Uncovering impact: the strengths and limitations of Computable General Equilibrium (CGE) modelling

What Are CGE Models?

Computable General Equilibrium (CGE) models are sophisticated, large-scale numerical frameworks that integrate economic theory with empirical data to evaluate the effects of policies or changes to a national or regional economy. These models incorporate real-world economic data into a system of equations that represent the structural relationships within an economy, including the responses of key agents such as households, firms, and governments.

CGE models capture both direct and indirect effects of policies/programs and produce estimates of how changes (or ‘shocks’, as they are commonly referred to) flow through the economy as indicated by aggregate measures such as output, consumption, employment and investment. It also provides insight into distributional effects, measuring impacts on specific industry sectors or regions.

CGE models are widely used by government, industry and academics to evaluate the impact of policy actions, programs and projects. The increasing use of CGE modelling in economic assessments reflects its ability to capture wide-ranging effects beyond a particular sector.

How do CGE Models work?

In CGE models an economy is represented as an interconnected system of markets, sectors, and agents, including households, firms, and governments. The model captures interactions between these agents and markets, encompassing production, consumption, investment, trade, and factor markets, like labour and capital. These interactions are specified in mathematical terms, with equations combined in a manner that allows the model to predict changes in variables such as prices, output, and economic welfare resulting from policy changes or public investments. By solving these mathematical equations numerically, CGE models simulate the equilibrium state of the economy under different scenarios, providing a powerful tool for analysing the effects of various economic policies, shocks, or structural changes on the economy as a whole.

When should CGE models be used?

CGE modelling is typically used when the key purpose of the analysis is to understand the wider (macroeconomic) impacts of policies/programs (for instance, to understand how policy changes affect variables like Gross Domestic Product (GDP), employment, consumption, investment, and trade) and/or when a policy or program has wide-scale economic impacts which are expected to flow across multiple sectors.

The macroeconomic impacts of a policy, project or other activity can be estimated using a variety of economic analysis tools. The most common methods used are input-output (IO) multiplier analysis and CGE modelling. The selection of the right tool is critical to the accuracy of the estimated impacts and depends upon the characteristics of the policy or project being examined. Sometimes a range of tools are required.

The main factors that need to be considered when analysing the macroeconomic impacts of a project or policy include:

1. the direct and indirect contribution to the economy as a result of the activities associated with the project or policy
2. any crowding out implications as resources are potentially diverted from other productive activities to undertake the project or policy being analysed
3. any productivity effects generated as a direct result of the policy or project activities – particularly any enduring productivity changes or productivity impacts on other activities not directly associated with the project or policy
4. any changes to the factors of production in the economy
5. any implications associated with changes in terms of trade or foreign income transfers
6. the extent of any dynamic element to the size of any of the above effects (for example, associated with different phases of the project).

CGE models can account for all these factors in a robust manner.

What are some of the strengths of CGE models?

One of the key strengths of CGE models is their flexibility. They can be tailored to simulate a wide array of economic policies and shocks, ranging from trade agreements, fiscal reforms, or spending programs. Their ability to account for both price and quantity adjustments in response to policy changes makes them a preferred tool for government agencies, research bodies, and international institutions such as the World Bank, OECD, and IMF, as well as consulting firms like ours.

CGE models mimic the workings of the economy, enabling a more robust analysis of the macroeconomic impacts of policies and programs (compared to other tools like IO models). CGE models:

1. consider resource and budget constraints
2. allow prices and wages to vary
3. allow factors of production to vary
4. allow changes in productivity and taxes
5. allow substitution between different sources (e.g. domestic vs imported), between different commodities (e.g. gas vs electricity) or between different technologies (e.g. coal, gas, wind, solar etc. generation technologies)
6. all markets clear.^[1]

What are the limitations of CGE models?

CGE modelling isn’t without its limitations. It is a complex tool, with many thousands of equations and outputs being processed and generated, and takes a significant level of expertise to be able to properly run and analyse the model. Furthermore, there are high barriers to entry from a data and computational resource standpoint, meaning that the ability to access the data needed to create the inputs, as well as the access to a computer powerful enough to run the model, leaves CGE modelling only readily available to implement by specialist economic entities such as reserve banks, academic institutions, or private sector advisory firms such as ACIL Allen.

Even when an organisation possesses the necessary tools to implement a CGE model effectively, it's important to recognise that it's not a universal solution for all impact assessment needs. Specifically, CGE modelling presents several limitations:

• Unsuitable for Small-Scale Policy Changes: Due to its economy-wide scope, CGE modelling is not appropriate for measuring the impacts of policy or program changes expected to have relatively minor economic effects.
• Limited Indicator of Social Welfare Changes: While all government initiatives have some economic impact, this doesn't automatically translate to an improvement in overall social welfare, which CGE models may not accurately reflect.
• Difficulty Incorporating Non-Market Impacts: CGE models struggle to include detailed analyses of environmental, health, and other social impacts, as well as the nuanced distribution of these impacts.
• Restricted Comparative Capability: Generally, CGE models do not offer decision-makers a straightforward and objective means to evaluate and compare competing proposals on an equal footing.

In conclusion, CGE models stand as powerful tools for macroeconomic analysis, offering a comprehensive framework to understand the intricate and widespread impacts of policies and economic shifts. Their capacity to account for market interactions, resource constraints, and dynamic adjustments provides valuable insights for governments, industries, and researchers seeking to evaluate broad economic consequences. However, as highlighted, the complexity, data requirements, and inherent limitations regarding small-scale impacts, social welfare indicators, non-market factors, and comparative analysis necessitate a nuanced understanding of when and how to best deploy these sophisticated models within the broader toolkit of economic assessment.