Dynamic Stochastic General Equilibrium (DSGE) Models Are Sometimes Described as “Toy Economies”

Kydland and Prescott (1982) and Long and Plosser (1983) were particularly important in transforming the rational expectations revolution into the rigid orthodoxy of dynamic stochastic general equilibrium (DSGE) models. DSGE models are dynamic because they describe the behaviour of an imaginary economy over time. They are stochastic because some of the key variables of the model such as productivity and labour supply are subject to random shocks. Finally, they are general equilibrium models because all markets are considered at once.

DSGE models are sometimes described as ‘toy economies’ to underline how much they simplify real economies. A modern economy has many people and many goods, each different from the others. It changes continuously with innovations and surprises at every turn. DSGE models boil all this diversity down to a few equations representing, typically, one person, the representative individual, choosing how to distribute one good, labelled ‘consumption’, over time given a production technology that can change only when a random shock alters one or more coefficients of the equation linking a few inputs to the output of the one consumption good. Even the more elaborate DSGE models such as the important model of Smets and Wouters (2003) do not exceed about 30 equations.

—Roger Koppl, From Crisis to Confidence: Macroeconomics after the Crash, Hobart Paper 175 (London: Institute of Economic Affairs, 2014), 50.