Economics

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The most recent and complete economic model documentation is available on Pardee's website. Although the text in this interactive system is, for some IFs models, often significantly out of date, you may still find the basic description useful to you.

The economics model of IFs forecasting system draws on two general modeling traditions. The first is the dynamic growth model of classical economics. Within IFs the growth rates of labor force, capital stock, and multifactor productivity largely determine the overall size of production and therefore of the economy. The second tradition is the general equilibrium model of neo-classical economics. IFs contains a six-sector (agriculture, raw materials, energy, manufactures, services, and ICT) equilibrium-seeking representation of domestic supply, domestic demand, and trade. Further, the goods and services market representation is embedded in a larger social accounting matrix structure that introduces the behavior of household, firm, and government agent classes and the financial flows they determine. 

Goods and Services Market

 

System/Subsystem
Goods and Services
Organizing Structure
Endogenously driven production function represented within a dynamic general equilibrium-seeking model
Stocks
Capital, labor, accumulated technology
Flows
Production, consumption, trade, investment
Key Aggregate  Relationships 
(illustrative, not comprehensive)
Production function with endogenous technological change; price movements equilibrate markets over time
Key Agent-Class Behavior  Relationships
(illustrative, not comprehensive)
Households and work/leisure, consumption, and female participation patterns;
 
Firms and investment;
 
Government decisions on revenues and on both direct expenditures and transfer payments

Households, firms, and the government interact via markets in goods and services. There are obvious stock and flow components of markets that are desirable and infrequently changed in model representation. Perhaps the most important key aggregate relationship is the production function. Although the firm is an implicit agent-class in that function, the relationships of production even to capital and labor inputs, much less to the variety of technological and social and human capital elements that enter a specification of endogenous productivity change (Solow 1957; Romer 1994), involve multiple agent-classes. In the representation of the market now in IFs there are also many key agent-class relationships as suggested by the table.

 

Financial Flows / Social Accounting

 

System/Subsystem
Financial
Organizing Structure
Market plus socio-political transfers in Social Accounting Matrix (SAM)
Stocks
Government, firm, household assets/debts
Flows
Savings, consumption, FDI, foreign Aid, IFI credits/grants, government expenditures (military, health, education, other) and transfers (pensions and social transfers)
Key Aggregate  Relationships 
(illustrative, not comprehensive)
Exchange rate, movements with net asset/current account level; interest rate movements with savings and investment
Key Agent-Class Behavior  Relationships
(illustrative, not comprehensive)
Household savings/consumption;
 
Firm investment/profit returns and FDI decisions;
 
Government revenue, expenditure/transfer payments;
 
IFI credits and grants

Households, firms, and the government interact in markets, but more broadly also via financial flows, including those related to the market (like foreign direct investment), but extending also to those that have a socio-political basis (like government to household transfers). A key structural representation is the Social Accounting Matrix (SAM).

The structural system portrayed by SAMs is well represented by stocks, flows, and key relationships. Although the traditional SAM matrix itself is a flow matrix, IFs has introduced a parallel stock matrix that captures the accumulation of assets and liabilities across various agent-classes. The dynamic elements that determine the flows within the SAM involve key relationships, such as that which constrains government spending or forces increased revenue raising when government indebtedness rises. Many of these, as indicated in the table, represent agent-class behavior.

The model can represent the behavior of households with respect to use of time for employment and leisure, the use of income for consumption and savings, and the specifics of consumption decisions across possible goods and services. And it represents the behavior of governments with respect to search for income and targeting of transfers and expenditures, in interaction with other agents including households, firms, and international financial institutions (IFIs).

IFs thus represents equilibrating markets (domestically and globally) in goods and services and in financial flows. It does not yet include labor market equilibration.

Dominant Relations: Economics

 In any long-term economic model the supply side has particular importance. In IFs, gross domestic product (GDP) is a function of multifactor productivity (MFP), capital stocks (KS), and labor inputs (LABS), all specified for each of six sectors. This approach is sometimes called a Solowian Cobb-Douglas specification, but IFs helps the user get inside the multifactor productivity term, rather than leaving it as a totally exogenous residual.

The following key dynamics are directly related to the dominant relations:

  • Multifactor productivity is a function partly of exogenous specification of an annual growth rate in it for the systemic technology leader, base rates of relative technological advance in other countries determined via an inverted U-shaped function that assumes convergence with the leader, and of an exogenously specified additive factor for control of specific regions or countries.
  • Multifactor productivity is, however, largely an endogenous function of variables determined in other models of the IFs system representing the extent of human, social, physical, and knowledge capital; their influence on production involves coefficients that the user can control.
  • Capital stock is a function of investment and depreciation rates. Endogenously determined investment can be influenced exogenously by a multiplier and the lifetime of capital can be changed.
  • Labor supply is determined from population of appropriate age in the population model (see its dominant relations and dynamics) and endogenous labor force participation rates, influenced exogenously by the growth of female participation.

