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Modelling impacts of free trade agreements on the Scottish economy

This report explores the modelled impact of several free trade agreements on the Scottish economy, including the UK–EU Trade and Cooperation Agreement. It considers the impact on the economy as a whole, as well as at a sectoral level, utilising Gravity modelling and Computable General Equilibrium.


Approach to assessing economic impact

The impacts of FTAs on the Scottish economy are estimated in this analysis using the Scottish Government’s Computable General Equilibrium (CGE) and gravity model. Both CGE and gravity models are standard tools in trade policy analysis.

Table 1 provides an overview of the models used.[10] A gravity model of trade is used to source assumptions around potential changes in trade barriers as a result of trade agreements. Gravity models are used to estimate the effect of trade policies (such as free trade agreements) and other variables (such as distance) on trade between two countries. The gravity model is also used to simulate the general equilibrium impact of FTA scenarios on economic variables such as output, exports, and imports for each sector.

A CGE model is then used to provide a more comprehensive assessment of the cumulative impact of scenarios, including the impact on macroeconomic variables such as GDP or employment as well as sectoral impacts. A CGE model, unlike the gravity model used, incorporates input–output linkages between industries and more detailed treatment of the economy.[11] This means that sectoral results from the CGE model presented in this report account for wider supply chain effects of changes in trade barriers as well as wider economic effects.

Any economic model is only an approximation of a real economy, making simplifications where necessary in order to capture the most important real-world impacts while abstracting out others. This means there is always a degree of uncertainty when using models to understand complex systems such as the Scottish or global economy. Gravity models and CGE models make different simplifications and different assumptions, meaning they are unlikely to produce identical results. This means that using the two frameworks in parallel can provide a greater degree of assurance than using one in isolation: if the two models produce broadly similar results despite their fundamentally different approaches, we can be more confident that the results successfully capture the likely behavioural impact. Both modelling frameworks complement and depend on each other, with the assumptions for CGE modelling sourced from the gravity model whilst the CGE provides impacts on a wider set of economic variables.

Table 1: Models used
Gravity Model CGE model

Overview

In its simplified formulation, predicts international trade flows based on economic sizes and distance between two countries (in analogy to Newtonian gravity). Modern gravity models can take account of many other variables that can predict trade, including sharing a common language and having a free trade agreement. Using econometric estimation based on large bilateral trade datasets, one can find the impact that one or more of these variables has on trade, and then use this to simulate scenarios based on changing these variables. For example, estimate FTA effect and then simulate the impact of a new FTA between two countries.

Outputs

Change in:

  • Exports
  • Imports
  • Output

Broken down by:

  • Industry sector
  • Country

Data

International bilateral trade data, for a large set of years, many countries, and broken down by industry sector

Overview

Based on macroeconomic equations which describe how key economic variables depend on one another, and input–output data which describe supply chain links between different sectors in the economy. A user can apply an external shock to the system, such as a reduction in trade costs (for example as a result of signing a free trade agreement). This shock affects prices, which in turn affect both the supply side and the demand side of the economy. The model computes how various quantities would have to adjust to balance supply and demand, and the user can interrogate the details of the new equilibrium.

Outputs

For the country on which the CGE model is based:

  • GDP
  • Employment
  • Exports
  • Imports

Aggregate and broken down by industry sector

Data

Inbuilt Social Accounting Matrix, which includes input–output data for all sectors of the economy

Table 2 provides a summary of scenarios considered in this report. These include the impact of FTAs with all non-EU partners and the combined impact of FTAs with non-EU partners and the UKEU TCA.

Table 2: Scenarios
Scenario Assumptions

Scenario 1 – Non-EU FTAs

Combined impact of trade agreements with Australia, India, Switzerland, and Türkiye

For Australia and India, our scenario considers a reduction in trade costs in all sectors of the economy according to the results of our sector-specific partial gravity estimation reflecting the impact of an average trade deal.

For Switzerland and Türkiye, the existing trade agreements significantly liberalised trade in goods, so the greatest gains from enhanced agreements will materialise through reduced barriers in services trade.

  • For Switzerland, we shock trade costs in finance and insurance; professional, scientific, and technical activities; and administrative and support service activities.
  • For Türkiye, we shock transportation and storage; professional, scientific, and technical activities; and administrative and support service activities.

Scenario 2 – Non-EU FTAs and UKEU TCA

Combined impact of trade agreements with Australia, India, Switzerland and Türkiye, and the UKEU TCA

Non-EU FTAs: same assumptions as above

UKEU TCA: introduce trade costs across all sectors

Contact

Email: EUEA-SG@gov.scot

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