The impact of interdependence on economic policy design

The impact of interdependence on economic policy design The case of the USA, EEC and Japan

A. J. Hughes Hallett

The worlds industrialized economies have become increasingly interdependent over the past 30 years. The policy implications of this mutual dependence obviously depend on the spill-over effects between economies, but, because simplified models of hypothetical economies have been used, work on this topic has left unanswered the question of how much the policy choices are afected. This paper applies diflerent strategies to linked models of the US, EEC and Japanese economies to evaluate the importance of spill-over effects in policy design. The results indicate that interdependence has strong but asymmetric eflects due to differing degrees of market flexibility. The US perjormance dominates, while Japanese policies have little impact on the rest of the world. Kqvwords: Economic policy; Dynamic games; Spill-over effects The interdependence of the world’s industrial economies poses problems of both measurement and management. Over the past decade, the annual economic summit meetings have shown that the Western policy makers are fully aware of the mutual dependence of their economies. But those meetings have also shown that policy makers are as yet unable to design and operate a viable programme of coordinated economic policies. At the 1986 Tokyo Summit, for example, the coordination of economic policies was advocated at the same time as the participating countries were announcing conflicting policy changes for their own economies. With the increasing integration of the Western economies, it is simply not possible to operate independent national economic policies without allowing for the

The author is with the Department of Newcastle, Newcastle-upon-Tyne,

of Economics, University NE1 7RU, UK.

I am most grateful to Andre Dramais for helpful discussions and to the EEC Commission for their support. However, none of the opinions expressed here necessarily reflects their views or policies. I am also grateful for the helpful comments of the referees. Final manuscript

received 5 January

0264-9993/87/030377-20

1981

$03.00 0

1987 Butterworth

expected changes in foreign activity. Since 1975, policy makers have used the annual summit meetings to exchange information about their economic decisions, priorities and their understanding of the economic responses. But, since no lasting cooperative policy measures have emerged from that forum, governments have in practice been obliged to pursue independent national policies and to use that extra information to reduce the adverse domestic effects of interdependence. The danger here is clear enough: unsynchronized policies may actually turn out to limit our ability to control individual economies. In fact many commentators (eg Thurow 1241) have argued that this will inevitably lead to isolationist (if not outright protectionist) policies to arrest the integration process and to make national policy making effective again. Signs of that tendency are not hard to find in recent events. This paper analyses the implications of interdependence for policy design in the world’s three main industrial blocs: the USA, the EEC and Japan. A number of papers have been published on this theme, but they have almost all used partial models of two hypothetical economies restricted to having their interdependence defined by identically symmetric and

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377

Interdependence and economic policy design: A. .I. Hughes Hallen

constant spill-over effects.’ Few consider either the case or multicountry asymmetrically dependent economies. Similarly theoretical models have been used to illustrate the transmission mechanisms between economies, the fact that policy effectiveness may be altered by interdependence, and the fact that policy coordination can bring gains. But very few of those models describe how interdependence should affect policy design or are able to determine the signs of the net policy spill-overs between economies. In reaction to that, we focus on the policy interactions between the USA, EEC and Japan using the EEC Commission’s own forecasting and policy simulation model, COMPACT, which describes the three economies and their trade and capital linkages. This exercise covers the period 1977 to 1981 and is able to identify some of the difficulties posed by uncertainty by comparing the optimal policies and their (expected) outcomes computed before and after a major unanticipated shock (the doubling of oil prices in 1979). It also shows to what extent alternative strategies would have been able to bring the recession of that period to an end and how the ability to end that recession is affected when countries adopt different non-cooperative or isolationist positions. The main problem in these policy simulations is to identify the roles played by direct spill-over effects, the feedback effects from domestic policy changes and finally what the foreign policies are likely to be and the effect of predictable foreign countermeasures following a domestic policy change. To accommodate these elements systematically, the policy simulations are conducted in the framework of a game in which countries act and react to each others’ expected policies through time. Then different policy strategies can be compared by adopting different assumptions about the amount of information on the policy interactions which is incorporated in each country’s decision rule. The benchmark (conjectural variations) solution takes full account of interdependence with respect both to the inherent policy spill-overs and to those created by the active countermeasures to domestic policies taken abroad. The open loop Nash solution is simpler: it ignores any predictable countermeasures to domestic policy. This strategy acknowledges interdependence and that domestic policies must therefore depend on the policies to be expected abroad, but it ignores the fact that domestic policy changes will have a predictable impact on foreign economic conditions and that foreigners will therefore adjust their actions to accommodate those impacts. Isolutionist policies are simpler still: they

’ Hamada and !4akuri [ 121, Currie and Levine I81, Miller and Salmon [211, Oudiz and Sachs [221, Taylor 1231.

378

ignore the spill-over effects of foreign decisions on domestic targets in computing the domestic decisions but not in computing their expected outcomes. Policy makers therefore recognize interdependence, but they consider it too insignificant to be worthwhile incorporating in their decision rules. Finally the myopic solution is the simplest of all: spill-over and feedback effects are completely ignored and policy makers do not perceive that there is any interdependence at all. The impacts of (different aspects of) interdependence can then be measured by comparing the benchmark solution to the policies obtained by progressively simplifying the decision rules until interdependence is no longer recognized. Economic theory has also highlighted the problem of interactions between economies - although it has remained surprisingly silent on how policy should be designed in these circumstances. Most of this theory has grown up around the liberalization of capital controls during the 1960s and 197Os, because the increased capital mobility had the effect of amplifying the movements in reserves, and hence money stock, beyond what policy makers had planned for their domestic targets. For example, the Fleming-Mundell model confirmed the common experience that a small country typically finds fiscal policy ineffective under flexible exchange rates (but monetary policy powerful), whereas monetary policy becomes ineffective under fixed exchange rates. But countries which are large (in the sense of domestic changes having significant effects abroad) find that both fiscal and monetary policies are effective, if only weakly so. Thus, with increasing interdependence, the neglect of spill-over effects and their repercussions has become an important critique of contemporary economic policies. Moreover, in compensating for the weakened policy responses, endogenous decision rules tend to exaggerate those spill-over effects. Cooper [71suggests that this was the main feature of the economic difficulties of the 197Os, since countries designed their policies to secure national goals without regard to either the effects elsewhere or the actions being taken by others. That would, for example, have exaggerated the severity of the 1975 and 1979 recessions. Not all countries are so large as to have significant impacts on the fortunes of others, but the USA, Japan and the larger European members of OECD are certainly in that category. Another case where policy interactions have often frustrated domestic policy is exchange rate management. The futility of competitive devaluations was demonstrated in the 1930s. In the 1970s it was hoped that flexible exchange rates would succeed in insulating economies from external events and hence free policy making from ‘foreign’ interference. Theory, however,

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Interdependence and economic policy design: A. J. Hughes Hallett

implied that exchange rate management only altered the time paths by which certain predictable results were reached, so that policy was at best relevant for securing transitory benefits (see eg Dombusch 191). And that was borne out; flexible exchange rates have provided very limited insulation (Williamson [271). In fact experience has shown that not all countries can reduce inflation by tight money and currency appreciation because the output and employment losses turn out to be larger than any of them planned as a result of the negative spillovers between economies. If, on the other hand, all countries expand together the inflation costs will be larger, and employment gains smaller, than expected because of the adverse spill-overs. Such surprises can only be avoided if policy makers anticipate the consequences of current and future foreign policies correctly.

The model and the policy problem The model The empirical exercises which follow are based on the EEC Commission’s forecasting and policy analysis model, COMPACT (Dramais 1101). At present, this model contains three economic blocks describing the EEC, the US and the Japanese economies, plus equations representing aggregate activity in the Rest of the World. The EEC module is derived from the behaviour of the EEC totals which are determined by the relevant national models of the COMET model system (Barten et al 121). The US and Japanese modules are derived from

’ Assessments made by Hickman [131 and Hooper [151 based on a wide range of standardized simulations performed on 12 multicountry models for the Brookings Conference on Empirical Macroeconomics for Interdependent Economies. At least two of these models also base themselves on larger well established multicountry models. Of course the fact that COMPACT’s performance was similar to the other models could just mean they all have similar shortcomings. However, the 32 Brookings conference simulations showed clear cases of model ‘outliers’, not always involving the same models, but COMPACT provided neither upper nor lower bound simulation paths. Generally speaking, the sharp divergences appeared six years out from the common starting point and separated the models with rational expectations from those with other expectations mechanisms. The divergences, however, were much sharper when exchange rate changes were explicitly simulated so exchange rate targets or instruments were ruled out here. Apart from that, the direction of a policy change was consistent across models and consistent with prior information, but turning points were less well determined. Finally, the models’ multipliers agree that (i) the USA has larger domestic monetary multipliers, while other countries have equal or larger domestic fiscal multipliers; (ii) the spill-over multipliers from the USA usually (but not uniformly) dominate those from the EEC or Japan; (iii) the US multipliers tend to converge considerably faster than those of the EEC; and (iv) monetary changes usually provide asymmetric impacts with the USA dominating. Only the last one appears not to hold for COMPACT, but that may be due to differences in the definition of monetary policy. Some models take monetary changes as variations around a fixed nominal interest rate path (as here), while others use variations around a constant monetary aggregate.

ECONOMIC

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the corresponding national models of the Japanese Economic Planning Agency (EPA) model. It is not unusual to link national models from different sources (eg the LINK system) and it appears from a range of simulation and multiplier tests that the COMPACT system is no more unreliable in performance than the other multicountry models now available.2 The COMPACT model contains a Keynesian equilibrium framework with adaptive expectations. The policy multipliers for the EEC block (over the period 1977-81) will be found in Tables 7, 10 and 11 in the Appendix. The corresponding policy multipliers for the US and Japanese blocks are set out in Tables 8, 12 and 13 (for the US targets) and 9, 14 and 15 (for the Japanese targets). In its structural form, COMPACT contains 50 equations, in addition to the equations which describe the trade, capital and price linkages between countries. Thus the three traditional spill-over mechanisms are represented, while each national model contains descriptions of final demand, output, factor demands and supplies, wages-prices, public sector receipts and expenditures, financial relations and the balance of payments components. Further detail is provided by:

(0 the attention paid to both stock and flow equilibria

(ii) (iii)

(iv)

(v)

(vi)

in the flow of funds transactions between economic agents: households, enterprises, government and the foreign sector; the inclusion of wealth effects in consumers’ demand; the disaggregation of total unemployment into classical, Keynesian and frictional shares using a labour market disequilibrium approach; the integration of the distinction between Keynesian and classical unemployment into the wage determination process and, via wages, into the inflation process; the integration of the balance of payments item into the determination of the public sector borrowing requirement and the money supply; and the exchange rate, which is determined by the outcome for the current and capital accounts and floats with exchange reserves held constant in relation to imports.

l?te policy

scenario

We consider here the problem of steering the major policy targets of each country through the world recession of 1977-81. Following the policy statements issued at recent summit meetings, those targets were taken to be GDP, total investment, inflation, unemployment, government net borrowing and the (current account) balance of trade. The most important policy instruments used in this period were direct and indirect taxes, social

379

Interdependence and economic policy design: A. J. Hughes Hallett Table 1. The objectives of economic policy lW7-81.

