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-26-

constant in the U.S. both increases the frequency and the amplitude of
the income cycle. The first property tends to auger in favor of the
theoretical results, the second against it.

Foreign income is very nearly the same on impact (there is less
than .01% difference between the two strategies) and conforms to our
theory on the basis of the sum of squared deviations, arguably the most
useful measure, although by some other criteria the theory is
contravened. Third country effects are an important factor in comparing
the two policy strategies. Only in Germany does comparing income
conform to the theory, and it is the DM which has the largest
depreciation. That is, it is only the DM which has unambiguously
depreciated against all of the MCM currencies.

The potential policy variables behave as expected once th2 lag
in the Canadian dollar equation (in the case of exchange rates) and
income lags in the demand for money functions (in the case of interest

rates and Ml) are allowed for.

III.C The Securities Shock

In this, the final shock analyzed in this section, we simulated
a change in asset preferences on the part of private wealth holders.
Specifically, we postulate a shift of 4 billion dollars (U.S.) into home
currency bonds (C$, ¥, DM or £) from U.S. dollar-denominated bonds. To
the degree that portfolio managers view home and foreign currency bonds,
suitably adjusted for exchange rate expectations, as perfect substitutes
for one another, there will be no discernible macro-economic effects due

to this change in preferences. But if wealth holders will hold different


ALTERNATIVE FINANCIAL STRATEGIES: THE RESULTS OF SOME POLICY
SIMULATIONS WITH THE MULTI-COUNTRY MODEL

*
By Richard N. Haas and Steven A. Symansky~/

1. Introduction

In this paper, we report on a set of policy simulations with
the Multi-Country Model (MCM) developed by the staff of the Federal
Reserve Board,

A description of the MCM is outside the domain of this paper.
We will simply point out that it is a large scale econometric model which
explicitly models the economies of the U.S. and four of its largest
trading partners. Particular emphasis is placed on international
linkages and financial relationships. Full descriptions of the model are
available elsewhere ./ This paper reports on an exercise which is the
first attempt to use the MCM to systematically analyze alternative
financial policies. In particular, we have chosen to compare and
contrast the properties of the MCM with the small theoretical models of
Bryant (1980) and Henderson (1982). These open-economy models are
extensions of the classic Poole (1970) article. In its simplest form,
they are designed to answer the question of which instruments policy
makers should control in order to most effectively minimize variations in

output when confronted by various types of unforseen shocks to the

*/ 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 othe rmembers of its staff. The authors are
indebted to Ralph Bryant, Chuck Freedman, Peter Clard, Dale Henderson,
Peter Hooper and Caryl McNeilly for helpful advice and comments.
Nevertheless the usual caveat applies.


-69-

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Qua) su --- ~  WOONS ALT



-80-

FOREIGN" GOODS/DOMESTIC GOODS SHOCK ooo INTVEN (ER)

FIX RATE M1 EXOG BASE EX0G M2 EX0G

TABLE
XZCF_ER X1CF_ER X6CF_ER X7CF_ER
CINTVEN CINTVEN” CINTVEN” CINTVEN
* 75 1 -0.968 Qo. 0. 0.
* 75 2 -0.37 Q. 0. 0.
* 75 3 -0.299 0. 0. 0.
* 75 4 -0.281 oO. oO. 0.
* 76 1 -0.231 oO. 0. 0.
* 76 2 -0.256 0. 0. 0.
* 76 3 -0.261 0. . 0. 0.
* 76 4 -0.252 0. 0. 0.
* 77 21 -0.229 0. 0. 0.
* 772 -0.218 0. 0. 0.
* 77 3 -0.215 0. 0. 0.
* 77 4 -0.22 0. oO. 0.
“* 78 1 -0.218 0. 0. . 0.
* 78 2 -0.244 0. 0. 0
* 78 3 -0.269 0. 0. 0.
* 78 4 -0.311 0. oO. 0.
* 79 1 -0.33 0. 0. 0.
* 79 2 -0.367 Oo. 7 0. 0.
* 79 3 -0.403 0. 0. 0.
* 79 4 -0.463 0. oO. 0.
* 80 1 -0.503 0. 0. 0.
* 80 2 -0.539 0. 0. 0.
* 80 3 -0.571 0. 0. 0.
* 80 4 -0.68 0. 0. 0.

TABLE 30


~16-

our priors only on impact. The dramatic cycle reflects the large weight
given to U.S income. In the U.S. there is an extremely strong investment
multipler-accelerator mechanism, which is particularly volatile in the
presence of variable rates.

The various aggregates behave as expected as does the exchange
rate. The interest rate, which is positive at the end of the simulation,

poses no problem once the income overshooting is allowed for.

Germany
In Germany, output patterns also conform to the pattern

suggested by theory. In contrast to Canada, however, both the rates-and
aggregates-constant policies lead to overshooting, though endogenizing
the rates accelerates the return to the long-run level of output by
moderating fluctuations in it. In both cases a trade surplus
attributable to decreases in income and prices is the source of the
initial rebound (and overshoot) in income. A traditional accelerater-
multiplier has come into play by the second half of the simulation,

Only on impact is the response of foreign income unambigsously
in accordance with the theory. The high volitility of the U.S.
investment function when aggregates are fixed again provides the
explanation for subsequent longer-run behavior.

Interest rates fall on impact as expected, and then cycle in a
fashion consistant with output and price patterns, again as expected.
The exchange rate is depreciated relative to the baseline, throughout the
simulation. This reflects the fact that the lagged cummulated current
account plays an expectational role in the MCM. Thus the current-account

deficit, which is a product of the shock, gives rise to expectations of a


-75-

FOREIGN GOODS/DOMESTIC GOODS SHOCK

FIX RATE Nl EXOG BASE EXOG = M2_- EXOG
TABLE
XZCF_PCER_ X1CF_PCER_ X6CF_PCER_ X7CF_PCER_
CGNP CCGNP CGNP CGKP
* 75 1 -0.184 -0.165 -0.182 0.123
* 75 2 -0.117 -0.097 -0.109 -0.132
x 75 3 -0.107 -0.076 -0.095 0.071
TR O4 -0.115 -0.078 -0.097 -0.035
* 76 1 -C.113 -0.072 -0.095 0.096
* 76 2 -0.043 * -9.001 -0.023 -0.056
* 76 3 -0.034 0.009 -0.014 -0.001
* 76 4 -0.04 0.007 -0.016 -0.044
* 77 1 -0.039 0.006 -0.015 -0.059
* 77 2 -0.039 0.005 -0.013 0.028
* 77 3 -0.032 0.007. -0.007 -0.001
* 77.4 -0.032 0.01 -0.002 0.033
* 78 1 -0.019 0.016 0.008 0.02
* 78 2 -0.003 0.026 0.023 0.032
* 78 3 -0. 0.023 0.024 -0.004
* 78 4 -0.006 0.022 0.027 -0.006
& 79 1 -0.003 0.017 0.027 -0.034
* 79 2 -0.004 0.012 0.026 -0.026
x 79 3 -0.011 0.004 0.019 -0.007
* 79 4, -0.027 -0.001 0.016 -0.004
* 80 1 -0.032 - -0.005 0.012 0.002
* go 2 -0.028 -0.006 0.01 0.012
* 80 3 -0.024 -0.006 0.008 0.021
* B80 4 -0.049 -0.007 0.005 0.006

TABLE 25

GNP (PCER)


4) Mo, + M

The first two elements in equation 4) describe the effect of
changes in domestic interest rates on narrow money which is unambiguously
negative. The first four elements describe the same interest rate effect
on droadly defined money. The effect may be positive or negative.
Perraps this is best seen by referring to the last four elements of the
equation which summarize the interest rate effects on the bond market.
Assuming gross substitution (i.e., Bag + Fee > 0), it appears that if
there are sufficiently strong negative RD effects on both types of bonds,
then the bond market reaction can be negative. This implies that it is
possible for the interest rate effect on the demand for broad money to be
positive.

Should this be the case, then the money market equilibrium
line, MM, in Figures 1 and 2 is negatively, not positively, sloped. In
this case, the output consequences of increased demand for home goods
will be the exact reverse of the conventional case. In the conventional
case, an increase in goods demand causes both interest rates and output
to ‘increase with the rise in the latter, tempering the former. However,
if money-market equilibrium is described by a negative line in home
interest rate-output space, (i.e., the interest rate elasticity of the
demand for money is positive) then the increase in interest rates
associated with the demand shift is large enough to actually result in a
lower level of output after the increase in aggregate demand ._/ Thus
interest rates and output are inversely related to one another when there

is a shift in goods demand .2/ In these circumstances, the conventional


- 40

Property common to most of the reported simulations. More specifically,
seemingly small differences in consumption functions--the inclusion of a
net worth term in Canada, an inflationary term in Japan and a sterling M3
term in the U.K.--were reponsible for a good deal of diversity among the
various country results. In some cases these are features that can be
incorporated into a small theoretical model, in others perhaps they are
best allowed for by incorporating them into the analysis less
rigorously.

One item of particular note is the discovery of the importance
of the precise definition of the monetary aggregate in an open economy.
Apparently differences in the definition of money can, in some
circumstances, be more important than the choice of regime (fixed
aggregates or fixed rates) in stabilizing output.

What has made this project both difficult and challenging is
the absence of a small number of generally accepted statistical measures
of simulation results. We formulated our experiments in terms of wether
a given financial policy would lead to more or less movement in income
than an alternative policy. There are a variety of ways of measuring and
describing the behavior of income over various subperiods of the
simulation. We have tried to be generous with tables of actual values
and a variety of computed statistics and charts while, at the same time,
trying to be clear as to our own interpretation of them. We may
actually have imposed more order than was warranted.

Given the similar structural and conceptual similarities among
the MCM models, there is an amazing amount of diversity in the simulation
properties of the various country models 20/

Finally, it seems appropriate to mention potentially useful


-65-

GROSS NATIONAL PRODUCT

SECURITIES SHOCKS

CANADA PERCENT CHANGE JAPAN PERCENT CHANGE
es ee 79) TT tyrrry1T7 0.05
~, H .
= i \H 1.00 ; 0
Pu
| i + 0.50
: SD nna 0. A 0.05
aa eee . = 0.50 L 4
ee 1.00 0.10
UK PERCENT OOS. GERMANY PERCENT aie
= wee 4 = 4
a Dane fa) a a anna s" )
— 0.05 — 0.01
Joo tdi tii 0.10 Ly tii tiittist} 0.02
1976 1978 1880 1976 1978 1980

setteseeeeeeees FIXED AGGREGATES
------- = FIXED RATES

FIGURE 7


-36-

foreigners. As mentioned earlier, the base constant case is similar to

the fixed-rates case, but it does dominate it.

IVA. The Home Goods-Home Savings Shift

This case is analytically similar to the above case except that
there is no change in import leakages (i.e., external constraint)
associated with the consumption function shift. This means that the
total income effect of a given exogenous shock will be greater, as will
be the interest rate effect. The appreciation of the exchange rate
serves to amplify the income diminishing effects of the shock when M2 is
held constant compared to the (much smaller) appreciation resulting when
Ml is fixed. The contractionary impact of the appreciation is so great
that it is possible for M2 to be an inferior strategy to even a rates-
constant strategy for a real-side shock. And, by the criterion of the
sum of squared deviations, this is exactly what happens here. In
addition, we find that the very interest inelastic-M2 function requires
very large interest rate movements to stabilize M2, as opposed to the
other more narrowly defined measures of money. These relatively large
interest rate movements were also found in the previous shock. It is
worth noting that, except on impact, the fixed rates case dominates the

fixed aggregates model when base is exogenous.

IVB. The Home Bond-Foreign Bond Shock
This is a case where an M2 constant policy is clearly
preferable to a rates-constant policy for all time dimensions except on

impact. There are two questions to be answered here. First, why is MZ a


-68-

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-46-

FOREIGN GNP

FOREIGN GOODS/DOMESTIC GOODS SHOCKS

PERCENT CHANGE

T Thott HT 0.40
4 0.20 CANADA PERCENT CHANGE
‘ pa TTT] 0.10
i f my
0
i J 0.2
us PERCENT CHANGE
' 4300 0.10
1
d
4 4 2.00 UK PERCENT CHANGE
i 0.06
Li 4 1.00 0.04
= Meenas | 9 0.02
GERWANY PERCENT CHANGE +0
= 0.05 0.02

1876 1978 1980

ae pee

seeeeeeeeteeeee = FIXED AGGREGATES
o------ = FIXED RATES

4 Ltt tii) 0.05
1976 1978 1980

FIGURE 4&


a

a

RWNHE RUNES UNE EWN EWN SUN

~88-

DOMESTIC GOODS/SAVINGS SHOCK

FLX. RATE

XZCD, PCER_

CER

oo

CocPDD OAC OCOO OOO OODODD0O00

Ml EXOG

X1CD_PCER_

CER

0.085
0.138
0.15

0.12

0.075
0.026
-0.014
-0.044
-0 064
-0.072
-0.069
-0.066
-0.066
-0.067
-0.061
-0.048
-0.037
-0.025
-0.01

0.902
0.003
-0.004
-0.007
-0.015

TABLE 37

-0.
-0.
-0.
-0.
-0.
-O1

-0

-0.
-0.
-0.
+059
-0.
-0.
-0.
-0.
-0.
-0.
-0.
-0.
-0.
-0.
-0.
-0.
-0.
-0.

