Evaluating International Economic Policy with the Federal ...Note. We thank Shaghil Ahmed, David...

Evaluating International Economic Policywith the Federal Reserve’s Global Model

Andrew Levin, John Rogers, and Ralph Tryon, ofthe Board’s Division of International Finance,prepared this article. Asim Husain provided researchassistance.

FRB/Global is a large-scale macroeconomic modeldeveloped and maintained by the staff of the Boardof Governors of the Federal Reserve System. Themodel contains the equations of the FRB/US model(discussed in the April 1997 issue of theFederalReserve Bulletin) to represent the macroeconomicstructure of the U.S. economy. In addition, FRB/Global contains eleven other blocks of equations torepresent each of the foreign Group of Seven (G-7)industrial economies (Canada, France, Germany,Italy, Japan, and the United Kingdom), Mexico, andfour other groups of industrial and developingeconomies.

Simulation experiments conducted with FRB/Global assist the Board in analyzing sudden changesin external macroeconomic variables and alternativepolicy responses in foreign economies. For example,experiments with FRB/Global provide useful infor-mation about the effects of exchange rate movementsor oil price changes on U.S. unemployment and infla-tion. The alternative scenarios studied with FRB/Global also provide a valuable input to forecasts offoreign activity and the U.S. external sector.

Over the past several years, two important featureshave been added to the structure of FRB/Global.First, the equations have been reformulated to ensurelong-run stability: In response to a macroeconomicdisturbance, each economy represented in FRB/Global gradually converges to a balanced growth (orequilibrium) path, that is, a path in which actualoutput is equal to potential gross domestic productand in which every inflation-adjusted variable hasa constant ratio to potential GDP. The inflation rate

adjusts to a target level determined by monetarypolicy, and all relative prices reach constant values.

Fiscal solvency (a condition in which the stock ofgovernment debt grows no faster than nominal GDP)is maintained by assuming the gradual adjustment ofa country’s tax rate. Similarly, national solvency (acondition in which the stock of net external debtgrows no faster than nominal GDP), is ensured by theassumption that the risk premium on a country’sexternal liabilities rises when net external debt ishigh relative to nominal GDP.

The second feature added to FRB/Global is theexplicit treatment of expectations. In the model,agents’ expected values of future variables directlyinfluence interest rates, consumption and investmentexpenditures, the aggregate wage rate, and theexchange rate. Thus, the way in which agents formexpectations can have important implications for thesimulation results. In FRB/Global, simulations can beperformed under either of two assumptions about thenature of expectations: (1) limited-information expec-tations, under which agents have incomplete informa-tion about the structure of the global economy or(2) model-consistent expectations, under whichagents possess all the information contained in themodel.

This article provides a historical perspective on thedevelopment of FRB/Global and an overview of themodel’s blocks of equations for foreign countries.We use three simulation experiments to highlight thedynamic properties of FRB/Global: a reduction inU.S. government purchases, a depreciation of the U.S.dollar, and an increase in the price of oil exported bycountries in OPEC (the Organization of PetroleumExporting Countries). The article also illustrates otheruses of FRB/Global by examining the spillovereffects of fiscal and monetary policy under alternativeEuropean monetary policy regimes.

A HISTORICALPERSPECTIVE ONFRB/GLOBAL

In the mid-1970s, a variety of factors—increasedeconomic interaction among countries, the first(1973) shock to oil prices, and the floating of

Note. We thank Shaghil Ahmed, David Bowman, Flint Brayton,Christopher Erceg, Dale Henderson, Jaime Marquez, DavidReifschneider, Robert Tetlow, and Volker Wieland for valuable com-ments and suggestions during the development of FRB/Global and thepreparation of this article.

exchange rates—combined to raise interest in globalmacroeconomic modeling. Against this background,the Board’s staff began the development of a large-scale macroeconometric model called the Multicoun-try Model (MCM) to provide an empirical frameworkfor analyzing interactions among the major industrialcountries. One of the first models of its kind, theMCM consisted of about 1,000 equations dividedinto six blocks: one representing the U.S. economy(with a more detailed external sector than in previousmodels); four others representing Canada, Germany,Japan, and the United Kingdom; and an aggregateblock representing the rest of the world.1 From 1979onward, the Board staff regularly used the MCM tosimulate the effects of alternative policy scenariosand external shocks.

In the early 1980s the staff significantly modifiedthe MCM with regard to exchange rate determinationand the capital account of the balance of payments.2

Empirical considerations also led to the eliminationof detailed representations of banking sectors fromthe equation blocks of individual countries. In subse-quent versions of the MCM, the monetary authoritieswere assumed to control either the money stock orthe short-term interest rate. Finally, in the wake ofthe second (1979) OPEC oil price shock, the MCMwas extended to provide explicit treatment of the oilsector.

In the mid-1980s, many of the equations in theMCM were re-estimated using methods suggestedby David Hendry and other econometricians at theLondon School of Economics.3 The re-estimationimproved the fit and the dynamic properties of theequations and represented a first step toward ensuringthe long-run stability of the model. In the late 1980s,the equations in the Board staff’s model of the U.S.

economy (the MPS model) were linked with theforeign equation blocks of the MCM. FRB/Globalhas continued this approach of linking foreign equa-tion blocks with the staff’s domestic U.S. model.

Another major restructuring and re-estimation ofthe MCM came in 1991–92. The model continued touse individual country blocks for the United States,Canada, Germany, Japan, and the United Kingdom,while the rest-of-world block was disaggregated intoseven blocks of equations representing France, Italy,Mexico, the smaller industrial countries, the newlyindustrializing economies, OPEC countries, and otherdeveloping countries and economies in transition. Amultilateral trade structure replaced the bilateral one,thereby greatly simplifying the data requirements andthe analysis of simulation results for each countryand region. The resulting arrangement—twelve coun-tries and regions, each with an equation block con-taining multilateral trade equations—is used in thecurrent version of FRB/Global.

The staff’s most recent reassessment of the MCMbegan in 1993 and culminated in FRB/Global in1996.4 Explicit treatment of expectations enabledthe model to capture the notion that news aboutfuture economic developments can directly affectthe current economy; for example, the adoptionof a multiyear deficit reduction package can generatean immediate drop in long-term interest rates. Toensure the long-run stability of the model, error-correction mechanisms were incorporated into thebehavioral equations, and constraints that preservefiscal and national solvency were imposed.5 Thelong-run stability of FRB/Global permits simulationsunder either model-consistent or limited-informationexpectations.6

1. Guy Stevens led the effort to develop the MCM; see Guy V.G.Stevens, Richard B. Berner, Peter B. Clark, Ernesto Herna´ndez-Cata´,Howard J. Howe, and Sung Y. Kwack,The U.S. Economy in anInterdependent World: A Multicountry Model(Board of Governors ofthe Federal Reserve System, 1984).

2. In particular, equations based on the portfolio balance approachto the determination of exchange rates were replaced by modifieduncovered interest parity relationships, a specification based on inter-est rate differentials. The change was prompted by a lack of empiricalsupport for the portfolio balance model and by the attractive proper-ties of the overshooting model of Dornbusch, which incorporatedassumptions of open interest parity, nominal price rigidities, andmodel-consistent expectations (Rudiger Dornbusch, ‘‘Expectationsand Exchange Rate Dynamics,’’Journal of Political Economy,vol. 84, December 1976, pp. 1161–76).

3. The results of these and other changes to the MCM are describedin Hali Edison, Jaime Marquez, and Ralph Tryon, ‘‘The Structure andProperties of the Federal Reserve Board Multicountry Model,’’Eco-nomic Modelling,vol. 4 (April 1987), pp. 115–315.

4. This work drew heavily on the experimental multicountry modelof Joseph E. Gagnon, ‘‘A Forward-Looking Multi-Country Model:MX-3,’’ International Finance Discussion Papers 359 (Board of Gov-ernors of the Federal Reserve System, 1989).

5. The constraints of fiscal and national solvency in FRB/Globalare similar to those used in the IMF’s multicountry model, MULTI-MOD; see P. Masson, S. Symansky, R. Haas, and M. Dooley, ‘‘MUL-TIMOD: A Multi-Region Econometric Model,’’ International Mone-tary Fund,World Economic Outlook,July 1988, pp. 50–104.

6. To represent limited-information expectations, FRB/US uses acore vector autoregression with auxiliary equations (see F. Braytonand P. Tinsley, eds., ‘‘A Guide to FRB/US: A Macroeconomic Modelof the United States,’’ Finance and Economics Discussion Series1996-42 (Board of Governors of the Federal Reserve System, 1996);see also Flint Brayton, Eileen Mauskopf, David Reifschneider,Peter Tinsley, and John Williams, ‘‘The Role of Expectations in theFRB/US Macroeconomic Model,’’Federal Reserve Bulletin,vol. 83(April 1997), pp. 227–45. Individual regression equations are used togenerate each of the expectation variables in the foreign blocks ofFRB/Global.