Targets GDP Investment (total) Inflation (consumer prices) Unemployment Net lending by government Balance of trade (current account) Instruments Direct taxation (total) Indirect taxation (total) Social security contributions Government expenditures (and public investment) Official discount rate

EEC ideal

USA ideal

Japan ideal

Units

3.5 5.5 5.0 3.0 -2.0 0.0

3.5 5.5 5.0 4.0 -0.5 0.0

5.0 7.0 4.0 1.0 -1.0 0.1

% % % % % %

13.0 13.0 16.0

12.0 _a 6.5

8.0 3.6 17.5

% current GDP % current GDP % current GDP

D1Cl.X Irar ss

46.0 7.5

12.0 7.5

15.0 6.5

% current Level

G R

growth growth growth labour current current

Sylllbol

pa pa pa force GDP GDP

a denotes this instrument was not used. The taxation variables are defined as total receipts as a percentage and corporation taxes; indirect tax covers sales and excise taxes (Eurostur Reviews.

security contributions, government expenditures plus public investment and the official discount rate. These policy variables have been set out for each country in Table 1, together with their ideal values and their units of measurement. The ‘ideal’ instrument values were intended to hold constant the average share of each instrument in GDP, together with an ideal real rate of interest of 2.5 % . The ‘ideal’ target values reflect what was considered as reasonable rates of change, given their values over the period 1970-77. Investment in particular was set to regain its pre-1973 share of GDP. It would be interesting to extend this list of targets and/or instruments, but this scenario will identify the main scope and limitations of policy interventions in an interdependent world - at least as the policy makers perceived it at the time. However, the policy selection techniques outlined below are extremely efficient; the numerical solutions took less than four seconds per country on a standard university computer installation. Thus policy searches (over alternative scenarios, information sets or priority schemes etc) are cheap enough to be carried out on a routine base. It would therefore be extremely easy to generate specific advice for any alternative policy problem. The policy impacts at home and abroad According to this model, EEC monetary policies have rather less effect on their domestic targets than their US counterparts do on theirs. Moreover, the US policy changes would achieve their effects much more quickly.3 Monetary policy, in particular, is more effec-

3 The domestic

380

policy multipliers

appear in Tables 7 to 9.

GDP

GDP INV CPI LINE NL B

of GDP. Direct tax covers household

tive in dealing with inflation, output and unemployment in the USA than it is in the EEC. The USA can also use government expenditures for the output and employment targets, whereas the EEC might use government expenditures for boosting output and indirect taxes for moderating inflation. It is not clear whether any policy specialization pattern should emerge from this (cf Hughes Hallett 1191). On average, US and Japanese policies have a greater impact on their domestic targets than do EEC instruments on EEC targets. This characteristic is mainly due to the greater market flexibilities found in the US and Japanese economies, so that policy changes are translated more rapidly and more strongly into target changes. These more flexible responses show up most clearly in US/Japanese responses to government expenditure changes; but interest rate changes also generate more powerful and quicker responses in the USA than in the EEC. Otherwise the EEC instruments which are relatively more powerful than in the USA or Japan indirect taxes and social security contributions - are those which will tend to induce relative price changes, including real wage changes. Finally there is a clear tendency for policy effects to persist in the EEC targets, rather than to appear and die away as they do in the USA. That is another sign of the sluggishness of the EEC economy compared to the flexibility of the USA. It is this flexible response property of the USA economy, rather than its sheer size, or its relative ‘closedness’ compared to Europe or Japan, which turns out to be the key that provides the USA with the ability to improve its own performance and to absorb the shocks emanating from abroad. The USA therefore appears to dominate the EEC or Japanese economies in

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Interdependence and economic policy design: A. .I. Hughes Hallett

the short run. Turning now to the spill-over policy multipliers (Tables 10 to 15), we find that Japanese policy has very little impact on either the USA or the EEC whereas the latter can both affect Japanese targets. This would suggest that Japan will naturally play as a ‘follower’ in a non-cooperative policy game and as such will finish up with results somewhere between those of the two main protagonists (the USA and the EEC). It also suggests that Japan would secure smaller gains by cooperation (and smaller losses from badly coordinated policies), but that its variables will be more sensitive to changes in strategy by the other two countries. The spill-overs between the USA and EEC appear to be more evenly matched. Changes in US taxes, social security contributions and government expenditures affect the EEC slightly more than vice versa. They also have stronger cumulative effects. The EEC’s interest rates, on the other hand, affect the USA more than vice versa, although the impacts peak after about three years and then fall away. According to this model, it is the US budgetary policy which is important for the European economies. If the USA expands its budget deficit this will have some (but not especially strong) positive effects on the EEC; but if it restricts its monetary growth at the same time, those locomotive effects will be reduced or even removed. A similar but weaker locomotive effect on the USA is possible following an EEC fiscal expansion; but tight EEC money (either induced by high US interest rates and the need to protect European exchange rates, or for reasons of holding domestic inflation down) would certainly obliterate those positive spill-overs and slow down any world recovery.

Non-cooperative

policies with anticipations

In a non-cooperative world, each government must condition its decisions on the actions to be expected from rational policy makers abroad. They must also expect that foreign decision makers will, at the same time, be choosing their policies in the same way. This means each decision rule must evaluate the expected foreign responses to domestic policy adjustments, as part of the usual joint determination of the decision values themselves. Otherwise surprises cannot be avoided, since it is inconsistent to determine Country 2’s policies, x(*) say, using a rule which specifies ~x’*‘l~x(” # 0 but ~x(‘)/dx’*’ = 0, while assuming at the same time that x(I) depends on a rule in which ~x(‘)/ax(‘) # 0 but L+x(~)/~x(‘)= 0 (Cooper 171). Similarly, if the assumed policy responses differ from actual policy reactions (ie the conjectured ~x’*‘/~x”) value used to derive the rule for x(I) differs from the value computed when

ECONOMIC MODELLING July 1987

optimizing the rule for xc”), then policy makers will make systematic ‘errors’ because they fail to base their decisions on rational expectations of future actions abroad. Two country

games

One solution method which does evaluate policy reaction functions jointly with the decision values is discussed in Hughes Hallett [ 17, 191 and Brandsma and Hughes Hallett (51. Consider a two country policy game. Let each country have mi domestic targets, yy), and n, policy instruments, xl’), subject to non-controllable (random) events sy) over the decision periods t = 1 . . . T. The decision variables are therefore yci)’ =
of each country

i= 1,2

are

(1)

where B”’ and A(‘) are positive definite and symmetric matrices. Let the two economies be linked through the world economy yr = f(y,, yr-l, x?,

x1*‘, 4

(2)

where e, represents any non-controllable variables. The constraints on each country’s targets can then be condensed to 0) = Y

~~i.l~x~l~+~~1.2~X~2’+So

i=1,2

(3)

where R”,j), i= 1,2, are (miTxttj7) matrices containing submatrices of dynamic multipliers R,‘f j) = ayj”laxy) if t >k and zeros elsewhere. Thus R 08~) measures the responses of country i’s targets to its own instruments, and R”,j’ the spill-over effects from country j’s decisions. Each policy maker will therefore find his own targets constrained by j?(l) = R@*‘)f(‘)+ [R(i~j)$j)+c(i)l where c(l) = rci) - y(i)d + xjR(i.j)X(j)d. In the absence of any cooperation, the optimal decisions (x(I)*, x(*)*) will satisfy w(‘)(x(‘)*,x(j)*) < w(‘)(x(i),x(j)*) for i=l and 2, and all feasible x(j) #xc’)*. This equilibrium holds only when both countries perceive that no further gains can be made by varying their reactions to the decisions currently expected from their opponents, because to do so would trigger counterreactions (in the opponent’s interest) which more than offset any gains made by the

381

Interdependence and economic policy design: A. .I. Hughes Hallen first country. ’ But whenever net gains can be made despite foreign responses, a further round of policy adjustments must be expected. Since x”) will be determined by a similar rule, the necessary conditions for jointly optimal decisions by both countries are satisfied by solving d&)/d$)

+ [(ay(i)/axfi))ax”)/ax’i’ ++(i)/dXfi)] r&+,#)/avV) = 0

(5)

for i= 1 and 2 simultaneously. Let D(j) = d~(‘)/dx(“. Then inserting trial values (I$“, 05’)) into (5), automatically generates the policy values:

where

It is worth emphasizing that this solution recognizes that equilibrium can only hold when no player can expect to make further gains by adjusting his reactions despite predictable foreign responses. It therefore specifies that decision makers may alter their conjectures about an opponent’s reactions only in a way which is Pareto-improving for both countries, since alternative conjectures would certainly be violated because no country would unilaterally react in a way which would make it worse off. There is no point in making irrational conjectures about rational opponents. In this context one cannot expect any sovereign government to adjust its responses unilaterally against its own interests because that would amount to making intercountry comparisons without any compensating policy bargain. On completing this ‘downhill’ search, the optimal decisions can be written as x:(i)* = _[G~)‘B(i)G~)+A(i)]-lG(i)‘~(i)~,i(d”’) * i*=1,2

(8)

where G(i) = R&i) + R(i,j)D(j) * * 05’1,

=

F’:‘;,

R”.”

+

D;‘_

i=1,2

andj#i

(7)

We need to check that these adjustments do in fact provide gains for one or both countries; indeed in the absence of such a restriction the iteration at (7) typically produces multiple solutions and may even fail to converge. To overcome that problem, we can replace Dzi, with yi Dyl 1 + (1 -~i)D~’ where 0 < yi < 1 is chosen (at each step) so as to force $*y, and x’E, ‘down-hill’ - ie so that

for i= 1 and 2. That modification introduces a directed search in which at least one country is better off (and neither worse off) at each step. An exhaustive search will then identify the optimal decisions (x(I)*, x@)*) as defined by the joint minima specified above.’

[ 111. SeeUlph 1261 and Holt [ 141 for applications of the conjectural varia-

4 The conjectural variations method was introduced by Frisch

tions method. Basar 131 contains a convenient technical summary. Brandsma and Hughes Hallett [51 extend it for any number of targets and decision periods and for asymmetric decision makers. 5 The choice of starting point is arbitrary, but is likely to be. the zero conjectures (open loop Nash) solution. Since the latter exists here (Aubin ill), this search will terminate. This ‘downhill’ search is similar to the selection device introduced by Tumovs 9 and d’t?rey 1251 who ick conjectural variations such that (x(I), X( )) mimmtxes WC” + WJ. Th e crucial difference is that the Pareto-improving steps in this paper avoid any intercountry comparisons, whereas the Tumovsky-d’Orey procedure might (in a general non-cooperative framework) involve trading one country’s success against the other’s failure without side payments.

