This chapter uses a static (one-period) economy to illustrate how general equilibrium works in macroeconomic models; if it helps, it explains the “GE” part while later chapters take care of the “DS” components. This goal is attained by introducing the notion of a competitive equilibrium -- a description of the optimal choices of all agents in the economy that lays out a blueprint for characterizing and solving it. The emphasis is on pedagogy and not realism, but understanding the contents of this chapter is key for the material ahead.

This chapter introduces the canonical real business cycle model, understood as an infinite-horizon economy in which the representative household derives utility from consumption and leisure and the representative firm uses capital and labor to produce output -- and output is subject to stochastic productivity shocks. This model is the basic building block of models with real frictions -- those that abstain from nominal (monetary) rigidities. In a second step, the chapter complements the exposition by introducing the indivisible labor model of Hansen.

This chapter introduces fiscal policy in a broad way. Starting from a canonical real business cycle model, the chapter shows by example how to incorporate government expenditure, taxation, and debt into the model. Since these policy frictions affect the behavior of the representative household or the representative firm, they are important tools that help macroeconomists understand the role of fiscal policy over business cycle fluctuations.

The chapter illustrates what business cycle fluctuations look like in the United States. It shows real-world data to identify what Lucas calls economic variable co-movements, which are the key properties of the data that economic models should replicate.

This chapter shows how all the concepts introduced earlier can be put to use. It does so by introducing the concept of log-linearization and, in a second step, using the method of undetermined coefficients, which allows model variables (“control variables”) to be put as functions of a group of “state variables.” While doing this process by hand is cumbersome, computer software -- in particular, Dynare -- can easily handle it.

This chapter illustrates how to add stochastic shocks to an economy; if it helps, it explains the “S” part of “DSGE.” In particular, the chapter models shocks as Markov processes, for which the dynamics of the shock depend only on the value that the shock takes today.

This chapter introduces nominal frictions via the canonical New Keynesian model, which is the basic building block of models with nominal frictions. In this model, a representative household, a final goods firm, a continuum of intermediate goods firms, and a government/central bank interact in the economy. Different from the canonical real business cycle model, all relevant prices are set in nominal terms and, moreover, the prices of the intermediate goods are sticky -- they do not adjust instantaneously. This feature opens the door to monetary policy (controlled by the central bank) to modify the equilibrium in the economy. The goal of the chapter is to lay out the equilibrium conditions of the model, a process that is far from trivial.

This chapter shows how, under certain circumstances, a social planner problem offers the same outcomes as a competitive equilibrium. This fact is useful as competitive equilibria are complicated objects to work with. If a social planner problem yields the same optimal choices as the competitive equilibrium, then it makes sense to work from a planner’s perspective. The chapter emphasizes the conditions that guarantee this equivalence holds, and introduces a working example that remains useful throughout the book.

This chapter introduces a set of real frictions that affect how the representative household values streams of consumption. Habit persistence (in consumption), as the name implies, modifies the canonical real business cycle model by inducing habits that make it costly (in utility terms) for the representative household to make large adjustments in its consumption stream. In a second step, the chapter shows how preference shocks -- to the marginal utility of consumption or leisure -- can be introduced to the canonical real business cycle model.

This chapter introduces a set of real frictions that affect how the capital accumulation process works. Taking the canonical real business cycle model as a starting point, investment adjustment costs make it costly for the representative household to vary the scale of investment relative to its steady-state value. Variable capacity utilization reflects the fact that the capital stock can be used to various degrees of intensity and, consequently, more intensive usage results in a higher depreciation rate.

This chapter takes the equilibrium conditions of the canonical New Keynesian model and log-linearizes them. This process yields the standard “three-equation” system (the IS curve, Phillips curve, and Taylor rule) often found in the literature. An example shows how Dynare can generate a stochastic simulation of the model and how monetary policy has real effects over the economy.

This chapter presents a second pass at parametrizing an economic model. The goal is to understand how Dynare can implement a Bayesian estimation procedure, and how Bayesian estimation can be used to complement the ideas behind calibration.

This chapter presents a first pass at parametrizing an economic model. The goal is to understand how a calibration exercise yields reasonable estimates for parameters, and how these parameters are consistent with a set of real-world targets that the user gets to choose.

This chapter shows how an infinite-horizon economy works almost like a finite-horizon economy -- with some minor differences. The goal of the chapter is to introduce the notion of the steady state, which is a dynamic equilibrium of the economy. Steady states are important for two reasons: first, because most economies (and all economies in the book) converge to them -- and remain in the steady state unless a shock moves the economy away from it. Second, because the solution techniques offered in the book rely on approximations around the steady state.

This chapter presents an introduction to Dynare, which is a computer software that macroeconomists use to solve DSGE models. It illustrates basic functions and potential pitfalls through a working example that resembles one of the social planner problems from earlier chapters.

This chapter expands the static general equilibrium economy: first, by adding a second period (a two-period economy) and second, by extending to an arbitrary large (but finite) horizon. If it helps, this chapter explains the “D” part of “DSGE.” The goal of the chapter is to show by example that a multi-period (but finite) economy works almost like a static economy -- with some minor differences. The chapter relies on the notion of a competitive equilibrium -- a description of the optimal choices of all agents in the economy that lays out a blueprint for characterizing and solving it. The emphasis is on pedagogy and not realism, but understanding the contents of this chapter is key for the material ahead.