-0

BASE EX0G

X6CD_PCER_
CER

co7
019
032
022
013

02g
046
057

CER (PCER)

M2 EXOG

X7CD_PCER_

055°

048
041
034
027
019
012
006
002
004
008
016
021
024

CER

4.317
1.532
0.415
-1.665
-2.133
-2.273
-1.085
0.206
0.687
1.874
1.536
0.953
-0.04
-0.729
71.255
-0.947
0.449
0.137
0.594
0.617
0.334
-0.084
-0.231
-0.372


adjustment. If, however, the authorities strive to maintain both the
money supply and the stock of official reserves (i.e., their holdings of
foreign currency bonds) constant, then the interest rate and the exchange
rate must adjust to equilibrate the altered demands and the unchanged
asset supplies. The increased demand for home-currency assets will, in
the first instance, put downward pressure on the interest rate and tend
to appreciate the exchange rate. The new equilibrium will occur in the
triangle ADC in Figure 2. The appreciation will shift the MM function to
the right, the bond-market function upwards from Bg! and the XX function
to the left. Output will rise if the expansionary effects of lower
interest rates outweigh the contractionary effects of an appreciated
currency. Conversely, if the exchange rate effect is greater, output
will fall. In either case the variability of income is higher with fixed
aggreates than fixed rates.

The following chart was prompted by a similar one found in
Bryant (1980). It summarizes the effect on output in three possible
cases--a shift in demand to foreign goods from home goods, a shift from
home savings to increased consumption of home goods, and a shift in asset
preferences in favor of home-currency bonds. The first two shocks are
depicted in Figure 1, the last in Figure 2. The chart also lists a
column for the foreign country. One of the issues we discuss in this
paper is whether the preferred policy choice from the home country's
point of view is also preferred by foreign countries or whether it
creates a policy conflict. The last column of the chart summarizes this
topic. The deriviation of the results is not shown here but can be found
in Henderson (1982) .4/ The intuition is none the less straight-forward.

Consider the second case in Chart 1, an increase in consumption


II--The Theoretical Underpinnings

The basic issue that we are trying to analyze with the MCM has
its earliest expression in the classic work by Poole (1970). In that
paper, the question of stabilizing interest rates as opposed to monetary
aggregates is analyzed in terms of the source of the exogenous
disturbances. The criterion for preferring one regime to another is
based on the variance of real output. As it turns out, real ou:put is
better insulated from financial shocks (e.g. exogenous shifts in the
supply or demand for money) if interest rates are pegged, rathe~ than if
the money supply is fixed. Similarly, the effect of real-side
disturbances (e.g., shifts in the consumption or investment functions) on
income are less if the aggregate is fixed than if the interest rate is
held constant. In the former case, induced changes in interest rates
serve to moderate the impact on income.

In what follows, we attempt to sketch out the theoretical model
that we use as a reference point. The particular theoretical model that
we describe in this section does not correspond in all respects to the
MCM. We shall occassionally discuss differences between the two in the
next two sections. Never the less, they share many common properties and
a study of a small theoretical model was a useful first step in
developing our intuition about the properties of the large scale MCM. A
rigorous derivation and presentation of the theoretical model can be
found in Henderson (1982). A narrative description of the same type of

model can be found in Bryant (1980, Chapter 21).


~43-

9/ For technical reasons the real-side shocks were scaled differently.
With M2 exogenous, the necessary interest rate changes for the real side
shoc<s were so large the model failed to solve.

10/ while the differences can be pronounced, they are not totally
unexpected. See Haas and Symansky IFDP #214.


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-65-

CANADA FOREIGN GNP FOR THE POUR PERIOD SAMPLE -

XCF

FIX RATE 41 EXOG BASE EXOG
MEAN 0.0029 -0.0014 0.0003
VARIANC)? 0.0002 0.0002 0.0002
SQDEV 0.0005 0.0006 0.0006
ABS 0.0373 0.0387 0.0366

CANADA J?OREIGN GNP FOR THE EIGHT PERIOD SAMPLE -

XCF

PX RATE 41 EXOG BASE EXOG
BEAN -0.0056 -0.0081 -0.0077
VARIANCE 0.0002 0.0002 0.0002
SQDEV 0.0013 0.0017 0.0016
ABS 0.0933 0.0979 0.0994

CANADA VOREIGN GNP FOR THE FULL PERIOD SAMPLE -

XCF

FX RATE 41 EXCG BASE EXOG
MEAN -0.0046 0.0024 0.0015
VARIANCE 0.0001 0.0001 0.0001
SQDEV 0.0017 0.0033 0.0025
ABS 0.159 0.2379 0.2048

TABLE 33

FOREIGN

M2 EXOG

-0.0145
0.0003
0.0016
0.0743

FOREIGN

M2 EXOG

0.0008
0.0006
0.0044
0. 1678

FOREIGN

S2 EXOG

0. 0043
0.0004
0.0095
0.3961

SHOCK

SHOCK

SHOCK


International Finance Discussion Papers

Number 235

December 1983

ALTERNATIVE FINANCIAL STRATEGIES: THE
RESULTS OF SOME POLICY SIMULATIONS
WITH THE MULTI-COUNTRY MODEL

by

Steven A. Symansky
Richard D. Haas

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.


We begin, in Section II, with a short exposition of the
underlying theoretical models. In Section III, we describe and analyze
the simulation results of three different types of shocks on the five MCM
countries. Section IV develops the idea, again with simulations, that
the choice of a monetary aggregate is particularly important in an open
economy. In the final section we summarize our findings and draw some

conclusions.


31-

Unitec! Kingdom
The U.K. is the only country in which the domestic income path

contravenes the theory in all regards. It is clear that holding rates
constant exacerbates income movements rather than eliminates them. The
problem here again is the inclusion of sterling M3 as an argument in the
consumption function. Holding the short-term rate constant opens up a
gap between it and the discount rate in the U.K. model. As a result time
deposits, an M3 component, fall off, consumption drops and income
follows. In addition, consumption declines because of the anomalous
modelling of tax receipts in the U.K.. An increase in intervention is
assumed to cause tax revenue to rise and thus disposable income to fall.
The path of foreign income is in agreement with the theoretical

model.

IV. The Choice of an Aggregate

In the last section we postponed a full explanation of the
rationale for using a narrow definition of money in those simulations
where a monetary aggregate was held constant. In this section we want to
develop this idea by first making some elementary theoretical points and
then examining some simulations that differ only in the measure of money
which is stabilized.

The basic point is easily stated in a closed system, In this
case, with conventional assumptions about the sign of partials in asset
demand functions and the assumption of gross substitutability, it can be
shown t:hat the interest rates and the demand for money are inversely

related. However, in an open economy there is another asset (in addition


-90-

DOMESTIC GOODS/SAVINGS SHOCK ooo REV_COXFAFL (ER)

FIX RATE Ml EXOG BASE EXOG M2 EXOG

NZCD ER --XICD_ ER. X@CD_ER. X7CD_ER_
REV CDYFAFL REV_CDKFAFL RFV CDNFAFL REV CDNFAFL

75 1 -0.199 0. () 0.
732 -0.266 0. ) 0.
753 -0.286 QO. 0 0.
75 4 -0.334 QO. 0 O.
7601 -0. 382 0. 0 QO.
76 2 -0.402 0. 0 oO.
76 3 -9.408 QO. Cc C.
76 4 -6.436 0. ( QO.
71 -0.459 0. to) 6.
772 -0.488 0. 0 0.
77,3 -0.501 0. 0 0.
77,4 -9.529 0. to) 0.
78 1 -0.531 oO. 0 0.
78 2 -0.525 QO. () 0.
78 3 -0.524 0. to 0.
78 4 -0.548 0. 0 0.
79° 1 -0.541 0. 0 oO.
7g 2 -0.556 Q. i) c.

3 -0.568 0. 0 oO.
ty ot -0.623 G. ¢ C.
Bet -0.665 0. te) C.
B02 -0.681 So. ¢ 0.
so 3 -0.68 0. () 0.
30 4 -0.804 QO. () 0.

TABLE 39


-85-

DOMESTIC GOOLS/SAVINGS SHOCK --- CGXP (PCL)

FIX. RATE Ml EXOG BASE EX0G 2 EX0G

XZCD_PCEK_ X1CD_PCER

X6CD_PCER_  X7CD_PCER_

CGRP CGKP CGNP CGNP
* 75 1 0.247 0.228 0.246 -0.596
75 2 0.186 0.167 0.187 0.322
75 3 0.133 0.108 0.136 -0.159
75.40 02169 U.082 Q.11l 0.116
7 1 6.092 6.06 6.082 0.006
* 76 2 0.042 0.06 C041 0.117
* 76 3 0.011 -0.025 0.013. 0.057
* 76 4 -0.004 -0.036 -0. 0.122
* 77 1 -0.011 -0.036 -0.007 0.156
*. 77 2 -0.017 -0.035 -0.011 -0.1
* 77 3 -0.026 -0.033 -0.017 -0.013
* 77 4 -0.044 -0.034 -0.024 -0.1
e786 1 -G.057 -0.038 -0.036 -0.038
* 78 2 -0.08 -0.047. -  -0.054 -0.017
* 76 3 -0.083 ~0.039 0.055 0.052
*. 78 4 -0.098" -0.032 -0.055 0.04
* 7S Y -0.094 -0.022 -0.051 0.085
» 79 2 -0.09} -0.012 -0.046 0.068
* 79 3 -0.082 0.001 -0.035 6.011
> 79 4 -0.095 0.009 -0.027 -O.
* gO 1 -0.091 0.018 -C.017 -0.025
2 -0.079 0.021 -0.011 -0.025
* eG 3 -0.065 0.02 -0.005 -0.038
Bo & -0.093 0.02 6.001 -0.001

TABLE 38


-13-

goods and home savings. Both of these are real shocks and correspond to
the top two rows of Chart 1 in the last section. The third shock is a
financial shock consisting of a shift in asset preferences between home
and foreign currency assets. It corresponds to the bottom row in the
summary chart. The simulations were run over a 24 quarter period. In
the case of the goods shocks, the disturbance was a one quarter change in
demand, while the securities shock was a change in the one quarter flow.
It was felt that these transitory shocks were preferable to permanent
shocks because they do not pose the same conceptual problems for the
long-run expected level of the exchange rate and prices. The two goods
shocks were applied to each of the five MCM countries individually. The
securities shock was run with the four non-U.S. MCM countries; the model
structure would make running the shock on the U.S. a redundant exercise.
Unlike the presentation of classical statistical results, there
is no well-defined manner of presenting simulation results. We have
chosen to use a variety of methods, which all tend to tell the same
story. Following the narrative discussion is a set of charts and tables.
All| of these results are presented in terms of deviations from the
baseline solution. Both home income and a weighted average of foreign
income are plotted for each country. These results, as well as values of
the interest rate, exchange rate, the money supply and intervention are
presented in tabular form. Finally, summary statistics for home and
foreign income (means, variance, squarred deviations, and the sum of
absolute deviations) over four different time horizons are presented,
Before we begin to analyze the individual shocks, it is
important to spell out exactly what we mean by the various rates and

aggregates which we will alternately endogenize and exogenize in the


-55-

GROSS NATIONAL PRODUCT

DOMESTIC GOODS/SAVINGS SHOCKS

JAPAN : PERCENT CHANGE
fT TITTY 2.50
— 2.00 CANADA PERCENT CHANGE
4 1.50 T 1 bitty 1.50
— 1.00
= 1.0
— 0.50 0
a wit 0 — 0.50
L- yj 0.50 .
ena 0
us PERCENT CHANGE .
1 4 zone“) 0.50
L 4
% UK PERCENT CHANGE
= 1.50
4
= 4 1.00
!
1 + 0.50
Van
Vey
rod acoe| 4
fi, 2 L¥PsedestToii
ny 7 1976 1878 1980
ay = 1
- = FIXED AGGREGATES
an = FIXED RATES
Lj 4 Litt 1

