RDP 2009-10: Global Relative Price Shocks: The Role of Macroeconomic Policies Appendix A: The G-Cubed Model

The G-Cubed model is an intertemporal general equilibrium model of the world economy. The theoretical structure is outlined in McKibbin and Wilcoxen (1998).^[11] A number of studies – summarised in McKibbin and Vines (2000) – show that the G-Cubed modelling approach has been useful in assessing a range of issues across a number of countries since the mid 1980s.^[12] Some of the principal features of the model are as follows:

• The model is based on explicit intertemporal optimisation by the agents (consumers and firms) in each economy. In contrast to static computable general equilibrium (CGE) models, time and dynamics are of fundamental importance in the G-Cubed model. The MSG-Cubed model is known as a dynamic stochastic general equilibrium (DSGE) model in the macroeconomics literature and a dynamic intertemporal general equilibrium (DIGE) model in the CGE literature.
• In order to track the macroeconomic time series, the behaviour of agents is modified to allow for short-run deviations from optimal behaviour either due to myopia or to restrictions on the ability of households and firms to borrow at the risk-free rate on government debt. For both households and firms, deviations from intertemporal optimising behaviour take the form of rules of thumb, which are consistent with an optimising agent that does not update predictions based on new information about future events. These rules of thumb are chosen to generate the same steady-state behaviour as optimising agents so that in the long run there is only a single intertemporal optimising equilibrium of the model. In the short run, actual behaviour is assumed to be a weighted average of the optimising and rule-of-thumb assumptions. Thus aggregate consumption is a weighted average of consumption based on wealth (current asset valuation and expected future after-tax labour income) and consumption based on current disposable income. Similarly, aggregate investment is a weighted average of investment based on Tobin's Q (a market valuation of the expected future change in the marginal product of capital relative to the cost) and investment based on a backward-looking version of Q.
• There is an explicit treatment of the holding of financial assets, including money. Money is introduced into the model through a restriction that households require money to purchase goods.
• The model also allows for short-run nominal wage rigidity (by different degrees in different economies) and therefore allows for significant periods of unemployment depending on the labour market institutions in each economy. This assumption, when taken together with the explicit role for money, is what gives the model its ‘macroeconomic’ characteristics. (Here again the model's assumptions differ from the standard market-clearing assumption in most CGE models.)
• The model distinguishes between the stickiness of physical capital within sectors and within countries and the flexibility of financial capital, which immediately flows to where expected returns are highest. This important distinction leads to a critical difference between the quantity of physical capital that is available at any time to produce goods and services, and the valuation of that capital as a result of decisions about the allocation of financial capital.

As a result of this structure, the G-Cubed model contains rich dynamic behaviour, driven on the one hand by asset accumulation and, on the other, by wage adjustment to a neoclassical steady state. It embodies a wide range of assumptions about individual behaviour and empirical regularities in a general equilibrium framework. The interdependencies are dealt with by using a computer algorithm that solves for the rational expectations equilibrium of the global economy. It is important to stress that the term ‘general equilibrium’ is used to signify that as many interactions as possible are captured, not that all economies are in a full market-clearing equilibrium at each point in time. Although it is assumed that market forces eventually drive the world economy to neoclassical steady-state growth equilibrium, unemployment does emerge for long periods due to wage stickiness, to an extent that differs between economies due to differences in labour market institutions.

Footnotes

Full details of the model can be obtained by contacting the authors. [11]

These issues include: Reaganomics in the 1980s; German unification in the early 1990s; fiscal consolidation in Europe in the mid 1990s; the formation of NAFTA; the Asian crisis; and the productivity boom in the United States. [12]