Introduction to the Symposium: The Discipline of Applied General Equilibrium
Author(s): Timothy J. Kehoe and Edward C. Prescott
Source: Economic Theory, Vol. 6, No. 1, Symposium: The Discipline of Applied General
Equilibrium (Jun., 1995), pp. 1-11
Published by: Springer
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Econ.
Theory
6,1-11
j-i
(1995)
Economic
Theory
?
Introduction
to the Symposium:
Springer-Verlag
The discipline
1995
of
applied general equilibrium*
Timothy
J. Kehoe
and Edward C. Prescott
of Minnesota,
MN
of Economics,
55455, USA, and
Department
University
Minneapolis,
Research Department,
Federal Reserve Bank of Minneapolis,
250 Marquette
Ave., Minneapolis,
MN
55480,USA
Received:
August
30,1994;
revised
version
October
12,1994
in applied research imposes
Summary. The use of general equilibrium models
a discipline in which model structures can easily be compared and contrasted and
model results can be interpreted using a well understood
and rigorously developed
theoretical framework. These features allow researchers to compare results across
efforts and to build on the experience of others in deriving results and
modeling
formulating questions. This paper first presents a brief critical history of applied
general equilibrium analysis.
papers in this issue.
It then summarizes
the contributions
of eight other
1. Introduction
(1954) judged the Walrasian
Schumpeter
general equilibrium model to be the "the
an
of
economist
that will stand comparison with the achievements
only work by
theoretical physics." Since Schumpeter's
researchers have made
time, economic
considered scientific progress not only on the theory of general equilibrium but on
its applications. This issue contains eight papers that illustrate the power of applied
(GE) as applied science.
general equilibrium
Applied general equilibrium analysis here is defined to be the numerical imple
mentation
of general equilibrium models calibrated to data: An applied GE model is
a computer representation of a national economy or a group of national economies,
each of which consists of consumers, producers, and possibly a government. The
model's people make many of the same sorts of transactions as do their counterparts
in the world. Consumers,
for example, purchase goods from producers,
supply
factors of production,
save, and pay taxes to and receive transfer from the govern
*
of
for helpful discussions
We are grateful to Gary Hansen,
Ellen McGrattan,
and Richard Rogerson
at the University
of the Applied Theory Workshop
of
this paper. We also want to thank the members
who helped referee and edit the papers in this issue: Fernando
Alvarez, Raphael Bergoeing,
Minnesota,
Ron
Antonia Diaz, Ron Edwards, Andres Erosa, Terry Fitzgerald,
Betsy Caucutt, Ricardo Cavalcanti,
Gecan,
expressed
Gollin,
Doug
herein are
Minneapolis
Karine
those
or the Federal
Moe,
Fran?ois
Ortalo-Magne,
of the authors
and not necessarily
Reserve System.
and Marcelo
those
Veracierto.
of the Federal
Reserve
The
views
Bank
of
2
T. J. Kehoe
and E. C. Prescott
ment. Theory and measurement,
often in the form of statistical estimates, are used to
select a parametric class of GE models. Inmost cases, data are then used to calibrate
so that it mimics
the model
the world as closely as possibly along a limited, but
The researcher can then perform experiments
number
of
dimensions.
clearly specified,
with the applied GE model to derive quantitative answers to well-posed
questions.
These questions can involve the use of theory
for example, What are the welfare
effects of a policy change? These questions can also involve tests of theory
for
a
Are
the
results
consistent
with
observations?
model
economy
example,
generated by
in which model
The use of GE models
imposes on researchers a discipline
structures can easily be compared
results can be
and contrasted
and model
a
and
well
understood
theoretical
framework
interpreted using
rigorously developed
that matches well the way the economic data are collected and reported. These
features allow researchers to compare results across modeling
efforts and to build on
the experience of others in deriving results and formulating questions. Although
these features are important for regarding applied GE as scientific research, there is
another feature that is sometimes even more essential: in applied GE experiments,
as much as success; a gross
failure is not only possible but often contributes
an
from the world
inconsistency between the results of
experiment and observations
creates a paradox that can only be resolved by further developments
in the theory
the model.