1976 1978 1980

FIGURE 5


TABLE

+ ee Re

ph a 2 ee eo a a a s

yun
Uuuw

ee)
DARK

PUNY PWN RUN RWNeE PUNE Rw

-97-

SECURITY SHOCK ---

FIX. RATE

Ml EXOG

XZCS_PCER_° X1CS_PCER_
CER CER

1.851
-101
+641,
+092
-706
+47

+289
-198
+18

-169
+146
+133
+151
187
+22

+23

+238
.253
+228
-156
046
.05

-141
+226

FPESDDDDDDVCODCCD ODOC OKKE ND

i
°

SEXOANDSDDDDDDOCOCOO DOO OOO Oe
1
°

f
°

TABLE 45

BASE EXOG

X6CS_PCER_
CER

1.652
2.131
2.039
1.628
1.212
0.884
0.769
0.748
C.767
0.773
0.757
0.73
0.703
0.675
0.644
0.615
0.589
0.547
0.488
0.313
0.124
-0.037
0.155
-0.213

CER (PCER)

M2 EXoG

X7CS_PCER_
CER

1.663
-1.865
-3.46
3.472

+ 71.648

0.631

1.733

2.15

1.438

0.589
-1.127
-1.966
2.235
-2.077
1.187
-0.265

0.35

0.488
-0.102
0.95
-1,65
-1.694
-1.364
-0.879


-76-

FOREIGN GOODS/DOMESTIC GOODS SHOCK - FGN? (PCER)

> FIX RATE M1 EXOG RASE EXOG - M2 EXOG

TABLE

XZCF_PCER  X1CF_PCER_ X6CF_PCER_ X7CF_PCER

FGNP - FGNP FGNP FGNP

* 75 1 0.018 0.017" 0.017 0.008
* 75 2 0.004 0. 0.002 -0.027
* 75 3 0.002 -0.003 ~0.001 -0.013
* 75 4 -0.013 -0.019 -0.016 -0.026
* 76 1 -0.016 -0.022 -0.02 -0.015
* 76 2 -0.014 -0.017 -0.017 0.009
* 76 3 -0.014 -0.014 -0.016 0.031
* 76 4 -0.012 -0.006 -0.009 0.039
* 771 -0.01 0.002 -0.003 0.041
* 77 2 -0.008 0.008 0.001 0.036
* 77 3 -0.007 0.013 0.005 0.02

* 77 4 -0.007 0.015 0.007 0.005
* 78 1 -0.005 0.016 0.009 -0.008
* 78 2 -0.004 ° 0.016 0.01 -0.012
” 78 3 -0.003 0.014 0.01 -0.011
* 78 4 -0.002 0.013 0.011 -0.002
* 79 1 -0.002 0.012 0.011 0.007
* 79 2 -0.001 0.009 0.01 0.015
* 79 3 -0.001 0.007 - 0.009 0.018
* 79 4 -0.002 0.005 0.008 0.015
* go 1 -0.003 0.002 0.006 0.006
* 80 2 -0.003 -0. 0.003 -0.003
* 80 3 -0.003 -0.003 0.002 -0.013
* 80 4 -0.004 -0.006 0. -0.017

TABLE 26


-37-

superior aggregate to Ml and base, and second, why doesn't a rates-
constant regime dominate a fixed M2 policy in the same way that it does a
fixed-Ml or base policy?

The first question can be answered in a relatively
straightforward fashion. The less interest and exchange rate sensitive
the demand for money is, regardless of its sign, the less responsive
output will be. This is the case in the Canadian model and explains why
M2 is a superior aggregate to Ml or base in the face of a shift in asset
preferences.

The second question concerning the relative superiority of a
constant M2 over a rates constant policy is more puzzling, at least on
the surface. Alternatively stated, why should a policy which presumably
allows absolutely no variation in either the exchange rate or the
interest rate from a financial disturbance have more of an effect on home
output than a policy which does? The answer is two-fold. First, the
rates-constant policy does have output implications via the service
account. This aspect was discussed in the last section. Second, the
relative absence of movement in income when M2 is held constant is due
not to the fact that components of income are largely unaffected by the
large interest and exchange rate cycles but because they tend to offset
one another. A trade and an investment cycle are superimposed on one
another in such a fashion that variations in output are minimized. In
general, this need not be the case. It is not so much related to the use
of M2 as an aggregate, per se, as it is to the particular lags applied to
the interest rate and the exchange rate in the investment and trade
functions respectively.

In sum it seems likely, given the small effects of exchange


-49-

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OE yL*0- at) 982°0- yo LL *

"0 =: 999° 0- ‘oO s88"0- € lf *

"0 = $6S*0- 0 96°0- zl

0 L19°0- - “0 tyort- tT 4L *

‘0 178 "0- ‘0 = €60°I- » OL *

0 =: 990°I- 0 n9E°1- € 9 *

“0 649° I- az) £8s*1- z 9L
OLE” z- ‘0 — SBB*T- 1 9L »#

‘0 Tegs*Z- ‘O)) €€LI- > SL»

‘O- 9€E°E- ‘0 ST9°T- € sl

‘OB 1z"E- .70 Lytt- z SL

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> Calva) (90v)  Calvu) (yov)

a1UVL

sa NVdVE

_¥AOOHS SONTAVS/Sd009 NOIaU0d


TABLE

ee ee ee ee

BWNP SUN RUNNY RUN PRUNE PWN

-79-

FOREIGN GOODS/DONESTIC GOONS SHOCK

FIN RATE M1 EXOG = BASE EXOG ~=-M2._: EXOG.
X2CF_PCER_ XICF_PCER_ X6CTM PCER_ X7CF_PCER_
oul cM od

-0.167 0. -0.176 3.112
-0.174 0. -0.172 0.223
-0.213 0. -0.197 1,228
-0.233 0. -0.177 -0.103
0.246 0. 0.164 -0.074
-0.224 0. -0.118 “1.455
-0.219 0. -0.13 -0.702
~0.215 a. -0.131 ~0.339
0.2 0. -0.123 -0.138
-0.199 9. -0.119 1.08
-0.198 a. -0.112 0.803
-0.181 0. 0.091 0.756
-0.152 Q. ~0.066 9.191
0.13 o. -0.041 0.028
~0.113 0. -0.023 0.503
-0.1 0. -0.007 -0.323
~0.082 0. 0.01 -0.337
0.072 a 0.024 -0.022
-0.075 0. 0.026 0.304
-0.085 0. 0.028 0.372
-0.084 C. 0.032 0.211
-0.087 0. 0.032 0.055
-0.093 0. 0.025 0.027
-0.117 0. 0.021 -0.2

TABLE 29

Ml (PCER)


TALLE

Ae EME HEE HR EH HM EEE HEE EH ED

Pr

Whee PUNY

(Se Ce Sa ed

-89-

DOMESTIC GOOLS/SAVINGS SHOCK

FIX. RATE

M1 EXOG

BASE Ex0G

N2

Chl (PCER)

EXOG

XZCD_PCER_ NICD PCER_ X6CP_PCER_  X7CE_PCER_
cri

Cul

0.207
0.292
0.367
0.357
0.341
0.334
0.311
0.26

G.202
0.161
0.127

0.068

0.012
-G.05
-0.096
-0.141
-0.177
0.222
-0.246
-G.277
-0.3
79.316
-9.308
-5.32

cx

ce

oO. 0.191
oO. 0.268
oO. 0.336
0. 0.28

0. 0.241
Cc. 0.212
0. 0.219
0. 0.19

oO. 0.151
Oo. 0.124
0. 0.101
0. 0.C61
QO. 0.017
oO. -0.028
o. -0.057
0. -0.677
CQ. + -C.099
Q. -0.122
QO. -G.124
0. -0.197
i) -0.097
0 -9.087
2 -0.065
C -9.046
TABLE 38

-8.667
0.c0°
-1.598
2.219
1.929
3.114
1.251
0.023
0.015
-2.796
1.554
-1.351
6.011
C.645
1.62
0.884
0.549
-0.112
-0.755
-0.663
-0.298
© .267
0.203
0.575


-44-

Bibliography

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

Haas, Richard and Steven Symansky, “Assessing Dynamic Properties of the
MCM: A Simulation Approach," International Finance Discussion
Paper, No. 214, Federal Reserve Board, Washington, D.C., 1983.

Henderson, Dale W., “The Role of Intervention Policy in Open Economy
Financial Policy: A Macroeconomic Perspective," International
Finance Discussion Paper, 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, Iowa 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, 1983.

Jonson, P.D., and R.G. Trevor, "Monetary Rules: A Preliminary Analysis,"
The Economic Record, Vol. 57, No. 157, 1981.

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

Quantitative Studies, "FRB Multicountry Model," Federal Reserve Board,
Washington, D.C., 1983.

Stevens, Guy V.G., et. al., U.S. Economy in an Interdependent World: A

Multicountry Model, Federal Reserve Board, Washington, D.C.
T984.



-2-

economy. The answer, equally simply put, is that it depends on the
source of the initial disturbance: output is best insulated from
disturbances originating in the home goods market by holding aggrecates
(i.e., money and official reserves) constant, while financial
disturbances are best dealt with by fixing interest and exchange rates.2/
Furthermore, if either a goods market disturbance or an asset market
disturbance involves the foreign country as well as the home country,
then these theoretical models suggest that there is no policy conflict
between the home and foreign authorities; the same policy prescription is
appropriate for both countries. However, cases of policy conflict can
occur if the shock is confined to one country. In some cases it can be
shown that the optimal policy for one country is inimical to the foreign
economy.

A number of results emerge from the simulations. In some
instances they point out areas of the econometric model that suggest
themselves for further development, such as the specification of the
consumption function. In other cases, the simulations draw attention to
items that are frequently abstracted from in theoretical models: factors
that can not be safely ignored by policy makers. Three of these factors
are the effect that changing the indebtedness has on balance of payments
through service flows, third country effects, and the richer dynamics
included in large scale models. Finally, and of some policy interest, is
the discovery in the simulations of the added importance of the
definition of money in an open economy. Specifically, the existance of
foreign currency denominated bonds can potentially alter the interest
rate elasticity of the demand for broadly defined money enough to .e a
concern for policy makers who are considering an aggregates-constant

policy.


-67-

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CANADA FOREIGN GNP FOR THE FOUR PERIOD SAMPLE -

xcs

FX RATE
MEAN 0.0453
VARBIABCE 0.0008
SQDEV 0.0106
ABS 0.1812

CAWADA FOREIGN GNP FOR THE EIGHT PERIOD SAMPLE -

xcs

FX RATE
MEAN -0.0623
VARIANCE 0.0007
SQDEV 0.0358
ABS 0.4985

CANADA FOREIGN GNP FOR THE Fi

xcs

FX RATE
MEAN 0.0312
VARIANCE 0.0126
SQDEV 0.3138
ABS

2.1682

-102-

M1 EXOG

0.0077
0.0006
0.0021
0. 0803

M1 BXOG

-0. 0383
0.0032
0.0344
0.8174

BASE EBXOG

0.0088
0.0004
0.0016
0.071

BASE EX0G

-0.0345
0.003
0.0303
0.3821

ULL PERIOD SASPLE -

Bl EXOG

-0. 0648
0.0037
0.1851
1.6655

BASE EXOG

~-0.0888
0.0044
0.2906
2.2371

TABLE 49

SECURITY

B2 EXOG

-0. 0446
0.0046
0.0217
0. 2339

SECURITY

N2 EXOG

-0.0528
0.0037
0.0484
0.5146

SECURITY

M2 EXOG

-0.0001
0.0043
0.0991
1.2675

SHOCK

SHOCK

SHOCK


-27-

relative supplies of assets only at different relative prices, then the
exchange rate and interest rates must adjust with noticable effects on
activity.

This simulation experiment corresponds to the description in
the final row of Table 1. Assuming aggregates are constant, there will
be downward pressure on the home interest rate and upward pressure on the
external value of the home currency. The affect on income is ambiguous--
the lower interest rates should increase output, the appreciated home
currency should lower it. There is no motivation in the theoretical
models for output to change if rates are held constant. In this case,
the central bank has simply accommodated the changed preferences of the
public, The classic Poole results hold and there is no policy conflict
between nations.

