Economics 216 The Macroeconomics of Economic Development

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Economics 216The Macroeconomics ofEconomic
Development

• Lawrence J. Lau, Ph. D.
• Kwoh-Ting Li Professor of Economic Development
• Department of Economics
• Stanford University
• Stanford, CA 94305-6072, U.S.A.
• Winter, 1999-2000
• Phone [phone] Fax [phone]
• Email ljlau_at_stanford.edu Website
  www.stanford.edu/ljlau

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Lecture 15Applied General Equilibrium Models

• Lawrence J. Lau, Ph. D.
• Kwoh-Ting Li Professor of Economic Development
• Department of Economics
• Stanford University
• Stanford, CA 94305-6072, U.S.A.
• Winter, 1999-2000

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General Equilibrium Models of the Economy

• Under the assumptions of
• (1) concave technologies
• (2) quasiconcave preferences
• (3) price-taking behavior
• (4) profit maximization by producers
• (5) utility maximization by households.
• Characterization of a competitive general
  equilibrium (Excess demand is less than or equal
  to zero in every market)
• Existence
• Uniqueness
• Optimality

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General Equilibrium Models of the Economy

• Welfare Theorem A competitive general
  equilibrium is efficient
• Converse Theorem An efficient allocation can be
  realized as a competitive general equilibrium

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Why is Partial Equilibrium Analysis not Enough?

• Everything depends on everything else
• Other things are not equal
• Example A given policy measure may change both
  the supply and the demand sides with the outcome
  on both the equilibrium price and quantity not
  easily predictable a priori

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Why Applied (Computable) General Equilibrium
(CGE) Models?

• Analytical indeterminacy of effects
• Need to know magnitude as well as direction
• Analytical intractability--substitution of
  numerical simulation for analysis
• Sensitivity analysis

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A Simple Static Applied General Equilibrium
Model Specification

• Economic agents
• Households (utility functions)
• Firms (production functions)
• Goods and factors
• Initial Endowments
• Leisure
• Inventory
• Capital
• Behavior
• Utility maximization
• Profit maximization
• Markets
• Simultaneous clearing with zero excess demand of
  all goods

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A Simple Static Applied General Equilibrium
Model Specification

• Choice of a numeraire good (zero degree
  homogeneity)
• Choice of assumptions on the utility and
  production functions
• Choice of functional forms for utility and
  production functions

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Specification

• Households (Preferences)
• Demander of goods for consumption
• Supplier of labor
• Supplier of saving
• Owner of capital
• Firms (Technologies)
• Demander of capital
• Demander of labor
• Supplier of goods for consumption and investment

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Specification

• There is no government, no external sector, no
  money and no financial sector

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The Simplest System of Equations
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General Equilibrium
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Determination of the ParametersCalibration
versus Econometric Estimation

• The derivation of the numerical values of the
  parameters
• The calibration approach
• matching quantities and prices in the base period
• overly dependent on assumptions on the functional
  forms
• The econometric approach
• estimating parameters on the basis of a
  time-series of observations
• permits validation of estimated values of
  parameters with actual empirical experience
• functional form and other assumptions can be
  empirically tested

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Solution of the ModelThe Choice of Algorithms

• Fixed point algorithms (Scarf)

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Welfare Analysis

• Compensating variations--the sum of additional
  consumer expenditures required in order to
  achieve the old levels of utilities at the new
  prices
• Equivalent variations--the sum of the additional
  consumer expenditures required in order to
  achieve the new levels of utilities at the old
  prices
• The social welfare function (interpersonal
  comparison of utilities required)

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Extension to Multiple Periods

• A sequence of static general equilibria linked by
  endogenously determined savings and investments
• The rate of time preference (choice between
  present and future consumption)
• The assumption of intertemporal separability
• U(C1, C2, , CT) ? Ut (Ct)

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The Importance of the Terminal Conditions

• For finite horizon models, it will be optimal to
  allow the capital stock to go to zero at the
  terminal point, which cannot possibly correspond
  to a real world situation
• The terminal conditions have a significant impact
  on the simulation results
• Solutions
• Infinite horizon (steady-state) models
• Ad hoc savings function

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The Role of Rational Expectations

• A rational expectations general equilibrium
  implies that the prices in every period must be
  ex ante anticipated by the economic agents
• A backward recursive solution algorithm is
  required

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Extension to Open Economies

• Trade (Exports and Imports)
• Foreign direct investment
• Foreign portfolio investment, loans and aid
• Tariffs, quotas, and other non-tariff barriers
• The exchange rate
• Technology transfer

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The Introduction of GovernmentExpenditures and
Taxes

• Government expenditure (public consumption) can
  be treated as an argument in the utility function
• Government can also be treated as an independent
  economic agent, with its own objective function
  and behavioral assumptions
• Government expenditures and public capital stocks
  may affect both the consumption behavior of
  households and production behavior of firms
• Likewise, government taxation may also affect
  both the consumption behavior of households and
  production and investment behavior of firms

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The Introduction of Money and the Financial Sector

• The neutrality of money--the absence of money
  illusion (Is it true?)
• Does indexing have an impact? (it may depend on
  anticipations/expectations)
• The Cash-in-Advance Constraint

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The Possibility of Multiple Equilibria

• Multiple equilibria are possible
• flat indifference surfaces
• rational expectations equilibria
• Rank-ordering multiple equilibria

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The Importance of Sensitivity Analysis

• The robustness of the simulation results must be
  tested with sensitivity analysis

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The Role of UncertaintyIncompleteness of Markets

• Availability of futures markets
• Availability of insurance markets
• Availability of contingent markets