-17-

in the first line of the table, which shows what happens to eu the
"competitiveness" measure of the real exchange rate, comparing foreign
and domestic price levels in a common currency (also recall that an
appreciation of the dollar means a drop in e). Both models suggest that
the amount of real appreciation is somewhat less than 10 percent and that
the real exchange rate gradually is returning toward its value in the
control solution as time goes on.

In section one of this paper, I pointed out that the models
permit cross-border price discrimination, allowing systematic deviations
from the law of one price. Therefore, the three measures of the real
exchange rate (relative export price, relative import price, and
competitiveness) differ from one another. In fact, relative export
prices, ee closely track competitiveness in both models. However, real
import prices, a) do not move as much as the other real exchange rate
measures in the MPS model and they move hardly at all in the MCM
simulation.

Because import prices hardly move in the MCM model, the
domestic price level, p, shows little direct effect from the appreciation
of the dollar. The drop in the price level and interest rates in the MCM
simulation is due almost entirely to weakness in real GNP. Recall that
in the “PS model the domestic price level depends on competitiveness, eu
rather than on real import prices, en Thus, the monetary effect is not

short-circuited as it is in the MCM model; still, the direct effect of

the real exchange rate on domestic prices is only about half the value


-ll-

be remembered that in the econometric models the real exchange rate is
not unique, and the impact.of this will be discussed in the third section
of this paper.

First, I develop the aggregate supply curve, using a markup
equation and a combined Phillips Curve/Okun's Law relationship. All

variables should be interpreted as percent deviations from a control

solution.

a

(12) p= .7w + .le

(13) w= .2y +p

where p is the price level, w is the wage rate, e is the real exchange
rate and y is real output. In the price markup equation, the coefficient
on wages of .7 was chosen to reflect the share of labor cost in output.
Similarly, the coefficient of .1 on the real exchange rate was chosen to
‘ceflect the ratio of imports to domestic output. Implicitly, all imports
are treated as intermediate goods in this set-up, and there are no
additional "competing-goods" effects.

The MCM and MPS models differ in their choice of the real
exchange rate that is used in the price equation. The MCM model uses
real import prices, which is consistent with my formulation (the
coefficient also is close to the value I have used). In order to allow
for “competing-goods" effects, the MPS model uses the competitiveness
measure of the real exchange rate (the price of foreign output relative -
to U.S. output, converted to a common currency), but the coefficient on

this real exchange rate is only .05, about half of what I have assumed.


-21-

2. Variable Names

concept MPS variable MCM variable

e, -(10+pxpfwl-fpcpimw) -(10+up-ufpe fw10)
en -( pxpfwl-pemnp) -C€up - upmgnfl)
ey -(10+pexnas-fpcpimw) -(10+upxnag-ufpce fw10)
P pxpfwl up

i rtb urs

y XGNP ugnp

y XGNP ugnp

Cc epce uc

I eh+epdteps uifp

x exnag uxgni

x" exnag uxgna

M emnp umgnfl

T eex-eim unetxni


If I myself were building a simulation model, I would use a
combination of theory and statistical procedures to generate the
parameters. For example, I would constrain my money demand equat‘ion to
be homogenous in the price level, even though the data might appear to
suggest otherwise because of a poor match between theoretical and
measured construct, technological change over the sample period, or other
sources of noise. On the other hand, T would have diffuse priors
regarding the dynamic response path of exports to relative price changes,
and for this I would rely on statistical procedures, even though the same
data problems are present as in money demand. While this approach
offends Bayesian purists, it seems to be the revealed preference of most
model-builders.

The choice of when to impose coefficients and when to allow
them to be data-driven is somewhat subjective. With regard to the MCM
and MPS models, my main disagreement along these lines is in the way
exchange rate changes are not passed through fully into changes in export
and import prices. This is an issue on which I believe theory could be
used to overturn statistical results. I make this point in the first
section of this paper.