We turn to the four country simulations. (There is no separate
U.S. simulation. It would contain no new information, being simply the

weighted mirror image of the four simulations that are presented.)

Initially, Canadian income is best stabilized by holding rates
constant, as is expected. However, there is clearly a problem with this
policy over the second half of the simulation. The oft neglected service
account is at the root of this. Part of the shock involves increasing
official holdings of U.S. bonds. This stock increase eventually has
substantial, and continuing, foreign investment receipt implications on
the service account. This is one aspect of the model which is sensitive
to levels of the baseline variables, not just changes in them. In

particular, the export surplus, and hence income, would have been less,


-23-

its subsequent effect on the consumption function (exactly as described
in he Canadian case) is a principle reason for the overshooting of
income. A second reason is the effect of higher domestic prices on net
exports and the subsequent effect of this variable in the dynamics of the
income determination process.

The information describing the path of foreign income is more
mixed, On impact, income abroad conforms to our priors, but thereafter
it is less clear that there is a policy conflict. What is clear is that
endogenizing the rates leads to a shorter income cycle though not
necessarily one larger in amplitude.

The increase in the short-term interest rate merits some
coment. The impact value is a good deal less than in the second
quarter. This reflects the role of free reserves in the interest-rate
equation. (Actually, the equation is more accurately described as a
demand for free reserves function normalized on the interest rate.) The
coefficient on lagged free reserves is slightly larger than its
contemporaneous value. This, coupled with the fact that free reserves
may be required to move a great deal to stabilize central bank money,
means that the dynamics of the interest rate can be complex.

The exchange rate appreciates on impact, as expected, but by
the third quarter depreciates below the baseline. This reflects the
important role played by the lagged cumulative current account as an
expectational variable. The expansion has led to deficits, which have in
turn caused speculators to position themselves for a downward adjustment
in the exchange, rate and, in so doing, cause a depreciation to come
about.

When rates are fixed, the lagged cumulated current account


35-
similar to the fixed-rates policy. In sum, we have no prior notion that
exogenizing either base or M2 is necessarily preferable to a rates-

constant policy.

The Home Goods-Foreign Goods Shock

This is the case where a fixed aggregate should dominate a
fixed rate strategy for reasons discussed earlier. This statement is
true as long as we restrict our definition to M1 or base. However, the
situation changes when M2 is entertained as a possible definition. Of
the three measures, it is the most interest inelastic (albeit with a
"perverse" sign) and this is enough to minimize the disturbance to real
output. This need not necessarily be the case. If the income
multiplier effect is strong, then the interest and exchange rate effects
will be also. Here the shock involves not only a shift in the
consumption function, but an increase in imports. Thus the net effect on
income and other variables is less than it would be if the consumption
function alone shifted. We shall return to this point in discussing the
next simulation.

Thus, while fixing M2 does best stabilize income in this case.
It is associated with extreme variation in the interest rate and exchange
rate. In other words, M2 stabilizes output despite, not because of, the
exchange rate effects. That these exchange rates effects can be
destabilizing to income can be verified by examining foreign income.
Here the high variability in income outside Canada can be traced to the
volatility of the exchange rate. There is a clear policy conflict here.
M2 is preferred from a Canadian perspective while, (except on impact) any

other measure of money or a rates-constant policy would be preferred ‘by


-59-

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TABI.E

Se ee ee ee ee

BPWNF RE WNE RUN BWNY RUN RUN

-7]-

FOREIGN GOODS/DOMESTIC GOODS SHOCK

RS (ER)

FIX RATE Ml EXOG BASE EXOG ~=—M2._ EXOG

XZCF_ER_CRS X1CF_ER_CRS X6CF_ER CRS X7CF_ER CRS
0. -0:13 0.004 2.497
0. -0.06 -0..004 1.052
0. -0.061 -0.006 -0.559
0. -0.059 -0.026 0.622
0. ~0.054 -0.029 0.144
0. 0.01 -0.024 1.067
0. -0.008 0.002 0.042
0. -0.01 0.003 0.145
0. -0.008 0.004 -0.135
0. -0.008 0.002 -0.872
0. -0.007 0.001 -0.203
0. -0.002 -0. -0.186
0. 0.005 -0.001 0.219
0. 0.012 -0. 0.146
0. 0.01 Q. 0.406
0. 0.0} 0.001 0.068
0. 0.012 0.001 0.081
0. 0.009 0.002 -0.163
0. 0.001 0.001 -0.253
0. 0. 0.003 -0.153
0. 0.003 0.004 0.005
0. -0. 0.004 0.065
0. -0.005 0.004 0.027
0. 0.004 0.003 0.138

TABLE 27


-29-

the model. Ml moves in harmony with income. Intervention is not only
large on impact, as expected, but stays relatively large throughout the
simulation, Normally, the cumulated basic balance serves as an
expectational variable in the exchange-rate process. However, when the
exchange rate is fixed, the same speculative forces that lead to an
appreciation give rise to capital inflows and increases in official

reserves.

Germany
Germany is the one country which comes the closest to
satisfying all of the conditions implied by the theory. When rates are
held constant, there is almost no variation in output. The small
deviations that are measurable can be traced to the service account.
The impact effect of both the exchange rate and the interest
rate is small relative to the delayed effect. It is only after two
quarters of simulation that the effect on rates is noticably different

from the fixed-rates case.

Jagan
Japan is the one country where an aggregates-constant policy
causes income to rise on impact. This fits within the range of
theoretically possible outcomes, but it does raise the question of how
the specification in Japan differs from the other MCM countries. The
answer is found in an aspect of the consumption function already
discussed. Specifically, the asset preference shift leads to a home
currency appreciation and a lower inflation rate. This, in the Japanese

model alone, leads to less savings and higher income. Eventually though,


~95-

SECURITIES SHOCK _ FGNP (PCER)

FIX RATE NL EXOG BASE EXOG M2 EXOG

TATLE

XZCS PCER_ X1CS_PCER_ Xf#CS_PCER x7cS PCER_

FGNP FONP FGNP ~~ FGEP
«78 1 -0.009 0.029 0.028 9.028
* 78 2 -0.039 0.026 0.023: -0.005
e 78 3 -0.059 0.001 0.002 -9.084
* 75 4 -0.074 -0.025 -0.018 -0.118
* 761 -0.082 -0.044 -0.035 -0.126
* 76 2 -0.08 -0.069 -0.06 -0.093
* 76 3 -0.082 -0.098 -0.091 -0.043
* 76 4 -0.073 -0.127 -0.124 0.018
* 77 1 -0..065 -0.142 -0.148 0.074
* 77 2 -0.053 -0.152 -0.165 0.107
* 77 3 -0.047 -0.159 -0.18° 0.11
* 7) b -0.029 ~0.156 -0.187 0.08
* 71 -0.018 -0.144 -0.184 9.039
* 78 2 0.001 -0.121 -0.167 -0.008
* 733 0.015 -0.1 -0.151 -0.045
* 73 4 - 0.059 -0.079 -0.137 -0.054
* 7901 0.082 -0.055 -0.114 0.044
* 77 2 0.108 -0.033 -0.091 -0.015
* 79 3 0.128 -0.021 -0.077 0.018
* 73 4 0.182 -0.013 -0.064 0.041
* 80 1 9.214 -0.019 -0.063 0.043
* 80 2 U.219 -0.014 -0.048 0.043
* Bn 3 0.203 -0.017 -0.042 0.027
* 80 4 0.246 -0.024 -0.038 0.006

TABLE 43


-10-

SUMMARY OF SHORT-RUN OUTPUT EFFECTS
FROM VARIOUS EXOGENOUS DISTURBANCES

TYPE OF AT HOME ABROAD POLICY
DISTURBANCE Rates Fixed Aggregates fixed Rates Fixed Aggregates fixed CONFLICT?
In My pt M4 re
fo Ry et Rt et NO
decrease in demand for Y ++ Y Y +t Yt
Income falls more in the fixed Income rises less in the fixed both countries

home goods.

prefer to fix

rate case. There is no decrease rate case. The increase in de-
in the interest rate or deprecia- |mand is partially offset by inter-|aggregates
tion to moderate aggregate demand. jest rate increases and appreci-
ation of the foreign currency.
Increase in demand for Mt rt M+ rt YES
home goods equal to R+ e+ Rt e+ home country
decrease in savings. Y ++ Yt Yt Y +t prefers fixing

An increase in interest rates and
appreciation of the home currency
moderate demand in the aggregates
fixed case. This income changes
less there.

Variable exchange rate exacer-
bates the export stimulus

aggregates, the
foreign country
prefers fixing
rates.

Increase in demand for
home currency bonds
equal to decrease in
demand for foreign
currency bonds.

A (unchanged) ry
R+ ey
Y (unchanged) Y+

Income is unaffected if the
authorities stabilize rates.

M (unchanged) ry
R +
Y (unchanged) Y

Income may increase or decrease
if aggregates are stabilized.
The interest and exchange rates
work at cross purposes.

NO

toth countries
prefer to fix
rates.

= Money
= Foreign Exchange Reserves
= Output

e
r

= exchange rate (home currency/foreign currency)
= interest rate



TABLE

ee ee ee ee

PUNY RWN YP ER WN EF RWN EP EWNY BUNY

-78-

FOREIGN GOODS/DOMESTIC GOODS SHOCK -_

FIX RATE Ml EXOG BASE EXOG = M2._- EXOG

XZCF_PCER_ X1CF_PCER_ X6CF_PCER_ X7CF_PCER_

CER CER CER CER

0. 0.146 -0.062 -1.625
0. -0.191 -0.081 -0.796
a. -0.185 -0.079 -0.604
0. -0.159 -0.078 0.082
0. -0.13 -0.074 0.332
0. -0.081 -0.066 0.936
0. 0.046 -0.041 0.688
0. ~0.024 -0.02 0.231
0. 0.015 -0.005 -0.1
0. -0.013 0.002 -0.724
0. -0.012 0.003 -0.759
0. “0.011 0.001 -0.598
0. 0.008 -0.002 -0.187
0. -0.004 .  -0.007 0.093
0. -0.005 -0.012 0.389
0. -0.009 -0.017 0.361
0. -0.012 -0.021 0.259
0. -0.016 -0.023 0.018
Q. -0.024 -0.025 -0.226
0. -0.029 -0.025 -0.314
0. -0.03 -0.025 -0.227
0. -0.027 -0.022 -0.08
0. -0.026 -0.02 0.004
0. -0.023 -0.019 0.11

TABLE 28

ER (PCER)


~84-

DOMESTIC GOODS/SAVINGS

CANADIAN SHOCKS

GNP PERCENT CHANGE INTEREST RATE ABSOLUTE CHANGE
TUTPTTT TTT . q TUT TTT TTT
; i} : ] TUTTPTTT] 5 ; 5 r TOT TUT pry try) 6.00
. . \
hy tr — 4.00
1 ie) \
! - rr A — 2.00
TT 0.20 H a \ ec. ‘
H vi x H peer] vs 0
. 4. viv
rr 0.400 HY 4 2.00
0.60 !
BASE ABSOLUTE CHANGE EXCHANGE RATE PERCENT CHANGE
re — 4.00
rn :
a 1
Hin A wk ——"| + rc n — 2.00
pA ee a = Q \ mm
i Vv ‘ / \ -.
1 v eee \ aS 0
1 = \ aT ws ‘:
: po
H 20 = sl - 2.00
Mt PERCENT CHANGE FOREIGN GNP PERCENT CHANGE
A : ry | 0.10
aan = 2.00 rm
U \ yoy a 6 : ] \
Ki re aa 0
1 Vv — 2.00 \
t
Le 4 4.00 ant
! _ \
Tr 6.00 ned -| 0.10
Top titi tit} 8-08 [oe ee RO
1976 1878 1980

1976 1978 1980

FIXED RATE

M1 EXOGENOUS
BASE EXOGENOUS
M2 EXOGENOUS

FIGURE 10


elasticity of the demand for home money is higher, absolutely, than the
income elasticity in the demand for home currency bonds. It is further
assumed that residents may hold the bonds of both countries but only hold
the currency of their own country. These factors imply a bond market
equilibrium, BB in Figure 1, with a flatter slope than the money-market
equilibrium line. The supply of bonds, an outside asset, is taken to be
exogenous.

