RDP 8901: The World Economy from 1979 to 1988: Results from the MSG2 Model 4. Simulation Properties

This section presents policy multipliers for fiscal and monetary policies in the U.S., Japan, and Germany.^[4] It examines both unanticipated and anticipated policy changes. As with any policy change in a rational expectations model, we must be careful to specify precisely the entire future path of policies.

i. Fiscal Policy Transmission

In this section we examine the effects of fiscal expansions in the U.S., Japan and Germany. In implementing a change in fiscal policy, it is important that tax and spending policies in any country be consistent with the intertemporal budget constraint facing each government. The actual policy change is a permanent increase in the level of government expenditure with taxes only rising due to endogenous changes in tax receipts resulting from changes in economic activity. Over time, taxes on labour income are also assumed to rise to cover the increasing interest burden of a rising stock of public debt. The overall fiscal deficit remains permanently higher although the primary fiscal spending (defined as spending net of interest repayments minus total taxes) eventually turns to a surplus to prevent the explosive growth of government debt.

We examine two alternative fiscal expansions. The first is a permanent increase of 1 percent of GNP in the level of government expenditure. The second is an announced gradual expansion of fiscal spending equal to one percent of GNP in the first year, two percent of GNP in the second and then permanently 3 percent of GNP from the third year onwards. The announced policy is assumed to be perfectly credible to the private sector.

Table 7 contains the results for the case of a permanent 1 percent of GNP increase in real government expenditure in the U.S.. All variables are expressed as deviations from an initial baseline. GDP is recorded as a percentage deviation from the initial baseline (e.g. 0.56 percent of GDP in year 1). The budget deficit and the trade balance are reported as deviations from baseline in percent of potential GDP. Thus, in year 1, the fiscal deficit rises relative to the baseline by 0.79 of one percent of U.S. potential GDP. Inflation and interest rates are reported as deviations in percentage points relative to the baseline (rather than as deviations as a percent of their baseline values). Thus, inflation is seen to fall by 0.11 percentage points in year 1, while short-term interest rates increase by 1.17 percentage points (i.e. 117 basis points). The four U.S. bilateral exchange rates are reported as a percentage change from baseline values. Note that a negative value for the exchange rates indicates an appreciation of the U.S. dollar.

Now, let us consider the simulation results for the U.S. fiscal expansion. What should we expect from theory? From the Mundell-Fleming model, we should expect that a bond-financed fiscal expansion in the presence of perfect substitutability of home and foreign financial assets should result in a rise in domestic income and an appreciation of the U.S. dollar exchange rate. Indeed, GDP rises by 0.56 percentage points in the first year, while the dollar appreciates by 5.0 percent vis-a-vis the yen, 4.5 percent vis-a-vis the Deutschemark and the REMS currency (called ems) and 4.0 percent vis-a-vis the ROECD currency (called roec). The rise in output and the appreciation of the dollar produces a large trade deficit in the U.S., equal to 0.39 percent of GDP in the first year of the fiscal expansion. Note that there is some slight crowding out of private investment and private consumption in the U.S.. The rise in real interest rates dominate the effects of a stronger economy. The effect on consumption is ambiguous as the forward looking component falls due to higher interest rates while the proportion driven by current disposable income rises. The effect on investment is also ambiguous. The share market falls because the higher real interest rate dominates the effect of higher output on the valuation of future profitability.

Importantly, the Mundell-Fleming model teaches that the transmission effect of a U.S. fiscal policy expansion on foreign output is ambiguous, for the reasons already alluded to. On the one hand, world interest rates rise, which tends to depress foreign income. On the other hand, U.S. demand for foreign products rises, which tends to raise foreign income through a spurt in exports. As described in Bruno and Sachs (1985, chapter 6), and in Oudiz and Sachs (1984), the transmission is more likely to be negative if foreign wages and prices rise rapidly in response to the depreciation of the foreign currencies vis-a-vis the dollar following the U.S. fiscal action. If foreign wages and prices are fixed, then the U.S. fiscal expansion will tend to be positively transmitted.

As can be seen from Table 7, the effect of the permanent fiscal expansion is positive transmission to each region. The positive transmission is almost dissipated after the first year in Japan although output in other regions stays above baseline for a number of years. Wages adjust slowly in Europe whereas they adjust very quickly in Japan. As is evident from the table, the negative effects on foreign consumption and investment resulting from higher interest rates start to dominate the expansionary effects of greater exports to the U.S. as soon as the second year for Japan. Note that inflation is increased throughout the world following the U.S. fiscal expansion. Most of the inflationary effect abroad arises because the foreign currencies depreciate against the dollar after the U.S. fiscal expansion.

