Excel-based Macroeconomic Simulator

Welcome to the Macroeconomic Simulator
The simulator has been designed and programmed by Javier Lozano, Lecturer in Economics, University of the Balearic Islands, using models from the book.

Download The Macroeconomic Simulator.

What can the simulator do?

The simulator allows you to analyze a wide range of scenarios using the IS-PC-MR model of the book and the model of debt dynamics.

Using the simulator, you can replicate the macroeconomic scenarios already considered in the book (as for instance, the effect of a temporary positive demand shock in a closed economy). This allows students to become familiar with the dynamic adjustment processes in the models. They can plot the impulse-response functions and match them with the adjustment to shocks set out in diagrams, text and equations in the book.

There are a number of versions of the simulator: closed economy (Chapter 3; IS-PC-MR), open economy with flexible exchange rates (Chapter 9; IS-PC-MR-RX), and open economy with fixed exchange rates (Chapter 12), which comes with two variations – with and without an endogenous stabilizing fiscal policy rule. The debt dynamics component matches the presentation in Chapter 14.

The simulator allows you to:

• Analyze in an accessible way complex scenarios (as, for instance, several shocks and policies, either simultaneous or sequential) that are too cumbersome to be tackled algebraically or with the IS-PC-MR diagrams.
• Combine in an integrated way the IS-PC-MR model of Chapter 3 with the public debt model of Chapter 14, considering, for instance, the consequences of macroeconomic shocks and policies for debt sustainability.
• Understand case studies and current macroeconomic policy issues. Examples are provided below.
• Consider the implications for stabilization of the presence of random shocks.
• Analyze the effects of shocks and disinflationary policies with different degrees of hysteresis.
• Play a monetary policy game, based on the IS-PC-MR model, where the student sets the nominal interest rate.
• Choose the type of economy (closed or open) and exchange rate regime (flexible/fixed; with endogenous/exogenous fiscal policy).
• Choose from a range of shocks: demand shock, supply shock, inflation shock, shock to commercial banks’ risk premium.
• Calibrate the model with parameter values of your choice, varying the sensitivity of inflation to the output gap, the sensitivity of expenditure to the interest rate and the degree of inflation inertia/ credibility of the central bank’s inflation target.
• Look at the model’s results displayed in time series figures as impulse response functions rather than in IS-PC-MR figures. This allows students both to develop their intuition about the effects of shocks and parameter changes and to compare the time paths of outcomes with those in real world economies.

Where are the simulator exercises in the book?

Chapter 3, p. 113-115
Chapter 4, p. 147
Chapter 9, p. 329-330, 349
Chapter 12, p. 444-445, 465
Chapter 14, p. 544

More exercises for the simulator to illustrate its potential for classroom use

1. The crisis, the zero lower bound and the inflation target (see Chapters 3, 7 and 13).
2. Changes in taxation: the demand and supply side models (Chapters 1, 2 and 3)
3. Inflation expectations and economic performance in the 1970s (Chapters 2 – 4; also 6)
4. The Great Moderation (Chapters 3 and 4)
5. Anchored inflation expectations and the deflation trap (Chapters 3, 4, 7, 13)
6. The simulator meets real world data: the Japanese economy since the 1990s (Chapters 3, 4, 13)
7. The simulator meets real world data: macroeconomic behaviour of the Eurozone between 2005 and 2013 (Chapter 12)
8. This exercise explores the effects of demand shocks and disinflationary policy in an economy with hysteresis effects

1. The crisis, the zero lower bound and the inflation target (see Chapters 7 and 13)

Read the following excerpt from an article written by Oliver Blanchard and co-authors entitled ‘Rethinking macroeconomic policy’ published in 2010.

“When the crisis started in earnest in 2008, and aggregate demand collapsed, most central banks quickly decreased their policy rate to close to zero. Had they been able to, they would have decreased the rate further: estimates, based on a simple Taylor rule, suggest another 3 to 5 percent for the United States. But the zero nominal interest rate bound prevented them from doing so. One main implication was the need for more reliance on fiscal policy and for larger deficits than would have been the case absent the binding zero interest rate constraint.

It appears today that the world will likely avoid major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates, and a larger and larger output gap. But it is clear that the zero nominal interest rate bound has proven costly. Higher average inflation, and thus higher nominal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions.”

Source: Blanchard, O.; Dell’Ariccia, G. and Mauro, P. (2010). “Rethinking macroeconomic policy” Journal of Money, Credit and Banking, 42(S1), pp.199-215. (An earlier version is available here).

