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General Equilibrium Modelling and Trade Policy Analysis

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Title: General Equilibrium Modelling and Trade Policy Analysis


1
General Equilibrium Modelling and Trade Policy
Analysis
  • Marco Fugazza
  • DITC, UNCTAD
  • 15 September 2006

2
Outline
  • Why are economic models needed?
  • What kinds of models are commonly used for trade
    policy analysis?
  • Basics of CGE Modelling
  • What is involved in a policy simulation?
  • What should we know of trade liberalization CGE
    simulations?
  • An Application
  • How can modeling better assist policy making?

3
Why are economic models needed?
4
Why are economic models needed?
  • 1. Without theory, practice is but routine born
    of habit.
  • 2. (S)He who loves practice without theory is
    like the sailor who boards ship without a rudder
    and compass and never knows where he may cast.
  • Being denied a sufficiently secure experimental
    base, economic theory has to adhere to the rules
    of logical discourse and must renounce the
    facility of internal inconsistency. A deductive
    structure that tolerates a contradiction does os
    under the penalty of being useless since any
    statement can be derived flawlessly and
    immediately from that contradiction. In its
    mathematical form, economic theory is open to an
    efficient scrutinity for logical errors.
  • 4. In attempting to answer the question Could
    it be true?, we learn a good deal about why it
    might not be true.

5
  • 1. Without theory, practice is but routine born
    of habit. Louis Pasteur
  • 2. (S)He who loves practice without theory is
    like the sailor who boards ship without a rudder
    and compass and never knows where he may cast.
    Leonardo da Vinci
  • 3. Being denied a sufficiently secure
    experimental base, economic theory has to adhere
    to the rules of logical discourse and must
    renounce the facility of internal inconsistency.
    A deductive structure that tolerates a
    contradiction does os under the penalty of being
    useless since any statement can be derived
    flawlessly and immediately from that
    contradiction. In its mathematical form, economic
    theory is open to an efficient scrutinity for
    logical errors. Gérard Debreu (Nobel Prize
    winner,1983)
  • 4. In attempting to answer the question Could
    it be true?, we learn a good deal about why it
    might not be true. Kenneth Arrow (Nobel Prize
    winner, 1972)

6
Why are economic models needed?
  • The use of economic models should help improve
    policymaking. How?
  • They provide a theoretically consistent framework
    for analyzing trade policy questions
  • Models can provide a handle on complicated
    questions
  • Models can help give greater intellectual support
    for a chosen trade policy
  • The use of models can provide a common language
    for policy discourse or debate
  • But models should complement rather than
    substitute for policy making

7
Models commonly used for trade policy analysis
8
Models used for trade policy analysis
  • Simulation models they help answer What if
    types of questions ( projections) Partial
    Equilibrium Models, General Equilibrium models
  • Econometric Models
  • gravity models reduced form can be used to
    establish whether certain economic variables have
    an effect on a variable of interest (Does GSP
    increase trade?)
  • Macro-econometric models tools for projections
    of aggregates but no info on the industrial
    structure of the economy may lack
    micro-foundations
  • Simulation (econometric) models are deterministic
    (stochastic)

9
A Partial Equilibrium Analysis
Price
Impact of wheat market on rest of the economy can
be neglected
DS
Pw(1t)
Pw
DD
Wheat
10
A General Equilibrium Analysis
spending on goods and services
Savings
Investments
goods and services
Households
Firms
FDI
Factor services of production
exports
imports
Factor incomes
REST OF THE WORLD
11
GE or PE analysis?
  • Nature of policy change
  • Does it cut across many markets or sectors?
  • Potential impact of change
  • Are there economy-wide impacts?
  • Constraints imposed by availability of data and
    resources (financial and skills)
  • PE data and models free
  • CGE data single country (SAM) could be free,
    multiple country (GTAP from 360 to 4600)
  • CGE models free (GTAP) but may need software for
    mathematical programming to run (LINKAGE, MIRAGE)

12
Basics of CGE Modelling
13
A Typology of CGE Modeling
Static regions, sectors, factors, economic
agents set of economic behaviors
relationships
Micro-Simulation Models representative agents
hypothesis removed
DynamicStatic features explicit inter-temporal
features
14
CGE Standard Model Elements I
  • Input Output Economics SAMs
  • Behavioral Relationships/ Agents
  • Supply
  • Demand
  • Trade
  • Government
  • Pricing and Imperfect substitutes
  • Policy tax equivalents
  • Closure
  • Accounting identities
  • Endogenous/exogenous variables
  • Macroeconomic assumptions
  • Exchange rate determination
  • Solution
  • Equilibrium
  • Linearization
  • Percent change variables

