A Custom Made CGE Model for an Isolated, Politically Non-recognized Small Island Economy: Exogenous Income Shock to the North Cyprus Economy

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1 A Custom Made CGE Model for an Isolated, Poltcally Non-recognzed Small Island Economy: Exogenous Income Shock to the North Cyprus Economy Nuru Grtl*, Sevn Ugural** Abstract The objectve of ths study s to construct a sngle-country general equlbrum model for North Cyprus economy and explore the mpact of external ncome shock on the economy as a whole. The model t s the frst comprehensve model descrbng the economc actvtes n North Cyprus and t s constructed usng a 3-level nested CES functon n producton, utlty maxmzaton structure n consumpton and nvestment demand. Government sector spends the fxed proporton of ts revenues on commodtes, and a trade closure s determned by Armngton and CET functons for mport demand and export supply of goods and servces. North Cyprus economy s a small sland economy. Sgnfcant trade barrers exst prmarly due to unrecognzed status of the Turksh Republc of North Cyprus as a soveregn state. Therefore the unstable poltcal envronment makes the North Cyprus economy hghly vulnerable to external shocks. Imposng external ncome shock by 40 percent accelerated the expendtures but resulted n greater trade defct n North Cyprus. Despte the adverse effect on the trade balance, results show that output of constructon, wholesale & trade and hotels & restaurants ncreased and household s utlty ncreased due to hgher ncome. In the frst secton, the study gves the bref descrpton and recent economc developments n North Cyprus Next secton s the lterature revew, followed by the methodology used n ths paper. Fnally the paper presents the mplcatons of the external ncome shock on man macroeconomc varables. Keywords: General Equlbrum Model, Foregn Savngs, Mgrant Remttances, North Cyprus JEL Classfcaton: C68 * PhD Canddate, Eastern Medterranean Unversty, Faculty of Busness and Economcs, Department of Economcs, Gazmagusa, TRNC. E-mal: nuru.grtl@emu.edu.tr ** Assoc. Prof. Dr., Eastern Medterranean Unversty, Faculty of Busness and Economcs, Department of Economcs, Gazmagusa, TRNC. E-mal: sevn.ugural@emu.edu.tr 1

2 1. Introducton Economc solaton from the world economy due to the current poltcal stuaton has led to lmted producton capablty n North Cyprus. Due to the market neffcency n goods and factors market, North Cyprus economy fals to utlze ts resources and thus, t has been extremely dffcult to acheve ts economc goals. The economy s hghly dependent on the Turksh economy; besdes, beng a small sland wth specfc features, North Cyprus economy suffers from hgh taxaton, dutes and transportaton costs. Turksh Cyprot economy has been negatvely affected by the nternatonal economc and fnancal crses n the recent years. Despte the varous attempts to resolve the current stuaton n Cyprus, solaton and poltcal unrecognton on the north part of the sland stll contnues. In Aprl 2003, crossng the Green Lne became possble and the movement across the Green Lne by the both Turksh and Greek Cyprots seems benefted the economes of both communtes accordng to the Economc Interdependence Report (2011). The report shows that, consumer expendtures accelerated snce 2003 and socal nsurance payments and health servces, wholesale & retal sectors, hotels & restaurants have all benefted the Turksh Cyprot economy by an estmated 185 mllon Euros n It s also estmated n expendture terms that, n 2009 funds movng from south to north Cyprus were 192 mllon Euros (342 mllon TL) of whch, 118 mllon Euros comes from the Toursts, and 74 mllon Euros s due to labor ncome, pensons and trade. Snce 2003 the characterstc of the labor market n the North has changed. Large numbers of Turksh Cyprot workers wthout any restrcton are movng towards the Green Lne and those who work n the South, transfer ther earnngs n the form of remttances to the North part of the sland. Overall, 35 percent of the Turksh Cyprots who regstered as employed n the south part of the sland manly work n the constructon sectors. Ths s due to the nonrecognton of ther qualfcatons and communcaton problems n Greek language. The effect of the labor moblty not only ncreased the wage earnngs of host country employees but also attracted the foregn workers from Turkey. Under these crcumstances Turksh Cyprot workers who leave the workforce, are replaced by the mmgrant workers comng from Turkey. Our concern n ths study s to study the macroeconomc consequences of mgrant remttances due to labor moblty on the Island. The surge n mgraton and remttances has receved ncreasng attenton for decades. Bayangos and Jansen (2011) analyzed the effect of the mgraton 2

