## _wp10152 ## Source details **Canonical URL:** [_wp10152](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2010/_wp10152.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2010/_wp10152.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2010/_wp10152.pdf.json) --- ### Purpose and context - The Group of Twenty has recently emerged as the premier forum for international macroeconomic policy coordination and is a focal point of multilateral surveillance at the International Monetary Fund. - The paper presents a first fully disaggregated attempt, to the authors' knowledge, to develop and estimate a structural macroeconometric model to inform monetary policy analysis and forecasting for the Group of Twenty. ### Modeling approach - The model is based on the panel unobserved components model introduced by Vitek (2009), related to the global vector autoregressive model introduced by Pesaran and others (2004). - Comparison of modeling frameworks: - Global vector autoregressive (GVAR) models: consist of a large number of interconnected reduced form vector autoregressive models of large open economies which are estimated individually subject to small open economy restrictions. - Panel unobserved components models: consist of a large number of interconnected structural unobserved components models of large open economies which are estimated jointly subject to cross economy parameter restrictions. ### Model scope and structure - The paper develops a panel unobserved components model of the monetary transmission mechanism in the world economy, disaggregated into twenty national economies along the lines of the Group of Twenty. - The structural macroeconometric model features extensive linkages between the real and financial sectors, both within and across economies. - Economies included: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Korea, Mexico, Russia, Saudi Arabia, South Africa, Spain, Turkey, the United Kingdom, and the United States. ### Applications and uses - Demonstrated monetary policy analysis and forecasting applications include: - Measurement of monetary conditions. - Analysis of the monetary transmission mechanism. - Generation of conditional forecasts of inflation and output growth. - Estimation and forecasting are based on a Bayesian framework for incorporating judgment concerning the paths of unobserved variables. ### Relation to other multilateral surveillance models - The model fills a gap in the suite of multilateral surveillance models at the IMF. - Comparisons with alternative models: - Global Projection Model (GPM) documented in Carabenciov and others (2008): also designed to inform monetary policy analysis and forecasting in the world economy; estimated variants currently cover about five economies and feature lower levels of disaggregation within their output and financial markets. - Global Integrated Monetary and Fiscal Model (GIMF) documented in Kumhof and others (2010): provides a theoretically coherent framework for the joint analysis of monetary and fiscal policy in the world economy, which is beyond the scope of both alternative models; calibrated variants currently cover about five economies and have yet to be adapted to forecasting. ### Paper organization - Section II: Description of the panel unobserved components model of the world economy. - Section III: Estimation of the model. - Section IV: Monetary policy analysis within the framework of the estimated model. - Section V: Forecasting. - Section VI: Conclusion. ### Model structure and estimation - Developed a panel unobserved components model of the world economy that links multiple structural unobserved components models of large open economies via trade and financial linkages. - Model features: - Cyclical components: multivariate linear rational expectations model of the monetary transmission mechanism derived from postulated behavioral relationships; cyclical and trend components additively separable. - Trend components: modeled as independent random walks. - Monetary transmission operates via interest rate and exchange rate channels; includes a financial accelerator linked to the real value of an internationally diversified equity portfolio. - Estimation approach: - Bayesian estimation procedure that conditions on informative priors for conditional mean parameters and diffuse priors for conditional variance parameters. - Joint estimation based on levels of a total of 156 endogenous variables observed for 20 economies over the period 1999Q1 through 2009Q4. - Economies: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Korea, Mexico, Russia, Saudi Arabia, South Africa, Spain, Turkey, the United Kingdom, and the United States. - Observed endogenous variables: the price of output, the price of consumption, the quantity of output, the quantity of domestic demand, the short term nominal interest rate, the long term nominal interest rate, the