CGE and DSGE Models Reconciliation Sherman Robinson Peterson

CGE and DSGE Models: Reconciliation? Sherman Robinson Peterson Institute For International Economics (PIIE) PIIE-UCB Macro Workshop, February 2020

Introduction: CGE and DSGE models • Computable General Equilibrium (CGE) models • Multi-agent, multi-market. Optimizing producers and households interact across product and factor markets to determine equilibrium prices and factor returns. Patron saint: Walras • Dynamics: multi-sector growth model. Patron saint: Solow-Swan • Dynamic Stochastic General Equilibrium (DSGE) models • Dynamic neoclassical growth models with forward-looking optimizing agents. Few agents and markets. • Optimal saving behavior. Patron saint: Ramsey 2

CGE/DSGE: Similarities • General equilibrium: simulate operation of commodity and factor markets • Equilibrium conditions are “descriptive” in that they are assumed to describe the results of agent interaction across markets in actual economies • CGE: profit-maximizing producers and utility-maximizing consumers: • DSGE: add dynamic optimization with intertemporal utility functions, endogenous savings behavior, and perfect foresight 3

Descriptive Equilibria • Equilibrium concept: very powerful in an empirical model • Describes the results of a process that need not be specified in the model • Need not describe or specify disequilibrium behavior. Need only solve for equilibrium. • Need not discuss how individual agents interact to achieve equilibrium • “Descriptive” if it can be validated empirically for the domain of applicability of the model • Behavioral, theoretical, and statistical validation 4

Descriptive Equilibria • Use of equilibrium concepts greatly simplifies model specification and, often, solution • Enhances model clarity and transparency: model behavior consistent with economic theory • Facilitates validation: “predictable” empirical results from “shocks” • Compare with “System Dynamics” models that specify “rules of motion” but no equilibrium—very hard to tell what is going on or to validate the model • Models written as difference equations, but no validation of behavior or dynamic adjustment process 5

Equilibria: Forward-Looking Dynamic CGE/DSGE Models • DSGE models—variants of the Ramsey model • Single household maximizes discounted utility • Optimizes savings rates over time • Producers maximize present value of discounted profits • All agents have perfect foresight • Models specified to have steady-state solutions • Multisectoral dynamic CGE models • Recursive dynamic models: common, no perfect foresight • Neoclassical optimal growth models • Roe et al. , Multisectoral Growth Models: Theory and Application • Existence/stability of steady state solutions 6

Macroeconomics: Keynesian • Short to medium-run focus: widen the domain of applicability of simulation GE simulation • Capital “fixed” by sector: Marshallian short run • Want to analyze macro “shocks”: • • Asian and other financial crises Structural adjustment programs (World Bank) Impact of stabilization programs (IMF) Changes in trade policy: trade wars • Issue: Can factors be involuntarily unemployed? • Old and new Keynesian models 9

CGE/DSGE: Macro Flows • All economywide models include macro aggregates: • C, I, G, E, M • Macro flow equilibrium in CGE/DSGE models requires: • S-I balance • G-T balance • E-M balance • DSGE/CGE models: loanable funds market • Convert financial markets (assets, money) in a macro model into a “shock” on the flow equilibrium in the loanable funds market in the CGE/DSGE model 10

CGE/DSGE: E-M balance • All trade focused CGE/DSGE models have a functional relationship between the trade balance (E-M) and the real exchange rate (relative price of traded/non-traded goods) • Armington specification implies that all goods are imperfectly tradable, so “non-traded” share is large (D = GDP – E). • In practice, CGE/DSGE models will solve for 2 out of 3 variables: trade balance (E-M), “nominal” exchange rate (EXR), and an anchor price index (P). • Specify (E-M) and P, model solves for R • Specify R and P, model solves for E-M • Specify R and E-M, model solves for P 11

Global CGE/DSGE Models: E-M Balance • Global CGE/DSGE models determine world prices that clear world markets for commodities and determine real exchange rates that equilibrate trade balances • Same mechanisms as in single-country models, but addition of a global clearing requirement: Sum of E-M globally must be 0. • All CGE/DSGE models are Walrasian: only relative prices • Numeraire choice for countries: P or R are common • Global numeraire: $US is common, but also a basket of OECD currencies • Choice matters for “valuing” E-M by countries. They represent a “claim” on the exports of the numeraire countries. 12

GTAP Model: Questions • Does the GTAP model use CET functions for export supply? This is an extension of Armington in CGE models. • Are the national trade balances (E – M) endogenous or fixed? A standard version of GTAP endogenizes international capital flows, and hence the trade balances. • What are the national numeraires? A version of GTAP uses a wage as the national numeraire (which is Keynes in the General Theory, but odd in CGE models). • Issue of defining the real exchange rate • Is GTAP using uniform CES elasticities for all countries? 13

Macro Closure: S-I, G-T, E-M • How to achieve macro balances • Walras Law: determine 2, the 3 rd must balance • A K Sen article on macro closure in the 1960 s • Heated debates in the 1970 s in the CGE literature • • Neoclassical, Structuralist, Johansen, Keynesian, Kaldorian S-I balance: S determines I; I determines S G-T balance: G or T adjust; G-T financed by “borrowing” E-M balance: E-M exogenous, R adjust; R fixed, E-M adjusts • Issue: Is there involuntary unemployment? • Old and New Keynesian models 14

Full Employment Closures • “Compositional” macro • Factor markets clear, ensuring full employment and essentially fixed GDP • Closure rules affects macro aggregates (C, I, G, E, and M), but not aggregate GDP • Will affect “welfare” if E-M adjusts • Absorption (welfare) = GDP + M - E • Minimal strain on the neoclassical paradigm, but inadequate for any Keynesian model 15

Unemployment Closures • Links between demand aggregates and real supply (GDP) • Must assume non-neoclassical factor markets • Must stretch the neoclassical paradigm for a Keynesian model • Common approach: fix wage/rental rate, model will respond with quantity adjustment on employment/capital utilization • Factor markets do not clear by wages. Two common variants: • Firms on demand curve for labor • Firms not on demand curve for labor • Introduce a “wage curve” into the CGE model • Reduced form, but strong empirical support • Unemployment equilibrium imposed: consistent with Keynesian view 16

Conclusion • Keynesian macro closure is more difficult in a DSGE model • Endogenous optimal saving mechanism makes it difficult to implement a Keynesian multiplier link between aggregate demand the factor markets • CGE models are more flexible in macro “closure” mechanisms, but DSGE models are catching up • Both CGE and DSGE models involve “flow” equilibria in macro balances, less treatment of asset market • Essentially a flow-of-funds model • Standard CGE models do not take account of asset holdings of various agents. “Financial” CGE models do. • More asset “action” in DSGE models? 17