Abstract
This Selected Issues paper analyzes the current account performance of Denmark in 1993–98. The paper presents a brief review of structural features of the external current account. It looks at the decline in export market share and concludes that it reflects primarily cyclical factors and the unwinding of an unsustainable export market gain immediately after the German unification. The paper also examines implications for fiscal policy of Denmark’s decision to remain for the time being outside the European Monetary Union.
II. Is the Need for Fiscal Policy Flexibility Larger for an EMU Outsider than for an EMU Insider? Results from a Simulation Exercise15
A. Introduction and Summary
22. Exchange rate stability against the core European currencies, in particular against the deutsche mark, has been one of the cornerstones of macroeconomic policies in Denmark since the early 1980s. The policy of stable exchange rates has gained widespread support, and served as an anchor for policies in other areas. Because of its disciplinary role, the policy of fixed exchange rates is widely seen as a major contributing factor to Denmark’s improved macroeconomic performance over the past 15 years—strong average growth; one of the best inflation performances in Europe; a shift in the current account from chronic deficits to surpluses; a marked improvement in public finances; and a strong decline in the unemployment rate since 1993.
23. Although Denmark has participated in all European exchange rate arrangements since the “snake” was introduced in 1972, the starting date of the fixed exchange rate is considered to be 1982. The new fixed exchange rate policy declared by the new government that took office in September 1982 constituted an integral part of a broad change in the overall economic policy strategy, which resulted in the correction of large macroeconomic imbalances. A tight peg to the deutsche mark has been maintained since then, and has been replaced by a peg to the euro at the beginning of 1999. Denmark’s commitment to the policy of stable exchange rates helped impose policy discipline in other areas, and gained considerable credibility over the past 15 years, as reflected in declining interest rate differentials with the anchor country (Figure II-1).
Denmark: Interest Rate Differentials with Germany, 1979-98
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Source: IMF, International Financial Statistics.Denmark: Interest Rate Differentials with Germany, 1979-98
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Source: IMF, International Financial Statistics.Denmark: Interest Rate Differentials with Germany, 1979-98
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Source: IMF, International Financial Statistics.24. Denmark was one of the first countries to satisfy the entry criteria into the European Monetary Union, but—in line with the Edinburgh Decision—it opted out of participating in EMU from the outset. In the policy debate, the most important argument against participation in the monetary union was some loss of political independence and less influence on decision making.16 Following the referendum, which in 1993 accepted the Maastricht Treaty with the opt-out clauses specified in the Edinburgh Decision, the authorities announced that Denmark would continue to participate in exchange rate cooperation within the European Monetary System. This regime choice was underpinned by the argument that the policy of stable exchange rates is strongly associated with consistent policies and good macroeconomic performance in Denmark.
25. Since the Danish economy has been operating under a fixed exchange rate regime over the past 15 years, for most of this period under conditions of unimpeded international capital mobility,17 it has adopted the monetary policy stance of the anchor country.18 Without recourse to independent monetary policy, fiscal policy had to take on a role as a major instrument for stabilization policy, and it has been actively used as a countercyclical device.19 In general, the “need” for fiscal policy depends on the economy’s structure and its environment, which jointly determine the magnitude of output fluctuations and the effectiveness of policies. This chapter examines whether a particular structural feature of the economy—namely, the choice of not participating in the European Monetary Union, but fixing the exchange rate in ERM2—has a substantial effect on the short to medium term challenges for fiscal policy in mitigating output fluctuations.
26. To provide a tentative answer, a simple two-country stochastic model is calibrated in the tradition of the monetary policy rule literature to reflect some characteristics of the Danish economy and its links with the euro area. For the small economy, two alternative exchange rate arrangements, which are likely to remain under consideration in Denmark in the near future—joining the monetary union; or remaining an “outsider”—are examined. Stochastic simulations are then used to quantify the expected variability of output and inflation in a low inflation environment under the alternative exchange rate regimes. As fiscal policy is assumed away in the model, the simulated volatility of output is interpreted as an indicator of the need for fiscal policy. To gauge whether the choice of an “outsider” fixed exchange rate regime significantly influences the challenges for fiscal policy, the variability of output under the “outsider” case and under the “insider” counterfactual scenario are compared.
27. Under the baseline scenario, output and inflation are found to be about 10 and 5 percent more variable, respectively, in an “outsider” regime than under an “insider” arrangement. The higher variabilities are due to variations in the outsider’s risk premium, and imply that the need for fiscal policy is slightly larger in the outsider case.
28. Although differences between the “outsider” and “insider” regimes are not particularly large under the baseline, and thus the challenges facing fiscal policy are similar under the two exchange rate arrangements, some changes in the environment can widen the differences in output and inflation variability. Notably, the “outsider” country’s output and inflation could become substantially more volatile in periods of financial stress, or in case of erosion in the credibility of the peg. Negatively correlated output shocks in the two economies can also lead to relatively more variable output and inflation in the “outsider” case than in an “insider” scenario, which indicates that the burden falling on fiscal policy can become significantly larger for an “outsider.” Although the monetary policy followed by the large economy influences output variability under both the “insider” and “outsider” regimes, it is found to have no effect on the difference in the need for fiscal policy under the two exchange rate arrangements.
29. Although the above conclusions are based on a highly stylized model, they call attention to three important facts. First, an “EMU-outsider” fixed exchange rate regime is not equivalent to an “EMU-insider” one. In most instances, remaining an “outsider” implies higher output and inflation variability, and thus poses some additional challenges for the conduct of fiscal policy. Second, the differences between the two regimes can widen under certain circumstances. In particular, output fluctuations, and thus the need for discretionary countercyclical fiscal measures could be substantially larger under the “outsider” scenario than in the “insider” case. Third, monetary policy followed by the large economy is not immaterial for the magnitude of output fluctuations in the small economy.
30. The remainder of the chapter is organized as follows. Section B describes the model and its main parameters, and summarizes the most important assumptions. The simulation results are presented in Section C.
B. Description of the Simulation Framework
31. The simple model used in the simulations links a “large” and a “small” economy via trade and exchange rates. A simple linear aggregate framework often applied in the monetary policy rules/inflation targeting literature is adopted to characterize the two economies.20 Although the relations of this model are not directly derived from microfoundations, a number of recent papers, such as Rotemberg and Woodford (1998a) and (1998b), Christiano and Gust (1998), or Erceg, Henderson and Levin (1998) present similar models based on maximizing behavior and rational expectations.
32. The asymmetry in country size is assumed to be sufficiently large so that behavioral relations in the large economy can be characterized independently of the small economy. In contrast, developments in the large economy have a nonnegligible influence on the small economy via three possible channels. First, external demand for the small country’s products has a direct influence on output. Second, inflation in the small country is related to foreign inflation via import prices. Third, domestic interest rates are intimately linked to foreign interest rates. Via these channels shocks to the large economy, as well as policy changes, are transmitted to the small economy.
33. Two alternative exchange rate regimes are examined. In the first case, the small country is an “EMU-outsider”—it pegs its nominal exchange rate to the large economy’s currency, but nominal interest parity holds only up to a risk premium factor. In the second case, the small country is an “EMU-insider”—currency union is modeled by assuming that the nominal exchange rate is fixed in terms of the large country’s currency, and that uncovered nominal interest parity holds.
34. The stylized nature of the model necessitates a number of simplifying assumptions, which are spelled out in the remainder of this section. The most important of these assumptions are summarized in Box II-1.
Summary of Simplifying Assumptions
The world consists of only the small and the large country. Notwithstanding that trade with third countries is nonnegligible in Denmark, constituting 30 percent of trade and 10 percent of GDP, economic linkages with the euro area countries are strong.1 In addition, policies in the EMU area—especially in Germany—have also served as a reference in the policy debate and direction over the past 15 years.
The role of the large country is passive. It is assumed that the large economy is not subject to country-specific inflation shocks; and that policies are consistent and sustainable over the long run.2 Although the I difference between the magnitude of output and inflation fluctuations under the “insider” and “outsider” regimes may depend on these factors, 3 attempts at quantifying their effects just a few months after the advent of the European Monetary Union would be difficult and is beyond the scope of this paper.