Now open the simulator and choose the closed economy version. Then reset all shocks by clicking the appropriate button on the left-hand side of the main page. Use the simulator and the text above to work through the following questions:

a) Apply a permanent 4.6% negative demand shock when the inflation target is 2%. Save your data. Now apply the same shock when the inflation target is 4%. Save your data. Observe and explain the differences between both scenarios. Explain the relationship between your results and Blanchard’s statements.
b) Now apply the same permanent 4.6% negative demand shock when the inflation target is 3%. Save your data. Do you think the central bank is following the optimal policy (that is, the one set by the MR) in each and every period? Does the central bank manage to set the interest rate below the stabilization rate? Explain your answers. (Hint: show this case using the IS-PC-MR diagram).

2. Changes in taxation: the demand and supply side models (Chapters 1, 2 and 3)

Consider the following hypothetical conversation between three economists about the effects on the economy of a permanent increase in direct taxes on labour income:

ECONOMIST 1: “This policy is contractionary and disinflationary, but only in the short run”
ECONOMIST 2: “The tax increase will have an inflationary effect that will make the central bank put the brake on the real economy. Most of the contractionary effect will be permanent”
ECONOMIST 3: “This measure will not have any effect on inflation and, therefore, no consequences for monetary policy will follow.”

Now, open the simulator and choose the closed economy version. Then reset all shocks by clicking the appropriate button on the left-hand side of the main page.

In the simulator, implement the appropriate shocks and evaluate the validity of each economist’s claim. Can you reconcile their different views? (Hint: think that this policy may have both demand and supply effects.)

3. Inflation expectations and economic performance in the 1970s (Chapters 2 – 4; also 13)

According to some interpretations, the persistently high inflation and low economic growth in the 1970s were due to the inability of monetary authorities to react quickly to the supply shocks of the decade, allowing the spurt in inflation to increase inflationary expectations. For instance, read the following text and figure from the European Central Bank’ monthly bulletin:

“A crucial shortcoming of US monetary policy during those years was its inability to detect the 1970s productivity slowdown in real time, which resulted in a systematic over-estimation of the actual extent of slack existing in the economy. Given the extensive reliance of US policy-makers on output gap measures as indicators of future inflationary pressures, such over-estimation automatically translated into the excessively loose monetary policy.”

Figure Q3. Comparison between retrospective and real time output gaps, USA 1965-1985

Source: ECB (2010) “The «Great Inflation»: lessons for monetary policy”. In the ECB Monthly Bulletin, May 2010. URL:
https://www.ecb.europa.eu/pub/pdf/other/mopo_strat_art1.pdf?b19aa418314b36e5c21fe296a788b20b

When central Banks reacted at the beginning of the 1980s, an especially sharp increase in the interest rates was needed to curb the high inflation expectations, causing a severe recession.

This exercise aims to understand the macroeconomic experience described above using the simulator. Now, open the simulator and choose the closed economy version. Then reset all shocks by clicking the appropriate button on the left-hand side of the main page. Use the simulator and the information above to work through the following questions:

a) Apply a permanent 3% negative supply shock. Now go to the “Inflation, income and interest rates figures” (button in the top left-hand side of the main page). There, click on the box “show the case when it takes five periods for the central bank to recognize a change in equilibrium income” (center of the screen). Save your data. Now, in the figures, the solid lines represent the case where, as conventional, we assume that the central bank knows in real time the equilibrium output level. The dashed lines represent the case when the central bank believes equilibrium output stays constant after the shock and only realizes about the change five periods after its occurrence.
b) Considering the delay-in-perception case compared to the conventional, no-delay-in perception-case, why does the interest rate increases less at the beginning? Why does inflation rise more?
c) Can you identify in the figures the moment when the central bank realizes about its mistake in the estimation of the output gap? How does it react in terms of interest rate setting? What are the consequences of this reaction for GDP and inflation?
d) Considering just the sequence of periods between the shock and its realization by the central bank, what is the sign of the true output gap?; what is the sign of the output gap according to the central bank estimations?; why does the central bank keep on increasing the interest rate?
e) Above it is said that “When central banks reacted at the beginning of the 1980s, an especially sharp increase in the interest rates was needed to curb the high inflation expectations, causing a severe recession.” How is this experience reflected in your simulation?

4. The Great Moderation (Chapters 3 and 4)

Consider the following text:

“During the nearly three decades from the 1980s to 2007, developed economies and, especially, the US experience low volatility in inflation, employment and economic growth. Thus, in historical context, business cycles were more moderate, expansions more prolonged and recessions milder.

