RDP 2009-10: Global Relative Price Shocks: The Role of Macroeconomic Policies 4. The Model

G-Cubed is a widely used dynamic intertemporal general equilibrium model of the world economy (which can be thought of as a hybrid dynamic stochastic general equilibrium (DSGE) model).^[2] In the version used in this paper, there are 15 regions (Table 2), each with six sectors of production. The model produces annual results for trajectories running decades into the future.

Table 2: Economies in G-Cubed Model

United States	China
Japan	India
United Kingdom	Other Asia
Germany	Latin America
Rest of euro area	Other LDC (less developed countries)
Canada	Eastern Europe & former Soviet Union
Australia	OPEC
Rest of the OECD

Because G-Cubed is an intertemporal model, it is necessary to calculate a baseline, or ‘business-as-usual’ solution before the model can be used for policy simulations. In order to do so, we begin by making assumptions about the future course of key exogenous variables. We take the underlying long-run rate of world population growth plus productivity growth to be 1.8 per cent per year, and take the long-run real interest rate to be 4 per cent. We also assume that tax rates and the shares of government spending devoted to each commodity remain unchanged.

In the G-Cubed model, projections are made based on a range of input assumptions. There are two key inputs into the growth rate of each sector in the model. The first is the economy-wide population projection, which differs by economy according to the mid-projections made by the United Nations.^[3] The second is the sectoral productivity growth rate. For the baseline, we follow McKibbin, Pearce and Stegman (2007), where each energy sector in the United States is assumed to have a rate of productivity growth of 0.1 per cent over the next century. Each non-energy sector has an initial productivity growth rate close to historical experience but gradually converging to 1.8 per cent per year in the long run. We then assume that each equivalent sector in each of the other economies will catch up to the US sector in terms of productivity, closing the gap by 2 per cent per year, except for developing countries, which are assumed to close the gap by 1 per cent per year. The initial gaps are therefore critical for the subsequent sectoral productivity growth rate. We assume that the initial gap between all sectors and the US sectors are equal to the gap between aggregate purchasing-power-parity (PPP) GDP per capita between each economy and the United States. We cannot easily use sectoral PPP gap measures because these are difficult to get in a consistent manner and with a sufficient coverage for our purposes. Thus the initial benchmark is based on the same gap for each sector as the initial gap for the economy as a whole. If we then have evidence that a particular sector is likely to be closer to, or further away from, the US sectors than the aggregate numbers suggest, we adjust the initial sectoral gaps while attempting to keep the aggregate gaps consistent with the GDP per capita gaps.

Given these exogenous inputs for population growth and the growth of productivity across sectors, we then solve the model with the other drivers of growth, namely capital accumulation and sectoral demand for inputs of energy and other materials, which are all endogenously determined. Critical to the nature and scale of growth across economies are the assumptions outlined above plus the underlying assumptions that: financial capital flows to where the return is highest; physical capital is sector-specific in the short run; labour can flow freely across sectors within a country but not between economies; and international trade in goods and financial capital is possible, subject to existing tax structures and trade restrictions. Thus the economic growth of any particular economy is not completely determined by the exogenous inputs in that country alone, since all countries are linked through goods and asset markets.

In the analysis in this paper, we start with a projection of the model from 2002 onwards assuming steady-state growth in productivity as described above. We impose each shock, generate results in terms of deviations from the baseline and thereby determine the contribution of each shock to changes in relative prices and macroeconomic variables.

4.1 Policy Responses

The results of this exercise will depend on the monetary and fiscal reactions. We assume that fiscal deficits are not changed in these results so as to focus on the core shocks without any fiscal stabilisers; that is, any changes in revenue are offset by changes in government spending spread across sectors based on historical spending shares. Of course, alternative assumptions regarding fiscal policy will change the results. The monetary responses have each economy following a Henderson-McKibbin-Taylor (HMT) rule shown in Equation (1), with different weights on inflation (π) relative to target (π^T), output growth (Δy) relative to potential growth (Δy^T) and the change in the exchange rate (Δe) relative to target (Δe^T).

The assumed parameter values are set out in Table 3. Note that China and most developing economies have a non-zero weight on the change in their exchange rate relative to the US dollar.

Footnotes

Appendix A provides additional details. See McKibbin and Wilcoxen (1998) for a complete description. This paper uses version 84O of G-Cubed. [2]

See <http://esa.un.org/unpp/index.asp>. [3]