Wednesday, June 25, 2014

Brian Romanchuk — Monetary Frictions In DSGE Models

In an earlier article, I described a simple "endowment" model economy which was based on it working paper by John Cochrane. In that article, prices were extremely flexible, and the only means to pin down the initial price level is via the governmental budget constraint, which is a concept referred to as the Fiscal Theory of the Price Level. In this article, I explain the concept of monetary frictions, which creates an independent means of determining the initial price level. Once these frictions are introduced, the validity of the government budget constraint is more problematic.

What Is The Objective Of This Article?

This article and other related ones represents a first draft of ideas that I am going to incorporate into a book on the theory of fiscal policy. I have strong objections to the representation of fiscal policy within Dynamic Stochastic General Equilibrium (DSGE) models. In this article and the previous I present a simplified DSGE model and how it is supposed to be analysed. One difficulty in following the logic is that the model is very unrealistic, which is an inherent property of these models.
Once I have covered the base ideas, I will be easier to explain my criticisms.
Bond Economics
Monetary Frictions In DSGE Models
Brian Romanchuk

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