Exchange-Rate Modelling in the EPA World Economic Model

Abstract

The aim of this paper is to report on our experience concerning the exchange-rate modelling in the EPA World Economic Model which is currently in the process of development at the Economic Planning Agency. The model is a multicountry model involving nine individual country models and a small regional block, which are linked together through a trade-linkage submodel and other channels of direct linkages. Section II of this paper will summarize the main features of this model. In Section III I shall first discuss some problems involved in endogenizing exchange rates in macroeconometric models, and then explain a particular approach to be used extensively in individual country modelling. It is based on a search method that determines the exchange rate which equilibrates the foreign exchange market in each period. Section IV then reports how this approach has worked out in our country models of Japan, the United States, West Germany, and the United Kingdom. It will also report on the Canadian and Australian models which adopt somewhat different approaches. Finally, in Section V, I shall discuss the differences in macroeconomic behaviour under alternative exchange-rate arrangements, based on simulation analyses of those models mentioned above. The discussion will reveal various important channels through which exchange-rate flexibility transmits the effects of exogenous and policy disturbances to the entire economy.

The present paper draws heavily on Amano, Sadahiro, and Sasaki (1981) and Amano, Maruyama, and Yoshitomi (1981). The author is grateful to all members of the EPA World Economic Model Project. However, no responsibility for the views expressed in this paper should be attributed to the Economic Planning Agency. The author is also indebted to Dr Michel Dombrecht for his valuable comments on an earlier draft.