Abstract
This Selected Issues paper and Statistical Appendix assesses Switzerland’s recent real GDP performance in terms of underlying movements in potential output and the cyclical output gap. The paper highlights that Swiss real GDP has been stagnant since 1990, after expanding at an average rate of some 1¾ percent during 1977–90. The evidence presented indicates that potential output growth during 1991–95 was significantly below historical average. This paper also tries to assess the possible effects of stage 3 of European Monetary Union on Switzerland.
II. Possible Effects of European Monetary Union: An Analysis Using Multtmod Simulations11
This chapter examines the possible effects on Switzerland of stage 3 of European Monetary Union (EMU). The initial ramifications of EMU on the Swiss economy will depend on a number of factors, including investors’ perceptions about the macroeconomic and financial discipline within EMU. Concerns about such discipline could well lead to an increase in investors’ preferences for assets denominated in hard currencies outside the new euro area, including the Swiss franc. This paper focuses on the macroeconomic implications of such an increase in the demand for Swiss franc-denominated assets on the Swiss economy and considers alternative policy responses.
Using MULTIMOD, the IMF’s global macroeconometric model, a number of scenarios are examined in order to gauge the possible effects of EMU on the Swiss economy. Modeling the effects of a shift in investors’ preferences towards assets denominated in Swiss francs is, however, complicated for a number of reasons. First, the magnitude and persistence of the preference shift toward Swiss franc-denominated assets is a matter of conjecture. Second, for a small open economy such as Switzerland, the impact of such asset preference shifts on the exchange rate and domestic interest rate is not independent of the policy rules adopted by the authorities. MULTIMOD simulations are used in this paper to analyze alternative scenarios derived from different assumptions about the magnitude and persistence of the increased demand for Swiss franc-denominated assets that could be stimulated by EMU and to then investigate the effects of various policy responses.
Before proceeding, however, it is useful to review some salient features of the Swiss economy. Over the last three decades, the Swiss have enjoyed relatively low rates of inflation and a trend appreciation in the real effective exchange rate. Households in Switzerland also appear to have a significantly lower rate of time preference compared to other OECD countries. This low rate of time preference is reflected in a domestic saving rate (30 percent of GDP) and ratio of net foreign assets to GDP (over 100 percent) that are among the highest in OECD countries. Swiss real interest rates—adjusted for the real exchange rate appreciation—have been markedly lower than real interest rates in other industrialized economies including Germany, although this differential relative to Germany has narrowed. This departure from the standard open interest parity condition has been interpreted as an exchange rate risk discount—indicating a willingness by foreign investors to hold Swiss franc-denominated assets, even though these assets yield a lower rate of return than assets denominated in other hard currencies.12
Since the beginning of the 1990s, economic performance in Switzerland has deteriorated, with an average real growth rate close to zero and an unemployment rate much higher than its historical average. A sharp appreciation of the Swiss franc from 1993 through 1995 caused a decline in net exports and is widely regarded as having dampened aggregate output growth. In this context, a further appreciation of the Swiss franc could significantly worsen prospects for economic recovery and medium-term growth. Hence, an analysis of the channels through which EMU could affect the Swiss economy is of considerable interest.
Possible responses by monetary and fiscal policy to exchange rate appreciation pressures are, however, constrained by present circumstances in Switzerland. The official discount rate was lowered during 1996 to 1 percent, and overnight market rates are currently around 1½ percent. Such low interest rates limit the scope for further easing of monetary policy, given the nominal rate floor of zero percent. The effectiveness of fiscal policy at the Confederation (federal) level, on the other hand, is limited by the relative openness of the Swiss economy, for example, an expansionary fiscal policy could result in higher imports and would lead, ceteris paribus, to pressures on the currency to appreciate, thereby dampening the direct aggregate demand effects on real GDP. These issues are highlighted in the MULTIMOD simulations. In addition, the effectiveness of fiscal policy for short-run demand management in Switzerland has been limited by the relatively small size of the Confederation budget, excluding transfers, the procyclical behavior at lower levels of government, and substantial policy inertia imparted by political institutions.
The simulation experiments indicate that monetary policy is likely to be a more effective tool than fiscal policy for stabilizing domestic output in response to portfolio preference shifts in favor of Swiss franc-denominated assets. The magnitude and persistence of such asset preference shifts is difficult to determine in advance, but the effectiveness of policy measures in stabilizing output depend on a prompt and commensurate policy response to these shifts. The simulations also illustrate the additional risks posed by the constraints on monetary policy in responding to external shocks in an environment with low levels of domestic inflation and nominal interest rates. These constraints make it all the more important that monetary policy responses not be delayed. Alternative monetary policy strategies for reducing short-run output losses from upward pressures on the Swiss franc are examined—either increasing the rate of growth of money supply within the monetary targeting framework or explicitly allowing monetary policy to be guided by exchange rate developments. The simulations indicate that stabilizing output in the short run using monetary policy does entail the risk of increasing inflation over the medium term. This highlights the premium placed on timely policy responses.
Many of the issues discussed in this paper are also studied in a Swiss report prepared by an EMU Working Group of the Kommission für Konjunkturfragen (KfK). This report presents a less formal, but more comprehensive, analysis of various possible scenarios related to EMU and their potential effects on Switzerland and also evaluates different policy responses that could be appropriate under these scenarios. The main points of this report are summarized in the next section of the paper and provide a useful conceptual framework for the MULTIMOD analysis that follows.
Section B describes the extension of MULTIMOD to incorporate certain key features of the Swiss economy and highlights some modeling issues that are of particular relevance to the questions addressed in this paper. Section C presents simulation results under alternative assumptions about the nature of the increase in foreign investors’ demand for Swiss franc-denominated assets. The effects of alternative policy responses are then analyzed. The conclusions are presented in Section D.
A. The Swiss Report on the Economic Implications of EMU
The KfK’s EMU Working Group was commissioned by the government to prepare a report on the possible economic implications of EMU for Switzerland. This working group was composed of individuals from various branches of government and the Swiss National Bank (SNB) as well as representatives from academia, private research institutes, and private sector banks. The report—entitled “Switzerland and the European and Economic Monetary Union: An Analysis of the Economic Aspects”—was published in November 1996.
The report first delineates four distinct scenarios, while emphasizing that the actual outcome would be expected to be some combination of these scenarios. Scenario 1 envisages that the third stage of EMU would be initiated as planned on January 1, 1999, and would be limited to a core of stability-oriented countries, including Germany and France, that satisfied a strict application of the convergence criteria. The European Central Bank (ECB) would focus monetary policy towards price stability; budget deficits and public debt within the monetary union would be kept low; and a sanctioning mechanism in the fiscal area would be introduced and received favorably by financial markets. Initial uncertainties and technical difficulties could lead to an interest rate premium on the euro and large exchange rate fluctuations, leading to an appreciation of the Swiss franc in the short run. In the longer run, however, these would be reversed as the credibility of ECB and the euro are established.
Scenario 2 considers a more liberal interpretation of the convergence criteria that would enable virtually all countries of the EU to join the monetary union at the time of its formation. The absence of pressures to attain the Maastricht criteria and the lack of an effective mechanism for enforcing fiscal discipline within the currency union is then seen as likely to reduce the urgency for fiscal consolidation. The ECB would include countries without a tradition of price stability and the presence of countries with high levels of public debt would exert pressures for looser monetary policy. Thus, there would be a greater likelihood that investors would not have much confidence in the euro. This lack of financial markets’ confidence would likely result in a longer-lasting flow of financial capital towards assets denominated in hard currencies outside the EMU, including the Swiss franc. This could produce a more persistent appreciation of the Swiss franc.
The formation of the monetary union would be postponed in scenario 3 to a fixed date in the future in order to give countries more time to meet the convergence criteria, although the legal basis for such a postponement was viewed as strongly disputed. Postponement to a fixed date would permit EU governments to continue consolidation efforts and would enable a stricter application of the Maastricht criteria and also more extensive preparatory work on a common monetary policy. These developments could increase confidence in the euro. Under these circumstances, risk premiums on interest rates and exchange rates would decrease; any upward pressure on the Swiss franc would be temporary. Further developments and prospects were seen to correspond to those under scenario 1.
