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Tuesday, December 10, 2013

Theme: Concerns With DSGE Models

This theme post gives an overview of my complaints (and possibly praise) about Dynamic Stochastic General Equilibrium (DSGE) models in economics. This post will be updated over time, as material is added.


DSGE models have become the standard macro modelling technique for mainstream economists, particularly at central banks. These models are fairly controversial, particularly after the financial crisis after 2008-2009.

Unfortunately for the point of view of writing about DSGE models, this is actually a very wide class of mathematical models, which are not just used in macroeconomics. There are uses in overlapping generations models (which model consumer behaviour, but abstract out the rest of the economy), and pricing of financial instruments. I am not really interested in those uses of DSGE models, and nothing I write applies to those forms of DSGE mathematical models; I am only referring to the DSGE models applied to macro analysis.

Within the macroeconomic usages, there are two broad classes: Real Business Cycle (RBC) models, and an offshoot, New Keynesian models. The RBC models came first, and assumed completely flexible prices. The New Keynesian models added price stickiness, which changes the cyclical behaviour of the models considerably. Thousands of these models have been churned out by academics and central banks, and they often add various "frictions" to adjust the behaviour of the models.

Endowment Economy Example

In a series of posts, I discuss a simple "endowment" economy (an economy where output happens without a labour/consumption trade-off). I explain what the solution looks like, and I discuss the problems with the government budget constraint. These problems cast doubt on the model solutions that are discussed in the literature.

Complaints About DSGE Assumptions

There are many who object to the assumptions based on microeconomic theory embedded in these models. The use of a representative household, which is assumed to live forever and rationally plan out a consumption path for all time, is a particular point of scorn.

Justification Of DSGE Models

The justifications given for the use of DSGE models include:
  • Sensible reaction of embedded expectations to policy changes ("Lucas Critique").
  • A unified, flexible framework for analysis.
  • The use of math, instead of literary exposition, (hopefully) gives an objective measure of whether academic articles represent new knowledge or not. (As an example of the problems with non-mathematical economic theory, Austrian economics has largely devolved into parsing texts written by dead economists.)
  • Mathematical models can be fitted (calibrated) to real world data, leading to quantitative predictions for scenario analysis.
I am sympathetic to these aims, although I am cautious about how well mathematical models can predict cyclical behaviour. As such, I am not too concerned about many of the complaints about some of the assumptions based on microeconomics.

These models have a large number of free parameters. Since an infinite number of nonlinear models can have the same linear approximation ("linearisation"), the calibration techniques could conceivably identify the correct linearisation, even if the nonlinear model they use is incorrect. This means that scenario analysis output would be correct, even if they have the wrong nonlinear model.

External References:

(This is under construction.)


Complaint: DSGE Models Are Mathematically Or Economically Incoherent

DSGE models, as currently described in the literature, appear to have problems with the mathematics and/or macroeconomic dynamics.


Complaint: DSGE Models Cannot Be Properly Fitted To Data

If DSGE models cannot be fitted correctly to the data ("calibrated" in economist-speak; "identified" to control systems engineers), the empirical arguments in their defense disappear.

Other Complaints

(c) Brian Romanchuk 2013

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