-16-

reduce exports sharply. In Japan the percentage fall in output actually
exceeds that in the United States by the end of the period.
Nevertheless, the magnitude of the effects are in general moderate --
the growth rate of real income is reduced by about 1/2 percent per year,
while the inflation rate falls by a little less. Interest rates cecline
by less than one percentage point in Japan, and somewhat more in
Germany; the two countries' exchange rates appreciate by only 5-7
percent against the dollar.

Foreign response

Table 4 shows the results from a second simulation in which
foreign countries respond to the U.S. fiscal contraction by using
monetary policy to hold their real exchange rates constant. This
expansionary policy offsets one of the major sources of deflationary
pressure abroad, with the result that the fall in foreign income -s
greatly reduced. In Germany, real GNP falls by 0.9 percent at the end
of the period, instead of 1.8 percent, while in Japan output actually
rises slightly. In contrast, during the first two years of the two
simulations the output paths are very similar for both countries, since
at that point the chief influence is the loss of exports to the United
States.

The inflationary price paid for these gains is very modest,
which reflects in part the "stickiness" of the price determination
mechanism in the MCM. The increase in the money growth rate required to
maintain constant real exchange rates is about 1/2 percent per year in
Germany (for central bank money), and 1 to 2-1/2 percent per year in
Japan (for M2). Interest rates fall by 2 to 3 percentage points.

What is striking about this policy response is that it has

essentially no effect on the U.S. economy: the paths for income,


E(c*)

-lla-

Fiaure 1

I

U

INCREPSING

Ar

Uo INCREASING,

Cc,



-18-
the first simulation with no policy response) leads to a further
reduction in exports. In Germany this is offset by the positive effects
of stronger income in the United States, but in Japan exports and output
poth fall sharply. Japanese real GNP falls by over 3 percent by the end
of the simulation period. Clearly, U.S. policies do affect foreign
countries.
Joint policy response

Finally, we consider a simulation in which both the United
States and the foreign countries use monetary policy to offset the
effects of the initial fiscal contraction. The United States is assumed
to follow the same monetary growth path as in the previous simulation,
while Germany and Japan again use monetary policy to fix their real
exchange rates. Table 6 presents the results.

As in the earlier example, the foreign expansion maintains GNP
roughly unchanged in the face of the U.S. contraction, except in the
last two years for Japan, when income actually rises. Again, the
foreign policy response has only minor effects on U.S. income, prices,
interest rates, and current account. Thus we still conclude that U.S.
policies can be set independently of the foreign response.

However, the foreign monetary policy needed to stabilize real
exchange rates is very different in the last simulation (with U.S.
monetary accommodation) from the earlier simulation (without U.S.
accommodation). The foreign money growth rates shown in Table 6 are
more than twice as large as those in Table 4. Therefore, we conelude
that in responding to a given event, foreign economic policymaking
should, in general, take into account the response of U.S. econonic

policy to the same event.


-3-
analyzes the empirical results from our model simulations; the

conclusions follow in Section v.

I. The FRB Multicountry Model

The Multicountry Model (MCM) is a system of five quarterly
national macroeconomic models, at the center of which is a medium-sized
model of the U.S. economy .2 Linked to this U.S. model and to each other
are models of Canada, West Germany, Japan, and the United Kingdom.3 The
single models vary in size from 150 to 250 behavioral equations and
identities; also included in the system is an abbreviated sector
representing the rest of the world.

The system has three salient features relating to the
international scope of the MCM. The first is the endogeneity of the
bilateral dollar exchange rates. In the current version of the model,
exchange rates are determined by the open interest parity condition with
the expected exchange rate a function of relative price differentials.4
The second noteworthy feature of the model is the use of bilateral,
rather than aggregate, goods trade equations. These bilateral import
demand equations are used to explain each country's imports from each of
the cther countries. The third feature of interest is the oil sector:
the MCM models explicitly the consumption of and trade in oil; oil also
enters the supply side, as a factor of production.

In the typical MCM country model, prices and quantities are
determined by the behavior of four classes of economic agents: the
monetary authorities, the government, commercial banks, and firms and
households. The actions of these agents are modelled in the goods

market, the labor market, and the asset market. Each country is assumed


-l6a-
TABLE 4: US FISCAL CONTRACTION WITH FOREIGN MONETARY ACCOMMODATION

198604 1987Q4 198804 198904 199004
UNITED STATES
Real GNP (%)........... “1.5 -2.3 "2.5 1.6 "1.9
growth rate.......... “1.5 -0.8 -0.3 1.0 -0.3
Price level (%)........ -0.2 -0.6 71.4 72.2 -3.1
infl rate (+/-)...... 0.2 70.5 -0.7 -0.8 -0.9
Interest rate (+/-).... 1.3 -2.3 -3.3 -3.5 -4.6
Money supply--Ml (%)... 0.0 0.0 0.0 0.0 0.0
growth rate.......... 0.0 0.0 0.0 0.0 0.0
Trade balance ($B)..... 9.3 16.5 23.4 23.2 32.0
Current account ($B)... 11.1 26.0 45.5 60.6 94.4
Exch rate--FX/$ (%).... -1.1 72.3 3.2 -3.3 -3.8
Government deficit ($B) -9.0 -23.0 48.7 -74.8 118.6
GERMANY
Real GNP (%)........... -0.4 -0.7 -0.9 -0.7 -0.9
growth rate...... -0.4 -0.3 -0.2 0.2 -0.2
Price level (%)........ -0.1 -0.4 -0.7 -1.1 “1.6
infl rate (+7-)...... -0.1 -0.3 -0.3 -0.4 -0.5
Interest rate (+7-).... -0.9 71.5 -2.2 -2.3 -3.1
Money supply--CBM (%).. 0.3 0.8 1.4 1.8 2.3
growth rate.......... 0.3 0.5 0.6 0.4 0.5
Trade balance ($B)..... -1.9 3.6 “5.5 5.8 “8.2
Current account ($B)... -2.0 3.7 -5.9 6.8 -10.5
Exch rate--DM/$ (%).... 0.7 1.4 1.8 1.7 1.9
JAPAN
Real GNP (%)........... -0.5 -0.7 -0.6 0.2 0.7
growth rate.......... “0.5 -0.2 0.1 0.7 0.5
Price level (%)........ -0.0 -0.1 -0.2 -0.2 -0.1
infl rate (+/-)...... -0.0 -0.1 -0.1 0.0 0.1
Interest rate (+/-).... -0.8 1.4 71.9 -2.0 -2.
Money supply--M2 (%)... 9.9 2.0 3.5 5.0 7.7
growth rate......... . 0.9 1.1 1.6 1.4 2.8
Trade balance ($B)..... -3.5 -6.5 “9.4 “9.3 -11.9
Current account ($B). -3.7 8.3 -13.7 717.2 724.5
Exch rate--$/yen (%)... 0.6 1.1 1.2 0.7 0.3

