CGE and DSGE Models: Reconciliation? - PowerPoint Presentation

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

2. Introduction: CGE and DSGE modelsComputable General Equilibrium (CGE) modelsMulti-agent, multi-market. Optimizing producers and households interact across product and factor markets to determine equilibrium prices and factor returns. Patron saint: WalrasDynamics: multi-sector growth model. Patron saint: Solow-SwanDynamic Stochastic General Equilibrium (DSGE) modelsDynamic neoclassical growth models with forward-looking optimizing agents. Few agents and markets. Optimal saving behavior. Patron saint: Ramsey2

3. CGE/DSGE: SimilaritiesGeneral equilibrium: simulate operation of commodity and factor marketsEquilibrium conditions are “descriptive” in that they are assumed to describe the results of agent interaction across markets in actual economiesCGE: profit-maximizing producers and utility-maximizing consumers:DSGE: add dynamic optimization with intertemporal utility functions, endogenous savings behavior, and perfect foresight3

4. Descriptive EquilibriaEquilibrium concept: very powerful in an empirical modelDescribes the results of a process that need not be specified in the modelNeed 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 modelBehavioral, theoretical, and statistical validation4

5. Descriptive EquilibriaUse of equilibrium concepts greatly simplifies model specification and, often, solutionEnhances model clarity and transparency: model behavior consistent with economic theoryFacilitates 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 modelModels written as difference equations, but no validation of behavior or dynamic adjustment process5

6. Equilibria: Forward-Looking Dynamic CGE/DSGE ModelsDSGE models—variants of the Ramsey modelSingle household maximizes discounted utilityOptimizes savings rates over timeProducers maximize present value of discounted profitsAll agents have perfect foresightModels specified to have steady-state solutionsMultisectoral dynamic CGE modelsRecursive dynamic models: common, no perfect foresightNeoclassical optimal growth models Roe et al., Multisectoral Growth Models: Theory and ApplicationExistence/stability of steady state solutions6

7. Descriptive Dynamic EquilibriaAre Ramsey/DSGE/rational expectations model equilibria “descriptive”? Specification of agent behavior is not “realistic”.Signals agents see: perfect foresightAgents borrow only for intertemporal smoothingNo uncertainty. No “precautionary” savings motive. Ability to adjust easily: no borrowing constraints (with exceptions)Unemployment only because of distortions in labor/leisure choices by agents (e.g., Prescott)Realism of assumption of steady state growth paths7

8. DSGE ModelsKehoe and Prescott, Great Depressions of the Twentieth Century. Blurb by Thomas Sargent: “Studying this book is an excellent way to learn about how to apply and adapt the optimal growth model to understand the most disturbing of macroeconomic events of the twentieth century, great depressions. The book bristles with intriguing stories, creative ways of expressing them in terms of dynamic equilibrium models, and ambitious attempts to compare them with data.” Is “compare them with data” the same as “validation”? Are they descriptive models? Very stylized models. 8

9. Macroeconomics: KeynesianShort to medium-run focus: widen the domain of applicability of simulation GE simulation Capital “fixed” by sector: Marshallian short runWant to analyze macro “shocks”:Asian and other financial crisesStructural adjustment programs (World Bank)Impact of stabilization programs (IMF)Changes in trade policy: trade warsIssue: Can factors be involuntarily unemployed?Old and new Keynesian models9

10. CGE/DSGE: Macro FlowsAll economywide models include macro aggregates: C, I, G, E, MMacro flow equilibrium in CGE/DSGE models requires: S-I balanceG-T balanceE-M balanceDSGE/CGE models: loanable funds marketConvert financial markets (assets, money) in a macro model into a “shock” on the flow equilibrium in the loanable funds market in the CGE/DSGE model10

11. CGE/DSGE: E-M balanceAll 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 RSpecify R and P, model solves for E-MSpecify R and E-M, model solves for P11

12. Global CGE/DSGE Models: E-M BalanceGlobal CGE/DSGE models determine world prices that clear world markets for commodities and determine real exchange rates that equilibrate trade balancesSame 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 pricesNumeraire choice for countries: P or R are commonGlobal numeraire: $US is common, but also a basket of OECD currenciesChoice matters for “valuing” E-M by countries. They represent a “claim” on the exports of the numeraire countries.12

13. GTAP Model: QuestionsDoes 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 rateIs GTAP using uniform CES elasticities for all countries?13

14. Macro Closure: S-I, G-T, E-MHow to achieve macro balancesWalras Law: determine 2, the 3rd must balanceA K Sen article on macro closure in the 1960sHeated debates in the 1970s in the CGE literatureNeoclassical, Structuralist, Johansen, Keynesian, KaldorianS-I balance: S determines I; I determines SG-T balance: G or T adjust; G-T financed by “borrowing”E-M balance: E-M exogenous, R adjust; R fixed, E-M adjustsIssue: Is there involuntary unemployment?Old and New Keynesian models14

15. Full Employment Closures“Compositional” macroFactor markets clear, ensuring full employment and essentially fixed GDPClosure rules affects macro aggregates (C, I, G, E, and M), but not aggregate GDPWill affect “welfare” if E-M adjusts Absorption (welfare) = GDP + M - E Minimal strain on the neoclassical paradigm, but inadequate for any Keynesian model15

16. Unemployment ClosuresLinks between demand aggregates and real supply (GDP)Must assume non-neoclassical factor markets Must stretch the neoclassical paradigm for a Keynesian modelCommon approach: fix wage/rental rate, model will respond with quantity adjustment on employment/capital utilizationFactor markets do not clear by wages. Two common variants: Firms on demand curve for laborFirms not on demand curve for laborIntroduce a “wage curve” into the CGE modelReduced form, but strong empirical supportUnemployment equilibrium imposed: consistent with Keynesian view16

