NEMO – a New Macro Model for Forecasting and Monetary Policy Analysis

NORGES BANK Economic bullEtin 1/2009 (Vol. 80) 39-47 NEMO (“Norwegian Economy Model”) is Norges Bank’s new forecasting and monetary policy analysis model.1 The model is based on international research and model development over the past 10–15 years and has many features in common with similar models in other central banks.2 NEMO has been under development since autumn 2004 and has been used previously to analyse specific developments in the Norwegian economy. NEMO is based on the assumption that Norway with a national currency can determine its own inflation level over time. Therefore, a model requirement is that monetary policy anchors inflation expectations. This means that monetary policy is decisive in bringing inflation back to target. In the model, it is assumed that economic agents, such as households and firms, look ahead when making decisions concerning consumption, investment, wages and prices and base these decisions not only on today’s economic policy but also on their expectations concerning future policy. In addition, the model builds on the experience of the 1970s and 1980s which indicated that unemployment could not be reduced permanently by accepting higher inflation. Because of price and wage stickiness, monetary policy can still influence demand and hence output and employment in the short and medium term. Various agents’ behaviour is modelled explicitly in NEMO, based on microeconomic theory. A consistent theoretical framework makes it easier to interpret relationships and mechanisms in the model in the light of economic theory. One advantage is that we can analyse the economic effects of changes of a more structural nature. In NEMO, developments in the Norwegian economy can be explained by changes in firms’ technology, competitive conditions in product and labour markets, by household preferences between consumption and leisure, and by monetary policy. The structural framework makes it possible to provide a consistent and detailed economic rationale for Norges Bank’s projections for the Norwegian economy. This distinguishes NEMO from purely statistical models, which to a limited extent provide scope for economic interpretations. NEMO may be referred to as a new-Keynesian DSGE model (dynamic stochastic general equilibrium model). This model class is characterised by the bridge it builds between new classical theory (where agents have rational expectations and maximise utility/profits over time) and Keynesian theory (where imperfect competition and nominal rigidities lead to wage and price stickiness). As a result, the model takes on new classical features in the long term (supply-determined output) and Keynesian features in the short to medium term (demand-determined output). When NEMO was constructed, particular emphasis was given to developing a model that would be a useful decision-making tool in monetary policy. Therefore, it has been constructed with a view to being transparent and manageable. Output, price-setting, wage formation and all the main demand components are modelled and NEMO – a new macro model for forecasting and monetary policy analysis