Tables 8 and 9 show the effects of permanent fiscal expansions in Japan and Germany, respectively. Note the following important point. The Japanese and German fiscal expansions have almost no effect on U.S. GDP, as a result of the fact that these economies are considerably smaller than the U.S. A one percent of GDP Japanese bond-financed fiscal expansion is seen to appreciate the yen by 6.65 percent, and to worsen the Japanese trade balance by about 0.84 percent of Japanese GDP. Overall, the call for a Japanese fiscal expansion can be seen to have very mixed merit. U.S. output is unlikely to change much, and could even decline in response to a Japanese expansion. The U.S. trade balance would improve by only 0.09 percent of U.S. GDP (less than $4 billion) for each increase in Japanese government spending of 1 percent of GDP. On the other hand, the Japanese trade surplus would fall substantially with an increase in Japanese public spending. For Germany, these remarks hold even more strongly. Germany (without the REMS) is simply too small to have any major effect on the rest of the industrial economies.

Table 10 shows the same experiment for an announced gradual increase in fiscal expenditure in the U.S.. The experiment is a rise in fiscal expenditure of 1 percent of GDP in year 1, 2 percent of GDP in year 2 and 3 percent of GNP from year 3 onwards. Since this simulation involves an anticipated sequence of future deficit increases in the U.S., the forward-looking properties of the assets markets in the MSG2 model are important in the analysis.^[5] The policy announcement leads to a rise in long interest rates and a fall in short interest rates. The U.S. dollar appreciates against the other major currencies which leads to a fall in U.S. exports. The long interest rate rise leads to a fall in domestic demand which together with the fall in exports, lowers GDP in the first year. Over time as the spending increases take effect GDP rises until the fourth year when conventional crowding out begins to take hold. Interpreted in terms of the Gramm-Rudman package, the announcement of the future fiscal cuts raises output currently, mainly by reducing long-term real interest rates and depreciating the dollar upon the announcement of the policy. Later on, as the fiscal deficits are actually cut, then the negative demand effects on the economy of the fiscal contraction show up in reduced output and employment.

The anticipated fiscal expansion is now negatively transmitted to each region through large rises in long real interest rates throughout the world.

ii. Monetary Policy Transmission

In this section we examine the consequences of a sustained monetary expansion. Both a one-off increase in the rate of growth of money (i.e. a rise in the level of money balances) and a permanent increase in the anticipated rate of growth of money are examined.

As with fiscal policy, the international transmission of monetary policy has a theoretically ambiguous sign. A domestic monetary expansion tends to depreciate the home exchange rate and to reduce world real interest rates. The exchange rate depreciation shifts demand away from other countries and towards the home country, while the reduction in world real interest rates tends to raise demand in the rest of the world. In the simple Mundell-Fleming model, in which output prices and nominal wages are fixed in the other countries, the exchange rate effect dominates, so that foreign output falls when the home country increases the money supply. Home monetary expansion is then beggar-thy-neighbour. In more elaborate models with wage price dynamics, either the exchange rate channel or the interest rate channel might dominate.

Monetary policy is also ambiguous with respect to the effect on the domestic trade and current account balances. Higher domestic money improves international competitiveness by depreciating the home exchange rate. Assuming that the standard Marshall-Lerner conditions hold (as they do in the MSG2 model), this effect tends to improve the trade balance and current account. On the other hand, the fall in interest rates tends to raise investment demand and to lower savings, thereby worsening the trade and current account balances. The overall effect is ambiguous.

Finally, note the magnitude of the effect of a monetary expansion on the nominal exchange rate. It is well known from the Dornbusch (1976) model that the exchange rate will depreciate upon a permanent, once-and-for-all increase in the money supply, but that the size of the impact depreciation may exceed (“overshoot”) or fall below (“undershoot”) the long-run change in the nominal rate, which just equals the proportionate change in the money stock. If the effect of the exchange rate on domestic demand is large (through the effect on the trade balance), and if the effect of domestic demand on money demand is large (through the income elasticity of demand for money), and if the exchange rate depreciation causes a rapid rise in domestic prices, then it can be shown that home nominal interest rates will tend to rise after the money expansion, and the home exchange rate will tend to undershoot its long-run change. If on the other hand, one or all of these three channels is weak, then domestic nominal interest rates will tend to fall after the money expansion, and the exchange rate will tend to overshoot its long-run change.