In the fourth scenario, EMU would be postponed indefinitely and with the prospect of creeping rejection of the EMU project. Differences in fiscal positions, including on the sanctioning of excessive deficits, are seen as expressing deeper political tensions. With an uncertain future for EMU, pressures for fiscal consolidation would dissipate and fiscal policies would turn expansionary. The EU currencies would, at best, remain linked to one another via an exchange rate mechanism. The deutsche mark and related European currencies would appreciate against other international hard currencies, including the Swiss franc.
After discussing these scenarios, the report differentiates between two frameworks for conducting monetary policy in the face of challenges posed. One option would be to link the Swiss franc to the euro in some manner. The SNB could orient its monetary policy towards maintaining a particular nominal exchange rate relationship between the Swiss franc and the euro or towards limiting such exchange rate fluctuations within a band of differing possible widths. A closer linkage, however, would increase the risk of speculative pressures that could make such an exchange rate policy a costly undertaking for the SNB. In particular, a higher inflation rate could result as money supply expansion is incompatible with desired inflation. Also the closer the exchange rate link, the more the scope for an independent monetary policy by Switzerland is reduced; monetary policy decisions would effectively be taken by the ECB where Switzerland would not be represented.
If the Swiss franc exchange rate were fixed on a long-term basis, ECB policy would, in effect, determine the inflation rate in Switzerland, which would imply an increase in domestic inflation from its current level. Interest rates would also rise to the euro level or judging by present differentials with German long-term interest rates by over 200 basis points. Real interest rates were viewed as increasing with adverse implications: Domestic debtors would lose, given variable interest rates. Holders of fixed-interest rate assets would incur capital losses. Higher mortgage rates would lead to a fall in real estate prices. Domestic industry would lose its locational advantage and have to lower capital intensity of production. Banks could no longer profit from the good reputation of the Swiss franc.
A temporary exchange rate link, on the other hand, would enable domestic monetary policy to remain more oriented towards price stability in the long run, although an expansive, inflationary monetary policy might be necessary in the short run. Fighting inflation entails high costs, owing to indexing mechanisms (including between apartment rents and mortgage interest rates) and highly protected markets that limit price flexibility and prolong the process of reducing inflation.
The second broad option would be for monetary policy to retain its present monetary targeting framework, including a flexible exchange rate, as well as its medium-term orientation toward price stability. In this case, the SNB relies on the inbuilt “automatic stabilizers” of monetary targeting. In particular, a currency appreciation would slow domestic activity which in turn lowers the expansion of money demand. As a result and given steady money supply growth, interest rates will fall, slowing currency appreciation. These developments would support a revival in activity. If the operation of “automatic monetary stabilizers” were not sufficient to prevent a marked appreciation of the Swiss franc, a discretionary easing of monetary policy could be considered to offset pressures for a currency appreciation. The danger in this course of action would be that, as is well known, the effects of monetary policy on output are manifested only with a considerable lag. Further, expansionary monetary policy could result in an increase in medium-term inflation as economic activity recovered. Thus, the trade-off between a short-term slowdown in economic activity and a later inflation resurgence might be unavoidable.
The report notes that, no matter which course of action were adopted, an announcement of the orientation of monetary policy would be of great importance. The announcement of an exchange rate target at a given parity or in the form of a not overly wide band could, however, offer too large a target for speculation. A “non-quantified” announcement that monetary policy would consider exchange rate developments to a greater degree could, on the other hand, limit the appreciation of the Swiss franc and reduce the risk of speculation against the franc. Under this circumstance, as long as it was made clear that the SNB would still give first priority to price stability, the danger of a decline in the SNB’s credibility was viewed as limited, especially given its good track record.
The report recommends that, in response to scenarios 1 or 3 (a “hard” euro or postponement of the third stage of EMU), the SNB should maintain an autonomous monetary policy. The costs of a temporary slowdown in economic activity due to the likely exchange rate appreciation were viewed as lower than the costs associated with a future fight against inflation that would be unleashed by the short-run easing of monetary policy necessary to defend against excessive appreciation. Scenario 2 (a “soft” euro) was considered to be the bane of the Swiss economy, since the alternatives would then be to accept a strong appreciation of the Swiss franc or to fix the exchange rate, accepting the costs of euro levels of inflation and interest rates. Under Scenario 4 (gradual abandonment of EMU), a temporary easing of monetary policy was deemed necessary to avoid deflationary tendencies in the economy. Underlying these recommendations was the recurrent theme that an expansionary stance of monetary policy in the short run would inevitably have inflationary consequences over the medium term. Thus, a key challenge for economic policy would be to balance the costs of short-term output losses against the costs of reducing a near-term rise in inflation.
The report also noted that monetary policy, although circumscribed by various factors, would be the most effective policy instrument for responding to an EMU-related shock. The report viewed as impracticable other options such as controls on capital inflows, sterilized intervention, and the splitting of the exchange rate whereby different exchange rates would apply to current account and capital account transactions. In addition, fiscal policy was viewed as likely to be of limited effectiveness, particularly given the current level of the public debt. Enhancing the flexibility of labor markets and fostering increases in technological and other dimensions of international competitiveness of the industrial sector were mentioned as being necessary to mitigate the effects of EMU-related shocks on the Swiss economy, although these measures were unlikely to have much impact in the short run.
The report’s final section summarized some key recommendations of the working group. In the event of the emergence of an EMU where policies were not stability-oriented, it would be difficult for Switzerland to insulate itself completely from the consequences—either of an overshooting exchange rate or of higher imported inflation. The report recommended that, in any case, it would be appropriate for the SNB to continue to pursue an autonomous monetary policy which could be used to dampen the impact of external influences. A sustained exchange rate peg, on the other hand, would eliminate Switzerland’s real interest rate advantage. The working group counseled the SNB to monitor macroeconomic developments carefully and decide on a case-by-case basis between a monetary policy that limits itself exclusively to automatic monetary stabilizers and a discretionary loosening of monetary policy. In the case of sharp and persistent upward pressures on the exchange rate, the working group argued that a temporary exchange rate peg was a last resort option that should not be ruled out. In addition, the SNB should publicly clarify that exchange rate developments were a factor in monetary policy decisions without making pronouncements that would give speculators a firm exchange rate target. In order to ensure that banks domiciled in Switzerland are not placed at a disadvantage to their competitors abroad, it was deemed desirable for Swiss Interbank Clearing to join the EMU’s Real Time Gross Payments System (TARGET).
The remainder of this paper provides the staffs quantitative assessment of the economic implications of the third stage of EMU on the Swiss economy and the potential effectiveness of alternative policy responses. Although the staffs MULTIMOD analysis was undertaken independently, the main issues and scenarios are similar to those described in the KfK report.
B. Analytical Issues in Modeling a Shift in Investor Preferences
MULTIMOD is a general equilibrium macroeconometric model developed at the IMF to analyze the transmission of changes in macroeconomic policy within and across countries.13 The model is not intended as a tool for making unconditional forecasts. Rather, MULTIMOD takes the World Economic Outlook (WEO) forecasts made by IMF country specialists as the baseline for simulation scenarios analyzing the effects of policy changes or other exogenous changes in the economic environment. The basic version of MULTIMOD is an annual model that includes each of the G-7 countries and two country blocks that aggregate the small industrial countries and developing countries, respectively. For the purposes of this paper, Switzerland has been modeled separately, while the other small industrial countries remain in a single block.
Some features of MULTIMOD are worth highlighting before proceeding. The model derives a consistent path for all endogenous variables in response to exogenous shocks, while respecting stock-flow equilibrium conditions during the transition to the new steady state. The model incorporates forward-looking expectations and these expectations are imposed in a model-consistent manner. Since the model has an explicit characterization of technology, household preferences, and other structural features, it is possible to calibrate it to replicate certain stylized facts and thereby gain a better understanding of the economy’s dynamic properties. For instance, under certain assumptions, an economy with a lower rate of time preference than that implied by the world real interest rate would have a relatively high domestic saving rate, a trend appreciation of the real exchange rate and a path of accumulation of net foreign assets similar to that observed for Switzerland. Thus, in addition to policy experiments, the model could provide a basis for explaining certain relevant stylized facts.
