Fakhri Hasanov[1] and Frederick Joutz[2] A macroeconometric ...

Fakhri Hasanov[1] and Frederick Joutz[2]
A macroeconometric model for making effective policy decisions in the
Republic of Azerbaijan Abstract
We developed a macroeconometric model with the objective of analyzing and
forecasting the effects of various domestic policy measures and external
shocks, particularly changes in oil price, world income on the Azerbaijani
economy. It consists of 13 stochastic equations and 13 identities and
covers the real, monetary, fiscal and external sectors of the Azerbaijan
economy. The General to Specific Strategy is applied to the quarterly data
over the period of 2000-2010 in the framework of Cointegration and Error
Correction Modeling. This is publically available the first econometric
model of the Azerbaijani economy that its stochastic equations are the
error correction equations which provide information about the long-run
equilibrium and short-run dynamics between the variables as well as speed
of adjustment from the latter to the former. This information would be
useful for the decision makers in increasing an effectiveness of the policy
measures in the Azerbaijani economy.
CONTENT 1. Introduction
2. Literature Review
3. Theoretical-conceptual structure of the macroeconometric model
3.1. Real Sector
3.2. Fiscal Sector
3.3. External Sector
3.4. Monetary Sector
3.5. Domestic Prices and Wages Sector
4. Database
5. Econometric Methodology
6. Results of the Empirical Estimation
6.1. The Real Sector
6.2. The Fiscal Sector
6.3. The Monetary Sector
6.4. Domestic Prices and Wages Sector
6.5. External Sector 7. Model-based Simulations
7.1. In-Sample Simulations 8. Conclusion Reference Appendixes 1. Introduction
Widespread use of macroeconometric models is going to continue and change
as research progresses, the economy develops, and the needs of model users
adjust (Bardsen et al, 2005; Bardsen and Nymoen, 2008; Wallis, 1993, 2000).
Well-chosen models simplify and clarify economic problems by focusing on
the factors judged most essential to their understanding. Importantly,
models are also frameworks for how the economy has on average behaved in
the past, and of the degree to which its current or prospective behavior
might differ. For these general, but practical reasons economic policy
needs models (Jadhav, 2004). A macroeconometric model can serve for one or
more of the three basic objectives: explanation, prediction and evaluation.
Its use is useful for policy in several ways. By using a model, a
policymaker can identify and evaluate the impact of alternative economic
policies, policy choice or measure on the economy in terms of sustainable
and long-term development without having to actually face the shock or
implement the policy (Boulanger and Brechet, 2005; Coletti and Murchison,
2002). Economic models provide scientific bases for policy measures and
therefore serve to enhance policy credibility. That is why policymakers
widely use macroeconometric models of national economies for conducting in-
depth policy analysis and forecasting the future course of the economy (Ra
and Rhee, 2005).
Azerbaijan economy demonstrates rapid economic growth mainly driven by the
oil sector in recent years. It is noteworthy that according to official
statistics, GDP in real terms grew approximately 2.5 times during the
period 2004-2008 bringing Azerbaijan to leading positions in the world with
34.5% in 2006[3]. Increased oil extraction, surge in oil prices and its
exports leads to huge inflow of foreign exchanges into the country, which,
in turn, creates great opportunities for implementation of large scale
infrastructure projects contributing to socio-economic development of the
economy. However, the given boom in the oil sector in parallel with the
above-mentioned noble infrastructure development intentions also causes
some macroeconomic problems. As such, there is an increasing dependence of
the state budget on the oil revenues resulting in the high fiscal
expansion, raising the price levels, appreciating exchange rate, while
lowering the share of the non-oil sector output in GDP as well as the share
of the non-oil exports in total exports. According to official statistics,
the share of the non-oil value added and exports in the GDP and total
exports respectively decreased from 66.2% and 52.5% in 2004 to 38.2% and
4.7% in 2008. Moreover, the share of the oil revenues in the government
revenues increased from about 40% in 2004 to 80% in 2008, while the real
effective exchange rate appreciated approximately two-fold during 2004-
2008[4]. It is worth mentioning that a sharp decline in the price of oil in
the world markets caused by the recent global financial crisis led to some
negative consequences in the Azerbaijani economy.
