The Economics Underlying NiGEM

StructureProductionPrice SettingLabour MarketsConsumptionIncomeWealthFinancial MarketsMonetary RulesBond & Equity MarketsPublic SectorIncome TaxExternal TradeReferences

The major country models rely on an underlying constant-returns-to-scale CES production function with labour-augmenting technical progress.

where is Q is real output, K is the total capital stock, L is total hours worked and t is an index of labour-augmenting technical progress. This constitutes the theoretical background for the specifications of the factor demand equations, forms the basis for unit total costs and provides a measure of capacity utilization, which then feed into the price system. The approach to the estimation of the production function is set out in Barrell and Pain (1997). The elasticity of substitution is estimated from the labour demand equation, and in general it is around 0.5. This estimate is used in the calibration of the other parameters of the production function, and an estimate of technical progress is calculated. Similar results can also be produced with systems estimation s Barrell, Guillemineau and Holland (2007) show.

Demand for labour and capital are determined by profit maximisation of firms, implying that the long-run labour-output ratio depends on real wage costs and technical progress, while the long-run capital output ratio depends on the real user cost of capital:

where w/p is the real wage and c/p is the real user cost of capital. The user cost of capital is influenced by the forward-looking real long-run interest rate, as well as by corporate taxes and depreciation. The user cost of capital variable is calculated from data for the past, and is a weighted average of the cost of equity finance and the margin adjusted long real rate, with weights that vary with the size of equity markets as compared to the private sector capital stock. These issues are discussed in Barrell and Holland (2007) where the consequences of individual firms taking account of risk on their investments is analysed. The risk premium mark up above the risk free user cost can be varied in scenarios and forecasts, and it affects investment. Investment is determined by the error correction based relationship between actual and equilibrium capital stocks, where the speed of adjustment, for instance in the US, depends on Tobin's Q and government investment depends upon trend output and the real interest rate in the long run.