NOTE: Amounts shown are deviations from baseline
(%) = percent, (+/-) = absolute deviation
Dollar values converted at baseline rates


-19a-

Fioune 1

ForziaN)
Porny

of,

eA, eA,

US Poucy


-l7a-
TABLE 5: US FISCAL CONTRACTION WITH US MONETARY ACCOMMODATION

198604 198704 1988Q4 198904 199004
UNITED STATES
Real GNP (%)......--6- -1.0 -0.9 -0.3 0.7 0.1
growth rate.......... 71.0 0.1 0.7 1.0 -0.8
Price level (%)..... . -0.0 -0.2 0.4 -0.6 0.8
infl rate (+/7-)...... -0.0 -0.1 -0.2 -0.2 -0.2
Interest rate (+/-).... -2.0 "4.4 * -4.4 4.6 “4.7
Money supply--M1 (%) 1.5 3.5 4.5 4.5 4.0
growth rate........-+ 1.5 2.0 1.0 -0.0 -0.5
Trade balance ($B)..... 6.9 11.6 16.0 18.0 27.3
Current account ($B) 8.1 26.3 45.0 64.1 93.1
Exch rate--FX7$ (%). -2.7 -8.0 -9.5 -11.3 -12.0
Government deficit ($B) -20.7 56.8 -104.9 -137.6 -168.8
GERMANY
Real GNP (%).. se eeee -0.3 -0.9 -1.2 -1.7
growth rate. . -0.3 -0.5 -0.2 -0.5
Price level (%) 0.5 -1.7 -2.1 -2.6
infl rate (+7-)... 0.5 -0.6 -0.3 0.5
Interest rate (+/-).... 0.6 -1.2 -1.2 71.4 -1.8
Money supply--CBM (%).. 0.0 0.0 0.0 0.0 0.0
growth rate.......-- . 0.0 0.0 0.0 0.0 0.0
Trade balance ($B)..... -1.0 -2.4 5.8 -7.4 -12.0
Current account ($B)... 0.4 -0.2 -2.4 "2.6 -7.3
Exch rate--DM/$ (%).... 3.2 8.6 10.9 12.5 12.6
JAPAN
Real GNP (%)... -1.0 -2.2 72.9 -3.1 -3.4
growth rate. . 1.0 1.3 -0.7 -0.2 -0.3
Price level (%). -0.1 -0.4 -0.6 -0.9 71.2
infl rate (+7-).. . -0.1 0.3 -0.2 -0.3 -0.3
Interest rate (+7-).... -0.3 0.6 -0.7 -0.7 -0.7
Money supply--M2 (%)... 0.0 0.0 0.0 0.0 0.0
growth rate.......-.- 0.0 0.0 0.0 0.0 0.0
Trade balance ($B)..... -6.3 -11.1 -17.2 -17.6 -24.1
Current account ($B)... 6.3 12.4 -20.6 22.6 -31.0
Exch rate--$/yen (%)... 3.4 9.2 10.3 12.6 13.8

NOTE: Amounts shown are deviations from baseline
(%) = percent, (+/-) = absolute deviation
Dollar values converted at baseline rates


-l4a-
TABLE 3: US FISCAL CONTRACTION WITH NO MONETARY ACCOMMODATION

198604 198704 1988Q4 19894 199004

UNITED STATES

Real GNP (%).... oe “1.5 "2.3 -2.5 71.6 -1.9

growth rate. 71.5 -0.8 -0.3 0.9 -0.3
Price level (%).... -0.1 -0.6 71.3 -2.1 -3.0

infl rate (+/-).. -0.1 -0.4 -0.7 70.8 -0.9
Interest rate (+/-).... -1.2 -2.3 “3.2 “3.4 “4.5
Money supply--Ml (%) 0.0 0.0 0.0 0.0 0.0

growth rate.......... 0.0 0.0 0.0 0.0 0.0
Trade balance ($B)..... 9.3 16.9 24.1 24.1 32.7
Current account ($B) 11.2 26.1 45.4 59.8 92.7
Exch rate--FX/$ (%).... -1.8 3.6 -5.2 5.5 6.8
Government deficit ($B) “8.9 22.6 47.6 -72.6 114.9

GERMANY

Real GNP (%)........... 0.4 0.9 “1.3 -1.8

growth rate......... . 0.4 -0.4 -0.5 -0.3
Price level (%)........ -0.3 -0.7 71.2 -2.4

infl rate (+/-)...... -0.3 -0.4 -0.5 -0.7
Interest rate (+/-).... -0.5 0.8 -1.1 -1.2 -1.8
Money supply--CBM (%).. 0.0 0.0 0.0 0.0 0.0

growth rate.......... 0.0 0.0 0.0 0.0 0.0
Trade balance ($B)..... -1.8 3.9 “0 -9.1 -12.9
Current account ($B)... 1.3 -2.9 -5.3 -7.2 -11.3
Exch rate--DM/$ (%).... 1.7 3.6 5.2 5.4 6.4

