1 Modeling the Global Economy: Lessons from the MSG3/G-Cubed Multi Country Models Warwick J. McKibbin Centre for Applied Macroeconomic Analysis ANU & Lowy Institute for International Policy, Sydney & The Brookings Institution. Presentation prepared for MLC, 30 April 2007

2 Overview Intertemporal general equilibrium models as a modeling strategy The G-Cubed and MSG3 models Benchmarking the model to a base year for projections Some lessons –Composition of household wealth matters –Volatility of financial prices when sticky physical capital –Relative prices matter for macroeconomic outcomes –Real exchange rates important for potential output –Policy transmission Fiscal/ versus monetary Permanent versus temporary versus anticipated –Role of international financial capital flows which sticky physical capital in transmission Conclusion

Types of Structural Global Models

4 Intertemporal GE models Domestic –Jorgenson-Wilcoxen US model Multi-Country –The MSG2 Multi-Country Model –(McKibbin & Sachs) –The G-Cubed Multi-Country Model – (McKibbin & Wilcoxen) G-Cubed Environment G-Cubed (Asia Pacific) G-Cubed (Agriculture) G-Cubed (Demographics) The MSG3 Multi-Country Model

5 Dynamic Intertemporal GE Models integrates the key features of the other types of models mix of econometric estimation and calibration of large structural models annual frequency problem with large degree of disaggregation because of complexity of the numerical algorithms needs

6 Features of MSG/G-Cubed models Dynamic Intertemporal General Equilibrium Multi-Country Multi-sectoral Econometric Macroeconomic

7 The MSG2 Multi-country model ( ) McKibbin and Sachs

8 The MSG2 Model Countries United States - Taiwan Japan - Malaysia Germany - Indonesia France - Thailand Canada - India United Kingdom -Philippines Italy - Hong Kong Austria - Singapore Australia - Korea New Zealand China

9 The MSG2 Model Classic Mundell-Fleming Model with extensions 1 production sector in each country macroeconomic focus International capital and trade flows Forward looking expectations by some agents Rigidities in physical capital formation but highly mobile financial capital Unemployment is labour markets due to institutional factors

10 The G-Cubed Model (1991- ) McKibbin & Wilcoxen

11 The G-Cubed Model –Countries (8+ including combinations of the following) United States Japan Australia New Zealand Canada Mexico Europe Rest of OECD Brazil Rest of Latin America China India Eastern Europe and Former Soviet Union Oil Exporting Developing Countries Other non Oil Exporting Developing Countries

12 The G-Cubed Model –Sectors – Electric Utilities – Gas Utilities – Petroleum Refining – Coal Mining – Crude Oil and Gas Extraction – Other Mining – Agriculture, Fishing and Hunting – Forestry and Wood Products – Durable Manufacturing – Non Durable Manufacturing – Transportation – Services Capital Producing sector

13 The G-Cubed (Asia Pacific) Model

14 Countries United States Japan Australia New Zealand CanadaKorea Rest of the OECD Thailand Indonesia China Malaysia Singapore Taiwan Hong Kong Philippines India Oil Exporting Developing Countries Eastern Europe and the former Soviet Union Other Developing Countries

15 G-Cubed (Asia Pacific) –Sectors Energy Mining Agriculture Durable Manufacturing Non-Durable Manufacturing Services Capital producing sector

16 The G-Cubed (Agriculture) Model

17 G-Cubed (Agriculture) –Countries –United States –Japan – Australia – EU12 – Canada – Mexico – ROECD – China & Hong Kong – ASEAN – Taiwan – Korea – ROW

18 –Sectors Food grains (rice and wheat) Feed grains Non-grain crops Livestock and its products Processed food Forest and Fishery Mining Energy Textile and Clothing Other non-durable consumer goods Durable consumer goods Services Capital Producing sector G-Cubed (Agriculture)

19 G-Cubed (Demographics)

20 G-Cubed (Demographics) Countries –Japan –USA –Western Europe –Rest of OECD –Eastern Europe and the Former Soviet Union –China –India –Other Asia –Latin America –Other Developing Countries

21 Sectors Energy Non-Energy

22 Structure of the Models AGENTS MARKETS Households Goods & Services Firms Factors of Production Governments Money Bond Equity Foreign Exchange

: The Structure of the G-Cubed Use Table A) Interindustry transactions. B) Industry sales to final demand sectors. C) Purchases of primary factors by industries. D) Purchases of primary factors by final demand sectors.

