Danish Rational Economic Agents Model, DREAM

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

2. 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)

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

4. 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

5. 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

6. 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

7. 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

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

9. 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

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

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

12. 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

13. 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

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

15. 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)

16. 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)

17. 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

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

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

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

21. 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?

22. 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

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

24. Results

25. Alternative: tax rise

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

27. 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