Monetary Policy: Shocks and EffectivenessBanco Central do Brasil

Rio de Janeiro, 11 July 2003

“The IMF Global Economic Model (GEM)” Presented By

Alessandro RebucciIMF Research Department

Introduction

• Since Obstfeld-Rogoff (JPE, 1995) seminal paper, there have been numerous theoretical contributions in the so-called NOEM literature

• Complex models, largely not yet brought to the data

• Dornbusch-Mundell-Fleming paradigm not yet supplanted

• However, efforts are now underway at several policy institutions to use this framework

• The Global Economic Model (GEM) is an attempt at using this new technology at the IMF

Outline of the presentation

• What is GEM?

• How is GEM solved, calibrated, and evaluated?

• How can GEM be used for macroeconomic analysis and policy evaluation?

What is GEM?• GEM (Pesenti, forthcoming IMF WP) is a NOEM model

• NOEM models (unlike MULTIMOD) are SDGE models with monopolistic competition, nominal rigidities, and trade derived from specialization, preferences and technology

• In these models there is an explicit role for monetary policy, stemming from the distortions mentioned, and an explicit role for other policies (e.g., fiscal, trade, etc.) could be introduced.

• In principle, policy evaluation can be welfare-based and may be more robust to the Lucas critique

• GEM is “richer” than the typical academic NEOM model

K L L* K*

TN INTERMEDIATE

GOODS

T* N*

QNN

M M* Q* NN*

A A*FINAL

GOODS

I GAC GA

* C* I*

HOME FOREIGN

GEM is a multi-country, multi-sector model: Baby GEM’s Structure

GEM has more shocks and frictions than the typical NOEM model:

• Technology (productivity, depreciation rate)

• Preferences (home bias, openness, labor effort)

• Financial Intermediation (UIP)

• Adjustment costs on import and investment

• Habit persistence in consumption

• Segmented good markets across countries

• Cost of adjusting nominal good prices

Standard assumptions on asset markets and government behavior

• Asset markets complete within countries but incomplete across countries

• Endogenous monetary policy by means of interest rate rules

• In the current version, Ricardian equivalence holds (representative agent model, no distortionary taxation)

• Structural reforms may be analyzed in comparative static exercises

How is GEM solved?

• The SS is solved numerically (in portable Troll) by using an iterative, Newton-Raphson-type algorithm to deal with large, non-linear models—Juillard and Laxton forthcoming IMF WP

• The deterministic PF solution of the non-linear model is obtained by using a variant of this algorithm—Armstrong et al (1998) and Juillard et al (1998)

• Stochastic RE solutions may be obtained by taking either first- or higher-order approximations using DYNARE (an interface for a set of MATLAB tools designed to study both linear and nonlinear SDGE models, assembled by Juillard and Laxton and freely available on request from dlaxton@imf.org)

How is GEM calibrated and evaluated?

• Thus far, GEM has been calibrated based on information from various sources: central banks’ “inside” view of the monetary transmission mechanism, existing literature, and unconditional moments of the data; no model evaluation

• However, ways to implement parameter estimation and model evaluation by using available, numerical Bayesian techniques (e.g., Smets and Wouters, 2003) are now being explored and a WP will summarize results

• Also, comparable input-output data for a significant number of countries have now been purchased from ECOMOD

How has GEM been used for macro analysis and policy evaluation?

• Monetary rules for emerging, transition economies (Laxton-Pesenti, JME 2003)

• Explaining the US dollar and trade balance in the late 1990s (Hunt-Rebucci, forthcoming IMF WP)

• Product and labor market liberalization in the euro area (Bayoumi-Laxton-Pesenti, forthcoming IMF WP and Spring 2003 WEO)

• Transmission of energy price shocks (Hunt, forthcoming US Article IV Consultation)

• Impact of G3 exchange rate volatility on emerging markets (Bayoumi-Pesenti-Rebucci-Spatafora, forthcoming WEO)

Laxton-Pesenti (2003)

• Ask how to modify interest rate rules for small, open, transition economies

• Conclude that the interest rate rule that minimizes inflation and output variability is more aggressive with respect to inflation and less aggressive with respect to the output gap than normally found

• Find some role for inertia in the policy rate

• Find no role for the exchange rate over and above its effects on CPI inflation

Hunt and Rebucci (2003)• Focus on the US dollar and trade balance in the second

half of the 990s and ask whether the Balssa-Samuelson effect (BS) of a productivity shock in the tradable sector may explain their behavior

• Show that BS effect may explain only about half of the exchange rate appreciation. Some uncertainty about the shock’s persistence and a broadly defined “capital flow” are needed to match the data more satisfactorily.

Bayoumi-Laxton-Pesenti (2003)• Examine the benefits from increasing competition in the euro area

to US levels

• Find that such a change would increase output substantially and reduces nominal inertia in the euro area:

– There are different effects from increases in competition in labor and product markets. Labor market reforms have a larger impact on nominal flexibility, and a lower impact on investment and on the rest of the world.

• There can also be substantial spillovers to the rest of the world. (In contrast to the domestic effects, these spillovers are sensitive to the parameterization. In particular, they depend on the degree of substitutability of home and foreign goods, with lower substitutability creating greater spillovers.)

Hunt (2003)• Focuses on the effect of large changes in energy prices and

ask when they can lead to stagflations as seen in the 1970s

• Key difference w.r.t. previous studies is that energy is used both as an intermediate input in production and consumed directly

• For large, permanent energy price shocks to be stagflationary, workers must resist the decline in their real consumer wage and monetary policy must be accommodative

Bayoumi-Laxton-Pesenti-Rebucci-Spatafora (2003)

• Examine effects of G3 exchange rate volatility on emerging markets.

• Three country version of GEM, two large countries (US and EU) and one small (EM). Volatility modeled as variance of the risk premium shock. Examine both spillovers to EM under alternative policy and structural scenarios, and whether reducing G3 exchange rate volatility would benefit EM given that this may result in greater interest rate volatility.

• Preliminary results: this kind of volatility raises consumption and output variability in EM, the more so the higher the level of debt and the less the currency composition of debt and trade are aligned. However effects are not large in absolute terms.

• Lower G3 exchange rate volatility does not appear to benefit EM

because of costs from more interest rate volatility, assuming that variance of risk premium shocks doesn’t fall.

How will GEM be used in the near future?

• Work in progress on emerging market economies

– Parameterize model to yield “original sin and sudden stops” to analyze welfare impact of these forms of financial market incompleteness

– Analyze impact of FTAs on business cycles of emerging economies

– Compare typical emerging economy in Europe, South East Asia and Latin America

– Monetary rules for small, open emerging economies– ...

• Work in progress on other issues

– Add equity trade and FDI to analyze role of capital flows composition in exchange rate dynamics

– Monetary rules for small, open advanced economies

– Monetary policy under the zero-bound constraint

– Compare welfare analysis of policy rules with results derived from ad hoc objective functions

– ...