A low inflation environment is assumed. It is assumed that inflation has no tendency to ratchet up. Although this assumption is warranted by the limitations of the model, it can also thought to be a reasonable characterization of a medium term outlook predicated on a sustained benign inflationary environment.
Only one (short term) interest rate is considered. In Denmark, long-term interest rates have a strong effect on economic activity, while short-term interest rates have a much smaller impact on GDP. Thus, the effects of changes in the interest rate on output are likely to be overstated in case long-term and short-term interest rates are not closely related. 4
The structure of the aggregate demand and supply relationships does not change with the exchange rate regime. This assumption may not hold up to scrutiny, because upon entry to EMU, structural parameters may change in response to the regime shift. For example, domestic output may depend more strongly on foreign output; the way and extent of the effect of monetary policy on aggregate demand may change; or there can be shifts in the nature, distribution, and correlation of shocks. However, the lack of a convincing counterfactual gives little basis for an alternative.
The assumed stochastic structure is highly simplified. In particular, permanent shocks to inflation are abstracted away, and exchange rate related shocks are assumed to be unrelated to output and inflation shocks. Abstracting from permanent shocks is considered to be permissible as the paper focuses on the scope for short to medium term stabilization policy, and not on secular trends. The stochastic independence assumptions imply that policy responses to idiosyncratic disturbances on the goods, labor, and foreign exchange markets, rather than possible consequences of systemic shocks are examined. Arguably, the former is more relevant for quantifying the scope for countercyclical policy.
The large economy
35. The large economy is assumed to operate as described by the following three relationships:
The variable yf denotes the deviation of real output from trend, πf stands for the deviation of inflation from trend, and if represents the deviation of nominal interest rate from trend. All three variables are assumed to be stationary. This simplifying assumption is applied to avoid divergence in inflation rates due to different stochastic shocks in the two economies. Nonstationarity would trivially and necessarily result in the unsustainability of a fixed exchange rate regime.21 are independently and identically distributed stochastic disturbances, which are assumed to originate from the behavior of the private sector.
36. Equation (1) is a standard reduced form aggregate demand relationship for a closed economy: output depends negatively on the lagged real interest rate. For more realistic dynamics, some degree of output persistence is assumed with λɛ[0,1]. Equation (2) is a stylized aggregate supply relationship in the form of a Phillips curve: inflation depends on its own lagged value, and on the level of economic activity. Equation (3) captures the monetary policy rule in the form of a (lagged) Taylor rule: nominal interest rates are set based on past output and inflation developments.22 Monetary policy is tightened whenever inflation or output exceed their target value (which are assumed to be zero), and relaxed whenever inflation or output fall below their respective targets.
37. The motivation for modeling the large country’s monetary policy in the form of a Taylor rule is provided by a series of papers by Taylor and Clarida et al.23 These studies find evidence that the behavior of the Fed and of the Bundesbank is well-approximated by a Taylor rule over select periods of the post-Bretton Woods era. It is probably not misguided to assume that the ECB’s monetary policy would ex ante be possible to describe in a similar fashion.
The small economy
38. The small economy’s structure is kept as close as possible to the large economy’s. In particular, the following relationships describe output and inflation:
Equation (4) represents an open economy aggregate demand curve. In addition to the (lagged) real interest rate, foreign output (y), which proxies for external demand, and the real exchange rate (e, measured in logs), which captures price competitiveness of foreign and domestic goods, also influence output.24 Equation (5) expresses domestic inflation as a weighted average of price increases in domestically produced and imported goods, with w denoting domestic wage growth (measured as deviation from trend),25 and E standing for the nominal exchange rate (measured in DKK/euro so that an increase corresponds to a nominal depreciation). Using the relationship Aln(£) = Ae - nf+ n, and rearranging (5) yields the more convenient form (5’):
Wage growth is determined by a reduced form Phillips curve relationship:
where q> and /care positive parameters, and ew is a stochastic disturbance term.
39. Assuming that the nominal exchange rate is constant,26 the evolution of the real exchange rate is determined by inflation differentials:
40. Finally, the model is closed by specifying the relationship between domestic and foreign interest rates. When the small country is an “insider”, currency union implies that uncovered interest parity holds, i.e.
If the economy is an “outsider” pegging its currency to the large economy, domestic interest rates are linked to the large country’s interest rate via covered interest parity, that is, the nominal interest rate will be determined by the foreign interest rate up to a risk premium.
Equation (8b) is the interest parity relationship, while equation (9) specifies the risk premium, which is assumed not to take negative values. In order to assure the risk premium’s nonnegativity, restrictions (to be discussed below) are imposed on the functional form, and on the stochastic process ερ
41. Comparing equations (8a) and (8b)-(9) makes it obvious that the only feature differentiating the “outsider” regime from the “insider” one is the presence of the risk premium ρ.
Shocks and parameters
42. The major parameters of the model are based on Ball (1998), and the (annual) ADAM model of the Danish economy maintained by the Statistical Office of Denmark and used by the Ministry of Finance and the Ministry of Economic Affairs. However, inasmuch as the stylized model described above deviates both from models commonly used in the monetary policy rule literature and from the more detailed and realistic ADAM model, complete consistency of parameters could not be achieved. Table II-1 reports the baseline parameter values used in the simulations.
Baseline Parameter Values
Baseline Parameter Values
| Name | Value | Description |
|---|---|---|
| λ | 0.5 | Output persistence |
| α | 0.5 | Sensitivity of output with respect to real interest rate |
| β | 0.2 | Sensitivity of output with respect to foreign output |
| γ | 0.3 | Sensitivity of output with respect to the real exchange rate |
| δ | 0.6 | Share of domestic wages in price index |
| φ | 0.4 | Wage and price persistence |
| κ | 0.5 | Slope of aggregate supply |
| θx | 1 | Sensitivity of interest rate rule with respect to inflation |
| θy | 0.5 | Sensitivity of interest rate rule with respect to output |
| Var(εy) | 1 | Variance of foreign output shocks |
| Var(εyf) | 1 | Variance of domestic output shocks |
| Var(εпf) | 0.25 | Variance of common price shocks |
| Var(εW) | 0.25 | Variance of domestic price shocks |
| Var(εp) | 0.06 | Variance of shocks to risk premium |
| Corr(εy, εyf) | 0 | Correlation of foreign and domestic output shocks in baseline |
Baseline Parameter Values
| Name | Value | Description |
|---|---|---|
| λ | 0.5 | Output persistence |
| α | 0.5 | Sensitivity of output with respect to real interest rate |
| β | 0.2 | Sensitivity of output with respect to foreign output |
| γ | 0.3 | Sensitivity of output with respect to the real exchange rate |
| δ | 0.6 | Share of domestic wages in price index |
| φ | 0.4 | Wage and price persistence |
| κ | 0.5 | Slope of aggregate supply |
| θx | 1 | Sensitivity of interest rate rule with respect to inflation |
| θy | 0.5 | Sensitivity of interest rate rule with respect to output |
| Var(εy) | 1 | Variance of foreign output shocks |
| Var(εyf) | 1 | Variance of domestic output shocks |
| Var(εпf) | 0.25 | Variance of common price shocks |
| Var(εW) | 0.25 | Variance of domestic price shocks |
| Var(εp) | 0.06 | Variance of shocks to risk premium |
| Corr(εy, εyf) | 0 | Correlation of foreign and domestic output shocks in baseline |
43. Of the aggregate demand parameters common to the small and the large country, output persistenc (X) is assumed to be 0.5, which implies that 75 percent of the adjustment of aggregate demand to shocks happens within 2 years, and 99 percent of the adjustment is completed within 7 years. A one percentage point increase in the real interest rate is assumed to decrease output by 0.5 percent over the short run.
44. The small country’s foreign trade related parameters are based on the income and price elasticities of exports and imports estimated for Denmark for the ADAM model. The (long-run) elasticity of exports with respect to export market growth was estimated at 0.4, which—assuming an export to GDP ratio of about 40 percent—translates approximately into a 0.2 percent change in domestic output in response to a 1 percent change in foreign output (β=0.2). When calculating the current account, it is assumed that an output gap of 1 percent increases imports by 0.6 percent of GDP, which again, under an import to GDP ratio of 40 percent approximately corresponds to the estimated income elasticity of imports.27 In the simulations it is assumed that a one percent depreciation of the real exchange rate improves the current account by 0.3 percent of GDP (γ=0.3). With exports to GDP and imports to GDP ratios at about 40 percent, this corresponds to a current account elasticity of 0.75 with respect to the real exchange rate. This value is close to the estimated (long-run) unit elasticity in ADAM.
