Some Notes on Historical, Theoretical, and Empirical Background of DSGE Models

Slanicay, Martin Article Some Notes on Historical, Theoretical, and Empirical Background of DSGE Models Review of Economic Perspectives Provided in Cooperation with: Masaryk University, Faculty of Economics and Administration Suggested Citation: Slanicay, Martin (2014) : Some Notes on Historical, Theoretical, and Empirical Background of DSGE Models, Review of Economic Perspectives, ISSN 1804-1663, De Gruyter, Warsaw, Vol. 14, Iss. 2, pp. 145-164, https://doi.org/10.2478/revecp-2014-0008 This Version is available at: https://hdl.handle.net/10419/179808 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/ REVIEW OF ECONOMIC PERSPECTIVES – NÁRODOHOSPODÁŘSKÝ OBZOR, VOL. 14, ISSUE 2, 2014, pp. 145-164, DOI: 10.2478/revecp-2014-0008 Some Notes on Historical, Theoretical, and Empirical Background of DSGE Models1 Martin Slanicay 2 Abstract: In this paper I present the historical, theoretical and empirical background of DSGE models. I show that the fundament of these models lies in optimizing agents framework and argue which impulses fueled the development of DSGE models. I demonstrate the evolution of DSGE models with an accent on the role and effects of the monetary policy, using distinction between RBC models and New Keynesian models. I explain the paradigm shift from the RBC models to the New Keynesian models by pointing out the main pitfalls of the RBC models and showing how adding nominal rigidities to the otherwise standard RBC models enhances empirical properties of these models. I also discuss how nominal rigidities are modeled in New Keynesian DSGE models and what the pros and cons of different approaches are. Finally, I review the most important New Keynesian theories of nominal rigidities and some of the empirical evidence on price and wage rigidities. Key words: DSGE model, RBC, New Keynesian, monetary policy, business cycle, price rigidity, wage rigidity JEL Classification: B22, E32 Motivation DSGE models represent the core of contemporary macroeconomics focusing on monetary policy and business cycle. In a practical way, they are widely used by central banks for monetary policy analyses and forecasting. Therefore, it is important to know why these models emerged and how they have evolved. Knowing about motivation which formed the basis of their development helps us understand the abilities and limits of these models. In this paper I therefore present the historical, theoretical, and empirical background of DSGE models. At first I show that the fundament of these models lies in optimizing agents framework. Subsequently, I argue which impulses fueled the development of DSGE models, and that all of them were related to the widened dissatisfaction of economists with large scale neo-Keynesian macroeconometric models, on both theoretical and practical levels. The evolution of DSGE model is demonstrated with an accent on 1 This work was supported by funding of specific research at ESF MU, project MU- NI/A/0775/2013. I also thank Jan Čapek, Mirek Hloušek, and two anonymous referees for their helpful comments and suggestions. 2 Masaryk University, Faculty of Economics and Administration, Department of Economics, Lipová 41a, Brno 602 00, [email protected] REVIEW OF ECONOMIC PERSPECTIVES 146 the role and effects of the monetary policy, and a distinction between RBC models and New Keynesian models is used. 3 I discuss the main features of both RBC and New Keynesian models and explain the paradigm shift from the RBC models to the New Keynesian models by pointing on the main pitfalls of the RBC models and showing how adding some "Keynesian" assumptions, namely nominal rigidities, to the otherwise standard RBC models enhances empirical properties of these models. I also discuss how these assumptions are modeled in New Keynesian DSGE models and what the pros and cons of different approaches are. Consequently, I review the most important New Keynesian theories of nominal rigidities and some of the empirical evidence on price and wage rigidities. The rest of this paper proceeds as follows. The next section presents the nature of DSGE models, explain what the impulses for creation of such models were, and show how these models evolved over time, and why. Section 3 discusses the most important New Keynesian theories of price and wage rigidities. Section 4 reviews some of the empirical evidence on price and wage rigidities. The last section concludes. History Nature of DSGE Models DSGE is an acronym for Dynamic Stochastic General Equilibrium. DSGE models are dynamic macroeconomic models of business cycle behavior of an economy. Their distinctive feature is that they are derived from the microeconomic foundations. These models usually assume optimizing agents 4 which usually form rational expectations 5 and maximize their objective functions subject to their respective constraints. 