Dynamic Stochastic General Equilibrium Models and Their Discontents

The papers in this session all feature dynamic stochastic general equilibrium (DSGE) models that combine theory and empirics in a tractable manner. These models are an impressive response to the Lucas critique that reduced-form models cannot accurately respond to changes in fundamental behavior. However, because of the need to integrate many theoretical insights, DSGE models have some general characteristics that need to be taken into account when using the results in policy analysis. One concern is that it is difficult to move these models far from equilibrium because agents are highly forward looking and policymakers do the right thing, which makes it difficult to explain the length and depth of the current recession. This high degree of foresight also complicates the analysis of fiscal policy, as it tends to reduce the impact of Keynesian demand effects compared with classical supply responses. Finally, international spillovers are often underestimated, as these mainly come through financial links that are not well articulated in DSGE models. None of this implies that DSGE models should be abandoned, but it does suggest that their results should include a health warning.