The proximate determinant of exchange rates in MULTIMOD is an equation for open interest parity across short-term interest rates in different countries; that is, the Swiss short-term interest rate is equal to the expected appreciation of the Swiss franc relative to any other currency plus the short-term interest rate on assets denominated in the latter currency.14 More specifically, the open interest parity equation that determines the Swiss franc-DM exchange rate is as follows:
where SWI and DMI are the nominal short-term interest rates on assets denominated in Swiss francs and deutsche marks, respectively; ER is the nominal exchange rate expressed as DM per Swiss franc (i.e., an increase in the exchange rate indicates an appreciation of the Swiss franc); and RES_ER is a residual term. The expected values of both ER and RES_ER are unobservable. Forward-looking expectations of the nominal exchange rate are, however, generated internally by the model and are consistent with forecasted values. The residual term RES_ER reflects deviations from open interest parity and is interpretable as a premium paid for holding Swiss franc-denominated assets. A negative residual indicates that investors are willing, at the margin, to accept a lower nominal rate of return on assets denominated in Swiss francs than in DMs. In simulations of the model, reducing this residual (i.e., making it more negative) is the obvious way of modeling an increase in investors’ preferences for assets denominated in Swiss francs.
There is, of course, a real counterpart to the open interest parity equation that was described above in nominal terms. The trend real appreciation of the Swiss franc in recent years despite a persistently lower real interest rate in Switzerland than in Germany indicates that there was a persistent residual in the interest parity relationship in real terms also, which reflects the lower real return that investors appear to be willing to accept for the privilege of holding Swiss franc-denominated assets.15
Both real and nominal outcomes are of interest in these simulations. MULTIMOD works with an interest parity equation that is defined in nominal terms but the differential would carry through in real terms. The nominal interest parity equation is crucial because the conduct of monetary policy is through instruments such as the nominal interest rate and the presence of a floor on nominal interest rates therefore has important implications. To account for the effects of an interest rate floor, a nonlinear money demand specification was estimated for Switzerland. The estimated elasticities appeared quite reasonable (see Appendix I) but there are some important caveats. First, the span of the available time series data is not long and does not cover many periods with low levels of interest rates and inflation. Second, nonlinear models are difficult to estimate with much precision and, in particular, statistical tests for discriminating among different nonlinear models have limited power. Given the importance of this issue for the operation of monetary policy in an environment with low nominal interest rates, however, the use of a nonlinear specification could not be avoided.16
A second dimension in which MULTIMOD is nonlinear is the Phillips curve relationship. Although the long-run Phillips curve is vertical, the model allows for short-run inflation-unemployment tradeoffs. The convexity in the short-run Phillips curve implies that demand management policies can not significantly boost output in the short run without severe inflationary consequences. In addition, the forward-looking structure of expectations and the role for policy credibility in the model could result in downward inflation inertia. This implies that a substantial and prolonged contraction of output would be required to lower inflation in response to large aggregate demand shocks that drive output above potential. The convexity also implies that the attainment of a very low level of inflation may involve substantial real costs in terms of output and unemployment.
Estimating a nonlinear Phillips curve for each country is, unfortunately, fraught with complications, in part stemming from the wide confidence intervals around the parameter estimates. The general strategy that has been employed for MULTIMOD is to estimate a nonlinear Phillips curve using pooled data from the G-7 countries and to impose those common parameters on all industrial countries.17 Although the data do not reject the use of common parameters among the G-7 countries, using the same parameters for Switzerland raises a number of issues. Switzerland’s unemployment history has been different from that of the G-7 countries. Switzerland has traditionally had a lower measured unemployment rate than has been observed in G-7 countries. In addition, wage differentiation and nominal wage flexibility appear to be greater in Switzerland than that prevailing in most European industrial economies (see the 1996 OECD Economic Survey of the Swiss economy). Both of these considerations, but particularly the latter one, suggest that the short-run trade off in Switzerland may be better than that for the G-7 countries. However, in the absence of a well-grounded empirical alternative, the nonlinear Phillips curve specification with parameters based on G-7 data was retained for the MULTIMOD simulations because this specification has important implications for the conduct of monetary policy.18 A nonlinear short-run Phillips curve implies, for instance, that prompt actions to offset positive aggregate demand shocks can reduce the need to take stronger compensating actions down the road to reduce inflationary pressures. On the other hand, the real costs of reducing inflation to very low levels could be quite substantial. In a world rife with uncertainty, including uncertainty about the levels of potential output and the output gap, the nonlinear Phillips curve places a premium on forward-looking and timely policy actions that could minimize the deleterious effects of exogenous shocks.
Another important issue that arises in adapting MULTIMOD to the Swiss economy concerns the re-estimation of certain equations. Previously, all small industrial countries (SIC) were grouped into one block and parameters were estimated for this block as a whole. In the context of a small open economy, the trade equations are of particular interest and, therefore, these equations were re-estimated for Switzerland. The export and import volume equations for manufactured goods were re-estimated for Switzerland using annual data over the period 1970-1995 as was the export price equation. The parameter estimates for the re-estimated equations were different from the previously estimated SIC parameters, but the differences were not large. The estimated equations and the coefficient estimates are presented in Appendix 1. These equations have more explanatory power, as measured by the adjusted R squared, for the Swiss data than the corresponding equations for the SICs. For certain equations such as the oil consumption equation, individual country estimation yielded very imprecise and sometimes implausible estimates. Hence, pooled estimates from the full model have been retained.
It is also necessary, from a theoretical perspective, to impose the small open economy assumption on the model for Switzerland. In practice, this simply meant that changes in Swiss variables are constrained not to have an effect on any global variables. This assumption is particularly important when analyzing the effects of changes in the stance of macroeconomic policies in Switzerland. It implies, for instance, that changes in Swiss interest rates do not affect the benchmark “world interest rate”.
C. MULTIMOD Simulations
This section presents results from a set of MULTIMOD simulations that attempt to model the possible effects of EMU on Switzerland.19 Many of the scenarios presented in this section are similar to those discussed in the KfK report. A possible scenario could run as follows: in early 1998, an announcement is made—based on data for 1997—concerning the initial participants in stage 3 of EMU in 1999. The group of countries could be large and based on a “flexible” interpretation of the Maastricht criteria. The resulting euro is perceived as a “soft” currency by market participants and the new European Central Bank (ECB) lacks the credibility of the outgoing Bundesbank. Consequently, holders of the new euro prefer to hold assets denominated either in higher-yield currencies (e.g., pound sterling or U.S. dollar) or low-yield currencies (i.e., Swiss franc) outside EMU.
The magnitude of such portfolio shifts is a matter of conjecture and the share that would be directed towards Swiss franc-denominated assets is difficult to predict ex ante. In early 1997, Swiss short-term interest rates are about 375 basis points and 400 basis points, respectively, below comparable rates for U.S. dollar and pound sterling denominated assets. These differentials could make it very expensive to move into Swiss franc assets rather than assets denominated in dollars or sterling. An additional consideration in the simulations is that, reflecting uncertainty, the euro interest rate could rise above the present baseline interest rate for deutsche mark-denominated assets, placing upward pressures on Swiss interest rates. For analytical purposes, in the simulations presented below, these considerations will be examined separately. It should be recognized that the eventual outcome is likely to be some combination of these effects.
As noted earlier, a shift in investor sentiment can be introduced in the model by changing the exogenous residual term in the open interest rate parity equation. A decrease in this residual reflects an exogenous increase in the preference of foreign investors for assets denominated in Swiss francs. Given the world interest rate, the combination of domestic interest rate declines and exchange rate appreciations that maintain the interest parity condition are then determined by the dynamics of behavioral relationships in the model.
In MULTIMOD, a monetary feedback rule based on money targeting is used to anchor nominal variables over the medium term, although this rule operates somewhat flexibly in the short run. In the short run, nominal money balances are allowed to adjust to changes in the price level and output.20 This feedback rules appears to be a reasonable representation of the regular operation of the Swiss monetary policy framework. The nonlinear specification of the money demand function prevents the interest rate in any of the simulations from falling to zero. The monetary feedback rule is assumed to be credible and known to all agents. Thus medium-term inflation and inflationary expectations are anchored.
