Download The Equity Risk Premium (μ)

Changes in Equity Risk Perceptions:
Global Consequences and
Policy Responses
Warwick J McKibbin
ANU and Brookings Institution
And
David Vines
Oxford, ANU and CEPR
Presented at the Bank of Canada Workshop on “Global Models and the Transmission of Shocks, 22 May 2003
Background
 Two broad views of the current global economic
slowdown
• The result of weak aggregate demand that can be offset
through appropriate adjustments to monetary policies
• The results of a reduction in aggregate supply resulting
from
 A downward revision in productivity growth in the OECD
 The collapse of the “new economy” bubble
 An increase in risk since September 11 and the war on terrorism
Goals of the Paper
 To understand the current world economic slowdown in
terms of the contribution of supply versus demand shocks
when an equity bubble bursts
 To explore the transmission of equity risk shocks between
countries
 To explore the optimal response of monetary policy in
response to a sharp equity price adjustment
 To explore whether there are gains to policy coordination in
response to equity price shocks
Attempt to Quantify the Key Issues using
a global model
Use the MSG3 model version 50o
(2 sector version of G-Cubed)
New version based on GTAP I/O data
www.gcubed.com
The G-Cubed Model
 Key features
• Based on explicit intertemporal optimization by
households and firms in each economy in a dynamic
setting
• Substantial sectoral dis-aggregation with
macroeconomic structure
• Explicit treatment of financial assets with stickiness in
physical capital differentiated from flexibility of financial
capital
• Short run deviation from optimizing behavior due to
stickiness in labor markets, myopia
• Short run “New Keynesian” Model with Neoclassical
steady state
G-Cubed Model
 12 sectors production in each economy
• Plus a capital good producing sector
• Plus a household durable production sector (I.e. housing)
 Estimation of KLEM technology in production and
consumption
 Tracks flows of international trade at the sectoral level
 Tracks flows of international capital
 Distinguishes between relatively traded and non trade goods
(all goods are potentially tradeable)
: The Structure of the G-Cubed Use Table
1
...
12
C
I
G
1
...
A
B
12
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
Derivative Models
We aggregate the full G-Cubed model by sectors and
countries to create models suitable for particular purposes:
G-Cubed (Asia Pacific)
G-Cubed (Agriculture)
G-Cubed (Environment)
MSG3 (macro)
Countries In G-Cubed (Asia Pacific)











United States
Japan
Australia
New Zealand
Rest of the OECD
Korea
Thailand
Indonesia
China
Malaysia
Singapore
Taiwan
Hong Kong
Philippines
India
Oil Exporting Developing Countries
Eastern Europe and the former Soviet Union
Other Developing Countries
Sectors in G-Cubed (Asia Pacific)






Energy
Mining
Agriculture
Durable Manufacturing
Non-Durable Manufacturing
Services
The MSG3 Model
Sectors:
Energy
Non – Energy
Capital goods producing sector
Household capital sector
The MSG3 Model
Countries:
United States
Japan
Australia
Canada
United Kingdom
Germany
Austria
France
Italy
Rest of Euro Zone
Rest of OECD
China
non Oil Developing countries
Eastern Europe and Russia
OPEC
Exchange rate Regime:
float
float
float
float
float
Euro (floating)
Euro (floating)
Euro (floating)
Euro (floating)
Euro (floating)
float
peg to $US
peg to $US
float
peg to $US
The Equity Risk Premium (μ)
dQit  i I
 J it 
d it
= (rt +  i  t )  it  (1   2 )
 Pit (1   4 ) 

dt
dK it 2
 K it 
2
The Equity Risk Premium (μ)

