Elements of a Computable General Equilibrium Model

In this chapter, we deconstruct the computable general equilibrium model and describe its core elements. These include sets, endogenous and exogenous variables, exogenous parameters, behavioral and identity equations, and model closure. We describe prices, price normalization, price transmission, and the numeraire. We explain how the CGE model runs and how to carry out an experiment. A computable general equilibrium (CGE) model is a system of mathematical equations that describes an economy as a whole and the interactions among its parts. A model this comprehensive is more complex than the bicycle industry model we built in Chapter 1, but it need not be a “black box.” In this chapter, our objective is to introduce, at a general level, the model's elements and mechanics. Even so, for many students, it may suffice to skim this chapter and return to it as needed as your modeling skills progress. For now, we also set aside any consideration of the economic theory that governs behavior in the model. Here, we do not consider how the model describes the motivations behind producers’ decisions about how much to produce or consumers’ decisions about how much to buy, or a nation's choice between consumption of its domestic production and imported goods. Of course, the economic properties of a CGE model are its real heart and soul, but they also present a much broader area of study; most of the other chapters in this book address this study. In this chapter, we deconstruct the CGE model to describe its core elements. We show that a CGE model and the simple bicycle model share many features, such as exogenous and endogenous variables, market-clearing constraints, and identity and behavioral equations. We explain and compare linearized and nonlinear expressions of the behavioural equations in a CGE model. We describe how the price of a single good changes as it moves along the supply chain from producers to consumers and the implications for price transmission. We explain the practice of normalizing prices and the role of the price numeraire. We introduce model closure, which is the decision about which variables are exogenous and which are endogenous. We also describe how the CGE model runs by explaining the sequence of model calibration or consistency check, baseline model solution, and model experiment.