TABLE 8: STERILIZED FISCAL SHOCKS FINANCED PARTLY BY FOREIGN CURRENCY BONDS ~~

PRICE LEVEL

(PERCENTAGE DEVIATION PROM BASELINE)

All C$ Debt \ 4s C$/ 3 US$ Dedt

Qi 0.082 0.081
Q2 0.168 - 0.165
Q3 0.259 0.252
Q4 0.349 0.336
Qs ° 0.424 o.40r -
6 0.505 0.489
Q7 0.597 . 0.545

- 8 . 0.696 os 0.621
Qo 0.784" 0.679
quo . . 10.873 . 0.735
Quy 0.961 - 0.788
Qu2 1.04 6.828
Qu3 1.095 0.84 -

 Q4 1.149 0.846 --
Qus + 2.21 0.853
Qué: . 1.27 “2° 0.85
Qu7 . 1.304 0.819
Qs 1.343 0.788
quis. 2.401 0.769
Q20 1.447 * 0.731 -
Q2 1.454 . 0.649
Q22 1.464 : . 0.566

- Q23 : 1.497 0.501

Q24 1.527 : 0.426


(F2)

dy G{m[1 -. c* + m*] - m*n] m(1.- c*)G
(5-1) = =

am* 2 2
(1 - c* + m*) (1 - c* + m*)
dy m* (1 - c¥ + m*) -(1 -c*) [1 - c¥ + m*]G
(5-2) —= GL -1j]= .
dm 2
(1 - c* + m*) (1 - c* + m*)

Subtracting 5-2 from 5-1 we get

(5-3) m- [1 - c® +m*].

For reasonable values of these parameters, 5-3 will be < 0 which implies
that equal (and small) changes in m and m* will reduce the government
spending multiplier. However, in our experiments we doubled elasticities
and not marginal propensities to import. Because imports are a small
fraction of GNP in the U.S. relative to the U.S trading partners, we
effectively increase (dY/dm*) significantly more than (dY/dm). Thus
from the U.S. point of view, the first term in 5-3 is increased by a
factor greater than one and it is quite possible that 5-3 could > 0.

6/ There are two items worth mentioning here. They both concern the
fall on impact of British and Japanese real income following a
depreciation of sterling and the yen. This comes about in Japan because
of a large deficit on service account. In the U.K. this is the result of
a relatively strong consumption function effect. A depreciation causes
personal disposable income via a J-curve, to fall. This effect on
consumption more than outweighs the expansionary effects of the real
trade balance for several quarters.

7/ The effect of the intervention shock is not long lasting, mainly
Because the specifications of the exchange rate (net capital flow)
equations. The flow rather than the stock of net private capital enters
the behavioral equations. This framework is consistent with the
hypothesis that assets are almost perfect substitutes and there are long
adjustment lags (see Hooper et. al. (1983).)


~9-

isolation. Generally this is exactly what happens, although the
increased amplitudes in the strong U.S. and German income cycles can
temporarily cause output to be lower in the coordinated case. This can
be seen in Table 1 in the columns labeled "ALL".

Prices have risen more in all countries, except the U.S., when
there is coordinated expansionary policy. For all of the foreign
countries the increase in aggregate demand has been reinforced by a
depreciation of the home currency, which puts additional upward pressure
on prices by making foreign produced goods more costly in terms of the
home currency. In the U.S. the dollar on a 10-country trade weighted
average basis depreciates due to a trade deficit with countries outside
the four MCM countries. However the dollar appreciates bilaterally
against each of the other MCM countries because of the relatively larger
increase in U.S. interest rates. The subsequent effect on U.S. import
prices is enough to more than offset the price effects of increased
demand; thus U.S. prices are actually lower in the case where all
countries increase government expenditures together than where the U.S.
expands its economy in isolation. The lower U.S. prices in the
coordinated case feed through money demand functions to eventually cause
interest rates to be lower in this case than in the single country case.

The penultimate fiscal shock presented in Tables 1-4 is the
result of shocking a second model, a model identical to the MCM in all
respects save for the fact that all import income elasticities have been
doubled.4/ We did this to see if by altering the degree of openness in
the madel we would find that there was a corresponding decrease in the
effectiveness of policy as defined by a reduction of the conventional

income multiplier. Similarly we wanted to see if there were stronger


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-4.

A third feature of the model is the recent addition of an oil
sector. Here the model has been enlarged to model explicitly the
consumption and trade of oil, as well as the domestic price effects of oil
price shocks. Furthermore we have attempted to capture some of the
financial effects of oi] price shocks by including an OPEC net worth
variable in the various exchange rate (capital flow) equations. A full
description of each of the country models has been done elsewhere;
nevertheless a brief overview of the prototype country model is useful
before we begin our examination of the simulation experiments.

The typical model distinguishes four classes of agents: the
monetary authority, commercial banks, the government, and private non-
bank agents (i.e. firms and households). The actions of these agents
are modeled in several markets: the goods market, the labor market, and
the asset markets.

