Danish Rational Economic Agents Model, DREAM Poul Schou March 2, 2006

Outline of presentation Purpose & short history of CGE models How to build and use a large-scale CGE model: Danish Rational Economic Agents Model (DREAM)

Computable General Equilibrium models A child of economic theory Main purpose: Quantify magnitudes of theoretical results (important for policy)

Definition of a CGE model ”Equilibrium”: supply and demand behaviour determined by optimizing agents. Flexible prices of (at least) some goods and factors of production → market equilibria ”General”: several optimizing agents and markets ”Computable”: use data from real economies, solved on a computer

History of CGE models Leif Johansen (1960) 1960’es:structure of (theoretical) general equilibrium models developed and refined, cf. Arrow & Hahn, 1971 Development of large-scale macro- econometric models Scarf (1967) designs algorithm for numerically specified G.E. models

History: 1970’es New economic regime: Rising energy prices, break-down of international monetary system, stagflation Better hardware, software and data bases→ increasing interest for CGE models, also among decision-makers

Advantages of CGE models Quantify magnitudes Identify net results of counter-acting effects Able to cope with complex problems Solid micro-economic foundation Able to analyze welfare effects Able to analyze policy fundamentally different from initial position

Drawbacks of CGE models Specification of functional forms Calibration Economic theory not sufficiently well- developed in all fields May become rather complex

Static CGE models ”Big and simple” Very disaggregated input-output system Perfect competition in all markets Only distortion: taxes/duties/subsidies Main uses: Trade agreements & trade policy, environmental policy

Dynamic CGE models Explicit periodization Rich theoretical structure Rational (forward-looking) expectations → simultaneous models → huge computational power requirements Aggregate production structure

Danish CGE models GESMEC (1993, Economic Council) Mobi-DK EPRU model Various ad hoc models

Motivation for DREAM Wish to create comprehensive model for long-term simulations of Danish economy Utilize state-of-the-art economic theory Analyze demographic changes Evaluate structural reforms with respect to welfare, intergenerational distribution, macroeconomic performance and fiscal sustainability

Institutional setting Research project initiated in January 1997 Originally located in Statistics Denmark, from 2002 an independent research unit affiliated with the Danish Ministry of Finance Independent board 8 full-time economists and 3 students

Challenge of building DREAM Choose level of details, theoretical setting and data use Demographics important → focus on population projections and generations Independent population projections

Main principles Optimizing households and firms Other institutions: Pension funds, government, foreign sector Important markets: Labour market, goods markets, financial markets Base-line projection is a sequence of temporary equilibria leading to a steady state (Dynamic calibration)

Households I OLG model: 85 overlapping generations Representative household in each generation Consumption-saving choice (intertemporal optimization) Labour supply and consumption mix choice (intratemporal optimization)

Households II Specification of functional form important In principle: Should be based on empirical investigation of elasticities, etc. In practice: A few functional forms typically used (C-D, CES, nested CES) DREAM typically uses nested CES functions

Firms Two private production sectors: Construction Other private goods Representative firms maximize value of shares

Market structure Imperfect competition in goods market Union-like behaviour in labour market → positive profits and unemployment

Government sector Produces goods Collects taxes Supplies government services Pays out transfers and subsidies Behaves rather mechanically Very detailed modelling of taxes and transfers

Calibration and data ”Calibration”: Process which determines parameters to make data fit the theoretical model Data come from national accounts, labour force statistics, Law Model and various other sources How are parameters in DREAM determined?

How do you execute DREAM? DREAM runs on a powerful PC System of premodels, main model and modules for reporting Execution takes about 1 hour Main programming language: GAMS Presentation is Excel-based

Results Projection 100 years ahead Calculates NA measures, utility levels of all generations, age-distributed income and wealth levels, etc.

Results

Alternative: tax rise

Endogenous developments Terms-of-trade gain Unemployment changes Capital-labour ratio changes ”Free” savings of households disappear Endogenous policy adjustment

Main uses of DREAM Is fiscal policy sustainable? Macroeconomic and welfare consequences of tax, labour market and other reforms Consequences of changes in mean life- time, fertility, immigration and integration Used for some masters’ theses