The larger economic model provides also representation of and some control over sector-specific consumption patterns; trade including protectionism levels and terms of trade; taxation levels; economic freedom levels; and financial dynamics around foreign aid, borrowing, and external debt.

Social Accounting Matrix Approach in IFs

A SAM integrates a multi-sector input-output representation of an economy with the broader system of national accounts, also critically representing flows of funds among societal agents/institutions and the balance of payments with the outside world. Richard Stone is the acknowledged father of social accounting matrices, which emerged from his participation in setting up the first systems of national accounts or SNA (see Pesaran and Harcourt 1999 on Stone’s work and Stone 1986). Many others have pushed the concepts and use of SAMs forward, including Pyatt (Pyatt and Round 1985) and Thorbecke (2001). So, too, have many who have extended the use of SAMs into new frontiers. One such frontier is the additional representation of environmental inputs and outputs and the creation of what are coming to be known as social and environmental accounting matrices or SEAMs (see Pan 2000). Another very productive extension is into the connection between SAMs and technological systems of a society (see Khan 1998; Duchin 1999). It is fitting that the 1993 revision of the System of National Accounts by the United Nations began explicitly to move the SNA into the world of SAMs.

The SAM of IFs is integrated with a dynamic general equilibrium-seeking model. The structural representation is a variant and to some degree an extension of the computable general equilibrium formulations that often surround SAMs. In wrapping SAMs into CGEs, Stone was a pioneer, leading the Cambridge Growth Project with Alan Brown. That project placed SAMs into a broader modeling framework so that the effects of changes in assumptions and coefficients could be analyzed, the predecessor to the development and use of computable general equilibrium (CGE) models by the World Bank and others. Some of the Stone work continued with the evolution of the Cambridge Growth Model of the British economy (Barker and Peterson, 1987). Kehoe (1996) reviewed the emergence of applied general equilibrium (GE) models and their transformation from tools used to solve for equilibrium under changing assumptions at a single point in time to tools used for more dynamic analysis of societies.

The approach of IFs is both within these developing traditions and an extension of them on five fronts. The first extension is in universality of the SAM representation. Most SAMS are for a single country or a small number of countries or regions within them (e.g.. see Bussolo, Chemingui, and O’Connor 2002 for a multi-regional Indian SAM within a CGE). The IFs project has created a procedure for constructing relatively highly aggregated SAMs from available data for all of the countries it represents, relying upon estimated relationships to fill sometimes extensive holes in the available data. Jansen and Vos (1997: 400-416) refer to such aggregated systems as using a "Macroeconomic social Accounting Framework." Each SAM has an identical structure and they can therefore be easily compared or even aggregated (for regions of the world).

The second extension is the connecting of the universal set of SAMs through representation of the global financial system. Most SAMs treat the rest of the world as a residual category, unconnected to anything else. Because IFs contains SAMs for all countries, it is important that the rest-of –the-world categories are mutually consistent. Thus exports and imports, foreign direct investment inflows and outflows, government borrowing and lending, and many other inter-country flows must be balanced and consistent.

The third extension is a representation of stocks as well as flows. Both domestically and internationally, many flows are related to stocks. For instance, foreign direct investment inflows augment or reduce stocks of existing investment. Representing these stocks is very important from the point of view of understanding long-term dynamics of the system because those stocks, like stocks of government debt, portfolio investment, IMF credits, World Bank loans, reserve holdings, and domestic capital stock invested in various sectors, generate flows that affect the future. Specifically, the stocks of assets and liabilities will help drive the behavior of agent classes in shaping the flow matrix.

The IFs stock framework has been developed with the asset-liability concept of standard accounting method. The stock framework is also an extension of the social accounting flow matrix, and the cumulative flows over time among the agents will determine the stocks of assets or liabilities for all agents. If the inflow demands repayment or return at some point in future, it is considered as liability for that agent and an asset for the agent from which the flow came. For example, in IFs, if a government receives loans (inflow) from other countries, the stock of those loans is a liability for the recipient government and an asset for the country or countries providing the loans.

The fourth extension is temporal and builds on the third. The SAM structure described here has been embedded within a long-term global model. The economic module of IFs has many of the characteristics of a typical CGE, but the representation of stocks and related agent-class driven behavior in a consciously long-term structure introduces a quite different approach to dynamics. Instead of elasticities or multipliers on various terms in the SAM, IFs seeks to build agent-class behavior that often is algorithmic rather than automatic. To clarify this distinction with an example, instead of representing a fixed set of coefficients that determine how an infusion of additional resources to a government would be spent, IFs increasingly attempts partially to endogenize such coefficients, linking them to such longer-term dynamics as those around levels of government debt. Similarly, the World Bank as an actor or agent could base decisions about lending on a wide range of factors including subscriptions by donor states to the Bank, development level of recipients, governance capacity of recipients, existing outstanding loans, debt-to-export ratios, etc. Much of this kind of representation is in very basic form at this level of development, but the foundation is in place.

