1. 1 Modeling the Global Economy: The MSG3/G-Cubed Multi Country Models Warwick J. McKibbin Centre for Applied Macroeconomic Analysis (CAMA), CBE, ANU & Lowy Institute for International Policy, Sydney & The Brookings Institution. Lecture Notes for ANU Course on Modeling Open Economy, May 2007

2. 2 Overview Using Models A Short History of Global Modeling Intertemporal general equilibrium models as a modeling strategy The G-Cubed and MSG3 models Issues in estimation versus calibration Benchmarking the model to a base year for projections Simulations and Scenarios An Example of why dynamic models are useful Running the G-Cubed model –Inflation target –Country risk shock (bubble bursting)

3. 3 What Features are Important in a Model? Does the model explain anything we observe today or in the recent past? ; –Model validation is important Estimation of parameters Replication of history over time and key case studies Evaluation of projections or forecasts Is the model continually reviewed by experts who actually use it?; Is the model published in the refereed academic literature?; Is there a full listing of all equations available on request?; Is the model generally open to evaluation by others?;

4. Types of Structural Global Models

5. 5 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 Oz –Cubed (Australia detail) I- Cubed (India detail)

6. 6 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

7. 7 Features of MSG/G-Cubed models Dynamic Intertemporal General Equilibrium Multi-Country Multi-sectoral Econometric Macroeconomic

8. 8 Overall model development strategy Funding is both through research grants and private consulting Hub and spoke approach to coordinating a global research project (different strategy to Project Link) –The model is managed/developed in the core research team in Australia and Syracuse –Users (researchers/ governments/ financial investors) in different countries feed back to the core group both their own developments of the model as well as funding the core for new developments. All of which which we are able to incorporate into the model over time

9. 9 The MSG2 Multi-country model (1984-1994) McKibbin and Sachs

10. 10 Development and Subscription Funding –McKibbin Software Group Inc – US Congressional Budget Office – The Brookings Institution – US Department of Commerce –US Government – United Nations – World Bank – Australian Treasury – Centre for International Economics – Nomura Research Institute – Daewoo Research Institute (Korea) – Warwick Modeling Bureau – Many Academic Colleagues

11. 11 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

12. 12 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

13. 13 The G-Cubed Model (1991- ) McKibbin & Wilcoxen

14. 14 Development and Subscription Funding –Major Funding The Brookings Institution United States Environmental Protection Agency United States National Science Foundation McKibbin Software Group Inc – Minor Funding through consultancies United Nations World Bank Australian Dept of Environment/AGO New Zealand Department of Commerce Canadian Dept of Finance

15. 15 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

16. 16 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

17. 17 The G-Cubed (Asia Pacific) Model

18. 18 Countries United States Japan Australia New Zealand CanadaKorea United KingdomRest 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

19. 19 G-Cubed (Asia Pacific) –Sectors Energy Mining Agriculture Durable Manufacturing Non-Durable Manufacturing Services Capital producing sector

20. 20 The G-Cubed (Agriculture) Model

21. 21 G-Cubed (Agriculture) –Countries –United States –Japan – Australia – EU12 – Canada – Mexico – ROECD – China & Hong Kong – ASEAN – Taiwan – Korea – ROW

22. 22 –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)

23. 23 Oz-Cubed –Countries –Australia –Rest of World –Sectors 57 sectors

24. 24 I-Cubed Model –Countries –India –USA –Rest of World –Sectors 21 sectors

25. 25 MSG3 Model Many countries 2 sectors –Energy –Non-energy

26. 26 Structure of the Models AGENTS MARKETS Households Goods & Services Firms Factors of Production Governments Money Bond Equity Foreign Exchange

27. : 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.

28. Sector Model

29. 29 Data Used in Estimation Value data from US benchmark input-output tables –1958, 1963, 1967, 1972, 1977, 1982 Prices from US Bureau of Labor Statistics Standardized industry classifications –Redefinition and reclassification Eliminated secondary products –Redefinition and reclassification Aggregated to 12 sectors Corrected treatment of consumer durables –Investment rather than consumption Reallocated construction to final investment

30. 30 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

31. 31 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

32. 32 Households –2 types A) maximize an intertemporal utility function consisting of all goods and services produced domestically and overseas, subject to an intertemporal budget constraint that the present value of consumption is bounded by the present value of after tax income from all sources B)Base aggregate consumption expenditure on an optimal rule of thumb with current consumption of each good allocated so as to maximize contemporaneous utility

33. 33 Firms –2 types A) Maximise their share market value (the present value of the future stream of dividends) subject to production technology, a cost of adjustment model of capital and taking prices as given. They base their calculation on a summary of the future measured by Tobin’s Q. B) Base investment on a backward looking Tobin’s Q that eventually converges to the long run Tobin’s Q