Temporary portfolio preference shifts
First, a scenario is considered where investors temporarily increase their preferences for Swiss franc-denominated assets due to the uncertainty and possible instability engendered by the formation of EMU. A plausible scenario would be one where investors’ preferences shift for a few years and then, as the uncertainties concerning EMU diminishes, the preference of international investors for Swiss franc-denominated assets would gradually decline. A key feature of this transitory preference shift is that it does not alter any long-run fundamentals of the Swiss economy even though it could have important short-run effects.
This scenario is modeled as a temporary change in the residual of the interest parity equation. The effect that the change in this residual has on interest rates and exchange rates is determined by the properties of the model. The residual is lowered (i.e., made more negative relative to its baseline level) by 0.05 for three years beginning in 1998, by 0.025 in the fourth year, and is set to zero thereafter. The simulations are presented in Chart II-1, with a few key variables also shown in Table II-1 as Scenario 1A.21 This scenario assumes a delayed reaction of monetary policy, i.e., short-run interest rates are kept unchanged in the first year. Consequently, the full impact of the preference shift is on the nominal exchange rate, which appreciates by nearly 4½ percent in the first year, while the real exchange rate appreciates by over 2½ percent.22 Investment increases due to the decline in ex ante real interest rates, even though nominal short-term interest rates do not decline in the first year.23 On the other hand, given that Switzerland is a very open economy, the trade balance deteriorates sharply in the short run due to the exchange rate appreciation. The net contractionary impact leads to a fall in disposable income and, hence, in consumption. Overall, real GDP contracts by about 1¼ percent. The deterioration in the current account balance also implies a decline in the ratio of net foreign assets to GDP.24
Switzerland: Temporary Portfolio Preference Shift with a Delayed Monetary Reaction
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: Temporary Portfolio Preference Shift with a Delayed Monetary Reaction
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: Temporary Portfolio Preference Shift with a Delayed Monetary Reaction
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Multimod Simulation Scenarios
Multimod Simulation Scenarios
| 1998 | 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | ||
|---|---|---|---|---|---|---|---|---|---|
| Output gap | |||||||||
| Scenario 1A | -1.19 | -1.00 | -0.55 | 0.26 | 0.70 | 0.32 | -0.10 | -0.30 | |
| Scenario IB | -0.81 | -0.75 | -0.50 | 0.18 | 0.59 | 0.26 | -0.11 | -0.27 | |
| Scenario 1C | -0.72 | -0.65 | -0.44 | 0.16 | 0.51 | 0.21 | -0.11 | -0.24 | |
| Scenario ID | -1.25 | -1.22 | -0.88 | 0.16 | 0.85 | 0.52 | -0.01 | -0.32 | |
| Scenario IE | -1.25 | -1.22 | 0.15 | 0.61 | 0.95 | 0.37 | -0.24 | -0.51 | |
| Scenario IF | -0.53 | -0.61 | -0.55 | 0.36 | 0.97 | 0.31 | -0.36 | -0.61 | |
| Scenario 2A | -0.40 | -0.28 | -0.10 | 0.04 | 0.11 | 0.10 | 0.05 | 0.00 | |
| Scenario 2B | -0.15 | -0.03 | 0.07 | 0.07 | 0.05 | 0.01 | -0.01 | -0.02 | |
| Scenario 3 | -0.20 | -0.13 | -0.04 | 0.02 | 0.05 | 0.05 | 0.02 | -0.00 | |
| GNP inflation | |||||||||
| Scenario 1A | -0.25 | -0.38 | -0.48 | -0.31 | 0.12 | 0.44 | 0.46 | 0.27 | |
| Scenario IB | -0.16 | -0.27 | -0.35 | -0.23 | 0.12 | 0.38 | 0.37 | 0.20 | |
| Scenario 1C | -0.16 | -0.24 | -0.31 | -0.18 | 0.12 | 0.33 | 0.32 | 0.16 | |
| Scenario ID | -0.26 | -0.45 | -0.63 | -0.49 | 0.02 | 0.50 | 0.61 | 0.43 | |
| Scenario IE | -0.26 | -0.45 | -0.35 | 0.06 | 0.75 | 1.17 | 1.11 | 0.78 | |
| Scenario IF | -0.10 | -0.18 | -0.25 | -0.02 | 0.58 | 0.94 | 0.80 | 0.40 | |
| Scenario 2A | -0.12 | -0.21 | -0.26 | -0.25 | -0.19 | -0.12 | -0.07 | -0.05 | |
| Scenario 2B | -0.05 | -0.07 | -0.05 | -0.02 | 0.02 | 0.03 | 0.03 | 0.02 | |
| Scenario 3 | -0.06 | -0.10 | -0.13 | -0.12 | -0.09 | -0.06 | -0.03 | -0.03 | |
| Short-term nominal interest rate | |||||||||
| Scenario 1A | 0.00 | -1.55 | -2.39 | -2.22 | -1.18 | -0.12 | 0.50 | 0.59 | |
| Scenario IB | -1.03 | -1.83 | -2.33 | -2.06 | -1.06 | -0.09 | 0.44 | 0.50 | |
| Scenario 1C | -0.95 | -1.68 | -2.13 | -1.85 | -0.92 | -0.07 | 0.37 | 0.40 | |
| Scenario ID | 0.00 | -1.20 | -1.60 | -1.95 | -1.44 | -0.35 | 0.47 | 0.71 | |
| Scenario IE | 0.00 | -1.20 | -1.02 | -1.64 | -0.88 | 0.36 | 1.11 | 1.16 | |
| Scenario IF | -1.75 | -1.70 | -1.69 | -2.18 | -1.77 | 0.00 | 0.92 | 0.95 | |
| Scenario 2A | -0.56 | -0.97 | -1.21 | -1.32 | -1.29 | -1.19 | -1.08 | -1.00 | |
| Scenario 2B | -0.88 | -1.01 | -1.23 | -1.13 | -1.03 | -0.96 | -0.92 | -0.92 | |
| Scenario 3 | -0.28 | -0.48 | -0.61 | -0.66 | -0.64 | -0.59 | -0.54 | -0.50 | |
| Nominal effective exchange rate | |||||||||
| Scenario 1A | 4.26 | 2.19 | 1.64 | 0.34 | 0.06 | 1.21 | 1.21 | 0.84 | |
| Scenario IB | 3.00 | 1.96 | 1.67 | 0.30 | -0.13 | 0.88 | 0.97 | 0.55 | |
| Scenario 1C | 3.17 | 2.19 | 1.89 | 0.39 | -0.24 | 0.64 | 0.71 | 0.35 | |
| Scenario ID | 4.49 | 2.86 | 2.49 | 0.46 | -0.09 | 1.30 | 1.64 | 1.19 | |