JAPAN

Real GNP (%).. -0.7 -1.5 72.1 -2.2 -2.8

growth rate . -0.7 -0.8 0.6 0.1 "0.5
Price level (x). . -0.1 -0.2 -0.4 0.6 0.9

infl rate (+/-).. -0.1 -0.1 -0.2 0.2 -0.3
Interest rate (+/-).... 0.2 0.4 -0.6 -0.6 -0.7
Money supply--M2 (%). 0.0 0.0 0.0 0.0 0.0

growth rate.......... 0.0 0.0 0.0 0.0 0.0
Trade balance ($B)..... 4.2 8.8 13.2 ~14.8 -20.4
Current account ($B)... “4.1 9.7 715.4 719.0 26.9
Exch rate--$/yen (%)... 2.1 3.6 5.1 5.4 7.3

NOTE: Amounts shown are deviations from baseline
(4) = percent, (+/-) = absolute deviation
Dollar values converted at baseline rates


-8-

The Gramm-Rudman Act utilizes two mechanisms to enforce its
deficit targets. First, it amends the regular congressional budget
process. This has included making the reconciliation process earlier in
the budget cycle and the provision for only one annual congressional
budget resolution. Other changes mandate new procedures that are
designed to make enforcement of budget targets stricter and more
certain.

The second mechanism that the Gramm-Rudman Act uses to enforce
deficit targets is a procedure for automatic outlay cuts called
sequestration. This process is triggered if the estimate of the deficit
for the coming fiscal year prepared by the Congressional Budget Office
and the Office of Management and Budget just before the fiscal year
begins exceeds the limit for that year specified in the Act. Ever after
this process is triggered, Congress is given the opportunity to assert
priorities other than those embodied in the automatic formula provided
that the Congressional alternative brings the deficit within the
required limits.

In modelling the Gramm-Rudman Act in this paper, it is assumed
that U.S. macroeconomic authorities surrender control over one of their
policy instruments, namely government spending. (It is assumed that tax
rates do not change, in accord with current administration policy.)

Thus government spending is effectively predetermined because the

government deficit is limited by the Gramm-Rudman Act. We assume that
the constraint imposed by the act is always binding. U.S. governnent
spending is forced to be cut from the baseline in accordance with the

numbers in Table 2.


IFDP
NUMBER

273
272
271

270

269
268

267

266

265
264

263

262

261

~25-

International Finance Discussion Papers

TITLES

1985
(partial listing)
An Analysis of the Welfare Implications of
Alternative Exchange Rate Regimes: An
Intertemporal Model with an Application

Expected Fiscal Policy and the Recession
of 1982

Elections and Macroeconomic Policy Cycles

Assertion Without Empirical Basis: An
Econometric Appraisal of Monetary Trends
in... the United Kingdom by Milton Friedman
and Anna J. Schwartz

Canadian Financial Markets:
Proposal for Reform

The Government's

Was It Real? The Exchange Rate Interest
Differential Relation, 1973-1984

The U.K. Sector of the Federal Reserve's
Multicountry Model: The Effects of
Monetary and Fiscal Policies

Optimal Currency Basket in a World of
Generalized Floating: An Application to
the Nordic Countries

Money Demand in Open Economies:
Substitution Model for Venezuela

A Currency

Comparing Costs of Note Issuance Facilities
and Eurocredits

Some Implications of the President's Tax
Proposals for U.S. Banks with Claims on
Developing Countries

Monetary Stabilization Policy in an Open
Economy

Anticipatory Capital Flows and the Behaviour
of the Dollar

AUTHOR(s)

Andrew Feltenstein
David Lebow

Anne Sibert
William H. Branson
Arminio Fraga
Robert A. Johnson

Kenneth Rogoff
Anne Sibert

David F. Hendry
Neil R. Ericsson

Garry J. Schinasi

Richard Meese
Kenneth Rogoff

Hali J. Edison

Hali J. Edison
Erling Vardal

Jaime Marquez
Rodney H. Mills

Allen B. Frankel

Marcus H. Miller

Arnold Kling


-22-

Footnotes

* Both authors are Economists in the Division of International Finance
at the Board of Governors of the Federal Reserve System. The views
expressed herein are solely those of the authors and do not
necessarily represent the views of tne Federal Reserve System or any
members of its staff.

1 Their paper also contains a good list of references to the
theoretical literature. See for example Hamada (1974, 1976)
Canzoneri and Gray (1983), Miller and Salmon (1985) and’ Buiter and
Marston (1985).

2 For complete details on the theoretical basis of the MCM see Stevens
et al. (1984). For an update on the MCM theoretical basis see
Edison, Marquez, Tryon (1986).

3 Henceforth we refer to West Germany as Germany.

4 For more detail on the exchange rate in the MCM see Hooper (1986).

5 See references cited in note 1.


-5-

short-term interest rate adjusts to clear money market. Money demands
by the public (currency, demand deposits, and time deposits) and by the
banking sector (free reserves) are modelled explicitly. Long-term
interest rates are modelled as distributed lags on the short-term rate.

The MCM is in many ways a conventional demand-oriented
macroeconometric model -- the innovations are chiefly in the modelling
of trade and exchange rates, and in the multicountry structure. In
particular, the treatment of expectations and aggregate supply is quite
conventional, which does raise some questions about the appropriate way
to model policy regime changes. Expectations of future prices and
exchange rates are both modelled explicitly in the MCM country model;
however, expectations are determined by an adaptive structure, and are
not "forward-looking". Exchange rate expectations are used in the
determination of the spot exchange rate, while price expectations offset
nominal wages and the real interest rate, which appear throughout the
model.

