DSGE Models and Central Bank Policy Making: A Critical Review

Transcription

1 DSGE Models and Central Bank Policy Making: A Critical Review Shiu-Sheng Chen Department of Economics National Taiwan University Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

2 Motivations On July 20, 2010, the U.S. House of Representatives Committee on Science and Technology held a hearing on Building a Science of Economics for the Real World. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

3 Motivations The hearing explored the failure of mainstream macroeconomic models to foresee the recent financial and economic collapse the promise and the limits of modern macroeconomic theory in policy making. The macroeconomic model called the Dynamic Stochastic General Equilibrium model (DSGE) is favored today, from academy to the world s central banks. However, prominent economists disagree on the extent to which applying this theoretical model to policy decisions is practical. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

4 Motivations The hearing explored the failure of mainstream macroeconomic models to foresee the recent financial and economic collapse the promise and the limits of modern macroeconomic theory in policy making. The macroeconomic model called the Dynamic Stochastic General Equilibrium model (DSGE) is favored today, from academy to the world s central banks. However, prominent economists disagree on the extent to which applying this theoretical model to policy decisions is practical. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

5 Motivations The hearing explored the failure of mainstream macroeconomic models to foresee the recent financial and economic collapse the promise and the limits of modern macroeconomic theory in policy making. The macroeconomic model called the Dynamic Stochastic General Equilibrium model (DSGE) is favored today, from academy to the world s central banks. However, prominent economists disagree on the extent to which applying this theoretical model to policy decisions is practical. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

6 Agenda for Today s Talk Introduction to DSGE models. To be fair, DGSE and similar macroeconomic models were first conceived as theorists tools. But why, then, are they being relied on as the platform upon which so much practical policy advice is formulated? The critiques on the DSGE models. The perspectives on the DSGE models. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

7 Agenda for Today s Talk Introduction to DSGE models. To be fair, DGSE and similar macroeconomic models were first conceived as theorists tools. But why, then, are they being relied on as the platform upon which so much practical policy advice is formulated? The critiques on the DSGE models. The perspectives on the DSGE models. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

8 Agenda for Today s Talk Introduction to DSGE models. To be fair, DGSE and similar macroeconomic models were first conceived as theorists tools. But why, then, are they being relied on as the platform upon which so much practical policy advice is formulated? The critiques on the DSGE models. The perspectives on the DSGE models. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

9 Part I Introduction to DSGE Models Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

10 Introduction to DSGE Models What is DSGE Model? Dynamic Stochastic General Equilibrium Model Dynamic: studying how the economy evolves over time. Stochastic: the economy is affected by random shocks. General Equilibrium: It depicts the macro-economy as the sum of individual choices and decisions made by firms, households, the government, and the central bank, according to their own preferences and views about the future. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

11 Introduction to DSGE Models What is DSGE Model? Dynamic Stochastic General Equilibrium Model Dynamic: studying how the economy evolves over time. Stochastic: the economy is affected by random shocks. General Equilibrium: It depicts the macro-economy as the sum of individual choices and decisions made by firms, households, the government, and the central bank, according to their own preferences and views about the future. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

12 Introduction to DSGE Models Advantages of the DSGE Models Provide a coherent framework of analysis. This coherence is brought by restricting acceptable behavior of agents to dynamic utility maximization and rational expectations. The dynamic mechanics are more transparent and clear and (impulse response functions with structural shocks). Overcome the Lucas Critique (Policy experiments are more reliable) Lucas (1976) argues that the Keynesian Macroeconometric models are useless for policy analysis because they fail to take expectations seriously. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

13 Introduction to DSGE Models Advantages of the DSGE Models Provide a coherent framework of analysis. This coherence is brought by restricting acceptable behavior of agents to dynamic utility maximization and rational expectations. The dynamic mechanics are more transparent and clear and (impulse response functions with structural shocks). Overcome the Lucas Critique (Policy experiments are more reliable) Lucas (1976) argues that the Keynesian Macroeconometric models are useless for policy analysis because they fail to take expectations seriously. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

14 Introduction to DSGE Models Advantages of the DSGE Models Provide a coherent framework of analysis. This coherence is brought by restricting acceptable behavior of agents to dynamic utility maximization and rational expectations. The dynamic mechanics are more transparent and clear and (impulse response functions with structural shocks). Overcome the Lucas Critique (Policy experiments are more reliable) Lucas (1976) argues that the Keynesian Macroeconometric models are useless for policy analysis because they fail to take expectations seriously. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