One of the possible explanations of the Great Moderation is based on the institutional change in monetary policy, where a policy regime based on inflation as the target, the interest rate as the instrument, and the independence of the central bank becomes widespread. This policy regime, it is argued, had beneficial effects on the formation of expectations giving confidence about the capacity and will of the central bank to maintain the inflation rate around the target. This allowed a more moderate response of monetary policy to inflationary shocks. It also reduced the need of central banks to cool the economy facing too fast aggregate expenditure growth.”

In this exercise you have to think about the Great Moderation, as described above, with the help of the simulator. Now open the simulator and choose the closed economy version. Then reset all shocks by clicking the appropriate button on the left-hand side of the main page. Use the simulator and the text above to work through the following questions:

a) Apply a 3% inflationary shock. Save your data. Now, change the value of c (degree of inflation inertia/credibility of the central bank) to 0.5 and apply again the same shock. Save your data. Compare both scenarios in terms of the volatility (that is, degree of deviation with respect to equilibrium) of output and inflation, and the policy response. Explain how well your results correspond to the text above.
b) Apply a temporary 3% positive demand shock. Save your data. Now, change the value of c (degree of inflation inertia/credibility of the central bank) to 0.5 and apply again the same shock. Save your data. Compare both scenarios in terms of the volatility (that is, degree of deviation with respect to equilibrium) of output and inflation, and the policy response. Explain how well your results correspond to the text above.

5. Anchored inflation expectations and the deflation trap (Chapters 3, 4, 7, 13)

In a speech, US Federal Reserve Board Governor, Ben Bernanke, said the following:

“The anchoring of inflation expectations near 2 percent has been a key factor influencing interest rates over recent years. It almost certainly helped mitigate the strong disinflationary pressures immediately following the crisis.”

This exercise uses the simulator to understand the above statement and, specifically, how the degree of inertia/credibility of the central bank affects the probability of a deflationary trap. Now open the simulator and choose the closed economy version. Then reset all shocks by clicking the appropriate button on the left-hand side of the main page. Use the simulator and the text above to work through the following questions:

a) Apply a permanent 5% negative demand shock. Save your data.
b) Change the value of c (degree of inflation inertia/credibility of the central bank) to 0.5 and apply again the same shock. Save your data.
c) Compare both scenarios in terms of the trajectories of the variables.
d) Now concentrate on the data of t=5 (when the shock hits) and explain differences and similarities in terms of the rate of inflation and the interest rates. Specifically, and given that the inflation rate is the same, why do you observe different nominal and real interest rates between both scenarios?

6. The simulator meets real world data: the Japanese economy since the 1990s (Chapters 3, 4, 13)

Begin by looking at the following macroeconomic data for Japan.

Figure Q6a. Inflation and growth in Japan, 1990-2012

Source: World Development Indicators. World Bank. http://data.worldbank.org/data-catalog/world-development-indicators

Figure Q6b. Nominal interest rate set by the Bank of Japan, 1990-2014

Source: Bank of Japan. http://www.stat-search.boj.or.jp/index_en.html

The experience of Japan since the 1990s is usually presented as an example of a deflationary trap. However, if we examine the data, we can see prolonged periods of deflation with nominal interest rates close to zero, but no downward deflationary spiral.

This exercise aims to reconcile the IS-PC-MR model with Japan’s data and to see that this data can be explained by the model when you do not assume full inflationary inertia.

Start by opening the simulator and choosing the closed economy version. Then reset all shocks by clicking the appropriate button on the left hand side of the main page. Then, set the following parameter values a = 0.2 and a = 0.5 . Now, change the value of c (degree of inflation inertia/credibility of the central bank) to 0.5. Use the simulator to work through the following questions:

a) Apply a permanent 8% negative demand shock. Save your data.
b) Use the impulse response functions to help explain the path of the economy following the shock. Is there a deflationary trap? Why? Is there a deflationary spiral? Why?
c) Apply a permanent increase of public expenditure of 1% in period 10 alongside the original demand shock. Save your data.
d) Use the impulse response functions to find out whether the fiscal stimulus has managed to take the economy out of the trap.
e) Now let us assume a permanent increase of public expenditure of 6% in period 10 alongside the original demand shock. Save your data.
f) Use the impulse response functions to find out whether the 6% fiscal stimulus has managed to take the economy out of the trap.

7. The simulator meets real world data: macroeconomic behaviour of the Eurozone between 2005 and 2013 (Chapter 12)

First, have a look at the following macroeconomic data for the Eurozone.
Figure Q7a. Inflation in the Eurozone, 2005-2014

Source: European Central Bank. http://sdw.ecb.europa.eu/home.do;jsessionid=2ED084D395EA14D903DE3EEF4118FFFE
Figure Q7b. Nominal interest rate set by the ECB, 2005-2014

Source: European Central Bank. http://www.ecb.europa.eu/home/html/index.en.html
Figure Q7c. Year on year growth of real GDP in the Eurozone, 2000-2014

Source: IMF. http://www.imf.org/external/data.htm

Figure Q7d. OECD estimate of the output gap in the Eurozone, 2005-2015 (dashed line is forecast)

Source: OECD. http://www.oecd.org/statistics/

The following figure shows the series jointly.