To provide a rough indication of the importance of
expectations and supply effects in the MCM for the sorts of policy
exercises reported in this paper, we present some summary multipliers in
Table 1. The table shows the effects on real GNP and prices of
standardized fiscal and monetary shocks, for the U.S. and foreign
countries. The results can be interpreted as a measure of the degree of
crowding out and neutrality of money in the model. The results also
show the extent of foreign linkages in the MCM.

The table shows that crowding out of a U.S. fiscal shock is
virtually complete after six years. Money is not neutral in the United

States over this simulation period, but the positive effects of the


-y-
to produce a composite consumption-investment commodity. By assumption,
goods produced in the different countries are imperfect substitutes.

Aggregate demand is divided into six major components:
personal consumption, fixed investment, inventory investment, government
spending, exports, and imports. Consumption depends upon private
disposable income and net worth following the life cycle hypothesis.
The fixed investment equations are based on neo-classical investment
theory, being positively related to changes in income and negatively to
changes in the user cost of capital. Inventories act as a buffer stock
and absorb any discrepancy between production and sales. Real
government spending is assumed to be exogenous. Imports and exports of
goods and services are broken down into merchandise trade, investment
income, and other services.

The supply side of the prototype country model treats
potential GNP as a function of the capital stock and labor force using a
Cobb-Douglas production function. Capacity utilization is identified by
the ratio of actual to potential GNP. The labor market is assumed not
to clear completely in any one period, allowing for the existence of
labor unions and minimum wage laws. The wage equation follows the
familiar Phillips-Lipsey-Friedman approach: the change in wages is a
function of unemployment and the expected inflation rate. The expected
inflation rate is represented by a distributed lag on past price changes.
Prices themselves are determined by a markup over average costs, which
include wage costs adjusted for changes in labor productivity, and the
cost of imports (including oil).

In the prototype model, the money market focuses on the role

of reserves in the system. For a given level of base money the


-15-
reduces profit margins. Again, this effect offsets the inflation caused
by the dollar depreciation.

All of these factors tend to cause the U.S. current account
position to improve. Falling income lowers goods imports, while the
reduction in interest rates reduces investment income payments. The
dollar depreciation and the fall in prices tend to increase exports
although on balance exports fall because foreign income is reduced. The
net result is a substantial improvement in the U.S. current account. We
might note that because the United States has a large net external debt
in the baseline simulation changes in U.S. interest rates have an
imporzant direct effect on the current account. This effect cumulates
as current account improvements reduce the stock of liabilities to
foreigners.

In general, the effects on the U.S. economy appear to be of
moderate magnitudes. Real income falls by 1-1/2 percent in the first
year and by 2-1/2 percent after three years before recovering somewhat.
(In the long run these decreases would be almost completely reversed.)
The inflation rate falls slightly, by 0.5-0.9 percent, and the exchange
rate depreciates by only 5-7 percent. Nominal interest rates fall
substantially, by 1.2 percentage points after four quarters and by 4.5
percentage points at the end of the simulation. As noted, the current
account improvesquite substantially by the end of this period.

In Germany and Japan the effects of the U.S. fiscal
contraction are felt on a direct reduction in demand for exports and as
an appreciation of their exchange rates which further lower exports.
Prices and interest rates fall, as in the United States but the current
account in both countries goes into deficit.

Initially, the impact on real income is smaller abroad than in

the United States, but over time the effects of the dollar depreciation


-7-

temporary increase in money growth are substantially reduced. The
foreign models, taken together, exhibit noticeably less crowding out and
neutrality of money than does the U.S. model. Finally, the spillover
effects of U.S. policy on foreign economies are very strong, but foreign
policy has much smaller effects on the United States. (The transmission
effects are primarily through exchange rate changes, which affect

foreign economies more than the United states.)

II. The Gramm-Rudman Act

This section briefly outlines some of the institutional
aspects of the Balanced Budget - Deficit Reduction Act of 1985, also
known as the Gramm-Rudman Act. In addition, it gives some indication
how this will impact government spending. The Gramm-Rudman Act targets
are now binding on the U.S. administration and congressional budget
proposals. Table 2 shows what these limits are. Under the new law the
administration may not propose a budget with deficits that exceeds these
specific limits nor may Congress adopt a budget resolution which

proposes higher deficits.

Table 2
Gramm-Rudman Deficit Limits

(Fiscal years, billions of current dollars)

1986 1987 1988 1989 1990-1991

Maximum allowable deficit 172 144 108 72 36 0)
(in budget deliberations )

Trigger for automatic 172 154 118 82 46 te)
outlay cut mechanism


-18a-
TABLE 6: US FISCAL CONTRACTION WITH US AND FOREIGN MONETRY ACCOMMODATION

198604 198704 198804 198904 199004
UNITED STATES
-1.0 -1.0 -0.3 0.7 0.0
. 1.0 0.0 0.7 1.0 -0.7
Price level (%). nee 0.1 -0.3 -0.6 -0.8 -1.0
infl rate (+7-)...... “0.1 -0.2 -0.3 -0.2 -0.2
Interest rate (+/7-).... 72.0 4.5 “4.6 “4.7 4.8
Money supply--Ml (%)... 1.5 3.5 4.5 4.5 4.0
growth rate.......... 1.5 2.0 1.0 -0.0 -0.5
Trade balance ($B)..... 6.9 10.6 14.4 15.5 25.5
Current account ($B)... 7.8 25.4 45.2 64.9 96.0
Exch rate--FX/$ (%).... -1.0 4.8 -5.9 -7.3 -7.9
Government deficit ($B) -20.9 -57.3 106.9 141.4 -175.5
GERMANY
-0.2 “0.1 -0.0 0.3 -0.0
-0.2 0.1 0.1 0.3 -0.3
0.2 0.5 0.8 -1.0 -1.2
-0.2 -0.3 -0.3 -0.1 -0.3
Interest rate (+/-).... -1.6 -3.0 -3.3 -3.5 3.6
Money supply--CBM (%).. 0.7 1.7 2.8 3.5 4.0
growth rate.......... 0.7 1.1 1.1 0.7 0.5
Trade balance ($B). 71.9 -2.5 -3.0 -1.7 -2.7
Current account ($B)... 72.5 2.9 “3.9 "2.6 “4.5
Exch rate--DM/$ (%).... 0.6 3.2 3.8 4.6 5.1
JAPAN
Real GNP (%). -0.3 -0.3 0.5 1.8 2.5
srowth rate -0.3 0.0 0.8 1.3 0.8
Price level (%) -0.0 -0.1 0.0 0.1 0.5
infl rate (+/-). 0.0 -0.1 0.1 0.2 0.3
Interest rate (+/-).... -1.4 -2.8 3.0 -3.0 3.1
Money ssupply--M2 (%)... 2.1 5.4 8.0 10.7 13.4
growth rate.......... 2.1 3.3 2.5 2.8 2.7
Trade lbalance ($B)..... 3.7 -6.7 “9.5 -9.8 -12.7
Current account ($B)... 4.3 -10.2 717.2 722.2 -29.8
Exch rate--$/yen (%)... 0.4 2.7 3.0 3.5 3.3

