Computable general equilibrium

What Is Computable General Equilibrium?

Computable general equilibrium (CGE) is a class of economic models used to analyze how various shocks or policy changes affect an entire economy. As a core element of economic modeling and policy analysis, CGE models simulate the complex interactions between different sectors, households, and the government within an economy. They are "computable" because they are designed to be solved numerically, providing quantitative estimates of economic outcomes, and "general equilibrium" because they aim to capture the equilibrium across all markets simultaneously, unlike partial equilibrium models that focus on a single market in isolation. A computable general equilibrium model achieves this by ensuring that demand and supply are balanced in all interconnected markets, including goods, services, labor, and capital⁸.

History and Origin

The conceptual foundations of computable general equilibrium models are rooted in general equilibrium theory, which posits that all markets in an economy are interconnected and influence each other. While the theoretical framework dates back to Léon Walras in the late 19th century, the practical application and development of CGE models began in earnest in the mid-20th century. A pivotal moment in the history of CGE modeling was the work of Norwegian economist Leif Johansen, who in 1960 published "A Multi-Sectoral Study of Economic Growth." This pioneering work is widely recognized as the first operational computable general equilibrium model, calibrated to the Norwegian economy of 1950.⁷ Johansen's model integrated concepts like input-output analysis with elements of neoclassical theory, laying the groundwork for the modern CGE framework.

Key Takeaways

• Computable general equilibrium (CGE) models analyze economy-wide effects of policy changes or external shocks.
• CGE models simulate simultaneous interactions across all markets, including goods, services, labor, and capital.
• They are quantitative tools used by governments and academic institutions for policy assessment.
• CGE models require extensive data, typically organized into a social accounting matrix.
• Their strength lies in capturing indirect and economy-wide impacts, such as intersectoral linkages and resource reallocation.

Formula and Calculation

A computable general equilibrium model is not defined by a single formula but rather by a system of simultaneous equations that describe the behavior of economic agents and the structure of the economy. These equations include:

• Production functions: These describe how factors of production (e.g., labor, capital) are transformed into goods and services by firms. For example, a common specification is the Constant Elasticity of Substitution (CES) production function:
  $Q = A \left[ \alpha K^{-\rho} + (1-\alpha) L^{-\rho} \right]^{-\frac{1}{\rho}}$
  Where:

  • ( Q ) = Output
  • ( A ) = Total Factor Productivity (TFP)
  • ( K ) = Capital input
  • ( L ) = Labor input
  • ( \alpha ) = Distribution parameter (share of capital in production)
  • ( \rho ) = Substitution parameter (related to elasticity of substitution)

• Utility functions: These represent how households derive satisfaction from consuming goods and services, influencing their demand patterns.

• Market clearing conditions: These ensure that supply equals demand for every good, service, and factor in the economy, determining market prices.

• Government accounts: Equations detailing taxes, government spending, and budget balances.

• External sector accounts: Equations covering trade and capital flows between the domestic economy and the rest of the world.

The process of populating the model with specific numerical values for parameters (e.g., elasticities, shares) is known as calibration. This involves using a base year's economic data, often organized in a Social Accounting Matrix (SAM), to ensure the model accurately replicates the initial state of the economy.⁶ Once calibrated, the model can be used to simulate policy changes or external shocks by altering relevant exogenous variables and computing a new equilibrium.

Interpreting the Computable General Equilibrium

Interpreting the results of a computable general equilibrium (CGE) model involves understanding how a simulated policy change or external shock propagates through the interconnected markets of an economy. Unlike simpler microeconomic or macroeconomic analyses that might focus on direct impacts, CGE models reveal both direct and indirect effects. For example, a change in trade policy might directly affect import prices, but a CGE model can also show how this impacts domestic industries, employment, wages, investment, and even household consumption patterns as resources reallocate across sectors.

Analysts typically compare the model's "counterfactual" results (the economy after the simulated change) against a "benchmark" or "baseline" scenario (the economy without the change).⁵ The differences highlight the estimated economic consequences. Key outputs to interpret include changes in:

• Gross Domestic Product (GDP): Overall economic output.
• Sectoral output and employment: How specific industries and their workforce are affected.
• Household income and consumption: The impact on different income groups and their purchasing power.
• Trade balances: Changes in exports and imports.
• Government revenues and expenditures: Fiscal implications of policies.

The results are presented as percentage changes or absolute values relative to the baseline, providing a comprehensive picture of the economy's adjustment to a new equilibrium.

Hypothetical Example

Consider a hypothetical country, "Diversifica," that implements a new fiscal policy involving a significant increase in carbon taxes on its manufacturing sector to fund green energy subsidies. A computable general equilibrium model could be used to analyze the economy-wide impacts.

1. Baseline Scenario: The CGE model is first calibrated to represent Diversifica's economy in the current year, including its existing production structure, household consumption, trade patterns, and government finances.
2. Policy Shock: The carbon tax is introduced as an exogenous shock in the model, increasing production costs for manufacturing firms, and simultaneously, the green energy subsidies are applied.
3. Model Simulation: The CGE model solves for a new equilibrium where all markets adjust. This involves:
   • Manufacturing firms might reduce output or shift production methods to lower carbon emissions, potentially leading to job losses or wage changes in that sector.
   • Consumers might face higher prices for manufactured goods.
   • The green energy sector expands due to subsidies, attracting labor and capital from other sectors.
   • Government revenue from carbon taxes increases, which is then re-circulated through subsidies.
   • Overall GDP, trade balances, and household incomes adjust to these shifts.
4. Result Interpretation: The model's output would show, for example, that while the manufacturing sector contracts by 2% and loses 1% of its workforce, the green energy sector expands by 5% and gains 0.5% of the national workforce. Overall, GDP might slightly decline or increase depending on the efficiency gains from green energy and the severity of the carbon tax. The model also calculates the net effect on government revenue and the country's overall carbon emissions, providing policymakers with a quantitative basis for evaluating the policy's effectiveness and its broader economic trade-offs.

