Economic Modeling in the Nordic Countries [1st Edition] 9781483294872

Table of contents :
Content:
Contributions to Economic AnalysisPage ii
Front MatterPage iii
Copyright pagePage iv
Introduction to the SeriesPage v
IntroductionPages vii-xiiLars Bergman, øystein Olsen
AcknowledgementsPage xiii
Comparative properties of the Nordic modelsPages 3-53John D. Whitley
MODAGA macroeconometric model of the Norwegian economyPages 55-93Ådne Cappelen
Integration of real and monetary sectors in ADAMPages 95-114Carsten Boldsen Hansen, John Smidt
KESSU IV: An econometric model of the Finnish economyPages 115-137Martti Hetemäki
The structure and foundations of the BOF4 modelPages 139-183Hanna-Leena Männistö, Juha Tarkka, Alpo Willman
KOSMOS - A short term model for SwedenPages 185-196Lars Ernsäter, Tomas Nordström
The structure and working of MSG-5, an applied general equilibrium model of the Norwegian economyPages 199-236Erling Holmøy
MECMOD - A medium term CGE model for SwedenPages 237-262Tomas Nordström
An applied general equilibrium model of the Swedish economyPages 263-296Tohmas Karlsson
Author indexPages 297-298

Citation preview

CONTRIBUTIONS TO ECONOMIC ANALYSIS 210

Honorary Editor: J. TINBERGEN

Editors: D. W. JORGENSON J. -J. LAFFONT

NORTH-HOLLAND AMSTERDAM · LONDON · NEW YORK · TOKYO

ECONOMIC MODELING IN THE NORDIC COUNTRIES

Edited by Lars BERGMAN Stockholm School of Economics Stockholm, Sweden

0ystein OLSEN Research Department Central Bureau of Statistics Oslo, Norway

1992

NORTH-HOLLAND AMSTERDAM · LONDON · NEW YORK · TOKYO

ELSEVIER SCIENCE PUBLISHERS B.V. Sara Burgerhartstraat 25 P.O. Box 211, 1000 AE Amsterdam, The Netherlands

ISBN: O 444 89653 8

© 1992 ELSEVIER SCIENCE PUBLISHERS B.V. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the publisher, Elsevier Science Publishers B . V , Copyright & Permissions Department, P.O. Box 521, 1000 AM Amsterdam, The Netherlands. Special regulations for readers in the U.S.A. - This publication has been registered with the Copyright Clearance Center Inc. (CCC), Salem, Massachusetts. Information can be obtained from the CCC about conditions under which photocopies of parts of this publication may be made in the U.S.A. All other copyright questions, including photocopying outside of the U.S.A., should be referred to the copyright owner, Elsevier Science Publishers B . V , unless otherwise specified. No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. This book is printed on acid-free paper. PRINTED IN THE NETHERLANDS

INTRODUCTION TO THE SERIES This series consists of a number of hitherto unpubhshed studies, which are intro­ duced by the editors in the behef that they represent fresh contributions to economic science. The term "economic analysis" as used in the title of the series has been adopted because it covers both the activities of the theoretical economist and the research worker. Although the analytical methods used by the various contributors are not the same, they are nevertheless conditioned by the common origin of their studies, namely theoretical problems encountered in practical research. Since for this reason, busi­ ness cycle research and national accounting, research work on behalf of economic policy, and problems of planning are the main sources of the subjects dealt with, they necessarily determine the manner of approach adopted by the authors. Their methods tend to be "practical" in the sense of not being too far remote from appli­ cation to actual economic conditions. In additon they are quantitative. It is the hope of the editors that the publication of these studies will help to stimulate the exchange of scientific information and to reinforce international cooperation in the field of economics. The Editors

vil

Introduction Lars Bergman and Oystein Olsen This volume presents a selection of macroeconomic models used, or intended for, economic forecasting or policy analysis in the four Nordic countries Denmark, Finland, Norway and Sweden. T h e book may be regarded as a successor of t h e overview of macroeconomic models given in Bjerkholt and Rosted (1987). T h e latter reported from a seminar in Lyngby, Denmark, in 1984, where economists and model builders associated with t h e respective Ministries of Finance met to exchange ideas and share experiences of model development and use for policy purposes in the respective countries. In spite of many similarities in social strucure and political system, the tra­ ditions of applying macroeconomic models in t h e decision making process in the Nordic countries are somewhat different. Norway and Finland have t h e longest traditions in integrating the use of formal models in the process of economic plan­ ning and decision making. Denmark has gradually adopted a way of organizing model development and use t h a t is quite similar to the Norwegian system, while in Sweden the role of macroeconomic models used for policy purposes has been less consistent. Norwegian economists, particularly Ragnar Frisch and Leif Johansen, have played a crucial role in the development and use of macroeconomic models for policy purposes. Already in the 1930s Frisch worked on t h e principles of national accounting and econometric modelling. After t h e war he was instrumental in making the Institute of Economics at t h e University of Oslo a laboratory for macroeconomic modelling, and in t h e late 1940s and early 1950s he was much ahead of his time in initiating several ambitious econometric models. Johansen, who was one of Frisch's students, combined Leontief's input-output approach, Walrasian general equihbrium theory and the neoclassical theory of economic growth into the socalled MSG-model, which was completed in t h e late 1950s (Johansen (I960)). T h e MSG-model became a generic contribution which years later led to t h e development of applied general equilibrium (AGE) models. In the other Nordic countries, formal models have generally played a some­ what less prominent role in economic planning and policy analysis. Yet the Norwegian example and the general developments in t h e field have stimulated some significant modelling efforts in these countries, and macroeconomic models

viii

Introduction

iiave gradually been integrated in t h e foreccisting and policy evaluation work in the respective Ministries of Finance. During the last 10-15 years the economic policies of many industrialized coun­ tries have been directed towards deregulation of markets, with special focus on supply side measures. This development Wcts to a large extent triggered by t h e supply shocks during the 1970s and t h e problems of traditional d e m a n d side policy to restore macroeconomic balances and economic growth. T h e strong and unpredictable fluctuations in t h e economies also strongly influenced t h e construc­ tion and use of macroeconomic models. Firstly, model builders naturally sought remedy to the foreca^st errors t h a t had been experienced earlier. Increased ef­ forts were m a d e to model production and other parts of the supply side of t h e economy, and the mechanism of relative price formation became more i m p o r t a n t . Secondly, the philosophy of t h e major model users gradually evolved in t h e direc­ tion of putting less weight on fine tuning in conducting short t e r m stabilization policy, stressing instead structural reforms. In the Nordic countries both model builders and analysts in the Ministries of Finance have been influenced by these trends during recent years. T h u s , hence t h e models used for policy analyses have been gradually revised. Among t h e new developments are efforts of integrating the real and financial sectors of t h e economy and t h e specification of policy measures aimed at affecting t h e supply side of t h e economy. Still, most short and medium t e r m macroeconomic models used by t h e Nordic governments continue to emphasize demand side responses. On the other hand, supply side considerations and relative prices are t h e main focus in applied general equihbrium (AGE) models used for long t e r m projections and analyses of resource allocation. Several projects in t h e spirit of Johansen's MSG model have been launched during the last decade aiming at developing suitable frameworks for t h e evaluation of supply side measures, such as major tax reforms, t r a d e liberalization or ambitious environmental policies. T h e MSG model has been revised to be more suitable to study welfare effects, and in t h e other countries, in particular in Sweden, new A G E models have been developed in the same spirit. T h e meeting in Lyngby in 1984 stimulated to closer contacts between model builders and users in the Nordic countries. At a seminar in Oslo in September 1989 new features and model applications were discussed. A main purpose of this seminar was to evaluate t h e models used by the Ministries of Finance, with special attention to the role of relative prices and their t r e a t m e n t of the supply side. In addition, a systematic comparison of results from model simulations on t h e main macroeconomic models in t h e four Nordic countries was initiated. T h e purpose of this book is to present papers and topics t h a t were discussed at the Oslo meeting. T h e different chapters of the volume fall naturally in two parts. In Part One the focus is on t h e short-to-medium t e r m models. T h e

Introduction

ix

front chapter, written by John D, Whitley at t h e University of Warwick, UK, presents the results from t h e model comparison project mentioned above. T h e ESRC Macroeconomic ModeUing Bureau at Warwick has significant experience in undertaking such comparisons and evaluations. Five macroeconomic models are considered: ADAM from t h e Department of Budget, Denmark, M O D A G from the Central Bureau of Statistics, Norway, K O S M O S from t h e Natinal Institute of Economic Research in Sweden, KESSU IV of t h e Finnish Ministry of Finance and B 0 F 4 of the Bank of Finland. T h e models can all be characterized as Keynesian in the short run. T h e long run properties vary somewhat, b o t h with respect to t h e specifiation of t h e supply side, monetary aspects and foreign trade. An important purpose of this study is thus t o analyze t h e significance of these differences when systematic simulation experiments are carried out on t h e various models. In t h e subsequent chapters t h e five models are presented and discussed in more detail. T h e current version of t h e Norwegian m e d i u m t e r m model MODAG is presented by Ádne Cappelen, T h e M O D A G model is t h e successor to MODIS, t h a t from the early 1960s was t h e main accounting and modelling framework of t h e Norwegian government in conducting National Budgets (see Bjerkholt and Longva (1980)). While t h e latter model was basically an input-output model with a Keynesian consumption function, more relations describing economic behaviour have been included in M O D A G . Supply side factors are i m p o r t a n t in determining the long run properties of t h e model framework, while in t h e short to medium t e r m the demand side is still dominating. No a t t e m p t is m a d e to model t h e effects of imbalances in the economy on domestic interest rates, which are assumed to be determined by international levels even in t h e short run. In the next chapter Carsten Boldsen Hansen and John Smidt describe t h e Danish macroeconomic model ADAM, This model was adopted by t h e Danish Ministry of Finance in t h e mid-1970s, while t h e responsibility for maintanance and development was placed at t h e Central Buraeu of Statistics, Denmark, i.e. the same kind of organization as in Norway. T h e current version of ADAM emphasizes t h e integration of t h e real and monetary sectors of t h e economy, and the chapter in this book focuses on these links. In contrast t o t h e M O D A G model, interest rates may be quite sensitive to changes in fiscal policy. Like in Norway, t h e tradition of using macoreconomic models for m e d i u m t e r m analyses in Finland goes back to t h e 1960s. T h e first version of t h e KESSU model was developed within t h e Economic Council. Later t h e model was transferred to t h e Ministry of Finance, and t h e more recent versions have been developed by t h e Economics Department of t h e Ministry. Over t h e years, more behavioural equations have been added to the model structure, including some supply side elements. In the latest model version, KESSU IV, presented in this book by Martti Hetemäki, a monetary block with endogenous interest rates is introduced. Finland is represented by two models in this volume, t h e other being t h e

χ

Introduction

BOF4 model of the Bank of Finland, presented by Hanna-Leena Männistö, Juha Tarkka and Alpo Willman. T h e B O F model, which originated around 1970, is a quarterly model of the Finnish economy used regularly by the Bank of Finland for forecasting purposes or analysis of the economic development in t h e short to medium term. T h e model clearly belongs to the neoclassical synthesis tradition of macroeconomics, where the significance of supply side factors increase in t h e long run. In addition, as a central bank model monetary aspects and policy instruments are naturally central. In Sweden medium t e r m economic modelling has traditionally been less ambi­ tious than in the other Nordic countries, despite the fact t h a t socalled " M e d i u m Term Studies" (MTS) have been undertaken since World War II. Since t h e early 1970s the E M M A model has been used by the Ministry of Finance, but it was never integrated in the economic planning process in the same way as models in Norway and Finland. (For a presentation of this model, see Olofsson (1987)). Quite recently, a new institutional setting has been decided for the use of mod­ els for macroeconomic planning in Sweden. T h e National Institute of Economic Research (NIER) has been given the task of developing and maintaining formal models, while the Ministry of Finance is responsible for using the models for the MTSs. Thus, during recent years, a new set of models has grown up aimed for both long run resource allocation studies (see part two of this volume) and short to medium term analyses. One of the models aimed at medium t e r m analyses, KOSMOS, is presented here by Lars Ernsäter and Tomas Nordström. This model is developed within the research department of the N I E R and is intended for use both by that institute and by the Ministry of Finance. KOSMOS may be charac­ terized as a Keynesian macro model with endogenous price and wage formation. Presently, there is no financial side in the model, and both t h e exchange r a t e and the interest rate are determined exogenously. In Part Two of the book the focus switches to a presentation of three models t h a t all may be classified as applied general equilibrium (AGE) models. Erling Holm0y presents the structure and working of MSGS, the current version of t h e equilibrium framework originated by Leif Johansen. T h e empirical properties of this model are illustrated by presenting calculations of the effects of increases in the capital stock on relative prices and the sectoral allocation of o u t p u t s and re­ sources. Special attention is given to the question of how the modelling of external trade affects t h e empirical results. While in previous versions of t h e MSG model trade flows were exogenous (export volumes and import shares), these model blocks in MSG-5 are based on the Armington approach, where t r a d e volumes are determined by relative prices between Norwegian and foreign prices. W i t h high and increasing degree of substitutability between Norwegian and foreign products the structure apppraches the small open economy assumption. In his paper, Holm0y analyzes both empirically and analytically the impacts of capital

Introduction

xi

deepening under varying specifications of foreign trade. T h e two other general equilibrium models presented in this book are both Swedish. Tomas Nordström describes t h e model MECMOD which is developed and maintained by the N I E R institute in Sweden. M E C M O D is basically a static A G E model, where substitution possibilities both domestically and be­ tween Swedish and foreign goods are described by CES aggregates. T h e model system was used by the Ministry of Finance for t h e Medium Term Survey (MTS) 1990, where it replaced the previously mentioned E M M A model. Like MSG-5, M E C M O D is designed for apphcations for a wide range of issues, hke taxation, energy policy and trade policies. T h e model constitutes a rather flexible system, designed to be modified according t o t h e problem in question. In the final chapter, Tohmas Karlsson presents an A G E model aimed at an­ alyzing medium t e r m and long run structural issues. In particular, the model is constructed as a tool for studying allocational and distributional effects of the recent Swedish tax reform. On the supply side, the endogenous labour supply can be distributed between the regular market or used for production in the house­ hold production process. A motive for including this as a model feature, is t h a t the latter activity is not subject to taxation.

