A Critical Discussion of the Relative Successes and Shortcomings of Dynamic Stochastic General Equilibrium Models

From the late 20^th Century, Dynamic Stochastic General Equilibrium (DSGE) models grew exponentially in popularity and prowess, used by an overwhelming proportion of central banks in the developed world (Coenen et al., 2012) to provide (at least) theoretical foundations for advisory policy stances. With the dawn of the financial crisis and Great Recession, several of the models’ flaws with regard to forecasting both downturn and recovery were brought to light. However, proponents maintain its superiority to alternatives based on DSGE’s fundamental components, which are often a source of major critique. This essay will begin with an explanation of the general DSGE model, in understanding the theory I endeavour to demonstrate reasons for the models widespread success, before the dominant literary critiques and suggested modifications in response are assessed.

In adherence to Lucas’ critique of policy variations in traditional Keynesian models’ causing systematic fluctuations in both the “optimal decision rule of economic agents and… the structure of econometric models” themselves (Lucas, 1976), DSGE models take their theoretical microfoundations from a representative agent with rational expectations, for whom utility maximisation, subject to a budget constraint, occurs intertemporally. Exogenous, stochastic shocks impact upon these optimality pathways for consumption demand, labour supply and monetary holdings (Dullien, 2009). Deriving pathways through log-linearisation of agents’ intertemporal consumption (Euler) equation at the economy’s steady state gives rise to the New Keynesian IS (NKIS) demand function.

γt=Etγt+1–1/σ(it–Etπt+1–rtn)

(Equation 1. Dullien, 2009. Appendix).

Maintaining the microfounded foothold of Real Business Cycle (RBC) models, alongside the Neoclassical, Walrasian assumption of general equilibrium (in which all markets clear instantaneously; Snowdon and Vane 2005), DSGE models attempt to rectify the empirical disparity of some RBC assumptions, by incorporating New Keynesian elements. The first, Calvo pricing, holds that a proportion of firms change prices in each time period, allowing for some level of price-stickiness in the economy (Calvo, 1983). Using constant elasticities of substitution to model aggregate consumption, product heterogeneity is valued, thus allowing for monopolistic competition and firms’ mark-up on marginal costs (Dixit and Stiglitz, 1977). Incorporating these assumptions, the economy’s supply side is modelled as a New Keynesian Phillips Curve (NKPC).

πt=βEtπt+1+κγt

(Equation 2. Dullien, 2009)

These equations, and the two aforementioned New Keynesian assumptions, allow for the stabilisation role of monetary policy, in which interest rates are set by an independent central authority in response to fluctuations in output and inflation (compared to the potential and target levels, respectively). The disparity in adjustment times between prices (staggered) and wages (instant, as the labour market clears) and the deterministic nature of interest rates on demand (NKIS) mean monetary po