798 Federal Reserve Bulletin October 1997

THE STRUCTURE OFFRB/GLOBAL

FRB/Global consists of twelve blocks of equations,with each block describing the economy of a countryor a group of countries. The U.S. block of FRB/Global is taken directly from the staff’s model of thedomestic economy, FRB/US, which consists of about50 behavioral equations and about 250 accountingidentities. Among the FRB/US behavioral equationsare 4 that determine foreign aggregate demand, theinflation-adjusted (real) effective exchange rate, theoil import price deflator, and net investment incomefrom abroad. FRB/Global replaces these 4 equationswith about 1,400 equations that provide a much moredetailed representation of macroeconomic develop-ments outside the United States.

Six blocks of FRB/Global represent the foreignG-7 industrial countries (Canada, France, Germany,Italy, Japan, and the United Kingdom). The equationblocks for the foreign G-7 countries representmedium-sized open economies in which, in theshort run, aggregate demand determines output andemployment, and wages and prices respond slowly tomacroeconomic shocks (a formulation in accord withneo-Keynesian theory). Eventually, however, wagesand prices adjust to ensure that the economies returnto a balanced growth path, with output at potentialand unemployment at the natural rate (a result con-forming to neoclassical theory). Gradual movementof the direct tax rate ensures long-run fiscal solvency,while the determination of the risk premium onexternal liabilities ensures national solvency.7

To incorporate these features, the equation blockfor each foreign G-7 country consists of about60 behavioral equations and about 100 accountingidentities. The specification of these equations isnearly identical for each country. The behavioraldifferences among the six economies have beenderived from estimation and from calibration of themodel; the differences in monetary and fiscal policiesamong the six depend on the assumptions of a par-ticular simulation scenario.

The remaining five blocks of equations in FRB/Global represent Mexico; 16 smaller OECD coun-tries (SOECD); the newly industrializing economiesof Hong Kong, Korea, Singapore, and Taiwan

(NIEs); the 16 countries with fuel-oriented exports(OPEC); and the rest of the world (ROW), whichcomprises about 140 developing economies andcountries in transition.

The structure of the equation blocks for Mexico,the NIEs, and the SOECD is fairly similar to that ofthe foreign G-7 country blocks but with somewhatless disaggregation: Each of these blocks consists ofabout 45 behavioral equations and about 75 account-ing identities. The OPEC and ROW blocks are muchsmaller, with about 15 behavioral equations and25 accounting identities each.

Each block of equations in FRB/Global may bedivided into five sectors: domestic spending, fiscalaccounts, the external sector, aggregate supply (pro-duction, employment, wage and price determination),and financial markets (interest rates and exchangerates). The remainder of this section outlines thespecification of these sectors for the foreign G-7countries, highlights the role of expectations, andoutlines the features that ensure the long-run stabilityof the model. For more details about the foreignblocks of FRB/Global, see appendixes A and B.

Domestic Spending

In the foreign G-7 equations of FRB/Global, sixexpenditure variables constitute domestic spending:private consumption expenditures, business fixedinvestment, residential investment, changes in busi-ness inventories, government fixed investment, andother government spending on goods and services(referred to as government consumption). Real pri-vate expenditures for consumption and for invest-ment are determined endogenously (that is, by themodel) through assumptions and empirical findingsembodied in behavioral equations. Real governmentconsumption and investment, on the other hand, areindependent variables—they are determined exog-enously (that is, outside the model).

The behavioral equation for each component ofprivate expenditure incorporates an error-correctionmechanism that permits realistic short-run dynamicswhile ensuring that the level of expenditure graduallyadjusts to a long-run equilibrium growth path—thatis, a stable ratio of expenditures to real GDP. Theequilibrium path of each expenditure variable can beshifted by a permanent change in real interest ratesor other specific macroeconomic variables. For exam-ple, the equilibrium path of real private consumptiondepends on real disposable income and the laborforce participation rate as well as the long-term realinterest rate (see box ‘‘Determining Private Con-

7. The risk premium on external liabilities (also known as thesovereign risk premium) refers to the extra rate of return demanded bycreditors to compensate them for holding government bonds that havesome degree of credit risk. Credit risk is the risk that the government,or sovereign, will not fully redeem the bonds at maturity. In themodel, the risk premium on the net foreign holdings of a country’sgovernment bonds rises when those holdings are rising relative to thatcountry’s GDP.

Evaluating International Economic Policy with the Federal Reserve’s Global Model799

sumption Expenditures’’). The equilibrium paths ofreal business fixed investment and residential invest-ment are each determined by real GDP, the long-termreal interest rate, and the corresponding depreciationrate. Finally, the equilibrium path of real inventoryinvestment depends on domestic sales and the short-term real interest rate (see box ‘‘Determining Busi-ness Inventory Investment’’).

The determination of business fixed investmentprovides a useful example of the long-run stabilityand flexible dynamics associated with an error-correction mechanism. In each period, the businesscapital stock changes by the amount of business fixedinvestment less depreciation. Assuming competitivemarkets for inputs (land, labor, and capital) and out-put, microeconomic theory holds that the marginalproduct of capital should equal the real rental rate oncapital, which is the sum of the real interest rate andthe depreciation rate. In FRB/Global, the marginalproduct of capital is inversely proportional to theratio of capital to GDP (the Cobb–Douglas produc-

tion function). Therefore, in the model’s long run,business fixed investment is determined in a mannerthat will maintain the capital–output ratio at a levelconsistent with the long-term real interest rate and thedepreciation rate.

In the short run, however, fluctuations in thegrowth of real GDP strongly influence business fixedinvestment through an accelerator effect. Businessfixed investment also incorporates a partial adjust-ment mechanism: For each of the foreign G-7 econo-mies, the gap between current fixed investment andits equilibrium level shrinks at an estimated rate ofabout 25 percent per quarter.

For an illustration of these properties in the deter-mination of business fixed investment, consider apermanent 1 percent increase in real GDP (bothactual and potential) for Germany, with no change inthe real rental rate on capital (chart 1, top panel). Thedynamic accelerator generates a 3.5 percent increasein business fixed investment during the first year andan additional 0.75 percent increase over the subse-

Determining Private Consumption Expenditures

The equilibrium level of real private consumption expendi-tures,C, depends on real disposable income,Y; the ex antelong-term real interest rate,RL; and the labor force participa-tion rate,L/POP.1 An accounting identity relates nominaldisposable income to nominal GDP, net investment incomefrom abroad, and taxes less government subsidies and trans-fers to households; thenY is computed by deflating nominaldisposable income by the consumption price index. Thedetermination ofRL is described below. The labor forceparticipation rate is exogenously determined.

For each foreign G-7 country, statistical analysis has beenused to verify that the ratio of private consumption todisposable income,C/Y, has a stationary long-run relation-ship with RL and L/POP, and to estimate the short-runand long-run characteristics of this relationship.2 The table

1. In the foreign G-7 equation blocks of FRB/Global, private consumptionexpenditures depend on current and past income so that consumption issensitive to movements in temporary as well as permanent income. InFRB/US, consumption expenditures also depend on financial wealth and thepresent discounted value of expected future labor and transfer income so thatconsumption is less sensitive to fluctuations in temporary income; in futurework, we plan to investigate specifications in the foreign-country equationsof FRB/Global that are comparable to those in FRB/US.

2. The labor force participation rate is highly significant in explaininglong-term changes in private saving rates in Germany, Japan, and the UnitedKingdom, perhaps because the private saving rate tends to decline as a higherfraction of the population reaches retirement age. The labor force participa-tion rate is not, however, statistically significant in explaining the privatesaving rate in Canada. For Italy, the relationship between the private savingrate and the rates of long-term interest and labor force participation appearsto be nearly nonstationary; for France, no satisfactory estimates of therelationship could be obtained, so the relationship in Germany was used forFrance as well.

below summarizes the response of private consumption tochanges in disposable income and the long-term real inter-est rate. In Germany, for example, a permanent 1 percentagepoint increase inRL is estimated to reduce private consump-tion 0.23 percent within one quarter and 0.76 percent in thelong run.

In the short run,C exhibits partial adjustment in responseto permanent changes inY and RL because of liquidityconstraints, information lags, and other factors. In Ger-many, for example, a permanent 1 percent change inYgenerates an immediate 0.73 percent change inC, so thatthe consumption–income ratio temporarily falls. The gapbetween the actual consumption–income ratio and its equi-librium value subsequently shrinks at a rate of 30 percentper quarter (not shown in table).

Determinants of private consumption expenditures

Canada France Germany Italy Japan U.K.

