Back Matter

Back Matter

Author(s):
Hamid Faruqee, Douglas Laxton, Bart Turtelboom, Peter Isard, and Eswar Prasad
Published Date:
May 1998
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    Work on a more extensive disaggregation of the developing and transition economies is under way, and changes in the core set of industrial countries and country groups will be required in the context of European Economic and Monetary Union.

    A no-Ponzi-game condition—that asymptotically the real interest rate must exceed the growth rate—is often imposed in optimizing models that are used for policy analysis; see, for example, the discussions of basic infinite-horizon models and overlapping-generations models in Blanchard and Fischer (1989). In MULTIMOD, the difference between the steady-state levels of the real interest rate and the growth rate depends on the parameters of the production function, the rate of depreciation, the rate of time preference, and the level of world government debt.

    Among the earliest of these models, each focusing on only a single economy, were Klein and Goldberger (1955), Klein and others (1961), and Duesenberry and others (1965). Bryant, Hooper, and Mann (1993) provides descriptions of, and references to, a number of the multicountry macroeconometric models that are currently in use; see also Edison, Marquez, and Tryon (1987), Gagnon (1991), Helliwell and others (1990), McKibbin and Sachs (1991), and Meredith (1989).

    The procedure for making a system of estimated equations consistent with an externally generated baseline forecast essentially involves solving for, and imposing, a set of residuals under which the estimated model generates the baseline solution. Strictly speaking, the World Economic Outlook baseline projects only over a five-year horizon. The manner in which the baseline path is extended beyond this horizon is discussed in Section III.

    Indeed, in many contexts the effects of shocks, measured as deviations from the baseline path, are largely independent of the specific baseline forecast.

    Loosely speaking, the main criteria for incorporating an estimated equation specification are that the specification should be based to a large extent on underlying theory and should not generate an unrealistic degree of macroeconomic variability when embedded into the MULTIMOD system of equations. Thus, in comparison with models for which short-term forecasting accuracy is a high priority, MULTIMOD has been estimated with a relatively low willingness to sacrifice theoretical foundations in order to obtain better goodness of fit.

    See Helliwell (1993). Model-consistent expectations appear to be relatively more attractive for asset markets, and adaptive expectations more popular for markets with greater inertia in price adjustment.

    For example, the Federal Reserve Board's FRB/Global Model (see Levin, Rogers, and Tryon, 1997) relies on backward-looking (“limited-information”) expectations as its base case, although it can also be simulated under the assumption of model-consistent expectations.

    Among those who blame misleading economic theories for the “great inflation” in the United States in the late 1960s and 1970s, Taylor (1996, p. 184) notes that during that period, “the idea that there is a long-run Phillips curve trade-off began to appear in textbooks, newspapers, and even the Economic Report of the President; the inflation cost of an overheated economy, according to this theory, was simply a higher rate of inflation, not rising inflation.” Studies by economic historians, such as De Long (1996), add support for this view by rejecting the alternative hypothesis that supply shocks (especially oil price shocks) were the main source of the rise in inflation. Taylor also emphasizes the coincidence in timing between the monetary disinflation of the 1980s and the incorporation into macroeconomics of more reasonable models of expectations and price adjustment, attributable largely to research started by Lucas (1972).

    By intrinsic macroeconomic dynamics, we mean those dynamics that may be assumed to be invariant to the types of policy experiments that are being considered. Of course, for enormous changes in policy rules, contract length as well as the degree of nominal indexation may change, and it then becomes difficult to determine precisely what is structure. However, by assuming that inflation expectations partly reflect the model-consistent solution, MULTIMOD at least makes some attempt to control for the first-order effects of the Lucas critique.

    “The departure from strict superneutrality reflects the fact that MULTIMOD embodies an “inflation tax.”

    In this regard, analysis of how rational agents form expectations when it takes time to learn about the nature of various policy changes and other exogenous shocks remains an important area for additional research.

    In this respect, the methodology for solving MULTIMOD Mark III is similar to that for solving the Bank of Canada's Quarterly Projection Model—see Laxton and Tetlow (1992) and other references cited in Section III.

    As noted earlier and elaborated in Section V, inflation expectations are only partially forward looking.

    See Masson and Symansky (1992), Masson and Turtelboom (1997), and the discussion in Section VIII below.

