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(1+t) 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” Dynamic=Static 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 • = > 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 + Imports=Consumption

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 46% 30% 55% 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 welfareby closure Source: UNCTAD

40. Fixed Trade BalanceWelfare compared with standard closure Japan USA Source: UNCTAD

41. Trade elasticitiesWelfare compared with standard closure Japan Source: UNCTAD

42. Fixed wagesWelfare 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 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 20*20 (max 30*30) • 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