Welfare effects of demand management policies: Impact multipliers under alternative model structures

This paper explores the sensitivity of multiplier estimates under three alternative assump- tions about factor supply. For this purpose, we have used a general equilibrium model of Ma- laysia which allows endogenous determination of factor and output prices and which permits substitution in both production and demand in response to price. The structure of the model and three alternative factor supply assumptions under which the model can be solved are described. These alternative assumptions amount to alternative "closure rules." The results of a general increase in demand as estimated under each of the alternative closures are then presented. Finally, we examine the results of two specific types of demand increase under each of the closure rules, focusing especially upon welfare related variables such as real household consumption levels. INTRODUCTION Policy makers are often concerned with estimating the total impact of various types of initial shock upon output and employment levels in the economy. This has produced a substantial interest in impact multipliers and their measurement. The existing literature on impact multipliers is based on a very limited characterization of the interrelationships involved in general equilibrium. The familiar multipliers derived from the simple open Leontief model take account only of linkages arising from the domestic interme- diate requirements of production, on the assumption that input-output and employment coef- ficients are fixed. However, second-round effects are obviously not limited only to these link- ages. Increased production leads to increases in household income, which in turn lead to increases in household consumption and subsequent increases in production. The simplest case of multipliers that take account of the linkages from initial production changes to income and consumption changes, and thence to second-round production changes, is of those derived from a closed Leontief model in which consumption demand is endogenously determined. Several studies have examined such multipliers for economies as a whole and for particular regions. 1 This approach is more general since it takes account of the circular flow from production to income and consumption. Furthermore, it permits quanti- fication of impact multipliers for the incomes of different household groups, thus introducing a distributional element into the analysis. However, it remains limited by the assumption of fixed coefficients in defining the production, employment, income distribution, and consump- tion relationships in the economy. This assumption reflects an extremely restricted view of the economy. Under the usual profit maximizing assumptions, the fixed coefficients assump- tions underlying the closed Leontief model are valid only in a world in which all primary fac- tors are available in infinitely elastic supply at fixed prices (together with some homogeneity assumptions discussed below). Such a system is entirely demand driven, being uncon- strained on the supply side. Once we allow for supply constraints, the fixed coefficients assumption is difficult to main- tain. Increases in output levels lead to increases in the demand for primary inputs, and some of these are likely to be in fixed supply. In this case, we must allow prices of these inputs to rise, which in turn alters output prices. These price changes will lead to some substitution in