NOTE: Amounts shown are deviations from baseline
(%) = percent, (+/-) = absolute deviation
Dollar values converted at baseline rates


International Finance Discussion Papers
Number 286

July 1986

AN EMPIRICAL ANALYSIS OF POLICY COORDINATION IN THE
UNITED STATES, JAPAN AND EUROPE

by

Hali J. Edison and Ralph Tryon

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
acknow].edgment that the writer has had access to unpublished material)
should be cleared with the author or authors.


-10-

Or, as in the cases analyzed by Oudiz and Sachs, the trade
might occur in macroeconomic policy. One country might inflate its own
economy slightly past the optimal point, raising income but at the cost
of a deterioration of the exchange rate. The expansion would, however,
benefit foreign economies by raising demand for their exports. In
exchange for this, the foreign economies could inflate their own
economies, offsetting the exchange rate change and raising income in the
first country.

For clarity we term these three types of policy interaction
"synchronization", "coordination", and "cooperation" respectively. In
this paper we focus on the gains from coordination, as defined here.
This is in contrast to much of the recent work in this area, which
considers the question of policy cooperation, as we use the term. Our
interest in this aspect stems not from any presumption that the exchange
of information is either more or less important than policy trading, but
rather from our desire to explore another side of the question.

The basic theoretical framework we use adopts the classical
convention of Tinbergen of targets and instruments in a multicountry
environment (see Oudiz and Sachs (1984))5. In the general framework an

n country world economy is considered in which each country has k

targets. For each country i there is a vector of targets Ti = (ti,

tees Tj). The itD country has m controls or policy instruments

pi = (pt dp veeey pi ). The macroeconomic authorities of each country
choose Pi in a way which will maximise their own utility, ui(T!). In an
interdependent world the Ti will be a function of all n countries!
controls. Therefore, to maximize its utility, country 1's authority

will have to condition on what the other n-1 countries are doing.


-9-
III. Strategic Considerations in Economic Policy-Making

The term "coordination" can refer to several aspects of the
way in which countries jointly formulate their economic policies. Here
we consider three possibilities.

The first concerns the timing of joint policy actions.
Suppose, for example, that two countries agree to intervene in the
fore:gn exchange markets to support a particular currency. The outcome
might. be different depending on whether or not the intervention occurred
simu.taneously (that is, was coordinated). It is entirely conceivable
that nonlinearities in the system could cause the exchange rate to
respond more if both countries intervened together, than if each
intervened, by the same amount, a month apart. (The G-5 intervention in
September 1985 might be an example of such a case.)

A second type of coordination involves exchanging information
among countries about the policy stance of each. Following, say, an
unexpected change in oil prices, individual countries would face the
problem of determining the appropriate policy response. The best policy
for one country might depend on what action was taken by another. For
example, if one country responded by easing its monetary policy, that
country's trading partners might want to ease its monetary policies to
keep real exchange rates unchanged.

Finally, countries might engage in cooperative policy
"trading" in which one country undertakes a policy action which lowers
its own welfare but helps others, in return for similar concessions by
foreign countries. An obvious example is in negotiating tariff
reductions, where one country might agree to stop protecting an

important domestic industry in return for access to a foreign market.


IFDP
NUMBER

286

285

284

283

282

281

280

279

278

277

276

275

274

-24-

International Finance Discussion Papers

TITLES

1986

An Empirical Analysis of Policy
Coordination in the United States,
Japan and Europe

Comovements in Aggregate and Relative
Prices: Some Evidence on Neutrality

Labor Market Rigidities and Unemployment:
the Case of Severance Costs

A Framework for Analyzing the Process
of Financial Innovation

Is the ECU an Optimal Currency Basket?

Are Foreign Exchange Forecasts Rational?
New Evidence from Survey Data

Taxation of Capital Gains on Foreign

Exchange Transactions and the Non-neutrality

of Changes in Anticipated Inflation

The Prospect of a Depreciating Dollar
and Possible Tension Inside the EMS

The Stock Market and Exchange Rate Dynamics

Can Debtor Countries Service Their Debts?
Income and Price Elasticities for Exports
of Developing Countries

Post-simulation Analysis of Monte Carlo

Experiments: Interpreting Pesaran's (1974)
Study of Non-nested Hypothesis Test Statistics

A Method for Solving Systems: of First Order

Linear Homogeneous Differential Equations
When the Elements of the Forcing Vector
are Modelled as Step Functions

International Comparisons of Fiscal Policy:

The OECD and the IMF Measures of Fiscal
Impulse

AUTHOR(S)
Hali J. Edison
Ralph Tryon
B. Dianne Pauls
Michael K. Gavin
Allen B. Frankel
Catherine L. Mann

Hali J. Edison

Kathryn M. Dominguez

Garry J. Schinasi

Jacques Melitz
Michael K. Gavin
Jaime Marquez

Caryl McNeilly

Neil R. Ericsson

Robert A. Johnson

Garry Schinasi

Please address requests for copies to International Finance Discussion
Papers, Division of International Finance, Stop 24, Board of Governors of

the Federal Reserve System, Washington, D.C. 20551.