382

and d(i) = c(i) + R(i,j)F(j)c(j) * * depend on F2’ which is defined by (6) but evaluated with the reaction terms at termination (Dz’, 0:‘). Certainty equivalence has also been applied to each objective, Eli(@), where Eh( .) = E(. (f&J denotes an expectation conditional on country i’s information at t. The computed policies can therefore be conditioned on a single information set representing either one or the other government’s view of the past and future at a given moment. As such they can be revised by reoptimizing them conditional on successive information sets (Ori+for t=2. . .T and i= 1,2).6 Multicountry games The quadratic loss functions, w”’ in (l), will now be extended to describe the objectives of i= 1. . .p countries. The multipliers in the condensed model (3) will likewise be partitioned between p countries: ii)

Y

_

E

p.jyJ)

+

cU)

i=l.

. .p

(9)

j=l

where

6 See Hughes Hallett I171 for the derivation of (8) and these reoptimized decisions.

ECONOMIC

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Interdependence and economic policy design: A. J. Hughes Hallett S(i)_y(i)d

=

c(i)

Cp+J)x(j)d

+

faces the constraints

The multiplier matrices ff’,j) contain domestic (i=j) and spill-over (i #j) policy responses as before, and they will be block lower triangular in structure. The first order conditions (including conjectural variations) will now be satisfied by solving _D(‘.2)

I .

. . . . . . _iyP.l)

1

s+,.....

--

_Di’;4’

42,

. . . . . . .

. . . . . . .

*. *.

*.

*. *. -.

‘.

a.

’

F”’

=

Z(P)

S+, . . . . . . . . . . . i

,x,+1

. . . . . . . .

s+l

,$)

T(i)=

[~(i.i)+~(~..)[c(~!,]-l~(..~',,]f(i)+d(~)

(13)

where R(L) =

. . . R&t-l), R(m+l) . . . R(Q)]

[R&l)

and where d(i) = c(i) + RO,.l(C(f;,]-le(,,

F’$, cCp) (10)

That means the optimal non-cooperative decisions country i are once again given by (8) where

for

where C(i) =

R(O)

+

R(it.)[c~)]-lD~ai)

*

is constructed using the terminal values of the iteration following (10). Hence the p country policy problem has been replaced by p independent country selection problems with transformed policy responses.

and

depend on C(i) = R&i) + s

i

Optimal non-cooperative strategies

RKj)D,‘j.i)

j#i

Thus trial or assumed values for all the policy reaction (conjectural variations) terms induce an iterative process just as in the two country case. Now any p- 1 optimal strategies can be expressed in terms of the remaining country’s decisions. If each country can substitute the decisions of the other countries out of the model (9), it will reduce the problem to one involving only its own decision variables (parallel to the steps from (6) to (8) above). Write (10) compactly as

(11) From this, the decisions of p - 1 countries (_$iJ,, j # i) can be written in terms of the last country’s decisions @(ii,) by solving (11) for x’!!, in terms of x”;i,. Technically that implies:

= [c”;;,]-’ f(P)*

&,

+ D(;$~:u)*)

(12)

(i)

where the subscript (i) denotes the i”’ subvector (ie _@I* and Fti rc”‘) have been deleted from _&+Iand e,+i. Here C(:‘l, is the cofactor of I in the i,i”’ submatrix position of DS+l, and 0:;‘: is the associated i” column block of D,+, with the I matrix deleted. In that case country i

ECONOMIC

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vs isolationist

What policy improvements on the historical performance are available when the reactions of other countries are allowed for in a rational but non-cooperative manner? How are these improvements distributed between countries, and are the gains significant? The historical comparisons Table 2 sets out the average decision values, and the associated target outcomes, for a range of different priority (or objective function) specifications. These decision values are obtained from the optimal noncooperative solution (8) based on (13), and represent the best strategies which each country could adopt in the absence of explicit cooperation but allowing fully for the policy reactions and feedbacks to be expected from abroad.’ Table 2 indicates the sensitivity of these strategies to different priority schemes for the case where individual target failures and individual instrument failures are penalized equally, but target failures as a group are penalized at 100 times, 10 times, equally or at l/10” or l/100” the rate of instrument failures (corresponding to B = crl, where OL= 100, 10, 1, 0.1, 0.01 respectively, in the notation of (1) where A = I).

’ The complete (year-by-year) results are very extensive. They are reproduced in Hughes Hallett I171 and are available from the author. Average values are used here for the sake of clarity and for simplicity 0’;) in (8) was estimated using a single step of (10) with an open loop Nash starting position.

383

Interdependence and economic Table 2. Optimal non-cooperative

policy design:

A. .I. Hughes

Hallen

policies for the EEC, USA and Japan B=looF

B=lOl

(averaged

B=I

over 1977-81)

under different prioritie~.~-~

B=O.ll

B=O.OlI

Hl8tOl-iU8l

policies For the EEC GDP INV CPI UNE NL B

2.11 5.13 5.01 4.71 -2.73 1.08

2.27 4.83 5.10 5.24 -2.99 0.26

2.24 4.57 5.15 4.96 -3.50 0.86

2.19 4.01 5.24 5.35 -3.89 1.03

3.06 3.43 4.23 5.50 -3.97 1.07

1.96 0.82 9.46 6.04 -3.92 -0.30

DtUX Itar ss G R

11.99 13.55 15.87 45.37 6.16

12.07 13.39 16.60 46.3s 7.4

12.34 13.51 16.12 46.01 1.44

12.73 13.41 15.97 46.10 7.3s

12.93 13.21 15.97 46.1s 1.47

13.26 13.69 15.95 47.16 10.94

3.27 5.14 4.99 6.17 -0.72 1.16

2.32 5.09 6.13 6.58 -0.93 1.11

2.66 4.50 8.07 6.99 -0.21 1.25

3.53 3.12 9.83 7.58 0.22

4.47 -0.76 10.17 7.61 -1.41 -0.80

1.52 -4.11 9.82 6.72 -1.75 -0.83

18.12 1.4s 11.01 15.97

13.00 6.22 10.86 11.79

12.17 7.37 11.32 9.50

12.24 7.09 11.72 7.77

12.0s 6.61 12.11 7.42

12.50 6.60 11.92 10.83

4.60 6.48 4.14 1.87 -1.72 0.34

3.71 6.94 3.82 2.43 -2.27 0.43

2.82 7.56 3.41 2.28 -2.87 -0.03

4.49 7.82 2.77 2.38 -3.63 0.35

6.52 11.08 2.13 2.63 -5.07 -0.21

3.48 6.20 5.00 2.10 -4.80 0.35

9.25 4.46 14.20 12.52 8.16

6.10 5.59 17.09 13.36 6.34

7.55 4.73 17.28 13.89 6.54

8.13 4.05 17.56 14.20 6.55

8.09 3.76 17.58 14.39 6.59

8.36 3.54 17.66 14.26 6.93

For the USA GDP INV CPI UNE NL B Dtax ss G R For Japan GDP INV CPI UNE NL B Dtar Irar ss G R

0.04

a For definitions of symbols and units, see Table 1; b these are ex post optimal decisions, incorporating actual realizations of the uncontrollable variables; ’ column headings (B= 1001 etc) refer to the loss function (1). The matrix A in (1) is set to the identity matrix throughout.

The results generated by these different priority schemes are remarkably stable - with the exception only of certain of the US and Japanese variables in the two extreme cases where the relative target priorities differ by a factor of 10 000. Hence one can be fairly sure that direct taxes in the EEC should be reduced by about 0.75% of GDP from their recent levels;* that indirect taxes and social security contributions should remain at their historical levels of 13.5 % and 16 % of GDP respectively; and that government expenditures and interest

* These figures correspond to the middle solution; B=I. The historical policies underlying Table 2 are (averaged) actual values for the policy instruments and (average) target values obtained by simulating the model under the same information set as used in the policy calculations of Table 2. There are no adjustments to improve the tracking of endogenous variables.

384

rates should fall by about 1% of GDP and 3.5 percentage points respectively. This would lead to 0.5-0.75% extra GDP growth, 3.5% extra investment annually, a positive balance of trade and an inflation rate which is cut in half. Moreover unemployment would be lower by 1% , and government borrowing lower by 0.5 % of GDP. One can also see that to reach its targets the EEC must lower its interest rates quite sharply - in direct contrast to the corresponding US strategy; and also reduce its taxes and government expenditures moderately. Such policies would improve the investment, unemployment and government borrowing targets in the EEC at the expense of GDP growth and the trade balance. The results in Table 2 also show the US economy to be significantly more flexible than the EEC economy and that policy interventions can succeed in improving the target variables (especially investment and inflation)

ECONOMIC

MODELLING

July 1987

Interdependence

relatively easily. To do that it is necessary to raise interest rates compared to those in the EEC and Japan, while also raising taxes, raising the social security taxes, and holding government expenditures a little below recent levels. In fact, in order to avoid the extra financing burden, and the possibility of investment being crowded out, the budget deficit would be reduced in this strategy. Excluding the two extreme cases (columns 1 and 6), the outcome of such a policy would be roughly 1% extra GNP growth per year, 8% extra investment, 2-4% less inflation, the same unemployment, 1% less government borrowing and a positive balance of trade. In the event the USA actually superimposed an increased budget deficit on that strategy, in order to increase growth and employment, while containing inflation by tight money and an appreciating exchange rate. The Japanese economy is also flexible enough for the targets to be improved relatively easily by suitable interventions. Those improvements are achieved by switching from direct to indirect taxation (direct taxes fall by 2.5 % , and indirect taxes rise by 2 % of GDP, compared to historical levels), reducing social security contributions and government expenditures slightly (by about 0.5% of GDP), and by holding interest rates just below recent levels. This would lead to slightly faster growth (0.25-0.5% pa), 1% more investment, 1% less inflation, the same unemployment, but 2.5 % less government borrowing and an unchanged trade balance. In each of these exercises, flexibility of responses to policy changes is a matter of the flexibility of relative price or real wage responses,’ since the instruments are either quantities or nominal interest rates. 77re influence of d@erent target priorities For the EEC there is a mild shift of target values towards their ideals, and instruments away from theirs, as the priorities on targets are increased (the lefthand columns of Table 2); and there is a mild shift in the opposite direction as those priorities are decreased in the righthand columns. The direction of those shifts is, of course, predictable. What is important is the small size of the shifts. Target growth rates are affected by less than 1% (investment by 1.75%), and the remaining variables by 1% or less of GDP, despite radical changes of priorities at home and abroad. The instrument changes are likewise 1% of GDP at most. This implies

and economic policy design:

A. J. Hughes Hallett

that the European economy is very sluggish and that big changes of policy emphasis are unlikely to generate any performance short-term changes in substantial (particularly for output and employment growth). The US optimal strategies, on the other hand, are more sensitive to variations in the priorities which their own and foreign governments set to guide their economic plans. The tendency towards ideal target values (and away from ideal instrument values) on the left of the table, and vice versa on the right, is more pronounced. Average target growth rates vary by up to 6% pa, and the instrument values by 6% of GDP while the interest rate varies by 8.5 percentage points. Yet these variations are confined to jumps in the two extreme cases (on the left where the instruments are ‘liberated’, and on the right where the targets are ‘liberated’). In fact, priority changes by factors of up to 100, from the middle four columns, generate sensitivities no greater than those found in the EEC case. However, there are two exceptions to this result: changes in policy emphasis can produce significant changes in inflation and the interest rate. Hence we might expect that the USA would be more interested than its partners in using tight monetary policies as an anti-inflation device. Finally the Japanese strategies are also sensitive to priority variations, but not to the same extent as the US strategies. The same characteristic of jumps in the two extreme cases appears; in the targets when they are ‘liberated’ on the right and in the instruments when they are ‘liberated’ on the left. But again there is no great sensitivity when priority changes are restricted to factors of 100. Thus extreme US ambition can cause some negative spill-overs on the EEC and Japan without unleashing serious retaliatory effects. But the Japanese are able to adjust their instrument values to offset most of those spill-overs and to limit the damage to the inflation and investment targets. In contrast, the EEC can do rather little to avoid the consequences of a US drive for domestic success. The USA may therefore appear to dominate the policy making process and the USA and Japan may also turn out to have more policy interests in common than either do with the EEC. The contrast between the US and EEC performances, on the other hand, highlights the importance of flexible economic responses for the successful management of interdependent economies. Policy continuity

9 Flexibility is reflected in the speed with which targets respond to a policy change and in the small size of interventions needed to achieve a given target change. Flexibility is not uniform across targets (for example, unemployment in the EEC is inflexible, but inflation is a relatively flexible target) and is not necessarily revealed in the absolute target adjustments.

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Continuity is a characteristic which is highly valued by policy makers, so it is important to summarize the yearby-year values which underlie Table 2. For the EEC, high target priorities would mean a volatile trade balance, abrupt changes in direct taxes and

385

Interdependence and economic policy design: A. J. Hughes Hallen

social security contributions and wild fluctuations in the interest rate; but these movements yield only modest gains in inflation, investment and unemployment. Low target priorities, on the other hand, would imply extremely stable values for all variables, with small losses in the investment and employment targets. It would therefore be difficult to achieve much improvement in the targets, in practice, because high target priorities will lead to unacceptable instrument trajectories. That illustrates the difficulty of overcoming the sluggishness of the EEC responses. For the USA, high target priorities imply volatile levels of government borrowing, abrupt changes in direct taxes, large and unacceptable shifts in social security contributions and government expenditures and impossibly wild fluctuations in interest rates. Low target priorities, however, bring large fluctuations in investment plus an alarming acceleration in GNP growth, inflation and unemployment. In Japan, high target priorities lead to fluctuating growth rates, and sudden large changes in direct taxes, social security contributions, government expenditures and interest rates, which would be unacceptable. Low target priorities would lead to a fluctuating negative trade balance and sudden shifts in investment. The equal priorities @=I) solution seems therefore to give the best results for policy makers who are concerned about the ability of their economies to absorb target and instrument adjustments. lo

Spill-overs and the impact of interdependence on policy design 7&e strategies Having established the general characteristics of noncooperative ‘anti-recession’ strategies for the EEC, USA and Japan, we can go on to investigate the extent to which interdependence has influenced their design. The first problem is to identify the roles played by direct spill-over effects, the feedback effects from abroad and the effects of predictable foreign countermeasures following a domestic policy change. That is done here by comparing strategies which differ by how much information about policy interactions is incorporated. We stick to the case of B=Z throughout. The first four columns of Table 3 contain optimal cooperative strategies at various stages of simplification. The conjecfz4raf variations solution is the optimal non-

” But that solution is not without some large or sudden adjustments, so we tried to fine tune it in an attempt to smooth out the offending trajectories. However, the results made only a marginal contribution and are therefore not reported here. They are given in Hughes Hallett 1171.

386

Table 3. Optimal policies for tbe EEC, USA and Japan (averaged over 1977-81) under different strategies.” Myopicb

LsolationistC Open loop

Conjectural

Na&

variationse

For the EEC GDP 2.20 INV 4.47 CPI 5.18 UNE 5.58 NL -2.78 B 0.15 Dtar 12.58 Itar 13.52 ss 16.07 G 45.61 R 7.62

2.24 4.55 5.16 5.24 -3.33 0.78 12.58 13.52 16.07 46.61 7.62

2.21 4.52 5.12 4.94 -3.51 1.04 12.32 13.50 16.00 45.98 7.51

2.24 4.57 5.14 4.96 -3.50 0.86 12.34 13.51 16.12 46.01 7.44

For the USA GDP 2.47 INV 4.53 CPI 8.47 UNE 6.95 NL -0.29 B 1.08 Dmx 12.17 ss 7.44 G 11.34 R 9.63

2.57 4.49 8.41 6.97 -0.31 1.29 12.17 7.44 11.34 9.63

2.64 4.49 8.04 6.98 -0.22 1.27 12.15 7.39 11.32 9.48

2.66 4.50 8.07 6.99 -0.22 1.25 12.17 7.37 11.32 9.50

For Japan GDP 2.80 INV 7.25 CPI 4.74 UNE 1.81 NL -3.36 B 0.51 Drax 8.52 Imx 3.41 ss 17.71 G 14.14 R 6.22

2.71 7.27 3.81 2.21 -3.11 -0.05 8.52 3.41 17.71 14.14 6.22

2.84 7.16 3.46 2.30 -2.89 0.35 7.47 4.77 17.30 13.90 6.56

2.82 7.56 3.41 2.28 -2.87 -0.03 7.55 4.73 17.28 13.89 6.54

a These are ex post optimal decisions, incorporating aCNd realizations; b myopic solutions ignore interdependence in both decision and expected outcome calculations; ’ isolationist solutions ignore interdependence only in the decision calculations; * open loop Nash ignores opponents’ reactions; ’ conjectural variations is the fully optimal non-cooperative solution.

cooperative solution defined by (8) and (13) and used in Table 2. It therefore contains a complete allowance for interdependence, both with respect to the inherent spillovers from abroad and to predictable countermeasures induced abroad. The open loop Nash solution simplifies that solution by ignoring any predictable foreign countermeasures to the proposed domestic policy changes. In that case policy makers acknowledge interdependence but they ignore the fact that the impact of domestic policy changes on foreign economic conditions will induce foreign decision makers to adjust their actions to accommodate those impacts. Isolationist policies ignore (in addition) the spill-over effects from

ECONOMIC MODELLING July 1987

Interdependence

abroad under either existing or changed policies while accommodating them in calculating the target expectations. Hence policy makers recognize economic interdependence, but they think it is too insignificant to be worth incorporating in their decisions. Finally the myopic solution ignores all spill-overs and feedbacks in calculating both the target and instrument values. In that case policy makers do not perceive that there is any interdependence at all. The point in comparing the myopic and isolationist solutions (columns 1 and 2) is therefore to identify the net foreign spill-over effects on each target, since these solutions differ only in their target calculations. Comparison of the isolationist and open loop Nash solutions (columns 2 and 3) then identifies the policy ‘feedback’ effects since, in the latter, each country reacts fully to the policies expected abroad but continues to assume foreign policy responses will be fixed (at zero) with respect to those changes made at home. Finally, comparison of the open loop Nash and conjectural variations solutions (columns 3 and 4) reveals the effects of predictable foreign countermeasures since, in the latter, each country now assumes that others, as well as itself, will anticipate the policy changes in other countries and will adjust its own responses accordingly. For computational purposes, the conjectural variations solution is given by (8) and (13). The open loop Nash solutions follow from (10) at s= 1 with @j’ = 0. The isolationist and myopic solutions are obtained from (10) with ff’j) = 0, i#i, and then inserting the results into (3) respectively without and with R(‘j) = 0. Empirical

results

From Table 3 we can see that there is not much that the EEC can, or should, do about interdependence in a noncooperative environment. The nef spill-overs are small in themselves and they are hardly modified by feedbacks or countermeasures abroad. Expansionary policies abroad have a small positive (locomotive) effect on EEC investment and employment. The balance of trade would improve while government borrowing increases without any accompanying average price changes. Moreover an isolationist policy would appear to overreact with respect to employment creation since the spill-overs will generate more employment than was bargained for. But those positive spill-overs also induce a larger trade surplus and hence a capital outflow if monetary policy is not tightened, but an increased government borrowing requirement if monetary policy is tightened. However, in the event, interest rates do not fall and prices only start to rise slightly at the end of the period (compared to the myopic simulation). So it appears that the govemment has been forced to sterilize the increase in reserves in order to prevent any expansion in the money supply

ECONOMIC

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and economic policy design: A. J. Hughes Hallett

which would then threaten the inflation target. The government would then sell bonds, and thus increase its borrowing, to the extent of the trade surplus. A small amount of monetary expansion must nevertheless get through since interest rates do not rise despite the bond sales. The international transmissions affecting Europe therefore operate through income and monetary linkages rather than the terms of trade. Recognition of the feedback effects induced by this policy position should lead the EEC to reduce taxes and government expenditures, while interest rates, the government’s borrowing, the trade surplus and employment all rise. The government may try to correct its earlier overreaction, but spill-overs from expansion at home combine with expansionary policies abroad to produce feedbacks which magnify the original (positive) spill-overs. Thus the trade surplus increase tends to boost employment again (hence a fiscal contraction is appropriate). But it also requires further bond sales to sterilize the increase in money supply (reserves) and contain inflation. This time the sterilization is more complete and leads to higher interest rates. Finally, if foreign countermeasures to these policy changes are included the picture hardly changes, except that the trade surplus increases by less. Interdependence is relatively unimportant for noncooperative policy making in the USA. Expansion abroad has a positive (locomotive) effect on output and this arises mainly through a larger trade surplus and the usual income linkage. Government borrowing changes only slightly while inflation and unemployment fail to come down. In fact, compared to the myopic solution, the higher inflation and unemployment levels are shifted to the end of the period. So the government must have let the extra reserves provide for an expansion of the money supply, rather than attempting to tighten an already restrictive monetary policy or to reflate via a budget deficit. This mildly expansionary policy is not offset by changes abroad (where expansion continues), so the feedbacks provide a little more output expansion but slightly less inflation. The latter is presumably due to the anticipated success of foreign policy in holding inflation down to levels significantly below the US rate (since there is, if anything, a relaxation of US monetary policy in column 3). Allowing for foreign countermeasures then implies virtually no further impacts. Japanese policy making, on the other hand, is sensitive to interdependence, according to this model. Expansion abroad causes negative spill-overs on output and employment through a deteriorating trade balance. That contractionary pressure permits a reduction in government borrowing; the reduced foreign exchange reserves are used to restrict monetary growth at