15
CGE Standard Model Elements II
  • Calibration/Benchmarking
  • Aggregation
  • Agents
  • Goods/Sectors
  • Experiments
  • Welfare Measures
  • Projections
  • What if
  • Extensions
  • Imperfect Competition, IRS
  • Product Differentiation
  • Dynamics
  • Results Comparisons

16
Input-Output economics SAMs
  • Production Intermediates Value Added
  • Production Intermediate demand Final Demand
  • Macroeconomic accounting identities to capture
    income flows, tax incidence, trade and payments,
    and savings-investment balances
  • gt SAMs capture circular flow of income and
    expenditure

17
Input-Output economics SAMs
spending on goods and services
Savings
Investments
goods and services
Households
Firms
FDI
Factor services of production
exports
imports
Factor incomes
REST OF THE WORLD
18
Input-Output economics SAMs
  • Whether neoclassical, strucuralist,
    neo-Keynesian, or Monetarist, a CGE modeler must
    respect accounting identities and equilibrium
    conditions. Hence, most applied work is based on
    a social accounting matrix to benchmark
    (calibrate) a model and to represent relevant
    accounting identities.
  • SAMs capture equilibrium conditions
  • Walras law applies

19
Decision Making and Institutions
  • Linkages in SAMs are accounted for by modelling
    the decision-making process of the firm, the
    consumer, as well as other economic agents and
    institutions production and demand structure
  • Trade results from that decision-making processes
    and their interaction with institutions
  • Production- Exports ImportsConsumption

20
Closing the Model
  • Need to define a numéraire (walras law allows to
    drop one market)
  • Assumption about the adjustment mechanism in
    factor and commodity markets
  • Macro closure
  • Macro accounting balance (gvt expenditure and
    deficit aggregate saving and investment balance
    of trade and -real- exchange rate)
  • Macro adjustment mechanism (exogenously
    determined)

21
Closing the Model
  • Johansen closure investment is exogenous and
    consumption is the adjustment variable
  • Keynesian closure nominal wage is fixed and
    employment is the adjustment variable
    (unemployment)
  • Kaldorian closure wages could be less or equal
    to the marginal product of labor (exploitation of
    labor model)
  • Classical closure prices and wages are the
    adjustment variables (constant employment) and
    investment becomes endogenous and adjusts to
    total savings available
  • Foreign borrowing (Robinson) trade balance is
    endogenous, current account and hence net capital
    inflows are the adjustment variable

22
Beyond the Standard Model
  • Economies of scale, monopolistic competition and
    differentiated products
  • Institutional features of a particular economy
    (e.g. tax collection costs)
  • Specific features of a policy instrument
  • Increase effort on estimation of substitution
    elasticities
  • Dynamics to account for dynamic aspects (policy
    credibility capital accumulation FDI knowledge
    accumulation and spillovers) and adjustment
  • Account for the extensive margin of trade (the
    small-shares issue)

23
CGE Dynamic Models
  • Recursive
  • solves annually
  • Current economic conditions (e.g. the
    availability of capital) are dependent on past
    outcomes but are unaffected by forward looking
    expectations
  • Linked with a macro econometric to include
    exogenously projected changes in demographic
    trends or in technology baseline scenario
  • Impact of policy change is given with respect to
    the baseline scenario (sector specific TFP and
    real GDP growth are solved endogenously)

24
CGE Dynamic Models
  • Forward looking
  • Ramsey model, OLG, Infinite lived consumer with
    financial market
  • No extensive baseline scenario trade
    performance-productivity linkage gvt investment
    on infrastructure and TFP linkage investment in
    education and labor productivity linkage
  • Could account for transitionary disequilibrium
    states (true adjustment process?)

