Chapter

IV Some Standard Simulations

Author(s):
International Monetary Fund
Published Date:
July 1990
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The main linkages among the regions modeled are the endogenous determination of prices and volumes of goods traded and the endogenous determination of exchange rates and interest rates. In this respect, the model is a dynamic version of the Mundell-Fleming model, incorporating many of the extensions to that model that have been developed over the years. That basic framework has proved a useful and robust tool for the analysis of economic policies. The signs of transmission effects of economic policies, and also the magnitudes of their domestic effects, depend on a number of key parameters, including the degree of price stickiness, the elasticity of expenditure with respect to interest rates, the degree of openness to trade, and the size of trade elasticities. Estimates of these key parameters are necessary to evaluate the transmission effects, which are calculated by computer simulation of the model.

To understand the model’s properties, it is useful to examine simulations of changes in the major exogenous variables. In particular, since the model is primarily used to analyze the effects of industrial country policies, simulations are presented of standardized changes in the fiscal policy instruments in all the industrial countries and of changes in the monetary policy instruments for the industrial countries not part of the ERM of the EMS. These simulations are not meant to suggest desirable or likely changes in exogenous variables, but rather to elucidate the functioning of the model. In applying these shocks, care was taken not to depart from the historical experience of the countries concerned, nor to perform experiments that violate governments’ budget constraints, in the sense that governments are allowed to increase their debt as a ratio of GNP without limit. This would be so, for instance, if the experiment was a permanent increase in bond-financed government expenditures, without an eventual increase in taxes. The model contains a tax rule that tends to stabilize the ratio of bonds to GNP, so that explosive growth in debt is ruled out. The fiscal shocks reported below are for a permanent 5 percent of GNP increase in government spending relative to baseline from 1990 onward. The permanent increase in government spending relative to its baseline level results in a permanent increase in taxes.

A few words are necessary to explain how the simulations were performed. The exogenous and some endogenous variables were first projected forward beyond the historical period; in most cases, the projections were simply those implied by the most recent projections of the World Economic Outlook. The model was then used to calculate the residuals in the behavioral equations that would give the values of the endogenous variables, given the exogenous variables. Thus, the model itself is not used for making forecasts; instead the baseline projection is imposed on the model.

A complication in solving the model is the existence of expectations variables. These variables are constrained in the solution procedure to equal the values for the relevant future time period that the model produces—that is, the expectations are made to be consistent with the model’s predictions. This is achieved through a procedure that implements the Fair-Taylor algorithm, which constrains expectations and model solutions to be the same, to a preset tolerance, by iterating.

To reduce the impact on the simulation results of arbitrary terminal conditions, the model has to be solved beyond the period of interest. In the simulations reported below for 1990–95, the model was in fact solved for 20 additional years, to 2015. In addition, the terminal conditions themselves are adjusted to be consistent with the long-run responses of the model to the shock in question. For instance, a permanent increase in government spending raises taxes and reduces both human wealth and the market value of the capital stock in the long run; their levels are adjusted downward in the first year following the simulation period (that is, 2016 for the simulations shown here) to reflect the drop in their steady-state values. Similarly, monetary shocks change the long-run levels of nominal variables that are forward looking, such as the absorption deflator and the exchange rate: these are also adjusted in the period following the end of the simulation horizon to reflect changes in their steady-state values.

Table 9 gives the result of an increase in U.S. fiscal expenditures of 5 percent of GNP. The impact multiplier (scaled for the size of the shock) is equal to 0.7 for the United States, which is somewhat below the mean for existing multicountry models (and 0.5 below the multiplier reported in the previous version of the model).27 The lower multiplier in this version of the model is primarily attributable to a larger negative response of domestic demand to higher interest rates. In addition, this simulation represents a permanent increase in government spending while the fiscal shock in Masson and others (1988) was transitory, thus limiting the rise in long-term interest rates. With the passage of time, the positive effect on output disappears, because of crowding out of demand through two channels—higher interest rates and an appreciation of the dollar. The reduced capital stock has long-lasting negative effects on output. The nominal effective exchange rate appreciates by 5 percent on impact.

