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1 Working Paper A Dynami Computable General Equilibrium (CGE) Model for South Afria: Extending the Stati IFPRI Model James Thurlow T R A D E A N D I N D U S T R I A L P O L I C Y S T R A T E G I E S

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3 TRADE AND INDUSTRIAL POLICY STRATEGIES (TIPS) Vision To be a soure of independent eonomi poliy and researh leadership to government and ivil soiety in SA and the region. Mission Developing an internal ritial mass of intelletual apaity to undertake and disseminate groundbreaking and relevant eonomi researh. Stimulating debate between poliy pratitioners and the wider researh ommunity to generate viable poliy options. Building on our links with key international poliy-relevant institutions to draw the quality of our researh efforts ever loser to international best pratie. TIPS Board Alan Hirsh (Chairperson, Member & Diretor) Lael Bethlehem (Member) Lesetja Kganyago (Member) Leslie Maasdorp (Member) Merle Holden (Member & Diretor) Stephen Hanival (Diretor) Stephen Yeo (Member) Tshediso Matona (Member & Diretor) The Presideny City of Johannesburg National Treasury Goldman Sahs International University of Natal Trade and Industrial Poliy Strategies Bannok Consulting Ltd (UK) Department of Trade and Industry (the dti) TIPS Advisory Board Al Berry University of Toronto (Canada) Bernard Hoekman World Bank Mar Ivaldi Université des Sienes Soiales de Toulouse, Frane Rohinton Medora International Development Researh Centre, Ottawa, Canada For more information about TIPS and its ativities, please visit our website at For enquiries about TIPS Working Papers and other publiations, please ontat us at publiations@tips.org.za

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5 TIPS WORKING PAPER SERIES 2004 Author(s) Title Format James Thurlow Nimrod Zalk Ron Sandrey Rob Davies and Dirk Ernst van Seventer James Hodge Nik Vink Penny Hawkins Simon Roberts A Dynami Computable General Equilibrium (CGE) Model for SA: Extending the Stati IFPRI Model WP The Role of Dynami Produts in Global Integration Impliations for SA WP Non-Tariff Measures Faing Exports from South and Southern Afria WP A Three-gap and Maro Deomposition Analysis for SA, * WP Universal Servie Through Roll-out Targets and Liene Conditions: Lessons from Teleommuniations in SA* WP The Influene of Poliy on the Roles of Agriulture in SA* WP SA s Finanial Setor Ten Years On: Performane Sine Demoray* WP The Role for Competition Poliy in Eonomi Development: The SA Experiene* WP Eletroni: asp?id=707 Eletroni: asp?id=741 Eletroni Eletroni Eletroni Eletroni Eletroni Eletroni * Presented at the TIPS/DPRU Annual Forum 2003 and published in Development Southern Afria Vol. 21, No. 1, Marh 2004

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7 A Dynami Computable General Equilibrium (CGE) Model for South Afria: Extending the Stati IFPRI Model James Thurlow International Food Poliy Researh Institute, Washington, D.C. L Institut de Reherhe pour le Développement, Paris University of Natal, Durban February 2004

8 Published 2004 by Trade and Industrial Poliy Strategies (TIPS) P.O. Box 87643, Houghton 2041, Johannesburg, SA 2004 Trade and Industrial Poliy Strategies All rights reserved. No part of this book may be reprinted or reprodued or utilised in any form or by any eletroni, mehanial, or other means, now known or hereafter invented, inluding photoopying and reording, or in any information storage or retrieval system, without permission in writing from the publishers. National Library of SA A atalogue reord for this book is available from the National Library of SA TIPS Working Paper Series (WP1-2004) A Dynami Computable General Equilibrium (CGE) Model for South Afria: Extending the Stati IFPRI Model by James Thurlow ISBN:

9 1. Introdution Model Desription Within-period Speifiation...3 Prodution and Pries...4 Institutional Inomes and Domesti Demand...7 System Constraints and Maroeonomi Closures Between-period Speifiation Limitations of the Model...13 Stati and Dynami Equilibrium...14 Prodution and Fator Demand...15 Final Demand...15 Foreign Trade Desription of the South Afrian Soial Aounting Matries Broad Comparison of South Afria and Other Countries Setoral Prodution and Trade Fator Markets Households Government Savings, Investment, and the Current Aount Appliations of the Model and Areas for Further Researh...41 Past and Potential Appliations of the South Afrian Model...42 Areas for Further Supporting Researh...42 Referenes...43 Appendix A: Model Speifiation...46 A.1 Additions to the Stati Model...46 Regional Disaggregation of International Trade...46 Upward-Sloping Fator Supply Curve...49 Fator-Speifi Produtivity...50 A.2 Dynami Model Speifiation...50 Population Growth...51 Labour Fore Growth...52 Capital Aumulation...53 Total and Fator-Speifi Produtivity Growth...55 Government Consumption and Transfer Spending...55 A.3 Complete Model Listing...55 Symbol...56 Symbol...56 Sets...56 Symbol...57 Symbol...57 Symbol...58 Symbol...58 Appendix B: Constrution of the Soial Aounting Matries...62 B.1 Seleting Base Years...62 B.2 Maro SAM and Disaggregation...63 B.3 Balaning the SAM...72 Appendix C: Disaggregated Tables from the Soial Aounting Matries

