Table 2: Comparative U.K. Model Properties
Government Expenditure SimuTat Ton
10% Increase in Government Expenditure

Year MCM LBS NIESR MCM LBS NIESR
Difference GNP Difference Consumption

1 1.89 1.22 1.45 44 32 49
2 1.79 1.49 1.65 65 56 83
3 1.81 1.73 1.68 86 64 75
4 1.65 1.95 1.77 72 62 75
Difference Investment Nifference Inventories

1 31 07 98 53 023 28
2 31 07 032 33 -049 ll
3 30 -06 914 97 -070 05

4 19 03 09 -18 -080 04


-l1-

An additional fiscal policy simulation is considered. In this
scenario it is assumed that all the MCM countries coordinate their fisca
policies such that each country increases their government spending by
2.2% of the value of real GNP in the first quarter of 1977. Table 4
shows the effects of coordinated fiscal policy. When all the countries
reflate together the effect on U.K. GNP is greater than if it had
expanded in isolation. Prices rise in all countries under a coordinated
expansionary policy. The increase in U.K. prices and aggregate demand is
reinforced by a relatively greater depreciation of the pound. The dollar
appreciates bilaterally against the pound and other MCM currencies
because of a relatively larger increase in U.S. interest rates. Because
the pound depreciates by so much and all countries have increased their
demand for U.K. goods the trade balance deficit is smaller in the joint
expansion than in the single country case. This result seems to indicate
that the U.K. in terms of their income and balance of payments goals are
much better off when all countries reflate together.

The second type of shock considered is the effect of the
increase in the general level of interest rates caused by an increase in
the minimum lending rate, The minimum lending rate is increased by 300
basis points in the second quarter of 1977 and sustained for five years
until the fourth quarter of 1982. ‘This simulation is not presented as a
realistic policy experiment. The main concern is to show as clearly as
possible, the various routes through which monetary policy operated in
the U.K. sector of the MCM model,

The main channel through which monetary policy influences the

U.K. sector of the model is through the effects of interest rates on the


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II. Development and Structure of the MCM

The aim of the MCM project has been to develop an econometric
model which could be used for simulation and forecasting exercises within
the Division of International Finance at the Federal Reserve Board. Four
objectives governed the project ;4/ these were as follows:

(1) To determine endogenously, the international transactions
and important exchange rates between the United States and
other major countries.

(2) To analyse and quantify the impacts of changes in foreign
economic policies and other shocks (including oi] price
and asset market shocks) on U.S. international
transactions, exchange rates and important domestic
variables, such as GNP, inflation, interest rates, and
unemployment.

(3) To analyse and quantify the effects of economic
developments in the United States, including policy
changes, on foreign countries and to quantify the feedback
of these effects on U.S. international transactions,
exchange rates, and the domestic economy.

(4) To analyse the effects of exchange rate market
intervention, both by the United States and by foreign
countries,

After considerable debate it was decided to build the MCM as a

system of quarterly national macroeconomic models at the center of which

is a medium-sized modei of the U.S. economy. Linked to this U.S. model


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COMPARISON OF UK AND MCM GOV'T POL SHOCK
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-15-

Vv. Conclusion

The purpose of this paper is to describe and to analyse in some
detail the J.K. sector of the MCM. The analysis focuses on the effects
of shifts in U.K. monetary and fiscal policies at three levels: 1)
within the unlinked U.K. sector, 2) within the linked MCM framework, and
3) within the linked MCM under the assumption that U.K. policy shifts are
coordinated with those in other countries. It is difficult to appraise
the simulation results described in the paper because large macro models
are complex and often difficult to decifer. In most respects, but not
all, the properties of the MCM model accord closely with the analytical
properties of a standard IS-LM framework.

I would like to draw attention to two features of the results
which have been illustrated in the experiments.

The first feature is that monetary policy has a significant
impact on investment in the J.K. sector, largely in the non-residential
component. This is somewhat different from the results reported in
Bladen-Hovell, et.al. (1982) using the National Institute model and the
Treasury model and those I have reported using the National Institute and
Londor' Business School models. It reflects the MCM's specification of
the two investment functions and their interest-rate responsiveness.