There are two prominent effects of an exchange rate shock,
which will be referred to throughout this paper as the "fiscal effect"
and the "monetary effect."3 The fiscal effect is the contractionary
effect of a real appreciation on the trade balance. The monetary effect
is expansionary: an appreciation of the dollar lowers import prices,
tending to reduce the domestic price level and thereby money demand.

This leads to lower interest rates and more spending in interest-


-18-

used in the envelope calcuation. In the MPS simulation, downward
pressure on prices and interest rates from the exchange rate largely is
offset by upward pressure from the stronger economy (the IS curve shifts
to the right rather than to the left, as will be explained below).

Looking at the domestic expenditure components, consumption and
investment show almost no response to lower interest rates in the MCM
model over the first 2 years of the simulation. At the end of the third
year, a favorable impact on investment finally begins to appear.

Overall, domestic spending in the MCM model has less interest sensitivity
than in the MPS model and much less interest, sensitivity than in the
envelope model. Of course, this tends to reduce the monetary effect of
an exchange rate shock in the MCM.

The sizable increase in consumption stands out in the MPS
model. Much of this increase is due to two questionable non-neutralities
in the simulation. One is that a shock that reduces prices raises real
transfer payments, which are held exogenous in nominal terms. The
marginal propensity to consume out of transfers is essentially one, so
that this non-neutrality is significant.5 Another non-neutrality is that
lower prices increase the perceived value of real assets, such as land,
as the perceived price of these assets catches up to the aggregate price
level gradually over a three-year period. This quirk in specification
causes perceived real wealth to vary inversely with the price level in
the short run, so that a drop in price raises consumption.

Turning to the trade balance, nonagricultural exports, X',
respond more in the MPS model. However, the MCM model includes an effect

of the appreciation on agricultural exports, so that overall goods

exports, X, fall by about the same amount in the two simulations.


-24-

References

Brayton, Flint and Eileen Mauskopf, "The MPS Model of the United States
Economy," unpub., Feb., 1985.

Cooper, Richard N., "Comment," Brookings Papers on Economic Activity
1985:1, 245-248.

Glassman, James E., "The Influence of Exchange Rate Movements on
Inflation in the United States," Economic Activity Section Working
Paper No. 46, Federal Reserve Board, April, 1985.

Hooper, Peter, "International Repercussions of the U.S. Budget Deficit,"
Internatioal Finance Discussion Paper No. 246, Federal Reserve
Board, Sept., 1984.

Kling, Arnold, "Anticipatory Capital Inflows and the Behavior of the
Dollar," unpub., August, 1985.

Okun, Arthur, "Inflation: Its Mechanics and Welfare Costs," Brookings
Papers on Economic Activity 1975:2, 351-390.

»Prices and Quantities. Washington, D.C.: Brookings Institution,
1981.

Sachs, Jeffrey D., "The Policy Mix and the Dollar: 1985," Brookings
Papers on Economic Activity 1985:1, 117-198.

Stevens, Guy V.G., Richard B. Berner, Peter B. Clark, Ernesto Hernandez-
Cata, Howard J. Howe, and Sung Y. Kwack, The U.S. Economy in an
Interdependent World: A Multicountry Model, Federal Reserve Board,
1984.



1. Results of a

-20-

10 percent nominal appreciation of the dollar starting

in 1979: Ql
MCM

concept units 79:1 79:4 80: 81:4 79:1 79:4 80:4 81:4
eo % -9.8 -8.7 -7. -6.8 -9.3 8.5 8.1 -7.6
en % -1.6 -3.7 -5. 4.8 -1.2 -2.9 -2.4 -2.0
ey a -9.4 -8.0 -6. -5.8 -9.2 -7.8 -7.3 6.8
Pp % al -.3 - -1.0 -.1 -.8 -1.2 -1.6
i p-p. -.1 -.4 - -.3 -.4 -1.0 -1.6 -1.7
y % al 4 1.1 -.4 -.3 -.6 -.0
y 728 1.6 5.3 12. 17.0 -6.1 -3.8 8.2 -.1
c 728 -6 4.0 9. 14.6 -.9 1.0 -2.4 3
I 72s +2 8 2. 4.6 -.6 2 ~.2 3.6
x 72S «1 -3.2 00-4. 3.2 -.7  -1.7  -4.1 9 -2.6
x' 72$ 1 -3.2 -4. -3.2 -.6 -1.4 -3.3 -1.8
M 728 3 2.1 3. 4.3 -.1 1.6 7 9
T 72$ 8 -.l 0 -l. -4.9 -4.6 -5.1 -5.6 4.1


