Peter Westaway

A forward looking model of housing construction in the UK

Abstract This paper identifies and juxtaposes different approaches to modelling housing construction. The first two are based on dynamic marginal pricing considerations and emphasize adjustment costs and the necessary time to build respectively. Importantly, both these models introduce some degree of forward looking behaviour into the house building decision. Both approaches are able to explain aspects of UK housing starts, 1970–90. Non-nested testing showed that the time to build story is more powerful in explaining the data set at hand. However, we have not been able to find any evidence in support of third hypothesis, namely that quantity signals, proxied by turnover in the housing market, influence starts. The start to completion lag, in turn, is found to be affected by the interest rate representing the oppurtunity cost of delayed completions.

The Role of Macroeconomic Models in the Policy Design Process

This note examines the role of macroeconomic models in the policy design process. It discusses some of the general issues that need to be addressed if macroeconomic mo dels are to make an important contribution to the policy debate. More topically, it illustrates the role that can be played by using policy optimisation techniques on the National Institute UK model to examine some of the macroeconomic policy options currently facing policy makers. The need for some form of tool to analyse the broad problems of macroeconomic policy should be self-evi dent. For policymakers, their calculation of the appropri ate response to a particular problem will always depend on their precise objectives and on how they think the economy will react under different policy settings. Tak ing the current conjuncture, a number of questions must be faced. How quickly should interest rates be raised in response to current or prospective inflationary pressure? How soon should interest rates be lowered again as inflation subsides? How far can unemployment be expected to fall and what can policy do to influence this? How quickly should the public finances be returned to wards balance? How much scope is there for tax cuts? What policies can be implemented to improve the long run rate of growth of the UK economy? As acknowledged in a recent report by the ESRC Ma cromodelling Consortium,

The State of the Public Finances

The public sector borrowing requirement (PSBR) was £36-7 billion (6 per cent of GDP) in the last fiscal year and was forecast by the government in the March Budget to rise to £50 billion (8 per cent of GDP) in the current fiscal year. Yet as recently as 1988/9, the public sector was able to make a debt repayment of £14-7 billion (3 per cent of GDP). Such a large change has prompted concerns about the present state of the public finances and indeed caused the government to set in place future increases in taxation designed to ameliorate the situation. The purpose of this note is to assess the sustainability of the current fiscal position. In doing this we pay par ticular attention to the development of the stock of public sector debt in relation to national income and the public sectors stock of capital. Whereas the PSBR measures the amount of borrowing the public sector needs to do within a particular period, the debt stock measures the total amount of obligations to pay interest that the public sector has outstanding. It is this concept that is most useful in discussing the sustainability of fiscal policy. The ultimate constraint on the budgetary decisions of the public sector is that it is able to pay the interest on its debt. Interest payments will tend to rise in line with the debt stock and, for given interest rates, will tend to rise as a proportion of GDP when the debt stock is rising as a proportion of GDP. Such a situation is not sustainable: ultimately the public sector would be forced to change its budgetary policy or repudiate its debt. It is also important to examine the relationship between the evolution of the public sectors debt stock and the amount of capital it owns. Public sector capital assets typically provide services over a number of years. Some investments, such as council houses, generate future revenue for the public sector. Other items of cap ital expenditure, such as expenditure on roads, do not (as yet) provide a direct source of future revenue. In either case it can be argued that it is appropriate for the public sector to finance such capital expenditure by borrowing and that the revenue required to finance the interest payments on the resulting debt will become due in line with the services provided by the capital. For capital that generates revenue, the revenue itself can be used to cover the interest. For capital that does not generate revenue, the tax levied to finance interest payments can be seen as a payment for services provided. We begin by considering the proximate causes of the sharp change in the state of the public finances since 1988/89 and attempt to quantify the extent to which those changes are related to the general economic cycle. Cyclical changes in the fiscal position are less worrying than other more structural changes since there is a tend ency for them to be reversed as the economy recovers, ensuring that they do not have a long term adverse effect on the debt stock. Our estimates suggest that around 2Vi percentage points of the 9 percentage point swing in the PSBR/GDP ratio since 1988/9 can be directly attributed to the econ omic cycle. Borrowing is presently being used to finance both current and capital spending, with non-oil tax rev enues some 2 percentage points lower, as a proportion of GDP, than at the trough of the previous two recessions in the UK. In this light the recent decisions to restrain public sector pay and announce future tax increases appear to have some justification. We also examine the long-run trends in the PSBR over the last two decades and attempt to isolate the factors that have led to a generally lower rate of borrowing. If it is reasonable to expect these factors to continue then the recent increase in the PSBR might be viewed as a tempor ary aberration about a gradual downward trend. Finally we consider the future prospects for the public sector finances using the Governments own projections for its spending and tax plans together with our forecast for the development of the economy more generally. This makes it possible to calculate the likely path for the ratios of both the debt stock and the capital stock to GDP in the medium term on the basis of the announced budgetary policy of the government. Our analysis suggests that the current fiscal policy is sustainable, in that the forecast suggests that the recent actions announced by the government will tend to stabil ise the PSBR at some 2Vi per cent of GDP by the late-1990s, with the ratio of general government gross debt to GDP tending to 50 per cent. We also explore the impact on the fiscal position of a failure by the govern ment to implement its announced policies. This shows that the actions that the authorities presently intend to undertake are necessary to prevent the outlook becoming significantly worse. A comparison of the changes in the components of the PSBR in the prospective recovery with those in earlier

A Forward-Looking Approach to Learning in Macroeconomic Models

This paper illustrates how learning can be incorporated into an existing forward-looking macroeconomic model as an alternative to the more conventional but arguably more extreme assumption of model consistent or rational expectations. The key characteristic of the model consist ent learning approach to be adopted here is that agents are assumed to know the true structure of the model but that they need to learn about some parameters of that system, for example those defining the governments pol icy decision rule. Importantly, models solved under this assumption retain the property that the current behav iour of economic agents can be influenced by the expected future effects of policy changes. This type of learning may be contrasted with one where economic agents may also be uncertain about some structural par ameters of the true model but in addition, they do not possess sufficient information to form future expec tations consistent with their estimated model. As a conse quence, expectations are formed using backward-looking reduced form equations with par ameters which agents continuously learn about. This approach, known as boundedly rational learning, has been adopted in Hall and Garratt (1992) who apply these techniques to a full-scale non-linear macroeconometric model.