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This chapter introduces the long-run structural approach to modelling. It makes brief comparisons with the key alternative approaches, namely large-scale simultaneous equation models, unrestricted and structural VARs, dynamic stochastic general equilibrium models, and New Keynesian models. The strengths of the long-run structural modelling approach are summarized and the organization of the book is described.

A number of numerical methods are discussed for solving dynamic stochastic general equilibrium models that fall within the common category of discrete state‐space methods. These methods can be applied in situations where the state space of the model in question is given by a finite set of discrete points; in these cases the methods provide an ‘exact’ solution to the model in question. However they are frequently applied in situations where the model's state space is continuous in which case the discrete state space can be viewed as an approximation to the continuous state space. Discrete state‐space methods are discussed in the context of two well‐known examples: a simple one‐asset version of Lucas's (1978) consumption‐based asset pricing model and the one‐sector neoclassical growth model. The discussion does not aim to exhaust the list of possible discrete state‐space methods as they are very numerous; rather it describes several examples that illustrate the basic principles involved. The main sections of the chapter describe the basic principles of numerical quadrature underlying most discrete state‐space methods, show how they can be applied in a very straightforward way to problems in which the state space consists entirely of exogenous state variables, and describe methods that can be used when there are endogenous state variables. The last section notes the several files associated with the chapter for use with MATLAB.

This chapter will critically examine today’s common ways to build equilibrium models. These specifically include Dynamic-Stochastic General Equilibrium models, game theoretical models and empirical GE models. Each of these types of equilibrium model try to address the issues of how a model’s decision makers get the information needed to guarantee the attainment of a state of equilibrium. The chapter addresses the alleged limits of general equilibrium models (particularly the issues of dynamics, time and expectations), the current attempts to overcome the limits of general equilibrium models, and three empirical alternatives to Walrasian general equilibrium models. These alternatives include the Computable General Equilibrium models and the Applied General Equilibrium models. The third model involves building econometric models only after evaluating the statistical properties of the data before using them in the model.

This chapter discusses the three lines of research used in assessing basic models of fluctuations in competitive markets, namely research with the use of Dynamic Stochastic General Equilibrium models, a typical Sunspot model, and a combination of Keynesian theory, the Samuelson destabilizing accelerator, and the Philips curve. It explains that the Dynamic Stochastic General Equilibrium models provide simpler solutions, as they answer simple first-order conditions of asset pricing, and address labor fluctuations. This chapter also includes sample problems regarding alternative shocks in the government and households, incomplete capital depreciation, a Real Business Cycle model with generations, and with autocorrelated shocks.

This chapter describes a classic theme of international macroeconomics, that is, the gains from policy cooperation in the presence of policy spillovers across countries. In this chapter, a calibrated two-region dynamic stochastic general equilibrium (DSGE) model with nominal rigidities as a framework for the analysis is adopted, with which a quantitative evaluation of those cooperation gains is provided. The New Area-Wide Model (NAWM) version is developed at the European Central Bank (ECB), calibrated to match a number of features of the U.S. and euro area economies. Thus, the findings of this chapter suggests that if simple, self-oriented interest rate rules are pursued by the Fed and the ECB, the losses relative to the full cooperation case will be limited to about one-tenth of steady state consumption.

This chapter examines the evolution of econometric research in business cycle analysis mainly during the 1960-90 period. It shows how the research was dominated by an assimilation of the tradition of NBER business cycle analysis by the CC approach, catalysed by time-series statistical methods. It also shows how the research has branched into various directions, such as the DSGE based model simulations for theory verification, device of various cyclical measures, among which forecasting has remained the least successful. Methodological consequences of the assimilation are critically evaluated in light of the meagre achievement of the research in predicting the current global recession.

This chapter examines how each central bank (Federal Reserve and the European Central Bank) has performed in recent years with the aim of understanding the similarities and differences. It is observed that the paths of both interest rates and real output in the two economies have been different over the years. These differences reflect differences in policy, differences in structure (e.g., flexible versus rigid labor markets, bank versus open market finance, etc.), or differences in the nature of the shocks. The chapter estimates a small-scale monetary dynamic monetary stochastic general equilibrium (DSGE) model for each country that is flexible enough to allow for differences in policy, structure, and shocks. The principal finding is that the sluggish behavior of the euro area economy relative to the United States primarily reflects differences in shocks.

