Approximating Terms of Trade Effects in Single Country CGE Models

Abstract

Single country computable general equilibrium (CGE) models often assume price taking behavior in world markets that may miss potentially important terms of trade effects in trade-exposed sectors. In this paper, we assess numerical evidence for modeling large open economies and develop a methodology for parameterizing a reduced form approximation of international trade linkages from a multi-regional global economy model. Simulated export demand and import supply elasticities suggest that assuming price taking behavior (e.g., small open economy assumption) may miss important impacts in export markets and some commodity import markets. We show that a reduced form approach to capturing terms of trade effects can perform well relative to an analogous multi-regional static model with explicit trade linkage. We also illustrate how the calibration procedure can be extended to a dynamic model using U.S. EPA’s SAGE model. Our modeling scenarios demonstrate the relative importance of the large open economy assumption in non-trade policy applications, which can be significant.