changes in equity risk perceptions: global consequences and policy responses warwick j mckibbin anu...

Changes in Equity Risk Perceptions:Global Consequences and

Policy Responses

Warwick J McKibbinANU and Brookings Institution

And

David VinesOxford, ANU and CEPR

Presented at the Bank of Canada Workshop on “Global Models and the Transmission of Shocks, 22 May 2003

Background

Two broad views of the current global economic slowdown• The result of weak aggregate demand that can be offset

through appropriate adjustments to monetary policies• The results of a reduction in aggregate supply resulting

from A downward revision in productivity growth in the OECD The collapse of the “new economy” bubble An increase in risk since September 11 and the war on terrorism

Goals of the Paper

To understand the current world economic slowdown in terms of the contribution of supply versus demand shocks when an equity bubble bursts

To explore the transmission of equity risk shocks between countries

To explore the optimal response of monetary policy in response to a sharp equity price adjustment

To explore whether there are gains to policy coordination in response to equity price shocks

Attempt to Quantify the Key Issues using a global model

Use the MSG3 model version 50o

(2 sector version of G-Cubed)

New version based on GTAP I/O data

www.gcubed.com

The G-Cubed Model

Key features• Based on explicit intertemporal optimization by

households and firms in each economy in a dynamic setting

• Substantial sectoral dis-aggregation with macroeconomic structure

• Explicit treatment of financial assets with stickiness in physical capital differentiated from flexibility of financial capital

• Short run deviation from optimizing behavior due to stickiness in labor markets, myopia

• Short run “New Keynesian” Model with Neoclassical steady state

G-Cubed Model

12 sectors production in each economy• Plus a capital good producing sector• Plus a household durable production sector (I.e. housing)

Estimation of KLEM technology in production and consumption

Tracks flows of international trade at the sectoral level Tracks flows of international capital Distinguishes between relatively traded and non trade goods

(all goods are potentially tradeable)

: 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.

1

...

12

C

I

G

X M

1

...

A

B

12

R

K

C

Kc

D

L

Derivative Models

We aggregate the full G-Cubed model by sectors and countries to create models suitable for particular purposes:

G-Cubed (Asia Pacific)

G-Cubed (Agriculture)

G-Cubed (Environment)

MSG3 (macro)

Countries In G-Cubed (Asia Pacific)

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

Sectors in G-Cubed (Asia Pacific)

Energy Mining Agriculture Durable Manufacturing Non-Durable Manufacturing Services

Sectors:EnergyNon – EnergyCapital goods producing sectorHousehold capital sector

The MSG3 Model

Countries: Exchange rate Regime:United States floatJapan floatAustralia floatCanada floatUnited Kingdom floatGermany Euro (floating)Austria Euro (floating)France Euro (floating)Italy Euro (floating)Rest of Euro Zone Euro (floating)Rest of OECD floatChina peg to $USnon Oil Developing countries peg to $USEastern Europe and Russia floatOPEC peg to $US

The MSG3 Model

The Equity Risk Premium (μ)

K

J)(1P2

dK

dQ)(1 )+(r =

dtd

it

it

2

4I

iti

it

it2ittit

it

The Equity Risk Premium (μ)

t

tsssR

i

iiI

kJi

iiit dse

k

Jp

dk

dQp )))(()((

2

4ˆ,ˆ

*2 ˆ

ˆ

2)1()1(

The Results

The Simulations

1) Baseline 2002 • Assumptions about

population growth by country Productivity growth by sector catching up by 2% per year to US leading

sector Given tax rates, monetary growth rates etc in all countries

• Solve for rational expectations equilibrium for the global economy

2) apply the change in equity risk premium• Permanent versus temporary• US versus OECD Wide

Capital Stock (non Energy)

-120-100-80-60-40-20

0204060

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050

USA (P) China (P)

USA (T) China (T)

GDP

-30

-25

-20

-15

-10

-5

0

5

10

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050

USA (P) China (P) USA (T) China (T)

