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 modelling 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.
Terminology As a practical matter, people often use the term "DSGE models" to refer to a particular class of classically quantitative econometric models of business cycles or economic growth called real business cycle (RBC) models.Christiano (2018) DSGE models were initially proposed in the 1980s by Kydland & Prescott, and Long & Plosser;Long & Plosser (1983) Charles Plosser described RBC models as a precursor for DSGE modeling.Plosser (2012)
As mentioned in the Introduction, DSGE models are the predominant framework of macroeconomic analysis. They are multifaceted, and their combination of microfoundations and optimising economic behaviour of rational agents allows for a comprehensive analysis of macro effects. As indicated by their name, their defining characteristics are as follows:
Dynamic: The effect of current choices on future uncertainty makes the models dynamic and assigns a certain relevance to the expectations of agents in forming macroeconomic outcomes. Stochastic: The models take into consideration the transmission of random shocks into the economy and the consequent economic fluctuations. General: referring to the entire economy as a whole (within the model) in that price levels and output levels are determined jointly. This is opposed to a partial equilibrium, where price levels are taken as given and only output levels are determined within the model economy. Equilibrium: In accordance with Léon Walras's General Competitive Equilibrium Theory, the model captures the interaction between policy actions and behaviour of agents.
RBC modeling
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 aforementioned DSGE models are seen to be an update of real business cycle (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.A "complete market", aka an "Arrow-Debreu market," or a "complete system of markets," is a market with two conditions: (a) negligible transaction costs, and therefore also perfect information, and (b) there is a price for every asset in every possible state of the world. 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: Microeconomic data cast doubt on some of the key assumptions of the model, such as: perfect credit- and insurance-markets; perfectly friction-less labour markets;In such friction-less labour markets, fluctuations in hours worked reflect movements along a given labour-supply curve or optimal movements of agents in and out of the labor force. See Chetty et al (2011). etc. They had difficulty in accounting for some key properties of the aggregate data, such as: the observed volatility in hours worked; the equity premium; etc. Open-economy versions of these models failed to account for observations such as: the cyclical movement of consumption and output across countries;Backus et al (1992) the extremely high correlation between nominal and real exchange rates;Mussa (1986) etc. They are mute on many policy related issues of importance to macroeconomists and policy makers, such as the consequences of different monetary policy rules for aggregate economic activity.
The Lucas critique
In a 1976 paper,"One of the most famous papers in macroeconomics". Goutsmedt et al. (2015) 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: Given that the structure of an econometric model consists of optimal decision-rules of economic agents, and that optimal decision-rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models.Lucas (1976)
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,Goutsmedt et al. (2015) and by Jacob Marschak, in his 1953 contribution to the Cowles Commission Monograph, where he submitted that In predicting the effect of its decisions (policies), the government...has to take account of exogenous variables, whether controlled by it (the decisions themselves, if they are exogenous variables) or uncontrolled (e.g. weather), and of structural changes, whether controlled by it (the decisions themselves, if they change the structure) or uncontrolled (e.g. sudden changes in people's attitude).
The Lucas critique is representative of the paradigm shift that occurred in macroeconomic theory in the 1970s towards attempts at establishing microfoundations.
Response to the Lucas critique In the 1980s, macro models emerged that attempted to directly respond to Lucas through the use of rational expectations econometrics.Harrison et al. (2013)
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."Kydland & Prescott (1982) 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.Woodford, 2003, pp. 11–12.Tovar, 2008, pp. 15–16. 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 generalCooley (1995) and its authors were awarded the 2004 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel.
DSGE modeling Structure 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.Sbordone et al (2010) 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:BBLM del Dipartimento del Tesoro, Microfoundations of DSGE Models: I Lecture, 7 June 2010
Perfect competition in all markets All prices adjust instantaneously Rational expectations No asymmetric information The competitive equilibrium is Pareto optimal Firms are identical and price takers Infinitely lived identical price-taking households
to which the following frictions are added:
Distortionary taxes (Labour taxes) – to account for not lump-sum taxation Habit persistence (the period utility function depends on a quasi-difference of consumption) Adjustment costs on investments – to make investments less volatile Labour adjustment costs – to account for costs firms face when changing the level of employment
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.
Demand defines real activity as a function of the nominal interest rate minus expected inflation, and of expectations regarding future real activity.