price of equity, the nominal bilateral exchange rate, and the prices of energy and nonenergy commodities. - Judgment on trend paths derived from Hodrick and Prescott (1997) filter preliminary estimates. - Posterior mode calculated by numerical maximization; sufficient condition for unique stationary rational expectations equilibrium (Klein (2000)) satisfied in a neighborhood around the posterior mode. - Parameter estimation results reported for period 1999Q3 through 2009Q4. ### Key empirical findings - Business cycle synchronization: - Business cycle fluctuations became increasingly synchronized within the Group of Twenty during the estimation sample, culminating in a strong synchronized global expansion followed by a precipitous synchronized global contraction (the Great Recession). - In most economies the contraction was primarily attributable to a collapse in domestic demand; a notable exception is China, where robust domestic demand was dominated by a collapse in net exports. - Terminal output gap estimates generally remain negative and large; exceptions: Brazil, China and Indonesia where terminal output gaps are positive but small. Argentina, Australia and India have negative but small terminal output gaps. - Monetary and financial conditions: - Loose financial and monetary conditions prevailed throughout the Group of Twenty during the build up to the Great Recession. - In the Euro Area and the United States, loose monetary and financial conditions were attributable originally to low long term real interest rates, and subsequently to high real equity prices. - During the Great Recession, collapses in real equity prices and real effective currency appreciations contributed to an abrupt tightening of monetary and financial conditions in these economies. - Predictive indicators: - Both the output gap and the monetary conditions gap are leading indicators of inflation; usefulness varies across economies and horizons. - The output gap is generally more useful for predicting inflation at short horizons, while the monetary conditions gap tends to be more useful at longer horizons. - The monetary conditions gap is a leading indicator of the output gap; it is most useful for predicting the output gap in China and Saudi Arabia (reflecting fixed exchange rate regimes) and within the Euro Area. - Impulse responses and transmission: - Domestic supply shock: inflation rises, output gap falls; monetary conditions are tightened (raise short term nominal interest rate) and real effective currency appreciates. - Foreign supply shock (US): inflation falls in other economies except China and Saudi Arabia (their fixed exchange rate regimes); output gap falls in Canada and Mexico due to high trade integration with the United States. - Domestic demand shock: inflation and output gap rise; monetary conditions tightened, real effective currency appreciates. - Foreign demand shock (US): inflation and output gap rise in other economies; strength of transmission increases with trade integration with the United States (largest output responses: Canada, then Mexico). - Domestic monetary policy shock: a rise in short term nominal interest rate causes real effective appreciation and declines in inflation and output gap; for economies with flexible inflation targeting, peak inflation control effects generally realized after 6 quarters, while peak output stabilization effects occur with a delay of 5 quarters. - Foreign monetary policy shock (US): reduces inflation and output gap in other economies eventually; transmission strength increases with trade integration with the United States and decreases with nominal bilateral exchange rate flexibility (largest output responses: China and Saudi Arabia, followed by Canada and Mexico). - World commodity price shocks: inflation rises and output gap falls in most economies; largest inflation responses to world energy shocks: Korea; to world nonenergy shocks: China (reflecting high commodity import intensities). - Variance decompositions and historical decompositions: - Short horizons: unpredictable fluctuations in inflation primarily due to domestic and foreign supply shocks or world commodity price shocks; output gap unpredictability primarily due to domestic and foreign demand shocks; monetary conditions gap unpredictability primarily due to domestic monetary policy or world risk premium shocks. - Long horizons: primary determinants of unpredictable variation in inflation, the output gap, and the monetary conditions gap are domestic and foreign supply shocks or world commodity price shocks (common sources). - Historical decompositions attribute inflation deviations to combinations of domestic and foreign supply and demand shocks, world risk premium and commodity price shocks; output gap dynamics primarily to domestic and foreign demand shocks; monetary conditions gap cycles primarily to domestic monetary