45. Parameters of the Phillips curve relationship are based on estimates for selected European countries.28 The assumed inflation persistence of 0.4 (the parameter φ) is consistent with the ADAM estimates for Denmark on one hand.29 and with the average persistence estimated for EMU countries in Kincaid and others (1997) on the other. The slope of the Phillips curve (the parameter κ) is calibrated at 0.5. This is consistent with a 1 percentage point increase of the actual unemployment rate to above the structural unemployment rate leading to 0.4 percentage point lower inflation rate (as estimated in Kincaid and others (1997) for Germany), and a labor share of about 2/3.30
46. The specification of parameters related to the foreign exchange market is ad hoc, and should be considered as a tentative benchmark.31 While in a two-country model there is no meaningful foreign exchange market for an “EMU-insider”, in the case of an “EMU-outsider” fixed exchange rate regime, influences originating from the foreign exchange market appear in the specification of the risk premium. The risk premium is assumed to include three components: a “ceteris paribus” constant outsider premium; a “credibility cost” component; and a random shock. The base level of the risk premium is an irrelevant nuisance parameter and does not influence the simulation results. 50 basis points, a value close to Denmark’s experience over the past 6 months, was chosen as its numerical value. The “credibility component” intends to capture the idea that an appreciated real exchange rate puts the peg under stress, as market participants start to question its sustainability. The “price” of defending the nominal exchange rate is a higher risk premium, and it is assumed that this “price” is quadratic in the extent of real appreciation. This element of the risk premium was calibrated such that the “credibility cost” of a 1 percentage point real appreciation is 5 basis points, while a 2 percentage point real appreciation costs 20 basis points.32 The third (stochastic) component of the risk premium captures disturbances on the foreign exchange market. To summarize, the risk premium was formulated as:
where dev(.) is an operator which determines the extent of real appreciation.33
47. The large country ys monetary policy rule is parameterized based on a numerical search for the optimal lagged Taylor rule. Assuming that the policymaker minimizes a weighted sum of the variance of inflation and the variance of output, the expected value of the loss function was calculated for a range of monetary policy rule parameters. Figure II-2 shows the results when the weight on output is 0.25 and the weight on inflation is 0.75. The graph illustrates that the loss function is fairly flat whenever the monetary policy function’s parameters are between 0.5 and 1. This feature is not sensitive to the loss function’s weights. In light of this, a monetary policy function that changes the interest rate one for one in case of deviations of inflation from the target, and changes the interest rate by 0.5 percent for a 1 percent change in the output gap was chosen. According to the monetary policy rule recommended by Taylor (1993), the interest rate would react more to inflation—there would be a 1.5 percent change for every percentage point deviation from the inflation target. Due to the parameterization of the model, this would clearly be suboptimal in the current setting because of the smaller persistence of inflation.34 With smaller inflation persistence, a larger policy response to inflation deviations would be destabilizing.
Denmark: Social Cost of Inflation and Output Variability
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Denmark: Social Cost of Inflation and Output Variability
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Denmark: Social Cost of Inflation and Output Variability
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
48. Five stochastic shocks are considered, which are assumed to be independent in the baseline. The large country is subject to output shocks (εyf), which do not have a direct impact in the small country. In contrast, the large economy’s inflation shocks (εyf) folly influence the small country’s inflation as well, so they can be considered common shocks and can be thought of as truly exogenous to both countries, e.g. effects of oil and commodity price changes. Similarly, the small country is hit by output and inflation shocks (εy and εw respectively). The latter could be interpreted as supply shocks emanating from, say, wage bargaining behavior, and are taken to be orthogonal to common inflation shocks. These four stochastic disturbances—domestic and foreign output and inflation shocks—are assumed to be normally distributed with zero mean. Variances of the inflation shocks are calibrated at 0.25, meaning that about 5 percent of the time, the magnitude of the shock exceeds 0.5 percent; and about 1 percent of the time it exceeds 1 percent. Output shocks are assumed to be larger, with variance about unity, and in the baseline, the correlation between the two countries’ output shocks is taken to be zero. The remaining stochastic disturbances are shocks to the risk premium (ερ). Shocks to the risk premium are drawn from a truncated normal distribution; are constrained to be larger than minus 20 basis points (so that the risk premium does not fall below 30 basis points); and have a zero mean and a 14 basis point standard deviation.
49. Table II-2 presents the historical and simulated variance of the output gap, inflation, and the current account for the small country, as well as the correlation coefficients between these variables. The calibrated model generates an output gap variance that exceeds somewhat the observed variance in Denmark over the past 12 years. Correspondingly, the stochastic model displays fluctuations with amplitude larger than that of the Danish business cycle. The length of the fluctuations is about 12-15 periods, longer than the empirical counterpart of 7 to 8 years (see Figures II-3 for typical simulated paths of select variables). As to the variance of inflation, historical data provide little help, because they are derived from a period of relatively high and variable inflation. It can be hypothesized, that a supposed low inflation environment would be characterized by substantially lower inflation variability than observed in the past. The model generates a current account that is markedly less variable than Denmark’s actual current account in the recent past. Historically, the variance of the current account was of the same magnitude, or larger, as the variance of the output gap, while the simulated variance is about one third of that. Regarding the correlation coefficients, the model generates a strong negative correlation between the output gap and the current account, which is in accordance with the historical behavior of these variables. In the model, inflation and the output gap are positively correlated with a coefficient about 0.5. The empirical correlation coefficient between these two variables for the 1987-1998 period is 0.44, very close to the simulation results, but its value strongly depends on the time period examined.35
Variance and Covariance of the Output Gap, Inflation, and the Current Account1/
Variances around zero.
Variance over the 1980-1998 period.
Variance and Covariance of the Output Gap, Inflation, and the Current Account1/
| Variance, Output gap | Variance, Inflation | Variance, current account | Correlation, output gap and inflation | Correlation, output gap and current account | |
|---|---|---|---|---|---|
| Historical (1987-1998) | 3.25 2/ | 8.27 | 3.48 | 0.44 | -0.87 |
| Simulated “EMU outsider” | 8.87 | 1.14 | 1.13 | 0.55 | -0.74 |
| Simulated “EMU insider” | 3.50 | 1.09 | 0.99 | 0.52 | -0.76 |
Variances around zero.
Variance over the 1980-1998 period.
Variance and Covariance of the Output Gap, Inflation, and the Current Account1/
| Variance, Output gap | Variance, Inflation | Variance, current account | Correlation, output gap and inflation | Correlation, output gap and current account | |
|---|---|---|---|---|---|
| Historical (1987-1998) | 3.25 2/ | 8.27 | 3.48 | 0.44 | -0.87 |
| Simulated “EMU outsider” | 8.87 | 1.14 | 1.13 | 0.55 | -0.74 |
| Simulated “EMU insider” | 3.50 | 1.09 | 0.99 | 0.52 | -0.76 |
Variances around zero.
Variance over the 1980-1998 period.
Denmark: A Simulated Path of Output
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Denmark: A Simulated Path of Output
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Denmark: A Simulated Path of Output
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Denmark: A Simulated Path of Inflation
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Denmark: A Simulated Path of Inflation
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Denmark: A Simulated Path of Inflation
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Denmark: A Simulated Path of the Current Account
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Source: Staff estimates.Denmark: A Simulated Path of the Current Account
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Source: Staff estimates.Denmark: A Simulated Path of the Current Account
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Source: Staff estimates.50. The shortcomings of the simulated model—longer business cycles and less volatile current account—originate in the simplifying assumptions, namely, in the highly stylized treatment of the large economy. As a result, the large economy displays long and relatively small fluctuations in the simulations, which tend to lengthen the cycles in the small economy and to compress the volatility of its current account. The creation of the European Monetary Union clearly represents a regime change, which may have an influence on the European business cycle. Although it can be speculated that with stronger links between the EMU member countries after the creation of the monetary union, there will be greater need to insure against country-specific shocks, and fluctuations will diminish, it is also possible that integration will lead to more synchronized business cycles in member countries, and thus to larger fluctuations for the monetary union as a whole.
