QUEST III with R&D is one of the latest versions of the class of Dynamic Stochastic General Equilibrium (DSGE) models developed by the European Commission. The QUEST model is a simulation tool to analyze the effects of structural reforms and the response of the economy to a variety of shocks.
Over the last few decades the field of macroeconomic modelling has witnessed a strong progress in the development of new models, recording deep changes both in methodological and theoretical aspects. One of the most successful implementations of these developments has been reached by the DSGE models that integrate typical Keynesian elements (such as imperfect competition and frictions in price setting) into a dynamic general equilibrium framework (e.g. Galí and Gertler, 2007;Christiano et al., 2005). Equilibrium conditions for the main aggregate variables are derived from the optimising behaviour of households and firms, and combined with the market clearing conditions.
This approach establishes a direct relationship between the structural features of the economy and parameters in reduced form, something that was not always possible in large macroeconometric models. In DSGE models, the calibrated (or estimated) parameters represent deep structural parameters and are thus independent of the conduct of monetary and fiscal policy. From this point of view, DSGE models are not subject to the Lucas (1976) critique, contrary to the traditional macroeconometric models in which the estimated parameters are not invariant to policy shifts or to expected policy changes. This is an important reason why traditional models are not well suited for the analysis of structural reforms or to analyse the effects of different policy interventions.
The QUEST III model belongs to the class of large-scale DSGE models. In particular, the version of model used at the Department of Treasury is an extension of the DSGE model for quantitative policy analysis developed at the Directorate General for Economic and Financial Affairs at the European Commission (see Ratto et al., 2008), augmented with endogenous growth (see Roeger et al., 2008) modelled in the framework developed by Jones (1995, 2005) to adapt the Romer's (1990) model with endogenous development of the R&D sector. In our simulation exercises we use the version of the model calibrated for Italy, already employed by the Commission in multi-country analyses of structural reforms by the European Commission (e.g. D'Auria et al. 2009).
The endogenous growth version of QUEST III is particularly well-suited to analyse the impact of structural economic reforms enhancing growth in the context of the Lisbon Strategy. By including several nominal and real frictions, modelling markets as imperfectly competitive, the model can be used to study the effects of competition-enhancing policy.
On the other hand, endogeniszing factors which determine growth allows the study of policies and reforms aimed at increasing the rate of knowledge creation, while the specification of employment in three skill categories (low, medium, high) allows to address policy measures like increasing the social benefits for low-skilled workers, changing the skill composition of the labour force, promoting high skilled immigration policies and subsidizsing employment of the high-skilled workers in the R&D sector.