YShort run . . . .58 .73 .73 .10 .62 .29Long run . . . 1.0 1.0 1.0 1.0 1.0 1.0

RLShort run . . . −.13 −.23 −.23 −.05 −.23 −.19Long run . . . −.37 −.76 −.76 −2.4 −1.5 −.65

Note. The first two rows indicate the elasticity of private consumptionexpenditures,C, with respect to a permanent change in real disposableincome,Y. The last two rows indicate the percentage change inC arisingfrom a permanent 1 percentage point increase in the ex ante long-term realinterest rate,RL. The ‘‘short run’’ is the first quarter; the ‘‘long run’’ is thesteady-state.


quent two years. These changes in investment repre-sent a small fraction of the existing stock of businessfixed capital, so that the capital stock rises graduallyin response to the output shock. With a constant realrental rate, the equilibrium value of the capital–output ratio remains unchanged, so that the capitalstock eventually stabilizes at 1 percent above itsinitial level. Given the constant depreciation rate,fixed investment also rises 1 percent in the long run.

A permanent 1 percentage point increase in the realrental rate on capital in Germany, with no change inactual or potential output, also illustrates the model’sadjustment properties (chart 1, bottom panel). Thedrop in the equilibrium capital–output ratio leads toa 1.8 percent reduction in business fixed investmentover the first several years. The stock of businessfixed capital gradually falls about 0.4 percent, to itsnew equilibrium level, with a similar long-run dropin the level of business fixed investment.

Fiscal Accounts

The model’s representation of the fiscal accounts ofthe foreign G-7 countries is relatively straightfor-ward: Government expenditures consist of consump-tion, investment, subsidies, transfers to households,and interest payments; government revenues come

from direct taxes, social security payroll taxes, fueltaxes, and other indirect taxes. The most importantfeature of this sector is that the direct tax rate isdetermined endogenously to prevent a shock fromcausing a continuous rise or fall in the ratio of realgovernment debt (nominal debt deflated by the GDPprice deflator) to potential GDP. That is, each coun-try’s block of equations has a specified target path forthe debt–GDP ratio; if a shock causes the ratio todeviate from that path, the direct tax rate is adjustedto ensure that the ratio gradually returns to its target.

For an illustration of this mechanism, consider theeffects of a permanent reduction in governmentconsumption expenditures under two different fiscalpolicy assumptions. Under the first assumption, thetarget ratio of government debt to GDP is unchanged.In this case, the direct tax rate will gradually movedownward so that the drop in government spending ismatched by a similar drop in direct tax revenue andby a corresponding increase in disposable income. Asalready noted, the equilibrium level of private con-sumption expenditures moves in proportion to realdisposable income. Thus, in the long run, the drop in

Determining Business Inventory Investment

In the equations for each foreign G-7 country, real inven-tory investment depends on domestic sales, the stock ofbusiness inventory, and the ex ante short-term real inter-est rate. Domestic sales include all private and govern-ment consumption and fixed investment expenditures.The equilibrium ratio of the inventory stock to domesticsales depends on the cost of holding inventories, which ismainly determined by the ex ante short-term real interestrate. Thus, with domestic sales held unchanged along aconstant growth path, an increase in the short-term realinterest rate reduces the target stock of business inven-tories and thereby depresses the equilibrium level ofinventory investment.

In the very short run, an increase in the level ofdomestic sales generates negative inventory investmentas firms use inventories as a buffer against suddenchanges in sales. The target inventory–sales ratio remainsunchanged, assuming a constant short-term real interestrate. Thus, over the medium term, the increase in domes-tic sales stimulates higher inventory investment until thestock of business inventories eventually rises in propor-tion to the increase in domestic sales.

1. Illustration of error correction in FRB/Global:Business fixed investment in Germany

2 4 6 8 10 12 14Years

1.5

1.0

0.5

0–

+

0.5

1.0

2.0

3.0

4.0

5.0

Percent

Response to 1 percent rise in real GDP

Business fixed investment

Real GDP

Capital stock

Response to 1 percentage point rise in real interest rate


government consumption is offset by a roughly equalincrease in private consumption.

Under the second assumption, the debt–GDP targetratio gradually adjusts downward toward a newvalue, so that the direct tax rate remains constant overthe first twenty-five years of the experiment. Duringthis period, lower real interest rates stimulate privateexpenditures to keep real output at potential andavoid deflationary pressures, and potential GDP itselfgradually rises in response to the higher level ofprivate investment. Eventually, however, the down-ward trajectory of the debt–GDP ratio must be haltedby reducing the direct tax rate, so that the long-runeffects are the same as those described for the previ-ous experiment.

The External Sector

For each foreign G-7 country, exports and importsare divided into three components: fuel, nonfuel mer-chandise, and services.

The volume of net fuel imports equals the differ-ence between domestic fuel production and domesticfuel consumption, in which fuel production is deter-mined exogenously, and fuel consumption dependson domestic nonfuel output and the relative price offuel.

The imports of services and nonfuel merchandiseare determined as follows. Under the assumption ofworldwide balanced growth in the long run, the equi-librium ratio of real nonfuel merchandise importsto real domestic spending is set by the ratio of theimport price deflator for nonfuel goods to the pricedeflator for nonfuel domestic output. In the short run,real nonfuel merchandise imports adjust at a rate of30 percent per quarter toward the equilibrium level.The determination of imports of services involves therelative price of such imports and follows essentiallythe same error-correction mechanism as nonfuelmerchandise.

Exports of services and nonfuel merchandise aredetermined by error-correction mechanisms (see box‘‘Determining Export Volumes’’).

Aggregate Supply

For each foreign G-7 country, wage and pricedetermination causes the rates of inflation and unem-ployment to move inversely in the short run (adownward-sloping Phillips curve); in the long run,unemployment settles on its ‘‘natural’’ rate, the pointat which the inflation rate is constant (a vertical

Phillips curve). For example, a monetary stimulusinitially generates a drop in the unemployment rateand a relatively small increase in wage and priceinflation; as wages and prices rise further, unemploy-ment gradually returns to its natural rate.

In particular, real GDP is determined by aggregatedemand, which is the sum of domestic spending andnet exports. The employment level (and hence theunemployment rate) adjusts to equate aggregatesupply to aggregate demand. Potential GDP is deter-mined by the size of the labor force, the naturalunemployment rate, the stocks of business fixed capi-tal and residential capital, and net fuel imports. Whenoutput exceeds potential (unemployment is below thenatural rate), wages initially move little but graduallyrise in response to pressures generated by excessaggregate demand. An error-correction mechanism

Determining Export Volumes

For each foreign G-7 country, the volume of nonfuelmerchandise exports,Xg, is determined by foreign trade-weighted imports,M*, and relative prices,RPxg. We usethe equation block for Germany to illustrate the construc-tion of the variables for foreign demand and relativeprices.

Foreign demand for German exports is the weightedaverage of nonfuel goods imports by Germany’s tradingpartners, in which the weights are constructed using thebilateral export data for Germany. The relative-price vari-able measures German competitiveness in each of itsexport markets. For example, the share of Germanexports in total French imports depends on the relativeprice of German exports compared with other exportersto France. Thus, in constructing the relative-price mea-sure for Germany,RPxg, the French component is definedas the ratio of the German nonfuel goods export pricedeflator to the weighted average of foreign export prices,in which the weights are constructed using bilateralimport data for France. Finally, the overall measure ofGerman competitiveness,RPxg, is computed as a weightedaverage across German export markets, using bilateralexport weights for Germany.

Using these measures of foreign demand and relativeprices, an error-correction mechanism determines the vol-ume of nonfuel merchandise exports. With constant rela-tive prices, the ratio ofXg to M* remains on its baselinepath; that is, each country exports a fixed share of worldimports. If relative prices change, the ratio ofXg to M*gradually adjusts toward its new equilibrium value ata rate of 15 percent per quarter. Real exports of servicesare determined by a similar error-correction mechanisminvolving foreign trade-weighted service imports and therelative price of service exports.


ensures that the price deflator for domestic outputgradually moves toward its equilibrium path, whichis a markup over the aggregate wage rate and thedomestic fuel price index.

The specific formulation of aggregate wage behav-ior depends on how expectations are formed. Underlimited-information expectations, the aggregate wageinflation rate is a function of past wage inflation rates,current and past output gaps, consumer price inflationrates, and short-term interest rates.8 Under model-consistent expectations, the aggregate wage rate isdetermined by the overlapping nominal wage con-tract specification of Taylor. In this case, the newwage contracts signed each period depend on expec-tations about future aggregate wages and deviationsof unemployment from its natural rate; the aggregatewage rate is defined as the average value of the wagecontracts currently in effect.9

Financial Markets

The financial-market equations for the foreign coun-tries cover short- and long-term interest rates,expected inflation, and exchange rates. For countrieswhose currencies are assumed to be pegged to theGerman mark, interest rates and expected inflationmove in parallel with the corresponding variables inGermany, apart from an endogenously determinedrisk premium on each country’s external liabilities.The premium is related to the ratio of net externaldebt to GDP and helps avoid continuously rising orfalling levels of net external debt.

