Economics 216 The Macroeconomics of Economic Development

Economics 216The Macroeconomics ofEconomic Development

Lawrence J. Lau, Ph. D.

Kwoh-Ting Li Professor of Economic DevelopmentDepartment of Economics

Stanford UniversityStanford, CA 94305-6072, U.S.A.

Winter, 1999-2000

Phone: 1-650-723-3708; Fax: 1-650-723-7145Email: [email protected]; Website: www.stanford.edu/~ljlau

Lecture 15Applied General Equilibrium Models

Lawrence J. Lau, Ph. D.

Kwoh-Ting Li Professor of Economic DevelopmentDepartment of Economics

Stanford UniversityStanford, CA 94305-6072, U.S.A.

Winter, 1999-2000

Lawrence J. Lau, Stanford University 3

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

Lawrence J. Lau, Stanford University 4

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

Lawrence J. Lau, Stanford University 5

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

Lawrence J. Lau, Stanford University 6

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

Lawrence J. Lau, Stanford University 7

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

Lawrence J. Lau, Stanford University 8

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

Lawrence J. Lau, Stanford University 9

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

Lawrence J. Lau, Stanford University 10

Specification There is no government, no external sector, no money and

no financial sector

Lawrence J. Lau, Stanford University 11

The Simplest System of EquationsHouseholds

Demand for consumption = DC (r*, w*, K-1, SS)

Supply of labor = SL (r*, w*, K-1, SS)

Supply of savings = SS (exogenously given)

Firms

Demand for capital = DK (r*, w*)

Demand for labor = DL (r*, w*)

Supply of output = SO (r*, w*)

Lawrence J. Lau, Stanford University 12

General Equilibrium

General Equilibrium

Demand for capital = DK (r*, w*) = Supply of capital = K-1

Demand for labor =DL (r*, w*)=Supply of labor= SL (r*, w*, K-1, SS)

Supply of output = SO (r*, w*) = Demand for consumption+Savings

= DC (r*, w*, K-1, SS) + SS

Lawrence J. Lau, Stanford University 13

Determination of the Parameters:Calibration 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

Lawrence J. Lau, Stanford University 14

Solution of the Model:The Choice of Algorithms Fixed point algorithms (Scarf)

Lawrence J. Lau, Stanford University 15

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)

Lawrence J. Lau, Stanford University 16

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)

Lawrence J. Lau, Stanford University 17

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

Lawrence J. Lau, Stanford University 18

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

Lawrence J. Lau, Stanford University 19

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

Lawrence J. Lau, Stanford University 20

The Introduction of Government:Expenditures 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

Lawrence J. Lau, Stanford University 21

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

Lawrence J. Lau, Stanford University 22

The Possibility of Multiple Equilibria Multiple equilibria are possible

“flat” indifference surfaces rational expectations equilibria

Rank-ordering multiple equilibria

Lawrence J. Lau, Stanford University 23

The Importance of Sensitivity Analysis The robustness of the simulation results must be tested

with sensitivity analysis

Lawrence J. Lau, Stanford University 24

The Role of Uncertainty:Incompleteness of Markets Availability of futures markets Availability of insurance markets Availability of contingent markets