14.5 Conclusion: Toward DSGE Models

If you go on to take more advanced courses in macroeconomics, you will likely learn about a class of models called dynamic, stochastic, general equilibrium models, often abbreviated as DSGE models. These models are dynamic because they trace the path of variables over time. They are stochastic because they incorporate the inherent randomness of economic life. They are general equilibrium because they take into account the fact that everything depends on everything else. In many ways, they are the state-of-the-art models in the analysis of short-run economic fluctuations.

The dynamic AD–AS model we have presented in this chapter is a simplified version of these DSGE models. Unlike analysts using advanced DSGE models, we have not started with the household and firm optimizing decisions that underlie the macroeconomic relationships. But the macro relationships that this chapter has posited are similar to those found in more sophisticated DSGE models. The dynamic AD–AS model is a good stepping-stone between the basic model of aggregate demand and aggregate supply we saw in earlier chapters and the more complex DSGE models you will see in a more advanced course.


There is one subset of the DSGE models—one that is summarized by just as few equations as our dynamic AD–AS model—that has become known as the new neoclassical synthesis model. It gives equal billing to important classical and Keynesian ideas. On the classical side, the synthesis model involves long-run monetary neutrality and rational expectations, and it respects the maxim that the behavioural rules followed by all households and firms in the model be explicitly derived as optimal responses to the challenges that these agents face. On the Keynesian side, the synthesis model stresses the volatility tradeoff that follows from the existence of some market failure. It is by allowing for market failure that the synthesis model provides a rigorous micro foundation for the proposition that the government attempts to stabilize the economy may be formally justified. Our dynamic, but simplified, analysis in this chapter is meant to introduce students to this important synthesis of classical and Keynesian ideas that has emerged over the last two decades.3 In the Appendix to this chapter, we introduce students to a few of the recent developments on each of the classical and Keynesian sides of this synthesis.

Beyond paving the way for more advanced work, our dynamic AD–AS model also yields some important lessons. It shows how various macroeconomic variables—output, inflation, and real and nominal interest rates—respond to shocks and interact with one another over time. It demonstrates that, in the design of monetary policy, central banks face a tradeoff between variability in inflation and variability in output. Finally, it suggests that central banks need to respond vigorously to inflation to prevent it from getting out of control. If you ever find yourself running a central bank, these are good lessons to keep in mind.