Computable General Equilibrium Modeling and Its Application in Trade Policy Analysis Lecture 1: Intr

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Computable General Equilibrium Modeling and Its
Application in Trade Policy Analysis Lecture 1
Introduction

• Zhi Wang
• U.S. International Trade Commission
• E-Mail zhi.wang_at_usitc.gov

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Outline

• Structure and Contents of the course
• Importance, feasibility and limitations of
  economic modeling
• Current difficulties in developing policy
  modeling systems
• What is a Computable General Equilibrium Model
  and its General Structure
• Why we need CGE model in Trade policy Analysis

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Why We Emphasis Applied Economic Modeling ?

• There is no clear division between theoretical
  and applied modeling
• From theory to theory with numbers, to numbers
  with theory
• Applied CGE modeling
• A clear policy orientation
• A concern for accurate and current dada as basis
  for the modeling exercise
• Model structure determined by the data, not
  selective use of data to fit a theoretical
  structure

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Sequences of lectures

• Introduction
• Basic Structure for CGE Models
• Data Structure An Accounting Framework and
  Benchmark Data Set for CGE Analysis
• GAMS Lab 1 Basic Programming in General
  Algebraic Modeling System

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Sequences of lectures (cont.)

• Constraint matrix balance procedure and its
  applications in data reconciliation
• Application of static CGE model in trade policy
  analysis the impact of economic integration of a
  greater China
• Application of recursive dynamic CGE model in
  trade policy analysis the economic impact of
  China and Taiwan joining the WTO
• GAMS Lab 2 calibration and simulation of CGE
  models

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The Importance of Economic Policy Modeling and
Simulations (cont.)

• Unlike most physical scientists, who can test
  their ideas on controlled experiments in
  laboratories, economists have to rely primarily
  on natural experiments for their data.
• Classical economists, like K. Max, believes that
  study economics, one can use neither the scalpel
  nor the chemical reagent, the only mean is the
  abstract ability of human beings.

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The Importance of Economic Policy Modeling and
Simulations (cont.)

• The Rapid development of modern computer and IT
  provide the means for todays economists to
  examine their ideas by a computer-based
  simulation model before they put into practice.
  Simulation and economic modeling has become a
  major field in applied economics
• Numerous historical examples show that any
  implementation of improper economic or social
  policy on a large scale would lead to economic
  disaster and social chaos, requiring years to
  readjustment at a very high cost.

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Feasibility and Limitations of Economic Policy
Modeling

• We could neither include every aspect of the
  world economy in to a mathematical model, nor
  could we quantify every step of certain policy
  implementation precisely in a computer simulation
  model. What the best we may do is to estimate
  roughly what shock a policy may bring about on
  the world economy under certain assumptions and
  simplifications.
• Our logic is simple if a policy can not prove
  its feasibility and consistency in a computer
  simulation model which properly captures the
  major stylized facts of that economy, it is
  unlikely to be feasible and consistency in the
  real economy. Similar to jet designers always
  implement their new design in physical models and
  through "wind tunnel" tests before permitting the
  jet go into the air.

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The History and Development of CGE Models

• One of the major advances in applied economics
  since the 1970s is converting the well-known
  Walrasian general-equilibrium structure from an
  abstract representation of an economy into
  realistic models of actual economies to conduct
  policy evaluations by specifying production and
  demand functions and incorporating data of the
  real world.
• Hundreds of such models have been built and
  applied to a number of policy issues, ranging
  from public finance and taxation, economic
  integration, GATT negotiations, and issues of
  North-South trade, to the evaluation of
  development strategies and energy and environment
  policies for almost all the major countries in
  the world.

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Current Problems in Developing CGE Policy
Modeling Systems

• In the earlier days of CGE modeling, algorithmic
  and computer power were the main constraints.
  Both the technical difficulties and computing
  costs were associated with the process of finding
  numerical equilibrium of the model, while they
  are no longer problems today. Statistics show
  that the numerical solution does not account for
  more that 15 of the modeling effort
• Model formulation, implementation, data
  preparation and transformation, and
  interpretation of simulation results have become
  major burdens of the modeling process
• The CGE models built by professionals in academic
  institutions are still some distance from the
  kind of practical policy evaluation tool that can
  be easily understood and used by policy maker in
  the government

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Current Problems in Developing CGE Policy
Modeling Systems (cont.)