15 Introduction to DSGE Models Historical Background Indeed, the DSGE approach is not new at all. What was DSGE Model? The Real Business Cycle (RBC) models in 1980s. Kydland and Prescott (1982) Long and Plosser (1983) However, why did the RBC models fail to grab Central Bankers attention? Well, the related question is: why are the Central Bankers so fascinated with DSGE models nowadays? Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

16 Introduction to DSGE Models Historical Background Indeed, the DSGE approach is not new at all. What was DSGE Model? The Real Business Cycle (RBC) models in 1980s. Kydland and Prescott (1982) Long and Plosser (1983) However, why did the RBC models fail to grab Central Bankers attention? Well, the related question is: why are the Central Bankers so fascinated with DSGE models nowadays? Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

17 Introduction to DSGE Models Historical Background Indeed, the DSGE approach is not new at all. What was DSGE Model? The Real Business Cycle (RBC) models in 1980s. Kydland and Prescott (1982) Long and Plosser (1983) However, why did the RBC models fail to grab Central Bankers attention? Well, the related question is: why are the Central Bankers so fascinated with DSGE models nowadays? Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

18 Introduction to DSGE Models Historical Background Indeed, the DSGE approach is not new at all. What was DSGE Model? The Real Business Cycle (RBC) models in 1980s. Kydland and Prescott (1982) Long and Plosser (1983) However, why did the RBC models fail to grab Central Bankers attention? Well, the related question is: why are the Central Bankers so fascinated with DSGE models nowadays? Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

19 Introduction to DSGE Models Historical Background In the past, RBC models have the following features: Flexible prices Focus on calibration. Moments matching and policy experiments. However, no emphasis on estimation and forecasting. The RBC models (old DSGE models) have difficulty to match persistence in data with i.i.d. structural shocks (weak internal propagation mechanism). Most importantly, the RBC models emphasize real shocks only. Although some researchers try to incorporate money into the RBC models, it is in general found that money is neutral under flexible-price framework. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

20 Introduction to DSGE Models Historical Background In the past, RBC models have the following features: Flexible prices Focus on calibration. Moments matching and policy experiments. However, no emphasis on estimation and forecasting. The RBC models (old DSGE models) have difficulty to match persistence in data with i.i.d. structural shocks (weak internal propagation mechanism). Most importantly, the RBC models emphasize real shocks only. Although some researchers try to incorporate money into the RBC models, it is in general found that money is neutral under flexible-price framework. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

21 Introduction to DSGE Models Historical Background In the past, RBC models have the following features: Flexible prices Focus on calibration. Moments matching and policy experiments. However, no emphasis on estimation and forecasting. The RBC models (old DSGE models) have difficulty to match persistence in data with i.i.d. structural shocks (weak internal propagation mechanism). Most importantly, the RBC models emphasize real shocks only. Although some researchers try to incorporate money into the RBC models, it is in general found that money is neutral under flexible-price framework. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

22 Introduction to DSGE Models Historical Background In the past, RBC models have the following features: Flexible prices Focus on calibration. Moments matching and policy experiments. However, no emphasis on estimation and forecasting. The RBC models (old DSGE models) have difficulty to match persistence in data with i.i.d. structural shocks (weak internal propagation mechanism). Most importantly, the RBC models emphasize real shocks only. Although some researchers try to incorporate money into the RBC models, it is in general found that money is neutral under flexible-price framework. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

23 Introduction to DSGE Models Historical Background In the past, RBC models have the following features: Flexible prices Focus on calibration. Moments matching and policy experiments. However, no emphasis on estimation and forecasting. The RBC models (old DSGE models) have difficulty to match persistence in data with i.i.d. structural shocks (weak internal propagation mechanism). Most importantly, the RBC models emphasize real shocks only. Although some researchers try to incorporate money into the RBC models, it is in general found that money is neutral under flexible-price framework. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

24 Introduction to DSGE Models Historical Background In the past, RBC models have the following features: Flexible prices Focus on calibration. Moments matching and policy experiments. However, no emphasis on estimation and forecasting. The RBC models (old DSGE models) have difficulty to match persistence in data with i.i.d. structural shocks (weak internal propagation mechanism). Most importantly, the RBC models emphasize real shocks only. Although some researchers try to incorporate money into the RBC models, it is in general found that money is neutral under flexible-price framework. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