underlying
This paper first presents a brief critical history of applied GE analysis and then
of the papers in this issue. One paper (Mercenier)
summarizes
the contributions
of equilibria in a popular class of applied GE
deals with the possibility of multiplicity
models. Another (Rogerson, Rupert, and Wright) provides an independent measure
of a crucial parameter in an applied GE model that has been successful inmatching
business cycle observations. Two papers (Gravelle and Kotlikoffand
Imrohoroglu,
and
of
welfare
government
Joines) perform
policy. Another
analysis
Imrohoroglu,
three (Cooley, Hansen, and Perscott; Kehoe, Polo, and Sancho; and Ljungqvist and
Sargent) report results of experiments where the theory performs well in matching
observations. Yet another (Cho and Cooley) reports the results of an experiment
where
a plausible
innovation
in the theory fails to match
observations
from the
world.
as a whole,
these eight illustrate the diversity of approaches encompassed
for doing economic
GE
by applied
analysis. Applied GE is a set of principles
a
a
not
In
model.
research,
answering
specific question, the researcher still
particular
must decide what abstraction
ismost useful for that question: whether, for example,
Taken
to use a static or a dynamic model, what assumptions
organization within the model economy, and so on.
to make
about
industrial
2. History
analysis of
Although
applied GE can trace its roots back to the input-output
of
numerical
Leontief
narrowly
general equilibrium
(1941, 1953),
applications
defined began with the work of Harberger
(1962) and Johansen (1960). Harberger
used a model with two production sectors, one corporate and the other noncorporate,
calibrated to U.S. data from the 1950s, to calculate the incidence of the corporate
of applied
Discipline
general
equilibrium
3
to
a model with
19 production
sectors, calibrated
sources
to
in
of economic growth
data from 1950,
Norway
identify the
Norweigian
over the period 1948-53.
Work on applied GE models
received a crucial stimulus from the research of
of economic equilibria. Scarf developed an
Scarf (1967, 1973) on the computation
tax. Johansen
income
used
GE model. Refinements
algorithm for calculating an equilibrium of a multisectoral
the most significant
of this algorithm are still used by some modelers.
Probably
of Scarf swork, however, were to establish a close connection between
consequences
applied GE research and the theoretical research of such economists as Arrow and
Debreu (1954) and McKenzie
(1951) on the existence of equilibrium in very general
and to inspire a generation of Yale graduate students to enter the applied GE
to applied GE modeling.)
field. (Arrow and Kehoe (1994) discuss Scarfs contributions
models
Early
static models
students are Shoven and Whalley
of Scarfs most prominent
(1972), who
to
a
framework
multisectoral
calibrated,
analyze the
general equilibrium
developed
tax policy. Shoven and Whalley
welfare impact of government
(1984,1992) provide
in the
surveys of this work and the large literature that has followed it. Early models
were
of
the
determination
tradition
static, studying
explicitly
Shoven-Whalley
a
stocks
of
the
evolution
in
Later
models
studied
capital
single period.
equilibrium
Two
over time in a framework where the people in the model either solve static problems
(as in Johansen's model) or, what is almost the same, where people have myopic
that is, they expect current relative prices to persist in the future; see
expectations,
Fullerton,
Shoven, and Whalley
(1983) for an example of the latter approach.
and Goulder
(1985) developed a perfect foresight version of the Fullerton
lower impact of
model
and showed that it predicts a substantially
Shoven-Whalley
tax
in
than does the
taxes
to
the
States
United
consumption
switching from income
Ballard
version with myopic expectations.
tradition have stressed developing
in the Shoven-Whalley
Researchers working
results that are
and producing
for applied GE models
theoretical underpinnings
to be compared with those of simpler theoretical frameworks. They have
meant
their results with outcomes of policy changes in the
spent little effort in comparing
are not
that these models
world. Whalley
(1986, 1988), for example, contends
to
intended to forecast the values of economic variables, but rather
provide useful
to undertake more informed, and presumably
insights that may help policymakers
to suggest that
more desirable, policy actions. This line of thought has led toWhalley
in
abandoned
should be perhaps altogether
the concept of positive economics
some of
illustrated
GE
however,
by
developments,
modeling.
Subsequent
appplied
the papers in this issue, have shown applied GE to be a valuable tool in positive
economics.
Further
Several
policy
development
in static models
to do
other groups of researchers began using static applied GE models
around
centered
One
such
and
Shoven
after
group
(1972).
