Pissing Down Your Leg

Thoughts on Economics and Economic Policy

The Needed Assumptions of DSGE

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Noah Smith has a great post on whether or not macroeconomic models are biased in one political direction or the other. He reaches the (correct, in my opinion) conclusion that they do have a conservative bias, mainly because they are so simplified that there can be no useful role for government.

I think the most useful post is the list of assumptions in the original Kydland and Prescott Real Business Cycle paper. With so many assumptions, that model is basically useless. Smith goes on to point out that if you relaxed even the ones that are most problematic (in my opinion: representative agent modeling, rational expectations, and flexible prices) you quickly get a model that is completely unwieldy.

Why so use these models at all? They are mathematically complex, they are micro-founded (sort of), and they give little to no role for government.

Personally, I didn’t like these models when I learned them, and I still don’t find them useful. Give me a partial-equilibrium model with a little more realism any day.

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Written by Liam C Malloy

February 21, 2012 at 10:37 am

Posted in Uncategorized

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