We present a stylized intertemporal forward-looking model that accommodates key regional economic features, an area where the literature is not well developed. The main difference, from the standard applications, is the role of saving and its implication for the balance of payments. Though maintaining dynamic forward-looking behaviour for agents, the rate of private saving is exogenously determined and so no neoclassical financial adjustment is needed. Also, we focus on the similarities and the differences between myopic and forward-looking models, highlighting the divergences amongst the main adjustment equations and the resulting simulation outcomes.
Highlights
► First systematic exploration of forward-looking regional CGE models ► Forward-looking and myopic models, if comparable, have identical long-run solutions. ► Apparent differences in fact reflect different macroeconomic adjustment processes. ► These processes may differ significantly between regional and national economies.
Regional Computable General Equilibrium (CGE) models solve complex optimization problems within individual time periods in order to determine a complete allocation of a region's resources between alternative uses. However, such models often lack forward-looking expectations and this has been regarded as a matter of concern (Partridge and Rickman, 1998 and Partridge and Rickman, 2010). In this paper we attempt to identify how significant the lack of forward-looking expectations is in this setting. In particular, we build a stylized forward-looking CGE model applicable in a regional context. Results from simulations using this model are then compared to those from a similar model where the adjustment processes between periods have a myopic, backward-looking, recursive-dynamic structure.
In this comparison of results we find the simulation differences are small. The long-run equilibria are identical. Furthermore, the adjustment paths generated by the two models are not radically different. We suggest two possible reasons why the importance of incorporating forward-looking expectations into regional CGE models might have been overstated. First, in previous comparisons using national models, the fully dynamic forward-looking model has often been compared to either a static model or one with passive investment. Second, the usual mechanism and closures that are applied in national intertemporal CGE models misrepresent the adjustment mechanisms that typically occur within an individual region.
The structure of the remainder of the paper is as follows. In Section 2 we provide a background discussion of the theoretical issues. In Section 3 we outline the model structure. In Section 4 we deal with the calibration method. In Section 5 we present the simulation strategy and in Section 6 we discuss the simulation results. In Section 7 we summarize the main results of the paper and we conclude in Section 8.
We argue that the conventional intertemporal consumer optimization, based on neoclassical or Fisherian analysis of intertemporal resource allocation, seems to be inappropriate from a regional point of view. The consumer intertemporal maximization process not only yields the time path of consumption, but also the time path of savings which became a function of total financial assets. Thus, not only is the instability between current income and current consumption, related to the permanent income hypothesis approach, relevant here, but more emphasis is put on the dynamic path of savings where households are liable for all the financial needs of the region. In turn, this implies an imposed balance of payments adjustment mechanism.
Furthermore, we question the plausibility, from a regional point of view, of the imposition of an intertemporal budget constraint where internal and external debts are made repayable from the private sector. No internal and external debt sustainability problems occur in a region. Deficit in the current account cannot be seen as hypothetical surplus in later periods making external debt repayable because there is no requirement to do so, and foreign debt, especially for declining regions, is the result of capital subvention supplied by supra-regional institutions, such as a national Government or the European Union. Regional public deficits are not a problem at all, given only that the national government remains committed to the maintenance of the Union. It would, therefore, be a mistake to allow consumers to take the public deficit into account in their intertemporal optimization problem, as no taxes will be imposed to cover it and no change in consumption plans is required. As we noted above, regional policy is an exogenous variable for regions so no Ricardian equivalence of regional fiscal deficits applies.
We have also argued that some of the objections to myopic models, such as the presumed lack of capital adjustment in the myopic model and differences in long-run steady state results between myopic and forward-looking models, cannot be correct. In some articles, forward-looking models are compared with myopic specifications that preclude any adjustment in investment and consumption. The usual assumptions are passive investment (or investment held constant to the base year in real terms) and consumption simply obtained as a fixed share of current income. In this paper, myopic and forward-looking models that are genuinely comparable generate the same results in the long-run. The only difference, though of course it may be a significant one, is in the transitional pathway. Thus in comparing the long-run impact of a policy, agents' expectations do not matter. However, it does become an issue if we are interested to the short-run impacts of policies and the dynamic paths to new equilibria. These conclusions hold for any given macroeconomic “closure”, but these should be carefully chosen to reflect the particular regional context, including the degree of fiscal autonomy. Future research will extend the intertemporal regional analysis in two important respects to: accommodate the multi-regional case; relax the assumption of infinitely lived agents.