387

Interdependence and economic policy design: A. J. Hughes Hallen comparatively low interest rates. The outcome is therefore lower inflation. The feedback effects from the action of this policy on expansion abroad suggest that a switch from direct to indirect taxes and reductions in social security contributions and government expenditures would restore the balance of trade and, hence, output growth. That provides the domestic stimulus which, as we noted at the start, the Japanese economy needs. However, the reduction in government borrowing would generate extra unemployment, while the increased reserves would have to be sterilized in order to secure reductions in inflation at the same time. Hence the rise in interest rates. If predictable foreign countermeasures are included Japanese policies are scarcely modified, except that increases in investment expenditures substitute for the trade surplus of other solutions. Policy conflicts induced by interdependence The comparative insensitivity of the EEC and US economies (and their best non-cooperative policies) to spill-overs and feedbacks from abroad does not mean that the spill-over effects themselves are small. We saw earlier that individually some are quite large (principally those from EEC monetary policy and US budgetary policy) and correspond to the results of the standard theoretical models which analyse the spill-over channels one by one. What the empirical results show however is that the net spill-over effects are rather small. That may arise first because the spill-overs between two countries are conflicting and roughly balanced so that they cancel out. For example, expansion in the EEC and USA had negative spill-overs on Japan in this model and that will diminish any positive spill-overs which a Japanese expansion could otherwise have had on either the USA or EEC. Second, it may be that the use of one instrument in a certain country has spill-overs on a foreign target which conflict with the spill-overs generated by the use of another instrument in that country on the same foreign target. For example, according to the multipliers of this model, expansion in the USA which is generated through reduced taxation and social security contributions will produce, unit for unit, two exactly equal and opposite spill-overs on unemployment in Europe. Similarly, the spill-overs on EEC inflation from a US expansion generated by increased government expenditures together with lower interest rates would have strongly conflicting effects. Third, there is the possibility that a spill-over from one country conflicts with a similar spill-over from another. In this model, for example, expansion in the USA and Japan driven by cuts in direct taxes would have opposing effects on the EEC’s trade balance. Fourth, it may also turn out that policy

388

rules are insensitive to spill-over effects, even when the economies concerned are sensitive to them. This would happen if the spill-overs on one target called for an instrument to be adjusted in a certain way, while the spill-overs on another target called for that instrument to be adjusted in the opposite direction.” The international nature of economic policy in the major industrial economies can therefore lead to a wide range of policy conflicts within a particular economy, over and above those already inherent in trying to reach two conflicting domestic targets with a limited set of domestic instruments. For example, if the EEC were to rely on the locomotive effects of US expansion to raise output and employment, it would find the conflicting impacts on the EEC would not reduce unemployment at all. Similarly, if the EEC hoped to exploit those locomotive effects for raising output while directing its domestic policy towards the reduction of inflation, it would only be successful if the USA simultaneously relaxed its monetary control by lowering interest rates. If the USA did tighten its monetary control (as it did in this period), then the spill-over effects would add to the inflationary pressure in domestic expansion and would thereby create more of a policy conflict than would have been apparent from considering just the EEC by itself. The point here is that interdependence means that open economies are potentially subject to many more policy conflicts than closed economies. It is not always practical to use theoretical models to analyse those conflicts since there are three transmission channels (via income, monetary and relative price changes) and we need to evaluate the net effects when all three channels are operating. No theoretical model has yet managed to treat all three channels because it is too difficult to sign the combined effect of all the partial derivatives of different instruments, activated in different periods, on each target in each period. Because of the possibility that the intereconomy transmission mechanisms will be oversimplified, in addition to any misspecifications within the national models, this type of misspecification bias is potentially more serious in multicountry policy analysis.

” It is important to realize that, for all these reasons, policy spill-over effects (and hence the importance of accommodating interdependence in policy design) may actually be quite small despite large spill-over multipliers. Thus a high degree of interdependence is a necessary, but certainly not sufficient, condition for an evaluation of foreign policies to be important for domestic decisions. In fact this may be the reason why Caruoneri and Minford [61 - who draw a similar conclusion for different reasons - find that the degree of interdependence is not a particularly important factor in determining the gains from policy coordination. Notice also that a high degree of interdependence does not necessarily imply large spill-over multipliers, since cumulating small multipliers of like signs could imply large spill-over effects.

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Interdependence and economic policy design: A. J. Hughes

Activism and the flexibility of the economic responses Harmonized policies have often been proposed as a way of reducing fluctuations in key variables (see Begg 141, Marris [20]).‘2 This section examines the vigour of the various non-cooperative policy sequences. A simple index of the vigour with which instruments are used, and of the variability of the target values which result, is the standard deviation of each variable over the planning period. These are set out in Table 4 for each strategy. It is clear that simplifying the decision rule (from the optimal one (column 4) to those which ignore interdependence (columns 1 and 2)) hardly affects the activism of the instruments at all. For the USA, no instruments are affected; for the EEC, direct taxes have to become more active, and social security contributions less active, as soon as interdependence is allowed for; and the activism of indirect taxes in Japan is replaced by that in direct taxes. Thus, apart from some substitution between the fiscal instruments when interdependence is recognized, policy spill-overs do not materially affect the vigour of the policy. The general result is that activism varies more between countries than it does between strategies. The US policies are substantially more vigorous than those in either Japan or the EEC. The variability of US instruments is two to three times higher than their EEC counterparts. Whether this implies that the US economv is harder to steer (and hence needs great policy interventions), or was merely further out of adjustment than the EEC in this period, is not clear. But these results certainly do underline the greater flexibility of the US economy because the target responses associated with each instrument change must have been sufficiently large and quick to warrant making those changes, despite the fact that instrument ‘failures’ are penalized at the same rate as target ‘failures’. That is evidently not true for the EEC, so the initial instrument levels tend to be maintained period by period. Even the Japanese instruments (social security contributions excepted) are used more vigorously than their EEC counterparts. This lack of flexibility in the European economies naturally makes the job of improving economic performance harder. It may go a long way to explaining the poor economic record of Europe in comparison to the USA and Japan and why it has proved so much more difficult to start a recovery, and to overcome unemployment, in the EEC economies. The consequences of European economic inflexibility

I2 See also the views expressed by Helmut Schmidt, V. Giscard d’Estaing, Martin Feldstein and Laurence Klein, in various issues of ne Economisr between February and June 1983.

ECONOMIC MODELLING July 1987

Table 4. Tbe variance USA and Japan. Myopic

Hallett

of optimal (ex post) policies for the EEC,

Isolation- Open ist

Conject- Hlatorlcal pOliCkS Ural variation

For tbe EEC GDP INv CPI UNE NL B Dtax ItaX ss G R

0.78 2.06 0.82 0.88 1.03 0.65 0.28 0.83 0.40 1.04 0.49

0.50 1.99 0.76 0.47 0.91 0.83 0.28 0.83 0.40 1.04 0.49

0.79 1.99 0.71 0.58 0.87 1 sa 0.77 0.92 0.34 1.14 0.52

0.79 2.03 0.69 0.58 0.87 1.74 0.17 0.93 0.22 1.13 0.46

1.54 3.28 1.50 1.08 0.76 0.80 0.16 0.09 0.54 1.58 3.09

For the USA GDP INV CPI UNE NL B Dtax SS G R

1.71 4.79 2.12 2.14 2.12 1.20 1.10 1.47 3.50 0.99

1.70 4.79 2.29 2.18 2.05 1.18 1.10 1.47 3.50 0.99

1.71 4.78 2.22 2.19 2.08 1.18 1.12 1.47 3.42 0.96

1.72 4.78 2.22 2.19 2.06 1.18 1.12 1.47 3.41 O.%

4.05 10.56 2.86 0.78 0.87 0.40 0.27 0.27 1.65 3.09

For Japan GDP INV CPI VNE NL B Dtax Itax ss G R

2.69 3.69 1.27 0.16 1.04 1.25 0.63 1.26 0.36 1.94 0.77

2.12 3.64 1.44 0.76 1.57 1.15 0.63 1.26 0.36 1.94 0.77

2.13 3.54 1.65 0.89 1.43 0.99 1.10 0.85 0.37 1.86 0.73

2.57 3.59 1.66 0.87 1.46 1.02 1.08 0.84 0.36 l.% 0.68

3.07 3.76 1.57 0.10 1.74 1.31 0.59 0.05 0.98 1.69 2.14

are to be seen again in the variability of the targets in Table 4. Once again, with one or two exceptions, simplifying the solution used makes virtually no difference. But the Americans also succeed in making greater and more frequent adjustments to their targets - there is twice as much adjustment for each US target compared to each EEC target. Since each strategy has been optimized, smaller movements than these in the US targets would have necessarily implied inferior results; and in fact Table 3 shows the US targets were closer to their desired values on average than those in the EEC (inflation and unemployment excepted). The Americans are therefore able to profit from the relative flexibility of their economy; the same is clearly true of Japan, although the adjustments are less marked. These remarks have focused only on the ability to steer policy targets rapidly from some unfavourable

389

Interdependence and economic policy design: A. J. Hughes Hallett position towards new desired levels. They do not account for any preferences for smooth transitions (which would require the objective functions to penalize large changes, as well as deviations from the ideal levels). If one favours stability or gradual changes and continuity of policy - presumably because it breeds confidence and greater investment - then the US shortrun success would seem less important. There is obviously a potential conflict here between stability (in a broad sense) and the ability to adapt rapidly to the consequences of shocks and foreign policy changes, and this can only be treated as a question of priorities. However, these results do point out that the inability to adjust to a new situation carries its own costs, and that might cause a greater loss of confidence than the uncertainty which calls for a series of decisive policy changes.

The impact of uncertainty Measures

of the importance

on policy design

of uncertainty

One of the main issues in economic planning is the role played by uncertainty, or imperfect information, in policy design. The results discussed so far are strictly only applicable to the perfect information case, and therefore do not shed much light on the impact of uncertainty on policy selection. This section reviews the effects of uncertainty on optimal cooperative and non-cooperative strategies for the EEC, USA and Japan. There are obviously two aspects to this problem. There is the ex ante question of how much policy makers can, in advance, reduce the risks imposed by incomplete or imperfect information. The appropriate measure of the importance of uncertainty in this sense is given in Hughes Hallett 1161 and involves the variance-covariance matrices of the noncontrollable elements 8) of (13). Risk sensitive decision rules might then be used. The second problem is the ex post one: how much can the policy makers actually do about random shocks or information errors as they arise? That is a matter of the scope available to policy makers for revising their policy values, during the life of those policies, in order to reduce the predictable consequences of some specific shock or error. The answer to that question must depend on the shocks and errors actually encountered and may reflect whether the policy maker was ‘lucky’ or not. The impact of uncertainty in this sense can be seen in the difference between the open loop (unrevised) and closed loop (optimally revised in response to the shocks) policy sequences generated by each solution type in the circumstances of interest. Unfortunately complete tests of the importance of uncertainty were not possible here because the relevant stochastic properties of the model are as yet unknown.