Permanent Versus Temporary

Employment

-15

-10

-5

0

5

10

15

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050


Real Interest Rates

-4.5-4

-3.5-3

-2.5-2

-1.5-1

-0.50

0.5

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050



Current Account

-12

-10

-8

-6

-4

-2

0

2

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050


Real Exchange Rates

-40

-30

-20

-10

0

10

20

30

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050



OECD – Wide versus US Only

GDP

-6

-5

-4

-3

-2

-1

0

1

2

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050

USA (S) China (S)

USA (A) China (A)

Capital Stock (non Energy)

-16-14-12-10-8-6-4-2024

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050

USA (S) China (S)

USA (A) China (A)


Real Interest Rates

-2.5

-2

-1.5

-1

-0.5

0

0.5

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050

USA (S) China (S)

USA (A) China (A)

Employment

-3

-2

-1

0

1

2

3

4

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050

USA (S) China (S)

USA (A) China (A)


Current Account

-1-0.8-0.6-0.4-0.2

00.20.40.60.8

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050

USA (S) China (S)

USA (A) China (A)

Real Exchange Rates

-5-4-3-2-1012345

2000

2005

2010

2015

2020

2025

2030

2035

2040

2045

2050

USA (S) China (S)

USA (A) China (A)

Key Points

Equity Risk shock in the US is a large negative supply shock reducing the desired capital stock

Domestic variables in the US not affected much by whether the shock is in the US or in the OECD but international trade and capital flows and exchange rates are affected

Developing countries absorb some of the capital released and help reduce the global demand effect of the shock but very quickly diminishing returns in capital accumulation

US details for OECD – Wide Temporary

National Acounts

-6

-5

-4

-3

-2

-1

0

1

2000

2003

2006

2009

2012

2015

2018

2021

2024

GDP Consumption Investment

Exports Imports

Assets

-80

-60

-40

-20

0

20

40

60

2000

2003

2006

2009

2012

2015

2018

2021

2024

Capital Wealth H Wealth

Bonds For'n Assets

Employment and Inflation

-3-2.5

-2-1.5

-1-0.5

00.5

1

1.52

2000

2003

2006

2009

2012

2015

2018

2021

2024

Employment CPI Inf lation PPI Inf lation

Wages and Prices

-6

-4

-2

0

2

4

6

2000

2003

2006

2009

2012

2015

2018

2021

2024

Wage CPI PPI


Asset Prices

-20

-15

-10

-5

0

5

10

2000

2003

2006

2009

2012

2015

2018

2021

2024

Nominal r Real r

Tobin q (nonenergy) Tobin Q Housing

Exchange Rates

-5

-4-3

-2-1

0

12

34

5

2000

2003

2006

2009

2012

2015

2018

2021

2024

Real Eff ER Nominal Eff ER


Key Points

Investment falls Consumption rises

• Housing prices rise which dampen the negative impact on wealth and consumption

Net exports improve• Capital outflow depreciates the currency• External balance acts as stabilizer except when all countries have

the shock

Real wages need to fall Aggregate demand falls as does aggregate supply

Optimal Policy Response

itiitt

t

itW

'

0

Policy makers choose a vector of instrument Ui to minimize:

Where τ is a vector of targets (inflation and employment), δ is a discount rate(10%) and Ω is a matrix with the diagonal elements being a set of weights on each target

Policy optimization

Two cases• Countries have weight of 2 on inflation and 1 on

employment (infemp)• Countries have weight 2 on inflation and zero on

employment (inf)

Optimal US Response to OECD-Wide

Nominal Interest Rates

-2

-1.5

-1

-0.5

0

0.5

1

2000

2003

2006

2009

2012

2015

2018

2021

2024

USA (infemp) USA (inf)