25 Introduction to DSGE Models Historical Background In the past, RBC models have the following features: Flexible prices Focus on calibration. Moments matching and policy experiments. However, no emphasis on estimation and forecasting. The RBC models (old DSGE models) have difficulty to match persistence in data with i.i.d. structural shocks (weak internal propagation mechanism). Most importantly, the RBC models emphasize real shocks only. Although some researchers try to incorporate money into the RBC models, it is in general found that money is neutral under flexible-price framework. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

26 Introduction to DSGE Models Historical Background So how can we expect that Central Bankers would enjoy a model that monetary policy plays no role? Nowadays, the development of DSGE models become a broad-ranging search to discover a set of frictions to reproduce realistic dynamics. In particular, the most popular frictions are the Keynesian elements such as sticky prices/wages. Frictions such as stick prices open up the possibility of the non-neutrality of monetary policy. No wonder the central bankers like the models now. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

27 Introduction to DSGE Models Historical Background So how can we expect that Central Bankers would enjoy a model that monetary policy plays no role? Nowadays, the development of DSGE models become a broad-ranging search to discover a set of frictions to reproduce realistic dynamics. In particular, the most popular frictions are the Keynesian elements such as sticky prices/wages. Frictions such as stick prices open up the possibility of the non-neutrality of monetary policy. No wonder the central bankers like the models now. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

28 Introduction to DSGE Models Historical Background So how can we expect that Central Bankers would enjoy a model that monetary policy plays no role? Nowadays, the development of DSGE models become a broad-ranging search to discover a set of frictions to reproduce realistic dynamics. In particular, the most popular frictions are the Keynesian elements such as sticky prices/wages. Frictions such as stick prices open up the possibility of the non-neutrality of monetary policy. No wonder the central bankers like the models now. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

29 Introduction to DSGE Models Historical Background So how can we expect that Central Bankers would enjoy a model that monetary policy plays no role? Nowadays, the development of DSGE models become a broad-ranging search to discover a set of frictions to reproduce realistic dynamics. In particular, the most popular frictions are the Keynesian elements such as sticky prices/wages. Frictions such as stick prices open up the possibility of the non-neutrality of monetary policy. No wonder the central bankers like the models now. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

30 Introduction to DSGE Models Historical Background So how can we expect that Central Bankers would enjoy a model that monetary policy plays no role? Nowadays, the development of DSGE models become a broad-ranging search to discover a set of frictions to reproduce realistic dynamics. In particular, the most popular frictions are the Keynesian elements such as sticky prices/wages. Frictions such as stick prices open up the possibility of the non-neutrality of monetary policy. No wonder the central bankers like the models now. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

31 Introduction to DSGE Models Historical Background It is thus called a New Keynesian DSGE model, and I will call it a New DSGE Model, in short. Moreover, new DSGE models start to focus on structural estimations (GMM, MLE, Bayesian). So it is also called an Estimated DSGE Model, which is able to provide forecasts on a regular basis. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

32 Introduction to DSGE Models Historical Background It is thus called a New Keynesian DSGE model, and I will call it a New DSGE Model, in short. Moreover, new DSGE models start to focus on structural estimations (GMM, MLE, Bayesian). So it is also called an Estimated DSGE Model, which is able to provide forecasts on a regular basis. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

33 Introduction to DSGE Models Historical Background It is thus called a New Keynesian DSGE model, and I will call it a New DSGE Model, in short. Moreover, new DSGE models start to focus on structural estimations (GMM, MLE, Bayesian). So it is also called an Estimated DSGE Model, which is able to provide forecasts on a regular basis. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

34 Introduction to DSGE Models Macroeconometric Models, SVAR and DSGE Models Macroeconometric SVAR Models DSGE Models Models Dynamic Yes Yes Yes Stochastic Regression Residuals Structural Shocks Structural Shocks General Loosely based on Based on Explicitly based on Equilibrium theory in ad hoc economic structure optimization in manner and theory coherent manner Invalid Exogeneity Yes No No Assumption Policy Experiment Yes Yes Yes (Reliable?) (No) (Yes) (Yes) Forecast Yes Yes Yes Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

35 Introduction to DSGE Models DSGE and Central Banks According to the overall victory for DSGE models in the above Table, no wonder why DSGE models are becoming increasingly popular in central banking circles over the past decade. European Central Bank US Federal Reserve Bank Sveriges Riksbank Bank of Canada Bank of England Norges Bank Bank of Finland Reserve Bank of New Zealand Bank of Spain Central Bank of Brazil Central Bank of Chile Central Reserve Bank of Peru Bank of Thailand IMF Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

