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Dynamic stochastic general equilibrium modeling (abbreviated as DSGE, or DGE, or sometimes SDGE) is a macroeconomic method which is often employed by monetary and fiscal authorities for policy analysis, explaining historical time-series data, as well as future forecasting purposes.DSGE econometric modeling applies general equilibrium theory and microeconomic principles in a tractable manner to postulate economic phenomena, such as economic growth and business cycles, as well as policy effects and market shocks.
As a practical matter, people often use the term "DSGE models" to refer to a particular class of econometric, quantitative models of business cycles or economic growth called real business cycle (RBC) models.Considered to be classicly quantitative, DSGE models were initially proposed by Kydland & Prescott, and Long & Plosser; whereby Charles Plosser described RBC models as a precursor for DSGE modeling.
As mentioned in the Introduction, DSGE models constitute the predominant framework of macroeconomic analysis through their coherent combination of micro-foundations and optimising economic behaviour of rational agents. DSGE models are multi-faceted which allow for a more comprehensive analysis of macro effects, and their defining characteristics indicative through their name, are as follows:
The formulation and analysis of monetary policy has undergone significant evolution in recent decades and the development of DSGE models has played a key role in this process. As was afore mentioned DSGE models are seen be an update of RBC models.
Early real business-cycle models postulated an economy populated by a representative consumer who operates in perfectly competitive markets. The only sources of uncertainty in these models are "shocks" in technology.RBC theory builds on the neoclassical growth model, under the assumption of flexible prices, to study how real shocks to the economy might cause business cycle fluctuations.
The "representative consumer" assumption can either be taken literally or reflect a Gorman aggregation of heterogenous consumers who are facing idiosyncratic income shocks and complete markets in all assets.These models took the position that fluctuations in aggregate economic activity are actually an "efficient response" of the economy to exogenous shocks.
The models were criticized on a number of issues:
In a 1976 paper,Robert Lucas argued that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. Lucas claimed that the decision rules of Keynesian models, such as the fiscal multiplier, cannot be considered as structural, in the sense that they cannot be invariant with respect to changes in government policy variables, stating:
This meant that, because the parameters of the models were not structural, i.e. not indifferent to policy, they would necessarily change whenever policy was changed. The so-called Lucas critique followed similar criticism undertaken earlier by Ragnar Frisch, in his critique of Jan Tinbergen's 1939 book Statistical Testing of Business-Cycle Theories, where Frisch accused Tinbergen of not having discovered autonomous relations, but "coflux" relations,and by Jacob Marschak, in his 1953 contribution to the Cowles Commission Monograph, where he submitted that
The Lucas critique is representative of the paradigm shift that occurred in macroeconomic theory in the 1970s towards attempts at establishing micro-foundations.
In the 1980s, macro models emerged that attempted to directly respond to Lucas through the use of rational expectations econometrics.
In 1982, Finn E. Kydland and Edward C. Prescott created a real business cycle (RBC) model to "predict the consequence of a particular policy rule upon the operating characteristics of the economy."The stated, exogenous, stochastic components in their model are "shocks to technology" and "imperfect indicators of productivity." The shocks involve random fluctuations in the productivity level, which shift up or down the trend of economic growth. Examples of such shocks include innovations, the weather, sudden and significant price increases in imported energy sources, stricter environmental regulations, etc. The shocks directly change the effectiveness of capital and labour, which, in turn, affects the decisions of workers and firms, who then alter what they buy and produce. This eventually affects output.
The authors stated that, since fluctuations in employment are central to the business cycle, the "stand-in consumer [of the model] values not only consumption but also leisure," meaning that unemployment movements essentially reflect the changes in the number of people who want to work. "Household-production theory," as well as "cross-sectional evidence" ostensibly support a "non-time-separable utility function that admits greater inter-temporal substitution of leisure, something which is needed," according to the authors, "to explain aggregate movements in employment in an equilibrium model."For the K&P model, monetary policy is irrelevant for economic fluctuations.
The associated policy implications were clear: There is no need for any form of government intervention since, ostensibly, government policies aimed at stabilizing the business cycle are welfare-reducing.Since microfoundations are based on the preferences of decision-makers in the model, DSGE models feature a natural benchmark for evaluating the welfare effects of policy changes. Furthermore the integration of such microfoundations in DSGE modeling enables the model to accurately adjust to shifts in fundamental behaviour of agents and is thus regarded as an "impressive response" to the Lucas critique. The Kydland/Prescott 1982 paper is often considered the starting point of RBC theory and of DSGE modeling in general and its authors were awarded the 2004 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel.