XU

References B j e r k h o l t , O. a n d R o s t e d J . ( e d s . ) ( 1 9 8 7 ) : Macroeconomic Medium Term Models in the Nordic Countries. North-Holland Publishing Company, Am­ sterdam. B j e r k h o l t , O. a n d L o n g v a , S. ( 1 9 8 0 ) : MODIS IV - A Model for Economic Analysis and National Planning. Central Bureau of Statistics, Oslo. O l o f s s o n , T . ( 1 9 8 7 ) : An Econometric Model for Medium-Term Analysis ( E M M A ) . In Bjerkholt, 0 . and Rosted, J. (eds.) (1987). J o h a n s e n , L. ( 1 9 6 0 ) : A Multi-Sectoral Study Holland Publishing Company, A m s t e r d a m

of Economic

Growth.

North-

XIU

Acknowledgements T h e content of this book is based on presentations of papers at a seminar on Nordic macroeconomic models in Oslo in September 1989. T h e authors are grate­ ful to the Ministries of Finance in Denmark, Finland, Norway and Sweden for their generous support b o t h t o t h e seminar and to t h e completion of this book. T h e editors would also like to give credit to Svein Longva as a co-organizer of t h e modelling seminar and for his initiative in launching t h e book project. Finally, the book would not have been finished within t h e time limit without t h e excellent text processing work of Kari Anne Lysell and her endless patience with authors and editors. T h a n k s also to Marit Vagdal, Andre Hansen and Elisa Holm for their contributions to text processing and drawing of graphs.

Economic Modeling in the Nordic Countries L. Bergman and 0 . Olsen © 1992 Elsevier Science Publishers B.V. All rights reserved.

Comparative properties of the Nordic models JohnD. Whitley*

1

Introduction

Macroeconometric forecasts tend to be constructed for different purposes and hence comparison of their properties must take this into account. However it is usually possible to make meaningful comparisons by careful experimental de­ sign features, such as ensuring comparable input shocks and similar policy back­ grounds. W h e n t h e models relate to different countries another dimension is added to the comparability problem, since differences arise either from a different economic approach or from different national characteristics. In t h e current exer­ cise we compare five macroeconometric models of the Nordic countries covering four different countries. This follows a similar comparative exercise reported by Lybeck et al. (1984) although their sample overlaps with the present set of models in only one case, and covers three rather t h a n four different nations. Another rel­ evant predecessor is the volume by Bjerkholt and Rosted (1987) which describes t h e properties of four of t h e models analyzed here, although it contains no com­ parative analysis of t h e Nordic models. Such is t h e progress in macroeconometric modelling t h a t one might realistically expect t o observe change in model prop­ erties for a later vintage of t h e same models. Five models of four economies are considered, of mid-1989 vintage. They are ADAM from t h e D e p a r t m e n t of t h e Budget, Denmark; KOSMOS from t h e National Institute of Economic Research, Sweden; MODAG from t h e Central Bureau of Statistics, Norway; and two models from Finland - those of the Ministry of Finance (KESSU IV) and t h e Bank of Fin­ land ( B 0 F 4 ) . In the period between completion of this project and publication several revisions have taken place to t h e models. This is an inevitable problem *The helpful comments of many of the Nordic modellers are gratefully acknowledged, partic­ ularly those of Alpo Willman, Finn Lauritzen, Per Caliesen, Jan Hansen, Frode Finsas, Niklas Wellfelt and August Leppa. My colleague at the ESRC Macroeconomic Modelling Bureau, Ken Wallis, has also contributed many useful insights. All errors and ommissions are my own responsibility however.

4

J.D,

Whitley

in comparative model exercises. It should be noted however t h a t the version of MODAG had been unchanged since 1986 but t h a t subsequently several revisions have been made which have important effects on overall model properties (in particular on medium-term responses). T h e main changes and their implications are described in Appendix B . T h e models themselves are described in greater detail in other papers in this volume and are summarised in table 1. T h e y have been built for different purposes with some emphasising m e d i u m t e r m planning (MODAG, ADAM) and others like B 0 F 4 designed more with policy scenarios in mind. They are all based on standard approaches to econometric estimation and hence are conventional estimated macroeconometric models rather t h a n of the calibrated general equilibrium approach. In the present paper we use six standard simulations to analyze the models, three which can be classed as fiscal policy shocks; one which describes t h e impact of interest rates in the models; and two which relate to changes in t h e external environment. We do not discuss t h e results of each experiment in equal depth since there are often common mechanisms operating for each model across t h e different simulations. T h e paper is set out as follows. In t h e first section we brieñy discuss t h e main structural features of t h e five models. This is done in as comparative a manner as possible. In t h e second section we set out t h e n a t u r e of t h e model simulations and we discuss issues of experimental design. This is followed by an account of the main simulation results in t h e third section of the paper. Section 4 then reviews t h e simulation findings using various s u m m a r y statistics in order to highlight some of the differences in the simulation responses. Comparisons with previous studies are presented in Section 5 and conclusions are set out in Section 6.

2

An outline of the models

In this section we review some of the main structural features of t h e models. A tabular summary is given in table 1. In t h e discussion of simulation results in Sections 3 and 4 we a t t e m p t to relate the reduced form properties of t h e models back to elements of the structure and hence some basic description of comparative model structures is useful. All the models can be classified as small open-economy models. T h e y all have a structure t h a t can be characterised as Keynesian in t h e short-run, t h a t is fluctuations in o u t p u t are primarily demand determined with wage and price adjustment sticky. In B 0 F 4 t h e long-run position can b e reasonably clearly identified as neo-classical by inspection of single-equation properties although this leaves t h e empirical question of how long it takes to reach this long run to be resolved. In the other models t h e long run is less visible in t h e structure and simulation analysis is necessary to describe its characteristics.

Comparative

Properties

of the Nordic Modeh

5

T h e models all use t h e income-expenditure framework. As in other countries this reflects more the framework of the national acccounts and availability of d a t a t h a n a methodological approach. T h e more disaggregated models include input-output sectors b u t this can be regarded as methodology for tackling t h e disaggregation issue rather t h a n one which plays a fundamental role in explain­ ing model properties. T h e models include t h e so-called Scandinavian model of inflation (or t h e law of one price) in varying degrees, and they all draw a distinc­ tion between the open or exposed sector and t h e sheltered sectors of t h e economy. In the Finnish models (KESSU IV and B 0 F 4 ) this ensures equality of domestic and foreign prices, full purchasing power parity holds in t h e long run for t h e open sectors. In the sheltered sectors of B 0 F 4 the hypothesis of profit maximization implies t h a t prices are determined by short run marginal costs. In KESSU IV prices in the sheltered sectors are determined by average unit costs; in some cases these include t h e cost of capital and an allowance for the growth in demand. Foreign prices do not affect t h e price of domestic value-added. In ADAM sector o u t p u t prices are set by both domestic costs and foreign competitors' prices with a relative weight of 60:40 in manufacturing (both in t h e short and long r u n ) . A distinction m a d e by ADAM is t h a t import prices have a 40 per cent adjustment to domestic costs - in t h e other models import prices are almost entirely deter­ mined by world prices. Export prices in A D A M are influenced by b o t h domestic costs and competitors' prices, with a further influence from capacity utilization.

2.1

Wage formation

Where the Scandinavian model is more common across t h e models is in t h e role of manufacturing as a wage leader although this does not apply for M O D A G under a demand shock. T h e implicit hypothesis of wage determination is t h a t of a bargaining model. This is particularly so for B 0 F 4 where there is a distinction between the negotiated and t h e actual wage. T h e negotiated wage is driven by a target (after tax) level of real income. T h e actual wage depends on t h e negotiated wage in the short run b u t in t h e long run is determined by expected prices, unemployment, t h e change in income taxes, and t h e real-wage gap. T h e latter is determined by t h e difference between t h e lagged real product wage and the warranted wage, given by t h e marginal product of labour. T h e expectations t e r m includes both forward and backward-looking elements, t h e main instance where some (implicit) forward-looking behaviour enters into any of t h e Nordic models. KOSMOS and A D A M both contain t h e long-run property t h a t t h e wage share is inversely related to unemployment with short-run deviations possible due to direct and indirect taxes, prices, productivity and foreign prices for K O S M O S , and prices and income taxes for A D A M . Unemployment benefits have a longrun effect in this model. M O D A G contains t h e same short-term variables as

6

J.D.

Whitley

KOSMOS and additionally a t e r m in employer taxes, but is specified in difference form and so does not have a long-run solution for the real wage, leaving this to be determined elsewhere in t h e model. Nor does it have dynamic homogeneity. KESSU IV also distinguishes between negotiated and actual wages with t h e latter adjusting to ensure t h a t the real product wage is constant when measured in efficiency units (technical progress is labour-augmenting).

2.2

Production technology and factor demands

Both ADAM and B 0 F 4 contain explicitly estimated production functions. In t h e case of ADAM the approach is a putty-clay vintage approach for manufacturing whose main role is t h e generation of capacity utilization. Although the labour demand equations for 13 sectors are not directly derived from t h e production technology the investment equations are. In B 0 F 4 a CES production function is used for five industrial sectors. This is used to derive the labour demand equation. Capital accumulation affects productivity growth, and the resultant marginal costs appear in t h e price equations. M O D A G uses an inverted pro­ duction function to determine labour demand as does K O S M O S , whilst KESSU IV uses profit functions to derive factor demand equations. MODAG does not contain relative factor prices in its employment relationships. T h e manufacturing employment equations in MODAG include capital stock variables, with techno­ logical progress measured by a time trend. T h e production function is such t h a t the elasticity of labour with respect to output decreases as capacity utilisation grows. Many of the manufacturing sectors within this model exhibit increasing returns to scale. In contrast t h e other models typically have unit partial elastic­ ities between o u t p u t and employment. W i t h a profit-maximising approach t h e employment relationships in KESSU IV do not include o u t p u t as an explana­ tory variable. T h e approach in KOSMOS is cost-minimisation but the estimated equations cover only 20 per cent of total employment. Only ADAM and B 0 F 4 explicitly includes hours of work. All the models have a role for interest rates in the investment equations, in many cases these appear as part of the user cost variable. In B 0 F 4 investment depends on t h e gap between the marginal product of labour and the user cost of capital; ADAM and KOSMOS contain a similar Tobin's Q effect. MODAG also contains a variable representing t h e supply of internally-generated funds and external availability of credit, although this is only important in a few sectors of the model, mainly those which are export-oriented.

Comparative

2.3

Properties

of the Nordic Models

7

Private consumption

All but KESSU IV contain an aggregate consumption relationship. Current real disposable income appears in all models which gives t h e m a Keynesian rather than life-cycle interpretation. Interest rates enter directly in K O S M O S (in a nominal form), KESSU IV and B 0 F 4 . However, interest rates can also operate through revaluation of wealth, and wealth effects are included in ADAM (through financial and physical wealth), KESSU IV, and B 0 F 4 , t h e latter through liquid assets. Although KOSMOS contains no direct wealth effects, inflation enters as an explanatory variable in the consumption equation. In principle the inclusion of both nominal interest rates and inflation could be interpreted as a real interest rate effect but the inflation reponse is only one-half the size of the interest r a t e response. M O D A G includes a credit variable in its consumption equation, and t h e income variable is weighted by marginal propensities to consume out of different kinds of income. Long-run income elasticities in t h e models are often less t h a n unity.

2.4

Labour force participation

T h e labour force participation decision is one of the determinants of t h e supply side in the models. Aside from demographic factors which are exogenous in si­ mulation analysis, the labour force is treated exogenously in ADAM and KESSU IV and only depends on lagged employment in K O S M O S , reflecting the so-called discouraged worker effect. T h e discouraged worker effect is also important in B 0 F 4 through an employment variable but real incomes and real wages are also included. In M O D A G there is an 8 sector breakdown with the ratio of real dis­ posable wages to non-labour real income important for groups such as pensioners whereas the demand for labour, measured by t h e unemployment rate, is t h e most important factor for youths and married women.

2.5

External trade

T h e behaviour of the trade sector in the models is of critical importance in de­ termining overall model properties. T h e exchange rate is fixed in all t h e models and hence import prices can also be regarded as largely exogenous. An exception is ADAM where import prices are sensitive to domestic costs. T h e assumptions m a d e in the Finnish models (KESSU IV and B 0 F 4 ) mean t h a t o u t p u t of t h e tradable sectors are supply determined. T h e demand curve for multi-lateral ex­ ports in B 0 F 4 (80 per cent of exports) is downward sloping in the short run so t h a t competitiveness plays a role, b u t in t h e long run t h e demand curve becomes horizontal and the price elasticity of exports tends to infinity. Exports of services

8

J.D.

Whitley

have a long-run price elasticity of around unity. In ADAM t h e explanatory vari­ ables determining the share of exports are relative prices (long-run elasticity of -1.3) and capacity utilisation. An important distinction in M O D A G is between resource based products (which account for some 40 per cent of exports) which are capacity constrained, and the rest of exports (primarily manufactures). T h e latter are assumed to depend on t h e size of the world market (with an aver­ age long-run elasticity of 1.7) and price competitiveness (long-run elasticity of -1.3). However there are long adjustment lags before these long-run responses are achieved, noting t h a t t h e long-run demand elasticity is large relative t o t h a t in the other Nordic models. In KOSMOS only exports to the O E C D are modelled and these only account for 50 per cent of exports. In the long run t h e export shares in demand are given by relative prices with an average price elasticity of -2.4. T h e general approach to modelling imports is to explain imports by t h e level of domestic activity and by relative prices. Where the dependent variable is the import share in domestic demand (as in ADAM, M O D A G , KESSU IV and KOSMOS) the long-run activity elasticity is constrained to unity, whereas in B 0 F 4 , where t h e level of imports is the explanatory variable, the estimated longrun activity elasticity is just above unity. Measures of capacity pressure are to be found in the import relationships of ADAM. T h e long-run price elasticity is smaller in KOSMOS (-0.4) t h a n in t h e other models, the consensus being around -0.8. MODAG makes a distinction between competitive and non-competitive imports, the latter being determined by commodity balances: the estimated price elasticity referring to competitive products so t h a t t h e average elasticity over all imports is be closer to the estimate of K O S M O S .

2.6

Financial sectors

Three of the models (ADAM, KESSU IV and B 0 F 4 ) contain fully fledged finan­ cial sectors which determine interest rates from equilibration of t h e supply and demand for money. KESSU IV assumes t h a t capital is mobile so t h a t t h e domes­ tic interest rate is closely tied to t h e world interest rate. In A D A M and B 0 F 4 domestic and foreign assets are assumed to be imperfect substitutes. T h e main role of the financial sectors in these models is to calculate sector balances and their financing implications. T h e feedbacks to the rest of the model are through t h e determination of interest rates, for t h e calculation of interest payments and for derivation of stocks of personal sector assets (wealth). Interest rates are typically determined in a market-clearing framework. Although these models generate es­ timates of monetary growth this has no direct role to play in the structure of these models. There is no financial model for M O D A G or K O S M O S .

