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Modeling the Global Economy:
The MSG3/G-Cubed Multi Country
Models
Warwick J. McKibbin
Centre for Applied Macroeconomic Analysis (CAMA),
CBE, ANU
& Lowy Institute for International Policy, Sydney
& The Brookings Institution.
Lecture Notes for ANU Course on Modeling Open Economy, April 2009
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Overview
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Using Models
A Short History of Global Modeling
Intertemporal general equilibrium models as a modeling strategy
The G-Cubed and MSG3 models
Issues in estimation versus calibration
Benchmarking the model to a base year for projections
Simulations and Scenarios
An Example of why dynamic models are useful
Running the G-Cubed model
– Inflation target
– Country risk shock (bubble bursting)
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What Features are Important in a Model?
• Does the model explain anything we observe today or in the recent
past? ;
– Model validation is important
• Estimation of parameters
• Replication of history over time and key case studies
• Evaluation of projections or forecasts
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Is the model continually reviewed by experts who actually use it?;
Is the model published in the refereed academic literature?;
Is there a full listing of all equations available on request?;
Is the model generally open to evaluation by others?;
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Types of Structural Global Models
Structural Global
Models
Input/Output
Models
Computable General Equilibrium
Models (CGE)
Models
Dynamic Intertemporal General Equilibrium
Models
Old Style Macroeconometric
Models
1960s/70s
Modern Macroeconometric Models
1980s/90s
Dynamic Stochastic General Equilibrium
(DSGE) Models
Intertemporal GE models
• Domestic
– Jorgenson-Wilcoxen US model
• Multi-Country
– The MSG2 Multi-Country Model
– (McKibbin & Sachs)
– The G-Cubed Multi-Country Model
– (McKibbin & Wilcoxen)
• G-Cubed (Environment)
• G-Cubed (Asia Pacific)
• G-Cubed (Agriculture)
• G-Cubed (Demographics)
• The MSG3 Multi-Country Model
• Oz –Cubed (Australia detail)
• I- Cubed (India detail)
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Hybrid DSGE Models
• integrates the key features of the other types of models
• mix of econometric estimation and calibration of large
structural models
• annual frequency
• problem with large degree of disaggregation because of
complexity of the numerical algorithms needs
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Features of MSG/G-Cubed models
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Dynamic
Intertemporal
General Equilibrium
Multi-Country
Multi-sectoral
Econometric
Macroeconomic
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Overall model development strategy
• Funding is both through research grants and private
consulting
• Hub and spoke approach to coordinating a global
research project (different strategy to Project Link)
– The model is managed/developed in the core
research team in Australia and Syracuse
– Users (researchers/ governments/ financial investors)
in different countries feed back to the core group both
their own developments of the model as well as
funding the core for new developments. All of which
which we are able to incorporate into the model over
time
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The MSG2 Multi-country model
(1984-1994)
McKibbin and Sachs
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Development and Subscription Funding
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McKibbin Software Group Inc
US Congressional Budget Office
The Brookings Institution
US Department of Commerce
US Government
United Nations
World Bank
Australian Treasury
Centre for International Economics
Nomura Research Institute
Daewoo Research Institute (Korea)
Warwick Modeling Bureau
Many Academic Colleagues
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The MSG2 Model
• Countries
• United States
• Japan
• Germany
• France
• Canada
• United Kingdom
• Italy
• Austria
• Australia
• New Zealand
• China
- Taiwan
- Malaysia
- Indonesia
- Thailand
- India
-Philippines
- Hong Kong
- Singapore
- Korea
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The MSG2 Model
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Classic Mundell-Fleming Model with extensions
1 production sector in each country
macroeconomic focus
International capital and trade flows
Forward looking expectations by some agents
Rigidities in physical capital formation but highly
mobile financial capital
• Unemployment is labour markets due to institutional
factors
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The G-Cubed Model
(1991- )
McKibbin & Wilcoxen
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Development and Subscription Funding
– Major Funding
• The Brookings Institution
• United States Environmental Protection Agency
• United States National Science Foundation
• McKibbin Software Group Inc
– Minor Funding through consultancies
• United Nations
• World Bank
• Australian Dept of Environment/AGO
• New Zealand Department of Commerce
• Canadian Dept of Finance
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The G-Cubed Model
– Countries (8+ including combinations of the following)
• United States
• Japan
• Australia
• New Zealand
• Canada
• Mexico
• Europe
• Rest of OECD
• Brazil
• Rest of Latin America
• China