Secondly, the contrast between the unlinked simulation and the
linked simulation especially for a fiscal policy shock, is marked.
Allowing for feedback effects from the other MCM countries, illustrates
an additional feature of the MCM. For the fiscal policy simulation, for
example, the income stimulus in the linked simulation is substantially
lower because of further increases in interest rates. Moreover, the MCM
provides an interesting vehicle for considering coordinated policy

action.


-7-

IV. Simulations

Two types of policy shocks are considered in this section:
fiscal and monetary. The instruments which are used to initiate these
policies are changes in the level of real government spending and changes
in central bank discount rate--in the U.K. case, the Minimum Lending
Rate (MLR). It is recognised that the Bank of England has implemented
changes in monetary policy through instruments other than MLR. However,
given the scope of the model, I shall focus on this instrument in the
analysis of the effects of changes in U.K. monetary policy. Furthermore,
it is assumed that the government deficit is financed by changes in the
stock of sterling-denominated bonds.

The general simulation properties of the model are the product
of the cyclical state of the economy as well as the model's structure.
That. is, when the economy is operating with slack, the response of
activity and prices to an expansionary fiscal policy will differ from
those that occur when the economy is at full employment. To overcome
this problem one could repeat the stimuli in various time periods with
different degrees of slack to derive different multiplier. Some
experimentation of this was done for the fiscal shock, but the results
were quite similar such that I only report one set of results.

In conducting the experiments, base-line paths are generated
using actual values for all the exogenous variables. Historical
simulations are used to examine the MCM because it eliminates
complications introduced when forecasting exogenous variables. The

residuals of the behavioural equations are added back to make the


-4-

rate which generates substitution among the competing sources can be
handled explicitly. For example, if one country's currency appreciates
against anothers, it is possible to measure the extent to which trade
between the two countries is directly affected.

In the current version of the MCM, an oil sector has been
added / The MCM now models explicitly the consumption of and trade in
oil. Oil also enters the supply side, implicitly, as a factor of
production. The price of oil enters as a determinant of domestic prices.
In addition, an OPEC wealth (cumulated current account) variable enters
into exchange rate equations (inverted asset demand equations), capturing
some of the financial effects of an oil price shock.

Overall, the MCM now consists of about 1000 equations;
revisions to the system are undertaken on an ongoing basis. For example,
the current modelling staff is involved in reevaluating the various
sectors of the model, revising the theoretical basis, and reestimating
the model. A larger, more enriched rest of world sector is also being
developed. The general strength of this model lies in its emphasis of
international linkages. Before describing the simulation results, a

brief description of the basis prototype model is presented.


-3-

and to each other, are four quarterly macroeconomic models for Canada,
Germany, Japan and the United Kingdom. The single models vary in size
from 180 to 300 behaviourial equations and identities. While the
international aspects of these country models have been emphasised, each
country model is sufficiently developed to be used individually as well
as fully linked with other countries in the MCM framework. Also included
in the system is an abbreviated sector representing the rest-of-world
(ROW). This sector includes the determination of income and prices,
trade flows and some OPEC financial flows.

The system has three salient features, all of which relate to
the international scope of the MCM. The first is the endogeneity of four
bilateral-dollar-exchange rates. In the current version of the model,
exchange rates appear as dependent variables in renormalised equations
for net-private-capital flows 2/ In these equations, exchange rates are
expressed as functions of interest rate differentials, and factors
affecting exchange-rate expectations (relative prices, inflation rates
and cummulated current accounts) and net private capital flows o/ This
treatment differs from the original version of the MCM, in which exchange
rates were solved for implicitly to clear the balance of payments in each
country.