-23-

Refer ences

Buiter, W.H. and R.C. Marston (1985) International Economic Policy
Coordination, Cambridge University Press, Cambridge, 1985.

Canzoneri, M.E. and J. Gray (1983) "Two Essays on Monetary Policy in an
Inter'dependent World," forthcoming in International Economic Review.

Edison, H.J., J. Marquez and R. Tryon (1986) "The Structure and
Properties of the Multicountry Model of the Federal Reserve Board,"
forthcoming in Economic Modelling.

Hamada, K. (1974), "Alternative Exchange Rate Systems and the
Interdependence of Monetary Policies," in R.Z. Aliber ed. National
Monet.ary Policies and the International Financial System, University of
Chicago Press, Chicago pp 13-33.

Hooper, P. (1986) "Exchange Rate Simulation Properties of the MCM,"
European Economic Review, 30, pp. 121-198.

Hamada, K. (1976) "A Strategic Analysis of Monetary Interdependence,"
Journal of Political Economy, vol 84, August pp 77-99.

Miller, M. and M. Salmon (1985) "Dynamic Games and Time Inconsistency of
Optimal Policies in Open Economies," in W. Buiter and R. Marston edited
International Economic Policy Coordination, Cambridge University Press,
Cambridge, 1985.

Oudiz, G. and J. Sachs (1984), "Macroeconomic Policy Coordination Among
Industrial Economies," Brookings Papers on Economic Activity, No. 1 pp
1-76. :

Stevens, G.V.G., R.B. Berner, P.B. Clark, E. Hernandez-Cuta, H.T. Howe
and 5$.Y. Kwack (1984), The U.S. Economy in an Interdependent World: A
Multicountry Model, Washington, Board of Governors of the Federal
Reserve System.



-6-
Table 1. Fiscal and Monetary Multipliers in the MCM

(amounts are cumulative percentage deviations from baseline)

year: 1 2 3 4 5 6

U.S. fiscal shock!
U.S. GNP 1.6 1.8 1.4 0.9 0.5 0.1
U.S. prices 0.1 0.4 0.9 1.4 1.9 2.3
foreign GNP 0.3 0.7 0.9 0.9 1.0 1.0
foreign prices 0.2 0.4 0.6 0.7 1.0 1.2

U.S. monetary expansion2

U.S. GNP 0.4 1.5 2.2 2.0 1.4 0.9
U.S. prices 0.1 o.4 0.8 1.4 2.1 2.6
foreign GNP -.2 -.7 -.8 -.8 -.9 “161
foreign prices -.4 -.6 -.7 -.7 -.9 1.1
foreign fiscal shock3
U.S. GNP 0.3 0.5 0.4 0.2 0.1 0.0
U.S. prices 0.0 0.2 0.3 0.4 0.6 0.7
foreign GNP 1.1 1.4 1.3 1.2 1.1 1.1
foreign prices 0.0 0.3 0.6 0.9 1.2 1.6
foreign monetary expansion
U.S. GNP 0.0 0.0 0.0 0.1 0.1 0.0
U.S. prices -.1 -.2 -.2 -.1 -.1 0.0
foreign GNP 0.3 1.5 2.3 2.2 1.8 1.5
foreign prices 0.5 0.6 0.7 1.1 1.5 2.0

This table is adapted from the results presented at the recent Brookings
Institution Conference on Empirical Macroeconomics for Open Economies
(March 1986). (Money growth rates are held exogenous in all countries
unless noted.)

1 Permanent increase of U.S. real government expenditures of one
percent of baseline GNP.

2 One-time increase in U.S money growth rate of four percentage points.

3 Permanent increase in foreign real government expenditures of one
percent of baseline GNP.

4 One-time increase in foreign money growth rate of four percentage
points.


-17-

prices, interest rates, and the current account are virtually identical
in the two simulations. The implication of this result is that, at
least for policy changes of this order of magnitude, the United States
can effectively ignore the foreign response in calculating its own
optimal policy. We will return to this theme later in the paper.

U.S. response

In Table 5 we show the results of the opposite case, in which
the United States does ease its monetary policy to accommodate the
fiscal contraction, but foreign countries do not. We assume that the
U.S. monetary reaction is aimed at stabilizing real GNP, rather than the
real exchange rate. This choice of target is motivated by the
commonplace obser vation that the United States is a less open ard
outward-looking economy than is Germany or Japan.

We should note that in our model it is not generally possible
to use monetary policy to hold real GNP in the United States to an
arbitrary path in the face of a shock. (This is because of the nature
of the lagged response of demand to interest rate changes.) Therefore,
we have selected a path for monetary growth which substantially reduces
the decline in U.S. GNP, without trying to eliminate the decline
entirely.

In this simulation, U.S. GNP returns (approximately) vo the
baseline path after the first two years. The monetary expansion reduces
nominal interest rates, which fall by about 4-1/2 percentage points.
This leads to a depreciation of the dollar of 12 percent by the end of
the period. Despite the dollar's depreciation, the inflation rate is
slightly lower throughout the simulation.

These benefits come, however, at the expense of the cther

countries. The additional depreciation of the dollar (as compared with


-20-
to hit its target exactly, which greatly simplifies the task of
computing the optimal policies.

We first suppose that policymakers do not know where the new
Nash equilibrium (point N) is. Indeed, they naively assume that policy
abroad will remain unchanged while their own countries take action.