-15-

that [ have packed about as much interest sensitivity as possible into
domestic spending.
Now, we are ready to compare the fiscal and monetary effects of

an appreciation. Putting (16) into (21) gives
(23) -y = .35(.4e - .5e)

The coefficient .35 is a multiplier that reflects all of the coefficients
on y. The first term inside parentheses is the fiscal effect, and the
second term is the monetary effect. The expansionary monetary effect is
slightly larger, so that a 10 percent appreciation (drop in e) would
raise real GNP in the envelope model by about 1/3 of one percent.

Note that some of the parameter values that boost the monetary
effect (low interest elasticity of money demand, high interest elasticity
of domestic spending) tend to reduce the multiplier. Also note that it
would be very easy to obtain the result that an appreciation is
contractionary. For example, if only half of a real exchange rate change
is passed through to domestic prices over the relevant time horizon, this
would reduce the monetary effect from -.5 to -.25, which is smaller than
the fiscal effect. The same result would be obtained if we were to halve
the assumed interest elasticity of domestic spending.

The conclusions that I would draw from the envelope
calculation are the following:

(1) A relatively large real appreciation of the dollar would

have a relatively small net effect on real GNP.


This befuddling set of relative prices can be reduced to a
single measure if we invoke the law of one price: if you trade RCA's for
Sony's in one country, you should be able to make the same deal in the
other country. Another way of putting this is that the dollar price of a
Sony should be the same in either country.

(9) Pg = 8c. OF oie - 5 Sy
Note that if the law of one price holds, the price of a Sony cannot be
sticky in terms of both currencies. If it is perfectly sticky in terms
of yen, then a change in the exchange rate will cause the dollar price to
move. My prior is that in the short run the Sony price is sticky in
terms of both currencies but that in the medium run (one to two years)
the law of one price holds. Almost all of the change in price that
occurs following a change in the nominal exchange rate will take place in
the dollar price, but if the U.S. export market is important to Sony the
dollar price may not adjust fully, in which case the law of one price
suggests that the yen price absorbs some of the exchange rate shock.

An alternative hypothesis to the law of one price is that firms
maintain a systematic policy of price discrimination. Having chosen a
dollar price for its televisions, Sony sticks to that price regardless of
its relationship to the dollar-equivalent cost of producing a Sony or to
the possibility for cross-border arbitrage that exists when the dollar
price differs in the two countries. While this is not entirely
incredible, I feel that it certainly is questionable, and indeed it

clearly becomes absurd as the size of the exchange rate shock gets Large:


understate the effect of exchange-rate changes on U.S. prices. Moreover,
a drop in oil prices also has an expansionary effect on the real trade
balance in

the near term, since the demand for imported oil is inelastic in the
short run.

In conclusion, the effect of an appreciation of the dollar on
real GNP in the United States probably is close to zero. If oil prices
are unaffected by the value of the dollar, then an appreciation almost
surely is contractionary. If oil prices indeed fall when the dollar
appreciates and if domestic spending is highly sensitive to the interest

rate, then an appreciation could be slightly expansionary.


sensitive consumption and investment categories. In terms of an IS-LM
diagrem, the fiscal effect is a leftward shift of the IS curve and the
monetary effect is a rightward shift of the LM curve.

In section two of this paper, I develop the envelope
calculation to determine whether it is plausible for the expansionary
monetary effect to outweigh the contractionary fiscal effect. It turns
out that an appreciation indeed could be expansionary; however, this
requires spending to be somewhat more sensitive to interest rates and the
domest:ic price level to be somewhat more sensitive to exchange rates than
the data appear to indicate.

