The Structure of the Model
MAKRO is based in state-of-the-art economic theory.
MAKRO is, for the most part, a structural model, built upon real and nominal frictions. The model is based in state-of-the-art economic theory which starts from the idea of many representative households optimising their utility with perfect foresight.
Households are modelled by an overlapping generations model such that each cohort is specifically modelled. Each cohort is modelled upon their entrance into the labour-market, receiving a structural labour market participation rate in accordance with the labour market projection. Each generation saves and consumes from a combination of their wealth, income and future expected income. Savings consist of pension savings, shares, bonds and liquid funds. Furthermore, agents invest in housing and take out mortgages. A household’s labour behaviour is modelled in another model that utilises individual-specific data on age, education, marginal tax rates and replacement ratio. Actual employment is dependent on the economic climate since involuntary unemployment depends on labour demand.
Wages in the model are set the labour market negotiated levels and cannot change in the short run in response to changes in labour demand, which is the primary reason for cyclical fluctuations in the unemployment rate within the model.
Firms produce using inputs of material, capital and labour. The labour demand is determined by the firms’ productivity, which is in itself determined by the demand for the products they produce. Inertia in wage and prices imply that firms can adjust their labour inputs and production in response to changes in demand for their product. Investments in companies are based on the expected future demand for goods and relative prices, including interest and taxation. Installation costs of investments result in adjustments being gradual. Firms are owned through shares by households, pension funds and foreign owners. The price of domestic shares depend on the future earnings of the firms.
Demand is determined by raw material demand, household consumption, public consumption, investment and exports. Raw material demand is determined by production. Household consumption is determined by household wealth, income, expected future income as well as propensity to consume. Propensity to consume is largely determined by age so demographic changes will affect consumption. Propensity to consume is also determined by employment as income is highly dependent on employment status. This produces a model with a feedback mechanism between employment and product-demand. Investment depends on both household investment, public investment and firm investment. Exports depend on Danish competitiveness in the world market as well as the economic situation abroad.
The effect of short-term fluctuations in the model are adjusted to what is empirically observed in the development of the economy. This is done by matching the model’s reactions to selected shocks to empirically estimated reactions. In the short term, this is essential as cyclical conditions will typically dominate fluctuations in the economy.
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