APPENDIX Re-estimating the Model Equations for Switzerland
This appendix briefly describes the results of the re-estimation of the money demand equation and the main trade equations in the model for Switzerland. Except in the case of the money demand function, the regression specifications are identical to those used for all other countries in MULTIMOD. A detailed description and derivation of the specifications can be found in Masson, Symansky, and Meredith (1990). All regressions were estimated using annual data from 1971 to 1995 obtained from the OECD Analytical Database.
This chapter was prepared by Douglas Laxton and Eswar Prasad.
For a recent analysis of Switzerland as a low “interest rate island”, as well as additional references on this issue, see Mauro (1995).
The level of the exchange rate, particularly in the long run, is of course determined by economic fundamentals.
Mauro (1995) presents evidence showing that the real interest differentials between Switzerland and other countries reflect premia attributable to lower foreign exchange rate risk on Swiss franc-denominated assets rather than premia paid by investors to have deposits located in Switzerland owing to “safe haven” considerations.
This approach does not capture the institutional features that could account for the nominal interest rate floor at zero percent, but it has the merit of avoiding discontinuities that could complicate model simulations. See Chadha and Tsiddon (1996) for a theoretical analysis of the consequences of this floor for monetary policy and its effects on output variability.
The functional form, econometric procedure, and estimation results are described in detail in Laxton, Meredith and Rose (1995). Debelle and Laxton (1996) argue that, for certain G-7 countries, a nonlinear Phillips curve model fits the data better than linear models.
A preliminary examination of the data by staff at the SNB has found a nonlinear relationship; overheating has a greater upward impact on inflation than the downward impact on inflation of economic slack.
Note that the simulation results are all expressed as deviations from the baseline staff projections taken from the October 1996 World Economic Outlook.
For instance, consider an asset preference shift that would normally result in a change in domestic interest rates. If domestic interest rates were for some reason constrained to remain temporarily unchanged, the nominal money supply would have to adjust to accommodate the change in money demand.
Note that the numbers of the scenarios described in this section do not correspond to those in the KfK report.
In MULTIMOD, the real effective exchange rate is calculated as the ratio of the home country’s export price to a foreign price that includes weighted averages of foreign GDP deflators and competitors’ export prices.
Note that the figure only shows the ex-post realization of interest and inflation rates in response to a sequence of shocks. Investment decisions at each point in time are based on current and future ex-ante real interest rates, which are not shown here. The investment equation in MULTIMOD is a formulation based on Tobin’s Q. See Masson, Symansky and Meredith (1990) for more details.
Although it is not apparent from the chart, which shows the simulation results only through the year 2010, the net foreign assets to GDP ratio does return to base line over the longer term in this and all other simulations below. The desired NFA/GDP ratio in the model is influenced by fundamental determinants such as the rate of time preference, the real interest rate, and the planning horizon of agents in the model.
The response of imports is similar in the two simulations since the smaller exchange rate appreciation in the latter simulation is offset by the effects of stronger domestic activity. The effect of the differences in exchange rate responses is primarily reflected in the responses of exports.
Changes in the stance of fiscal policy could influence the long-term credibility of fiscal discipline and, if these effects were strong enough, could have the opposite effect on the exchange rate. This channel is probably not very important in the case of Switzerland.
Simulation results showed, for instance, that the external sector leakages resulting from an exchange rate appreciation caused by even a large increase in government expenditure (five percentage points of GDP), coupled with the crowding out effects caused by an increase in interest rates, yielded a trivial short-run output response.
Strictly speaking, this persistent shift is long-lived (over twenty years) but not permanent. Hence, the steady state is not affected and potential output returns to its baseline level in the very long run. For expositional purposes, the phrase medium term here refers to a horizon of about five to seven years, while the phrase long run refers to a longer time horizon but does not reflect the effects that are permanent.
Akerlof, Dickens and Parry (1996) argue that standard measurements understate the extent of actual nominal wage rigidity in the United States. Their analysis suggests that attempting to reduce inflation that is already at low levels could have significant real economic costs in terms of output and employment.
That is, for a given level of the real exchange rate, the share of imports in total domestic absorption is assumed to remain constant over the long run.