Chapter

Introduction

Author(s):
Hamid Faruqee, Douglas Laxton, Bart Turtelboom, Peter Isard, and Eswar Prasad
Published Date:
May 1998
Share
  • ShareShare
Show Summary Details

I Overview

MULTIMOD (MULTI-region econometric MODel) was initially designed to analyze the macroeconomic effects of industrial country policies on the world economy. Since it was first described and documented by Masson and others (1988), the model has been extended in a number of directions, primarily for the purpose of increasing its usefulness in assisting with the IMF's multilateral surveillance over the policies of its members. A first set of revisions and extensions of the model, leading to MULTIMOD Mark II, was described by Masson, Symansky, and Meredith (1990). A number of additional changes have subsequently been implemented and were recently consolidated into MULTIMOD Mark III.

This paper describes the Mark III generation of MULTIMOD and its key properties in a manner intended to be intelligible to a wide spectrum of macroeconomists. It includes a discussion of the evolution, philosophy, and basic structure of the model (Section II), sections on the major innovations in the core version of MULTIMOD Mark III (Sections IIIVII), and a discussion of several extensions of the model and the applications for which they have been developed (Section VIII). A summary description is provided in Box 1. Other boxes present selected simulations describing the responses of macroeconomic variables to different types of shocks; see table of contents. The results of additional “standard simulations” that can be performed on the model (and compared with Mark II simulations)—as well as a technical guide to MULTIMOD that will be of interest primarily to economists engaged in constructing and simulating structural macroeconometric models—will be provided on the IMF's internal Web site and will be released at some point on its external Web site (http://www.imf.org). The Web sites will also be used as vehicles for disseminating information in a timely manner about future extensions of MULTIMOD. It is anticipated that MULTIMOD will continue to evolve over time, not only as a reflection of ongoing efforts to refine the behavioral equations of the model, but also to incorporate changes in the core set of countries and country groups.1

What's New?

Macroeconometric models evolve for at least four reasons. The first simply reflects the fact that the initial stages of model construction necessarily involve simplifications, and the passage of time provides opportunities for specification improvements and extensions of coverage. A second reason is that the leading issues for macroeconomic policy evolve with the performance of economies and the thinking of economists, challenging the model builder to anticipate and adapt. A third reason is that access to new or more extensive data sets facilitates the empirical evaluation of behavioral hypotheses. And fourth, advances in computer hardware and software, and in algorithms for solving large nonlinear systems of equations, continue to loosen the technical constraints on the scale and complexity of the models.

The Mark III version of MULTIMOD differs from its predecessor in several important respects. New features include a core steady-state analogue model, a new model of the inflation-unemployment nexus, an extended non-Ricardian specification of consumption-saving behavior, and improved specifications and estimates of investment behavior and international trade equations. In addition to these changes in model specification, the introduction of a new solution algorithm has greatly increased the robustness, speed of convergence, and accuracy of the simulations and made it easier to develop certain modified versions of MULTIMOD that were difficult to solve with the Mark II algorithm.

Because the theoretical foundations of MULTIMOD include the premise that economic agents form their expectations in a forward-looking manner, the medium- and long-run properties of the model have an important influence on its predictions of the short-run responses to exogenous policy adjustments or other shocks. In this connection, one of the important new features of the Mark III generation is its more appealing approach to defining the long-run properties of the model's baseline path. As noted in Section II, the database for MULTIMOD simulations consists of the projections over a five-year horizon from the IMF's World Economic Outlook. In constructing a baseline path for MULTIMOD Mark II, the projected behavior of economic variables beyond that horizon was constrained to be consistent with the simplifying assumptions that primary fiscal and trade balances converge gradually to zero (thereby gradually stabilizing the stocks of public and international debt relative to GDP) and that the real rate of interest converges to the steady-state rate of growth.

Box 1.MULTIMOD: Summary of the Mark III Generation

MULTIMOD is a dynamic multicountry macro model of the world economy that has been designed to study the transmission of shocks across countries as well as the short-run and medium-run consequences of alternative monetary and fiscal policies. It has several variants, the current versions of which are referred to as the Mark III generation. The core Mark III model includes explicit country submodels for each of the 7 largest industrial countries and an aggregate grouping of 14 smaller industrial countries. The remaining economies of the world are then aggregated into two separate blocks of developing and transition economies. Extended versions of MULTIMOD include separate submodels for many of the smaller industrial countries, and work has been initiated on expanding the analysis of the developing and transition economies.

The basic structure and properties of MULTIMOD are meant to represent well-established views about how modern industrial economies function and interact with each other. A consistent theoretical structure is employed for all industrial economies, and cross-country differences in the behavior of agents (or the functioning of markets) are reflected in different estimated parameter values. The model converges to a balanced-growth path that is characterized by a full stock-flow equilibrium in which debtor countries service the interest payments on their net foreign liabilities with positive trade balances.

The MULTIMOD modeling system includes a well-defined steady-state analogue model for each country and for the world economy as a whole. These steady-state models serve two roles. First, they are used to construct terminal conditions for the dynamic models. Second, they can be used to study the long-run effects of shocks that have permanent consequences for saving, capital formation, output, real interest rates, real exchange rates, and so on. The basic structure of MULTIMOD is simple enough that it is fairly straightforward to estimate additional country models for the smaller industrial economies.

Despite the focus on medium- and long-run properties, MULTIMOD also exhibits important short-run Keynesian dynamics that result from significant inertia in the inflation process. The MARK III generation features a nonlinear relationship between unemployment and inflation that reflects short-run capacity constraints and insider-outsider influences on wage setting. The asymmetric property of the Phillips curve provides a fundamental role for stabilization policies that is absent from linear models of the business cycle.