3 remttances on compettveness and accordng to the authors remttances consttute an nflow of fnance whch may lead to an apprecaton of the real exchange rate undermnng the compettveness of the traded-goods sector and, n partcular, of exports; the so-called Dutch dsease effect. However, an ncrease n remttances may affect compettveness also through other channels. An ncrease n remttances nflows s assocated wth an out-mgraton of workers decreases domestc labor force, moreover, households recevng remttances may use the hgher ncome to reduce work effort and ncrease lesure or educaton, whch wll further reduce the labor supply. The reducton of the labor supply may also lead to an ncrease n the wage level, whch wll ncrease producton cost and reduce compettveness. In ths paper, we develop a CGE model whch reveals the characterstcs of the North Cyprus economy as well as the labor market features. In the model, ndustres are broken down nto 13 sub-ndustres. However, there are four factors of producton n the 3-level nested CES producton functon and for the benchmark year, outcome reveals the value added of the economy. Then value added together wth the ntermedate producton gves the total output n The frst and the last nput-output matrx s prepared n 1998 and we are assumng that the structure n North Cyprus has not changed snce There are many studes n the lterature analyzng the mgraton mpact on productvty and t s emprcally proved that mmgraton benefts the host countres f the sklls are complement wth the other producton factors n economes n the long-run, even though mmgraton lowers the wage earnngs of the natonals. However, mgraton may negatvely affect the host country s productvty when they are substtute to the producton factors. Accordng to Borjas (1994), there can be harmful effects despte the benefts of mmgraton when mgraton occurs. For example, f mmgrants lack the sklls that employers demand and fnd t dffcult to adapt, mmgraton may sgnfcantly ncrease the costs assocated wth ncome mantenance programs as well as exacerbate the ethnc wage dfferentals already exsts n the host country. Conversely, f mmgrants are complements then addtonal labor force should result n an ncrease n the earnngs and also employment opportuntes of natves n the long run. In ths study, workers are categorzed nto two groups n order to analyze ther contrbuton n producton separately. To dstngush labor, we used 1996 Census of North Cyprus, where labor force n each ndustry s classfed by ther educaton level. In the producton functon land and natural resources s also ncluded. Accordng to PRIO (2006), land prces n the North rose by 3

4 417 percent between the frst half of 2003 and the frst half of Despte the hgher land prces, property prces are stll more expensve n the South relatve to the prces n the North. Easng the borders between the North and the South parts of Cyprus had certanly ncreased the expectatons on the soluton of the Cyprus problem. The rest of the economy s ncluded n the CGE model as follows. Households, who own the producton factors, try to maxmze ther utlty ther preferences are shown wth the Cobb- Douglas utlty functon. They demand traded goods and servces. Busnesses nvestment decson s constraned wth the total savngs n North Cyprus and ther behavor s shown n the Cobb-Douglas functon. Government collects drect and ndrect taxes through the crcular flow and ther expendtures on goods and servces and on transfers are the fxed proporton of ther total revenues. Export supply and mport demand functons are represented by the CET and CES functons wth Armngton assumptons respectvely. 2. Background Notes of the North Cyprus Economy In North Cyprus, there s large flow of savngs comng from elsewhere, manly from Turkey and the UK, and the nvestment expendtures are fnanced jontly by domestc savngs and foregn savngs. On the other hand, branches of Turksh Banks collect savngs n North Cyprus and these savngs are used to fnance nvestment elsewhere. Consderng all mentoned above, there s potental of captal flow nto the country as well as savng nflow as economc crcumstances change. Therefore as captal nflows, prospectve ncrease of rate of return would have drect and upward effect on land and natural resource prces. Table 1 presents the savng-nvestment shares, publc expendtures and trade balance n real GDP. 4

5 Table 1: Savng, Investment and Trade Balance Shares n Real GDP Total Investment Fxed Investment Publc Investment Prvate Investment Foregn Savngs Domestc Savngs Total Savngs Publc Revenues Total Expendture Current Expendture Foregn Trade Balance Source: State plannng Organzaton of TRNC As t s ndcated n Table 1, perods are chosen to mplement the crcumstance of the economy before the recesson started n North Cyprus. Easng the borders n 2003 had a postve mpact on the country s growth performance. Turksh Cyprot economy experenced a rapd rate of growth trend between 2003 and 2007, due to postve effect of expectatons on soluton on Cyprus problem and EU perspectve framework. In ths perod the real growth rate of GDP and GNP progressed between 10.6 and 14.2 percent and 11.4 and 15.4 percent respectvely accordng to State plannng Organzaton of TRNC (Turksh Republc of North Cyprus). However, hgh growth rate of prvate nvestments has affected trade volume, mports ncreased. Greater producton and employment provded hgh growth rate on publc dsposal ncome. Hgher government ncome provded expanson on publc current expendtures and publc nvestments decreasng the publc savng defct. As prvate sector nvestment expendtures have ncreased more than consumpton expendtures, mprovement has been acheved n prvate sector savngs desgnated for nvestments. 5

