public balance. In this way the two approaches span two orthogonal dimensions
of possible reform directions.
4AnapplicationforDenmark
The following provides an application of the approach outlined above for Den-
mark.
4.1 The DREAM model12
The analysis is conducted using a large scale dynamic CGE model, named
DREAM, which has been developed with the purpose of evaluating medium-
to-long term effects of fiscal policy in Denmark. This model is thus quite appro-
priate for assessing issues of fiscal sustainability and to evaluate the sensitivity
to changes in key variables.
The model is based on an overlapping generation structure, and the focus is
on demographic developments and the Danish public sector. DREAM represents
a small open economy with a fixed exchange rate regime, perfect mobility of
capital and residence based capital taxation, implying that the nominal interest
rate is given by the international capital market. Danish and foreign products
are considered imperfect substitutes in both production and consumption, and
foreign trade is modeled using the Armington approach. Prices and wages are
therefore influenced by internal Danish economic developments.
The core of DREAM is the household structure. The model uses the detailed
pro jection of the Danish population presented in section 3.1. The adult popula-
tion is divided into 85 generations, each consisting of cohorts in a 1-year interval,
starting with people who are 17 years of age. For each generation a representa-
tive household is constructed. Children are distributed between the households
according to the age-specific fertility rates of the demographic forecast.
Each representative household optimizes its labour supply, consumption,
and savings decision in each period given perfect foresight. Savings take place in
owner-occupied dwellings, financial assets (stocks and bonds) and labour market
(second pillar) and private (third pillar) pension schemes. The labour market
is characterized by unionized behavior giving rise to structural unemployment.
There are two private production sectors: a construction sector and a sector
producing other goods and services. Firms optimize intertemporally and use
labour, capital and materials in the production process. Investments are subject
to convex costs of installation, giving rise to gradual capital adjustments. Like
the labour market, product markets are characterized by imperfect competition.
An exogenous Harrod-neutral, labour-augmenting productivity growth rate of
2 percent annually and an exogenous foreign inflation rate of 2 percent are
assumed.
12The Danish Rational Economic Agents Model. For details see Knudsen, Pedersen, Pe-
tersen, Stephensen and Trier (1998,1999) and Pedersen, Stephensen and Trier (1999). More
information can be found at www.dreammodel.dk.
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