The goods market consists of the conventional elements of
aggregate demand --consumption, investment, the net trade balance, and
government expenditure. The supply side is based on a Cobb-Douglas
Production function and a labor market which does not clear completely in
any given period. This gives rise to a positive output elasticity in the
aggregate supply function. In the model inventory changes serve as a
short-term buffer.

Prices are determined by a mark-up over average cost. Thus the
price equations include as determinants wages, capacity utilization, and
foreign export prices adjusted by the exchange rate. The money market
focuses on the role of reserves in the system. For a given unborrowed

base, the short-term interest rate adjusts to clear the various demands

for base. The short-term bond market is the omitted market.</ Of course


~18-

alternative finacial policy regimes. The paper examines the simulation
properties of the MCM in light of the theoretical work of Poole (1970),
Henderson (1982) and Bryant (1980). In that paper we extend their work by
analyzing to what extent the conclusions are dependent upon the specific

monetary aggregate that is targeted.


-12-

300 and 450 million Canadian dollars a quarter and amounted to 4-1/2
billion Canandian dollars at the end of 6 years. While these results seem
to indicate that Canadian and U.S. dollar bonds are imperfect substitutes
(a topic discussed in the following section) this would be a misleading
characterization. The 4.5 billion of intervention is quite sizeable as it

represents almost 12% of the outstanding Canadian bond stock.

Financial Shocks

The financial policy shocks reported here are of two types;
changes in central hank discount rates and sterilized intervention. We
begin by discussing the interest rate shocks. It is possible to simulate
open market operations in all of the models except the U.K; however,
comparable monetary simulations across the MCM countries, with their very
different monetary institutions, are best achieved by shocking the
discount rate. In these simulations, summarized in Tables 9-12, we
raised the central bank's discount rate enough to cause short-term
interest rates to rise by 100 basis points on impact. The shock was
calculated by making use of the known coefficients in the commercial
banking system's demand for free reserves, but ignoring any feed-back
effects on the supply of free reserves. Consequently the impact effects
are not precisely 100 basis points.

The results of this shock applied to each country individually
are relatively straightforward. Increased interest rates and the
resulting appreciation of the home currencies both work to decrease
demand and diminish output. As mentioned earlier, the U.K. model differs

in its financial structure from the MCM prototype. In this case alone,


-14-

influence of the exchange rate on aggregate demand outweighs the foreign
income response.

Exchange rate effects are particularly important when examining
price behavior. In the MCM an exchange rate appreciation feeds through
into domestic prices via a fall in the home currency price of imported
goods. Since there is less of an appreciation when all interest rates
move together than when a country changes its rate in isolation, it is not
surprising to find the effects of generally weaker exchange rates and
lower foreign prices outweighing the effects of decreased aggregate
demand. It may seem counter intuitive that price effects are smaller for
a given country when all countries contract rather than just a single
country. However, the key price variable for this comparison should be
the world price level. We find (although not shown in the table) that
the world price level, as an aggregate, is lower when all of the MCM
countries tighten up together than when a single country pursues the same
policy in isolation.

The final financial policy to be discussed is central bank
intervention in the foreign exchange market. We want to focus exclusively
on that aspect of financial policy that is unique to intervention, the
changing of the currency composition of assets in the hands of the public.
To that end we will define our simulation experiment solely in terms of
sterilized intervention. That is, we hold the monetary base to the
control solution throughout the simulation. Thus any economic effects
that occur come about because of the change in the composition of the
currency of assets backing base money, and not from any changes in the
size of the monetary base that would normally be associated with

intervention. For intervention so defined to have an effect, there must


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(F1)
Footnotes

* The authors have benefitted from comments by Peter Clark, Michael Dooley, Dale
Henderson, Peter Hooper, Caryl] McNeilly, Ralph Bryant, and Chuck Freedman on an
earlier draft as well as discussions with Ralph Tryon and Tom Glaessner on
several aspects of the U.K. and Japenese models. Nevertheless, this paper
represents the views of the authors and should not be interpreted as reflecting
the views of the Board of Governors of the Federal Reserve System or members of
its staff.

1/ The original version of the MCM is documented in Howe et. al. (1981) and in
The U.S. Economy in an Interdependent World; a Multicountry Model, Federal
Reserve Board, Washington, D.C. (forthcoming). The oi) sector is found in Tryon
(1982); the capital account (exchange rate) in Hooper et. al. (1983); the
Japanese monetary sector in Glaessner (1982); the German monetary sector in
oe” (1981); and the U.S. international accounts in Hooper and Stekler
1983).

2/ In some ongoing research in the Federal Reserve System we have modeled the
Bond market for Canada, Japan, and Germany. The empirical results regarding
asset substitutability by and large conform to the current version of the MCM.

3/ This result is straightforward. Given a simple linear version of a model
where m and c are marginal propensity to import and consume, Y is real income, G
is government spending, and * represent foreign variables we get

(3-1) Y= cY + m*Y* = mY + G
(3-2) Y* = c¥Y* + mY - m*Y* + G*.

Letting G* = 0, solving (3-2) for Y*, and substituting into (3-1) gives
m*

(3-3) Ye cY + ( aE - 1) my +G
and solving for the reduced form of Y gives
G
(3-4) Y=
l-c- mm +m.

