The purpose of this note is to discuss the role of forward-looking behaviour in wage formation in the major economies, and to analyse the implications for policy analysis using the National Institute Global Econometric Model, NIGEM. Our policy analyses are directed at issues relating to the ERM. The first section of the note discusses nominal inertia and staggered contracts (see Taylor, 1980), whilst the second discusses bargaining and wage formation, using the analysis discussed in Layard, Nickell and Jackman (1991). The third section discusses some empirical work on wages undertaken at the Institute, whilst the fourth section analyses the implications of forward-looking wages for our model NIGEM. The final section concludes.

This paper analyses the role of wealth in the National Institute model of the World Economy (NIGEM). It also addresses the issues of fiscal solvency and the rote of the government budget constraint. We start with a brief theoretical and empirical overview of wealth and consumption functions. We then describe the introduction of public sector blocks into the model and summarise our approach to the determination of wealth. The paper then reports on a set of diagnostic simulations using NIGEM. We analyse the effects of a permanent fiscal expansion and its implications. We also discuss the importance of solvency constraints on the government in the solution of a forward looking model without Ricardian equivalence. We then analyse the effects of a change in equity prices in one country relative to those in the rest of the world.

Business cycle developments in the major seven economies have not been particularly well synchronised in the last two years. The US, Canada and the UK have been in recession, whilst Germany and Japan have been growing strongly. We are predicting that this asynchronicity will continue over the next eighteen months, with growth slowing in Japan and Germany whilst a mild recovery takes place in the English speaking world. However there are some signs that the recovery, at least in the US, is likely to be rather slower than we had anticipated in our August forecast. The Federal Reserve in the US has clearly been concerned about the most recent signals from the American economy, and it encouraged a cut in interest rates on 6th November. The Japanese authorities have also cut interest rates in this quarter, and we anticipate that there will be no substantial increases in German interest rates.

GNP growth in the major seven economies continues to decline from the cyclical peak reached in 1988. The latest national accounts statistics show that all major seven economies are now growing more slowly than they did last year, with the United States, United Kingdom and Canada in recession. This slowdown in activity appears to have been caused primarily by the tightening of monetary policy that occurred between 1988 and 1990. Short-term interest rates rose by 4.4 percentage points in Germany between 1987 and 1990, by 3 percentage points in Japan between 1987 and 1990, and by 2.2 per cent in the United States between 1987 and 1989.

The start of hostilities in the Gulf in January appears to have removed some of the uncertainties surrounding the oil market, and oil prices have dropped to around 20 dollars per barrel. This development should help sustain growth and reduce inflation over the next two years. Box A sets out some calculations of the effects of the change in our oil price assumptions on our forecast. The appreciation of the D-Mark bloc and the emergence of a recession in the US driven by a wave of bank failures has persuaded us to be less optimistic then we were in our last forecast. Table 1 summarises the outlook. We are forecasting a slowdown in the rate of growth in the major economies in 1991, with some recovery in 1992 and thereafter. The slowdown has already taken place in the US, the UK and Canada, whereas in 1990 Japanese and German growth was at historically high levels. Chart 1 plots levels of capacity utilisation in the major economies. Only in the US has output clearly fallen below capacity, but record levels of utilisation in Japan, Germany and France inevitably imply some slowdown in growth from recent levels.