VLCopy

15.1 Introduction In this chapter, we learn

how business cycle models and growth models are connected at the frontier of macroeconomics.

that DSGE models incorporate microfoundations, dynamics, general equilibrium, and a panoply of shocks.

that DSGE models make quantitative predictions about how the economy evolves over time in response to shocks.

15.2 A Brief History of DSGE Models

Real business cycle models Very first DSGE models Used Solow model of growth to study

macroeconomic fluctuations Introduced total factor productivity

(TFP) shocks Positive shock: new technology,

institutions Negative shock: institutions, taxes

Economy starts in equilibrium Real shock: Productivity increases Working more pays off Firms hire workers, unemployment goes down Workers earn more, consume more, save more Investment increases, capital increases, MPK

decreases, etc. etc. Eventually the effects of every single shock peter out,

but shocks of different sign and size occur again and again in an unpredictable way

Economic variables fluctuate, business cycles arise

Modern DSGE models include more shocks (real and nominal, international, financial)

Are built using these types of components: endogenous variables shocks and features of the economy that affect the

way shocks impact endogenous variables over time (incorporated in equations).

Different DSGE models often involve different features of the economy. Nominal rigidities Adjustment costs Heterogeneity Incomplete markets

DSGE models are complex to solve mathematically because they involve many individual decisions.

Features and Mathematics

Dynamic stochastic General Equilibrium

Economy consists of Households Firms Government Central bankTheir (forward-looking, optimizing) behavior is described with equations

optimizing behavior results in

Dynamicevolution of:

Question: How does a stochastic shock feed through the economy? How do the variables react?

15.5 Quantitative DSGE Models

Full DSGE models incorporate the complete dynamic response of all economic variables to all shocks.

The Smets-Wouters model incorporates all the shocks weve discussed earlier and includes both sticky prices and sticky wages.

An impulse response function shows how one macroeconomic variable of interest responds over time to an economic shock.

The next slide shows the impulse response function for GDP in the estimated Smets-Wouters model: By what percent does GDP change after a

temporary 1 percentage point increase in the fed funds rate?

Impulse Response Functions

Models within the DSGE framework make precise quantitative predictions about the complete dynamics of a host of endogenous variables.

It is the most complete framework economists have to study and understand macroeconomic fluctuations

The models weve seen so far are a just first step