On DSGE Models

This 2018 Journal of Economic Perspectives essay by Lawrence Christiano, Martin Eichenbaum, and Mathias Trabandt is a perspective/survey defense of dynamic stochastic general equilibrium (DSGE) modeling rather than an empirical study: it traces how the DSGE research program evolved from real business cycle (RBC) models through New Keynesian DSGE to post-crisis models with financial frictions, argues that the transparency of these models’ microfoundations is a virtue because it exposes suspicious assumptions to scrutiny against micro data, explains why the pre-crisis vintage of these models failed to predict the 2008 financial crisis, and closes with a point-by-point rebuttal of Joseph Stiglitz’s (2017) critique of the DSGE program. The authors argue RBC models (Kydland-Prescott 1982; Long-Plosser 1983) “crumbled” under three forces – micro evidence against frictionless labor markets, failure to match aggregate facts such as hours volatility and the equity premium, and the absence of any role for money – and that the New Keynesian DSGE models that followed can reproduce the hump-shaped consumption, investment, and output responses to a monetary policy shock (estimated under recursive/Cholesky identification on US data, 1951Q1-2008Q4, a pattern the authors report as robust across lag lengths of one to five quarters and multiple sample start dates) only by combining habit formation in consumption, investment adjustment costs, and Calvo (1983) nominal price/wage rigidities with features that keep marginal cost nearly acyclical. In the Christiano-Eichenbaum-Trabandt (2016) Bayesian re-estimation of the Christiano-Eichenbaum-Evans (2005) model that the essay treats as its illustrative case, the posterior mode implies firms reprice roughly once every 2.3 quarters, households reset wages about once a year, the habit-formation coefficient is 0.75, and the elasticity of investment to a one percent temporary rise in the price of installed capital is 0.16, with the fit to the hump-shaped facts depending critically on sticky nominal wages – a flexible-wage counterfactual “deteriorates drastically.” On the crisis, the authors concede that DSGE models’ failure to signal the buildup of shadow-banking vulnerability “is correct” as a criticism, but frame it as a failure of the broader economics profession rather than something specific to DSGE, and defend the relative absence of large financial frictions in pre-crisis models by noting that postwar US recessions were not historically tied to financial disturbances and that the financial accelerator mechanism (Bernanke-Gertler-Gilchrist 1999) that some models did include had only “a modest quantitative effect” on estimated dynamics. The essay then surveys post-crisis extensions – rollover-crisis and fire-sale models of financial intermediaries (Gertler-Kiyotaki), risk-shock models in which time-varying cross-sectional dispersion of firm returns (Christiano-Motto-Rostagno 2014) is reported to account for about 60 percent of the variance of US business cycles versus roughly 13 percent for technology shocks, zero-lower-bound (ZLB) and nonlinear models attributing much of the Great Recession to financial frictions interacting with a binding ZLB, a government-spending multiplier the authors describe as “much larger than one” at the ZLB and “substantially below one” away from it, the “forward guidance puzzle” (standard models make forward guidance implausibly powerful), and heterogeneous-agent (HANK) models – before rebutting Stiglitz (2017) on four specific fronts: that modern DSGE estimation does not rely on HP-filtered data, that pre-crisis DSGE models did incorporate financial frictions, that interest-rate spreads do appear as central endogenous variables in some models, and that household heterogeneity is an active DSGE research frontier (HANK). The authors judge Stiglitz’s criticisms “not informed” while explicitly acknowledging that DSGE models will not reliably predict the next crisis and that the modeling program is “an organic process” of ongoing interaction between data and theory.

Martin S. Eichenbaum | Macro Paper Warehouse

On DSGE Models