Appendix A: summary of key forecast assumptions.

The forecasts for the world and the UK economy reported in this Review are produced using NIESR's model, NiGEM. The NiGEM model has been in use at the National Institute for forecasting and policy analysis since 1987, and is also used by a group of about 50 model subscribers, mainly in the policy community. Most countries in the OECD (1) are modelled separately, and there are also separate models of China, India, Russia, Hong Kong, Taiwan, Brazil, South Africa, Estonia, Latvia, Lithuania, Slovenia, Romania and Bulgaria. The rest of the world is modelled through regional blocks so that the model is global in scope. All models contain the determinants of domestic demand, export and import volumes, prices, current accounts and net assets. Output is tied down in the long run by factor inputs and technical progress interacting through production functions, but is driven by demand in the short- to medium-term. Economies are linked through trade, competitiveness and financial markets and are fully simultaneous. Further details on the NiGEM model are available on http://nimodel.niesr.ac.uk/.

There are a number of key assumptions underlying our current forecast. The interest rates and exchange rate assumptions are shown in tables A1-A2. Our short-term interest rate assumptions are generally based on current financial market expectations, as implied by the rates of return on treasury yields of different maturities. Longterm interest rate assumptions are consistent with forward estimates of short-term interest rates, allowing for a country-specific term premium in the Euro Area. The ECB raised interest rates by 25 basis points at the beginning of April, and financial markets are currently pricing in a rise in interest rates in the US by the end of this quarter, despite the continued expansionary rhetoric from the Federal Reserve. The Bank of Japan intends to hold the current interest rate target range of 0-0.1 per cent unchanged in the short term, in order to support economic growth after the twin disasters of March 2011. New Zealand has also suffered from natural disasters, and decided to cut interest rates by 50 basis points in March 2011. In contrast, emerging economies are fighting against strong inflation, notably due to raising prices of food and oil. In a context of tightening monetary policy, most Asian economies have now increased their key interest rates in order to curb inflation. The People's Bank of China recently raised its key interest rate for the fourth time since October 2010, and was joined by Indonesia, Singapore, Taiwan and India. In Russia, the key interest rate was also raised in February 2011 from its record low of 7.5 per cent, but is now expected to remain unchanged until the fourth quarter to protect the recovery in economic growth.

[FIGURE A1 OMITTED]

Figure A1 illustrates our projections for real long-term interest rates in the US, Euro Area, Japan and Canada. Long real rates followed nominal rates to a recent low in August 2010, but have since recovered in the US and the Euro Area. They remain exceptionally low in Canada and Japan. The monetary stance will remain expansionary until 2013-14, when real interest rates in North America are expected to stabilise close to historical levels. A somewhat higher level in the Euro Area reflects the risk premium on sovereign debt in Greece, Ireland and Portugal. We see real interest rates in Japan stabilising around a level rather below international rates of return.

Long real rates are illustrative measures of the state of the economy, but do not reflect the actual borrowing costs faced by firms, which pay a premium above tile risk-free rates to reflect the risk of default. Figure A2 illustrates the spread between corporate bond yields and 10-year government bond yields in the US, UK and Euro Area. Following the collapse of Lehman Brothers in September 2008, corporate spreads jumped to their highest level since the Great Depression. After falling to recent lows in April 2010, spreads seem to have stabilised, maintaining nonetheless a positive margin over the low levels seen in 2000-2006.

[FIGURE A2 OMITTED]

Nominal exchange rates against the US dollar are generally assumed to remain constant at the prevailing rate at the beginning of April 2011 in the short term. After that, they follow a backward-looking uncovered-interest parity condition, based on interest rate differentials relative to the US. Figure A3 illustrates the effective exchange rate projections for the US, Euro Area, Japan, Canada and the UK. The US dollar has weakened relative to other currencies since mid-2010, reflecting the looser monetary policy stance compared to most of the rest of the world. The rise in the yen has temporarily abated, alleviated to some degree by the coordinated intervention by the G-7 economies to restrain upward pressure on the yen after the earthquake of March 2011, which led to the repatriation of overseas funds to finance reconstruction efforts. Meanwhile, the euro has strengthened against the dollar during the first months of 2011, as the ECB raised interest rates ahead of the other major central banks. Sterling lost nearly 20 per cent of its value between the end of 2007 and end of 2009, but has been broadly stable since then. The Canadian dollar tends to follow the oil price closely, and has followed it upward over the past two quarters.

