An essay on the history of DSGE models∗

Genaro Martı́n Damiani†

arXiv:2409.00812v1 [econ.GN] 1 Sep 2024

Departamento de Economı́a
Universidad Nacional del Sur

September 2024

Abstract
Dynamic Stochastic General Equilibrium (DSGE) models, which are
nowadays a crucial element of the set of quantitative tools that policy-
makers have, did not emerge spontaneously. They rely on previously
established ideas in Economics and relatively recent advancements in
Mathematics. I aim to provide a comprehensive coverage of their history,
starting from the pioneering Neoclassical general equilibrium theories and
eventually reaching the New Neoclassical Synthesis (NNS). I thoroughly
present the mathematical tools involved in formulating a DSGE model. I
claim that this history has a mixed nature rather than an absolutist or
relativist one, that the NNS may have emerged due to the complemen-
tary nature of New Classical and New Keynesian theories, and that the
recent adoption and development of DSGE models by central banks from
different countries has entailed a departure from the goal of building a uni-
versally valid theory that Economics has always had. The latter means
that DSGE modeling has landed not without loss of generality.

Keywords: DSGE models; New Neoclassical Synthesis; Economic Methodol-

ogy.

JEL Classification: B13, B22, B23, B41.

∗I am indebted to F. G. Poinsot and F. A. Tohmé for their valuable suggestions.

† E-mail: [email protected]

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1 Introduction
Economics has always been concerned with providing a theoretical framework
to evaluate the potential outcomes of a policy. Smith, Ricardo, and Mill used
deductive and non-formalized schemes to determine the directions in which each
variable would move.1 Modern economic theory, however, goes beyond just
predicting directions; It attempts to predict the magnitudes of the variations in
each variable that a policy may cause.
Nowadays, Dynamic Stochastic General Equilibrium (DSGE) models are the
standard theoretical framework for quantitative policy-making analyses. First
introduced by Kydland and Prescott (1982), these sophisticated mathematical
formalizations have gained wide acceptance by policy-makers in recent decades.
Furthermore, government institutions, especially central banks, do not only use
DSGE models but also actively develop them.
It would be inaccurate to claim that these models appeared from outer space.
Many of the ideas behind their equations, which have been in continuous evo-
lution (but often at an accelerated pace during economic crises), can be traced
back to the theories of Classical economists, and most of the mathematical tools
on which DSGE models rely are relatively new.
This essay has two goals. Firstly, it aims to outline the history of DSGE
models in the most comprehensive way possible. Secondly, it seeks to analyze
some aspects of this history, elucidating why it has been a mixed evolution and
not an absolutist or relativist one, the potential reasons behind the convergence
towards a New-Neoclassical Synthesis (NNS), and the implications of DSGE
modeling on the methodological principles of Economics.
The manuscript is organized as follows: Section 2 briefly revisits (focusing
on the ideas rather than the models) some of the most relevant Neoclassical,
Keynesian, and monetarist general equilibrium analyses; Section 3 formally in-
troduces the mathematical instruments developed during the twentieth century
that allowed for a transition into dynamic general equilibrium (DGE) models
and eventually into DSGE ones; Section 4 presents the fundamentals of the New
Classical and New Keynesian schools of thought; Section 5 provides some in-
sight into the recent history of DSGE models (RBC models, NNS, usage in the
field of policy-making, and some of the criticism received after the 2008 crash);
and Section 6 offers an analysis of the history as a whole.2
1 Thenumerical examples they give only have illustrative purposes.
2Ibelieve that the works by the Classics can be overlooked for the sake of conciseness,
as their market interconnection ideas materialized in the Neoclassical general equilibrium
theory. In addition, although Keynesian and monetarist models are not often classified as
general equilibrium ones, as they involve at least two markets in which feedback effects are
present, I think they might not be regarded as partial equilibrium models; instead, labeling
them as utterly simplified general equilibrium models might be more appropriate.

2
2 Before DGE models
2.1 The Neoclassical general equilibrium framework
The idea of a general equilibrium was originally thought and formalized by
Walras (1874). He modeled a one-period economy with n competitive, complete,
and interconnected markets on which the agents seek to maximize their welfare.
In the basic version (pure exchange economy), Walras assumes the existence of
a certain number of commodities whose initial endowments are taken as given.
The more complex version (exchange and production economy) forgoes this
assumption, making the outputs of each commodity endogenous and dependent
on the number of units of each input allocated to its production. In both
cases emerges a system of equations for which there is a vector of relative (with
respect to a commodity known as the numeráire) prices such that the excess of
demand in each market is equal to zero, meaning that they are, simultaneously,
in equilibrium. An important conclusion that can be found in Walras’ work is
the holding of the Classical Dichotomy, this is, the idea of money only affecting
nominal variables and not real variables. Other important result is the Walras’
Law, which states that, if n−1 of the n markets are in equilibrium, the remaining
one must also be.
Pareto (1909) enhanced the Walrasian general equilibrium framework. He
developed and incorporated ordinal utility functions, disaggregated subsystems
of equations for each agent, and formulated the notion of Paretian optimality
to provide mathematical proofs of the welfare-maximizing proprieties that a
competitive general equilibrium has.3
As groundbreaking as general equilibrium analysis may seem in retrospect,
initially, it received much less attention than partial equilibrium analysis. It was
not until the appearance of the first Keynesian macroeconomic models (com-
mented in the subsequent subsection) that general equilibrium models began to
gain popularity.
Apart from Walras and Pareto, the Stockholm School of Economics may
have done the most significant works on general equilibrium models during this
period. Wicksell (1893) incorporated Bohm-Bawerk’s ideas about capital into
a general equilibrium framework, building a distribution theory for wages, rent,
and interest. Later (1898), he partially relied on this theory to formulate the
notion of the natural interest rate; deviations from which are associated with
fluctuations in prices that only cease when the market interest rate returns to
its natural level. Cassel’s (1919) general equilibrium model uses a “revealed
demand”4 approach rather than a marginal utility one and studies exchange
and production in the case of a uniformly progressing economy. Perhaps the
3 Pareto’s welfare theorems’ proofs were not strictly correct. Like Walras, he ad-hoc stated

that a unique general equilibrium would exist almost every time we had a system with the
same number of equations as unknowns. However, I believe they are not to blame for this
mistake; they were less fortunate than Arrow and Debreu (1954) or McKenzie (1954, 1959) in
the sense that they did not have any fixed point theorem (presented in the next section) at
hand.
4 This expression is attributed to Samuelson (1993).

3
most widely known general equilibrium model from this school of thought is the
H-O model (Heckscher, 1919; Ohlin, 1924, 1933), which studies how relative
factor abundance determines outputs (both in quantities and composition) and
trade patterns across countries.

2.2 Keynesian Economics and general equilibrium

During the Great Depression, Keynes (1936) attacked the Classical and Neo-
classical theoretical frameworks in a rather unconventional way, as they had
often been criticized due to their generalistic pretensions. He claimed that they
were “applicable to a special case only and not to the general case ... the charac-
teristics of the special case assumed ... happen not to be those of the economic
society in which we actually live” (p. 1). In other words, Keynes criticized the
existing theories for their lack of generality. As suggested by the title of his
book, he was concerned with developing a General Theory, capable of explain-
ing and providing a solution to the ongoing economic crisis.5 To accomplish
this, the author introduced the notions of stickiness in prices and wages, money
illusion, static expectations, marginal efficiency of capital, liquidity preference,
and even more nowadays familiar ideas. With these concepts, he built a theory
whose main claim is that, albeit the economy inevitably oscillates “round an in-
termediate position appreciably below full employment and appreciably above
the minimum employment a decline below which would endanger life” (p. 254),
economic policy has the potential to influence both the mean position and the
patterns (i.e., duration and magnitude) of these fluctuations.
Ironically, Hicks (1937) criticized Keynes’ work on the basis that it lacked
generality. He suggested that “we may call it, if we like, Mr Keynes’ special
theory” (p. 152). Of course, Hicks’ contributions went far beyond a comment.
He developed the first version of the IS-LM model, integrating (mostly) Keyne-
sian and Neoclassical ideas into what he referred to as a “Generalized General
Theory” (p. 156). In this model, the interaction of the investment goods market
and the money market simultaneously determines national income and interest
rates.
There exist other versions of the IS-LM model (varying in complexity and
popularity), all of which serve as examples of Keynesian general equilibrium
models. Early ones include those from Harrod (1937) and Meade (1937). The
simplified versions still taught in undergraduate courses are based on the works
by Modigliani (1944), Samuelson (1948, 1955) and A. H. Hansen (1949, 1953),
often regarded as Neo-Keynesian models.6 Some extensions of the basic IS-LM
model are the two-period IS-LM model (Modigliani, 1944), the AS-AD model
5 Pigou, who was one of the theorists Keynes criticized most, claimed that “Einstein actually

did for Physics what Mr. Keynes believes himself to have done for Economics. He developed a
far-reaching generalisation, under which Newton’s results can be subsumed as a special case”
(1936, p. 115).
6 However, their content is far more Keynesian than Neoclassical. A well-balanced model is

