A Primer On Static Applied General Equilibrium Models

Federal Reserve Bank of Minneapolis Quarterly Review Spring 1994, Volume 18, No. 1

A Primer on Static Applied General Equilibrium Models
Patrick J. Kehoe Adviser Research Department Federal Reserve Bank of Minneapolis and Associate Professor of Economics University of Minnesota Timothy J. Kehoe Adviser Research Department Federal Reserve Bank of Minneapolis and Professor of EconomicsUniversity of Minnesota

The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.

Static applied general equilibrium (AGE) models have been used extensively over the past 20 years to analyze government policies in both developed and less developed countries. (See, for example, Shoven and Whalley 1984,1992.) Not surprisingly, static AGE models were also the tools of choice when researchers began studying the potential impact of the North American Free Trade Agreement (NAFTA) on the Canadian, Mexican, and U.S. economies (Francois and Shiells 1994). In another article in this issue, we examine some specific applications of static AGE models to NAFTA. Here, though, we try to describe the basicstructure of AGE models and give some sense of their reliability. In this article, we construct a simple model and use it in a series of examples to explain the structure of static AGE models. We then extend our model to include increasing returns to scale, imperfect competition, and differentiated products, following the trend of AGE modeling over the last 10 years. We also present an example thatprovides some clues about the reliability of these models. Our example compares a static AGE model’s predictions with the actual data on how Spain was affected by entering the European Community (EC) between 1985 and 1986. We find that, at least when exogenous effects are included, a static AGE model’s predictions are fairly reliable. But these models are not perfect. One reason static AGE models havebeen so popular is that they stress the interaction among different industries, or sectors. Because they emphasize the impact of reallocating resources across sectors of an economy, these models are good tools for identifying winners and losers under a policy change. They fail to capture the effect of a policy change on the dynamic aspects of an economy, however. A policy change such as NAFTA islikely to directly affect dynamic phenomena such as capital flows, demographics, and growth rates. Here, we merely indicate that, good as they are, static AGE models have their limitations. In our other article in this issue, however, we present some preliminary results which demonstrate that dynamic modeling of the effects of a policy change like NAFTA is an area of research that deserves moreattention. Basics Like any economic model, an AGE model is an abstraction that is complex enough to capture the essential features of an economic situation, yet simple enough to be tractable. Our model is a computer representation of a national economy or a group of national economies, each of which consists of consumers, producers, and possibly a government. The consumers in the computer model do manyof the same things their counterparts in the world do: They purchase goods from producers, and in return, they supply factors of production. They may also pay taxes to the government and save part of their income. To analyze the impact of a change in government policy with a static AGE model, we use the comparative statics methodology: We construct the model so that its equilibrium replicatesobserved data. We then simulate the policy change by altering the relevant policy parameters and calculating the new equilibrium. Performing policy experiments is obviously less costly in a computer economy than in the world economy. But the ultimate value of the procedure depends on how well the model with the simulated

policy change predicts what would have happened if the policy change had...