DSGE models explained in English!

I had pointed to this senate hearing on DSGE models.

I was reading this charter presented at the hearing. It does the unthinkable — explains DSGE models in English.

First what does DSGE mean?

The dominant macro model has for some time been the Dynamic Stochastic General Equilibrium model, or DSGE, whose name points to some of its outstanding characteristics. “General” indicates that the model includes all markets in the economy. “Equilibrium” points to the assumptions that supply and demand balance out rapidly and unfailingly, and that competition reigns in markets that are undisturbed by shortages, surpluses, or involuntary unemployment. “Dynamic” means that the model looks at the economy over time rather than at an isolated moment. “Stochastic” corresponds to a specific type of manageable randomness built into the model that allows for unexpected events, such as oil shocks or technological changes, but assumes that the model’s agents can assign a correct mathematical probability to such events, thereby making them insurable. Events to which one cannot assign a probability, and that are thus truly uncertain, are ruled out.

And how does it work?

The agents populating DSGE models, functioning as individuals or firms, are endowed with a kind of clairvoyance. Immortal, they see to the end of time and are aware of anything that might possibly ever occur, as well as the likelihood of its occurring; their decisions are always instantaneous yet never in error, and no decision depends on a previous decision or influences a subsequent decision. Also assumed in the core DSGE model is that all agents of the same type – that is, individuals or firms – have identical needs and identical tastes, which, as “optimizers,” they pursue with unbounded self-interest and full knowledge of what their wants are. By employing what is called the “representative agent” and assigning it these standardized features, the DSGE model excludes from the model economy almost all consequential diversity and uncertainty – characteristics that in many ways make the actual economy what it is.

The DSGE universe makes no distinction between system equilibrium, in which balancing agent-level disequilibrium forces maintains the macroeconomy in equilibrium, and full agent equilibrium, in which every individual in the economy is in equilibrium. In so doing, it assumes away phenomena that are commonplace in the economy: involuntary unemployment and the failure of prices or wages to adjust instantaneously to changes in the relation of supply and demand. These phenomena are seen as exceptional and call for special explanation.

All this is pretty well put. It then explains how this model became so popular in policymaking and provides references for the same. There is also a discussion of economists interpretation of DSGE models.

Useful stuff.

It is amazing to see all this debate enfold. But again the problem is not with models. The problem is with economists and some super-economists who just sold this model all over the world. The limitiations were just put on the backburner. In moderation years it looked too good to be true as it fitted so well. And in times like this again it looks too good to be true as it nothing really fits and is unbelievable that we let this model go this far.

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2 Responses to “DSGE models explained in English!”

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