Sector Model

25 Key Features Significant dis-aggregation of the demand and supply side of the major economies ; demand and supply equations are based on a combination of intertemporal optimizing behavior and liquidity constrained behavior; Explicit treatment of asset markets including money; Sticky wages based on labour market institutions imply unemployment can persist for many years

26 Key Features Distinction between stickiness of physical capital within sectors and countries and the flexibility of financial capital which immediately flows to where expected returns are highest Extensive econometric estimation of key consumption and production substitution elasticities

27 Financial Markets Financial markets exist for –Money –Government Bonds – Equity – Foreign Assets – Foreign Exchange Each financial asset represents a claim over real resources –Money over purchasing power –Bonds are claims over future tax collections –Equity is a claim over the future dividend streams –Foreign assets are claims over the future exports

28 Generating a Baseline Projection Usually 2 approaches to policy analysis in the new generation of global models (CGE or macro) –Assume at a steady state and analyze deviations from steady state –Assume the observed data in a given year is on the stable manifold of a system dynamically adjusting to a long run steady state

29 Generating a Baseline Projection Given values for all exogenous variables the model is solved for an equilibrium over time in which all equations hold given current and expected future variables. Underlying the projection is a convergence model for sectoral productivity growth and exogenous population projections We adjust the model so that we exactly generates the base year data set (2002). Adjustments are made to constants in behavioral equations –In arbitrage equations this is equivalent to calculating risk premia

31 Generating a Baseline Projection This generates a baseline projection or forecast from 2002 We then step the model forward to 2003 adjusting the information set for 2003 to generate a baseline from 2003 to 2100

32 Running Scenarios Once the baseline is generated we run scenarios by changing exogenous variables or initial conditions The information set for markets is critical –Suppose we expect a shock what does the anticipation do before the actual shock occurs Information sets can be changed by the user unexpectedly over time so we can ask questions like: –Suppose we expected a shock but it doesn’t happen –Suppose we don’t expect a shock and it suddenly occurs

33 Research Projects/ Challenges Model Development Estimation at a more detailed level (with Peter Wilcoxen) to enable more flexible aggregation. Incorporating uncertainty in long term projections (Peter Wilcoxen and various students at Syracuse) Incorporating learning by agents (Kang Yong Tan) Incorporating demographic variables following Blanchard/ Yaari/ Weil (Jeremy Nguyen) Projecting productivity and convergence (Alison Stegman) Emissions projections for climate predictions (Alison Stegman) - testing convergence

34 Research Projects/ Challenges Model Development Modeling developing countries –Modeling transition economies such as Vietnam (Hong Giang-Le) –Tajikstan (Zavkiev Zavkijon) Incorporating Infectious diseases (WHO project) (with Alexandra Sidorenko)

35 Research Projects/ Challenges Improving Macroeconomic Dynamics Need to integrate the global structural models with the more data intensive VAR approach –Using the G-Cubed model to generate restrictions on multi-country VARS following Pagan and others With Dungey, Fry, Pagan

36 Background Papers

37 Trade Liberalization in a Dynamic Setting by Warwick J. McKibbin

38 A New Millenium Round In 2000, it is announced that existing tariffs will be reduced by 1/3 from 2000 to 2010 in most countries Tariffs on goods trade are based on the GTAP4 database (see Table 3a) For services it is assumed there is a cost reduction based on work by Centre for International Economics (see Table 3b)

53 Summary Largest gains to countries liberalizing most short run losses outweighed by long run gains trade impacts /exchange rate adjustments tend to be the opposite in the short run relative to the medium run (role of intertemporal budget constraints)