Working Paper No. 421 Global rebalancing: the macroeconomic impact on the United Kingdom

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1 Working Paper No. 421 Global rebalancing: he macroeconomic impac on he Unied Kingdom Alex Haberis, Boan Markovic, Karen Mayhew and Pawel Zabczyk April 2011

2 Working Paper No. 421 Global rebalancing: he macroeconomic impac on he Unied Kingdom Alex Haberis, (1) Boan Markovic, (2) Karen Mayhew (3) and Pawel Zabczyk (4) Absrac This paper considers he implicaions for he Unied Saes, he Unied Kingdom and he res of he world (ROW) of shocks ha may conribue o a furher reducion in global curren accoun imbalances using a dynamic sochasic general equilibrium (DSGE) model. We consider a shock ha increases domesic demand in he ROW; a shock ha reduces domesic demand in he Unied Saes; and a supply shock ha raises US produciviy relaive o oher counries. The impac on oupu and inflaion depends on he naure of he shock ha drives global rebalancing. An increase in domesic demand in he ROW would raise expors and oupu, bu would also conribue o increased inflaionary pressure in he Unied Kingdom. Furher weakness in US domesic demand is likely o weigh on oupu and inflaion. Produciviy gains in he Unied Saes relaive o oher counries would worsen he Unied Kingdom s curren accoun posiion, pushing down on oupu, bu would lead o reduced inflaionary pressure in he Unied Kingdom. Key words: Global imbalances, curren accoun, DSGE models. JEL classificaion: F41, F47, D58. (1) Bank of England. alex.haberis@bankofengland.co.uk (2) Naional Bank of Serbia. boan.markovic@nbs.rs (3) Bank of England. karen.mayhew@bankofengland.co.uk (4) Bank of England. pawel.zabczyk@bankofengland.co.uk The views expressed in his paper are hose of he auhors, and no necessarily hose of he Bank of England or he Naional Bank of Serbia. We are graeful o Gianluca Benigno, Kaie Farran, Laura Povoledo, Laura Piscielli and Moren Spange for useful commens. The bulk of he research in his paper was compleed in December This paper was finalised on 16 March The Bank of England s working paper series is exernally refereed. Informaion on he Bank s working paper series can be found a Publicaions Group, Bank of England, Threadneedle Sree, London, EC2R 8AH Telephone +44 (0) Fax +44 (0) mapublicaions@bankofengland.co.uk Bank of England 2011 ISSN (on-line)

3 Conens Summary 3 1 Inroducion 4 2 The model Households Firms Governmen The uncovered ineres rae pariy condiion Calibraion 9 3 Resuls A posiive demand shock in he res of he world A negaive demand shock in he Unied Saes A posiive produciviy shock in he US raded goods secors Wha if Asian currencies remained fixed o he dollar? 14 4 Comparison of resuls from oher work 15 5 Conclusion 18 Appendices 19 References 23 Working Paper No. 421 April

4 Summary Global curren accoun imbalances widened sharply in he years preceding he financial crisis of And, alhough since he onse of he crisis global imbalances have narrowed somewha, hey remain subsanial. The implicaions of an unwinding in global imbalances are of grea ineres o policy makers and academics and furher global rebalancing is widely hough o be desirable for he world economy. This paper considers he implicaions for he Unied Saes, he Unied Kingdom and he res of he world (ROW) of shocks ha may conribue o a furher reducion in global curren accoun imbalances using a dynamic sochasic general equilibrium (DSGE) model. These models are a sandard ool for analysing macroeconomic relaionships. The phrase dynamic general equilibrium indicaes ha hey allow for inerrelaionships beween he differen pars of he economy (and, in his case, beween counries) ha ake ime o unfold; he word sochasic ha random shocks arrive o disurb he equilibrium. We consider a posiive demand shock in he ROW, which is inerpreed as represening counries wih curren accoun surpluses. This is calibraed o be consisen wih feaures of pas surplus reversals as sudied by he IMF. A similarly sized negaive demand shock in he Unied Saes (and he Unied Kingdom) is also considered. Finally, we consider he effecs of a supply shock ha raises US produciviy growh relaive o oher counries, which is calibraed o mach he Unied Saes produciviy advanage over is rade rivals in he recen pas. We consider he effecs of hese shocks under he assumpions ha nominal exchange raes are flexible and also when he ROW pegs o he dollar. We find ha he demand shocks, calibraed as above, in eiher he ROW or he Unied Saes would lead he US curren accoun posiion o close from is end-2009 level. The supply shock we consider would no be sufficien o close he defici. The quaniaive differences o he simulaion resuls under he differen assumpions abou he ROW s exchange rae regime are small. This is because, in our model, inflaion in he ROW and he Unied Saes aduss o deliver he real exchange rae movemens, and associaed expendiure swiching. This may, of course, no accuraely reflec wha happens in pracice. The implicaions for oupu and inflaion and he serling real effecive exchange rae depend on he naure of he shock ha drives global rebalancing. A rebalancing of surplus counries demand owards consumpion would boos demand, pushing up on firms real marginal coss, hereby raising inflaionary pressures in he Unied Kingdom. This shock would be associaed wih a depreciaion of he serling real effecive exchange rae. Furher weakness in domesic demand in he Unied Saes would conribue o weaker oupu and inflaion in he Unied Kingdom, and a real appreciaion of serling. Produciviy gains in he Unied Saes would lead he Unied Kingdom o impor more US goods, weighing down on oupu. Inflaionary pressures would also be reduced in his scenario, and here would be a real depreciaion. Working Paper No. 421 April