6 Table 2 presents the sector shares n real GDP between 2000 and As t s shown, the lowest share has been experenced n agrcultural sector due to the negatve clmatc condtons n Cyprus. Table 2: Dstrbuton of Gross Domestc Product by Sector (%) Agrculture Industry Quarryng Manufacturng Electrcty - Water Constructon Trade-Toursm Wholesale and Retal Trade Hotels and Restaurants Transport-Communcaton Fnancal Insttutons Ownershp Of Dwellngs Busness and Personal Servces Publc Servces Import Dutes Source: State plannng Organzaton of TRNC Largest sector share n GDP belongs to the publc servces, followed by trade and toursm sector and transport and communcatons. Postve developments and growth n physcal producton durng the 2003 and 2007 perod has also been due to ncrease n foregn demand. The constructon sector has ncreased ts share n the economy as a result of speedng up of the nfrastructural nvestments. Apart from larger amount of new nvestments n toursm sector, renovaton, local and foregn demand for dwellngs and hgher publc nfrastructural nvestments have all caused the rapd growth n constructon and sectors. 6

7 3. Lterature Survey There are varous studes n the lterature usng the CGE model approach; to smulate the welfare effects of trade lberalzaton, exchange rate regme, envronmental effect, mgraton on so on. General equlbrum models are wdely used when t comes to show the dstrbutonal effects of the exogenous shocks both on the man macro varables as well as at the ntermedate level dependng on how the model s structured. Stfel and Thorbecke (2003) bult a CGE model for the Afrcan economy to stmulate the welfare effects of trade lberalzaton specfcally on poverty. Ther study provdes the bass for analyzng the dstrbuton of modern and nformal sector actvtes n both rural and urban areas. The evdenced that changes n populaton shares of the soco-economc groups that follow populaton shfts have mportant mplcatons for the magntude of changes n natonal poverty. Okkers (2005), takng labor heterogenety and all the channels nto account bult a CGE model to stmulate the effect of mmgraton n Belgum. Hs results show that although mmgraton s macro-economcally benefcal, there s sgnfcant adverse effect of mmgraton at the dstrbutonal stage. Study by Brown and Leeves (2007) addresses the nterrelatonshps between mgraton, remttances and household ncome n two Pacfc Island countres, Fj and Tonga. The analyss ams to dentfy the effects on household ncome sources of the combned mpacts of the mgrant s absence and the nflow of remttances, takng nto account how mgraton and remttances can have both postve and negatve effects. The emprcal analyss s based on household survey data collected by the authors and they used the methodology developed by Taylor et al. (2003) to conduct ther fndngs. Ther results ndcate that mgraton can have sgnfcant effects on subsstence ncome, although nether mgraton nor remttances appear to any sgnfcant effects on market agrcultural actvtes. Iyjaz and Aftab (2011) analyzed the welfare mpact of labor emgraton and workers' remttances and ther fndngs suggest that remttances are an mportant fnancal nflow snce remttances s a bg source of foregn exchange earnngs. Negatve outflow of labor force s beng cancelled out by a postve nflow of workers remttances to Pakstan. However, 7