All the above-mentioned facts indicate that the Azerbaijani economy in some
extent depends on its oil revenues and thereby, it is very sensitive to a
volatility of oil price in the world markets.
Making effective policy decisions in line with the goals of the sustainable
development of the country is very important, but it is heavily constrained
by some difficulties in the above-mentioned circumstances. One of the key
pre-requisites of making effective policy decisions is make them
empirically justifiable by carrying out a proper analyses and developing
sound forecasts of macroeconomic indicators. First, it requires a well-
designed and well-specified macroeconomic model. By using macroeconomic
model, one can evaluate impacts of external shocks (for example, changing
in price of oil in the world markets) as well as internal policy changes
(for example, changes in exchange and interest rates and etc.) on the
economy. For instance, what would be the inflation effects of the oil price
if it remains 75 USD/Barrel for the next three years. Inversely, let us
assume that the government targets to increase public investment by 7% in
each of subsequent next three years. How and in which extent the related
macroeconomic variables have to changes in order to meet this target?
Solutions of such policy exercises require a well-designed macroeconomic
model, which is able to provide a comprehensive analysis and forecast of
macroeconomic indicators.
The objective of the study is building and using macroeconometric model,
which can provide comprehensive analysis and forecast of the short run
impacts of various policy measures and external shocks on the Azerbaijani
economy. Practical contribution of the study The possible contributions of the study would be:
. it provides an modifiable/flexible macroeconometric model, which
describes important within- and between sectorial relationships with
as simple and proper way as possible by taking country specific
features into account;
. it helps to make effective policy decisions in terms of the
sustainable economic development during and especially after the oil
boom by conducting various simulations based on different policy
scenarios;
. it can serve as a common tool for policymakers and by this way can
contribute to an enhancing the coordination among them;
. it is a contribution to the experience literature on building and
effectively using macroeconometric models in the natural resource rich
small open economies. Macroeconomic modeling experience in the Republic of Azerbaijan Note that in order to get a comprehensive macroeconomic model, some
important initiatives have been made since 1990s. A number of projects have
been implemented in the government agencies and academic organizations: in
the Ministry of Economic Development (MED hereafter), the Ministry of
Finance (MF hereafter), the Ministry of Taxes (MT hereafter), the Central
Bank of the Republic of Azerbaijan (CBAR hereafter) and the State Oil Fund
of the Republic of Azerbaijan (SOFAZ hereafter).
Division namely "Modeling social-economic processes" at the Institute of
Cybernetics has developed macroeconometric models under supervising
professor Y.Hasanli for analyzing and forecasting macroeconomic indicators
of the Azerbaijan economy (Hasanli and Ismayilov, 1998; Hasanli and Imanov,
2001; Hasanli, 2007).
In order to properly implement real and monetary policies and effectively
coordinate them, Financial Program Projection - FPP has implemented in MF
and MED as well as in CBAR with technical support of the International
Monetary Fund.
By technical support of the Technical Assistance to Commonwealth
Independent State (TACIS hereafter) of European Commission and by applying
a macroeconomic experience of the European Union counties, another
macromodel project has been implemented in Azerbaijan over the period 1998-
2006 (TACIS, 2006).
Oil sector augmented macroeconomic equilibrium model of the Azerbaijani
economy, covering government sector, balance of payment, non-oil and oil
sectors, has been built during the period 2001-2004 by financial support of
the Asian Development Bank (ADB hereafter). The model (ADB Annual Report,
2001).
In 2004-2008, Institute for Scientific Research on Economic Reforms (ISRER)
of MED has constructed a model incorporating linkages between markets and
economic agents of the Azerbaijan economy.
Moreover, ISRER has been also involved in the project namely "AzMod"
supported by the ADB and implemented by EcoMod modeling company during the
2004-2006