The Role of Services in Modelling the Global Economy

The service sector is a large part of industrialised economies and plays an increasingly important role in developing economies. International trade in services is also an expanding part of the global economy yet the service sector is frequently ignored in empirical modelling because of the limited availability of data, in particular for the bilateral flow of services between economies. Some studies have incorporated service industries explicitly in examining issues such as microeconomic reform in Australia or the effects of international agreements such as the GATS. However these studies have tended to focus on the static effects of changes in resource allocation rather than the effects on growth and capital accumulation of such an important sector. This paper first outlines how the service sector is incorporated into the G-cubed dynamic general equilibrium model of the world economy and then examines two simulations. The first simulation is a rise in total factor productivity growth in the service sector in Australia. The second simulation is an equivalent increase in total factor productivity growth across all service industries globally. The shock that only occurs in Australia has a large effect on Australian GDP because the service sector is a large part of the economy and has significant linkages to other sectors in the economy. In addition, the rise in productivity of Australian service industries leads to a significant capital inflow, attracted by a higher return to capital in the service sector. This inflow of capital appreciates the real exchange rate and raises the price of exports (including services) which worsens the trade balance in the short to medium term and lowers output in some sectors. However, over time, output in all sectors is higher than otherwise because of the effect of higher productivity on wealth in the long run. The effect on Australian GDP of a global shock in productivity is not much different to the effects of a shock to Australian productivity only. A foreign productivity shock leads to a fall in the relative price of foreign goods reducing demand for Australian goods but raising global wealth, increasing demand for all goods. These effects tend to offset each other.