• India
• Eastern Europe and Former Soviet Union
• Oil Exporting Developing Countries
• Other non Oil Exporting Developing Countries
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The G-Cubed Model
– Sectors
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Electric Utilities
Gas Utilities
Petroleum Refining
Coal Mining
Crude Oil and Gas Extraction
Other Mining
Agriculture, Fishing and Hunting
Forestry and Wood Products
Durable Manufacturing
Non Durable Manufacturing
Transportation
Services
Capital Producing sector
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The G-Cubed (Asia Pacific) Model
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Countries
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United States
Japan
Australia
New Zealand
Canada
Korea
United Kingdom
Rest of the OECD
Thailand
Indonesia
China
Malaysia
Singapore
Taiwan
Hong Kong
Philippines
India
Oil Exporting Developing Countries
Eastern Europe and the former Soviet Union
Other Developing Countries
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G-Cubed (Asia Pacific)
– Sectors
• Energy
• Mining
• Agriculture
• Durable Manufacturing
• Non-Durable Manufacturing
• Services
Capital producing sector
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The G-Cubed (Agriculture) Model
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G-Cubed (Agriculture)
– Countries
– United States
– Japan
– Australia
– EU12
– Canada
– Mexico
– ROECD
– China & Hong Kong
– ASEAN
– Taiwan
– Korea
– ROW
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G-Cubed (Agriculture)
– Sectors
• Food grains (rice and wheat)
• Feed grains
• Non-grain crops
• Livestock and its products
• Processed food
• Forest and Fishery
• Mining
• Energy
• Textile and Clothing
• Other non-durable consumer goods
• Durable consumer goods
• Services
Capital Producing sector
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Oz-Cubed
– Countries
– Australia
– Rest of World
– Sectors
• 57 sectors
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I-Cubed Model
– Countries
– India
– USA
– Rest of World
– Sectors
• 21 sectors
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MSG3 Model
• Many countries
• 2 sectors
– Energy
– Non-energy
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Structure of the Models
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AGENTS
Households
Firms
Governments
MARKETS
Goods & Services
Factors of Production
Money
Bond
Equity
Foreign Exchange
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: The Structure of the G-Cubed Use Table
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12
C
I
G
1
...
A
B
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R
K
C
Kc
L
A) Interindustry transactions.
B) Industry sales to final demand sectors.
C) Purchases of primary factors by industries.
D) Purchases of primary factors by final demand sectors.
D
X
M
Sector Model
Sector Model
Output
CES
Capital
Labor
CES
Electricity
Natural Gas
Refined Oil
Coal
Crude Oil
Energy
Materials
CES
Mining
Agriculture
Forestry and
Wood
Durables
Nondurables
Transportation
Services
Data Used in Estimation
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Value data from US benchmark input-output tables
– 1958, 1963, 1967, 1972, 1977, 1982
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Prices from US Bureau of Labor Statistics
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Standardized industry classifications
– Redefinition and reclassification
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Eliminated secondary products
– Redefinition and reclassification
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Aggregated to 12 sectors
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Corrected treatment of consumer durables
– Investment rather than consumption
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Reallocated construction to final investment
Key Features
• Significant dis-aggregation of the demand and supply
side of the major economies ;
• demand and supply equations are based on a
combination of intertemporal optimizing behavior and
liquidity constrained behavior;
• Explicit treatment of asset markets including money;
• Sticky wages based on labour market institutions imply
unemployment can persist for many years
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Key Features
• Distinction between stickiness of physical capital within
sectors and countries and the flexibility of financial
capital which immediately flows to where expected
returns are highest
• Extensive econometric estimation of key consumption
and production substitution elasticities
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Households
– 2 types
• A) maximize an intertemporal utility function
consisting of all goods and services produced
domestically and overseas, subject to an
intertemporal budget constraint that the present
value of consumption is bounded by the
present value of after tax income from all
sources
• B)Base aggregate consumption expenditure
on an optimal rule of thumb with current
consumption of each good allocated so as to
maximize contemporaneous utility
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Firms
– 2 types
• A) Maximise their share market value (the
present value of the future stream of dividends)
subject to production technology, a cost of
adjustment model of capital and taking prices
as given. They base their calculation on a
summary of the future measured by Tobin’s Q.