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11 1. Introdution Computable general equilibrium (CGE) models are widely used for poliy-analysis in many ountries. In the past a number of CGE models have been developed for South Afria, and used to assess a broad range of poliy issues. 1 However, the pereived omplexity of this analytial approah, and the onentration of apaity within a small number of aademi or related institutions, have generally led poliy-makers, analysts and other researhers to avoid diretly using CGE models in their analysis or deision-making. Sine CGE modelling provides both an eonomy-wide assessment of poliies and a framework in whih the workings of poliies an be more easily understood, it is the objetive of this paper to present a ore South Afrian model that redues the initial ost of undertaking CGE analysis. The ore model an then be adapted aording to the interests of individual researhers or poliy-makers. Furthermore, sine the strength of the model is dependent on its ability to reflet the speifi struture and workings of the South Afrian eonomy, it is hoped that the ore model will be developed further as more supporting evidene and researh beomes available. The model presented in this paper has at its ore the stati model used by the International Food Poliy Researh Institute (IFPRI) as desribed in Lofgren et al. (2002). The model is reursive dynami and is therefore an extension of the IFPRI model and the earlier stati South Afrian model presented in Thurlow and van Seventer (2002). The onstrution of the South Afrian model takes plae in two stages. At the first stage the struture and interations of the eonomy within and aross time periods is speified in a set of mathematial equations. Setion 2 desribes the speifiation and limitations of the South Afrian model without the aid of mathematis. Sine the underlying stati South Afrian model is essentially that of the IFPRI standard model, Appendix A first presents the differenes in the mathematial equations between these two models, before desribing the mathematis of the model s dynami speifiation. The seond stage of onstruting the model involves the ompilation of a database that desribes the South Afrian eonomy and is used to assign values to the parameters of the mathematial equations. This proess is alled the alibration of the model. The most important database for CGE model alibration is a soial aounting matrix (SAM). Two SAMs are ompiled for South Afria for the years 1993 and 2000, thus allowing the model to assess the impat of both past and 1 See Thurlow and van Seventer (2002) for a brief review of past eonomy -wide modeling in South Afria. 2

12 future poliies. Setion 3 desribes the South Afrian eonomy as it is represented in the SAMs and other relevant data soures. Appendix B desribes the SAM onstrution proess, and Appendix C presents a series of disaggregated SAM tables that inform the disussion in Setion 3. Finally, Setion 4 onludes the paper by desribing existing appliations of the models and identifying areas where further researh is needed to address the limitations of the model. 2. Model Desription The dynami South Afrian model desribed below has developed from the neolassialstruturalist modelling tradition originally presented in Dervis et al (1982), and has at its ore the stati CGE model desribed in Lofgren et al (2002) and Thurlow and van Seventer (2002). The model is formulated as a set of simultaneous linear and non-linear equations, whih define the behaviour of eonomi agents, as well as the eonomi environment in whih these agents operate. This environment is desribed by market equilibrium onditions, maroeonomi balanes, and dynami updating equations. The model belongs to the reursive dynami strand of the dynami CGE literature, whih implies that the behaviour of its agents is based on adaptive expetations, rather than on the forwardlooking expetations that underlie alternative inter-temporal optimisation models. Sine a reursive model is solved one period at a time, it is possible to separate the within-period omponent from the between-period omponent, where the latter governs the dynamis of the model. Although a detailed mathematial desription an be found in Appendix A and in Lofgren et al (2002), this setion presents a more disursive overview of the model s struture Within-period Speifiation The within-period omponent desribes a one-period stati CGE model. The following desription of this model is divided into the derivation of prodution and pries, and the generation of institutional inomes and demand. Equilibrium is maintained through a series of system onstraints whih are disussed last. 2 The model and underlying data is available from Trade and Industrial Poliy Strategies ( or from the author (j.thurlow@giar.org). 3

13 Prodution and Pries The model identifies 43 produtive setors or ativities that ombine primary fators with intermediate ommodities to determine a level of output. The four fators of prodution identified in the model inlude apital, unskilled and semi-skilled, skilled, and highly-skilled labour. 3 The tehnology underlying prodution is depited for a single produer in Figure 2.1. Produers in the model make deisions in order to maximize profits subjet to onstant returns to sale, with the hoie between fators being governed by a onstant elastiity of substitution (CES) funtion. This speifiation allows produers to respond to hanges in relative fator returns by smoothly substituting between available fators so as to derive a final value-added omposite. Profitmaximization implies that the fators reeive inome where marginal revenue equals marginal ost based on endogenous relative pries. One determined, these fators are ombined with fixed-share intermediates using a Leontief speifiation. The use of fixed-shares reflets the belief that the required ombination of intermediates per unit of output, and the ratio of intermediates to valueadded, is determined by tehnology rather than by the deision-making of produers. The final prie of an ativity s output is derived from the prie of value-added and intermediates, together with any produer taxes or subsidies that may be imposed by the government per unit of output. Figure 2.1: Prodution Tehnology 1 Commodity Output Commodity 1 Leontief Commodity Output Commodity n Ativity Output Leontief Value added CES Intermediates Leontief Primary Fator 1 Primary Fator n Intermediate Input 1 Intermediate Input n Imported Domesti 1 CES is a onstant elastiity of substitution aggregation funtion. Leontief is fixed shares. 3 A detailed aount of the different fator ategories is provided in Setion 3. 4

