RDP 8901: The World Economy from 1979 to 1988: Results from the MSG2 Model 2. The World Economy 1978 to 1987

Table 1 shows the swings in real exchange rates from 1978 to 1987. It must be pointed out that the exchange rate data is an average of daily rates for the year in question and understates some of the major swings within years. To supplement this table we present end of period real exchange rates in Table 1a. The general trend in the data is quite clear. The U.S. dollar appreciated from mid 1980 to early 1985 against all major currencies. Since 1985 the dollar has depreciated against all major currencies. Despite the general trend there are some interesting differences between currencies. The dollar appreciated against the yen almost continually from 1979 to 1982. It then stabilized (on an annual average basis and relative to the earlier swings) from 1982 to late 1984 before depreciating substantially from 1985 to 1988. The Deutschemark on the other hand, appreciated relative to the dollar during 1979 and 1980 before a substantial depreciation from mid-1980. This depreciation then continued to 1985. The Deutschemark has followed the yen in appreciating against the dollar during 1986 and 1987.

Table 2 clearly shows the shift in current account balances over the recent decade. The U.S. economy has moved from approximate balance in 1978–79 to a large deficit in 1987. Correspondingly, Japan and Germany have moved further into surplus with the other major countries contributing very little. The overall current account balance of the OECD has remained virtually unchanged.

The dynamics of adjustment of the current account is worth examining closely. The U.S. current account balance began deteriorating in 1982 and the deterioration accelerated during 1983. Japan on the other hand began moving towards surplus from 1981, while the German surplus did not accelerate until 1984.

Table 3 shows the change in fiscal policies in each of the major regions.^[1] The measure used in the table is the general government fiscal position as defined by the OECD. It therefore includes both state and local government. From this table it can be seen that the U.S.

fiscal deficit increased in two distinct stages. The first in 1980 and 1981 and the second, more dramatic, from 1982 to 1987. The first is primarily due to a slowing U.S. economy while the second period is due to a change in the stance of fiscal policy as well as a recession. This is discussed in more detail below where the fiscal policy announcements are discussed. As shown later, the first period of rising fiscal deficits was forecast by the OECD while the second was not.

In contrast, the Japanese fiscal deficit fell continually from 5.5 percent of GNP in 1978 to 0.2 percent of GNP in 1987. Germany on the other hand experienced an increasing deficit to 1981 which peaked at 3.7 percent of GNP. The German deficit then declined from 1982 onwards to 1.7 percent of GNP in 1987.

Table 4 gives an overall summary of the main features we are attempting to explain. The table contains results for the U.S., Japan and West Germany for output, inflation, short and long nominal interest rates, trade balances, fiscal deficits and real and nominal exchange rates for the period 1978 to 1987. The general trends in the data are clear from this table: slowing world inflation, a rise in world interest rates to 1981 and subsequent falling, a growing U.S. trade deficit and Japanese and German trade surpluses, a large real appreciation then depreciation of the U.S. dollar and divergent real growth relative to trend, with the U.S. contracting until 1983 and then growing strongly and Germany and Japan consistently growing below trend.

In undertaking the tracking exercise in a forward looking model such as the MSG2 model we have to make assumptions about the expected future stance of exogenous policy. The problem of dealing with expected policy is dealt with simply in this paper. There are various sources of information available on fiscal deficits such as the Congressional Budget Office forecasts and Administration forecasts for the U.S. or OECD forecasts for a broader range of countries. The OECD forecasts are the most convenient to use, both because of coverage and availability. The procedure followed here is to use the two-year forecasts for fiscal deficits contained in the “OECD Economic Outlook”. Past the two-year period we assume that the deficit is unchanged as a percent of GNP from the last forecast (except where noted for the Gramm-Rudman simulation).

Table 5 contains the budget deficit forecasts for the U.S., Japan and Germany given by the OECD since 1979. This table is constructed using the December Economic Outlook for each year. The first column of the table gives the year that the forecast was published. For each country there are two columns. The first column gives the expected fiscal outcome for the year of the forecast as well as the following year. The second column gives the actual outcome. For example, in 1980 the forecast for the U.S. deficit was 1 percent of GNP in 1980 and 0.6 percent of GNP in 1981. The actual outcome for 1980 was a deficit of 1.3 percent of GNP and for 1981 was a deficit of 1.0 percent of GNP.

It can be seen that the rise in the U.S. deficit in 1980 was a little larger than forecast in 1979. The deficit in 1982 was a large surprise from the point of view of 1981; the forecast being 1.3 percent of GNP and the outcome 3.5 percent of GNP. The actual outcomes from 1983 to 1986 were less expansionary than forecast in each year. In the case of Japan, the gradual decline in deficits was forecast one year ahead, although the forecast deficit tended to be smaller than the outcome between 1980 and 1983 and larger than the outcome between 1984 and 1987; Japanese deficits fell slightly more slowly than forecast in the earlier period and faster than forecast in the later period. The opposite pattern emerges for Germany. From 1980 to 1984, the projected deficit was well above the actual outcome. For example in 1981 the deficit for 1982 was forecast to be 4 percent of GNP and the actual outcome was 3.3 percent. Similarly in 1982 the deficit for 1983 was forecast to be 4.1 percent of GNP while the actual outcome for 1983 was 2.5 percent of GNP. This suggests that either German fiscal policy was surprisingly tight or the economy grew surprisingly fast in these years. Since 1985, the forecast deficit has been smaller than the outcome.

Table 6 gives a very rough guide to the general setting of policy as discussed in the OECD Economic Outlook corresponding to the relevant year. Obviously, this table is very subjective but it does give some guidance as to the interpretation of policy stance at the time as well as expected policy changes. For example, in 1980 there was discussion of fiscal cuts in Japan as well as discussion of possible U.S. tax cuts from 1981. Monetary policy was described as easing in major countries except the U.S. which was following a tight monetary policy (however interpreted).

The discussion of policy stance and direction of fiscal forecasts give some guidance to the assumed expectations used in the tracking exercise in section 5.

Footnote

The appropriate measure of fiscal stance would be an inflation adjusted structural fiscal deficit. We present the actual deficit because this is the relevant concept for the tracking exercise and it does provide some evidence on fiscal stance. In a full model simulation the inflation and cyclical adjustment is implicitly accounted for. [1]