5 1 Inroducion Global curren accoun imbalances widened sharply in he years preceding he financial crisis of And, alhough global imbalances have narrowed somewha since he onse of he crisis, hey remain subsanial. The Unied Saes and he Unied Kingdom have run persisen curren accoun deficis (Char 1). As a counerpar o his, China, oil exporing counries, and Japan, among ohers, have been in surplus. The larges share of global defici posiions is accouned for by he Unied Saes, where he defici hroughou he 2000s has been greaer as a proporion of GDP han a any ime in he previous 70 years peaking a around 6 of GDP in 2006 (Char 2). Agains his, he widening in global surplus posiions was largely he resul of greaer surpluses in China and oil exporers. By 2009, he US curren accoun defici had fallen o around half is 2006 level as a share of GDP. Over his period, here has been a real depreciaion in he dollar effecive exchange rae of around 5. Char 1: World curren accoun balance Char 2: US curren accoun US China Oher Oil exporers of w orld GDP Source: Auhors calculaions based on he IMF s April 2010 World Economic Oulook daabase. Source: Bureau of Economic Analysis. The implicaions of an unwinding in global imbalances are of grea ineres o policymakers 1 and academics. I has been argued ha global imbalances conribued o he origins of he crisis, and ha one of he effecs of he Grea Recession has been he narrowing in imbalances ha has been observed since hen (see, for insance, Asley e al (2009) and Blanchard and Milesi- Ferrei (2009)). Furhermore, i has been suggesed ha furher global rebalancing would be desirable for he world economy (for insance, see he IMF s April 2010 World Economic Oulook). Work by Obsfeld and Rogoff (2000, 2004, 2005, 2007) has highlighed he effecs of he US curren accoun reversal on he dollar exchange rae. Bu relaively lile work has been done on he wider macroeconomic effecs, paricularly for economies ouside he Unied Saes. Moreover, mos of he analysis ha has been done has concenraed on purely domesically driven shocks ha migh unwind he US curren accoun defici. Given ha he curren accoun defici reflecs imbalances elsewhere in he world, hen any analysis should also consider he possibiliy of evens happening ouside he Unied Saes. 1 See, for example King (2005, 2010) or Bernanke (2005). Working Paper No. 421 April

6 In his paper, we invesigae he macroeconomic implicaions for he Unied Kingdom, he Unied Saes and he res of he world (ROW) of various shocks ha improve global imbalances using a hree-counry calibraed dynamic sochasic general equilibrium (DSGE) model. Under our hree-counry caegorisaion, he Unied Saes and he Unied Kingdom are defici counries while he ROW is in surplus. Given he small conribuion of he curren accoun defici o global imbalances overall, global rebalancing is equivalen o an improvemen in he US curren accoun posiion. Therefore, we focus on shocks ha lead he US defici o narrow. In paricular, we consider a posiive demand shock in he ROW ha is calibraed o be consisen wih feaures of pas surplus reversals as sudied by he IMF (April 2010 WEO). A similarly sized negaive demand shock in he Unied Saes (and he Unied Kingdom) is also considered. Finally, we consider he effecs of a supply shock ha raises US produciviy growh relaive o oher counries. This is calibraed o mach he faser produciviy growh he Unied Kingdom enoyed relaive o is rade parners in he mid-o-lae 1990s. We consider he effecs of hese shocks under he assumpions ha nominal exchange raes are flexible and also when he ROW pegs o he dollar. This exercise is relaed o earlier work by Spange and Zabczyk (2006), which also uses he hree-counry seing ha is necessary o analyse he macroeconomic implicaions of global rebalancing for he Unied Kingdom. Bu, in his paper, by using a fully specified DSGE model, we exend ha work by allowing oupu, he real exchange rae and he curren accoun all o respond endogenously o shocks. This gives a fuller descripion of he macroeconomic consequences of rebalancing and, by allowing quaniies o adus also, i reduces he exen o which rebalancing mus come hrough movemens in he real exchange rae alone. Our simulaion resuls sugges ha demand shocks of he size ha we consider, in eiher he ROW or he Unied Saes, would lead he US curren accoun posiion o close from is end level. The supply shock we consider would no be sufficien o close he defici. The quaniaive differences o he simulaion resuls under he differen assumpions abou he ROW s exchange rae regime are small. This is because, in our model, inflaion in he ROW and Unied Saes aduss o deliver he real exchange rae movemens, and associaed expendiure swiching (albei in a way ha may no accuraely reflec wha happens in pracice). The implicaions for oupu and inflaion and he serling real effecive exchange rae depend on he ype of he shock ha unwinds imbalances. When rebalancing is driven by an increase in surplus economies domesic demand, oupu is increased. This pushes up on firms real marginal coss, raising inflaionary pressures in he Unied Kingdom. By conras, a decline in domesic demand in he Unied Saes would conribue o weaker oupu and inflaion in he Unied Kingdom. A posiive supply shock in he Unied Saes would lead he Unied Kingdom o impor more US goods, weighing down on oupu. Inflaionary pressures in he Unied Kingdom would also be reduced and he real exchange rae would depreciae. The remainder of his paper is srucured as follows: Secion 2 presens he model and calibraion; Secion 3 presens he resuls; Secion 4 reviews previous work in his area and discusses how our resuls compare o oher esimaes in he lieraure; and Secion 5 concludes. Working Paper No. 421 April