[FIGURE A3 OMITTED]

Our oil price assumptions for the short term are based on those of the US Energy Information Administration, who use information from forward markets as well as an evaluation of supply conditions. In the longer term, ,we assume that real oil prices will rise in line with the real interest rate. The oil price assumptions underlying our current forecast are reported in figure A4 and in table 1 at the beginning of this chapter. Oil prices averaged $78.8 per barrel in 2010, based on the average of Brent and Dubai spot prices. Prices rose steadily in the last quarter of 2010, reflecting tight demand and supply balances and emerging unrest in North Africa. Oil prices rose sharply in the first quarter of 2011 in response to the Libyan crisis, reaching well above $100 per barrel in March 2011. We assumed that oil prices will average $115 per barrel this year and more than $120 per barrel in 2012.

[FIGURE A4 OMITTED]

[FIGURE A5 OMITTED]

Our equity price assumptions for the US reflect the return on capital. Other equity markets are assumed to move in line with the US market, but are adjusted for different exchange rate movements and shifts in country-specific equity risk premia. Figure A5 illustrates the equity price assumptions underlying our current forecast. Global share prices rose sharply in the final quarter of 2010 and first quarter of 2011. Share prices in Canada have now regained their pre-crisis peak, whilst those in the US and Germany are expected to remain below by around 15 and 20 per cent, respectively. Share prices in Japan have declined relative to the other major economies, and recorded a sharp decline in the wake of the tsunami crisis.

Fiscal policy assumptions for 2011-12 follow announced policies. Average personal sector tax rates and effective corporate tax rate assumptions underlying the projections are reported in table A3. Government revenue as a share of GDP reported in the table reflects these tax rate assumptions and our forecast projections for income and profits, as well as our projections for consumption tax revenue. Consumption tax revenue projections also reflect indirect tax cuts in Germany in 2011 and indirect tax rate rises in the UK, Italy and France in 2011. Income tax rates are expected to rise in Australia, Canada, Finland, France, Greece and Portugal in 2011, whereas consolidation measures in the US and UK are based on spending cuts. Government spending is also expected to drop sharply as a share of GDP in Spain this year, with more modest adjustments planned in Belgium, Canada, Denmark, Finland, Germany, Italy and Sweden.

DOI: 10.1177/0027950111411371

NOTE

(1) With the exceptions of Iceland, Luxembourg, Turkey and Chile.

Table A1. Interest rates

Per cent per annum

                    Central bank intervention rates

                US    Canada   Japan   Euro Area    UK

2008           2.09    3.04    0.46      3.90      4.68
2009           0.25    0.44    0.10      1.28      0.65
2010           0.25    0.59    0.10      1.00      4.50
2011           0.43    1.39    0.12      1.51      4.72
2012           1.16    2.51    0.23      2.75      1.47
2013           2.14    3.28    0.36      3.66      2.40
2014-18        4.05    4.29    1.01      4.77      3.78

2010      Q1   0.25    0.25    0.10      1.00      0.50
2010      Q2   0.25    0.34    0.10      1.00      0.50
2010      Q3   0.25    0.76    0.10      1.00      0.50
2010      Q4   0.25    1.00    0.10      1.00      0.50

2011      Q1   0.25    1.00    0.10      1.00      0.50
2011      Q2   0.39    1.30    0.10      1.46      0.50
2011      Q3   0.50    1.51    0.12      1.69      0.75
2011      Q4   0.59    1.74    0.15      1.91      0.89

2012      Q1   0.77    2.20    0.20      2.35      1.12
2012      Q2   1.03    2.41    0.22      2.62      1.35
2012      Q3   1.29    2.61    0.25      2.88      1.58
2012      Q4   1.54    2.82    4.27      3.15      1.81

2013      Q1   1.80    3.02    0.30      3.41      2.04
2013      Q2   2.03    3.19    0.34      3.58      2.28
2013      Q3   2.26    3.36    0.38      3.75      2.52
2013      Q4   2.48    3.53    0.42      3.92      2.76

                   10-year government bond yields

               US    Canada   Japan   Euro Area   UK

2008           3.6    3.6      1.5       4.2      4.5
2009           3.2    3.2      1.3       3.7      3.7
2010           3.2    3.2      1.2       3.3      3.6
2011           3.5    3.4      1.3       4.2      3.7
2012           4.0    3.9      1.4       4.5      4.0
2013           4.3    4.2      1.5       4.7      4.3
2014-18        4.8    4.7      1.9       5.0      4.8

2010      Q1   3.7    3.5      1.3       3.5      4.1
2010      Q2   3.5    3.5      1.3       3.4      3.7
2010      Q3   2.8    3.0      1.0       3.1      3.2
2010      Q4   2.9    3.0      1.0       3.4      3.3