    In Mark III, the group comprises six high-income oil exporters—Kuwait, Libya, Oman, Qatar, Saudi Arabia, and United Arab Emirates—corresponding to the World Economic Outlook group of capital-exporting developing countries. The work program for the near future includes redefining the aggregation scheme for the nonindustrial economies and enhancing the models of their macroeconomic behavior.

    A modified version of the Mark II model disaggregates the main developing country bloc into four separate groups: Western Hemisphere, Africa, the group of four newly industrialized economies, and an aggregate of the other non-oil developing countries. See Bayoumi, Hewitt, and Symansky (1995) and the discussion in Section VIII below.

    The group of net creditor developing countries is assumed to produce only oil.

    The discount rate that enters the calculations of human and nonhuman wealth includes the exogenous rate of population growth and the after-tax interest rate applicable to saving (the nominal riskless rate of interest plus a premium that reflects both the credit risk on personal income and the probability of death).

    As discussed in Section V, the issue of whether fiscal policy has non-Ricardian effects continues to be actively debated as an empirical proposition. The rationale for adopting the Mark III consumption-saving specification in a model used for policy analysis comes partly from the appeal of the theoretical framework, but also reflects a balancing of the prospective welfare costs of type 1 and type 2 policy errors. Fiscal policy actions based on erroneous prescriptions from a non-Ricardian model when the “true model” was Ricardian would presumably tend to be less costly than fiscal policy inaction based on erroneous analysis with a Ricardian model when the “true model” was non Ricardian.

    Measures of nominal and real effective exchange rates are also constructed in MULTIMOD using the IMF's Information Notice System weights (for a description of these weights, see McGuirk (1987) and Zanello and Desruelle (1997)).

    For the developing country blocs, the public and private sectors are essentially treated as an aggregate, with no separation between government spending and private spending and no explicit treatment of taxes.

    One of the modified versions of MULTIMOD (see Section VIII) includes indirect taxes as well as the direct taxes on labor and capital incomes.

    For some purposes, it is appropriate to “turn off” the tax rate reaction function and to allow debt to accumulate under a constant basic tax rate.

    See the discussion in Masson, Symansky, and Meredith (1990), pp. 11–12.

    As with the fiscal policy feedback rules, the parameters of these monetary policy reaction functions are imposed, with parameter values set at levels that make the model stable.

    We plan to undertake such an analysis over the next year in conjunction with regrouping some of the industrial countries in the context of European Economic and Monetary Union.

    To the extent that the Mark III and Mark II models embody the same reaction functions, comparisons of “standard simulations” of the two models can be revealing. However, for models with forward-looking expectations, which take account inter alia of the nature of policy behavior, the optimal forms of monetary policy reaction functions are model specific, and one can question the meaningfulness of comparing standard simulations of models with either different optimal policy reaction functions or common suboptimal reaction functions.

    Neither of the developing country models contains a monetary sector.

    These assumptions, which are retained from the Mark I model, are consistent with the paradigm that the Organization of Petroleum Exporting Countries sets the price of oil and serves as residual supplier. It may be noted that inventories of oil are not explicit in the model; changes in inventories are implicitly included in consumption.

    The paradigm is a crop harvest or production from mines, where individual producers are too small to influence the price and where the marginal costs of expanding contemporaneous supply are infinite.

    Implicitly, any actual outputs and exports of primary commodities by the industrial countries are aggregated with their out-puts and exports of the main composite goods.

    Debt interest payments are calculated net of interest receipts on international reserve assets.

    Neither the data nor the model is adequate for considering other factors relevant to the sectoral allocation of investment.

    This description is oversimplified, of course, because it takes as given the steady-state levels of saving and investment. In general, the steady-state values of saving, investment, and most other variables depend on exogenously specified assumptions about certain variables and key parameters; see Section III.

    In moving to a modeling system with parallel dynamic and steady-state equations, Mark III has followed in the footsteps of other national and two-region models that have been designed for policy analysis. For examples of such models and some relevant applications, see Laxton and Tetlow (1992), Black and others (1994), Bryant (1996), Coletti and others (1996), Faruqee, Laxton, and Symansky (1997), Bryant and Zhang (1996a, 1996b), and Black and others (1997).

    This simplification is made for expositional purposes. In Mark III, the rate of return on net foreign assets is a blend of the rate of return on a short-term debt instrument and the rate of return on a long-term debt instrument.