For the countries with independent monetary poli-cies, the monetary policy regime and the method ofexpectations formation are crucial in the determina-tion of long-term interest rates, expected inflation,and the bilateral U.S. dollar exchange rate.

Short-Term Interest Rates

In a typical FRB/Global simulation, Canada, Ger-many, Japan, and the United Kingdom follow inde-pendent monetary policies using a rule of the formproposed by Henderson and McKibbin and by

Taylor.10 Under this form of rule, the short-terminterest rate is adjusted in response to the currentoutput gap and to the current deviation of consumerprice inflation from an exogenously specified target.France and Italy are usually assumed to maintainfixed exchange rates with respect to the Germanmark. Although these are typical monetary policyassumptions, FRB/Global has been designed so thatthey can be modified easily from one simulation tothe next, a feature that will be highlighted later in thisarticle.

Long-Term Interest Rates

Under limited-information expectations, the long-term nominal interest rate is specified as a function ofcurrent and past short-term interest rates, inflationrates, and output gaps. The long-term interest ratealso exhibits partial adjustment, so that the spreadbetween short-term and long-term rates initiallywidens and then gradually shrinks in response to ashock to the short-term interest rate. Under model-consistent expectations, the long-term interest rate isdetermined as a geometrically declining weightedaverage of future short-term interest rates.

Expected Inflation

Under limited-information expectations, short-termexpected inflation is equal to the current inflationrate; long-term expected inflation is a moving aver-age of current and past short-term inflation rates, witha relatively slow adjustment of 5 percent per quarterin response to a persistent change in the inflation rate.Under model-consistent expectations, short-termexpected inflation is equal to the actual one-step-ahead inflation rate, while long-term expected infla-tion is determined as a weighted average of futureshort-term inflation rates (using the same geometri-cally declining weights as in the long-term interestrate equation).

Exchange Rates

For those countries with independent monetary poli-cies, the bilateral exchange rate under both limited-

8. Regression analysis has been used to estimate the parameters ofthis relationship for each foreign G-7 country.

9. John Taylor, ‘‘Aggregate Dynamics and Staggered Contracts,’’Journal of Political Economy,vol. 88 (February 1980), pp. 1–23. Thisspecification of wage determination under model-consistent expecta-tions is highly simplified; alternative specifications of wage determina-tion for the foreign G-7 countries will be considered in subsequentresearch.

10. In Carnegie–Rochester Conference Series on Public Policy,vol. 39 (June 1993), see Dale Henderson and W. McKibbin, ‘‘AComparison of Some Basic Monetary Policy Regimes for OpenEconomies: Implications of Different Degrees of Instrument Adjust-ment and Wage Persistence,’’ pp. 221–318; and John Taylor, ‘‘Discre-tion versus Policy Rules in Practice,’’ pp. 195–214.


information and model-consistent expectations isdetermined by real interest parity (the bilateral differ-ential in real interest rates) and the risk premium onexternal liabilities, which depends on the ratio of netexternal debt to GDP, both measured in U.S. dollars(see box ‘‘Determining Exchange Rates under Alter-native Types of Expectations’’). Thus, an increase inthe relative magnitude of U.S. net external debt putsdownward pressure on the real value of the dollar,thereby preventing explosive paths for the net stockof external debt.

Under either method of expectations formation, anunanticipated temporary increase in U.S. interest ratesgenerates an initial rise in the exchange value of theU.S. dollar, followed by depreciation back toward itsequilibrium value, a point referred to as purchasing

power parity. For example, under limited-informationexpectations, the bilateral exchange rate depends onthe corresponding differential in long-term interestrates as adjusted for long-term expected inflation. Inthis case, a 1 percentage point increase in the differ-ential between U.S. and German long-term real inter-est rates generates a 0.08 percent real appreciation ofthe dollar against the German mark.

Under model-consistent expectations, the exchangerate is determined by short-term real interest parity. Ifthe U.S. three-month real interest rate temporarilyexceeds the German three-month real interest rate by1 percentage point, then investors are willing to holdassets denominated in German marks only if the U.S.dollar is expected to depreciate 1 percent against themark over the subsequent quarter. Thus, the tempo-rary interest rate differential generates an immediate1 percent jump in the value of the dollar, followed bydepreciation back to its long-run value in the subse-quent period.

THE DYNAMIC PROPERTIES OFFRB/GLOBAL

The dynamic properties of FRB/Global are describedhere through three simulation experiments, eachfeaturing a different type of shock: an exogenousreduction in U.S. government spending, an exog-enous depreciation of the exchange value of the U.S.dollar, and an exogenous increase in the OPEC oilexport price. In each experiment, expectations areassumed to be formed with limited information.

The effects of each shock are evaluated under twoalternative U.S. monetary policy rules: ‘‘active’’ and‘‘passive.’’ Under the active rule, the nominal federalfunds rate adjusts in response to the output gap and tothe deviation of consumer price inflation from thetarget rate. Thus, for each percentage point that out-put exceeds potential, the short-term nominal interestrate rises 50 basis points. For each percentage pointincrease in average annual inflation (based on thecurrent and previous three quarters), the short-termnominal interest rate rises 150 basis points. Under thepassive monetary policy rule, the nominal federalfunds rate is held constant throughout the simulation.

In each simulation experiment, Canada, Germany,Japan, and the United Kingdom follow independentmonetary policies under the same active monetarypolicy rule just described for the United States.Meanwhile, the French franc, Italian lira, andSOECD currencies remain fixed to the German mark.The Mexican peso and the OPEC and ROW cur-rencies are assumed to be pegged to the U.S. dollar,while the NIE currencies are assumed to be pegged toa trade-weighted basket of foreign currencies.

Determining Exchange Ratesunder Alternative Types of Expectations

Limited-information expectations:

ˆ ˆRERt = 0.08[(RLtUS − Πt

US) − (RLt − Πt)]

− 0.1NXDEBTtUS − NXDEBTt

GDPVDtUS + GDPVDt

Model-consistent expectations:

ˆ ˆ ˆRERt − RERt+1 = (RStUS − πt

US) − (RSt − πt)

− 0.1NXDEBTtUS − NXDEBTt

GDPVDtUS + GDPVDt

Definitions

RERt = the natural logarithm of the bilateral realexchange rate as adjusted by consumerprices, where the exchange rate is definedin units of local currency per U.S. dollar

RLt = the current long-term interest rate

RSt = the current short-term interest rate

NXDEBTt = the net external debt position inU.S. dollars

GDPVDt = nominal GDP in U.S. dollars

Long-term expected inflation,Πt, is computed usinglimited-information expectations. The one-step-aheadinflation rate,πt+1, and the one-step-ahead real exchangerate,RERt+1, are computed using model-consistent expec-tations. TheUS superscript indicates the correspondingvariable in the U.S. block of equations. Each equationincludes an intercept and a residual term (not shown).


The results of each experiment are reported interms of deviations from the baseline path; the con-struction of the baseline is described in appendix C.

Experiment 1: A Reduction in U.S. GovernmentSpending

In this experiment, real U.S. government purchasesof goods and services are permanently reduced by1 percent of the baseline path of U.S. GDP, starting inthe first quarter of year 1, while U.S. tax rates are heldconstant through year 14. During year 1, the spendingreduction amounts to about $70 billion. Because thespending shock originates within the United States,where foreign trade is a fairly small part of theeconomy, the experiment also serves as a usefulbenchmark for comparing the simulation results fromFRB/Global with those from FRB/US.

The two models generate nearly identical paths forU.S. real GDP and consumer price inflation (chart 2,top panels). In FRB/US, the two foreign variablesthat enter into the determination of U.S. net exports—

the trade-weighted real exchange rate and foreigntrade-weighted GDP—are each determined by asingle equation; in FRB/Global, they are jointlydetermined by 1,400 equations. Yet, in the case of thereal exchange rate, the paths generated by the twomodels are quite close, especially over the first threeyears of the simulation (chart 2, bottom-left panel).The differences in the paths for foreign GDP areslightly larger (bottom-right panel), but the effect onU.S. exports (not shown) is small.

This example illustrates the general result that,for domestic shocks, FRB/Global produces essen-tially the same results as FRB/US. Thus, the naturalrole for FRB/Global is in analyzing the effects of U.S.shocks on foreign economies and the effects of exter-nal shocks on the U.S. economy as well as foreigneconomies.