The fifth and final extension has already been discussed. In addition to the SAM, The IFs forecasting system also includes a number of other models relevant to the analysis of longer-term forecasts. For example demographic, education, health, agriculture, and energy models all provide inputs to the economic model and SAM, as well as responding to behavior within it. The effort is to provide a dynamic base for forecasts can be made well into the 21st century. It is important to quickly emphasize that such forecasts are not predictions. Instead they are scenarios to be used for thinking about possible alternative longer-term futures.


 As a graduate student in what is now the Josef Korbel School of International Studies, Anwar Hossain worked with Barry Hughes in the development of the SAM structure and database for IFs (see Hughes and Hossain 2003); his help was much appreciated.

Economic Flow Charts

Overview

This section presents several block diagrams that are central to the two major components of the economics model, the goods and services market—with special emphasis on the production function— and the broader SAM. 

The economic model represents supply, demand, and trade in each of six economic sectors: agriculture, primary energy, raw materials, manufactures, services, and information/communications technology. The model draws upon data from the Global Trade and Analysis Project (GTAP) with 57 sectors as of GTAP 8; the pre-processor collapses those into the six IFs sectors and theoretically could collapse them into a different aggregated subset.

Inventories (or stocks) are the key equilibrating variable in three negative feedback loops. As they rise, prices fall, increasing final demand (one loop), decreasing production (a second loop), and thereby in total decreasing inventories in the pursuit over time of a target value and equilibrium. Similarly, as inventories rise, capacity utilization falls, decreasing production, and restraining inventories.
Econ1.png

Physical investment and capital stocks are the key driving variables in an important positive feedback loop. As capital rises, it increases value added and GDP, increasing final demand and further increasing investment. Similarly, government social investment can increase productivity, production and inventories in another positive feedback loop.

The figure below also shows some production detail. A-matrices, which are specified dependent on the level of development (GDP per capita), allow the computation from value added of gross production and of the production that is available, after satisfaction of intersectoral flows, for meeting final demand. It is the balance of this production for final demand with actual final demand that determines whether inventories grow or decline.

The calculation of gross production (ZS) in value terms within the economic model is overridden by calculations of physical production converted to value in the agricultural and energy models when respective switches (AGON and ENON) are thrown as in the default of the IFs Base Case scenario.

Value Added

 A Cobb-Douglas production function determines value added. Thus two principal factors are capital and labor. Labor is responsive not just to population size and structure, but to the labor participation rate, including the changing role of women in the work force. Accumulated growth in the level of technology or multifactor productivity (MFP), in a "disembodied" representation (TEFF), modifies these factors. Immediate energy shortages/shocks can also affect value added.

Valueadd.png

Multifactor Productivity

The technological factor in the production function is often called multifactor productivity (MFP). The basic value of MFP is a sum of a global productivity growth rate driven by the economically advanced or leading country/region (mfpleadr ), a technological premium dependent on GDP per capita, and an exogenous or scenario factor (mfpadd ).

In addition, however, other factors affect productivity growth over time. These include a wide range of variables, such as the years of education that adults have (EDYRSAG25) and the level of economic freedom (ECONFREE), which respectively are among the variables that affect change in MFP associated with human and social capital. 

MFP.png

Economic Aggregates and Indicators

Based on value added and population, it is possible to compute GDP, GDP at purchasing power parity, and a substantial number of country/region-specific and global indicators including several that show the extent of the global North/South gap.
Econaggregatesindic.png

Household Accounts

HHaccounts.png

The most important drivers of household income is the size of value added and the share of that accruing to households. That share, divided further into unskilled and skilled households, is initialized with data from the Global Trade and Analysis Project and changes a function driven by GDP per capita. Household income is augmented by flows from government and firms (dividends and interest). Most of household income will be used for consumption, but shares will go back to the government via taxes and to savings.

Once the total of household consumption is known, if is divided across the sectors of IFs using Engel elasticities that recognize changing use of consumption as levels per capital rise




Firm Accounts

 Firms retain as income the portion of total value added that is not sent to households in return for labor provided. Income of firms functioning within a country (ownership in IFs is not designated as domestic or international) benefit from inflows of portfolio and foreign direct investment. Firms direct their income to governments in the form of tax payments, to households as dividends and interest, to the outside world as portfolio or foreign direct investment, and to savings (available for investment).
Firmaccounts.png

Government Accounts

Govtacc1.png

Government revenues come from taxes levied on households and firms. The total expenditures are a sum of two sub-categories, direct consumption and transfer payments (the latter in turn being a sum of payments for pensions/retirement and welfare.

