Comparing Policy Impacts of Different Household Demand Systems in a CGE Model

In any computable general equilibrium model (CGE), assumption on its household demand system needs to be made for households to determine their demands on consumption goods, along with assumptions on production functions for firms to determine their demands on inputs for production. Different assumptions can lead to different results. The degree of differences depends on particular simulations, which can be big or small. Australian Treasury has recently developed a computable general equilibrium model. The model is global and recursively dynamic. The model allows flexible sectoral and regional disaggregation, depending on policy problems to be modelled. The model assumes AIDADS (an implicitly directly additive demand system) household demand which, according to published literature, better captures the endogenous changes in income elasticity with changes in income over time. The model also assumes sector-specific capital and allows capital to be under-utilised to maintain a required minimum rate of return for each sector. In this paper, the above Treasury CGE model is used to investigate how the assumption on household demand system affects the model results under policy. In doing so, three household demand systems are tested in the Treasury CGE model, namely the linear expenditure system (LES), the constant difference elasticity (CDE) demand system and the AIDADS. Four hypothetic policy cases are simulated, which are higher food price, higher household income tax, higher labour productivity and carbon pricing. The analysis will study the income elasticity path with changing income over time, the impacts on Gross Domestic Product and the international trade effects under the three household demand systems. It is intended that this analysis will provide useful insights for understanding long run properties of the model under each household demand system and whether each demand system reasonably captures the expected long run behaviour of the model. ...