RDP 8712: Policy Analysis with the MSG2 Model 1. Introduction

Warwick J. McKibbin

November 1987

This paper focusses on the consequences for a small open economy, such as Australia, of macroeconomic policies in the rest of the OECD. The analysis in this paper uses a dynamic intertemporal general equilibrium model to calibrate the macroeconomic linkages in the world economy. This model, which is called MSG2, is a further development of the MSG model that has been used in earlier studies.[1] The new MSG2 model is a six region macroeconomic model of the world economy with several dozen behavioural equations per region. It is a familiar macroeconomic model yet is derived using principles usually associated with computable general equilibrium models.[2] It is distinctive in solving for a full intertemporal equilibrium, with agents having rational expectations of future variables, particularly in the asset markets.[3]

An overview of the model is given in section 2. The version of MSG2 used in this paper also includes a new module for Australia.[4] In section 3, the model is used to examine the domestic and international transmission of monetary and fiscal policy. It is also used to examine the implications of the Gramm-Rudman budget reduction package on the world economy and on Australia in particular. Section 4 contains a summary and conclusions.

Footnotes

See Sachs and McKibbin (1985), McKibbin and Sachs (1986), Ishii, McKibbin and Sachs (1986). [1]

For example see Dixon et al (1982) and Deardorff and Stern (1986). This differs from the standard macroeconomic model approach taken by most macroeconomic modellers. Further details can be found in McKibbin (1986) and McKibbin and Sachs (1987). [2]

The use of rational expectations in the foreign exchange market has also recently been implemented in an Australian model by Murphy (1986) in the AMPS model. The crucial role of expectations is also recognised in the RBII model (Jonson et al) (1976)) which assumes expectations are driven by signals contained in changes in buffer stocks, such as monetary disequilibrium. [3]

The reader is referred to McKibbin and Siegloff (1987b) for further detailed development of the Australian module. [4]