    If the real interest rate was less than the growth rate, there would be no real costs, and indeed there would be potential benefits, from delaying fiscal consolidation. In fact, if the real interest rate were less than the growth rate and independent of fiscal policy, a government could reduce tax rates, issue debt instruments, and allow growth in its tax base to eliminate the debt. For this reason, most theoretical optimizing models used for policy analysis impose a no-Ponzi-game condition; see, for reference, the discussion in Blanchard and Fischer (1989).

    The real long-term interest rate in the steady state is assumed to be 5.25 percent, reflecting an assumption that the equilibrium term premium is 100 basis points.

    This capability reflects advances in solution methodology.

    The TROLL programs used to create SSMOD and DYNMOD for Mark III build up the world models by combining the codes of individual country models. This means that it is straightforward to simulate and study the individual country SS and DYN models in isolation. Obviously, this approach can save considerable time and computer resources in analyzing shocks where there are only second-order feedback effects across countries.

    The horizon over which variables converge to steady-state values in the baseline solution of the model may differ from the time it takes to achieve convergence in the shock-minus-control values of the same variables. In the Mark III baseline, real interest rates and some real growth rates reach their steady-state values within 10 or 20 years, while demographics take more than half a century to settle down to a zero rate of population growth in all countries.

    See Juillard and Laxton (1996), and Juillard and others (1998) for a comparison of the properties of this algorithm with those of conventional first-order methods.

    Thus, the Phillips curve is vertical in the long run, and any attempt to hold unemployment below its natural rate will result in accelerating inflation; see Friedman (1968). The incorporation of a supply side into what was essentially a Keynesian paradigm is sometimes referred to as the “neoclassical synthesis.”

    In early versions of macroeconomic models, it was quite common to set Φ equal to zero because model builders did not have access to robust solution algorithms for solving models where agents were assumed to have some knowledge of the underlying structure and policy process.

    The simple representation in Figure 1 abstracts from any lagged inflation terms.

    This type of convexity was an important feature of the original curve introduced by Phillips (1958) and discussed by Lipsey (1960) and several others. Macklem (1996) and Clark and Laxton (1997) provide a brief history of convexity in the Phillips curve and explain why it was overshadowed by other issues.

    If the degree of convexity in the short-run Phillips curve is independent of the long-term inflation objective, as in Mark III, then it will still be true that the long-run Phillips curve is vertical and the average unemployment rate will be independent of the target inflation rate. However, if convexity in the short-run Phillips curve becomes greater at very low inflation rates, as suggested by Akerlof, Dickens, and Perry (1996), then there may be a permanent trade-off between inflation and unemployment at low inflation rates.

    See Mankiw (1988) and De Long and Summers (1988).

    See also Isard and Laxton (1996), Clark and Laxton (1997), Debelle and Vickery (1997), Laxton, Rose, and Tambakis (1998), and Faruqee, Laxton, and Rose (1998). Studies by Laxton, Rose, and Tetlow (1993), Laxton, Meredith, and Rose (1995), Bean (1996), Turner (1995), Clark, Laxton, and Rose (1995, 1996), Macklem (1996), Fisher, Mahadeva, and Whitley (1996), Dupasquier and Ricketts (1997), and McDonald (1997) have also found evidence of asymmetries in the inflation process for several industrial countries using different empirical specifications.

    This functional form is a slight generalization of the one employed in the TRYM model—see Australia (1996)—and is very similar to the function that was estimated in Chadha, Masson, and Meredith (1992).

    See Fuhrer and Moore (1995) for a derivation of a model with backward- and forward-looking components in a linear Phillips curve framework.

    For discussions of the analytics of disinflation in models with backward- and forward-looking components, see Buiter and Miller (1985) and Chadha, Masson, and Meredith (1992). Equation (9) includes both real and nominal rigidities. For a summary of the recent literature on the microfoundations of the Phillips curve and the importance of both nominal and real rigidities, see Ball and Mankiw (1994).

    Clark, Laxton, and Rose (1996) and others have shown that the Michigan Survey of one-year-ahead inflation expectations provides significant information content in quarterly inflation equations.

    This first step is based on an assumption that most of the variation in long-term bond yields is a result of variation in long-term inflation expectations. The measure of the equilibrium world real interest rate term is meant to account for the trend increase (low frequency variation) in the equilibrium real interest rate that has been a result of the rise in world government debt;for details, see Debelle and Laxton (1997). Goodfriend (1993) and Barr and Campbell (1996) argue that most of the high-frequency variation in long-term bond yields is driven by inflation scares rather than by historical movements in the ex ante real rate of interest.

