RDP 8901: The World Economy from 1979 to 1988: Results from the MSG2 Model 1. Introduction

Between 1979 and 1985 the U.S. dollar appreciated by over 40 percent in real terms relative to other major currencies. The U.S. dollar then depreciated by close to 50 percent relative to the same currencies between 1985 and 1988. The U.S. current account deficit rose from approximately zero in 1979 to 3.6 percent of GNP in 1987 while over the same period the current account surpluses of Japan and Germany grew from close to zero to 3.7 and 3.9 percent of own GNP respectively. There are many possible explanations of these wild swings in the world economy. These include divergent fiscal policies in the main countries, divergent monetary policies, trade frictions, flight to the U.S. “Safe Haven”, cessation of lending to developing countries, and shifts in productivity between countries, to name the popular examples.

The purpose of this paper is to use the MSG2 model of the world economy to examine the role played by monetary and fiscal policies in the major industrialized countries in explaining the 1980s. As well as providing some evidence on the factors responsible for the large swings, this exercise also indicates how the MSG2 model tracks the recent decade and is a valuable form of model validation. Of course, evidence of a good performance in tracking the 1980s using only changes in monetary and fiscal policies, exogenous oil price shocks and lending to developing countries does not mean that the model necessarily captures the actual factors but it is encouraging evidence.

Section 2 of the paper examines the behaviour of key macroeconomic variables for the major regions of the world economy during the 1980s. The MSG2 model is then introduced in section 3. The properties of the model are examined in section 4 using multipliers for exogenous changes in policy. The tracking performance is assessed in section 5. Section 6 summarizes the major results of the paper and discusses the policy implications of the analysis including the appropriate policy mix in the major economies to redress the large imbalances which continue to threaten economic stability in the world economy.

We find that changes in macroeconomic policy explain a substantial part of the experience up to 1985. The exact timing of the turn around in the U.S. dollar is not completely explained by the model. The appreciation of the U.S. dollar relative to the Deutschemark from the end of 1984 to the first months of 1985 appears to be an overshoot. The size of the decline in the U.S. dollar during 1986 and 1987 is difficult to explain by observed policy actions alone, although once anticipated policies are considered, such as an anticipated relaxation of U.S. monetary policy and tightening of Japanese and German monetary policy, the model tracks the experience reasonably well.