policy and world risk premium shocks. - During the build up to the Great Recession: positive domestic demand shocks (sometimes amplified by foreign demand or world risk premium shocks) accumulated excess demand and were reflected in a synchronized global rise in inflation, amplified by positive world commodity price shocks. - During the Great Recession: negative domestic and foreign demand shocks (often amplified by world risk premium shocks) rapidly eliminated excess demand pressure; monetary conditions tightened abruptly due to risk premia reversals, contributing to synchronized global fall in inflation, amplified by negative world commodity price shocks. - China exception: positive domestic demand shocks dominated by negative foreign demand shocks. ### Forecasting - Forecasting framework: - Bayesian forecasting procedure combining restricted forecasts from the estimated panel model with judgment (International Monetary Fund judgment). - Restricted forecasts incorporate common global assumptions: specified paths of energy and nonenergy commodity prices and constant real effective exchange rates (to align with World Economic Outlook of April 2010). - Combined forecasts are recursive weighted averages: weight on restricted forecasts decreases with objective uncertainty (time varying forecast error covariance matrix) and increases with subjective uncertainty associated with judgmental forecasts. - Forecast performance: - Sequential unconditional forecasts demonstrate the model can predict business cycle turning points and suggested that a synchronized global moderation was overdue by the time of the Great Recession. - The model generally underpredicted the severity of the synchronized global contraction and overpredicted its disinflationary impact. - Conditional forecasts (combined with judgment) unanimously point to a sustained synchronized global recovery; restricted forecasts generally indicate a stronger but less durable recovery than envisaged in the World Economic Outlook (which incorporates structural rebalancing). - Conditional forecast decompositions: - The pessimism embodied in the judgmental forecasts of output growth is primarily attributed to economy specific combinations of negative domestic and foreign demand shocks. ### Policy implications and recommendations for further research - Monetary policy implications: - Global synchronization of business cycles implies rising relevance of global considerations to monetary policy analysis and forecasting; monetary policy responses to spillovers are necessary given trade and financial linkages. - The monetary conditions gap (financial conditions gap plus real effective exchange rate) is a valuable indicator for policy, with its composition and predictive power differing across economies and regimes. - Flexible inflation targeting central banks face a supply-demand tradeoff when confronted with domestic supply shocks (inflation up, output down), while domestic demand shocks generally do not create a tradeoff. - Research recommendations: - Augment the model by explicitly incorporating a fiscal transmission mechanism: the paper notes that it implicitly treats fiscal policy as a source of business cycle fluctuations to which monetary policy must respond, but the Great Recession accentuated the countercyclical stabilization role of fiscal policy — augmenting the model with a fiscal transmission mechanism remains an objective for future research. - Continue progressive research strategy using the estimated panel unobserved components model as a framework to consolidate theoretical and empirical knowledge and to diagnose model deficiencies. - Further work could examine robustness to alternative priors, alternative specifications of capital controls and exchange rate regimes, and extensions that endogenize fiscal policy responses. *Source: _wp10152 - Introduction* ### Introduction ........................................................................................................... ### Introduction ### Purpose and context - The Group of Twenty has recently emerged as the premier forum for international macroeconomic policy coordination and is a focal point of multilateral surveillance at the International Monetary Fund. - The paper presents a first fully disaggregated attempt, to the authors' knowledge, to develop and estimate a structural macroeconometric model to inform monetary policy analysis and forecasting for the Group of Twenty. ### Modeling approach - The model is based on the panel unobserved components model introduced by Vitek (2009), related to the global vector autoregressive model introduced by Pesaran and others (2004). - Comparison of modeling frameworks: - Global vector autoregressive (GVAR) models: consist of a large number of interconnected reduced form vector autoregressive models of large open economies which are estimated individually subject to small