The annual government balance is the difference between revenues and expenditures and increments or decrements government debt in absolute terms and as a portion of GDP. That stock variable in turn sends back signals to both revenue and expenditure sides of the model so as to keep the debt at reasonable levels over time.

The level of government consumption and its distribution across targets are important policy-relevant variables in the model. Government consumption is spread across several target spending categories: military health, education, traditional infrastructure, other infrastructure, research and development, other/residual, and foreign aid). The distribution to most of those categories is endogenously determined by functions, but other models in the IFs system provide special signals for military, education, and traditional infrastructure spending. Demand for military spending involves action-reaction dynamics (when a switch is turned on) and threat levels. Demand for educational and infrastructure involves full models. Demands will not equal supply and all demands are normalized to the supply, but special protection can be given to the demands for education and infrastructure spending.

Educational spending by level of education (primary, secondary, and tertiary) is further broken out of total educational spending in the education model but targets can be changed via a multiplier. 

Govtacc2.png
Savingsinvestment.png

Savings and Investment

Savings is a sum of the savings by households, firms, the government (its fiscal balance) and net foreign savings. Investment is most immediately a sum of gross capital formation and changes in inventories.

As in other parts of the IFs economic model, there will not be an exact equilibrium between savings and investment in any given time step. The system will chase equilibrium over time with the help of two mechanisms. The smoothed pattern of savings over time will affect investment. So, too, will interest rates that respond to changes in inventories or stocks of goods and services.

Trade

The trade algorithm of IFs relies on a pooled rather than bilateral trade approach. That is, it does not track exactly who trades with whom, maintaining instead information on gross exports and imports by sector and in total. The algorithm sums import demand and export capacity across all traders (in a given sector), defines world trade as the average of those two values, and then normalizes demand and capacity to the total of world trade to determine sectoral exports and imports by geographic unit.

Trade.png

International Finance

The current account depends on international loan repayments and foreign aid flows as well as on the trade balance. The exchange rate floats with the debt level (in turn responsive to the current account balance) and is the key equilibrating variable in two negative feedback loops that work via import demand and export capacity (see description of trade).

Intlfinance.png

Income Distribution

Domestic income distribution is represented by the Gini coefficient. That is calculated with a Lorenz curve that looks at the share of population and income held by the only two subgroups for which we have that information, namely unskilled an
Incomedist.png
d skilled households. That part of the calculation is fundamentally mechanical. The complicated part of the specification is the division of the population into unskilled and skilled labor portions and thus households. We have built formulations for that driven by the formal years of education attained by adults and the GDP per capita.

Given domestic Gini indices, it is also possible to compute global Gini indices, both treating countries as wholes (GINI) and computing across the world at the household level (GINIFULL).













Poverty

The calculation of poverty levels is fairly straightforward if one has the average level of consumption per capita (or income) and its distribution as indicated by the Gini index (and if one assumes that the distribution underlying the Gini index is log-normal). The internal calculation using those variables will, however, almost inevitably produce a rate of poverty at odds with the provided by national surveys. We therefore compute a ratio of those in the first year to allow adjustment in forecast years of the values from the lognormal calculation.

As a rough check on the values produced by lognormal calculation we also compute a value of poverty estimated from a cross-sectional function linking GDP per capita (and PPP) and Gini to rates of poverty.

Poverty.png
Economic Equations

Overview

The growth portion of the goods and services module responds to endogenous labor supply growth (from the demographic model), endogenous capital stock growth (with a variety of influences on the investment level), and a mixture of endogenous and exogenous specification of advance in multifactor productivity (MFP). The endogenous portion of MFP represents a combination of convergence and country-specific elements that together create a conditional convergence formulation.

The equilibrium-seeking portion of the goods and services market module uses increases or decreases in inventories and prices (by sector) to balance demand and supply. Inventory stocks in each sector serve as buffers to reconcile demand and supply temporarily. Prices respond to stock levels. The central equilibrium problem that the module must address is maintaining domestic and global balance between supply and demand in each of the sectors of the model. IFs relies on three principal mechanisms to assure equilibrium in each sector: (1) price-driven changes in domestic demand; (2) price-driven changes in trade (IFs represents trade and global financial flows in pooled rather than bilateral form); and (3) stock-driven changes in investment by destination (changes in investment patterns could also be price-driven, but IFs uses stocks because of its recursive structure, so as to avoid a 2-year time delay in the response of investment).

The economic model makes no attempt through iteration or simultaneous solution to obtain exact equilibrium in any time point. In addition to being observationally obvious, Kornai (1971) and others have, of course, argued that real world economic systems are not in exact equilibrium at any time point, in spite of the convenience of such assumptions for much of economic analysis. Similarly, the SARUM global model (Systems Analysis Research Unit 1977) and GLOBUS (Hughes 1987) used buffer systems similar to that of IFs with the model "chasing" equilibrium over time.