Monopolistic comp: costs, foreign prices, capacity

Mark-up on costs: import prices

Inverted production function: increasing returns to scale

Neo-classical: interest rates, factor prices, credit supply

Bargaining approach (aggregate equation): prices, profit share, unemployment rate

Implicit production function: output, hours worked

Tobin's Q: relative factor prices, change in output

Labour demand

Investment

sensitive to domestic costs Industry Phillips curves: productivity taxes, prices, unemployment

1225 equations 183 stochastic

9rT equations

92 stochastic

Annual 31 sectors 41 commodities

MODAG

Annual 20 industries 72 final demands

ADAM

Wages

Price setting

Size

Aggregation: time space

Model

Tobin's Q: output, utilization

Cost minimizing: relative factor prices, output

Bargaining approach (manufacturing leading sector): long-run wage share depends on unemployment

Mark-up: costs, foreign prices

467 equations 21 stochastic

Semi-annual 8 sectors

KOSMOS

Neo-classical, profit maximizing: user cost of capital, output

Profit maximization in open sectors: relative prices closed sectors: output, relative prices

Negotiated wage exogenous: wage drift such that real wage constant in efficiency units

Scandinavian model: domestic price tied to world price in open sectors

969 equations 240 stochastic

Annual 28 sectors

KESSU IV

Neo-classical, profit maximizing: user cost of capital. output

Inverted (CES) production function; slow adjustment of working hours towards production function requirement

Bargaining approach (manufacturing wage leader): target real wage in short run unemployment rate, ratio real wage to marginal product of labour in long run

PPP: long-run equality of prices, marginal costs and foreign prices in the open sector

272 equations 70 stochastic

Quarterly 5 production sectors 16 final demands

BOF4

Table 1: Main characteristics and key explanatory variables of the NORDIC models

"C

'" KQ

W

Β

Δ=Δ.

increase t h e domestic prices relative to the world market prices in order to keep the t r a d e balance constraint satisfied. Therefore, an increase in one of t h e two factor prices must lead to a fall in t h e other. In t h e case with infinitely large t r a d e elasticities, t h e domestic prices have to stay constant. An increase in, say, w will in this case stop all activity in the exposed sectors and result in an infinitely large trade deficit. T h e necessary decline in 7 will be determined by t h e technology in the exposed sector which is able to give t h e highest remuneration to labour and capital.

5

Effects of increasing the capital stock

We will now use the insight from t h e previous section to interprete the numerical results of increasing the total capital stock by 5% in t h e implemented model. An increase in t h e capital stock can be shown as a downwards shift in t h e capital locus in t h e (ly, 7)-space. This can be seen from equation (38) holding t h e wage rate constant. We get: (40) W i t h the approximations discussed in the previous section, t h e shift in t h e

230

Ε. Holm0y

Figure 6: T h e relationship between the capital cost, 7, and t h e wage rate, w, on the capital market locus {AA) and the trade balance locus {BB). Large trade elasticities. K\ > KQ» W

A'

A

capital market locus is negative as in a one-sector model; an increase in the capital/labour ratio reduces t h e marginal productivity of capital per capita and thereby the equilibrium rate of return to capital. T h e higher is the substitutability between labour and capital, t h e smaller is the necessary decline in the rate of return. Our multi-sector/multi-factor model may modify this intuition from the standard text-book growth model in various directions. Here we consentrate on the role played by the trade elasticities. Increasing these proportionally, the covariance will also increase. Hence the covariance t e r m will gradually dominate the denominator in (40) and diminish the fall in 7. Not surprisingly, we see t h a t the Rybczynski effect plays an increasing role as the model converges towards t h e assumption of perfect substitutability between domestic and foreign products. In t h e limiting case it is well known t h a t the necessary increase in aggregate capital demand is brought about by an expansion of the sectors producing goods with t h e highest input-output corrected capital/labour ratios, while t h e output in the other sectors as a whole is reduced. No factor substitution is needed on the micro level and the factor prices are independent of the domestic supply of primary factors. (This holds as long as t h e sectoral capital/labour ratios span t h e corresponding aggregate ratio). T h e effects on the factor prices of a positive shift in the supply of capital are shown in figure 5 and 6 above. In the case of relatively small t r a d e elasticities we should therefore expect a reduction in both the wage rate and the capital cost. For larger t r a d e elasticities

An Applied General Equilibrium Model of the Norwegian Economy

2 31

the wage rate should change in t h e opposite direction and t h e absolute values of t h e changes should decrease. Let us see how these conclusions conform with the numerical results generated by MSG-5. Table 2 reports the changes in t h e factor prices, t h e price indices on main macroeconomic aggregates and t h e corresponding volume changes. T h e t r a d e elasticities used in t h e base case are taken from t h e MODAG-model (e^ = M* in the table). T h e table also reports t h e results when the model is simulated with t r a d e elasticities t h a t are 5 and 10 times higher. Table 2: Changes in main macroeconomic aggregates caused by a 5 per cent increase in the total capital stock. Trade elasticities (e^). Stationary percentage deviation from respective reference scenario.

e^ = M'

t" = 5M*

Price indices: Cost of capital Wage rate GDP-deflator Imports Exports Private consumption Investment

= 10Μ·

-15.10 -2.80 -4.28 0.00 -2.16 -3.92 -2.27

- 8.90 1.60 -0.47 0.00 -0.35 -0.86 -0.07

-8.10 1.90 -0.14 0.00 -0.17 -0.59 0.10

Volumes: GDP Imports Exports Private consumption Investment

2.77 1.87 3.83 2.16 4.24

2.42 3.14 3.16 2.91 3.70

2.41 3.42 3.23 3.02 3.67

T h e simulation results for the factor prices are well in hne with the conclusions drawn in the analytical discussion above. T h e fact t h a t the wage rate increases slightly more when the trade elasticities are increased from 5M* to lOM*, can be understood from figure 6; the effect of a smaller shift in t h e capital locus on the wage r a t e is dominated by t h e effect of a more downward sloped trade balance locus. However, we should not forget t h a t our analytical conclusions were based on several approximations of many effects actually at work in the numerical model. T h e changes in the price indices on the main macro economic aggregates will depend on their input-output corrected cost shares of labour and capital. As

232

Ε. Holm0y

expected, the domestic price level is more invariant w.r.t. t h e change in t h e capital stock when t h e t r a d e elasticities are increased, due to our t r a d e balance constraint. Turning to t h e changes in t h e corresponding volumes, these are much more insensitive to t h e t r a d e elasticities. T h e marginal elasticity of G D P w.r.t. capital is about 0.5. Investment increases less t h a n t h e capital stock, reflect­ ing t h a t t h e average depreciation r a t e declines due to non-proportional sectoral changes. Through t h e consumption growth, t h e production of housing services increases and in this sector t h e depreciation rate is much lower t h a n in t h e other sectors. Note t h a t t h e consumption growth is an increasing function of t h e t r a d e elasticities. T h e reason is t h a t for small t r a d e elasticities t h e reduction in t h e domestic prices necessary to keep t h e value of net export constant, implies a significant loss in terms-of-trade. T h e deterioration in terms-of-trade has to be compensated by quantity changes crowding out consumption in favour of net ex­ ports. T h e G D P growth is a h t t l e lower when t h e t r a d e elasticities are increased. T h e reason is t h a t t h e non-proportional sectoral changes brings about a realloca­ tion of production factors reducing t h e average marginal product of t h e factors. This happens because t h e factor prices, including t h e wage rates and capital costs, differ between sectors. T h e positive relation between import growth and t h e t r a d e elasticities has also to do with non-proportional industrial expansion; t h e growth process induced by t h e increase in t h e capital stock, favours sectors with relatively high direct and indirect input of imports. Table 3 provides a complete picture of t h e sectoral changes in o u t p u t caused by t h e capital growth. Remember t h a t we present and discuss stationary multi­ pliers only. This means t h a t t h e sectors producing capital goods mainly, are only affected by the increase in replacement investment. During a dynamic process where net investment takes place, t h e changes in these sectors (most notably t h e construction sector) are much larger t h a n indicated by t h e stationary multipliers. T h e stationary changes in gross production in sector j is given by: Xi = Σ UPS

^ ( h i i + ^fP"

+ (V' - P'C)E:

- ßE:iPCi

- PC))

(41)

-^j

We should be aware t h a t t h e input-output structure of t h e model introduces a significant degree of complementarity between t h e sectors; an increase in t h e final demand for product i will increase gross production in all sectors t h a t are verti­ cally integrated in t h e supply of this product. T h e production of non-tradeables (like dwellings, domestic transport and other private services) is basically af­ fected through t h e changes in consumer demand. Private consumption in fixed prices increases by 2-3% depending on t h e t r a d e elasticities. This leads to nonproportional industrial expansion according to t h e adjusted Engel-elasticities. Furthermore, there will be a relative price effect in favour of t h e most capital

An Applied General Equilibrium Model of the Norwegian Economy

233

intensive goods. Table 3: Changes in gross production caused by a 5 per cent increase in t h e capital stock. Stationary percentage deviation from respective reference scenarios

Agriculture Forestry Fishery Production of consumer goods Manufacture of intermediate and equip­ ment capital goods Manufacture of pulp and paper articles Manufacture of industrial chemicals Petroleum refining Manufacture of metals Manufacture of metal products, machinery and equipment Building of ships and oil plattforms Electricity supply Construction, excl. oil well drilling Retail trade Domestic transport Finance and insurance Dwellings Other private services

e^ = M' -0.48 9.65 0.37 4.42

= 5M* -0.66 9.65 -0.95 6.55

= 10Μ· -0.65 11.27 -1.03 10.08

8.39 11.42 11.48 1.40 5.75

5.86 11.59 12.25 1.52 6.70

5.91 16.33 18.42 1.53 10.13

13.75 4.37 3.01 1.87 2.07 5.00 0.84 5.88 3.06

3.02 -2.78 3.24 1.01 1.88 4.76 0.97 5.42 2.85

-2.94 -3.16 3.55 1.08 1.42 5.00 0.96 5.38 2.82

For tradeables the export growth and the reduction of import shares must be taken into account. For estimated t r a d e elasticities (e^ = M*) this increase in international competitiveness is reflected by the expansion of manufacturing industries producing intermediate and capital goods, pulp and paper articles, industrial chemicals, metal products, machinery and equipment. T h e growth in forestry is partly related to t h e growth in t h e manufacturing of pulp and paper articles. As t h e trade elasticities increase, we should expect a higher degree of specialization according to t h e increasing importance of t h e Rybczynski effect. Note, however, t h a t an increase in t h e capital stock not necessarily will favour those exposed industries with t h e highest input-output corrected capital/labour ratios. T h e reason is t h a t t h e expansion of t h e sheltered industries may in fact reduce the capital supply available for t h e exposed industries. T h e expansion

234

Ε. Holm0y

of capital intensive industries like dwellings and domestic transport contributes to a modification of t h e Rybczynski effect. T h e exposed industries t h a t turns out to have "comparative advantage" are t h e typically resource based industries manufacturing of pulp and paper, industrial chemicals and metals. This p a t t e r n of expansion also increases t h e demand for timber and electricity. In addition, domestic consumer goods increase their market share. T h e expansion of these industries reallocate resources from manufacturing of metal products, machinery and equipment, and manufacturing of ships, rigs, etc. These industries are the "loosers" in the process of specialization among the exposed industries.

A η Applied General Equilibrium Model of the Norwegian Economy

235

References B e r g m a n , L. ( 1 9 8 5 ) : Extensions and Applications of t h e MSG-model; a brief Survey. In F0rsund, F.R., M. Hoel and S. Longva (ed.): Production^ MultiSectoral Growth and Planning^ North-Holland Publishing Company, Ams­ terdam. B i 0 r n , Ε . , S k j e r p e n , Τ . a n d A a s n e s s , J . ( 1 9 8 8 ) : Engel Functions, panel d a t a and latent variables. Discussion Paper no. 4 1 , Central Bureau of Statistics, Oslo. B j e r k h o l t , O . , L o n g v a , s., O l s e n 0 . a n d S t r 0 m , S. ( 1 9 8 3 ) : Analy­ sis of supply and demand of electricity in the Norwegian economy. Samfunns0konomiske studier 53, Central Bureau of Statistics, Oslo. B y e , T . a n d F r e n g e r , P. ( 1 9 9 2 ) : Factor substitution, Non-Homotheticity and technical change in t h e Norwegian production sector. Discussion Paper no. 72, Central Bureau of Statistics, Oslo. C a p p e l e n , A. ( 1 9 9 1 ) : M O D A G . A Medium Term Macroeconometric Model of the Norwegian Economy. Discussion Paper no. 67, Central Bureau of Statistics, Oslo. B y e , B . a n d H o l m 0 y , E . ( 1 9 9 2 ) : Dynamic equihbrium adjustments to a terms of t r a d e disturbance. Forthcoming in t h e series Discussion paper, Central Bureau of Statistics, Oslo. F0rsund, F., Holm0y, E., M 0 r k v e d , O.J., N o r m a n , V . and S0rensen, R . ( 1 9 9 1 ) : Potential efficiency gains in t h e public sector in Norway (in Norwegian). SNF-rapport 4 / 9 1 . G l o m s r 0 d , S., J o h n s e n , Τ . a n d V e n n e m o , H . ( 1 9 9 2 ) : Stabilization of emissions of C 0 2 : A computable general equilibrium assessment. Scandi­ navian Journal of Economics, 94(1)H o l m 0 y , E . , H o l t s m a r k , B . a n d S t r 0 m , B . ( 1 9 9 2 ) : MSG-5. A complete description of the system of equations. Forthcoming in t h e series Rapporter, Central Bureau of Statistics, Oslo. H o l m 0 y , E . o g V e n n e m o , H . ( 1 9 9 1 ) : Capital Income Taxation and the User Cost of Capital in Norway: Effects of a Suggested Reform. Report no. 29/91 in t h e series Economic Research programme on taxation. T h e Norwegian Research Council for Applied Social Science, 1991.

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J o h a n s e n , L. ( 1 9 6 0 a ) : A Multi-Sectoral Study Holland Publishing Company, Amsterdam.

of Economic

Growth.

