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Introduction to the economic model DREAM

The purpose of the DREAM model is to analyse the long-term challenges of the Danish welfare state. One question that it aims to answer is: will future government revenue be sufficient to cover government expenditure? In addition to addressing this question, it also provides a suitable framework for economic policy analysis.

Objective

The macroeconomic model, DREAM, is developed to analyse the long-term challenges that the welfare state faces. This is achieved by detailed modelling of the institutions that affect the government’s revenue and expenditure. In doing so, the model can also be utilised to evaluate the effect of economic policies.

Description

The main objective of the DREAM model is to give insight into the long-term developments of government finances. Is fiscal policy sustainable given taxes are unchanged? To answer this question, forecasts of government revenue and expenditure are required.

In the construction of DREAM, emphasis has been put on thoroughly describing economic factors that influence government finances as well as the economy in general. To name a few: the aging of the population, retirement from the labour market, developments in education levels and composition, oil and gas in the North Sea, political reforms, etc.

Long-term economic developments are largely determined by population demographics, education, labour force participation and pension savings. For this reason, forecasts of these variables are made separately and then combined to forecast the relationship between these factors in a general equilibrium model.

The general equilibrium model DREAM forecasts economic factors such as GDP, net exports, consumption, public spending, tax revenue, and resultantly, the government balance and debt.

The results of a DREAM forecast are summarised by an indicator of fiscal sustainability. The indicator measures the extent to which expected future government revenue can cover expected future expenditure.

In addition to generating government budget forecasts, DREAM is suitable for evaluating the long-term effects of a broad range of specific policy reforms. What are the long-term effects of an increase in the labour force due to an increase in the pension age? What are the effects of an increase in the number of graduates with tertiary education? Or what happens if immigrant employment rates converge with the that of Danes?

Introduction to the DREAM-model-system

Methodology

The DREAM model is used to make baseline scenarios for the long-term development of the economy. A baseline scenario is a forecast that gives the best estimated outcome for the economy in the long-run. This forecast is calculated by fixing fiscal policy (i.e. constant tax rates and public spending), by accounting for demographic changes and general economic growth. The baseline scenario also accounts for the effect of future policy changes passed in parliament, such as increased statutory pension age.

The model is also suitable for evaluating the effects of economic policies. This is achieved by changing the economic projection to reflect the policies in question and then comparing the outcome with the baseline scenario as described above.

The DREAM model is used by the Danish Economic Council (De Økonomiske Råd) to evaluate the fiscal sustainability of government policy as well as long-term effects of policy proposals. The model has also been used by government commissions, interest groups, think tanks, and others.

DREAM's long term forecast of the Danish economy

Background

DREAM has been under development since 1997. The model was developed with the goal of analysing the long-term challenges faced by the welfare state. One of those challenges was, and still is, the aging of the Danish population. A main purpose of the model was to assess whether the public sector had the resources to maintain the level of welfare expenditure given an ageing population and increasing longevity. At the time this was not the case and the DREAM model was used to help identify policies aimed at making the welfare state sustainable.

Economic Theory

The foundation of DREAM model is economic theory and how the economy develops in the long-run. Because of its long-run focus, the model’s theoretical framework is not intended to capture business cycles, but rather a “normal” or average state of the economy. DREAM is not used for short-term prognoses.

It is the prevailing view among economists that market mechanisms and supply side effects are dominant factors for economic development in the long run. As such, DREAM is a structural general equilibrium model. It applies economic theory to provide a quantitative description of the interactions within the economy. In a general equilibrium model, both supply and demand are modelled explicitly, and agents optimise to the best of their ability under constraints and assuming that the economy settles in a steady state and at a structural level. The model’s parameters are set so that the theoretical model can explain the relationships observed in the data from Statistics Denmark.

Short-run considerations are not made within the DREAM model but are instead calculated by projections made outside of the model by separate macroeconometric models. These models calculate the component forecasts of DREAM.

The method adopted by DREAM differs from those used by the macroeconometric models. The DREAM approach is to adapt the economic relationships to empirically best fit the observed economic developments. In contrast, the macroeconometric models typically assume that supply adjusts to demand and that wages and prices are sticky. As such, the macroeconometric models are well-suited for short-run economic forecasts.

Documentation of the macroeconomic model