    Reliable survey measures of inflation expectations for other countries span substantially shorter time periods than the data for the United States.

    The standard error of this estimate is 0.18. Users of MULTIMOD may vary this parameter in simulation mode.

    The term “policy credibility” refers here to the speed with which inflation expectations adjust in response to announced changes in policy obxjectives for inflation.

    The estimation strategy employed here is considerably different from what has been employed in the recent U.S. academic literature on Phillips curves. The latter literature imposes a very strong form of the rational expectations hypothesis, where agents do not make serially correlated forecast errors even in small samples. In structural models, this extreme form of rational expectations breaks down quickly with modest amounts of uncertainty, which explains why these models are rejected overwhelmingly by less restricted time-series representations of the data. For evidence of autocorrelated forecast errors and historical regime shifts in the inflation process, see Evans and Wachtel (1993), Laxton, Ricketts, and Rose (1994), and Ricketts and Rose (1995).

    Recent studies focusing on the behavior of long-term interest rates suggest that market participants in some cases revise their expectations of long-term inflation very slowly in response to observed inflation performance. For example, Gagnon (1996) shows that the Fisher equation holds surprisingly well if long moving averages of past inflation are used to measure long-term inflation expectations.

    Using a multiple regime-switching model, Laxton, Ricketts, and Rose (1994) show that, because of historical inflation bias, it may take the monetary authorities a considerable length of time to establish credibility in a low-inflation regime and that, along the transition path, there will be a persistent period of excess supply until credibility has been established. However, in any one particular draw, inflation expectations will converge slowly and then suddenly credibility will improve when the time-series properties of the inflation process become consistent with the underlying policy fundamentals. This view of the importance of policy credibility can account for slow adjustment on the one hand, as well as for cases where long-term interest rates jump because market participants become convinced that the monetary authorities and democratic process are committed to low inflation. This can explain, for example, why it has taken a very long time for long-term inflation expectations in Canada to fall below rates in the United States, but how certain countries that appear to be committed to Economic and Monetary Union have experienced a very rapid decline in their long-term interest rate differentials with Germany.

    Kuttner (1992, 1994) adopts a strategy that is closest to the one we follow, but he assumes that the Phillips curve has a linear specification.

    The software package that was used to estimate the model was TSP.

    Specifications of the derived demand for labor typically also include a real wage disequilibrium term, as in Bartolini, Razin, and Symansky (1995). However, the estimated parameter on this term is usually found to be fairly small compared with the role of the output gap, and this effect is ignored in Mark III.

    The model was estimated this way because there was significant residual autocorrelation when the model was estimated with ordinary least squares in a few countries. This autocorrelation is probably a result of inconsistencies in the filtered estimates of the natural rate and potential output. In the future it would be preferable to develop model-consistent measures of these trend variables in a larger system that embodies equation (15).

    The relatively low parameter estimate on the output gap for Italy presumably is not attributable to extremely low variability in the underlying unemployment rate. One possibility is that Italy has had larger shocks to the natural rate of unemployment than Japan and that the simple univariate filter that is being used to estimate potential output fails to capture the direct link from changes in the natural rate to potential output. As a consequence, we would expect that the parameter estimate on the output gap may be biased downward, and this can perhaps account for why the model doesn't fit nearly as well for Italy as it does for the other countries. In future work, we hope to develop system estimates of potential output and the natural rate that will alleviate any problems of this type.

    These estimates are based on the latest available input-output tables; see the notes to Table 4.

    The revival of the classical view and the Ricardian equivalence proposition was led by Barro (1974). See Barro (1989) for a more recent review.

    The seminal paper is Diamond (1965); see Persson (1985) for open economy extensions. See Bernheim (1989) for a more recent review of the neoclassical approach to budget deficits.

    See Jappelli and Pagano (1989) for an international comparison of age-earnings profiles (and capital market imperfections).

    See Bernheim and Bagwell (1988) for a critical review on the dynastic approach.

    In a survey of empirical tests for Ricardian equivalence, Seater (1993) claims that the evidence is supportive of the equivalence proposition; at the same time, however, he acknowledges that the results of various studies correlate closely with the political leanings of the investigator (p. 184). See Barro (1989) and Bernheim (1989) for opposing interpretations of the empirical evidence.

    See Blanchard (1985). If the probability of death goes to zero, agents have infinite horizons.