Patinkin’s (1956) one, which builds a Walrasian-like general equilibrium framework simplified
in four markets (labor, consumption goods, money, and bounds), and, in contrast with the
murkiness of the IS-LM models, explicitly uses Walras’ Law to find an equilibrium.

4
(Brownlee, 1950), and the Mundell-Fleming model (Fleming, 1962; Mundell,
1963).
Another well-known (post) Keynesian formulation is the Phillips curve, which
posits a long-term trade-off between inflation and unemployment. In its original
form (Phillips, 1958), it was a partial equilibrium analysis of the labor market
that established a connection between the rate of change in the money wage
and the unemployment rate. However, as discussed in (Samuelson & Solow,
1960), it was quickly reinterpreted in general equilibrium terms by theories of
demand-pull and cost-push, demand-pull, and demand-shift, which hypothe-
sized why the aforementioned relationship between inflation and unemployment
might arise.
A shared feature among these Keynesian general equilibrium models was
the absence of microfoundations. The relationships between aggregate variables
were taken as given instead of explicitly derived from an individual utility-
maximizing framework. These relationships were frequently simplified using
fixed parameters, such as the marginal propensity to consumption. However,
more complex functions could arise, as was often the case with non-transactional
money demand.

2.3 Monetarism and general equilibrium models

Emerging in the 1950s, the ideas of this school of thought were the first objection
to the Keynesian paradigm. One of the innovative elements that made mone-
tarism a formidable challenger was the systematic usage of statistical analysis
to discard incorrect theoretical formulations.
Among their most important contributions are the reinterpretation of the
Fisher’s (1912) quantity equation of money as a money demand curve (Fried-
man, 1956), adaptative expectations (Cagan, 1956), the permanent-income hy-
pothesis (Friedman, 1957), the money multiplier (Brunner, 1961; Brunner &
Meltzer, 1964), and the Non-Accelerating Inflation (or natural) Rate of Unem-
ployment (Friedman, 1968).
In contrast with Keynesians, monetarists believe that prices and wages are
naturally flexible and that any sort of stickiness can only occur due to govern-
ment intervention. In addition, they view the economy as inherently stable,
attributing variations in the quantity of money as the primary cause of unnec-
essary fluctuations in output and employment.
Within the monetarist framework, a long-term trade-off between inflation
and employment cannot exist. Friedman (1968) and Phelps (1967) argue that
high inflation rates can reduce unemployment below its natural rate as long as
the observed inflation remains above its expectation; yet in the long term, ex-
pected inflation converges to its realization, thus motivating workers to demand
higher wages, which ultimately leads back the economy to its natural rate of un-
employment. In other words, monetarism claims that the Classical Dichotomy
between nominal and real variables holds in the long term.
While somewhat skeptical about complex mathematical developments, mon-
etarists formulated various extensions of the IS-LM model (Christ, 1967; Ott

5
& Ott, 1965; Pesek & Saving, 1968; Silber, 1970) and elaborated a few general
equilibrium models (Brunner & Meltzer, 1972; Friedman, 1970, 1971; Silber,
1970). Like the Keynesian ones, they lacked solid microfoundations, which later
became a source of criticism.
Lastly, a common conception between Keynes and Friedman deserves to be
remarked: Both valued and sought generality in their theories. When comment-
ing on Marshallian theory, Friedman asserted that “it would be highly desirable
to have a more general theory ... one that would cover ... both those cases in
which differentiation of product or fewness of numbers makes an essential dif-
ference and those in which it does not” (1953, p. 38). Moreover, the quote for
which Friedman is most known, even among non-academic people, reflects the
generality that his theory attempted to have: Inflation is always and everywhere
a monetary phenomenon.7

3 New mathematical methods, new models

3.1 Fixed point theorems
Fixed point theorems have been essential for modern economic modeling as
they allow economists to provide a rigorous proof of equilibrium existence when
dealing with complex models.
So, in this subsection, I present Brouwer’s (1911), Banach’s (1922), Schauder’s
(1930), and Kakutani’s (1941) fixed point theorems. These are the most fre-
quently utilized in general equilibrium, DGE, and DSGE models.8

Theorem 1 Brouwer’s fixed point theorem: Let S be a nonempty, com-

pact, and convex subset of a finite-dimensional normed linear space. For every
continuous function f : S → S, there exists x ∈ S such that f (x) = x.

Theorem 2 Banach’s fixed point theorem: Let X be a complete metric

space. For every contraction mapping f : X → X, there exists a unique x ∈ X
such that f (x) = x.

Theorem 3 Schauder’s fixed point theorem: Let S be a nonempty, com-

pact, and convex subset of a normed linear space. For every continuous function
f : S → S, there exists x ∈ S such that f (x) = x.

Theorem 4 Kakutani’s Fixed point theorem: Let S be a nonempty, com-

pact, and convex subset of a finite-dimensional normed linear space. For every
closed, convex-valued correspondence φ : S ⇒ S, there exists x ∈ S such that
φ(x) = x.
7 Italics are mine.
8 If interested in proofs, unfamiliar with certain concepts, or both, see Carter (2001).

6
3.2 Modern optimization theory
During the mid-twentieth century, new developments emerged in the field of op-
timization theory. These works have allowed for dynamic microfounded frame-
works (i.e., based on intertemporal maximization of utility or profits) in eco-
nomic models. In this subsection, I shall present Pontryagin’s Maximum Prin-
ciple (Pontryagin, 1962), and dynamic programming (Bellman, 1954, 1957).9
The presentation of the former is based on Intriligator (2002), while the latter
follows Ljungqvist and Sargent (2000).

3.2.1 Pontryagin’s Maximum Principle

Let t ∈ [t0 , t1 ] be a continuum of time, where t0 is the initial time and t1 is
the terminal time (it might be infinite). Let xt = (x1t , x2t , ..., xnt ) ∈ Rn be the
vector of state variables at any time t, living in the euclidean space E n . Let
ut = (u1t , u2t , ..., urt ) ∈ Rr be the vector of feasible control variables at any
time t, living in the convex and compact subset U of the euclidean space E r .
Starting at the initial state x0 and ending at the terminal state x1 , the
state trajectory can be defined as a sequence {xt } = {xt ∈ E n : t0 ≤ t ≤ t1 }
that is a continuous function of time. The control trajectory is a sequence
{ut } = {ut ∈ U : t0 ≤ t ≤ t1 }, which is assumed to be a piece-wise continuous
function of time.
The objective functional is a mapping from control trajectories to real num-
bers that takes the form:
Z t1
max J = I (x, u) dt + F (x1 )
{ut } t0

s. t.
ẋ = f (x, u) , x0 given, x1 given, {ut } ∈ U,
where I(x, u) is the intermediate function, F (x1 ) is the final function, and ẋ =
f (x, u) is the equation of motion, all of which are assumed to be continuously
differentiable.
Note that the equation of motion consists of n differential equations that
provide the time rate of change of the state variable. We can define an n-
dimensional vector of costate variables y (one corresponding to each differential
equation) that can be thought of as a set of dynamic Lagrange multipliers.
Provided they are nonzero continuous functions of time, the Lagrangian of the
problem is:
Z t1
L= {I (x, u) + y [f (x, u)] − ẋ} dt + F (x1 ) .
t0
9 I will not show Karush-Kuhn-Tucker optimization (Karush, 1939; Kuhn & Tucker, 1951),

as it is mostly used for finite time horizon models that will not be formally presented in this
essay.