Whalley
analysis
4
T. J. Kehoe
and E. C. Prescott
on developing
countries; a survey of its work is
presented by Dervis, de Mel?, and Robinson
(1982). Another group has come to
prominence
doing policy analysis in Australia; a summary of early work by this
Sutton, and Vincent
group is given by Dixon, Parmenter,
(1982); a more recent
survey is presented by Dixon, Parameter, Powell, and Wilcoxen
(1992).
There is a large and expanding
literature on multisectoral
applied GE models.
the World
Bank
and
focused
A recent
search of the EconLit database produced
references to more than 200
books and journal articles on this subject. Prominent
contributors
besides those
mentioned
above
include Ginsburgh
and Waelbroeck
(1981), Jorgenson
(1984),
and Manne
(1985). There have also been numerous collected volumes of papers on
this subject: Scarf and Shoven (1984); Piggott and Whalley
(1985,1991); Srinivasan
and Whalley
and
Zalai
(1986); Bergman, Jorgenson,
(1990); Taylor (1990); Don, van
de Klundent,
and van Sinderen (1991); and Mercenier
and Srinivasan (1994).
In contrast
to work in the Shoven-Whalley
tradition, some other applied GE
have attempted to address policy issues in areas where rigorous theory has not
been developed. The World Bank group in particular has been criticized for spending
little effort in building the theoretical foundations of their models. Srinivasan (1983),
for example, characterizes their work as being "full of examples of less than complete
models
of even elementary aspects of general equilibrium theory."
understanding
Over the past decade, many researchers have begun to incorporate dynamics
into their multisectoral
these models, how
applied GE models. Before discussing
we
to
another
should
mention
innovation
static
multisectoral
ever,
significant
the addition of increasing returns to scale and imperfect
applied GE models:
to this area was provided by Harris
The
contribution
competition.
pioneering
who
showed
that
these
into a static model of the
(1984),
phenomena
incorporating
Canadian
economy
substantially
higher
lead to predicted gains from trade liberalization
that are
than those found inmodels with constant returns to scale and
Later researchers,
such as Brown and Stern (1989), have
could
perfect competition.
extended this approach
in the theory of
and have tied it to theoretical developments
of Dixit and Stiglitz (1977) and to the new trade theory
monopolist
competition
and Krugman
surveyed by Helpman
(1985); Kehoe and Kehoe
(1994) provide an
overview of these sorts of models.
Such models have received public attention
in
recent discussions
of the economic
Free Trade
impact of the North American
see Francois and Shiells (1994).
Agreement;
Although
they have been used to analyze a number of important policy issues,
current applied GE models with increasing returns and imperfect competition
force
uneasy marriages between partial equilibrium models of monopolistic
competition
and the general equilibrium framework. Ginsburgh
(1994), for example, has pointed
out the sensitivity of model results to the seemly arbitrary choice of numeraire
in
on
more
firms' profit maximization
has
work
and
called
for
the
problems
theory
underlying
Deterministic
these models.
dynamic models
that are best
Some of the earliest static applied GE models dealt with phenomena
of
handled in a dynamic framework; Johansen (1960) dealt with the determinants
Discipline of applied general equilibrium
5
(1962) and Shoven and Whalley
growth, and Harberger
(1972) dealt with the
incidence of the tax on corporate capital income. Over the past decade researchers
have begun to construct applied GE models that are fully dynamic in the sense that
the people in the model solve intertemporal maximization
problems with foreword
are
some
behavior.
In
of
these
models
there
looking
people who live as long as the
and
model
include Lipton and Sachs (1983); Manne
(often infinitely); examples
Preckel (1985); Jorgenson and Yun (1986); Erlich, Ginsburgh,
and van der Heyden
and Summers (1989). In other models
there are overlapping
(1987); and Goulder
include
Summers
and
Auerbach
and Kotlikoff
generations; examples
(1981)
(1987).
severe
GE
models
faced
limits because
Early dynamic applied
computational
compute equilibria in a number of periods, and so
they needed to simultaneously
were highly aggregated
sectors and/or
in terms of the number of production
consumers. As computer hardware and computational
have
algorithms
improved,
limits have become much less important and models have become
computational
more disaggregated; Kehoe (1991) presents a survey of algorithms used to compute
the equilibria of deterministic
applied GE models.
