Macroeconomic modelling

of natural disasters:
dynamics of impact propagation?

Presented at the Advising Group Meeting of

the Information and Indicators program
for Disaster Risk Management Project
January 13, 2004, Washington, D.C.
1
 Contents

l Introduction
l Modelling work on macroeconomic effects
l Assessing the effects of external shocks and
unscheduled events
l Financial programming
l The World Bank RMSM model
l The merged model and RMSM-X
l Three-Gap models
l The International Institute for Applied System
Analysis (IIASA) model
l Input-output analysis and the SIM model

2
 Introduction
§ The body of research on the modelling of
macroeconomic effects of disasters is very
limited
§ The existing models offer the generalised
framework, aim to provide the empirical
modelling and lack either theoretical
development or the analysis of macroeconomic
effects. Thus, more empirical evidence and/or
case studies on actual disasters are required
to test them in terms of its validity and
predictability
§ The dynamics of recovery and reconstruction
impacts need to be considered
§ Is it possible to construct a unique theoretical
framework for disasters as a phenomenon? 3
 Key characteristics
§ Developing countries tend to be prone to
sudden crises and changes in macroeconomic
aggregates. Macroeconomic shocks and their
propagation mechanisms are likely to differ in
developing countries
§ Most countries in LAC could be characterized
as middle-income countries
§ Urbanization rates and the proportions of
agricultural output as a percentage of total GDP
indicate that agriculture is an important, but not
dominant, sector
§ Indices of industrial output are used to measure
business cycle fluctuations
§ Manufacturing sector accounts for a significant
fraction of total GDP 4
 Figure 1a
Structure of Output
(Value added, in percent of GDP)

Agriculture Industry Services

Africa Asia

Benin 1980 Bangladesh 1980

1995 1995
Burundi 1980
1995 India 1980
1995
Cameroon 1980
1995 Indonesia 1980
1980 1995
Côte d'Ivoire
1995
1980
Korea 1980
Ethiopia 1995
1995
1980 Malaysia 1980
Ghana 1995 1995
1980 1980
Kenya 1995
Nepal
1995
1980
Malawi 1995 Pakistan 1980
1995
1980
Nigeria 1995
Philippines 1980
1980 1995
Tanzania 1995
Sri Lanka 1980
1980
Zambia 1995
1995

1980 1980
Zimbabwe Thailand 1995
1995

0 20 40 60 80 100 0 20 40 60 80 100

Source: World Bank. 5

 Figure 1b
Structure of Output
(Value added, in percent of GDP)

Agriculture Industry Services

Latin America Middle East and North Africa

1980
Argentina 1995 Algeria 1980
1995
1980
Bolivia 1980
1995 Egypt
1995
1980
Brazil 1995
Jordan 1980
1980 1995
Chile 1995
Mauritania 1980
1980
Colombia 1995
1995

1980 1980
Costa Rica Morocco
1995 1995
1980 1980
Ecuador 1995 Oman
1995
1980
Jamaica 1995 1980
Syria 1995
1980
Mexico 1995 1980
1980
Tunisia 1995
Peru 1995
1980
1980 Turkey 1995
Uruguay 1995
1980 1980
Venezuela 1995 Yemen 1995

0 20 40 60 80 100 0 20 40 60 80 100

Source: World Bank. 6

 Modelling work on
macroeconomic effects

7
 Models on natural disasters

Model Key features Main results

Aggregate S hort/medium Y reduction, P increase,

demand/supply L o ng term foreign aid and altruistic
Growth model No specific countries behaviour change results
(Dacy -Kunreuther, Marginal productivity differs
1969) s e c t o r a ll y , I N V s h o u l d b e
oriented to productive sectors
I n p u t-o u t p u t , S -I, S hort/medium Long term aggregate effects
growth model L ong term not significant, distribution
( A l b a l a -B e r t r a n d , D eveloping countries effects mainly
1993)
Interregional i n p u t- Short/medium Effects of capital loss on
output Japan economy
(Okuyama, 1996)
Growth model Long term Mitigation investment diverts
(Tol/Leek, 1999) No specific countries C a n d I N V affecting current
and future output
I n p u t-o u t p u t Dynamic formulation Effects of recovery and
Sequential Japan reconstruction over time
Interindustry Model
(SIM)
(O k u y a m a , 2 0 0 0 )

8
Assessing the effects of
external shocks and
unscheduled events

9
McCarthy, Neary, and Zanalda (1994)
Step 1: estimate impact of three components on
BOP, expressed as a percentage of output.
l Terms of trade, interest rate effect, changes in

global demand.
è Terms of trade shock: measured as the market

value of the net import effect.

