Indexed on: 01 Dec '86Published on: 01 Dec '86Published in: Staff papers - International Monetary Fund. International Monetary Fund
This paper describes the construction and use of a small macroeconomic model, MINIMOD, of the United States and its major industrial trading partners. The goal is to have a readily understandable and transparent model of manageable size that is suitable for policy analysis. Consequently, an eclectic theoretical model has been specified for each of the two economies, with equations for aggregate demand and supply of goods and capital accumulation, and with consistent treatment of government and private sector flows of funds. The model was specified such that it has desirable long-run properties, including the neutrality of money and the property that government debt cannot grow without limit relative to output. Values for the parameters of the model were obtained, with a few exceptions, from the properties of a larger, multicountry model; the paper describes the methodology of reducing a larger model to its core interactions using partial simulation techniques. The model is simulated to gauge the effects of changes in monetary and fiscal policies under two alternative assumptions concerning expectations of future rates of inflation, of long-term bond rates, and of the exchange rate: (i) expectations adapt to past movements in the variables, or (ii) expectations are consistent with the model's own predictions. The simulations imply that an increase in the money supply is likely to depreciate the exchange rate and to stimulate output in the home country, as prices are slow to adjust; in the long run, however, real magnitudes will be unaffected. Government spending increases also have a temporary stimulatory effect on output in the home country, but, for unchanged money supplies, tend to appreciate the exchange rate. These conclusions are common to many macroeconomic models. However, MINIMOD also makes it possible to see how sensitive the results are to assumptions concerning expectations. It is shown that the paths of major macroeconomic variables may be quite different in the two cases mentioned above. In particular, in response to a money supply change, the exchange rate is likely to overshoot its equilibrium value under consistent expectations, though not under adaptive expectations, and output effects are likely to be smaller under consistent expectations. Government expenditure changes seem to have more similar effects in the model under the two expectations assumptions, though the changes induced in the exchange rate and in long-term bond rates are larger with model-consistent expectations. It is also shown that in this case, credible, preannounced policy changes may have substantial effects before they are actually implemented: a future fiscal contraction may in fact have a stimulatory effect on output when it is announced, because of a decline in long-term interest rates and a depreciation of the currency.