3
estimate the economic impact of military buildups, events that are arguably unrelated to
macroeconomic conditions, but also to estimate the effects of tax changes.
11
DSGE Models
DSGE models are also used to estimate fiscal multipliers.
12
In DSGE models, people are assumed
to make decisions about how much to work, buy, and save on the basis of current and expected
future values of wage rates, interest rates, taxes, and government purchases, among other things.
As a result of those and other assumptions about individuals’ and businesses’ behavior, such
models offer a clear perspective on the causal relationships among economic variables.
13
A thorough grounding in economic theory allows DSGE models to avoid the difficulties of
interpretation that arise with purely statistical approaches to analyzing data. In addition, the explicit
assumptions about economic decision-making in DSGE models are less dependent on historical
data than in macroeconometric models.
14
Therefore, DSGE models can be particularly useful when
analyzing the effects of changes in fiscal policies that have not been observed previously.
DSGE models often include assumptions that seem at odds with important features of the real-
world economy.
15
For example, such models do not usually allow for underutilized resources in an
economy, such as involuntary unemployment or unused capital. In addition, people are generally
assumed to have full access to credit markets so that they can borrow to maintain their
consumption in the face of a temporary loss of income, and the Federal Reserve is often assumed
to respond to changes in fiscal policies, thereby excluding situations in which actions by the
Federal Reserve are constrained by a zero lower bound on nominal interest rates.
16
11
For examples of studies focusing on military buildups, see Ramey (2011a), and Ramey and Shapiro (1998), and for discussion of
the challenges associated with focusing on military buildups (namely, factors that could raise or dampen multipliers in such
periods), see Ramey (2011b, p. 677). Some articles in this literature (such as Owyang et al. 2013) do not adjust results for tax
increases that have often accompanied military buildups, but others make such an adjustment to generate results more applicable
to the case of deficit-financed government spending (including Ramey 2011a). For examples of studies that use the narrative
approach to estimate the effects of tax changes on economic activity, see Romer and Romer (2010), and Favero and Giavazzi
(2012).
12
DSGE models are “dynamic” because they focus on how an economy evolves over time, “stochastic” because they take into
account that the economy is affected by random shocks (owing to technological change, for example), and “general equilibrium”
because they assume that people make decisions in response to prices in the economy (such as wages and rates of return on
saving) and that prices change in response to those decisions.
13
DSGE models differ from traditional macro models in that they include micro-founded elements describing the optimal behavior
of economic agents.
14
DSGE models are generally calibrated so that macroeconomic variables, such as the total amount of labor supplied and the size of
the capital stock, match the amounts in the U.S. economy, or they are estimated using aggregate data to determine some key
parameters. See Fernández-Villaverde and Rubio-Ramírez (2006) for a detailed discussion of how DSGE models are estimated.
See Coenen et al. (2012) for a comparison of significant model features and parameters of several DSGE models used by
policymaking institutions in Canada, Europe, and the United States.
15
For example, see Parker (2011) and Fair (2012), who criticize several modeling choices made in many DSGE models. In addition,
Leeper et al. (2011) observe that a tight range for estimates of the multiplier is imposed by the assumptions and choices made by
researchers when using DSGE models. See also Chari et al. (2009), who argue that DSGE models rely on so many improvised
modeling assumptions that their conclusions are unavoidably ambiguous for policy analysis.
16
DSGE models also are typically built on the assumptions that people have full information about the current economy and future
economic developments and that they logically base their current decisions on a full lifetime plan. In extreme form, those
assumptions imply that people anticipate that increases in government spending or decreases in taxes will eventually lead to lower