Two "physical" or "commodity" models in IFs, agriculture and energy, have structures very similar to each other and to the economic model. They have partial equilibrium structures that optionally, and in the normal base case, replace the more simplified sectoral calculations of the goods and services market module.

The goods and services market sits within a larger social accounting matrix that tracks financial flows among households, firms, and the government. The integrated economic model also allows computation of income distribution and poverty rates.

The Goods and Services Market

The Production Function: Basic Overview

 Cobb-Douglas production functions involving sector-specific technology or multifactor productivity (TEFF), capital (KS) and labor (LABS) provide potential value added (VADDP) in each sector, taking into account the level of capacity utilization (CAPUT), initially set exogenously (caputtar ). In a multi-sector model the functions require sectoral exponents for capital (CDALFS) and labor that, assuming constant returns to scale, sum to one within sectors.

Solow (1956) long ago recognized that the standard Cobb-Douglas production function with a constant scaling coefficient in front of the capital and labor terms was inadequate because the expansion of capital stock and labor supply leave a large portion of economic growth unexplained. It then became standard practice to represent an exogenously specified growth of technology term in front of the capital and labor terms as "disembodied" technological progress (Allen 1968: Chapter 13). Romer (1994) began to show the value of unpacking such a term and specifying its elements in the model, thereby endogenously representing this otherwise very large residual, which we can understand to represent the growth of multifactor productivity (MFP).

In IFs that total endogenous productivity growth factor (TEFF) is the accumulation over time (hence a stock like labor and capital) of annual values of growth in multifactor productivity (MFPGRO). There are many components contributing to growth of productivity, and there is a vast literature around them. See, for example, Barro and Sala-i-Martin (1999) for theoretical and empirical treatment of productivity drivers; also see Barro (1997) for empirical analysis (or McMahon 1999) for a focus on education.

In the development of IFs there was a fundamental philosophic choice to make. One option was to keep the multi-factor productivity function very simple, perhaps to restrict it to one or two key drivers, and to estimate the function as carefully as possible. Suggestions included focusing on the availability/price of energy and the growth in electronic networking and the knowledge society.

The second option was to develop a function that included many more factors known or strongly suspected to influence productivity and to attempt a more stylistic representation of the function, using empirical research to aid the effort as much as possible. The advantages of the second approach include creating a model that is much more responsive to a wide range of policy levers over the long term. The disadvantages include some inevitable complications with respect to overlap and redundancy of factor representation, as well as some considerable complexity of presentation.

Because IFs is a thinking tool and an extensively integrated multi-model system, the second approach was adopted, and the production function has become an element of the economic model that will be subject to regular revision and enhancement. IFs groups the many drivers of multifactor productivity into five categories, recognizing that even the categories overlap somewhat. The base category is one that represents core technological development and transfer elements of convergence theory, with less developed countries gradually catching up with more developed ones. The four other categories incorporate factors that can either retard or accelerate such convergence, transforming the overall formulation into one of conditional convergence.

The convergence base . The base rate of multifactor productivity growth (MFPRATE) is the sum of the growth rate for technological advance or knowledge creation of a technological leader in the global system (mfpleadr ) and a convergence premium (MFPPrem) that is specific to each country/region. The basic concept is that it can be easier for less developed countries to adopt existing technology than for leading countries to develop it (assuming some basic threshold of development has been crossed). The base rate for the leader remains an unexplained residual in the otherwise endogenous representation of MFP, but that has the value of making it available to model users to represent, if desired, technological cycles over time (e.g. Kondratief waves). The base also includes a correction term (MFPCor) that is initially set to the difference between empirical growth of MFP (calculated the first year as a residual between factor growth and output growth) and the sum of the technological leader and convergence premium terms. Over time, the correction term is phased out, but the four other terms (below) become key drivers of country-specific productivity. In fact, significant change in the other terms can either undercut the foundational convergence process or greatly augment it.

Human capital . This term has multiple components, including changes in educational spending as a portion of GDP, educational attainment of adults, and changes in health expenditure. For example, Barro and Sala-i-Martin (1999: 433) estimated that a 1.5% increase in government expenditures on education translates into approximately a 0.3% increase in annual economic growth.

Social capital . Similarly, social capital representation aggregates several components including economic freedom and absence of overt social conflict. Illustratively, the value of the parameter for economic freedom (elgref ) was estimated in a cross-sectional relationship of change in GDP level from 1985 to 1995 with the level of economic freedom. Similarly, Barro places great emphasis in his estimation work on the "rule of law".

Physical capital . In collaborative work with the IFs project, Robert Ayres correctly emphasized the close relationship between energy supply availability and economic growth. For instance, a rapid increase in world energy prices (WEP) essentially makes much capital stock less valuable. IFs uses world energy price relative to world energy prices in the previous year to compute an energy price term. The physical capital term also represents the extent of various types of infrastructure in a society.