Active U.S. Monetary Policy Rule

Examining the U.S. government spending shockover its first three years provides a good comparison

2. Comparison of FRB/Global and FRB/US: A shock in U.S. government spending

2 4 6 8 10 12 14Year

2.0

1.0

0–

+

Percent

1.0

0.5

0–

+

Percent

U.S. GDP

Real exchange rate

Consumer price inflation

Foreign GDP

FRB/Global

FRB/US

Note. For definition of shock, see note to table 1.

2 4 6 8 10 12 14Year

0.50

0.25

0–

+

Percent

0.2

0.1

0–

+

Percentage points


of its effects on four of the countries with indepen-dent monetary policies—the United States, Canada,Germany, and Japan—under both active and passiveU.S. monetary rules (chart 3, sections A and B). Inthe active-policy experiment, real GDP in Canadaclosely tracks the contraction and recovery in U.S.output (chart 3.A, top-left panel), inasmuch asexports from Canada to the U.S. comprise a relativelylarge share of aggregate demand in Canada. The U.S.contraction has a much smaller effect on Japan andGermany.

The active monetary policy rule prescribes a cut inshort-term interest rates in each country (chart 3.A,bottom-left panel). The short rate in Canada falls afull percentage point, whereas the Japanese and Ger-man short rates fall only about 20–40 basis points.

Long-term real interest rates in all three foreigncountries fall less than in the United States(chart 3.A, bottom-right panel). Thus, each foreigncurrency exhibits real appreciation relative to the U.S.dollar (see the equations for determining exchangerates), accounting for the depreciation in the trade-weighted U.S. real exchange rate (chart 2, bottom-leftpanel).

The U.S. fiscal shock under an active U.S. mone-tary policy improves the U.S. trade balance by about$15 billion (table 1.A); the improvement arisesfrom a combination of the depreciation in the realexchange rate and lower domestic spending. The U.S.current account improves even more as lower rates ofprofit and interest reduce the rates of return paid ondirect investment and portfolio liabilities. The rise inU.S. net exports is reflected in a fairly even drop innet exports among the other eleven blocks. The rest-of-world (ROW) trade balance is determined by theconstraint that the global trade deficit remain at itsbaseline value. Nevertheless, the decline of about$5 billion in ROW net exports seems to be reasonablein light of the fact that the ROW block accounts forabout 30 percent of U.S. imports.

Passive U.S. Monetary Policy Rule

When the United States maintains a constant fed-eral funds rate, U.S. real GDP remains stagnant, atabout 1 percent below baseline, during the first threeyears of the simulation (chart 3.B, top-left panel),while consumer price inflation falls because of thedownward-sloping short-run Phillips curve (top-right panel). Thus, expected long-term inflation falls,and the long-term real interest rate graduallyincreases (bottom-right panel). Meanwhile, falling

foreign real interest rates in response to the activemonetary policy rules in Canada, Germany, and Japanlead to real appreciation of the U.S. dollar. As longas the U.S. federal funds rate remains constant, thesecontractionary influences will grow in magnitude,

1. Effects of selected shocks on the trade balances andcurrent accounts of countries and country groups inFRB/Global, years 1 through 3U.S. dollars

A. U.S. government spending shock

Country orregion

Trade balance Current account

Year Year

1 2 3 1 2 3

United States. . . . . . . . 15.1 16.9 11.8 24.3 27.8 23.7Germany. . . . . . . . . . . . .1 .2 .1 −.8 −.8 −1.3Japan. . . . . . . . . . . . . . . −.6 −1.4 −1.6 −5.3 −7.4 −9.0Canada . . . . . . . . . . . . . −1.5 −1.3 −1.2 −1.0 −.9 −.9France. . . . . . . . . . . . . . .1 −.3 −.7 −.4 −1.0 −1.7Italy . . . . . . . . . . . . . . . . .1 −.3 −.4 .0 −.7 −.9United Kingdom . . . . −.8 −.6 −.4 −1.6 −1.8 −1.8Smaller OECD. . . . . . −1.0 −1.7 −1.1 −.8 −1.6 −1.1Mexico . . . . . . . . . . . . . −.3 −.5 −.6 −.2 −.4 −.6NIEs . . . . . . . . . . . . . . . −1.6 −1.2 −.4 −1.1 −1.2 −.8OPEC . . . . . . . . . . . . . . −4.4 −3.0 −1.0 −4.9 −4.1 −2.8ROW . . . . . . . . . . . . . . . −5.1 −6.8 −4.3 −8.3 −7.9 −2.9

B. U.S. currency shock

United States. . . . . . . . −2.8 23.8 34.7 −3.6 18.1 28.2Germany. . . . . . . . . . . . 2.2 4.3 2.8 −2.4 −2.0 −4.3Japan. . . . . . . . . . . . . . . −1.1 −5.6 −10.5 −1.4 −3.8 −10.6Canada . . . . . . . . . . . . . .5 1.2 .6 .3 .8 .5France. . . . . . . . . . . . . . 3.7 2.3 −1.6 1.6 −1.2 −5.9Italy . . . . . . . . . . . . . . . . 2.4 .4 −1.1 3.1 −1.9 −3.5United Kingdom . . . . −3.0 −4.0 −4.1 −3.1 −10.0 −10.0Smaller OECD. . . . . . 3.3 −.9 −2.4 5.8 2.1 .8Mexico . . . . . . . . . . . . . .4 1.4 1.8 −.5 .0 .5NIEs . . . . . . . . . . . . . . . −12.1 −14.2 −13.5 −5.3 −6.4 −6.7OPEC . . . . . . . . . . . . . . −7.1 −2.1 −.2 −9.7 −5.2 −3.5ROW . . . . . . . . . . . . . . . 13.5 −6.7 −6.4 15.1 9.6 14.5

C. OPEC oil export price shock

United States. . . . . . . . −13.1 −4.0 −1.8 −14.2 −3.1 −1.0Germany. . . . . . . . . . . . −4.7 −3.3 −3.0 −4.6 −3.8 −3.8Japan. . . . . . . . . . . . . . . −12.3 −7.9 −5.7 −11.4 −10.1 −9.3Canada . . . . . . . . . . . . . 1.3 .3 .2 .9 .5 .5France. . . . . . . . . . . . . . −2.7 −2.1 −1.9 −2.6 −2.5 −2.6Italy . . . . . . . . . . . . . . . . −3.0 −2.6 −2.3 −3.2 −3.1 −2.9United Kingdom . . . . .5 −.2 −.2 .0 −1.0 −1.1Smaller OECD. . . . . . −1.2 .2 1.7 −1.1 .1 1.6Mexico . . . . . . . . . . . . . 1.4 1.4 1.4 1.4 1.6 1.5NIEs . . . . . . . . . . . . . . . −3.2 −4.4 −4.8 −2.5 −3.0 −3.7OPEC . . . . . . . . . . . . . . 34.5 26.8 21.8 35.3 30.7 28.0ROW . . . . . . . . . . . . . . . 2.7 −4.1 −5.5 2.0 −6.1 −7.2

Note. Each shock begins at the start of year 1. In each simulation, the U.S.monetary authorities follow the active monetary policy rule, in which the fed-eral funds rate is adjusted to counteract movements in the output gap and indeviations of consumer price inflation from the target rate.

The U.S. government spending shock is a permanent reduction in spendingequal to 1 percent of the baseline path of U.S. GDP.

The U.S. currency shock is a 5 percent depreciation in the exchange value ofthe U.S. dollar versus the Canadian dollar and a 10 percent depreciation versusthe currencies of the rest of the G-7, the smaller OECD countries, and the newlyindustrializing economies (NIEs).

The OPEC oil export price shock is an increase of $5 per barrel above thebaseline path.


3. U.S. government spending shock under active and passive U.S. monetary policy rules

0.5

0–

+

Percentage points

1.0

0.5

0–

+

0.5

PercentA. Active monetary policy rule

Output gap

Short-term nominal interest rate

Consumption price deflator

Long-term interest rate

Germany

Canada

Japan

United States

B. Passive monetary policy rule

Output gap




0.25

0–

+

Percentage points

1.0

0.5

0–

+

0.5

Percent

1 2 3Year

0.5

0–

+

0.5

Percentage points

1.0

0.5

0–

+

0.5

Percent

1 2 3Year

0–

+

0.25

0.50

Percentage points

1.0

0.5

0–

+

0.5

Percent

Note. For definitions of shock and active monetary policy rule, see note to table 1.


generating an explosive downward spiral for U.S.output and prices.11

Experiment 2: A Depreciation in the ExchangeValue of the U.S. Dollar

In this simulation, the exchange value of the U.S.dollar depreciates 5 percent against the Canadiandollar and 10 percent against the currencies of theother foreign G-7 countries, the SOECD, and theNIEs. After the depreciation in year 1, these exchangerates remain fixed at the new level throughout thesimulation period. Because the depreciation is nottriggered by a change in expectations about futureinterest rates, it may be viewed as arising from anexogenous downward shift in preferences for holdingdollar-denominated assets.