8 emgrants do contrbute postvely towards the GDP n Pakstan despte the contrbuton of emgrants the contrbuton of local labor force s more than that of the emgrants. In another analyss, Ottavano and Per (2007) usng the supply drven component of mmgraton tred to analyze the consequences of mgraton on wages, consumpton and housng prces of natves n smple general equlbrum framework. They founded that, there are postve and sgnfcant wage and housng prce effects whch are caused by mmgraton. In an economy wth workers of dfferent sklls, natves respond to nflow of mmgrants by movng around and upgradng ther jobs, as there are complementartes between the sklls and servces produced by natves and mmgrants. Although mmgrants have a small and negatve effect on wages of unsklled natves, ths negatve effect due to ncrease n the supply of unsklled workers are partly compensated by the complementartes wthn the skll groups. Barajas, Cham, Hakura and Montel (2011) analyzed the effect of worker remttances on the equlbrum real exchange rate n recpent countres. Ther fndngs show that, large nflows of worker remttances have been perceved as posng macroeconomc challenges for the recpent countres. The authors thnk that worker remttances challenge the equlbrum mechansm as large nflows of worker remttances could lead to the emergence of Dutch dsease, that s, remttance nflows could result n an apprecaton of the equlbrum real exchange rate that would tend to undermne the nternatonal compettveness of domestc producton, partcularly that of nontradtonal exports. However, Wllams (2003) contrbutes on the debate usng three-regon, three factor, and sxgood mult-natonal computable general equlbrum model. The model was constructed as follows; for the one type of producer, captal s explctly ncluded n the nested CES type producton functon together wth unsklled labor. Then for the second type of producer, agan CES type producton functon s used where sklled labor and composte of unsklled labor and captal are used as nputs to the producton functon. Each producer mnmzes ther cost functons subject to ther producton functons. As a result factor demand functons are derved to be used n the CGE model. The author ncluded captal ncome n household ncome assumng two types of households exsts n the model namely rch and poor. Each household s assumed to have a dfferent type of nested CES utlty functon. They try to maxmze ther utlty subject to 8

9 ther ncome constrants. One type of households derved demand functons consst of composte traded and non-traded goods on the other hand, the other household demands only traded goods. Government sector also s ncluded to mpose taxes and redstrbute ncome among the households. It s assumed that government budget to balance n ths analyss. Then the model s calbrated usng (assumng) the elastcty of substtuton between composte traded and nontraded goods for the households and the values used for the elastcty of substtuton among the producton factors also are based on some assumptons. The author concludes hs analyss mentonng some mportant lmtatons. Frst of all, CGE models are statc models and they cannot forecast the tmng of adjustments from benchmark to counterfactual equlbrum. Those statc models cannot capture any addtons to human captal that occur over tme. Because of the data lmtatons, the author aggregated the entre rest of the world nto one regon and ths was unrealstc. Smulaton mpacts of varous shocks fluctuate wdely from one study to another. CGE model s wdely used to quantfy the effects of those shocks on economes whch takes all the channels nto account such as, the lnks between captal and labor and the nteractons between the factor markets, good and servce markets, therefore t seems to be an approprate tool to stmulate the non-factor external ncome shock on the North Cyprus economy. 4. Methodology and Algebrac Modelng The sngle-country general equlbrum model wth references to the case- specfc features of North Cyprus s constructed as follows. There are 2-goods tradable and non-tradable, 4- factors, 13-ndustres. In the producton process we use a 3-level nested CES functon. Household s utlty maxmzaton s constraned by ther ncome whch are factor ncome and the transfers they receve. A constraned optmzaton functon for nvestment demand s represented by Cobb-Douglas functon and government sector s ncluded where fx proporton of ther revenue s spent on goods and servces. Fnally, trade closure s determned by Armngton and CET functons for mport demand and export supply of goods and servces. Households: There s only one type of household who demand goods and servces. Households have the followng type of utlty functon. 9

10 n (1) 1 alphac U C = 1,...,13 where alphac 1 Household s ncome comes from the factors of producton and from the government transfers shown by the followng equaton. MY lw. LS hw. HS kw. KS rw. RS Trans (2) Ther ncome s subject to taxaton, then household save some proporton of ther ncome. Fnally dsposable ncome n other words, households budget constrant s derved as follows. M (1 tm). MY SH (3) Households then maxmze ther utlty functon subject to ther budget constrant and the derved demand for the commodtes s shown as; C 1. alphac. M (4) PC Producton: There are four factors of producton unsklled labor, sklled labor, captal and land and they are represented by the 3-level nested CES producton functon. Producton at the ntermedate level s represented by the Leontef functon and that s based on the 1998 nputoutput table. Output for the whole economy s produced by addng the sum of ntermedate nputs to the value addedva. Chart 1 presents the factor shares n value added where LS s the unsklled labor supply, HS s the sklled labor supply, KS s the captal stock and fnally RS represents the land and natural resources n North Cyprus. Then the producton process s shown by the followng CES functon (Equaton 5). 10

11 11 Fgure 1: Factor shares n Output Source: Input-Ourput Tables, (1 ) 1,...,13 J G XD A K L H R Where XD A VA Producers mnmze the average cost of producton subject to the nested CES producton functon and factors demand derved from the optmzaton are as follows. * e e e e e e e e k K J k l (6) * e e e e e e e e l L J k l (7)