17. ConclusionKeynesian macro closure is more difficult in a DSGE modelEndogenous optimal saving mechanism makes it difficult to implement a Keynesian multiplier link between aggregate demand and the factor marketsCGE models are more flexible in macro “closure” mechanisms, but DSGE models are catching upBoth CGE and DSGE models involve “flow” equilibria in macro balances, less treatment of asset marketEssentially a flow-of-funds modelStandard CGE models do not take account of asset holdings of various agents. “Financial” CGE models do.More asset “action” in DSGE models? 17

18. “Financial” CGE ModelsCGE model as the core “supply side” in a broader financial macro modelNeed to have many sectors in order to analyze issues of structural adjustment and trade shocksExchange rate and trade balance shocksInternational price shocks (e.g., Oil)Different modeling philosophies in the same neoclassical theoretical frameworkImplicit in DSGE models, which neglect the financial side18

19. Orthodox School“There is only one Model, and its prophet is Walras” The Walrasian model is truth and should not be corrupted to analyze macro issuesStick to relative prices, resource allocation, and full employment in the long runYale: Srinivasan, Kehoe, WhalleySchizophrenia with DSGE models: neoclassical growth model with a few features to incorporate macro concerns19

20. Eclectic SchoolIntegrate financial variables and asset markets into neoclassical Walrasian CGE model. Draw from all schoolsState of the art in CGE models:Bourguignon, Branson, and de Melo McKibbin-Sachs and McKibbin-WilcoxenAgénor (World Bank, Manchester)All incorporate a standard CGE model (e.g., the 1-2-3 model) to specify the supply side of a macro model20

21. Ecumenical School: A Modular Approach“Render unto Walras the things which are Walras’, and unto Keynes the things which are Keynes’.”Separate real and financial models, CGE and macro models Specify each model in its own theoretical frameworkThe issue is to link the modelsVariables exogenous in one model are endogenous in the otherNeed to have the CGE model incorporate the results of the macro model 21

22. Ecumenical School: A Modular ApproachBuild two models: A modular approachCGE supply-side modelMacroeconomic modelFormally link the models:Robinson/Tyson.Dixon et al.Clean division between the modelsLinks to force consistency between macro and CGE models22

23. Ecumenical SchoolProblems.Same agents in both models doing very different things:E.g., savings as flow equilibrium versus asset allocation equilibriumSome variables jointly determined, with potential conflicts (e.g, exchange rate) Schizophrenia shared by literature on micro foundations of macro.Still no fundamental reconciliation23

24. Macro Closure Approach: Implement ModularityTell the macro story outside the CGE model.Explicit macro-econometric modelMacro “story”: informal specification of a macro model Impose the results on the CGE model. No money, assets, or financial variables in the CGE model. Define “macro closure” rules to ensure macro flow equilibrium in the CGE model24

25. ReferencesBrenner, T. and C. Werker (2007). “A Taxonomy of Inference in Simulation Models.” Computational Economics, Vol. 30, pp 227-244.Edmonds, B. and S. Moss (2004). “From KISS to KIDS—an ‘Anti-Simplistic’ Modelling Approach. International Workshop on Multi-Agent Systems and Agent Based Simulation. Springer Berlin/Heidelberg, pp. 130-144.Gintis, Herbert (2007). “The Dynamics of General Equilibrium.” The Economic Journal, Vol. 117, No. 523, pp 1280-1309. Gintis, Herbert (2009). The Bounds of Reason: Game Theory and the Unification of the Behavioral Sciences. Princeton: Princeton University Press, Second edition.25

26. ReferencesGintis, Herbert (2000). Game Theory Evolving: A Problem-Centered Introduction to Modeling Strategic Interaction. Princeton, NJ: Princeton University Press.Kehoe, Timothy and Edward C. Prescott, eds. (2007). Great Depressions of the Twentieth Century. Federal Reserve Bank of Minneapolis. Peters, Ole (2019). “The ergodicity problem in economics.” Nature Physics, Vol. 15 (December), pp 1216-1221.26

27. ReferencesPyka, Andreas and Claudia Werker (2009). “The Methodology of Simulation Models: Chances and Risks.” Journal of Artificial Societies and Social Simulation,” Vol. 12, No. 4, p 1. Robinson, Sherman. 1989. “Multisectoral Models.” Chapter 18, in Handbook of Development Economics. H. Chenery and T.N. Srinivasan (eds.). Amsterdam: North-Holland Publishing Co, pp. 885-947. Robinson, Sherman. 2006 . “Macro Models and Multipliers: Leontief, Stone, Keynes, and CGE Models.” Chapter 11 in Alain de Janvry and Ravi Kanbur, eds. Poverty, Inequality and Development: Essays in Honor of Erik Thorbecke. New York: Springer Science, pp. 205-232.27

28. ReferencesRobinson, Sherman. 1991. “Macroeconomics, Financial Variables, and Computable General Equilibrium Models.” World Development. Vol. 19, No. 11, pp. 1509-1525. Weisberg, Michael (2013). Simulation and Similarity: Using Models to Understand the World. Oxford: Oxford University Press. Devarajan, Shantayanan, Jeffrey D. Lewis, and Sherman Robinson. 1993. “External Shocks, Purchasing Power Parity, and the Equilibrium Real Exchange Rate.” World Bank Economic Review. Vol. 7, No. 1, pp. 45-63. 28