Static vs Dynamic – should we care?

The new model allows researchers and policymakers to track the economic effects of an underlying shock to changes in the circular flow of income among the different agents in the economy.

The recent development of a Static Computable General Equilibrium model for Malta, jointly between the Central Bank of Malta, the University of Malta, and the University of Macerata, has added a useful tool to the armoury of models employed by the Ministry of Finance and the Central Bank of Malta, both to understand better the impact of shocks to certain economic variables on the rest of the economy and government finances as well as to enable policymakers to get a better handle on the likely effects of certain decisions.

In layman’s terms, the new model allows researchers and policymakers to track the economic effects of an underlying shock to changes in the circular flow of income among the different agents in the economy, be they producers, consumers, or government. Additionally, because the model contains highly disaggregated information on the real gross value added of 44 commodities and on 44 economic activities, it yields a precise sectoral analysis of the total effects generated by that economic shock or policy implementation.

For example, the developers of the model considered a 1 per cent increase in investment and what happens to the gross value added (GVA) of 10 commodities most likely to be impacted by the increase.  All the commodities in question would see their GVA increase by between 0.17 per cent (the lowest impact on activities of membership organisation) to 0.84 per cent (the highest impact on mining, quarrying and construction).

They also found that the 1 per cent increase in investment would boost capital formation by 1.19 per cent, private consumption by 0.12 per cent, real GDP by 0.09 per cent, real disposable income by 0.12 per cent, and employment by 0.16 per cent.  Additionally, the government balance would improve by 0.06 per cent of GDP.  However, there would be an increase of 0.10 per cent in prices and consumption, and a deterioration of the current external balance of payments with a minor negative impact on exports compounded by a much larger imports bill.

A simulation of the impact of a 1 per cent appreciation of the exchange rate on gross value added of ten activities showed that there would be adverse impacts in all of them, ranging from -0.09 per cent in advertising to -0.24 per cent in the wholesale trade.

The same 1 per cent appreciation of the exchange rate yielded the result that capital formation would increase by 0.09 per cent, private consumption by 0.32 per cent, and real disposable income by 0.33 per cent.  The government balance would remain practically the same. However, in comparison with the previous simulation, there would be decreases in prices (-0.62 per cent), real GDP (-0.07 per cent), employment (-0.18 per cent), and in the trade balance (around -0.20 per cent). 

Finally, the effects of an increase in household income tax were explored.  Here too, the impact on the GVA of 10 economic activities would be quite negative, ranging from -1.70 per cent in the manufacture of textiles and clothing to -2.49 per cent in real estate.

Not unexpectedly, the only positive impacts here would be an improvement of 0.80 per cent in the government balances and one of 0.38 per cent in exports, whereas all the other parameters (real GDP, prices and consumption, gross capital formation, real disposable income, and employment) would see declines.  The most notable would be drops of -2.65 per cent in real disposable income, -2.71 per cent in consumption, and -0.84 per cent in employment.

As I said, this economic model is a static one.  It helps understand the relationship between different macroeconomic variables, say consumption., income and investment, when the economy is in a stable or stationary position at a particular point in time.  So, it is not possible to explain the process of change and how any adjustment has taken place.  Without going into too much technical jargon, the layman shouldn’t find it difficult to understand that a simplistic model of a state of equilibrium would be Y=C+I, where Y = National income/output, C = total consumption expenditure, and I = Total investment expenditure. So aggregate supply (Y) is equal to aggregate demand (C+I).  Provided there is no disturbance, the equilibrium between demand and supply will be maintained at some level E.

Mind you, the policymaker can analyse the equilibrium at different points in time and can then compare one or more equilibriums.  So, the original equilibrium might be achieved at a point where the National income is E whereas an increase in investment might cause a different equilibrium to be achieved at a higher National income E1 or a decrease in investment might lead to an equilibrium at a lower National income E2.  But that’s it.  The policymaker is none the wiser how the economy’s complicated mechanism actually moved from one equilibrium to the other, though he can now make easy comparisons between them.

Let me give an illustration.  For example, in a static model there can be no changes in savings or dissavings, since otherwise assets would be changing.  That is, the net investment of a particular economic sector must be zero (gross investment = depreciation), the savings of a household must be zero, and the savings of the government must be zero (a balanced budget).   Again, the model must assume that there is no excess labour and capital (otherwise, for example, excess labour would lead to a decrease in wages), and production must be equal to sales (otherwise if production is greater than sales, then goods will pile up in warehouses).  Similarly, Interest rates must be static and the financial market in equilibrium.

Obviously, in the real world nothing is static.  This is why the Central Bank also has what is known as a dynamic equilibrium model.  In such a model, the policymaker can analyse not only where any new equilibrium is established but also how the economy got to it.  In other words, he will be able to see the particular path followed by the economy and how long it took it to get from one equilibrium to another. 

Let me relate this to the real world.  I come from the world of aviation, so I know that an aircraft flies in a dynamic state only if its direction, height and speed are uncertain.  All three could change if the aircraft goes into an area of turbulence or if the aircraft has to make an unexpected rapid descent to avoid another aircraft unexpectedly flying nearby.  That uncertainty is also present in the real world economy, where it is extremely difficult, if not impossible, to make correct predictions about such fluctuations. 

Earlier, I talked about an increase in household tax and its effects.  OK, the researchers established that it would lead to a reduction in consumption.  But how?  We do not know exactly why.  Was it because households, having become relatively poorer, have decided to have less children, thus probably leading to a decrease in the population?  Or was it because the members of the household changed their spending habits, eating more food but going to the cinema less often?  In a static model, we just don’t know.  We also do not know at what rate these changes are occurring.

I can give you another example.  Being involved in the study of poverty, I could tell you that, if minimum wages remain stuck at a low level while other wages are increasingly rapidly, it is more than likely that a higher number of people would become at risk of poverty.  But I wouldn’t know why; whether it is because prices of good in general increased and made the real income of such people lower or whether it is because the physical or mental health of the people concerned deteriorated and they became unemployed.

One might therefore reasonably conclude that it is always better to use a dynamic model for policymaking purposes.  But, alas, dynamic models also have their shortcomings.  They are hugely complex, cannot keep up with the speed at which economic factors change, are subject to differences in interpretation, and can go completely wrong if a major crisis – like Covid, for example –  makes people behave irrationally.

It is no wonder, then, that policymakers have such a difficult life.  Nothing is ever guaranteed, except that, more often than not, they will get it wrong.  And woe to them when they do, because the man in the street doesn’t give a fig about whether the model they used was static or dynamic.

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