1

ECA macroeconomic model for short

and long term forecasts
VIRTUAL COURSE 2020

ECA SRO-WA, xxx September 2020

 Objectives of the course 2

At the end of this course, the participants should be familiar with:

 The theoretical overview of the ECA macro model and its key theoretical foundations;

 The structure of the model;

 The key equations (core and non-core) integrating the model;

 An overview of the construction of a macro econometric model;

 A step-by-step demonstration of forecasting and policy analysis using ECA model;

 The tools to assess the performance of the forecasts

 Layout
I. The Building block of ECA Model
 Why ECA macro model ?
 Model type and structure
 Key model assumptions
 Model variables
 Relationship between variables
 Equations and Estimations
 Model building
 Create a model object in E-views
3
II. Case Study: Djibouti
 Model interface menu
 Vocabulary of forecasting
 In-sample vs Out of sample forecasts
 Deterministic Forecast
 Stochastic Forecasts
 Alternative forecasting scenarios
 Assessing Forecasting accuracy
 Key references
 Why ECA Macro Model? 4

 In response to major constraints in economic modelling most African countries are

facing:
 Lack of a critical number of nationals with the requisite skills to carry economic forecasting
 The use of a one-size-fits-all model missing to account for the context prevailing in each country
 Data challenges

 In line with ECA mandates to build State members capacity to design policy informed
by economic analysis
 Good Forecasting and evaluation of various shocks and policies are critical to good policy
 I. ECA Model: type & structure 5

 The model consists of four sectors giving a comprehensive view of the entire economy
 Households: consumption, savings, supply labor and capital
 Firms: use of labour and capital to produce output
 The government and the central bank: conduct fiscal policy and monetary policy
 Foreign sector: record the balance of payments

 Characterized by the long-run neoclassical supply-side and the short-run Keynesian demand side

 Follows the specification of the world economic framework model (WEFM) and oxford Economics

 A macro-econometric model developed in E-views

 Structural: different equations relate aggregate variables based on economic theory
 Eclectic: some coefficients are estimated while others are calibrated
 Key Model Assumptions 6

 Keynesian short-run characteristics

 Sticky price and output depicted by aggregate demand
 Neoclassical long-run characteristics
 Output determined by the supply side factors (labour, capital and total factor productivity)
 Small economy which cannot influence its term of trade

 Monetary policy based on Taylor’s rule in the context of inflation targeting

 Expectations are assumed adaptive though subject to Lucas Critique

 Investment equations rest on the Tobin’s Q ratio

 Consumer spending is assumed to be consistent with the life cycle and permanent income
theories
 Model Variables 7

 Variables divided into demand and supply and into core and non-core variables

 Core variables refer to all basic variables:

 Core demand variables: aggregate expenditure components at constant and current prices;
monetary policy variables and financial variables
 Core supply variables: prices, natural levels of output, unemployment and real wages

 Non-core variables are specific to countries' objective and depending on data availability:

 Non-core demand variables: disaggregated consumption and investment for instance

 Non-core supply variables: employment and nominal earnings
 Relationship between variables 8

Figure 1 key drivers of aggregate demand and supply

Goods Markets (IS) Money Market (LM) Drivers of supply

Consumption Short term interest

Capital accumulation Labour market

Inventory levels

Prices
Exports and Imports Exchange rate

Key drivers of Aggregate demand Monetary policy Fiscal policy

 Schematic of the key drivers of aggregate demand and supply

 Equations and Estimations 9

Figure 2: Specification process  The modeling strategy accounts for both

Raw series
long run and short run dynamics in the
economy
Plots and unit
root tests  Short-term forecasting with VAR models
Test result
Test result  Long-term supported by a cointegration
All I(0)
Two or more I(1) framework using error correction model
(ECM)
Cointegration test
(k-1) lags
 ECM estimates the speed at which a
dependent variable returns to its equilibrium
after a shock to one or more independent
Test result Test result
variables
No cointegration J cointegrations
 Specification determined by the statistical
properties of the variables (whether they are
stationary in level or in difference or
Specification Specification Specification
whether they are cointegrated).
VAR in levels VAR (k-1) in VECM (k-1) and j
with k lags differences cointegrations
 Model Building 10

