UNIVERSITY OF JOHANNESBURG

Department of Economics and Econometrics

Semester test 1: 23 August 2010

Course: Econometrics honours

Model building

Examiners: Dr I Botha

Time: 90 minutes

Marks: 75

This paper consists of 2 pages.

An Excel file is provided, with data that can be used to answer the question.
Question 1 [32]
1. Discuss the modeling conflicts that Adrian Pagan report on in the
Pagan report for the UK economy. [10]
Modelling conflicts
As recounted above, the history of economic modeling can be regarded as one of
attempting to solve a conflict between the distinct desires that a model should be
both
theoretically and empirically coherent. By the first we mean that the model
outcomes can be explained by reference to some agreed-upon conception of the
way in which the economy is thought to function, while the second relates to the
ability of the model to explain the history of that economy. For many reasons it
has proven impossible to satisfy both desires simultaneously, and therefore a
trade-off is perceived to exist. One might conceive of this trade-off as a curve like
that in Figure 1. At one end of the curve are theoretical models that have never
been exposed to an historical data set, while, at the other, there are models that
fit every quirk in the data set but whose outcomes are impossible to interpret.
Being at either of these points is not particularly attractive to a policy-maker and
so models used in the
policy process have always been located along the interior points on the curve.
Of the categories of models listed previously, DSGE models tend to be closer to
the left-hand end of the curve, while the early macro models were close to the
right-hand end. Over time the curve has shifted outward and it has been possible
to attain the same degree of empirical oherence with stronger theoretical
constructs. Often this has simply been a reflection of
the development of computer power: some theoretical models that today appear
to provide a reasonable match to the data could not have been solved 20 years
ago.
At any point in time, there will be a frontier of ‘best-practice’ models that shows
the combinations of empirical and theoretical coherence that are attainable.
There is no precise way of determining this frontier but sometimes opinions form
about what is on and off the
frontier. Thus, Type I hybrid models would now seem to be below the frontier, as
one can achieve the same degree of empirical coherence with a clearer
theoretical structure by using their Type II cousins. However, just as with all trade-
offs in economics, where a model is located on the best-practice curve is a
function of the constraints that come from the institutional structure in which the
models are to operate. For academics, best practice, or what is ‘state of the art’
for them, tends to be taken as being towards the left-hand end of the curve,
although in recent times they have shown a greater interest in attaining empirical
coherence. For policy modellers it has always been towards the right-hand end,
although, as we have documented, the adoption of the hybrid class of models has
moved the standard much closer to the centre of the curve, while the IDSGE
models of some central banks lie even further up towards the left-hand end.

2. Explain the identification problem that occurs when using simultaneous

equation models. [10]
Problem of determining the structural equations, given knowledge of
the reduced form, this is the identification problem. Can we obtain
knowledge of the structural parameters once reduced form is
estimated. Un, exactly, over. Examle supply and demand Q = a+P+e
only info is market values of P and Q and where they intersect is the

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 equilibrium. No way to determine true supply and demand slopes
given only equilibrium data. Cannot determine the structural
parameters from the reduced form because rf = only equal to the errors
– cannot determine slopes and intercepts from this. So a lot of demand
and supply curves consistent with the same rf. Even with infinite data
points the demand and supply curve will be unidentified. To be
identified we need further information. Add another variable to demand
such as income, so now income determines demand and income vary
over time – so the demand curve will shift, forming the supply curve.
So identification is possible by the existence of prior info about the
exogenous variable, income. The supply curve is identified because of
the excluded exogenous variable that is included in the demand curve.
If we include a variable in the supply curve not in the demand, demand
will be identified.
3. Make use of a diagram and explain and define the simulation time
horizons. [10]
Backcasting
Expost simulation of historical simulation (estimation period T1 to T2)
Ex post forecast (T2-T3 (today))
Ex ante forecast
4. What are the main reasons why simulations of models are performed?
[2]
Model testing and evaluation, historical policy analysis, forecasting
Question 2 [43]

Consider the following simple macroeconomic model of an economy and

answer the questions that follow:
Ct = α 1 + α 2Yt + α 3rt + ut Eq1

It = β 1 + β 2rt +β 3Yt + ut Eq2

rt = γ 1 + γ 2It + γ 3Mt + ut Eq3

Yt = Ct + It + Gt Eq4

Where:

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Yt = GDP (excluding net exports)
Ct = Consumption expenditure
It = Investment
Gt = Government expenditure
rt = interest rates
M=money demand

1. Which part of the

economy does this model represent? Is this specification a good
representation of the main drivers of the South African economy?
Why? [5]
Gross domestic expenditure; Yes, because we have a demand side
economy driven by consumption.
2. Specify your model
according to the guideline above, report and motivate your
specification. Do these equations comply with the statistical and
econometric criteria? [15]
T’s, F, R, econometric and economic
3. Construct this model in
Eviews and report the block structure of your model. [3]
4. Block 1: 4 Simultaneous Equations (2 feedback vars)
5. chh(1)
i(2)
r(3)
y(4)

6. According to the block

structure of your model how would you change your estimation
method/s and why? [5]

Will use 2sls because we might have and endogeneity problem where
the errors are correlated with the endogenous explanatory variables.
7. Simulate your model
statically and evaluate your results. What does a static solution mean?
[5]
One step ahead forecasts use the actual to forecast.

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Describe each endogenous variable’s performance in the model.
Identify over and under prediction. Possible problems
8. How does the dynamic
solution compare to the static solution? What is the difference between
a static and a dynamic solution? [5]
Describe each endogenous variable’s performance in the model.
Identify over and under prediction. Possible problems
Take your forecast as the actual to make another forecast.
9. Which process will you
follow to make forecasts for this model? [5]
Will make assumptions for M and G before solving the model out of
sample. Will compare the forecasts with the last 5 periods. If there is a
smooth transition the forecasts can be used if there is a definite break
from actual to forecasts residual analysis is needed. Look at the
residuals of the problems identified. If it is not within the 95%
confidence level will add addfactors to correct this residual for the
future. Make new forecasts and repeat until fixed.

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