| Scenario IE | 4.49 | 2.86 | -1.04 | -0.35 | -1.19 | -0.36 | -0.70 | -1.74 | |
| Scenario IF | 2.14 | 1.98 | 1.88 | -0.72 | -1.79 | -0.10 | -0.10 | -0.98 | |
| Scenario 2A | 1.34 | 0.91 | 0.87 | 1.08 | 1.39 | 1.67 | 1.86 | 1.93 | |
| Scenario 2B | 0.52 | 0.40 | 0.41 | 0.62 | 0.75 | 0.78 | 0.74 | 0.66 | |
| Scenario 3 | 0.65 | 0.43 | 0.41 | 0.51 | 0.67 | 0.81 | 0.89 | 0.93 | |
| Real effective exchange rate | |||||||||
| Scenario 1A | 2.56 | 1.11 | 0.49 | -0.54 | -0.68 | 0.29 | 0.65 | 0.54 | |
| Scenario IB | 1.82 | 1.06 | 0.69 | -0.32 | -0.55 | 0.30 | 0.60 | 0.48 | |
| Scenario 1C | 1.92 | 1.23 | 0.88 | -0.17 | -0.53 | 0.21 | 0.45 | 0.34 | |
| Scenario ID | 2.70 | 1.49 | 0.90 | -0.69 | -1.08 | 0.06 | 0.66 | 0.66 | |
| Scenario IE | 2.70 | 1.49 | -1.18 | -0.77 | -0.89 | 0.34 | 0.83 | 0.67 | |
| Scenario IF | 1.31 | 1.15 | 0.97 | -0.68 | -1.06 | 0.57 | 1.10 | 0.82 | |
| Scenario 2A | 0.79 | 0.40 | 0.23 | 0.20 | 0.28 | 0.39 | 0.48 | 0.51 | |
| Scenario 2B | 0.31 | 0.20 | 0.17 | 0.31 | 0.41 | 0.46 | 0.47 | 0.44 | |
| Scenario 3 | 0.38 | 0.19 | 0.10 | 0.09 | 0.13 | 0.19 | 0.23 | 0.24 | |
Multimod Simulation Scenarios
| 1998 | 1999 | 2000 | 2001 | 2002 | 2003 | 2004 | 2005 | ||
|---|---|---|---|---|---|---|---|---|---|
| Output gap | |||||||||
| Scenario 1A | -1.19 | -1.00 | -0.55 | 0.26 | 0.70 | 0.32 | -0.10 | -0.30 | |
| Scenario IB | -0.81 | -0.75 | -0.50 | 0.18 | 0.59 | 0.26 | -0.11 | -0.27 | |
| Scenario 1C | -0.72 | -0.65 | -0.44 | 0.16 | 0.51 | 0.21 | -0.11 | -0.24 | |
| Scenario ID | -1.25 | -1.22 | -0.88 | 0.16 | 0.85 | 0.52 | -0.01 | -0.32 | |
| Scenario IE | -1.25 | -1.22 | 0.15 | 0.61 | 0.95 | 0.37 | -0.24 | -0.51 | |
| Scenario IF | -0.53 | -0.61 | -0.55 | 0.36 | 0.97 | 0.31 | -0.36 | -0.61 | |
| Scenario 2A | -0.40 | -0.28 | -0.10 | 0.04 | 0.11 | 0.10 | 0.05 | 0.00 | |
| Scenario 2B | -0.15 | -0.03 | 0.07 | 0.07 | 0.05 | 0.01 | -0.01 | -0.02 | |
| Scenario 3 | -0.20 | -0.13 | -0.04 | 0.02 | 0.05 | 0.05 | 0.02 | -0.00 | |
| GNP inflation | |||||||||
| Scenario 1A | -0.25 | -0.38 | -0.48 | -0.31 | 0.12 | 0.44 | 0.46 | 0.27 | |
| Scenario IB | -0.16 | -0.27 | -0.35 | -0.23 | 0.12 | 0.38 | 0.37 | 0.20 | |
| Scenario 1C | -0.16 | -0.24 | -0.31 | -0.18 | 0.12 | 0.33 | 0.32 | 0.16 | |
| Scenario ID | -0.26 | -0.45 | -0.63 | -0.49 | 0.02 | 0.50 | 0.61 | 0.43 | |
| Scenario IE | -0.26 | -0.45 | -0.35 | 0.06 | 0.75 | 1.17 | 1.11 | 0.78 | |
| Scenario IF | -0.10 | -0.18 | -0.25 | -0.02 | 0.58 | 0.94 | 0.80 | 0.40 | |
| Scenario 2A | -0.12 | -0.21 | -0.26 | -0.25 | -0.19 | -0.12 | -0.07 | -0.05 | |
| Scenario 2B | -0.05 | -0.07 | -0.05 | -0.02 | 0.02 | 0.03 | 0.03 | 0.02 | |
| Scenario 3 | -0.06 | -0.10 | -0.13 | -0.12 | -0.09 | -0.06 | -0.03 | -0.03 | |
| Short-term nominal interest rate | |||||||||
| Scenario 1A | 0.00 | -1.55 | -2.39 | -2.22 | -1.18 | -0.12 | 0.50 | 0.59 | |
| Scenario IB | -1.03 | -1.83 | -2.33 | -2.06 | -1.06 | -0.09 | 0.44 | 0.50 | |
| Scenario 1C | -0.95 | -1.68 | -2.13 | -1.85 | -0.92 | -0.07 | 0.37 | 0.40 | |
| Scenario ID | 0.00 | -1.20 | -1.60 | -1.95 | -1.44 | -0.35 | 0.47 | 0.71 | |
| Scenario IE | 0.00 | -1.20 | -1.02 | -1.64 | -0.88 | 0.36 | 1.11 | 1.16 | |
| Scenario IF | -1.75 | -1.70 | -1.69 | -2.18 | -1.77 | 0.00 | 0.92 | 0.95 | |
| Scenario 2A | -0.56 | -0.97 | -1.21 | -1.32 | -1.29 | -1.19 | -1.08 | -1.00 | |
| Scenario 2B | -0.88 | -1.01 | -1.23 | -1.13 | -1.03 | -0.96 | -0.92 | -0.92 | |
| Scenario 3 | -0.28 | -0.48 | -0.61 | -0.66 | -0.64 | -0.59 | -0.54 | -0.50 | |
| Nominal effective exchange rate | |||||||||
| Scenario 1A | 4.26 | 2.19 | 1.64 | 0.34 | 0.06 | 1.21 | 1.21 | 0.84 | |
| Scenario IB | 3.00 | 1.96 | 1.67 | 0.30 | -0.13 | 0.88 | 0.97 | 0.55 | |
| Scenario 1C | 3.17 | 2.19 | 1.89 | 0.39 | -0.24 | 0.64 | 0.71 | 0.35 | |
| Scenario ID | 4.49 | 2.86 | 2.49 | 0.46 | -0.09 | 1.30 | 1.64 | 1.19 | |
| Scenario IE | 4.49 | 2.86 | -1.04 | -0.35 | -1.19 | -0.36 | -0.70 | -1.74 | |
| Scenario IF | 2.14 | 1.98 | 1.88 | -0.72 | -1.79 | -0.10 | -0.10 | -0.98 | |
| Scenario 2A | 1.34 | 0.91 | 0.87 | 1.08 | 1.39 | 1.67 | 1.86 | 1.93 | |
| Scenario 2B | 0.52 | 0.40 | 0.41 | 0.62 | 0.75 | 0.78 | 0.74 | 0.66 | |
| Scenario 3 | 0.65 | 0.43 | 0.41 | 0.51 | 0.67 | 0.81 | 0.89 | 0.93 | |
| Real effective exchange rate | |||||||||
| Scenario 1A | 2.56 | 1.11 | 0.49 | -0.54 | -0.68 | 0.29 | 0.65 | 0.54 | |
| Scenario IB | 1.82 | 1.06 | 0.69 | -0.32 | -0.55 | 0.30 | 0.60 | 0.48 | |
| Scenario 1C | 1.92 | 1.23 | 0.88 | -0.17 | -0.53 | 0.21 | 0.45 | 0.34 | |
| Scenario ID | 2.70 | 1.49 | 0.90 | -0.69 | -1.08 | 0.06 | 0.66 | 0.66 | |
| Scenario IE | 2.70 | 1.49 | -1.18 | -0.77 | -0.89 | 0.34 | 0.83 | 0.67 | |
| Scenario IF | 1.31 | 1.15 | 0.97 | -0.68 | -1.06 | 0.57 | 1.10 | 0.82 | |
| Scenario 2A | 0.79 | 0.40 | 0.23 | 0.20 | 0.28 | 0.39 | 0.48 | 0.51 | |
| Scenario 2B | 0.31 | 0.20 | 0.17 | 0.31 | 0.41 | 0.46 | 0.47 | 0.44 | |
| Scenario 3 | 0.38 | 0.19 | 0.10 | 0.09 | 0.13 | 0.19 | 0.23 | 0.24 | |
In the second year, interest rates begin to decline and, over the next two years, they fall by almost 2 percentage points relative to the baseline. As short-term interest rate in the WEO baseline increase, the interest rate floor is not binding in this scenario.