2011      Q1   3.4    3.3      1.2       4.0      3.7
2011      Q2   3.4    3.3      1.3       4.1      3.7
2011      Q3   3.6    3.5      1.3       4.2      3.7
2011      Q4   3.7    3.6      1.3       4.3      3.8

2012      Q1   3.8    3.7      1.4       4.4      3.9
2012      Q2   3.9    3.8      1.4       4.5      4.0
2012      Q3   4.0    3.9      1.4       4.6      4.1
2012      Q4   4.1    4.0      1.4       4.6      4.2

2013      Q1   4.2    4.1      1.5       4.7      4.2
2013      Q2   4.3    4.2      1.5       4.7      4.3
2013      Q3   4.4    4.3      1.5       4.8      4.3
2013      Q4   4.4    4.3      1.6       4.8      4.4

Table A2. Nominal exchange rates

                            Percentage change
                            in effective rate

             US    Canada   Japan   Euro   Germany   France
                                    Area

2008        -2.0    -1.7    12.9     5.1     2.0       2.6
2009         7.O    -3.0    15.5     6.0     2.4       1.7
2010        -3.1     9.4     4.5    -6.1    -3.6      -2.9
2011        -4.9     4.5     1.1     1.9     0.7       1.2
2012         0.3    -0.1    -0.7     0.5     0.2       0.3
2013         1.2    -0.9     1.1    -0.4    -0.3      -0.2

2010   Q1    1.1     3.8    -0.2    -4.3    -2.4      -2.1
2010   Q2    2.3    -0.6    -0.2    -5.5    -2.9      -2.8
2010   Q3   -1.2     0.1     6.7    -0.1    -0.2       0.0
2010   Q4   -2.9     1.6     1.7     2.5     1.1       1.3

2011   Q1   -1.2     2.0    -0.4    -0.6    -0.4      -0.2
2011   Q2   -2.1     1.9    -3.8     2.9     1.4       1.5
2011   Q3    0.0     0.0     0.0     0.0     0.0       0.0
2011   Q4    0.0     0.0     0.0     0.0     0.0       0.0

2012   Q1    0.3    -0.2     0.1     0.0     0.0       0.0
2012   Q2    0.3    -0.3     0.1    -0.1    -0.1       0.0
2012   Q3    0.3    -0.2     0.2     0.1    -0.1       0.0
2012   Q4    0.3    -0.2     0.2    -0.1    -0.1       0.0

2013   Q1    0.3    -0.2     0.3    -0.1    -0.1       0.0
2013   Q2    0.3    -0.2     0.3    -0.1    -0.1      -0.1
2013   Q3    0.3    -0.2     0.4    -0.1    -0.1       0.0
2013   Q4    0.3    -0.2     0.4    -0.1    -0.1       0.0

            Percentage change        Bilateral rate per US $
            in effective rate

              Italy    UK       Canadian    Yen    Euro    Sterling
                                   $

2008           2.5    -11.9      1.078     103.4   0.683    0.545
2009           2.4    -10.5      1.132      93.6   0.720    0.641
2010          -3.3     -0.2      1.026      87.8   0.755    0.647
2011           1.3     -0.6      0.967      83.7   0.704    0.616
2012           0.4      0.2      0.969      84.5   0.702    0.615
2013          -0.1      1.0      0.981      84.4   0.713    0.617

2010   Q1     -2.5     -1.0      1.023      90.7   0.722    0.641
2010   Q2     -3.1      0.4      1.039      92.0   0.787    0.671
2010   Q3      0.1      2.6      1.033      85.8   0.775    0.645
2010   Q4      1.5     -1.7      1.008      82.6   0.736    0.633

2011   Q1     -0.2      0.5      0.986      82.2   0.731    O.624
2011   Q2      1.6     -1.5      0.961      84.2   0.696    0.614
2011   Q3      0.0      0.0      0.961      84.2   0.696    0.614
2011   Q4      0.0      0.0      0.961      84.2   0.696    0.614

2012   Q1      0.0      0.2      0.964      84.3   0.698    0.614
2012   Q2      0.0      0.3      0.967      84.5   0.701    0.615
2012   Q3      0.0      0.3      0.970      84.5   0.703    0.615
2012   Q4      0.0      0.3      0.973      84.6   0.706    0.616

2013   Q1      0.0      0.3      0.977      84.6   0.709    0.616
2013   Q2      0.0      0.3      0.979      84.5   0.712    0.617
2013   Q3      0.0      0.2      0.982      84.4   0.714    0.617
2013   Q4      0.0      0.2      0.985      84.3   0.717    0.617