In section three, I examine the simulation results of the MPS
and MOM models. It turns out that an appreciation is more expansionary
in the MPS model than seems possible using the envelope calculation.
Consumption is boosted by several factors in the MPS model that make the
model "non-neutral" with respect to inflation. Two of these non-
neutralities, in particular, appear to be accidental yet significant. In
addition, as noted by Brayton and Mauskopf, the response of net exports
in the MPS model is muted by the technical procedures for simulating a
shock to the exchange rate.

The MCM model, on the other hand, probably understates the
monetary effect of an appreciation. Changes in exchange rates have an
implausibly small effect on import prices, leading to a weak impact on
domestic prices and interest rates. In addition, domestic spending shows
very little interest sensitivity in the MCM model, particularly in the
near term.

Both models treat oil prices as exogenous. As Glassman (1985)

and Sachs (1985) point out, this assumption may cause the models to


-16-

(2) It is possible, even in the absence of an effect on the
cost of imported oil, for an appreciation of the dollar to be

expansionary. However, the parameter assumptions needed for this result

appear to be extreme. If oil prices respond, then a positive effect on
GNP becomes more plausible, because the demand for imported oil tends to
be relatively inelastic in the short run, and any drop in price acts like
a transfer from oil exporters to the United States.

TII. Simulation Results

An experiment was run using the MPS and MCM models to simulate
a 10 percent nominal appreciation of the dollar over a three-year period
starting in the first quarter of 1979. The results are shown in table
one. Explanations of variables are found in tables two and three.

As noted earlier, real GNP (y) is consistently higher in the
MPS simulation and consistently lower in the MCM simulation. This is
not surprising, given the ambiguity found in the envelope calculation.
However, the magitude of the gain in real GNP in the MPS model far
exceeds that found in the envelope calculation, even though parameters
were chosen so as to maximize the expansionary monetary effect of an
appreciation. The peculiarities in the results from both models will be
addressed below.

The first point to be noted is that a 10 percent increase in
the nominal level of the dollar does not imply a 10 percent real
appreciation, As the stronger dollar restrains U.S. inflation and boosts
inflation abroad, the real exchange rate (which was employed in the

envelope calculation) moves by less than the nominal rate. This is shown


-6-

Next, consider three measures of relative prices, or of the

real exchange rate:

DPoy
(1) e. =—5 (compet it iveness)
c PR
P
(2) e = 58 (real import price)
Pox
(3) e == (real export price, inverted)
x Pre

The first measure, competitiveness, compares the price of a Sony sold in
Japan with the price of an RCA sold in the United States, adjusted for
the nominal exchange rate. If instead of televisions we were talking
about an auction market good, such as gold, this measure would be unity,
subject to the usual caveats about transportation costs and so forth.
Even with monopolistically competitive markets, it probably is
justifiable to argue that the equilibrium real exchange rate measured in
this way is determined in the long run, like all relative prices, by
tastes and technology.*

The other measures of the real exchange rate compare the price
of the two televisions in a common location. The real import price is
the price in the United States of a Sony relative to the price of an RCA.
The inverted real export price is the price in Japan of a Sony relative

to an RCA.


-22-

3. Variable Definitions

I. MPS

pxpfwl nonfarm business fixed-weighted deflator, net of indirect
business taxes
fpcpimw foreign CPI, multilateral weights

pemnp unit value index, nonpetroleum imports

pexnas implicit deflator for nonagricultural goods and service
exports

rtb treasury bill rate (3 months)

xgnp real GNP

epce real expenditure on consumption

eh real expenditure on residential fixed investment

epd real expenditure on producers’ durable equipment

eps real expenditure on producers’ structures

exnag real exports of nonagricultural merchandise

emnp real nonpetroleum merchandise imports

eex real exports, NIA basis

eim real imports, NIA basis

II. MCM
up absorption deflator

ufpcfwl0 foreign consumer price index
upmgnfl nonoil import unit value index

urs commercial paper interest rate, 4-6 months
ugnp real GNP

uc real expenditure on consumption

uifp real expediture on private fixed investment
uxgni real merchandise exports, NIA basis

uxgna real nonagricultural goods exports

umgnf1 real nonoil goods imports

unetxni real net exports, NIA basis


International Finance Discussion Papers

Number 260

August 1985

SIMULATING EXCHANGE RATE SHOCKS IN THE MPS AND MCM MODELS:
AN EVALUATION

by

Arnold S. Kling

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 materials)
should be cleared with the author or authors.


