GEM continues to be developed. Primarily, this reflects the enormous amount of work currently being done in academia using new open economy models to reexamine a range of issues, whose insights can provide ideas for how to improve GEM. In addition, as discussed earlier, the strong theoretical structure makes it complicated to add new features. This section discusses active development work on fiscal policy and international asset markets, including emerging market financing constraints. These areas have been chosen because of their relevance to the work of the IMF, in line with the overall philosophy underlying GEM.
Fiscal Policy
Fiscal policy remains an important macroeconomic lever for stimulating the economy and has been used actively in recent decades (see Figure 4.1). The main issue associated with this is the degree of Ricardian equivalence. Full Ricardian equivalence implies that changes in taxes and transfers have no impact on aggregate demand (as is currently the case in GEM). This is because consumers discount the future using the interest rates on government paper, so the value of tax cuts and subsequent tax increases offset each other, and people will fully offset a tax cut by higher saving. There are two main ways of creating more realistic short-term tax multipliers. One is to assume that some individuals act as if they do not have access to financial markets, but rather vary their consumption in line with their disposable income. Such rule-of-thumb consumers can be easily incorporated into existing models and provide a way of examining income distribution issues, but their behavior is highly mechanical, responding as much to a temporary tax cut as to a long-term one. The alternative is to assume that consumers have finite lives, adding a life-cycle dimension to consumption. This provides more realistic consumption dynamics, with spending responding less to a temporary tax cut than a long-term one as predicted by the permanent income hypothesis, but at the cost of adding considerable theoretical complexity. In addition, the supply-side effects of fiscal policy can be incorporated by adding distorting taxes. The explicit modeling of labor and product markets makes this an easy addition in GEM, in contrast to earlier models.
Structural Fiscal Balances in the Major Economic Regions
(General government as a percentage of potential output)
Source: IMF, World Economic Outlook.Structural Fiscal Balances in the Major Economic Regions
(General government as a percentage of potential output)
Source: IMF, World Economic Outlook.Structural Fiscal Balances in the Major Economic Regions
(General government as a percentage of potential output)
Source: IMF, World Economic Outlook.The plan is to adopt a two-track approach to incorporating fiscal policy into GEM. The main model will be altered to include distorting taxes and rule-of-thumb consumers, but not those with finite lives. Such a framework provides a reasonable way of dealing with changes in fiscal balances resulting from disturbances elsewhere in the model by taking account of the impact of automatic stabilizers. The second track involves developing an alternative version of the model that can be used to examine fiscal issues in more detail by incorporating finite-lived consumers with a simplified version of the rest of the economy based on the existing GEM framework. Adding such consumers with higher discount rates into the current GEM is extremely difficult, as its life-cycle implications are inconsistent with the assumption that consumer behavior can be calculated from the actions of a single representative individual, greatly complicating the theoretical structure. Early prototypes of both models have been created.
International Asset Markets
Gross holdings of other countries’ assets and liabilities have been rising rapidly across industrial countries in recent years as financial deregulation has reduced barriers to such transactions (Figure 4.2).3 This provides a new mechanism for transmission of the international cycle, as disturbances to future prosperity of domestic firms affect other countries through equity prices, reducing idiosyncratic shocks across countries and increasing the synchronization of the global business cycle.
Sum of International Assets and Liabilities in Major Advanced Economies
(In percent of GDP)
Source: IMF, Balance of Payments Statistics Yearbook.Sum of International Assets and Liabilities in Major Advanced Economies
(In percent of GDP)
Source: IMF, Balance of Payments Statistics Yearbook.Sum of International Assets and Liabilities in Major Advanced Economies
(In percent of GDP)
Source: IMF, Balance of Payments Statistics Yearbook.International models with strong theoretical foundations have generally assumed either that international asset markets are complete or that they are limited to transactions in a single bond (Lane, 2001). Complete markets imply that movements in consumption across countries should be highly correlated, responding little to country-specific changes in domestic output, predictions that are so different from the existing evidence that few policy models have adopted this approach. Rather, they have tended to assume that one bond is the only asset traded across countries, which eliminates the need to model demand across different assets. This was the structure in MULTIMOD and in the current version of GEM. However, globalization of financial markets is making this structure increasingly problematic.
The staff has been developing a prototype theoretical model in which all countries issue domestic debt and equity that can be traded in international markets (similar work is also being undertaken by others). Different payment profiles create demand for each asset and, it turns out, a higher rate of return for equities than bonds. Home bias in holding assets is modeled by assuming that there is a cost to holding each asset, and these costs are higher for foreign assets than their domestic equivalents. These costs can also be used to explain the inability of emerging markets to issue debt in domestic currency by assuming that the costs of foreigners holding such debt is extremely high. Initial simulations indicate that the addition of a wider range of assets produce more realistic cross-country correlations of countries’ consumption. Once the properties of this prototype model have been more fully investigated, the next stage will be to transfer the approach to GEM.
Another important issue in international asset markets is that for most emerging market countries access is constrained, costly, and volatile (Figure 4.3). In addition, access for specific countries often becomes expensive or constrained just when they would normally want to borrow because of short-term domestic difficulties. Among other consequences, constrained access means that fiscal policies become procyclical in economies where governments are highly dependent on foreign borrowing.
Capital Constraints for Emerging Markets
Sources: J.P. Morgan; and IMF, World Economic Outlook.Capital Constraints for Emerging Markets
Sources: J.P. Morgan; and IMF, World Economic Outlook.Capital Constraints for Emerging Markets
Sources: J.P. Morgan; and IMF, World Economic Outlook.There has been a large amount of recent work in the new open economy macroeconomic and related literature examining how to best characterize emerging market borrowing constraints. Much of this work has used the concept of the financial accelerator (Bernanke, Gertler, and Gilchrist, 1999). The cost of borrowing for a firm is inversely related to its net worth, so borrowing is increasingly difficult when the firm faces adverse shocks.4 This provides a reason why balance sheets matter for monetary policy transmission. It has been used to model domestic financial markets and banking systems, and has also been transferred to the analysis of foreign borrowing by emerging market countries, with the main issue being how to define net worth. Work on adding a financial accelerator to GEM is proceeding, with a particular focus on the consequences of limited access of emerging market countries to international financial assets.