The second noteworthy feature is the use of bilateral trade
equations rather than aggregate trade equations. These bilateral import-
demand equations are used to explain each country's (and ROW's) imports
from each of the other countries. The advantage of using bilateral trade

equations is that the effect of a change in any bilateral exchange rate


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-6-

The supply side of the prototype country model, treats
potential GNP as a function of the capital stock and labour force in the
context of a Cobb-Douglas production function. Capacity utilisation is
identified by the ratio of actual GDP to potential GDP. The labour
market is assumed not to clear completely in any one period and allows
for the existence of labour unions and minimum wage laws. The wage
equation (expressed as a four-quarter percentage change) follows the
familiar Phillips-Lipsey-Friedman approach. The change in wages is then
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 labour productivity, and cost
of imported imports including oi].

In the prototype model, the money market focuses on the role of
reserves in the system. For a given level of unborrowed base, short-term
interest rates adjust to clear the various demands for base money. To
incorporate institutional differences the original MCM model builders
altered the U.K. specification of the domestic financial sector. The
money market is not modelled explicitly in the U.K. model 2 Rather,
interest rates are determined in part by the Bank of England's exogenous
Minimum Lending Rate and in part by pressures in the government bond
market. The main reason historically for the U.K. model to deviate so
much from the prototype model is because the analysis of reserve behavior
in the U.K. was complicated by the presence of two reserve ratios. In a
paper by David Howard (1982) it is argued that if one added vault cash
(as excess reserves) to bank deposits, that a U.K. financial sector more

along the prototype model could have been devel oped .2/


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International Finance Discussion Papers
Number 267

October 1985

THE U.K. SECTOR OF THE FEDERAL RESERVE'S MULTICOUNTRY MODEL:
THE EFFECTS OF MONETARY AND FISCAL POLICIES

by

Hali J. Edison

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.


exchange rate depreciates. In general, prices tend to increase along
with the higher activity while unemployment tends to decline. In this
version of the MCM, fiscal policy is not completely crowded out as GNP
does increase by more than government spending. There is a real balance
effect in the consumption function, but because it depends in part on
£M3, private consumption is not completely crowded out. On the other
hand non-residential investment is highly interest rate sensitive and the
higher PSBR which leads to higher interest rates eventually chokes
investment off. As noted above the exchange rate falls which crowds out
U.K. net exports.

Table 2 presents a brief summary of similar fiscal simulations
on the National Institute (NIESR) model and the London Business School
model (LBS) provided by the Warwick Modelling Bureau. Note that both of
these models are simulated over forecast periods (1985Q1-198894) but a
10% increase in government expenditures is applied. The table
concentrates on the components of GNP. All three models share the common
feature that their intermediate government expenditure multiplier is
greater than one. The GNP pattern differs between the models. The NIESR
and the LBS are similar, both show smaller impact effects than the MCM,
but growing over time. The change in consumption between the models is
similar. Differences show up in investment and the international trade
sectors. The MCM shows fixed investment responding quite a bit to the
change in.government spending due to changes in interest rates while the
other two models do not. Likewise the MCM has a stronger import leakage
effect than the other two models. This result might be due to the

slightly different monetary assumptions used in the simulations. In all


~8-

endogenous variables follow their actual historical paths in the base-
line. The model is then run to consider each policy action and compared
with the base-line paths. Three simulations for each policy shock are
considered, The first simulation for each policy action considers the
U.K. separately and is referred to as the unlinked simulation. This type
of simulation enables one to compare the MCM U.K. sector to other U.K.
models, Next the U.K. sector is considered as part of the MCM and that
the policy action is only undertaken by the U.K., a linked simulation.
Lastly, I consider a linked simulation where all countries coordinate
their policies.

The first shock considered is the autonomous increase in U.K.
government expenditures. Real government expenditure is increased by
approximately 10% in the second quarter of 1977. This increase which is
equivalent to 2.2% of real GNP in 1977Q1, (a value of £1.36 billion
based in 1972 terms) is sustained over the next five years. It is
assumed that the government deficit is financed by the sale of gilts to
the public. Monetary policy is assumed to be accomodating.