390

The ex ante problem requires a complete multiperiod stochastic simulation of the whole model to pick out the variances and covariances of the ‘final form’ noncontrollable terms and disturbances, from which the relevant variance-covariance matrices can be built up. The second problem requires the simulation of sufficient shocks through the whole model to provide the noncontrollable terms and disturbances required to make up the sequence of information sets needed to create the policy revisions. That information was also not available, since the model was constructed by linking and re-estimating components from other larger models. However, it was possible to gather the information required to determine the initial (unrevised) expectation of the optimal policies and their outcomes; that is to generate the first period certainty equivalent values. These ‘forecasts’ of the various optimal strategies appear in Tables 5 (their average values) and 6 (their variability). Comparison of these values with the corresponding values from the perfect information cases (Tables 3 and 4) indicates clearly the potential impact of uncertainty on the decision variables in each strategy, and on their expected outcomes, for this particular planning problem. It does not, of course, show how much the authorities should have done about the shocks and errors which actually arose. Uncertainty

and non-cooperative

strategies

From Table 5 it is clear that uncertainty has little effect on impact of spill-overs or the effect of feedbacks and countermeasures; the non-cooperative solutions in Table 5 have very much the same relationship to one another as they did in Table 3. However, uncertainty has a substantial effect on policy design in general, in that the differences due to uncertainty between the corresponding strategies in Tables 5 and 3 are larger than the differences between the different strategies within either Table 5 or Table 3 (or between the strategies of the four central columns of Table 2 for that matter). In other words, uncertainty poses a greater problem than picking the wrong type solution or the wrong priority specification does. In this case it is likely to cause more problems for domestic policy makers than errors in the information used to model the decisions of other countries. The second general feature of Table 5 is that uncertainty appears to affect the US policies most, the Japanese policies rather less and the EEC’s policies relatively little. Indeed, output growth is the only EEC target affected, where, ex ante, an annual growth rate of 0.25% higher than was actually possible would have been expected. That is a measure of the depth of the recession, at its smallest, precipitated by the second oil crisis. But to maintain that performance in the face of recession would require fall in direct taxes (of 0.25% of

ECONOMIC

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July 1987

interdependence Table 5. Forecast optimal policiesfor tbe EEC, USA and Japan, based on the initial (1977) information set and averaged over 1977-81. Myopic

lSOl&iOlliSt

coqjechral variation

Historical policies

and economic policy design: A.J. Hughes Hallett

Table 6. The variance of forecast optimal policies for the EEC, USA and Japan.

Myopic

lEXMiOlli.St

col+zctural variation

HiSt0IiC.d

policies

For the EEC GDP 2.44 INV 4.51 CPI 5.21 UNE 5.43 NL -2.71 B 0.18 Dtax 12.84 1tax 13.49 ss 15.92 G 46.23 R 7.66

2.49 4.59 5.16 5.09 -3.26 0.80 12.a4 13.49 15.92 46.23 1.66

2.41 4.60 5.15 4.90 -3.32 0.68 12.62 13.48 16.06 46.15 7.81

1.96 0.82 9.46 6.04 -3.92 -0.30 13.26 13.69 15.95 47.16 10.94

For the EEC GDP 1.Ol INV 2.10 CPI 0.63 0.39 LINE NL 0.85 B 0.41 Dtax 0.33 Itax 0.56 ss 0.43 G 0.94 R 0.63

0.74 2.03 0.61 0.23 0.80 0.99 0.33 0.56 0.43 0.94 0.63

0.89 2.06 0.58 0.35 0.73 1.69 0.73 0.62 0.38 1.02 0.61

1.54 3.28 1.50 1.08 0.76 0.80 0.16 0.09 0.54 1.58 3.09

For the USA GDP 2.27 INV 5.02 CPI 6.74 UNE 6.97 NL 0.25 B 0.14 Dtax 11.99 SS 1.01 G 11.53 R 9.07

2.36 4.98 6.68 6.99 0.23 0.97 11.99 7.07 11.53 9.07

2.39 5.01 6.41 6.98 0.31 0.79 12.01 7.01 11.52 8.%

1.52 -4.11 9.82 6.72 -1.75 -0.83 12.50 6.60 11.92 10.83

For the USA GDP 1.07 INV 1.51 CPI 1.71 LINE 1.26 NL 0.66 B 0.39 Dtax 0.51 ss 1.29 G 2.29 R 0.22

1.04 1.51 1.83 1.31 0.60 0.57 0.51 1.29 2.29 0.22

2.01 1.50 1.77 1.29 0.63 0.55 0.46 1.28 2.21 0.28

4.05 10.56 2.86 0.78 0.87 0.40 0.27 0.27 1.65 3.09

For Japan GDP 4.02 INV 7.14 CPI 5.33 LINE 1.56 NL -2.25 B 0.83 Dtar 8.79 Itax 3.38 ss 18.12 G 14.29 R 6.28

3.93 7.16 4.41 1.96 -2.80 0.21 8.79 3.38 18.12 14.29 6.28

3.99 7.15 4.11 l.% -1.86 0.51 8.11 4.63 17.53 14.08 6.52

3.48 6.20 5.00 2.10 -4.80 0.35 8.36 3.54 17.66 14.26 6.93

For Japan GDP INV CPI LINE NL B Dtar Itax ss G R

0.79 2.07 2.28 0.58 1.12 1.58 0.75 0.36 0.54 0.16 0.31

0.84 2.01 2.16 0.72 0.94 1.65 0.99 0.28 0.52 0.16 0.43

3.07 3.76 1.57 0.10 1.74 1.31 0.59 0.05 0.98 1.96 2.14

GDP) and the interest rate (0.33 %) and a rise in govemment expenditures of 0.5 % of GDP. The net spill-over pattern is the same as in Table 3. In the USA, however, all targets except unemployment are affected by uncertainty - most notably inflation which would (ex ante) be expected to run at a rate of nearly 2% lower than was actually possible. That, plus losses of output growth, would normally be the measure of the US recession. But by letting their trade balance go into deficit (as they have done), the Americans could have actually increased production slightly and thereby preserved their employment position. Thus the costs of the recession would actually turn out to be extra inflation and a trade deficit. It would take increases in direct taxes, social security contributions and the interest rate, plus a fall in government expenditures, to maintain this outcome. Again, net spill-overs have followed the same pattern as in Table 3.

ECONOMIC MODELLING July 1987

0.73 2.15 1.24 0.29 0.53 1.34 0.75 0.36 0.54 0.16 0.31

Finally Japanese output, inflation and government borrowing are vulnerable to uncertainty. Here recession would force output below expected levels by more than 1% pa, leading to 0.5% less inflation but 0.25% more unemployment and 1% higher government borrowing. The only policy response to the recession would be to reduce direct taxes by 0.25 % and social security contributions by 0.5 % of GDP and thus the deficit financing just noted. There also appear to be some small changes in the spill-over/feedback pattern here. The positive spill-over on government borrowing in Table 3 would not have been expected, nor the positive feedback effect on investment and the negative one on the balance of trade.

Conclusions The policy simulations suggest that the net policy spillovers are small compared to the individual spill-over

391

Interdependence

and economic policy design: A. .I. Hughes Hallett

effects and are modified rather little by feedbacks or countermeasures taken abroad. For the EEC, expansionary policies abroad have a small positive (locomotive) effect on investment and employment. The balance of trade would improve while government borrowing increases without any accompanying inflation. Hence the international transmission mechanisms appear to affect Europe via income and monetary linkages, rather than via the terms of trade. Interdependence is also relatively unimportant for noncooperative policy making in the USA. Expansion abroad has a positive (locomotive) effect on output, and this arises through a positive effect on the trade balance and the usual income linkages. Government borrowing changes little, while inflation and unemployment fail to come down. Thus, while US monetary variables affect others, the USA is not much affected by monetary events abroad. Japanese policies are sensitive to interdependence. Expansion abroad actually causes negative spill-overs on output, because it permits the government to take advantage of the opportunity to cut borrowing and restrict monetary growth in order to overcome inflation and any trade surplus without expanding domestic demand. Thus Japan is likely to contribute relatively little to world recovery unless it takes steps to change its domestic economic structure. Indeed, Japanese policy impacts (rather than economic spill-overs) on the USA and EEC are weak enough to suggest that no policy changes, other than those which alter the economy’s structure, are likely to have much impact on the rest of the world. That naturally puts Japan in the position of a ‘follower’ in policy design. Market flexibility is a key element in international policy design. The relative flexibility of the US economy enables it to absorb shocks from abroad more easily, and therefore allows a better performance in the short run. This property was underlined by the vigour of US policy interventions compared to those in Japan and the EEC. This lack of flexibility in the European economies naturally makes the job of improving economic performance harder - especially with respect to employment creation. These results, and policy design itself, proved fairly robust to shifts in the planning priorities. However, it is also important to establish that the results are a reflection of the state of the world and are not entirely model dependent. Further research is therefore underway to demonstrate the robustness of these results to plausible changes in model specification. In particular we found that, although there were some large spill-over multipliers in the model, the net spill-over effects were small so that the impact of interdependence on policy (comparing the conjectural variations and myopic solutions) was also fairly small. Since interdependence has

392

increased rapidly over the past decade, this might mean the model now understates the degree of interdependence involed. But, in fact, the main improvements came from switching from historical policies to either myopic or optimal non-cooperative ones, so a systematic policy selection procedure appears to be more important than the precise strategy followed within that procedure. That suggests that our qualitative conclusions will be robust to model errors and that the really important thing is to improve the information about the assumptions, priorities and estimated responses which go into the national decision making processes.

References Methods of Game and 1 J.P. Aubin, Mathematical Economic Theory, North-Holland, Amsterdam, 1979. 2 A.P. Barten, G. d’Alcantara and C.J. Can-in, ‘COMET: a medium term macroeconomic model for the European Economic Community’, European Economic Review, Vol 7, 1976, pp 63-115. 3 T. Basar, ‘A tutorial on dynamic and differential games’, in T. Basar, ed, Dynamic Games and Applications in Economics, Springer Verlag, Berlin and New York, 1986. 4 D. Begg, 7?zeEconomics of ti oaring Exchange Rates: he L.esso of the 70s and the Z?qearch Programme for the 80&~ emorandum subyittti to & UK Treasury and Civil Service Committee/~Foy,@~n~&$~~&t&$ Mon ry Arrangements/Appe Marc% 983. 5 A.S. Brandsma and A.J. Hughes Hallett, ‘Economic conflict and the solution of dynamic games’, European Economic Review, Vol 26, 1984, pp 13-32. When Does Inter6 M.B. Canzoneri and P. Minford, national Policy Coordinarion Matter: An Empirical Analysis, Discussion Paper 119, Centre for Economic Policy Research, London, 1986. 7 R.N. Cooper, ‘Economic interdependence and coordination of economic policies’, in R. Jones and R.B. Kenen, eds, Handbook in International Economics, Vol II, NorthHolland, Amsterdam, 1985. policy 8 D. Currie and P.L. Levine, ‘Macroeconomic design in an interdependent world’, in W.H. Buiter and R.C. Marston, eds, Inrernational Economic Poliqy Coordination, Cambridge University Press, Cambridge and New York, 1985. 9 R. Dombusch, Open Economy Macroeconomics, Basic Books, New York, 1980. 10 A. Dramais, ‘Memo on the compact model simulations’, presented to the Brookings Conference ‘Empirical Macroeconomics for Interdependent Economies: Where Do We Stand?‘, lo-11 March 1986, Brookings Institution, Washington, DC. 11 R. Frisch, ‘Monopoly - polypoly - the concept of force in the economy’, International Economic Papers, Vol 1, 1951, pp 23-36. 12 K. Hamada and M. Sakuri, ‘International transmission of stagflation under fixed and flexible exchange rates’, JourMI of Political Economy, Vol 86, 1978, pp 877-895.