1 - c® + m*

From the second term on the right hand of (3-3) we can see that if m is small
(as in the U.S.) and m* is large (as in the European countries), trade leakages
can be small and this term can almost cancel out. Similarly taking the third
and fourth terms in the denominator of (3-4) yields

(3-5). -m'm + m_- mc* + mm* = m (1 - c*)
T - c® +m T- ch +m,

While this term is unambiguously >0, it again shows that a small m and a large
m* can produce a small value (i.e. very little foreign trade leakage).

4/ See Bryant (1980), chapter 12, for a discussion of the issues involved here,

5/ This result can be motivated using the simple model given in footnote 3. If
we differentiate (3-3) with respect to m and m* we get


TABLE 6: STERILIZED FISCAL SHOCKS FINANCED PARTLY BY POREIGN CURRENCY BONDS

EXCHANGE RATE (FOREIGN CUBRENCY/DOMESTIC CURRENCY)

(PERCENTAGE DEVIATION. FROM BASELINE)

All C$ Debt 4s C$/ 3s US$ Debt
Qu . -0.034 _ 70.016
Q2- 0.096 0.038 |
93 . 0.162 0.045
eu 0.108 0.089
Qs -0.052 0.243
6 -0.03 0.383
7 0.224 0.32 °
98 -0.48 . 0.243
Qe 0.714 0.214
qo. -0.854 0.254
igh. . "  =0,907 . 0.364
qg2 0 0.929 0.504
Qi3. -0.965 0.659
Qi4. ; “1.04 0.818
Qs . “1.232 0.996
a6 72.252 1.171
Q17 71.392" 1.352
qs . 1.536 1.548
ge: . “1.665 ‘1.778
0; -1.641- 2.188
R21 : -1.602 2.636
222 “1.621 . 3.043
423 . “1.674 3.402

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~16-

asset substitutability. While there is a currency depreciation, in no
case are the effects particularly strong or long lasting. Germany is
closest to the perfect substitutes case with a one quarter depreciation

of about .2 percent that has no substantial effect on any real side
variables. The exchange rate effects in the U.K. and Japan are stronger,
but still result in little price or income effect .o/ In Canada the effect
on the exchange rate is the strongest, and owing to the exchange rate
expectations process, the longest lasting. Nevertheless, the quantitative
effect is still rather weak.

To say that the quantitative effects are weak may be somewhat
misleading because it depends on the scale of the shock. The fiscal
shock comparison in Tables 5-8 indicate that sterilized intervention can
be effective in Canada. However, that shock represented large and
sustained intervention rather than just a once and for all change in the
currency composition of the central banks portfolio. We ran domestic
open market shocks (unreported here) in Canada and Germany in order gauge
the relative strength of sterilized intervention. The open market shocks
demonstrate that intervention has relatively weak effects. For example
in Canada an equivalent amount of open market operation has almost 10
times the impact on the exchange rate as the sterilized intervention and,
furthermore, the effect is sustained. The German results are roughly
similar; the open market operation is about 5 times as powerful as an
equivalent intervention shock 2/

In the simplest of models we would expect an exchange of home
currency assets for U.S. dollar assets by the central bank, ceteris
paribus, to raise home currency interest rates and lower the U.S.

interest rates. This is by and large what happens. The effect on U.S.


TABLE 15: INTERVENTION SHOCKS -- INTEREST RATE
(100 BASIS POINTS DEVIATION FROM BASELINE)

CANADA UK GERMANY JAPAN

Q1 -0. -0. 0.001 “0.
Q2. 0.001 -0. 0.006 0.
3 0.002 --0.. 0.007 0.
Q4 0.008 -0. 0.004 0.
05 0.01. +0. 0.004 0.
96 0.012 --0. 0.004 0.
Q7 . 0.003 --0.., 0.003" - 0.
98 0.003 -0. 0.003 0.
99 ; 0.002 -0. 0.003 0.
10 0,002 -0. 0.003 0.
Qit .0,002 -0. 0.003 0.
Qt2 0.002 0. 0.002 0.
Q13 0.001 Ow. 0.003 0.
14 ; 0.001 0. 0.002 0.
Q15 0.001 O., 0.002 0.
016 - 0.001 0. 0.002 0.
Q17 0. O.. 0.001 0.
Q18 0. 0... 0.002 . Oo.
019 0. 0.. 0.002 0.
Q20 0.005 0. 0.002 0.
921 0.007 0.. 0.002 0.
922 0.007 0. 0.002 0.
023 0.006 ‘0. 0.002 0.

Q24 0.006 0. - 0.002 0.


-6-

exchange market developments and those in which they don't. Similarly,
since the nominal budget deficit is endogenous, the method chosen to
finance government debt is of key importance. Unless otherwise stated, we
simulate under the following two assumptions. First, we assume that
central banks offset (i.e. sterilize) any monetary consequences of
exchange market intervention. Second, we assume that all budget deficits
are bond financed in domestic currency and, furthermore, this debt is an
"outside" asset. That is, private wealth holders do not systematically
alter their portfolios to fully offset new government bonds but rather
view these bonds as a net addition to wealth. We could conceivably have
chosen to have kept monetary policy constant by leaving interest rates
unchanged instead of the monetary base, but the results would have been
less illustrative of the general properties and dynamics of the model. It
is, after all, a model in which interest rates play an important role via
the investment function and the exchange rate. In some simulations in the
fiscal policy section, we relax this assumption and allow for domestic

money and foreign currency denominated bond financing of deficits.