7 2 The model Our analysis is conduced in a new open economy dynamic sochasic general equilibrium model, 2 which consiss of hree counries: he Unied Kingdom, he Unied Saes and he res of he world. There are hree ypes of agen in our model: households, firms and governmen Households Represenaive risk-averse households in each counry consume goods and supply labour o firms. The lifeime expeced uiliy of households is: 1 1 C M C M 1 H 1 H U E 1 C 1 M P 1 H (1) 0 0 where β<1 is he discoun facor, C is consumpion, 1-H is leisure, and M /P are real money balances. Following Neiss and Nelson (2003), we model he demand shock, ω, as a shock o consumpion preferences. Parameers ξ C, ξ M, ξ H, and χ represen elasiciies of subsiuion. They are all posiive and calibraed separaely for each counry. Labour supply, H, is perfecly mobile beween he raded (T) and non-raded (N) secors wihin each counry : H H T, H N, where H T H T zt dz and T N H N z N S T H dz are aggregaes across firms in each secor. S N N (2) Consumpion in counry consiss of a bundle of raded, C T, and non-raded, C N, goods: C C 1 1 C T, N, (3) where α represens he share of raded, and 1-α he share of non-raded goods in he consumpion baske. The subsiuabiliy beween raded and non-raded goods is given by he parameer μ. We furher divide he consumpion of raded goods ino consumpion of he ROW s goods and he consumpion bundle of periphery goods (P), which consiss of and US raded goods ROW C h C 1,,, 1 ROW C T P P T P ROW, T, for, US : h 1 (4) 1 2 The model is a modificaion of he one developed in he Bank of England and used in Markovic and Povoledo (2007). 3 Predominanly for he sake of parsimony, he model we use does no conain capial and by exension also invesmen. While his migh imply ha i canno replicae some episodes (eg high invesmen was ypically linked wih he US curren accoun defici up o 2000/01) i allows us o focus on he mos relevan aspec of he curren siuaion ie low US saving raes. 4 In addiion, oil producion and consumpion are no explicily modelled. Lipińska and Millard (2010) consider he effecs of echnology shocks in a hree-counry model wih wo oil-imporing counries and one oil-exporing counry. Working Paper No. 421 April

8 1 1 h C 1 US h C 1 C,,,, 1 T US, T, (5) P T 1 for US, ROW : h 1. For, ROW : h US 1 Therefore, he size of he Unied Kingdom s goods in he raded consumpion baske is γ γ P, he size of he Unied Saes goods γ P -γ γ P, and he size of he ROW s goods 1-γ P. The parameer ρ is he elasiciy of subsiuion beween ROW and P raded goods, and ψ is he elasiciy of subsiuion beween and US raded goods. Each individual consumpion good, wheher raded or non-raded, is furher differeniaed as a consan elasiciy of subsiuion baske of all varieies produced by he firms. The elasiciy of subsiuion beween individual varieies is given by parameer θ. The parameers h, h US, and h ROW represen home bias in consumpion. They are calibraed separaely for each counry. Households in counry maximise heir expeced uiliy in each period subec o he budge consrain, which is given in real erms as: US,, ROW, C US ROW P P P P P B B B M T US B ROW US, B, B ROW, US ROW 2 P 2 P 2 P B US US, 1 ROW 1i1 1i US 1 1 i 1 M 1 P P B T, N, R H W, 1, 1 BROW ROW P P (6) The budge consrain describes households resources, which consis of heir wage income, W, gross iniial bond holdings, B (denominaed in he issuer s currency), he profis from he ownership of firms in he raded and non-raded secors, Π T, and Π N,, lump-sum governmen ransfers, T, as well as lump-sum rebaes from he governmen, R. A he beginning of each period households allocae heir resources beween consumpion, real money balances, and nominal bond holdings ha pay a risk-free ineres rae, i. The exchange rae, ε, is defined as he price of counry s currency in erms of ROW s currency. The parameer η>0 is a small cos of holding bonds, which ensures he saionariy of he model Firms Traded, z T, and non-raded, z N, firms in any counry operae under condiions of monopolisic compeiion. Each period, firms in, say, he Unied Kingdom s raded secor maximise he presen value of heir expeced profis: 5 See Schmi-Grohe and Uribe (2003) and Ghironi and Meliz (2005) for furher deails. Working Paper No. 421 April

9 E C i i Ci / P i SRT i T T i,, C i0 C / P z H z W P (7) ~ z 1 z P z Y z SR T, T T, T, T, T T, T T (8) which consiss of heir sales revenues, SR, less he cos of producion. In order o change prices, firms have o pay a non-linear cos, Γ. This cos inroduces Roemberg-ype nominal rigidiies ino he model. Following Ireland (2001), i is modelled as a deviaion of inflaion from is seady-sae level: z 2,,, 1 2,, 1 P T zt T zt P T T The expeced profi is maximised subec o he downward-sloping demand for firms producs: 1 P T z,, T T, zt PC, T, P P, T, 1 P P, T, ~ Y i i US C P C ROW, T, The demand for he individual firm s raded goods comes from all hree counries in our model. Each firm in boh secors produces goods employing labour supplied by households as is only inpu. The echnology of producion is given as: ~ z A H z Y T, T T, T, ~ T z A H z Y N, N N, N, N (9) (10) (11) (12) where A T and A N represen secor-specific supply (produciviy) shocks, and ζ is he elasiciy of oupu wih respec o labour. 2.3 Governmen As here is no public spending, he governmen uses seignorage revenues o finance ransfers o households. The public budge consrain is balanced in each period and simply given as: M M 1 T (13) In his model, he governmen also represens he moneary auhoriy. As such, i follows an ineres rae feedback rule, argeing only he inflaion rae. In he log-linearised form his rule can be expressed as: i i ˆ i 1 1 i ar (14) Where ρ i and ρ π are non-negaive parameers, i is he deviaion of he nominal ineres rae from is seady-sae level, and π is he consumer price inflaion rae. Working Paper No. 421 April