3 There is a lot of different specifications of these models, with different assumptions which reflect the purpose for which these models were developed. Certainly, there is a difference betwe- en the "policy" models used by central banks for monetary policy analysis, and the "academic" models. The former contains all the bells and whistles in order to fit the macroeconomic data and provide reliable predictions, while the latter are highly stylized. Nevertheless, "policy" models are build on the grounds of "academic" models and the key features of "academic" and "policy" models, such as intertemporal optimization or Phillips curves, are very similar. Therefore, it seems correct to demonstrate the evolution of DSGE models using references to "academic" models, although "policy" models used by central banks are slightly more sophisticated. 4 Certain DSGE models assume non-optimizing agents which follow some kind of rule-of-thumb. As an example, we could mention the concept of non-ricardian households, proposed by Mankiw (2000), which is often used in DSGE models with government sector, for example see Coenen and Straub (2005). In order to get plausible impulse-responses of consumption to fiscal shocks, it seems that the model must contain some portion of non-optimizing households which deplete all their earnings in each period. This type of households is often labeled also as hand-to-mouth households. 5 One of the trends in the recent development of DSGE models is to relax the assumption of rational expectations. Researchers try to develop and improve models with bounded rationality, such as models with some learning mechanism of forming expectations, for example see Slobodyan and Wouters (2012). Volume 14, Issue 2, 2014 147 Let us take an example. 6 All these models usually assume representative households and firms. Households consume goods, supply labor, trade bonds or accumulate capital in order to maximize their utility function subject to numerous constraints (e.g. the budget constraint, labor demand constraint, Calvo constraint on the frequency of wage adjustment, law of motion for the capital, etc). Firms, on the other hand, produce goods and hire labor, trying to maximize their stream of profits subject to their respective constraints (e.g. the demand constraint and the Calvo constraint on the frequency of price adjustment). DSGE models are usually complemented by a reaction function of a central bank which takes the form of a variant of Taylor rule. Shortcomings of Neo-Keynesian Models The development of DSGE models, which began in the 1980s, was fueled by several impulses originated in the 1970s. These impulses were mainly connected with the practical failure of large-scale neo-Keynesian macroeconometric models as forecasting tools, and with widened dissatisfaction of economists with theoretical underpinning of these models. When Keynes published his General Theory in 1936, see Keynes (1936), it became an impulse for construction of large-scale macroeconometric models in a Keynesian style. These models took the form of a system of equations with ad-hoc postulated decision rules for the development of modeled variables inspired by the Keynesian macroeconomic theory. The beginning of these models can be dated to the late 1940s and they were most successful in the 1950s and 1960s; for example of these models see Klein and Goldberger (1955). The 1970s, however, witnessed the beginning of decline of these neo-Keynesian models and their ad-hoc modeling approach. There were several reasons for that. From the practical point of view, these neo-Keynesian models began to fail in their function of forecasting tools. The reason was obvious. The dynamics of these models depended heavily on the alleged trade-off between inflation and unemployment, expressed by the Phillips curve. Therefore, it was difficult for these models to explain the simultaneous increase of inflation and unemployment which occurred in the course of the 1970s. A number of empirical studies pointed out the weak forecasting performance of such models, often suggesting that simple statistical extrapolation of time series, with no connection to the economic theory, provides better forecasting performance than these structural neo-Keynesian models. For example of this literature see Nelson (1972). From the theoretical point of view, economists became dissatisfied with the theoretical underpinning of these neo-Keynesian models. They criticized the disequilibrium nature of these models and the lack of microfoundations for their main assumptions of price and wage rigidities. This wave of criticism inspired the research program of New Keynesian economics whose proponents sought for microfoundations of price and wage 6 This paragraph is intended to serve as a non-technical example of the usual structure of DSGE models for those readers who are not familiar with these models. Thus, the description of the model structure is inevitably arbitery, and it is possible to rewrite each sentence of this paragraph and still assume we are talking about DSGE models. Therefore, this paragraph does not have any ambitions to describe all different sorts and branches of DSGE models. REVIEW OF ECONOMIC PERSPECTIVES 148 rigidities. 