è Interest rate effect: change in world interest

rates multiplied by stock of interest rate sensitive

external debt.
è Changes in global demand: deviation of growth

of world export volumes from estimated trend

multiplied by initial export volume.
10
McCarthy, Neary, and Zanalda (1994)
l Step 2: estimate economy’s response to shocks.
è Level of demand: adjustment in imports from

reduction in aggregate demand; difference

between expected import volumes using
historical import elasticity of GDP using trend
growth versus actual GDP growth.
è Expenditure-switching measures: captured by

changes in export performance and the degree

of import intensity.
l Step 3: calculate additional net external financing
as the difference between the effect of all shocks
and the economy’s responses.
11
 Financial
Programming
l The Polak Model
l An Extended Framework

12
The Polak Model

13
l Considers small open economy, with fixed exchange
rate.
l Four Equations:

∆Ms = ∆L + ∆R (4)
∆Ms: money supply, ∆L: domestic credit, ∆R :
official foreign exchange reserves

∆R = X - αY + ∆F, 0 < α < 1, (5)

∆F: capital inflows

∆Md = v-1∆Y, v > 0, (6) 14

 v: income velocity of money

∆Ms = ∆Md (7)

Polak focus:
l Determine effects of changes in domestic credit on

foreign exchange reserves.

l Using (4), (6), and (7),
∆R = v-1∆Y - ∆L .
l Reserves will only increase when nominal money
demanded exceeds change in domestic credit.

15
Polak model structure:
Target Variables: ∆R
(change in official foreign reserve)
Endogenous Variables: ∆M, ∆Y, J = αY
(change in nominal money balances, change in nominal
output, imports)
Exogenous Variables: X, ∆F.
(exports, change in net capital flows)
Policy Instruments: ∆L.
(change in domestic credit)
Parameters: v, α.
(income velocity of money, marginal propensity to import)

16
Limitations of the Polak Model:
l Assumes that changes in domestic credit have no

effect on domestic money demand; in many

developing countries the bank credit-supply side link
is a critical feature of the economy.
l Assumes a stable money demand function; in

practice money demand tends to be unstable as a

result of volatile inflation expectations.

17
An Extended Framework

18
Khan, Haque, and Montiel (1990)
l Distinguishes between real and nominal output and

the sources of credit growth.

Extended framework equations:
l Consider single good economy where,

Y = Py
Y: nominal income, P: overall price index, and
y: real output.

∆Y = ∆Py-1 + P-1∆y

19
l Price changes: function of domestic price changes,
∆PD and exchange rate adjusted foreign prices
changes by,

∆P = δ∆ PD + (1 - δ)(∆E + ∆P*), 0 <δ <1

l Domestic credit

∆L = ∆Lp + ∆Lg,
∆Lp : private sector credit
∆Lg : government credit
∆Lp : f(demand for working capital), proportional to
changes in nominal output:

∆Lp = θ∆Y; 20
l Money supply identity:

∆M = ∆L + ∆R;
with
∆R = E∆R*

∆R = X - J + ∆F
X: Exports (exogenous); J: Imports in nominal terms,

J = EQJ,
QJ : import volume; E : nominal exchange rate
21
l Changes in import volume, related to the change in
output and the relative price of foreign goods,

∆QJ = α∆y + η[∆PD - (∆E + ∆P*)]

η > 0: import elasticity to relative price changes.

l Nominal value of imports:

J = J-1 + (QJ-1 - ηE-1)∆E

+ E-1[α∆y + η(∆PD - ∆P*)] (16)

22
l With relatively small QJ-1, a devaluation in the
nominal exchange rate (∆E > 0) will lower the
nominal value of imports, improve the trade balance
and increase official reserves.
l Income velocity: constant as in Polak model, money
market assumed to be in flow equilibrium.
l Government Budget Constraint: G - T = ∆L + ∆Fg,
budget deficit is financed by foreign borrowing or
changes in central bank credit.

23
 Structure of Extended Framework:
Target variables: ∆R, ∆PD
Endogenous variables: ∆Y, ∆Lp, ∆M, ∆P, ∆J, G-T
Exogenous variables: ∆y, ∆P*, X, ∆F = ∆Fp + ∆Fg
Policy instruments: ∆Lg, ∆E
Predetermined: y -1, P -1, QJ-1
Parameters: v, δ, α, θ, η.

24
 Figure 2
The Extended Financial Programming Model

∆R

E' M
~
∆R

M
B

~
∆PD ∆PD

Source: Adapted from Khan, Montiel, and Haque (1990, p. 161).