open economy restrictions. - Panel unobserved components models: consist of a large number of interconnected structural unobserved components models of large open economies which are estimated jointly subject to cross economy parameter restrictions. ### Model scope and structure - The paper develops a panel unobserved components model of the monetary transmission mechanism in the world economy, disaggregated into twenty national economies along the lines of the Group of Twenty. - The structural macroeconometric model features extensive linkages between the real and financial sectors, both within and across economies. - Economies included: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Korea, Mexico, Russia, Saudi Arabia, South Africa, Spain, Turkey, the United Kingdom, and the United States. ### Applications and uses - Demonstrated monetary policy analysis and forecasting applications include: - Measurement of monetary conditions. - Analysis of the monetary transmission mechanism. - Generation of conditional forecasts of inflation and output growth. - Estimation and forecasting are based on a Bayesian framework for incorporating judgment concerning the paths of unobserved variables. ### Relation to other multilateral surveillance models - The model fills a gap in the suite of multilateral surveillance models at the IMF. - Comparisons with alternative models: - Global Projection Model (GPM) documented in Carabenciov and others (2008): also designed to inform monetary policy analysis and forecasting in the world economy; estimated variants currently cover about five economies and feature lower levels of disaggregation within their output and financial markets. - Global Integrated Monetary and Fiscal Model (GIMF) documented in Kumhof and others (2010): provides a theoretically coherent framework for the joint analysis of monetary and fiscal policy in the world economy, which is beyond the scope of both alternative models; calibrated variants currently cover about five economies and have yet to be adapted to forecasting. ### Paper organization (as described) - Section II: Description of the panel unobserved components model of the world economy. - Section III: Estimation of the model. - Section IV: Monetary policy analysis within the framework of the estimated model. - Section V: Forecasting. - Section VI: Conclusion. *Source: _wp10152 - Introduction* ### conclusions and recommendations for further research. ### _wp10152 - conclusions and recommendations for further research. ### Model structure and estimation - Developed a panel unobserved components model of the world economy that links multiple structural unobserved components models of large open economies via trade and financial linkages. - Model features (preserve terminology): - Cyclical components: multivariate linear rational expectations model of the monetary transmission mechanism derived from postulated behavioral relationships; cyclical and trend components additively separable. - Trend components: modeled as independent random walks. - Monetary transmission operates via interest rate and exchange rate channels; includes a financial accelerator linked to the real value of an internationally diversified equity portfolio. - Estimation approach: - Bayesian estimation procedure that conditions on informative priors for conditional mean parameters and diffuse priors for conditional variance parameters. - Joint estimation based on levels of a total of 156 endogenous variables observed for 20 economies over the period 1999Q1 through 2009Q4. - Economies: Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Korea, Mexico, Russia, Saudi Arabia, South Africa, Spain, Turkey, the United Kingdom, and the United States. - Observed endogenous variables: the price of output, the price of consumption, the quantity of output, the quantity of domestic demand, the short term nominal interest rate, the long term nominal interest rate, the price of equity, the nominal bilateral exchange rate, and the prices of energy and nonenergy commodities. - Judgment on trend paths derived from Hodrick and Prescott (1997) filter preliminary estimates. - Posterior mode calculated by numerical maximization; sufficient condition for unique stationary rational expectations equilibrium (Klein (2000)) satisfied in a neighborhood around the posterior mode. - Parameter estimation results reported for period 1999Q3 through 2009Q4. ### Key empirical findings - Business cycle synchronization: - Business cycle fluctuations became increasingly synchronized within the Group of Twenty during the estimation sample, culminating in a strong synchronized global expansion followed by a precipitous synchronized global contraction (the Great Recession). - In most economies the contraction was primarily attributable to a collapse in domestic demand; a notable exception is China, where robust domestic demand was dominated by