This simulation illustrates the negative short-run consequences of a temporary increase in the demand for Swiss franc-denominated assets. Aggregate output and, in particular, the traded goods sector are adversely affected by the resulting real exchange rate appreciation. At the same time, the transitory nature of this shift implies that any possible long-run benefits from a lower interest rate are considerably muted.
We now consider alternative policy responses. It should be emphasized that the aim here is only to illustrate the effects of a range of policy actions, rather than to precisely determine the optimal policy response. The real appreciation in the exchange rate and the fall in output could potentially be offset by a more timely easing of monetary policy—the consequences of a lowering of interest rates in the first year are shown in Scenario IB (Chart II-2). The nominal exchange rate takes up less of the burden of adjustment in the first year and, consequently, the real exchange rate appreciation is much smaller than in Chart II-1 (also see Table II-1). This policy response has favorable implications for all components of domestic demand and, since the real exchange rate appreciation is more muted, also leads to a smaller deterioration in the trade balance.25 The output gap is thus smaller due to the rapid monetary accommodation in response to the external shock. This is achieved without a substantially different medium-term inflation outcome, indicating the benefits of a timely and appropriate monetary reaction.
Switzerland: Temporary Portfolio Preference Shift with a Timely Monetary Reaction
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: Temporary Portfolio Preference Shift with a Timely Monetary Reaction
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: Temporary Portfolio Preference Shift with a Timely Monetary Reaction
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Next, in response to the same shock, we consider the effects of fiscal policy. Contractionary fiscal policy could, through standard Mundell-Flemming channels, offset the appreciation of the real exchange rate generated by the shift in asset preferences.26 However, the direct negative effects on aggregate demand would tend to dominate the effects of resisting the exchange rate appreciation in the short run, exacerbating the short-run weakness in economic activity. Conversely, a fiscal expansion in isolation would also tend be of limited effectiveness as the direct expansionary effects on aggregate demand would be diluted by the consequent exchange rate appreciation, which would be unhelpful in view of the initially postulated excessive currency appreciation.27 Hence, any fiscal expansion aimed at stimulating demand may need to be accompanied by an greater easing of monetary policy.
Scenario 1C (Chart II-3) shows the effects of a temporary increase of 2 percentage points in the ratio of government expenditure to GDP that is accommodated by a concomitant lowering of short-term interest rates in response to the portfolio preference shift. The output and inflation effects of this policy mix are similar to those in the scenario with the monetary policy reaction (Chart II-2). Short-term interest rates decline marginally less and the exchange rate appreciates more in the short run. The principal effect of choosing between a monetary policy reaction and a mix of monetary and fiscal policy is on the composition of aggregate demand. In the latter case, private demand is crowded out to some extent by the increase in government consumption and the traded goods sector is more adversely affected.
Switzerland: Temporary Portfolio Preference Shift with a Monetary and Fiscal Policy Reaction
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: Temporary Portfolio Preference Shift with a Monetary and Fiscal Policy Reaction
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: Temporary Portfolio Preference Shift with a Monetary and Fiscal Policy Reaction
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
In the simulations presented above, it was assumed that the portfolio preference shift would occur in 1998, when the short-term interest rate is projected by the staff to be well above the nominal interest rate floor. If this preference shift occurred earlier, however, or if interest rates in 1998 turned out to be significantly lower, then the interest rate floor could become a tighter constraint on the interest rate channel for monetary policy. Another possibility is that the preference shift would be much larger than in the simulations presented here, again constraining the interest rate response to accommodate the shock. In this case, the effects of the preference shift on the domestic economy could be larger.
This is illustrated in the next simulation (Scenario ID), which repeats the same shock considered in the previous three simulations, but assumes that nominal short-term interest rates are fully constrained by the interest rate floor in the first year and can then fall by a maximum of 200 basis points in the following three years (Chart II-4). In this case, the exchange rate appreciation is larger and more persistent and, in addition, the smaller decline in interest rates yields a correspondingly smaller positive effect on domestic demand. Consequently, relative to the baseline, the cumulative output loss over the first three years is 3½ percent of potential output compared with over 2 percent in the scenario without the binding interest rate constraint (Chart II-2). The price level falls sharply in the short run, resulting in a decline in inflation that is balanced by a moderate increase of about ½ percentage points in medium-term inflation as prices return to their baseline level.
Switzerland: Portfolio Preference Shift with an Interest Rate Floor
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: Portfolio Preference Shift with an Interest Rate Floor
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: Portfolio Preference Shift with an Interest Rate Floor
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
This scenario highlights the real output costs of the constraints imposed on monetary policy in responding to an asset preference shift when the inflation rate and the short-term interest rate are at low levels. In the event that nominal interest rate reductions were constrained, a faster increase in the money supply could be engineered within the existing monetary targeting framework or, alternatively, monetary policy could be guided more explicitly by exchange rate developments. These policy responses are likely to have the effects of limiting the appreciation of the exchange rate and dampening short-term output losses, but at the cost of increasing medium-term inflation. The next two simulations consider the effects of these two strategies.
A simulation of the first type of policy response is shown in Scenario IE (Chart II-5), which assumes a five percent increase in the money supply target starting in the third year of the simulation. Since nominal interest rates are constrained in the model, the increase in the money supply target has the effect of depreciating the nominal exchange rate sharply. This gives a boost to the external sector and, consequently, has a positive effect on aggregate output. Relative to Scenario ID, this expansionary monetary policy results in an output gain of over 1½ percent over a three-year horizon. The cost of this policy, however, is a marked (although temporary) increase in medium-term inflation relative to the scenarios presented before, with inflation rising by over one percentage point above the baseline level by the sixth year of the simulation.
Switzerland: Portfolio Preference Shift with an Interest Rate Floor and Monetary Stimulus
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: Portfolio Preference Shift with an Interest Rate Floor and Monetary Stimulus
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: Portfolio Preference Shift with an Interest Rate Floor and Monetary Stimulus
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Scenario IF (Chart II-6) shows the effects of an credible temporary exchange rate ceiling, where the monetary authority tries to limit the initial nominal exchange rate appreciation to about 2 percent (relative to baseline) and then counters any further short-term upward pressures on the exchange rate. In this case, the output losses are smaller than in the previous scenario and, in addition, the medium-term inflation outcome is relatively subdued due to the more rapid response of monetary policy. Both these simulations are suggestive of the tradeoffs between output and inflation that will have to be faced when using the monetary policy instrument in response to EMU-related shocks.
Switzerland: Portfolio Preference Shift with a Temporary Exchange Rate Ceiling
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: Portfolio Preference Shift with a Temporary Exchange Rate Ceiling
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: Portfolio Preference Shift with a Temporary Exchange Rate Ceiling
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Persistent portfolio preference shift
An alternative scenario considered here is one where the shift in investors’ preferences in favor of assets denominated in Swiss francs is persistent. In this case, since Switzerland is a small open economy, the long-run adjustment effect would be borne entirely by the domestic interest rate, although a nominal interest rate floor could potentially complicate this adjustment process. Through its permanent effect on domestic interest rates and, hence, on capital accumulation, the long-term implications of a permanent asset preference shift are very different from those of a temporary shift. Consider a persistent shift in favor of financial assets denominated in Swiss francs modeled as a permanent reduction (of 0.01) in the residual term of the interest parity equation (Scenario 2A, Chart II-7). In this scenario, the increased preference for Swiss franc-denominated assets translates into persistently lower domestic interest rates and rates of return on real assets in Switzerland. The real exchange rate appreciates initially and then returns to baseline so that the long-run effect of this shift is transmitted entirely to the domestic interest rate.28 The persistent decline in the interest rate is accompanied by a reduction in the cost of capital, leading to an investment boom, which results in a gradual increase in the capital stock and an increase in the rate of growth of potential output.