7
Doing some manipulations, we can get:
Z t1
L= {H (x, u, y) − ẏx} dt + F (x1 ) − y1 x1 − y0 x0 ,
t0

where H(x, u, y) = I(x, u) + y[f (x, u)] is the Hamiltonian.

If the control trajectory changes from {ut } to {ut + ∆ut }, which implies a
change in the state trajectory from {xt } to {xt + ∆xt }, in an optimum, the
following condition must be held:
Z t1      
∂H ∂H ∂F
∆L = ∆u + + ẏ ∆x dt + − y1 ∆x1 = 0.
t0 ∂u ∂x ∂x1

Therefore, the necessary conditions for a maximum are:

∂H ∂H ∂F
= 0, ẏ = − , y1 = .
∂u ∂x ∂x1

We can combine the former two. Considering that ∂H/∂u = ∂I/∂u+y(∂f /∂u)
and deriving with respect to time, the first necessary condition can be re-
expressed as:    
d ∂I ∂f d ∂f
+ ẏ +y = 0.
dt ∂u ∂u dt ∂u
Replacing with ∂H/∂x = ∂I/∂x + y(∂f /∂x) in the second necessary condition
yields:  
∂I ∂f
ẏ = − +y
∂x ∂x
Combining these new expressions results in the Euler equation:
     
d ∂I ∂I ∂f ∂f d ∂f
− +y +y = 0.
dt ∂u ∂x ∂x ∂u dt ∂u
Regarding the last of the necessary conditions, it can be written way more
elegantly in what is known as the transversality condition:

lim yt ⊤ xt = 0.
t→t1

3.2.2 Dynamic programming

I will first show the deterministic version and then the stochastic version as an
extension. Let xt ∈ X be the vector of state variables at period t, where X is
a complete metric space. Let ut ∈ U be the k-dimensional vector of feasible
controls at period t, where U is a non-empty, compact, and convex subset of Rk .
Define f (xt , ut ) as a real-valued one-period return function r(xt , ut ) for which
continuity, concavity, and boundedness are assumed. Define xt+1 = g(xt , ut ) as
the transition equation (or the law of motion) and assume that g : X × U → X
is continuous.

8
 Starting in t = 0 from any x0 ∈ X given, we have to find a time-invariant
policy function h : xt → ut such that the infinite sequence of controls {ut }
generated by iterating in utP = h(xt ) and xt+1 = g(xt , ut ) maximizes the infinite
∞
sum of discounted returns t=0 β t r(xt , ut ), where 0 < β < 1.
In order to find h(xt ), it is necessary to define a value function v(x0 ) that
represents the optimal value of the problem when starting from any arbitrary
x0 ∈ X. We can express this function as:
n
X
v (x0 ) = max
∞
β t r (xt , ut ) s. t. xt+1 = g (xt , ut ) , x0 given.
{ut }t=0
t=0

The first decision can be considered separately from the future ones, yielding:
( " n
#)
X
v (x0 ) = max r (x0 , u0 ) + β max ∞
β t r (xt , ut )
u0 {ut }t=1
t=1

subject to xt+1 = g(xt , ut ), x0 given. Note that the term in square brackets
is equal to the optimal value of the decision problem in t = 1 starting from
x1 = g(x0 , u0 ). Replacing with v[g(x0 , u0 )] results in the Bellman equation:

v (x0 ) = max{r (x0 , u0 ) + βv [g (x0 , u0 )]}.

u0

It can be expressed fancier by dropping the time subscripts:

v (x) = max{r (x, u) + βv [g (x, u)]}.

u

The unique solution for the functional equation is a concave function. The
sketch10 of the proof goes as follows: The operator

T v = max{r (x, u) + βv [g (x, u)]}

u

maps a continuous bounded function v into a continuous bounded function T v.

As T satisfies monotonicity and discounting, it meets Blackwell’s (1965) suffi-
cient conditions to be a contraction mapping. Since X is a complete metric
space, by Banach’s theorem, v = T v (another form of expressing the functional
equation) has a unique fixed point in X. In addition, T maps concave func-
tions into concave functions. Therefore, the solution obtained for the functional
equation is a concave function.
Starting from any bounded and continuous v0 , the solution can be ap-
proached in the limit (j → ∞) by iterating on

vj+1 (x) = max{r (x, u) + βvj [g (x, u)]},

u

which yields an optimal time-invariant policy function ut ∗ = h(x∗t ).

10 See Stokey and Lucas (1989) for a complete proof.

9
 As proven by Benveniste and Scheinkman (1979), v turns out to be differ-
entiable off corners. Let x = xt and u = ut . The first-order condition can be
written as:

∂r (xt , ut ) ∂g (xt , ut )
+ β∇v (xt+1 ) = 0.
∂ut ∂ut
In addition, we have the envelope condition:
∂r (xt , ut ) ∂g (xt , ut )
∇v (xt ) = + β∇v (xt+1 ) .
∂xt ∂xt
Forwarding it one period, assuming ∂g(xt , ut )/∂xt = 0, and substituting in the
fist-order condition, we obtain the Euler equation:

∂r (xt , ut ) ∂r (xt+1 , ut+1 ) ∂g (xt , ut )

+β = 0.
∂ut ∂xt+1 ∂ut
Now, I will briefly present stochastic dynamic programming. Assume that
the transition equation is given by xt+1 = g(xt , ut , et+1 ), where et is a vector
of i.i.d. random variables. As et+1 is realized at t+1 (this is, after ut is chosen),
any state beyond xt is unknown at period t. Therefore, the problem becomes:
" n #
X
t
v (x0 ) = max ∞
E β r (xt , ut ) | x0
{ut }t=0
t=0

s. t.
xt+1 = g (xt , ut , et+1 ) , x0 given.
The stochastic Bellman equation is:

v (x) = max{r (x, u) + βE {v [g (x, u, e)] | x}}.

u

Again, there is a unique concave solution to the functional equation (the previous
proof sketch is still valid). In this case, however, we have a contingency plan
ut = h(xt ). It can be approached (starting from any bounded and continuous
v0 ) by iterating on:

vj+1 (x) = max{r (x, u) + βE {vj [g (x, u, e)] | x}}.

u

The first-order condition for this stochastic dynamic programming setting can
be expressed as:
 
∂r(xt , ut ) ∂g (xt , ut , et+1 )
+ βE ∇v (xt+1 ) | xt = 0.
∂ut ∂ut
Our envelope condition is:
 
