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Open Economy models

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1Chapter 4:Open Economy modelsNaturally, a very important task for the modeler is building open economy models, sincetrade and international investment policies are among the important policy problems facinggovernments. This chapter continues in the spirit of the previous chapters, presenting a series ofsimple models which incorporate features of open economy issues one by one. Here are themodel names with brief descriptions of their features.M41.GMS Small open economy 2x2M42.GMS Small open economy with a benchmark tariffM43.GMS Same as M42 except with a different price normalizationM44.GMS Small open economy with a benchmark quotaM45.GMS Small open economy with a benchmark voluntary export restraintM46.GMS Small open economy with a benchmark trade imbalanceM47.GMS An Armington formulationM48.GMS Large open economyM49.GMS Full two-country Heckscher-Ohlin modelM410.GMS International capital flowsModel 41Small open economy 2x2This is a very simple 2-good, 2-factor model in which the rest of the world is notexplicitly modeled. Trading opportunities are summarized by simple functions which allow theeconomy to transform one good (an export) into another (an import). The “technology” of thesefunctions represents world prices. If good X1 exchanges for two units of X2, then the world priceratio is implicitly given by p1/p2 = 2. We will assume that these technologies or price ratios arefixed in this model and the first few models to follow. This is commonly know as the “small-country assumption”: the country can trade as much or as little as it wants at fixed prices. We assume in the benchmark data that the country exports X1 in exchange for X2, but wewill allow for the fact that some policy or endowment change could actually reverse the direction2of trade by specifying (initially inactive) functions that transform goods in the opposite direction. Here is the initial data, in which 50 units of good X1 are exchanged for 50 units of good X2 at animplicit price ratio of p1/p2 = 1. Production Sectors ConsumerMarkets | X1 X2 E1 M2 W CONS----------------------------------------------------------------P1 | 150 -50 -100P2 | 50 50 -100PL | -100 -20 120PK | -50 -30 80PW | 200 -200PFX | 50 -50---------------------------------------------------------------- Technology parameters are specified in these functions that allow the modeler to change theterms of trade. These are given by:PARAMETERS PE2 Export price of good 2, PM1 Import price of good 1, PE1 Export price of good 1, PM2 Import price of good 2, TM2 Import tariff for god 2;PE1 = 1;PM2 = 1;PE2 = 0.99;PM1 = 1.01;E1 and M2 production activities that are the initially active trade links. E1 stands forexports of good X1 . While we could specify this activity as directly transforming X1 into X2 , inmore complicated models with many goods it proves useful to define another good which wewill call “foreign exchange” and whose price is denoted PFX. All trade is mediated through the“foreign exchange market”.Thus activity E1 transforms X1 into foreign exchange and M2, the import activity forgood 2, transforms foreign exchange into imports of good 2. These activities are given asfollows:$PROD:E1 O:PFX Q:(50*PE1) I:P1 Q:503$PROD:M2 O:P2 Q:50 I:PFX Q:(50*PM2) A:CONS T:TM2TM2 is an import tariff on good 2, which is initially set to zero. We also specify tradelinks in the opposite direction, which are initially inactive as noted above. At this point, we havean opportunity to make an important technical remark which may save the modeler some miserylater on. Suppose that good 1 can be transformed into good 2 at a price of one, and good 2 canbe transformed into good 1 at a price of 1. Then if the export of 50 units of good 1 and importsof 50 units of good 2 is an equilibrium, then so is the export of 100 units of good 1 followed bythe imports of 50 units of good 2 plus 50 units of good 1. In technical terms the model is “degenerate”, it has infinitely many solutions. In such asituation, the solver will either fail to converge, or converge to an arbitrary solution. The latterwill have net exports (exports minus imports) of X1 equal to 50 and net imports of X2 equal to50, but may involve any amount of gross trade.This is why we specify the prices or “terms of trade” differently for the activities M1 andE2, so that it is never profitable to export and import the same good. Here is the model. In the first counterfacual we impose a tariff and 5% and then a tariffof 10%. When you look at the listing files, you will see that the tariff of 10% is prohibitive, alltrade ceases. The last experiment returns the tariff to zero, and improves the terms of trade(relative prices of the export good) to 1.2.4$TITLE Model M41: Small open economy model. Two goods, two factors.$ONTEXT Production Sectors ConsumerMarkets | X1 X2 E1 M2 W CONS-----------------------------------------------------------------P1 | 150 -50 -100P2 | 50 50 -100PL | -100 -20 120PK | -50 -30 80PW | 200 -200PFX | 50 -50------------------------------------------------------------------$OFFTEXTPARAMETERS PE2 Export price of good 2, PM1 Import price of good 1, PE1 Export price of good 1, PM2 Import price of good 2, TM2 Import tariff for god 2;PE1 = 1;PM2 = 1;PE2 = 0.99;PM1 = 1.01;TM2 = 0;$ONTEXT$MODEL:M41$SECTORS: X1 ! Production index for good 1 X2 ! Production index good 2 E1 ! Export level of good 1 E2 ! Export level of good 2 M1 ! Import level of good 1 M2 ! Import level of good 2 W ! Welfare index $COMMODITIES: P1 ! Price index for good 1 P2 ! Price index for good 1 PFX ! Read exchange rate index5 PW ! Welfare price index


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