Macroeconomic modelling in developing countries

Macroeconomic modelling in developing countries has been going on for more than fifty years. Most models have been built by development partners to assist countries in macroeconomic management. Statistics Norway’s modelling project in Malawi follows along the same line, but includes two other dimensions; one is a close link to a parallel project on constructing a national account, and the second is a strong emphasis on capacity building. A major component of the strategy to add capacity has been everyday on-the-job training. A small aggregated model for the Malawian economy was gradually implemented as a first step towards a more disaggregated model. Using the disaggregated model made it apparent that the new methodology was a huge improvement on previous efforts.

The choice of what type of model to develop was based on its intended use and considering available data. As Malawi has undergone IMF programs for a long time, one of the design criteria was to make the model useful for forecasts and analysis related to such programs. Another criterion was that the model should be useful in preparing the national budgets, an area in which it has already proved helpful.

Macroeconomic models in the Klein – Tinbergen tradition has been used to explain demand-oriented fluctuations and to deal with short-run instability of output and employment using mainly stabilisation policies. The model, however, has been criticised as it does not consider the supply – side and the incorporation of production relations. Neither does it adequately capture the role of the money market, relative prices and expectations. Most governments now accept that an improved supply-side performance is the key to achieving sustained economic growth without a rise in inflation. To forecast implications of supply-side policies, aggregate supply and the input factor market need attention. In the Malawi model (referred to as MalawiMod), demand for production factors is modelled by industry within a neoclassical Cobb-Douglas framework where intermediate goods, labour and capital are used as input factors for production.

Whether to go for large scale models or to keep it small and simple is a recurrent theme. When the Malawi model project started we opted for a “large” model, mainly because we wanted the model to cover the whole economy, including the public and the monetary sectors, but also because we wanted the input-output table to be the core of the model in order to keep close contact with the structure of the national accounts.

Developing economies have distinctive characteristics that must be recognized. In Malawi, e.g. households and companies are exposed to credit and foreign exchange rationing. Another characteristic is the large amount of smallholder farmers who practice a “safety-first” strategy, i.e. to produce enough food for own consumption and only then adopt a profit maximizing strategy. This must be addressed carefully and one must consider how to incorporate the implications of this into private decision rules. Also the government budget requires attention. Its composition, in particular, differs noticeably from industrial countries. MalawiMod calculates government revenues and expenditures, and any deficit is financed by an increase in domestic credit.

One of the most severe problems facing developing countries is to stabilise their external balances. It is reasonable to assume that developing countries like Malawi have little influence on prices of traded goods, and, in particular, often face exogenous terms of trade. We have linked the foreign and monetary sectors through the balance of payments identity, and assume any trade deficit to be offset and accumulated into net foreign assets.

The degree of development of the financial system is influential when deciding on how to model the monetary account. Malawi, and most developing countries, is characterized by immature financial institutions, making it difficult to model the link between the exchange rate, interest rates and capital mobility. This is of particular relevance when it comes to attract foreign capital to level out any current account deficit and to attract foreign direct investments.