ABSTRACT
During the last decade Dynamic Stochastic General Equilibrium (DSGE) models along the lines of Erceg, Henderson and Levin (2000), Smets and Wouters (2003) and Christiano, Eichenbaum and Evans (2005) have become the workhorse framework for the study of monetary policy and inflation in the academic literature. However, despite its popularity, this approach – where the dynamics of the economy is derived from neoclassical microfoundations, the assumption of rational expectations and the condition of general equilibrium – has been starkly questioned from both the theoretical and empirical point of view by numerous researchers like Mankiw (2001), Estrella and Fuhrer (2002) and Solow (2004), among others. The criticisms focus primarily on the highly unrealistic assumptions concerning the alleged ‘rationality’ in the forward-looking behavior of the economic agents, and its failure to explain important empirical stylized facts.