C. Simulation Results
51. The model described in the previous section is utilized to quantify inflation and output variability in the small economy under the “insider” and “outsider” scenario. To accomplish this, the model is subjected to 200 realizations of a series of stochastic shocks over a 100-period horizon, and the average variances of output and inflation around zero are examined. The choice of the horizon is not motivated by the assumption that either the exchange rate regime, or the structure of the two economies is expected to remain unchanged for the foreseeable future. Rather, the dynamics of the model, in particular the relatively long fluctuations, require that a long time period spanning a number of cycles be considered to measure output and inflation variance with reasonable accuracy.
52. First, the quantitative effects of different kinds of stochastic shocks are examined in isolation to illustrate the relative importance of different shocks for output and inflation variability. When comparing the “EMU-outsider” and “EMU-insider” regimes, output and inflation variability are found to be slightly higher in the “outsider” case, but the magnitude of the differences between the two regimes is found to be minor.
53. Then, the joint effects of all stochastic shocks on output and inflation variability are considered. In the baseline scenario, output and inflation are found to be 10 and 5 percent more variable in the “outsider” case than in the “insider” scenario, indicating that although there is a difference in the need for fiscal policy under the two regimes, this difference is of moderate magnitude. After describing the baseline scenario, the correlation between the output shocks in the small and the large economy is allowed to vary. While stronger positive correlation diminishes the difference between the “outsider” and “insider” regimes, output and inflation become relatively more variable under the “outsider” arrangement when the correlation weakens and turns negative.
54. Next, output and inflation variability are traced as a function of the large country’s monetary policy rule. Large deviations in the foreign country’s monetary policy rule from the baseline are found to increase the variability of inflation and output in the small country under both exchange rate arrangements. The difference between inflation and output variability under the two regimes, however, is not sensitive to changes in the large country’s monetary policy rule.
55. Finally, it is illustrated that the difference between the “insider” and “outsider” regimes can become substantial if some of the model’s assumptions are modified. In particular, more volatile financial markets and weaker credibility of the “outsider” country’s peg are considered. Under either of the modified assumptions, the variables of interest become markedly more volatile for the “outsider” country. This illustrates that an “outsider” arrangement can potentially increase the vulnerability of the economy.
Output and inflation variability and the type of shocks
56. Table II-3 presents output, inflation and current account variance, allowing for stochastic shocks to the risk premium and to one additional variable. For example, in column 1 it is assumed that only shocks to the risk premium and to foreign output occur. The first two rows in Table II-3 illustrate the relative importance of the different shocks for the variability of output in the small economy. In the calibrated model, the most important source of output variability is domestic output shocks (column 3). The effects of foreign output shocks are weaker but also substantial (column 1), due partly to the fact that foreign shocks are only partially transmitted through trade, and partly to the assumption that output fluctuations in the large country are mitigated by monetary policy. In contrast, inflation shocks, in particular, common inflation shocks induce relatively little output volatility in the small economy. Rows 4 and 5 show the relative importance of different shocks for inflation variability. Foreign shocks and domestic output shocks produce similarly variable inflation in the small economy (columns 1-3), while domestic price shocks appear less important.
Variance of Output, Inflation and the Current Account—One Type of Shock and Foreign Exchange Market Disturbances Considered
Variance of Output, Inflation and the Current Account—One Type of Shock and Foreign Exchange Market Disturbances Considered
| Foreign output shock | Common inflation shock | Domestic output shock | Domestic inflation shock | |
|---|---|---|---|---|
| εyf,εE, εp | επf, εE, εp | εy, εB, εp | εw,εE, εp | |
| Var(y), EMU-outsider | 0.57 | 0.14 | 2.63 | 0.38 |
| Var(y), EMU-insider | 0.53 | 0.13 | 2.45 | 0.33 |
| Var(yf) | 1.37 | 0.08 | 0.00 | 0.00 |
| Var(π), EMU-outsider | 0.28 | 0.37 | 0.35 | 0.15 |
| Var(π), EMU-insider | 0.27 | 0.36 | 0.33 | 0.15 |
| Var(πf) | 0.59 | 0.34 | 0.00 | 0.00 |
| Var(CA), EMU-outs. | 0.14 | 0.03 | 0.76 | 0.07 |
| Var(CA), EMU-ins. | 0.14 | 0.02 | 0.73 | 0.06 |
| Average risk premium | 0.54 | 0.50 | 0.58 | 0.52 |
Variance of Output, Inflation and the Current Account—One Type of Shock and Foreign Exchange Market Disturbances Considered
| Foreign output shock | Common inflation shock | Domestic output shock | Domestic inflation shock | |
|---|---|---|---|---|
| εyf,εE, εp | επf, εE, εp | εy, εB, εp | εw,εE, εp | |
| Var(y), EMU-outsider | 0.57 | 0.14 | 2.63 | 0.38 |
| Var(y), EMU-insider | 0.53 | 0.13 | 2.45 | 0.33 |
| Var(yf) | 1.37 | 0.08 | 0.00 | 0.00 |
| Var(π), EMU-outsider | 0.28 | 0.37 | 0.35 | 0.15 |
| Var(π), EMU-insider | 0.27 | 0.36 | 0.33 | 0.15 |
| Var(πf) | 0.59 | 0.34 | 0.00 | 0.00 |
| Var(CA), EMU-outs. | 0.14 | 0.03 | 0.76 | 0.07 |
| Var(CA), EMU-ins. | 0.14 | 0.02 | 0.73 | 0.06 |
| Average risk premium | 0.54 | 0.50 | 0.58 | 0.52 |
57. Comparing inflation and output variability under the “insider” and “outsider” regimes reveals small differences, implying that the need for countercyclical fiscal policy is similar under both arrangements. In case of common inflation shocks (column 2), there is virtually no difference between the performance of the two regimes. The “EMU-insider” and the “EMU-outsider” regimes also perform similarly when foreign output shocks are considered. The “outsider’s” risk premium exceeds the deterministic benchmark level of 50 basis points by merely 2 basis points, the variance of inflation is almost the same under the two regimes, and the variance of output is only slightly higher under the “outsider” scenario than in the “insider” case (column 1).
58. If the economy is exposed to domestic output shocks (column 3) the difference between the “EMU-outsider” and “EMU-insider” regimes widens slightly. The outsider’s average risk premium increases by 7 basis points (from the deterministic benchmark of 50 basis points), due to the “credibility effect” whenever foreign and domestic inflation diverge such that the real exchange rate appreciates, defending the peg requires an increase in the risk premium for an outsider country. This adds some variability to the domestic real interest rate and thus to output. Nevertheless, differences between the two regimes remain modest: output and inflation variability under the “outsider” regime are less that 10 percent more variable than their counterparts under the “insider” scenario. A similar conclusion is achieved for the case of domestic price shocks (presented in column 4).
Output and inflation variability and the correlation of output shocks
59. This section examines whether the correlation of foreign and domestic output shocks influences the difference in output and inflation variability under the “insider” and “outsider” regimes. As the empirical evidence regarding the actual correlation of output shocks in Denmark and the Euro area is inconclusive, zero correlation was chosen as baseline.36 37
60. Table II-4 and II-5 present the results for select correlation coefficients. The benchmark case of no correlation (column 3) shows that under the “outsider” scenario, the need to occasionally defend the peg raises the risk premium by 13 basis points on average. The added variability in the real interest rate implies that output is by 10 percent more variable for an outsider than for an insider. Some of the added variability to output under the outsider regime is propagated to inflation, so that inflation variability is also slightly higher under the outsider arrangement. The higher variability of output under the “outsider” regime indicates that the need for countercyclical fiscal policy is larger in this case.