ECONOMIC MODELLING July 1987

Interdependence

13 B.G. Hickman, ‘The US economy and the international

14

15

16

17

18

19

transmission mechanism: a structural comparison of twelve multicountry models’, paper presented to the Brookings Conference ‘Empirical Macroeconomics for Interdependent Economies: Where Do We Stand?‘, lo-11 March 1986, Brook@ Institution, Washington, DC. C.A. Holt, ‘An experimental test of the consistent conjectures hypothesis’, American Economic Review, Vol 75, 1985, pp 314-325. ‘Summary description and analysis of P. Hooper, comparative model simulations’, paper presented to the Brookings Conference ‘Empirical Macroeconomics for Interdependent Economies: Where Do We Stand?‘, 10-l 1 March 1986, Brookings Institution, Washington, DC. ‘Measuring the importance of A.J. Hughes Hallett, stochastic control in the design of economic policies’, Economics Letters, Vol 8, 1981, pp 341-347. A.J. Hughes Hallett, ‘Non-cooperative strategies for dynamic policy games and the problem of time inconsistency’, Oxford Economic Papers, Vol 36, 1984, pp 381-399. A.J. Hughes Hallett, Policy Coordination and the Ineficiency of Competitive Decision Making Between Industrialised Economies, EEC Commission Report, Brussels, 1984. A.J. Hughes Hallett, ‘Autonomy and the choice of policy in asymmetrically dependent economies’, Oxford

and economic policy design: A. .I. Hughes Hallett

Economic Papers, Vol 38, 1986, pp 516-544. 20 S. Marris, Deficits and the Dollar: 7he World Economy at Risk, Institute for International Economics, Washington, DC, 1985. 21 M. Miller and M. Salmon, ‘Policy coordination and the time inconsistency of optimal policy in open economies’, Economic Journal, supplement, 1985, pp 124-135. 22 G. Oudiz and J. Sachs, ‘International policy coordination in dynamic macroeconomic models’, in W.H. Buiter and R.C. Marston, eds, International Economic Policy Coordination, Cambridge University Press, Cambridge and New York, 1985. 23 J.B. Taylor, ‘International coordination in the design of macroeconomic policy rules’, European Economic Review, Vol 28, 1985, pp 53-82. 24 L. Thurow, ‘America, Europe and Japan: a time to dismantle the world economy’, 7Jre Economist, 9 November 1985. 25 S.J. Tumovsky and V. d’Orey, ‘Monetary policies in interdependent economies with stochastic disturbances: a strategic approach’, Economic Journal, Vol 96, 1986, pp 696-72 1. 26 D. Ulph, ‘Rational conjectures in the theory of oligopoly’, international Journal of Industrial Organisation, Vol 1, 1983, pp 131-154. 27 J. Williamson, Global Macroeconomic Strategy, Institute for International Economics, Washington, DC, 1982.

Appendix The domestic and spill-over policy multipliers for the EEC, the USA and the Japanese modules of the COMPACT model are given in the following tables.

(9 Each country’s targets are measured as percentage rates

(ii)

(iii)

(iv)

of growth per year - excepting the current trade balances and net lending to the government, both of which are expressed as percentages of current GDP. The instruments are all measured as percentages of current GDP - excepting the interest rates which are expressed in levels. Hence these multipliers state the difference in (percentage) growth rates between the ‘shocked’ target values and the base case target values in each year, given a unit change in the stated instrument in the initial year (1977). A unit change is defined as increasing the instrument’s value by 1% of GDP, while all other instruments remain fixed at their base case values. For interest rates, a unit change is a 2% rise in their level. These multipliers are evaluated around the model’s projection using the historically chosen policies - the base case. For simplicity the multipliers are considered to be time-invariant (ie an instantaneous policy impact in 1977 is equal to that in 1978, 1979 . . . etc, for example). The model provides no evidence that this restriction was unwarranted. Each multiplier corresponds to an instrument change made in 1977.

ECONOMIC MODELLING July 1987

Table 7. Domestic policy multipliers: 1977 Instrument:

GDP IhV CPI LINE NL B Instrument:

GDP INV CPI LINE NL B Instrument:

GDP INV CPI UNE NL

B

EEC.

1978

1979

1980

1981

-0.79 -0.99 -0.21

-0.94 -1.65 -0.30

-0.93 -1.87 -0.32 0.40 0.40 0.70

-0.90 -1.92 -0.33 0.40 0.40 0.70

-1.1 -0.8 4.1 0.4 0.7 0.8

-1.0 -0.7 3.5 0.4 0.7 0.8

direct taxes

-0.38 -0.36 -0.10 0.10

0.20

0.30

0.70 0.20

0.50 0.40

0.40 0.50

indirect taxes

-0.2

-1.2

-1.2

-0.1

-0.5

-0.8

2.6 0.1

1.2 0.2

3.4 0.2 0.9 0.6

3.9 0.4 0.8 0.7

social security contributions

-0.45 -0.16 -0.08 0.11 0.85 0.30

-0.85 -0.90 -0.21 0.22

-0.80 -0.82 -0.29 0.36

0.91 0.61

0.77 0.75

-0.55 -0.40 -0.64 -0.30 -0.49 -0.64 0.23 0.16 0.56 0.54 0.60 0.42 continued on page 394

393

Interdependence

and economic policy design: A. J. Hughes Hallen Table 9. Domestic policy multipliers:

Table 7 (continued). 1977

1978

1979

1980

Instrument: GDP INV CPI UNE NL B

government expenditures 1.15 1.30 1.20 0.40 1.10 2.00 0.22 0.41 0.70 -0.05 -0.12 -0.23 -0.95 -0.74 -0.68 -0.32 -0.40 -0.39

1.00 1.06 0.70 -0.33 -0.67 -0.35

Instrument: GDP INV CPI LINE NL B

interest rate -0.20 -0.40 -0.20 -1.10 0.10 0.10 0.00 0.05 -0.10 -0.10 -0.05 -0.20

-0.50 -2.90 0.10 0.10 -0.20 -0.30

-0.05 -2.10 0.10 0.10 -0.20 -0.30

Table 8. Domestic policy multipliers:

1979

1980

1981

0.80 0.50 0.62 -0.38 -0.61 -0.32

Instrument: GDP INV CPI LINE NL B

direct taxes -0.21 -0.59 -0.11 -0.31 0.00 -0.05 0.05 0.08 0.80 0.75 0.10 0.12

-0.60 -0.05 -0.08 0.10 0.65 0.12

-0.48 0.18 -0.05 0.10 0.60 0.15

-0.32 0.52 -0.05 0.90 0.60 0.15

-0.60 -3.05 0.05 0.20 -0.20 -0.40

Instrument: GDP INV CPI UNE NL B

indirect taxes -0.18 -0.69 -0.11 -0.33 0.41 0.49 0.05 0.08 0.80 0.75 -0.08 -0.13

-0.79 -0.39 0.49 0.10 0.65 -0.15

-0.68 -0.38 0.41 0.15 0.60 -0.20

-0.44 -0.52 0.40 0.12 0.60 -0.22

Instrument: GDP INV CPI UNE NL B

social security contributions -0.39 -0.48 -0.61 -0.20 -0.35 0.00 -0.20 -0.08 -0.12 0.04 0.09 0.10 0.80 0.75 0.65 0.13 0.15 0.20

-0.49 0.30 -0.12 0.10 0.60 0.15

-0.39 0.48 -0.09 0.09 0.60 0.15

Instrument: GDP INV CPI UNE NL B

government expenditures 1.6 2.3 2.4 1.3 4.3 4.9 0.1 0.3 0.2 0.0 -0.1 -0.1 -0.8 -0.7 -0.7 -0.2 -0.3 -0.4

2.3 4.1 0.1 -0.1 -0.6 -0.5

2.0 3.6 -0.1 -0.1 -0.6 -0.5

Instrumenti GDP INV CPI UNE NL B

interest rate -0.1 -0.2 -0.1 -0.5 0.0 0.0 0.0 0.0 0.0 -0.1 0.0 0.0

-0.5 -1.0 -0.1 0.1 -0.1 -0.1

-0.4 -0.9 -0.1 0.1 -0.2 -0.1

1981

USA.

1979

1980

1981

-0.67 0.69 -0.29 0.50 0.65 0.29

-0.38 1.49 -0.60 0.42 0.62 0.50

-0.20 2.01 -0.81 0.40 0.60 0.27

Instrument: GDP INV CPI LINE NL B

social security contributions -0.88 -0.85 -0.70 -0.90 -0.62 0.59 -0.02 -0.08 -0.29 -0.42 -0.62 -0.61 0.82 0.75 0.65 0.53 0.63 0.88

-0.45 1.20 -0.52 -0.48 0.62 0.62

-0.30 1.89 -0.75 -0.42 0.61 0.37

Instrument: GDP INV CPI UNE NL B

government expenditures 1.30 2.10 2.50 2.30 5.10 6.50 0.10 0.10 0.20 -0.60 -1.20 -1.80 -0.90 -0.70 -0.60 -0.10 -0.20 -0.20

2.60 6.40 0.60 -1.80 -0.60 -0.30

2.40 6.00 0.80 -1.90 -0.50 -0.30

Instrument: GDP INV CPI UNE NL B

interest rate -0.80 -1.50 -1.40 -3.70 -0.20 -0.20 0.30 0.80 -0.05 -0.30 0.00 0.05

-0.40 -1.40 -0.90 0.50 -0.50 0.50

-0.10 -0.50 -1.00 0.40 -0.50 0.30

1977

1978

Instrument: GDP INV CPI UNE NL B

direct taxes -0.53 -0.82 -1.02 -0.73 0.02 0.02 0.31 0.61 0.75 0.68 0.25 0.62

394

1977

Table 10. Spill-over multipliers:

-0.4 -0.8 -0.1 0.1 -0.1 -0.1

EEC instrume nts on US targets. 1979

1980

1981

Instrument: GDP INV CPI UNE NL B

direct taxes -0.02 -0.03 -0.01 -0.02 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

-0.04 -0.04 -0.10 0.00 -0.01 -0.01

-0.04 -0.06 -0.10 0.00 -0.01 -0.01

-0.04 -0.07 -0.10 0.00 -0.01 -0.02

Instrument: GDP INV CPI UNE NL B

indirect taxes -0.01 -0.02 0.00 -0.01 0.10 0.20 0.00 0.00 0.00 0.00 0.00 -0.04

-0.04 -0.01 0.20 0.00 0.00 -0.05

1977 -1.10 -3.60 -0.60 0.90 -0.40 0.15

1978

Japan.

lW8

ECONOMIC

-0.40 -0.40 -0.02 -0.02 0.20 0.20 0.00 0.00 0.00 0.00 -0.10 -0.10 continued on page 395

MODELLJNG

July 1987

Interdependence and economic policy design: A. J. Hughes Hallett Table 11 (continued).

