Introduction section BRIDGE MODELS - Quantitative Tools for Business Cycle Analysis

BRIDGE MODELS - Quantitative Tools for Business Cycle Analysis

GEEM (General Equilibrium Environmental Model) is a large-scale macroeconomic model designed for the Italian economy in order to capture the interactions between climate-energy policies and the macroeconomic system in a fully microfounded set-up. The model, developed jointly by the Department of Treasury of the Italian Ministry of the Economy and Finance, and Sogei (IT Economia - Modelli di Previsione ed Analisi Statistiche), represents a useful tool for policy analysis in a set-up able to capture the dynamic linkages of the main macroeconomic variables, the interactions between rigidities on labour and product markets, and enables us to look into the effects of climate-energy policy interventions on economic performance in a consistent way.

GEEM has three key features.

First, the model embodies typical elements of the so-called New Neoclassical Synthesis, combining features at the heart of New Keynesian models, such as nominal rigidities in wages and prices, with features central to the Real Business Cycle (RBC) models, such as the systematic application of intertemporal optimization and of the rational expectations hypothesis in determining consumption, investment and factor supply decisions (e.g. Smets and Wouters, 2003, 2007; Galí and Gertler, 2007; Woodford, 2003, among others).

Second, the model incorporates an electricity sector distinguishing between fossil and renewable sources (RES). In this respect, GEEM is able to simulate, among other things, the dynamics of the most relevant economic variables in response to a progressive reduction in the emissions cap or an introduction of subsidies favouring the use of RES.

Third, the model embodies a transport sector given by fuel consumption on the household side. In this way, the model incorporates sectors subject to the cap-and-trade regulation according to the EU - European Trading System (ETS), involving a part of the manufacturing sector along with producers of electricity generated from fossil fuels, and sectors not covered by the cap system, such as the transport sector.

Given these features, GEEM can be used to analyze the response of the economy to a variety of standard shocks and policy interventions (e.g. technological changes, reduction in markups, fiscal reforms) under specific environmental policy regimes. This represents a significant strength of the model and highlights its flexibility.

Furthermore, GEEM allows for a comprehensive analysis of the macroeconomic impact of climate and energy policies designed to tackle emissions directly and/or to induce a major use of clean energy sources. Also, the model allows us to study the effects of different shocks and the performance of policy interventions in other domains, independently of climate and energy instruments available to and effectively used by the policy maker.

Thanks to this framework, the results obtained from the simulation of GEEM are consistent with and can be compared to those obtained from the main DGE models adopted by the European Commission for conducting economic policy evaluations and studying the impact of structural reforms (see, for instance, Ratto et al. 2009, Annicchiarico et al. 2013).

The methodology used in this model draws on the recent macro-environmental literature that makes use of the DGE framework to assess the impact of different climate and energy policies on economic activity (see among others, Annicchiarico and Di Dio (2015), Angelopoulos et al. (2013), Heutel (2012) and Fischer and Springborn (2011).

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