Fiscal Policy Shocks

In this section we examine the effects of an autonomous increase
in government expenditures. The shock is an increase in real government
expenditures equal to 1% the starting period's value of real GNP and held
constant throughout the 24 quarters of the simulation. We will present
simulation results for three policy assumptions concerning the financing
of the debt. Initially, we treat all debt as being sold to the public.
As one alternative we treat it as being sold to the central bank (i.e.

monetized). The results of these two sets of simulations are presented in


-5-

the various models try to incorporate institutional differences. In
particular the U.K. model and, to a lesser degree, the German model
differ from the prototype in their specification of domestic financial
markets.

The model assumes that neither the composite national goods nor
the home currency bonds of the MCM countries are perfect substitutes for
one another, even after exchange rate expectations have been taken into
account. Consequently, intervention policy has a role to play in the
model.

While the model is suitable for forecasting (and is periodically
used for that purpose) this paper focuses on the model's capability for
policy analysis. The model can be simulated under three alternative
exchange rate assumptions -- fixed rates, a pure float or a managed
float. Monetary and fiscal policy instruments can be specified in a
variety of different fashions. In this paper we present the results of
standard monetary and fiscal shocks, including simulations that examine
policies coordinated across countries, simulations that alter the degree
of openness of the model, and simulations that focus on the role of

sterilized intervention.

II. Simulation Results
In this section of the paper we present a variety of simulation
results that are designed to show the salient properties of the MCM, We
have done this by shocking various exogenous variables in the model.
Before discussing the specific’ simulation experiment, it is
important to specify the overall policy setting. Obviously, the effects

of policy will be different in cases in which central banks respond to


TABLE 7: STERILIZED FISCAL SHOCKS FINANCED PARTLY BY FOREIGN CURBENCY 5

INTEREST RATE

(100 BASIS POINTS DEVIATION FROM BASELINE)

All c§ Debt. C$/ % US$ Debt -

ql 0.033 0.034
Q@. 0.042 0.044
Q@3 . 0.055 0.052
Q4 0.274 0.263
Q5 0.315 0.298
6 0.363 0.345
qQ7 0.085 0.067
Qs -0.003 0.05
Q9 -0.043 0.02
qio 0.019 0.019
qll 0.082 0.023
Qu2 0.136 0.019
qu3 0.159 0.003
Qia 0.159 -0.014
Qis 0.15 -0.039
Qié 0.15 -0.062
qi? 0.146 -0.101
qQis 0.137 -0.133
Qug 0.141 -0.148
q20 0.425 0.056
gz 0.512 0.125
Q22 0.547 0.114
Q23 0.574 0.084
Q24 0

+582 0.05


-8-

exchange rates depreciate in order to attract enough capital from abroad
to equilibrate the system. Thus all of the home currencies weaken with a
fiscal shock. Table 4 shows the response of prices to a fiscal shock. As
expected the currency depreciation and increase in aggregate demand lead
to price increases in all countries, though owing to unique labor market
considerations the increase is relatively moderate in the U.K.

These four tables also present the results of monetizing both the
increased debt and the official reserve flows associated with the fiscal
shock (except for the U.K. where their financial structure precludes this
experiment). These simulation results are found in the columns labeled
"MON". As expected this accomodating monetary policy causes interest
rates to fall in the face of an expansionary fiscal policy. ( Although in
both the U.S. and German cases, Strong income growth brought on by an
investment accelerator gives rise, via the money demand process, to a
period of increased interest rates.) The decline in domestic interest
rates leads to an even greater domestic currency depreciation
supplementing the negative exchange rate effects of the reduced trade
balance. Given the additional source of aggregate demand and the currency
depreciation, prices are predictably higher when the debt is monetized
than when it is not. For similar reasons we would also expect income to
be higher and largely this is true, though near the end of the simulation
Germany is in a deceleration phase of the cycle.

The results of two other fiscal shocks are presented in the first
four tables; a case in which all countries expand together and the results
of altering the openness of the model. We begin with the former. One
would expect that when all countries are expanding together the effect

on any one country's income would be greater than when it expands in


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(ANITASYA HOUT NOITLYIATG AOVINADAAa) TIAATT AOINA -~- SMNOOHS ALWY LSAWaALNI =Zt ATavE -


International Finance Discussion Papers
Number 214

January 1983

ASSESSING DYNAMIC PROPERTIES OF THE MCM: A SIMULATION APPROACH

by

Richard D. Haas and Steven A. Symansky

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished
material) should be cleared with the author or authors.


