New-Area-Wide Model (NAWM)

The New-Area-Wide Model (NAWM) is a micro-founded open-economy model of the euro area, which is designed for use in the (Broad) Macroeconomic Projection Exercises regularly undertaken by ECB/Eurosystem staff and for policy analysis. It was recently developed by staff in the Econometric Modelling Division.

The NAWM succeeds the AWM which is a traditional macroeconomic model of the euro area that has been extensively used at the ECB over the past ten years. There are notable differences between the two models. The NAWM is neo-classical in nature and centred around intertemporal decisions of households and firms which are maximising expected life-time utility and the expected stream of profits, respectively. As a result, forward-looking expectations play a key role in influencing the adjustment dynamics of both quantities and prices, and changes in supply-side factors have a pronounced impact already in the short run. At the same time, the NAWM includes a number of nominal and real frictions that have been identified as empirically important, such as sticky prices and wages (so that some Keynesian features prevail in the short run), habit persistence in consumption and adjustment costs in investment. Moreover, it incorporates analogous frictions relevant in an open-economy setting, including local-currency pricing (giving rise to imperfect exchange-rate pass-through in the short run), and costs of adjusting trade flows. In contrast, the AWM features predominantly Keynesian behaviour in the short run, even though it has a basic neo-classical steady state.

The development of the estimated version of the NAWM has been guided by two important considerations, namely to provide a comprehensive set of core projection variables, and to allow conditioning on monetary, fiscal and external developments which, in the form of technical assumptions, are an important element of the ECB/Eurosystem staff projections.

Therefore the key features of the model are:

1. Its scale - compared with a typical DSGE model - is relatively large.
2. Employing Bayesian methods, it estimates 18 key macroeconomic variables, including real GDP, private consumption, total investment, government consumption, exports and imports, a number of deflators, employment and wages, and the short-term nominal interest rate.
3. Data on the nominal effective exchange rate, euro area foreign demand, euro area competitors’ export prices as well as oil prices are utilised, which are deemed important variables in the projections capturing the influence of external developments.
4. As a novel element, the recently compiled extra-euro area trade data (both volumes and prices) are used, which appears economically more compelling than the use of total trade data.
5. Conformable with the number of variables, 18 structural shocks are considered in the estimation. These shocks are latent factors with an economic interpretation that help in typifying the sources of the observed fluctuations in the data.

For details on the development of this model, see the ECB Working Paper No 944:The New Area-Wide Model of the euro area: A micro-founded open-economy model for forecasting and policy analysis download [1.91 MB]

New-Multi-Country Model (NMCM)

The New Multi-Country Model is a large-scale estimated model covering the five largest euro area countries. It has firm micro-economic foundations and can be characterised as a micro-founded New Keynesian model. Expectation formation is treated explicitly so that the model can be simulated under rational model consistent expectations or under learning expectations. Under learning agents adapt their expectations more gradually in response to economic shocks according to a learning rule, which in the NMCM is consistent with the model’s long-run solution and has stable properties.

The theoretic core of the model contains one exportable domestic good and one imported good and all central behavioural relations are based on the optimisation behaviour of three private sector decision making agents (i.e. households, labour unions and firms) and the reaction functions of the government sector and the central bank.

The model was developed at the European Central Bank with the aim for it to be used to produce forecasts, in particular in the context of the Eurosystem and ECB staff Macroeconomic Projection exercises, and to aid policy analysis. Its country-blocks can be used either on a single country basis (mainly for forecasting purposes) or as a linked euro area multi-country model (especially for policy analysis).

Key features of the model

1. The theoretical core of the model consists of three optimising private sector decision making representative agents, i.e. utility maximising households, profit maximising firms and trade unions, which minimise the quadratic loss function under the staggered wage adjustment assumption. Monopolistically competing firms set prices, and choose inventories and factor demands under the assumption of indivisible labour. Output is in the short run demand-determined. Monopoly unions set wages and overlapping generation households make consumption/saving decisions.
2. The production technology is described by a normalised Constant Elasticity of Substitution (CES) function, allowing for non-unitary elasticity of substitution between labour and capital, non-constant augmenting technical progress and heterogeneous sectors with differentiated price and income elasticities of demand.
3. Under learning expectations, agents optimise their behaviour under uncertainty concerning the process driving future developments in fundamentals but without uncertainty concerning the model’s deep parameters.
4. The behavioural equations and the production function are estimated on the basis of quarterly national historical data from the 1980s onwards.
5. In the linked version of the model the cross-country linkages occur through four channels: trade volumes; trade prices; common monetary policy and a common exchange rate.