12 H R * * se se 1. h 1 1 se se se se se 1se. j 1. h ge ge 1. r 1 1 ge ge ge ge ge 1ge. g 1. r. G. XD (8) (9) Then composte prce j for composte nput J s calbrated, substtutng optmum labor L and captal K combnatons nto the cost functon and composte prce g for composte nput calbrated usng optmum combnatons of J and H. G s After all, zero proft condton holds n producton where total revenue from producng the output equals the total cost of producton. Results are shown n table 1 are consstent wth the benchmark equlbrum. Table 3: Domestc output and composte nputs produced wthn the Nested Producton Stage (Values are n Current prces, TL) XD % 1. Crop Producton 18,163, ,503, ,263, Lvestock Producton 18,683, ,835, ,759, Forestry 114, , , Fshng 339, , , Quarryng 2,100, , , Manufacturng 40,450, ,032, ,943, Electrcty - Water 12,787, ,636, ,294, Constructon 31,712, ,202, ,465, Wholesale and Retal Trade 47,780, ,665, ,351, Hotels and Restaurants 35,901, ,050, ,612, Transport and Communcaton 12. Fnancal Insttutons 32,935, ,644, ,691, Dwellngs Busness and J 46,163, ,777, ,999, Personal & Publc Servces Total 377,115,512 95,378, ,824,474 Source: GAMS output for the North Cyprus Economy s CGE model 89,982, ,946, ,466, % G % 12

13 Investment: Investment purchases such as physcal captal, machnery and equpment by the prvate and publc corporatons are fnanced by the total savngs n the economy. Total savngs consst of prvate savngs, publc savngs and foregn savngs. Prvate savngs are endogenously determned n the model and publc and foregn savngs are exogenously fxed varables. In other words, publc savngs and foregn savngs closure the government budget and trade balance respectvely. Prvate and publc sectors then demand those captals whch s determned through Cobb-Douglas functon shown below. I S. I P (10) * 1 I Where, n 1 I 1 Government: Government collects drect and ndrect taxes and spends the fxed proporton of ts revenue on communty servces and consumpton goods. However, government also makes transfer payments and the ncluson of the transfer payment s shown n equaton (2). In our model, government expendtures are exogenous, tax nstruments are endogenous to reflect (ncrease) the revenues and government balance s fxed. Followng equatons represents the government s behavor t the model. n and TAXR EG SG 1 EG CG Transf (11) Rest of the World: Demand for mported commodtes s represented by CES functon wth Armngton (1969) assumpton to dentfy traded goods and servces n-use, separately. The assumpton s wdely used n the CGE models to defne demands for domestcally produced commodtes, as well as demand for mported goods when the products are natonally dfferentated followng Lloyd and Zhang Wth the Armngton structure, two-stage budgetary allocaton procedure s assumed. Frstly, budget s allocated among the domestcally demanded commodtes and then 13

14 expendture on each commodty s allocated between domestc and mported commodtes. In order to derve the demand for domestc and mported commodtes, frms mnmze ther cost, subject to ther CES type producton functon and solvng the problem yelds the followng mport demand functons. T T T 1 T 1 1 T T T. T SX XDD T PDD T PDD T PIM. AR T T T 1 T 1 1 T T T T SX IM T. PIM. 1 T. PDD T. PIM. AR (12) (13) For the supply of exported commodtes, each ndustry produces a composte commodty XD whch can be exported and/or sold domestcally n the market. In ths structure, exports and domestcally sold products are assumed to be dfferentated by market (wth respect to ther prces), wth the relatonshp between them represented by a constant elastcty of transformaton (CET) functon. CET functon descrbes the market transformaton process and each frm allocates ts output between the domestc and export markets. Domestc supply functon for goods s derved from the frst order condtons and followng supply functons are obtaned. 1 1 T 1 T 1 T 1 T 1 1 T 1 T 1 T XD T XDD T PDD T. PE 1 T. PDD. T 1 1 T 1 T 1 T 1 T 1 1 T 1 T 1 T XD.. 1 T E T PE T. PE 1 T. PDD. T 1 T 1 T (14) (15) Fnally trade balance s shown n equaton (16) where foregn savng s exogenously n fxed. PMW. IM PEW. E SF (16) 1 1 n 14