* dQi

it    (1   2 ) pi
dki
t


 Jˆi 
I i
 
 (1   4 ) p
 kˆ 
2
 i
Jˆ , kˆ
2

e ( R ( s )    ( s ))( s t ) ds


The Results
The Simulations
 1) Baseline 2002
• Assumptions about
 population growth by country
 Productivity growth by sector catching up by 2% per year to US leading
sector
 Given tax rates, monetary growth rates etc in all countries
• Solve for rational expectations equilibrium for the global
economy
 2) apply the change in equity risk premium
• Permanent versus temporary
• US versus OECD Wide
Permanent Versus Temporary
GDP
Capital Stock (non Energy)
10
60
40
20
0
-20
-40
-60
-80
-100
-120
5
0
-5
-10
-15
-20
-25
20
00
20
05
20
10
20
15
20
20
20
25
20
30
20
35
20
40
20
45
20
50
20
00
20
05
20
10
20
15
20
20
20
25
20
30
20
35
20
40
20
45
20
50
-30
USA (P)
China (P)
USA (T)
China (T)
USA (P)
China (P)
USA (T)
China (T)
Permanent Versus Temporary
Employment
Real Interest Rates
15
10
5
0
-5
-10
20
00
20
05
20
10
20
15
20
20
20
25
20
30
20
35
20
40
20
45
20
50
-15
USA (P)
China (P)
USA (T)
China (T)
20
00
20
05
20
10
20
15
20
20
20
25
20
30
20
35
20
40
20
45
20
50
0.5
0
-0.5
-1
-1.5
-2
-2.5
-3
-3.5
-4
-4.5
USA (P)
China (P)
USA (T)
China (T)
Permanent Versus Temporary
Current Account
Real Exchange Rates
0
20
-2
10
-4
0
-6
-10
-8
-20
-10
-30
-12
-40
USA (P)
China (P)
USA (T)
China (T)
20
00
20
05
20
10
20
15
20
20
20
25
20
30
20
35
20
40
20
45
20
50
30
20
00
20
05
20
10
20
15
20
20
20
25
20
30
20
35
20
40
20
45
20
50
2
USA (P)
China (P)
USA (T)
China (T)
OECD – Wide versus US Only
GDP
Capital Stock (non Energy)
2
1
0
-1
-2
-3
-4
20
00
20
05
20
10
20
15
20
20
20
25
20
30
20
35
20
40
20
45
20
50
-5
-6
20
00
20
05
20
10
20
15
20
20
20
25
20
30
20
35
20
40
20
45
20
50
4
2
0
-2
-4
-6
-8
-10
-12
-14
-16
USA (S)
China (S)
USA (S)
China (S)
USA (A)
China (A)
USA (A)
China (A)
OECD – Wide versus US Only
Real Interest Rates
Employment
4
0.5
3
0
2
-0.5
1
-1
0
-1.5
-1
-3
-2.5
20
00
20
05
20
10
20
15
20
20
20
25
20
30
20
35
20
40
20
45
20
50
-2
20
00
20
05
20
10
20
15
20
20
20
25
20
30
20
35
20
40
20
45
20
50
-2
USA (S)
China (S)
USA (S)
China (S)
USA (A)
China (A)
USA (A)
China (A)
OECD – Wide versus US Only
Current Account
0.8
0.6
0.4
0.2
0
-0.2
-0.4
-0.6
-0.8
-1
Real Exchange Rates
20
00
20
05
20
10
20
15
20
20
20
25
20
30
20
35
20
40
20
45
20
50
20
00
20
05
20
10
20
15
20
20
20
25
20
30
20
35
20
40
20
45
20
50
5
4
3
2
1
0
-1
-2
-3
-4
-5
USA (S)
China (S)
USA (S)
China (S)
USA (A)
China (A)
USA (A)
China (A)
Key Points
 Equity Risk shock in the US is a large negative
supply shock reducing the desired capital stock
 Domestic variables in the US not affected much by
whether the shock is in the US or in the OECD but
international trade and capital flows and exchange
rates are affected
 Developing countries absorb some of the capital
released and help reduce the global demand effect
of the shock but very quickly diminishing returns in
capital accumulation
US details for OECD – Wide Temporary
Assets
National Acounts
0
40
-1
20
-2
0
-3
-20
-4
-40
-5
-60
-6
-80
GDP
Consumption
Exports
Imports
Investment
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
60
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
1
Capital
Wealth
Bonds
For'n Assets
H Wealth
US details for OECD – Wide Temporary
Wages and Prices
Employment and Inflation
6
2
1.5
1
0.5
0
-0.5
-1
-1.5
-2
-2.5
-3
4
2
0
-2
-4
Employment
CPI Inflation
PPI Inflation
20
12
20
15
20
18
20
21
20
24
20
00
20
03
20
06
20
09
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
-6
Wage
CPI
PPI
US details for OECD – Wide Temporary
Exchange Rates
Asset Prices
-5
-10
-15
20
00
20
03
20
18
20
21
20
24
20
06
20
09
20
12
20
15
20
00
20
03
-20
Nominal r
Real r
Tobin q (nonenergy)
Tobin Q Housing
Real Eff ER
20
21
20
24
0
20
12
20
15
20
18
5
5
4
3
2
1
0
-1
-2
-3
-4
-5
20
06
20
09
10
Nominal Eff ER
Key Points
 Investment falls
 Consumption rises
• Housing prices rise which dampen the negative impact on wealth
and consumption
 Net exports improve
• Capital outflow depreciates the currency
• External balance acts as stabilizer except when all countries have
the shock
 Real wages need to fall
 Aggregate demand falls as does aggregate supply
Optimal Policy Response
Policy makers choose a vector of instrument Ui to
minimize:





i it
W it t 0

t
'
it
Where τ is a vector of targets (inflation and employment), δ
is a discount rate(10%) and Ω is a matrix with the diagonal
elements being a set of weights on each target
Policy optimization
 Two cases
• Countries have weight of 2 on inflation and 1 on
employment (infemp)
• Countries have weight 2 on inflation and zero on
employment (inf)
Optimal US Response to OECD-Wide
Nominal Interest Rates
GDP
0.5
0
0
-1
-0.5
-2
-1
-3
-1.5
-4
-2
-5
USA (infemp)
USA (inf)
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
1
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
1
USA (infemp)
USA (inf)
Optimal US Response to OECD-Wide
Inflation
Employment
2
2
1.5
1
0.5
0
-0.5
-1
-1.5
-2
-2.5
-3
1.5
1
0.5
0
-0.5
-1
USA (infemp)
USA (inf)
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
-1.5
USA (infemp)
USA (inf)
Optimal US Response to OECD-Wide
Real Exchange Rate
Consumption
1
2.5
0.8
2
0.6
1.5
0.4
1
0.2
0.5
0
0
-0.2
-0.6
-1
-0.8
-1.5
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
-0.5
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
-0.4
USA (infemp)
USA (infemp)
USA (inf)
USA (inf)
Key Points
 Not a lot monetary policy can do to offset the shock
except in the very short run
Optimal French Response to US Shock
Assets
National Acounts
0.2
6
0.15
5
4
0.1
3
0.05
2
1
0
-0.05
-0.15
-2
GDP
Consumption
Exports
Imports
Investment
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
0
-1
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
-0.1
Capital
Wealth
Bonds
For'n Assets
H Wealth
Optimal French Response to US Shock
Wages and Prices
Employment and Inflation
0.5
0.1
0.08
0.06
0.04
0.02
0
-0.02
-0.04
-0.06
-0.08
-0.1
0.4
0.3
0.2
0.1
0
-0.1
-0.2
Employment
CPI Inflation
PPI Inflation
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
-0.3
Wage
CPI
PPI
Optimal French Response to US Shock
Exchange Rates
Asset Prices
2
0.4
0.3
1.5
0.2
1
0.1
0
0.5
-0.1
0
Nominal r
Real r
Tobin q (nonenergy)
Tobin Q Housing
20
12
20
15
20
18
20
21
20
24
-0.5
20
00
20
03
20
06
20
09
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
-0.2
Real Eff ER
Nominal Eff ER
Key Points
 Impact on France of OECD wide shock similar to the
results for the US
 Impacts on France of US shock very different
• Positive French supply shock but negative external
demand shock
US Results for Cooperation
Inflation
Employment
1
1.5
0.5
1
0
0.5
-0.5
0
-1
-0.5
-1.5
-1
-2
-1.5
Non Coop
Coop
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
2
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
1.5
Non Coop
Coop
Europe Results for Cooperation
Inflation
Employment
2
2
1.5
1
0.5
0
-0.5
-1
-1.5
-2
-2.5
-3
1.5
1
0.5
0
-0.5
-1
Non Coop
Coop
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
20
00
20
03
20
06
20
09
20
12
20
15
20
18
20
21
20
24
-1.5
Non Coop
Coop
Conclusion
 Shocks to equity risk premia have significant
effects on the real economy
 Both aggregate demand and supply are affected.
 Monetary policy can help in the short to smooth the
adjustment but it can do little to offset the
underlying shock
Conclusion
 Transmission
• Within countries an equity risk shock





lowers real interest rates,
Lowers real wages
causes a capital outflow,
raises other asset prices like housing
Lowers investment but raises consumption and net exports
• Across Countries





lowers real interest rates,
causes a capital inflow,
raises all asset prices including equities and housing
Raises investment and consumption
Lowers net exports
Conclusion
 Monetary Policy Response
• Within countries experiencing an equity risk shock
 Demand falls more than supply thus a loosening of monetary policy can
dampen to employment losses in the short run
• In countries not experiencing an equity risk shock
 Demand rises more than supply
 Employment rises but inflation falls due to falling prices in affected
countries and an exchange rate appreciation
 Interest rates should fall because of a fall in the global real interest rate
Conclusion
 Gains from Policy Coordination
• Compared the the optimal non-cooperative policies there
is little gained from cooperation in the face of an OECD
wide shock
• In reality the current policy stance of the G7 particularly
Europe and Japan are very far from the optimal policies
in this paper (real interest rates in Europe and Japan are
too high). To the extent that real world cooperation might
move these region towards more sensible policy,
cooperation could achieve significant gains
Background Papers
www.gcubed.com
www.sensiblepolicy.com