25
Micro-Macro Models
  • Combination of a Micro Simulation model (base on
    Household surveys fiscal and labor) and a CGE
    model
  • Ideal to assess the impact of macroeconomic
    (trade) policies and shocks on poverty/
    inequality MAMS (maquette for MDG simulation)
  • Two types of combination
  • Fully-integrated the household model built
    directly into the CGE CGE model with
    heterogeneous agents (high complexity)
  • Sequential (top-down) CGE simulation results are
    passed on to an household model (macro and micro
    need not to be reconciled but possible lack of
    coherence)

26
Micro Simulation Models
  • Micro-accounting models the day after approach
  • Capture 1st order effects
  • No behavioral response
  • Behavioral Models
  • Capture 2nd order effects
  • Behavioral response
  • Reduced form or Structural
  • Dynamic versus Static models
  • Dynamic is usually associated with aging of
    information
  • Dynamic could be behavioral

27
What is involved in a policy simulation?
28
What is involved in a policy simulation?
Economy before trade policy change
Economy after trade policy change
Policy change
Difference between the two is attributed to
policy change
29
What is needed for a policy simulation?
MODEL / Closure
Inputs
Outputs
30
What are the inputs?
  • Baseline data
  • trade flows
  • levels of protection
  • input-output structure national income
    aggregates
  • Measure of responsiveness of economic agents to
    price changes (i.e. elasticities)
  • Policy - negotiating scenario
  • Sectors (Agriculture, NAMA, etc.)
  • Depth of liberalization

31
What are the Outputs?
  • Configuration of the economy after policy change
  • Overall income gains/losses from policy change
  • Sources of income gain
  • Sectoral (agriculture vs. NAMA)
  • Policy instrument (market access or domestic
    support)
  • Winners or losers (at the country level)
  • Changes in pattern and volume of trade and income
  • Story to explain how inputs and model combine
    to determine the output/outcome

32
Tracing Differences in Results
  • Deterministic outcome is completely determined
    by choice of inputs and model (no residuals)

MODEL
Inputs

Outputs
  • Differences in simulation results differences
    in choice of inputs and model/closure
  • Story must explain why the choice of inputs and
    model is appropriate/optimal for the policy
    question of interest

33
Towards an objective look at trade
liberalization CGE simulations
34
Doha Round CGE Simulations
  • Common results
  • Multilateral liberalization is beneficial at the
    global level
  • There are potential gains for developing
    countries
  • Developing countries own liberalization is an
    important source of their gains
  • Removing subsidies may damage net food importer
    countries

35
Doha Round CGE Simulations
  • Results differ among studies on how gains are
    redistributed
  • 1. What share of the benefits goes to developing
    countries?
  • 2. What share comes from agriculture
    liberalization? From NAMA?

36
What are the gains for developing countries?
Full liberalization scenario. Million 1997
30
55
46
21
37
What share of the gains comes from agriculture
liberalization ?
Results based on the full liberalization scenario
38
How important are assumptions?
  • Examine one scenario with differing assumptions
  • Scenario 50 cut in all tariffs and subsidies
  • Standard closure
  • Fixed trade balance
  • Fixed wages (unskilled unemployment) in
    developing countries
  • Double trade elasticities (substituability
    between domestic and foreign products)

39
Global welfare by closure
Source UNCTAD
40
Fixed Trade Balance Welfare compared with
standard closure
Japan
USA
Source UNCTAD
41
Trade elasticities Welfare compared with
standard closure
Japan
Source UNCTAD
42
Fixed wages Welfare compared with standard
closure
China
Source UNCTAD
43
Other assumptions we ignore
  • CRTS
  • Perfect competition
  • Static/dynamic
  • Technology
  • Productivity
  • Key elasticities e.g. K/L substitutability
  • Aggregation

44
An Application The potential for South-South
Trade
45
Setting a Policy Simulation
  • Qualifying the general issue of interest what
    is at stake ? analysis
  • Choice of aggregation
  • Model specification and Closure
  • Choice of scenario to be simulated
  • Presentation of the results
  • Interpretation of the results

46
What is at stake?
Trade weighted average applied tariffs (inc.
preferences) by development status
Developed Developing Least developed

Source
Developed 2.1 9.2 11.1
Developing 3.9 7.2 14.4
Least developed 3.1 7.2 8.3
Total 2.9 8.1 13.6
Source Computed from TRAINS/WITS (2004)
47
Aggregation
  • South-South trade is the focus
  • keep as many southern countries as possible (21)
  • Identify those sectors with the highest
    protection among developing countries (20) and/or
    with little access to norther markets
  • Adjust the country-groups selection in accordance
  • General hints
  • Aggregation is usually 2020 (max 3030)
  • Different aggregations affect differently the
    level of protection an distortion that will
    characterize the simulation exercise (could
    hide/highlight gains and losses ) and thus the
    expected gains from the policy simulation

