The Effects of American Policies - A New Classical Interpretation

The world economy is modelled by linking nine small country models of the 'new classical' type, and adding three blocs of trade equations to cover the smaller economies. The model (like the Liverpool Model of the United Kingdom) assumes rational expectations and market clearing (there are union and non-union sectors in the labour market). These assumptions distinguish it from available multi-country models such as Project Link, which tend to be very large and preserve a traditional Keynesian approach. Policy simulations show that bond-financed United States deficits generate approximately 100 percent 'crowding out' through higher interest rates, while United States monetary policy is very potent (a 1 percent once-for-all rise in the money supply raises world GNP by 0.8 percent in year 1). Recent world experience is argued to be consistent with these results. The large United States deficits have not been 'stimulatory' but have raised world real interest rates substantially. The United States monetary contraction in 1980-81 and expansion in late 1982 have been the major cause of the latest world business cycle. The model also indicates that, even though theoretically possible, international 'fine-tuning' is unnecessary as the model is fairly rapidly self-stabilising. Planned 'locomotive' policies - i.e., rises in budget deficits and money growth - will have their principal effect on inflationary expectations. Predictability of policy is clearly desirable. At the 'micro' country level, it would pay EEC governments to borrow less when United States deficits have pushed world interest rates up; this would ease pressure on the world capital market.