DSGE, Monetarism, Keynesianism, and Schools of Thought

DSGE models: attempt to explain aggregate economic phenomena (growth, business cycles, effects of monetary and fiscal policy)

Dynamic (studies how the economy changes over time), stochastic (takes shocks like price changes, technology changes into affect)

Key components:
• Preferences
• Technology
• Institutional framework
• Rational expectations

Schools of thought that use DSGE models:
• Real business cycle
• New Keynesian

Schools of thought:

Monetarists:
• Economy’s performance is determined by changes in the money supply
• Economic well being can be adjusted by changes in the money supply

Important things to monetarists:
• Long run neutrality and short run money non-neutrality
o Money is neutral in the long run if the supply and demand choices of people reflects only concern for the underlying quantities of goods and services that are consumed or produced
o Short run money non-neutrality means that changes in money supply take place very gradually (RBC economists don’t think this exists)
• Distinction between real and nominal interest rates
o Real interest rates take expected inflation into account, as rational people would do as they make trade offs between the present and the future.
• M1 and M2
• No permanent tradeoff between unemployment and inflation
• Monetary policy is more potent than fiscal policy when it comes to stabilizing the economy

Not widely practiced today.

Keynesians:
• Focused on the effects of aggregate demand on output and inflation
• Stressed the importance of fiscal policy, and the powerlessness of monetary policy (not actually a thing anymore)
• Changes in aggregate demand have their greatest effect on real output and unemployment, not on prices. (Phillip’s curve)

Things important to Keynesians:
• Sticky prices and wages
• Increases in government spending causes an increase in output
• Prices, and especially wages, respond slowly to changes in supply and demand, resulting in periodic shortages and surpluses, especially of labor.