7 Also, after the seminal paper of Muth (1961), who introduced the concept of rational expectations, economists became widely dissatisfied with the ad-hoc treatment of expectations in the form of adaptive expectations in these models. However, the most fundamental criticism of these neo-Keynesian models, known as the Lucas critique, can be found in Lucas (1976). Lucas criticized usefulness of ad-hoc constructed large-scale macroeconometric models for predictions of effects of changes in economic policy, arguing that predictions of such effects, based entirely on the relationships observed in the historical data, are useless. He claimed that because the parameters of those models are not structural, i.e. not policy-invariant, they will necessarily change whenever an economic policy is changed. Therefore, policy conclusions based on these models would be potentially misleading. Evolution of RBC Models The development of DSGE models is connected to an effort to derive a model which would be more immune to the Lucas critique, i.e. a model containing parameters which could be considered independent of the economic (monetary) policy. That is why DSGE models came into existence. These models are derived from microeconomic foundations and their parameters are functions of some "deep parameters", such as discount factor, elasticity of substitution among goods, elasticity of intertemporal substitution, elasticity of labor supply, etc. These "deep parameters" (related to preferences, technology and resource constraints) can be regarded as independent of the monetary policy. Seminal papers by Lucas and Prescott (1971) and Lucas (1972) can be considered as the predecessors of DSGE models. Some authors, e.g. Diebold (1998) or Woodford (2003), label these models as New-Classical models and consider them to be the first generation of DSGE models. From the historical perspective, these authors divide DSGE models into three groups: (i) New-Classical models, (ii) Real Business Cycle models, and (iii) New Keynesian models. By contrast to them, Galí (2008) considers only the latter two groups of models as DSGE models. I prefer Galí’s sorting for the following reason. Although the New-Classical models, represented by Lucas and Prescott (1971) or Lucas (1972), employ optimizing agents framework, their analysis is only partial in the sense that each paper focuses on a part of an economy only. For example, Lucas and Prescott (1971) examine the investment behavior of a firm which faces stochastic demand, however, the demand is postulated ad-hoc, and thus does not result from optimizing behavior of households. Similarly, Lucas (1972) examines optimizing behavior of households, however, the supply side of the economy is not explicitly modeled there. In my view, the first DSGE model was formed by Finn E. Kydland and Edward C. Prescott, see Kydland and Prescott (1982). Their concepts became the core of the real business cycle (RBC) theories. After their seminal paper had been published, many other RBC models appeared, for example see Prescott (1986) or Long and Plosser (1983), each of them with different assumptions and purposes. All of them had several common features, though. RBC models in general assume perfect competition on the goods and labor markets and flexible prices and wages. The concept of RBC models 7 A representative collection of the most influential papers can be found in Mankiw and Romer (1991a) and Mankiw and Romer (1991b). Volume 14, Issue 2, 2014 149 caused extensive reactions. There were three reasons for that: (i) the methodological approach described above; (ii) success in matching some business cycles patterns; and (iii) policy implications of these models. The calibrated RBC models were successful in matching some patterns of unconditional second moments of a number of macroeconomic time series, including their relative standard deviations and correlations, see Long and Plosser (1983) or Prescott (1986). King and Rebelo (1999) also show that after plugging the actual sequence of technology shocks (proxied by the estimated innovations in an AR process for the Solow residual) as an input in the RBC model, the resulting equilibrium paths of output and labor input match the observed historical patterns of those variables surprisingly well. A nice survey of the contributions of RBC models to our understanding of business cycle fluctuations, as well as