DRI Model of the U.S. Economy -- Model Documentation
December 1, 1993
The Energy Information Administration (EIA) uses models of the U.S. economy developed by Data Resources, Inc. (DRI) for conducting policy analyses, preparing forecasts for the Annual Energy Outlook, the Short-Term Energy Outlook, and related analyses in conjunction with EIA's National Energy Modeling System (NEMS) and its other energy market models. Both the DRI Model of the U.S. Economy and the DRI Personal Computer Input-Output Model (PC-IO) were developed and are maintained by DRI as proprietary models. This report provides documentation, as required by EIA standards for the use of proprietary models; describes the theoretical basis, structure and functions of both DRI models; and contains brief descriptions of the models and their equations.
For the last four decades, economists have theorized and developed models of the U.S. economy. Models built in the 1950's and 1960's were largely Keynesian income expenditure systems that assumed a closed domestic economy. High computation costs during estimation and manipulation, along with the underdeveloped state of macroeconomic theory, limited the size of the models and the richness of the linkages of spending to financial conditions, inflation, and international developments. Since that time, however, computer costs have fallen spectacularly; theory has also benefitted from four decades of postwar data observation and from the intellectual attention of many eminent economists.
An Econometric Growth Model
The DRI Model of the U.S. Economy (hereafter, DRI U.S. Model) incorporates the best insights of many theoretical approaches to the business cycle: Keynesian, neoclassical, monetarist, supply-side, and rational expectations. In addition, the DRI U.S. Model embodies the major properties of the long-term growth models presented by James Tobin, Robert Solow, Edmund Phelps, and others. This long-term structure guarantees that robust long-run properties will temper short-run cyclical developments.
In growth models, the expansion rate of technical progress, the labor force, and the capital stock determine the productive potential of an economy. Both technical progress and the capital stock are governed by investment, which in turn must be in balance with post-tax capital costs, available savings, and the capacity requirements of current spending. Thus, for example, monetary and fiscal policies will influence the short- and the long-term characteristics of such an economy through their impacts on national saving and investment.
A modern model of output, prices, and financial conditions is melded with the growth model to present the detailed, short-run dynamics of the economy. In specific goods markets, the interactions of a set of supply and demand relations jointly determine spending, production and price levels. Typically, the level of inflation-adjusted demand is driven by prices, income, wealth, expectations, and financial conditions. The capacity to supply goods and services is keyed to a production function combining the basic inputs of labor hours, energy usage, and the capital stocks of equipment and structures. The "total factor productivity" of this composite of tangible inputs is linked to accumulated expenditures on research and development. Prices adjust fully to gaps between current production and supply potential and to changes in the cost of inputs.
For financial markets, the model predicts exchange rates, interest rates, stock prices, loans, and investments interactively with the preceding variables. The Federal Reserve sets the supply of reserves in the banking system and the fractional reserve requirements for deposits. Private sector demands to hold deposits are driven by household disposable income, business cash flow, expected inflation, and by the deposit interest yield relative to the yields offered on alternative investments. Banks and other thrift institutions, in turn, set deposit yields based on the market yields of their investment opportunities with comparable maturities and on the intensity of their need to expand reserves to meet legal requirements; in other words, the contrast between the supply and demand for reserves sets the critical short-term interest rate for interbank transactions, the Federal funds rate. Other interest rates are keyed to this rate, plus expected inflation, Treasury borrowing requirements, and sectoral credit demand intensities.
The labor market has three basic components. The supply of labor positively responds to the perceived availability of jobs and, albeit weakly, to the wage level. Demand for labor is keyed to the level of output in the economy and the productivity of labor, capital, and energy. Because the capital stock is largely fixed in the short run, a higher level of output requires more employment and energy inputs. Such increases are not necessarily equal to the percentage increase in output because of the improved efficiencies typically achieved during an upturn.
Wages, the price of labor, are adjusted to bring demand and supply into balance. Excess supply is obviously registered by a high unemployment rate, which reduces the rate of increase in wages. The expansion of wages in a fully employed economy is set by the growth in the expected value of output per hour. Wages will increase more rapidly the greater the expected expansion rates of labor productivity and output prices. Tempering the whole process of wage and price determination is the exchange rate; a rise signals prospective losses of jobs and markets unless costs and prices are reduced.