Under the active as well as the passive monetarypolicy regime, the exchange rate depreciationimproves U.S. external competitiveness and stimu-lates net exports, thereby raising real GDP about0.6 percent within about a year (charts 4.A and 4.B,top-left panels). The exchange rate depreciation alsopasses gradually into U.S. import prices and ulti-mately into higher consumer price inflation (top-rightpanels). The active monetary policy rule prescribesan increase of almost 150 basis points in the federalfunds rate by the middle of year 2 and graduallypushes up the long-term real interest rate (chart 4.A,top-right panel).

Under the active U.S. monetary policy rule, theU.S. trade balance displays a standard J-curveresponse to the exchange rate depreciation, with asmall initial deterioration yielding to an improvementof $35 billion by the end of year 3 (table 1.B). TheU.S. current account improves a smaller amount ashigher rates of interest and profit generate higher netfactor payments. Japan and the NIEs bear the bruntof the increase in U.S. net exports. The ROW is notseverely affected—its price level adjusts fairlyquickly to maintain a constant trade-weighted realexchange rate.

Experiment 3: An Increase in OPEC OilExport Prices

In this case, the export price of OPEC oil increases$5 per barrel above its baseline path in year 1 and

remains fixed at $5 above the baseline thereafter(chart 5 and table 1.C). This shock roughly corre-sponds to a 25 percent rise in the fuel import pricesfaced by all countries and regions in the model.Under the active monetary policy rule, the U.S. con-sumer price level rises about 0.3 percent by the endof year 1 (chart 5.A, top-right panel).

To push inflation back toward its target rate, theactive policy raises the federal funds rate 20 basispoints, causing a mild contraction in which U.S. realGDP falls about 0.3 percent (chart 5.A, top-leftpanel). As inflationary pressures subside, the federalfunds rate returns to baseline, and by year 3 theoutput gap is almost closed. By contrast, U.S. outputremains close to the baseline under a constant federalfunds rate (chart 5.B, top-left panel), but consumerprices rise about 0.5 percent (chart 5.B, top-rightpanel), nearly twice as much as under the activepolicy rule.

ILLUSTRATIVEAPPLICATIONS OFFRB/GLOBAL

FRB/Global can be used to analyze the spillovereffects of fiscal and monetary policy under alternativeEuropean monetary policy regimes, an area of inter-est given the movement toward a European monetaryunion. Simulations inform the forecasts of theBoard’s staff regarding foreign activity and the U.S.external sector. This section discusses three examplesof such simulations.

A Comparison of EMS and EMU

The first scenario highlights the effects of differentmonetary policy regimes on simulations for Franceand Germany of a fiscal shock originating in Ger-many. The shock is a permanent increase in Germangovernment spending equal to 1 percent of GermanGDP beginning at the outset of year 1. Althoughhypothetical, this shock is comparable to the fiscalexpansion in Germany that followed reunification in1990.

The scenario covers two monetary policy regimes:the current arrangements (the European MonetarySystem, or EMS) and those envisioned under theEconomic and Monetary Union (EMU). Under theEMS regime, monetary policy in Germany followsan active rule (German short rates respond to devia-tions of German output and inflation from target),while France, Italy, and the SOECD countries peg

11. These results are consistent with standard economic theory,which holds that the domestic price level is indeterminate (that is, nottied down by macroeconomic fundamentals) under a fixed nominalinterest rate.


4. U.S. currency shock under active and passive U.S. monetary policy rules

1.0

0.5

0–

+

0.5

Percentage points

0.5

0–

+

0.5


Output gap



Long-term real interest rate

Germany

Canada

Japan

United States


Output gap




0.4

0.2

0–

+

0.2

Percentage points

1.0

0.5

0–

+

0.5

Percent


1 2 3Year

1.0

0.5

0–

+

Percentage points

0.5

0–

+

0.5

1.0

Percent

1 2 3Year

0.3

0.2

0.1

0–

+

0.1

Percentage points

1.0

0.5

0–

+

0.5

1.0

Percent


5. Shock to the export price of OPEC oil under active and passive U.S. monetary policy rules

0.2

0–

+

0.2

0.4

0.6

Percentage points

0.2

0–

+

0.2

0.4


Output gap




GermanyCanadaJapan

United States


Output gap




0.1

0–

+

0.1

Percentage points

0.2

0.4

Percent


1 2 3Year

0.4

0.2

0–

+

0.2

0.4

Percentage points

0.4

0.2

0–

+

0.2

Percent

1 2 3Year

0.1

0–

+

0.1

Percentage points

0–

+

0.2

0.4

0.6

Percent


their currencies to the German mark.12 In this experi-ment, the United States, Canada, Japan, and theUnited Kingdom follow independent monetary poli-cies under the EMS.

Under the model’s EMU regime, the EuropeanCentral Bank would implement monetary policy forthe member countries; it would use an active mone-tary policy rule in which the interest rate on thecommon currency (the euro) responds to the weightedaverage of the output gaps and inflation deviations ofall member countries. This rule highlights the con-trast between the EMU and the EMS regimes; in thelatter, short-term interest rates in all member coun-tries are determined by the output and inflation gap inGermany (apart from a risk premium on externalliabilities).

The actual composition of the EMU and the rela-tive influence of its members remain open issues. Forthis experiment, all members of the European Unionexcept the United Kingdom are assumed to join theEMU, and the influence of specific countries in theequation governing the European Central Bank’ssimulated response are represented by weights cal-culated from the relative dollar values of GDP ofthe member states. On that basis, Germany’s weightis slightly more than1⁄4, France and Italy each havea weight of about1⁄5, and the SOECD weight isabout1⁄3.

Under the EMS, the fiscal expansion in Germanyhas a direct positive effect on German GDP andprices (chart 6.A, top panels). The German centralbank responds to the shock by raising short-terminterest rates substantially (about 75 basis points)(chart 6.A, bottom-left panel). France must raiseinterest rates by a similar magnitude in order tomaintain the exchange rate peg (chart 6.B, bottom-left panel). The interest rate hike in France hasstrongly contractionary effects on real GDP andprices in France (chart 6.B, top panels), which areonly partially offset by higher net exports toGermany.

Under the EMU regime, the same fiscal shockproduces a rise in the interest rate in each country(about 60 basis points) that is somewhat smaller thanunder the EMS (as noted, about 75 basis points)(chart 6.A and 6.B, bottom-left panels). The smallerrise in interest rates reflects the fact that the EuropeanCentral Bank adjusts interest rates according to theeffects of a shock on the output gaps and inflationrates of all member countries. Under the EMU, the

effects of a German-specific fiscal expansion on therates of GDP and inflation in all member countriesare much smaller than the effect on Germany; there-fore, interest rates rise less than they do under theEMS, in which interest rates target only the Germanoutput and inflation gaps.

In addition, output and prices in Germany risemore under the EMU than they do under the EMSin response to the fiscal expansion (chart 6.A, toppanels). These results highlight the point that relativeto the EMS, the EMU will tend to generate somewhathigher variability of output and inflation in Germanybecause German short-term interest rates will reflecteconomic conditions in all member countries and notjust those in Germany, as they do under the EMS.

Likewise, under the EMU, the contractionaryeffects in France arising from fiscal expansion inGermany are much smaller than they are under theEMS (chart 6.B). In particular, the variability ofFrench output and inflation are markedly lower.These results illustrate the general point that, as mod-eled by FRB/Global, a country that currently pegs itscurrency to the German mark will tend to reduce thevolatility of its output and inflation by joining EMU.

A Comparison of Independent Monetary Policyand Participation in EMU

Although countries that currently participate in theEMS (other than Germany) may experience a reducedvolatility of inflation and output under the EMU, anon-EMS country joining the EMU presumablywould sacrifice some control over domestic macro-economic outcomes by giving up its independentmonetary policy. To test the latter proposition, weanalyze a fiscal shock similar to that consideredabove—a permanent increase in fiscal spending of1 percent of GDP—but this time within the UnitedKingdom instead of Germany. We consider its effectson the United Kingdom under each of two monetarypolicy scenarios: U.K. membership in the EMU andan independent monetary policy in the UnitedKingdom.

Under the EMU scenario, the European CentralBank is assumed to adjust interest rates using theactive monetary policy rule discussed above, exceptthat the United Kingdom is now included in the setof member countries. In this simulation, the UnitedKingdom receives a relatively small GDP-basedweight of1⁄8. Under an independent monetary policy,the United Kingdom uses a variant of the activemonetary policy rule, in which the short-term interestrate is adjusted to keep U.K. output at its target level.

