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Dynamic stochastic general equilibrium models have grown in importance at many of the world’s central banks as tools to inform economic outlooks and formulate policy strategies.
The models, which emphasize the dependence of current choices on expected future outcomes, are familiar to policymakers and academics, but are less well known outside these circles.
Sbordone et al. introduce the basic structure, logic, and application of the DSGE framework to a broader public by providing an example of its use in monetary policy analysis.
The authors estimate a simple DSGE model, highlighting the core features that it shares with more elaborate versions. They apply the estimated model to study the sources of the sudden rise in inflation in the first half of 2004.
A key lesson derived from the study is that the management of expectations can be a more effective tool for stabilizing inflation than actual movements in the policy rate.
The lesson is consistent with the amount of attention and speculation that usually surround central bankers’ pronouncements on their likely future actions.
About the Authors
Argia M. Sbordone is an assistant vice president and Andrea Tambalotti a senior economist at the Federal Reserve Bank of New York; Krishna Rao is a graduate student at Stanford University; Kieran Walsh is a graduate student at Yale University.
The views expressed in this summary are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.