Table 10 (continued). 1980

1981

Instrument: GDP INV CPI LINE NL B

social security contributions -0.02 -0.03 -0.04 0.00 0.00 -0.01 0.00 -0.01 -0.05 0.00 0.00 0.01 0.00 0.00 -0.01 -0.02 -0.50 -0.20

1977

-0.03 -0.10 -0.06 0.01 -0.01 -0.15

-0.02 -0.10 -0.07 0.02 -0.10 -0.15

Instrument: GDP INV CPI UNE NL B

government expenditures 0.04 0.06 0.03 0.01 0.02 0.01 0.00 0.02 0.05 0.00 -0.02 -0.02 0.00 0.01 0.01 0.01 0.04 0.12

0.02 0.00 0.08 -0.02 0.01 0.13

0.02 0.00 0.10 -0.01 0.01 0.11

Instrument: GDP INV CPI UNE NL B

interest rate -0.26 -1.10 -0.08 -0.18 0.78 -0.36 0.00 -0.60 -0.10 -0.10 0.10 0.76

-0.50 -1.08 0.22 -0.18 -0.20 -0.64

-0.92 -1.28 0.06 -0.26 -0.20 -0.22

Table 11. Spill-over targets. 1977

1978

multipliers:

1978

1979

-0.98 -2.00 0.20 -0.08 -0.20 0.48

EEC instruments

on Japanese

1979

1980

1981

Instrument: GDP INV CPI UNE NL B

direct taxes -0.04 -0.05 -0.01 -0.03 0.00 0.00 0.00 0.00 0.00 0.00 0.00 -0.10

-0.05 -0.04 -0.01 0.00 -0.01 -0.10

-0.05 -0.08 -0.01 0.00 -0.01 -0.10

-0.05 -0.10 -0.10 0.00 -0.02 -0.20

Instrument: GDP INV CPI UNE NL B

indirect taxes -0.01 -0.03 0.00 0.00 0.10 0.10 0.00 0.00 0.00 0.00 0.00 -0.10

-0.05 -0.01 0.20 0.00 0.00 -0.20

-0.05 -0.01 0.20 0.00 0.00 -0.30

-0.05 -0.01 0.20 0.00 0.00 -0.40

Instrument: GDP INV CPI UNE NL B

social security contributions -0.05 -0.18 -0.25 0.00 -0.04 -0.15 0.00 -0.01 -0.05 0.00 0.01 0.08 0.00 -0.02 -0.02 -0.08 -0.20 -0.25

-0.20 -0.11 -0.12 0.15 -0.04 -0.20

-0.11 -0.10 -0.15 0.10 -0.03 -0.10

Instrument: GDP INV CPI UNE NL B

government expenditures 0.12 0.36 0.52 0.05 0.22 0.48 0.04 0.08 0.20 -0.05 -0.12 -0.23 0.01 0.02 0.04 0.10 0.25 0.15

0.50 0.62 0.24 -0.33 0.04 0.10

0.45 0.45 0.20 -0.38 0.03 0.10 continued

ECONOMIC

MODELLING

July 1987

Instrument: GDP INV CPI UNE NL B

interest rate -0.13 -0.56 -0.04 -0.90 0.39 0.18 0.00 -0.30 -0.05 -0.05 0.05 0.38

Table 12. Spill-over multipliers: 1977

-0.49 -1.00 0.10 -0.04 -0.10 0.24

-0.25 -0.54 0.11 -0.09 -0.10 -0.32

US instruments

-0.46 0.69 0.03 -0.13 -0.10 -0.11

on EEC targets.

1978

1979

1980

1981

-0.15 -0.06 0.00 0.02 -0.02 -0.10

-0.20 -0.10 -0.04 0.10 -0.08 -0.12

-0.17 -0.12 -0.10 0.10 -0.06 -0.10

-0.10 -0.08 -0.10 0.08 -0.05 -0.04

Instrument: social security contributions GDP -0.10 -0.16 -0.22 INV 0.00 -0.07 -0.11 CPI 0.00 0.00 -0.04 UNE 0.00 -0.02 -0.10 NL 0.00 -0.02 -0.05 B -0.20 -0.16 -0.20

-0.19 -0.11 -0.10 -0.10 -0.07 -0.14

-0.20 -0.08 -0.10 -0.08 -0.07 -0.02

Instrument: GDP INV CPI UNE NL B

government 0.10 0.00 0.00 0.00 0.00 0.00

0.40 0.40 0.10 -0.10 0.10 0.20

0.30 0.60 0.10 -0.10 0.20 0.30

Instrument: GDP INV CPI LINE NL B

interest rate -0.10 -0.20 0.00 -0.10 0.00 0.10 0.00 -0.10 0.00 0.00 0.00 0.00

-0.10 -0.20 0.10 -0.10 -0.10 -0.10

0.00 -0.30 0.20 -0.10 -0.10 -0.20

Instrument: GDP INV CPI UNE NL B

direct taxes -0.02 0.00 0.00 0.00 0.00 -0.05

Table 13. Spilkwer targets.

expenditures 0.30 0.40 0.10 0.20 0.00 0.10 0.00 0.00 0.00 0.10 0.10 0.10

multipliers:

1977

-0.20 -0.10 0.10 -0.10 -0.10 -0.10

US instruments

on Japanese

1978

1979

1980

1981

-0.10 -0.05 0.00 0.10 -0.02 -0.33

-0.27 -0.10 -0.03 0.05 -0.04 -0.41

-0.20 -0.10 -0.08 0.08 -0.06 -0.30

-0.05 -0.05 -0.10 0.05 -0.05 -0.10

Instrument: GDP INV CPI UNE NL B

direct taxes -0.03 0.00 0.00 0.00 0.00 -0.60

Instrument: GDP INV CPI VNE NL B

social security contributions -0.09 -0.11 -0.28 0.02 -0.05 -0.12 0.00 0.00 -0.03 0.00 0.02 0.05 0.00 -0.02 -0.04 -0.25 -0.32 -0.42

-0.25 -0.10 -0.10 -0.08 -0.08 -0.10 0.06 0.05 -0.06 -0.05 -0.32 -0.16 continued on page 3%

395

Interdependence

and economic

policy design:

A. J. Hughes

Hallen

Table 13 (continued).

Table 15. Spill-over targets.

1977

on US

1980

1981 1979

1980

1981

0.5 0.4 0.1 -0.1 0.1 0.2

0.5 0.6 0.1 -0.1 0.2 0.3

Instrument: GDP INV CPI VNE NL B

direct taxes 0.0 -0.02 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.02 0.03

-0.03 0.0 0.0 0.0 0.0 0.03

-0.04 0.0 0.0 0.0 0.0 0.05

-0.02 0.0 0.0 0.0 0.0 0.05

-0.3 -0.3 -0.1 0.1 -0.1 -0.1

-0.2 -0.3 -0.1 0.1 -0.1 -0.1

Instrument: GDP INV CPI VNE NL B

indirect taxes 0.0 -0.02 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.02 0.03

-0.03 0.0 0.0 0.0 0.0 0.04

-0.04 0.0 0.0 0.0 0.0 0.04

-0.02 0.0 0.0 0.0 0.0 0.04

Instrument: GDP INV CPI VNE NL B

social security contributions 0.0 -0.02 -0.03 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 -0.02 -0.03 -0.03

-0.04 0.0 0.0 0.0 0.0 -0.05

-0.02 0.0 0.0 0.0 0.0 -0.05

0.0 0.0 0.1 0.0 0.0 0.1

0.0 0.0 0.0 0.0 0.0 0.1

0.0 0.0 o,o 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0

Instrument: GDP INV CPI VNE NL B

interest rate -0.1 -0.2 0.0 -0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 -0.1

multipliers:

1978

-0.3 -0.2 -0.1 0.0 0.0 -0.1

1977

Japanese

instruments

1979

1980

on EEC

1981

1978

Instrument: GDP INV CPI VNE NL B

direct taxes 0.0 0.0 0.0 0.0 0.0 0.02

0.01 0.0 0.0 0.0 0.0 0.03

0.01 0.0 0.0 0.0 0.0 0.04

0.02 0.0 0.0 0.0 0.0 0.04

0.02 0.0 0.0 0.0 0.0 0.04

Instrument: GDP INV CPI VNE NL B

government 0.0 0.0 0.0 0.0 0.0 0.0

Instrument: GDP INV CPI VNE NL B

indirect taxes 0.0 0.01 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.02 0.03

0.01 0.0 0.0 0.0 0.0 0.04

0.02 0.0 0.0 0.0 0.0 0.04

0.02 0.0 0.0 0.0 0.0 0.04

Instrument: GDP INV CPI VNE NL B

interest rate 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Instrument: GDP INV CPI VNE NL B

social security contributions 0.0 0.01 0.01 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 -0.20 -0.03 -0.04

0.02 0.0 0.0 0.0 0.0 -0.04

0.02 0.0 0.0 0.0 0.0 -0.30

Instrument: GDP INv CPI VNE NL B

government 0.0 0.0 0.0 0.0 0.0 0.0

0.2 0.2 0.2 -0.1 0.1 0.2

0.2 0.2 0.2 -0.1 0.1 0.2

Instrument: GDP INv CPI VNE NL B

interest rate 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0

396

instruments

1979

government 0.1 0.0 0.0 0.0 0.0 0.0

1977

Japnnese

expenditures 0.3 0.4 0.1 0.2 0.0 0.1 0.0 0.0 0.0 0.1 0.1 0.1

1978

Instrument: GDP INV CPI VNE NL B

Table 14. Spilhver targets.

multipliers:

expenditures 0.2 0.2 0.1 0.1 0.1 0.1 0.0 -0.1 0.0 0.1 0.1 0.2

0.0 0.0 0.0 0.0 0.0 0.0

expenditures 0.0 0.0 0.0 0.0 0.0 0.1 0.0 0.0 0.0 0.0 0.0 0.1

0.0 0.0 0.0 0.0 0.0 0.0

ECONOMIC MODELLING July 1987