##
ISLM Macroeconomic Model Part-V

(Scenario Setting and Forecasting)

#### (What happens if contractionary monetary policy was exercised?)

You can find the Eview file (here). You should be familiar with the previous posts. Find the Part-I (here), Part-II (here) Part-III (here) and Part-IV (here).By now we have performed a dynamic stochastic forecasting. We have assumed the Government expenditure follows some Seasonal ARMA process and money supply is fixed at 970 units.

Now, in this blogpost, I will answer what will happen while the scenario changes, say, the money supply was reduced to 900 units as a contractionary monetary policy.

Here is my video post.

Click to

**ModelA**, then click to

**Scenario**, then

**Scenario 1**(if scenario 1 is not give click the Create New Scenario), then click to

**Overrides**.

Inside Overrides,

**type M**and click

**OK**. Because we are trying to alter the values of Money supply.

Then, to recheck, go to

**ModelA**, then

**View**, then

**Variables**, there you should see the variable for

**money supply colored with Red**, Right click that

**m**, and go to

**properties**, the you will see

**Overridden Exog as M_1**.

Next, you need to make series as M_1. For in

**command window**write series M_1=M.

Now double

**click M_1**, then jump to

**2000Q1 Cell**, click to

**Edit**, and change the values to

**900 for all cells till 2005Q4**. We are doing this for our assumption of contractionary monetary policy in which the money supply was reduced from 970 units to 900 units.

Now once again open

**ModelA**, then click to

**Solve**, then setup the everything like following.

Now, once again open

**ModelA**, then click

**Proc**, then

**Make Graph**, set the following setting. Make sure you

**check the compare Baseline and Active Scenario 1**for comparing the Baseline i.e with 970 values of M and scenario 1 with 900 unit of money supply. Also

**set the sample for Graph**as

**1996Q1 2005Q4**, just to make graph more appropriate to view.

So compare to the baseline scenario (when money supply was 970), when the money supply was reduce to 900 unit (in scenario 1), the interest rate rises because the money is less in supply and lower money supply leads to higher price of money (i.e interest rate). Due to higher interest rate investment fell down (blue line is below green line), lower investment mean lower growth or Y, and lower consumption.

Well, at the end, I must say, these forecasts are still not quite appropriate for policy implication because the dip retrenchment in each graph for out of sample makes forecast questionable. However, there are two ways to solve the problem.

Method 1: As we know in dynamic forecasting (here), there was a huge gap in investment so to deal with such problem we can include the lags in the equation of investment.

Method 2: A better alternative would be to try to modify the variables in the equation so that the equation can provide some explanation for the sharp rise in investment during the 1990s. An alternative approach to the problem is to leave the equation as it is, but to include an add factor in the equation so that we can model the path of the residual by hand (Eviews 9, Users Guide II).

In the next blog, I will show you how can we make forecasts better including an add factor in the equation.

References:

Eviews 9, Users Guide II.