∂r (xt , ut ) ∂g (xt , ut , et+1 )
∇v(xt ) = + βE ∇v (xt+1 ) | xt .
∂x ∂x

10
After assuming ∂g(xt , ut )/∂xt = 0, combining them yields the stochastic Euler
equation:
 
∂r (xt , ut ) ∂r (xt+1 , ut+1 ) ∂g (xt , ut , et+1 )
+ βE | xt = 0.
∂u ∂x ∂u

3.3 Equilibrium characterization in the absence of a closed

solution
When dealing with complex models, as a closed solution is nonexistent, we
often have to rely on other methods in order to solve them. A frequently utilized
approach, especially by the first DSGE models, is to characterize the equilibrium
based on its Pareto optimality proprieties, as posited by Debreu (1954). The
presentation of this method follows Stokey and Lucas (1989).
Let S be a normed linear space. There are I consumers, indexed by i =
1, 2, ..., I. Consumer i has a set of available commodity consumption choices
Xi ∈ S. The preferences of this consumer are represented by a utility function
ui : Xi → R. There are J firms, indexed by j = 1, 2, ..., J. Firm j has a set of
technological possibilities Yj ∈ S. This firm evaluates them based on the total
profits yielded by each alternative.
An allocation (x, y), where x = (x1 , x2 , ..., xI ) and y = (y1 , y2 , ..., yI ), de-
scribes the consumption choice of each consumer and the production choice of
each firm. An allocation is feasible if xi ∈ X for all i, yj ∈ Yj for all j, and
PI PJ
i=1 xi − j=1 yi = 0.
We say that an allocation is Pareto optimal if it is feasible and if there is
no other feasible allocation such that ui (x′i ) ≥ ui (xi ) ∀i and ui (x′i ) > ui (xi ) for
some i. A price system is defined as a continuous linear functional ϕ : S → R. A
competitive equilibrium [(x, y), ϕ] is an allocation together with a price system
such that (x, y) is feasible, x ∈ Xi and ϕ(x) ≤ ϕ(x0i ) implies ui (x) ≤ ui (x0i ) for
all i, and y ∈ Yj implies ϕ(y) ≤ ϕ(yj0 ) for all j.
Now, consider these assumptions:

* Xi is convex for all i.

* ui : Xi → R is continuous.
* For each i, if x, x′ ∈ Xi , ui (x) > ui (x′ ), and θ ∈ (0, 1), then we have
ui [θx + (1 − θ)x′ > ui (x′ )].
PJ
* The set Y = j=1 yj is convex.
* Either the set Y has an interior point or S is finite dimensional.

* For each i and each x ∈ Xi , there exists a sequence {xn } in Xi converging

to x such that ϕ(xn ) < ϕ(x) for all n.

11
If they hold, then every competitive equilibrium is Pareto optimal and vice
versa.11 In Section 5.1, it will be shown how a DSGE model can be solved using
this method.

4 New Classical and New Keynesian Economics

4.1 The state-of-the-art in the late 1960s
Before delving into the New Classical and New Keynesian schools of thought, I
believe it is a good idea to present a DGE model from immediately before their
emergence. Sidrauski’s (1967) model, built upon the Ramsey-Cass-Koopmans
model (Cass, 1965; Koopmans, 1965; Ramsey, 1928), offers a good portrait.
Assume a representative economic unit whose preferences are represented by
the strictly concave C 2 instantaneous utility function Ut = U (ct , mt ), where ct
and mt denote real consumption and real cash balances at time t, respectively.
The latter is given by mt = Mt /pt Nt , where Mt is the nominal cash balance,
pt is the nominal price of the homogeneous output, and Nt is the number of
individuals in the economic unit.
The functional constraints are:

at = kt + mt ,

y(kt ) + vt = ct + st ,
st = it + xt ,
it = k̇t + (δ + n) kt ,
and
xt = ṁt + (πt + n) mt ,
where at is the total endowment of nonhuman wealth (a0 is assumed to be given),
kt is the capital stock, y(kt ) is homogeneous output, st are gross real savings,
it is gross capital accumulation, xt is the gross addition to the holdings of real
cash balances, k̇t is the net addition to the capital stock, δ is the instantaneous
rate of capital depreciation, n is instantaneous rate of growth of the number of
individuals in the economic unit, and π is the expected rate of changes in prices.
With some operations, they can be summarized in a stock constraint at =
kt + mt and a flow constraint ȧt = y(kt ) + vt − (πt + n)mt − (δ + n)kt − ct .
Denote ρ > 0 as the subjective rate of time preference of the economic unit,
λt as the Lagrange multiplier attached to the flow constraint, and qt as the
Lagrange multiplier attached to the stock constraint. The Hamiltonian of this
problem can be written as: Z ∞
{U (ct , mt )
0
11 The proof of this statement, which is beyond the scope of this brief presentation, requires

an application of the Hahn-Banach theorem (another relatively new mathematical tool).

12
+ λt [y (kt ) + vt − (πt + n) mt − (δ + n) kt − ct ȧt ] + qt (at − kt − mt )}e−ρt dt.
We have the following Euler equations:
∂U (ct , mt )
= λt ,
∂ct
∂U (ct , mt )
= λt (πt , qt /λt + n) ,
∂mt
dy
− (δ + n) = qt /λt ,
dk
and
λ˙t /λt = ρ − qt /λt .
Regarding the transversality condition, it can be expressed as:
lim at λt e−ρt = 0.
t→∞

From these optimality conditions, we can derive demand functions for consump-
tion, real cash balances, and capital:

c = c (a, π, v) , m = m (a, π, v) , k = k (a, π, v) .

Now, consider adaptative expectations of the form π̇ = b(ṗ/p − π), where
b > 0. In addition, assume that the money supply grows at a constant rate
θ = Ṁ /M , the population grows at a constant rate n = Ṅ /N , and each eco-
nomic unit receives the same amount of net transfers (v = θm). With these
assumptions, we can express the aggregate demands for consumption and real
cash balances as ĉ = (k, θ, π) and m̂ = (k, θ, π), respectively.
In an equilibrium growth path, at any time, the money market satisfies the
condition
M/pN = m̂ (k, θ, π) ,
the rate of change in the capital stock is given by
k̇ = y (k) − ĉ (k, θ, π) − (δ + n) k,
and the expected inflation rate is
θ − π − n − [y (k) − ĉ (k, θ, π) − (δ + n) k]
π̇ = .
1 + b (∂ ṁ/∂π) (1/ṁ)
With these equations, we finally obtain a steady state k̇ = π̇ = 0 that reflect
the Classical Dichotomy:
c∗ = y (k ∗ ) − (δ + n) k ∗ , π ∗ = θ − n.
As this model shows, immediately before the Rational Expectations revo-
lution, intertemporal microfoundations were already embedded in the body of
macroeconomic theory. However, there was a significant flaw in models of this
kind: The implicit assumption that agents make optimal decisions over a set
of feasible infinite-horizon plans while processing information using a rule of
thumb such as adaptative expectations. Fortunately, rational expectations were
just around the corner.

13
4.2 The New Classicals and the Rational Expectations
Revolution
This school of thought emerged during the early 1970s in the context of a sup-
ply crisis for which solid explanations were unavailable. The New Classical
economists were mainly concerned with providing plausible explanations for
economic cycles, developing a framework that contemplates intertemporal util-
ity maximization, competitive yet incomplete information markets, and rational
expectations to accomplish it.12
The latter, although not their original development, has been their hallmark.
In the words of its creator, John Muth, this concept means that “the subjective
probability distribution of outcomes ... tend to be distributed, for the same
information set, about ... the objective probability distribution of outcomes”
(1961, p. 316). This implies that agents make use of the available information
in the most efficient way possible in order to forecast the future values of the
relevant variables.
In all likelihood, the most emblematic model from this school of thought
is the Lucas’ (1972, 1973, 1975) islands model. We have an economy with i =
1, 2, ..., n islands. Each representative agent on island i produces a homogeneous
commodity Yit using only its labor Lit , so that Yit = Lit . The instantaneous
utility functions is U (Cit , Lit ) = Cit −L1+γ
it /(1+γ), where Cit is the consumption
of agent i at period t and γ is the disutility of working. Under the assumption of
no investment opportunities, the budget constraint is given by (Pit /Pt )yit = Cit ,
where Pit is the price of commodity i at period t and Pt is the (unknown) price
level at period t. For the sake of simplicity, certainty-equivalence behavior is
assumed. We have to maximize
∞
" #
Yit1+γ

X
t Pit
Et β Yit − .
t=0
Pt 1+γ

In this simplified version, the first-order condition is:

 1/γ
Pit
Yit = .
Pt
Using lowercase letters to denote logarithms of the corresponding uppercase
variables, we have the supply function:
s rit
yit = ,
γ
where rit = pit − pt . As said before, pt is unknown, so rit has to be estimated
conditional on the observation of pit . Mathematically:

s 1
yit = E [rit | pit ] .
γ
12 In general, incomplete information is modeled considering homogeneous commodity or

factor markets composed of different uncommunicated islands (Phelps, 1969).

