dsge for dummies
May 27, 2026
in this post, i explain the dsge model used by the new york federal reserve bank. i also aim to include the “math behind the model” as how i wish i could have read this in maybe high school.
IN PROGRESS!
Update as of May 27 2026: here is first draft.
“I’d rather have Bob Solow than an econometric model, but I’d rather have Bob Solow with an econometric model than without one.”
To explain something i care about to people who are curious about it,..; hi henry and nayan : )
What is a DSGE model? DSGE models are simply quantitative models used to forecast the effects of policy on macroeconomic forces.
Fairly simple: centered around three “blocks” : demand, supply, and a monetary policy equation
Demand: Real output is defined by a function of the ex ante real interest rate and expectations of future real activity. This captures two key assumptions: first, when real interest rates are temporarily high, people and firms would rather save than consume or invest, and second, that people are willing to spend more when they expect brighter futures, regardless of the level of interest rates.
Supply: Inflation and expectations of future inflation are defined by the level of activity that emerges from the demand block. When times are good, firms have to raise wages to persuade employees to work longer hours, which in turn increase marginal costs and induce higher prices. The higher people expect inflation to be in the future, the higher firms will raise prices, leading to inflation in the present moment.
Monetary policy: Monetary policy is endogenously defined by these supply and demand blocks. The central bank will set the interest rate as a function of inflation and real activity. Recall that central banks tend to raise the short-term interest rate when the economy is overheating and lower it in times of weak demand. In adjusting the nominal interest rate, monetary policy manages real output and hence regulates inflation.
We call this class of models dynamic because expectations of the future are a key determinant of today’s outcomes. Indeed, expectations are the main channel of monetary policy transmission. You don’t have to go far to see this in action. Look at the bankers and traders on the edge of their seats listening to the Federal Open Market Committee speeches. Communications are increasingly being used to shape expectations (though that seems to be more effective in financial markets and not in your regular consumers).
MORE TO COME.
Sources: DSGE Model-Based Forecasting by Marco del Negro and Frank Schorfheide