    The case of population (and productivity) growth is addressed later.

    Labor supply is taken to be inelastically supplied. Hence, the labor-leisure decision is not part of the consumer's optimization problem. See Ludvigson (1996) for a recent paper on fiscal policy effects with endogenous labor supply.

    The term pw(s,t) in the dynamic budget constraint reflects the efficient operation of the life insurance or annuities market. See Yaari (1965) or Blanchard (1985).

    This result assumes logarithmic utility. The case of constant relative risk aversion (CRRA utility) (see also Blanchard, 1985) and the implications of different intertemporal substitution elasticities are explored in Faruqee, Laxton, and Symansky (1997).

    For a given (world) real interest rate, individual human wealth can be written as

    h(s,t)t[y(s,v)τ(s,v)]e(r+p)(vt)dv.

    To derive aggregate variables, we simply sum over all existing generations (or dynasties). Specifically, aggregate variables, denoted by uppercase letters, are derived by integrating over all existing cohorts or generations (indexed by s):

    X(t)tx(s,t)pep(ts)ds.

    To simplify notation, the time arguments in the equations have been dropped in the text, except where potential ambiguities may arise. The time index is reintroduced in the tables.

    Blanchard (1985) examines the case of declining individual income profiles; the more realistic case of nonmonotonic (concave) earnings profiles is mentioned only in passing (footnote 75). Both cases introduce a saving-for-retirement motive and open up the possibility that the economy may be dynamically inefficient (that is, may overaccumulate capital).

    As discussed later, the parameters in equation (21) are chosen such that the weighting function is assumed to be nonnegative and initially increasing; by an adding-up constraint, we also require that

    a1pα1+p+a2pα2+p=1.

    Integrating up equation (23) yields the definition of the human wealth component H1:

    H1(t)t[Y(v)T(v)]e(r+p+α)(vt)dv,

    where the following boundary condition is assumed to be satisfied: limvH1(v)e(r+p+α1)=0;H2 is derived equivalently from equation (24). Hence, disposable labor income is effectively discounted at a rate that depends on r + p + α1 and r + p + α2.

    Another critical parameter affecting the degree of debt non-neutrality is the elasticity of intertemporal substitution, which determines the sensitivity of consumption to changes in interest rates. See Faruqee, Laxton, and Symansky (1997) for a discussion.

    Following Lucas (1967) and Treadway (1969), installation costs are quadratic in the deviation of the investment-capital ratio from its steady-state value:

    A=χ2[1K(δ+g+n)]2K,

    where g is the long-run growth rate, n is the long-run rate of population growth, and χ is a scale parameter in the adjustment cost function. For now, we consider the case where g = n = 0; population and productivity growth are introduced later. For convenience, we assume χ = 1 throughout this section. Investment behavior is discussed more fully in Section VI.

    See also Turnovsky (1996) for a similar small open economy model (with Fisherian separability), but in the context of endogenous growth.

    Assuming that F(K, L) is homogeneous-of-degree-one in its arguments, we can write the production function as LF(K/L, 1) = f(K)[≡F(K, 1)] at L = 1. Also, the following conditions are assumed to apply to guarantee the existence of an interior steady-state solution: 0limkf(K)r+δlimk0f(K). Strict concavity of f(K)—an increasing function—guarantees uniqueness.

    In the case of public investment, the model would need to be revised to include the contribution of the public sector to the domestic capital stock.

    With a time-varying rate of interest, the present value of labor income that comprises human wealth is given by

    H(t)t[Y(v)T(v)]etv(r(z)+p)dzdv.

    Differentiating this expression with respect to time yields the dynamic equation for human wealth shown in Table 6.

    From the equation, permanent-income consumers who comprise 1 − λ, of the population hold all the financial wealth W in the economy. This is because agents are born without wealth and younger agents do not save (that is, accumulate wealth) initially while liquidity constrained.

    By adding up, we have β ≡ a1pl(p + α1), λ1 ≡ 1 − e−(α1+p)(t−τ(t)), λ2 ≡ 1 − e−(α2+p)(t−τ(t)), where τ(t) is an index of the oldest generation still liquidity constrained at time t. By construction, λ2 > λ1, and both parameters can be greater than λ for plausible (hump-shaped) income profiles.

