About the MSG2 Model

The MSG model was developed by Warwick McKibbin and Jeffrey Sachs, in two distinct stages. The first model called MSG formed the basis of a number of papers by the authors in the mid 1980s. This earlier model was a macroeconomic model of the world economy with rational expectations in the foreign exchange market. The parameters were essentially reduced form parameters calibrated to the estimates of existing macroeconometric models. The model was then completely reconstructed beginning in 1986, following the approach taken by CGE modellers which focuses on individual optimization by economic agents. This new model, called MSG2, is documented in McKibbin and Sachs (1991). The MSG2 model, like CGE models, is based more firmly on micro-foundations than the standard macroeconometric model. But it is also dynamic: it is described by its authors as a dynamic general equilibrium model of a multi-region world economy. Explicit intertemporal optimization of agents forms the basis of structural behavioral equations: in contrast to static CGE models, time and dynamics are of fundamental importance. In addition, as in all macroeconomic models, there is an explicit treatment of the holding of financial assets including money.

In order to be able to fit macro time series data the behaviour of agents is modified to allow for short run deviations from optima l behaviour either due to myopia or to restrictions on the ability of households and firms to borrow at the risk free bond rate on government debt. Deviations from intertemporal optimizing behaviour take the form of rules of thumb which are consistent with an optimizing agent that does not update predictions based on new information about future events. These rules of thumb are chosen to generate the same steady state behaviour as optimizing agents. Actual behaviour is assumed to be a weighted average of the optimizing and rule of thumb assumption. For example, aggregate consumption is a weighted average of consumption based on wealth and consumption based on current disposable income. The other key modification to the standard market clearing assumption in CGE models is the allowance for short run nominal wage rigidity in different countries. As a result, the model has a mix of Keynesian and Classical properties.