10 2.4 The uncovered ineres rae pariy condiion The uncovered ineres rae pariy (UIP) condiion in he model is modified o ake ino accoun he difference in bond holding coss beween bonds of differen issuer counries. 6 In he loglinearised form, he UIP condiion beween he Unied Saes and he Unied Kingdom akes he following form: US US US US BUS, B, uip ˆ 1 ˆ US P P E i i e (15) 2.5 Calibraion The model is calibraed o mach key srucural feaures of he Unied Kingdom, he Unied Saes and he ROW economies. The parameers, repored in Table A, are aken from oher relevan lieraure, our calculaions and hisorical daa. We se he quarerly discoun facor, β, a 0.99 in order o approximae he annual equilibrium real ineres rae of 4. The ineremporal elasiciy of subsiuion in consumpion, ξ C, is aken from Chari, Kehoe, and McGraan (2002). We calibrae he weigh of leisure in he uiliy funcion, φ, in order o mach he seady-sae fracion of ime households spend working o a hird. 7 The elasiciy of labour in he producion funcion, ς, is calibraed o mach he raio of wages o oupu of 0.7, as in Harrison e al (2005) for he Unied Kingdom, and Roemberg and Woodford (1999) for he Unied Saes and he res of he world. The values for he elasiciies of subsiuion beween various consumpion bundles parameers μ, ψ, and ρ are all aken from Obsfeld and Rogoff (2005). The elasiciy of subsiuion beween individual goods, θ, is aken from Roemberg and Woodford (1999) for he Unied Saes and he ROW, and Benigno and Thoenissen (2003) for he Unied Kingdom. 8 The values for he preference bias parameers counry size, γ, and home bias, h are se o mach empirically observed rade shares. The model implied raios of impors o GDP for he Unied Kingdom, Unied Saes and he ROW mach hose in he daa 28, 12.5 and 4.5, respecively. The calibraion also ensures ha he shares of, US and ROW impors coming from heir respecive rading parners maches hose observed in he daa. The share of raded goods, α, is aken from Spange and Zabczyk (2006) for he Unied Kingdom, and he Inernaional Moneary Fund (2005) 9 for he Unied Saes and he ROW. We se he cos of holding bonds, η, a a very small value, following Ghironi and Meliz (2005). The cos of price adusmen, ф, which governs he nominal rigidiies in he model, is based on he calibraion in Harrison e al (2005). 6 See Benigno (2001) for furher deails. 7 This yields he Frisch elasiciy of labour supply equal o 3, which falls wihin he range of esimaes found in Gali, Gerler and Lopez-Salido (2005). 8 Our choice of θ implies a seady-sae mark-up of prices over marginal coss of approximaely 14, which is he value calibraed in Markovic and Povoledo (2007). 9 See Globalizaion and exernal imbalances, Chaper 3, World Economic Oulook, April Working Paper No. 421 April

11 Table A: Parameers in he model PARAMETER VALUE US ROW Discoun facor ξ c ξ h ς Ineremporal elasiciy of consumpion Ineremporal elasiciy of leisure Elasiciy of labour supply in he producion funcion Elasiciy of subsiuion Nominal rigidiy Elasiciy of subsiuion beween and US goods Elasiciy of subsiuion beween ROW and US and Elasiciy of subsiuion beween raded & non-raded Weigh on leisure in he uiliy funcion 1 (a) Counry size Share of raded in oal goods h Home bias parameers a Cos of holding bonds parameer i AR coefficien in policy rule Coefficien on inflaion in policy rule (a) As noed in he ex he value of his coefficien is se so as o ensure ha hours worked in each counry in he seady sae equal a hird. The large cross-counry differences reflec differen seady-sae levels of consumpion and wages which are magnified by he relaively high value of he ineremporal elasiciy of subsiuion. 3 Resuls In his secion we analyse he macroeconomic implicaions of hree shocks ha in heory could conribue o an unwinding of he US curren accoun defici. These are an increase in domesic demand in he res of he world; a fall in domesic demand in defici counries; and a supply shock ha gives rise o relaively high growh in US produciviy compared o oher counries. In wha follows, we discuss he calibraion for each shock and highligh he channels hrough which each shock propagaes focusing in paricular on he response of variables. The main findings we presen are for he simulaions under he assumpion ha he hree counries operae flexible exchange rae regimes. We also consider he responses o he same shocks when he res of he world pegs is nominal exchange rae o he US dollar. A full se of chars for each shock (under flexible exchange raes) is given a he end of he paper. Working Paper No. 421 April