a discussion of some open issues and recent trends in DSGE modeling can be found in Rebelo (2005). When it comes to the policy implications, RBC models imply that the business cycle is primary caused by real forces, especially by productivity shocks. Given the main assumption of these models that individuals and firms respond optimally to these shocks and that there are no frictions (nominal or real), recession is a result of optimal decisions of individuals in the economy and does not, therefore, represent a period with an inefficient allocation of resources. Moreover, economic policy focusing on eliminating such deviations is not desirable because these business cycle fluctuations are, through the lens of RBC models, optimal. Technological progress was given a new interpretation. Traditionally, economists had viewed technological progress as a source of long-term growth unrelated to business cycles. In RBC models, nonetheless, technological progress became the main source of economic fluctuations. Shortcomings of RBC Models The controversial policy implications of RBC models made many researchers empirically evaluate the impact of technology shocks. 8 They employed distinct methodology, empirical strategy and used various data, however, they all brought similar results. They provided unambiguous evidence that (i) positive technology shocks generate a negative short-run comovement of output and labor input, thus causing unemployment rate to rise in the short run; and (ii) the contribution of technology shocks to the business cycle fluctuations is quantitatively small. These findings reject the key predictions of the RBC models, namely (i) positive comovement of output, labor input, and productivity in response to technology shocks; and (ii) technology shocks as the dominant source of business cycle fluctuations. Neutrality of the monetary policy is another controversial implication of RBC models. According to majority of RBC models, monetary policy has no effects on real variables even in the short run. 9 Neutrality of monetary policy is strongly at odds with the long and widely held belief of economists that monetary policy has the power to influence 8 A nice survey of this literature can be found in Galí and Rabanal (2005). 9 The monetary policy is slightly non-neutral in a few RBC models but its effects on real variables is very limited and almost negligible. These models assume either the utility function of households, which is non-separable in real money balances, or "cash in advance" constraint. REVIEW OF ECONOMIC PERSPECTIVES 150 output and unemployment, at least in the short run, see the narrative evidence of Friedman and Schwartz (1963), or a more recent paper by Christiano, Eichenbaum and Evans (1998). A tough criticism of RBC models, namely the model assumptions and implications of Prescott (1986), can be found in Summers (1986), who criticizes the approach towards parameterization of the model, arguing that the model parameters, namely (i) the share of household time devoted to market activities, (ii) average real interest rate, and (iii) elasticity of labor supply, are calibrated to extremely unrealistic values. He also calls into questions the interpretation of movements in TFP as technological shocks, arguing that real sources of technological regress are hard to find and that movements in TFP can actually be the result of labor hoarding. However, the main objection to Prescott’s analysis is that it neglects the nominal variables, namely price level and inflation. The model also does not offer any explanation for exchange failures observed during economic downturns. Evolution of New Keynesian Models All shortcomings of RBC models mentioned above led to evolution of the so-called New Keynesian models (henceforth NK models). New Keynesian models adopted the methodology and the underlying structure of RBC models, i. e. principles of optimizing agents. However, unlike RBC models, NK models were enhanced with some "Keynesian" assumptions, namely monopolistic competition on the goods and/or labor markets, price and wage rigidities, etc. 10 It can be argued that labeling these models as "Keynesian" can be slightly misleading. There are no traditional Keynesian concepts of effective aggregate demand, spending and investment multipliers, investment accelerator or liquidity trap. Several authors, see Goodfriend and King (1997), call this new paradigm the "new neoclassical synthesis". This name originates from the fact that the models have "classical" spirit of clearing markets, and economies are supposed to have certain self-regulating power. In the case of an unanticipated shock, the economy deviates from its equilibrium, however, after a certain amount of time it reverts back to the equilibrium. The length of the adjustment process is influenced by the degree of nominal and real