eventually causes the price of imports to fall. This is due not to some
long-run cyclical behavior of the model, but because the depreciation
eventually lowers the foreign price level, and this gets passed through
fully into our import prices (ay = 1), while only half of the

depreciation itself is passed through. Although this absurd result takes

several. years to develop, it lowers my confidence in the short-run price

behavior of the model.


if it costs $300 to produce a Sony, will Sony really stick to a $200
price in the United States?

Neither the MPS model nor the MCM model imposes the law of one
price as a long-run property. The import price equation in each model

is, in effect,

(10) log(p,) = a, log(n) + a,log( Po)

The law of one price states that in the long run a, = a, = 1. Tn the MPS

model, ay = a, = .8 and in the MCM model ay = -5 and a, = 1 in che long
run. If the equations were so disaggregated that they literally dealt
with Sony televisions, these results would be shocking. Given the level
of aggregation and noise in the data, one can see how the results are
plausible, but still it is questionable whether they provide appropriate
input for a simulation model. It is easy to defend cross-border price
discrimination as a short-run property. It even may be plausible that
exchange rate changes are not passed through as swiftly as domestic cost
changes into export prices (because exchange rates are more volatile and
in order to avoid the cost of unnecessary price changes firms adopt a
"“yait-and-see" attitude when exchange rates move). However, the long-run
violation of the law of one price in the equations serves to cast doubt
on their short-run credibility as well.

One example of the results one can find if the law of one price

is not imposed is that in the MCM model a depreciation of the dollar


I. The Exchange Rate and the Terms of Trade
The effect of a change in the nominal exchange rate on real
variables depends on the behavior of relative prices. The purpose of
this section is to discuss the effect of the exchange rate on relative
prices, because this turns out to be a source of conflict between my
priors and the MPS and MCM models, particularly the latter.

Let me start with the following definitions of prices.

=$ . . a

(1) Pp RCA’ the dollar price of an American television
= yen + soe

(2) Pg = Sony? the yen price of a Japanese television

(3) n= pao the nominal exchange rate (a rise in n means a

depreciation of the dollar)

(4) = YE" the yen price of an American television sold in
Pre “RCA
Japan
(5) =$ , the dollar price of a Japanese television sold
Ps Sony P

in the United States
I assume that the two brands of television are imperfect substitutes and
that both the dollar price of RCA televisions and the yen price of Sony
televisions are sticky in the short run, because these are what Okun

(1975,1981) would call "customer market" goods.


-19-

Imports fall by much less in the MCM, because of the lack of response of
import prices noted earlier.

In the MPS model, GNP net exports,T, does not reflect the
change in goods exports and imports. Brayton and Mauskopf (1985) explain
that a technical problem in the simulation exercises causes the trade
balance in services to improve, offsetting the adverse effect on goods.
As a result, in the MPS model the deterioration in the trade balance in
goods has almost no effect on the overall net export picture.

When the odd service sector behavior is combined with the
questionable non-neutralities in the MPS model, the result is that the IS
curve shifts to the right in response to an appreciation. That is how
the MPS model gets an increase in GNP that is three times as much as
would be predicted by the envelope calculation that was biased to
maximize the expansionary monetary effect of a stronger dollar.

On the other hand, the MCM model suppresses the monetary effect
in two ways. First, it has a minimal effect of exchange rates on import
prices. Second, its domestic spending components show relatively little
interest sensitivity.