In contrast to static models whose comparative
is analyzing issues
advantage
that involve different sectors of an economy,
the comparative
advantage of deter
is analyzing issues that involve such phenomena as capital
dynamic models
is also important for address
and growth. Yet sectoral disaggregation
accumulation
some
for
issues.
Echevarr?a
example, has shown that incorporat
(1992),
ing
dynamic
into
the
neoclassical
sectoral
growth model can significantly
ing
disaggregation
to
the
observations.
model's ability
match growth and development
improve
ministic
Business
cycle models
The current approach to analyzing business cycle phenomena
incorporates aggre
gate uncertainty as well as dynamics. This approach was initiated by Kydland and
Prescott (1982); Cooley (1995) provides a recent survey of the large amount of work
that has followed. Applied GE business cycle models are often highly aggregated,
but they need not be: Recent work by Hornstein
and Praschnik
(1994) shows how
across sectors
a GE business cycle model can be used to capture the comovements
observed in the data. Rios-Rull
(1995) presents a survey of applied GE business cycle
consumers.
models with heterogeneous
There are two stages to an applied GE business cycle experiment: The researcher
the equilibrium behavior of the people in the model economy,
begins by computing
that is, their decision rules. He or she then feeds a series of random shocks into the
model and compares properties of the generated time series data with properties of
for example, did
and Prescott
data from the world. The Kydland
(1982) model,
a good job of matching many of the variances and covariances
in data from the
United States. An important finding of their experiment was that the theory resulted
in a variance in hours work that differed significantly from that in the data. This
in which
the Kydland-Prescott
formulation,
(1985) to modify
finding led Hansen
of
labor
workers were homogeneous,
indivisibility:
(1988) theory
using Rogerson's
a little less during a period with a negative
rather than all workers working
technology
shock, some workers
became
unemployed.
Actually,
the Hansen
model
6
T. J. Kehoe
and E. C. Prescott
overaccounted
for the variance in hours. Yet a further development
by Kydland and
in both the number of workers and in the
Prescott
(1989) allows for variations
number of hours per worker. This model ismore successful than either the original
in matching
model or the Hansen model
the variance in hours
Kydland-Prescott
found in the data.
This sort of interplay between
is frequent in GE
theory and measurement
to match the data are easily
because failures of a model
business cycle modeling:
interpreted within the context of a well understood
theory: they point to obvious
directions for future research. This characteristic
represents a significant advantage
of the applied GE approach over the alternative of "accepting" or "rejecting" models
based on formal statistical tests, at least as they are usually employed. Even Gottfries
(1991), defending the use of formal statistical theory against Summer's (1991) charge
of its irrelevance inmacroeconomics,
admits that the results of applied GE models
are easier to understand
tests.
than the results of statistical hypothesis
3. Using
theory
A number
to
of the papers in this issue illustrate the ability of applied GE models
an
GE
and
for
model
Sancho,
analyze policy. Kehoe, Polo,
example, present
applied
of the Spanish economy, constructed
in the Shoven-Whalley
tradition, that had
previously been used to predict the impact of the changes in fiscal and trade policy
enacted in Spain in connection with its 1986 entry into the European Community.
in relative prices and resource
The model
is static and focuses on movements
allocation across 12 different industrial sectors. The Kehoe-Polo-Sancho
model had
that
in
in
in
1986
would
the
fiscal policy
result in
changes
predicted
Spain
a substantially higher indirect tax burden and significant changes in relative prices
across sectors. Subsequent
to be fairly
experience has shown these predictions
accurate.
an overlapping
and Kotlikoff
paper by Gravelle
generations
develops
consumer
in which the representative
in each generation
lives for 55 (year
sectors include
sectors. Some production
periods and there are 11 production
in
firms. There are three factors of production
corporate and noncorporate
input. Gravelle and Kotlikoff use this
period
capital, labor, and managerial
to estimate the welfare gains of the 1986 Tax Reform Act in the United
The
model
long)
both
every
model
in the corporate
income
States. They find gains resulting from the reduction
tax contained
in this legislation
that are four times as large as those found by
static models
that follow the Harberger
(1972)
(1962) and Shoven and Whalley
are
on
both
Their
Gravelle
and
Kotlikoff
dependent
explain,
findings,
approach.
shifts
distortions
and the ability to model
the ability to identify intertemporal
in some industries. They have,
between corporate and noncorporate
production
that incorporates
both dynamic and sectoral
therefore, chosen to use a model
detail.