14
 Now, define the aggregate demand (in logarithms) as ytd = mt − pt , where
mt is the money supply at period t. It is assumed that the demand for good i
at period t is given by
d
yit = (mt − pt ) + zit − η (pit − pt ) , η > 0,

where zit is the good-specific demand shock at period t. Provided that pt and
rit are normally and independently distributed, as pit = pt + rit , the latter is
also normal. Furthermore, E[rit | pit ] becomes a linear function of the form:

σr2
E [rit | pit ] = E [rit ] + (pit − E [pt ]) .
σr2 + σp2

Since this model is symmetric, E [rit ] = 0 must be satisfied for all i = 1, 2, ..., n.
Therefore:
σ2
E [rit | pit ] = 2 r 2 (pit − E [pt ]) .
σr + σp
The supply curve for agent i at period t becomes:

s 1 σr2
yit = θ (pit − E [pt ]) , θ= .
γ σr2 + σp2

Assuming that both prices and output are equal to their mean in the aggre-
gate, after averaging across producers, we obtain:

yts = θ (pt − E [p]) .

Recalling that the aggregate demand is given by ytd = mt − pt , in equilibrium:

1 θ θ θ
pt = mt + E [pt ] , yt = mt − E [pt ] .
1+θ 1+θ 1+θ 1+θ
Taking expectations in the equation of prices leads to the conclusion that E[pt ] =
E[mt ]. Employing the mathematical artifice mt = E[mt ] + (mt − E[mt ]), the
equilibrium of this economy is described by:
1 θ
pt = E [mt ] + (mt − E [mt ]) , yt = (mt − E [mt ]) .
1+θ 1+θ
The observed component of aggregate demand, E[mt ], has only nominal effects,
while its unobserved component, E[mt ] − mt , may have real effects. If there is a
higher realization of mt given its distribution, output will increase in the short
term. However, if there is an upward shift in the distribution of mt but the
realization of mt − E[mt ] is the same, the output level will not be affected. In
other words, only unexpected changes in monetary policy can cause fluctuations
in output around its natural value, which is equal to 1 (or 0 in logarithms) in
this simplified version.
To summarize, in this model, economic cycles are caused by unanticipated
changes in the money supply. Due to imperfect information, agents may not

15
tell whether the product they sell has experienced a real or a nominal shift in
demand. If the former is perceived to have changed, temporary oscillations in
output around its natural trend will occur, at least during the narrow window
of time that agents with rational expectations need in order to realize they
were mistaken. Note that involuntary unemployment cannot exist within this
framework (not even during the trough of an economic cycle), as the unemployed
agents are those who choose not to work at the current price of output.
The works by this group of authors do not stop there. A pioneering stochastic
partial equilibrium analysis of the labor market that studies the phenomenon of
(voluntary) unemployment in further detail can be found in Lucas and Prescott
(1974). Regarding fiscal policy, Barro (1974, 1979) formalized the concept of
Ricardian Equivalence under the assumption of ultrarrationality 13 , showing that
a fiscal expansion financed by debt has no real effects, even in the short run, as
agents are aware that it will lead to heavier tax duties in the future and conse-
quently tend to save more in the present to prepare for the future implications
of the policy.
In terms of policy-making, two main developments from the New Classical
economists ought to be highlighted.14 The first one is the Lucas’ (1976) critique,
which posits that non-microfounded models cannot accurately evaluate the out-
comes of any policy because they only rely on superficial parameters estimated
from historical data, failing to account for changes in agents’ expectations and
behavior that result from any policy. The other one is the concept of a time
inconsistency introduced by Kydland and Prescott (1977), which suggests that
discretionary policy might not achieve its purposes because agents with rational
expectations understand that, once their decisions have been taken, the policy-
maker has an incentive to deviate from its announcements, making this kind of
policy non-credible, ineffective, and normatively less desirable than strict rules.

4.3 The New Keynesian reply

New Keynesian Economics emerged in the late 1970s after the rational expec-
tations revolution amid macroeconomic instability. While sharing many of the
methodological foundations of the New Classicals, it is a New Keynesian belief
that monetary and fiscal policy might have a significant role as stabilization
tools due to wage stickiness, price stickiness, and imperfect competition.
The early works from this school of thought (Fischer, 1977; Phelps & Taylor,
1977; Taylor, 1979, 1980) showed, using partially microfounded models, that
monetary policy can have a non-ephemeral influence on the economy even in
the presence of rational expectations.
Fischer’s model is great for exposition purposes. Assume that labor contracts
are drawn up to maintain the real wage constant for two periods. More precisely,
wt−i = Et−i [pt ], i = 1, 2, where wt−i denotes the nominal wage accorded at
13 Roughly speaking, this notion implies that the households are fully aware of the govern-

ment’s intertemporal budget constraint.

14 Three if we consider the remarkable work by Sargent and Wallace (1975).

16
period t − i that will remain at period t and Et−i [pt ] is the expectation of the
log-price level pt at period t − i.
On the supply side, during period t, half the firms operate in the first year
of a labor contract signed at t − 1, while the other half, in the second year of a
labor contract signed t − 2. The aggregate supply of output is assumed to be
given by:
2 2
1X 1X
yts = (pt − wt−i ) + vt = (pt − Et−i [pt ]) + vt ,
2 i=1 2 i=1

where vt is an AR-1 process vt = ρ1 vt−1 + ϵt (it is assumed that ϵt an i.i.d. error

with expectation equal to zero).
Aggregate demand takes the form

ytd = mt − pt − zt ,

where mt is the logarithm of the money supply and zt is an AR-1 process

zt = ρ2 zt−1 + ξt (we again assume that ξt is an i.i.d. error with mean zero).
In this model, the rational expectations of pt at each period can be expressed
as follows:
Et−2 [pt ] = Et−2 [mt ] − Et−2 [(zt + vt )]
and
2 1 1 2
Et−1 [pt ] = Et−1 [mt ] + Et−2 [mt ] − Et−2 [(zt + vt )] − Et−1 [(zt + vt )] .
3 3 3 3
At this point, assume a money supply rule mt = avt−1 + bzt−1 , where a and
b are parameters fixed by the central bank. As all the disturbances are observed
at period t − 1, there is no difficulty for the public in calculating the money
supply at period t, hence Et−1 [mt ] = mt . However, at period t − 2, we have
Et−2 [mt ] = aρ1 vt−2 + bρ2 zt−2 .
Having made all these assumptions, we can obtain the output level of this
economy:
1 1
yt = (ϵt + ξt ) [ϵt−1 (a + 2ρ1 ) + ξt−1 (b − ρ2 )] + ρ21 vt−2
2 3
and its asymptotic variance

ρ41
   
2 2 1 4 2 a (4ρ1 + a) 2 1 1 2 b (2ρ2 − b)
σy = σϵ + ρ + + + σξ + ρ − .
4 9 1 1 − ρ21 9 4 9 2 9

The conclusion of this model is that, although monetary policy cannot affect the
output level in the long term (ϵt−1 = ξt−1 = 0), in the short and the medium
run, it can affect its variance. This is due to the existence of nominal rigidities.
In the case of this model, the central bank minimizes σy2 by setting a = −2ρ1
and b = ρ2 ).

