Dynamic Stochastic General Equilibrium Models in Macroeconomics (DSGEs)

03 Aug 2015 15:05

Pretend that the national economy consists of a single person, the "representative agent". This agent owns all the goods, especially all the capital goods, and does all the work in the economy. The agent is greedy for material consumption, and lazy. To consume, which it likes, it must produce, which is a matter of indifference, except that to produce it must work, which it dislikes. If it produces more now than it consumes, it can save the difference as capital goods, which make its future labor more productive. There are also shocks to "technology", i.e., to how effectively it can use capital to turn labor into consumption goods; rather bizarrely, these shocks are both negative and positive, which means that it regularly forgets productive technologies, and not because better replacements have come along.

In addition to being greedy and lazy, the agent is is determined to act now so as to maximize not present utility, but the discounted future stream of utility at all times (since it is also immortal). Fortunately, it is incredibly foresighted, and knows the exact distribution of future shocks to technology. (This distribution is not changed by anything the agent does; or, if you like, it always acts in such a way that its expectations are exactly fulfilled.) Possessing unlimited cognitive resources, it is easy for the agent to solve the resulting dynamic programming problem optimally. This will not lead to a smooth pattern of production, investment and consumption; if, for instance, there is a big negative shock to technology, and shocks are persistent, it becomes rational to slack off now, and enjoy leisure; extra work will be more rewarded later when the agent will have remembered how to do stuff. These fluctuations are, supposedly, the fluctuations of the macroeconomy, the business cycle.

I have sketched this sort of model in a deliberately hostile way, because I think such things are remarkably silly. But many very eminent economists regard them very highly indeed. Mostly I think this reflects badly on the discipline of macroeconomics, but it does raise some interesting technical problems, like:

(You might well ask "where is the equilibrium, let alone the general equilibrium, in a model with one agent and no trade?" You might very well ask that.)