CGE Models: First and Second Generations for Developing Economies

In order to discuss how to incorporate poverty analysis in a CGE model, we need a clear understanding of the structure of CGE models as such. As a first step in understanding the CGE models, we can start with the Walrasian "fundamentalist" approach to general equilibrium. Essentially, the problem here is to find a set of prices (a price vector) that will clear all markets.¹³

The producers maximize profit and the consumers maximize utility. All markets including futures markets must exist and all uncertainty must be subject to actuarial calculation of risk.¹⁴. It is clear that while theoretically elegant and analytically impressive, the conditions in many actual economies do not approximate this theoretical model.

In the Keynesian type macroeconomic models at any rate, there can also be underemployment equilibrium. There is thus a tension between such macroeconomic models and the Walrasian general equilibrium models where full price flexibility ensures full employment at market clearing wage level.

As Robinson (2003) observes:

The literature on CGE models is replete with debates about the macro properties of these models, and a number of different schools of thought have emerged concerning how, or indeed whether, one should incorporate macro features into these SAM-based models. No clear consensus has emerged, which is hardly surprising since the debate really concerns the theoretical dividing line between Walras and Keynes, and the micro foundations of macro models--- or the lack thereof. (p. 1)

It is not relevant here to outline the contours of this debate, except to keep in mind that one of the uses of the fixed price multipliers model discussed in the previous section is to capture the unemployment equilibria under the assumption of excess capacity. I will also review the most significant aspect of the differences among various models which arises often from the choice of different closure rules. However, we need to keep firmly in mind that a CGE model in its origin--- and initial historical development--- is Walrasian in spirit.

At the applied level, a CGE model incorporates all the flow variables that can be captured in a SAM.¹⁵ These include production activities, factorial income distribution and household income distribution among other variables. The importance of both the factorial income distribution and household income distribution for poverty analysis in a CGE model are intuitively obvious. However, proper modelling strategy for these distributions in a CGE model is far from obvious. Later, we will have an occasion to deal with the issues that arise in this context in some concrete examples of CGE models for poverty analysis.

As implied before, the Walrasian spirit of a CGE model is shown in its determination of only relative prices, with some price index being chosen as the numeraire. The model also incorporates the assumption of 'no money illusion'--- all supply and demand equations are homogeneous of degree zero with respect to prices.¹⁶ If all prices are multiplied by a fixed number, the equilibrium quantities do not change at all.

There is also much discussion in the CGE modelling literature about the various "closure rules" for the models. The discussion about macro-closures, initiated by Sen (1963), was revived by Taylor and Lysy (1979) who found that the choice of macro-closure to a large extent affected the policy simulation results obtained with a CGE model. As the previous discussion already indicates, the macroeconomic modelling is forced to depart from the Walrasian assumptions embodied in a "fundamentalist" CGE model. This also leads to the "closure rule problem". Because the short-run macro CGE models do often deviate from the Walrasian closure, a separate literature has grown up around the various alternatives.

There are mainly two ways to interpret and define the closure rule problem. In mathematical terms, the problem boils down to the simple notion that the model should consist of an equal number of equations and endogenous variables. Thus, the closure rule problem is the decision the model builder has to make on which variables are endogenous and which variables are exogenous. Alternatively, if the model is built in the Walrasian tradition and all decisions are based on optimizing behavior, the closure rule problem involves the introduction of macroeconomic constraints that impinge upon the microeconomic behavior of individual agents. One then needs to introduce additional balancing equations. (Ginsburgh and Keyzer, 1997) In general, a closure rule is determined by the theoretical preferences of the model builder and, in her view, empirically the most plausible adjustment processes.

We may recall that starting with Hume and his price-specie flow mechanism, the classically inspired trade theories have implied a trade balance of zero in equilibrium. But in the real world data the trade balance is rarely zero. Does this mean that the equilibrium assumption is somehow violated? The most widely practiced way of handling this nonzero trade balance is to make it exogenous. Typically, trade imbalances find their counterpart in the saving-investment imbalance.

Looked at in this way, trade imbalances can be treated as foreign saving flowing in with a trade deficit, and of savings flowing abroad when trade balance is positive. However, this does raise the question of why people at home or abroad would be willing to save and lend--- a question that can only be answered in an explicitly intertemporal model. Thus, static CGE models which treat trade balance as exogenous are, in fact, compressions at a point in time of a more fully specified intertemporal equilibrium model.

There is also the related issue of how to bring in balance the traded with the nontraded sector, and the domestic economy with the rest of the world. This is done by making flexible another relative price. This is the relative price of traded and nontraded goods, or under the purchasing power parity and small country assumption, the real exchange rate. Naturally, modelers tend to specify an implicit functional relationship between the real exchange rate and the trade balance. Increased flow of foreign savings raises the relative price of nontraded goods which is equivalent to an appreciation of the real exchange rate in these models (Devarajan, Lewis and Robinson, 1993). There is a shift of production away from exports goods producing sectors to nontraded goods and services. Consumers shift demand to cheaper imports and the new trade balance equals the exogenous flow of higher foreign savings.²⁰

This is perhaps a good place to shift our attention from foreign savings to domestic savings and investment, with the role of the government as a key macroeconomic entity. Recall from the previously introduced SAM accounts that the savings-investment account collects savings and spends money on investment goods. The flow equilibrium condition is that savings must equal investment. Some mechanism is clearly needed to achieve this balance, as our previous discussion of the closure rules already indicated.

The common strategy here is to specify savings parameters by household types. These fixed parameters map income to savings. A fairly common (neoclassical) assumption is also to assume that all savings are spent on investment. Thus under this closure rule there is no "paradox of thrift". Either through loanable funds markets or a more direct allocation rule (this is often the case), savings are translated into investment. However, this is not the only way to relate savings and investment, and even here, as the reference to the loanable funds markets hints, the full specification of a 'savings-driven' model on the financial side is often missing. Important questions regarding the saving-investment links need to be raised. These include: why save at all? Why spend on investment rather than on consumption? Who owns the new capital stock? Do actors have and care about an asset portfolio? Introduction of proper dynamics is necessary to answer these and other similar questions.

The question of private savings is also related to that of public savings and dissavings, as the case may be. But the government does more than generating savings or dissavings. It collects taxes, makes transfer payments and purchases goods and services. Through all these activities it can affect the flow of income and consumption of all or some socioeconomic groups. Hence, an intuitive link between government’s actions and poverty is justified. Later, we will see how this link can be made more explicit in a causal sense. For the moment, let us simply observe that in most CGE models government is a rules-based (but not necessarily a utility maximizing) actor. Typically, the monetary side is absent or sketchy. Usually, there is a flow-of-funds specification, but no consideration of how the government finances its deficit. There is simply a crowding out of private investment.

Thus, the trade balance, private saving-investment balance and the public sector balance are all treated in a somewhat ad hoc fashion, but in a way this treatment broadly respects the relative price flexibility in the Walrasian spirit. However, the previous discussion also raises the question of including dynamic considerations explicitly. In particular asset endowments, markets and expectational dynamics may need to be included. Opening up the model in this way, also carries the danger of making it less tractable. This explains why dynamic CGE models to this day are not as well developed as a reasonable theoretical critique would demand. It would seem reasonable, for example, to expect that an 'ecumenical' approach could postulate the possibility of unemployment, informal labor markets, financial markets for various assets and their relation to the real sectors. Such a 'realistic' model could better capture the location and dynamics of poverty among other things. Better policy analysis prospects may be an important motivation for searching for such models.

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