Table 9.Increase of U.S. Government Spending by 5 Percent of GNP, 1990–95(Percentage deviation from baseline unless otherwise noted)
199019911992199319941995
United States
Real GNP3.71.6–0.5–2.2–3.3–3.5
Real domestic demand4.62.70.8–0.7–1.7–2.1
GNP deflator0.61.62.73.43.53.2
Short-term interest rate (percent)0.20.81.52.02.11.7
Long-term interest rate (percent)1.31.61.71.40.80.1
Nominal effective exchange rate5.05.04.63.72.30.8
Current account balance1–0.5–0.4–0.5–0.7–0.8–0.8
General government financial balance1–3.0–2.9–2.7–2.5–2.1–1.4
Gross private investment1–3.9–5.1–6.3–6.8–6.7–6.0
Japan
Real GNP0.50.30.20.30.40.5
GNP deflator0.10.30.40.30.2–0.1
Short-term interest rate (percent)0.20.40.50.50.3–0.0
Nominal effective exchange rate (percent)–2.5–2.5–2.4–2.0–1.4–0.5
Current account balance10.40.40.40.50.50.5
Germany, Fed. Rep. of
Real GNP0.60.40.40.60.70.8
GNP deflator0.10.30.40.40.30.1
Short-term interest rate (percent)0.20.30.40.30.20.0
Nominal effective exchange rate (percent)–1.0–1.0–0.9–0.8–0.5–0.1
Current account balance10.50.50.70.80.90.9
United Kingdom
Real GNP0.30.1–0.1–0.10.00.2
GNP deflator0.10.30.30.20.0–0.2
Short-term interest rate (percent)0.20.40.50.40.2–0.0
Nominal effective exchange rate (percent)–1.2–1.2–1.2–1.1–0.8–0.4
Current account balance10.30.20.20.10.00.0
France
Real GNP0.30.20.20.10.10.1
GNP deflator0.10.20.30.50.60.6
Short-term interest rate (percent)0.10.20.20.20.10.0
Nominal effective exchange rate (percent)–1.4–1.3–1.1–0.7–0.30.2
Current account balance10.20.20.20.20.30.3
Italy
Real GNP0.40.10.0–0.1–0.1–0.1
GNP deflator0.10.20.30.30.20.1
Short-term interest rate (percent)0.10.20.20.20.1–0.0
Nominal effective exchange rate (percent)–1.3–1.2–1.0–0.6–0.20.2
Current account balance10.20.10.10.10.00.0
Canada
Real GNP1.70.2–0.7–1.4–1.6–1.4
GNP deflator0.40.91.41.51.40.9
Short-term interest rate (percent)0.61.11.51.61.40.8
Nominal effective exchange rate (percent)–1.3–1.6–2.1–2.4–2.6–2.6
Current account balance11.40.80.4–0.0–0.3–0.5
Smaller industrial countries
Real GNP0.70.50.30.1–0.1–0.2
GNP deflator0.10.40.60.70.70.5
Short-term interest rate (percent)0.10.20.20.20.20.0
Nominal effective exchange rate (percent)–1.9–1.8–1.6–1.0–0.40.3
Current account balance10.40.50.50.50.40.3
Capital exporting developing countries
Real GDP1.30.6–0.0–0.5–0.7–0.7
Other developing countries
Real GDP (percent)0.80.40.0–0.2–0.4–0.4
GNP deflator (percent)–2.9–2.7–2.3–1.6–0.80.1
Real imports (percent)4.41.7–0.3–1.6–2.1–2.0
Interest payments2–0.30.82.13.43.73.2
Current account balance10.0–0.0–0.1–0.1–0.0–0.0
World prices (in dollars)
Price of oil–3.0–2.5–1.8–0.80.11.0
Price index of commodities1.4–2.3–4.0–4.3–3.6–2.2

As a percent of GNP.

As a percent of exports.

As a percent of GNP.

As a percent of exports.

Effects on the output of other countries of the fiscal expansion in the United States are also positive; they benefit from increased expenditure in the United States as well as their own currency depreciation. However, interest rates rise in all countries, and this increase has some unfavorable effects on the developing countries because of higher debt service. Interest payments as a percentage of export earnings rise over time, despite substantial increases in exports. Since the developing countries are assumed to peg their real exchange rate relative to a basket of industrial country currencies, they tend to experience a real depreciation against the dollar in this simulation.

An unexpected U.S. monetary expansion is presented in Table 10. In this simulation, the target for the U.S. stock of base money is increased by 10 percent in 1990, and kept at this higher level thereafter. Since the model is neutral with respect to nominal shocks in the long run, eventually the result will be an increase in the U.S. price level by 10 percent and a depreciation of the dollar by the same amount. It can be seen that by 1995, the U.S. GNP deflator level has increased by 13.1 percent; because the model reaches equilibrium in a cyclical fashion, the price level overshoots its equilibrium level for a time. On impact, the monetary expansion substantially lowers the short-term interest rate and stimulates output in the United States; but over the medium run both the short-and long-term rates increase; the exchange rate also overshoots its long-run level (that is, the nominal U.S. effective exchange rate depreciates by more than 10 percent in the first year), as is to be expected in a model with price stickiness.

