Thursday, July 19, 2012

A bit of history, plus plus

From St. Louis, from the Working Papers, U.S. Monetary Policy: A View from Macro Theory (PDF, 20 pages) by William T. Gavin and Benjamin D. Keen:
The state of the art in macroeconomics has changed dramatically since the 1960s. Models built then had fixed parameters that predicted aggregate outcomes without taking account of how expectations about future policy would affect people’s behavior. As late as 1975, the state of the art was an optimal control model with fixed parameters. The model was useful in guiding spaceships to the moon and in developing optimal input policies for manufacturing machines, but it could not predict how policy could achieve macroeconomic stabilization because it did not take account of how people would change their behavior when new policies were introduced.

The first major breakthrough in modern macro theory was the rational expectations revolution in which economists learned how to put forward-looking behavior in the linear IS/LM model. For the policy advisor, an important contribution of this literature was to teach us that we should not use models with backward-looking inflation expectations to perform counterfactual policy simulations.

Once economists realized the insights and benefits from using models in which people formed expectations optimally, it was natural to move to models in which all behavior was assumed to be optimizing. The second major breakthrough, then, was the first DSGE model— the real business cycle (RBC) model developed by Kydland and Prescott (1982). This model begins with households that maximize utility and firms that maximize profits. The single driving process in this model was a stochastic technology factor.

The DSGE policy model has monetary policy operating with an interest rate rule. Until the late 1990s, models usually assumed the money supply was an exogenous autoregressive process. Gavin, Keen, and Pakko (2005) show that these models cannot account for the time-series properties of inflation and market interest rates. The state-of-the-art policy model today is a New Keynesian DSGE model with sticky prices and Taylor-type interest rate rules.
From a footnote in that paper: "Our model is solved and estimated using the techniques embedded in the Dynare software."

What is Dynare? Dynare is a free software...

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