By applying dynamic principles, dynamic stochastic general equilibrium models contrast with the static models studied in applied general equilibrium models and some computable general equilibrium models.
DSGE models employed by governments and central banks for policy analysis are relatively simple. Their structure is built around three interrelated sections including that of demand, supply, and the monetary policy equation. These three sections are formally defined by micro-foundations and make explicit assumptions about the behavior of the main economic agents in the economy, i.e. households, firms, and the government.The interaction of the agents in markets cover every period of the business cycle which ultimately qualifies the “general equilibrium” aspect of this model. The preferences (objectives) of the agents in the economy must be specified. For example, households might be assumed to maximize a utility function over consumption and labor effort. Firms might be assumed to maximize profits and to have a production function, specifying the amount of goods produced, depending on the amount of labor, capital and other inputs they employ. Technological constraints on firms' decisions might include costs of adjusting their capital stocks, their employment relations, or the prices of their products.
Below is an example of the set of assumptions a DSGE is built upon:
to which the following frictions are added:
The models' general equilibrium nature is presumed to capture the interaction between policy actions and agents' behavior, while the models specify assumptions about the stochastic shocks that give rise to economic fluctuations. Hence, the models are presumed to "trace more clearly the shocks' transmission to the economy."This is exemplified in the below explanation of a simplified DSGE model.
As such a complete simplified model of the relationship between three key features is defined. This dynamic interaction between the endogenous variables of output , inflation, and the nominal interest rate, is fundamental in DSGE modelling.
Two schools of analysis form the bulk of DSGE modeling:the classic RBC models, and the New-Keynesian DSGE models that build on a structure similar to RBC models, but instead assume that prices are set by monopolistically competitive firms, and cannot be instantaneously and costlessly adjusted. Rotemberg & Woodford introduced this framework in 1997. Introductory and advanced textbook presentations of DSGE modeling are given by Galí (2008) and Woodford (2003). Monetary policy implications are surveyed by Clarida, Galí, and Gertler (1999).
The European Central Bank (ECB) has developeda DSGE model, called the Smets–Wouters model, which it uses to analyze the economy of the Eurozone as a whole. The Bank's analysts state that
The main difference between "empirical" DSGE models and the "more traditional macroeconometric models, such as the Area-Wide Model",according to the ECB, is that "both the parameters and the shocks to the structural equations are related to deeper structural parameters describing household preferences and technological and institutional constraints." The Smets-Wouters model uses seven Eurozone area macroeconomic series: real GDP; consumption; investment; employment; real wages; inflation; and the nominal, short-term interest rate. Using Bayesian estimation and validation techniques, the bank's modeling is ostensibly able to compete with "more standard, unrestricted time series models, such as vector autoregression, in out-of-sample forecasting."
Bank of Lithuania Deputy Chairman Raimondas Kuodis disputes the very title of DSGE analysis: The models, he claims, are neither dynamic (since they contain no evolution of stocks of financial assets and liabilities), stochastic (because we live in the world of Keynesian fundamental uncertainty and, since future outcomes or possible choices are unknown, then risk analysis or expected utility theory are not very helpful), general (they lack a full accounting framework, a stock-flow consistent framework, which would significantly reduce the number of degrees of freedom in the economy), or even about equilibrium (since markets clear only in a few quarters).
Willem Buiter, Citigroup Chief Economist, has argued that DSGE models rely excessively on an assumption of complete markets, and are unable to describe the highly nonlinear dynamics of economic fluctuations, making training in 'state-of-the-art' macroeconomic modeling "a privately and socially costly waste of time and resources".Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, wrote that
N. Gregory Mankiw, regarded as one of the founders of New Keynesian DSGE modeling, has argued that
In the 2010 United States Congress hearings on macroeconomic modeling methods, held on 20 July 2010, and aiming to investigate why macroeconomists failed to foresee the financial crisis of 2007-2010, MIT professor of Economics Robert Solow criticized the DSGE models currently in use:
Commenting on the Congressional session,The Economist asked whether agent-based models might better predict financial crises than DSGE models.