Practical Applications

Computable general equilibrium (CGE) models are widely applied by governments, international organizations, and academic institutions to analyze various economic policies and external shocks. Their ability to capture economy-wide interdependencies makes them invaluable for complex policy assessments.

• Trade Policy Analysis: CGE models are extensively used to evaluate the economic impact of trade agreements, tariffs, quotas, and other trade barriers. For instance, the USITC CGE Model is employed by the U.S. International Trade Commission to analyze the economy-wide effects of U.S. commercial policy, including import restraints and free trade agreements.⁴
• Environmental and Climate Policy: They are crucial for assessing the economic costs and benefits of policies related to climate change, carbon taxes, emissions trading schemes, and renewable energy subsidies. The IMF-ENV model, developed by the International Monetary Fund, is a global dynamic CGE model used to examine the macroeconomic and structural shifts arising from climate mitigation and energy policies.³
• Taxation and Fiscal Reform: Governments use CGE models to project the effects of changes in tax rates, subsidies, and government spending on income distribution, consumption, investment, and sectoral output.
• Development Economics: In developing countries, CGE models can analyze the impact of structural adjustment programs, foreign aid, and agricultural policies on poverty, income inequality, and economic growth.
• Labor Market Analysis: They can simulate the effects of minimum wage changes, immigration policies, or skill development programs on employment levels, wages, and labor reallocation across sectors.

These applications provide policymakers with comprehensive insights into the potential ripple effects of their decisions across the entire economy.

Limitations and Criticisms

Despite their widespread use, computable general equilibrium (CGE) models have several limitations and have faced criticisms.

• Data Intensive and Complexity: Building a comprehensive CGE model requires a vast amount of detailed, consistent data, particularly a well-constructed social accounting matrix. Data limitations can constrain the model's accuracy and sectoral detail. The complexity of the models can also make them difficult to understand and interpret for non-specialists.
• Assumption Sensitivity: CGE models rely heavily on numerous assumptions about economic behavior, functional forms (e.g., production functions, utility functions), and parameter values (elasticities). The choice of these assumptions can significantly influence results. Different assumptions can lead to different policy conclusions, and the models are often sensitive to the calibrated parameters.²
• Neoclassical Foundations: Most CGE models are rooted in neoclassical economic theory, assuming perfect competition, rational agents, and full employment of resources in the long run. These assumptions may not always hold true in real-world economies, particularly in the short run or during periods of market failures or significant unemployment.
• Short-Term Dynamics: CGE models are generally better suited for analyzing medium- to long-term effects of policies and structural changes rather than short-term macroeconomic fluctuations. They typically do not capture business cycles, monetary policy effects, or financial market dynamics.¹
• Policy Endogeneity: CGE models often treat policies as exogenous shocks, meaning they don't account for how policies might be influenced by economic outcomes or political processes.
• Forecasting vs. Simulation: CGE models are primarily simulation tools used for "what-if" analysis rather than precise forecasting. They show how the economy might respond to a change, given the model's structure and assumptions, rather than predicting exact future states.

These limitations underscore the importance of using CGE model results as one input among many in the policymaking process, alongside other analytical tools and expert judgment.

Computable General Equilibrium vs. Macroeconomic Modeling

While computable general equilibrium (CGE) is a form of macroeconomic modeling, the terms are not interchangeable, and there are key distinctions in their scope and methodology.

In essence, CGE models represent a specific, highly detailed, and interlinked approach within the broader field of macroeconomic modeling, emphasizing the general equilibrium interactions that occur when policies or shocks affect an economy.

FAQs

What is the primary purpose of a computable general equilibrium model?

The primary purpose of a computable general equilibrium (CGE) model is to analyze the economy-wide impacts of policy changes or external shocks. It helps policymakers understand how a change in one sector or market can ripple through the entire economy, affecting different industries, households, and trade patterns.

How do CGE models differ from partial equilibrium models?

CGE models differ from partial equilibrium models by analyzing all markets simultaneously, seeking a new equilibrium where demand and supply balance across the entire economy. Partial equilibrium models, in contrast, focus only on a single market or sector in isolation, assuming that changes in that market do not significantly affect others.

What kind of data is used in a CGE model?

A core component of data used in a CGE model is the social accounting matrix (SAM). A SAM provides a comprehensive, consistent snapshot of all economic transactions within an economy for a specific year, detailing the flow of income and expenditure between different agents (households, firms, government, rest of world) and sectors. The model also uses various parameters, such as elasticities of substitution in production and consumption.

Can CGE models predict economic crises?

CGE models are generally not designed for short-term forecasting or predicting economic crises. They are primarily simulation tools that analyze the medium to long-term structural changes in an economy resulting from a specific policy or shock. Their typical neoclassical assumptions, such as full employment, limit their ability to model cyclical fluctuations or financial market instability.