Table 1 reports that an increase in government spending tends
to have an immediate and sustained positive effect on income. Initially,
both consumption and investment increase, however, over time the long-
term interest rate increases significantly because of the need to finance
the government deficit. Investment falls or is crowded out as a result
of these higher rates. The trade balance as well as the current account
are adversely affected by the rise in government spending. Even with
higher interest rates, capital inflows do not reverse the negative

effects of a current account deficit. The bilateral dollar-pound


5.

III, Basic Features of the Prototype Model in the MCM

This section describes the prototype MCM model and notes how
the'U.K. sector differs. Prices and quantities are determined in the
typical model by the behaviour of four classes of economic agents: the
monetary authorities, the government, commercial banks and private non-
bank sector (firms and households). The action of these agents are
modelled in the goods market, the labour market, and the asset market.
Each country is assumed to produce a composite consumption-investment
commodity. By assumption, goods produced in the different countries are
imperfect substitutes.

Aggregate demand (GNP) is broken down into six major
components: personal consumption, fixed investment, inventory
investment, government spending, exports and imports. Standard economic
theories are used to develop these equations. Consumption depends upon
private disposable income and net worth following the life cycle
hypothesis. Fixed investment is based on neo-classical theory. It is
positively related to current and lagged changes in income and negatively
to current and lagged changes in user cost of capital. In general, the
investment functions through the user cost of capital are a crucial link
between the real and monetary sector in each economy. Inventories act as
a buffer stock and absorb any remaining discrepancy between production
and sales. Real government spending is assumed to be exogenous. Import
and export of goods and services are broken down into merchandised trade,
investment income, and other services. The import-demand equations are
modelled bilaterally and play a key role in transmitting external

influence to a given country model.


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Footnotes

1. Germany pertains to West Germany.

2. For a complete description of the original version of the MCM, see
Stevens, et.al., (1984).

3. For a more recent update to the equations used in this paper, see
Federal Reserve Board (1983).

4. These initial goals were first outlined in Berner, et.al., (1976).

5. For a complete description of how exchange rates are treated in the
model, see Hooper, et.al., (1982).

6. For comparison to other U.K. models, see Andrews and Barr (1985).

7. The changes to the MCM that this entailed are explained in Tryon
(1982).

8. In appendix G of Stevens, et.al., the features of the U.K. financial
sector and its development are described in more detail.

9. Preliminary research along these lines are currently being considered
for the MCM model.

10. Current research is being undertaken to revise this consumption
equation and will be replaced shortly.


I. Introduction

In the last decade, policymakers appear to have become more
concerned about the interdependence of the world's economies. Events
such as the collapse of Bretton Woods, the quadrupling of oi] prices in
the early 1970's and the more recent problems of repayment of
international debt of the 1980's have dramatised the importance of
external factors on an individual country's economy. This change in
perspective is true not only of European policymakers, but also of those
in the United States. It was immediately following the international
economic crises of the early 1970's that work was begun to construct the
Multicountry Model (MCM), at the Federal Reserve. One of the main
purposes of this model, which consists of five single-country macro
models (United States, Canada, Japan, Germany and the United Kingdom) 2/
and an abbreviated rest-of-world (ROW) sector, has been to analyse the
effects of international shocks on the U.S. economy .2/

The purpose of this paper is to describe and to analyse in some
detail the U.K. sector of the wc .3/ The analysis focuses on the effects
of shifts in U.K. monetary and fiscal policies at three levels: 1)
within the unlinked U.K. sector, 2) within the linked MCM framework, and
3) within the linked MCM under the assumption that U.K. policy shifts are
coordinated with those in other countries.

The plan of the paper is as follows: A brief overview of the
purpose and structure of the MCM is presented in Section II. The salient
features of the prototype MCM country model are described in Section III.
In Section IV simulation results are presented, focusing on the linkages
between the U.K. and the rest of the MCM and on the difference between
U.K. models and the U.K. section of the MCM. Some concluding remarks are

contained in Section V.