14 In addition to its multi-setor speifiation, the model also distinguishes between ativities and the ommodities that these ativities produe. This distintion allows individual ativities to produe more than a single ommodity and onversely, for a single ommodity to be produed by more than one ativity. 4 Fixed-shares govern the disaggregation of ativity output into ommodities sine it is assumed that tehnology largely determines the prodution of seondary produts. These ommodities are supplied to the market. Figure 2.2 traes the flow of a single ommodity from being supplied to the market to its final demand. The previous figure showed how a single produer ould supply more than one of the 43 ommodities identified by the model. In the figure below, the supply of a partiular ommodity from eah produer is ombined to derive aggregate ommodity output. This aggregation is governed by a CES funtion whih allows demanders to substitute between the different produers supplying a partiular ommodity, in order to maximise onsumption subjet to relative supply pries. Substitution possibilities exist between prodution for the domesti and the foreign markets. This deision of produers is governed by a onstant elastiity of transformation (CET) funtion, whih distinguishes between exported and domesti goods, and by doing so, aptures any time or quality differenes between the two produts. Profit maximization drives produers to sell in those markets where they an ahieve the highest returns. These returns are based on domesti and export pries (where the latter is determined by the world prie times the exhange rate adjusted for any taxes or subsidies). Under the small-ountry assumption, South Afria is assumed to fae a perfetly elasti world demand at a fixed world prie. The final ratio of exports to domesti goods is determined by the endogenous interation of relative pries for these two ommodity types. Commodities that are exported are further disaggregated aording to their region of destination under a CES speifiation. Allowing substitution between regions is preferable to the use of fixed shares, sine hanges in relative pries aross regions should lead to a shift in the geographi omposition of exports. Domestially produed ommodities that are not exported are supplied to the domesti market. Substitution possibilities exist between imported and domesti goods under a CES Armington speifiation (Armington, 1969). Suh substitution an take plae both in final and intermediates 4 For example, although the agriultural setor s primary output is agriultural produts, this setor might also produe some proessed food produts. Therefore this single setor or ativity an produe more than one produt or ommodity. Conversely, sine food is also produed by the proessed food setor, the ombination of agriultural and proessed food prodution suggests that some ommodities an also be produed by more than one ativity. 5

15 usage. The Armington elastiities vary aross setors, with lower elastiities refleting greater differenes between domesti and imported goods. 5 Again under the small ountry assumption, South Afria is assumed to fae infinitely elasti world supply at fixed world pries. The final ratio of imports to domesti goods is determined by the ost minimizing deision-making of domesti demanders based on the relative pries of imports and domesti goods (both of whih inlude relevant taxes). Imports are further disaggregated aording to their region of origin using a CES funtion. This speifiation allows for regionally speifi tariffs, and for substitution between regions following hanges in relative import pries. Figure 2.2: Commodity Flows 1 Commodity Output Ativity 1 CES Commodity Output Ativity n Aggregate Commodity Output Aggregate Exports CES Region 1 Exports Region n Exports CET Region 1 Imports Region n Imports CES Aggregate Imports Domesti Sales CES Composite Commodity Household Consumption + Government Consumption + Investment + Intermediate Use 1 CES is a onstant elastiity of substitution aggregation funtion. CET is onstant elastiity of transformation funtion. 5 The use of an Armington speifiation is justified by the likely heterogeneity of ommodities within broad ommodity ategories, and by the observed two-way trade between South Afria and its trading partners. See Setion 3 and Appendix C for the values of the Armington elastiities used in the model. 6

16 Transation osts are inurred on exports, imports and domesti sales. These osts are treated as a fixed share per unit of ommodity, and generate demand for trade and transportation servies. The final omposite good, ontaining a ombination of imported and domesti goods, is supplied to both final and intermediate demand. Intermediate demand, as desribed above, is determined by tehnology and by the omposition of setoral prodution. Final demand is dependent on institutional inomes and the omposition of aggregate demand. Institutional Inomes and Domesti Demand The model distinguishes between various institutions within the South Afrian eonomy, inluding enterprises, the government, and 14 types of households. The household ategories are disaggregated aross inome deiles with the exeption of the top deile, whih has five inome divisions. Figure 2.3 summarises the interation between institutions in the model. The primary soure of inome for households and enterprises are fator returns generated during prodution. The supply of apital is fixed within a given time-period and is immobile aross setors, thus implying that apital earns setor-speifi returns. Unskilled and semi-skilled, and skilled labour supply is assumed to be perfetly elasti at a given real wage. Highly-skilled labour fae upward-sloping labour supply urves, with wage elastiities determining adjustments to supply following hanges in real wages. 6 Eah ativity pays an ativity-speifi wage that is the produt of the eonomy-wide wage and a fixed ativity-speifi wage distortion term. This speifiation, in whih fator returns are setor-speifi, is preferable to the use of simple average wages, sine average fator returns in South Afria are observed to vary both aross oupations and setors. Final fator inomes also inlude remittanes reeived from and paid to the rest of the world. Households and enterprises earn fator inomes in proportion to the implied share that they ontrol of eah fator stok. Enterprises or firms are the sole reipient of apital inome, whih they transfer to households after having paid orporate taxes (based on fixed tax rates), saved (based on fixed savings rates), and remitted profits to the rest of the world. Households within eah inome ategory are assumed to have idential preferenes, and are therefore modelled as representative onsumers. In addition to fator returns, whih represent the bulk of household inomes, households also reeive transfers from the government, other domesti institutions, and the rest of the world. Household disposable inome is net of personal inome tax (based on fixed rates), savings (based 6 The motivation for adopting these labour market losures for eah of the three labour ategories is presented in Setion 3. 7