Variance of Output, Inflation and the Current Account—Different Correlations of Output Shocks
Variance of Output, Inflation and the Current Account—Different Correlations of Output Shocks
| Corr(εy, εyf)=+1 | Corr(εy, εyf)=+0.5 | Corr(εy, εyf)=0 | Corr(εy, εyf)=-0.5 | Corr(εy, εyf)=-1 | |
|---|---|---|---|---|---|
| Var(y), EMU-outsider | 2.85 | 3.36 | 3.87 | 4.41 | 4.73 |
| Var(y), EMU-insider | 2.78 | 3.17 | 3.50 | 3.85 | 3.96 |
| Var(yr) | 1.46 | 1.47 | 1.46 | 1.47 | 1.47 |
| Var(π), EMU-outsider | 1.33 | 1.24 | 1.14 | 1.11 | 0.98 |
| Var(π), EMU-insider | 1.32 | 1.21 | 1.09 | 1.03 | 0.88 |
| Var(πf) | 0.94 | 0.92 | 0.91 | 0.92 | 0.93 |
| Var(CA), EMU-outs. | 0.61 | 0.77 | 1.04 | 1.27 | 1.46 |
| Var(CA), EMU-ins. | 0.54 | 0.75 | 1.00 | 1.21 | 1.38 |
| Average risk premium | 0.54 | 0.58 | 0.63 | 0.67 | 0.71 |
Variance of Output, Inflation and the Current Account—Different Correlations of Output Shocks
| Corr(εy, εyf)=+1 | Corr(εy, εyf)=+0.5 | Corr(εy, εyf)=0 | Corr(εy, εyf)=-0.5 | Corr(εy, εyf)=-1 | |
|---|---|---|---|---|---|
| Var(y), EMU-outsider | 2.85 | 3.36 | 3.87 | 4.41 | 4.73 |
| Var(y), EMU-insider | 2.78 | 3.17 | 3.50 | 3.85 | 3.96 |
| Var(yr) | 1.46 | 1.47 | 1.46 | 1.47 | 1.47 |
| Var(π), EMU-outsider | 1.33 | 1.24 | 1.14 | 1.11 | 0.98 |
| Var(π), EMU-insider | 1.32 | 1.21 | 1.09 | 1.03 | 0.88 |
| Var(πf) | 0.94 | 0.92 | 0.91 | 0.92 | 0.93 |
| Var(CA), EMU-outs. | 0.61 | 0.77 | 1.04 | 1.27 | 1.46 |
| Var(CA), EMU-ins. | 0.54 | 0.75 | 1.00 | 1.21 | 1.38 |
| Average risk premium | 0.54 | 0.58 | 0.63 | 0.67 | 0.71 |
Variance of Output, Inflation and the Current Account in Percent of the Outsider Regime’s Baseline Performance—Different Correlations of Output Shocks
Variance of Output, Inflation and the Current Account in Percent of the Outsider Regime’s Baseline Performance—Different Correlations of Output Shocks
| Corr(εy, εyf)=+1 | Corr(εy, εyf)=+0.5 | Corr(εy, εyf)=0 | Corr(εy, εyf)=-0.5 | Corr(εy, εyf)=-1 | |
|---|---|---|---|---|---|
| Var(y), EMU-outsider | 74% | 87% | 100% | 114% | 122% |
| Var(y), EMU-insider | 72% | 82% | 90% | 99% | 102% |
| Var(yf) | 38% | 38% | 38% | 38% | 38% |
| Var(π), EMU-outsider | 117% | 109% | 100% | 97% | 86% |
| Var(π), EMU-insider | 116% | 106% | 96% | 90% | 77% |
| Var(πf) | 82% | 81% | 80% | 82% | 82% |
| Var(CA), EMU-outs. | 52% | 74% | 100% | 122% | 140% |
| Var(CA), EMU-ins. | 51% | 72% | 96% | 116% | 133% |
Variance of Output, Inflation and the Current Account in Percent of the Outsider Regime’s Baseline Performance—Different Correlations of Output Shocks
| Corr(εy, εyf)=+1 | Corr(εy, εyf)=+0.5 | Corr(εy, εyf)=0 | Corr(εy, εyf)=-0.5 | Corr(εy, εyf)=-1 | |
|---|---|---|---|---|---|
| Var(y), EMU-outsider | 74% | 87% | 100% | 114% | 122% |
| Var(y), EMU-insider | 72% | 82% | 90% | 99% | 102% |
| Var(yf) | 38% | 38% | 38% | 38% | 38% |
| Var(π), EMU-outsider | 117% | 109% | 100% | 97% | 86% |
| Var(π), EMU-insider | 116% | 106% | 96% | 90% | 77% |
| Var(πf) | 82% | 81% | 80% | 82% | 82% |
| Var(CA), EMU-outs. | 52% | 74% | 100% | 122% | 140% |
| Var(CA), EMU-ins. | 51% | 72% | 96% | 116% | 133% |
61. Comparing the columns of Tables II-4 and II-5 shows that output variability increases steadily under both regimes as the correlation of output shocks is varied from +1 to -1, illustrating that the burden on fiscal policy to stabilize output increases as the shocks become less synchronized. Indeed, the difference between the two polar cases is over 40 percent for the outsider regime, and 30 percent for the insider. Inflation variability shows the opposite pattern, decreasing as the correlation coefficient is varied from +1 to -1, but the differences at the two extremes are similarly sizeable. These results are the net of two opposing effects. On one hand, if output shocks are strongly positively correlated, the large economy’s monetary policy is more appropriate for the small economy, so the adopted monetary policy stance should be more successful in mitigating the effects of stochastic shocks and should reduce the variability of both inflation and output. On the other hand, if output shocks in the two economies are positively correlated, the small economy in fact receives a larger output shock, because domestic booms tend to coincide with expanding export markets, and busts with weak demand abroad. Larger shocks, ceteris paribus, would increase volatility. In case of output, the first effect dominates, while in case of inflation the second effect is larger.
62. Tables II-4 and II-5 show that the difference between the variability of inflation and output under the “insider” and “outsider” regimes shrinks as output shocks in the large and the small economy become more strongly positively correlated, and thus the need for countercyclical fiscal policy becomes more similar under the two arrangements. The opposite happens under the assumption of strongly negatively correlated output shocks. In the extreme case of perfect negative correlation (column 5), output variability is 20 percent higher, and inflation is 9 percent more volatile under the “outsider” regime than under the “insider” scenario. The widening difference in output variability under the two regimes indicates that fiscal policy under an “outsider” arrangement faces a relatively larger challenge to stabilize output than in an “insider” scenario whenever output shocks in the small and the large country are strongly negatively correlated.
63. The average level of the risk premium also varies with the correlation of output shocks. It reaches its lowest level in the case of a strong positive correlation coefficient (column 1), and is highest when output shocks are strongly negatively correlated (column 5). The reason for this is that with more synchronized output movements in the two economies, inflation rates also tend to move more closely together. When inflation in the small economy tracks inflation in the large economy, the real exchange rate (which depends on the inflation differential) will become appreciated less often, and thus pressure on the “outsider’s” exchange rate will occur less frequently. On average, this will result in a lower risk premium. The opposite argument applies in the case when output shocks are negatively correlated, inflation movements in the two economies are less synchronized, and the average risk premium is higher.
Output and inflation variability and the foreign policy rule
64. This section examines whether the monetary policy followed by the large economy has an important influence on output and inflation variability, and thus on the need for fiscal policy in the small economy. Changes in the monetary policy rule in the foreign country can affect the small country via several channels. First, a different monetary policy rule will influence the typical variability of output and inflation in the large economy, and the resulting changes in the volatility of foreign output will be propagated to the small economy’s export demand. Second, under a fixed exchange rate arrangement, changes in foreign inflation volatility will have a direct influence on the volatility of real exchange rates and inflation as well.38 Third, changes in the large economy’s interest rate response to shocks will be directly transmitted to the small economy via the (covered or uncovered) nominal interest rate parity relationship.39
65. Tables II-6 and II-7 present the results obtained by varying the sensitivity of the large economy’s monetary policy rule to output. Because the baseline parameter values characterize a near-optimal monetary policy reaction function (as explained in Section B), the variability of output and inflation in the large economy is expected to remain flat or to increase as the monetary policy rule deviates from the baseline. Indeed, the simulations show that these variables remain stable for smaller deviations (columns 2 and 4), but they increase as the deviation becomes larger (columns 6 and 7).