North-

J o h a n s e n , L. ( 1 9 6 0 b ) : Rules of T h u m b for the expansion of industries in a process of economic growth. Econometrica no. 2, 1960 J o h n s e n , Τ . A . ( 1 9 9 1 ) : ModeUing the supply of hydro power electricity in Norway (in Norwegian). Rapporter 91/12, Central Bureau of Statistics, Oslo. L i n d q u i s t , K . G . ( 1 9 9 1 ) : ModeUing Norwegian export of different manufactur­ ing goods on annual data. Unpubhshed paper. Central Bureau of Statistics, Oslo. L o n g v a , S., L o r e n t s e n , L. a n d O l s e n 0 . ( 1 9 8 5 ) : T h e Multi-Sectoral Growth Model MSG-4. Formal Structure and Empirical Characteristics. In F0rsund, F.R., M. Hoel and S. Longva (ed.): Production, Multi-Sectoral Growth and Planning. North-Holland Publishing Company, Amsterdam. M o u m , K . ( e d , ) ( 1 9 9 2 ) : Climate, economy and policy measures (in Norwe­ gian). Rapporter 9 2 / 3 , Central Bureau of Statistics, Oslo. N o r m a n , V . ( 1 9 9 0 ) : Assessing trade and welfare effects of trade liberalization. A comparision of alternative approaches to C G E modelling with imperfect competition. European Economic Review 34M y s e n , H . T . ( 1 9 9 1 ) : Substitution possibihties between fuels and electric­ ity in the production sectors in a macroeconomic model (in Norwegian). Rapporter 9 1 / 7 , Central Bureau of Statistics, Oslo. GfFerdal, E . , T h o n s t a d , K . a n d V e n n e m o , H . ( 1 9 8 7 ) : MSG-4; a Complete Description of the System of Equations, Rapporter 87/14, Central Bureau of Statistics , Oslo. S h o v e n , J. a n d W h a l l e y , J . ( 1 9 8 4 ) : Applied General Equihbrium Models of Taxation and International Trade: An Introduction and Survey, Journal of Economic Literature, 22. S v e n d s e n , 1. ( 1 9 9 1 ) : T h e import submodel of MODAG and KVARTS. Rapporter 90/20, Central Bureau of Statistics, Oslo. V e n n e m o , H . ( 1 9 9 1 ) : An applied general equihbrium assessment of t h e marginal cost of pubUc funds in Norway. Discussion Paper no. 62, Central Bureau of Statistics, Oslo.

Economic Modeling in the Nordic Countries L. Bergman and 0 . Olsen © 1992 Elsevier Science Publishers B.V. All rights reserved.

237

MECMOD - A medium term CGE model for Sweden Tomas Nordstrom

1

Introduction

MECMOD^ is a model - or rather a model system - which is developed and main­ tained by the National Institute of Economic Research for t h e official Medium Term Survey (MTS) at the Ministry of Finance in Sweden. In M T S 1990 t h e model replaced E M M A and LEMMA which had been used by t h e Ministry of Finance for 10-15 years in diflFerent versions. There are several reasons why new models were required for t h e M T S . T h e first was to give t h e models a more firm base in economic theory by deriving t h e equations from optimizing behaviour as far as possible.^ T h e second motive was to create models which are more easily adaptable to different applications. Finally, there was a strong need to make models more simple to handle and transfer between different users. T h e last point is not t h e least important in the new institutional setting of MTS-modelling in Sweden, where model use and model development is separated between t h e Ministry of Finance and t h e National Institute of Economic Research. M E C M O D is basically a static CGE-model of a rather traditional design.^ Compared to other models of this type it is a small model with only eight pro­ ducing sectors in t h e standard version. T h e r e are three primary factors of pro­ duction - fixed capital and two kinds of labour called "skilled" and "unskilled" labour. T h e supply of each type of labour is exogenous for t h e economy as a whole, while capital is supplied to t h e economy at a given price."* All factors can move freely between domestic sectors. Perfect competition is assumed in all markets and there are no scale economies. Foreign t r a d e is modelled with finite ^Medium term CGE-model ^Cf. the discussion of earlier MTS-models in Persson and Svensson (1987). Based on their paper, a dynamic general equilibrium model has also been developed for the MTS by the National Institute of Economic Research. ^Cf. the survey in Bergman (1985). Labour supply functions have recently been incorporated into MECMOD. However, they are not included in the version presented here.

238

Τ. Nordström

elasticities. There is only one type of domestic consumer. T h e model is run with exogenous (net) investment and closed with either exogenous current account or exogenous savings-ratio in t h e household sector. T h e foreign price level is chosen as numeraire. There are five kinds of substitution mechanisms in the model economy. T h e first one is between home goods and foreign goods in foreign use (exports), and the second one between home and foreign goods in domestic use (imports). These substitution possibilities relate to goods of t h e same classification. T h e third t y p e of substitution relates to t h e representative consumer's choice between goods of different classification. T h e fourth and fifth substitution mechanisms concern t h e choice of factor intensities in production of goods and services. Each represen­ tative firm (or government agency) is assumed first to choose an optimal mix of skilled and unskilled labour, and then to decide on the use of labour versus physical capital. All substitution is derived from CES-functions. T h e pros and cons of flexible aggregation is discussed in section 2, together with the rationale behind t h e choice of aggregates in the present version of MECM O D . All equations are given in section 3. Calibration procedures and choice of parameter values are briefly discussed in section 4. Finally, some simulations and sensitivity tests are accounted for in section 5. Technical definitions of goods and factors are given in appendix A, which also includes a complete list of variable names.

2

Aggregates

Within the Medium Term Survey CGE-models are used for analysis of a wide range of issues, e.g. taxation, energy policy, foreign trade. Obviously there is no unique definition of production sectors, goods and factors t h a t will suit all conceivable applications. There are broadly speaking two approaches t o this problem. One is to build a large model in terms of number of sectors and factors to make it possible to encompass all issues, t h a t one can foresee when building the model. T h e second approach is to build a "new" model for each different application. T h e first approach was t h e one chosen in earlier MTS-models. There are some advantages associated with this approach. T h e MTS-model serves to some extent as a framework for integration of sectoral studies most of which are conducted outside the Ministry of Finance. Results from such studies are sometimes taken as direct input in MTS-models. Some "stability" in t h e definitions of aggregates is required to make this process run smoothly. Also t h e sectoral results from MTS-scenarios are often taken as input into other model-based analyses outside t h e M T S . Frequent changes of classifications will reduce this possibihty. Finally,

A Medium Term CGE Model for Sweden

239

the empirical basis of the model can be gradually strengthened if aggregates are kept unchanged for some time. T h e second approach, which has been chosen for the M E C M O D - s y s t e m , im­ plies t h a t aggregates and specifications are adjusted to the application at hand. T h e rationale behind this approach is t h e desire to keep t h e model within man­ ageable size and still preserve a potential for a wide range of applications, some of which may not even have been foreseen when t h e model building started. Models which are gradually added to will soon be too hazy to be intelligible even to t h e model technician himself. T h e present approach can be described as a way to make "fresh starts" in the model specification cheap by preparing for t h e m in t h e construction of t h e model-system. Most of the advantages of a general purpose model listed above are lost with this approach. On t h e other hand tailor-made models will hopefully contribute to more penetrating analyses of t h e issues at hand by making it possible to concentrate on essential mechanisms and aggregates and relieve t h e model user from dead-weight losses due to superfluous details. T h e a t t e m p t to maintain flexibility so far mainly concerns the definition of sectors and factors of production. T h e database includes l O - d a t a for 45 business sectors, which permits a suflSciently broad spectrum of aggregation possibilities for MTS-purposes. Also the detailed account for some 25 types of labour accord­ ing to socioeconomic status and sex gives t h e M E C M O D - s y s t e m a potential for analysis of issues related to t h e changing structure of the labour force. In MTS-applications it seems necessary, however, to use some standard clas­ sification of sectors and factors to integrate results from partial analyses or to produce input for other models. As the main t h e m e in M T S is to analyse growth possibilities and structural change in a 10-15 years perspective, a classification of sectors according to factor intensities seems appropriate. A similar approach is found in Haaland (1987). In a study by Ohlsson and Vinell (1987) deahng with t h e growth prospects for the Swedish industry, manufacturing subsectors are defined and analysed in terms of factor intensities and openness to foreign competition. T h e standard version of M E C M O D is based on definitions used in this study. T h e model distinguishes between eight producing sectors - six business sectors and two public sectors according to Table 1. As can be seen from column 1 in the table, the labour-intensive sector uses more labour hours per unit value added t h a n any other goods producing sector. T h e service sectors, however, are even more labour-intensive (except for dwellings) as could be expected. Skilled labour is defined as high level white-collar workers and entrepreneurs with academic education, plus middle level white-collar workers with technical training.^ From column 2 it is also evident t h a t t h e share ^Definitions of sectors and labour categories are given in appendix A.

Τ. Nordström

240

Table 1: Factor intensities and export shares Labour", tot=100 1 2 3 4 5 6 g k

Capital-intensive Labour-intensive Skill-intensive Protected Dwellings Private services Central government Local government Total

63 108 95 104 24 118 125 125 100

Share skilled^ percent 14 10 22 7 16 12 26 12 13

Capital tot=100 76 45 43 43 381 53 79 64 100

Export share"*, percent 55 36 68 5 0 11 0 0 20

Hours worked/value added in 1988 prices * Skilled labour hours/total labour hours ^ Capital stock in 1988 prices/value added in 1988 prices Export in 1988 prices/gross output in 1988 prices

of skilled labour in t h e skill-intensive sector is much higher t h a n in any other goods producing sector. It should be noted, however, t h a t production of central government services uses an even higher share of skilled labour as defined in the model. Goods producing sectors do not generally show a higher capital-output ratio t h a n the service producing sectors, even apart from dwellings.^ Private services include capital-intensive communications and public services use a lot of buildingcapital.^ Among goods producing sectors t h e capital intensive sector uses twice as much or more capital per unit of value added t h a n t h e other sectors. T h e export share of gross o u t p u t displays a very distinct p a t t e r n . T h e three first sectors, which are defined as exposed to foreign competition, are outstanding, with more t h a n 60% export share in t h e capital- and skill-intensive sectors. ^The model sector "dwellings" also includes electricity, gas and water, which are highly capital-intensive. ^The capital-output ratio in public services may have been overestimated for (at least) two reasons. The first is that capital stocks for business sectors and public services respectively are taken from different sources. The business sector stocks are taken from Hansson (1989), while the public sector stocks are taken from National Accounts and are known to be biased upwards. The rather crude adjustment that was made before including the stocks in the database may have been insufficient. The second reason for overstating the public capital-output ratio is that output in public sectors as measured by National Accounts does not include (imputed) profits. A higher level of value added would be reported had net profits been included.

A Medium Term CGE Model for Sweden

241

To gain some idea about possible general equlibrium effects of changes in ex­ ogenous variables the relative size of the sectors and their factor use is i m p o r t a n t . It may be t h a t e.g. the share of skilled labour in production of private services is not very large. T h e size of the sector may however make it a very important employer in t h e market for skilled labour. Table 2 shows the distribution of total value added, labour, capital and exports between t h e eight model sectors in 1988. Table 2: Sectoral structure in 1988. Percentage share of total

Capital-intensive Labour-intensive Skill-intensive Protected Dwellings Private services Central gov Local gov Total

Value added 5 5 9 15 14 29 5 17 100

Hours worked 3 6 9 16 3 35 6 22 100

Skilled labour 4 5 15 9 4 32 12 20 100

Capital stock 4 2 4 7 53 16 4 11 100

Exports 24 13 42 5 0 16 0 0 100

It is obvious from t h e table t h a t t h e three sectors exposed to foreign competi­ tion are small compared to most other sectors in the model in terms of o u t p u t and employment. Together they account for no more t h a n one fifth of G D P . However, almost all impulses from t h e outside world via changing relative goods prices are channeled through these sectors. T h e three exporting sectors also use only one fourth of the total supply of skilled labour. T h e relatively high intensity of skilled labour in t h e public sector implies t h a t different growth rates for public services may have substantial effects on the market for skilled labour and indirectly on the competitiveness of t h e most important exporting sector in the model economy. T h e potential competition for resources is even more evident in t h e market for real capital between t h e capital-intensive sector, which accounts for more t h a n one fourth of total exports, and dwellings. In t h e model version with intersect oral, but not international, capital mobility, small changes in the demand for dwellings may strongly affect t h e growth potential for t h e capital-intensive sector.

3

Equations

This section presents the equations of the standard version of M E C M O D in the same form as they appear in t h e model program. T h e list of equations is com-

242

Τ. Nordström

píete, which means t h a t it includes cahbration constants in t h e lO-system and discrepancies in the National Accounts.

3.1

Demand for goods

Private consumption It is assumed t h a t a representative consumer distributes a given amount of expenditures between goods according to a CES utility function. Derivation of the expenditure function, i.e. the minimal expenditure necessary to achieve a certain level of utility, gives the optimal demand for consumption goods PKi as: PPK

PKL

.

,

„

PPKi where spk is t h e elasticity of substitution in t h e CES utility function, PKL is total consumption expenditures, PPK is the aggregate consumer price and PPKi is the price of good i including commodity taxes.® F i x e d i n v e s t m e n t a n d c h a n g e s in s t o c k s Net investment is exogenous. Since there is no a t t e m p t to introduce quasidynamics into this model version there is no endogenous link whatsoever between capital stocks and net investment, neither on sectoral level nor in t h e aggregate economy. It is possible, and in fact often done, to introduce a kind of dynamics into CGE-models by letting investment during one period, say five years, transform into capital stocks in t h e next period. This step is not taken in M E C M O D since the intention is to run t h e model together with a truly dynamic aggregated model. Even though net investment in each sector, NINVi, is exogenous, depreciation is determined by an exogenous depreciation r a t e depi and the capital stock C¿. Gross investment is then given by^: INV

= ¿ ( i V / i V V ; + depi. Ci) + INVR

(2)

»•=1

where INVR

is the discrepancy in National Accounts between sectoral invest-

ment and total investment. Changes in stocks, LA, are exogenous.

^Variable names and notational conventions are stated in appendix A. ^Indices running from 1 to 6 indicate that they relate to business sectors. Indices runnmg from 1 to k also include central government g and local government k.