GDP

-5

-4

-3

-2

-1

0

1

2000

2003

2006

2009

2012

2015

2018

2021

2024



Employment

-3-2.5

-2-1.5

-1-0.5

00.5

11.5

2

2000

2003

2006

2009

2012

2015

2018

2021

2024


Inflation

-1.5

-1

-0.5

0

0.5

1

1.5

2

2000

2003

2006

2009

2012

2015

2018

2021

2024



Consumption

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

2000

2003

2006

2009

2012

2015

2018

2021

2024


Real Exchange Rate

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

2000

2003

2006

2009

2012

2015

2018

2021

2024


Key Points

Not a lot monetary policy can do to offset the shock except in the very short run

Optimal French Response to US Shock

National Acounts

-0.15

-0.1

-0.05

0

0.05

0.1

0.15

0.2

2000

2003

2006

2009

2012

2015

2018

2021

2024

GDP Consumption Investment

Exports Imports

Assets

-2

-1

0

1

2

3

4

5

6

2000

2003

2006

2009

2012

2015

2018

2021

2024

Capital Wealth H Wealth

Bonds For'n Assets


Employment and Inflation

-0.1-0.08

-0.06-0.04-0.02

0

0.020.040.06

0.080.1

2000

2003

2006

2009

2012

2015

2018

2021

2024

Employment CPI Inflation PPI Inflation

Wages and Prices

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

0.4

0.5

2000

2003

2006

2009

2012

2015

2018

2021

2024

Wage CPI PPI


Asset Prices

-0.2

-0.1

0

0.1

0.2

0.3

0.4

2000

2003

2006

2009

2012

2015

2018

2021

2024

Nominal r Real r

Tobin q (nonenergy) Tobin Q Housing

Exchange Rates

-0.5

0

0.5

1

1.5

2

2000

2003

2006

2009

2012

2015

2018

2021

2024

Real Eff ER Nominal Eff ER

Key Points

Impact on France of OECD wide shock similar to the results for the US

Impacts on France of US shock very different • Positive French supply shock but negative external

demand shock

US Results for Cooperation

Employment

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2000

2003

2006

2009

2012

2015

2018

2021

2024

Non Coop Coop

Inflation

-1.5

-1

-0.5

0

0.5

1

1.5

2

2000

2003

2006

2009

2012

2015

2018

2021

2024

Non Coop Coop

Europe Results for Cooperation

Employment

-3-2.5

-2-1.5

-1-0.5

00.5

11.5

2

2000

2003

2006

2009

2012

2015

2018

2021

2024

Non Coop Coop

Inflation

-1.5

-1

-0.5

0

0.5

1

1.5

2

2000

2003

2006

2009

2012

2015

2018

2021

2024

Non Coop Coop

Conclusion

Shocks to equity risk premia have significant effects on the real economy

Both aggregate demand and supply are affected. Monetary policy can help in the short to smooth the

adjustment but it can do little to offset the underlying shock

Conclusion

Transmission• Within countries an equity risk shock

lowers real interest rates, Lowers real wages causes a capital outflow, raises other asset prices like housing Lowers investment but raises consumption and net exports

• Across Countries lowers real interest rates, causes a capital inflow, raises all asset prices including equities and housing Raises investment and consumption Lowers net exports

Conclusion

Monetary Policy Response• Within countries experiencing an equity risk shock

Demand falls more than supply thus a loosening of monetary policy can dampen to employment losses in the short run

• In countries not experiencing an equity risk shock Demand rises more than supply Employment rises but inflation falls due to falling prices in affected

countries and an exchange rate appreciation Interest rates should fall because of a fall in the global real interest rate

Conclusion

Gains from Policy Coordination• Compared the the optimal non-cooperative policies there

is little gained from cooperation in the face of an OECD wide shock

• In reality the current policy stance of the G7 particularly Europe and Japan are very far from the optimal policies in this paper (real interest rates in Europe and Japan are too high). To the extent that real world cooperation might move these region towards more sensible policy, cooperation could achieve significant gains

Background Papers

www.gcubed.com

www.sensiblepolicy.com

changes in equity risk perceptions: global consequences and policy responses warwick j mckibbin anu...

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