a collapse in net exports. - Terminal output gap estimates generally remain negative and large; exceptions: Brazil, China and Indonesia where terminal output gaps are positive but small. Argentina, Australia and India have negative but small terminal output gaps. - Monetary and financial conditions: - Loose financial and monetary conditions prevailed throughout the Group of Twenty during the build up to the Great Recession. - In the Euro Area and the United States, loose monetary and financial conditions were attributable originally to low long term real interest rates, and subsequently to high real equity prices. - During the Great Recession, collapses in real equity prices and real effective currency appreciations contributed to an abrupt tightening of monetary and financial conditions in these economies. - Predictive indicators: - Both the output gap and the monetary conditions gap are leading indicators of inflation; usefulness varies across economies and horizons. - The output gap is generally more useful for predicting inflation at short horizons, while the monetary conditions gap tends to be more useful at longer horizons. - The monetary conditions gap is a leading indicator of the output gap; it is most useful for predicting the output gap in China and Saudi Arabia (reflecting fixed exchange rate regimes) and within the Euro Area. - Impulse responses and transmission: - Domestic supply shock: inflation rises, output gap falls; monetary conditions are tightened (raise short term nominal interest rate) and real effective currency appreciates. - Foreign supply shock (US): inflation falls in other economies except China and Saudi Arabia (their fixed exchange rate regimes); output gap falls in Canada and Mexico due to high trade integration with the United States. - Domestic demand shock: inflation and output gap rise; monetary conditions tightened, real effective currency appreciates. - Foreign demand shock (US): inflation and output gap rise in other economies; strength of transmission increases with trade integration with the United States (largest output responses: Canada, then Mexico). - Domestic monetary policy shock: a rise in short term nominal interest rate causes real effective appreciation and declines in inflation and output gap; for economies with flexible inflation targeting, peak inflation control effects generally realized after 6 quarters, while peak output stabilization effects occur with a delay of 5 quarters. - Foreign monetary policy shock (US): reduces inflation and output gap in other economies eventually; transmission strength increases with trade integration with the United States and decreases with nominal bilateral exchange rate flexibility (largest output responses: China and Saudi Arabia, followed by Canada and Mexico). - World commodity price shocks: inflation rises and output gap falls in most economies; largest inflation responses to world energy shocks: Korea; to world nonenergy shocks: China (reflecting high commodity import intensities). - Variance decompositions and historical decompositions: - Short horizons: unpredictable fluctuations in inflation primarily due to domestic and foreign supply shocks or world commodity price shocks; output gap unpredictability primarily due to domestic and foreign demand shocks; monetary conditions gap unpredictability primarily due to domestic monetary policy or world risk premium shocks. - Long horizons: primary determinants of unpredictable variation in inflation, the output gap, and the monetary conditions gap are domestic and foreign supply shocks or world commodity price shocks (common sources). - Historical decompositions attribute inflation deviations to combinations of domestic and foreign supply and demand shocks, world risk premium and commodity price shocks; output gap dynamics primarily to domestic and foreign demand shocks; monetary conditions gap cycles primarily to domestic monetary policy and world risk premium shocks. - During the build up to the Great Recession: positive domestic demand shocks (sometimes amplified by foreign demand or world risk premium shocks) accumulated excess demand and were reflected in a synchronized global rise in inflation, amplified by positive world commodity price shocks. - During the Great Recession: negative domestic and foreign demand shocks (often amplified by world risk premium shocks) rapidly eliminated excess demand pressure; monetary conditions tightened abruptly due to risk premia reversals, contributing to synchronized global fall in inflation, amplified by negative world commodity price shocks. - China exception: positive domestic demand shocks dominated by negative foreign demand shocks. ### Forecasting - Forecasting framework: - Bayesian forecasting procedure combining restricted forecasts from the estimated panel model with judgment (International Monetary Fund judgment). - Restricted forecasts