The economics underlying NiGEM

Financial markets

Interest rates and exchange rates are set differently in forecast and simulation mode, as in a forecast the markets contain information, and we would normally only depart from market paths for interest rates and exchange rates when we feel we have specific model based information. Forecasts are generally based on judgments about interest rates and exchange rates. These judgements depend both on model outturns, the implications of small forecasting models, and the discussion of prospects amongst the group. Once interest rates and exchange rates are set financial market developments follow, with an evaluation of potential profits based on the model forecast and hence the construction of a forecast for equity prices. These model based exercises influence forecast outcomes significantly

In scenario mode, forward looking nominal long rates and long real rates are a forward convolution using expected short-term nominal and real interest rates respectively Forward looking exchange rates have to look one period forward along the arbitrage relation involving domestic and foreign short term interest rates, with expected exchange rates next period being solved for in the same way to produce a forward recursion. Forward looking equity prices are solved out from the discounted sum of expected discounted profits. The discount factor is made up of the nominal interest rate and the risk premium on equity holding decisions. There are equations for long rates and equity prices in backward scenarios.

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