• B) Base investment on a backward looking
Tobin’s Q that eventually converges to the long
run Tobin’s Q
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Investment Model
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Firms invest to maximize share market value
Capital specific to each sector
Household capital modeled as well
Adjustment costs:
K i = J i   i K i
  Ji 
 J i
I i  1 
 2 Ki 
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Some firms have adaptive expectations about q
Effect of Adjustment Costs
Total Cost
of
Investment
1 Year
2 Years
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Capital
Stock
Sharp swings in investment are expensive.
Financial vs. Physical Capital
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Physical capital immobile
– Difficult to move once installed
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Financial capital is perfectly mobile
– Ownership of physical assets or debt instruments
– Can be traded at will
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Together, these imply that shocks have:
– Large short-run effects on asset prices
– Little short-run effect on stocks
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Physical capital stocks adjust slowly to new conditions
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Effect of Shocks on Financial Assets
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Effect of an adverse shock to demand for an asset
Asset Price
S
short run
P1
S
P2
D2
K3
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K2
K1
long run
D1
K
Initial large drop in price of assets (red arrow)
Over time, K falls and P slowly recovers (blue arrow)
Governments
• Governments provide public goods that enter
into the utility functions on households
(additively separable) and transfer payments;
• They collect a wide variety of taxes on income
of firms households, imports, sales.
• Governments are subject to the intertemporal
budget constraint that the present value of
spending and transfers is bounded by the
present value of future tax collections.
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Countries
• Countries are collections of individual firms,
households and governments that trade goods
and services as well as financial assets;
• Labor is immobile between countries but mobile
within countries;
• Financial capital is mobile within and between
countries;
• Physical capital is sector and country specific at
any point in time and subject to adjustment
costs over time.
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Role of Money
• Money is required for transactions between all
agents. There is a technology that combines
money with produced goods and services and
the combined product is what is available in the
market.
• The supply of money is determined by a
central bank in each economy in conjunction
with assumptions about the monetary regime
which is represented by a HendersonMcKibbin- Taylor type rule of the form
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Henderson-McKibbin-Taylor Rule
(6) it = it 1 +  ( t   t )   ([ y t  y t 1 ]  [ y t  y t 1 ])   ([et  et 1 ]  [et  et 1 ])
In equation (6) it is the short term policy interest rate in period t and it-1 is the
policy interest rate in the previous period; Πt is actual inflation in period t; [yt-yt-1] is
the change in the log of output (or output growth) in period t and [et-et-2 ] is the
change in the log of the nominal exchange rate relative to the $US in period t.
Corresponding variables with a bar overhead indicate desired values of these target
variable.
Financial Markets
• Financial markets exist for
– Money
– Government Bonds
– Equity
– Foreign Assets
– Foreign Exchange
• Each financial asset represents a claim over real
resources
– Money over purchasing power
– Bonds are claims over future tax collections
– Equity is a claim over the future dividend streams
– Foreign assets are claims over the future exports
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Goods and Services Markets
• Households, Firms and Governments trade goods
and services and price for each is assumed to clear
the markets at an annual frequency
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Factor Markets
– Labor Markets
• Nominal wages are set by different institutional
structures in each country;
• Given the nominal wage and the market prices
for goods and services firms higher labor until
the real wage in each sector equals the
marginal product of labor;
• Aggregate unemployment can result although
over time it is assumed that unemployment
tends to force the nominal wage towards the
labor market clearing level.
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Factor Markets
– Capital
• once installed physical capital is costly to move;
• Capital produces a flow of services for firms
that have installed a capital stock through
investment decisions in the past;
• Investment is subject to rising marginal costs
of installation and depreciation over time.