incorporate common global assumptions: specified paths of energy and nonenergy commodity prices and constant real effective exchange rates (to align with World Economic Outlook of April 2010). - Combined forecasts are recursive weighted averages: weight on restricted forecasts decreases with objective uncertainty (time varying forecast error covariance matrix) and increases with subjective uncertainty associated with judgmental forecasts. - Forecast performance: - Sequential unconditional forecasts demonstrate the model can predict business cycle turning points and suggested that a synchronized global moderation was overdue by the time of the Great Recession. - The model generally underpredicted the severity of the synchronized global contraction and overpredicted its disinflationary impact. - Conditional forecasts (combined with judgment) unanimously point to a sustained synchronized global recovery; restricted forecasts generally indicate a stronger but less durable recovery than envisaged in the World Economic Outlook (which incorporates structural rebalancing). - Conditional forecast decompositions: - The pessimism embodied in the judgmental forecasts of output growth is primarily attributed to economy specific combinations of negative domestic and foreign demand shocks. ### Policy implications and recommendations for further research - Monetary policy implications: - Global synchronization of business cycles implies rising relevance of global considerations to monetary policy analysis and forecasting; monetary policy responses to spillovers are necessary given trade and financial linkages. - The monetary conditions gap (financial conditions gap plus real effective exchange rate) is a valuable indicator for policy, with its composition and predictive power differing across economies and regimes. - Flexible inflation targeting central banks face a supply-demand tradeoff when confronted with domestic supply shocks (inflation up, output down), while domestic demand shocks generally do not create a tradeoff. - Research recommendations: - Augment the model by explicitly incorporating a fiscal transmission mechanism: the paper notes that it implicitly treats fiscal policy as a source of business cycle fluctuations to which monetary policy must respond, but the Great Recession accentuated the countercyclical stabilization role of fiscal policy — augmenting the model with a fiscal transmission mechanism remains an objective for future research. - Continue progressive research strategy using the estimated panel unobserved components model as a framework to consolidate theoretical and empirical knowledge and to diagnose model deficiencies. - Further work could examine robustness to alternative priors, alternative specifications of capital controls and exchange rate regimes, and extensions that endogenize fiscal policy responses. *Italic: Source: _wp10152 - conclusions and recommendations for further research.* ### References ### _wp10152 - References ### IMF Working Papers - Carabenciov, I., I. Ermolaev, C. Freedman, M. Juillard, O. Kamenik, D. Korshunov, D. Laxton, and J. Laxton, 2008, “A Small Quarterly Multi-Country Projection Model with Financial-Real Linkages and Oil Prices,” IMF Working Paper No. 08/280 (Washington). - Kumhof, M., D. Laxton, D. Muir, and S. Mursula, 2010, “The Global Integrated Monetary and Fiscal Model (GIMF) – Theoretical Structure,” IMF Working Paper No. 10/34 (Washington). - Vitek, F., 2009, “Monetary Policy Analysis and Forecasting in the World Economy: A Panel Unobserved Components Approach,” IMF Working Paper No. 09/238 (Washington). ### Time Series, Filtering, and Unobserved Components - Engle, R., and M. Watson, 1981, “A One-Factor Multivariate Time Series Model of Metropolitan Wage Rates,” Journal of the American Statistical Association, Vol. 76, pp. 774–81. - Hodrick, R., and E. Prescott, 1997, “Post-War U.S. Business Cycles: A Descriptive Empirical Investigation,” Journal of Money, Credit, and Banking, Vol. 29, pp. 1–16 (The Ohio State University Press). - Kalman, R., 1960, “A New Approach to Linear Filtering and Prediction Problems,” Transactions ASME Journal of Basic Engineering, Vol. 82, pp. 35–45 (American Society of Mechanical Engineers). ### Econometric Methods, Bayesian and Multivariate Models - Geweke, J., 2005, “Contemporary Bayesian Econometrics and Statistics,” Wiley Series in Probability and Statistics. - Klein, P., 2000, “Using the Generalized Schur Form to Solve a Multivariate Linear Rational Expectations Model,” Journal of Economic Dynamics and Control, Vol. 24, pp. 1405–23. - Pesaran, M., T. Schuermann, and S. Weiner, 2004, “Modeling Regional Interdependencies Using a Global Error-Correcting Macroeconometric Model,” Journal of Business and Economic Statistics, Vol. 22, pp. 129–62. *Source: _wp10152 - References* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2010/_wp10152.pdf_