MULTIMOD assumes that behavior is completely forward looking in asset markets and partially forward looking in goods markets, but it is possible to study the effects of shocks under alternative assumptions about expectations formation and the degree of policy credibility. The model is solved with state-of-the-art simulation algorithms that have been designed specifically for such systems of equations.

Consumption-saving behavior is based on an extended Blanchard-Weil-Buiter paradigm in which agents are assumed to have finite planning horizons. The model has been extended to allow for realistic age-earnings profiles and for the fact that a significant proportion of consumption is constrained by disposable income insofar as households are unable to borrow against future labor income streams.

Investment behavior is based on Tobin's q theory, according to which the desired rate of investment exceeds the steady-state rate as long as the expected marginal product of capital is greater than its replacement cost. The model allows for significant adjustment costs.

MULTIMOD has a standard specification of import and export behavior that embodies the notion that countries trade in diversified products. Import volumes are a function of the main components of aggregate demand, with import contents of the different components calibrated on the basis of information from input-output tables. Exports are modeled to approximately represent the mirror image of the foreign import demand functions.

Exchange rates and interest rates are related by an adjusted interest parity condition that can allow for persistent risk premiums. MULTIMOD provides a fundamental role for the real exchange rate, both in equilibrating aggregate demand and supply in the goods market and in ensuring that flow relationships are consistent with consumers' desired rates of asset accumulation. The short-run properties of the model to some extent mimic the properties of the Dornbusch overshooting model insofar as asset market prices are free to jump, while wages and other prices are characterized by stickier intrinsic and expectational dynamics.

The fiscal policy instruments include government absorption, distortionary capital taxes, and nondistortionary labor taxes (labor supply is exogenous). In the core version of MULTIMOD, government absorption is exogenous and the aggregate tax rate is endogenized to ensure that the ratio of government debt to GDP converges to a target level. However, in the short run, it is possible to treat all three fiscal instruments as exogenous variables.

Given the forward-looking nature of MULTIMOD, the fundamental role of the monetary authorities is to provide an anchor for inflation expectations. This can be accomplished in many ways. Options available in the core version of Mark III include fixed exchange rates, money targeting, inflation targeting, and nominal income targeting.

MULTIMOD has not been designed to be a forecasting tool. The baseline corresponds to the medium-term World Economic Outlook projections, which reflect the detailed knowledge and judgments of the IMF's country economists. These medium-term projections are then extended into a model-consistent balanced-growth path where the real interest rate is greater than the world real growth rate.

MULTIMOD is available to the public and can be obtained through e-mail to multimod@imf.org.

These assumptions are not imposed in constructing baselines for MULTIMOD Mark III. Instead, as described in Section III, the projected behavior of economic variables beyond the five-year horizon of the World Economic Outlook is tied to terminal conditions determined endogenously and consistently from a system of steady-state analogue equations, SSMOD. Among other things, SSMOD has the property that the real interest rate exceeds the rate of growth,2 and so MULTIMOD is now capable of providing a more appealing characterization of the macroeconomic effects of fiscal adjustments and a richer analysis of sustainability issues.

MULTIMOD Mark II did not focus explicitly on the unemployment rate and characterized inflation simply in terms of the GDP deflator, with no attention to the consumer price index (CPI). This has now changed, giving MULTIMOD several other new features. In particular, as described in Section IV, Mark III includes a new model of the inflation process. The domestic GDP deflator is determined by an expectations-augmented Phillips curve, and the CPI is determined by a weighted combination of the prices of domestically produced goods and the prices of imported goods. The Phillips curve relationship is asymmetric around the natural rate of unemployment, which has important implications for the design of macroeconomic stabilization policies.

Thanks to a debate rekindled by Barro (1974), it has become widely appreciated over the past two decades that the effects of fiscal policy on macroeconomic behavior in a forward-looking model depend on the extent to which the private sector expects that public sector imbalances will be evened out over time, so that an increase in the current fiscal deficit, for example, can be anticipated to imply a higher future tax burden, other things equal. However, the sensitivity of private sector behavior to policy adjustments can also depend importantly on factors other than the nature of expectations. In this regard, a second new feature of MULTIMOD Mark III is the manner in which the specification of consumption-saving behavior reflects the composition of wealth, the finite life cycles of households, and constraints on the ability of households to borrow against their future lifetime income streams. In Mark II, private consumption was assumed to be directly proportional to the sum of human wealth (that is, discounted after-tax labor income) and financial wealth, with human wealth discounted over an infinite horizon. In Mark III, the hypothesized behavior of private consumption has been modified in several respects, as described in Section V, embodying the assumptions that individual households optimize their consumption-saving behavior over finite lifetimes and face liquidity constraints on their abilities to borrow against future income. The two key parameters of the new consumption-saving model— the intertemporal elasticity of substitution and the share of consumption that is sensitive to disposable income—are estimated from the time-series properties of consumption after a realistic structure is imposed on life-cycle age-earnings profiles obtained from cross-sectional data.

The macroeconomic effects of policy actions or other exogenous shocks depend importantly on the responsiveness of aggregate demand to interest rates and exchange rates. Accordingly, finding realistic specifications for the behavior of investment and international trade volumes and, in particular, capturing their sensitivities to interest rates and exchange rates are key challenges in macroeconomic modeling. In this regard, MULTIMOD Mark III reflects efforts to improve the specifications of both the investment and the trade equations, as described in Sections VI and VII.

    Other Resources Citing This Publication