Another
paper in this issue that uses a deterministic
dynamic applied GE
and
Joines,
model, by Imrohoroglu,
Imrohoroglu,
analyzes the impact on welfare
of potential reforms to the social security system in the United States. Like Gravelle
these researchers employ an overlapping generations model. Unlike
and Kotlikoff,
Discipline
of applied
general
7
equilibrium
across
and Kotlikoff,
they choose to abstract away from heterogeneity
across consumers:
sectors but not heterogeneity
there is a single
consists of a continuum
of consumers
sector, but each generation
production
who can live for up to 65 periods and face individual risk with respect to both
Because there is no aggregate uncertainty,
the equilibrium
income and mortality.
Gravelle
production
of the model
is deterministic
but it requires specifying distributions
of consumer
Since the Imrohoroglu-Imrohoroglu-Joines
model does
types in each generation.
not include annuity markets,
social security provides
insurance against
living
too long. In addition,
that social security reduces the capital stock may even
there is potential for capital overaccumulation.
Imrohoroglu,
and
Joines
find that, although a calibrated version of the current
Imrohoroglu,
of capital in their model, elimin
social security system leads to underaccumulation
to
The optimal
social
would
lead
overaccumulation.
ating
security entirely
to
to
not
annual
benefits
60
retirees
would
system
percent of their
provide
equal
as
current
it
does
lifetime
the
income,
average
system, nor would
employement
be beneficial
provide
because
no benefits;
rather,
the optimal
replacement
ratio
in their model
is 30
percent.
but not
Another
away from aggregate,
paper in this issue that abstracts
individual uncertainty,
is that of Ljungqvist and Sargent. In the Ljungqvist-Sargent
who face uncertain
model there is a continuum of infinitely lived consumer/workers
on
about
the
and
while
and
wages
ty
job security
job
uncertainty about wage offers
in a very simple
while looking for a job. The authors embed a job search model
are
to
the
GE
resolve
able
framework.
apparent puzzle of why for may
applied
They
same
a
at
rate
the
time that it had a generous
low
Sweden
had
years
unemployment
income tax
system. They find the anwer in Sweden's high marginal
unemployment
rates: high tax rates reduce workers' incentives to switch jobs in response to changes
economic opportunities.
to do policy
The different papers in this issue that use applied GE models
because
they ask different questions. As
analysis choose different abstractions
a group these papers illustrate the flexibility of applied GE models and its ability to
address a wide range of policy questions.
4. Testing
theory
Some of the papers in this issue show how applied GE models can be used to test
current theory. The tests take a variety of forms: Some papers test whether the results
are consistent with observations
from the world.
of an applied GE experiment
Others test whether the results are robust to changes in the structure of the model
economy used in the experiment.
or not we can develop an innovation
in the theory to
In a sense, whether
resolve an apparent puzzle in the data is a test of the applied GE methodology.
of the papers
in this issue and many
and Sargent
The paper by Ljungqvist
in the equity premium puzzle literature inspired by the work of Mehra and Prescott
(1985) fall into this category. This issue also includes papers that explicitly test
established
data.
theory by comparing
the results generated
by applied GE models
with
8
T. J. Kehoe
and E. C. Prescott
The first of these is the paper by Kehoe, Polo, and Sancho. These authors stress
to do policy analysis lies in its
that the value of an applied GE model constructed
to
do
conditional
What
would
be
the
ability
prediction:
impact of a given policy on
a particular set of variables, everthing else being equal? They test the results of their
to analyze the impact of the policy reforms that accompanied
model constructed
into
the
in 1986 by comparing
its results with
Spain's entry
European Community
the changes in relative prices and resource allocation that took place in Spain during
the period 1985-87. They find that, at least when the effects of two major exogenous
shocks are included, the model does a remarkably good job in tracking these
changes. Kehoe, Polo, and Sancho also examine the sensitivity of their results to
of the behavior of the government
alternative
and foreign sector,
specifications
which are exogenous in their model, and to alternative specifications of labor market
behavior. The arbitrainess of these alternative specifications,
usually referred to as
closure rules, is one of themain sources ofWhalley's
(1988) worries about comparing
results with data. Kehoe, Polo, and Sancho find that their results are robust to these
to do
Their work should encourage other researchers
alternative
specifications.
similar testing of their applied GE models. Shortcomings
in conditional predictions
and
of a model would then provide motivation
for further theoretical development
further testing.
results with
The other paper that tests a theory by comparing
experiment
from the world
is that of Cho and Cooley, which builds money
observations
and rigid nominal contracts into a GE business cycle model.