Knowledge Capital . This fourth term includes changes in the R&D spending, computed from government spending (GDS) on R&D as a portion of total government spending (GOVCON) contribute to knowledge creation, notably in the more developed countries. Globerman (2000) reviewed empirical work on the private and social returns to R&D spending and found them to be in the 30-40% range; see also Griffith, Redding, and Van Reenen (2000). Many other factors undoubtedly contribute to superior knowledge development diffusion. This term represents especially the extent of economic integration with the global economy via trade.

All of the elements computed in the human, social, physical and knowledge capital terms are used in shaping economic productivity and growth rates of the model on a differential basis–that is, they are computed and evaluated relative to underlying "expected" patterns given overall economic development levels. Their actual levels can be above or below expected ones and they can therefore either add to or slow down the productivity growth rate. See the detailed equations of the production function for elaboration. <header><hgroup>

The Production Function: Detail

</hgroup></header> The core equation for the production function computes value added (VADD) from technology (TEFF), capital (KS), labor (LABS), and capacity utilization (CAPUT), with a time-constant scaling parameter (CDA) assuring that gross production is consistent with data the first year. GDP is, of course, the sum across sectors of valued added. Although the production function can serve all sectors of IFs, the parameters agon and enon act as switches; when their values are one, production in the agricultural and primary energy sectors, respectively, are determined in the larger, partial equilibrium models and the values then override this computation (see documentation on those models for detail).

http://www.du.edu/ifs/help/media/images/econ-module/econeq1.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq2.png

where

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http://www.du.edu/ifs/help/media/images/econ-module/econeq4.png

Other topics in our documentation explain the dynamics underlying change in capital stock (through investment and depreciation) and labor supply (through demographic change and participation patterns). The rest of this topic will focus on the computation of the elements that go into the MFP or technology term (TEFF), working our way progressively deeper into their determinants.

At the most basic level the stock term is simply an accumulation of the annual increments in MFP. 

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The annual growth in MFP (MFPGRO) consists of a base rate linked to systemic technology advance and convergence (MFPRATE) plus four terms that affect MFP growth over time as a result of human, social, physical, and knowledge capital. 

http://www.du.edu/ifs/help/media/images/econ-module/econeq7.png

Each of the following subsections elaborates one of the five terms.

Annual Base Technology Growth in MFP

The base rate related to technology or other factors unexplained by the four capital terms is anchored by an exogenous specification of the sector-specific rate of advance in the systemic leader’s technology (mfpleadr ); the leader is assumed to be the United States. (The rate in the leader's ICT sector gradually convergences over time to that of the service sector.) On top of that is an endogenously computed premium computed for convergence of each country/region (MFPPrem), a term that is a function of GDP per capita at PPP, the function for which posits an inverted-V shape with the greatest potential for technological convergence to the leader among middle-income countries. In this calculation there needs to be a correction factor (MFPCor), computed to assure that the actual rate of this growth is consistent with the actual amount of growth for a country/region (MFPGRO) that is unexplained by capital and labor growth in the first model run year. That correction factor converges to 0 over the number of years specified by mfpconv . This convergence assumption has significant implications for model behavior because it tends to slow down growth in countries (like China) that have had a burst of growth beyond that which the rates of the leader and the catch-up factor would lead us to anticipate and to speed up growth in countries (like the transition states of Central Europe) that have suffered a reduction similarly unexpected by the basic formulation.

http://www.du.edu/ifs/help/media/images/econ-module/econeq8.png

where

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http://www.du.edu/ifs/help/media/images/econ-module/econeq10.png&nbsp;and

http://www.du.edu/ifs/help/media/images/econ-module/econeq11.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq12.png

It is possible for the regionally and sectorally specific MFP correction terms (MFPCOR) to still leave a small discrepancy between the global economic growth in the data and the initial growth rate in the model. To avoid this, we also compute a global correction factor (MFPGloCor) as the region/country and value added weighted sum of the individual country-sector terms divided by the global and regional sums of value added.

In addition to the basic technology terms and the correction factors, there are three parameters in the MFPRATE equation (with zero values as the default) that allow the model user much control over assumptions of technological advance. The first is basic parameter (mfpbasgr ) that allows a global growth increment or decrement; the second is a parameter (mfpbasinc ) that allows either a constant rise or slowing of growth rate globally, year by year, where zy is the count of the model run years across time; finally is a frequently-used parameter (mfpadd ) allowing flexible intervention for any country/region.

Driver Cluster 1: Human Capital

The general logic of each the four driver clusters around human, social, physical, and knowledge capital is the same. Each cluster aggregates several variables that generally contribute to productivity. For each variable, such as average years of adult education in the human capital cluster, there is an expected value and an actual value. It is the difference between actual and expected values that gives rise to a positive or negative contribution to productivity and growth. Most expected values are identified in a relationship with GDP per capita at PPP.