This gives us points A; (corresponding to Table 4) and Ag (Table 5).
The Nash equilibrium is the point at which countries optimize given
full knowledge of others' responses. This is shown at point N, which
corresponds to the simulation in Table 6. Our results suggest that for
U.S. policy, there is only a slight difference between Az, where the
foreign response is ignored, and the Nash equilibrium, where the foreign
reaction is taken into account. This is shown by drawing point Ap on a
vertical line beneath N. On the other hand, the optimal foreign policy
response changes considerably depending on whether or not the U.S.
action is taken into account. Thus, point A; is well below N on the
vertical axis. :

With this framework we are not able to obtain any explicit
measures of the welfare gain associated with obtaining information about
foreign policy. However, the difference in real income corresponding to
the difference between points N and A; is of the order of one percent,
and the implied monetary policy differ by a factor of two. Therefore,
it seems fair to describe the differences as important.

With our framework we are also unable to say much about the
location of the cooperative point C. (Indeed, when we reduce the policy
problem to one target and one control the Nash equilibrium is

pareto-efficient and there are no further gains from cooperation to be


-2-
and a large U.S. current account deficit. The authorities have been
under substantial pressure both at home and from abroad to change the
policy mix, and recent months have indeed seen several steps in this
direction.

However, if the U.S. government lowers spending there would be
a significant tendency to lower real income in the United States, and
through lower U.S. imports, in the rest of the world. This could
potentially lead to a world-wide recession. On the other hand, dart of
this recession could be offset by the expansion of other OECD economies,
Japan and Germany in particular. An important question is how other
OECD economies can act effectively in response to changes in U.S.
economic policy. In this paper we consider this as a problem in the
empirical analysis of policy coordination.

We examine the impact of the U.S. Balanced Budget and Deficit
Act of 1985 (also referred to as the Gramm-Rudman Act) on the U.5.
economy and on Germany and on Japan. The paper seeks to evaluate
different policy responses to this change in U.S. policy. In
particular, we consider first an independent response by Germany and
Japan, made in the absence of complete information about the extent of
U.S. monetary accommodation, and a similar response for the United
States. We then analyze some of the implications of a fully coordinated
response. The aim of the paper is to provide an empirical evaluation of
the gains from coordination using simulations with the Federal Reserve
Board's Multicountry Model (MCM).

The plan of the paper is as follows: Section I gives a brief
overview of the MCM model properties. Section II describes the basic
features of the Gramm-Rudman Act, and Section III discusses our

framework for the analysis of coordination. Section IV presents and


-12-

At the Nash equilibrium, point N, country 1's expectation for
country 2's policy, Ey, (CoN), is equal to that policy, CoN, and
similarly, Eo(CqN)=c4N. At this point each side is optimizing given the
actual policy of the other player -- this is not true at point A. The
difference between the two points is that at A, expected foreign policy
is not equal to actual foreign policy. Because countries must act
without knowledge of actual policy abroad, welfare is reduced.

In other words, while the Nash equilibrium N is not a
cooperative equilibrium, it is coordinated in the sense that each side
has {ull knowledge of what the other is doing. (This knowledge might be
communicated directly, or it might be obtained by predicting foreign
behavior given knowledge of the underlying economic structure.)

Of course, the Nash equilibrium is not optimal either, because
welfare could still be improved by a trade. Raising C; above its Nash
valu2 would change U; only slightly, because U; is maximized with
respect to Cy; at N. But Up would clearly rise. A similar argument
applies for Co, and by raising both C; and Co an efficient point such as
C can be reached. Notice that reaching C requires more than an exchange
of information -- it requires an agreement in which each party agrees to
make a sacrifice for the good of the other. This is what we term policy
"cooperation".

In their pioneering article, Oudiz and Sachs make use of the
properties of the Nash equilibrium (together with other assumptions) to
infer the policymakers' utility functions. This, together with the
parameters of the structural model, enables them not only to find an

efficient point such as C but to measure the welfare gain from moving


-14-
instruments - monetary and fiscal policy - and three targets -- GNP,
inflation, and the real exchange rate.

We start by describing the underlying baseline projection used
in the analysis. The baseline used for these simulations is essentially
Similar to that used for the Brookings Conference on Empirical
Macroeconomics (March 1986). The common elements in the baseline are
the components of GNP, prices, exchange rates, and interest rates in
each country. For the most part, these paths are extrapolations of
forecasts obtained from the OECD Economic Outlook for December 1984.

For t;:he period beyond which forecasts have been prepared by the OECD, we
extrapolated at the growth rates projected by the OECD for the first
half of 1986. Exchange. rates and interest rates are held constant over
the projection period using 1985Q4 data. This baseline path is treated
as the initial Nash equilibrium. That is, each country is assumed to
have achieved its optimal policy mix given the other countries' policy
actions, prior to the passage of the Gramm-Rudman Act.

The initial effects

Table 3 summarizes the effects of the Gramm-Rudman law in the
absence of any other policy reaction either in the United States or
abroad. (All countries are assumed to keep their money supplies
unchanged.) In this model, the reduction of government spending in the
United States leads directly to a reduction in real income. With a
fixeci path for the money supply, interest rates fall leading toa
depreciation of the dollar. (The reduction in real income tends to
reduce imports and therefore to cause the dollar to depreciate; this
effect is offset by the lower interest rates). Prices fall (relative to

the taseline) as output falls because excess capacity in the economy


An Empirical Analysis of Policy Coordination in the
United States, Japan and Europe
by

Hali J. Edison and Ralph Tryon*

In the postwar period, trading and financial ties have
increased dramatically among the industrialized countries. These ties
imply that one country's economic policies have spillover effects on
other countries' welfare and consequently have implications for their
economic policies. This interdependence suggests that coordination of
economic policy between countries is important. However, as Oudiz and
Sachs (1984) put it, "the advocacy of international coordination has
been far more plentiful than its actual implementation." This paper
aims to shed some light on the potential gains from coordination.