Variance of Output, Inflation and the Current Account—Different Degrees of Responsiveness of Monetary Rule to Output
Variance of Output, Inflation and the Current Account—Different Degrees of Responsiveness of Monetary Rule to Output
| Baseline | |||||||
|---|---|---|---|---|---|---|---|
| θy=0.75 | θy=0.625 | θy=0.5 | θy=0.375 | θy=0.25 | θy=0.125 | θy=0 | |
| Var(y), EMU-outsider | 4.13 | 3.87 | 3.87 | 3.79 | 3.55 | 3.84 | 3.87 |
| Var(y), EMU-insider | 3.73 | 3.50 | 3.50 | 3.42 | 3.23 | 3.45 | 3.45 |
| Var(yf) | 1.48 | 1.47 | 1.46 | 1.47 | 1.51 | 1.59 | 1.68 |
| Var(π), EMU-outsider | 1.17 | 1.14 | 1.14 | 1.18 | 1.16 | 1.27 | 1.34 |
| Var(π), EMU-insider | 1.12 | 1.09 | 1.09 | 1.12 | 1.11 | 1.21 | 1.27 |
| Var(πf) | 0.88 | 0.91 | 0.91 | 0.94 | 0.98 | 1.05 | 1.12 |
| Var(CA), EMU-outsider | 1.11 | 1.02 | 1.04 | 0.98 | 0.91 | 0.94 | 0.89 |
| Var(CA), EMU-insider | 1.06 | 0.98 | 1.00 | 0.94 | 0.88 | 0.90 | 0.84 |
| Average risk premium | 0.62 | 0.62 | 0.63 | 0.62 | 0.62 | 0.62 | 0.62 |
Variance of Output, Inflation and the Current Account—Different Degrees of Responsiveness of Monetary Rule to Output
| Baseline | |||||||
|---|---|---|---|---|---|---|---|
| θy=0.75 | θy=0.625 | θy=0.5 | θy=0.375 | θy=0.25 | θy=0.125 | θy=0 | |
| Var(y), EMU-outsider | 4.13 | 3.87 | 3.87 | 3.79 | 3.55 | 3.84 | 3.87 |
| Var(y), EMU-insider | 3.73 | 3.50 | 3.50 | 3.42 | 3.23 | 3.45 | 3.45 |
| Var(yf) | 1.48 | 1.47 | 1.46 | 1.47 | 1.51 | 1.59 | 1.68 |
| Var(π), EMU-outsider | 1.17 | 1.14 | 1.14 | 1.18 | 1.16 | 1.27 | 1.34 |
| Var(π), EMU-insider | 1.12 | 1.09 | 1.09 | 1.12 | 1.11 | 1.21 | 1.27 |
| Var(πf) | 0.88 | 0.91 | 0.91 | 0.94 | 0.98 | 1.05 | 1.12 |
| Var(CA), EMU-outsider | 1.11 | 1.02 | 1.04 | 0.98 | 0.91 | 0.94 | 0.89 |
| Var(CA), EMU-insider | 1.06 | 0.98 | 1.00 | 0.94 | 0.88 | 0.90 | 0.84 |
| Average risk premium | 0.62 | 0.62 | 0.63 | 0.62 | 0.62 | 0.62 | 0.62 |
Variance of Output, Inflation and the Current Account in Percent of the Outsider Regime’s Baseline Performance—Different Degrees of Responsiveness of Monetary Rule to Output
Variance of Output, Inflation and the Current Account in Percent of the Outsider Regime’s Baseline Performance—Different Degrees of Responsiveness of Monetary Rule to Output
| Baseline | |||||||
|---|---|---|---|---|---|---|---|
| θy=0.75 | θy=0.625 | θy=0.5 | θy=0.375 | θy=0.25 | θy=0.125 | θy=0 | |
| Var(y), EMU-outsider | 107% | 100% | 100% | 98% | 92% | 99% | 100% |
| Var(y), EMU-insider | 96% | 90% | 90% | 88% | 83% | 89% | 89% |
| Var(yf) | 38% | 38% | 38% | 38% | 39% | 41% | 43% |
| Var(π), EMU-outsider | 103% | 100% | 100% | 104% | 102% | 111% | 118% |
| Var(π), EMU-insider | 98% | 96% | 96% | 98% | 97% | 106% | 111% |
| Var(πf) | 77% | 80% | 80% | 82% | 86% | 92% | 98% |
| Var(CA), EMU-outsider | 107% | 98% | 100% | 94% | 88% | 90% | 86% |
| Var(CA), EMU-insider | 102% | 94% | 96% | 90% | 85% | 87% | 81% |
Variance of Output, Inflation and the Current Account in Percent of the Outsider Regime’s Baseline Performance—Different Degrees of Responsiveness of Monetary Rule to Output
| Baseline | |||||||
|---|---|---|---|---|---|---|---|
| θy=0.75 | θy=0.625 | θy=0.5 | θy=0.375 | θy=0.25 | θy=0.125 | θy=0 | |
| Var(y), EMU-outsider | 107% | 100% | 100% | 98% | 92% | 99% | 100% |
| Var(y), EMU-insider | 96% | 90% | 90% | 88% | 83% | 89% | 89% |
| Var(yf) | 38% | 38% | 38% | 38% | 39% | 41% | 43% |
| Var(π), EMU-outsider | 103% | 100% | 100% | 104% | 102% | 111% | 118% |
| Var(π), EMU-insider | 98% | 96% | 96% | 98% | 97% | 106% | 111% |
| Var(πf) | 77% | 80% | 80% | 82% | 86% | 92% | 98% |
| Var(CA), EMU-outsider | 107% | 98% | 100% | 94% | 88% | 90% | 86% |
| Var(CA), EMU-insider | 102% | 94% | 96% | 90% | 85% | 87% | 81% |
66. Columns 1 and 2 in Tables II-6 and II-7 illustrate cases when the foreign monetary policy rule is more responsive to output than under the baseline (presented in column 3), while columns 4 through 7 show scenarios where the policy responsiveness is lower than in the baseline. Looking at the rows that report inflation and output variance reveals that both inflation and output variability show a slight U-shaped pattern in the small economy under both regimes. While inflation variability is minimal under the baseline (column 3), the lowest output variability is reached when foreign interest rates are somewhat less sensitive to output than under the baseline policy rule (column 5). This means that the need for countercyclical fiscal policy action in the small country would be smaller if monetary policy in the large economy responded less to output than in the baseline. The intuition is straightforward—the baseline monetary policy is not optimal for the small economy for output stabilization purposes. Changes in foreign output are only partially transmitted to the small economy through trade, so the interest rate response to output under the baseline foreign monetary policy rule is “excessive” from the small country’s point of view. Hence, decreasing the foreign monetary policy rule’s sensitivity of interest rates to output somewhat helps decrease output variability in the small economy under a fixed exchange rate regime. The beneficial effects of importing a monetary policy stance that is more appropriate are, however, somewhat mitigated by the adverse effects of higher output variability in the large economy (which follow from the fact that this monetary policy rule is not optimal for the large economy). Lowering the foreign interest rate rule’s sensitivity to output beyond a threshold leads to higher output variability in the small economy as well, due to two effects. First, the rise in foreign output variability associated with a sub-optimal monetary policy rule is transmitted through trade, and continues to contribute to higher output variability in the small economy. Second, below some threshold value, monetary policy response with respect to foreign output becomes “insufficient” even from the small country’s point of view.
67. The “insider” and “outsider” regimes are characterized by the same respective output variances in the baseline scenario than in the case of a monetary policy that is completely non-responsive to output (columns 3 and 7 in Tables II-6 and II-7). However, inflation variance is about 15 percent higher in the polar case than under the baseline. The difference in inflation and output variability under the two regimes is not sensitive to changes in the foreign monetary policy rule. Output remains about 10 percent more variable, and inflation variability is about 6 percent higher under an “outsider” regime than under an “insider” arrangement regardless of the sensitivity of the large country’s monetary policy rule to output.