    In terms of specific cohorts, the number of individuals (or dynasties) born as part of cohort s is a proportion of the contemporaneous population given by N(s,s) = bN(s), and the number of these individuals surviving at time t > s is given by N(s, t) = bN(s)e−p(t−s).

    We now have β ≡ a1b/(b + α1), λ1 ≡ − e−(α1+b)(t−1(τ)), λ2 ≡ − e−(α2+b)(t−1(τ))

    Lowercase variables with a time and a generation index refer to individual measures, whereas lowercase variables with only a time argument reflect per capita measures (in units of labor efficiency): x(t) = X(t)/L(t) = X(t)e−(n+g)t. Government spending in labor efficiency units is denoted gvt, to avoid confusion with the growth rate.

    Together, the conditions for nonnegative and initially increasing income profiles imply

    α2a1>α2a2>α1a1>α1a2.

    In reality, individuals generally experience a discontinuous fall in labor supply and wage earnings with retirement. However, given that individuals retire at different ages, the representative income profile averaged over many individuals may be approximated with a smooth function. See also Blanchard (1985) and Saint-Paul (1992).

    Cross-sectional data on real labor income were readily available only for Canada and the United States. For convenience, only the U.S. data are used, although both data sets appear some-what similar.

    The cohort ranges are 18–24, 25–34, 35–44, 45–54, 55–64, and 65 +.

    This will certainly be the case if aggregate labor productivity growth affects absolute labor incomes for all age groups proportionately without affecting the relative (cross-sectional) distribution of income.

    NLLS estimates of the vector of parameters (α, a) seek to minimize the sum of squared residuals u from the following regression: ryt = f(t, α, a) + ut, where f(.) follows from equation (46).

    The imposed parameters are obtained through grid search.

    The theoretical distribution also includes an asymptotic tail of (arbitrarily) old people, whereas in reality this distribution is clearly truncated at some finite maximum age. This latter issue is not too severe a problem given that the very old generations form an increasingly small (infinitesimal) proportion of the population.

    As a share of the total population, the number of survivors from a generation born at time s remaining at time t is equal to be−p(t−s); with a stationary population in steady state, b = p and n = 0. Using this expression, we approximate the model's steady-state age distribution across the (discrete) age groups as shown in the table.

    The calculated birth rate—defined as the relative size of new arrivals (that is, youngest cohort) as a share of the existing adult population—varied from 2½ percent to 3 percent for the United States over the sample period. The average growth rate for the adult population was about ½ of 1 percent over the same period, implying a death rate of 2−2½ percent.

    The estimate of 0.41 here relates to the proportion of consumption that is interest sensitive and needs to be multiplied by a factor of (1 − λ) before comparison with estimates of the elasticity of substitution for aggregate consumption. Patterson and Pesaran (1992) and Attanasio and Weber (1993) place the latter in the range of 0.1 to 0.3; Hall (1988) argues that it may be lower than 0.2.

    The tax cut takes the form of a lowering of the basic tax rate by 2 percentage points of nominal GDP for five years, holding constant the tax rate on capital income; it thus amounts essentially to a lowering of the tax rate on labor income.

    In the full model simulations, the world real interest rate is endogenous and determined by equilibrating world savings and investment. Bayoumi and Laxton (1994) consider the effects of fiscal policy when real interest rate differentials depend on the level of government debt.

    It is assumed that the revenue function has already been maximized vis-à-vis other variable production factors.

    The growth rate of GDP is a composite variable comprising technological progress and labor force dynamics.

    Technically, qt is the Lagrange multiplier on the constraint in equation (49).

    This model is a special case of a more general investment function that includes imperfectly competitive goods markets and imperfect capital markets. Substituting equations (51), (53), and the first derivative of (47) into equation (52) gives an equation that can be estimated in the following “flexible-accelerator” form:

    where the parameters κ are functions of the rate of depreciation, the growth rate of the economy, the tax rate on capital income, and the value of χ in the adjustment-cost function. While the presence of the quadratic term in equation (54) indicates the presence of adjustment costs, the absence of an aggregate cash-flow measure and the aggregate business sector debt implies that there are no distortions (tax-induced or other) that would lead to meaningful financial policies (that is, preference for equity over debt finance, or paying dividends). See Bond and Meghir (1994) for an indepth discussion and empirical implementation and Epstein and Denny (1983) for a rigorous analysis of the flexible-accelerator specification of the adjustment-cost model.

