# **2. Methodology**<sup>**5**</sup>

A number of methodologies can be employed to simulate an income or consumption distribution and associated poverty measures when household survey data are missing. However, not all of them are adequate in addressing the kind of questions posed above. In this paper we propose a micro-simulation model focused on multiple transmission channels which seem appropriate for the Serbian context, namely (i) labor markets as a key pathway for the deterioration of the economic situation in Serbia over the past years; as well as (ii) non-labor income components, mainly international remittances; and (iii) price changes.

The micro-simulation approach superimposes macroeconomic projections on behavioral models built on last available household survey (HBS 2010). The model is loosely based on previous approaches to microsimulation described in Bourguignon, Bussolo and Pereira da Silva (2008) and Ferreira, et al. (2008) – with an important simplification of omitting the computable general equilibrium (CGE) component, which is difficult to employ in most developing countries. Instead the approach described here links the behavioral model to sectoral and aggregate macroeconomic data for Serbia in 2011, and extrapolates the microeconomic snapshot of a future scenario from this projection.<sup>6</sup> Using actual macroeconomic data for the period 2010-2011, we are able to predict income distributions at the individual and household level. The poverty and distributional assessment can be performed by comparing the simulated scenario with 2010 data. The model focuses on labor markets and (international) remittances as transmission mechanisms and allows for changes to labor income- modeled as employment changes, earning changes or a combination of both- and changes to non-labor income, modeled as a change to (international) remittances.<sup>7</sup> These changes can be positive or negative depending on the trends outlined by the macroeconomic inputs. The model is able to capture most of the changes in total income since in most cases labor income and remittances account for a significant proportion of household income.<sup>8</sup> Reasonable assumptions are made about impacts on the other sources of income, such as capital and financial income or public transfers, as discussed below.

## _2.1 The microsimulation model setup_

The simulation process is accomplished in three main steps. The first step consists of using household data for the latest available year (i.e HBS 2010) to _estimate_ a set of parameters and unobserved characteristics for various equations of the household income generation model developed by Bourguignon and Ferreira (2005). This model allows accounting for multiple transmission channels and working at the individual/household level. The first component of the model is an identity that defines the per capita income in a household _h_ as the ratio between the total household income and the total number of members (<sup>_n_</sup> _h_<sup>) in that household:</sup> The total household income, expression in brackets of equation (1), is the result of the addition of two main sources of family income: _labor_ and _non-labor_ income. At the same time, the total family labor income is the aggregation of earnings in different economic sectors across members. So, for each individual we see not only if she (he) participates (or not) in the sector but also if she (he) receives (or not) an earning for that job. The

> 5 This section is based on the Manual for the ADePT Simulation module which can be consulted for further details.

> 6A similar approach has been applied recently to update poverty and distributional studies on a number of developing countries, including Costa Rica, Panama, Moldova, Tajikistan and Mexico.

> 7 Note that simulating international remittances is not exclusive of applying the same method to other non-labor income component. However, macro projections for this component are required in order to estimate the simulated distribution.

> 8 Labor income represents more than 40% of total household income while remittances only about 2%.

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