68. Tables II-8 and II-9 present the simulation results when the sensitivity of the foreign policy rule with respect to inflation is varied. Columns 1 and 2 represent cases when monetary policy in the large economy responds more to inflation than under the baseline (presented in column 3). Columns 4 through 7 show scenarios under monetary policy rules that are less sensitive to inflation. The results are qualitatively similar to the case of changing sensitivity to output. First, output and inflation in the large economy become more variable as the monetary policy rule deviates from the baseline. Second, both output and inflation variance display a U-shaped pattern in the small country. While the variance of inflation is minimal under the baseline (column 3), the variance of output reaches its minimum when the foreign monetary policy rule reacts less to inflation than under the baseline (column 4). Third, the difference between output and inflation variability under the two regimes is not sensitive to changes in the large economy’s monetary policy rule.
Variance of Output, Inflation and the Current Account—Different Degrees of Responsiveness of Monetary Rule to Inflation
Variance of Output, Inflation and the Current Account—Different Degrees of Responsiveness of Monetary Rule to Inflation
| Baseline | |||||||
|---|---|---|---|---|---|---|---|
| θπ=1.5 | θπ=1.25 | θπ=1 | θπ=0.75 | θπ=0.5 | θπ=0.25 | θπ=0 | |
| Var(y), EMU-outsider | 4.48 | 3.92 | 3.87 | 3.64 | 3.80 | 4.13 | 4.74 |
| Var(y), EMU-insider | 4.15 | 3.55 | 3.50 | 3.28 | 3.38 | 3.71 | 4.25 |
| Var(yf | 1.86 | 1.60 | 1.46 | 1.41 | 1.42 | 1.48 | 1.63 |
| Var(π), EMU-outsider | 1.37 | 1.22 | 1.14 | 1.14 | 1.21 | 1.35 | 1.60 |
| Var(π) EMU-insider | 1.32 | 1.17 | 1.09 | 1.09 | 1.14 | 1.29 | 1.52 |
| Var(πf) | 1.07 | 0.98 | 0.91 | 0.92 | 0.95 | 1.01 | 1.14 |
| Var(CA), EMU-outsider | 1.18 | 1.03 | 1.04 | 0.95 | 0.93 | 0.98 | 1.08 |
| Var(CA), EMU-insider | 1.15 | 0.99 | 1.00 | 0.91 | 0.88 | 0.92 | 1.00 |
| Average risk premium | 0.62 | 0.62 | 0.63 | 0.62 | 0.62 | 0.62 | 0.62 |
Variance of Output, Inflation and the Current Account—Different Degrees of Responsiveness of Monetary Rule to Inflation
| Baseline | |||||||
|---|---|---|---|---|---|---|---|
| θπ=1.5 | θπ=1.25 | θπ=1 | θπ=0.75 | θπ=0.5 | θπ=0.25 | θπ=0 | |
| Var(y), EMU-outsider | 4.48 | 3.92 | 3.87 | 3.64 | 3.80 | 4.13 | 4.74 |
| Var(y), EMU-insider | 4.15 | 3.55 | 3.50 | 3.28 | 3.38 | 3.71 | 4.25 |
| Var(yf | 1.86 | 1.60 | 1.46 | 1.41 | 1.42 | 1.48 | 1.63 |
| Var(π), EMU-outsider | 1.37 | 1.22 | 1.14 | 1.14 | 1.21 | 1.35 | 1.60 |
| Var(π) EMU-insider | 1.32 | 1.17 | 1.09 | 1.09 | 1.14 | 1.29 | 1.52 |
| Var(πf) | 1.07 | 0.98 | 0.91 | 0.92 | 0.95 | 1.01 | 1.14 |
| Var(CA), EMU-outsider | 1.18 | 1.03 | 1.04 | 0.95 | 0.93 | 0.98 | 1.08 |
| Var(CA), EMU-insider | 1.15 | 0.99 | 1.00 | 0.91 | 0.88 | 0.92 | 1.00 |
| Average risk premium | 0.62 | 0.62 | 0.63 | 0.62 | 0.62 | 0.62 | 0.62 |
Variance of Output, Inflation and the Current Account in Percent of the Outsider Regime’s Baseline Performance—Different Degrees of Responsiveness of Monetary Rule to Inflation
Variance of Output, Inflation and the Current Account in Percent of the Outsider Regime’s Baseline Performance—Different Degrees of Responsiveness of Monetary Rule to Inflation
| Baseline | |||||||
|---|---|---|---|---|---|---|---|
| θπ=1.5 | θπ=1.25 | θπ=1 | θπ=0.75 | θπ=0.5 | θπ=0.25 | θπ=0 | |
| Var(y), EMU-outsider | 116% | 101% | 100% | 94% | 98% | 107% | 122% |
| Var(y), EMU-insider | 107% | 92% | 90% | 85% | 87% | 96% | 110% |
| Var(yf) | 48% | 41% | 38% | 36% | 37% | 38% | 42% |
| Var(π), EMU-outsider | 120% | 107% | 100% | 100% | 106% | 118% | 140% |
| Var(π), EMU-insider | 116% | 103% | 96% | 96% | 100% | 113% | 133% |
| Var(πf) | 94% | 86% | 80% | 81% | 83% | 89% | 100% |
| Var(CA), EMU-outsider | 113% | 99% | 100% | 91% | 89% | 94% | 104% |
| Var(CA), EMU-insider | 111% | 95% | 96% | 88% | 85% | 88% | 96% |
Variance of Output, Inflation and the Current Account in Percent of the Outsider Regime’s Baseline Performance—Different Degrees of Responsiveness of Monetary Rule to Inflation
| Baseline | |||||||
|---|---|---|---|---|---|---|---|
| θπ=1.5 | θπ=1.25 | θπ=1 | θπ=0.75 | θπ=0.5 | θπ=0.25 | θπ=0 | |
| Var(y), EMU-outsider | 116% | 101% | 100% | 94% | 98% | 107% | 122% |
| Var(y), EMU-insider | 107% | 92% | 90% | 85% | 87% | 96% | 110% |
| Var(yf) | 48% | 41% | 38% | 36% | 37% | 38% | 42% |
| Var(π), EMU-outsider | 120% | 107% | 100% | 100% | 106% | 118% | 140% |
| Var(π), EMU-insider | 116% | 103% | 96% | 96% | 100% | 113% | 133% |
| Var(πf) | 94% | 86% | 80% | 81% | 83% | 89% | 100% |
| Var(CA), EMU-outsider | 113% | 99% | 100% | 91% | 89% | 94% | 104% |
| Var(CA), EMU-insider | 111% | 95% | 96% | 88% | 85% | 88% | 96% |
69. Quantitatively, substantial deviations from the baseline in the sensitivity of the large economy’s monetary policy rule with respect to inflation have stronger implications for the small country’s output and inflation variability than similar deviations in the sensitivity with respect to output. In the extreme case when monetary policy does not respond to inflation (column 7 in Table II-9), output is about 20 percent more variable under both regimes than in the baseline, and inflation variability exceeds its baseline level by about 40 percent. The comparable magnitudes in cases when monetary policy does not respond to output (from column 7 of Table II-7) are 0 and about 15 percent, respectively. The large differences stem from the fact that while shocks to foreign output are only partially transmitted to the small economy through trade, inflation shocks to the large economy fully affect inflation in the small country.40 Thus, whether the imported monetary policy is “appropriately” responsive to inflation has more important repercussions for the small country than its responsiveness to output.
Output and inflation variability and the vulnerability of the peg
70. The previous results, which found that under the baseline the difference between the “insider” and “outsider” regimes is quite small in terms of output and inflation volatility, and therefore the challenges facing fiscal policy are similar under the two exchange rate arrangements, depend strongly on the joint underlying assumptions of (i) orderly conditions in international financial markets; and (ii) credible commitment by the outsider country to the exchange rate peg.41 This section illustrates that in case these assumptions are relaxed, both output and inflation become substantially more variable under the “outsider” regime than under the “insider” arrangement, indicating a larger need for fiscal policy in the former case.
71. First, the possibility of financial market turbulence is considered by modifying the assumption about the distribution of stochastic shocks to the risk premium (ερ). In particular, the distribution is assumed to have higher mean, larger variance, and fatter tails (so that extreme values of the shock become more likely).42 The average shock is calibrated at 200 basis points, and the maximum value is assumed to be 450 basis points. These magnitudes are in the range of “shocks” observed during the 1992 ERM crisis. Figure II-4 gives an illustration of a series of risk premium shocks under the assumption of calm and turbulent financial markets.