That is, there is a tendency for most developmentally supportive variables to advance in a rough relationship with each other and with GDP per capita (Kuznets 1959 and 1966; Chenery and Syrquin 1975; Syrquin and Chenery 1989; Sachs 2005). To the degree that they do, such advance can be understood to be consistent also with the overall technological advance of the country. If, however, a variables such as years of formal education attained by adults exceeds the typical or expected value for a country at a given level of GDP per capita, we can expect that variable to add something more to productivity. Similarly, falling behind the expected value could retard productivity advance. To illustrate and emphasize this point, even a country for which adult education levels advance could find that education is not keeping up with the advance in other developmental variables including GDP per capita and find that its education levels move from contributing to productivity enhancement to decrementing that productivity enhancement.

In the human capital cluster there are six variables that add to or subtract from the human capital (MFPHC) term: the educational spending contribution (EdExpContrib), the years of adult education contribution (EdYearsContribub), the boost from life expectancy years (LifExpEdYrsBoost) assumed to generate (via mfpedlifexp ) extra years of education, the stunting contribution (StuntContrib) related to undernutrition of children, the disability contribution (DisabContrib) related to morbidity from the health model, and vocational education contribution (edVoccontrib) resulting from growth (or decline) in vocational share of lower and upper secondary enrollment,. The first five of these six drivers have a similar formulation while the formulation for vocational education is slightly different. The first five, as computed in IFs often as a result of extended formulations and even other models of system (as with life expectancy, computed in the health model) are compared with an expected value. In the case of disability, the expected value is set to the world average level (WorldDisavg), but all other expected values (EdExpComp, EdYrsComp, LifExpComp, and StuntingComp) are computed as functions of GDP per capita at PPP. As the provision of vocational education does not follow any common pattern or trend and is rather a matter of policy choices made (or will be made) by the particular country, it was not possible to calculate an expected value for this variable We have instead computed the vocational education contribution from changes in vocational share over time with appropriate moving averages to capture the lag required in materializing such contribution and to smooth out the contribution over time. (Note: In the base case of the model, vocational shares do not change and as such EdVocContrib is zero).

In each case a parameter drawn from study of the literature and/or our own analysis converts the difference between actual and expected into a positive or negative contribution to MFP. (Because of the recursive structure of IFs, some terms rely on variables from the previous time step, estimated from the current time step with a correction factor based on initial GDP growth.)

http://www.du.edu/ifs/help/media/images/econ-module/econeq13.png

where

http://www.du.edu/ifs/help/media/images/econ-module/econeq14.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq15.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq16.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq17.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq18.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq19.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq20.png

where

Vocational contribution for lower secondary is calculated as:

http://www.du.edu/ifs/help/media/images/econ-module/econeq21.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq22.png

A similar calculation is done for upper secondary vocational and the two are averaged as shown below:

http://www.du.edu/ifs/help/media/images/econ-module/econeq23.png

Driver Cluster 2: Social Capital

The logic of comparison of actual with expected values is the same as that described above for human capital in the case of the six factors that contribute to social capital: economic freedom as in the Fraser Institute measure (EconFreeContrib), government effectiveness as in the World Bank measure (GovtEffContrib), corruption as in the Transparency International measure (CorruptContrib), democracy as in the Polity project measure (DemocPolicyContrib), freedom as in the Freedom House measure (FreedomContrib), and conflict as in the IFs project's own measure tied in turn to the work of the Political Instability Task Force (ConflictContrib). In each case other than that for conflict, the expected values (EconFreeComp, GovEffectComp, CorruptComp, DemocPolityComp, and FreeComp) are computed from functions with GDP per capita at PPP. In the case of conflict, the expected value is set at the initial year's value (and the comparison is reversed because lower conflict values contribute positively to MFP).

http://www.du.edu/ifs/help/media/images/econ-module/econeq24.png

where

http://www.du.edu/ifs/help/media/images/econ-module/econeq25.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq26.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq27.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq28.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq29.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq30.png

Driver Cluster 3: Physical Capital

The logic of the physical capital cluster is again parallel to that of the human and social capital clusters and involves the comparison of an actual (that is, IFs computed) with an expected value. The formulation for MFPPC can actually take several forms depending on the value of a switching parameter (inframfpsw ) but the standard form involves four contributions, from traditional infrastructure (InfraTradContrib), ICT infrastructure (InfraICTContrib), other infrastructure spending level (InfOthSpenContrib), and the price of energy (EnPriceTerm). The last term is included because higher prices of energy can make some forms of capital plant no longer efficient or productive.

