Page 34 - Azerbaijan State University of Economics

THE JOURNAL OF ECONOMIC SCIENCES: THEORY AND PRACTICE, V.72, # 2, 2015, pp. 32-42

country is small enough not to influence world market prices, i.e. it faces fixed world
prices for exports and imports.
The CGE model employed in this paper is commonly known as a 1-2-3 model.
The model developed in this paper, thus, refers to one country with two producing
sectors and three goods. The commodities produced by a country are an export good
E which is not demanded domestically and sold to foreigners. The second one is a
domestic good D which is sold in the country domestically. Finally, the third good is
an imported good M which is not produced domestically but imported from abroad.
There are three actors in the model which are: a producer, a household, and the rest
of the world. The equation below is the most achievable combinations of E and D that
can be realized:
=
with Ω describing a constant elasticity of transformation (CET).
The composite commodity existing of D and M is consumed by the single
consumer domestically. In multisector models we extend this treatment to many
sectors, assuming that imported and domestic goods in the same sector are imperfect
substitutes: an approach which has come to be called the Armington assumption.
Following this treatment, we assume the composite commodity is given by a
constant elasticity of substitution (CES) aggregation function of M and D:

with µ describing the elasticity of substitution, i.e. consumers maximize utility
which is equivalent to maximizing Q in this model.
Equations (1) to (22) below illustrate an extended version of the 1-2-3 model
to include government revenue and expenditure as well as savings and investment.
Most governments use taxes and subsidies as well as expenditure policy to adjust
their economy. Therefore, four tax instruments are included: an import tariff, an
export subsidy, an indirect tax on domestic sales, and a direct tax rate.
The single household saves a fixed fraction of its income. Public savings
(budgetary deficit or surplus) is defined as the balance of tax revenue plus foreign grants
and government expenditures (all assumed to be determined exogenously). The Current
Account balance, taken to represent foreign savings, is the residual of imports less
exports at world prices adjusted for grants and remittances from abroad. Output is fixed.
Foreign savings are also presently fixed, i.e. the model is savings-driven. Aggregate
investment adjusts to aggregate savings.
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