12 3.1 A posiive demand shock in he res of he world An unwinding of he US curren accoun defici may be brough abou by a shock ha leads o an increase in domesic demand in he ROW. In he April 2010 WEO, he IMF highlighs ha an increase in domesic demand in surplus counries would be needed o offse declines in domesic demand in defici counries such as he Unied Saes and he Unied Kingdom for a susained recovery in he world economy. Given he absence of invesmen and governmen spending in our se-up, we model his increase in domesic demand as a posiive consumpion preference shock, which leads o a rise in ROW consumpion (ie domesic demand) and oupu. To calibrae he ROW domesic demand shock, we draw on evidence on hisorical curren accoun surplus reversals from he April 2010 WEO. This work focuses on five case sudies ha had similar characerisics preceding heir curren accoun reversals o hose in counries ha have large surpluses oday. I finds ha in he couple of years following a reversal, privae consumpion growh was beween 1 and 3 percenage poins (pp) above pre-reversal growh raes. Therefore, we simulae a shock ha raises he level of consumpion by around 5 relaive o is saring posiion afer wo years. This is consisen wih faser consumpion growh of around 2.5pp relaive o pre-reversal rends for wo years. This fairly sizable shock, which is owards he op of he IMF s range, is moivaed by oday s hisorically large curren accoun imbalances. 10 The chars in Appendix 1 show he effecs of his shock on he Unied Kingdom, Unied Saes and ROW. The increase in consumpion in he ROW leads o an increase in ROW oupu; he deerioraion in he curren accoun posiion, of around 1 of GDP, is no sufficien o reduce aggregae demand in he ROW. A he wo-year horizon, his shock improves he US curren accoun by around 2.5 of GDP, which would be sufficien o close he defici a is end-2009 levels. This is driven by he rise in demand for US oupu by ROW consumers and expendiure swiching by US households o US oupu, which is now cheaper following a depreciaion of he US real effecive exchange rae of around 4. The curren accoun also improves for similar reasons, hough he depreciaion of he Unied Kingdom s real effecive exchange rae is smaller, a around 3. The increase in ROW consumpion leads real ineres raes o increase inernaionally, leading consumpion in he Unied Saes and he Unied Kingdom o decline. However, he improvemens in he US and curren accoun posiions are enough o offse he declines in consumpion in hose economies, so US and aggregae demand rises overall. The increases in demand push up on firms real marginal coss and lead inflaion raes o increase in he Unied Saes, Unied Kingdom and he ROW. 11 Therefore, an increase in 10 We have chosen o analyse he effecs of emporary, raher han permanen, shocks. Implicily, his reflecs our belief ha he US curren accoun defici is he resul of emporary shocks occurring in he pas. We hink hese shocks have caused he sysem o move away from is seady sae, wihou changing i. Accordingly he world economy could be expeced o converge back o he original seady sae. To undersand he ransiional dynamics back o he seady sae, we herefore focus on emporary shocks likely o unwind he defici. By doing ha we are ignoring base effecs, ie he fac ha shocks could have a differen effec when hey occur in a sysem ha is in seady sae, raher han ou of seady sae. Analysing he impac of permanen shocks, base effecs and revaluaion effecs would make ineresing exensions o he paper. 11 These increased inflaion raes do no explicily reflec increases in commodiy prices, which are absen from his model. Lipińska and Millard (2010) consider he inernaional spillover effecs of produciviy shocks in a model wih explici commodiy producion and consumpion. Working Paper No. 421 April

13 domesic demand in he ROW improves global imbalances wihou losses in oupu in any of he counries, bu a he cos of higher inflaionary pressures around he world. 3.2 A negaive demand shock in he Unied Saes In his subsecion, we consider he effecs of a fall in Unied Saes domesic demand on global imbalances. Domesic demand in he Unied Saes fell subsanially following he financial crisis in and furher falls may, for insance, be riggered by anoher loss of confidence. As wih he posiive domesic demand shock in he ROW, we model his decline in domesic demand as a consumpion preference shock (albei wih he opposie sign). To faciliae comparisons wih he simulaion in Secion 3.1, he fall in US domesic demand is calibraed o be of he same magniude as he rise in ROW demand. The chars in Appendix 2 show he responses of he Unied Saes, Unied Kingdom and he ROW o his shock. A he wo-year horizon he shock improves he US curren accoun by close o 3 of GDP ha is, enough o close he curren accoun defici fully a is end-2009 level. The improvemen in he US curren accoun posiion reflecs a fall in US impor demand and expendiure swiching o US oupu by US consumers as a resul of he depreciaion of he US real effecive exchange rae, which is around 4. ROW and consumers also increase heir spending on US oupu. Bu since he improvemen in he curren accoun balance is no enough o offse he fall in domesic demand, US oupu falls in response o his shock. The impac on he Unied Kingdom of a shock o domesic demand in he Unied Saes depends on wheher he shock occurs only in he Unied Saes or is common o boh he Unied Saes and he Unied Kingdom. A shock o US domesic demand in he absence of a common shock in he Unied Kingdom causes he curren accoun balance o worsen, as US demand for goods declines. There is a small appreciaion of he real effecive exchange rae, despie an iniial depreciaion. Given he fall in world real ineres raes resuling from he decline in US consumpion, consumers in he Unied Kingdom are able o raise heir own consumpion, o heir benefi. However, he worsening of he curren accoun posiion is such ha overall aggregae demand in he Unied Kingdom falls. Applying he same shock o boh he Unied Kingdom and he Unied Saes gives a similar paern of responses (boh qualiaively and quaniaively) in he Unied Kingdom as in he Unied Saes. Consumpion, oupu and inflaion all fall, while he curren accoun balance improves and he real effecive exchange rae depreciaes (Appendix 2B). In response o a negaive demand shock in he Unied Saes (and he Unied Kingdom), oupu in he ROW declines, consisen wih he deerioraion in he curren accoun balance. As well as reflecing he decline in US (and ) demand for ROW oupu, he deerioraion in he ROW curren accoun balance is driven by expendiure swiching by ROW consumers o he now cheaper US (and ) goods (resuling from he real effecive appreciaion of he ROW exchange rae). Owing o he Unied Kingdom s small share in world oupu, he quaniaive impac on he ROW is broadly similar for shocks o he Unied Saes alone and o boh he Unied Saes and Unied Kingdom ogeher. Working Paper No. 421 April

