Handbooks of Research Methods and Applications series
Edited by Nigar Hashimzade and Michael A. Thornton
Chapter 18: The science and art of DSGE modelling: I – construction and Bayesian estimation
The past forty years or so have seen a remarkable transformation in macro-models used by central banks, policymakers and forecasting bodies. In this chapter and the next, we discuss how the different elements of modern macroeconomic models can be seamlessly integrated in a framework encompassing the different stages of model building, estimation and policy analysis. We describe the development of the building blocks of such models, showing that the main features of New Keynesian (NK) Dynamic Stochastic General Equilibrium (DSGE) models consist of a ‘Real Business Cycle’ (RBC) core, with an outer shell that includes nominal rigidities and other frictions. We then discuss how to take these models to the data, focusing on empirical implementations based on Bayesian system estimation methods. The road of macroeconomic modelling is full of twists and turns, but the different directions taken seem to have converged to what is still, to a large extent, the consensual synthesis. Indeed, the models that are now the mainstay for policy analysis and forecasting depart significantly from previous approaches in that they strike a balance between internal consistency, empirical adherence and adequacy for policy analysis.
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