17 on fixed marginal propensities), and remittanes to the rest of the world. Consumer preferenes are represented by a linear expenditure system (LES) of demand, whih is derived from the maximization of a Stone-Geary utility funtion subjet to a household budget onstraint. Given pries and inomes, these demand funtions define households real onsumption of eah ommodity. The LES speifiation allows for the identifiation of supernumerary household inome that ensures a minimum level of onsumption. Figure 2.3: Institutional Inomes and Domesti Demand Ativity 1 Fator Employment Ativity n Fator Employment Labour Aggregate Fator Inome Capital Households Transfers Enterprises Taxes Government Taxes Consumption Taxes Consumption Goods Market Investment Savings Savings Capital Market Savings Transfers Remittanes Borrowing Rest of World Remittanes Transfers The government earns most of its inome from diret and indiret taxes, and then spends it on onsumption and transfers to households. Both of these payments are fixed in real terms. The differene between revenues and expenditures is the budget defiit, whih is primarily finaned through borrowing (or dis-saving) from the domesti apital market. Although not shown in Figure 2.3, the government also makes payments to the rest of the world. In the urrent model the government s role as a onsumer is treated separately from the prodution of government servies. The latter is speified as an ativity produing servies for whih the government institution is the primary onsumer. 8

18 Savings by households and enterprises are olleted into a savings pool from whih investment is finaned. This supply of loanable funds is diminished by government borrowing (or dis-saving) and augmented by apital inflows from the rest of the world. There is no expliit modelling of the investment deision or the finanial setor within a partiular time-period, with savings equalling investment as per the ex post aounting identity. This impliitly assumes that the neessary adjustment in the interest rate takes plae to ensure that savings equals investment in equilibrium. The disaggregation of investment into demand for final ommodities is done using fixed shares, with hanges in aggregate investment leading to proportional inreases in the demand for individual ommodities. Therefore there is no real ompositional shift in investment following hanges in relative ommodity pries. Prodution is linked to demand through the generation of fator inomes and the payment of these inomes to domesti institutions. Balane between demand and supply for both ommodities and fators are neessary in order for the model to reah equilibrium. This balane is imposed on the model through a series of system onstraints. System Constraints and Maroeonomi Closures Equilibrium in the goods market requires that demand for ommodities equal supply. Aggregate demand for eah ommodity omprises household and government onsumption spending, investment spending, and export and transation servies demand. Supply inludes both domesti prodution and imported ommodities. Equilibrium is attained through the endogenous interation of domesti and foreign pries, and the effet that shifts in relative pries have on setoral prodution and employment, and hene institutional inomes and demand. The equilibrating of fator demand and supply is dependent on how the relationship between fator supply and wages is defined. As disussed above, apital is fully employed and setor-speifi, implying that setor-speifi wages adjust to ensure that demand for apital equals total supply. Unemployment amongst unskilled and semi-skilled, and skilled labour is assumed to be suffiiently large suh that wages are fixed in real terms and supply passively adjusts to math demand. Highlyskilled labour is neither fully employed nor signifiantly unemployed to justify either a fixed supply or a fixed wage. Rather the supply of this fator is responsive to hanges in real wages, whih adjust to ensure that demand and supply are equal in equilibrium. 9

19 The model inludes three broad maroeonomi aounts: the urrent aount, the government balane, and the savings and investment aount. In order to bring about equilibrium in the various maro aounts it is neessary to speify a set of marolosure rules, whih provide a mehanism through whih adjustment is assumed to take plae. For the urrent aount it is assumed that a flexible exhange rate adjusts in order to maintain a fixed level of foreign borrowing (or negative savings). In other words, the external balane is held fixed in foreign urreny. This losure is appropriate given South Afria s ommitment to a flexible exhange rate system, and the belief that foreign borrowing is not inexhaustible. However given movements in South Afria s urrent aount balane, it might be neessary to exogenously adjust foreign savings based on observed trends and let the exhange rate adjust aordingly. In the government aount the level of diret and indiret tax rates, as well as real government onsumption, are held onstant. As suh the balane on the government budget is assumed to adjust to ensure that publi expenditures equal reeipts. This losure is hosen sine it is assumed that hanges in diret and indiret tax rates are politially motivated and thus are adopted in isolation of hanges in other poliies or the eonomi environment. Although the government and urrent aount losures an be seleted based on urrent government poliies, the hoie of a savings-investment losure is less obvious. Aording to Nell (2003), the relationship between saving and investment remains one of the most debated and ontroversial issues in maroeonomis. On the one hand, neolassial and reent endogenous growth theory maintains that it is prior savings that is most important when determining an eonomy s level of investment and output. This view suggests that savings is exogenous, and that investment adjusts passively to maintain the savings-investment balane. By ontrast, a more Keynesian view reverses the ausality found in neolassial theory by arguing that investment is exogenous and that it is savings that adjusts. Finally, there might exist, as in the ase of some developed ountries, a twoway ausality between savings and investment. In suh ases both the level of savings and investment are endogenously determined and may both adjust in response to poliy-hanges. The hoie of whih diretion of ausality is appropriate for South Afria might have impliations for the outomes of poliies. For example, under the more neolassial approah and in the ase trade liberalization, a redution in tariff revenue will derease the level of government savings and thereby rowd-out private investment. Under the exogenous investment paradigm, maintaining the level of investment would require that savings would have to inrease through inreases in domesti 10