36 Introduction to DSGE Models DSGE and Central Banks However, before the central bankers proceed to move to the new framework, some warnings about the flaws and limitations of DSGE models should be heeded. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

37 Introduction to DSGE Models The State-of-the-Art DSGE Models Smets and Wouters (2007) model a large set of persistent exogenous shocks: total factor productivity investment-specific technology risk premium government spending price mark-up wage mark-up monetary policy a large set of frictions: sticky wages and prices sticky adjustment of capacity utilization investment adjustment cost habit formation in consumption a Taylor-rule-type monetary policy Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

38 Introduction to DSGE Models The State-of-the-Art DSGE Models The model is able to track and forecast 7 macroeconomic time series data very well. GDP consumption investment prices wages employment short-run interest rates Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

39 Introduction to DSGE Models The State-of-the-Art DSGE Models I focus on this popular model because it is widely considered to be the state-of-the-art DSGE model. A version of the Smets-Wouters model is now being used to inform policymaking at the European Central Bank. Hence, new DSGE models that follow approximately this recipe are being formulated and coming into use at central banks around the world. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

40 Introduction to DSGE Models The State-of-the-Art DSGE Models I focus on this popular model because it is widely considered to be the state-of-the-art DSGE model. A version of the Smets-Wouters model is now being used to inform policymaking at the European Central Bank. Hence, new DSGE models that follow approximately this recipe are being formulated and coming into use at central banks around the world. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

41 Introduction to DSGE Models The State-of-the-Art DSGE Models I focus on this popular model because it is widely considered to be the state-of-the-art DSGE model. A version of the Smets-Wouters model is now being used to inform policymaking at the European Central Bank. Hence, new DSGE models that follow approximately this recipe are being formulated and coming into use at central banks around the world. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

42 Part II Critiques on New DSGE Models Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

43 Critiques Critiques on New DSGE Models The critiques I am going to offer are not meant to humiliate the new DSGE models; however, I think that the policymakers should ask hard questions about the value of the model before adopting the new approach. The critiques: Lucas Critique strikes back The shocks are dubiously structural Empirical performance of the model Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

44 Critiques Critiques on New DSGE Models The critiques I am going to offer are not meant to humiliate the new DSGE models; however, I think that the policymakers should ask hard questions about the value of the model before adopting the new approach. The critiques: Lucas Critique strikes back The shocks are dubiously structural Empirical performance of the model Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

45 Critiques Lucas Critique Strikes Back Indeed, the new DSGE models do not have solid micro-foundation. That is, some of the parameters are not deep enough to be immune to the Lucas Critique. The deep parameters are those that do not vary with policy regime changes. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

46 Critiques The Lucas Critique Lots of models in economics can be re-written as y t = x t +be t y t+1, b < 1. By imposing no bubble condition, the solution is y t = b j E t x t+j j=0 Suppose that x t follows a stationary AR(1) process x t = φx t 1 +ε t, φ < 1, ε t i.i.d. (0,σ 2 ) Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

47 Critiques The Lucas Critique Hence, and the model solution is E t x t+j = φ j x t, y t = 1 1 bφ x t. It is called a reduced-form solution. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

48 Critiques The Lucas Critique The structural model is y t = b j E t x t+j j=0 The reduced-form representation y t = 1 1 bφ x t depends on the process for x t with a particular form. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

49 Critiques The Lucas Critique Hence, if the x t process change, the reduced-form process will change. For instance, if the precess changes to x t = ωx t 1 +ε t, the reduced-form representation changes as well: 1 y t = 1 bω x t Robert Lucas pointed out that the reduced-form econometric model based on historical data ŷ t = ˆβx t is useless for policy analysis. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

50 Critiques The Lucas Critique Hence, if the x t process change, the reduced-form process will change. For instance, if the precess changes to x t = ωx t 1 +ε t, the reduced-form representation changes as well: 1 y t = 1 bω x t Robert Lucas pointed out that the reduced-form econometric model based on historical data ŷ t = ˆβx t is useless for policy analysis. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

51 Critiques Lucas Critique Strikes Back Well, what s wrong with the new DSGE models? The new DSGE models generally exogenously impose that firms can only change prices at certain exogenously chosen points in time those points may be stochastic (Calvo pricing) or deterministic (Taylor contracts). These frictions are ad hoc, i.e., no micro-foundation for price stickness is provided. The deep parameters that govern the firms optimal choice to fix the price have not been investigated. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