-12-

components of real expenditures. In the MCM both residential and non-
residential investments are functions of user-cost of capital which are
themselves functions of the interest rates. Consumption is not directly
affected by interest rates, only through the real balance effect. In the
MCM the exchange rate is quite interest rate sensitive. A rise in the
U.K. treasury-bill rate causes sterling to appreciate. This in turn
exerts influences on several parts of the model, most importantly on the
trade sector.

Table 5 reports the simulation results of the U.K. monetary
policy shock on the U.K. sector alone (unlinked). Increased interest
rates and the resulting appreciation of the home currency work to
decrease demand and output. Consumption rises slightly in the first two
quarters, partly because higher interest rates raise household interest
receipts initially resulting in higher disposable income and partly by
wealth effects. Wealth is proxied by both net worth which falls and by
sterling M3, which rises throughout the period 20/ As a consequence of
the decline in output, prices are lower and unemployment is up slightly.
Short-term interest rates remain rather high because income and prices do
not feed directly back into the financial market to moderate the rise in
interest rates. Furthermore, short-term rates do not fully or rapidly
feed through onto long-term rates. This dampened, somewhat, the decline
in investment and output. Another noteworthy feature is the improvenent
in the current account. For this particular shock, the trade balance
improves because the decline in demand reduces imports by more than the

sterling appreciation depresses net exports.


-14-

The pound exchange rate appreciates somewhat more in the coordinated
simulation than in the single linked simulation because U.K. interest
rates rise by more because of increases in U.S. interest rates. However,
the unlinked simulation shows more appreciation of the pound than the
single linked case because the feedback effects tend to dampen exchange
rate movements. Note that the results in the other four countries vary
somewhat from each other. This feature is similar to the findings of
OECD study by Larsen, Llewellyn and Porter (1983), where they also

consider the effects of coordinated monetary policy within the OECD.


ABSTRACT:

The purpose of this paper is to describe and to analyse in some
detail the U.K. sector of the Federal Reserve's Multicountry Model (MCM).
The analysis focuses on the effects of shifts in U.K. monetary and fiscal
policies at three levels: 1) within the unlinked U.K. sector, 2) within
the linked MCM framework, and 3) within the linked MCM under the
assumption that .K. policy shifts are coordinated with those in other
countries. In comparing the unlinked MCM U.K. sector with other U.K.
models such as the LBS and National Institute it is found that all the
models have similar government expenditure multipliers but the components
of GNP respond quite differently. The contrast between linked and
unlinked simulation illustrates the importance of international feedback

effects.


Graphs 1 - 3

COMPARISON OF UK AND MCM GOV'T POL SHOCK
UNLINKED VS LINKED MODEL

| TIT] TTT TTT

UK EGNP
MCM EGNP

MCM ECURBAL

UK ECURBALD |.“

UK ERSLA
MCM ERSLA

| Litititilins

1980

1982

2.10

1.90

1.70

1.50

0.00
1.25

2.50
3.75
5.00

0.40
0.30

0.20
0.10

0.10


The U.K. Sector of the Federal Reserve's MultiCountry Model:

The Effects of Monetary and Fiscal Policies

Hali J. Edison”
International Finance Division
Board of Governors of the

Federal Reserve System

*

This paper was prepared for ESRC Macroeconomic Modelling Seminar,
University of Warwick, 2-4 July 1984. The author would like to thank
Peter Hooper and an annoynomous referee for their comments and John
Whitley of the Warwick Modelling Bureau for running comparable U.K.
simulations. She also acknowledges the able assistance of Sean Doyle in
creating the tables and Dan Laredo the graphs. Furthermore, this paper
represents the views of the author and should not be interpreted as
reflecting the views of the Board of Governors of the Federal Reserve
System or other members of its staff. The usual caveats apply.


References

Andrews, M. and D. Barr (1985) “The Treatment of the Exchange Rate in
Large-Scale Macro Models" forthcoming in Wallis et.al. Models of
the U.K. Economy 1985, Oxford, Oxford University Press.

