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Thursday, October 8, 2020

"DSGE Models Are Just Arbitrage-Free Pricing Models"

The easiest way to understand DSGE macro models are that they are just arbitrage-free pricing models. If one understands how arbitrage-free pricing models are used in fixed income analysis, one can immediately grasp what a DSGE model can -- and cannot -- do.

I owe this observation to Warren Mosler, who noted this in a conversation. Beyond that, I am unsure who has also noted this. Since option-pricing models are one class of models within the Dyamic Stochastic General Equilibrium family, the observation should not be controversial -- but the implications of the "just" in the sentence would presumably be.

I will start off my tour of DSGE macro filling out what this observation means. Although I believe that I understood what Warren Mosler meant by that statement, it is a safe bet that many readers will not. Even experts in option pricing might visualise arbitrage-free models differently, and so might draw completely different implications. As such, I need to do some background work, in the form of primer(s) on arbitrage-free pricing models. Since these articles are meant to be stand-alone pieces that should be of interest to those with a hankering for fixed income quantitative content, they will not immediately appear to fit into my narrative about DSGE macro.

Since I have not written them, I cannot guess how many articles it will take to cover the topic. 

(c) Brian Romanchuk 2020

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