# 3.2.The Global Income Distribution Dynamics Model

**The first step in the microsimulation exercise is to implement a set of changes in the household surveys’ demographic structure** . The population growth adjustment is particularly important in countries with rapid demographic changes. In practical terms, the adjustment for population growth allows the analysis to explicitly take into account the changes in the size of the working-age population.<sup>13</sup> We perform population and education projections during the first stage of the microsimulation model and in creating the baseline scenario for the CGE model. For each country, we construct the demographic profile in two steps. First, the age and gender composition are exogenously determined following medium variant estimates from the World Population Prospects (UN DESA 2019). In the second step, following Bourguignon and Bussolo (2013), country-specific educational profiles are constructed using initial educational achievement levels observed in the household surveys with some conservative yet simple assumptions about educational progress.

**The microsimulations’ second step adjusts individual factor returns by skill and sector in accordance with the results of the CGE model** . The GIDD imposes an entirely new vector of earnings on each worker, conditional on each worker’s individual characteristics. In a basic setup, the CGE and GIDD can be linked with two sectors (agricultural and non-agricultural) and two types of workers (skilled and unskilled) but depending on the quality of the data and the scope of the study, this restriction can be relaxed.<sup>14</sup> The GIDD reallocates workers moving them out from shrinking into expanding sectors. The sectoral reallocation process estimates the probability of each worker to be reallocated into new sectors, based on individual characteristics. Once workers are reallocated, a new vector of earnings is generated using estimates from a set of Mincer equations. To account for unobserved characteristics, each individual residual is brought into the new sectors and scaled accordingly. This latter process assures that an individual switching sectors can carry his unobservable personal characteristics - beyond age, experience and years of schooling.

**The third step adjusts average wages between groups of workers and sectors** . While the second step operates at the individual level, the third step operates at the group level scaling the average wages for each type of worker and sector. In practical terms, one group is selected as numeraire, i.e. unskilled agricultural, and average wages for each group are scaled relative to the numeraire. Within a group, all earnings are scaled with respect to the numeraire group. Operating through changes in relative wages guarantees internal consistency between macro and micro results considering that in the CGE-GIDD linkage, initial relative wages were obtained from the micro data and feed into the global CGE model. It is important to highlight that until this point the microsimulation has operated only in relative terms.

**Lastly, GIDD adjusts the average income/consumption per capita to guarantee that it changes exactly in line with the CGE results** . After creating new earnings for workers, a vector of per capita household income is constructed considering new earnings and household size. When information about the relationship between incomes and savings exists, if not, a one-to-one passthrough from per capita household income to consumption is assumed. In this regard, **GIDD constructs a household-specific deflator to adjust for changes in relative prices** . The price deflator is constructed using initial and final price indexes of food versus non-food expenditure from the macro model and household-specific budget consumption shares for food and non-food expenditure observed in the micro data. Food and non-food shares can be adjusted estimating a Lorenz’s curve of budget share expenditure on food and total per capita household consumption. These steps are explained in detail in the annex of this paper.

> 13 For the case of Sri Lanka, as will be shown later, working age population is projected to diminish by approximately 100,000 individuals by 2030.

> 14 See for instance, World Bank (n.d.).

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