General Equilibrium Analysis

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General Equilibrium Analysis

• Frank van Tongeren

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Computable General Equilibrium models

• Stylized (but useful) 123 model
• CGE model Iran much more detail (Wednesday)
• GTAP global model, much detail

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Basic modeling rule

• KISS
• Keep
• It
• Simple,
• Stupid

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Plan

• 123-model
• Graphical analysis
• Assignment
• Equations
• Spreadsheet implementation (Egypt)
• Assignment
• more assignments (make Iran model)

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123 model

• Capture mechanisms by which external shocks and
  domestic policies ripple through the economy
• Many problems (and solutions) are related to
  links between external sectors and domestic
  economy
• Minimum requirements for an interesting model
• 1 small country
• 2 producing sectors nontradable tradable
• 3 goods nontraded, import, export
• Devarajan-Go-Lewis-Robinson-Sinko (1997), Chapter
  6 of Applied methods in trade policy analysis A
  Handbook, Francois and Reinert, eds., Cambridge
  University Press.

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123 model

• 1 country, 2 sectors, 3 goods
• Very simplistic stylized model, but
• mechanisms are transparent
• can be solved graphically, analytically, or with
  Excel
• behavior is similar to that of more complex models

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Basic general equilibrium model elements

• 1 producer
• 1 consumer
• 1 domestic market
• Balance of trade

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Producers
Export good (E)
Xg(E,D)
Domestic good (D)
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Producers
Export good (E)
Xg(E,D)
PD/PE
Domestic good (D)
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Producers
E
Export good (E)
Xg(E,D)
PD/PE
D
Domestic good (D)
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Consumers
Import good (M)
Qf(M,D)
Domestic good (D)
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Consumers
Import good (M)
I(M,D)
Qf(M,D)
Domestic good (D)
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Consumers
Import good (M)
I(M,D)
PD/PM
Qf(M,D)
Domestic good (D)
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Linking elements of the model (1)

• Domestic markets
• Supply needs to equal demand for the domestic,
  non-traded good (D) DS DD

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Domestic market
E
Producers
DS
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Domestic market
M
Consumers
E
DD
Producers
DS
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Domestic market
M
Consumers
E
DD
45o
Domestic markets
Producers
DS
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Domestic market
M
Consumers
E
DD
DD1
45o
Domestic markets
DS1
Producers
DS
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Linking elements of the model (2)

• Trade balance
• Imports (M) have to be financed by exports (E)
  and flows of foreign money (B) PM M PE E B
• Relation between imports and export depends on
  terms of trade (the ratio of export prices to
  import prices), while foreign capital determines
  the intercept
• Initially assume that B is zero (runs through
  origin) and that world market prices are 1 (450
  angle)

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Balance of trade
M
Consumers
Balance of trade
E
DD
DD1
45o
Domestic markets
DS1
Producers
DS
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Balance of trade
M
Consumers
Balance of trade
M1
E
DD
E1
DD1
45o
Domestic markets
DS1
Producers
DS
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Basic general equilibrium model
I(M,D)
M
Consumers
Balance of trade
PD/PM
PM M PE EB
Qf(M,D)
E
DD
45o
Xg(E,D)
PD/PE
Domestic markets
DDDS
Producers
DS
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Assignment 2

• Graphically analyze your policy
• Import tax increased import price
• Foreign capital inflow
• Discuss the results for the country
• production goods produced and their prices
• consumption goods consumed and their prices
• trade balance imports, exports
• welfare