Former Chief Economist and Senior Vice President of the World Bank Paul Romer A as the difference between growth of output Y and growth of an index X of inputs in production.has criticized the "mathiness" of DSGE models and dismisses the inclusion of "imaginary shocks" in DSGE models that ignore "actions that people take." Romer submits a simplified presentation of real business cycle (RBC) modelling, which, as he states, essentially involves two mathematical expressions: The well known formula of the quantity theory of money, and an identity that defines the growth accounting residual
Δ%A = Δ%Y − Δ%X
Romer assigned to residual A the label "phlogiston" while he criticized the lack of consideration given to monetary policy in DSGE analysis.
Joseph Stiglitz finds "staggering" shortcomings in the "fantasy world" the models create and argues that "the failure [of macroeconomics] were the wrong microfoundations, which failed to incorporate key aspects of economic behavior". He suggested the models have failed to incorporate "insights from information economics and behavioral economics" and are "ill-suited for predicting or responding to a financial crisis."Oxford University's John Muellbauer put it this way: "It is as if the information economics revolution, for which George Akerlof, Michael Spence and Joe Stiglitz shared the Nobel Prize in 2001, had not occurred. The combination of assumptions, when coupled with the trivialisation of risk and uncertainty...render money, credit and asset prices largely irrelevant... [The models] typically ignore inconvenient truths." Nobel laureate Paul Krugman asked, "Were there any interesting predictions from DSGE models that were validated by events? If there were, I'm not aware of it."
Austrian economists reject DSGE modelling. Critique of DSGE-style macromodeling is at the core of Austrian theory, where, as opposed to RBC and New Keynesian models where capital is homogeneouscapital is heterogeneous and multi-specific and, therefore, production functions for the multi-specific capital are simply discovered over time. Lawrence H. White concludes that present-day mainstream macroeconomics is dominated by Walrasian DSGE models, with restrictions added to generate Keynesian properties:
Hayek had criticized Wicksell for the confusion of thinking that establishing a rate of interest consistent with intertemporal equilibriumalso implies a constant price level. Hayek posited that intertemporal equilibrium requires not a natural rate but the "neutrality of money," in the sense that money does not "distort" (influence) relative prices.
Post-Keynesians reject the notions of macro-modelling typified by DSGE. They consider such attempts as "a chimera of authority,"pointing to the 2003 statement by Lucas, the pioneer of modern DSGE modelling:
A basic Post Keynesian presumption, which Modern Monetary Theory proponents share, and which is central to Keynesian analysis, is that the future is unknowable and so, at best, we can make guesses about it that would be based broadly on habit, custom, gut-feeling,etc. In DSGE modeling, the central equation for consumption supposedly provides a way in which the consumer links decisions to consume now with decisions to consume later and thus achieves maximum utility in each period. Our marginal Utility from consumption today must equal our marginal utility from consumption in the future, with a weighting parameter that refers to the valuation that we place on the future relative to today. And since the consumer is supposed to always the equation for consumption, this means that all of us do it individually, if this approach is to reflect the DSGE microfoundational notions of consumption. However, post-Keynesians state that: no consumer is the same with another in terms of random shocks and uncertainty of income (since some consumers spend will every cent of any extra income they receive while others, typically higher-income earners, spend comparatively little of any extra income); no consumer is the same with another in terms of access to credit; not every consumer really considers what they will be doing at the end of their life in any coherent way, so there is no concept of a "permanent lifetime income,", which is central to DSGE models; and, therefore, trying to "aggregate" all these differences into one, single "representative agent" is impossible. These assumptions are similar to the assumptions made in the so-called Ricardian equivalence, whereby consumers are assumed to be forward looking and to internalize the government's budget constraints when making consumption decisions, and therefore taking decisions on the basis of practically perfect evaluations of available information.
Extrinsic unpredictability, post-Keynesians state, has "dramatic consequences" for the standard, macroeconomic, forecasting, DSGE models used by governments and other institutions around the world. The mathematical basis of every DSGE model fails when distributions shift, since general-equilibrium theories rely heavily on ceteris paribus assumptions.They point to the Bank of England's explicit admission that none of the models they used and evaluated coped well during the financial crisis, which, for the Bank, "underscores the role that large structural breaks can have in contributing to forecast failure, even if they turn out to be temporary."