14 3.3 A posiive produciviy shock in he US raded goods secors On he supply side, he US curren accoun could improve if here were higher produciviy growh in he Unied Saes compared o he res of he world. This was he case in he 1990s, when produciviy growh in boh he US raded and non-raded goods secors oupaced is maor compeiors. Therefore, in his secion we consider a posiive produciviy shock o he raded goods secor in he Unied Saes. (Resuls for a produciviy shock o he non-raded secor are broadly similar and are no repored.) A posiive produciviy shock in he raded goods secor leads o a rise in raded goods oupu and a fall in raded goods prices. The fall in he price of US raded goods relaive o raded goods abroad causes a swich in global demand owards US goods US consumers swich o buying more of heir own raded goods and foreign consumers buy more US expors. This improves he US curren accoun. The increase in world demand for US goods causes a nominal dollar appreciaion and his, along wih he fall in domesic prices, pushes down on inflaion and simulaes demand in he Unied Saes. US consumers expec he increase in heir incomes o die away over ime and so smooh heir consumpion by lending some of heir higher income abroad. This also acs o improve he curren accoun. To calibrae he size of he produciviy shock, we focus on produciviy growh in he raded secor in he mid-o-lae 1990s. In his period, he average annual produciviy growh rae in he Unied Saes oalled 6, whereas ha in he Unied Kingdom, Japan, Germany, France and Ialy averaged 2.5. We herefore simulae a scenario where US produciviy growh is 3.5 higher han he ROW and he Unied Kingdom for wo years, bu he differenial hen dies away over ime. 12 Alhough produciviy growh in he Unied Saes has been high compared wih oher developed counries since he crisis, arguably, his scenario is opimisic for US produciviy growh relaive o he ROW. This is because, in recen years, he imporance in world rade of developing economies (many of which are he surplus counries ha are represened by he ROW) has grown significanly. These economies have relaively high produciviy growh raes, which he Unied Saes may sruggle o oupace. According o he chars in Appendix 3, a he wo-year horizon, he US curren accoun o GDP raio improves by 0.8pp, US raded oupu is 6 higher, US oal oupu rises by, and inflaion falls by over 1pp. The US moneary auhoriy reacs o he fall in inflaion and cus ineres raes by around 45 basis poins. The US erms of rade deerioraes by over 3 as he price of US raded goods falls relaive o raded goods produced abroad bu he inernal real exchange rae appreciaes as non-raded goods become more expensive relaive o raded goods. The laer reflecs he well-known Balassa-Samuelson effec. This offses some of he erms of rade deerioraion and he overall US real effecive exchange rae depreciaes slighly a firs, bu over ime, appreciaes by around In line wih previous exercises, we implemen his as a emporary shif in produciviy levels, which implies he produciviy growh profile described above. Working Paper No. 421 April

15 A posiive produciviy shock in he US raded secor has wo offseing effecs on oupu in he oher wo counries. Firs, here is a boos o oupu in he Unied Kingdom and he ROW as US incomes rise and along wih hem US demand for and ROW expors. Second, oupu in he Unied Kingdom and he ROW falls as world demand shifs owards relaively cheaper US goods. Our resuls show ha he laer effec dominaes and hus oupu in he Unied Kingdom and ROW falls. The fall in demand for goods (boh by and US consumers) resuls in a deerioraion of he curren accoun o GDP raio of around pp. Producers reduce heir prices as hey ry o regain marke share and his, along wih he fall in impor prices from he Unied Saes, resuls in a 0.9pp fall in consumer price inflaion a he wo-year horizon and a pp fall in ROW CPI inflaion. Ulimaely, and ROW agens end up consuming more as hey can now afford more of he cheaper US impors. Tha said, no including capial and invesmen in he model migh mean ha we overesimae he impac of produciviy shocks on he US curren accoun. This could happen for wo main reasons. Firs, some of he increase in demand for capial could be saisfied hrough increases in impors. Second, consumers migh wan o ake advanage of higher levels of fuure producion by consuming more oday, which would also end o increase he defici. To summarise, he posiive shock o he US raded secor resuls in a fall in oupu and inflaion in he Unied Kingdom a he wo-year horizon, bu again consumpion increases due o he increase in impors from he Unied Saes. Inflaion also falls in he ROW bu oupu is less affeced han in he Unied Kingdom. The US experience is differen from he demand shock in ha now oupu and consumpion boh rise, whereas inflaion falls. Noably, he response of he curren accoun o GDP raio (0.8pp) is smaller in he case of his shock han afer he previously discussed demand shocks. 3.4 Wha if Asian currencies remained fixed o he dollar? In realiy, a number of counries operae nominal exchange rae pegs wih he US dollar. This has been he case for China and many oil exporers, which accoun for a large share of he ROW s surpluses. In his secion we examine he effecs of he ROW pegging is nominal exchange rae wih he Unied Saes. We implemen his policy as in Markovic and Povoledo (2007); in ha paper, he auhors consider he effecs of differen shocks under differen exchange rae regimes using a similar model, bu calibraed o he Unied Saes, Europe and Asia. The resuls are repored in Table B. For he mos par, he differences beween floaing and fixed exchange raes are no quaniaively large. This is likely o be because, o an exen, inflaion in he ROW and he Unied Saes aduss o deliver he equilibraing real exchange rae movemens. In pracice, i is common for he foreign exchange inervenions associaed wih mainaining an exchange rae peg o be serilised, which neuralises he impac on he domesic price level, a leas in he shor-run. Working Paper No. 421 April

16 Our simulaions show ha here is a lile less rebalancing when he ROW operaes an exchange rae peg wih he Unied Saes in response o boh a posiive demand shock in he ROW and a negaive demand shock in he Unied Saes han oherwise. In boh insances he change in real exchange raes is smaller (hough only slighly so, given he responses of inflaion), leading o less of an expendiure swiching effec following he shocks. The quaniaive differences beween responses o posiive produciviy shocks in he US rading (and non-rading) secor are also small for floaing and fixed exchange raes regimes. The ROW s peg affecs he Unied Kingdom s response o he demand shocks in he ROW and Unied Saes in differen ways. In response o he posiive demand shock in he ROW, when he ROW pegs o he dollar, he Unied Kingdom sees a smaller real exchange rae depreciaion and less of an improvemen in is curren accoun posiion. By conras, in response o a negaive US demand shock, he ROW s peg increases he impac on he Unied Kingdom s curren accoun posiion, which worsens by more compared o when exchange raes are flexible. Tha is, he ROW s peg appears o reduce he impac of ROW shocks on he Unied Kingdom s real exchange rae and curren accoun (which is also rue for he Unied Saes); bu i minimises he impac of US shocks on he ROW s curren accoun and real exchange rae, leading o greaer flucuaions in he corresponding variables for he Unied Kingdom. Table B: Overview of simulaion resuls for fixed exchange raes beween US and ROW Calibraed size of he shock US Oupu Inflaion Real exchange rae Oupu Inflaion Real exchange rae A posiive demand shock in he ROW A negaive demand shock in he US A negaive demand shock in he US and he A posiive produciviy shock in he US raded secor * * The iniial negligible move in he US real effecive exchange rae is subsequenly followed by an appreciaion of. 4 Comparison of resuls from oher work In his secion we review selecively he lieraure on rebalancing, focusing on papers ha consider he implicaions of an unwinding of he US curren accoun defici from he viewpoin Working Paper No. 421 April