15 5. Data and Calbraton When we started modelng the frst CGE model of the North Cyprus economy, several ssues have arsen. At the very begnnng of constructon of the CGE model, we needed to calbrate some of the varables n order to complete the model. In practce, data representng benchmark equlbrum that are used n calbraton are constructed from natonal accounts and other government data sources. Calbraton nvolves one year s data and consstent data s shown n the SAM n Appendx. Requred values for the relevant elastctes dentfy other parameters such as dstrbuton parameters; are based on other sources. Thus, elastcty of substtuton parameters s taken exogenously from the varous resources. Elastcty of substtuton parameter values are very mportant as they specfy the curvature of the soquants and ndfference surfaces, wth ther poston gven by the benchmark equlbrum data. After completng all the varables and the parameters needed for the model, the system s valdated and the model s run for the benchmark year. Equlbrum condtons whch characterze the model are whether demand equals supply n goods market and factors market. However, n the labor market, we assume there s no unemployment and thus, labor supply equals the labor demand. System constrants are satsfed through the optmzaton processes at each sub secton. Fnally, Walrasan constrants are mposed and homogenety tests are appled to verfy the relablty of the model. 6. Prelmnary Smulaton Results and Concluson At the frst stage, the model was solved for the base year wthout mposng any changes n the parameters or exogenous varables so that the optmal soluton replcates the orgnal values for the benchmark year. Then, benchmark year results are saved for comparson wth the results of the smulatons mplemented at the second stage. The study focuses on the mpacts of the remttances (non-factor ncome) on man macro-economc varables. We assumed that, Turksh Cyprots (unsklled workers) who work n the South Cyprus are replaced by the Turksh workers. Although labor s moble across the borders, there s no change n labor supply. We also assumed that, land and sklled labor endowments are exogenously fxed and wages, rent and return on captal adjust after the shocks are beng mplemented. In order to show the mpact of non-factor ncome on macro-economc varables, we ncreased foregn savngs by 40 percent and allowed 15

16 captal movement n our model. Smulaton results on man macro-economc varables are shown n the followng tables. Table 4: Counterfactual Equlbrum Compared to Benchmark Equlbrum Benchmark Smulaton % Change Investment 49,779,827 67,731, Stocks 3,075,951 3,075, Consumpton 188,419, ,534, Publc Expendtures 62,884,655 67,385, Imports 163,766, ,633, Import dutes 23,527,821 23,527, Exports 111,904, ,026, GDP 228,769, ,591, Source: GAMS output for the North Cyprus Economy s CGE model 40 percent ncrease n foregn savngs ncreased consumpton expendtures by 1.65 percent, government expendtures by 7.16 percent and nvestment expendtures by 36.6 percent. Investment expendtures ncreased dramatcally and the man source of the growth n nvestment expendtures s the savngs. Ths suggests two thngs; frst, the shock s mposed on the foregn savngs and that drectly fnance country s domestc nvestments secondly, 15.8 percent rse n mports and reducton n exports n real terms deterorates the foregn trade balance. Although GDP ncreased by 2.11 percent n nomnal terms, t s observed that, trade defct as percentage n nomnal GDP ncreased by 37 percent. The prce effects, ncome effect and the changes n consumers utlty are also shown n Table 5. It s clearly seen that households are better off. Wth addtonal transfers nto ther budget, ther utlty ncreased by 1.51 percent. Tax revenues are ncreased by 8.96 percent and ncome ncreased by 4.87 percent. 16

17 Table 5: Counterfactual Equlbrum Compared to Benchmark Equlbrum Smulaton ( % Change) HHs Savng 4.87 Foregn Savng Publc Savng 0.00 Tax Revenue 8.96 Income 4.87 Expendture 4.87 Household's Utlty 1.51 Unsklled labor wage 4.45 Sklled labor wage 5.25 Captal return 3.42 Rent 5.54 CPI 3.21 Source: GAMS output for the North Cyprus Economy s CGE model In our analyss, we had assumed that wages, rent and return on captal adjusts to keep the factors market n equlbrum and foregn exchange rate s fxed as the North Cyprus economy s too small to affect the world prces. It s observed n Table 5 that wages of unsklled and sklled labor ncreased by 4.45 percent and 5.25 percent respectvely. Return on captal ncreased by 3.42 percent and ths s reflected by the 1.6 percent captal nflow. Fnally land prces ncreased by 5.54 percent together wth 3.21 percent ncrease n consumer prce ndex. The mcro-smulatons n Table 6 presents the sectoral changes n output, domestc output suppled on the domestc market and the domestc sales of composte commodtes demanded by ntermedate users and fnal demanders. It s observed that output ncreased n constructon sector by percent, wholesale & trade sector by 4.26 percent and hotels and restaurants sector by 6.40 percent. Reducton n manufacturng sector s output by 22.8 percent mples that producton n manufacturng goods heavly depends on the mported materals. As ts show n column (3), domestc sales of manufacturng goods ncreased by 6.71 percent after the shock. It was ponted out by the varous studes that snce 2003 constructon and related sectors busted. The smulatons also reveal that domestc output suppled on domestc market n quarryng and 17