Christian Muellerpoints out that the fact that DSGE models evolve (see next section) constitutes a contradiction of the modelling approach in its own right and, ultimately, makes DSGE models subject to the Lucas critique. This contradiction arises because the economic agents in the DSGE models fail to account for the fact that the very models on the basis of which they form expectations evolve due to progress in economic research. While the evolution of DSGE models as such is predictable the direction of this evolution is not. In effect, Lucas' notion of the systematic instability of economic models carries over to DSGE models proving that they are not solving one of the key problems they are thought to be overcoming.
Federal Reserve Bank of Minneapolis president Narayana Kocherlakota acknowledges that DSGE models were "not very useful" for analyzing the financial crisis of 2007-2010 but argues that the applicability of these models is "improving," and claims that there is growing consensus among macroeconomists that DSGE models need to incorporate both "price stickiness and financial market frictions."Despite his criticism of DSGE modelling, he states that modern models are useful:
Still, Kocherlakota observes that in "terms of fiscal policy (especially short-term fiscal policy), modern macro-modeling seems to have had little impact. ... [M]ost, if not all, of the motivation for the fiscal stimulus was based largely on the long-discarded models of the 1960s and 1970s.
In 2010, Rochelle M. Edge, of the Federal Reserve System Board of Directors, contested that the work of Smets & Wouters has "led DSGE models to be taken more seriously by central bankers around the world" so that "DSGE models are now quite prominent tools for macroeconomic analysis at many policy institutions, with forecasting being one of the key areas where these models are used, in conjunction with other forecasting methods."
University of Minnesota professor of economics V.V. Chari has pointed out that state-of-the-art DSGE models are more sophisticated than their critics suppose:
Chari also argued that current DSGE models frequently incorporate frictional unemployment, financial market imperfections, and sticky prices and wages, and therefore imply that the macroeconomy behaves in a suboptimal way which monetary and fiscal policy may be able to improve.Columbia University's Michael Woodford concedes that policies considered by DSGE models might not be Pareto optimal and they may as well not satisfy some other social welfare criterion. Nonetheless, in replying to Mankiw, Woodford argues that the DSGE models commonly used by central banks today and strongly influencing policy makers like Ben Bernanke, do not provide an analysis so different from traditional Keynesian analysis:
Macroeconomics is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and government spending to regulate an economy’s growth and stability. This includes regional, national, and global economies. According to a 2018 assessment by economists Emi Nakamura and Jón Steinsson, economic "evidence regarding the consequences of different macroeconomic policies is still highly imperfect and open to serious criticism."
New Keynesian economics is a school of macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics.
This aims to be a complete article list of economics topics:
Business cycles are intervals of expansion followed by recession in economic activity. They have implications for the welfare of the broad population as well as for private institutions. Typically business cycles are measured by applying a band pass filter to a broad economic indicator such as Real Gross Domestic Production. Here important problems may arise with a commonly used filter called the "ideal filter". For instance if a series is a purely random process without any cycle, an "ideal" filter, better called a block filter, a spurious cycle is produced as output. Fortunately methods such as [Harvey and Trimbur, 2003, Review of Economics and Statistics] have been designed so that the band pass filter may be adapted to the time series at hand.
Monetary economics is the branch of economics that studies the different competing theories of money: it provides a framework for analyzing money and considers its functions, and it considers how money, for example fiat currency, can gain acceptance purely because of its convenience as a public good. The discipline has historically prefigured, and remains integrally linked to, macroeconomics. This branch also examines the effects of monetary systems, including regulation of money and associated financial institutions and international aspects.
A macroeconomic model is an analytical tool designed to describe the operation of the problems of economy of a country or a region. These models are usually designed to examine the comparative statics and dynamics of aggregate quantities such as the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the level of prices.
Edward Christian Prescott is an American economist. He received the Nobel Memorial Prize in Economics in 2004, sharing the award with Finn E. Kydland, "for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles". This research was primarily conducted while both Kydland and Prescott were affiliated with the Graduate School of Industrial Administration at Carnegie Mellon University. According to the IDEAS/RePEc rankings, he was the 19th most widely cited economist in the world in 2013. In August 2014, Prescott was appointed as an Adjunct Distinguished Economic Professor at the Australian National University (ANU) in Canberra, Australia.
Neutrality of money is the idea that a change in the stock of money affects only nominal variables in the economy such as prices, wages, and exchange rates, with no effect on real variables, like employment, real GDP, and real consumption. Neutrality of money is an important idea in classical economics and is related to the classical dichotomy. It implies that the central bank does not affect the real economy by creating money. Instead, any increase in the supply of money would be offset by a proportional rise in prices and wages. This assumption underlies some mainstream macroeconomic models. Others like monetarism view money as being neutral only in the long-run.