Table 10.Increase of 10 Percent in the U.S. Money Supply Target(Percentage deviation from baseline unless otherwise noted)
199019911992199319941995
United States
Real GNP4.56.25.02.2–0.9–3.4
Real domestic demand3.84.73.81.8–0.4–2.2
GNP deflator1.03.05.88.911.513.1
Short-term interest rate (percent)–3.2–4.1–2.9–0.71.53.0
Long-term interest rate (percent)–1.9–0.70.82.02.42.1
Nominal effective exchange rate–12.6–10.1–6.7–4.0–2.9–3.6
Current account balance1–0.70.30.60.50.2–0.3
General government financial balance1–0.30.30.0–0.6–1.2–1.6
Gross private investment18.35.72.1–1.4–3.7–4.6
Japan
Real GNP–0.3–0.8–1.0–0.9–0.50.0
GNP deflator0.20.40.70.70.60.3
Short-term interest rate (percent)–0.1–0.00.30.50.70.5
Nominal effective exchange rate (percent)6.75.23.21.60.91.1
Current account balance10.1–0.3–0.4–0.30.10.4
Germany, Fed.Rep. of
Real GNP–0.3–1.2–1.2–0.70.00.8
GNP deflator0.10.30.30.30.20.1
Short-term interest rate (percent)–0.10.00.10.30.30.2
Nominal effective exchange rate (percent)3.02.31.50.80.60.9
Current account balance1–0.1–0.8–0.8–0.50.20.8
United Kingdom
Real GNP0.4–0.5–0.8–1.0–0.9–0.6
GNP deflator0.20.60.80.90.70.4
Short-term interest rate (percent)–0.2–0.00.30.60.70.5
Nominal effective exchange rate (percent)3.52.91.91.10.60.5
Current account balance10.60.10.0–0.0–0.1–0.2
France
Real GNP0.2–0.4–0.30.00.30.6
GNP deflator0.00.0–0.1–0.1–0.10.1
Short-term interest rate (percent)0.00.10.10.10.10.1
Nominal effective exchange rate (percent)3.02.21.30.70.61.1
Current account balance10.1–0.3–0.3–0.2–0.10.0
Italy
Real GNP0.1–0.2–0.00.10.20.2
GNP deflator0.00.10.10.10.20.2
Short-term interest rate (percent)0.00.10.10.10.10.1
Nominal effective exchange rate (percent)2.72.01.20.70.61.1
Current account balance10.2–0.10.00.0–0.0–0.1
Canada
Real GNP0.40.40.1–0.7–1.7–2.2
GNP deflator0.31.02.02.83.23.1
Short-term interest rate (percent)–1.0–0.90.01.32.42.8
Nominal effective exchange rate (percent)9.98.77.05.23.62.3
Current account balance11.71.91.91.71.20.6
Smaller industrial countries
Real GNP–0.1–0.5–0.3–0.00.10.2
GNP deflator0.10.30.40.50.50.4
Short-term interest rate (percent)0.00.00.10.10.10.1
Nominal effective exchange rate (percent)4.23.11.80.90.81.5
Current account balance10.1–0.2–0.10.10.20.3
Capital exporting developing countries
Real GDP1.21.31.00.4–0.2–0.7
Other developing countries
Real GDP (percent)0.70.80.60.3–0.1–0.4
GNP deflator (percent)11.610.28.26.56.06.7
Real imports (percent)3.83.43.01.5–0.4–1.5
Interest payments2–2.2–5.1–5.6–3.8–0.42.5
Current account balance10.10.20.1–0.0–0.1–0.0
World prices (in dollars)
Price of oil9.48.36.85.96.17.3
Price index of commodities14.113.69.95.83.12.7

As a percent of GNP.

As a percent of exports.

As a percent of GNP.

As a percent of exports.

Effects on foreign economies are mixed. Monetary policy is negatively transmitted to other industrial countries as a result of the appreciation of their exchange rates but positively transmitted through increases in U.S. demand. Developing countries experience a small rise in GDP and a substantial decline in their ratio of interest payments to exports, as a result of lower U.S. interest rates. Since, as mentioned above, the model takes the oil price (in real terms) to be exogenous, it has not changed as a result of the shock, but the dollar price has risen. Moreover, the U.S. monetary expansion has raised world demand for oil, also increasing the GDP of the oil exporting countries.

Tables 1121 (in Appendix I) give results for the same fiscal and monetary shocks for the other industrial countries. They are qualitatively similar to those in Tables 9 and 10. Note that monetary shocks are not included for France, Italy, and the smaller industrial countries, since monetary policies in these countries are constrained by the need to limit deviations of their exchange rates vis-à-vis the deutsche mark. Fiscal multipliers are considerably lower for the more open countries, such as Germany. Although France is also open, the ERM arrangement requires the fiscal expansion to be accompanied by some monetary easing. Another difference relative to Table 9 is that transmission effects are smaller, since these countries are smaller than the United States.

Monetary policy in Germany actually has positive spillover effects for the other ERM countries, since these countries must pursue expansionary monetary policies to avoid exchange rate changes relative to the deutsche mark.28 It also follows that German fiscal policy has negative spillover effects since the other ERM countries must contract their money supplies in the wake of higher German interest rates.

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