Since the equivalent of the penicillin, or the more modest aspirin, has yet to be discovered in economics, people find much room for intellectual and friendly speculation on how the economy—as our social body—can be put under our firm control. As economists we are usually interested in how production is organized and in how whatever is produced is eventually distributed among consumers.
All these activities take place within specific institutions we know as markets.
Applied General Equilibrium | kycimaqaho.gq
It is common to distinguish two large and distinct groups of agents—households and firms. Each of these groups plays a different role in the marketplace and in the whole economic system as well, depending on the particular type of commodity being traded. The model we describe in this chapter is a skeleton model upon which more in depth specifications will be developed later.
Our purpose is to lay out in a very transparent way the main structure of the basic model and we do so by omitting almost all the details that would play a significant role in dealing with real life policy applications. The simple model corresponds to an economy with no government and no foreign trade. The absence of government means that no economic activity is taxed and no government spending is allowed.
In a similar vein, all goods are produced and consumed within the country with no domestic goods being diverted abroad as exports and no foreign goods being hauled into the country as imports. The only economic agents are households or consumers and firms or producers. The simple model outlined in the previous chapter is now going to be adapted to incorporate a government sector.
In the world of model-building, it becomes imperative to simplify the full range of economic activities undertaken by the government if we want to keep the model under development at a tractable level.
For this reason we will consider the government taking two basic types of decisions, the first one regarding the level and composition of taxation, the second one dealing with its expenditure and transfers program. Taxes will affect consumers and producers plans by modifying the prices they face—via indirect taxes—and their disposable income—both through indirect and direct taxes. On the other hand, government spending will modify final demand faced by firms either through its direct purchase of goods and services or by the induced changes in consumption demand resulting from transferring income to households.
In an economy with fixed resources, however, the activities of the government have an unmistakably re-distributive flavor.
Income is extracted from the private sector and then poured back in a different mix. Whether these activities promote welfare, or not, is an issue that numerical general equilibrium can suitably address. The basic model we have thus far developed offers a comprehensive view of the resource allocation process in a closed economy with or without a government sector. These settings, valuable as they are as learning devices, are nonetheless restricted as far as actual policy applications are concerned. We need to further elaborate the model structure and we will do so next by introducing an external sector—hence opening the economy to trading partners—and by allowing some domestic resources, most notably labor, to remain partly unused.
These are two phenomena that cannot be ignored in any economy-wide modeling exercise that wants to be capable of handling real-world issues.
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Finally, we will discuss a limitation of the present version of the model which is more of an empirical and data related nature and has to do with the fact that the goods demanded by households may not correspond to the goods produced by firms. In Chaps.
Starting with the standard textbook version of a private, closed economy we showed how the different pieces of the model interact with each other to give rise to a system of equations that capture and describe market equilibrium. The addition of the government and the external sector, as well as the modification of the labor market to allow for unemployment, provided a more realistic picture of an actual economy and laid the grounds for the study of various policy issues.
CGE models are based on macro balancing equations, and use an equal number of equations based on the standard macro balancing equations and unknowns solvable as simultaneous equations, where exogenous variables are changed outside the model, to give the endogenous results.
Applied General Equilibrium
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