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-15-

be some difference in the foreign and domestic currency bonds held by the
central bank. If, allowing for expected exchange movements, they are
perfect substitutes, sterilized intervention would be an empty exercise
and one would not logically expect any financial or real effect to result.
Of course, in this, case unsterilized intervention would still be an
effective policy, but it would rely entirely on monetary effects for its
potency. In the case where bonds are perfect substitutes, there is no
difference between unsterilized intervention and open market operations.
Similarly, the presence of imperfect substitutability in asset markets
allows us to view intervention as a policy tool separate and distinct from
open market policy. In this case sterilized and unsterilized intervention
have qualitatively similar properties but quantitatively different
effects.

The important empirical issue then centers on the imperfections
in asset substitutability. We have experimented with a variety of
specifications in the MCM concerning exactly this issue. It is important
to point out that our research in this area is still ongoing and
consequently all of the results of our intervention shocks are very
Provisional. (In fact, in some preliminary unpublished empirical work by
members of Federal Reserve Board Staff, we find that assets are even
closer substitutes than are indicated by the current version of the MCM).

We simulated four instances of sterilized intervention by having
each of the non-U.S. MCM countries buy 1 billion dollars worth of U.S.
securities while sterilizing all monetary effects of the purchase. Tables
13 to 16 summarize the results of the shock for incomes, exchange rates,
interest rates, and prices. The country results differ among themselves

somewhat owing largely to differences in the coefficients that describe


TABLE 16: INTERVENTION SHOCKS -- PRICE LEVEL
(PERCENTAGE DEVIATION FROWN BASELINE)

CANADA OK GERMANY JAPAN
Q1 0.01 9-0... 0.013 0.023
02 0.019 0.007 0.011 0.025
93 0.022 0.029 0.009 -0.004
a4 0.023 0.038 0.007 0.003
05 0.021 0.033 0.004 0.
06 0.019 0.014 0.003 0.
Q7 0.018 0.018 0.002. 0.001
98 0.018 0.021 0.001 0.002
09 ~ 0.018 0.019 0. 0.001
Qi0 . 0.018 0.016 -0. 0.001
Q11 0.017 0.013 -0.001 0.
Q12 0.018 0.012 -0.001 0.002
Ql 0.018 0.012 -0.001 0.003
Q14 0.018 0.011 -0.001 0.004
Q15 0.016° 0.01 -0,001 0.005
Q16 0.016 0.908 -0.001- 0.006
Quy 0.016 0.008 -0.001. 0.005
Q18 0.015 0.007 -0.001 0.004
Q19 - 0.014 - 0.006 .-0.002 0.004
920 0.014 0.005 -0.002 0.003
021. 0.014 0.004 -0.002 0.002
Q22 0.012 0.003 -0.003 0.003
923 0.01 0.002 -0.003 0.006

Q24 0.01 0.001 -0.003 0.007


-7-

Tables 1-4, which give the impact on each country's GNP, exchange rate,
interest rate and price level. In addition, for Canada, we run one
simulation where one half the deficit is financed by the sale of bonds
denominated in U.S. dollars. These results are given in Tables 5-8. All
tables present the shock minus control values; for GNP, exchange rates,
and prices. The results are in terms of percentage changes, while the
interest rate impacts are given as one hundred basis point deviations.
The key at the bottom of Table 1 explains the assumption underlying each
of the fiscal simulations.

The first shock discussed is the bond financed increase in real
government expenditures. The results are found in the columns marked
"ST". The responses of income in each country, shown in Table 1, differ
somewhat from one another, but nevertheless some common elements emerge.
The income response is higher in the U.S. than in other countries. This
is partially due to a short lived U.S. inventory effect and to the fact
that the foreign trade sector in the U.S. is not a major source of
income-induced leakages. Foreign feedbacks generate an increase in U.S.
exports that are comparable to the increase in U.S. imports .2/ This
is not true in the other country models. Secondly, an investment
accelerator-multiplier mechanism is strong in the U.S. model, as it is in
the German model.

Tables 2 and 3 show the exchange rate and interest rate effects
of the fiscal shocks. The very elastic demand for base money in general
and free reserves in particular, in most of the models, means that
interest rates rise very little in response to a fiscal shock. The
capital flow generated by interest rate changes alone are insufficient to

provide enough of an offset to the current account. Consequently the


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TABLE 13: INTERVENTICN SHOCKS -- GNP
(PERCENTAGE DEVIATION FROM BASELINE)

CANADA UK GERMANY JAPAN
Qi 0.012 -0.029 0.001 ~0.013
92 0.03 -0.04 0.004 ~0.012
93 0.031 -0.06 0.002 0.015
4 0.031 -0.024 0.002 “0.015
05. "0.024 -0.015 0.002 0.02
06 0.022 -0. - 0.002 0.009
Q7. 0.018 -0.007 0.003 0.012
08 0.022, 0.003 0.003 0.006
09 0.018 0.008 0.001 0.012
10. - 0.019 0.014 0. 0.002
Q11 “0.016 = 0.012 --0.001 0.006
Q12 “0.021 0.014 -0.002 0...
013 0.017 0.015 -0.003 0.008
Q14 0.014 0.016 ~0.003 ,0.002
015 0.01 0.015 -0.003. 0.005
Q16 0.016 0.013 -0.003' 0.002
017 "0.012 0.011 -0.003 0.012 - -
Q18 0.011 0.01 -0.003 0.005
019 0.01 0.009 -0.003 0.011
Q2 0.017 0.008 --0.003 0.003
921 0.016 0.006 -0.002 0.021
922 0-011 0.003 -0.002 0.011
023 0.006. 0.003 -0.002 0.015
024 "0.015 0.003 -0.001 0.004

