DSGE Models: A User Guide for Policymakers

Lawrence Christiano

Overview:

In the past decade, dynamic, stochastic, general equilibrium (DSGE) models suddenly came into widespread use in central banks around the world. I will review the empirical and policy reasons for this development. On the empirical side, the models provide a quantitatively interesting resolution for a long-standing puzzle for monetary economics: that economic activity expands quickly and inflation slowly, in the wake of a monetary shock. In addition, the models do as well or better than atheoretical time series methods in forecasting important variables such as inflation and output. On the policy side, DSGE models provide important input into policy debates. For example, they contributed to the discussion about the desirability of inflation targeting and the effectiveness of the Taylor principle in achieving those targets. DSGE models play a central role in the recent debate about the dangers posed by the zero lower bound on the nominal rate of interest and about the appropriate policy responses. DSGE models have also been useful in addressing other questions raised by the recent financial crisis. They can be used to ask to what extent financial markets may be a source of shocks to the real economy, as well as how interest rate policy should respond to those shocks. In addition, DSGE models have been used to put structure on the discussion about unconventional monetary policy and what that policy can accomplish when the interest rate hits the zero bound.

Lecture Handout.

Background readings

General reference: Lawrence J. Christiano, Mathias Trabandt, and Karl Walentin, DSGE Models for Monetary Policy Analysis, In Benjamin M. Friedman, and Michael Woodford, editors: Handbook of Monetary Economics, Vol. 3A, The Netherlands: North-Holland, 2011, pp. 285-367. ISBN: 978-0-444-53238-1 © Copyright 2011 Elsevier B.V. North-Holland.

The primary reference for the discussion about financial frictions: Christiano and Daisuke, Government Policy, Credit Markets and Economic Activity.

Other references on financial frictions:

Bernanke, Gertler and Gilchrist’s classic 1999 paper.

Christiano, Motto, Rostagno (2003): Using the BGG model to analyze the cause of the US Great Depression, and the reason it lasted so long.

Government spending and the zero bound:

Christiano, Eichenbaum and Rebelo (2009) When is the Government Spending Multiplier Large?