25
The World Bank RMSM
Model

26
Revised Minimum Standard Model:
l Precursor to the RMSM-X model.

l Developed in the early 1970s.

l Objective: make explicit the link between medium-

term growth and its financing.

27
Five relationships (prices taken as given):

è I = ∆y/σ (22)
σ : incremental capital-output ratio (ICOR).
è Imports:

J = αy, 0 < α < 1 (23)

è Cp = (1 - s)(y - T), (24)

0 < s < 1: marginal propensity to save.

28
è Balance-of-payments identity:

∆R = X - J + ∆F (25)
è National income identity:

y-1 + ∆y = Cp + G + I + (X - J) (26)

29
The structure of RMSM:
Target Variables: ∆R, ∆y.
Endogenous Variables: I, Cp, J.
Exogenous Variables: X .
Policy Instruments: G, T, ∆F
Predetermined: y-1
Parameters: σ, s, α.

30
Two-Gap Mode:
l Determine financing requirements for alternative

target rates of output growth and official reserves.

l Determine feasibility of particular growth rate given

alternative financing scenarios.

Saving Constraint:
l Begin with national income accounting identity,

I = (y - T - Cp) + (T - G) + (J - X) (30)

(y - T - Cp): private sector savings;

(T - G) : public sector savings;
(J - X ): foreign savings. 31
 Figure 4
The RMSM Model in Two-Gap Mode

I T Zone II
S
Zone IV

Zone I

45º
Zone III
S

∆F

32
Three criticisms:
l Difficulty identifying binding constraint a priori.

Assumes imports as essential for investment

and growth; however, saving gap can also be
closed by combination of reducing imports or
increasing exports, thereby freeing foreign
exchange necessary for investment.
l Incomplete; essentially a growth-oriented model

with emphasis on a small number of real variables

and no financial side.
l Relative prices and induced substitution effects

among production factors (and their possible

impact on exports, for instance) are neglected.
33
The Merged Model
and RMSM-X

34
The Merged IMF-World Bank Model
l Combines extended model and RMSM model.
l As in extended model, relative prices affect imports

and domestic absorption.

Equations:
l Changes in real output,

∆y = σI/(1 + ∆P),
∆Y = ∆Py-1 + P-1∆y,

∆P = δ∆PD + (1 - δ)∆E,
∆P* = 0 35
l Domestic credit

∆L = ∆Lp + ∆Lg,
with
∆Lp = θ∆Y.

l Money supply identity

∆M = ∆L + ∆R,
with
∆R = E∆R*

36
l Balance of payments:

∆R = X - J + ∆F,
with
∆F = (1 + ∆E)∆F*,
X: exogenous.
l Nominal imports:

J = J-1 + (QJ-1 - ηE-1)∆E + E-1(α∆y + η∆PD).

37
l Money demand:

∆Md = v-1∆Y.
l Flow equilibrium of the money market:

∆Ms = ∆Md

38
l Government budget constraint:

G - T = ∆Lg + ∆Fg.
l Private Sector Budget Constraint:

(Y - Cp - T) - I = ∆Md - ∆Lp - ∆Fp

Cp = (1-s)(y - T), private sector budget constraint
implies,

I = s(Y-1 + ∆Y - T) + ∆Lp + ∆Fp - ∆Md. (47)

39
Structure of the merged model:
Target Variables: ∆R,∆PD, ∆y
Endogenous Variables: ∆Y, ∆Lp, ∆M, ∆P, ∆J, G-T
Exogenous Variables: X, ∆F = ∆Fp + ∆Fg
Policy Instruments: ∆Dg, ∆E, G or T
Predetermined: y-1, P-1
Parameters: ν, δ, α, θ, η.

40
 Figure 9.5
The Merged IMF-World Bank Model

∆y
M
Y
~
A' ∆y B E'

A E

Y
M

~ ~
∆PD ∆PD ∆R ∆R
41
The RMSM-X Framework
Expanded version of the RMSM model (see World
Bank, 1997b):
l Merged IMF-World Bank model described earlier
(adds to the RMSM model a price sector, a monetary
sector, and government accounts, along the tradition
of the financial programming approach.
l In practice, RMSM-X models fairly detailed;
l General RMSM-X model characteristics: often consist
of four economic sectors: the public sector, the
private sector, the consolidated banking system, and
the external sector.

42
l Budget constraints associated with each sector.
l National accounts derived via aggregation of the
sectoral budget constraints serve to close the RMSM-
X model.
l Two types of financial assets, money and foreign
assets in standard model, some versions include
(particularly for middle-income countries) domestic
bonds.
l Money demand function frequently follows Polak
model; constant income velocity of money.