INTERVENTION SHOCKS ARE THE STERILIZED PURCHASE OF
, ONE BILLION DOLLARS WORTH .OF U.S. SECURITIES


-3-

various factors affecting exchange rate expectations, including relative
prices, inflation differentials and the cumulative current account. (The
details of this specification and the estimated equations are presented in
Hooper et.al. (1983).) Thus, for a given current account, exchange rates
can be viewed as being directly determined in the asset market. Over
time, as the current account responds to exchange rate movements it will
effect the level of the exchange rate both by altering exchange rate
expectations as well as by changing the size of the international wealth
transfers. In other words, in the long run the size of the asset market
itself is endogenous to the model.

This endogeneity of the exchange rate induces the capital flows
required to offset exogenous shocks either to the current account or to
the capital account. Thus a trade surplus (or a private speculative
inflow or the sale of foreign currency by the central bank) requires a
private capital outflow to equilibrate the system . This is accomplished
in the model through a change in the relative rates of return of home and
foreign currency assets. With home and foreign currency interest rates
determined principally by domestic financial considerations, the spot rate
must appreciate relative to the expected spot rate. This impact
appreciation of the home currency gives rise to an expected depreciation
and thus provides the motivation for the required capital outflow.

A second noteworthy feature of the model is the use of bilateral
trade equations. The model is structured so that changes in one country's
imports are automatically reflected as changed exports and aggregate
demand elsewhere in the model. Thus a rather elaborate set of trade
linkages is fully articulated in a manner that transmits commodity

demands completely among the MCM countries.


~10-

“spill-over" effects when economic integration is increased. Once again
we simulated bond financed fiscal shocks in Germany, Canada, and the
U.S.

These results labeled “OPEN" are also presented in the first
four tables. In Canada we do in fact find that the income effects of
fiscal shocks are muted by increasing the degree of goods market
integration. This is not the case throughout the simulation period in
Germany however. There the income effect is lower initially for the
"more open" system, but eventually is greater. This increase in the
amplitude of the cycle is attributable to the role past current account
deficits play in the exchange rate determination process. By increasing
the MCM import elasticities the marginal leakages in Germany were
increased. Thus the same change in income gives rise to substantially
larger deficits. As these deficits accumulate, speculators view a
depreciation as more likely and restructure their portfolios in a way
that does in fact cause the N-Mark to depreciate. This process, which
becomes significant with the passage of time, leads to an export led
income cycle. Consequently, the German income multiplier is higher in
the long run for the case where import elasticites have heen increased
than in the standard case.

The U.S. income multiplier shows a reversal of this pattern.
This happens because .S. imports are a relatively small fraction of GNP
compared to the other MCM countries. Therefore doubling all of the trade
equations' elasticities resulted in more of an increase in the marginal
propensity to export than the marginal propensity to import for the U.S.
once foreign income repercussions have been allowed for.2/ Over time,

the accelerator process drives the income response down.


TABLE 5: STERILIZED FISCAL SHOCKS FINANCED PARTLY BY FOREIGN CURRENCY BONDS --

GNP (PERCENTAGE DEVIATION FROM BASELINE)

[art FISCAL SHOCKS ARE SUSTAINED INCREASES IN GOVERNMENT SPENDING EQUAL TO ONE
PERCENT OF GNP IN THE FIRST PERIOD (1975 Q1) ]

All C$ Debt’ 's C$/3F US$ Debt!
Qu 1.014 9. 1.013 °°
Q2 1.066. 1.063
Q3 1.049 1.043 *
Qs 1.05 1.039
Qs 0.989 - 0.873
Q6 0.981 0.956
Q7 0.981 ; - 0.943
98 - 1,023 : 0.956
Qs 1.007 0.921 ©
go L.OLL 0.911;
“QU 0.988 0.869 -
Qi2 1.025 0.872 -"
Qi3 ; 1.011 0.85
os ; _ 0.998. ; 0.81 +
. 0.95 0.738
Qié 1.005 0.737
Qu? 0.974. 0.717.
Qis . 0.979 0.702
Qu9 . 0.942 0.627
Q20 0.974 ° ; 0.601
Q2h 0.943 0.552
Q22 0.941 0.517
Q23 . . 0.878 -+ 0,405

Q24 + 0.897, 0.346


-2-

I. Overview of the Multi-Country Model

The Multi-Country Model is a large scale econometric model
developed in the Federal Reserve Board's Division of International
Finance. It consists of macro econometric models of five countries -- the
U.S., U.K., Canada, Germany, and Japan -- as well as an abbreviated
rest-of-the-world sector. Particular attention has been paid to the
international aspects of macroeconomic behavior but each country model is
sufficiently developed that it can be used individually as well as fully
linked with other countries in the model. When the country models are
linked together and simulated, as is the case in this paper, economic
impulses are transmitted from one country to another by trade flows,
capital flows, exchange rates, prices and interest rates.