The natural inclination of many readers may be to view Figure 1
as a conventional IS-LM-BP diagram. The parallels are strong and in
analyzing many questions no harm would be done by interchanging the two
diagrams. However, they are not identical and it is useful to spell out
how they differ. First, the BB line is not the same as the external
constraint facing the economy. It does not incorporate export and import
functions. It is not a difficult task to incorporate these
considerations and, over a wide range of import propensities and asset
substitutability parameters, the results are unlikely to be qualitatively
affected. Second, the textbook IS-LM-BP diagram treats the price level
as exogenous whereas Figure 1 does not. In the diagram, the price level
has been solved for by using the aggregate supply relationship that holds
when the nominal wage rate is consistent with full employment. Finally,
the traditional model is an end-of-period balancing model, whereas the
model described in Figure 1 is a beginning-of-period model. This means,
for example, that any wealth changes produced by a current account
imbalance affect the system at the beginning of the next period, not at
the end of the current period.

Consider the shift of the goods-market equilibrium, from XX to

ree in Figure 1. Such a shift might reflect either a shift in a


CANADA DOMESTIC GNP FOR THE FOUR PERIOD SAMPLE -

XCP

MEAN »
VARIANCE
SQDEV

ABS

CANADA DOMESTIC GNP FOR THE EIGHT PERIOD SAMPLE >.

XCF

MEAN
VARIANCE

SQDEV
ABS

CAKADA DCMESTIC GNP FOR THE FULL PERIOD SAMPLE -

XCF

MEAN
VARIANCE
SQDEV
ABS

FX RATE

-0.1309
0.0013
0.0723
0.5236

FX RATE

~0.0942
0.0027

0.0897
0.7536

PX RATE

-0.0458
0.0022
0.1008
1.1003

~82-

41 ~EXOG

70.1045
0.0017
0.0488
0.418

A1 EXOG

-0.0594
0.0037

0.0542
0.508

81 EXOG

-0.0147
0.0023
0.0569
0.6818

TABLE 32

BASE EXOG

-0.1207
0.0017
0.0633
0.4826

BASE EXOG

-0.0788
0.0034

0.0732
0.6302

BASE EXxOG

70.0193
0.003
0.0779
0.8722

FOREIGN

2 EXOG
0.0065
0.0129

0.0389
0. 3616

FOREIGN

M2 EXOG

~-0.0086
0.0062

0. 044
0. 4682

FOREIGN

82 EXxOG

-0.0023
0.0023
0. 0533
0.764

SHOCK

SHOCK

SHOCK


-93-

CANADIAN SECURITIES SHOCKS

eNP PERCENT CHANGE INTEREST RATE ABSOLUTE CHANGE
DT _TimT1M7] 2.00 TAL TT
- 1.50 - ears FR 0
— os 4 t SS
. “000 + 2.00
i — 0.50 \ /
+ 4
ie) ni = 4.00
0.50 i
1.00 mi — 6.00
BASE ABSOLUTE CHANGE EXCHANGE RATE PERCENT CHANGE
rN 25 2.00
MA a asd 6 1.00
0
i 72s 1.00
- = 50 2.00
3.00
75
Mt PERCENT CHANGE FOREIGN GNP PERCENT ‘CHANGE
ES = 8.00 L. 1 0.20
oy
i \ os a 6.00 a iQ | o.10
fF i \ / 34.00 . ’
! \ ! 7 - i / 0
He \Y / ~ = 2.00 \ “a | -
<= 9 Ars 0.10
Lt Pettitt 2.00 Lt stv tii 0.20
1976 19878 1980 1976 1978 i980
FIXED RATE

Mi EXOGENOUS
BASE EXOGENOUS
W2 EXOGENOUS

FIGURE 11


-61-

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967°0- 967" 0-
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TL°0- S69" I-
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£9L°€ Loee'
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sa

8ot’o Leto
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€Zz°0- 780°0
8110 980°0
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KKK EK KK KEKE RR RK KKK KE KK

HTUVL


-19-

alternative strategies shows that the response is very nearly the same in
both cases. The simulation results in Table 7 show, by mean and squared
deviation criteria, that the properties of the theoretical model are
violated for each and every time period.

The explanation of this puzzlement lies in the specification of
the consumption function coupled with the choice of aggregates stabilized
by the authorities. In the U.K., sterling M3 enters directly into the
corsumption functions. In the aggregates baseline simulation Ml is
fixed, and interest rates must fall to hold M1 at control because income
falls dramatically on impact. As interest rates fall, time deposits and
hence M3, and ultimately the consumption function, shift downward.

The theoretical results might ‘have held if the simulation had fixed M3,
or if M3 did not appear in the consumption function o/

In any event, the similar income paths suggest a very flat
implicit LM function in the U.K. monetary sector. In this case, there
is very little to choose between a rates-constant and an aggregates-
corstant strategy.

Were it not for the buffering effect of inventories the
difference between the two paths would be more pronounced. The inventory
equation is responsible for another feature of the simulations--their
extreme chopiness. The lagged coefficient on inventory investment is
-.7. Thus, once set in motion it causes income to follow a pattern of
damped, one period oscillations.

By virtually all of the criteria presented in Table 8, foreign
income behaves as expected in the U.K.. The four potential policy
variables (i.e., the two rates and the two aggregates) seem to conform to

the theoretical paradigm. The impact and short-run behavior in all cases


-48-

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L1T°0-
60T"0-

t2Z°0-
TL£Z°0-
see*o-
8L€°0-
8ey°0-

99°0-
80S°0-
$97°0-
1SS°0-
€£9°0-
9€L°0-

£979°0-
sts°0-
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Calva)

NVdVE

NOTgYOd

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a)
“0
“0
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“UO
°0
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“0
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°0
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(99v)

MTANM ZH NMTAANMS

ANNAN

ANMS

64
BL

82
BL
BL
dL
Le

SL
SZ
SZ
SL

RR KK KK

*«*

KKK KK

eK KEK EK

ee RK

aldvi


TABLE

thot OF

ee ee ee

BWNP RUNNY RWNP BRUNE RW BRUNE

-Bi-

FOREIGN GOODS/DONESTIC GOODS SHOCK ---
FIX RATE Ml EXOG = BASE EXOG ~=—M2._ EXOG
XZCF_ER_-YICF_ER_—-X6CF_ER X7CF_ER
CBASE CBASE CBASE CRASE ~

-0.788 0.436 0. 8.375
-0.308 0.172 0. -3.674
0.396 0.158 0. 1.647
0.373 ~0.085 0. 2.017
0.51 0.098 0. 1.549
0.52 0.084 0. -2.312
0.428 0.058 0. 0.267
0.494 0.064 oO. 0.519
0.569 0.051 0. 0.224
0.633 0.043 0. 2.867
0.677 0.03 0. 0.505
0.706 0.014 0. 0.596
0.744 -0.015 0. -0.747
6.776 -0..042 0. -0.349
0.778 -0.031 0. 1.408
0.779 -0.037 0. -0.121
0.849 -0.047 0. -0.307
0.918, -0.031 0. 0.608
0.975 0.002 0. 0.917
1.807 0.001 O. 0.595
1.366 -0.002 0. 0.375
1.922 0.004 0. -0.376
1.727 0.003 0. 0.281
2.102 0.001 0. -0.385

TABLE 31

BASE (ER)


-14-

simulations. The exchange rate is the bilateral U.S. dollar rate except
in the U.S. where it is the trade weighted value of the dollar. The
interest rate is the representative short-term interest rate. In the
U.S. and Germany, this is the 30 day treasury bill rate, in Japan it is
the gensaki rate. The finance company rate is used in Canada, while the
local authority rate is used in the U.K. Official foreign exchange
reserves are defined as the cummulated sum of earned foreign exchange
reserves. They do not include capital gains or SDR allocations.

The definition of the stock of money is far less obvious than
the definition of the above variables. Presumably in the real world, and
certainly in the MCM, the authorities can choose to stabilize any
collection of monetary assets either broadly or narrowly defined. The
central monetary aggregate in the prototype MCM country is unborrowed
reserves. The elasticity of this function is governed by the demard by
the banking system's demand for free reserves. As an empirical matter,
the interest rate elasticity tends to be very high in the MCM. In terms
of the IS-LM framework, this implies that the LM curve is quite flat.
Consequently, it is no surprise that there is not a great deal of
difference between the fixed-rates case and the case where unborrowed
reserves are fixed.

We have, therefore, opted not to stabilize unborrowed reserves
in our simulations. Rather we have chosen to stabilize Ml in the U.S.,
Canada, Japan, and the U.K., and central bank money in Germany. This has
the dual advantage of conforming much more closely to actual central bank
behavior as well as providing results which are much more interest‘ng to
discuss. This theme, the choice of an appropriate monetary aggregate, is

one we will return to again in the next section.


-56-

FOREIGN GNP

DOMESTIC GOODS/SAVINGS SHOCKS

JAPAN PERCENT CHANGE
TT TIT 0.20
| CANADA PERCENT CHANGE
0.10 ee
a a 0.10
Slo] 8 ry 4
= 8. ” eee uf 0
0.10 |
us - PERCENT O40 | 0. 10 ;
| 0.20 UK PERCENT CHANGE
Al 4 0.02
0
~ Ve A _
tee! 0.20 : yo ‘ 0
PERCENT CHANGE Siittcidl _
7 0.05 Lot tititititiit! 0.02
= 1976 1978 1980
at eaee ‘ 0 . . :
. / ease = FIXED AGGREGATES
— /4 = FIXED RATES
Met” ‘\ J
Lott tefiti) 0.05

1976 1978 1980

FIGURE 6


-4a-

We begin by focusing on three markets; the goods market, the
money market and the home bonds market. Aggregate demand is a positive
function of income in the home and in the foreign country, real interest
rates in both countries, and relative prices as well as the level of the
exchange rate and domestic prices. The latter two variables have "Pigou"
type effects. A drop in prices or a depreciation of the home currency
increases the value of wealth, measured in the home currency, and thus
increases consumption.2/ The exchange rate enters the relative price
variable directly and, as an element of price expectations, it also
appears in the real interest rate term. The supply of output derives its
elasticity from price surprises. Labor agrees to a one period nominal
wage, which without price prediction errors, would result in ful
employment output. If labor underforecasts the price level then the rea
wage will be low enough for output to exceed its full-employment level.
The loci of goods market equilibrium in nominal interest-real output
space is shown in Fig. 1 as line XX.

Money market equilibrium is depicted by loci MM. The demand
for money is a function of income, home prices, the price of the foreign
goods expressed in the home currency, the home (nominal) interest rate
and the foreign interest rate adjusted for exchange rate expectations.
Thus, the exchange rate enters both as a transactions variable and as a
rate-of-return variable. The supply of money is taken to be exogenous.

The demand for home currency bonds is a function of the same
variables as the demand for money functions in the two countries (as is
the demand for foreign currency assets, the omitted market in this
medel). Additionally, it is posited that the interest rate elasticity on

heme bonds is higher than that of home currency, and that the income


€2 J1avl

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-73-

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OLE oO tzit°o €000°0 €6Z0°0 SLLZ“°0 £260°0 csze"k 6S0L°%
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sav
Aaads
AONVIGVA
NVaR

sav
agqods
FORVIBVA
RYau

sav
azanic

FORVIGTA
avaa


-28-

had the level of U.S. interest rates not been as high as they were in
1979 and 1980. In the aggregates-constant policy, reserves don't change
and the service account cannot provide the impetus for growth in income.
In this case, the exchange rate effects dominate the interest rate
effects and income falls. This is generally the pattern, at least in the
short run, in the other countries.

By and large, foreign income does not totally conform to our
theory and thus a conflict between the home and foreign governments
occurs. U.S. income dominates foreign income, as defined from a
Canadian standpoint. In the short run the drop in Canadian inccme is
reflected, via conventional trade linkages, in the U.S. income. As
Canadian income becomes increasingly positive (because of the atove
mentioned service account effect), so it also does in the U.S. where it
is amplified by the vigorous multiplier/accelerator found in the U.S.
model. It appears that both the high level and the high variance of
income abroad is just an echo of the home income path and if the service
account item were smaller, then the simulations would conform mcre
closely to the theoretical results.

The pattern with variable rates is largely as expected. The
small impact U.S. dollar depreciation has, on balance, an expansionary
effect on U.S. income initally, though lower rates of Canadian ectivity
ultimately are reflected in the income paths of its trading partners.
Canadian interest rates fall on impact, as expected, but owing to lags in
the elements of the Ml function, and the small impact effect of the
exchange rate on income and prices, it is not until the second cuarter
that the decline is pronounced. The exchange rate appreciates though the

delayed effect is larger than the initial appreciation because cf lags in


-71-

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CH39d) TW --- MOGHS = ALIBNINS


-64-

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-2]-

understood and easily explained.