Figure 3: Steps in Econometric Model Building  Equations need to satisfy

 Select variables of the model
Economic theory
 Define exogenous and Data  Theoretical fundamentals
endogenous variables
 Statistical properties
 Good interaction with other equations
Causal relationship
in the model
Model Specification Choice of
among variables
VAR; VECM; etc.
econometric model  Four subtests to perform
 Statistical significance of the estimated
parameters
Estimation
 Expected theoretical signs of the
estimated parameters
Model checking
rejected
 Diagnostic tests for checking various
violations (normality, autocorrelation
Not rejected
and serial correlation,
heteroskedasticity etc.
Forecasting and policy analysis  Stability of the estimated equation
Create a model object in E-views 11

 Create a model object as follows:

 Go to “object” => “new object” =>
“model”.
 Name your model and press “OK”

 To copy equation into the model object

 Double click on a given equation.;
 then go to “view” => “representations”
 and copy the substituted coefficient to
paste in the model window.
 Right click after clicking on text in the
model window to paste equation.
 II. Case Study: Djibouti 12

 The goal is to forecast some key aggregates from 2017 onwards.

 Based on annual data, the sample period for model specification ends at 2016.

 Deterministic and stochastic dynamic forecasts are performed

 Model Interface Menu: variables 1/2 13

 To view the dependence structure of the

1. Double click on the model
2. Then on variables variables: click on “variables” at the model
interface menu.

 The model consists of 64 variables divided

into:
 55 endogenous variables
 9 exogenous variables
 Model Interface Menu 2/2 14

1. Double click the model

2. Click on equations

 The model is made of 55 equations

including identities
 To create identity equation:
 Go to the model interface,
 Click on equation and right click and
select insert.
 Enter the identity and click ok
In the model window, click on text

 Click on “Text” in the model interface to

see the internal representations of
equations with the estimated coefficients.
 Vocabulary of forecasting 15

 Simulation type:
 Deterministic simulation: single forecast rather than a distribution of feasible values.
 Stochastic simulation: distribution of forecast outcomes for each period in the forecast horizon
based on the random components of the model (the model's error term and its coefficient
uncertainty)

 Static forecasting: use of actual rather than forecasted value for the lagged variable provided
that actual data are available.
 Dynamic forecasting: use of previously forecasted values of the lagged left-hand variable to
forecast for the periods after the first period in the sample.

 Solution scenarios:
 Actuals: represent the original series
 Baseline: serves as a reference point when forecasting
 Solution sample: specify the sample period of interest.
In-sample vs Out of sample Forecasts 16

 In-sample forecast aims to see how best forecasts track the

actual values within the sample.
 Make the sample shorter than the available data and
use the data not included in the estimation to test the
forecast

 Out of sample forecast refers to forecast beyond the period

of actual values.

 Out of sample forecast requires assumptions for exogenous

variables over the forecast period (2018-2030) as indicated
in the red brackets.

 The green brackets show that endogenous variables are

missing over 2018-2030 before the forecast

 We will focus on out of sample forecast in what follows

 Deterministic Forecast Using the Model Object 1/3 17

Solution window on the right and new

Specify as follows and click ok
variables with the tag “_0” on the left

 To do deterministic forecast, click on “solve” in the model window and specify in the dialog box as indicated above (left)
 Compare the forecast variables ending with _0 with the real values:
 Hold CTRL key; select variables of interest; right click and “open” as a “group”
 Deterministic Forecasts Using the Model Object 2/3 18

“proc”  “Make Graph”

