General Principles for Specifying a Dynamic General Equilibrium Model

The Dynamic General Equilibrium Model (DGE) is characterized by various features. Firstly, a DGE is dynamic, which means that it considers an economy over time. Second, it considers a general economy, which implies that the modelled economy is fully specified. Lastly, the model relies on an equilibrium concept.

Most DGE models include a number of core of elements:

  1. Households

    Households represent the demand side of the economy. We need to specify their preferences over commodities and endowments. We also need to state the households’ objective, which usually is utility maximization. That is households try to maximize their preferences subject to a set of constraints.

  2. Firms

    Beside households, we need to specify the supply side. We specify an amount of firms and a technology that firms can use to produce and sell goods. Furthermore, we also need to define the goal of firms. Usually, the objective of firms consists in maximizing their profits subject to their production plans being technologically feasible.

  3. Institutions

    Additionally, we need to specify institutions, which usually includes a government and/or a central bank. Particularly, we need to specify the policy of the institutions. Thereby, the policy of institutions can be taken as given or being modelled as optimally chosen, subject to a government budget constraint.

  4. Information

    It is important to specify the information in the economy. That is, we need to specify who knows what at which point in time.

  5. Markets

    We need to implement markets and think of what kind of market we wish to model. Popular choices of markets include Arrow-Debreu, Sequential Markets and Incomplete Markets.

  6. Equilibrium Concept

    Finally, we need to specify the equilibrium concept. A possible choice is the competitive equilibrium, in which the price cannot be influenced by a single firm.

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