Editing Macroeconomic model (section)

===Dynamic stochastic general equilibrium models===
{{Main|Dynamic stochastic general equilibrium}}

Partly as a response to the [[Lucas critique]], economists of the 1980s and 1990s began to construct [[microfoundations|microfounded]]<ref>Edmund S. Phelps, ed., (1970), ''Microeconomic Foundations of Employment and Inflation Theory.'' New York, Norton and Co. {{ISBN|0-393-09326-3}}.</ref>  macroeconomic models based on rational choice, which have come to be called '''dynamic stochastic general equilibrium (DSGE)''' models.  These models begin by specifying the set of [[Agent (economics)|agents]] active in the economy, such as households, firms, and governments in one or more countries, as well as the [[preferences]], [[production function|technology]], and [[budget constraint]] of each one.  Each agent is assumed to make an [[Optimization (mathematics)|optimal choice]], taking into account prices and the strategies of other agents, both in the current period and in the future.  Summing up the decisions of the different types of agents, it is possible to find the prices that equate supply with demand in every market.  Thus these models embody a type of [[Nash equilibrium|equilibrium]] self-consistency: agents choose optimally given the prices, while prices must be consistent with agents’ supplies and demands.

DSGE models often assume that all agents of a given type are identical (i.e. there is a ‘[[Representative agent|representative]] household’ and a ‘[[Representative agent|representative]] firm’) and can perform perfect calculations that forecast the future correctly on average (which is called [[rational expectations]]).  However, these are only simplifying assumptions, and are not essential for the DSGE methodology; many DSGE studies aim for greater realism by considering heterogeneous agents<ref>{{cite journal |author-link=Per Krusell |first1=Per |last1=Krusell |author-link2=Anthony A. Smith Jr. |first2=Anthony A. Jr. |last2=Smith |year=1998 |title=Income and wealth heterogeneity in the macroeconomy |journal=[[Journal of Political Economy]] |volume=106 |issue=5 |pages=243–277 |doi= 10.1086/250034 |s2cid=17606592 }}</ref> or various types of [[adaptive expectations]].<ref>George W. Evans and Seppo Honkapohja (2001), ''Learning and Expectations in Macroeconomics''. Princeton University Press, {{ISBN|0-691-04921-1}}.</ref>  Compared with empirical forecasting models, DSGE models typically have fewer variables and equations, mainly because DSGE models are harder to solve, even with the help of [[Computational economics|computers]].<ref>DeJong, D. N. with C. Dave (2007), ''Structural Macroeconometrics''. Princeton University Press, {{ISBN|0-691-12648-8}}.</ref>  Simple theoretical DSGE models, involving only a few variables, have been used to analyze the forces that drive [[business cycles]]; this empirical work has given rise to two main competing frameworks called the [[Real business cycles|real business cycle model]]<ref>{{cite journal | last1 = Kydland | first1 = Finn E. | author-link = Finn E. Kydland | author-link2 = Edward C. Prescott | last2 = Prescott | first2 = Edward C. | year = 1982 | title = Time to Build and Aggregate Fluctuations | journal = Econometrica | volume = 50 | issue = 6| pages = 1345–70 | doi=10.2307/1913386| jstor = 1913386 }}</ref><ref>[[Thomas F. Cooley]] (1995), ''Frontiers of Business Cycle Research''. Princeton University Press.</ref><ref>Andrew Abel and Ben Bernanke (1995), ''Macroeconomics'', 2nd ed., Ch. 11.1, pp. 355-362. Addison-Wesley, {{ISBN|0-201-54392-3}}.</ref> and the [[New Keynesian economics|New Keynesian DSGE model]].<ref>{{cite journal |last1=Rotemberg |first1=Julio J. |first2=Michael |last2=Woodford |year=1997 |title=An optimization-based econometric framework for the evaluation of monetary policy |journal=NBER Macroeconomics Annual |volume=12 |pages=297–346 |jstor=3585236 |doi=10.1086/654340 |s2cid=154438345 |url=http://www.nber.org/chapters/c11041.pdf }}</ref><ref>{{cite book |last=Woodford |first=Michael |year=2003 |title=Interest and Prices: Foundations of a Theory of Monetary Policy |publisher=Princeton University Press |isbn=0-691-01049-8 }}</ref>  More elaborate DSGE models are used to predict the effects of changes in economic policy and evaluate their impact on [[Social welfare function|social welfare]].  However, [[economic forecasting]] is still largely based on more traditional empirical models, which are still widely believed to achieve greater accuracy in predicting the impact of economic disturbances over time.

====DSGE versus CGE models====
{{Main|Computable general equilibrium}}
A methodology that pre-dates DSGE modeling is '''computable general equilibrium (CGE)''' modeling. Like DSGE models, CGE models are often [[microfoundations|microfounded]] on assumptions about preferences, technology, and budget constraints. However, CGE models focus mostly on long-run relationships, making them most suited to studying the long-run impact of permanent policies like the tax system or the openness of the economy to international trade.<ref>{{cite journal |last1=Shoven |first1=John B. |first2=John |last2=Whalley |year=1972 |title=A general equilibrium calculation of the effects of differential taxation of income from capital in the US |journal=[[Journal of Public Economics]] |volume=1 |issue=3–4 |pages=281–321 |doi=10.1016/0047-2727(72)90009-6 |url=http://cowles.yale.edu/sites/default/files/files/pub/d03/d0328.pdf |access-date=2019-07-12 |archive-date=2022-02-26 |archive-url=https://web.archive.org/web/20220226182525/https://cowles.yale.edu/sites/default/files/files/pub/d03/d0328.pdf |url-status=dead }}</ref><ref>{{cite journal |last1=Kehoe |first1=Patrick J. |first2=Timothy J. |last2=Kehoe |year=1994 |title=A primer on static applied general equilibrium models |journal=Federal Reserve Bank of Minneapolis Quarterly Review |volume=18 |issue=1 |pages=2–16 |url=http://www.minneapolisfed.org/research/qr/qr1821.pdf }}</ref> DSGE models instead emphasize the dynamics of the economy over time (often at a quarterly frequency), making them suited for studying business cycles and the cyclical effects of monetary and fiscal policy.