Model Based Policy Analysis (Subject) / 3. Simulation models for policy analysis (Lesson)
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Why do we need economic simulation model? what are basic concepts and model elements? What kinds of models are there?
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 Why do we need economic simulation models? 1. we need economic simulation models tounderstand the mechanisms and linkages through which a policy measure affects the local, national and global economy on the microeconomic level (housholds & firms > income & profit) as well as on the macroeconomic level (GDP, output, trade) 2. policy simulation studies are used to inform policy makers, NGOs, academics, and other stakeholders about potential policy impacts 3. Policy makers can participate in forming simulation models 4. support of making economic policies 5. economic simulation model are a distillation of economic theory. That is why they make sure that policy making is guided by a correct understanding of how economies function 6. ESM enable us to evaluate different policy measures in a theoretically consitant, rigorous and quantitative way 7. ESM can confirm existing insights by providing an estimate of the likely gains of a policy measure 8. ESM can alert to unintended policy consequences
 What is an economic model? Simplified representation of an economic system, theory or real world phenomenon Abstract of the complexities of real world à capture the essentials of economic activity general assumptions: 1. ceteris paribus assumption: things outside the model do not change in the period of the study 2. optimization assumption: utility and profit maximization of economic agents Important: distinction between positive and normative analysis: description of what is versus how it should be
 What types of economic models are there? 1. Analytical/mathematical models: System of equations to solve for endogenous variables E.g. simple market equilibrium: supply and demand equation à supply= demand defines the market equilibrium 2. Empirical econometric models: Usually ex post, but can also be used for predictions Consider current behavior as a continuation of past behavior Use statistical methods for parameter estimation Computed with statistical software 3. Simulation: mathematical programming models: Exante policy analysis Emulate behavior of economic agents (consumers, producers) based on economic theory Standard assumptions: welfare maximization of economic agents (e.g. utility, profit), constant return to scales, perfect competition Computed with algebraic software
 What do policy simulation models consist of? And what do they do? 1. mathematical equations (including behavioral assumptions) based on economic theory and empirical knowledge 2. realworld data to which these equations are calibrated policy simulation models... ...simulate the effect of changes in exogenous variables ...explain the behavior of endogenous variables ...simulate policy scenarios and are compared to a baseline without any policy shock
 Explain how simualtion models can vary over scale, space and time horizon 1. Scale: a) Single economic agents vs. economy b) Optimization vs. equilibrium models > Optimization: maximization of utility/profits or minimization of costs by single economic agents, e.g. production decision of firm or consumption decision of household > Equilibrium: solve market equilibrium considering optimization of multiple agents. Types: Partial equilibrium model, general equilibrium model, farmhousehold model 2. Space: single region, multiregion, global 3. Time horizon (dynamics): a) Comparative static model: no time dimensions: period t and t+1, ony observe economy in a base year and after a new equilibrium is reached after a policy shock b) recursve dynamic model: includes a time dimension à model is solved annually where each year builds on the results of the previous year, includes assumptions over the future development of exogenous variables (e.g. technological change, population growth) Keep in mind: The larger the scale and space of a model, the more aggregated it becomes: National CGE: have on average 20 represantative households Global CGE: usually model one representative houshod per region
 What is a farmhousehold model? Give an example. Single household model, that models the simultaneous production and consumption decision of farm households when there is no separability, e.g. in the case of imperfect factor markets Example: o Maximization of a family farm’s income o Production of maize and sugarcane, subject to the following constraints: Land, labor, irrigation water o Calibrated by data about yield, land/labor/water requirements o Implementation of a biofuel subsidy for sugarcane
 What is a partial equilibrium model? Give an example. Model of one market (e.g. market for wheat), or multimarket model (e.g. the agricultural sector with markets for wheat, maize, corn etc.)  No or partial factor markets  Very flexible and detailed  Used when only interested in a specific market or sector Example: o Equilibrium price and quantities of a commodity in each region/world o Demand and supply function, subject to the following constraints:  Elasticity of demand and supply  Initial values of demand and supply o Calibration by data about intercept and slope of the functions, initial values, elasticities o Implementation of an import tariff
 What is a general equilibrium model?  model of the whole economy including all sectors and agents  sectors are linked via factor and commodity markets  Macroeconomic closures ensure consistency of microeconomic decisions with macroeconomic aggregates (e.g. exchange rate, savings and investment)  Used when interested in policy impacts on the whole economy, especially welfare impacts  Exists on different levels: national, regional, global  The economic and social linkages through which a policy measure affects the economy are considered, whereas ecological links are outside the markets and cannot be depicted in a CGE  Depicts the complete circular flow of income in an economy
 What are essential features of a CGE model? 1. Theoretical foundation: simultaneous equations that depict the behavior of economic agents based on Walrasian general equilibrium theory. 2. Data base: comprehensive and consistent data set, social accounting matrix (SAM)
 Explain the Walrasian General Equilibrium Theory.  buttom up approach  individual welfare maximization behavior of producers and households determines the aggregated macroeconomic outcome 1. Producers perform production activities that convert inputs into outputs maximize their profits depend on prices of all intermediate inputs, factors and outputs 2. Households sell own production factors such as labor, land and capital in order to buy commodities for consumption choose an affordable and utility maximizing bundle of commodities subject to their factor endowment and preferences > depends on price of commodity and the factor's owned > Equilibrium when there is a balance of supply and demand at all factor and product markets > equilibrium is induced by price mechanism  allocation is optimal and Paretoefficient  equilibrium: total demand = total amount produced, all factors available being employed in production