20 savings rates. In suh a ase, the level of disposable inome is redued with rowding-out effets on private onsumption. Reent work on this issue onluded that the long-run savings-investment relationship in South Afria has been one haraterized by exogenous savings with no feedbak from investment (Nell, 2003). Therefore the model adopts a savings-driven losure, in whih the savings rates of domesti institutions are fixed, and investment passively adjusts to ensure that savings equals investment spending in equilibrium. However, the inlusion of dynamis into the model allows past investment to influene eonomi growth in the eonomy, and thereby the level of savings available for investment in the urrent period. The dynamis of the model are disussed below. Finally, the onsumer prie index is hosen as the numéraire suh that all pries in the model are relative to the weighted unit prie of households initial onsumption bundle. The model is also homogenous of degree zero in pries, implying that a doubling of all pries does not alter the real alloation of resoures. 2.2 Between-period Speifiation While the stati model desribed above is detailed in its representation of the South Afrian eonomy within a partiular time-period, its inability to aount for seond-period onsiderations limits its assessment of the full effet of poliy and non-poliy hanges. For example, the model is unable to aount for the seond-period effet that hanges in urrent investment have on the subsequent availability of apital. In attempting to overome these limitations, the stati model is extended to a reursive dynami model in whih seleted parameters are updated based on the modelling of inter-temporal behaviour and results from previous periods. Current eonomi onditions, suh as the availability of apital, are thus endogenously dependent on past outomes, but remain unaffeted by forward-looking expetations. The dynami model is also exogenously updated to reflet demographi and tehnologial hanges that are based on observed or separately alulated projeted trends. The proess of apital aumulation is modelled endogenously, with previous-period investment generating new apital stok for the subsequent period. Although the alloation of new apital aross setors is influened by eah setor s initial share of aggregate apital inome, the final setoral alloation of apital in the urrent period is dependent on the apital depreiation rate and on setoral profit-rate differentials from the previous period. Setors with above-average apital 11

21 returns reeive a larger share of investible funds than their share in apital inome. The onverse is true for setors where apital returns are below-average. 7 Population growth is exogenously imposed on the model based on separately alulated growth projetions. It is assumed that a growing population generates a higher level of onsumption demand and therefore raises the supernumerary inome level of household onsumption. There is assumed to be no hange in the marginal rate of onsumption for ommodities, implying that new onsumers have the same preferenes as existing onsumers. Highly-skilled labour supply adjusts endogenously aross periods in response to ontinuing hanges in real wages. Between periods there may be an exogenous adjustment to the supply of this labour ategory as is typial in most reursive dynami models. This treatment of the model s labour supply dynamis assumes that for the highly-skilled labour ategory there is neither a binding supply-onstraint nor involuntary unemployment. Rather labour supply is seen as being driven by hanges in real wages, thus suggesting the existene of an effetive reservation wage. Unskilled and semi-skilled, and skilled labour supply within a partiular time period is infinitely elasti at a fixed real wage. As suh it is the real wage, rather than labour supply, that adjusts between periods. In the dynami model it is assumed that real wage hanges for unskilled and skilled workers are relative to previous period hanges in the real wage of highly skilled workers. This speifiation allows for the endogenous determination of wages for lower skilled workers, as well as the exogenous determination of skilled-unskilled wage onvergene rates. 8 Fator-speifi produtivity growth is imposed exogenously on the model based on observed trends for labour and apital. Growth in real government onsumption and transfer spending is also exogenously determined between periods, sine within-period government spending is fixed in real terms. Furthermore, projeted hanges in the urrent aount balane are exogenously aounted for. Finally, mining prodution is assumed to be predominantly driven by a ombination of hanges in world demand and pries, and other fators external to the model. One suh external fator might be the gradual exhaustion of non-renewable natural resoures. Aordingly, the value-added growth 7 See Dervis et al (1982) for a more detailed disussion of this and other approahes to modelling apital aumulation in CGE models. 8 Exogenously imposed wage onvergene (or divergene) suggests that there are there are fators outside of the model that are important in determining wages for unskilled and semi-skilled, and skilled workers. These fators might inlude the effetive bargaining of trade unions or hanges in South Afria s labour laws. As will be disussed in Setion 3, observed wage onvergene between highly-skilled and less-skilled workers justifies the urrent speifiation. 12

