1. Changes in Equity Risk Perceptions: Global Consequences and Policy Responses Warwick J McKibbin ANU and Brookings Institution And David Vines Oxford, ANU and CEPR Presented at the Bank of Canada Workshop on “Global Models and the Transmission of Shocks, 22 May 2003

2. Background  Two broad views of the current global economic slowdown The result of weak aggregate demand that can be offset through appropriate adjustments to monetary policies The results of a reduction in aggregate supply resulting from  A downward revision in productivity growth in the OECD  The collapse of the “new economy” bubble  An increase in risk since September 11 and the war on terrorism

3. Goals of the Paper  To understand the current world economic slowdown in terms of the contribution of supply versus demand shocks when an equity bubble bursts  To explore the transmission of equity risk shocks between countries  To explore the optimal response of monetary policy in response to a sharp equity price adjustment  To explore whether there are gains to policy coordination in response to equity price shocks

4. Attempt to Quantify the Key Issues using a global model Use the MSG3 model version 50o (2 sector version of G-Cubed) New version based on GTAP I/O data www.gcubed.com

5. The G-Cubed Model  Key features Based on explicit intertemporal optimization by households and firms in each economy in a dynamic setting Substantial sectoral dis-aggregation with macroeconomic structure Explicit treatment of financial assets with stickiness in physical capital differentiated from flexibility of financial capital Short run deviation from optimizing behavior due to stickiness in labor markets, myopia Short run “New Keynesian” Model with Neoclassical steady state

6. G-Cubed Model  12 sectors production in each economy Plus a capital good producing sector Plus a household durable production sector (I.e. housing)  Estimation of KLEM technology in production and consumption  Tracks flows of international trade at the sectoral level  Tracks flows of international capital  Distinguishes between relatively traded and non trade goods (all goods are potentially tradeable)

7. : The Structure of the G-Cubed Use Table A) Interindustry transactions. B) Industry sales to final demand sectors. C) Purchases of primary factors by industries. D) Purchases of primary factors by final demand sectors.

8. Derivative Models We aggregate the full G-Cubed model by sectors and countries to create models suitable for particular purposes: G-Cubed (Asia Pacific) G-Cubed (Agriculture) G-Cubed (Environment) MSG3 (macro)

9. Countries In G-Cubed (Asia Pacific)  United States Japan  Australia New Zealand  Rest of the OECD Korea  Thailand Indonesia  China Malaysia  Singapore Taiwan  Hong Kong Philippines  India  Oil Exporting Developing Countries  Eastern Europe and the former Soviet Union  Other Developing Countries

10. Sectors in G-Cubed (Asia Pacific)  Energy  Mining  Agriculture  Durable Manufacturing  Non-Durable Manufacturing  Services

11. Sectors: Energy Non – Energy Capital goods producing sector Household capital sector The MSG3 Model

12. Countries:Exchange rate Regime: United Statesfloat Japanfloat Australiafloat Canada float United Kingdomfloat GermanyEuro (floating) Austria Euro (floating) France Euro (floating) Italy Euro (floating) Rest of Euro Zone Euro (floating) Rest of OECDfloat Chinapeg to $US non Oil Developing countriespeg to $US Eastern Europe and Russiafloat OPECpeg to $US The MSG3 Model

13. The Equity Risk Premium (μ)

15. The Results

16. The Simulations  1) Baseline 2002 Assumptions about  population growth by country  Productivity growth by sector catching up by 2% per year to US leading sector  Given tax rates, monetary growth rates etc in all countries Solve for rational expectations equilibrium for the global economy  2) apply the change in equity risk premium Permanent versus temporary US versus OECD Wide

17. Permanent Versus Temporary

20. OECD – Wide versus US Only

23. Key Points  Equity Risk shock in the US is a large negative supply shock reducing the desired capital stock  Domestic variables in the US not affected much by whether the shock is in the US or in the OECD but international trade and capital flows and exchange rates are affected  Developing countries absorb some of the capital released and help reduce the global demand effect of the shock but very quickly diminishing returns in capital accumulation

24. US details for OECD – Wide Temporary

27. Key Points  Investment falls  Consumption rises Housing prices rise which dampen the negative impact on wealth and consumption  Net exports improve Capital outflow depreciates the currency External balance acts as stabilizer except when all countries have the shock  Real wages need to fall  Aggregate demand falls as does aggregate supply

28. Optimal Policy Response Policy makers choose a vector of instrument Ui to minimize: Where τ is a vector of targets (inflation and employment), δ is a discount rate(10%) and Ω is a matrix with the diagonal elements being a set of weights on each target

29. Policy optimization  Two cases Countries have weight of 2 on inflation and 1 on employment (infemp) Countries have weight 2 on inflation and zero on employment (inf)

30. Optimal US Response to OECD-Wide

33. Key Points  Not a lot monetary policy can do to offset the shock except in the very short run

34. Optimal French Response to US Shock

37. Key Points  Impact on France of OECD wide shock similar to the results for the US  Impacts on France of US shock very different Positive French supply shock but negative external demand shock

38. US Results for Cooperation

39. Europe Results for Cooperation

40. Conclusion  Shocks to equity risk premia have significant effects on the real economy  Both aggregate demand and supply are affected.  Monetary policy can help in the short to smooth the adjustment but it can do little to offset the underlying shock

41. Conclusion  Transmission Within countries an equity risk shock  lowers real interest rates,  Lowers real wages  causes a capital outflow,  raises other asset prices like housing  Lowers investment but raises consumption and net exports Across Countries  lowers real interest rates,  causes a capital inflow,  raises all asset prices including equities and housing  Raises investment and consumption  Lowers net exports

42. Conclusion  Monetary Policy Response Within countries experiencing an equity risk shock  Demand falls more than supply thus a loosening of monetary policy can dampen to employment losses in the short run In countries not experiencing an equity risk shock  Demand rises more than supply  Employment rises but inflation falls due to falling prices in affected countries and an exchange rate appreciation  Interest rates should fall because of a fall in the global real interest rate

43. Conclusion  Gains from Policy Coordination Compared the the optimal non-cooperative policies there is little gained from cooperation in the face of an OECD wide shock In reality the current policy stance of the G7 particularly Europe and Japan are very far from the optimal policies in this paper (real interest rates in Europe and Japan are too high). To the extent that real world cooperation might move these region towards more sensible policy, cooperation could achieve significant gains

44. Background Papers www.gcubed.com www.sensiblepolicy.com