Select as follows

 To graph forecast variables: click on “proc” in the model window and select “make graph”
 In the graph dialogue box, specify as indicated above (right visual aid)
 In the graph window, the active scenario is termed “new”. It can be also the “baseline” there.
 We will plot variables over the recent history from 2013. Let’s click “OK”
 Deterministic Forecasts Using the Model Object 3/3 19

Exports, goods and services Gross domestic product

Inflation, cpi Public Debt

Fixed Capital Formation/GDP GDP growth Productivity per worker Household consumption

 Actual values of the variables are in green while the model’s forecasts are in blue
 Stochastic Forecasts Using the Model Object 1/3 20

Select as follows

Solution window on the right and new

variables with the tag “_0” on the left

 Deterministic forecasts ignore random disturbances

 Stochastic simulations will allow us to measure uncertainty in the model. Errors bound and confidence intervals are added.
 Model solutions report series with the extension _0h (upper confidence bound), _0l (lower confidence bound) and _0m
(mean for all the forecasts produced) for the baseline scenario
 Stochastic Forecasts Using the Model Object 2/3 21

Select as follows
“proc”  “Make Graph”

 As before, “proc, make graph”

 Select “mean & confidence bounds ” under Make graph window and specify as indicated above and press “OK”
 Stochastic Forecasts Using the Model Object 3/3 22

Inflation, cpi Public Debt

Exports, goods and services Gross domestic product

Fixed Capital Formation/GDP GDP growth Productivity per worker Household consumption

 Forecasted values in blue are within the confidence bands which take into account uncertainty
 Alternative Forecasting Scenarios 23

Baseline scenario Alternative scenario:  Alternative scenario is a forecast conditional on different

scenario 1
assumptions for one or many exogenous variables.

 To solve the model under scenario 1, we create:

 cmud_1 reflecting an increase by 20% of import prices
excluding oil over 2017-2030
 wdr_1 indicating a decrease by 10% of aggregate
demand over 2017-2030

 Therefore, variable cmud (import prices excluding oil) is

higher under scenario 1(red brackets) compared with the
baseline scenario (blue brackets). The opposite is true for the
aggregate demand (wdr).

 Other exogenous variables such as population and trend

productivity growth remain unchanged
 Alternative Forecasting Scenarios 24

Select

 Now we will solve the model under the

baseline scenario and scenario 1
 Here we opt for deterministic simulation
 Tick the box “ solve for alternate along with
active and calc deviations”
 Click “edit scenario options” and indicate to
E-views variables that change under
scenario
 Here cmud wdr: E-views will override
cmud and wdr by cmud_1 and wdr_1
respectively
 Then solve the model
 Alternative Forecasting Scenarios 25

Inflation, cpi Public Debt Exports, goods and services Gross domestic product

Productivity per worker Household consumption

Fixed capital formation/GDP GDP growth

 The modeling strategy accounts for both

 Recall that we perform deterministic and dynamic forecast

 Assessing Forecasting Accuracy 26

 It is recommended to assess forecast performance using out of sample forecast tests rather than in-
sample tests.

 It is useful comparing your model forecasts with other external forecasts

 Small Root Mean Square of Errors (RMSE) is a good pointer for good forecast. Compute the RMSE
for every forecast horizon to distinguish between competing models
𝒇

𝑹𝑴𝑺𝑬 = 𝟏/𝒇 𝑭𝑬𝟐𝒕

𝟏

FE refers to forecast errors

 Key References 27

 United Nations Economic Commission for Africa (2019). Theoretical Foundation for the
Macroeconomic Model

 United Economic Commission for Africa (2018). Model Operational Manual

 Macroeconomic and Financial Management Institute of Eastern and Southern Africa (2012).
Macroeconomic Modeling and Forecasting Manual

 International Monetary Funds (2015). Macroeconometric Forecasting. Online course. www.edx.org

 United Nations Department of Economic and Social Affairs (2016). The World Economic Forecasting
Model at the United Nations
 28

THANK YOU

ECA / SRO-WA, xxx September 2020