Why I like DSGE models

Christoph has recently vented his frustration about “DSGE bashing” now popular in the econ blogosphere. I feel this frustration, too, not because I believe DSGEs are perfect, but because I think that much of the popular criticism is ill-informed. Since I have worked with DSGE models recently in my research, I can call myself a card-carrying member of the club of DSGE aficionados. So I thought I briefly explain why I like DSGEs and what I think they are good for.

I think of DSGE models as applying ordinary principles of economics – optimizing behavior and market equilibrium (GE for general equilibrium) – to a world that evolves over time (D for dynamic) and is subject to chance (S for stochastic). When I say optimizing behavior I don’t necessarily mean rational expectations and when I say equilibrium I don’t necessarily mean market clearing. There are DSGEs without rational expectations and with non-clearing markets out there, although admittedly they are not the most widely used ones. I find this general approach attractive, because it brings us closer to a Unified Economic Science that uses a single set of principles to explain phenomena at the micro level and at the macro level.

But that’s not the most important reason I like DSGEs, which is that it makes precise and thus helps clarify commonly held notions about business cycles, economic crises and economic. Take, for instance, the notion of “recession”. In popular discussion a “recession” is when GDP growth is negative or at least below what is conceived a normal or desirable rate. In DSGE models, a recession is a negative output gap: the difference between the actual level of output and that level which would occur if prices were fully flexible (the “natural rate of output”). DSGEs make it clear that a negative growth rate is not necessarily bad (if the weather is bad in April and better in May, you want production to go down in April and up in May) and a positive growth rate not necessarily good (two percent real growth can sometimes mean an overheating economy and sometimes be a sluggish one). You have to look at more than one variable (at least two, output growth and inflation) to decide whether the economy is in good or bad shape.

Another reason I like DSGEs is that they discuss economic policy in a much more coherent and sensible manner than most of the earlier literature – and much more so than the financial press. The important question about any policy X is not “Does X increase GDP or reduce unemployment or increase asset prices?”, but “Does X increase the utility of households?”. Also, because DSGEs are dynamic models, they put the focus on policy rules, i.e. how policymakers behave across time and in different situations, instead of looking only what policymakers do right now and in this particular situation.

There is a lot of valid criticism against DSGEs: they often are too simplistic and sweep important but hard-to-model aspects under the rug and they, as a result of that, have lots of empirical issues. But these things should encourage us to make DSGEs better, not return to the even more simplistic approaches that previously dominated macroeconomics.

4 thoughts on “Why I like DSGE models

  1. You are replacing an empirical notion of a recession by a theoretical construct that makes the statement “There would be no recessions if prices were fully flexible.” a tautology. This certainly precludes many explanations for why recessions, conventionally understood, happen. In particular, DSGEs as you treat them “sweep important but hard-to-model aspects under the rug” not because the models are not rich enough, but because alternative explanations are defined away.

  2. It’s a little bit hard to generalize, because DSGE is a label given to a broad range of models, including the RBC model and various New Keynesian models. “Recessions”, conventionally understood as phases of declining economic activity, are explained differently by different models. What I had in mind with the phrase you quote was the New Keynesian model which offers, I think, a particularly useful way to look at economic fluctuations, their sources and potential remedies — much more useful than the “GDP-up-good/GDP-down-bad” view that you get from the financial press or the textbook ISLM model. (It’s also a fact that, although sticky prices are the reason why output gaps arise in these models, making prices more flexible, does not necessarily improve social welfare!)
    The DSGE methodology precludes no explanations per se, it only insists they should make sense in a general equilibrium framework. That does rule out “dis-equilibrium” explanations of recessions, but I don’t think that’s very restrictive given that “equilibrium” is an extremely flexible notion (it merely means a situation in which the plans of economic agents are mutually compatible). Self-fulfilling crises, liquidity traps, debt deflation, sovereign default, credit cycles, secular stagnation, and currency crises all can be and have been incorporated in DSGE models. So I don’t see over-restrictiveness to be a big problem here.

  3. I am a bit confused now. A defense of DSGEs in the abstract is very different than a defense of NK models. So either the virtue of the model is that one gets a precise (re-)definition of recessions in general, or the claim is that the mechanism in NK models is a good explanation of recessions in that the empirical phenomenon is well represented by output gaps and the mechanism of NK models is plausible. In this case, one should make a case that this is indeed so. If the central mechanism driving a model is not correct, the model might do more harm than an overly simplistic model that at least nobody takes too seriously. The idea of output gaps certainly precedes the rise of DSGE models, Okun did his work in the 1960s. One can improve on the financial press without studying SLP first.

  4. I obviously failed to explain myself here. My only point in bringing up the issue of recessions was that this strikes me as an example where thinking through the implications of dynamic optimization with uncertainty (that’s what DSGEs are at core) is useful, because it makes you realize that not all economic fluctuations are socially harmful and that it is important to distinguish between “natural” fluctuations and wasteful ones — especially when designing stabilization policies.

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