43
l Some models disaggregate banking system
structure: here Ms is not equal to the sum of central
bank credit and official reserves; rather obtained as
the product of the monetary base and a constant
money multiplier.
l Prices: assume domestic and foreign goods are
imperfect substitutes, so that substitution effects can
be analyzed on the demand side.
l Imports: several categories with the demand a
function of the real exchange rate and either real
GDP or (e.g. imports of capital goods) gross
domestic investment.

44
l Consumption: generally assumed to depend only
on disposable income---thereby excluding
consumption-smoothing effects.
Model closures:
l Public sector closure: values for all variables
except public sector expenditure and domestic
borrowing specified; latter two variables then
determined by model.
l Private sector closure: values for government
expenditure and revenue are specified, and the
model estimates private sector variables.

45
 Marginal economic agent:
l In both approaches, likely disbursements from
external donors provide estimate of external
financing.
l External borrowing requirements determined
separately, through the balance-of-payments
identity.
l Gap financed by marginal economic agent.
l In public sector closure, central government is
marginal borrower and foreign commercial banks
are assumed to be the marginal foreign creditor.

46
l Policy closure as availability mode: all external
financing identified in advance and imports are
adjusted to equilibrate BOP.
l Programming Mode:
è targeted values given;

è RMSM-X then solved for mix of fiscal,

monetary and exchange rate policies consistent

with targeted values.

47
Three-Gap Models

48
l Two gap RMSM approach extended to three-gap
framework by Bacha (1990).
l Addition of fiscal gap links foreign exchange
availability directly to the rate of growth of
productive capacity and only indirectly to the actual
level of real output.

49
l Suppose (non-capital) imports are invariant and there
is an upper bound on exports, XN, based on external
demand.
l First gap: foreign exchange constraint,
~
I ≤ (XN + H)/δ

50
l Cp: assume exogenous.
~ ~
p
S =y - Cp
with y bounded from above by full capacity output.
l Second gap: saving constraint
~
I ≤ Sp + (T - G) + H
Setting up the fiscal constraint:
l Suppose:

è money money is only asset available;

è foreign capital inflows serve to finance

government’s budget deficit. 51

l Suppose: private and public investment are
complements:

Ip ≤ φIg,
φ: ratio of private to public investment in capital stock.

Ig + Igφ = I,
(1 + φ) Ig = I
l Third gap: fiscal constraint

I ≤ (1 + φ)[h(π, θ) + (T - G) + H]
52
 Figure 9.6
The Three-Gap Model

I F

G
S
(1+φ)[h(π ,Θ) + (T-G)]

I*
G

~
S p+ (T-G)
~
X/δ

0 H* H

Source: Adapted from Bacha (1990, p. 291).

53
The 1-2-3 Model

54
l Developed at the World Bank by Devarajan et al.
(1997),
CGE (computable general equilibrium) models.
l 1-2-3 captures features of CGE models: highly

disaggregated models (on both the demand and the

supply side) designed to study issues such as the
allocational and distributional effects of domestic and
external shocks (see Bandara, 1991).
l Demand side: typically consider several households.

l Price rigidities common.

55
The IIASA model

56
 Modelling approach

§ Developed by IIASA in collaboration with P.

Freeman, L. Martin, et al
§ Aimed at incorporating the potential macroeconomic
impacts of natural disasters into the macroeconomic
projections of developing countries
§ The methodology extends the RMSM-X model, the
model is supply-side oriented and focuses on short to
medium term macro imbalances, 10-year forecasting
period
§ The model offers an economy-wide consistency
framework

57
The SIM model

58
 Modelling approach

§ The Sequential Interindustry Model (SIM) was

first introduced by Romanoff and Levine in 1981
as an extension of input-output framework that
can trace the production process and the path
of an impact
§ SIM turns the static input-output analysis into a
dynamic formulation, incorporating production
chronology and appears to be particularly
useful to “simulate” the dynamic process of
impact propagation and structural change in the
short run
59
 Modelling approach

§ SIM connects the macroeconomic nature of

input-output analysis with the microeconomic
process of production process
§ The dynamics are represented by an
anticipatory as well as a responsive mode

60
 Conclusions

§ There is little research on the dynamics of

macroeconomic effects of disasters
§ The empirical evidence is limited and more
case studies are required to understand the
intertemporal path of impacts
§ Consistency models, extensions of the RMSM-
X, SIM and others may provide new insights on
the dynamics of impact propagation
§ Consider data limitations in developing
countries and the need to develop a
parsimonious economy-wide model
61