Macroeconomics

1 4-5

Conclusion: Toward DSGE Models

If you go on to take more advanced courses in macroeconomics, you will likely

learn about a class of models called dynamic, stochastic, general equilibrium

models, often abbreviated as DSGE models. These models are dynamic because

they trace the path of variables over time. They are stochastic because they incor-

porate the inherent randomness of economic life. They are general equilibrium

because they take into account the fact that everything depends on everything

else. In many ways, they are the state-of-the-art models in the analysis of short-

run economic fluctuations.

The dynamic AD –AS model we have presented in this chapter is a simpli-

fied version of these DSGE models. Unlike analysts using advanced DSGE

models, we have not started with the household and firm optimizing decisions

that underlie the macroeconomic relationships. But the macro relationships

that this chapter has posited are similar to those found in more sophisticated

DSGE models. The dynamic AD –AS model is a good stepping-stone between

the basic model of aggregate demand and aggregate supply we saw in earlier

chapters and the more complex DSGE models you might see in a more

advanced course.

The dynamic AD –AS model also yields some important lessons. It shows how

various macroeconomic variables—output, inflation, and real and nominal inter-

est rates—respond to shocks and interact with one another over time. It demon-

strates that, in the design of monetary policy, central banks face a tradeoff

between variability in inflation and variability in output. Finally, it suggests that

central banks need to respond vigorously to inflation to prevent it from getting

out of control. If you ever find yourself running a central bank, these are good

lessons to keep in mind.