A Medium Term CGE Model for Sweden

243

Intermediate demand Gross output in each sector is produced from intermediate goods and value added using Leontief technology with fixed coefficients. For technical reasons the input coefficients, insjj, are defined as shares of total use of intermediate goods, not as shares of gross o u t p u t Qj. T h e value added share of gross o u t p u t is fvj. The demand for intermediate use of good i is: INSDi

= ¿ insi, . (1 - fvj) i=i

· g,;

¿ = 1,..., 6

(3)

D o m e s t i c d e m a n d in b a s i c v a l u e s All components of demand are measured in constant purchasers' values. To determine the composition of demand for good i in terms of domestic production (in basic values) and imports (cif), domestic demand must also be measured in basic values, i.e. excluding commodity taxes and t r a d e margins. T h u s the strict adherence to National Accounts makes it necessary to define two measures of domestic demand in constant prices - one in purchasers' values and one in basic values. Commodity taxes are levied on private consumption only, while t r a d e margins apply to all components of domestic demand. Total domestic demand in basic values DZ for each commodity is:

DZi = {INSDi

+-

PK

:jTr + invi-INV

+ lai-LA)/{l

+ hmkiy,

i = l,...,6

(4)

INSDi (intermediate use), PKi (private consumption), invi-INV (investment), lüi' LA (changes in stocks) are components of domestic demand for commodity i in purchaser's values. All variables are measured in constant prices. Commodity taxes, itki^ and trade margins, /imA;,, measured in constant prices reflect t h e rates valid for the year chosen as index base for prices. D e m a n d for d o m e s t i c o u t p u t Domestic consumers, including firms and producers of public services, are assumed to treat domestic output and imports of commodities of the same type as imperfect substitutes. This is often referred to as the Armington-assumption. For each good t h e trade-off is described by a CES-function, which constitutes an inner nest in the aggregation of different types of goods (CES for private consumption and Leontief for other components of domestic d e m a n d ) . W i t h the usual optimality conditions demand for domestically produced goods Qi is derived from t h e unit cost function (11) for t h e composite good. Adding exports EX Pi and t h e lO-residual QRi gives demand for domestic o u t p u t :

Τ. Nordström

244

PDZi

sdzi

PQi\

DZi + EXPi-QRi-,

i = l,...,6

(5)

Value added is obtained by applying t h e exogenous value added share to gross output: FVi = fv,'Qi;

¿ = l,...,fc

(6)

Note t h a t production (or consumption) in public sectors is exogenous. D e m a n d for i m p o r t s As with domestic o u t p u t , demand for imports of good i is obtained from t h e unit cost function of t h e composite good (11): IMPi

= amf''-"^ ·

PDZi

sdzi

PIMPi

•DZi]

i = l,...,6

(7)

Exports Foreign as well as domestic consumers are assumed to make a difference between goods of t h e same classification depending on wether it is produced in Sweden or elsewhere. From a theoretical point of view this assumption, which is frequently used in CGE-modelling, does not fit very well with t h e common notion of Sweden as "a small open economy". For a medium to long run equlibrium model there is no good defence for using this specification, except for t h e fact t h a t pure theory otherwise predicts a much stronger specialization in trade between countries t h a n we in fact can observe. Even though Swedish goods are treated as imperfect substitutes for foreign goods, it is not necessary t o assume t h a t Swedish producers have monopoly power in foreign markets. We can add t h e assumption t h a t Swedish producers compete perfectly among themselves on all markets (which is not very realistic considering t h e fact t h a t t h e number of exporting firms in each sector is very small). In fact we have expanded t h e number of goods in t h e model with t h e number of traded goods. Even if Swedish and foreign goods of t h e same classification are not perfect substitutes it is still possible to make t h e m close substitutes by letting elasticities in imports as well as exports b e high. T h e export functions are: EXPi

= ati.

WMi.

PQi PWi

;

¿ = 1,...,6

(8)

w here WMi and PWi are indices of export market size and price level respectively.

A Medium Term CGE Model for Sweden

3.2

245

Prices

W i t h constant returns to scale and all factor inputs (labour and capital) mobile between sectors, domestic supply is completely elastic for each good. Goods prices are determined only by factor prices given by equilibrium in factor markets. Also supply of imports is completely elastic. Import prices are exogenous. Optimal factor allocation, with CES-aggregation of composite labour and capital to value added, and perfect competition give the value added price PFVi in terms of factor prices WTi and P C , : PFVi

= [{WTi/aliY"^'''

+ (PC¿/ac¿)'"*^^'] '-^'^"· ;

¿ = 1,...,

fc

(9)

This also applies to public services. O u t p u t prices PQi are computed from value added prices PFVi and prices on intermediate goods PDi'}^

PQi = fvi.

PFVi + (1 - fvi) · PPIi

·έ

insji · PD,-

¿ = 1,...,

fc

(10)

T h e bcLsic price of t h e composite good in domestic use PDZi is calculated from the import price PI Μ Pi and the price of domestic o u t p u t in basic values PQi according to t h e assumed CES-aggregation:

PDZi

= [{PIMPJamiY-"'^

+ {PQi/aqiY-""']

^

;

¿ = 1,..., 6

(11)

PDZi is t h e price of good i on domestic markets when it leaves t h e combined plant-import harbour. Before it reaches t h e u l t i m a t e consumer trade margins and commodity taxes are added. It is assumed t h a t t r a d e margins are added in equal proportion to all uses of t h e composite good except for exports. This is obviously a major simphfication.^^ In t h e first place some t r a d e margins are actually levied on exports, which can be seen from lO-data. Also t r a d e margins are much larger for private consumption (retail trade plus gross trade) t h a n for intermediate goods (gross trade only). However, a more detailed account for trade margins will greatly complicate t h e equations of t h e model. It is assumed t h a t the price of trade margins follows t h e price of private services, PQe, rather than t h e price of t h e good itself. This seems a reasonable ^^The PPIj's

are lO-calibration constants. Note the definition of input coefficients fvi and

insjii 6

6

^ insji = 1 and /v¿ Η- (1 - / ν , ) · insji = 1; i=i i=i

i = 1,...,

Trade margins may make up for a substantial part of the ultimate price for some goods.

246

Τ.

Nordström

assumption in the medium and long run. Domestic prices PDi including trade margins are: PDi = {PDZi

+ PQ^ · hmi)l{\

+ /imA;,);

¿ = 1,..., 6

(12)

Current trade margins can be changed exogenously by the parameter hrrii. T h e hmki^s are calibration constants. As with trade margins the t r e a t m e n t of commodity taxes is quite simphfied. There is only one net tax which covers both VAT and other commodity taxes as well as subsidies. T h e net tax is an ad valorem tax, while commodity taxes other than VAT and most subsidies are in fact quantity taxes. Also the tax base is assumed to consist of private consumption only, although other components of demand are taxable in reality. Prices of consumer goods PPKi including commodity taxes are given by: PPKi

= PPl

· PDi.

(1 +

¿^0/(1

+ itki);

¿ = 1,..., 6

(13)

where it i is the current commodity net tax rate and P P l and itki are calibration constants from the lO-system.^^ W i t h consumer demand derived from a CES utility function the true consumer price index P P A ' can be calculated from goods prices:

Investments in all sectors are assumed to consist of the same Leontief composite good making the aggregate price PINV on the common investment good equal to: 6

PINV

= PP2 . ^

invi · P A

(15)

t=l

where P P 2 is an lO-calibration constant. Finally the price of investments in stocks is: 6

PLA = PP3'Y^lai'PDi

(16)

t=l

with the calibration constant P P 3 . ^^The constant itki is actually a commodity tax rate in constant base-year prices. It is necessary to define such a constant because National Accounts use deflators for purchasers' values as well as basic values both of which are by definition equal to unity for the base year.

A Medium Term CGE Model for Sweden

3.3

247

Demand for factors of production

Each sector, including public services, uses three kinds of inputs - skilled and unskilled labour^^ together with capital - in a two-level CES production function. In the inner nest the two types of labour are aggregated to composite labour, which is combined with capital in the outer nest. For each sector the aggregate wage cost per hour WTi is given by: WTi = [{WTS

· wsi/alsiY-'''''

+ {WTU

· i/;u¿/a/u,)'"'"**](17)

WTS and WTU are equilibrium wages on t h e two labour markets. Even though the two types of labour are assumed to be perfectly mobile between sectors, observed wage levels in different sectors for each category are not equal. T h e initial distributions of wages, wsi and wui respectively, are kept unchanged in simulations. Derivation of (17), which is t h e m i n i m u m cost per unit composite labour AT,, gives sectoral demand for each type of labour AT Si and ATUii ATSi

=

sati

WTi

α/^Γ*^-^ . WTS.

ATUi = alur''-'

·

•ATi;

wsi

WTi

i=l,...,k

sati

T h e outer nest combines composite labour and capital to value added. demand is obtained by derivation of the unit cost function (9): ATi =

α/*^^·-' . (PFVi/WTiY^'"'

Ci = ac^^""'-' . {PFVi/PCiY^'''

(18)

- FVi] FVi]

¿ = 1 , . . . , ifc ¿ = 1,...,

Factor

(20) (21)

T h e price of capital PC,- is defined as the cost of using one unit of physical capital measured in constant prices: PCi = [ri'R-\-depi]'PINV',

i=l,...,k

(22)

where R is the avarage level of the real rate of return before taxes. As with labour the distribution of return to capital between sectors, r¿, t h a t can be observed for ^^Skilled and unskilled labour are defined in appendix A.

248

Τ. Nordström

the cahbration year is exogenous.^'*

3.4

Supply of factors of production

Factor supply in all three markets can be treated in two extreme ways. Either t h e supply is exogenous which makes factor prices endogenous, or factor supply is completely elastic with exogenous factor prices. T h e second alternative may seem more relevant for capital and is chosen for t h e MTS-version of M E C M O D . Some interesting results can be obtained by applying this approach to skilled labour as well, remembering t h a t t h e time perspective m a y be long enough t o treat t h e economy as open not only in goods- and capital-markets, but also in segments of the labour market.

3.5

Equilibrium in factor markets

T h e equlibrium conditions simply state t h a t total demand for each type of labour equals supply: k

LSS = Y^ATSi

(23)

t=l

k

LSU = Y^ATUi

(24)

t=l

In t h e capital market t h e real rate of return is given by t h e world market: RW = R

3.6

(25)

Closure rules and numeraire

Still one more relation is needed in t h e model to link t h e income and expenditure sides of t h e economy and to determine overall savings, i.e. t h e current account. To be more specific, consumer expenditures PKL in (1) are not yet determined. This can be done in basically two ways. Either household savings or t h e current account (trade balance) is exogenous. T h e choice of "closure rule" may differ between applications. If t h e current account is exogenous t h e closure rule deter­ mines t h e consistent level of private consumption expenditures. If, on t h e other ^'^This formulation of the model is dubious as is the corresponding assumption about wage differentials for homogenous labour. There may be several explanations for the observed sectoral differences in real rates of return. The most obvious reason is the fact that the calibration year is unlikely to exhibit a long run equlibrium position for all sectors. Another is difference in risk. Also no adjustment has been made for taxes. For labour one might also add the fact that beneath the two categories of labour there is a structure of skill that may differ between sectors.

A Medium Term CGE Model for Sweden

249

hand, household savings are exogenous, households' disposable incomes must be computed to determine consumption expenditures. This is done in M E C M O D with a fairly elaborate but principally simple scheme t h a t is fully consistent with the income and outlay tables of National Accounts. Finally, the exchange rate is assumed fixed and the foreign price level is the numeraire to which all prices in the model are related.

4

Calibration and parameter values

Most CGE-models are calibrated to a specific year for which an elaborated database has been compiled. T h e calibration year is also chosen as index base for prices, which facilitates the calibration procedure. T h e M E C M O D system makes it possible to calibrate the model for different years and with any year as price index base. T h e "natural" choice of base year is the same as t h e latest available complete National Accounts. T h e flexible calibration opportunities add some complications to calibration and model programs but have some distinct advantages. T h e freedom to choose base year for prices makes it possible to reproduce components of G D P according to National Accounts, which may help the model user to feel more familiar with actual figures in creating assumptions for simulations or interpreting t h e results. T h e freedom to choose t h e calibration year is potentially i m p o r t a n t . T h e usual calibration procedure assumes, often without exphcit discussion, t h a t t h e economy is in equilibrium in the calibration year. There is also sometimes a desire to choose the calibration year as late as possible to fill the model with "fresh" figures. These aims may be conflicting. T h e calibration procedure and time series d a t a base of the M E C M O D system makes it possible to test the importance of t h e choice of calibration year and to choose it at will. T h e cahbration procedure runs along standard hues. Assuming static equhbrium with perfect competition, unknown constants in utilility and production functions are solved to make t h e model solution for the calibration year reproduce observed prices and quantities. Substitution elasticities in t h e CES-aggregators must be assigned before calibration. T h e figures given in Table 3 are used in the present version of the model.

^^MECMOD includes a somewhat simplified version of the accounting scheme, which is used by the Ministry of Finance to decompose the current account into net lending in six domestic sectors: non-financial corporate enterprises, financial institutions, central government, local government, social security funds and households.

250

Τ.

Nordström

Table 3: Model parameters Export price elasticity Capital-intensive Labour-intensive Skill-intensive Protected Dwelling Private services Central government Local government

-4.0 -4.0 -4.0 -2.0 0.0 -1.0 -

Substitution elasticities Home/foreign L a b o u r / Skilled/ goods capital unskilled 0.8 0.8 1.6 0.8 0.8 1.6 0.8 0.8 1.6 0.4 0.6 1.6 1.2 0.0 0.6 0.2 1.2 0.6 1.2 0.0 1.2 0.0

T h e high export price elasticities chosen for competing sectors avoid too strong terms-of-trade effects in scenario applications. There seems to be some consensus in the empirical literature for labour-capital substitution elasticities between 0.5 and 1.0.^^ T h e distinction between different kinds of labour is not very common in CGE-modelling. Moreover, t h e elasticity might depend on t h e definitions of labour categories. T h e only basis for the numbers given in t h e table is a series of simulations in which t h e share of skilled labour was altered over a 10-year period. W i t h low elasticities, relative wages are compressed too fast. T h e substitution elasticity in private consumption, finally, is 0.8.

