DSGE Models are being thrashed everywhere. These are actually based on New Keynesian thinking which had become a vogue till this crisis. The New Keyensian thinking merges Keynes ideas (markets can fail) with classical economics (rational human beings). Wikipedia nicely explains it:
Two main assumptions define the New Keynesian approach to macroeconomics. Like the New Classical approach, New Keynesian macroeconomic analysis usually assumes that households and firms have rational expectations. But the two schools differ in that New Keynesian analysis usually assumes a variety of market failures. In particular, New Keynesians assume prices and wages are “sticky“, which means they do not adjust instantaneously to changes in economic conditions.
Wage and price stickiness, and the other market failures present in New Keynesian models, imply that the economy may fail to attain full employment. Therefore, New Keynesians argue that macroeconomic stabilization by the government (using fiscal policy) or by the central bank (using monetary policy) can lead to a more efficient macroeconomic outcome than a laissez faire policy would. However, New Keynesian economics is less optimistic about the benefits of activist policies than traditional Keynesian economics was.
The DSGE model is basically a generic term but has become associated with new Keynesian thinking. These models though have included Keynesian thinking, ignore the role of financial markets. They assume markets to be efficient and self-correcting and not worthy of being included in the models (see this criticism by Munchau and Otmar Issing).
Now these models are being increasingly used by central banks and are highly fashionable. With most central banks failing to see the crisis coming, the models are being questioned. The fact that financial crisis are pretty common how can models ignore them? True, any model takes time to develop but then why should central banks rely strongly on it?
Camilo Tovar of BIS has written an excellent primer(no equation, no Latin terms )to explain the basics of this DSGE model. Tovar adds apart from not including financial markets comprehensively, it also has a very limited role for currency risk premia and fiscal policies (follows Ricardian equivalence, no wonder we understand so little about fiscal policies). He also adds on DSGE modelling issues with emerging economies.
Quite a decent read. Despite his best attempt to explain in English, one needs some understanding of econometrics to understand the paper fully (needless to say, I still struggled with the paper and just got a feeler). He also has added a huge list of references and papers explaining DSGE models used by different central banks. (Though doubt any paper would be as simple as this one ).
One can also read Mankiw’s new chapter explaining basics of DSGE Models.
I came across this interesting link. NIPFP, Delhi based economic think-tank along with Department of Economic Affairs, Ministry of Finance has been organising training sessions on DSGE modelling! One is simply teaching about these models, it is altogether different to apply them for policies. Can DSGE model be applied in Indian setting? What changes does one make to make them suitable to Indian conditions? Anybody knows of any papers on any DSGE modelling in India, let me know.