    To maintain the consistency of the national income accounts in MULTIMOD, the marginal product of capital is also used in evaluating household wealth. In particular, since the marginal product of capital is larger than the real interest rate and is used to calculate the share of capital income in total income, it needs to be incorporated in the wealth terms used in consumption behavior as described in Section V, to make sure that aggregate factor income is consistent with the value of production.

    The literature provides a range of estimates. Summers (1981) estimates χ to equal 16.1. Eberly (1997) estimates linear and nonlinear investment equations on firm-level and aggregate data for 11 industrial countries. Based on aggregate measures constructed from the firm-level data in her sample, she finds estimates for χ between 1.4 and 3. Her instrumental variable estimates for firm-level equations are between 1.75 for Belgium and 9 for the Netherlands. Cummins, Hassett, and Oliner (1997) provide estimates on the order of 5–10 based on firm-level data in the United States.

    In the first year, the short-term real interest rate falls because the expected increase in the price level more than offsets the increase in the nominal short-term interest rate.

    We do not elaborate here on international trade in oil and non-oil primary commodities, which was discussed in Section II.

    The OECD has compiled input-output tables for the seven major industrial countries and also for Australia, Denmark, and the Netherlands. The latest versions of these tables (1990 for most countries) were used to compute import propensities for the components of domestic absorption as well as for exports. The last set of numbers reflects exports of goods and services that have a significant content of imported inputs.

    Potential output growth rates were computed using smoothed levels of potential output obtained from the World Economic Outlook database.

    In the core version of Mark III, this term is turned off in simulation mode. Future extensions of the model will incorporate endogenous total factor productivity growth, along the lines of the analysis in Bayoumi, Coe, and Helpman (1996).

    Measures of nominal and real effective exchange rates based on direct trade shares are also computed in the model. These weights take into account competition in third markets and also the differences among countries in the relative importance of international trade. The methodology for computing the weights is similar to that of the IMF's Information Notice System described in McGuirk (1987) and Zanello and Desruelle (1997).

    See Meredith (1997) for details on the derivation of these weights.

    The model contains equations for adjusted exports that are equal to unadjusted exports, determined using the export equations described above, plus, for each country, a coefficient times the excess relative to baseline of world import volumes over export volumes. This coefficient reflects the share of the country in total world trade in goods and nonfactor services excluding oil. The remaining discrepancy in nominal trade flows is allocated across countries in a similar fashion by adjusting import prices.

    As described in Masson, Symansky, and Meredith (1990), for all countries and country groups except the main developing country bloc, estimates of net foreign asset positions are constructed by cumulating measured current account balances. The net foreign asset position of the main developing country bloc is then constructed as a residual.

    The Mark III version of MULTIMOD has also been extended to allow for endogenous total factor productivity—see Bayoumi, Coe, and Laxton (1998).

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    126. The Adoption of Indirect Instruments of Monetary Policy, by a staff team headed by William E. Alexander, Tomás J.T. Baliño, and Charles Enoch. 1995.

    125. United Germany: The First Five Years—Performance and Policy Issues, by Robert Corker, Robert A. Feldman, Karl Habermeier, Hari Vittas, and Tessa van der Willigen. 1995.

    124. Saving Behavior and the Asset Price “Bubble” in Japan: Analytical Studies, edited by Ulrich Baumgartner and Guy Meredith. 1995.

    123. Comprehensive Tax Reform: The Colombian Experience, edited by Parthasarathi Shome. 1995.

    122. Capital Flows in the APEC Region, edited by Mohsin S. Khan and Carmen M. Reinhart. 1995.

    121. Uganda: Adjustment with Growth, 1987–94, by Robert L. Sharer, Hema R. De Zoysa, and Calvin A. McDonald. 1995.

    120. Economic Dislocation and Recovery in Lebanon, by Sena Eken, Paul Cashin, S. Nuri Erbas, Jose Martelino, and Adnan Mazarei. 1995.

    119. Singapore: A Case Study in Rapid Development, edited by Kenneth Bercuson with a staff team Robert G. Carling, Aasim M. Husain, Thomas Rumbaugh, and Rachel van Elkan. 1995.

    118. Sub-Saharan Africa: Growth, Savings, and Investment, by Michael T. Hadjimichael, Dhaneshwar Ghura, Martin Miihleisen, Roger Nord, and E. Murat Uçer. 1995.

    Note: For information on the title and availability of Occasional Papers not listed, please consult the IMF Publications Catalog or contact IMF Publication Services.

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