John Brian Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University, and the George P. Shultz Senior Fellow in Economics at Stanford University's Hoover Institution.
Microfoundations are the microeconomic behaviours of individual agents, like households or businesses, on which an economic theory is based. Research in microfoundations explores the link between macroeconomic and microeconomic principles in order to explore the aggregate relationships in macroeconomic models.
The neoclassical synthesis (NCS), neoclassical–Keynesian synthesis, or just neo-Keynesianism was a post-World War II academic movement and paradigm in economics that worked towards reconciling the macroeconomic thought of John Maynard Keynes with neoclassical economics. Being Keynesian in the short run and neoclassical in the long run, neoclassical synthesis allowed the economy to adjust via fiscal and monetary policies in the short run whilst predicting that equilibrium in the long run will be reached without state intervention. The synthesis, formulated by a group of economists, dominated economics in the post-war period and formed the mainstream of macroeconomic thought in the 1950s, 1960s and 1970s.
New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics, especially rational expectations.
Jordi Galí is a Spanish macroeconomist who is regarded as one of the main figures in New Keynesian macroeconomics today. He is currently the director of the Centre de Recerca en Economia Internacional at Universitat Pompeu Fabra and a Research Professor at the Barcelona Graduate School of Economics. After obtaining his doctorate from MIT in 1989 under the supervision of Olivier Blanchard, he held faculty positions at Columbia University and New York University before moving to Barcelona.
Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.
The new neoclassical synthesis (NNS), which is now generally referred to as New Keynesian economics, and occasionally as the New Consensus, is the fusion of the major, modern macroeconomic schools of thought - new classical macroeconomics/real business cycle theory and early New Keynesian economics - into a consensus view on the best way to explain short-run fluctuations in the economy. This new synthesis is analogous to the neoclassical synthesis that combined neoclassical economics with Keynesian macroeconomics. The new synthesis provides the theoretical foundation for much of contemporary mainstream economics. It is an important part of the theoretical foundation for the work done by the Federal Reserve and many other central banks.
Real business-cycle theory is a class of new classical macroeconomics models in which business-cycle fluctuations are accounted for by real shocks. Unlike other leading theories of the business cycle, RBC theory sees business cycle fluctuations as the efficient response to exogenous changes in the real economic environment. That is, the level of national output necessarily maximizes expected utility, and governments should therefore concentrate on long-run structural policy changes and not intervene through discretionary fiscal or monetary policy designed to actively smooth out economic short-term fluctuations.
Stock-flow consistent models (SFC) are a family of macroeconomic models based on a rigorous accounting framework, which guarantees a correct and comprehensive integration of all the flows and the stocks of an economy. These models were first developed in the mid-20th century but have recently become popular, particularly within the post-Keynesian school of thought. Stock-flow consistent models are in contrast to dynamic stochastic general equilibrium models, which are used in mainstream economics.
The Taylor contract or staggered contract was first formulated by John B. Taylor in his two articles, in 1979 "Staggered wage setting in a macro model'. and in 1980 "Aggregate Dynamics and Staggered Contracts". In its simplest form, one can think of two equal sized unions who set wages in an industry. Each period, one of the unions sets the nominal wage for two periods. This means that in any one period, only one of the unions can reset its wage and react to events that have just happened. When the union sets its wage, it sets it for a known and fixed period of time. Whilst it will know what is happening in the first period when it sets the new wage, it will have to form expectations about the factors in the second period that determine the optimal wage to set. Although the model was first used to model wage setting, in new Keynesian models that followed it was also used to model price-setting by firms.
A Calvo contract is the name given in macroeconomics to the pricing model that when a firm sets a nominal price there is a constant probability that a firm might be able to reset its price which is independent of the time since the price was last reset. The model was first put forward by Guillermo Calvo in his 1983 article "Staggered Prices in a Utility-Maximizing Framework". The original article was written in a continuous time mathematical framework, but nowadays is mostly used in its discrete time version. The Calvo model is the most common way to model nominal rigidity in new Keynesian DSGE macroeconomic models.
Emi Nakamura is a Canadian-American economist. She is the Chancellor's Professor of Economics at University of California, Berkeley.