There are several features of the MCM worth noting at the outset.
The first of these is the endogeneity of four exchange rates, specifically
the U.S. dollar rates of the Canadian dollar, pound sterling, D-mark and
yen. One is tempted to describe the exchange rate determination process
in the MCM in terms of the exchange rate that equilibrates the current and
capital accounts but this would be a misleading oversimplification. The
exchange rate enters equations which do not figure in the balance of
payments constraint (such as demand for money functions) and other
endogenous variables (such as interest rates) enter into equations that
describe components of the balance of payments.

Operationally, in the current version of the MCM, exchange rates
are specified as the dependent variable in net private capital account
equations. In these equations exchange rates are expressed directly as
functions of interest differentials, the net private capital flow (i.e.

official intervention and the current account), movements in net worth and


Bibliography

Bryant, Ralph C., Money and Monetary Policy in Interdependent Nations,
Brookings, Washington, D.C., 1980.

Glaessner, Tom, "Changes to the Financial Section within the Japanese Model,"
FRB memo. August 13, 1982.

Haas, Richard and Steven Symanksy, “Assessing Policy Strategies in a
Multi-Country Model," Federal Reserve Board, Washington, D.C., forthcoming.

Henderson, Dale W., “The Role of Intervention Policy in Open Economy
Financial Policy: A Macroeconomic Perspective," International Finance
Discussion Papers, No. 202. Federal Reserve Board, Washington, D.c.,
February 1982. Forthcoming in Lombra and Witte, editors, The
Political Economy of Domestic and International Monetary Relations
Ames, Towa State University Press, 1982.

Hooper Peter, Richard Haas, Steven Symansky, and Lois Stekler, “Alternative
Approaches to General Equilibrium Modeling of Exchange Rates and Capital
Flows: The MCM Experience, Zeitschrift fur Nationaloleonomic
forthcoming.

Hooper, Feter, and Lois, Stekler, "A Model of U.S. International Accounts:
Revision of U.S. Sector of the MCM", Federal Reserve Board.

Poole, William "Optimal Choice of Monetary Policy Instruments in a Simple
Stochastic Macro Model," Quarterly Journal of Economics, vol. 84
(May, 1970).

Howe, Howard, Ernesto Hernandez-Cata, Guy Stevens, Richard Berner, Peter Clark
ard Sung Y. Kwack, “Assessing International Interdependence with a Multi-
Country Model, Journal of Econometrics, (January, 1981)

Symansky, et. al., “Empirical Tests of Exchange Rate Determination in a
Portfolio Balance Model Under Alternative Expectations Hypothesis".
Paper given at the Econometric Society Meetings, Washington, D.C.,
December, 1981.

Symansky, Steven, "Changes in the German Monetary Sector of the MCM,"
FRB memo, November 23, 1981.

Tryon, Ralph, "Modeling Oi] Price Shocks in the FRB Multi-Country Model:
International Finance Discussion Paper, Federal Reserve Board,
Washington, D.C., forthcoming.


-13-

diminished output and lower prices do not feed directly back on financial
markets to moderate the initial interest rate increase. In the U.K.
short-term interest rates do not rapidly or fully feed through into long
rates and hence investment. Thus the output effect is very weak. The
-persistence of high interest rates in Japan is due to another reason.
Extremely interest rate elastic demands by the banking system result in a
very flat "LM" curve. Consequently, interest rates decline very little in
Japan as income falls. Given the strong multiplier-accelerator properties
of the U.S. and German models, the income effects in those countries are
not terribly surprising.

Perhaps of more interest is the case where all of the central
banks simultaneously raise their discount rates. Table 11 shows that a
coordinated interest rate change results in larger and longer interest
rate effects. (The failure of Canadian rates to rise initially as much
in the coordinated case as in the single country case reflects the unique
role that U.S. interest rates play in commercial bank asset demand
functions. Higher U.S. dollar interest rates cause a once and for all i
shift out of Canadian dollar assets.) Of course not all countries

currencies can appreciate in this case -- indeed only the trade weighted

dollar and sterling are up initially. Consequently less restrictions in
aggregate demand come about from exchange rate changes in this case than
in the single country cases. Offsetting this effect however is foreign i
demand. Table 9 shows that on balance these foreign demand effects more

than offset the exchange rate effect for Canada, the U.K. and, to a lesser

degree, Japan. On the other hand German and U.S. income seem to be more

strongly affected when they raise their rates in isolation because the


Introduction

This paper reports some simulations with the current version of
the Federal Reserve Board's multi-country model (MCM). This exercise was
undertaken largely to learn how changes to the MCM made over the last
several years have affected its simulation properties and to extend our
understanding of the model's policy implications. These changes include
the addition of an oil sector, some revisions of trade equations,
international accounts in the U.S., revised monetary sectors in Japan and
Germany, as well as the way in which exchange rates are modeled.2/

The most critical change deals with the behavior of exchange
rates. In both the early and most recent versions of the model the
exchange rate is viewed largely as an asset market phenomenon. The
differences are in the specifications. In the first version of the model
there were no explicit exchange rate equations; the exchange rate was
-solved for implicitly. In the current version we have renormalized a
balance of payments capital account behavioral equation for the exchange
rate. This has had the effect of substantially moderating exchange rate
variability in the model.

