Dynamic stochastic general equilibrium

Dynamic stochastic general equilibrium modeling (abbreviated as DSGE, or DGE, or sometimes SDGE) is a method in
macroeconomics that attempts to explain economic phenomena, such as economic growth and business cycles, and the effects of
economic policy, through econometric models based on applied general equilibrium theory and microeconomic principles.

Contents
Terminology
RBC modeling
The Lucas critique
Response to the Lucas critique
DSGE modeling
Structure
Schools
Criticism
From mainstream economists
From heterodox economics
Evolution of viewpoints
See also
Footnotes
References
Sources
Further reading
Software
External links

Terminology
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.[1] Considered to be classic quantitative DSGE
models are the ones proposed by Kydland & Prescott,[2] and Long & Plosser.[3] Charles Plosser has stated that DSGE models are
an “update” of RBC models.[4]

As their name indicates, DSGE models are dynamic (studying how the economy evolves over time), stochastic (taking into
account the fact that the economy is affected by random shocks), general (referring to the entire economy), and of equilibrium
(subscribing to the Walrasian, general equilibrium theory).[5]

RBC modeling
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.[1] 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.[6]

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.[note 1] 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;[note 2] 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;[7] the extremely high correlation between nominal and real exchange
rates[8]; 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.[1]

The Lucas critique

In a 1976 paper,[note 3] 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.[9]

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,[10] 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).[10]

The Lucas critique is representative of the paradigm shift that occurred in macroeconomic theory in the 1970s towards attempts at
establishing micro-foundations.

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.[11]
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."[2] 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.[2]

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."[2] 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.[11] 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.[12][13] The Kydland/Prescott 1982 paper is often considered the starting point of RBC theory and of DSGE
modeling in general[6] and its authors were awarded the 2004 Bank of Sweden Prize in Economic Sciences in Memory of Alfred
Nobel.[14]

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 share a structure built around three interrelated "blocks": a demand block, a supply block, and a monetary policy
equation. Formally, the equations that define these blocks are built on microfoundations and make explicit assumptions about the
behavior of the main economic agents in the economy, i.e. households, firms, and the government.[15] 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[16]

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 aquasi-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."[15]

Schools
Two schools of analysis form the bulk of DSGE modeling:[note 4] 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 developed[17] a DSGE model, called the Smets–Wouters model,[18] which it uses to
analyze the economy of the Eurozone as a whole.[note 5] The Bank's analysts state that

developments in the construction, simulation and estimation of DSGE models have made
it possible to combine a rigorous microeconomic derivation of the behavioural equations
of macro models with an empirically plausible calibration or estimation which fits the main
features of the macroeconomic time series.[17]

The main difference between "empirical" DSGE models and the "more traditional macroeconometric models, such as the Area-
Wide Model",[19] 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."[17] 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."[17]

Criticism

From mainstream economists

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).[20]

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".[21] Narayana Kocherlakota, President of
the Federal Reserve Bank of Minneapolis, wrote that

many modern macro models...do not capture an intermediate messy reality in which
market participants can trade multiple assets in a wide array of somewhat segmented
 markets. As a consequence, the models do not reveal much about the benefits of the
massive amount of daily or quarterly re-allocations of wealth within financial markets. The
models also say nothing about the relevant costs and benefits of resulting fluctuations in
financial structure (across bank loans, corporate debt, and equity). ...The models do not
capture an intermediate messy reality ... [and] do not reveal much about the benefits of
the massive amount of daily or quarterly re-allocations of wealth within financial
markets.[5]

N. Gregory Mankiw, regarded as one of the founders of New Keynesian DSGE modeling, has argued that

New classical and New Keynesian research has had little impact on practical
macroeconomists who are charged with [...] policy. [...] From the standpoint of
macroeconomic engineering, the work of the past several decades looks like an
unfortunate wrong turn.[22]

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:

I do not think that the currently popular DSGE models pass the smell test. They take it for
granted that the whole economy can be thought about as if it were a single, consistent
person or dynasty carrying out a rationally designed, long-term plan, occasionally
disturbed by unexpected shocks, but adapting to them in a rational, consistent way... The
protagonists of this idea make a claim to respectability by asserting that it is founded on
what we know about microeconomic behavior, but I think that this claim is generally
phony. The advocates no doubt believe what they say, but they seem to have stopped
sniffing or to have lost their sense of smell altogether.[23]

Commenting on the Congressional session, The Economist asked whether agent-based models might better predict financial
crises than DSGE models.[24]

Former Chief Economist and Senior Vice President of the World Bank Paul Romer[note 6] has criticized the "mathiness" of DSGE
models[25] and dismisses the inclusion of "imaginary shocks" in DSGE models that ignore "actions that people take."[26] Romer
submits a simplified[note 7] 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 A as the difference between growth of output Y and growth of an index X of inputs in production.