22 of these setors and the world prie of exports are updated exogenously between periods based on observed long-term trends. 9 The South Afrian dynami model is solved as a series of equilibriums, eah one representing a single year. By imposing the above poliy-independent dynami adjustments, the model produes a projeted or ounterfatual growth path. Poliy hanges an then be expressed in terms of hanges in relevant exogenous parameters and the model is re-solved for a new series of equilibriums. Differenes between the poliy-influened growth path and that of the ounterfatual an then be interpreted as the eonomy-wide impat of the simulated poliy. 2.3 Limitations of the Model Applied general equilibrium modelling is an important tool for poliy-analysis given that it is able to isolate the effets of individual poliies, while expliitly speifying the ausal mehanisms through whih poliies influene the eonomy. The CGE approah has advantages over data-based eonometri analysis, whih not only requires onsiderable and reliable time-series data, but also faes diffiulties in isolating the effets of individual poliies from other hanges in poliies and external fators. Furthermore, the setoral and institutional detail of the CGE model allows for a more detailed analysis of poliies than is typially possible with maro-eonometri models. Finally, CGE models have an advantage over partial equilibrium analysis in that they offer an eonomy-wide assessment of poliies, inluding the onurrent effets of poliy-hanges on prodution, employment, and poverty and inequality. However, while eonomy-wide models have ertain advantages over other methods of analysis, these models are more losely tied to theory, whih often inorporates or neessitates an abstration from the real workings of an eonomy. Therefore it is important to identify and aount for the limitations of the model, espeially in terms of its ability to reflet the ountry-speifi harateristis of the eonomy being studied. 9 Exogenously imposing a fator growth rate on a setor requires adjusting the apital aumulation proess. For example, reduing mining output when apital is setorally fixed leads to inreases in mining apital s profit-rate. Sine new apital alloation is driven by setoral profit -rate differentials, a mining high profit-rate will therefore attrat new investment. The mining setor therefore is exluded from the apital alloation deision after adjusting the stok of new apital to aount for depreiation and fixed apital hanges taking plae within the mining setor. 13

23 Stati and Dynami Equilibrium Perhaps the main ritiism of the stati model is that its ore formulation is losely tied to the Walrasian ideal of equilibrium (Dervis et al, 1982). In a pure neolassial setting, produers and onsumers reat passively to pries in order to determine their demand and supply shedules. Markets are therefore assumed to lear through the interation of relative pries, suh that equilibrium is ahieved in both goods and fator markets. However, it might be argued that that ertain institutional and strutural rigidities within the South Afrian eonomy result in ases of persistent disequilibrium or deviations from neolassial theory. The South Afrian model does attempt to inorporate some the pereived rigidities in the eonomy s fator markets. For example, apital is assumed to be immobile aross setors, and unskilled and semi-skilled, and skilled labour supply is unemployed at a fixed real wage. Furthermore, fator returns are assumed to vary aross setors based on observed and persistent setoral deviations from eonomy-wide averages. These rigidities allow for a onstrained general equilibrium that, while remaining lose to the Walrasian model, aounts for some of the observed strutural harateristis of the eonomy. However, Dervis et al. (1982) note that the adoption of a more Walrasian approah leads to problems in both fator and produt markets. In the ase of the latter, the South Afrian model retains a neolassial speifiation, and ignores suh onsiderations as the existene of imperfet ompetition and monopoly-priing. The model assumes there is no interation between monetary and real eonomies. The use of a numéraire and the lak of an expliitly modelled monetary setor imply that the model is essentially one of a barter eonomy in whih money is neutral. Taylor (1983), in outlining the struturalist approah, disounts money-neutrality by arguing that nominal hanges an influene the real eonomy, partiularly within the short-run and in respet to the demand for money balanes. Dervis et al. (1982) suggest however that, while separability is not always possible to preserve, the overall strength of the CGE approah lies in its ability to address questions of medium to long-term resoure alloation. The speifiation of apital aumulation and alloation within the dynami model also represents a deviation from the perfet neolassial inter-temporal equilibrium. Within the neolassial framework, market and prodution pries of apital are idential, within-period setoral profit-rates are equalised, and the eonomy moves along an inter-temporally effiient path haraterised by perfet foresight (Dervis et al., 1982). However, in the adaptive dynami South Afrian model, 14

24 apital is immobile aross setors and the alloation of new apital is partly determined by the distribution of previous-period apital inomes. Together these rigidities prevent both a within- and between-period equalisation of setoral profit-rates. By not determining the inter-temporally effiient alloation of apital the model greatly simplifies the investment alloation deision, and avoids having to expliitly model expetations. This speifiation an be justified on the grounds that agents within the South Afrian eonomy are unlikely to possess perfet foresight, and as suh, the inter-temporal effiient growth path is unlikely to be ahieved. Given the institutional and strutural rigidities of the South Afrian eonomy, the use of a more neolassial market-learing mehanism suggests that aution be exerised in interpreting the model s results. Most importantly, the model is not able to provide short-term preditions, but rather highlights the diretion and relative magnitude of adjustments to the eonomy following hanges in poliies, tehnology, and other external fators. Prodution and Fator Demand Prodution within the South Afrian model is governed by neolassial prodution funtions, whih may not reflet the speifi workings of individual setors. The model assumes onstant returns to sale, and models representative setors suh that all produers within eah setor are assumed to share the same behaviour. Capital and labour are treated as equally substitutable for one another, thus implying, for example, that unskilled labour is as substitutable for apital as is highly-skilled labour. Finally, all produers are assumed to be on their fator demand urve. This last assumption rules out the possibility of exess apaity and the hoarding of labour during eonomi downturns. Although it is possible to adopt more flexible speifiations of prodution, suh as translog or nested-ces funtions, these formulations require onsiderably more parameter estimates than are urrently available for South Afria. Furthermore, the relatively high setoral and fator aggregation of the model, and its medium to long-term fous, are likely to lessen the severity of the above limitations. For example, higher setoral aggregation redues the likelihood of monopoly-power within an individual setor. Final Demand Final household, government, and investment demand for eah ommodity is assumed to be a fixed share of aggregate institutional spending. Therefore expenditure shares for eah ommodity are fixed and do not adjust in response to hanges in relative pries. While this is unlikely to reflet 15

