummy variable was ommittedfrom the consumption
we wou~Id obtain R2 = .90~ therein.
The first two equations show that fixed investment
has alarger effect upon imports than have expo~ts~ whilst the
opposite applies to domestic production.    This is what
we should expect to find.    The sum of the coefficients
of {,I in the two equations is greater than !~ as is
also the sum of coefficients ell X + t~Ba; thus the
increase in imports and home production which is meeting
increased personal expenditure seems to vary very largely
in ste~ with the increase in exogenous demand.
The consumption function shows that in the
short run about two-thirds of any addition to personal
disposable income tends to be spent.     In the long run,
however~ the proportion of disposable income spent
- 7 -
appears to adjust itself to about .936
52. 5201 - = .9561508.81
since:
Personal disposable income, personal expenditure
and non-agricultural stock changes could be expressed
in terms of predetermined variables if desired.    It
should be noted that government expenditure does then
disappear from these equations.
The model may be applied to 1965-6 and to
1966-7~ though conditions in 1966 have shown so many
abnormal features that this does not constitute a fair
prediction ~est; it rather shows what might have been
expected to happen in more normal circumstances.
Using official and N.I.E.C. estimates and forecasts
[3,6] , estimating Yd as 816 in 1966 for the purpose of
t~e 1967 consumption forecast and assuming a 1966-7
earnings increase of ~ or 6.5 index points, we
obtain for the exogenous variables
/,I
AX
a
/.    e
/Yd- £~"~
Yd :/-1
~
196 5-6 1966-7
-9 17
31 33
-14 -2
9 9
2~.0 6.5
.0949 .0964
The predicted changes in the endogenous
variables then are as follows :
- 8 -
1965- 6
~,~o d el Of fi ci al K~o del
or NIEC
/. ~ 9 5 39.
A Y 67 47 60
/’ Yd 5 3 46
A C 50 24 45
B         2          4             -1o
n
1966- 7
Official
or NIBC
40
67
d4
6
Thus the model gives an estimate of how much
sharper gross national product and personal expenditure
would have risen in 1955-6 in the absence of strikes and
credit restrictions other than those holding back capital
formation¯     On the other hand, a pure model prediction
would give a smaller rise in imports and gross national
product than the N I B C forecast, and with Bn
for 1966, this would imply a fall in non-agricultural
stocks in 1967 by ~4 mill.     In an actual prediction one
would be inclined to make allowance for the deficiencies
in LM and A Y for 1965-6, though it is difficult to see
to what extent.
A number of questions remain unanswered.     To
what extent do the equations formulated and estimated
here have real structural content, and alternatively
how useful are they for prediction ; or else has the
model fallen between two stools?    If using it for
short-term forecasting, should one make use of independent
information about the endogenous variables, particularly
about non-agricultural stock changes, and if so, in
what way?    There is no simple answer to these questions.
What seems to have been established is the possibility
of building a reasonably satisfactory recursive macro-
economic model which includes a consumption function as
an integral part, and which permits fur.tker elaboration
by both improving the existing and a~ding on further
relationships.
[I]
[2]
[3]
[43
[s]
[6]
- 9 -
RHFHRHNCHS
Central Statistics Office, National income and
expenditure 1962~ 1964t 1965.
gconomic Research Institute, Staff of~ The Irish
~conomy in 1966a    H.S.R.I. Paper No. 33.
~inance, Department of,
for 1967.
Review of 1966 and Outlook
Friend, l.and Jones) R: C., Short-run forecasting
models incorporating anticipatory data" Models
of income de-termination,    Princeton 1964.
Leser, C: F~. V. ,
1966, E. S. R. !.
The Irish F~conomy in 1964 and
Paper No. 2’2.
National Industrial gconomic Council, Comments on
Department of Finance Report. ’Review of 1966 and
Outlook for 1967," Report No. 2U.


A New Basic Model of the Irish Economy. ESRI Memorandum Series No. 41 1966(?)

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