Article [ The NIME model of the World Economy - 13/02/2007]

The NIME model of the World economy

In the current version of the NIME model, the world is divided into six blocs, i.e. the euro-12 area, the bloc consisting of the three Western non-euro EU Member States, the twelve Eastern EU Member States, the United States, Japan and a bloc representing the rest of the world. All of these areas are linked together through trade and financial flows. Data for the euro area is aggregated using ECU/euro exchange rates. Data for the Western and for the Eastern EU Member States are aggregated into synthetic currency units.

In all of these blocs but two, i.e. the Eastern EU Member States and the rest of the world, we distinguish a household sector, an enterprise sector, a government sector and a monetary sector. A similar set of behavioural equations and accounting identities is specified for each sector across blocs, while the parameter values of the equations are obtained using econometric techniques applied to the aggregated, annual data of the different blocs.

The household sector allocates its total available means over goods and services, real money balances, residential buildings and other assets as a function of the nominal interest rate, the real interest rate, the user cost of residential buildings and a scale variable. This scale variable consists of the household sector’s assets (including bonds and residential buildings), its current income from assets, its current and expected future take-home labour income and its transfers. Error correction mechanisms and partial adjustment schemes are used to capture sluggish adjustment in house-hold’s expenditure plans. Moreover, households are liquidity-constrained in the short-run, implying that a fraction of its expenditures must be financed by disposable income.

The enterprise sector maximises its profits by hiring production factors and selling its output to final users. Gross output consists of goods for private consumption, investment and exports. There are three production factors: labour, fixed capital and intermediary imports. Error correction mechanisms and partial adjustment schemes are used to model the short-run demand for the production factors. In these demand schemes, the long-run factor demand equations are derived from a Cobb-Douglas production function with constant returns to scale.

Prices and wages are not fully flexible and clear the markets only in the long run. Moreover, country blocs are engaged in multilateral trade where importers are price setters and exporters are price takers, except for the price of oil which is determined outside the model. The (equilibrium) real wage rate is a weighted average of labour productivity and the reservation wage, while the natural rate of unemployment is determined by the gap between the take-home wage and the reservation wage of the employees.

Government income is determined by endogenous tax bases and predetermined tax rates, while its expenditures are to a large extent determined by the business cycle and trend growth. The automatic fiscal stabilisers operate on the expenditure side mainly through unemployment benefits and interest payments on government gross debt and, on the revenue side, mainly through direct wage income taxes, profit taxes, social security contributions and indirect taxes.

Short-term interest rates are set according to the Taylor principle. This implies that the monetary authorities increase (decrease) the short-term nominal interest rate more than proportionally to increases (decreases) in inflation, thus increasing (decreasing) real interest rates when inflationary pressures arise (subside). It also implies that the monetary authorities keep the short-term interest rate below (above) the equilibrium interest rate if demand is below (above) potential output. Long-term interest rates are determined by the term structure theory of interest rates. In this outlook, changes in an area’s nominal effective exchange rate are determined by changes in the interest rate differential and the (expected) inflation differential. The risk premia in the financial markets are assumed to remain constant.