18 constructon sectors ncreased by percent and percent respectvely. Wholesale & retal trade and fnancal nsttutons are also benefted by 3.69 percent and 2.11 percent respectvely. In column (3), domestc sales of composte commodtes demanded are presented and all the sectors except crop, lvestock and electrcty& water producton benefted wth addtonal ncome. Table 6: Changes n Output, Domestc Supply and Demand by Sector Output (XD) (1) Domestc Output Suppled on Domestc Market (2) Domestc Sales of Composte Commodtes (3) 1. Crop Producton Lvestock Producton Forestry Fshng Quarryng Manufacturng Electrcty - Water Constructon Wholesale and Retal Trade Hotels and Restaurants Transport and Communcaton Fnancal Insttutons Dwellngs Busness and Personal & Publc Servces Overall Impact Source: GAMS output for the North Cyprus Economy s CGE model (1) Domestc output (2) Exports are excluded from domestc output (3) Imports are ncluded 18

19 The am was to construct the frst CGE model for the North Cyprus economy and analyze the mpact of the external ncome shock on the man macro-economc varables and output. The smulatons showed that external ncome certanly stmulates the demand sde of the economy as nvestments, consumpton and government expendtures ncrease but at the same tme hgher mport demand deterorates the trade balance. Nomnal GDP ncreased around 2 percent, and consderng the hgher prce ndex Real GDP decreased. However, output whch conssts of value added and ntermedate nputs, decreased by 18 percent pror to the shock. Man sectors facng a declne n producton are manufacturng, quarryng, agrculture and electrcty & water. However, wages rent and captal prces ncreased as expected and there s a 1.6 percent captal nflow. Ths study focused only on the external ncome effect keepng the other model determnants constant. It s observed that our fndngs are consstent wth the offcal fndngs of North Cyprus State Plannng Organzaton that the economy experenced a growth after The CGE model results not only show the mpact of the smulatons at the aggregate level but also t enables us to vew the dstrbutonal effects n producton and demand sde n the economy. Imposng an external ncome shock was the frst scenaro we planned to mplement. It wll be very nterestng to show the combne effects of dfferent scenaros on the economy as there are many other nfluences, such as labor moblty across the borders, mmgraton ssues and frequent changes n the prces. Our economy s experencng a deep recesson and there are economc and poltcal nstabltes whch makes the economy vulnerable to changes. New reforms are mplemented, and many of other reforms are planned to take place n the new future. We suggest that the structure of the economy must be analyzed crtcally before mposng any changes n the structure. 19

20 References: Armngton, P.S. (1969). A Theory of Demand for Products Dstngushed by Place of Producton, IMF Staff Papers 16(1): Bayangos, V. and Jansen, K. (2011). Remttances and Compettveness: The Case of the Phlppnes. World Development, Vol. 39, No. 10, pp Barajas, A., Cham, R., Hakura, D., and Montel, P. (2011). Workers Remttances and the Equlbrum Real Exchange Rate: Theory and Evdence. Economa, Sprng Borjas, George J The Economcs of Immgraton. Journal of Economc Lterature, Vol. XXXII, pp Brown and Leeves (2007). Impacts of Internatonal Mgraton and Remttances on Source Country Household Incomes n Small Island States: Fj and Tonga. ESA Workng Paper No Census (1996). State Plannng Organzaton, TRNC. Cybc Report on Economc Interdependence (2011). Assessment of Current Economc Interdependence between the Greek Cyprot and the Turksh Cyprot Communtes and Recommendatons for Renforced Economc Convergence. Iyjaz, Z. and Aftab, K. (2011). Welfare Impact Analyss of Labor Emgraton and Workers' Remttances: A Case Study of Pakstan. Inter-dscplnary Journal of Contemporary Research n Busness, Vol.2, No.12. Lloyd, P. J. and Zhang X. (2006). The Armngton Model. Productvty Commsson, Australan Government, Staff Workng Paper, No: Okkerse, L. ( 2005). Effects of mgraton: an appled general equlbrum analyss for Belgum. JEL classfcaton: D58,F22,J61. Ottavano, G. and Per, G. (2007). The Effects of Immgraton on U.S. Wages and Rents: A General Equlbrum Approach. CReAM Dscusson Paper No. 13/07 PRIO Report 2/2006, The property regme n a Cyprus statement. Stfel D.C and Thorbecke E. ( 2003) A dual-dual CGE model of an archetype Afrcan economy: trade reform, mgraton and poverty. Journal of Polcy Modelng, Vol.25, pp Taylor, J. E. and I. Adelman. (2003) Agrcultural Household Models: Geness, evoluton and extensons.revew of Economcs of Households. Vol.1: pp