5 5.1

Simulations Scenario examples

In t h e Medium Term Survey published in spring 1990 a set of scenarios was simulated with M E C M O D . Construction of scenarios within t h e M T S draws on several models in a fairly unformalized process.^''. At some stage in this process ^^See for example Caddy (1976). ^•^Two other models were used in MTS 1990 - ISMOD and MAMMA. MAMMA is an aggre­ gated Mertemporal geneial equilibrium model first presented in Persson and Svensson (1987), It is used to analyse the dynamics of the economy's transition between difi'erent steady state growth paths, paying full regard to forward looking savings and investment decisions of rational agents. ISMOD was developed by the National Industrial Board in the late seventies to assist in the analysis of structural change in the manufacturing sector, which is split into some 30 subsectors. The distinctive feature of ISMOD is the division of capacity in each sector into several "profit classes", which makes it a vintage model. Technical change is partly endogenous and determinated by the rate of net investment in each sector

A Medium Term CGE Model for

251

Sweden

M E C M O D ' s exogenous variables are determined by other models or by separate forecasts. T h e basic scenario assumes t h a t t h e total labour force grows by 0.7% per year between 1988 and 2000 and t h a t the share of skilled labour is increased by 3 percentage points from 13 to 16%. T h e exogenous growth rate of t h e capital stock was put at 1.9% and government consumption growth rate at 1.2% per year. Besides these aggregate assumptions t h e model must be fed with sectoral inputs. Some of these are given in Table 4. Table 4: Sectoral assumptions 1988-2000 in basic scenario. Percentage growth rates

4.8 4.3 4.7 (4.1)

World market prices 2.4 3.0 3.4 (2.5)

-

-

(5.5)

(4.0)

-

-

World t r a d e Capital-intensive Labour-intensive Skill-intensive Protected Dwellings Private services Central government Local government

-

Technical change 2.1 3.0 3.1 2.6 0.0 1.3 0.0 0.0

T h e classification of sectors implies t h a t some export is present also for shel­ tered sectors. Although foreign t r a d e is small compared to o u t p u t , the model includes export functions with market size and relative price as arguments in these sectors as well. Technical change is labour augmenting and is assumed to influence the eflSciency of skilled and unskilled labour equally. T h e abscence of technical change in the public sectors is a mirror of the National Account convention. Some alternative scenarios were also given in the Medium Term Survey. In alternative 1 in Tables 5-6 the growth rate of technical change in the business sectors is assumed to be 0.9 percentage points above the basic scenario. T h e effects of an increased quality of labour is shown in alternative 2, where the share of skilled labour is further increased to 19% of the total labour force. All scenarios were run with exogenous t r a d e balance. Aggregate results are given in Table 5.

Τ. Nordström

252

Table 5: Scenarios 1988-2000, aggregate results. Percentage growth rates

Private consumption Public consumption Gross investment Exports Imports GDP Labour supply (exogenous): Total labour Skilled labour Unskilled labour Relative wages (skilled/unskilled)

Basic 2.2 1.6 1.8 4.9 4.4 2.2

Altl 2.9 1.6 3.3 5.8 5.4 2.9

Alt2 2.5 1.6 1.8 5.1 4.6 2.4

0.7 2.5 0.4 -1.2

0.7 2.5 0.4 -1.2

0.7 3.9 0.1 -2.5

T h e general outcome of t h e simulations as described by the aggregate balance of resources displays no surprises. G D P growth rate is 2.2% per year in the basic scenario. W i t h a more rapid technical change in alternative 1, G D P will grow faster. More fixed capital can be employed with profit which requires higher investments. Since the trade balance and p u b h c consumption are fixed, a faster growth in private consumption is nevertheless possible. T h e shift towards higher labour quality in alternative 2 will also raise the overall growth rate since skilled labour is more productive t h a n unskilled labour. Relative wages develop unfavourably for skilled labour in the basic scenario when its share of total labour supply increases. Skilled wage levels are still higher t h a n unskilled b u t t h e margin is reduced from 80% to less t h a n 60%. T h e wage difference is even more reduced in alternative 2. However, the displayed figures are wage costs. If one assumes t h a t the increas in skilled labour supply is caused by reduced marginal tax rates, the development of relative after tax wages will not be t h a t dramatic. Table 6 shows sectoral results for t h e three simulations. T h e basic scenario indicates favourable growth conditions for the skill-intensive sector relative to other exposed sectors. High market growth, high prices, fast technical change and cheap supply of skilled labour, all these factors contribute to fast output growth. T h e opposite holds for the capital-intensive sector.

A Medium Term CGE Model for

253

Sweden

Table 6: Scenarios 1988-2000, sectoral results. Percentage growth rates

Output: Capital-intensive Labour-intensive Skill-intensive Protected Dwellings Private services Total

Basic

Altl

Alt2

0.5 1.9 4.3 2.0 1.0 2.4 2.2

0.9 2.9 5.4 3.1 1.7 3.4 3.2

0.6 2.0 4.6 2.1 1.2 2.6 2.4

T h e overall increase in technical change in alternative 1 does not affect the sectoral structure very much. In alternative 2, however, the skill-intensive sector takes advantage of t h e increased supply and low price of its distinctive factor input.

5.2

Sensitivity tests

Estimates of substitution elasticities between skilled and unskilled labour are hard to find in econometric literature. Still they may be important in potential applications of t h e model. To show this an experiment is arranged, which implies an isolated shift in the structure of the labour force from unskilled to skilled labour. To be more specific, it is assumed t h a t the quantity of skilled labour is increased by 10 percent, while the total supply of labour hours is unchanged. This implies t h a t the supply of unskilled labour is reduced by 1.5%. All other exogenous variables are left unchanged. This experiment is repeated for three sets of elasticities - one with the standard values given in section 4, one with zero substitution in public sectors and one with half t h e standard values in all sectors. It is obvious from t h e two first columns in Table 7, t h a t a shift in t h e compo­ sition of the labour force produces substantially different effects on relative wages depending on the value assigned to the substitution elasticities between skilled and unskilled labour. From the third column one may also note t h e importance of t h e public sector in the market for skilled labour as defined in t h e model. W i t h no substitution at all in central and local government the entire increase of skilled labour must be absorbed in the business sector. This is possible only if relative wages of skilled labour is even more depressed t h a n in t h e bcise run. It should be noted t h a t the results may depend on the choice of closure rule and capital market specification.

Τ. Nordström

254

Table 7: Alternative substitution elasticities between skilled and unskilled labour. Percentage differences from base run Standard values" Labour supply: Skilled Unskilled Wages: Skilled Unskilled

Half of standard values

Zero substi­ tution in public sector

10.0 -1.5

10.0 -1.5

10.0 -1.5

-7.5 0.7

-13.4 2.6

-9.9 1.5

Standard values are 1.6 for goods producing sectors and 1.2 for services.

6

Concluding remarks

So far M E C M O D has primarily been used as t h e standard tool in construction of scenarios in the Swedish official Medium Term Surveys. T h e disaggregated database, however, gives the model system a broad potential for applications. Taxation and the size of t h e public sector, environmental issues, t h e role of ed­ ucation for the quality of t h e labour force are areas which are in focus of t h e present policy debate in Sweden. T h e use of the model within the Ministry of Finance also requires detailed income and expenditure accounts to be attached to the model, especially for the public sectors. Finally, more work could be done to overcome the shortcomings of the static model by further integration with more aggregated but truly dynamic models.

A Medium Term CGE Model for Sweden

255

References A r m i n g t o n , P . S . ( 1 9 6 9 ) : Adjustments of Trade Balances: Some Experiments with a Model of Trade among many Countries. I M F Staff Paper, 16. B e r g m a n , L. ( 1 9 8 5 ) : Extensions and Apphcations of t h e MSG-Model: A Brief Survey in F0rsund, F.R., Hoel, M., Longva, S. (ed): Production, Multi-Sectoral Growth and Planning, North-Holland, 1985. C a d d y , V . ( 1 9 7 6 ) : Empirical Estimates of t h e Elasticity of Substitution: A Review. Industries Assistance Commission, Melbourne, A u s t r a h a (mimeo). H a a l a n d , J . ( 1 9 8 7 ) : H O V M O D . A General Equihbrium Model for Norway as a Small Open Economy (in Norwegian). Center for Applied Research, report 20/87. Norwegian School of Economics and Business Administration, Bergen. H a n s s o n , B . ( 1 9 8 9 ) : Construction of Swedish Capital Stocks 1963-1987. Eco­ nomic Studies 89 (2)^ Department of Economics, Uppsala University, Upp-

O h l s s o n , L. a n d V i n e l l , L. ( 1 9 8 7 ) : Tillväxtens drivkrafter. Sveriges Industriforbund.

Stockholm,

P e r s s o n , T . a n d S v e n s s o n , L . E . O . ( 1 9 8 7 ) : New Methods in the Swedish Medium-Term Survey. Bilaga 3 Längtidsutredningen 1987.

Τ. Nordström

256

Appendix A: Data sources and variable names A.l

Definitions and datasources

S e c t o r classification M E C M O D distinguishes between eight producing sectors - six business sectors plus central and local government. T h e business sectors are broadly defined according to openness to foreign competition and intensity of factor use. Table A . l gives the exact definitions in terms of the classification in Swedish National Accounts. T h e table also gives the complete list of sectors in the disaggregated database. Time series generally cover t h e period from 1970. All variables related to production are taken from National Accounts except for capital stocks, which are taken from Hansson (1989), since they are no longer compiled by Statistics Sweden. T h e basic lO-table is from 1988.

Table A . l : Definition of industrial sectors'" 1

Capital-intensive goods

2100 2200 2300 3120 3421 3422 3521 3530 3710 3720

Iron ore mining Non-ferrous ore mining Other mining and quarrying Manufacture of beverage and tobacco Wood pulp industries Manufacture of paper and paperboard Manufacture of industrial chemicals Petroleum refining Iron and steel basic industries Non-ferrous metal basic industries

2

Labour-intensive goods

3112 3200 3411 3423 3510 3523 3811 3900

Import-competing food manufacturing Textile industries Saw mills Manufacture of fibreboards etc Manufacture of rubber products Manufacture of plastic products Manufacture of metal products Other manufacturing industries

A Medium Term CGE Model for

Sweden

Table A . l (cont.): Definition of industrial sectors" 3

Skill-intensive goods

3522 3812 3813 3814 3830 3843

4

Protected goods

1100 1200 1300 3111 3412 3430 3600

Manufacture of other chemical products Manufacture of machinery Manufacture of transport equipment Manufacture of professional measuring equipment etc Manufacture of electric machinery Ship building and repairing

5000

Agriculture, hunting Forestry and logging Fishing Protected food manufacturing Manufacture of wooden products Printing and publishing Manufacture of non-metallic mineral products Construction

5

Dwellings

8300 8400 4100 4200 4400

Letting of dwellings Letting of other premises Electricity, steam and hot water supply Gas manufacture and distribution Water works and supply

6

Private services

6100 6300 7100 7200 8100 8200 8500 9510

Wholesale and retail t r a d e Restaurants and hotels Transport and storage Communication Financial institutions Insurance Business services Repair services Other services

-

Figures refer to sector number according to Swedish National Accounts.

257

258

Τ. Nordström

Labour categories D a t a on the distribution of different kinds of labour between sectors are taken from the Household Census, which is carried out every fifth year in Sweden. This part of the database includes the distribution of 13 kinds of labour between all of the 47 sectors of the database. Besides, all labour categories are accounted for by sex. For each category t h e number of persons employed per sector and their labour income are available. Table A.2: Employment per sector and category in 1985. Household Census, hundreds of persons

Manual workers: Unskilled Experienced W h i t e - c o l l a r workers: Low level I Low level II Middle level, techn Middle level, non-techn High level, techn High level, non techn Entrepreneurs: Academic educ, techn Acad educ, non-techn Others Farmers Others:" Total

Manuf

Other Ind

Total Ind

Gov Sect

Total

3358 2221

4863 2629

8221 4851

4267 1687

12488 6538

563 501 735 450 226 384

1298 1798 672 1459 139 1059

1861 2299 1407 1909 365 1443

849 1461 236 3068 49 1893

2710 3760 1643 4997 415 3337

1 1 116 7 536

5 29 1004 879 1636

6 30 1120 886 2173

1 1 10 13 1403

7 31 1130 899 3576

9102

17475

26577

14940

41517

Pensioners, students etc

The labour categories are defined in terms of a socioeconomic classification. T h e standard classification was expanded for some groups to show separately technical occupation. T h e distribution of employment between categories and broad sectors in t h e economy is shown in Table A.2 and the avarage labour

A Medium Term CGE Model for

259

Sweden

income in Table A.3. Table A.3: Labour income per person in 1985 Household Census, thousands of SEK

Manual workers: Unskilled Experienced W h i t e - c o l l a r workers: Low level I Low level II Middle level, techn Middle level, non-techn High level, techn High level, non techn Entrepreneurs: Academic educ, techn Acad educ, non-techn Others Farmers Others: Total

Manuf

Other Ind

Total Ind

Gov Sect

Total

88.3 100.2

77.2 97.9

81.7 98.9

68.1 80.2

77.1 94.1

83.1 114.0 136.8 130.0 172.6 193.2

79.8 108.8 138.2 112.9 162.3 173.0

80.8 109.9 137.5 116.9 168.6 178.4

74.4 86.2 119.5 94.9 140.8 138.9

78.8 100.7 134.9 103.3 165.3 156.0

100.1 106.7 72.7 60.1 59.9

114.2 143.9 88.2 47.1 43.2

113.3 142.9 86.6 47.2 47.3

-

64.0 47.3 44.5

113.3 142.9 86.4 47.2 46.2

102.9

91.6

95.5

84.9

91.7

T h e definition of skilled labour in the model is chosen to include white collar workers at middle level with technical occupation, all white collar workers at high levels and all entrepreneurs with academic education. This makes up for some 13% of the total labour force. All employment and income figures are adjusted to National Account levels by simple scaling. A major obstacle is t h a t there is no information on hours worked in Household Census data. No a t t e m p t is m a d e to adjust for t h e possible bias in the computed hourly earnings levels. This fact makes it a bit dubious to use the data-set for female-male classifications of the labour force. Factor prices Factor prices are defined as labour cost per hour and capital cost per unit physical capital stock measured in 1988 prices. Aggregate labour wage costs are taken from

260

Γ. Nordström

National Accounts for each year. Relative costs for skilled and unskilled labour are available only for 1985 from t h e Household Census. Capital costs PC are computed from National Accounts as gross operating surplus OS divided by t h e capital stock C: PC =

OS = PFV

'FV-WT'AT

where PFVFV is value-added in current prices and WT-AT is total wage cost. Dividing PC by the price of investments goods PI and subtracting t h e depre­ ciation r a t e δ gives t h e net real rate of return on physical capital (before taxes):

R is t h e variable actually used in equilibrating t h e market for fixed capital in t h e model. From t h e definitions above t h e operating surplus can be written: OS = PFV

A.2

'FV-WT'AT

= PC'C

=

{R-]-6)'PI'C

Variable names

Each name consists of a **root" with a prefix or a suffix. Whenever applicable t h e prefix is always " P " which denotes the price and t h e suffix is always "L" meaning t h a t the variable is taken in current prices. W h e n the root only is assigned to a variable it denotes value in base-year prices. In the list of names below only suffix "L" is printed. It is understood t h a t if a variable exists in constant as well as current prices a price index also exists. Of course this notational convention is not relevant for all variables, e.g. labour which is measured in hours. Business sector variables are indexed with In some cases, such as wages, this index is extended to include also t h e government sector with indices "p" (central government) and "A:" (local government). Variables marked with · are endogenous in the model. Variables •ATi •ATSi •ATUi •Ci •D{L)i •DZ{L)i •EXP{L)i •FV{L)i

Hours worked, aggregate labour Hours worked, skilled labour Hours worked, unskilled labour Physical capital stock Domestic demand in basic values (incl. t r a d e margins) Domestic demand in basic values Exports Value added in basic values

A Medium Term CGE Model for Sweden

'IMP{L)i •INSD{L)i NINVi INV{L) LA{L) LSS LSU 'PK{L)i Ρ Pi, PPIi PWi 'Q{L)i 'R RW WMi 'WT{S, U)

Imports, cif Intermediate use of good i Net investment by investing sector Total gross investment Changes in stocks Supply of skilled labour Supply of unskilled labour Private consumption in purchaser's values lO-cahbration constant Export market price Gross o u t p u t in basic values Real rate of return, avarage level Real r a t e of return in world capital markets Index for export market Hourly wages and salaries including employer's contribution to social security (skilled, unskilled), avarage level

Parameters aci ae, aki ali alsi alui arrii aqi depi fvi hrui hmki insij invi Hi itki lüi r, sali sdzi sei sfvi

Capital parameter in production function Parameter in export function Parameter in utility function Labour parameter in production function Parameter for skilled labour in aggregate labour Parameter for unskilled labour in aggregate labour Parameter for imports in composite good P a r a m e t e r for domestic production in composite good Depreciation rate Value added share in gross o u t p u t Trade margin in current prices Trade margin in base-year prices Input coefficient Composition of investment good Commodity tax r a t e in current prices Commodity t a x rate in base-year prices Composition of inventory good Real rate of return distribution Elasticity of substitution between skilled and unskilled labour Elctsticity of substitution between domestic and foreign goods in domestic use Price elasticity of export demand Elasticity of substitution between aggregate labour and capital

261

262

spk wsi wui

Τ.