52 Critiques Lucas Critique Strikes Back Well, what s wrong with the new DSGE models? The new DSGE models generally exogenously impose that firms can only change prices at certain exogenously chosen points in time those points may be stochastic (Calvo pricing) or deterministic (Taylor contracts). These frictions are ad hoc, i.e., no micro-foundation for price stickness is provided. The deep parameters that govern the firms optimal choice to fix the price have not been investigated. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

53 Critiques Lucas Critique Strikes Back Well, what s wrong with the new DSGE models? The new DSGE models generally exogenously impose that firms can only change prices at certain exogenously chosen points in time those points may be stochastic (Calvo pricing) or deterministic (Taylor contracts). These frictions are ad hoc, i.e., no micro-foundation for price stickness is provided. The deep parameters that govern the firms optimal choice to fix the price have not been investigated. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

54 Critiques Lucas Critique Strikes Back Well, what s wrong with the new DSGE models? The new DSGE models generally exogenously impose that firms can only change prices at certain exogenously chosen points in time those points may be stochastic (Calvo pricing) or deterministic (Taylor contracts). These frictions are ad hoc, i.e., no micro-foundation for price stickness is provided. The deep parameters that govern the firms optimal choice to fix the price have not been investigated. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

55 Critiques The Shocks are Dubiously Structural A structural shock must have two properties The shocks must be uncorrelated with policy interventions. The shocks should have an appropriate economic interpretation. Most of the shocks in the new DSGE models: wage markup shocks price markup shocks government spending shocks risk premium shocks fail to meet the above requirements, and are dubiously structural. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

56 Critiques The Shocks are Dubiously Structural A structural shock must have two properties The shocks must be uncorrelated with policy interventions. The shocks should have an appropriate economic interpretation. Most of the shocks in the new DSGE models: wage markup shocks price markup shocks government spending shocks risk premium shocks fail to meet the above requirements, and are dubiously structural. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

57 Critiques The Shocks are Dubiously Structural In particular, wage markup shocks are frequently criticized on the basis that they have different and somewhat conflicted interpretations/policy implications. Wage markup shocks Bargaining power of the labor union (Allocation is inefficient, the optimal policy is to limit the monopoly power) Worker s leisure preference (Allocation is efficient, laissez-faire is optimal) Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

58 Critiques The Shocks are Dubiously Structural Moreover, price markup shocks are not orthogonal to other structural shocks. Price markup shocks Change in tax rate Degree of competition Clearly, these interpretations are affected by economic situations, which are certainly moved by monetary shocks. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

59 Critiques Empirical Evaluation of the Model The good performance (such as matching the AR(1) dynamics of several macroeconomic variables) may be due to the assumption of serially correlated shocks, which is in question. Morley (2010) describes that it is just like the the rabbit and the hat trick : a rabbit was stuffed into the hat and then a rabbit jumped out of the hat. What you put in is what you get out! Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

60 Critiques Empirical Evaluation of the Model The good performance (such as matching the AR(1) dynamics of several macroeconomic variables) may be due to the assumption of serially correlated shocks, which is in question. Morley (2010) describes that it is just like the the rabbit and the hat trick : a rabbit was stuffed into the hat and then a rabbit jumped out of the hat. What you put in is what you get out! Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

61 Critiques Empirical Evaluation of the Model The new DSGE model (i.e., Smets-Wouters medium-scale model) are fit to much smaller set of variables than that of the older macroeconometric models. The forecasting performance should be compared with older macroeconometric models, not the VAR/BVAR models. Variables are linearly detrended. Fail to account for possible unit root and cointegration. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

62 Critiques Empirical Evaluation of the Model The new DSGE model (i.e., Smets-Wouters medium-scale model) are fit to much smaller set of variables than that of the older macroeconometric models. The forecasting performance should be compared with older macroeconometric models, not the VAR/BVAR models. Variables are linearly detrended. Fail to account for possible unit root and cointegration. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

63 Critiques Empirical Evaluation of the Model The new DSGE model (i.e., Smets-Wouters medium-scale model) are fit to much smaller set of variables than that of the older macroeconometric models. The forecasting performance should be compared with older macroeconometric models, not the VAR/BVAR models. Variables are linearly detrended. Fail to account for possible unit root and cointegration. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

