As indicated by their name, their defining characteristics are as follows: The formulation and analysis of monetary policy has undergone significant evolution in recent decades and the development of DSGE models has played a key role in this process.
[2] RBC theory builds on the neoclassical growth model, under the assumption of flexible prices, to study how real shocks to the economy might cause business cycle fluctuations.
[12] In 1982, Finn E. Kydland and Edward C. Prescott created a real business cycle (RBC) model to "predict the consequence of a particular policy rule upon the operating characteristics of the economy.
Examples of such shocks include innovations, the weather, sudden and significant price increases in imported energy sources, stricter environmental regulations, etc.
The shocks directly change the effectiveness of capital and labour, which, in turn, affects the decisions of workers and firms, who then alter what they buy and produce.
[3] The authors stated that, since fluctuations in employment are central to the business cycle, the "stand-in consumer [of the model] values not only consumption but also leisure," meaning that unemployment movements essentially reflect the changes in the number of people who want to work.
"Household-production theory," as well as "cross-sectional evidence" ostensibly support a "non-time-separable utility function that admits greater inter-temporal substitution of leisure, something which is needed," according to the authors, "to explain aggregate movements in employment in an equilibrium model.
[15] The Kydland/Prescott 1982 paper is often considered the starting point of RBC theory and of DSGE modeling in general[7] and its authors were awarded the 2004 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel.
These three sections are formally defined by micro-foundations and make explicit assumptions about the behavior of the main economic agents in the economy, i.e. households, firms, and the government.
"[19] Bank of Lithuania Deputy Chairman Raimondas Kuodis disputes the very title of DSGE analysis: The models, he claims, are neither dynamic (since they contain no evolution of stocks of financial assets and liabilities), stochastic (because we live in the world of Knightian uncertainty and, since future outcomes or possible choices are unknown, then risk analysis or expected utility theory are not very helpful), general (they lack a full accounting framework, a stock-flow consistent framework, which would significantly reduce the number of degrees of freedom in the economy), or even about equilibrium (since markets clear only in a few quarters).
[29][note 9] Joseph Stiglitz finds "staggering" shortcomings in the "fantasy world" the models create and argues that "the failure [of macroeconomics] were the wrong microfoundations, which failed to incorporate key aspects of economic behavior".
"[30] Oxford University's John Muellbauer put it this way: "It is as if the information economics revolution, for which George Akerlof, Michael Spence and Joe Stiglitz shared the Nobel Prize in 2001, had not occurred.
The combination of assumptions, when coupled with the trivialisation of risk and uncertainty...render money, credit and asset prices largely irrelevant... [The models] typically ignore inconvenient truths.
Lawrence H. White concludes[33] that present-day mainstream macroeconomics is dominated by Walrasian DSGE models, with restrictions added to generate Keynesian properties: Hayek had criticized Wicksell for the confusion of thinking that establishing a rate of interest consistent with intertemporal equilibrium[note 11] also implies a constant price level.
They consider such attempts as "a chimera of authority,"[35] pointing to the 2003 statement by Lucas, the pioneer of modern DSGE modelling: A basic Post Keynesian presumption, which Modern Monetary Theory proponents share, and which is central to Keynesian analysis, is that the future is unknowable and so, at best, we can make guesses about it that would be based broadly on habit, custom, gut-feeling,[note 12] etc.
[35] Extrinsic unpredictability, post-Keynesians state, has "dramatic consequences" for the standard, macroeconomic, forecasting, DSGE models used by governments and other institutions around the world.
The mathematical basis of every DSGE model fails when distributions shift, since general-equilibrium theories rely heavily on ceteris paribus assumptions.
[40] Columbia University's Michael Woodford concedes[41] that policies considered by DSGE models might not be Pareto optimal[note 14] and they may as well not satisfy some other social welfare criterion.