IIIB. The Home Goods/Home Savings Shock

The theoretical model suggests that this shock will lead to a
policy conflict. The home countries can best dampen the effects of the
shift in its consumption function by fixing aggregates--the classic Poole
solution. The foreign countries will be disturbed more by the change in
the exchange rate which accompanies the home country's optimal policy
than if rates were fixed. Thus, the preferred policies of the two
countries conflict with one another: The home country wants a floating
exchange rate regime, the foreign country prefers a fixed-rate regime.

To investigate this issue, we shifted the consumption function
upwards by the same amount as the shock in the first case--5% of domestic
consumption. The shock is not quite symmetrical with the home
goods/foreign goods shock mentioned above. They differ not only in
direction, but also in the fact that in this case there is no exogenous
shift in imports, only a shift in the consumption function. Because
there is no direct disturbance to the balance of payments, the difference
between exchange rate regimes is lessened. This is certainly not to say,
however, that there are not significant and important differences between
the alternative policy strategies. We will therefore, as before, analyze

the results on a country by country basis.

Canada
In Canada, the conventional wisdom holds and fixing aggregates
does tend to buffer income more by inducing stabilizing movements in the

rates. This is particularly true with the passage of time. Income


-38-

rate movement on the demand for monetary assets, that fixing M2 will
stabilize output better than more narrowly defined aggregates though this
will involve substantial interest and exchange rate variation. However,
there is no theoretical presumption that it should dominate a fixed rate
regime, though it may do so if there are relatively complex lag

structures in the real side of the model.


-58-

Ol aTdVvL

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(aLvu) (99v) Cava) (99v) (ava) (99v) Cava) (99v) Calva) (99V)

a

TUL

xn _ oo. YavNVa > ANVRUZO : sn Nvave

(ugdd) dNOd > ==> NOOHS SONIAVS/SG009 IILSAWOG


-24-

plays an important role in determining the quantity of intervention.
The second quarter effects surpass the impact effects for central bank
Money. Lags on consumption and income in the currency and demand deposit

equations, respectively, account for this.

Japan

The econometric model results are in accordance with our prior
expectations. Holding aggregates constant is the preferred strategy,
though there is not a great deal of difference between the two policies.
There is not the overshooting of income in the aggregates-constant case
which we observed when there was a shift in preferences from home goods
to foreign goods. This is because the effect on the current account, and
hence exchange rate expectations, is milder when imports are not directly
affected in the shock. In addition, domestic spending is not very
sensitive to changes in the interest rate, especially in the short run.
The discussion of the "chopiness" of income in the Japanese home
goods/foreign goods shift discussed above applies here. It is traceable
to changed official indebtedness and seasonality in the service
accounts.

Foreign income is uniformly contrary to the predictions of the
theoretical model. Thus, in this case, the MCM suggests that the
potential for policy conflict is more imagined than real. A major part
of the explanation for this centers on the effect of third currencies.
For example, our theory suggests the Yen should appreciate with respect
to the foreign currency and it does in fact appreciate against all
currencies. However, the change is not proportional and the U.S. dollar

rises relative to the DM and pound sterling. Since the income multiplier


-91-

CANADA DOMESTIC GNP FOR THE FOUR PERIOD SAMPLE — DOMESTIC SHOCK

xcD

PX RATE 81 EXOG BASE EXOG M2 EXOG
MEAN 0.1689 0. 1465 0.17 -0.0793
VARIANCE 0.0038 0.0042 0.0036 0. 1576
SQDEV * 0.1254 0. 0986 0.1265 0.498
ABS . 0.6756 0.586 0.6802 1. 1932

CANADA DOMESTIC GNP FOR THE EIGHT PERIOD SAMPLE - DOMESTIC SHOCK

xcpD

FX RATE M1 EXOG BASE EXOG M2 EXOG
MEAN 0.102 0.0738 0.1032 -0.0019
VARIANCE 0.0075 0.0086 0.0074 0.0757
SQDEV 0.1357 0.1041 0. 1368 0.5297
ABS 0.8245 0.7122 0.8257 1.4948

CANADA DOMESTIC GNP FOR THE FULL PERIOD SAMPLE - DOMESTIC SHOCK

xcD

FX RATE N17 EXOG BASE EX0G 42 ExoG
MEAN -0.0119 0.0746 0.0156 0.0019
VARIANCE 0.0096 0.0049 0.0065 0.0259
SQDEV 0.2243 0.1173 0.1552 0.596
ABS 1.9258 1.1298 1.278 2..2757

TABLE 40


-45-

GROSS NATIONAL PRODUCT

FOREIGN GOODS/DOMESTIC GOODS SHOCKS

JAPAN PERCENT CHANGE
TFT 0.20
aie Ve af 7H 0.10
Li YYi all 9.40
fi ¥ . CANADA PERCENT CHANGE
LY ¥ 4 0.70 TT TTT
H + 1.00 fe ee 0
tr - 1.30 a
te — 1.60 [ of
eS 1.90 aia — 0.50
us PERCENT CHANGE 7
> 2.00 ff 7
f ! 1.00
ae 0 UK PERCENT CHANGE
i ” j 1.00
Li 4200 fh 7 0.50
3 He ; eo se. 8)
A
en ere
C L — 1.00
GERMANY PERCENT CHANGE § 4
F ze 1050) fT , vs
_ wv aN Tot tetttira} 2-9
a 1 0 1976 1978 1980
- — 0.50
seseeseeeenesee = FIXED AGGREGATES
------- = FIXED RATES
= LL titiitii 14.00

1976 1978. 1980

FIGURE 3


TABLE

ee ee ee 2

BPWNHE RUN ERWNE RE WNY RWNHYE BWNY

-86-

DOMESTIC GOODS/SAVINGS SHOCK

BASE EX0G

FGNP (PCER)

FIX RATE = M1. EXOG M2 EXOG
XZCD_PCER X1CD PCER X6CD PCER X7CD PCER
FONP FGNP . — FONP ~  FGNP 7
0.016 0.016 0.015 0.036
0.02 0.023 0.021 0.092
0.021 0.024 0.021 0.043
0.022 0.024 0.02 0.025
0.018 0.018 0.016 -0.029
0.012 0.009 0.009 -0.078
0.006 -0.061 0.001 -9.113
9.001 -0.011 -0.005 -0.11
-0.002 -0.017 -0.009 -0.087
-0.005 -0.021 -0.011 -0.052
-0.006 -0.022 -0.011 -0.
-0.008 -0.022 -0.011 0.034
-0.009 -0.022 -0.012 0.058
-0.01 -9.019 -0.011 0.06
-0.012 -0.017 -0.01 0.043
-0.016 -0.014 -0.01 0.013
-0.017 -0.01 -0.009 -0.008
-0.018 -0.005 -0.006 -0.024
-0.018 0.001 -0.004 -0.026
-0.019 0.008 -0. -0.012
-9.019 0.013 0.003 0.008
-0.016 0.019 0.008 0.031
-0.014 0.022 0.011 0.044
-0.014 0.023 0.012 0.045

TABLE 35.


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75
75
75
75

76
76
76

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77
77
78
78
78
78
79
79
79
75
80
80
80
80

ROD PONE BRUNE RWHP WNP PWN

-87-

DOMESTIC GOODS/SAVINGS SHOCK

€IX. RATE Ml EXOC. EASE

EXOG

RS (ER)

M2 EXOG

XZCD_ER_ ChE NICE_ER_CRS N@Ch_ER_CRS X7CP_ER_CKS

Q.1S7
0.134
0.124
0.092
0.07
0.045
0.027
0.01
-0.001
-C.004
-0.003
-6.012
-0.022
-0.031
-0.025
=0.024
-C.023
-0.017
-0.603
C.00)
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C.002
0.011
uv. 0.011

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TABLE 36

C.012
0.012
0.011
0.045
0.045
0.042
0.01

0.007

C€.605 ©

0.006
0.007
0.007
C.007
0.005
0.004
0.003
0.003
G.002
0.002
-0. 008
-¢.01

-0.01

-0,608
-0.006

6.725
-3.438
0.489
2.479
-0.°26
1.366
0.509
0.802
0.26€
2.05
0.104
0.263
-0.685
-0.625
“0.948
-0.013
0.095
0.432
0.547
G.193
=0.082
0.326
-C.086
-9.276


-32-

to narrowly defined money) that is negatively related to the domestic
interest rates, namely foreign currency bonds. Thus, it is possible for
the positive interest rate effect of an increase on the home rat2 on time
deposits, and hence broadly defined money, to dominate the negative
effect it has on narrowly defined money. A decrease in demand for
foreign currency bonds provides an additional source of allocatable
wealth.

This idea is illustrated with the aid of equations 1) through
4).

Equation 1) is the wealth (W) constraint for four types of
financial wealth: narrowly defined money (M), time deposits (D) which
together with M constitute broadly defined money, home-currency bonds (B)

and foreign currency bonds (F).

1) M+D+B+F=W

Equations 2) and 3) show the effects of altering the domestic

bond rate, RB, and the time deposit rate, RD, on the various assets in

equation 1) and impose the constraint that the net effect be zero.

2) ae 4 + D + B + F =0
RB ~ “pp * Opp + Beg * Fre
- + - -
dW :
3) ard ~ “ep * pp * Bay + Fen = 9

Equation 4) is the sum of equations 2) and 3).


Fig vre 2


-47-

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NOTAUOAI


coun:ry's consumption function or a shift in preferences from home goods
over foreign goods.

If the authorities respond to this perturbation by fixing money
and not intervening in the exchange market, then the home interest rate
will rise and the home currency will appreciate. This latter effect
leads to a moderation of the original increase in demand as well as a
decrease in the demand for money and home bonds. Thus equilibrium will
occur in the triangle ACD, at an income level no greater than Y If, on
the other hand, the authorities respond by fixing the interest and
exchange rates, then the stocks of money and bonds become endogenous and
will change until they pass through point E. At point E, the level of
income is at Yos a level that represents a larger disturbance in output
than occured when aggregates were held constant. By fixing aggregates,
in tris case, the damping effects of interest rates and exchange rates
are called into play. However, endogenizing these variables does not
always serve to diminish the effects of exogenous disturbances on output
and indeed may serve to exacerbate them. Such a case is shown in Figure
2.

Here the shock is a shift in asset preferences--an increase in
the demand for home currency bonds and a concomitant decrease in the
demand for foreign currency bonds. This is shown as a shift in the BB
line to BiB,

If neither the exchange rate nor the interest rate move, then
no pressure is exerted on output and it remains at Yor In this case, the
central bank has simply accomodated the shift in the public's asset
preferences by altering their own supplies in a manner which exactly

offsets the altered demands and eliminates any need for exchange-rate


-4]-

extensions of the project reported here. It would be interesting to let
policy makers react to the information content that potential policy
variables contain. (e.g., exchange rate and/or interest-rate movements
when aggregates are fixed.) More complex yet would be the extension of
this study to mixed strategies in the face of uncertainty. A quite
separate possibility would be the use of perfect foresight (rational)
expectations in simulation. Independent of this project, we have done
some preliminary work in this area, and it would be interesting to

incorporate that work in the present study.


-20-

behavior in all cases is exactly as expected. The cyclical behavior of
income is eventually reflected in the interest rate and exchange rate

behavior. (It should be mentioned that in the rates-constant case, the
local authority rate was fixed, not the short-term government rate whose

changes are reflected in Table 3.)

The U.S.

Income in the U.S. returns faster and sooner to its control
level when aggregates are fixed, exactly as theory suggests. However, it
overshoots and cycles enough to cause the summary statistics of Table 7
to indicate that a rates-constant policy dominates over the long-run,
Both trade and investment cycles contribute to this overshooting. This
investment behavior is the flip side of foreign income behavior (as
viewed from abroad) that has been discussed above. A strong
multiplier/accelerator mechanism in the U.S. model causes income to
overshoot even when rates are fixed.

The trade-weighted dollar generally depreciates as expected,
though in the final five quarters of simulation lower income has led to
an appreciation (the fact that the second quarter effect is larger than
the impact effect can be traced to lags in the Canadian dollar/U.S.
dollar equation.) Interest rates behave in the cyclical fashion required
to keep the economy on its demand for Ml function while income cycles.

Foreign income behavior conforms to our priors.