After presenting a brief description of the model, we examine the
response of the model to a variety fiscal and financial shocks. In these
simulations we allow for different sterilization and deficit financing
assumptions. In a companion paper, "Assessing Policy Strategies in a
Multi-Country Model," we compare alternative financial strategies in an
open economy. There we look to see if the model possesses the income
stabilization properties that are suggested by the theoretical work of

Poole (1970), Bryant (1980), and Henderson (1982).


-17-

interest rates, not shown on the tables, is negative, as expected, but
extremely small. The effect on home interest rates is straightforward in
Japan and Germany. In Canada interest rates fall very slightly on impact
owing to a momentary decrease in money demand that can be ultimately
traced to the J-curve phenomenon. In the U.K. the interest rate
determination process is heavily influenced by the developments in the
Eurodollar markets which in turn reflect U.S. money market conditions.
Thus lower U.K. rates in the short-run reflect the slight fall in U.S.
rates. In all countries interest rates are ultimately pushed slightly

above their control solutions by money demand considerations.

Conclusions

In this paper we have presented some results of a recent
simulation exercise with the MCM to get some idea of the current dynamic
Properties of the model. This has been accomplished through numerous
financial and real side shocks simulated under a variety of financial
policy assumptions. Because of the wide range of simulation experiments,
no one result or conclusion emerges; rather, these policy shocks have
enhanced our understanding of the model, pointed out areas where our
priors are not always justified because of model dynamics or special
institutional characteristics, and suggested areas where the model needs
additional work. Furthermore, this analysis provides a foundation for
investigating policy questions which we consider in a separate paper,
"Assessing Policy Strategies in a Multi-Country Model". In that paper we
extend our anlaysis to include an examination of the MCM's response to

different unanticipated foreign and domestic disturbances under


TABLE '4; INTERVENTION SHOCKS --

EXCHANGE RATE (FOREIGN CURRENCY/DOMESTIC CURRENCY)
(PERCENTAGE DEVIATION FROM BASELINE)

CANADA UK GERMANY JAPAW
Q1 =0.261 -0.457 -0.185 -0.355
Q2 70.225 0.028 -0.023 -0.062
Q3 0.119 -0.004 -0.017 -0.027
Q4 70.028 -0.034 -0.011 0.019
Qs. 0.025 -0.039 0.007 0.009
Q6 0.048 +0.027 0.015 0.078
Q7 0.048 0.003 -0.014 +0.01
Q8 0.042 0.003 0.015 0.003
Q9g 0.035 0.005 0.013 -0.003
Q10 © 0.032 -0.009 0.011 0.001
Q11. 0.029 -0.018 0.01 ~0.002
Q12 0.029 -0.007 0.009 -0.005
Q13 0.028 -0.005 0.008 -0.011
Qi4. 0.027 +0.004 0.008 -0.013
Qis. 0.027 -0.008 0.007 -0.014
Q16 0.028 -0.007 0.008 -0.017
e117 0.029 -0.005 -0.909 -0.017
Q18 0.031 -0.002 0.009 -0.017
Q19 0.033 -0.002 0.01 -0.017
Q20 0.039 -0. 0.01 -0.022
°Q24 0.047 0.001 0.012 -0.023
Q22. 0.052 0.004 0.013 -0.025
Q23. 0.054 0.005 0.013 ~0.028

Q24 : 0.057 0.008 0.014 -0.038


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Not shown in the tables are the effects on foreign income from
these fiscal shocks. There are two effects discernible here. First, in
increasing trade elasticities, more of a given domestic shock should spill
over and appear as increased export demand abroad and thus disturb income
there. Second, by increasing leakages, the various income multipliers
should be reduced (the U.S. case, described above, is an exception to
this) so that the same shock will result in less income change. These two
effects work in opposite directions. Examination of the simulation
results confirms this; instances of each effect dominating are found. Of
course if we had increased only the import coefficients in the home
country, the results would not be ambiguous; foreign spill-over effects
would increase because nothing has happened to diminish foreign income
multipliers.

In the final simulation, we reran the initial domestic bond
financed fiscal shock for Canada but assumed that half of the increase in
the fiscal deficit was financed abroad in U.S. dollar denominated bonds.
Tables 5-8 compare income, exchange rates, interest rates, and prices from
the original Canadian dollar bond financed fiscal deficit to the results
using this new financing assumption. When we assume that the deficit is
financed abroad, the capital flow and exchange rate effects are
substantially altered. In particular, the official foreign currency
inflow serves to offset the worsened current account. Thus when the
deficit is partially U.S. dollar financed the exchange rate need not
depreciate as much (as happens initially) or actually appreciates (which
ultimately occurs). Consequently, aggregate demand and prices are
noticeably diminished over the domestic currency bond financed case. What

isn't shown is the amount of sterilized intervention. This ran betweeen