From the Peterson Institute:
A number of economists have recently written about the pros and cons of dynamic stochastic general equilibrium models (DSGEs). (Among them, and in addition to my own piece, are Narayana Kocherlakota, Simon Wren-Lewis, Paul Romer, Steve Keen, Anton Korinek, Paul Krugman, Noah Smith, Roger Farmer, and Brad Delong.)
Here are my reactions to the debate:
I believe that there is wide agreement on the following three propositions; let us not discuss them further, and move on:
- Macroeconomics is about general equilibrium.
- Different types of general equilibrium models are needed for different purposes. For exploration and pedagogy, the criterion should be transparency and simplicity, and for that, toy models are the right vehicles. For forecasting, the criterion should be forecasting accuracy, and purely statistical models may, for the time being, be best. For conditional forecasting, i.e. to look for example at the effects of changes in policy, more structural models are needed, but they must fit the data closely and do not need to be religious about micro foundations.
- Partial equilibrium modelling and estimation are essential to understanding the particular mechanisms of relevance to macroeconomics. Only when they are well understood does it become essential to understand their general equilibrium effects. Not every macroeconomist should be working on general equilibrium models (there is such a thing as division of labor).
I see two propositions as more controversial:
- The specific role of DSGEs in the panoply of general equilibrium models is to provide a basic macroeconomic Meccano set, i.e. a formal, analytical platform for discussion and integration of new elements: for example, as a base from which to explore the role of bargaining in the labor market, the role of price-setting in the goods markets, the role of banks in intermediation, the role of liquidity constraints on consumption, the scope for multiple equilibria, etc. Some seem to think that it is a dangerous and counterproductive dream, a likely waste of time, or at least one with a high opportunity cost. I do not. I believe that aiming for such a structure is desirable and achievable.
- The only way in which DSGEs can play this role is if they are built on explicit micro foundations. This is not because models with micro foundations are holier than others, but because any other approach makes it difficult to integrate new elements and have a formal dialogue. For those who believe that there are few distortions (say, the believers in the original real business cycle view of the world), this is a straightforward and natural approach. For those of us who believe that there are many distortions relevant to macroeconomic fluctuations, this makes for a longer and messier journey, the introduction of many distortions, and the risk of an inelegant machine at the end. One wishes there were a short cut and a different starting point. I do not think either exists.