34. Investment Model Firms invest to maximize share market value Capital specific to each sector Household capital modeled as well Adjustment costs: Some firms have adaptive expectations about q

35. Effect of Adjustment Costs Sharp swings in investment are expensive.

36. 36 Financial vs. Physical Capital Physical capital immobile –Difficult to move once installed Financial capital is perfectly mobile –Ownership of physical assets or debt instruments –Can be traded at will Together, these imply that shocks have: –Large short-run effects on asset prices –Little short-run effect on stocks Physical capital stocks adjust slowly to new conditions

37. Effect of Shocks on Financial Assets Effect of an adverse shock to demand for an asset Initial large drop in price of assets (red arrow) Over time, K falls and P slowly recovers (blue arrow) P1P1 P2P2 S long run S short run D1D1 D2D2 Asset Price K K1K1 K2K2 K3K3

38. 38 Governments Governments provide public goods that enter into the utility functions on households (additively separable) and transfer payments; They collect a wide variety of taxes on income of firms households, imports, sales. Governments are subject to the intertemporal budget constraint that the present value of spending and transfers is bounded by the present value of future tax collections.

39. 39 Countries Countries are collections of individual firms, households and governments that trade goods and services as well as financial assets; Labor is immobile between countries but mobile within countries; Financial capital is mobile within and between countries; Physical capital is sector and country specific at any point in time and subject to adjustment costs over time.

40. 40 Role of Money Money is required for transactions between all agents. There is a technology that combines money with produced goods and services and the combined product is what is available in the market. The supply of money is determined by a central bank in each economy in conjunction with assumptions about the monetary regime which is represented by a Henderson- McKibbin- Taylor type rule of the form

41. Henderson-McKibbin-Taylor Rule

42. 42 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

43. 43 Goods and Services Markets Households, Firms and Governments trade goods and services and price for each is assumed to clear the markets at an annual frequency

44. 44 Factor Markets –Labor Markets Nominal wages are set by different institutional structures in each country; Given the nominal wage and the market prices for goods and services firms higher labor until the real wage in each sector equals the marginal product of labor; Aggregate unemployment can result although over time it is assumed that unemployment tends to force the nominal wage towards the labor market clearing level.

45. 45 –Capital once installed physical capital is costly to move; Capital produces a flow of services for firms that have installed a capital stock through investment decisions in the past; Investment is subject to rising marginal costs of installation and depreciation over time. Factor Markets

46. 46 –Energy and Materials in GCUBED Firms purchase the output of other sectors as inputs in production; Total demand for the materials and energy sectors is final demand plus demand for intermediate inputs in each sector; Factor Markets

47. 47 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

48. 48 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

50. 50 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

51. 51 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

52. 52 Use of Scenarios The most effective way to undertake scenario analysis is with an internally consistent and empirically relevant framework The models form the analytical and empirical basis for designing alternative scenarios

53. 53 Use of Scenarios Ask the question –What are the likely consequences of the Iraq War? Design the scenarios that give different insights to the question –Examine history (Gulf War I, Afghanistan, Vietnam, Korea) Wars always cost more than expected Costs are more than the fiscal outlays –Shocks to Government spending for the war (US, Aust, UK) Government spending for the peace (Europe/Japan) Increased global risk Impose the shocks in a consistent framework (a model) Interpret the results Assess the key sensitivities that drive the results Do people expect it to be temporary or more permanent?

54. 54 Scenario Examples The Aftermath of the Sept 11 Terrorist Attacks What if Japan Adopted a Sensible Macroeconomic Policy? The Consequences of WorldCom and Enron Collapses The War with Iraq: the compounding Effects of Oil Prices, Budgetary Costs and Uncertainty The SARS Outbreak: How Bad can It Get? Exploding Fiscal Deficits in the United States: Implication for the World Economy What if China Revalues Its Currency China: The Implications of Policy Tightening Oil Price Scenarios and the Global Economy The United States Current Account Deficit and World Markets

55. 55 Current Research Programs Global Demographic Change (Japanese Govt, IMF, G20) Economics of Infectious Diseases (WHO, NHMRC) Global trade policy (WTO) Macroeconomic imbalances Climate Change Policy Impact of China and India on the Global Economy

56. 56 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

57. 57 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)

58. 58 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

59. 59 An Example of the Importance of Dynamics

60. 60 Trade Liberalization in a Dynamic Setting by Warwick J. McKibbin

61. 61 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 For services it is assumed there is a cost reduction based on work by Centre for International Economics

76. 76 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)

77. 77 Background Papers www.gcubed.com www.economicscenarios.com

78. 78 Using the G-Cubed Model