Nordström

Elasticity of substitution in consumption Wage cost distribution, skilled labour Wage cost distribution, unskilled labour

Economic Modeling in the Nordic Countries L, Bergman and 0 . Olsen © 1992 Elsevier Science Publishers B.V. All rights reserved.

263

An applied general equilibrium model of the Swedish economy Tohmas Karlsson

1

Introduction

This paper presents a relatively small computable or applied general equilibrium model t h a t can be used to analyze m e d i u m and long run structural issues. One of the main motives behind the construction of t h e model was a desire to complement the calculations of distributional effects of the Swedish t a x reform, implemented during 1990-91, t h a t were based on tax- benefit models. Although these models replicate the t a x system in great detail they only capture direct impact effects since they do not incorporate any economic behaviour. Our model, on t h e other hand, concentrates on t h e economic behaviour and tries to assess t h e long run effects, after wages, prices and quantities have fully adjusted to a new equilibrium. T h e cost of this more sophisticated economic analysis is t h a t we are forced to model t h e tax reform in a very stylized fashion through a small number of effective tax rates. Thus, the two model approaches should be seen as complements rather t h a n substitutes in analyzing t h e t a x reform. Although t h e model is primarily designed for the purpose of evaluating t h e Swedish tax reform we will not pursue t h a t analysis here. Instead we concentrate on a general description of the model and its properties. In general, this t y p e of model focuses on sectoral allocation of factors of production, labour supply and consumption patterns, in response to a change in economic policy or other exogenous variables. Given t h a t we have d a t a on different household categories it is possible to compute quantitative measures of efficiency as well as distributional effects. T h e model belongs to t h e tradition of static computable general equilibrium models.^ T h u s , t h e time dimension is not explicitly modelled and there are no truly intertemporal decison problems to be solved. This means t h a t savings and investment decisons are treated in an ad-hoc manner. It is assumed t h a t households save a constant fraction of their income. However, savings has no effects upon production capacity nor future consumption. Instead of an exphcit ^For a comprehensive treatment of a typical (static) CGE model see Ballard et.al. (1985).

264

Τ. Karlsson

demand for investment over time we define the demand for new capital as t h e difference between the desired long run capital stock and the actual capital stock. T h e model includes four types of agents; producers, households, a government sector and the rest of the world. There are two types of labour; skilled and unskilled, both of which are assumed to be perfectly mobile between t h e sectors of the domestic economy. Households are endowed with labour and capital stocks, including household capital. We make a distinction between old or sector specific and new or mobile capital. T h e sector specific capital stocks as well as t h e total amount of new capital are exogenously given. T h e return to old capital stocks takes the form of quasi rent. Production employing old capital, whether it takes place in t h e business or in the household sectors, continues as long as t h e quasi rent is non-negative. In contrast to old capital, we assume t h a t new capital can be freely allocated between t h e production and household sectors. Thus, t h e net return of new capital must be equalized across sectors. There are a number of reasons for dividing capital into the categories old and new. First, by altering the relation between old and new capital we can simulate different degrees of capital mobility. In the very short run all capital can be considered to be of t h e old type with no mobility at all, whereas in t h e long run the entire capital stock is mobile.^ Secondly, substitution possibilities between factors of production are greater ex ante t h a n ex post. Thirdly, new technologies are often embodied in new investment. These facts can be incorporated in the model by interpreting new capital as capital t h a t has not yet been installed for a specific use. Lastly, t h e distinction between existing and new capital is also useful from a t a x perspective. T h e production sectors of the economy are divided into three tradeable and three non-tradeable sectors. In the tradeable sectors the o u t p u t prices are de­ termined by the world market. T h e non-tradeable sectors consist of housing, private services and public production. Households have preferences over con­ sumption of goods and leisure, which means t h a t labour supply is endogenous. There are two alternatives for t h e households to employ its labour supply; it can be offered for sale on the regular labour market or it can be used together with household capital in the household production process. A reason for explicitly modelling household production is t h a t those activities are not subject to tax­ ation, which induces substitution between taxable and non-taxable employment of the resources of households. There are two channels through which the rest of the world affects t h e do­ mestic economy. Firstly, t h e o u t p u t prices of t h e tradeable sectors, which are classified in terms of factor proportions of primary factors, are determined in t h e ^This distinction between old and new capital is adopted from Haaland (1987). See also Devarajan and Offerdahl (1989) for a discussion about the role of different assumptions regarding capital mobility in CGE models.

An Applied General Equilibrium

Model of the Swedish Economy

265

world markets and can thus be regarded as exogenous to t h e domestic produc­ ers. Secondly, we assume t h a t t h e interest rate is determined in t h e international capital market. T h e availability of an international capital market implies t h a t domestic supply and demand for new capital need not be equal in equilibrium. If demand for new capital exceeds supply, at a given interest rate, the difference is imported. T h e government sector collects taxes and given the exogenous public expen­ ditures and government savings, distributes transfers to households such t h a t it balances its budget. T h e model solves for the allocation of labour and new capital among t h e pro­ duction and household sectors, which in t u r n determines t h e o u t p u t of different goods. For each household category, we determine the supply of labour, the allo­ cation of its endowment of new capital between business production sectors and household capital and the expenditures among different consumption goods. In addition we determine the amount of foreign supplied new capital. Finally, t h e distribution of income is given by the equilibrium factor prices and the endowment of factors of production. T h e outline of the paper is as follows. Section 2 describes t h e behavioral assumptions of the agents in t h e model. In order to determine t h e properties of the model we compute a number of elasticities, which are presented in Section 3. T h e notation used, d a t a sources and the calibration procedure are provided in Appendices A-C.

2 2.1

The model The household sectors

Each household sector is comprised by two activities; a consumption and a pro­ duction sector. In t h e former we analyze a representative household in its role as a consumer, i.e. it demands goods, household services, leisure and supplies labour. T h e second subsector describes household production. Household services are supplied and labour and household capital are demanded. One can interpret the household production sector as the informal sector in the economy. T h e r e are two mechanisms which govern the allocation of resources between t h e formal and t h e informal sector in t h e model. T h e household first decides how to allocate its labour endowment between leisure and labour supply and then further divides its labour supply into one part going to t h e regular labour market and another part which is channeled to household production. Thus, note t h a t we distuingish between leisure and time devoted to work in household production. In addition, the household has to pay capital income taxes, but only on t h a t proportion of its endowment of new capital which is allocated to t h e business production sec-

266

Τ. Karlsson

tors. Consequently, t h e household can escape part of t h e capital income t a x by employing new capital in household production. Consumption demand and labour supply Each household is endowed with labour services, LEh, old stocks of household capital, KDho-, business production capital, Κ jo and new capital ASh^ As men­ tioned before there are two categories of labour used in t h e production sectors, skilled and unskilled. In order to connect t h e skill and household types we assume t h a t each household h is endowed with skill category h in the fixed proportion qhh of its total labour endowment. For convenience let us define t h e price of leisure as PFH = Y,W,-{l-TYu)-q,H

(1)

6

where Wh is the gross wage rate, and Tyh is the labour income t a x rate. T h e stocks of production capital are rented by the producers. T h e house­ hold can allocate its endowment of new capital, Λ5/ι, between household capital, KDhn^ used in household production and production capital, SF^,^ employed in t h e business sectors. T h e part of new capital which is allocated to household capital is derived through the demand for consumption services generated by household capital, which in t u r n implies a desired stock of household capital. T h e difference between t h e desired and the actual stock of household capital con­ stitutes the demand for new household capital. In a similar way t h e d e m a n d for new production capital is derived from the derived demand of o u t p u t s from the business production sectors. T h u s , the following accounting identity must be satisfied. ASK

= SF,

+ KDH,.

(2)

Expanded or full income equals t h e value of labour endowment, old and new capital income, government net transfers minus income taxes.

η = PFh'LEH+ßh'T.i^-''Fhj)'RKj

+ RDh-^{l-rKh)rw'PK-ASh-^TRh

(3)

i T h e second t e r m equals t h e household profit share times t h e after t a x value of t h e quasi-rent accruing to old capital, RKj, summed over all production sectors. T h e t a x rate Tphj takes into account both corporate and personal capital income taxes. T h e third t e r m denotes t h e quasi-rent accruing to t h e stock of old household capital, RDh^ which is not subject to taxation. T h e fourth t e r m is t h e after­ t a x capital income generated by t h e endowment of new capital, where rw is t h e

An Applied General Equilibrium Model of the Swedish Economy

267

international rate of interest, and PK t h e price of t h e capital good. Finally, t h e last term, TiZ^, represents government net transfers t o t h e household. T h e household has preferences over consumption of market goods and services, Chi. t h e non-market services, CDH. produced and consumed within t h e household and leisure, Fh- We assume t h a t t h e household maximizes utility, Uh, subject t o t h e income constraint. Utihty is specified as a two-stage CES-function. Nonmarket and market consumption goods are aggregated into a composite consump­ tion good which is then combined with leisure. Formally t h e decision problem of t h e household can be stated as maximize

η

=

Uh = Uh{Chi,-,

Σ

PCi.

Chn, Coh, Fh)

Cm + PCDK

' CDH + PFH

-F^

subject to

+ Sh

(4)

T h e first two terms on t h e right hand side of t h e budget constraint are t h e con­ sumption expenditures on market goods and on household production respec­ tively. T h e third t e r m equals t h e value of leisure and .S^ denotes household net savings. As mentioned, there is no explicit intertemporal decision problem involved. Instead we assume t h a t households save a constant fraction syn. which might differ between different household types, i.e. (5)

Sh = SYh ' Yh

By solving the decision problem of t h e household we get t h e Marshallian demand functions of market goods, household services, and leisure as functions of market good prices including sales tax, PC,-, t h e price of household services, PC^h. which are specific for each household type, net-of-tax wage rates and income. Cki

= CHÍÍPCÍ,

PCUK.

CDH = CohiPCi,

FH = FH{PCÍ,

PCoh

PCDH

LH = LEH

-

PFH.

YH)

(6)

PFH.

YH)

(7)

PFH,

FH

YH)

(8)

(9)

In t h e last equation above labour supply, LH, is defined as t h e difference between household labour endowment and t h e demand for leisure.

268

Τ. Karlsson

Household production T h e stock of household capital generates a flow of household services, Coh-, to the household. This flow may vary, for a given stock, with intensity of use or more generally with the employment of other inputs like labour. W h e n analyzing household production it is convenient to distinguish between production processes utihzing old and new household capital. T h e production function is specified as as CES-function for both processes. Since t h e stock of old household capital is fixed for each household the production process is subject to diminishing returns. We assume t h a t the household as a producer of household services using old household capital acts as if it is maximizing the quasi rent to t h e fixed factor. Formally the decision is maximize

[PCoh · XDho - PFh · LDho]

subject to

XDho = XDhoiLDho,

KDHO)

(10)

where, XDho is the output of household services, using labour, LD^o^ and t h e fixed stock of old household capital, KDho- Next, we derive t h e short run or restricted profit function RDk{PCDhj ΡΡκ·, KDho) and compute t h e supply func­ tion and t h e demand for labour by applying Hotelling's lemma. XDHO

= XDhoiPCoh.

LDho = LDUPCDH.

PFK,

KDHO)

(11)

PFh.

KDho)

(12)

Since old household capital is a fixed factor, we need to recognize the possibility t h a t household production, using old household capital, will continue only as long as variable costs are covered. More formally, this can be expressed as. [PCoh - PFh ' {LDho/XDho)]

· XDho > 0

(13)

After subtracting for depreciation we get t h e net return to old household capital. RDh = PCoh · XDho - PFk · LDho - Ρκ · SDO · KDho

(H)

When new household capital is used the production process is characterized by constant returns to scale, which means t h a t the actual o u t p u t is determined by t h e utility structure or demand conditions. T h u s , in this case we instead assume t h a t households minimize costs for a given output of household services. T h e decision problem for t h e household now becomes. minimize

[PFh - LDhn + PDhn · ΚDhn]

An Applied General Equilibrium

subject to

Model of the Swedish Economy

XDhniLDhn.

KDKU)

= XDhn

269

(15)

T h e solution to this problem is summarized by a unit cost function, UCohiPFh, PDhn). which hats as arguments net-of-tax wage rates and the rental price of new household capital. If unit cost exceeds t h e price, no production based on new capital is taking place. On the other hand, if production is positive we know t h a t unit cost must be equal to price. T h e decision whether new capital should be used or not is described by t h e following Kuhn-Tucker conditions. PCoh - UCoh < 0 iPCoH-UCnH)'XD,r.

= 0

(16)

T h e demand for labour and new household capital is obtained by applying Shephard's lemma. LDHn = LD^niPFh,

PDkn,

XD^n)

(17)

KDHn = KDhniPFn,

PD^„,

XD^n)

(18)

T h e rental price of new household capital is defined as. PDHn

=

{6Dn-{-rw)'PK

(19)

Note t h a t the rental price of new household capital does not depend on t a x rates since t h e return on household capital is not subject to taxation.