17
 The main critique this model received is that it does not explain how wage
stickiness emerges as a result of intertemporal optimizing behavior. However,
New Keynesian Economics offers three groups of microfounded explanations
for this phenomenon (Fischer took the first one for granted): Implicit con-
tracts (Azariadis, 1975; Baily, 1974; Gordon, 1976), efficiency wages (Shapiro &
Stiglitz, 1984; Solow, 1979), and the existence of insiders and outsiders (Lind-
beck & Snower, 1986, 1988).
Regarding price stickiness, the existence of menu costs is the main explana-
tion provided by the New Keynesians.15 There are two well-known models of
staggered prices, both of which are widely used in DSGE modeling.
The first one is Rotemberg’s (1982) model. At any period t, there is a price-
setting firm facing a trade-off between the cost of changing prices and the cost of
deviations from the optimal long-run price p∗t . The intertemporal cost function
this firm seeks to minimize can be written as
∞ h i
X
2 2
Et α p∗t+s − pt+s + (∆pt+s ) .
s=0

In s = 0, by the first-order condition:

α β
∆pt = α (p∗t − pt ) + βEt ∆pt+1 =⇒ πt = (p∗ − pt−1 ) + Et πt+1 .
1+α t 1+α
The other model is known as Calvo pricing (1983). At any period t, each
firm can adjust their prices with probability ρ (so, 1 − ρ is the probability of
being unable to). The probability of the price remaining at pt during period
t + s is (1 − ρ)s . When firms adjust their prices, they set pt so as to minimize
the cost of deviations from the optimal price p∗t . Their cost function is:
∞
1X s  2
γ Et pt − p∗t+s ,
2 s=0

where γ = β(1 − ρ). The first-order condition of this problem can be written as:
∞
X
γ s Et p∗t+s .
 
pt = (1 − γ)
s=0

The general price level is given by:

∞
X
pt = ρp∗t + (1 − ρ) pt−1 = ρ (1 − γ) γ s Et p∗t+s + (1 − ρ) pt−1 .
 
s=0

Lastly, the inflation rate of this economy is:

∞
X  ρ (1 − γ) ∗ γ
γ s Et p∗t+s − pt−1 =

πt = ρ (1 − γ) (pt − pt−1 ) + Et [πt+1 ] .
s=0
1 − ργ 1 − ργ
15 This idea was originally developed by Sheshinski and Weiss (1977).

18
This pricing mechanism, either in the basic version here presented or with some
extensions16 , is the most common pricing mechanism utilized in DSGE model-
ing.
The other significant contribution from this school of thought are the imper-
fect competition models (Akerlof & Yellen, 1985a, 1985b; Blanchard & Kiyotaki,
1987; Hart, 1979, 1982; Mankiw, 1985, 1988; Svensson, 1986). Mankiw’s 1988
model of monopolistic competition, despite being static and not based on the
typical Dixit and Stiglitz (1977) framework, offers a good overview of what these
models are, especially in terms of their implications for fiscal policy.17
Assume a representative agent whose utility function can be expressed as
U = α ln C + (1 − α) ln l, where C is the consumption of a homogeneous good, l
is leisure (the numeráire of this economy), and α ∈ (0, 1). Given the endowment
of time ω, the labor income is ω − l. Total net income is given by ω − l + π − T ,
where π denotes profits and T is a lump-sum tax. The agent’s budget constraint
is P C + l = ω + π − T , where P indicates the price of the consumption good.
Although this is not so New Keynesian, Gregory Mankiw assumes that the
labor market clears. This allows for the application of Walras’ Law; in other
words, all we have to do is find the equilibrium of the commodity market.
On the demand side, solving the consumer’s problem
max {α ln C + (1 − α) ln l} , s. t. PC + l = ω + π − T
C

yields the solution P C = α(ω + π − T ). Regarding the government, it has a

budget constraint T = G + W , where G represents its spending on output and
W is its spending on government workers’ wages. The total expenditure in the
homogeneous commodity is the sum of the consumer’s and the government’s
demands. In other words, Y = P C + G, or alternatively, Y = α(ω + π − T ).
On the supply side, there are n identical firms. The industry’s total output
is denoted as Q. As total expenditure is taken as given, Q = Y /P is the demand
function of the industry. The cost function of each firm is F + cQ, where F
is overhead labor and c is the labor-to-output ratio. The firms engage in an
oligopoly game, from which their profit margin µ = (P − c)/P is determined.
In the short term, as n is fixed, so is µ.
The total profits are equal to π = P Q − nF − cQ, or, what is equivalent,
π = µY − nF . By replacing in the aggregate demand equation, we obtain the
expression Y = α(ω + µY − nF − T ) + G. Solving for Y :
α (ω − nF − T ) + G
Y = .
1 − αµ
From this expression, we can derive the government purchases multiplier and
the tax multiplier, respectively:
∂Y 1 ∂Y −α
= , = .
∂G 1 − αµ ∂T 1 − αµ
16 SeeYun (1996) and Galı́ and Gertler (1999).
17 Theimplications of imperfect competition for monetary policy will be discussed in Section
5.2, where Ireland’s (2004) NNS model is presented.

19
Note that imperfect competition (µ > 0) is required for a traditional Keynesian
multiplier (this is, greater than the unit). In the long term, even without con-
sidering the budget constraint, a traditional Keynesian multiplier will not exist
because the entry of new firms will make µ equal to zero.
Combining both multipliers, the balanced budget multiplier (∆G = ∆T )
can be obtained:
1−α
.
1 − αµ
In the short term, the mechanism behind this multiplier is the following: The
initial net increase in expenditure, (1 − α)∆G, raises profits by µ(1 − α)∆G,
which in turn raises expenditure by αµ(1 − α)∆G, and so on.

5 DSGE Models
After revisiting the fundamentals of the New Classicals and the New Keynesians,
we can move on to DSGE models. While not presented here, the works by Lucas
and Prescott (1971) and Brock and Mirman (1972) are examples of stochastic
models from the previous decade that preluded what is covered in this section.

5.1 RBC models

Emerging during the early 1980s, in terms of assumptions, DSGE models built
by the Real Business Cycles (RBC) have many things in common with the New
Classical DGE models.18 In consequence, the RBC school authors are often re-
garded as a second wave of New Classical economists. However, there are some
nuances in the assumptions, as a result of which they arrive to different conclu-
sions. The most important of these nuances is that RBC models incorporate
stochastic shocks to technology, accounting for economic fluctuations that are
not caused by the government.19
In the realm of non-monetary RBC models, the most noteworthy are those
from Kydland and Prescott (1982), Long and Plosser (1983), G. D. Hansen
(1985), and Prescott (1986). Their fundamental premise is that agents cannot
fully distinguish between temporary and permanent technology shocks. In re-
sponse to a positive shock that is perceived as temporary, current investment
and working hours increase, leading to higher consumption of goods and leisure
in the future when the shock subsides and productivity returns to normal lev-
els. Economic cycles are driven by exogenous technological shocks rather than
government policy. Indeed, these models do not even include a government! In
what follows, I briefly show Prescott’s (1986) model:
At any period t, the output level Yt is determined by the production function
Yt = At f (Kt , Lt ), where Yt represents output, At is technology, Kt is capital,
18 While not revisited here, the works by Lucas and Prescott (1971) and Brock and Mirman

(1972) are examples of stochastic models from the previous decade.

19 Technological innovations are said to be the main cause behind these shocks, which is

indeed an idea Schumpeter (1939) put forward several decades before.

20
and Lt is labor. Constant returns to scale are assumed. Technology follows an
AR-1 process given by At = ρAt−1 + ϵt , where ϵt is an i.i.d. random error and
ρ ≈ 1. The prices of capital and labor are equilibrium time-invariant functions of
the economy’s state (At , Kt ), which means rt = r(At , Kt ) and wt = w(At , Kt ),
respectively. These pricing functions are known to all agents.
This model has a representative household who owns both capital and labor
endowments. The household has one unit of time each period, to be allocated
between work Lt and leisure lt such that Lt + lt = 1. The household’s income is
assigned in its totality between consumption Ct and investment Xt , subject to
the budget constraint Xt + Ct = wt Lt + rt Kt and the law of motion of capital
Kt+1 = (1 − δ)Kt + Xt , where δ is the depreciation rate. Assuming a C 2 strictly
concave instantaneous utility function U (Ct , lt ), the household’s optimization
problem is
X∞
max Et β t U (Ct , lt )
Ct ,lt
t=0

Xt + Ct = wt Lt + rt Kt , Kt+1 = (1 − δ) Kt + Xt , Lt + lt = 1.