12. Because the SOECD block includes Australia and NewZealand, the simulations are intended to only approximately representboth EMS and EMU.


6. German fiscal shock under EMS-style and EMU-style monetary policies

0.25

0.50

0.75

Percentage points

0–

+

0.5

1.0

1.5

PercentA. Effects on Germany

Real GDP

Short-term interest rate


Nominal exchange rate

EMUEMS

B. Effects on France

Real GDP




1.5

1.0

0.5

0–

+

Percent

0.1

0.2

0.3

0.4

Percent

Note. The shock begins at the start of year 1 and consists of a permanentincrease in German central government spending equal to 1 percent of GDP. Seetext for definition of monetary policy alternatives.

1 2 3 4 5Year

0.25

0.50

0.75

Percentage points

0.2

0.1

0–

+

0.1

B. Effects on France

Percent

1 2 3 4 5Year

0.15

0.20

0.25

Percent

0.1

0–

+

0.1

0.2

Percent


After the fiscal expansion in the United Kingdom,output there initially rises sharply (to 1 percent abovebaseline) if the country is in the EMU (chart 7,top-left panel); in contrast, an independent U.K.monetary policy could basically target output at base-line. The monetary tightening and the resulting rise inU.K. interest rates under an independent policy isconsiderably more aggressive than that which wouldbe taken by the ECB if the United Kingdom were oneof its members (bottom-left panel).

The simulation just described illustrates how acountry such as the United Kingdom stands to incursome increase in the variability of output and infla-tion by forgoing an independent monetary policy.Although the FRB/Global simulations help to assessthese costs, the simulations do not take into accountsome potential benefits of joining EMU, includingthe microeconomic benefits of lower transaction coststhat come with a common currency. Another poten-tial benefit is the ‘‘credibility effects’’ that couldreduce the risk premium on a country’s external

liabilities. That is, choosing to link its economy to acommon monetary policy could enhance a country’sstatus as an inflation fighter, which would tend tolower the risk premium on its external liabilities.

The Formation of Expectations

The final scenario examines the implications ofalternative assumptions about expectations. Theimplications are most apparent in the case of shockswhose effects arise after the start of the simulation.We compare the results obtained from expectationsthat are formed with limited information to the resultsobtained with model-consistent expectations—thoseformed with the benefit of all the information con-tained in the model.

Limited-information expectations depend exclu-sively on past information; hence, shocks are unfore-seen. By contrast, with model-consistent expecta-tions, agents are assumed to have perfect foresightabout the shock, meaning that they know the entire

7. U.K. fiscal shock: Effects on the United Kingdom under independent and EMU-style monetary policies

1 2 3 4 5Year

1

0–

+

1

2

3

Percentage points

0.5

0–

+

0.5

1.0

1.5

Percent

Output gap




EMU with U.K.

Independent U.K.

1 2 3 4 5Year

0–

+

0.5

1.0

Percentage points

0.5

0–

+

0.5

1.0

Percent

Note. The shock begins at the start of year 1 and consists of a permanentincrease in U.K. central government spending equal to 1 percent of GDP. Seetext for definition of the monetary policy alternatives.


future path of the variable whose value is beingexogenously changed in the simulation. The assump-tion of such foresight enables the model to capturethe notion that news about future economic develop-ments can affect the current economy.

Under each variant of the model, we consider theshort- and medium-term response of agents to anannouncement by the German government at thebeginning of year 1 that, at the beginning of year 3, itwill permanently add to its spending an amount equalto 1 percent of GDP. The monetary policy regimein years 1 and 2 is assumed to be the EMS; inyear 3, the EMU. (The United Kingdom conductsan independent monetary policy throughout thesesimulations.)

In Germany, limited-information expectations pro-duce no response until the spending rise is imple-mented in year 3 (chart 8). Even long-term interestrates fail to respond (bottom-right panel), an indica-tion that, until the shock is implemented, agents donot expect future short-term rates to rise. From year 3forward, however, the limited-information dynamicsare like those in the previous simulation of the effects

on Germany of a German fiscal expansion (chart 6.A)because that simulation was also conducted underlimited-information expectations.

Under model-consistent expectations, agents inyear 1 can use the information that the EuropeanCentral Bank will be in operation as of the beginningof year 3: As soon as the forthcoming year-3 shock isannounced, agents realize that the central bank willhave to raise short-term interest rates beginning inyear 3 to restrain the effects of the projected fiscalexpansion on output and prices. The expectation ofthe rise in future short rates (chart 8, bottom-leftpanel) causes an immediate rise in long-term rates(bottom-right panel). The rise in long rates in turncauses real activity to contract somewhat in years 1and 2, so in this simulation, a future fiscal expansionhas a contractionary effect in the short run.

Thus, FRB/Global accommodates two different,and somewhat extreme, perspectives on the forma-tion of expectations. The degree of divergence in theresults produced by each perspective in a given sce-nario depends on whether the effects of the shock areanticipated by economic agents.

8. Future German fiscal shock: Model-consistent vs. limited-information expectations

1 2 3 4Year

0–

+

0.5

1.0

Percentage points

0.5

0–

+

0.5

1.0

1.5

Percent

Real GDP




Model-consistent

Limited-information

Note. The shock, of the magnitude given in chart 6, is announced in year 1for implementation in year 3. See text for definition of expectations alternatives.

1 2 3 4Year

0.5

1.0

Percentage points

0.5

0–

+

0.5

1.0

1.5

Percent


APPENDIXA: THE FOREIGNG-7 EQUATIONBLOCKS

The equation blocks for the foreign G-7 countriescover government expenditures, tax revenue, netfactor income, potential output, aggregate wages, anddomestic prices.

Government Expenditures

Total government expenditures are divided into fivecomponents: consumption, investment, subsidies,transfers to households, and interest payments. Realgovernment consumption and investment expendi-tures on goods and services are exogenously deter-mined; the corresponding nominal values areobtained using price deflators for government con-sumption and investment. The nominal value ofgovernment subsidies moves proportionally withthe level of nominal GDP. In contrast, real transfersto households are assumed to be acyclical, depend-ing only on potential GDP; nominal transfers areobtained using the GDP price deflator. Finally, inter-est payments are computed by multiplying the stockof government debt by the average rate of return onoutstanding government securities. The average rateof return is assumed to be a weighted average of twocomponents: the current short-term Treasury bill rateand a moving average of past long-term bond rates.13

Tax Revenue

Total government revenues are divided into four com-ponents: direct taxes, social security payroll taxes,fuel taxes, and other indirect taxes.14 Direct tax reve-nue consists mainly of personal and corporate incometaxes and is computed by multiplying the direct taxrate by nominal net national product (nominal GDPplus net factor income from abroad, less depreciationallowances). The direct tax rate is endogenouslydetermined to stabilize the ratio of real governmentdebt to potential GDP.

Payroll taxes are assumed to vary proportionallywith labor income, which is the product of the hourly

wage rate and total employment.15 The fuel tax rate isspecified on a per-barrel basis, and the value of thetax per barrel is indexed to the GDP price deflator butnot to the current price of fuel. Other indirect taxes(for example, the value-added tax) are assumed tovary proportionally with the value of private con-sumption and investment expenditures.

Net Investment Income from Abroad

Net investment income from abroad is divided intofour components: direct investment payments andreceipts and portfolio investment payments andreceipts. Each of the four is computed by multiplyingthe outstanding stock of claims or liabilities by theappropriate rate of return. The rate of return on directinvestment liabilities varies with the domestic outputgap, while the rate of return on direct investmentclaims varies with a weighted average of foreignoutput gaps in which the weights are computed usingbilateral export data. The rate of return on portfolioliabilities is assumed to be a weighted average of twocomponents: the current short-term interest rate anda moving average of past long-term interest rates.Finally, the rate of return on portfolio investmentclaims is a weighted average of foreign rates ofreturn on portfolio investment liabilities, adjusted forexchange rate movements.

Potential Output

Potential domestic nonfuel output is determined by aCobb–Douglas production function exhibiting con-stant returns to scale with respect to labor, the busi-ness fixed capital stock, the residential capital stock,and domestic fuel consumption.16 Potential GDP isdefined as potential nonfuel output less net fuelimports, a formula that reflects the concept of GDPas a measure of value added (gross output less rawmaterials).

Aggregate Wages

Under limited-information expectations, the inflationrate of aggregate wages is specified as a function of

13. In all foreign G-7 country blocks, the weights on the short-termand long-term components are 10 percent and 90 percent respectively.The long-term component assigns weights of 0.05 to the currentlong-term bond rate and 0.95 to the previous period’s long-termcomponent. In future work, we intend to construct new weightsthat reflect cross-country differences in the maturity structure ofgovernment debt.

14. Strictly speaking, payroll taxes are a subcategory of directtaxes, so direct taxes in this discussion should be understood asreferring to the nonpayroll component of direct tax revenue.

