RDP 8901: The World Economy from 1979 to 1988: Results from the MSG2 Model 6. Conclusion

This paper has shown that the MSG2 model does a reasonable job in tracking the world economy for the decade of the 1980s, although it fails to pickup the surge and subsequent crash in share markets in 1987. It does this without using any constant adjustments to any equations but uses shocks to OPEC prices (which are assumed to be permanent each time they occur), lending to developing countries and actual and expected fiscal and monetary policies in the major OECD economies. It also illustrates the crucial point that monetary policy alone cannot solve the current trade imbalances in the world economy, even though it can have large effects on nominal exchange rates. In the MSG2 model, it is not possible to target a trade balance for any length of time using monetary policy, even though money has very strong output effects in the short-run.

We find that the major sources of swings in the real exchange rate can be fairly well explained by divergent monetary policies in 1982 and 1986–87 and divergent fiscal policies from 1982. The trade imbalances reflect the fiscal imbalances.

Another interesting result from the exercise is that, in examining the full period simulation, arbitrage conditions appear not to hold; expectations do not appear to be rational, yet they are by assumption. This is because in each period, expectations are assumed to be formed rationally based on all information available at the time. In subsequent periods, large unanticipated shocks occur in the world economy, so that expected variables and their actual outcome differ. This does not imply irrational behavior.

Several notes of caution should be re-iterated regarding the forecast from 1988. These results are based on the assumption that all fiscal policies are stable, in the sense that the ratio of government debt to GDP is stabilized in each region, through changes in tax policy. The smooth path from 1988 is premised on this assumption for fiscal policy and the assumption of no change in monetary policies. Any over-reaction of monetary tightness by monetary authorities in response to rising inflation can substantially change this path. The reader can get some indication of this by modifying the path in table 17 using the policy multipliers from tables 7 through 16.