17 of a quaniaive model. We also compare our resuls, summarised in Table C, wih hose of some previous sudies In a series of papers, Obsfeld and Rogoff (2000, 2004, 2005, 2007) develop a framework for analysing he effecs of shocks ha unwind he US curren accoun defici on he US real exchange rae. This framework is based on a saic wo or hree-counry model in which oupu is given exogenously and he real exchange rae aduss o unwind curren accoun imbalances. Obsfeld and Rogoff s 2005 paper uses a hree-counry model comprising he Unied Saes, Europe and Asia, while he ohers focus on wo-counry models feauring he Unied Saes and he ROW. The papers sugges ha an unwinding of he US curren accoun defici, from is wides poin of around 6 of GDP, migh lead o a depreciaion of he dollar real exchange rae of around 30. The 2005 paper also considers he unwinding of global imbalances when all hree regions have freely floaing exchange raes, and when he Asian currency says fixed agains he dollar, in which case here is a sharp appreciaion of Europe s currency. 13 To close he defici fully from is wides posiion, our resuls sugges ha a real depreciaion of beween and 10 would be necessary, depending on he shock. Naurally, his esimae is subec o large uncerainy, given ha i is based on a sylised model and informed bu arbirary assumpions abou parameers. This range is smaller han he defici-closing depreciaion prediced in Obsfeld and Rogoff s analysis. One explanaion ha may accoun for hese differences is ha Obsfeld and Rogoff assume ha oupu is held fixed ie heir model is of an endowmen economy. This means ha in heir framework prices have o do all he work o equilibrae demand and supply, hus exaggeraing he movemen of he real exchange rae. Adding o his, he exogenous oupu assumpion implies ha facors of producion are immobile beween secors. 14 Wih facor mobiliy, he inernal real exchange rae 15 would appreciae due o labour marke arbirage and offse he erms of rade deerioraion as i does in our analysis. However, in heir model, he inernal real exchange rae depreciaes, adding o he deerioraion in he erms of rade. Tha said, Ferrero e al (2008) find ha depreciaions of a similar size o hose found by Obsfeld and Rogoff are associaed wih rebalancing using a wo-counry DSGE model. Spange and Zabczyk (2006) use he framework developed by Obsfeld and Rogoff (2005) o analyse he effecs of shocks unwinding he US curren accoun defici on he real exchange raes for he Unied Saes, ROW and he Unied Kingdom. Using he equivalen calibraion for he elasiciy of subsiuion ha we have in his paper, Spange and Zabczyk (2006) find ha closing a defici of us over 6 of GDP, resuls in a 1.4 depreciaion of he serling real effecive exchange rae afer a shock in he US radable goods secor, and a 0.9 appreciaion afer a negaive shock o US demand. 16 Our resuls sugges similarly small movemens for he real effecive exchange rae. In paricular, for an unwinding of he US curren accoun a 6 of GDP, he real exchange rae is esimaed o appreciae by around 0.3 in response o a 13 I should be noed ha given he se-up of Obsfeld and Rogoff s model, ie flexible prices and an inflaion-argeing cenral bank, movemens in he nominal and real exchange raes are equal in heir analysis. 14 This assumpion is paricularly imporan for he real exchange rae effecs following a raded secor produciviy shock. 15 The inernal exchange rae reflecs he relaive price beween he raded and non-raded goods beween wo counries. 16 In Spange and Zabczyk he real exchange rae movemens range from a depreciaion of 1.4 o an appreciaion of 4.2 depending on model parameers. Here, we quoe heir figures for he same elasiciy of subsiuion parameers as we have in his model. Working Paper No. 421 April

18 negaive demand shock in he Unied Saes, depreciae by 6 in response o a posiive demand shock in he ROW and depreciae by around 2.3 in response o a posiive produciviy shock in he US radable goods secor. Blanchard e al (2005) use a porfolio balance model and esimae ha he dollar would need o depreciae by 90 o close he US curren accoun. Unlike Blanchard e al, where a movemen in he exchange rae is exogenously imposed, in our seing he exchange rae and he curren accoun are endogenously deermined and he fall in he dollar is a by-produc of fundamenal shocks ha rebalance global savings. Faruqee e al (2007) ask a similar quesion o ours. They use he IMF s Global Economic Model o simulae a loss in appeie for US asses, which improves he curren accoun by pp. They find a depreciaion of he US real effecive exchange rae (also immediae), of around 6. They also find ha his shock resuls in a fall in US oupu of around 1. Table C: Overview of simulaion resuls Oupu Calibraed size of he shock Shock necessary o improve US curren accoun by 1pp US US Inflaion Real exchange rae Oupu Inflaion Real exchange rae Oupu Inflaion Real exchange rae Oupu Inflaion Real exchange rae A posiive demand shock in he ROW A negaive demand shock in he US A negaive demand shock in he US and he A posiive produciviy shock in he US raded secor * * The iniial depreciaion of he US real effecive exchange rae is subsequenly followed by an appreciaion of The ineracion of global imbalances and moneary policy regimes has also been invesigaed. Markovic and Povoledo (2007) use a hree-counry model similar o he one used in his paper o analyse how he ransmission of US shocks o Europe migh be affeced by Asia s choice of exchange rae regime. They find ha when Asia pegs o he Unied Saes, he impac of US shocks on Europe is larger han oherwise, in line wih our findings for he impac of US and ROW shocks on he Unied Kingdom in his paper. Ferrero e al (2008) find ha he moneary policy regime has a bigger influence over he behaviour of domesic variables (such as inflaion Working Paper No. 421 April