2.2

The production sectors

Production of value added in each sector is governed by a two-stage CES produc­ tion function, where skilled and unskilled labour are aggregated to a composite labour input in the first stage. Next, this composite labour input is combined with old or new capital to produce value added. Finally, intermediate inputs are used according to a fixed-coefficient technology t o form domestic gross o u t p u t Xvj' Total gross o u t p u t , in each sector, is the sum of o u t p u t from production processes using old and new capital. T h u s , t h e o u t p u t from t h e two processes are perfect substitutes. Since old capital is assumed to be sector specific the return to old capital, the q u c t s i - r e n t , may differ between sectors. If t h e demand for o u t p u t is large enough or the output price is sufficiently high there is a positive demand for new capital. In order to attract new capital t h e r a t e of return t o capital must be at l e c t s t as high as t h e opportunity cost or the world market interest rate. T h e production function for the process using old capital exhibits decreasing returns

Τ. Karlsson

270

to scale since the old capital stock is fixed. In t h e process using new capital t h e production function is characterized by constant returns to scale. Due to the different technologies available it is analytically convenient to dis­ tinguish between old and new processes in exactly t h e same way as we did for household production. T h e decision problem for a producer using old capital is. bjo

maximize

subject to

Xjo = XjoiLtjo,

Kjo)

(20)

where, WP^j is the wage cost for t h e producer and equals t h e wage r a t e times one plus the rate of labour tax. By solving this decision problem we can derive the short run or restricted profit function, RKj{PXj,WPbj, Kjo), as a function of output prices, PXj, wage costs and the fixed capital stock. T h e supply function of gross o u t p u t and the demand for labour is obtained by applying Hotelhng's lemma. Xjo = Xjo{PXj.

WPBJ,

(21)

Kjo)

(22) Only if the quasi-rent is non-negative will old capital be used and production continued. Thus, the following condition must be satisfied:

pxj

- Σ

P^i

· «υ - Σ

i

wp^j

·

MXjo)

(23)

'Xjo>0

b

T h e net return to old production capital, which is subject to taxation, is deter mined as follows. RKj =

pxj'

Σ

Xjo -

' «0 ·

- Σ wp^j · ^ti^ -

P^'

'

(24)

Since the technology of new processes exhibits constant returns to scale t h e profit function is not well defined. We assume instead t h a t new firms minimize costs for a given o u t p u t . Thus, the decision problem for a producer employing new capital is. minimize

Σ WPhr Ltjn + PKjn ' Kjn + Σ P^i b

' «ΰ' * Xjn

L

subject to

Xjn{Lbjn.

Kjn) — X:

(25)

An Applied General Equilibrium

Model of the Swedish Economy

271

As before we describe the solution by a unit cost function, UCxj{WPi,j^ PKjn) with wage costs and the rental price of new production capital as arguments. As in the case of household production the decision whether new capital should be used or not is described by t h e Kuhn-Tucker conditions. PXj

- UCxj

{PXj-UCxj)^Xjn

< 0 = 0

(26)

T h e demand for primary factors of production is obtained by applying Shephard's lenuna. Uj.

= UiniP^h

Kjn = Kj„{PXj,

WP,J,

PKjn,

Xin)

(27)

WP,j,

PKjn,

Xjn)

(28)

Demand for intermediate goods is equal to.

^i = E«i.-E^.«

(29)

T h e capital good is defined as a composite good, consisting of fixed proportions of the gross o u t p u t of different sectors. T h e rental price of one unit of new production capital is t h e sum of t h e exogenous r a t e of depreciation, ¿ j n > and t h e gross return to new capital multiplied by t h e price of t h e capital good. (30) where, TCJ is t h e corporate t a x r a t e for sector j . T h e payment to old capital in each sector is defined residually after payments to labour and intermediate inputs. Total factor rewards is therefore, by definition, equal to total value added. According to Euler's theorem this also holds for t h e new production processes, providing t h a t factors are paid according to their marginal products.

2.3

The foreign sector

W h e n modeUing foreign t r a d e we follow the approach taken by Haaland (1987) and Haaland et.al. (1987). This involves abandonment of t h e Armington assumption of product heterogeneity and instead adopting an assumption of product homogeneity among different countries. We will here not discuss t h e relative

272

Γ. Karlsson

merits of the various approaches but refer to t h e discussion in t h e above men­ tioned sources.^ Given our assumption of exogenous world market prices, PWtd. for tradeables we can only determine net exports, Zt¿, in t h e model. PXtd = ER'PWtd Ztd = Σ Xtd.v - ltd - Ctd - INVtd - Gtd

(31) (32)

υ

where, ER is the exchange rate, Ctd is private consumption demand, INVtd de­ notes investment demand and Gtd represents an exogenous government demand. We define t h e trade balance as follows. TB = ^PXtd'Ztd

(33)

td

T h e existence of an international capital market enables t h e demand of new pro­ duction capital of the domestic producers to deviate from t h e aggregate domestic supply of new capital. If excess demand is positive, part of t h e stock of new pro­ duction capital is owned by foreign investors, whereas a negative excess demand indicates t h a t some of t h e domestic endowment of new capital is invested abroad. Thus, the foreign stock of new capital is equal to. KF

= J2KJ^-^SF,

j

(34)

h

By using t h e definition of t h e t r a d e balance we can express t h e current account as the difference between the value of net exports and interest payments to net foreign capital. CC = TB-rw'

2.4

PK · KF

(35)

The government sector

We divide t h e non-private sector into a p u b h c production sector and an institu­ tional sector, which we denote government. T h e public production sector employs labour and capital in order to produce gross o u t p u t in the same way as private production sectors as described above. In t h e t a x analysis, public production is kept constant, in order to evaluate changes in t h e tax structure rather t h a n in t h e average level of taxation. T h e function of t h e government sector is t o collect ^See also Whalley and Yeung (1984) for a discussion about different external sector specifi­ cations with respect to foreign export demand and import supply, especially in the context of model closure.

An Applied General Equilibrium

Model of the Swedish Economy

273

taxes and distribute transfers t o t h e private sector. T h e t a x rates used are effec­ tive rather t h a n statutory rates t h a t are meant t o capture t h e most important aspects of t h e t a x system. This is especially true for t h e corporate a n d personal capital income taxes. We have t h e following sources of t a x revenue: (i) Labour used as an input in t h e business production sectors, i^jv? are taxed at the rate τ^6>, whereas labour employed in household production is not taxed.

ΤΧι = ΣΣΣ^Ltj · Wb. Í 6 i . 6

j

(36)

V

(ii) T h e effective corporate t a x rate, t c j , apphed t o t h e net return on old pro­ duction capital yields t h e following t a x revenues TXoc

= Y,TcrRKi

(37)

i

(iii) T h e corresponding taxes on new production capital is TXNC

= Σ

^cj · i r ^ ^ ] ' PK ' Kjn

(38)

(iv) Final consumption goods, except household services, are taxed at rate Τ5,·, I.e.

ΤΧ8 = ΣΈ

^si · Chi 'Y^ruji. PXj

(39)

h i^D j where, rriji is an element in a matrix t h a t translates t h e demand for consumer goods into a demand for gross o u t p u t of t h e production sectors. (v) Household labour income taxes. TXY

= EE^h b

h

' Wb. Ilh -ELDh.) \

υ

' qik

(40)

J

where, τγ^, is t h e labour income t a x rate a n d t h e expression within parentheses equals t h e difference between labour supply and what is employed in household production. (vi) After production capital has been taxed at t h e corporate level it is also subject t o a personal income t a x at t h e rate TKH. giving t h e t a x payment TXoK

= ΣΈ^ΚΗ'βΗ'{^h j

rcj)' RK,

(41)

(vii) T h e corresponding taxes on t h e return t o new production capital equals

274

Τ.

ΤΧΝΚ

Karlsson

= Y.^Kh'rw' h

Ρκ ' SFH

(42)

Government expenditures on t h e gross o u t p u t from the production sectors, G j , in­ clude government investment as well as consumption. In addition the government sector provide transfers, TiZ, to the households. Furthermore, we assume t h a t government savings, GSAV, is exogenous. T h e n the government sector budget constraint can be written as TXL

+ TXoc

+

=

TXNC

+

TXs

TR-\-J2 PXj'

+ TXy

- f

ΤΧοκ

+

ΤΧ^κ

Gj + GSAV

(^^)

3

As can be seen from the budget constraint, total transfers to t h e households are determined as the difference between total tax revenues and the exogenously given government expenditures and savings. In order to determine the size of t h e government transfer to each household category, TRh^ we would ideally need to model the main features of the entire transfer system. Since this in itself is a formidable task we simply make t h e very crude assumption t h a t each household type receives a fixed proportion, fcy/i, of the total transfers, expressed by Τ RH = kTh · TR

2.5

(44)

The closure rule

T h e closure rule used in the model refers to the mechanism employed for equili­ brating savings and investment in a static model. Aggregate gross savings is the sum of household net savings, Sh. depreciation of old and new production and household capital, exogenous foreign savings, FSAV, and government savings, GSAV, which is also exogenous.

TSAV

=

YSh+PK' Σ Σ h

ι j

^

· Kjv+ΣΣ^ον' KD Ην

^FSAV^GSAV

(45)

h

T h e model is driven by savings in the sense t h a t aggregate gross investment de­ mand is assumed to adjust passively to aggregate gross savings. Real investment demand by sector of origin, /iVVj, is determined by applying fixed investment shares, fcj, to the total amount of savings. INVj

= kj. (TS AVI PXj)

(46)

An Applied General Equilibrium

Model of the Swedish Economy

275

It should be stressed that in the present model investment demand INVj is a flow variable and does not affect t h e productive capacity of t h e economy b u t only serves as a demand component of t h e production sectors. T h e demand for new production capital, Kjn, on the other hand, is a stock variable and constitutes a part of the productive capacity of t h e production sectors. T h u s , in t h e essentially static framework there are no formal links between investment d e m a n d and t h e demand for new production capital. In an intertemporal model investment de­ m a n d would be directly derived from the long run demand of capital. T h e fixed proportions, fcj, are computed solely by using benchmark d a t a , which by defini­ tion does not contain any amount of new capital. It would of course be possible to relate these shares to t h e relative amounts of new capital demanded by the production sectors, but this has not been implemented in t h e present version of the model.

2.6

Equilibrium conditions

A competitive equilibrium is a set of prices for non-tradeables, PXnt. wage rates, Wi, prices of household services, PCoh, and the exchange rate, ER, such t h a t the following conditions are satisfied: (i) Supply equals demand for each category, 6, of labour. Σ · = Σ Σ Ltjv + Σ Σ LDH. · qik h j ν h υ (ii) Supply equals demand on each market, nt, of non-tradeable goods. / V Xnt,v = Int n-Cnt + INVnt + Gnt

(47)

(48)

V

(iii) Supply equals demand for every household, A, of household services. ^XDhv = CDh υ (iv) Supply equals demand for foreign exchange. CC

2.7

+ FSAV

= 0

(49)

(50)

The numeraire

Since there is no financial sector in the model there is no mechanism through which the absolute price level is determined. As is customary in these kind of models, only relative prices are determined. By comparing t h e number of equa­ tions and variables in the model as presented above, one finds t h a t the number

276

Τ. Karlsson

of variables exceeds t h e number of independent equations by one. A numeraire must therefore be selected against which all price changes are normalized. We have chosen t h e exchange rate as t h e numeraire, and its value is set t o one. ER = 1

3

(51)

Properties of the model

Although t h e model is essentially static it involves a few simple dynamic elements. We denote t h e benchmark year, for which we have d a t a , by to a n d t h e solution year by Γ . By varying t h e time period T—towe can simulate, in a very crude way, t h e evolution of t h e economy over time. Below we augment t h e model, presented in section 2, with t h e equations needed t o capture t h e dynamic effects. First of all, t h e old production and household capital stocks depreciate at a fixed exogenous rate and at time Τ there are only fractions of t h e original old capital stocks left. Kj^T) KD^T)

= {l-6j,f-"'-KUto) = (1 - Soof-'"

(52) •Κ D M

(53)

T h e old, now smaller, capital stocks are still fixed in each production (household) sector, but they now constitute a less binding constraint for those sectors (house­ holds) t h a t cannot profitably employ their old capital stock."* During t h e t i m e span between t h e benchmark and t h e solution year we assume t h a t t h e economy accumulates real savings, ASh, which in our model is equivalent t o t h e domestic supply of new capital. If we assume t h a t household income grows at t h e r a t e of gYk per year and households save a constant fraction, syh, of their incomes we have t h e following domestic supply of new capital at t h e solution year. ASH{T)

= SY, . (1 + gYHf-'^

. YH{to)/PK{to)

(54)

T h e absolute amount of new capital t h a t we endow t h e economy with in a given year is exogenous, b u t by choosing different values for t h e solution year, T , we can alter t h e relative magnitudes between old a n d new capital. In this m a n n e r we can represent an economy in t h e short run by requiring t h a t only a small proportion of t h e total capital stock is of t h e new mobile type, whereas t h e long run can be depicted by letting all or almost all capital be mobile. Taking into account b o t h similiar model is used by Fullerton (1983), who analyzes how limited capital mobility affects the welfare gains from reforming the U.S. corporate income tax.

An Applied General Equilibrium Model of the Swedish

Economy

111

t h e endowment of new capital a n d t h e depreciation of t h e old capital stocks, t h e percentage net addition t o t h e aggregate capital stock in period Τ equals.

Δ/ίΓ(Γ) =

Σ(ΚΜ

h

- Ki,{T)+Y^{KDHo{to) -

}

KD^T)) (55)

h

Y,Kio{to) + Y,KDHo{to) 3

h

W h e n we increase t h e aggregate capital stock considerably, it seems reasonable t h a t we also allow t h e endowment of labour t o increase over time. This can b e interpreted as a growth in t h e population. If we assume t h a t t h e annual growth r a t e of household labour endowment equals gih, t h e labour supply a t t h e solution year is equal t o . LH{T)

= (1 + gi^^f-'" • LE,{to)

- FH{T)

(56)

Finally, we assume t h a t there is technical progress embodied in new capital. T h e rate of technical progress is of t h e Hicks-neutral type a n d pertains t o production as well as household capital. We denote t h e annual r a t e of technical progress in the production sectors by gxj and in t h e households by goh- T h u s , t h e production functions, employing new capital, in t h e business a n d t h e household sectors take t h e following form in t h e solution year.

VA^„iT) = il+gxjf-*