15. Hours of work are assumed to be constant in the currentversion of FRB/Global; this variable will be determined endogenouslyin future work.

16. These four inputs have output elasticities of 0.7, 0.15, 0.1, and0.05 respectively. Future work on FRB/Global will incorporatecountry-specific production parameters and will relax the assumptionthat the industrial sector uses a constant fraction of total domestic fuelconsumption.


past wage inflation rates as well as current and pastoutput gaps, consumer price inflation rates, and short-term interest rates. Under model-consistent expecta-tions, the aggregate wage rate is determined by over-lapping nominal wage contracts, as formulated byTaylor.17 At the beginning of each quarter, one-fourthof the work force is assumed to sign new wagecontracts of annual duration. When unemploymentremains at its natural rate, each contract specifies awage rate equal to the average expected aggregatewage rate over the subsequent year. In addition, thewage contract is adjusted to account for the averageexpected deviation of unemployment from its naturalrate over the subsequent year. In particular, for agiven value of the average expected aggregate wage,a 1 percentage point increase in unemploymentthroughout the coming year reduces the current con-tract wage rate 0.02 percent. Finally, the aggregatewage rate is defined as the average of the four wagecontracts currently in effect.

Domestic Prices

The price deflator for domestic nonfuel output isdetermined as a markup over the aggregate wage rateand the domestic fuel price index.18 The markup rateis assumed to be mildly procyclical: Given employ-ment and fuel costs, a persistent 1 percentage pointincrease in the output gap generates a 0.36 percentrise in the domestic nonfuel output price deflator. Thegap between the markup rate and its equilibriumvalue shrinks about 33 percent per quarter. Givenprices for fuel imports and exports and the pricedeflator for nonfuel output, nominal GDP is com-puted as nominal domestic nonfuel output less netfuel imports, and nominal domestic spending is com-puted as nominal GDP plus net nonfuel imports. TheGDP price deflator is then determined by the ratio ofnominal to real GDP, and the domestic spendingdeflator is determined as the ratio of nominal to realdomestic expenditures. The private and governmentprice deflators for consumption and investment moveproportionally with the domestic spending deflator,so that the relative prices of the components ofdomestic spending are held constant. Finally, thedomestic fuel price depends on the price of importedfuel and the fuel tax rate.

Import and Export Prices

The import price deflators for services and nonfuelgoods are determined by a weighted average of for-eign export prices converted into local currency units,with the weights constructed from bilateral importdata.

The export price deflators for services and nonfuelgoods are determined by the price of domestic non-fuel output and a weighted average of foreign outputprices converted into local currency, with the weightsconstructed from bilateral export data.

The price deflators for fuel exports and imports aredetermined by the local-currency equivalent of theOPEC oil export price, which is expressed in U.S.dollars per barrel.

APPENDIX B: OTHER FOREIGN-COUNTRYEQUATION BLOCKS OFFRB/GLOBAL

Three blocks of equations represent Mexico, theNIEs, and the SOECD. These three blocks have astructure similar to that of the foreign G-7 blocks butwith no disaggregation of private investment, govern-ment revenue, and the capital account. The currenciesof the SOECD are assumed to be pegged to theGerman mark, so that SOECD interest rates andexpected inflation move in parallel with the corre-sponding German variables, apart from differencesin risk premiums on external liabilities. Similarly,the Mexican peso is assumed to be pegged to theU.S. dollar, and the NIE currencies are assumedto be pegged to a trade-weighted basket of foreigncurrencies.

The OPEC block is intended to represent fuel-export-oriented developing economies with no inertiain their nominal macroeconomic variables. TheOPEC currencies are assumed to be fixed to the U.S.dollar, and the OPEC nonfuel output price leveladjusts in a flexible way to maintain a stable trade-weighted real exchange rate. OPEC imports adjustgradually to maintain a constant ratio of net externalassets to nominal GDP. The OPEC oil export price isendogenously determined by world fuel consumptionand a trade-weighted index of foreign prices con-verted into U.S. dollars. For example, a 1 percentincrease in world fuel consumption generates a 1 per-cent increase in the equilibrium OPEC oil exportprice, with an adjustment rate of 40 percent perquarter toward the new equilibrium price level.

The ROW block of FRB/Global plays a crucialrole in ensuring that all global adding-up constraintsare satisfied. Thus, all ROW variables related to the

17. Taylor, ‘‘Aggregate Dynamics and Staggered Contracts.’’18. The relative weights are identical to those in the production

function: 0.92 on labor and 0.08 on fuel.


current account and capital account are defined byaccounting identities; for example, ROW net nonfuelmerchandise exports are determined by the sum ofnet nonfuel merchandise imports of the other elevenblocks.

At the same time, the ROW block is intended to berepresentative of small open developing economieswith no nominal inertia. Thus, the ROW nonfueloutput price index adjusts fairly quickly in responseto changes in the ratio of net external debt to nominalGDP. Since the ROW currencies are assumed to befixed with respect to the U.S. dollar, these movementsin the ROW price level translate directly into thetrade-weighted real exchange rate, which in turninfluences the net exports of the other eleven blocksand contributes to the long-run stability of the globalmodel.

APPENDIX C: CONSTRUCTION OF THEFRB/GLOBAL BASELINE

The data used to construct the FRB/Global baselinecome from a variety of sources (table C.1). TheFRB/Global baseline (tables C.2 and C.3) is extrapo-lated to the fourth quarter of 2025 under the assump-tion of a gradual transition to a balanced growth path.Thus, all output gaps in the model are closed within

about ten years, and each component of aggregatedemand converges to a constant fraction of real GDP.Consumer price inflation gradually converges to aconstant rate of 3 percent, and each wage and pricedeflator eventually becomes constant relative to theconsumer price index. Finally, tax rates are adjustedso that fiscal balance is achieved within about twentyyears.

C.1. Sources of baseline data for FRB/Global variables

Variables Sources

United StatesDomestic FRB/US baselineExternal sector Baseline of a Federal Reserve

international transactions model

Foreign industrial countriesNational accounts, fiscal

and trade data BIS databaseForeign direct and portfolio

investment IMF balance of payments statisticsBilateral export and import shares IMF direction of trade statisticsFiscal data, stocks of government

debt IMF government finance statisticsOil production, consumption,

and trade OECD–IEA oil and gas statisticsOil prices and tax rates OECD–IEA energy prices and taxesReal capital stocks, depreciation

rates Penn world tables

Developing countriesMexico and NIEs data IMF international finance statisticsAdditional data for NIEs DRI databaseOPEC and ROW data IMF World Economic Outlook

BIS Bank for International SettlementsIMF International Monetary FundOECD–IEA Organisation for Economic Cooperation and Development–

International Energy Agency

C.3. Merchandise imports of the United States, Germany,and Japan in the FRB/Global baseline, distributed byexporterPercent

Exporter United States Germany Japan

United States. . . . . . . . . . . . . . . 5 19Germany. . . . . . . . . . . . . . . . 5 . . . 4Japan. . . . . . . . . . . . . . . . . . . 15 5 . . .Canada . . . . . . . . . . . . . . . . . 18 .5 3France. . . . . . . . . . . . . . . . . . 2 11 2Italy . . . . . . . . . . . . . . . . . . . . 2 8 2United Kingdom . . . . . . . . 3 6 2SOECD. . . . . . . . . . . . . . . . . 6 39 15Mexico . . . . . . . . . . . . . . . . . 8 .1 .4NIEs . . . . . . . . . . . . . . . . . . . 10 4 12OPEC . . . . . . . . . . . . . . . . . . 4 2 13ROW . . . . . . . . . . . . . . . . . . . 27 20 27

Total . . . . . . . . . . . . . . . . . . . 100 100 100

Note. Averages for 1995. Imports measured in U.S. dollars.. . . Not applicable.

C.2. Highlights of the FRB/Global baselinePercent

Country orregion Share of

world GDP

Ratio to country’s or region’s GDP

Exports Net externalassets

Governmentdebt

United States. . . . . . 24 11 −14 49Germany. . . . . . . . . . 8 24 11 77Japan. . . . . . . . . . . . . 15 10 20 59Canada . . . . . . . . . . . 2 38 −43 107France. . . . . . . . . . . . 5 24 −1 44Italy . . . . . . . . . . . . . . 4 24 −5 119United Kingdom . . 4 29 7 56SOECD. . . . . . . . . . . 12 27 16 63Mexico . . . . . . . . . . . 1 32 −65 n.a.NIEs . . . . . . . . . . . . . 3 56 16 n.a.OPEC . . . . . . . . . . . . 2 31 125 n.a.ROW . . . . . . . . . . . . . 20 20 −20 n.a.

Note. Averages for 1995.n.a. Not available.


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