25 atual institutional behaviour, the use of fixed shares is preferable to the use of a more flexible funtional form sine short and medium-term substitution possibilities are likely to be limited. Furthermore, there is no existing information on South Afria that ould inform the alibration of suh behaviour. This speifiation also does not allow household onsumption patterns to adjust following hanges in household inomes. The assumption that there is no inome effet on final demand, or that the inome elastiity of demand is unity, is unlikely to reflet reality. However, there is little reason to suspet that onsumption patterns will adjust signifiantly as long as the time-period over whih the model is used remains relatively short and inome hanges are small. Foreign Trade The model assumes that imports, exports, and domesti goods are imperfet substitutes. This assumption is more realisti than a perfet substitutes speifiation, sine the high setoral aggregation of the model inreases the likelihood of within-setor ross-hauling. However, in the ase of imports, the allowane for differentiated produts leads to the onstrution of a omposite good ontaining both imported and domesti ommodities. This marketed omposite good is then supplied to all omponents of demand, thus assuming that all onsumers of an individual ommodity have the same import-intensity of onsumption. For example, the import-share of the food omposite is the same for low-inome and high-inome households. This is likely to overstate the import-intensity of low-inome household food onsumption, and understate high-inome households import-intensity. By measuring trade poliy using fixed tariff rates, the model does not expliitly aount for the existene of quantitative restritions or differential tariff rates that are determined by trade volumes. While the use of quantitative restritions in South Afria had been greatly redued prior to the beginning of the 1990s, South Afria s use of formula duties persisted into the 1990s, mainly within the agriultural and textiles setors (Cassim et al, 2002). For these setors the model assumes that tariff rates are fixed simple ad valorum rates that are unaffeted by hanges in import-quantities. Assuming that some tariff rates do inrease as import volumes inrease, the urrent speifiation is likely to understate tariff rates following inreases in imports, and understate rates following delines in imports. However, Cassim et al. (2002) find that, even in the ase of agriulture, olletions rates are a good proxy for statutory rates, thereby lessening the likely severity of this limitation. 16

26 3. Desription of the South Afrian Soial Aounting Matries Typially the main database used to alibrate a CGE model is a soial aounting matrix (SAM), whih provides a omprehensive eonomy-wide representation of the eonomy for a partiular year. 10 However, while a SAM provides insight into the setoral and institutional struture of the eonomy, it does not ontain information on the behaviour of the ountry s eonomi agents, or the proess of dynamially updating the model aross time. In suh ases, information is taken from additional data soures and from the literature. Given both the data-intensity of the alibration proess, and the importane of this data in determining the results of the model, this setion provides an overview of the South Afrian eonomy as it is desribed by the data Broad Comparison of South Afria and Other Countries Two SAMs were onstruted for South Afria for the years 1993 and Table 3.1 disaggregates gross domesti produt (GDP) for these years. The largest omponents of demand are private and government onsumption, whih together aount for over 80 perent of total GDP at market pries. A omparison between 1993 and 2000 shows that, apart from developments in international trade, there has been little hange in the overall struture of GDP during the 1990s. However, exports and imports as a share of GDP have risen by six and eight perentage points respetively, possibly refleting inreased openness. By ontrast, the share of fixed investment in GDP has remained unhanged. Table 3.1: Struture of Gross Domesti Prodution (1993 and 2000) Value (Billions of Current Rands) Share of GDP (Market Pries) Private onsump tion Fixed investment Inventory hanges Government onsumption Exports Imports GDP (market pries) Net indiret taxes GDP (fator ost) Soure: 1993 and 2000 South Afrian SAMs 10 For a disussion of SAMs and their use in eonomy -wide poliy analysis see Dervis et al (1982), Pyatt and Round (1985) and Reinert and Roland-Holst (1997). 11 Appendies B and C provide a more detailed aount of the general struture of a SAM, as well as the data soures and proedures used to onstrut the South Afrian SAMs used in this thesis. Although this thesis onstruts and uses SAMs for 1993 and 2000, Thurlow and van Seventer (2002) offer a detailed desription of the 1998 South Afrian SAM. 17

