"It is hard for non-economists to understand how peculiar the predominant macroeconomic models were. Many assumed demand had to equal supply - and that meant there could be no unemployment. (Right now a lot of people are just enjoying an extra dose of leisure; why they are unhappy is a matter for psychiatry, not economics.) Many used "representative agent models" - all individuals were assumed to be identical, and this meant there could be no meaningful financial markets (who would be lending money to whom?). Information asymmetries, the cornerstone of modern economics, also had no place: they could arise only if individuals suffered from acute schizophrenia, an assumption incompatible with another of the favoured assumptions, full rationality." -- Joseph Stiglitz
As I understand it, Smets and Wouters (2007) is an example of a DSGE model widely approved of by mainstream economists. Sbordone et al. (2010) is a recent presentation of an introductory DSGE. One can see that the output of these models is a set of stochastic processes meant to model certain time series available in empirical data. Nominal interest rates, (real) income, the inflation rate, the volume of one-period government bonds, employment, and nominal wages are all examples of such time series. The input into such models is another set of stochastic processes. These inputs are given names that suggest they are random terms in functions characterizing either government entities - e.g., monetary policy shock - or agents in microeconomic models. Examples of the latter kind of names are a household discount rate shock, productivity shock, markup shock, and firm discount rate shock. Stochastic processes are specified by parameters of certain probability distributions. As one can see from the names of these inputs, the agents are supposed to be optimizing, including across time. A story, expressed in mathematics and supposedly of microeconomic equilibrium, connects the inputs to the outputs in the model. That is, the DSGE models are supposed to have microfoundations.
But they do not have microfoundations. I look for a number of mistakes in such models:
- Are inputs into production function measured in numeraire units? (The numeraire is often taken to be a basket of consumer goods.) Joan Robinson (1953-54) explains why measuring the quantity of capital in production functions in numeraire units is an error. Notice this is not solely a question of the aggregation of capital. A model can have a continuum of capital goods, yet still exhibit this mistake.
- Are representative agents used? Kirman (1992) explains why the use of representative agents is unfounded.
- Is money modeled? Frank Hahn (1965) explains why money does not matter in General Equilibrium models, even though it does seem to matter for actually existing capitalist economies. Mainstream economists have a couple of strategies for introducing money in an ad hoc way into DSGE models. But I am not convinced the typical modeler has ever managed to address Hahn's point.
- Is the possibility of multiple equilibria taken seriously? Is it demonstrated that non-equilibrium dynamic processes converge to the modeled equilibrium? Richard Goodwin (1990) illustrates what a macroeconomics looks like that, in contrast to typical DSGE models, takes dynamics seriously. Kirman (1989) shows that ignoring muliple equilibria and stability issues was demonstrated to be unfounded by the Sonnenschein-Mantel-Debreu results. Shiller (1978) long ago raised the issues of multiple equilibria and convergence. Shiller was critiquing the tradition out of which DSGE models evolved.
- Ricardo J. Caballero (2010) "Macroeconomics after the Crisis: Time to Deal with the Pretense-of-Knowledge Syndrome", MIT Dept. of Economics, Working Paper 10-16 (September 27)
- Richard M. Goodwin (1990) Chaotic Economic Dynamics, Oxford University Press.
- Robert J. Gordon (2010) "Is Modern Macro or 1978-era Macro More Relevant to the Understanding of the Current Economic Crisis".
- Frank H. Hahn (1965) "On Some Problems of Proving the Existence of an Equilibrium in a Monetary Economy", in The Theory of Interest Rates (Ed. by F. H. Hahn and F. Brechling), Macmillan.
- Frank Hahn and Robert Solow (1995) A Critical Essay on Modern Macroeconomic Theory, MIT Press.
- Kevin D. Hoover (1988) The New Classical Macroeconomics, Basil Blackwell.
- J. E. King (2010) "Microfoundations for Macroeconomics? The Pre-History of a Dogma, 1936-1975", HETSA 2010, (June)
- Alan Kirman (1989) "The Intrinsic Limits of Modern Economic Theory: The Emperor has No Clothes", Economic Journal, V. 99, N. 35: Supplement: Conference Papers: pp. 126-139.
- Alan P. Kirman (1992) "Whom or What Does the Representative Individual Represent?", Journal of Economic Perspectives, V. 6, N. 2 (Spring): pp. 117-136.
- Joan Robinson (1953-54) "The Production Function and the Theory of Capital", Review of Economic Studies, V. 21, N. 55: pp. 81-106.
- Argia M. Sbordone, Andrea Tambalotti, Krishna Rao, and Kieran Walsh (2010) "Policy Analysis Using DSGE Models: An Introduction", Federal Reserve Bank of NY Economic Policy Review.
- Robert J. Shiller (1978) "Rational Expectations and the Dynamic Structure of Macroeconomic Models: A Critical Review", Journal of Monetary Economics, V. 4: pp. 1-44.
- Frank Smets and Rafael Wouters (2007) "Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach", American Economic Review, V. 97, N. 3: pp. 586-606.
- Alessandro Vercelli (1991) Methodological Foundations of Macroeconomics: Keynes & Lucas, Cambridge University Press.
- Wynne Godley and Marc Lavoie (2007) Monetary Economics: An Integrated Approach to Credit, Money, Income, Production and Wealth, Palgrave MacMillan.