 What are the assumptions/elements that define a CGE model? How are the elements set up? 1. Behavioral equations a) System of linear and nonlinear equations: includes production functions that define production technologies and demand systems that define behavior of households b) Foreign trade: is modeled endogenously, goods of foreign origin being imperfect substitutes of domestic goods 2. Closure rules a) government closure: government tax income= expenditure b) Savingsinvestmen closure: savings= investments c) Numeraire: money is neutral, price index is chosen as numeraire (CPI) d) Commodity market balance: goods produced= goods consumed > no storage! e) Factor balance: determines supply and mobility of production factors. Factors can be fully employed and move from sector to sector. Demand for a factor= supply of a factor f) Balance of payments closure: regulates the current account (terms of trade) by a flexible exchange rate > neutral trade balance and neutral net factor income: total exports = total value imports g) In addition: aggregated market clearing equations provide for equilibrium on all markets and endogenously solve for prices Set up of the elements 1. Production block (+trade) 2. Price block: links producer prices to consumer prices (with taxes) and foreign to domestic goods 3. Institutions block: houselholds, enterprises, government, rest of the world (ROW) 4. System constraint block: closure rules
 What is a social accounting matrix and what do we need it for?  Heart of the model  Encompasses all income and expenditure flows of a particular year between ALL economic agents  SAM represents commodities and activities in detail  data sources for a SAM are: inputoutput tables, household surveys, government statistics etc.  total expenditures = total income  organized in a square matrix: rows list the income, whereas colums list the expenditures: A columns total must equal its respective row total Examples: C2: Commodities (domestic supply, sales taxes and import tariffs, import payments contribute to total supply) R2: commodities (intermediate demand, consumption spending, recurrent spending, investment demand, export earnings determine total demand of commocities) > total supply = total demand C1 = R1: Gross output = activity income C3 = R3: total factor income = total factor spending C4= R4: total household spending = total household income C5= R5: government expenditure = government income C6 = R6: total investment spending = total savings C7 = R7: foreign exchange inflow = foreign exchange outflow > SAM adds numbers to the closure rules!  a disaggregation of the different elements is possible
 What are basic model elements? 1. mathematical equations 2. Variables 3. Parameters 4. Data 5. Data sources
 Define mathematical equations s basic elements of a model.  System of equations with mathematical functions that explain behavior of economic agents and aggregates based on economic theory and empirical knowledge  Supply and producer behavior: Production functions, such as CobbDouglas, Leontief, CES (constant elasticity of substitution)  Demand and consumer behavior: consumption functions, such as CobbDouglas, StoneGeary, CDE (constant difference of elasticities)  Macroeconomic aggregates: identities like savings = investment, market clearing or flexible exchange rate to balance the current account  Equations consist of variables and parameters
 Define variables as basic elements of a model. 1. Endogenous variables: decision or outcome variables that are determined by solving the model 2. Exogenous variables: (policy) variables that are determined outside the model The larger the model, the more variables become endogenous, e.g. prices are endogenous in CGE models but exogenous in farm models o Farm/Household level: exogenous(prices, factor endowment), endogenous (farm output, farm income, farm consumption) o Sector level: exogenous (factor endowments, elasticities, policies), endogenous (prices, production, consumption) o national/global level: exogenous (factor endowments, elasticities, policies, macroeconomic variables), endogenous (prices, production, consumption, trade, income, growth)
 Explain Parameters as basic elements of a model. Parameters are always exogenous to the model and remain constant in the simulations They determine the behavior of mathematical functions by defining the direction and intensity of linkages between variables Functions are calibrated to these parameters Examples: substitution elasticity between different inputs, income elasticity of demand with respect to different products Sources: optimally empirical estimation, but often just plausibility considerations of lucky guesses Parameters have a vital influence on final model result and thus require sensitivity analysis

 Explain Data as a basic element of a model. "Initialization" and calibration of all variables and parameters to real world data initialization: exogenous and endogenous variables need initial values for the base year Calibration: equations are calibrated to parameter values kinds of data used Depending on the type of model typical variable data includes: values/quantities for output, consumption and/or prices Typical parameter data: inputoutput coefficients for production, substitution, trade and income elasticities Keep in mind: The larger the model, the more data is needed: e.g. CGE models require social accounting matrix (SAM) containing all income and expenditure flows in a country in a given year
 Explain data sources as a basic element of models. sources national accounts providing information (e.g. on total output, balance of payments and trade from statistical offices e.g. EUROSTAT (nationally representative) household surveys that provide information on consumption expenditure and factor endowments Government statistics for taxes and transfers For policies, new products, future global developments (climate change, population growth) more diverse data sources, e.g. market reports, expert knowledge, OECD projections, biophysical model outcomes (e.g. climate models, crop models), plausibility assumptions organization and formation Inputoutput tables that capture production linkages between different sectors and factors: often needed to be built from scratch through economic surveys and third party data
 What is GAMS? GAMS= General Algebraic Modeling System allows to formulate mathematical models in a way that is very similar to their mathematical description language is formally similar to common programming languages separation of logic: optimization problem independently of the data allows to build large maintainable models that can be increased in size without causing an increase in the complexity