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Increased import price
I(M,D)
M
Q1
PM M PE EB
PD/PM
Qf(M,D)
E
DD
Xg(E,D)
45o
PD/PE
X1
DDDS
DS
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Increased import price 2
I(M,D)
M
Q1
PM M PE EB
PD/PM
Qf(M,D)
E
DD
Xg(E,D)
45o
PD/PE
X1
DDDS
DS
1. The budget constraint for the consumer changes
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Increased import price 2
I(M,D)
M
Q1
PM M PE EB
PD/PM
Qf(M,D)
E
DD
Xg(E,D)
45o
PD/PE
X1
DDDS
DS
2. With less resources, the composite goods
prodcution shifts inward
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Increased import price 2
I(M,D)
M
Q1
PM M PE EB
PD/PM
Q2
Qf(M,D)
E
DD
Xg(E,D)
45o
PD/PE
X1
DDDS
DS
3.demand domestic good up, imports down, mkt
clearing domestic implies Ds up
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Increased import price 2
I(M,D)
M
Q1
PM M PE EB
PD/PM
Q2
Qf(M,D)
E
DD
Xg(E,D)
45o
PD/PE
X2
X1
DDDS
DS
4. More output for domestic use, less for export,
trade balance clears at lower level of imports
AND exports (and at new prices)
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Increased foreign capital inflow
I(M,D)
M
PM M PE EB
PD/PM
Q1
Qf(M,D)
E
DD
Xg(E,D)
45o
PD/PE
X1
DDDS
DS
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Increased foreign capital inflow 2
I(M,D)
M
Q2
PM M PE EB
PD/PM
Q1
Qf(M,D)
E
DD
Xg(E,D)
45o
PD/PE
X1
X2
DDDS
DS
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• GENERAL EQUILIBRIUM MODEL
• 123 simulation model

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Advantages of a general equilibrium model

• Accounting consistency
• Deals with inter-industry linkages
• Theoretical consistency through Walras Law
• if there is an equilibrium in N-1 markets, the
  Nth market is also in equilibrium
• Putting sector-effects in perspective
• Welfare analysis by including households

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Key features of the model

• Imperfect substitutability, both in production
  and consumption
• Homogeneous in prices only relative prices
  matter
• Walras Law holds

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Building the mathematical model

• Translate the graphical model to math
• producer
• consumer
• domestic market
• trade balance
• Add government
• Add savings and investment

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Real flows

• 1 Transformation X (CETEQ)
• 2 Supply of composite good QS (ARMG)
• 3 Domestic demand QD (DEM)
• 4 E/D ratio E/DS (EDRAT)
• 5 M/D ratio M/DD (MDRAT)

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Nominal (money) flows

• 6 Tax revenue equation Tax (TAXEQ)
• 7 Total income equation Y (INC)
• 8 Savings equation S (SAV)
• 9 Consumption equation Cn (CONS)

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Prices

• 10 Import price equation PM (PMEQ)
• 11 Export price equation PE (PEEQ)
• 12 Sales price equation PT (PTEQ)
• 13 Output price equation PX (PXEQ)
• 14 Supply price equation PQ (PQEQ)
• 15 Numeraire (exchange rate) R (REQ)

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Equilibrium conditions

• 16 Domestic good market (DEQ)
• 17 Composite good market (QEQ)
• 18 Current account balance (CABAL)
• 19 Government balance (GBUD)

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The 123 model in Excel (1)

• Parameters determine shape of functions
• Exogenous variables (policy instruments)
• world market prices (small country assumption)
• tariffs and taxes
• savings rate
• government expenditure (consumption and
  transfers)
• inflow of foreign money (grants, remittances,
  savings)
• aggregate output (X, assuming full employment)

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The 123 model in Excel (2)

• Endogenous variables
• levels goods (D, E, M, Q)
• money flows (taxes, income, savings, total
  expenditure)
• prices
• exchange rate
• investment, savings
• Equations
• Data for Egypt (1998)

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Assignment 3

• Analyze the outcomes of your policy
• import tax
• increase in foreign capital inflow
• How large is the shock applied?
• What is the impact on the endogenous variables in
  the model?

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Assignment 4 (extra)

• Put data for Iran in the model
• Analyze effects of increase of world price for
  exports (oil)
• What happens to exports, imports, supply of the
  domestic good?
• In the experiment you will see a an increase in
  the ratio Pd/Pe. Why?