Berner, R., P. Clark, H. Howe, S. Kwack, and G. Stevens (1976) "Modelling
the International Influences on the U.S. Economy: A Multi-Country
Approach," International Finance Discussion Paper No. 93, Board of
Governors of the Federal Reserve System, November.

Bladen-Hovell, R., C. Green and D. Savage (1983) "The Transmission
Mechanism of Monetary Policy in Two Large-Scale Models of the U.K.
Economy," Oxford Bulletin of Economics and Statistics, Vol. 44,
No. 1., pp. 15-29.

Federal Reserve Board (1983), "FRB Multicountry Model," Quantitative
Studies Section, Division of International Finance, Federal Reserve
Board, Washington, D.C.

Howard, D.H. (1982) “The British Banking System's Demand for Cash
Reserves," Journal of Monetary Economics, Vol. 9, pp. 21-41.

Hooper, P., R.D. Haas, S.A. Symansky and L. Stekler (1982), “Alternative
Approaches to General Equilibrium Modelling of Exchange Rates and
Capital Flows: The MCM Experience," International Finance
Discussion Paper No. 213, Board of Governors of the Federal Reserve
System, Washington, D.C., December.

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

Tryon, R. (1982), "Modelling Oi] Price Shocks in the FRB Multi-Country
Model" Board of Governors of the Federal Reserve System,
mimeograph.


-10-

three models monetary policy accommodates the growth in government
spending however, in the other two U.K. models there are auxiliary
assumptions about fixed nominal interest rates (LBS) and fixed real rates
(NIESR).

Table 3 reports the results of an increase in U.K. Government
spending when the U.K. sector is now linked to the rest of the MCM. This
simulation is of interest because it allows for third party effects to
feed through. This feature of linked simulation is unique; most other
U.K. models cannot provide such simulations since they concentrate on the
U.K. only. Table 3 shows the general pattern of the results is quite
similar for the linked and the unlinked simulations. In graphs 1-5 I
plot for comparison the results of GNP, prices, exchange rates, interest
rates and current account. It is clear from these graphs that allowing
for feedback effects in the linked simulation does alter the magnitudes
of the results. Initially the path of GNP is the same, but after a few
quarters the more rapid increase in interest rates in the linked
simulation lowers investment which in turn lowers income. The exchange
rate depreciates, which further chokes off demand. Prices are lower in
the linked model than the unlinked in part due to the exchange rate. The
exchange rate depreciates throughout the simulation which reflects the
deficit in the trade balance. In fact, the trade balance deficit is
quite a bit larger when we allow for feedback effects in the model. This
result indicates that allowing for feedback effects leads to more balance
of payments difficulties than is expected by the unlinked simulation. An

important result, surely, for the policy maker.


-13-

I now turn to the linked simulations for monetary policy.

These simulations are of interest because they permit us to illustrate
the ‘international financial transmission mechanisms. These simulations
also allow us to assess when a number of countries synchronise their
financial policies whether the effect on a country is markedly different
from what policy-makers might expect on the basis of a single-country
model result. Table 6 presents the single linked simulation results and
Table 7 gives the coordinated policy shock. The main difference in the
unlinked and the single linked shock is in the external sector of the
model, Both the exchange rate movement and the current account movements
are dampened in the linked model because of feedback effects of the other
countries. However, the rise in interest rates still leads to a steady
appreciation of the sterling exchange rate.

Prices, as shown in Table 6, do not fall by as much in the
linked case as in the unlinked case because the exchange rate does not
appreciate by as much. In general, a major change in just U.K. monetary
policy does not have large real consequences in the other MCM countries
because it does not affect U.K. income very much or influence monetary
developments abroad. The U.K. result is more representative of a small
country effect. An equivalent change in U.S. monetary policy, on the
other hand, cause larger feedback effects both real and monetary in other
countries.

Table 7 shows that a coordinated interest rate change results
in a greater decline in U.K. income and prices than in the linked single-
country shock. This result can be explained by the fact that monetary

contractions in other countries depress world income and prices more.