Macro-economy - GEM-E3

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Model Documentation - GEM-E3
Corresponding documentation
Model information
Institution Institute of Communication And Computer Systems (ICCS), Greece, .
Solution concept General equilibrium
Solution method The model is formulated as a simultaneous system of equations with an equal number of variables. The system is solved for each year following a time-forward path. The model uses the GAMS software and is written as a mixed non-linear complementarity problem solved by using the PATH algorithm using the standard solver options.
Anticipation Myopic

The model represents 38 countries/regions where each of the EU countries is represented separately. The model considers 31 sectors of production including separately each of the power generation sectors. The sectoral aggregation of the model is summarized in the following table.


Table 2: GEM-E3 sectoral aggregation

1. Agriculture 11. Non-metallic minerals 21. Non-Market services 30. Coal CCS
2. Coal 12. Electric goods Power Technologies 31. Gas CCS
3. Crude oil 13. Transport equipment 22. Coal fired
4. Oil 14. Other equipment goods 23. Oil fired
5. Gas 15. Consumer goods 24. Gas fired
6. Electricity supply 16. Construction 25. Nuclear
7. Ferrous metals 17. Transport (Air) 26. Biomass
8. Non-ferrous metals 18. Transport (Water) 27. Hydroelectric
9. Chemical products 19. Transport (Land) 28. Wind
10. Paper products 20. Market services 29.PV


The GEM-E3 model provides details on the macro-economy and its interaction with the environment and the energy system. The economy is represented in detail at macro level and also at micro level through detailed representation of agents' behavior. The model incorporates micro-economic mechanisms and institutional features within a consistent macro-economic framework and avoids the representation of behaviour in reduced form.

At micro level the model formulates in detail the supply and demand behaviour of the economic agents (production, consumption, investment, employment, allocation of their financial assets). Demand from the economic agents and the public sector form total domestic demand. Total demand is allocated between domestic and imported products. In this specification, a composite commodity which combines domestically produced and imported goods (imperfect substitutes) is used. Each country buys and imports at the prices set by the supplying countries.

Firms respond to market demand and formulate demand for intermediate inputs and factors of production (labour, capital, resources). They supply their goods and select a production technology so as to maximize their profit within the current year. The firms can change their stock of capital by undertaking investments. Supply and demand mechanisms determine equilibrium prices. In this process the GEM-E3 model takes fully into account macro level interactions and simultaneously includes all interrelated markets. The model formulates separately the supply or demand behaviour of the economic agents which are considered to optimize individually their objective while market derived prices guarantee global equilibrium, allowing the consistent evaluation of distributional effects of policies.

Model prices are the result of market equilibrium (demand and supply effects). On derived prices appropriate taxation is applied, to form prices as perceived by consumers. The main leading price is that of the composite good. Depending on the destination of a commodity, differentiated taxation may be applied, as for example indirect taxation or VAT.

The equilibrium of the real part is achieved simultaneously in the goods market and in the labour market. In the goods market a distinction is made between tradable and non tradable goods. For the tradable goods the equilibrium condition refers to the equality between the supply of the composite good, related to the Armington equation, and the domestic demand for the composite good. This equilibrium combined with the sales identity, guarantees that total resource and total use in value for each good are identical. For the non tradable, there is no Armington assumption and the good is homogeneous. The equilibrium condition serves then to determine domestic production.

The model is modularly built allowing the user to select among a number of alternative closure options and market institutional regimes depending on the issue under study. The GEM-E3 model includes projections of: full Input-Output tables by country/region, national accounts, employment, balance of payments, public finance and revenues, household consumption, energy use and supply, GHG emissions and atmospheric pollutants. The model considers the appropriate level with respect to geography, the sub-system (energy, environment, economy) and the dynamic mechanisms of agent's behaviour.

Investments

GEM-E3 is a recursive dynamic model (solved sequential over time). The sequential equilibria are linked through a motion equation regarding the update of the capital stock. According to the standard neoclassical approach agents investment decision depends on the rental cost of capital in the presence of adjustment costs and on its replacement cost. In GEM-E3 agents have myopic expectations. Their future planning is based on current prices. The basic methodological approaches to investment specification include the accelerator model and q of Tobin (1969).