Δ%A = Δ%Y − Δ%X

Romer assigned to residual A the label "phlogiston"[note 8] while he criticized the lack of consideration given to monetary policy
in DSGE analysis.[26][note 9]

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.”[27] 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.”[28] 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."[29]
From heterodox economics
Austrians reject DSGE modelling. Critique of DSGE-style macromodelling is at the core of Austrian theory, where, as opposed to
RBC and New Keynesian models where capital is homogeneous[note 10] capital is heterogeneous and multi-specific and,
therefore, production functions for the multi-specific capital are simply discovered over time. Lawrence H. White concludes[30]
that present-day mainstream macroeconomics is dominated by Walrasian DSGE models, with restrictions added to generate
Keynesian properties:

Mises consistently attributed the boom-initiating shock to unexpectedly expansive policy

by a central bank trying to lower the market interest rate. Hayek added two alternate
scenarios. [One is where] fresh producer-optimism about investment raises the demand
for loanable funds, and thus raises the natural rate of interest, but the central bank
deliberately prevents the market rate from rising by expanding credit. [Another is where,]
in response to the same kind of increase the demand for loanable funds, but without
central bank impetus, the commercial banking system by itself expands credit more than
is sustainable.[30]

Hayek had criticized Wicksell for the confusion of thinking that establishing a rate of interest consistent with intertemporal
equilibrium[note 11] also 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.[31]

Post-Keynesians reject the notions of macro-modelling typified by DSGE. They consider such attempts as "a chimera of
authority,"[32] pointing to the 2003 statement by Lucas, the pioneer of modern DSGE modelling:

Macroeconomics in [its] original sense [of preventing the recurrence of economic

disasters] has succeeded. Its central problem of depression prevention has been solved,
for all practical purposes, and has in fact been solved for many decades.[33]

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,[note 12] etc.[32] 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.[32] 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.[32]

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.[32] They point to the
Bank of England's explicit admission[34] 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."
Evolution of viewpoints
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."[5] Despite his criticism of DSGE modelling, he states that modern models are useful:

In the early 2000s, ...[the] problem of fit[note 13] disappeared for modern macro models
with sticky prices. Using novel Bayesian estimation methods, Frank Smets and Raf
Wouters[18] demonstrated that a sufficiently rich New Keynesian model could fit European
data well. Their finding, along with similar work by other economists, has led to
widespread adoption of New Keynesian models for policy analysis and forecasting by
central banks around the world.[5]

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.[5]

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."[35]

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:

The models have all kinds of heterogeneity in behavior and decisions... people's
objectives differ, they differ by age, by information, by the history of their past
experiences.[36]

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.[36] Columbia University's Michael Woodford concedes[37] that policies considered by DSGE
models might not be Pareto optimal[note 14] 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:

It is true that the modeling efforts of many policy institutions can reasonably be seen as
an evolutionary development within the macroeconomic modeling program of the postwar
Keynesians; thus if one expected, with the early New Classicals, that adoption of the new
tools would require building anew from the ground up, one might conclude that the new
tools have not been put to use. But in fact they have been put to use, only not with such
radical consequences as had once been expected.[38]

See also
Mathematical modeling Welfare cost of business cycles
Macroeconomic modeling New neoclassical synthesis
Large scale macro modeling Marginalism
Efficient market hypothesis Marshallian economics
Footnotes
1. 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.
2. 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).
3. "One of the most famous papers in
macroeconomics". Goutsmedt et al (2015)
4. It has been suggested that the difference between
RBC and New Keynesian models, when controlling
for key supply channels, can be limited. See Cantore
et al (2010)
5. The model does not analyze individual European
countries separately
6. Romer is considered a pioneer of endogenous
growth theory. See Paul Romer.
7. In Romer's words, "stripped to its essentials". Romer
(2016)
8. The term is used "to remind ourselves of our
ignorance," as Romer stated, and in honor of
American economist Moses Abramovitz, whose
1956 paper had criticized the importance given to
productivity increase in the modelling: "Since we
know little about the causes of productivity increase,
the indicated importance of this element may be
taken to be some sort of measure of our ignorance
about the causes of economic growth in the United
States and some sort of indication of where we need
to concentrate our attention." (Emphasis by Romer.)
Abramovitz (1965)
9. According to Romer, Prescott, in his University of
Minnesota lectures to graduate students, was saying
that "postal economics is more central to
understanding the economy than monetary
economics."
10. Meaning that it is costless to switch from one
investment into another
11. The so-called "natural rate."
12. See "animal spirits".
13. By the term "[statistical] fit", Kocherlakota is referring
to the "models of the 1960s and 1970s" that "were
based on estimated supply and demand
relationships, and so were specifically designed to fit
the existing data well." Kocherlakota (2010)
14. Any state of allocation of resources in which it is
impossible to make any one individual better off
without making at least one individual worse off is
denoted as being "Pareto optimal."

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15. Sbordone et al (2010)
4. Plosser (2012)
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Further reading
Canova, Fabio (2007). Methods for Applied Macroeconomic Research. USA: Princeton University Press.
ISBN 9780691115047.

Software
DYNARE (http://www.dynare.org), free software for handling economic models, including DSGE
IRIS (https://github.com/IRIS-Solutions-Team/IRIS-Toolbox/wiki/IRIS-Macroeconomic-Modeling-Toolbox), free,
open-source toolbox for macroeconomic modeling and forecasting

External links
Society for Economic Dynamics (https://web.archive.org/web/20070623182530/http://www.economicdynamics.or
g/society.htm) - Website of the Society for Economic Dynamics, dedicated to advances in DSGE modeling.
DSGE-NET (http://www.dsge.net), an "international network for DSGE modeling, monetary and fiscal policy"

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