In the case of this cluster only the expected value of the traditional infrastructure index (InfraIndTradComp) and the expected value of other infrastructure spending (InfraOthSpendComp) are computed as most other cluster elements are, namely as a function of GDP per capita at PPP. In the case of the ICT index contribution, the technology has been evolving so rapidly that there is not really a basis for an expected value with some stability over time. Instead the contribution from ICT is computed in terms of a moving average value of change over time, such that faster rates of change contribute more to MFP as the moving average expected value lags further behind the actual. In the case of the energy price term, the "expected" value is set equal to the energy price in the first year of the model run. As with other clusters and the variables in them, a single parameter links the discrepancy between actual and expected values to MFP.

http://www.du.edu/ifs/help/media/images/econ-module/econeq31.png

where

http://www.du.edu/ifs/help/media/images/econ-module/econeq32.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq33.png

where

http://www.du.edu/ifs/help/media/images/econ-module/econeq34.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq35.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq36.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq37.png

Driver Cluster 4: Knowledge Capital

Following the pattern of other MFP driver clusters, the one for knowledge accumulation includes terms that compare actual model and typical or expected values and use parameters to translate the differences into increments or decrements of MFP. In this case the three terms represent R&D spending (RDExpContrib), economic integration via trade with the rest of the world (EIntContrib) and the share of science and engineering among all tertiary degrees earned (EdTerSciContrib). In the first and third case the expected value (RDExpComp; EdTerGRSciEnComp) is a function of GDP per capita at PPP. In the second instance, there is no clear relationship between extent of economic integration and GDP per capita, so the model compares a moving average of trade openness (exports plus imports as a percentage of GDP) with the initial value of openness (because trade is computed later in the computational sequence for each year, the values of trade variables lag one year behind those of the production function). Given the extreme global range of trade openness, the elasticity term itself in this relationship is variable, with values decreasing when initial openness is greater (that is, countries that start with less openness gain more from the same percentage point increases in it).

http://www.du.edu/ifs/help/media/images/econ-module/econeq38.png

where

http://www.du.edu/ifs/help/media/images/econ-module/econeq39.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq40.png

where

http://www.du.edu/ifs/help/media/images/econ-module/econeq41.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq42.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq43.png

http://www.du.edu/ifs/help/media/images/econ-module/econeq44.png

Issues Concerning Parameterization and Interaction Effects

Although our approach to calculation of MFP creatively connects developments in many other models in the IFs system to it, parameterization of the effects individually and in interaction is complicated and uncertain. Hughes (2005) documented the original creation of the structure and its parameterization based on existing literature.

One of the concerns with this approach is the possibility of double counting of effects from the large number of variables fed into the MFP calculations. In general the project has dealt in part with this by selecting conservative values for the parameters when studies indicate possible ranges of contribution of the variables to productivity and/or growth. Another concern is that a very large or extreme advance by one or a small subset of variables could have inappropriately large impacts of productivity given the fundamental conceptual foundation of the approach in the notion that development involves widespread and reinforcing structural changes across many variables. In order to limit this possibility, we have created an algorithmic function (MFPContribAdj) to adjust the multiple MFP contributions and dampen especially high positive or negative contributions of the four cluster terms (MFPHC, MFPSC, MFPPC, and MFPKN). 

The Relationship of Physical Models to the Economic Model

IFs normally does not use the economic model's equations representing MFP and production for the first two economic sectors, because the agriculture and energy models provide gross production for them (unless those sectors are disconnected from economics using the agon and/or enon parameters). Instead, the two physical models provide gross production, translated to value terms, back to the economic model. See Section 3.2.3 for discussion of gross production.

In addition to this impact of the physical models on the economic model, there is one more of importance. Physical shortages on energy may constrain actual value added in each sector (VADD) relative to potential production. Economists typically do not accept such shortages as a real world phenomenon because (at least in theory) prices rise to clear markets; yet periods like the 1970s when governments intervened in those markets, such shortages do appear and they can in some IFs scenarios. In those situations, IFs assumes that energy shortages (ENSHO), as a portion of domestic energy demand (ENDEM) and export commitments (ENX) lower actual production in all sectors through a physical shortage multiplier factor (SHOMF). A parameter/switch (squeeze ) controls this linkage and can turn it off.

http://www.du.edu/ifs/help/media/images/econ-module/econeq45.png

where

http://www.du.edu/ifs/help/media/images/econ-module/econeq46.png

In addition, the translation of potential into actual production depends on the imports of manufactured goods (MKAV), which serve as a proxy for both availability of intermediate goods and for technological imports. A parameter (PRODME) also controls this relationship.

Although the IFs model represents prices in real terms (no monetary sector and no inflation), there are relative sectoral price changes (PRI). Some of those can be quite dramatic over time, especially in the agricultural and energy sectors where the equilibration of physical representations of supply and demand can swing those prices. Such relative price swings can, in the real world, give added drag or boost to the value added in certain sectors and for economies as a whole. To represent this we compute a relative-price adjusted version of value added (VADDRPA), which is the normal value added weighted by world sectoral prices (WP); the prices are lagged a year because of the recursive model structure.

http://www.du.edu/ifs/help/media/images/econ-module/econeq47.png