In my judgment, the truth probably lies somewhere between the
envelope model and the MCM model. The envelope model's strong response
of domestic prices to the real exchange rate is plausible theoretically
but appears to receive no empirical support. In addition, it probably
attributes too much interest sensitivity to domestic spending. The MCM

model represents the opposite extreme in both cases


Introduction

In 1983 and 1984, the United States economy staged a vigorous
economic recovery at a time when the value of the dollar was high and
rising, leading to a steady deterioration of the trade balance. The
strength of both the economy and the dollar exceeded most forecasts.
This caises a question: are there expansionary effects from a currency
appreciation that we overlook when we focus only on the trade balance?

The possibility of expansionary effects for the United States
of an appreciation of the dollar is heightened by the results of
simulating the MIT-Penn-SSRC (MPS) model of the U.S. economy, maintained
by economists in the domestic division of the Federal Reserve Board.
This model, described in Brayton and Mauskopf (1985), suggests that a 10
percent appreciation of the dollar indeed will raise U.S. real GNP. On
the other hand, the multi-country model (MCM), maintained by economists
in the international division of the Federal Reserve Board, has the more
conventional property that an appreciation is contractionary.!

The purpose of this paper is to try and resolve the issue of
whether or not an appreciation of the dollar is expansionary. This
necessarily involves an evaluation of the simulation properties of the
MPS and MCM models. To facilitate this evaluation, I develop a "back-of-
the-envelope" model to serve as a third alternative against which to
compare the two large econometric models.

Since the exchange rate is an endogenous variable, a question
arises as to how one may interpret an exchange rate "shock" to an
econometric model. In this context, it is best to view an exchange rate -

shock as a change in the risk premium or "asset preference parameter" in

the demand equations for domestic and foreign bonds.2


-12-

The wage equation assumes that prices feed through fully into
wages (recall that I have in mind a time horizon of at least three
years). The coefficient on output combines Phillips Curve and Okun's Law
estimates. Note, however, that the magnitude of this coefficient ought
to be a monotonic function of the time horizon considered: a one percent
rise in the GNP gap will depress wages relative to a control solution by
an amount proportional to the length of time the gap is maintained. One
other important remark is that all coefficients on y in the envelope
model affect the overall multiplier of the model but not the relative
magnitude of the fiscal and monetary effects.

Solving the wage-price block for an aggregate supply schedule,

we have (after rounding)

(14) p= .5y + .35e

A 10 percent real appreciation of the dollar (e down 10 percent) reduces
the .S. price level by 3-1/2 percent after a period of three years.
This is a larger effect than most existing estimates suggest, because I
assume a ful pass-through of the exchange rate onto import prices and a
direct impact on the markup. Implicitly, equation (14) may be assumed to
include the effect of the exchange rate on the dollar price of
internationally traded commodities, an effect which is a subject of
controversy. Glassman (1985) and Sachs (1985) offer critical surveys of
the empirical literature on the effect of exchange rate changes on
domestic prices.

The next step is to calculate the shift in the LM curve. We

approximate the money demand equation from the MPS model as


-14-

In the consumption function, real wealth is assumed to be unit elastic
with respect to the real interest rate, and the marginal propensity to
consume out of wealth is taken to be .1, which is somewhat larger than
the coefficient in the MPS model. Business fixed investment ordinarily
is found to have an interest elasticity of .2 or less, but we allow for

housing to add to this interest sensitivity.

The trade balance is determined as follows:

(20) T= -1.5y + 2e

The marginal propensity to import is assumed to be 1.5, while exports and

imports each are assumed to have a unit elasticity with respect to the

real exchange rate.

By weighting consumption, investment, and export and import

equations according to their share in GNP, we obtain the quasi-identity

(21) y = .6C + .1I5I + .1T

Solving (18)-(21) for the IS curve, we have

(22) y = -.27r + .4e

Equation (22) says that a 100 basis point rise in the real

interest rate (10 percent of a 10 percent control level) lowers real GNP

by 2.7 percent. That seems to me to be an enormous effect, indicating


ABSTRACT

In 1983 and 1984, the United States economy staged a vigorous
economic recovery at a time when the value of the dollar was high and
rising, leading to a steady deterioration of the trade balance. The
strength of both the economy and the dollar exceeded most forecasts.
This raises a question: are there expansionary effects from a currency
appreciation that are overlooked when we focus solely on the trade
balance?