48
Model and Closure
  • Model characteristics are likely to depend on
    your CGE skills
  • Standard GTAP is widely used but more and more
    imperfect competition in manufactures
  • Still prevalence of static models because of high
    computational resources required for the baseline
    scenario in recursive models
  • No a priori concerning the favorite closure
  • With a focus on developing countries fixed wage
    (flexible employment) for unskilled labor could
    be sensible
  • Standard non-standard fixed trade balance for
    all countries but the USA

49
Choice of Scenario
  • Pre-simulation to account for the aging of data
    and policy (e.g. China accession to the WTO, end
    of ATC)
  • Political Relevance Potential of south-south
    trade relevant in the context of GSTP
    negotiations (43 countries opening to the group
    of 77 China)
  • If not related to realistic scenarios (Doha
    negotiations) identify sector and country
    relevant scenarios (manufactures, agriculture and
    overall liberalization or tariff cuts/ across
    different regions)
  • In general tariff cuts are simulated together
    with export taxes and subsidies
  • Compensation of changes in tariff revenues (e.g.
    income is made endogenous) could be a major
    concern for developing countries

50
Presentation of Results
  • Present both absolute variations and proportional
    variations with respect to relevant initial
    values (welfare as a percentage of initial GDP)
  • Present the results of the same scenario obtained
    with at least one different closure from the
    favorite one (annex)
  • Results could be presented in aggregate form for
    sake of clarity with reference o fully
    disaggregated results in the text
  • Present the results obtained in a benchmark
    simulation usually full trade liberalization

51
Interpretation of Results
  • Are you sure you understand what is going on?
    (should be the case if good preliminary
    analytical work done for aggregation)
  • Results are your story and must reflect a good
    coherence between your scenario(s) and the
    various component of your modeling approach
  • Multiple scenarios and comparative analysis are
    less sensible to modeling specificities
    everything is relative
  • Simulations of a specific agreement/policy
    scenario must be based on the most realistic
    computational framework
  • Make sure that what your telling is in line with
    your assumptions (e.g. do not talk about changes
    in labor demand when employment is assumed to be
    fixed)

52
How can modelling better assist policy making?
  • A. Improving data
  • trade transaction costs
  • more disaggregated sectors
  • better disaggregation of regions/countries
  • protection in services
  • TNC activities FDI vs. Outsourcing
  • Households surveys to account for poverty and
    inequality impact

53
.... Contd
  • B. Improving modelling of
  • Better treatment of services
  • Adjustment costs
  • Functioning of factor (labour) markets
  • Tariff revenue implications of trade
    liberalization
  • Extensive margin of trade (potential for
    diversification productivity gains)
  • C. Improving confidence in simulation results
  • Sensitivity analyses within and across models
  • Ex-post verifications
  • Use also focused models

54
Demystifying Modelling Methods for Trade
Policy, Roberta Piermartini and Robert Teh,
Discussion Paper No. 10, World Trade
Organization, Geneva, Switzerland, September 2005
(http//onlinebookshop.wto.org/shop/article_detail
s.asp?Id_Article661)Structure of GTAP
,Thomas W. Hertel and Marinos E. Tsigas, Chapter
2 in T.W. Hertel (ed.), Global Trade Analysis
Modeling and Applications, Cambridge University
Press, 1997. (https//www.gtap.agecon.purdue.edu/r
esources/res_display.asp?RecordID413) Global
Trade Analysis Project (GTAP)http//www.gtap.agec
on.purdue.edu/ LINKAGE Technical Reference
Document, Dominique van der Mensbrugghe, DECPG,
World Bank, December 2005 (http//siteresources.wo
rldbank.org/INTPROSPECTS/Resources/334934-11007925
45130/LinkageTechNote.pdf)
References
55
References
Michigan Model of World Production and
Tradehttp//www.fordschool.umich.edu/rsie/model/
description.html Mirage, a Computable General
Equilibrium model for Trade Policy Analysis,
Bchir E., Y. Decreux, J-L. Guérin, S. Jean,
CEPPI http//www.cepii.fr/anglaisgraph/workpap/pd
f/2002/wp02-17.pdfWorld Scan Dynamic Model of
the World of the Netherlands Bureau of Economic
Policy analysis (CPB)http//www.cpb.nl/nl/pub/bi
jzonder/20/bijz20_c.pdf Harrison/Rutherford/Tarr
Multi-Regional Global Trade Modelhttp//dmsweb.
badm.sc.edu/Glenn/ur_pub.htm
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