Table A3. Government revenue assumptions

              Average income tax rate   Effective corporate tax rate
                  (per cent) (a)                (per cent)

                2010   2011   2012          2010   2011   2012

Australia       13.8   14.5   14.5          24.7   24.7   24.7
Austria         30.5   30.4   30.3          19.9   19.9   19.9
Belgium         32.3   32.0   33.0          24.5   24.5   24.5
Canada          20.9   22.0   22.0          23.8   24.3   25.1
Denmark         37.5   36.4   36.4          31.7   31.7   31.7
Finland         31.8   33.6   33.6          19.6   20.8   20.8
France          28.8   29.6   30.1          22.5   23.8   23.8
Germany         28.1   28.3   28.2          26.6   26.6   26.6
Greece          21.4   23.0   23.0          23.3   23.3   23.3
Ireland         20.2   20.2   20.2          10.3   10.3   10.3
Italy           28.8   28.1   28.0          26.2   26.6   27.0
Japan           21.8   21.8   21.8          26.9   27.2   27.6
Netherlands     32.2   31.4   31.4          20.0   20.3   20.3
Portugal        19.2   21.0   21.0          18.4   18.4   18.4
Spain           22.8   23.0   23.0          25.2   25.2   251
Sweden          31.1   31.1   31.1          17.9   18.1   18.4
UK              23.8   23.8   24.0          21.1   19.6   18.3
US              16.5   16.5   17.3          29.1   29.1   29.1

              Govt revenue (% of GDP) (b)

              2010       2011   2012

Australia     30.5       30.6   31.4
Austria       37.9       38.7   38.9
Belgium       42.4       43.1   43.6
Canada        35.4       35.4   35.4
Denmark       42.9       40.8   39.9
Finland       44.6       43.3   42.9
France        43.2       44.3   45.2
Germany       41.3       41.3   41.3
Greece        28.9       33.8   34.6
Ireland        8.2 (c)   31.5   33.6
Italy         44.0       43.1   42.3
Japan         32.6       33.2   33.5
Netherlands   36.9       37.1   38.1
Portugal      38.3       41.4   41.8
Spain         33.0       32.2   31.9
Sweden        44.8       44.6   44.2
UK            37.3       37.7   38.0
US            26.9       27.2   28.7

Notes: (a) The average income tax rate is calculated as total income
tax plus both employee and employer social security contributions as
a share of personal income. (b) Revenue shares reflect NiGEM
aggregates, which may differ from official government figures. (c)
Figures for Ireland in 2010 are distorted by bank recapitalisation
costs, which are treated as a negative income flow in NiGEM
calculations.

Table A4. Government spending assumptions (a)

                Gov't spending       Gov't interest        Deficit
              excluding interest   payments (% of GDP)   projected to
                  payments                                fall below
                                                              3%
              2010   2011   2012   2010   2011   2012       of GDP

Australia     32.5   32.1   31.7   1.8    2.0    2.0        2012
Austria       40.0   40.0   40.0   2.6    2.5    2.6        2014
Belgium       43.3   42.7   42.2   3.7    3.7    3.7        2012
Canada        37.2   36.6   36.1   3.7    3.5    3.4        2015
Denmark       43.7   42.6   41.5   2.1    2.1    2.1        2015
Finland       45.7   43.3   42.4   1.3    1.3    1.4        2009 (b)
France        47.7   47.6   46.9   2.5    2.6    2.8        2015
Germany       41.8   40.0   38.7   2.8    3.0    3.0        2011
Greece        33.2   33.6   32.6   6.3    8.2    9.6        2019
Ireland       36.8   37.5   35.5   3.4    5.6    6.6        2017
Italy         43.8   42.5   41.2   4.7    4.8    5.0        2016
Japan         37.5   37.8   37.0   2.8    2.9    2.8        --
Netherlands   39.9   38.4   37.9   2.4    2.4    2.5        2012
Portugal      43.7   43.5   42.1   3.1    4.0    4.9        2017
Spain         40.1   36.2   34.7   2.1    2.4    2.7        2018
Sweden        43.6   42.7   42.0   1.1    1.0    1.0        2009 (b)
UK            41.1   40.3   39.3   3.0    3.3    3.5        2017
US            34.8   33.9   32.6   2.7    2.8    2.9        --

Note: (a) Expenditure shares reflect NiGEM aggregates, which may
differ from official government figures. (b) The deficit in Finland
and Sweden  has not exceeded 3 per cent of GDP in recent history.