64 Critiques Empirical Evaluation of the Model No formal tests such as the Diebold and Mariano (1995) test are conducted for out-of-sample forecasts. Only a small set of variables is chosen to be observable variables (7 of 14). Guerron-Quintana (2010) find that the empirical results are not robust to the selection of observable variables. Using real time data from the US, Edge and Gurkaynak (2010) find that the Smets-Wouters medium-scale DSGE model forecasts inflation and GDP growth poorly. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

65 Critiques Empirical Evaluation of the Model No formal tests such as the Diebold and Mariano (1995) test are conducted for out-of-sample forecasts. Only a small set of variables is chosen to be observable variables (7 of 14). Guerron-Quintana (2010) find that the empirical results are not robust to the selection of observable variables. Using real time data from the US, Edge and Gurkaynak (2010) find that the Smets-Wouters medium-scale DSGE model forecasts inflation and GDP growth poorly. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

66 Critiques Empirical Evaluation of the Model No formal tests such as the Diebold and Mariano (1995) test are conducted for out-of-sample forecasts. Only a small set of variables is chosen to be observable variables (7 of 14). Guerron-Quintana (2010) find that the empirical results are not robust to the selection of observable variables. Using real time data from the US, Edge and Gurkaynak (2010) find that the Smets-Wouters medium-scale DSGE model forecasts inflation and GDP growth poorly. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

67 Part III Perspectives on New DSGE Models Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

68 Perspectives On The Perspectives of DSGE Modeling and Policy Making I will discuss perspectives from which the central bankers can have some ideas about what they should bear in mind when deciding to construct their own DSGE models. The new DSGE models are not yet useful for policy analysis. Inclusion of a more sophisticated financial intermediation sector. Better forecasting. More sensible shocks. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

69 Perspectives On The Perspectives of DSGE Modeling and Policy Making First, as criticized above, the new DSGE models are not yet useful for policy analysis. So do not be frightened and confused by these tedious and fancy mathematical equations. The current new DSGE model is full of dubious structures and features, which may mislead policymaking. Chari, Kehoe, and McGrattan (2009) Faust (2008, 2009) Keep in mind that the success in capturing business cycle dynamics may be simply made up by an implausible framework. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

70 Perspectives On The Perspectives of DSGE Modeling and Policy Making First, as criticized above, the new DSGE models are not yet useful for policy analysis. So do not be frightened and confused by these tedious and fancy mathematical equations. The current new DSGE model is full of dubious structures and features, which may mislead policymaking. Chari, Kehoe, and McGrattan (2009) Faust (2008, 2009) Keep in mind that the success in capturing business cycle dynamics may be simply made up by an implausible framework. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

71 Perspectives On The Perspectives of DSGE Modeling and Policy Making First, as criticized above, the new DSGE models are not yet useful for policy analysis. So do not be frightened and confused by these tedious and fancy mathematical equations. The current new DSGE model is full of dubious structures and features, which may mislead policymaking. Chari, Kehoe, and McGrattan (2009) Faust (2008, 2009) Keep in mind that the success in capturing business cycle dynamics may be simply made up by an implausible framework. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

72 Perspectives On The Perspectives of DSGE Modeling and Policy Making Second, consider the inclusion of a more sophisticated financial markets. For example, Financial vulnerabilities and crisis Collateral constraints and real estate markets Choice of exchange rate regime Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

73 Perspectives On The Perspectives of DSGE Modeling and Policy Making Next, seek for better forecasting of macroeconomic variables. The DSGE model may be useful as a mechanism for generating a prior which aids the estimation of a BVAR: DSGE-VAR, see Del Negro et al. (2004). The DSGE models need to forecast macroeconomic variables out-of-sample well in level (rather than the deviations from steady states) and in real time. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

74 Perspectives On The Perspectives of DSGE Modeling and Policy Making Next, seek for better forecasting of macroeconomic variables. The DSGE model may be useful as a mechanism for generating a prior which aids the estimation of a BVAR: DSGE-VAR, see Del Negro et al. (2004). The DSGE models need to forecast macroeconomic variables out-of-sample well in level (rather than the deviations from steady states) and in real time. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37

75 Perspectives On The Perspectives of DSGE Modeling and Policy Making Finally, all the structural shocks should be sensible. Shocks should have a good interpretation. It s better to assume an i.i.d. shocks. Shiu-Sheng Chen (NTU Econ) DSGE and Policy / 37