The sectoral and production structure of the g3 model

The sectoral and production structure of the g3 model is a pragmatic simplification of the structure of the Czech economy. The model economy is divided into a producer sector, a household sector, a state sector and an external sector.

The production structure of the model is shown in the scheme below. The core of the model is the intermediate goods production sector (Y). Using labour and capital, this sector produces intermediate goods, which are not intended directly for final use, but together with imported intermediate goods (N) comprise an input for the production of final goods for private and government consumption and exports. Each of the final goods production sectors can have a different ratio of domestic and foreign inputs with a different degree of mutual substitution. For example, for the export goods production sector (X) the model assumes high import intensity and a relatively low ability to substitute foreign inputs with domestic production in the short run.

ir_III_2008_box_1_img: The sectoral and production structure of the g3 model

Producers in individual production sectors are price-takers in terms of production inputs, so they can only decide how many goods they will produce and at what price. At the same time, prices of all goods are partly sticky. Producers cannot change their prices at any time, but only after some time has passed. Only a proportion of producers set their prices at any given moment; other producers index their prices to current inflation. In equilibrium, companies make a positive economic profit.

The production structure of the economy and the related flows of goods and services are reflected in the pricing of individual production sectors (consumer prices, export prices etc.). The degree of stickiness when price contracts are executed varies across the individual sectors. In the model, these linkages capture the gradual pass-through of demand and supply shocks to individual price categories. In the case of consumer prices, changes to regulated prices and indirect taxes also play a role.

The household sector consumes goods (C), rents capital to the intermediate goods production sector, offers labour to all production sectors and invests in domestic and foreign bonds. Households maximise their expected utility of consumption and leisure subject to budget constraints. As with producer pricing, wage creation is based on the assumption of stickiness. Only the wages of a proportion of households can be optimised at any given moment; the wages of the remaining households are set in line with the currently observed wage growth. Usable capital consists of the old capital stock and new capital goods (investment, I). Imperfect substitution between old and new capital is assumed.

The state sector is subdivided into the government and the central bank. The government collects taxes, distributes transfers and consumes government consumption goods (G). The government is allowed to generate public debt.

The central bank targets headline consumer goods price inflation and applies escape clauses to any first-round impacts of changes to indirect taxes. Headline inflation consists of regulated price inflation, unregulated price inflation and the effect of changes to indirect taxes. Unregulated price inflation consists of price inflation of inputs used in consumer goods production, i.e. intermediate consumption price inflation (domestic inflation pressures) and imported goods price inflation (external inflation pressures). Domestic inflation pressures stem from wage growth net of labour productivity growth and from growth in prices of capital goods. External inflation pressures are due to foreign prices of imported goods and the exchange rate.

In terms of world trade, the Czech economy is a small and highly open economy. External demand, prices and interest rates have a large impact on prices, production and employment. Domestic importers import goods at world prices and, conversely, exporters must compete with products from abroad. Exporters’ trade contracts are nominally sticky in foreign currency in the short run. An unexpected sudden exchange rate movement thus first affects exporters’ profit margins. Exporters can subsequently adjust their production prices, but at the risk of reducing their price competitiveness. Besides price competitiveness, the model also takes account of non-price competitiveness, reflecting developments in the structure of foreign trade and the growing share of goods requiring high technology and know-how.

In accounting terms, the external sector is described by the balance of payments. The difference between nominal exports and imports (putting it simply, the current account deficit) is offset by movements on the financial account relating to holdings of foreign bonds. Equilibrium is reached in bond trading through the uncovered interest parity. The interest rate differential between the foreign (EURIBOR) and domestic (PRIBOR) interest rate is offset by expected appreciation (depreciation) of the exchange rate, taking into account the risk premium.