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By Mehdi Farooq 25-03-2020

Demystifying the DSGE Model

(7 min read)
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DSGE models were bashed during the Great Recession for their inability to foresee the crisis. Yet, they are still central banks’ go-to macroeconomic tool to predict business cycle fluctuations, perform policy analysis, and communicate monetary policy expectations. Despite their negative press and widespread use, these models remain less well-known outside the macro circle. Here, in Part 1, we demystify the DSGE Model. In Part 2, we cover its limitations and introduce extensions of DSGE models. Finally, we will also analyse the forecasting performance of some of these models during the turbulent times of 2008 using the New York Fed working paper, DSGE Model-Based Forecasting.




Part 1

What Is a DSGE Model?

• Dynamic – how the economy changes over time

• Stochastic – how the economy is affected by random shocks

• General – applicable to the entire economy

• Equilibrium – assumes different markets within the economy clear every period

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