For details on the model please see ECB Working paper, No. 1315: The ECB's New Multi-Country Model of the Euro Area: NMCM - Simulated with Rational Expectations download [2.35 MB] and ECB Working paper, No. 1316: The ECB's New Multi-Country Model of the Euro Area: NMCM - with Boundedly Rational Learning Expectations download [2.3 MB] or refer to the contact persons below

Contact persons:

Alpo Willman, Principal Economist, Econometric Modelling Division
Allistair Dieppe, Senior Economist, Econometric Modelling Division
Alberto Gonzalez Pandiella, Economist-Statistician, Econometric Modelling Division

The Coenen-Wieland (2000) Model

The Coenen-Wieland (CW) Model is a small-scale model of aggregate supply and aggregate demand which is designed to capture the broad characteristics of inflation and output dynamics in the euro area. Since its development, the model has been mainly used as a laboratory for evaluating the performance of alternative monetary policy strategies in the vein of recent studies for the United States.

The supply side of the model incorporates price and wage staggering, with wage setters negotiating long-term nominal wage contracts with reference to both past contracts that are still in effect and to future contracts that will be negotiated over the life of the current contracts. If wage setters expect the output gap, that is the deviation of actual output from potential, to be positive they adjust the current wage contracts upward. As a result, inflation depends on own leads and lags, excess-demand conditions as well as transitory contract wage shocks, the latter resembling cost-push shocks.

There are two versions of the supply side which feature distinct types of staggered wage contracts: the nominal wage contracting specification due to Taylor (1980) and the relative real wage contracting specification by Fuhrer and Moore (1995). The two specifications differ with respect to the degree of inflation persistence that they induce, with Fuhrer-Moore-type contracts giving more weight to past inflation developments.

A simple aggregate demand relationship relates the output gap to several lags of itself, the ex ante long-term real interest rate and a transitory demand shock. The long-term real rate is determined jointly by a term-structure relationship and the Fisher equation. As a benchmark for conducting monetary policy experiments, short-term nominal interest rates are set according to a Taylor-type interest rate rule that relates the short-term nominal interest rate to developments in inflation and the output gap. Changes in the short-term nominal interest rate affect aggregate demand through their impact on the ex ante long-term real interest rate.

Working paper 30 - download [1.54 MB]

Smets-Wouters (2003) Model

Recent developments in the construction, simulation and estimation of dynamic stochastic general equilibrium (DSGE) models have made it possible to combine a rigorous microeconomic derivation of the behavioural equations of macro models with an empirically plausible calibration or estimation which fits the main features of the macroeconomic time series.

The main difference between empirical DSGE models and the more traditional macroeconometric models (such as the AWM) is that both the parameters and the shocks to the structural equations are related to deeper structural parameters describing household preferences and technological and institutional constraints.

These micro foundations have three advantages:

1. They provide a theoretical discipline on the structure of the model that is being estimated, which may be particularly helpful in those cases where the data themselves are not very informative, for example regarding the long-run behaviour of the economy or because there has been a regime change.
2. Being able to relate the reduced-form parameters to deeper structural parameters makes the use of the model for policy analysis more appropriate, i.e. less subject to the Lucas critique, as those structural parameters are less likely to change in response to changes in policy regime.
3. Micro-founded models may provide a more suitable framework for analysing the optimality of various policy strategies as the utility of the agents in the economy can be taken as a measure of welfare.

For these reasons, staff at the ECB and the Eurosystem have started to develop empirical DSGE models for monetary policy analysis. The Smets-Wouters (2003) Model is an example of such a medium-sized DSGE model, which has been estimated on the basis of quarterly euro area macro data. The model features three types of economic agents: households, firms and the central bank. Households decide how much to consume, how much to invest and how much to work and at what wage. Firms employ workers and capital and decide how much to produce and at what price to sell their products.

In addition to a number of real frictions such as habit formation in consumption and adjustment costs in investment, the model features nominal price and wage rigidities. The model is estimated using seven euro area macroeconomic series (real GDP, consumption, investment, employment, real wages, inflation and the nominal short-term interest rate). Using Bayesian estimation and validation techniques, it is shown that the estimated model is able to compete with more standard, unrestricted time series models, such as vector auto regressions (VARs), in out-of-sample forecasting.

Working paper 171 - download