The purpose of this paper is to try and resolve the issue of
whetner or not an appreciation of the dollar is expansionary. To do so,
I evaluate the simulation properties of the MPS and MCM models. As part
of tiis evaluation, I develop a "back-of-the-envelope" model to serve as
a third alternative against which to compare the two large econometric

models.


-23-

Footnotes

1. The MCM originally was described in Stevens, et al (1984),
and more recently in Hooper (1984). The simulation used in this paper
was run on a test version of the updated MCM, to be described in a
forthcoming paper by Hooper and others.

2. Kling (1985) shows that anticipated changes in interest
rates can cause shifts in current asset preferences, even in the absence
of a risk premium.

3. I have adapted the terms "fiscal" and "monetary" effect,
which were coined in some internal memoranda at the Federal Reserve Board;
I should not be credited with their origination,

4. Without a long-run equilibrium real exchange rate, it makes
little sense to express international interest parity conditions in real
terms. Cooper (1985) argues that real interest parity is tenuous
compared with nominal interest parity.

5. Whether transfers tend to be fixed more in nominal or real
terms is an empirical issue. However, I believe that the possibility
of fixed nominal transfer payments belongs in the catalogue of potential

rather than actual non-neutralities in the economy.


SIMULATING EXCHANGE RATE SHOCKS IN THE MPS AND MCM MODELS:

AN EVALUATION

Arnold S. Kling
Board of Governors of the
Federal Reserve System
Washington, D.C. 20551

August 1985

I have received helpful suggestions from numerous colleagues at the
Federal Reserve Board. In particular, the assistance of Flint Brayton

and
MCM
not
are

Peter Hooper in making available simulation results from the MPS and
models is gratefully acknowledged. Views expressed in this paper are
necessarily those of the Federal Reserve Board or its staff. Errors
my own.


-10-

The "back-of-the-envelope" Model

The purpose of this section is to provide a "back-of-the-
envelope" comparison of the effect of an exchange rate shock on the trade
balance (the fiscal effect) with its effect on interest-sensitive
domestic spending (the monetary effect). The comparison is supposed to
represent a three to four year time horizon. In order to gauge the
possibility that an appreciation is expansionary, I will choose parameter
values that, while within the range of realism, tend to magnify the
monetary effect. However, I leave out the possible expansionary effect
on the trade balance of a drop in oil prices due to an appreciation of
the dollar. In addition, I leave out the implications for spending of
any redistribution effects of an appreciation or of a general change in
the price level. In the MPS model, these "other" non-neutralities appear
to be either small or the result of unintentional specification
problems, so that leaving out such non-neutralities seems reasonable,

We will arrive at an equation of the form
a1) $2 = ur +yrp.)
de e rope
where y is real GNP, e is the real exchange rate, r is the long-term real
interest rate, » is a multiplier, T. is the response of the trade balance
to the exchange rate, and the remaining term gives the monetary effect of

an exchange-rate shock: Pe is the effect on the price level, mh is the

effect on the interest rate, and y, is the effect on spending. It should


-13-
(15) m- p= 9y- li

where i is the short-term nominal interest rate. Inverting this equation

and substituting for the price level from the aggregate supply curve

gives
(16) i = 10p + 9y = l4y + 3.5e
'y

A 10 percent real depreciation would raise i by 35 percent, or 350 basis
points if nominal rates were at 10 percent in the control solution. This
large effect reflects the interest-inelastic money demand function and
the sizable price effect of the exchange rate in the envelope model.

The long-term real interest rate, r, is assumed to change by half as much

as the short-term nominal rate. Therefore, the LM curve becomes
(17) rv = .5i = 7y + 1.8e

Finally, we build the IS curve. A change in the exchange rate
will cause movement along the IS curve because of (17) and also will
shift the IS curve by affecting the trade balance. Consumption and

investment are taken to be interest sensitive.

(18) ¢

ly - oir

(19) T= 1.5y - .5r