Economics 216 The Macroeconomics of Economic Development

1. 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: 1-650-723-3708; Fax: 1-650-723-7145 Email: ljlau@stanford.edu; Website: www.stanford.edu/~ljlau

2. 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

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 Equations Lawrence J. Lau, Stanford University

12. General Equilibrium 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 Lawrence J. Lau, Stanford University