More often than not, the impact effects of the home
good/foreign good shock conforms to the theory. In the two cases where

they don't--the U.K. and Japan--the reasons for this divergence are


-15-

IIIA. The Home Goods/Foreign Goods Shock

In this shock we decreased demand for the home good by 5% of
real domestic consumption for one quarter and increased the demand for
the foreign good by the same amount. The theoretical models predict that
both the home and foreign countries will better stabilize their output if
they both fix their respective money supplies and official stocks of
foreign currency bonds (hereafter “aggregates"), than if they stabilze
the interest rate and exchange rate (hereafter "rates"). Holding the
aggregates fixed induces lower interest rates and a depreciated currency
in the home country and higher interest rates abroad, all of which serve

to stabilize income in both countries.

Canada

The impact effect of the shock on Canadian output is indeed
less when aggregates are fixed, just as the theory suggests. Income
returns to its pre-shock level faster when interest rates are allowed to
fall and the exchange rate to depreciate. The exchange rate is
responsible for most of the improved relative performance of the
aggregates-constant case early on with interest rates becoming
increasingly important over time. In fact, endogenizing both of these
rates is enough to generate income overshooting; this doesn't occur when
rates are fixed. Income, in the fixed aggregates case, ultimately
returns to very nearly its initial level largely because of positive
interest rates that develop mid-way through the simulation.

Foreign income, as defined in the Canadian model, conforms’ to




-70-

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WAV


-25-

is higher in the U.S. than in these other countries, the net effect was
to dampen foreign income. Thus, in this case, foreign income is better

stabilized when exchange rates are flexible.

United Kingdom

The domestic income paths conform to expectations based on the
theoretical models. This was not the case when the shift in the
consumption function was accompanied by a shift in import demand (i.e.,
the home goods/foreign goods shift described earlier.). Apparently, this
reflects the impact the cumulated current account has on the exchange
rate. In the present case, the current account deficits are lower.
Consequently the impact appreciation is stronger and thus more effective
in buffering income.

The behavior of the. foreign income variable in the U.K. does
not, conform to our theory. This is the other side of the expectational
process alluded to above. The surplus that accumulates abroad are soon
reflected in both an expected, and then an actual, appreciation of the
foreign currency. Thus, foreign income is better stabilized if rates are

flexible than when they are held constant.

United States

The income path in the U.S. generates mixed results. On
impact it conforms (barely) to our theory, in the short run it doesn't,
while in the long run it does conform by some criteria, but not by
others, In the short run, flexible rates apparently do more than dampen
output, they trigger the accelerator/multiplier mechanism which is

particularly strong in the U.S. model. Thus it seems that holding M1


-11-

of the home good equal to a decrease in savings. If a shift up in the
consumption function in the home country is allowed to appreciate the
home currency (because the home authorities choose to stabilize
aggregates) then the effect on foreign income is amplified above and
beyond the expansionary effects that home output would have on foreign

output if rates were held constant.

III. The Simulation Results

Our motivation for undertaking this exercise was three-fold.
First, by conditioning our "priors" these small theoretical models serve
as a convenient reference point for larger (MCM) scale simulations. Our
in‘tial expectation was that these simulations might well uncover some
previously unknown problems with the model. Second, we thought that the
richness of a large model might point out some areas that the small
models might fruitfully be enlarged to incorporate. For example, the MCM
explicitly models the service account, allows for capital formation,
accounts for the effects of savings within the period (i.e., is an end-of-
period model), incorporates “third-country" effects in its analysis, and
has a rather elaborate dynamic structure. These are all areas which the
small models ignore as a matter of analytical convenience, yet they are
potentially important both in accurately modeling the economy and for
policymaking. Last, it was our hope that we might discover in our
simulations some aspect that would be of interest to policy makers. We
believe that the results of using alternative measures of money in the
fixed aggregates simulations shed some new light on the question of

whether broadly or narrowly defined money is potentially best suited to


-30-

the conventional effects come to dominate the income determination
process.

When rates are fixed, on the other hand, the “chopiness"
discussed in the other Japanese simulations is immediately apparent. The
stock of assets used in generating service flows, and thus net exports,
is transformed by a set of seasonal variables of alternating sign. This
explains the irregularities in the income pattern. The shift from a
strong negative effect to a path which seems to be very nearly certered
on zero is explained by the fact that there is an asymmetry between
income receipts and payments in the service account. Altering stccks of
claims and liabilities gives rise to the expected services flows, but
because of the empirically determined lags, they have a staggered impact
on net exports.

By all criteria (save the impact effect) the rates-constant
policy is superior, as theory suggests. The results are strengthened
more if we allow for the service account items discussed above.

Our theory is confirmed again when we examine income behavior
outside of Japan. In this case the fixed-rate strategy clearly dceminates
the alternative fixed-aggregate strategy. The depreciation of the
foreign currency has caused a trade cycle abroad.

The increased demand for Yen bonds drives the interest rate
down for two years. Ultimately, strong income growth coupled with the
need to hold Ml constant leads to a rise in the domestic interest rate
causing the Yen to appreciate. The subsequent overshoot is causec! by
current account deficits which develop in the course of the simulation

and lead to expectations of a depreciation.


y

-99-

SECURITY SHOCK --- REV_CDNFAFL (ER)

FIX RATE M1 EXOG BASE EXOG M2 EXOG

XZCS ER = -XICS_ERX6CS_ER_X7CS_ER
REV CDNFAFL REV CDXFAFL REV CDNFAFL REV CDNFAFI.

75
75
75
75
76
76

76
77
77
77
77
78
78

75
79
79
79
80
€0
80
&0

Rwy

PUNE EWN RW Ne PW BW Ne

28.689
11.379
10.692
10.727
10.245
10.098
9.816
9.838
9.688
9.808

9.812.

10.3

10.295
10.744
11.026
12.143
12.332
13.046
13.72S
15.384
16.254
16.834
16.909
20.058

lolo Roo RoRo Nokon o Mo)

S900DDDCOO0CO0”0

TABLE 47

SSPODODDDCDDDAGGOO GCC CO Co eoo00

SSP XVDPANDADDDGDAO D000 OO00 oo°0


CANADA FOREIGN GNP FOR THE FOUR PERIOD SAMPLE - DOMESTIC SEIOCK

xcpD

FX RATE
MEAN 0.0196
VARIANCE 0.
SQDEV 0.0016
ABS 0.0785

CANADA FOREIGN GNP FOR THE EIGHT PERIOD SAMPLE -

xcD

FX BATE
BEAN 0.0145
VARIANCE 0.0001
SQDEV 0.0021
ABS 0.1161,

CANADA POREIGN GNP FOR THE FULL PBRIOD SAMPLE - DOMESTIC SHOCK

- xcD
FX RATE
MEAN -0.0037
VARIANCE 0.0002
SQDEV 0.0051
ABS 0.3202

-92-

M1 EXCG
0.0217
0.

0.0019
0.0868

M1 EXOG
0.0128

0.0002
0.0025

0. 1261

41 EXOG

0.0008
0.0003
0.0072
0.3812

TABLE 41

BASE EX0G

0.019
0.
0.0015
0.0761

BASE EXOG

0.012
0.0001
0.0018

0.1062

BASE PX0G

0.0012
0.0001
0.0032
0.2445

42 EXOG

0. 0488
0.0009
0.0122
0.1952

DOMESTIC

M2 EXOG

0.0168
0.006
0.0439

0.5248

82 EXOG

-0. 0003
0.0031
0.0708
1.0711


-12-

stabilization purposes. (This idea is further developed in Section IV.)

In considering alternative policy regimes, we have chose? two
polar strategies. That is, we assume either that the authorities fix
both the money supply and the stock of foreign exchange reserves (and
thus allow the exchange rate and the interest rate to be endogenously
determined) or that they do exactly the opposite and fix both the
exchange and interest rates while endogenizing the two quantities. This
choice is consistent with the idea that these "pure" strategies can be
shown, in theory, to dominate the so called "mixed" strategies (i.e.,
fixing one rate and one quantity) Our simulations also assume that
policy makers do not respond to any information which the endogenously
determined variables provide, rather they set policy at the beginning of
the period and adhere to it. Consider, for example, the case where money
is fixed by policy makers to be consistent with some level of real
activity. Now imagine an unexpected positive real-side shock. Policy
makers observe an immediate but unexpected increase in the interest rate
(but, owing to measurement lags, cannot observe the increase in real
output). Assuming they can rule out a shift in the demand for money,
they can improve on the aggregates-constant policy by decreasing the
money supply in response to the information provided by the increase in
the interest rate. Of course it still remains true that an aggregates-
constant policy is superior to a rates-constant policy. The point is
simply that potentially this policy can be improved upon. This is a
refinement which our simulations do not incorporate but it is certainly
an area meriting future attention.

Three basic types of shocks were run. First, a switch in

demand from home goods to foreign goods and second, a shift between home


* .98-

SECURITY SHOCK eiatea Cul (PCR)

FIX. RATE Ml EXOG ~~ BASE EXOG M2 EXOG

TALLE

XZCS_PCER_ -X1CS_PCER_ XGCS_PCER_ X7CS_PCER_

cul cxT eM]

* 75.1 -0.109 oO. 0.408 0.385
* 75 2 -0.511 0. 0.202 6.321
* 15 3 -0.868 Oo. ¢ -0.774 &.7E8
* 75 4 -0.945 CG. -0.839 . 8.375
* 76 1 1.035 oO. -C.853 5.536
* 7 2 -1.148 6. -0.939 3.143
* 76 2 -1.366 6. -1.403 2.318
* 76 4 71.334 oO. ~1.645 © 1.06

+ 77 i -1.306 oO. -1.784 1.72)
x 77 2 -1.27 0. -1.981 1.929
x 77 3 -1.312 0. 2.245 4.833
x 774 -1.024 0. -2.271 4.994
x 78 1° -0.882 QO. 72.225 5.347
x 78 2 -0.668 Q. 5.565
* 7& 3 -U.436 c. 4.242
* 7€ & 6.077 G. 3.079
s 7¢ 1 0.344 oO. 2.345
* Fo 2 0.746 QO. 2.25

79 os 1.157 0 3.317
* Wy 1.908 QO. “4.505
yO EOL 2.371 c. 5.445
49 2 2.743 & 5.274
, o.03 2.879 Cc. 4.923
ek be 4 3.72 c 4.037

TABLE 8&6


-66-

FOREIGN GNP

SECURITIES SHOCKS

PERCENT CHANGE JAPAN

TITTY TIT T TTY)

mAoe0 8 6|. |!
4oto b*

| 0

— 0.10
0.20

PERCENT CHANGE GERMANY

0.01

Lititititiss) 0.01 | 4

PERCENT CHANGE
TTT Th

4 0.02

0.02
0.03

PERCENT CHANGE

0.02

— 0.01

0
0.01

Poridipi tir)

1980 1976

FIXED AGGREGATES
FIXED RATES

FIGURE 8

0.02

19180


eoo'o Gy PPMP vioa Neer YL

ZZ AlaVL

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z00°0 0 282° 01 0 950°0 0 co"0- x) To 3l ox
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£00°0- x) evz" Ol. a) 870°0 a) 1z0"0- “0 a) a
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600° 0- “0 169 OL “0 L0°0 “0 710° 0- a) € sl *
220° 0- xe) RIEU “0 "z70°0 xe) 600° 0- O foul ®
B99 0 69°87 “0 GRE LE “0 zov-0 a) T 4h x

CilLvu) (99V)  Cilva) Caov) Calva) (o990v) (ava) (Dov)
WAVE

A
un . vavvo xe NVave

Qa) NFALNI --= ADONS ALIN


-17-

depreciation which is reflected in downward pressure on the exchange
rate. Since this is a stock effect, and the initial shock is large
relative to the subsequent trade flows, the effect is long lasting. The
lagged cummulated current account is also the source of the continuing
loss of reserves in the rates-constant case. Here the expectation of a
weak currency manifests itself as a private capital outflow which must be
accommodated by the central bank if rates are to be held constant. It is
the lag on the expectational variable which explains why the second
quarter effects are larger than the impact effects for both the exchange
rate (aggregates-constant) and reserve losses (rates-constant) cases.
This partially delayed effect on reserves and hence on the central bank's
balance sheet is the reason why money drops more in the second quarter
than in the first. Other than this minor anomaly, the behavior of money

in the German model conforms to our theoretical priors.

Japan

Inspection shows that there is very little difference between
the rates-and aggregates-constant policies in the short run, but the
theory is contradicted to the degree that differences do exist, The
reason for this discrepancy is that the Japanese consumption function
contains an inflation term. High inflation rates discourage consumption
and encourage savings. When aggregates are fixed, the depreciation
quickly feeds through to the inflation rate. The resulting increase in
the inflation rate leads to a drop in the consumption function and hence
income. This effect is obviously absent in the rates-constant case.