21 The Input-Output Structure Of The Economy of Turksh Republc of North Cyprus ( 1998), State Plannng Organzaton, TRNC. The Turksh Cyprot Compettveness Report Wllams, M. F. (2003) Economc Impact of Increased Mexco-U.S. Labor Moblty: A Computatonal General Equlbrum Analyss. The Internatonal Trade Journal, 17(3),

22 Appendx Chart 1: CGE Model - The Market Supply Output Leontef Functon. CET Functon Value Added Input Output Imports Exports Domestc producton suppled on domestc market Upper Level CES Composte Input 2 Mddle Level CES Land CES wth Armngton Assumpton Supply Sklled Labor Composte Input 1 Lower Level CES Captal Unsllled Labor Chart 2: CGE Model Domestc Fnal Demand Domestc Fnal Demand Leontef Functon. Cobb- Douglas 2-Legged Nested CES Cobb- Douglas Intermedate Demand Investment Expendtures Consumpton Expendtures Government Expendtures CES Utlty Maxmzaton CES Utlty Maxmzaton Tradable Goods Servces 22

23 Table 8: Aggregated Socal Accountng Matrx of North Cyprus Factors of Producton Agents Labor L Labor H Land R Captal K Factors ( ) Industres (1-13) Households S-I Government Rest of World Taxes Total ,740, ,178, ,575, ,897, ,769, ,769, ,346, ,419,094 52,855,776 62,884, ,904, ,409, ,391,650 10,999, ,391, ,650,610-23,657,300 51,862,450 52,855, ,226,925 50,226, ,294, ,294, ,377,602 15,321,502 23,527,821 50,226, ,769, ,409, ,391,206 52,855,776 50,226, ,294,495 50,226,925 Source: Author s creaton 23

24 Table 7: The Model Notaton Varables: C I CG EG IM E K L H R J G XD VA SX XDD U PDD PIM Consumpton demand of commodtes Fnal demand of nvestment expendtures Publc consumpton expendtures Total government expendtures Imports Exports Demand for captal Demand for unsklled labor Demand for sklled labor Demand for productve land resource Composte value of captal-and-unsklled labor Composte value of captal-and-unsklled labor complements and sklled labor Proft Domestc Output Value Added Domestc sales of composte traded commodtes and servces Domestc output suppled on the domestc market Household's utlty Prces of domestc commodtes Prces of mported commodtes j, g Composte prces of composte nputs J and G Market prce for commodtes Commodty prces P Market prce for nvestment commodtes I PC P k, l, h, r Rate of return to captal, PE PX PMW PEW TAXR M Transf M Y S SH SG SF wage of unsklled labor, wage of sklled labor and rent Prces for exported commodtes Prces of composte commodtes World prce of mports World prce of exports Sum of drect and ndrect taxes Government transfer payments Household's budget Factor's ncome Total savngs Household's savngs Publc savngs Foregn savngs Parameters A Effcency parameter for CES producton functon AR Effcency parameter for CES mport demand functon T Effcency parameter for CET export supply functon e Elastcty of substtuton parameter at the frst nest of the poducton process se Elastcty of substtuton parameters at the mddle nest of the poducton process ge Elastcty of substtuton parameters at the upper nest of the poducton process T Elastcty of substtuton parameter for the CES mport demand functon T Elastcty of transformaton parameter for the CET export supply functon alphac Dstrbuton parameter for consumpton I G Dstrbuton parameter for Investment Dstrbuton parameter for Government Dstrbuton parameter Dstrbuton parameter Dstrbuton parameter Substtuton parameter Substtuton parameter Substtuton parameter Substtuton parameter Substtuton parameter Substtuton parameter Input-output coeffcent Margnal propensty to save m T o j mps 24