Forecasting with DSGE models

Dynamic Stochastic General Equilibrium (DSGE) models are designed to do policy analysis. They are based on microfoundations and calibrated or estimated to provide quantitative answers to policy scenarios and in particular study environments for which there is no historical precedent. These model are not designed for forecasting, traditional statistical tools, where ad-hoc models with minimal theory are fitted to the data, are optimized for this. But one may still ask whether DSGE models are any good for forecasting.

Rochelle Edge, Michael Kiley and Jean-Philippe Laforte take the the DSGE model used by the Federal Reserve Board to check on its forecasting performance and are surprised by its success. If fact, the specific DSGE model they use, dubbed "Edo", outperforms both the time-series model of the Fed and the staff predictions. Now, "Edo" is not a simple and small real business cycle model, it is a heavy beast with lots of details. Adding complexity allows a model to provide richer results, but contrarily to statistical models, it may lower the performance of a DSGE model. Indeed, adding new features may undo well-performing components of the model, as everything is interlinked ("general equilibrium"). It is all the more remarkable that this large model works so well.

Interestingly, this exercise is performed with real-time data, i.e., data that was available at the time the forecast would have been made, neglecting subsequent revisions. This is important from a policy point of view, as real-time forecasts are those that really matter for policy decisions.

To all naysayers, DSGE models are good for forecasting, and better than traditional models. The fact that they may not have predicted the current crisis does not mean that they need to be rejected en bloc. Did traditional, statistical models do any better? Of course not, as they are notoriously bad at predicting turning points. Also, the fact that DSGE models (among others) failed this time does not mean that suddenly all lessons learned from these models are not valid anymore and that Keynesian policies are suddenly effective again.