Switzerland: A Persistent Portfolio Preference Shift Without Monetary Accomodation
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: A Persistent Portfolio Preference Shift Without Monetary Accomodation
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: A Persistent Portfolio Preference Shift Without Monetary Accomodation
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
This simulation suggests that the Swiss economy would benefit from a persistent shift into Swiss denominated assets, particularly productive assets, since a persistent exogenous increase in the preference for Swiss franc-denominated assets feeds through into lower domestic interest rates and higher investment and increases potential output growth. All would not be well, however, from the Swiss point of view. The shift does have a contractionary effect on output in the short run. The real exchange rate appreciates, which leads to a deterioration in the trade balance and, in addition, private consumption declines temporarily. Inflation declines in the short-run, although not by very much. Nonetheless, it does raise the specter of a deflationary economy as the current inflation rate is around 1 percent, which could impose significant real costs in the event of future adverse shocks to the economy.29
The short-run adverse consequences of this shift could be mitigated by an easing of monetary policy, as shown in Scenario 2B (Chart II-8) where the medium-term money supply target is increased by 1 percentage point relative to its baseline. The real effects in the long run are of course similar to those in Scenario 2A (Chart II-7) but the short-run real differences are striking. The exchange rate appreciation is now substantially smaller in the short run and the effect on exports is considerably muted. In addition, the decline in the short term interest rate towards its long-run level is achieved more quickly, slightly sharpening the short-run investment response. The negative short-run effect on aggregate output is now virtually zero and actual output tracks potential output very closely. Following an initial decline, the price level, as measured by either the GDP deflator or the absorption deflator, returns to its baseline level, unlike in Scenario 2A where the decline in the price level is more persistent. A notable feature of this simulation is that, despite the easing of monetary policy, the business cycle stabilization effects are achieved without a significant increase in inflation, although this relatively benign outcome should be viewed relative to the significant inflation reduction achieved in Scenario 2A.
Switzerland: A Persistent Portfolio Preference Shift With Monetary Accomodation
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: A Persistent Portfolio Preference Shift With Monetary Accomodation
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: A Persistent Portfolio Preference Shift With Monetary Accomodation
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
These simulations indicate that, upon impact, an exogenous persistent increase in the preference of investors for Swiss franc-denominated assets could have beneficial long-term effects but negative short-run effects on the Swiss economy, although these short-run effects are more muted than in the case of a temporary asset preference shift. To minimize the initial output costs, the simulations suggest that monetary policy should be eased to mute the exchange rate appreciation and to provide support to the economy in the short run. As in the case of a temporary portfolio preference shift, countercyclical fiscal measures coupled with accommodative monetary easing could be even more effective in stabilizing output.
A change in the foreign interest rate
Finally, the baseline foreign interest rate could increase concurrently with a shift in investors’ preferences toward Swiss franc-denominated assets. The appropriate benchmark foreign interest rate is presumably a composite of interest rates in major industrial economies including Germany and the United States. For the purposes of this paper, baseline U.S. interest rates are assumed to be unaffected by the announcement of the participants in stage 3 of EMU and, thus, the deutsche mark interest rate is the key foreign interest rate. However, with the entry of Germany into EMU, the deutsche mark interest rate will disappear and the relevant point of comparison will be the euro interest rate. Since Germany has lower long-term interest rates than many major countries that could be part of EMU in 1999, it is plausible that the initial euro interest rate could be higher than the baseline DM interest rate in the WEO. Moreover, investors may require a higher rate of return on euro-assets owing to the initial lack of credibility of the ECB and, more generally, to compensate for the higher risk associated with this new asset.
Although the premium paid by investors for Swiss franc-denominated assets could still increase relative to the baseline, the net impact on Swiss interest rates can not be determined ex ante. For illustrative purposes, the euro interest rate was raised permanently by 50 basis points relative to the present baseline German interest rate in the simulation, while the residual in the interest parity equation was also reduced permanently as in the previous scenario. Both changes are assumed to be persistent. The simulation results (Scenario 3, Chart II-9) are quite similar to the simulation for Scenario 2A (Chart II-7). Although the profiles are similar, the effects of this composite shock on domestic interest rates, the components of domestic demand, the real exchange rate, and external demand are more muted than in Scenario 2A. For instance, the change in the rate of growth of potential output relative to the baseline is smaller in Scenario 3 than in Scenario 2A and so is the short-run decline in aggregate output. Consequently, the policy implications are also similar, except in terms of magnitudes needed to offset the adverse short-run effects.
Switzerland: A Higher Foreign Real Interest Rate
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: A Higher Foreign Real Interest Rate
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
Switzerland: A Higher Foreign Real Interest Rate
Citation: IMF Staff Country Reports 1997, 018; 10.5089/9781451807141.002.A002
It should be recognized, of course, that the relative magnitudes of the changes in the foreign interest rate and the premium on Swiss franc-denominated assets are difficult to determine ex ante. In addition, as noted earlier, the relevant “foreign interest rate” is a composite of interest rates not just in Europe but also in the other major industrial economies including the United States. The effects of EMU on interest rates in these other economies have been abstracted from in this exercise but could be potentially important from the Swiss perspective.
D. Conclusions
European Monetary Union is likely to have a significant effect not just on its participants but also on some neighboring countries with close economic and financial links to the EMU countries. This paper has examined the possible effects of EMU on one such country, Switzerland. As the target date for EMU approaches, the uncertainties surrounding the creation of EMU may lead to a shift in investors’ preferences towards assets denominated in hard currencies outside the EMU, including the Swiss franc. Using MULTIMOD, a number of illustrative scenarios were examined that suggest that the implications for the Swiss economy could range from being adverse to being quite beneficial. These simulations indicate that the magnitude and persistence of the shift in portfolio preferences could have an important bearing on the eventual outcome as would the policy response.
Determining the appropriate policy response is a difficult task that is further complicated by the current cyclical weakness of the Swiss economy. The effectiveness of expansionary fiscal policy is limited by the exchange rate implications; a fiscal expansion would have a positive impact on domestic demand in the short run, but at the cost of an appreciation in the real exchange rate, thereby dampening the net impact on aggregate output. On the other hand, a fiscal contraction would indeed induce a currency depreciation but the direct effects of reduced government consumption on domestic demand could outweigh the positive demand effects.
Thus, monetary policy appears to be a more effective tool for stabilizing output in response to the types of shocks analyzed in this paper, both through its effects on domestic demand and on the exchange rate. Even with an expansionary fiscal policy in the short run, monetary easing is required in order to dampen the adverse short-term output effects of these shocks. As indicated by the simulations, the inflationary consequences of a delayed monetary response to an asset preference shift could be larger than if the response were rapid and sufficiently large. The simulations also illustrated the additional risks posed by the constraints on monetary policy in responding to external shocks in an environment with low levels of domestic inflation and interest rates. In particular, over the next few years, monetary policy in Switzerland is likely to be faced with some difficult choices between short-run output losses and temporary but significant increases in medium-term inflation, although this trade-off could be mitigated by timely and forceful policy responses.
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.
A. The Money Demand Equation
The standard money demand specification is linear in the interest rate. Given Switzerland’s current low level of short-term interest rates, it was necessary to constrain the interest rate responses in the simulations from going below the nominal interest rate floor of zero percent. Hence, the following nonlinear specification was estimated:
where MB is the monetary base, PGNPNO is the non-oil GNP deflator, IR is the annualized 3-month nominal interest rate, and TREND is a time trend. Standard errors are reported in parentheses below the estimated coefficients. The estimated elasticities appear reasonable and, when the equation was used in MULTIMOD, yielded acceptable model properties. Using the CPI instead of the output deflator did not change the results very much. However, given the limited span of the available data and the limited number of time periods with low levels of interest rates that could be used to identify nonlinearities, the results of this estimation should be treated with caution.
B. The Trade Equations
The trade equations were estimated using volumes and prices for exports and imports of manufactured goods. The volume equation for imports of manufactures is as follows:
where the operator del indicates the first difference, IM stands for imports of manufactures, A is real domestic absorption, XM is export volume, PIMA is the import price for manufactures, PGNPNO is the non-oil GNP deflator, T is a time trend, and IM0-IM7 are the parameters to be estimated.
This specification permits a short-run effect of the change in the log of absorption that differs from its long-run effect, which is constrained to have a unit elasticity.30 The current change in relative prices is included, as well as its lagged ratio. Note that a weighted average of domestic absorption and of exports of manufactures is included to account for the fact that imported inputs are used in producing export goods and that an increase in the latter may therefore be associated with higher imports. The estimates are presented below, with the previous MULTIMOD estimates for the full block of smaller industrial countries (SIC) included for comparison.