The solution consists of two policy functions C(At , Kt ), l(At , Lt ), from which
and X(At , Kt ) and L(At , Kt ) can be derived.
The optimization problem of the representative firm is straightforward. It
can be expressed as:

max = At f (Kt , Lt ) − rt Kt − wt Lt .
Kt ,Lt

Solving it yields two policy functions K(At , Kt ) and L(At , Kt ) that allow for
the derivation of Y (At , Kt ).
Even this relatively simplified DSGE model lacks a closed solution.20 What
can be done, is to characterize the Pareto-optimal equilibrium using Debreu’s
results. The household’s policy functions will be optimal, given the pricing
functions and the law of motion of capital. The firm’s policy functions will also
be optimal, given the pricing functions. There will be spot market clearance, so
that Lt = L(At , Kt ), Kt = K(At , Kt ), and Xt (At , Kt )+C(At , Kt ) = Y (At , Kt ).
Furthermore, we will have a rational expectations equilibrium, which means that
Kt+1 = (1 − δ)Kt + X(At , Kt ).
Regarding RBC monetary models, the works by King and Plosser (1984),
Kydland (1989), and Cooley and Hansen (1989) are good references. Although
not very useful for policy-making purposes, the incorporation of money in a
RBC framework was a prelude of the upcoming extensions that were bound to
take place in the following decade and eventually lead to the New Neoclassical
Synthesis.
20 It is still possible to obtain an approximated closed solution through a linear-quadratic

approximation around the steady state (Kydland & Prescott, 1982), but it requires stronger
assumptions about the production function and the utility function.

21
5.2 The New Neoclassical Synthesis
RBC models were just some slight modifications away from becoming power-
ful instruments for policy-makers. During the 1990s, a new family of DSGE
models incorporated in them fiscal policy, market imperfections, and shocks on
other relevant variables such as the preferences (Benassy, 1995; Bernanke et al.,
1999; Christiano & Eichenbaum, 1992; Clarida et al., 1999; Kim, 1998; King
& Watson, 1996; Leeper & Sims, 1994; Rotemberg & Woodford, 1997). In the
first decade of the current century, another family of DSGE models made its
appearance, being in essence very similar to the previous, yet having higher
mathematical complexity than ever before in order to reach the highest level
of accuracy when representing an economy (Adolfson et al., 2007; Altig et al.,
2005; Christiano et al., 2005; Iacoviello, 2005; Smets & Wouters, 2003; Smets
& Wouters, 2007).
As a consequence of these new developments, by the end of the last cen-
tury, the idea of a New Neoclassical Synthesis (attributed to Goodfriend and
King (1997)) was quickly gaining popularity. Olivier Blanchard (2000) even
claimed that the new models “in either the New Keynesian or the New Classi-
cal mode (these two labels will soon join others in the trash bin of history of
thought) now examine the implications of imperfections, be it in labor, goods or
credit markets” (p. 17). But, what is this new consensus all about? Woodford
(2009) suggests five points in which the vast majority of macroeconomists now
agree: Macroeconomics should employ models with rigorous intertemporal gen-
eral equilibrium foundations, it is desirable to base quantitative policy analysis
on econometrically validated structural models, it is important to incorporate
expectations as an endogenous variable affected by policy decisions, real distur-
bances in general (not only technology shocks) are the most important source of
economic fluctuations, and monetary policy is effective as a means of inflation
control.
Now, I present a simplified model elaborated by Ireland (2004) in order to
illustrate the fundamentals of this New Neoclassical Synthesis.21
There is a representative household that begins each period t with money
Mt−1 and bonds Bt−1 (which will mature in the next period). This household
supplies Lt units of labor to the intermediate goods-producing firms, earning the
nominal wage rate Wt . In addition, the household receives nominal profits Dt
from these firms and a lump-sum money transfer Tt from the government. The
household’s income is to be allocated between consumption Ct of the finished
good (purchased at the nominal price Pt ), new bonds valued at Bt /rt (r is the
interest rate between t and t + 1), and money Mt to be carried into the next
period. The household’s problem is to maximize
∞
X
Et β t [zt ln Ct + ln (Mt /Pt ) − (1/η) Lηt ]
t=0

s. t.
21 Woodford (2003) develops another excellent NNS model.

22
 Mt−1 + Bt−1 + Tt + Wt Lt + Dt = Pt Ct + Bt /rt + Mt ,
where η ≥ 1. It is assumed that the preference shock zt follows an autoregressive
process ln zt = ρz ln zt−1 + ξt , where ξt is a normally distributed i.i.d. error. We
have the following solutions:
zt Wt
Lη−1
t =
C t Pt
and  
zt zt+1 Pt
= βEt .
Ct Ct+1 Pt+1
There is a representative finished goods-producing firm operating in a com-
petitive market. It utilizes Yit units of each intermediate good i ∈ [0, 1] (pur-
chased at the nominal price Pit ) to manufacture Yt units of the finished good.
This firm has a constant returns to scale technology:
Z 1 θt /(θt −1)
(θt −1)/θt
Yit di ≥ Yt ,
0

where θt measures the time-varying elasticity of demand for each intermediate

good, thus being a cost-push shock. It follows an autorregresive process ln θt =
(1 − ρθ ) ln θ + ρθ ln θt−1 + vt , with θ > 1 and 0 ≤ ρt < 1, where vt is a normally
distributed i.i.d. error. Profits are maximized by choosing, for all i ∈ [0, 1] and
t = 0, 1, 2...:
 −θt
Pit
Yit = Yt .
Pt
In equilibrium, profits are null due to competition. The price of output is then
given by:
Z 1 1/(1−θt )
Pt = Pit1−θt di .
0

Regarding the representative intermediate goods-producing firm, it operates

in a market of monopolistic competition, hiring Lit units of labor to produce Yit
units of intermediate good i according to a constants return to scale function

At Lit ≥ Yit .

Technology is assumed to follow a random walk with drift of the form ln at =

ln A + ln At−1 + ϵt , where a > 1 and ϵt is a normally distributed i.i.d error. We
have Rotemberg-type costs of nominal price adjustment:
 2
ϕ Pit
− 1 Yt ,
2 πPit−1

where ϕ represents the magnitude of the price adjustment cost and π is the
steady-state inflation rate. This firm has to choose a sequence to maximize its

23
total market value, which is given by:
∞
X
E0 β t (zt /Ct ) (Dit /Pt ) ,
t=0

where
 1−θt  −θt  2
Dit Pit Pit Wt Yt ϕ Pit
= Yt − Yt − −1
Pt Pt Pt Pt Z t 2 πPit−1

is interpreted as a measure of real profits. We have the following solution:

 −θt
Yt Pit
(θt − 1) =
Pt Pt
 −(θt +1)  2
Pit Wt Yt 1 Pit 1
θt −ϕ − 1 Yt
Pt Pt Z t Pt πPit−1 πPit−1
   
zt+1 Ct Pit Yt+1 Pit+1
+βϕEt −1 .
zt Ct+1 πPit−1 πPit Pit
In a symmetric equilibrium, Yit = Yt , Lit = Lt , Pit = Pt , and Dit = Dt for
all i ∈ [0, 1]. In addition, the market-clearing conditions are Mt = Mt−1 + Tt
and Bt = Bt−1 . Solving out for the real wage, hours worked, and real profits,
we obtain 2
ϕ  πt
Yt = Ct + − 1 Yt ,
2 π
 
zt zt+1 1
= βrt Et ,
Ct Ct+1 πt+1
and  η−1
1 Ct π  π
t Yt t

θt − 1 = θt −1 −ϕ
At zt π Atπ
 
zt+1 Ct Yt+1 πt+1 πt+1

+βϕEt −1 .
zt Ct+1 Yt π π
Define gt = Yt /Yt−1 , yt = Yt /At , ct = Ct /At , and at = At /At−1 . In addition,
consider Wt as the efficient output level and xt = Yt /Wt as the output gap. In
the absence of shocks, this economy converges to a steady-state growth path.
Along this path, the stationary variables remain constant (yt = y, ct = c, and
so on). Using hats to denote the percentage deviation of each variable from its
steady-state level (for example, ŷt = ln(yt /y)), log-linearization of the model
yields:
qt = ρz ln zt−1 + ξt ,
êt = ρθ êt−1 + εt ,
ât = ϵt ,