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Factor Markets
– Energy and Materials in GCUBED
• Firms purchase the output of other sectors as
inputs in production;
• Total demand for the materials and energy
sectors is final demand plus demand for
intermediate inputs in each sector;
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Generating a Baseline Projection
• Usually 2 approaches to policy analysis in the new
generation of global models (CGE or macro)
– Assume at a steady state and analyze deviations
from steady state
– Assume the observed data in a given year is on the
stable manifold of a system dynamically adjusting to a
long run steady state
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Generating a Baseline Projection
• Given values for all exogenous variables the model is
solved for an equilibrium over time in which all equations
hold given current and expected future variables.
• Underlying the projection is a convergence model for
sectoral productivity growth and exogenous population
projections
• We adjust the model so that we exactly generates the
base year data set (2002).
• Adjustments are made to constants in behavioral
equations
– In arbitrage equations this is equivalent to calculating
risk premia
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Generating a Baseline Projection
• This generates a baseline projection or forecast from
2002
• We then step the model forward to 2003 adjusting the
information set for 2003 to generate a baseline from
2003 to 2100
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Running Scenarios
• Once the baseline is generated we run scenarios by
changing exogenous variables or initial conditions
• The information set for markets is critical
– Suppose we expect a shock what does the
anticipation do before the actual shock occurs
• Information sets can be changed by the user
unexpectedly over time so we can ask questions like:
– Suppose we expected a shock but it doesn’t happen
– Suppose we don’t expect a shock and it suddenly
occurs
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Use of Scenarios
• The most effective way to undertake scenario analysis is
with an internally consistent and empirically relevant
framework
• The models form the analytical and empirical basis for
designing alternative scenarios
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Use of Scenarios
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Ask the question
– What are the likely consequences of the Iraq War?
Design the scenarios that give different insights to the question
– Examine history (Gulf War I, Afghanistan, Vietnam, Korea)
• Wars always cost more than expected
• Costs are more than the fiscal outlays
– Shocks to
• Government spending for the war (US, Aust, UK)
• Government spending for the peace (Europe/Japan)
• Increased global risk
Impose the shocks in a consistent framework (a model)
Interpret the results
Assess the key sensitivities that drive the results
• Do people expect it to be temporary or more permanent?
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Scenario Examples
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The Aftermath of the Sept 11 Terrorist Attacks
What if Japan Adopted a Sensible Macroeconomic Policy?
The Consequences of WorldCom and Enron Collapses
The War with Iraq: the compounding Effects of Oil Prices, Budgetary
Costs and Uncertainty
The SARS Outbreak: How Bad can It Get?
Exploding Fiscal Deficits in the United States: Implication for the
World Economy
What if China Revalues Its Currency
China: The Implications of Policy Tightening
Oil Price Scenarios and the Global Economy
The United States Current Account Deficit and World Markets
Collapse of the US Housing Market
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Current Research Programs
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Global Demographic Change (Japanese Govt, IMF, G20)
Economics of Infectious Diseases (WHO, NHMRC)
Global trade policy (WTO)
Macroeconomic imbalances
Climate Change Policy
Impact of China and India on the Global Economy
Monetary Cooperation in Asia
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Research Projects/ Challenges
• Model Development
• Estimation at a more detailed level (with Peter
Wilcoxen) to enable more flexible aggregation.