The estimation results indicate that the export volume equation for Switzerland does not differ substantially from the SIC parameters, although there are some differences (see Table II-1). For instance, the short-run effect of activity on imports is smaller than the SIC average. The estimates are generally quite plausible, with price and activity elasticities having the correct signs.
Estimates of Trade Equations for Switzerland
Estimates of Trade Equations for Switzerland
| Import Volume Equation | Export Volume Equation | Export Price Equation | ||||||
|---|---|---|---|---|---|---|---|---|
| Coefficient | Switzerland | SIC | Coefficient | Switzerland | SIC | Coefficient | Switzerland | SIC |
| IM0 | -0.757 | -0.790 | XM0 | -2.861 | -1.243 | PXM0 | 0.001 | -0.016 |
| (4.5) | (2.7) | (4.1) | (6.5) | (0.2) | (2.0) | |||
| IM1 | 1.977 | 2.104 | XM1 | -0.299 | -0.242 | PXM1 | 0.645 | 0.626 |
| (18.1) | (4.6) | (2.9) | (11) | (12.5) | (3.5) | |||
| IM2 | -0.225 | -0.670 | XM2 | 1.795 | 2.003 | PXM2 | 0.077 | 0.077 |
| (2.8) | (3.8) | (6.2) | (10.4) | (2.5) | ||||
| IM3 | -0.260 | -0.597 | XM3 | 0.772 | -0.633 | |||
| (3.0) | (2.9) | (3.9) | (8.8) | |||||
| IM4 | 0.483 | 0.511 | XM4 | -0.369 | -0.447 | |||
| (6.2) | (2.7) | (3.7) | (7.3) | |||||
| IM5 | 0.022 | 0.008 | XM5 | 0.022 | 2.696 | |||
| (4.1) | (1.6) | (3.4) | (2.0) | |||||
| IM6 | 0.000 | 0.000 | XM6 | 0.000 | -0.050 | |||
| (5.5) | (0.0) | (2.8) | (1.4) | |||||
| IM7 | 0.760 | 0.770 | ||||||
| (15.7) | ||||||||
| Rbarsq. | 0.950 | 0.761 | Rbarsq. | 0.797 | 0.611 | Rbarsq. | 0.871 | 0.614 |
| SER | 0.015 | 0.035 | SER | 0.019 | 0.036 | SER | 0.018 | 0.036 |
| DW | 2.71 | 2.07 | DW | 2.03 | 1.94 | DW | 1.33 | |
Estimates of Trade Equations for Switzerland
| Import Volume Equation | Export Volume Equation | Export Price Equation | ||||||
|---|---|---|---|---|---|---|---|---|
| Coefficient | Switzerland | SIC | Coefficient | Switzerland | SIC | Coefficient | Switzerland | SIC |
| IM0 | -0.757 | -0.790 | XM0 | -2.861 | -1.243 | PXM0 | 0.001 | -0.016 |
| (4.5) | (2.7) | (4.1) | (6.5) | (0.2) | (2.0) | |||
| IM1 | 1.977 | 2.104 | XM1 | -0.299 | -0.242 | PXM1 | 0.645 | 0.626 |
| (18.1) | (4.6) | (2.9) | (11) | (12.5) | (3.5) | |||
| IM2 | -0.225 | -0.670 | XM2 | 1.795 | 2.003 | PXM2 | 0.077 | 0.077 |
| (2.8) | (3.8) | (6.2) | (10.4) | (2.5) | ||||
| IM3 | -0.260 | -0.597 | XM3 | 0.772 | -0.633 | |||
| (3.0) | (2.9) | (3.9) | (8.8) | |||||
| IM4 | 0.483 | 0.511 | XM4 | -0.369 | -0.447 | |||
| (6.2) | (2.7) | (3.7) | (7.3) | |||||
| IM5 | 0.022 | 0.008 | XM5 | 0.022 | 2.696 | |||
| (4.1) | (1.6) | (3.4) | (2.0) | |||||
| IM6 | 0.000 | 0.000 | XM6 | 0.000 | -0.050 | |||
| (5.5) | (0.0) | (2.8) | (1.4) | |||||
| IM7 | 0.760 | 0.770 | ||||||
| (15.7) | ||||||||
| Rbarsq. | 0.950 | 0.761 | Rbarsq. | 0.797 | 0.611 | Rbarsq. | 0.871 | 0.614 |
| SER | 0.015 | 0.035 | SER | 0.019 | 0.036 | SER | 0.018 | 0.036 |
| DW | 2.71 | 2.07 | DW | 2.03 | 1.94 | DW | 1.33 | |
Next, we turn to the export volume equation. This equation incorporates an error-correction specification, uses weighted foreign absorption as an explanatory variable, and the price variable takes into account the price of exports relative to prices in the importer’s home market, as well as competition in third markets. The equation also allows for lagged real exchange rate effects and is written as follows:
where XM stands for the volume of exports of manufactures, REER is the real effective exchange rate, FA is the weighted average of foreign absorption, T is a time trend and XMO-XM6 are parameters to be estimated. The estimation results for the export volume equation for Switzerland are also similar to the results for the SIC block as a whole (Table II-1). The short-run elasticity of imports with respect to foreign absorption is 1.8, compared with a long-run elasticity that is imposed to be unity. The short-run price elasticity of exports is smaller than the long-run elasticity and all coefficients have reasonable signs.
Finally, the export price equation was also re-estimated using Swiss data. In the specification of this equation, the rate of change of export prices is assumed to be a linear combination of the rates of change of domestic and foreign non-oil export and output prices. In addition, the specification includes a lagged difference between domestic and export prices, thereby forcing export prices to rise one for one with domestic output prices in the long run. The estimated equation is as follows:
where PXM is the export price for manufactures, PGNPNO is the domestic non-oil output deflator, and PFM is a weighted average of competitors’ prices in foreign markets, and PXM0-PXM2 are parameters to be estimated. The coefficient estimates are presented in Table II-1, along with the estimates for the full SIC block.
References
Chapter II
Akerlof, George A., William T. Dickens, and George L. Parry, 1996, “The Macroeconomics of Low Inflation,” Brookings Papers on Economic Activity 1, 1–76.
Chadha, Bankim, and Daniel Tsiddon, 1996, “Inflation, Nominal Interest Rates, and the Variability of Output, IMF Working Paper 96/109 (Washington: International Monetary Fund).
Debelle, Guy, and Douglas Laxton, 1996, “Is the Phillips Curve Really a Curve? Some Evidence for Canada, the United Kingdom, and the United States,” IMF Working Paper 96/111 (Washington: International Monetary Fund).
Komission für Konjunkturfragen (KfK), 1996, “Die Schweiz und die Europäische Wirtschaftsund Währungsunion,” Report of Working Group on EMU, Supplement in: Die Volkswirtschaft, 12/96.
Laxton, Douglas, Guy Meredith, and David Rose, 1995, “Asymmetric Effects of Economic Activity on Inflation,” Staff Papers, International Monetary Fund, Vol. 42, 344–374.
Organization for Economic Cooperation and Development, 1996, OECD Economic Surveys 1996: Switzerland (Paris: OECD).
Masson, Paul, Steven Symansky, and Guy Meredith, 1990, “MULTIMOD Mark II: A Revised and Extended Model,” IMF Occasional Paper 71 (Washington: International Monetary Fund).
Mauro, Paolo, 1995, “Current Account Surpluses and the Interest Rate Island in Switzerland,” IMF Working Paper 95/24 (Washington: International Monetary Fund).
Zurlinden, Mathias, 1992, “Stabilitätspolitik in einem Mehrländermodell: Simulationsergebnisse für die Schweiz,” Geld, Währung und Konjunktur, Quartalsheft No. 3, 269–88 (Zürich: Swiss National Bank, September).
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).
A detailed description of the main features of the model can be found in Masson, Symansky and Meredith (1990). See Zurlinden (1992) for an earlier extension of MULTIMOD to Switzerland.
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.