rigidities. Graduality of the adjustment process makes room for potential welfare enhancing economic (monetary) policy which can minimize the distortions, and thus stabilize the economy around its equilibrium. From my point of view, it is rather neoclassical macroeconomics enhanced by some "Keynesian" assumptions which make these models more realistic. The distinction between New Keynesian models and RBC models is primarily based on assumptions of price and wage rigidities. Inclusion of price and wage rigidities into the model leads to different implications of the model. Monetary policy is no longer neutral 10 The relation between RBC models and NK models can be best explained by the fact that NK models often use RBC model equilibrium as a benchmark for measuring ineffectiveness arising from nominal rigidities and monopolistic competition. In fact, some NK DSGE models define output gap as a difference between the actual level of output and the natural level of output, where the latter is defined as an equilibrium of corresponding RBC model. Therefore, RBC models should be viewed as a point of departure for NK models. Volume 14, Issue 2, 2014 151 in the short run. As a consequence of the presence of nominal rigidities, changes in the short-term nominal interest rate are not offset by identical changes in the expected inflation, thus causing real interest rate to vary over time. Shifts in real interest rate cause changes in consumption and investment, which in turn bring changes in output and employment, the reason for that being that firms find it optimal to adjust their production to the new level of aggregate demand. In the long run, however, all prices and wages adjust, and the economy returns to its natural equilibrium. Modeling of Nominal Rigidities in New Keynesian Models Much empirical evidence proves that prices and wages do not change frequently, see survey in the last section. Also, extensive literature of New Keynesian economics provides theoretical justification for the assumption of price and wage stickiness, see discussion in the next section. Although all of the discussed theories can be seen as valid, it seems impossible to model them jointly in one model. There are two main approaches towards modeling of nominal rigidities in New Keynesian DSGE models: Calvo (1983) and Rotemberg (1982). Both approaches lead to FOC equation which can be transformed (under some conditions) into the Phillips curve equation which links current and expected inflation with marginal costs. The resulting equations are very similar and also imply similar inflation dynamics. Calvo (1983) develops a model in continuous time in which each firm is allowed to change its price only when it receives a random signal. Firms follow a perfect-foresight equation for the price-setting. In the Yun (1996) extension, firms are maximizing present value of real profits when they set prices. According to the Calvo-Yun setup, only 1-θ portion of firms (randomly chosen) can set their prices optimally in each period, while θ portion of firms leave their prices unchanged. Under such assumption, when firm is allowed to reset its price optimally, it takes into account the fact that it shall not be able to do it again for a certain amount of time. Therefore, firms choose their prices in order to maximize the discounted sum of their current and future profits, given the probability that their prices remain effective in the subsequent periods. The optimization problems of firms lead, after some mathematical manipulation, to the derivation of key equations in New Keynesian DSGE models: New Keynesian Phillips curve. Erceg, Henderson and Levin (2000) propose an application of Calvo mechanism for wage dynamics. In their setup, households choose their wages in order to maximize the discounted sum of their current and future utility, given the probability that their wages remain effective in the subsequent periods. This optimization problem leads, after some mathematical manipulation, to the derivation of wage Phillips curve. A modification of Calvo price (wage) setting mechanism, proposed by Galí and Gertler (1999), is often employed in literature. According to this modification, from θ portion of agents which cannot optimizes a ω portion of agents uses a simple rule-of-thumb and adjusts their prices (wages) according to the past inflation, and a 1- ω portion of agents leaves their price (wage) unchanged. 