Denmark: Shocks to Risk Premium
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Source: Staff calculations.Denmark: Shocks to Risk Premium
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Source: Staff calculations.Denmark: Shocks to Risk Premium
Citation: IMF Staff Country Reports 1999, 107; 10.5089/9781451811070.002.A002
Source: Staff calculations.72. Column 2 of Table II-10 reports the simulation results. While financial market turbulence increases the variability of both output and inflation in comparison with the baseline under the “outsider” regime, it has a larger effect on output variability. The intuition is that a more volatile risk premium directly influences real interest rates, and thus output, but it has no direct impact on inflation under a fixed exchange rate regime. The variability of inflation increases only as a result of higher output variability.
Variance of Output and Inflation Under the “Outsider” and “Insider” Regimes
Variance of Output and Inflation Under the “Outsider” and “Insider” Regimes
| Baseline | Financial market turbulence | Lower credibility of peg | |
|---|---|---|---|
| Var(y), outsider | 3.87 | 7.31 | 5.60 |
| Var(y), insider | 3.50 | 3.49 | 3.49 |
| Var(π), outsider | 1.14 | 1.70 | 1.40 |
| Var(π), insider | 1.09 | 1.10 | 1.10 |
| Average risk premium | 0.63 | 3.38 | 0.94 |
Variance of Output and Inflation Under the “Outsider” and “Insider” Regimes
| Baseline | Financial market turbulence | Lower credibility of peg | |
|---|---|---|---|
| Var(y), outsider | 3.87 | 7.31 | 5.60 |
| Var(y), insider | 3.50 | 3.49 | 3.49 |
| Var(π), outsider | 1.14 | 1.70 | 1.40 |
| Var(π), insider | 1.09 | 1.10 | 1.10 |
| Average risk premium | 0.63 | 3.38 | 0.94 |
73. Next, loss of credibility in the outsider country’s exchange rate peg is examined. This is modeled as an increase in the “cost” of real appreciation. In particular, the risk premium is assumed to rise by 20 basis points (instead of the baseline 5 basis points) in case the real exchange rate is 1 percentage point more appreciated than its equilibrium value, and by 80 basis points (instead of the baseline 20 basis points) in case of a 2 percentage point appreciation.
74. Column 2 of Table II-10 shows that the less credible peg increases the average risk premium by about 30 basis points from its baseline level, and makes (via the channel of more variable real interest rate) the “outsider’s” output and inflation substantially more variable than under the baseline or under the “insider” arrangement. Similarly to the case of financial market turbulence, this adverse development is more pronounced in the case of output than in the case of inflation.
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Prepared by Kornelia Krajnyak
For instance, participation in the EMU involves a transfer of monetary policy responsibilities from the national central bank to the ECB, which can be perceived as part of a wider process allocating various political prerogatives to supranational levels of government. Alesina and Wacziarg (1999) argue along these lines: “Firstly, European institutions have received policy attributions in practically every domain of public affairs—however limited these attributions may be… Secondly, the policies being transferred are in no way limited to those which seek to further the extent of economic integration within Europe. In fact, the list of policies with little or no economic content has grown steadily over time, and the extent of EU involvement in each of these policies has also deepened” page 26. Societies may dislike this process, which may have a substantial influence on the (essentially political) decision about entering the monetary union.
Capital controls were phased out in the early 1980s.
The idea of incompatibility of fixed exchange rates, independent monetary policy, and capital mobility goes back to Mundell (1963). Rose (1994) presents some empirical evidence on this issue.
The cyclical sensitivity of the budget is one of the highest among the industrial countries. In addition, countercyclical discretionary policy action has often been undertaken. For example, the current recovery was “jump-started” by a modest fiscal stimulus in 1993, and the authorities have repeatedly tightened fiscal policy in 1998-99 to prevent overheating.
See for instance Taylor (1998b) or Ball (1998).
With (φ=l, inflation would be nonstationary, In this case, the economy described by equations (1)-(3) can stay non-explosive only if the monetary policy response to inflation is aggressive enough. In this case, if a structurally similar other country “borrowed” this monetary policy, and was hit by stochastic shocks not perfectly correlated with the disturbances of the anchor country, it would become explosive with probability one. In a richer model, where real interest rates are linked to the marginal product of capital and thus to capital accumulation and reallocation, this outcome could be avoided.
Assuming that the shocks are realized after the policymaker sets interest rates for period t, lagged output and lagged inflation are sufficient statistics for the state of the economy, and an appropriately parametrized lagged Taylor rule and non-lagged Taylor rule will be equally efficient in stabilizing the economy.
The real exchange rate is based on the GDP deflator.
Trend wage growth in the small country and trend inflation in the large country are assumed to be the same.
Denmark pegs its currency to the euro with a 2.25 percent band. For simplicity, nominal exchange rate movements within the band are abstracted away, and it is assumed that the “outsider” arrangement involves strictly fixing the exchange rate to the large country’s currency.
This parameter (the income elasticity of imports) is necessary only for auxiliary calculations and does not appear in the equations.
Kincaid and others (1997), Chapter I, “Labor Market Asymmetries and Macroeconomic Adjustment.”
The lagged inflation term in the ADAM wage adjustment equation corresponds to the average of inflation over the previous two years, which is conceptually equivalent to a one year lag.
In ADAM, a 1 percentage point increase in the actual unemployment rate is estimated to decrease wage growth by 0.8 percentage points, regardless of the structural unemployment rate. As all variables are assumed to be detrended in the model, this estimate cannot be directly used.
As is well-known, empirical research on nominal exchange rates is far from fruitful, cf for example Meese (1990) and Frankel and Rose (1994) for an overview.
In general, the credibility of the peg would also depend on policy response to the real appreciation. Since monetary/exchange rate policy is the only instrument in the model, this consideration does not enter in the specification.
It is assumed that “credibility costs” are inherently asymmetric in the sense that while an appreciated real exchange rate leads to an increase in the risk premium, a depreciated real exchange rate does not trigger a matching decline. It should also be noted that the real exchange rate is supposed to be appreciated if its value falls below the threshold 0.83. The rationale for this is that in full deterministic equilibrium, the effect of a permanently higher real interest rate on output in the “outsider” country would be offset by a slightly depreciated real exchange rate. Correspondingly, the “outsider” country would run a small current account surplus. Thus, the choice of exchange rate regime is not neutral for the composition of aggregate demand in the model.
It is frequently assumed in the literature, cf. Taylor (1998b) or Ball (1998) that inflation (or supply) shocks are permanent, in line with Blanchard and Quah (1989). Other models, for example Erceg, Henderson and Levin (1998) or Christiano and Gust (1999), examine monetary rules under the assumption of less than fully persistent supply shocks. In addition, Ricketts and Rose (1995) find empirical evidence in the G-7 countries which indicates that inflation is mean-reverting in low inflation regimes. Here, it is assumed that all shocks, including supply shocks are temporary, which is consistent with the latter strand of theoretical models, and the evidence presented by Ricketts and Rose.
For example, the correlation coefficient is -0.44 for the 1980-1998 period.
See for instance Bayoumi and Eichengreen (1992) and (1996), Bayoumi and Prasad (1995) Fatas (1997), Kongsted and Konnerup (1998), OECD (1999). Although it could be argued that the correlation of shocks is bound to change after entry to the currency union, cf Frankel and Rose (1996), this possibility is not considered in the baseline.
An econometrician who, after observing the behavior of the two model economies, successfully recovers output shocks in the two countries, would however conclude that the shocks are positively correlated with a correlation coefficient slightly below 0.2. The reason is that the model separates the effect of the large country’s shock on the small country’s output from the “true” output shock in the small country by explicitly considering trade links, while the econometrician would not make this distinction.
See equation (5’) in Section B.
Equation (8a) and (8b) in Section B.
See equation (5) in Section B.
Another crucial assumption is no difference in domestic and foreign trend inflation. This assumption is not relaxed. Although it would be formally possible, it would not fit the logic of the argument applied in building and calibrating the model in Section B.
In particular, the shock is assumed to be uniformly distributed over the [-0.5, 4.5] interval.