• The major difficulties come from the fact that
  three representations of the same model are
  needed before any policy simulation can be
  carried out
• Any policy problem has a semantic description. It
  describes the policy issue and the model to
  address it in intuitive terms.
• Formal representation. The intuitive model are
  transformed into formal (mathematical) models by
  skilled analytical professionals. Policy makers,
  who are often not familiar with math notations,
  find those models difficult to understand.
• Computer and Algorithm representation. Any formal
  model needs an algorithm to solve, and any
  algorithms need a data structure and a problem
  representation, while problem representations
  that are meaningful to humans, are not acceptable
  to machines.

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Components in CGE Models

• A set of economic agents such as firms,
  households and government whose behavior is to be
  analyzed. Each agent has a set of endowments that
  can be used as production factors, such as labor
  and capital, and an economic account that records
  his revenues and expenditures
• Behavioral rules for these agents that reflect
  their assumed motivation such as profit
  maximization for firms and utility maximization
  for consumers.
• A set of signals observed by these agents on
  which they make their economic decisions, such as
  market prices or government rationing quotas.

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Components in CGE Models (cont.)

• Institutional structure of the model economy,
  which are the rules of the game by which various
  agents interact. For example, perfect competition
  implies that each agent is a price taker and
  prices are flexible.
• A set of explicit definitions of equilibrium
  conditions which are "system constraints" that
  must be satisfied for the whole economy but which
  are not taken into account by each individual
  agent in making his decisions.

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Equilibrium in CGE Models

• An equilibrium can be defined as a set of
  signals such that the resulting decisions of all
  agents jointly satisfy the system constraints.
  The signals represent the equilibrating variables
  of the model. For example, in a perfectly
  competitive CGE model the assumption that excess
  demand equals zero in all markets is a system
  constraint that defines the nature of
  equilibrium.

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Do CGE models only be applied to perfect
competitive market economies?

• There are different equilibrium concepts
• in the product and factor markets (Walrasian or
  micro)
• in financial or nominal flows (Keynesian or
  macro)
• in asset markets (another macro) in an
  inter-temporal process
• non-Walrasian equilibrium which depend upon the
  properties of demand and supply function under
  rationing.
• the behavior assumptions, the institution
  structure, the signals, and the system
  constraints or macro closures all can be
  specified by various completely different
  economic theories and under a wide variety of
  institutional assumptions.

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Justification - Why Should We Use CGE Analysis ?

• Theoretical consistency. Comparative statics and
  counterfactual simulations.
• Accounting consistency. Closed system with no
  leak.
• Capture both direct and indirect inter-sectoral,
  inter-regional, and inter-temporal effects
  induced by trade policy changes.

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Justification - Why Should We Use CGE Analysis ?
(cont.)

• Able to provide more concrete welfare analysis
  that influence real policy making.
• Able to analyze the tradeoff between efficiency
  and equity/distribution issues
• Able to analyze large, discrete, policy changes
  that far away from the baseline.

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Justification - Why Should We Use CGE Analysis ?
(cont.)

• the clear microeconomic structure with links
  between micro and macro aspect of the economy
  makes CGE model the soundest tool for
  quantitative policy analysis
• help analysts to understand the essential
  relationships relevant to particular policy
• very useful to build a bridge between economists
  and policy makers, and provide them with a base
  for dialogue.

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Knowledge required for CGE Analysis

• Knowledge of general equilibrium theory
• Knowledge of real world data. Be able to
  manipulate and convert it into a model admissible
  form
• Knowledge of computer programming. Be able to
  implement the model in computer
• Knowledge of policy issues and institutional
  structure

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Gains to Economic Growth from Trade
Liberalization

• More efficient allocation of production factors,
  including the migration of agricultural labor to
  manufacture activities, which increase labor
  productivity
• More rapid physical capital accumulation from a
  "medium-run growth bonus" which compounds the
  efficiency gain from trade liberalization,
  induces higher income for economic agents and
  lower price for capital goods, lead to higher
  saving and investment so that more physical
  capital stock available in the economy
• More rapid growth of total factor productivity
  (TFP) due to speeding technology transfer via
  expansion of capital and intermediate goods
  imports from other countries, especially from
  advanced industrial countries.