11 11 An identical equation can be derived using a different assumption that all non-optimizing agents partially adjust their prices according to past inflation. REVIEW OF ECONOMIC PERSPECTIVES 152 As mentioned earlier, New Keynesian Phillips curve can be also derived using the assumption of quadratic costs of price adjustment, see Rotemberg (1982). Under such assumption, firms can reoptimize their prices whenever they want. However, every price adjustment is costly and these adjustment costs depend quadratically on the magnitude of the price adjustment. DSGE models with sticky prices were subjected to much criticism, most of which was related to gaps between model implications and empirical facts. Ball (1994) pointed on the fact that models with staggered price adjustment imply surprising result that announced, credible disinflations cause booms rather than recessions. Fuhrer and Moore (1995) argue that sticky price models cannot explain observed persistence of inflation. Mankiw (2001) notes that sticky price models imply instant response of inflation to shocks in monetary policy, followed by a relatively quick convergence of inflation to the steady state. He argued that these models have trouble explaining why shocks to monetary policy have a delayed and gradual effect on inflation. The criticism of sticky price models mentioned in the previous paragraph inspired some economists to consider another type of nominal rigidities – sticky information. These models are often labeled as SIGE models (Sticky Information General Equilibrium models). The fundamental assumption of these models is that information about macroeconomic conditions disseminate slowly through the economy. The reason may be either costs of acquiring information or costs of reoptimization. The advantage of these models is that they employ only one type of rigidities - sticky information. Mankiw and Reis (2001, 2002) introduce the concept of sticky information and apply it on decision making process of households/firms and the resulting behavior of prices/wages. Reis (2006a, 2006b) discusses these issues in more detail. He examines conditions under which firms prefer setting a plan for prices they charge instead of setting a plan for quantity they sell. He also offers an explanation for why agents rationally choose to be inattentive to news, thus only sporadically updating their information. Mankiw and Reis (2007) and Reis (2009a) present the concept of sticky information in a fully articulated DSGE model, in the former case estimated on the data of the U.S. economy, in the latter case on the data of the U.S. and Euro Area economy. Ball, Mankiw and Reis (2005) and Reis (2009b) examine the issue of optimal monetary policy in SIGE model, from the theoretical point of view in the former case, in an empirical application on the U.S. economy in the latter case. Mankiw and Reis (2006) summarize the main features and implications of sticky information models and discuss how they correspond with empirical facts. Mankiw and Reis (2010) offers a survey of the research on imperfect information models of aggregate supply and the Phillips curve. The proponents of sticky information models argue that these models are more consistent in several aspects with the commonly held view on the effects of monetary policy than sticky price models. Unlike sticky price models, sticky information models imply that disinflations are always contractionary (although announced disinflations are less contractionary than surprising ones), while sticky price models allow for a boom after an announced, credible disinflation. As regards the effects of monetary policy Volume 14, Issue 2, 2014 159 Conclusion This paper discusses the historical, theoretical, and empirical background of DSGE models. I have shown that the fundament of these models lies in optimizing agents framework. I argue which impulses fueled the development of DSGE models, and that all of them were related to the widened dissatisfaction of economists with large-scale neo-Keynesian macroeconometric models, on both theoretical and practical level. The evolution of DSGE model is demonstrated with an accent on the role and effects of the monetary policy, using distinction between RBC models and New Keynesian models. I discuss the main features of both RBC and New Keynesian models and explain the paradigm shift from the RBC models to the New Keynesian models by pointing out the main pitfalls of the RBC models and showing how adding some "Keynesian" assumptions, namely nominal rigidities, to the otherwise standard RBC models enhances empirical properties of these models. I also discuss how these assumptions are modeled in New Keynesian DSGE models and what the pros and cons of different approaches are. Finally, I review the most important New Keynesian theories of nominal rigidities and some of the empirical evidence on price and wage rigidities. References AKERLOF, G. A., YELLEN, J. L. (1985a). A Near-Rational Model of Business Cycle with Wage and Price Inertia. Quarterly Journal of Economics, 100(Supplement), pp. 823-838. AKERLOF, G. A., YELLEN, J. L. (1985b). Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria? American Economic Review, 75(4), pp. 708-720. 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