With the passage of time, the Japanese results come closer to

satisfying our priors. By the end of the simulation, it is clear that


-100-

CANADIAN INTERVENTION *
SECURITIES ASSOLUTE CHANGE
. TT TTT 30
tr —
es 7 20
Lt ae
\ oa
Le ae “1 19
ia)
DOMESTIC GOODS/SAVINGS
0.00
SS _
‘
Nea,
L— Ne |= 0.50
\,
= M
1.00
FOREIGN GOODS/DOMESTIC GOODS
0.00
wae - A _
H ~ “N54 0.50
7 \,
LL -
!
- Lt turd} 1:09
1976 1978 1980

* FIXED RATE SHOCKS

FIGURE 12


22-

overshoots in both regimes but by less and more briefly in the fixed-
aggregates case. We can trace this outcome to the net worth term in the
consumption function. Initially, consumption rises more than income.
The excess of consumption over income comes from a trade deficit and a
draw-down of inventories. Lags in the consumption function magnify the
impact effect. This in turn causes net worth to become negative.
Ultimately, the persistent effect of a continuing lower level of wealth
outweighs the effect of a transitory increase in the consumption function
and causes income to fall below its initial value. The economy is
clearly smoothed better when interest and exchange rates are free to
move.

In the Canadian case, foreign income paths do seem to follow
the expected pattern. Foreign income rises with activity in Canada, the
more so if the Canadian dollar appreciates. Thus there is an inherent
policy conflict between Canadian and foreign authorities.

The behavior of the potential policy variables (i.e., the
various rates and aggregates in those simulations when they are
endogenous) is easily explained. The lag in the exchange rate equation
yields a larger change in the exchange rate one quarter after impact.
Income changes govern movements in money in the rates-constant case. The
cumulated basic balance, functioning as an exchange rate expectations
proxy, is the principle determinant of intervention when rates are

fixed.

Germany

In Germany, as in Canada, holding aggregates constant is the

preferred policy from the German point: of view. A drop in net worth and


-51-

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~96-

SECURITY SHOCK --- CRS (ER)

FIX. RATE M1 EXOG EASE EX0G 82 EXOG

a a

TABLE
22ZCS_ER_CkS X1CS_ER_CRS X6CS_ER_CRS X7CS_ER_CRS

* 75 1 6. -6.008 -0.317 -6.3
75 2 CG. -0.379 -0.059 6.436

75 3 0. -0.539 -0.045 -3.336

75 4 0. -0.573 -0.26 72.582

76 1 0. -0.568 -C.331 -0.287

76 2 0. ~0.586 -0.38 0.763

76 3. o. -0.665 -0.231 0.201
764 0. -0.619 -0.205 0.446
77,1 0. -0.521 -0.172 -0.685
772 0. -0.586 -G.163 -0.775
77°43 0. -0.601 0.165  -  -2.601
77, 47 0°. -0.578 -0.157 -1.871

78 1 6. -0.52 -0.151L -1.86
7B 2 oO. -0.46 -0.142 “1.59

78 2 C. -0.418 -0.13 -0.52

73 4 0. -0.394 “0.119 -0.239

* 7901 C. -C.339 -C.106 -0.17
* 79 2 0. 70.265 ~ = -0.087 -0.382
* 79 3 C. . 70.266 -0.09 -2.201
+ 79 4 0. 0.275 -0.262 -1.633
+ 8 1 a. -0.301 -0.295 -1.781
* 86 2 o. -0.274 +0.296 -1,185
+ 80 3 0. -0.286 -0.269 -0.856
+ 80 4 c. “0.311 -0.274 -0.596

TABLE 44


~34-

wisdom concerning the optimal policy strategy may not hold.

Thus the choice of an appropriate aggregate in an open ecoriomy
has an additional dimension. Policy makers must be alert to the fact
that foreign asset market considerations do affect the elasticity of the
demand for money and, in the limit, can reverse the sign of the home-
interest rate on the demand for broadly defined Money. Furthermore,
these factors may have substantial policy implications.

As it turns out, these conditions are met in the Canadian
portion of the MCM: the own effect of the interest rate on the demand for
time deposits is strong, as is the effect of interest-rate changes on the
demand for foreign bonds.

We simulated the same three shocks discussed earlier (foreign
goods for home goods, foreign savings for home savings, and foreign bonds
for home bonds) in the Canadian model with three definitions of money--
unborrowed base, Ml and M2--as well as the fixed rate regime 2/ In the
Canadian model (as well as the German, Japan, and U.S. model) the net
demand for base money is interest elastic. This modifies Figure 1 so
that the MM curve may be more elastic than the BB curve. In this
framework, a shift in goods demand may produce either more or less output
variation than the fixed rates case. While a positive demand shift
produces a higher interest rate, it also causes the exchange rate to
depreciate. To the extent that the increase in output resulting from the
depreciation outweights the dampening effect of higher interest rates,
the fixed-rates case may dominate fixed aggregates. Thus an ambiguity
arises over the correct policy choice and will depend upon the model's
parameters. As the simulations below indicate, in the fixed base

case, the MM line becomes nearly horizontal and the results are quite


-18-

the aggregates-constant policy is in fact the preferred strategy.

One striking feature of the simulations is the extreme
“chopiness” of Japanese output when rates are fixed. This is traceable
to the large impact effect of the shock on the stock of official exchange
reserves and the subsequent way in which this variable feeds through into
foreign investment receipts. In particular, a pattern of seasonal factors
which alternate in sign, is applied to the changed stock of reserves.

The behavior of foreign income on impact and over the following
two years conforms to the predictions of our theory (i.e., aggregates
constant is the preferred strategy). Over time, the volatility of U.S
income, apparently resulting from a strong accelerator, causes the
aggregates-constant strategy to induce a good deal more foreign income
instability.

Interest rates fall on impact, as expected, but go up as prices
and income levels rise above baseline. The other potential policy
variables--the exchange rate, Ml, and intervention--behave in the
expected fashion. The exchange rate remains depressed throughout the
entire simulation. Ml is also lower than control for all but a few
quarters at the end, where reserve increases which occur in the final
quarters of the simulation are monetized. Normally, we would expect
intervention to be negative--i.e., lead to a loss in reserves. This
happens for the first 19 quarters of the rates-constant simulation
until there has been enough downward price and income adjustment to cause

reserves to begin to climb.

The chart showing the pattern of output in the U.K. under the


~62-

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-94-

SECURITY SHOCK --- cGMP (PC

FIX. RATE M1 EXOG EASE EX0G 2 EXOG

XZCS_PCER_ X1CS_PCER_ X6CS_PCER_ X7CS_PCER

CGRP CGRP CGP CGRP
1 -0.141 -0.22 -0.182 * =0.184
2 -0.549 -0.754 -0.78 0.005
2 =6.618 -0.87 -0.933 -0.176
4 -0.518 -C.858 -0.922 6.038
1 -C.822, -0.902 -0.C75
2 -0.736 -0.841 0.015
3 -0.753 -0.927 -0.015
4 -0.761 -0.912 -0.
1 -C.631 -0.€78 -0.
2 0.575 -0.846 -0.
3 -C.556 -0.862 -0.
* 4 -0,522 -O.€5€ -0.
= 76 i -0. 464 -0.811 C.
* 78 2 -0.365 -0.71 Cc.
* 76 3 -0.291 0.627 oO.
* 78 4 -0.251 -C.582 9.659
» 79 1 -0.214 -0.52 -C.012
* 79 2 -0.176 -0.449 -0.664
* 79 3 -0.2 -0.434 -0.081
+ 79 4 -U.231 -0.411 -0.685
*® 80 1 -C.286 -0.408 -0.081
* BQ 2 -0.28 0.345 -0.039
' ec 3 -C.22 -0,229 0.003
eo 4 -0.334 -0.501 -0.

. TABLE 42


-39-

V. Conclusions

Large macro models are complex and cumbersome things. They are
often difficult to decipher in a straightforward manner. We have found
that it is useful, perhaps necessary, to approach our study of the
stabilization properites of the MCM by first using a very small
theoretical model to develop our "priors" on how an economy, and thereby
an econometric model of it, should respond to a variety of shocks under
different policy arrangements. Our purpose has been two-fold. First, we
thought it possible that by comparing results of MCM simulations with the
theoretical results of a small model, we might discover some flaws in the
econcmetric model which are not obvious when individual equations are
examined in isolation from one another. Indeed some of the specific
results discussed in the simulations reflected unanticipated and
undesirable interactions between equations. The systemic properties of
the model, given the perspective afforded by the small model, will lead
to scme modifications of the MCM (the interaction between the service
flows seasonal dummies and intervention is a case in point).

Secondly, and equally important, we hoped the structural and
dynamic richness of a large scale econometric model might point to
important elements from which the theoretical models have abstracted.

We have seen how important service flows can be when there are either
large changes in the stock of international indebtedness or large changes
in the interest rates which govern the size of flows of investment
payments and receipts. There are also circumstances in which third
country effects have been able to explain qualitative differences between
the empirical and theoretical models. Similarly, the one period

theoretical models lack the time dimension to encompass overshooting, a


CANADA DOMESTIC GNP FOR THE FOUR PERIOD SAMPLE -

xcs

BEAN

VARIANCE

SQDEV
ABS

CAKADA DOMESTIC GNP POR THE

rcs

MEAN
VARIANCE
SQDEV
ABS

CANADA DOMESTIC GNP FOR THE

xcs

KEAN
VARIANCE
SQDEV
ABS

FX RATE

-0.4563

0.046
0.9707
1.8251

FX RATE

0.471

0.0222
1.9301
3.7681

FX RATE

0.1634
0.4708
11.4696
13.6988

-101-

Bl EXOG

-0.6755
0.0947
2.1093
2.702

EIGHT PERIOD SAMPLE —-

M1 EXCG

-0. 7142
0. 0434
49.3841
S. 7133

FULL PERIOD SAMPLE -

M1 EXCG

-0.4756
0.057
6.739

11.4137

BASE EXOG

-0.7041
0.1261
2.3616
2.8166

BASE EXOG

-0.7998
0.0651
5.573
6.3982

BASE EXOG

-0.657
0.0602

11.7448

15.7689

TABLE 48

SECURITY

M2 EXOG

-0.0983
0.0093
0.0664
0.4027

SECURITY

M2 EXOG

~0.0733
0.0053
0.0802
0.5957

SECURITY SHOCK

M2 EXOG

-0.0505
0.006
0.1994
1.6968


-42-

Footnotes

1/ In particular, see Stevens (1983), Haas and Symansky (1983), Hooper,
et. al. (1983) and Quantitative Studies Section (1983).

2/ When referring to “aggregates constant" or “fixed rates" policies, we
imply targetting on a predetermined path which involves changes in
aggregates or rates over time, but which remain unchanged in the face of
real and financial disturbances.

3/ Assuming the country is a net holder of foreign currency assets.

4/ Henderson (1982) demonstrates that a policy conflict between the home
and foreign countries arises only in the second case (domestic goods for
savings). However, his result depends on the relative size of various
elasticities. For example, if the home country's import-income
elasticity is sufficiently large and the import-price elasticities are
relatively low, then a policy conflict could arise in case 1 and not
exist in case 2. While such outcomes are possible, our simulations do
not support this scenario.

5/ In the prototype MCM country, all of the aggregates and rates that
are fixed are endogenous variables. In order to allow policy makers to
completely control the relevant variables, it was necessary to modify the
MCM, In order to fix either the exchange rate or the level of
international reserves, the behavioral equation depicting central bank
intervention was dropped from the model. In the case of fixed exchange
rates, this allowed policy makers to intervene as much as necessary in
order to reach their exchange rate target. The interest rate on monetary
aggregate targets were achieved by allowing the authorities to intervene
in the domestic security market. However, owing to peculiarities in the
U.K. monetary sector, the discount rate, rather than open market
operations, was used as the endogenous policy instrument.

Open market operations are not explicitly modelled in the U.K.
monetary sector, the use of the discount rate provides a reasonable “as
if" story.

6/ In addition, tax receipts in the U.K. are positively related to
official financing. In this simulation, the loss of reserves decreases
taxes, increases disposable income and causes consumption to rise.

7/ If the positive elasticity of broadly defined money is sufficiently
Targe, it is possible that the model would be unstable. Specifically,
this will be the case if the MM line has more interest elasticity than
the XX line.

8/ This implicitly assumes that the demand for broad money while
Positive, is relatively interest inelastic. If it is very elastic,
interest rates will fall and output will rise in the face of an
expansionary shock. But the basic point remains: interest rates and
output are inversley related.