Figure 3: Investment decisions of firms

Figure 3 Investment decisions of firms.gif


Investment covers the change in firm's potential plus the capital depreciation. Using the average Tobin's q according to Hayashi (1982) the firm decides the optimal level of investment according to the rental price of capital and its replacement cost. It is also assumed that the firms always replace the depreciated capital.

The investment function takes into account: i) adjustment/installment investment costs, ii) flexibility to replace capital, iii) speed of adjustment, iv) exogenous firm's expectations on future profitability and v) productivity of capital. Investment increases the production potentials of the firm from the following period. The unit cost of capital results as the dual price of the equilibrium function of the available and the demanded capital stock.

Firm's investment is translated into demand for investment goods which are produced from the rest of the sectors of the economy through an investment matrix of constant coefficients. The investment demand of each branch is transformed into a demand by product, through fixed technical coefficients, derived from an investment matrix by product and ownership branch. The investment matrix is computed using the intermediate goods used in the production of capital goods and data provided in the literature on the inputs delivered by the sectors of the economy to the investments undertaken by each sector of production.

The standard approach when no additional data are available, is to use the same coefficient structure for each branch. This approach can be extended when additional information is available on investment by branch and on the structure of capital formation. In order to make changes in the investment matrix a simple procedure is followed. The initial investment matrix (with the same coefficients in each branch) is updated with the new investment shares. Then a RAS procedure is followed in order to ensure that the total of each row and column of the investment matrix remains constant and that the model remains balanced.

Public investment, assumed exogenous in the model, is performed by the branch of non-market services. Transfers to the households are computed as an exogenous rate per head times the population. On the receipt side, the model distinguishes between 9 categories of receipts namely: i) indirect taxes, ii) environmental taxes, iii) direct taxes, iv) value added taxes, v) production subsidies, vi) social security contributions, vii) import duties, viii) foreign transfers and viiii) government firms. These receipts are coming from product sales (i.e. from branches) and from sectors (i.e. agents). The receipts from product sales in value, which include indirect taxes, the VAT, subsidies and duties, are computed from the corresponding receipts in value, given the tax base and the tax rate. The receipts from agents are computed from the tax base and the tax rate (social security contributions, direct taxation), share of government in total capital income (for government firm's income) or exogenous (transfers from and to the ROW).

Transfers

The model allows for a free variation of the balance of payments, while the real interest rate is kept fixed. An alternative approach, implemented in the GEM-E3 model as an option, is to set the current account of a country or of the total EU with the rest of the World to a pre-specified value, in fact a time-series set of values, expressed as percentage of GDP. This value is obtained either as a result from the baseline scenario or is given by the modeller as a share of GDP. As a shadow price of this constraint, a shift of the real interest rate at the level of the EU is endogenously computed. This shift is proportionally applied to the real interest rates of each member-state.

The only direct transfers and value flows between branches and sectors in the model, refer to government revenue/expenditures through taxes/subsidies and world revenue/expenditures through imports/exports. Flows considered as revenues of branches (in fact product demand) coming from sectors are detailed in: final consumption of products by sector in value, which includes exports, investment by product and sector in value and stock variation in value.

The transfers between sectors include income flows as described in the SAM. These transfers formulate the disposable income of the households. The most important of these transfers include:

  • The dividends the firms pay to the households, which is proportional to the net revenues of the firms
  • The social benefits that the government pays to the households, which depends on the number of employees by branch and the rate of government payments to the unemployed
  • The direct taxes on the firms which is again proportional to the net revenues of the firms (now excluding dividends) and the households, where the tax is proportional to their disposable income
  • The payments of individuals to the government for social security.

The transfers between factors of production and the economic sectors are given in the SAM. The most important of these transfers include:

  • Revenues of sectors coming from factors , e.g. labour income of households. Flows considered as revenues of factors coming from branches represent the value added, in value
  • Flows from factors to factors and from factors to branches are equal to zero
  • Factor payments to sectors are coming from value added and distributed according to an exogenous structure.

The savings of each sector, which if summed up on all economic sectors are equal to total investments, are computed as the difference between revenues which consists of the receipts from the branches plus income from factors and sectors) and expenditures (which include final consumption and transfers to factors and sectors. The surplus/deficit of each sector, which is evaluated by subtracting investment and stock variation from gross savings, ensures that total sector savings equal total sector investments (this equality does not hold on a sector level).