Several important theoretical papers have been written on
policy coordination, but there is relatively little empirical work in
the area. Jeffrey Sachs and Gilles Oudiz, in the paper just referred
to, made a pathbreaking effort to measure the potential welfare gains
thet could be realized from policy coordination among Japan, Germany,
and the United States.! In our paper we work within the general
framework of Oudiz and Sachs, but we use a somewhat simpler empirical
methodology, and focus on a different aspect of the gains from policy
coordination.

Over the past five years, U.S. policy has been subject to much
eriticism by our major trading partners. One of the major sources of
friction has been the "mix" of U.S. fiscal and monetary policies. The
United States has been running a large government deficit, the
inflationary effects of which have been offset domestically by a
restrictive monetary policy. It is generally argued that the result has

‘
been higher real interest rates in the United States, a stronger dollar,


=19-

This result is an example of an important, and obvious,
asymmetry in the present-day world economy, that the United States isa
much larger and substantially less open economy than its major trading
partners. Therefore other countries must take into account U.S. policy
actions, but the United States need not take theirs into account). (Of
course, we have given an analysis of only one possible policymaking
problem -- it does not follow that in response to any shock the United
States could ignore the actions for foreign countries.)

This example also illustrates the scope for gains fron sharing
information about foreign economic policy responses. In the te-ms of
our earlier discussion, the Nash equilibrium (loosely) corresponds to
the last simulation, in which all parties optimize given full knowledge

of other countries policies.

Vv. Conelusion

We can represent these simulations in terms of our theoretical
framework using Figure 2. After the implementation of the Gramm-Rudman
Act the world economy finds itself at a point such as Az, which
corresponds to our first simulation (Table 3). At this point policy in
all countries is suboptimal given the changed conditions, which we model
as the imposition of a constraint on U.S. fiscal policy.

We assume that foreign fiscal policy remains unchanged
throughout, so that each country has only one policy instrument, namely
the money supply. We have further simplified the problem by assuming
that each country has only one target -- real GNP in the United States,

and the real exchange rate abroad. This assumption allows eact. country


ABSTRACT

Coordination of macroeconomic policy has been a major topic at
recent, summit meetings, and has been the subject of a number of
theoretical studies. However , relatively little empirical research
exists on policy coordination. This paper is an attempt to help fill
this gap. The paper considers the quantitative importance of the
coordination of fiscal and monetary policy under flexible exchange rates.
We also evaluate the mechanisms by which the effects of macroeconomic
policy are transmitted abroad. The nature of the equilibrium reached in
the absence of coordination is also analyzed, and the empirical results
are related to the theoretical literature. The analysis is based on

simulations with the Multicountry Model (MCM) developed at the Federal

Reserve Board.


-21-
realized.) Sachs and Oudiz analyze the gains to be realized in money
from N to C, and find them to be surprisingly small.

We conclude from our analysis that the information about other
countries' policies needed to support a Nash equilibrium is
quantitatively important. Another way of putting this is that the Nash
equilibrium appears to differ significantly from other possible
equilibria in the world economy, (for example, one in which countries
hold static expectations about foreign policy). The implication for the
modeller is that the choice of solution concept is quantitatively
important in doing policy analysis. The implication for the policymaker
is that institutions which ensure the interchange of information about
economic policy are an important form of policy coordination, perhaps at

least as important as explicit bargaining over joint policy actions.


-11-

In this paper three equilibria are considered. In the first
policymakers must form expectations under uncertainty about what.
foreignpolicy is. The second is a Nash equilibrium, or the
uncoordinated policymaking equilibrium. In this instance no trades are
being made; rather country 1 formulates its policy taking the actions of
the n-1 countries as known and given. In the Nash equilibrium each
country knows what every other country is doing and that they all know
and use the 'true' model. The last equilibrium considered is a
cooperative one in which some form of explicit cooperation takes place,
moving some or all countries to a higher level of utility.

These concepts can be illustrated for the case of two
countries, each with one policy instrument, using the standard
indifference curve framework, as shown in Figure 1. On the horizontal
axis the control variable is measured for country 1 and the vertical
axis depicts that for country 2. The curves in the diagram represent
the utility for each country -- actually a family of these curves could
be drawn,

Suppose country 1 expects country 2 to set its control
variable at E,(C2), where E,; denotes expectations by country 1. Then
country 1 chooses policy C;, expecting to reach point A;. Country 2
does likewise, expecting to reach Ap. The actual point reached by both
countries is A. In this example each country sets a higher value for
the control variable than expected by the other, so utility in each
country is higher than expected. But point A is clearly suboptimal --
each ccuntry, had it known the other would select a higher value for its

control, would have selected a still higher value for its own.


-13-

from N to C. The major difficulty with this analysis is that it
requires some very stringent assumptions. One needs to be able to
identify a particular period in time as a Nash equilibrium and to
specify the exact form of the policymakers' utility functions.

In this paper we use a less rigorous but, we think, equally
informative approach to study the difference between points such as A
and N, and N and C. We assume first that following a particular 2vent
(or "shock") each country's expectation about the stance of foreign
policy remains unchanged, and we consider various policy responses in
this case. We then consider the same type of policy response whe.
policymakers assume that a foreign policy reaction occurs. Finally, we
give a simple example of explicit policy cooperation, as defined above.
In order to evaluate gains and losses we offer a description of the
changes in income, prices, and the real exchange rate, rather than

trying to compute a single measure of utility.

IV. Empirical Simulations of Economic Policy Coordination

This section presents the results of a series of simulations
of the Gramm-Rudman law in the United States. The simulations were
performed using the FRB Multicountry Model (MCM) over the period
1986Q1-1990Q4. In the empirical implementation of our analysis cf
policy coordination we make several simplifying assumptions. First, it
is assumed that economic structure of the MCM is the true model cf the
world, and that policymakers believe this. Second, we consider policy
coordination among only three countries in the MCM: the United States,

Japan, and Germany. Finally, each country is assumed to have two policy