Let us now examine these effects in the MSG2 model. As seen in Table 11, a one percent U.S. monetary expansion raises U.S. output by 0.42 percent in the first year, and causes the exchange rate to depreciate by 1.5 percent, overshooting its long run level of 1 percent. Previous studies using this model found almost no overshooting. The reason for the current result is the assumption that import prices in the U.S. do not adjust fully to exchange rate changes in the short run. This is in line with in line with the empirical results of Baldwin and Krugman (1986) and Mann (1987). U.S. inflation increases by one-third of a percent, which is far more inflation per unit of demand stimulus than for fiscal policy, because of the opposite direction of effect on the exchange rate (i.e. for fiscal policy, the dollar appreciates, tending to reduce inflation; while for monetary policy, the dollar depreciates, tending to increase inflation). Remarkably, there is almost no international transmission of U.S. monetary policy to the output of the other countries. Moreover, the U.S. trade balance remains virtually unchanged.

Consider the effects on the direction of trade flows. The U.S. sells more to the rest of the world and buys more from the rest of the world. The other regions divert their own export sales from the non-U.S. market to the U.S. market. Total imports in the rest of the world remain unchanged, but shift in composition to a higher share of imports from the U.S. Total exports in the rest of the world also remain virtually unchanged, but shift to supply the growing U.S. market, and away from third, non-U.S. markets.

The same pattern of proportionate depreciation of the exchange rate, with no effect on the trade balance of the expanding country, or the outputs of the foreign countries, holds for a monetary expansion in the other OECD regions shown in tables 12 and 13. This general conclusion is a key one, for it says that floating exchange rates effectively insulate the output of countries from the monetary policies abroad. The U.S. would benefit little on the output side from discount rate cuts in Europe and Japan.

Compare in Tables 11 and 12 the output effects of a monetary expansion in the U.S. and in Japan. In the U.S. case, output rises relative to the baseline for more than five years. In the Japanese case, on the other hand, output rises in the year of the fiscal policy change, but then falls to close to the baseline level in the following years. The difference in behavior stems from the assumed difference in wage setting patterns in the two countries. In the U.S., nominal wages are set according to a partially backward looking indexation mechanism, which imparts nominal wage sluggishness in the model. In Japan, on the other hand, wages are set in an annual wage cycle, with the wages for the following year targeted, with rational expectations, to hit the labor-market clearing level. In a given year, the labor market can be jolted away from full employment because of unanticipated shocks that occur in the year, but in expectation, the labor market always clears in later years.

Table 14 presents the results for a permanent 1 percent increase in the rate of growth of money in the U.S.. Again the policy raises real output as wages take time to adjust to the higher underlying inflation rate. The nominal exchange rate depreciates by 3.1 percent in the first year but quickly converges to the steady state rate of depreciation of 1 percent a year. Nominal interest rates rise in this case because the expected price movements more than offset the short term liquidity effect of the monetary expansion. Inflation eventually settles down to 1 percent above the baseline. The transmission of the policy change is again small although in this case it is now more stimulative for the rest of the world.

iii. OPEC Oil Price Rise

Table 15 contains the results for an increase in OPEC oil prices. The actual simulation is a shift in OPEC supply which, without any demand response, would double world oil prices. In fact demand does respond and the price of oil only rises by 75 percent. The result is stagflation in each of the major economies. The yen and Deutschemark depreciate in real terms relative to the U.S. dollar because of the relative large U.S. domestic oil industry. Inflation disappears faster in Japan because of the flexibility of the Japanese labour market. Long real interest rates also rise in all countries because of a decline in capital intensity in each region.

iv. Cessation of Lending to Developing Countries

Table 16 contains the results of an exogenous reduction of lending to the LDC's. The reduction is assumed to be an aggregate reduction of 1 percent of U.S. GDP allocated between lending countries based on their share of lending in the 1986 base year.

The result of cutting funds to the LDC's is a trade balance surplus (or smaller deficit) relative to the baseline in the LDC's which is matched by worsening of trade balances in the industrial countries. The exogenous reduction in lending by the industrial economies leads to an excess of world savings which reduces world real interest rates sufficiently to equilibrate world savings and investment. Output initially falls in the industrialized economies due to the fall in LDC demand for industrial country goods, but the fall in output is offset due to the increase in domestic demand in each country resulting from the fall in real interest rates.

Footnotes

More detailed results for a wider range of shocks can be found in McKibbin and Sachs (1988b). [4]

Given the linearity of the model, by reversing the signs of the results this can be interpreted as the result of a credible Gramm-Rudman deficit reduction package. [5]