19 and oupu) compared o inernaional variables (such as he curren accoun and he real exchange rae). In general, mos analysis agrees on he direcional impac of a US curren accoun improvemen on he US dollar real effecive exchange rae, bu unsurprisingly, here is a lo of uncerainy as o he likely quaniaive impacs depending on he naure and calibraion of each model Conclusion In his paper we have used a hree-counry DSGE model o analyse he effecs of a number of shocks ha could conribue o a furher unwinding of global imbalances. Firs, we consider he effecs of a posiive domesic demand shock in he ROW, which here we inerpre as broadly represening surplus counries. This shock is calibraed o lif ROW consumpion by a similar amoun o some of he larger increases in consumpion seen in pas episodes of curren accoun surplus reversals, as sudied by he IMF. Second, we consider he effecs of a similarly sized shock ha reduces US consumpion. Finally, we consider he impac of a supply shock ha raises US produciviy relaive o oher counries. Our resuls sugges ha he demand shocks we analyse would be sufficien o close he US curren accoun defici a is end-2009 level. The supply shock in he Unied Saes, as calibraed, has a more modes impac on he US curren accoun defici. The resuls are no changed significanly when he ROW operaes a nominal exchange rae peg wih he Unied Saes. This is because inflaion raes change o deliver equilibraing adusmens in real exchange raes in our model. In pracice, however, serilisaion of any exchange rae inervenions associaed wih mainaining a peg are likely o limi heir effecs on he domesic price level, a leas in he shor run. In all our simulaions US saving mus increase o unwind he curren accoun defici, bu his does no necessarily imply a fall in US consumpion. In paricular, a posiive produciviy shock in he Unied Saes could raise boh consumpion and savings. The unwinding of global imbalances is likely o be followed by a rise in US oupu, unless i is o be brough abou by a negaive demand shock in he Unied Saes. This shock is also he only one which leads o a global fall in oupu. In all cases, he US real effecive exchange rae has o depreciae, alhough in he case of he produciviy shock o he US raded secor he iniial depreciaion is followed by an appreciaion induced by he Balassa-Samuelson effec. The implicaions for oupu and inflaion and he serling real effecive exchange rae vary depending on he naure of he shock ha drives global rebalancing. A rebalancing of surplus counries demand owards consumpion would boos oupu, hough would raise inflaionary pressures. This shock would be associaed wih a depreciaion of he serling real effecive exchange rae. Furher weakness in domesic demand in he Unied Saes would conribue o weaker oupu and inflaion in he Unied Kingdom, and a real appreciaion of serling. Produciviy gains in he Unied Saes, would lead he Unied Kingdom o impor more 17 Noe also ha since he model we use does no conain capial, direc comparisons of impulse responses o, say, produciviy shocks wih hose from models ha accoun for his adusmen channel need o be conduced wih care. Working Paper No. 421 April

20 US goods, weighing down on oupu. Inflaionary pressures would also be reduced in his scenario, and here would be a real depreciaion. Working Paper No. 421 April

21 Appendix 1: Impulse responses o a posiive demand shock in he res of he world US consumpion US oupu - - US CPI inflaion (annualised) consumpion oupu CPI inflaion (annualised) ROW consumpion ROW oupu ROW CPI inflaion (annualised) US nominal ineres rae 2.5 nominal ineres rae 2.5 ROW nominal ineres rae US real ineres rae 0.8 real ineres rae 0.8 ROW real ineres rae - US CA/GDP raio CA/GDP raio ROW CA/GDP raio US real effecive exchange rae real effecive exchange rae ROW real effecive exchange rae Working Paper No. 421 April

22 Appendix 2A: Impulse responses o a negaive demand shock in he Unied Saes US consumpion US oupu US CPI inflaion (annualised) consumpion oupu CPI inflaion (annualised) ROW consumpion ROW oupu ROW CPI inflaion (annualised) US nominal ineres rae nominal ineres rae ROW nominal ineres rae -0.7 US real ineres rae 0.8 real ineres rae 0.3 ROW real ineres rae US CA/GDP raio 3.5 CA/GDP raio ROW CA/GDP raio US real effecive exchange rae real effecive exchange rae ROW real effecive exchange rae Working Paper No. 421 April

23 Appendix 2B: Impulse responses o a negaive demand shock in he US and he US consumpion US oupu US CPI inflaion (annualised) consumpion oupu CPI inflaion (annualised) ROW consumpion ROW oupu ROW CPI inflaion (annualised) US nominal ineres rae nominal ineres rae ROW nominal ineres rae US real ineres rae 0.8 real ineres rae 0.8 ROW real ineres rae US CA/GDP raio 2.5 CA/GDP raio ROW CA/GDP raio US real effecive exchange rae real effecive exchange rae ROW real effecive exchange rae Working Paper No. 421 April

24 Appendix 3: Impulse responses o a posiive produciviy shock in he US raded secor US consumpion US oupu consumpion ROW consumpion oupu ROW oupu US CPI inflaion (annualised) CPI inflaion (annualised) - ROW CPI inflaion (annualised) -0.7 US nominal ineres rae nominal ineres rae ROW nominal ineres rae US real ineres rae real ineres rae 5 ROW real ineres rae US CA/GDP raio 0.8 CA/GDP raio ROW CA/GDP raio US real effecive exchange rae real effecive exchange rae ROW real effecive exchange rae 0.3 Working Paper No. 421 April

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