(This sort of exercise
shows the terminology "real business cycle model" to be unfortunate.) As Kydland
and Prescott (1989) have found, technology shocks can account for about 70 percent
like Fischer
in the postwar U.S. economy. Economists
of aggregate fluctuations
shocks acting through the propa
(1977) and Taylor (1980) have stressed monetary
of nominal contracts as a source of business cycle movements.
gation mechanism
Cho and Cooley use a carefully constructed and calibrated GE model to see whether
shocks acting through nominal contracts can result in business cycle
monetary
those in the data. They find that they are able to choose
that match
fluctuations
so that the fluctuations
in output
the length of a nominal contract in the model
as those in the data. Unfortunately,
the
in the model have the same magnitude
and
comovements
among such variables as output and real wages, and productivity
hours worked in the model economy are completely at odds with their counterparts
shocks
that the theory of monetary
conclude
and Cooley
as
a
contracts
of
business
fails
nominal
wage
cycles, although
theory
propagated by
some of the fluctuations
not accounted
for by
it may be useful in explaining
shocks.
technology
Another paper inwhich we learn from the failure of an applied GE experiment is
in the data.
Cho
that of Cooley, Hansen, and Prescott. In their model capital, like labor in the Hansen
labor,
(1985) model, can be unemployed. Given that idle capacity, like unemployed
it is tempting
is a feature of the world not found in simple GE business cycle models,
to hypothesize
idle capacity into the model will significantly
that incorporating
in that
The
results of this paper are negative
with
data.
the
match
the
improve
has
that
idle
Prescott
and
conclude
very
capacity
incorporating
Cooley, Hansen,
little effect on the properties of aggregate variables in their model. In fact, however,
of applied
Discipline
general
9
equilibrium
these results can be interpreted in a positive light: the standard GE business cycles
model is tested for robustness to the incorporation of idle capacity, and its principal
features are found to be remarkably robust.
The paper by Mercenier
involves a different test of robustness. Mercenier
presents a static, calibrated GE model with increasing returns and imperfect
to analyze the impact of
that has been constructed
competition
reforms instituted by the European Community
in 1992. He
assumes there is free entry and exit of firms in the model,
then
an
if
the
number
firms
in
is
but
of
fixed,
equilibria,
industry
the single market
shows that, if he
there are multiple
there is a unique
of equilibria makes policy analysis and conditional predic
equilibrium. Multiplicity
tion problematical,
and it is disturbing to find multiplicity
tied to a fairly arbitrary
structure.
his
about
market
Mercenier
interprets
assumption
findings as indicating
the need for more theoretical work on applied GE analysis with increasing returns
and imperfect competition.
5. Measurement
The seven papers discussed in the previous two sections represent final products in
that they present the results of applied GE experiments
that either use or test the
in contrast, represents an
theory. The paper by Rogerson,
Rupert, and Wright,
an important
intermediate
input in applied GE analysis. The authors measure
that
elasticity parameter of the preference structure in GE business cycle model
as well as market production.
allows for household production
In an earlier paper, McGrattan,
and Wright
Rogerson,
(1993) have found
that, for suitable values of the parameters of their preference structure, this model
the data better than, and has different policy
matches
from, the
implications
That the model matches
model without
household
corresponding
production.
the business cycle data well does not provide a very informative
test, however,
because the parameters of the model have been fitted to this data using a maximum
test of their structure is to compare
A more
likelihood method.
informative
these fitted parameters with ones obtained
from other data. They do this in
the case of a key parameter, the elasticity of substitution between home production
and market production,
using statistical techniques applied to household
panel
that they obtain
is reassuringly
close to
data. The measure
of the elasticity
to aggregate
time
of their model
that they had found by fitting the parameters
series data.
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