24
  
1
x̂t = Et x̂t+1 − (r̂t − Et π̂t+1 ) + 1 − (1 − ρz ) kt ,
η
η
π̂t = βEt π̂t+1 + (θ − 1) x̂t − êt ,
ϕ
and
ĝt = ŷt − ŷt−1 + qt
where êt = (1/ϕ)ϕ̂t = ρθ êt−1 +εt is the transformed cost-push shock (we assume
that εt is an i.i.d. normal error).
We are particularly interested in the versions of the expectational IS curve
(Kerr & King, 1996) and the New Keynesian Phillips curve (Roberts, 1995) this
model has. They are, respectively,
 
1
x̂t = Et x̂t+1 − (r̂t − Et π̂t+1 ) + 1 − (1 − ρz ) qt ,
η

and
η
π̂t = βEt π̂t+1 + (θ − 1) x̂t − êt .
ϕ
These expressions show that a trade-off between inflation and output gap sta-
bilization only arises in the presence of a cost-push shock; this is, shocks to
technology or preferences can be perfectly accommodated, at least in theory,
by the central bank. It can achieve, simultaneously, the stabilization of in-
flation and output gap by committing to a rule of monetary policy such that
the real market interest rate r̂t − Et π̂t+1 tracks the natural real interest rate
(1 − 1/η)(1 − ρz )qt . Peter Ireland considers a slightly modified Taylor’s (1993)
rule that is given by r̂t − r̂t−1 = θπ π̂t + θg ĝt + θx x̂t , where θπ , θg , and θx are
response parameters chosen by the central bank so as to minimize some social
loss function.

5.3 Policy-making
The development and use of macroeconomic models for policy-making by central
banks is not a recent phenomenon.22 In the US, this practice began in the
1960s with the FED-MIT-Penn model (Ando & Modigliani, 1969; De Leeuw &
Gramlich, 1968), which consisted of a data-driven (if not atheoretical) system of
hundreds of equations whose main aim was to predict the effects of alternative
economic policies.
Despite Lucas’ critique, replacing these models with microfounded ones took
almost two decades. The FRB/US model (Brayton & Tinsley, 1996) was the
first DSGE model developed and used by the FED as a tool for policy-making.
By the end of the next decade, most (if not all) central banks developed and
implemented one or more DSGE models each (Tovar, 2009). Given the ratio-
nale of this essay, the matter of concern is that the DSGE models developed by
22 See Bodkin et al. (1991) for a more in-depth discussion.

25
the central banks are theoretical constructs designed to encompass the partic-
ularities of the modeled economy, being only valid for that economy and under
specific circumstances. In other words, the formulation of a universal theory,
applicable to all time and space, no longer appears to be the main priority in
Macroeconomics.

5.4 Some critiques on DSGE modeling after the Great

Recession
Since the 2008 crisis, DSGE models have faced growing criticism for their inca-
pability of predicting it. However, the more substantial critiques are not those
focusing on the outcomes but rather those addressing the methodological mis-
takes that led to such outcomes. I present the two I consider more relevant.23
The first one states that the microfoundations underlying DSGE models are
not the correct ones since they do not incorporate the findings of the recent
empirical literature regarding the real-world behavior of the agents, as pointed
out by renowned economists like Robert Solow (2010), Olivier Blanchard (2016),
Joseph Stiglitz (2018), and others. In response, some recent DSGE models have
relaxed the assumption of perfect rationality (in terms of both maximization
of intertemporal utility and expectation formation) and conceded a more sig-
nificant role to the heterogeneity of the agents (Angeletos et al., 2018; Bordalo
et al., 2018; De Grauwe & Macchiarelli, 2015; Farhi & Werning, 2019; Gabaix,
2020; Hommes et al., 2023; Massaro, 2013; Pfäuti & Seyrich, 2022). A good
number of central banks are modifying their DSGE models in this direction,
according to a recent survey by Yagihashi (2020).
The second one was done by Paul Romer (2016). He says that the stochastic
nature of the DSGE models is a methodologically incorrect approach because
it attributes economic fluctuations to imaginary forces, represented by either
i.i.d. or Markov error terms, rather than to the decisions made by the agents,
which are the prominent causes behind them. According to him, in a DSGE
framework, the shocks causing fluctuations can fall into different categories,
such as “a general type of phlogiston that increases the quantity of consumption
goods produced by a given output ... a troll who makes random changes to the
wages ... a gremlin who makes random changes to the price of output” (p. 6).
Of course, this critique is irreconcilable with DSGE modeling.

6 Final comments
As it has been shown, DSGE models are, in essence, not as modern as one
might think. Many of their economic foundations had been formulated by earlier
theories, some dating back more than a hundred years before the appearance of
these models. However, what is entirely modern is the mathematical formulation
of the ideas, which was rather unfeasible for their original authors due to the
lack of the required mathematical tools.
23 A more detailed review can be found in Christiano et al. (2018).

26
 Is this history absolutist, relativist, or a mix of both? I believe the latter
is the most accurate assessment. Undeniably, the Rational Expectations Rev-
olution started a snowball of knowledge that ultimately led to DSGE models
and continues to expand. However, it is impossible to create a snowball without
snow, for if the macroeconomic conditions that prevailed until the early 1970s
had not changed, it would have been pointless to develop new theories in order
to explain what the old ones could not. Furthermore, if the weather does not
allow for its existence, a snowball melts, meaning that continuous changes in
the real world (something normal since the 1970s) are required to incentivate
new theorizing. Finally, if one attempts to pick up some snow and add it to
the snowball without mittens, it will only result in hand ice burns; what I mean
by this is that without the context-independent mathematical advancements of
the twentieth century, it would have been impossible to represent an economy
with a DSGE model. Taking all the factors into account, I believe it is clear
that this history has shown (at least up to now) a mixed evolution.
Another question that might come to mind is why there has been a conver-
gence between New Classical and New Keynesian Economics. I hypothesize that
the main reason is the complementary nature of both approaches. As we have
seen, their models are methodologically very similar; just a few assumptions
vary. It might be proper to claim that the New Classicals are more concerned
with the long term (where rigidities are non-existent), while the opposite is true
for the New Keynesians. Therefore, it seems natural to take the best aspects of
both approaches in order to advance towards a more comprehensive theoretical
framework. Can a synthesis be established without complementarity? Some
cases from other sciences suggest that the answer is negative. In Statistics, no
probability interpretation can reconcile frequentists and Bayesians. In Physics,
quantum mechanics and relativity theory are still not unified into a unique
framework (despite Einstein’s attempts!). However, this is merely a hypothesis.
There are not enough arguments to categorically support that complementarity
is a necessary (much less a sufficient) condition for the merging of two theories.
Last but not least, DSGE models have landed not without loss of generality.
In less than 100 years, we have left behind the “generality battle” between
Keynes and Hicks, something that is indeed Classical heritage. To a good extent,
modern economic theories are meant to be valid only in a specific place and time.
This is reflected, for example, in the discussion of the causes behind inflation:
Macroeconomics has moved from “inflation is always and everywhere a monetary
phenomenon” to a collection of models in which the underlying mechanisms of
inflation dynamics are considerably different from one to another.
To conclude this essay, I wish to inform the reader about some of its lim-
itations, the addressing of which remains for future research. It neglects the
development of the statistical tools that allowed for estimating DSGE models.
The feedback effects between econometric estimation techniques and theoreti-
cal modeling of the last few decades have not been considered. The choice of
starting point is arbitrary, as the essay could have begun, for example, with the
theory of growth. Finally, merely the fundamentals of each school of thought
have been covered.

27
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