27 Although some indiation of the struture of prodution in South Afria is provided in the table, more disaggregated data is required if the CGE model is to aurately apture the ountry-speifi interations of the eonomy. The following subsetions largely follow the model speifiation in Setion 2 by first outlining the struture of prodution and trade, before disussing the workings of the ountry s fator markets. Subsequent setions review the institutional organisation of the eonomy, the omposition of the savings-investment relationship, and the ountry s urrent aount balane. At eah stage partiular attention is paid to the interation between model speifiation, losure, and alibration. Table 3.2: Comparison of South Afria and Other World Regions (1993) South Afria Latin Ameria and Caribbean Sub- Saharan Afria1 East Asia and Paifi South Asia World GDP per apita (1995 $US) Share of GDP (Market Pries) Private onsumption Investment Government Exports Imports GDP (market pries) Share of GDP (Fator Cost) Agriulture Industry Servies Total Prodution Manufaturing Soure: 1993 South Afrian SAM; World Development Indiators (World Bank, 2002). 1. Sub-Saharan Afria inludes South Afria. 3.2 Setoral Prodution and Trade As mentioned in Setion 2, the South Afrian model identifies 43 produtive setors or ativities whih ombine fators and intermediates to arrive at a total level of output. Table 3.3 shows the struture of prodution aross aggregate setors for the years 1993 and This setion aggregates setors and institutions to allow for a more aessible overview of the eonomy. Fully disaggregated tables are inluded in Appendix C and are referred to as required. 18

28 Although the share of primary prodution in South Afria is relatively low when ompared to other developing ountries, the first two olumns of the table indiate that the agriultural and mining setors together aount for one-tenth of total GDP at fator ost, with gold generating over half of total mining value-added. 13 Mining-related ativities also play an important role as refleted the share of the metals and mahinery setor, of whih almost two-thirds is attributable to metals and metal-benefiiation. Other large manufaturing setors inlude hemials, and proessed foods. Despite the importane of the primary and seondary setors, servies are responsible for generating the largest share of GDP. In aggregate, these setors aount for almost two-thirds of national prodution. Within servies the government setor is the largest ontributor generating around onefifth of GDP. Trade and finanial servies are the largest non-government setors, together aounting for over a quarter of total prodution. A omparison between 1993 and 2000 shows that there has been a shift out of manufaturing and into servies over the last deade. Table 3.3: Prodution Struture (1993 and 2000) Share of GDP at Fator Cost Share of Capital in Setoral Value-Added Share of Value-Added in Setoral Output Agriulture Mining Food produts Textile produts Wood / paper Chemials Non-metal minerals Metal and mahinery Sientifi equipment Transport equipment Other manufaturing Eletriity / water Constrution Trade / atering Transport / omm Finanial servies Other servies Government servies Manufaturing Non-govern. servies All setors Soure: 1993 and 2000 South Afrian SAMs The seond two olumns in the table show the perentage ontribution of apital to total valueadded within eah setor. Agriulture in South Afria, unlike in most other developing ountries, is highly apital-intensive, with apital aounting for around two-thirds of value-added. Other highly apital-intensive setors inlude the energy, and finanial servies setors. Conversely, the most 13 See Table C.1 in Appendix C. 19

29 labour- intensive setors are textiles, onstrution, and government servies. Although nongovernment servies tend to be more apital-intensive than manufaturing, the hemials setor inludes petroleum proessing, whih is the most apital-intensive disaggregated setor. Between 1993 and 2000 there has been an overall inrease in the apital-intensity of prodution, with apital s share in total value-added inreasing from 45.9 to 48.9 perent. A deomposition of this hange finds that almost two-thirds of the rise in apital-intensity has been driven by the government, finanial, and ommuniation servies setors. The remaining hange is evenly distributed aross mining and manufaturing. Sine output omprises both fator and intermediate inputs, the final two olumns of the table show the ontribution of value-added to the total value of prodution. In the ontext of eonomy-wide modelling, those setors with the lowest value-added shares are the setors with the largest bakward linkages to the rest of the eonomy. The table suggests that setors with high apitalintensities are also likely to have high fator-intensities. Suh setors inlude agriulture, energy, and the servies setors. By ontrast, setors with a larger share of intermediates in total output tend to be more labour-intensive. This is the generally the ase for the manufaturing setors, and for textiles and vehiles in partiular. Therefore the struture of manufaturing justifies the inlusion of bakward linkages into the speifiation of the South Afrian model. Finally, there has been a shift in the fator- intensity of prodution between 1993 and Although the aggregate share of valueadded has remained unhanged at around half of total output, this is largely a result of inreased fator-intensity within the large government setor. Table 3.4 shows the omposition and struture of South Afria s trade with the rest of the world. Although mining ontributes only seven perent to GDP, it is the single most important soure of foreign earnings for South Afria. The first two olumns of the table show that in 1993 mining aounted for 41 perent of export earnings, with gold dominating this setor. 14 However, between 1993 and 2000 there was a substantial deline in gold prodution, whose share of exports fell from 26.5 to 10.1 perent. This ollapse in gold exports has been partially ushioned by the rapid rise in other mining exports. 15 Aggregate manufatured exports are equally important for South Afria, generating 42.4 perent of total export earnings. However, most manufatured exports originate from within the metals and mahinery setor, and are therefore mining-related. For example, in 1993 iron, steel, and other 14 See Table C.2 in Appendix C. 15 Other mining is largely omprised of non-oal and non-gold mining and servies inidental to mining. 20

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