• Incorporating uncertainty in long term projections
(Peter Wilcoxen and various students at Syracuse)
• Treasury Project on Australia’s greenhouse target
• New model for Africa
• Details model of Korea
• Imperfect competition
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Research Projects/ Challenges
• Improving Macroeconomic Dynamics
• Need to integrate the global structural models with the
more data intensive VAR approach
– Using the G-Cubed model to generate restrictions on
multi-country VARS following Pagan and others
• With Dungey, Fry, Pagan
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An Example of the Importance of Dynamics
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Trade Liberalization in a Dynamic Setting
by
Warwick J. McKibbin
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A New Millenium Round
• In 2000, it is announced that existing tariffs will be
reduced by 1/3 from 2000 to 2010 in most countries
• Tariffs on goods trade are based on the GTAP4 database
• For services it is assumed there is a cost reduction
based on work by Centre for International Economics
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Figure 1: Impact of a new WTO Round on Real GDP
(OECD Economies)
0.8
0.7
% deviation from base
0.6
0.5
USA
0.4
Japan
Australia
Korea
0.3
ROECD
0.2
0.1
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-0.1
Figure 2: Impact of a new WTO Round on Real GDP
(non OECD)
3
2.5
% deviation from baseline
2
Indonesia
Malaysia
Philippines
1.5
Singapore
Thailand
China
1
India
Taiwan
Hong Kong
0.5
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-0.5
Figure 3: Impact of a new WTO Round on Real Consumption
(OECD Economies)
1.6
1.4
% deviation from base
1.2
1
USA
0.8
Japan
Australia
Korea
0.6
ROECD
0.4
0.2
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-0.2
Figure 4: Impact of a new WTO Round on Real Consumption
(non OECD)
8
7
% deviation from baseline
6
5
Indonesia
Malaysia
4
Philippines
Singapore
3
Thailand
China
India
2
Taiwan
Hong Kong
1
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-1
-2
Figure 5: Impact of a new WTO Round on Real Exports
(OECD Economies)
3.5
3
% deviation from base
2.5
2
USA
Japan
1.5
Australia
Korea
ROECD
1
0.5
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-0.5
Figure 6: Impact of a new WTO Round on Real Exports
(non OECD)
12
10
% deviation from baseline
8
Indonesia
6
Malaysia
Philippines
4
Singapore
Thailand
China
2
India
Taiwan
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-2
-4
-6
Hong Kong
Figure 7: Impact of a new WTO Round on Trade Balances
(OECD Economies)
0.3
0.25
% baseline GDP deviation from base
0.2
0.15
USA
0.1
Japan
Australia
Korea
0.05
ROECD
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-0.05
-0.1
-0.15
Figure 8: Impact of a new WTO Round on Trade Balances
(non OECD)
2
% baseline GDP deviation from baseline
1
Indonesia
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Malaysia
Philippines
Singapore
-1
Thailand
China
India
-2
-3
-4
Taiwan
Hong Kong
Figure 9: Impact of a new WTO Round on Real Effective Exchange Rates
(OECD Economies)
0.6
0.4
% deviation from base
0.2
USA
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-0.2
-0.4
-0.6
-0.8
Japan
Australia
Korea
ROECD
Figure 10: Impact of a new WTO Round on Real Effective Exchange Rates
(non OECD)
3
2.5
% deviation from baseline
2
Indonesia
1.5
Malaysia
Philippines
1
Singapore
Thailand
China
0.5
India
Taiwan
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-0.5
-1
-1.5
Hong Kong
Figure 11: Impact of a new WTO Round on Employment
(OECD Economies)
0.6
0.5
0.4
% deviation from base
0.3
0.2
USA
Japan
0.1
Australia
Korea
ROECD
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-0.1
-0.2
-0.3
-0.4
Figure 12: Impact of a new WTO Round on Employment
(non OECD)
1.5
% deviation from baseline
1
Indonesia
Malaysia
0.5
Philippines
Thailand
China
India
0
Taiwan
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-0.5
-1
Hong Kong
Figure 13: Impact of a new WTO Round on Real Interest Rates
(OECD Economies)
0.16
0.14
0.12
% point deviation from base
0.1
0.08
USA
0.06
Japan
Australia
0.04
Korea
ROECD
0.02
0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-0.02
-0.04
-0.06
Figure 14: Impact of a new WTO Round on Real Interest Rates
(non OECD)
0.5
0.4
% deviation from baseline
0.3
0.2
Indonesia
Malaysia
0.1
Philippines
Singapore
0
Thailand
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
-0.1
China
India
Taiwan
-0.2
-0.3
-0.4
-0.5
Hong Kong
Summary
• Largest gains to countries liberalizing most
• short run losses outweighed by long run gains
• trade impacts /exchange rate adjustments tend to be the
opposite in the short run relative to the medium run (role
of intertemporal budget constraints)
75
Background Papers
www.gcubed.com
www.economicscenarios.com
76
Using the G-Cubed Model
http://www.msgpl.com.au/modelusers/GCUBEDlite
77