ABSTRACT
DSGE models are a natural benchmark in macroeconomics, since an economy is a general equilibrium of all the constituent markets running over time and subject to shocks. But an economy is much more complex than any model could be. So, a model has to be an abstraction. It is useful if it is able to isolate core issues. The canonical DSGE model seeks to explain fluctuations from shocks to preferences or technology, when representative agents with rational expectations optimise over time in perfect markets. The Keynesian behavioural consumption function with a constant marginal propensity to consume gives way to the first-order condition (FOC) from intertemporal utility maximisation. There are new insights from forward-looking behaviour, which were not there in the earlier models with static expectations.1