This chapter reviews the theory related to business cycles. After outlining early approaches (including the multiplier-accelerator interaction and Goodwin cycles), it proceeds to discuss the modern debates between New Classical/Real Business Cycle (RBC) theorists and New Keynesians. This discussion is structured at various levels: more intuitive and discursive, then more analytical with the development of a formal RBC model and of a Dynamic Stochastic General Equilibrium model that synthesizes the two approaches. The chapter continues with a review of Vector Autoregressions. Finally, a narrative of a number of episodes is offered: the Great Depression, post-World War II cycles, Japan, effects of oil on business cycles, and the Great Recession (2007–9) and the subsequent slow recovery. The overarching philosophy is that a suite of models, old and new, and approaches, modelling, econometric, and narrative, are useful in offering complementary perspectives.

This chapter describes the oil shocks using a dynamic stochastic general equilibrium (DSGE) model for the Korean economy. The Korean economy depends entirely on imports for its acquisition of crude oil, and households, entrepreneurs, and policymakers are interested in knowing to what extent the rise in oil prices affects the economy. Within an Bayesian estimation framework including DSGE-vector autoregressions (VARs), the empirical analysis used is based on Korean aggregate data. Using Bayesian analysis, the model is used to check the importance of each channel that transmits an oil price shock to the economy. It is found that the model economy produces reasonable posterior estimates of the structural parameters and works relatively well compared to impulse responses from the VAR with optimal prior weight from the DSGE model. A more elaborated model on government behavior is anticipated to investigate the pass-through of oil price shocks.

This chapter examines the implications of current account adjustment for monetary policy. A two-country monetary dynamic stochastic general equilibrium (DSGE) model with nominal rigidities and incomplete international financial markets to study the role of global imbalances is developed. The framework is initialized to match the recent U.S. account deficit and its overall indebtedness with respect to the rest of the world. It is found that good monetary management can significantly mitigate any pain from current account adjustment. A policy that works well under either the slow or fast burn scenarios is domestic inflation targeting. By contrast, attempts to peg the exchange under the fast burn can lead to considerable damage to the economy. On the other hand, consumer price index (CPI) inflation targeting is relatively harmful under full exchange rate pass-through, but not so much when the latter is partial.

This chapter is devoted to the solution, identification, and estimation of rational expectations (RE) models. It begins with an overview of solution techniques, distinguishing between RE models with and without feedbacks from the decision (or target) variables to the state variables. It also considers models with and without lagged values of the decision variables. In the case of RE models with feedbacks, it argues that it is best to cast the RE models as a closed dynamic systems should be j not i and problems with word maths before solving them. The chapter then turns to the identification of structural parameters of dynamic stochastic general equilibrium (DSGE) models and estimation of RE models in general. Exercises are provided at the end of the chapter.

This chapter describes the mechanism and implications of globalization that raises the sensitivity of inflation to movements in exchange rates. The evidence from industrialized economies suggests that pass-through of exchange rate movements into import prices is imperfect. A model of imperfect pass-through is developed that is based on a combination of nominal rigidities and endogenous destination-specific markup adjustment. This model of imperfect pass-through is then integrated into a complete dynamic monetary stochastic general equilibrium (DSGE) model with nominal rigidities, in order to study the implications for optimal monetary policy. It is also shown that the optimal policy does not necessarily imply that the real exchange rate should be less volatile than the terms of trade; whether that is the case or not depends on a number of characteristics of the economies involved.

This chapter defines the use of the Dynamic Stochastic General Equilibrium (DSGE) models with perfect or imperfect competitions. It states that the solution to fluctuations brought by demand shocks is to introduce different models for nominal price and wage rigidities to the system. It indicates that several formalizations of rigidities have responded well to nominal shocks. This chapter also includes sample problems regarding the Taylor model, inflation persistence, Calvo and Calvo-Fischer: Comparative Dynamics, and DSGE model with sticky wages.