What is the DSGE Model in economics?

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I’ve tried reading the page about the DSGE Model, but I got lost in many references that I encountered. What is the DSGE Model, and what is its implications?

In: Economics

Anonymous 0 Comments

This is not going to be ELI5, but I’ll try to make things simple.

DSGE models are models that are used to study macroeconomic phenomena like business cycles, growth, unemployment, etc.

Their features are spelled out in the acronym, which stands for Dynamic Stochastic General Equilibrium.

Let’s start with the last two, since they are more straightforward to explain. A general equilibrium model is a model that tries to explain the behavior of all the markets of its simulated economy (general) by assuming that supply and demand balance out (equilibrium) and markets “clear”, ie all those willing to buy and sell at the market price can do so. So for example a general equilibrium model can have two markets, one for goods and one for labor, and two types of agents, households and factories. Households supply labor and buy goods, factories supply goods and buy labor. You model these with a series of equations, and find the solutions for things like how many goods are produced or how many hours do people work.

Dynamic stochastic (remember, that’s the DS in DSGE) modeling adds two additional wrinkles to this setup: things change over time (dynamic) and they do so randomly (stochastic). So going back to our basic example of households and factories, you could model a productivity factor that changes over time (this could be a proxy for things like technology/innovation). At each point in time, the factory has a different productivity so it will want to hire people differently. Similarly, households will want to save in good times and spend in bad times.

In general, DSGE models have two main uses: simple ones are a basic way to model complex behavior in “toy” economies so that you can understand the impact of things like changes in productivity on an economy. Complex ones that are much richer in detail than what I’ve described so far are used by central banks and other institutions to create their economic forecasts. Generally speaking, DSGE models used to make a lot of simplifying assumptions that made them highly unrealistic, but a lot of theoretical work in the past 10-15 years has greatly improved their realism.