Figure Q7e. Growth, inflation and the policy interest rate in the Eurozone, 2005-2014

Source: ECB http://www.ecb.europa.eu/home/html/index.en.html and IMF http://www.imf.org/external/data.htm

a) Looking at the data and using additional information obtained by yourself, try to explain the reasons for the fall in the rate of growth in the periods 2007-09 and 2011-13, the behavior of inflation and the monetary policy (nominal interest rate) applied by the ECB during the whole period.
b) Now open the simulator and choose the closed economy version. Then reset all shocks by clicking the appropriate button on the left hand side of the main page. Then, set the following parameter values a = 0.5, initial stabilizing real interest rate = 2% and a = 1. Now, change the value of c (degree of inflation inertia/credibility of the central bank) to 0.2. Set the long-run growth rate equal to 1%. Apply simultaneous permanent negative demand and supply shocks of 6% and 3%, respectively. Finally, consider that in t = 7 there is a 3% permanent fall in public expenditure. Save your data.
c) Using the impulse response functions, describe the behaviour of the simulator during periods 1 to 9 (both included). Compare this behaviour with the real data about the Eurozone during the period 2005-2013, indicating the qualitative and quantitative similarities and differences. Note that the concept of inflation used in the simulator is closer to core inflation than to headline inflation.
d) Using the impulse response functions, describe and explain the simulator behaviour from t=10 onwards. Does the output gap close? Why?
e) Some economists argue for an increase of the inflation target to escape from the zero-bound nominal interest rate trap. Using the data of section b) to consider the effects of increasing the inflation target to 6% in t=10. Compare this case with the path followed when no increase of the target is implemented. Explain the effects of the increase in the inflation target and the mechanism through which this policy operates (Hint: remember that we have set the simulator to have only partial inflation persistence).

8. This exercise explores the effects of demand shocks and disinflationary policy in an economy with hysteresis effects.

To understand the results, first consider that in the simulator hysteresis effects are modelled as potential GDP being equal to the average of the four equally-weighted lags of actual GDP. Second, also notice that the central bank is modelled as ignoring the hysteresis effects, that is, the central bank assumes that potential GDP is independent of actual GDP. Up to now this is the case for many central banks, as, for instance, the European Central Bank.

Now, open the simulator and choose the closed economy version. Then reset all shocks by clicking the appropriate button on the left hand side of the main page.

Next, in the main page, set "yes" in the appropriate box at the left-bottom side of the page to allow for hysteresis effects. Then, use the simulator to work through the following questions:

a) Implement a disinflationary policy allowing for a change in the inflation target from 8% to 2% (be sure to check the box "In period 10 there is a change in inflation target" and to type the new target both at the right hand side at the top of the main page). Pay attention to the dashed lines in the "Inflation, income and interest rates figures", which reflect the case with hysteresis. Does inflation converges to the new target? Does GDP converges to its initial level? What about the interest rates? Think of the reasons for the different evolution of GDP and the interest rates compared to the case with no hysteresis (solid lines). To have a better understanding, examine the evolution of potential GDP and the output gap by clicking on the blue box at the center of the "Inflation, income and interest rates figures" page.

b) Thomas Michl, in this paper finds that "After a demand shock, if inflation expectations are not anchored, these mechanisms generate persistence but not true hysteresis. But if expectations are partially (as they seem to be) or fully anchored, a demand shock will have a permanent effect on output". To reproduce this result, first reset all shocks by clicking the appropriate button on the left hand side of the main page. Then, in the main page, set "yes" in the appropriate box at the left-bottom side of the page to allow for hysteresis effects.

Now, implement a permanent 2% negative demand shock. Why do the hysteresis effects of the shock tend to vanish in the long run (to have a better picture of the long run, you may want to consult the numerical results) - Hint: think of the compensating hysteresis effects of countercyclical monetary policy.

Maintaining the permanent 2% negative demand shock, now reduce the degree of inflation inertia/increase the degree of central bank's credibility from 1 to 0.2. Notice that now the shock produces a permanent hysteresis effect. Try to explain why this is the case, focusing on the different policy reaction to the shock and to the different behavior of inflation expectations. Specifically, explain why the central bank has a milder reaction to the shock and how this determines the stronger hysteresis effects. Do you think the central bank would apply a different policy if it was aware of the hysteresis effects? Explain.