Dynamic Macroeconomics

1.1.4 Deterministic and Stochastic Dynamic General Equilibrium Models
Both the new classical and the new Keynesian approaches coexist today, in
the context of what Goodfriend and King [1997] have termed the “new
neoclassical synthesis.” This synthesis is based on DSGE models, which
may or may not satisfy the conditions for optimality of the Arrow-Debreu
model. They share many common elements but are also characterized by
important differences with regard to their accounts of aggregate fluctuations
and their implications for monetary policy.
18
In a different development, after a long pause, growth theory has
displayed significant progress since the 1980s in the context of what has been
called “new growth theory.” This work has focused on the exploration of the
implications of increasing returns to scale, the role of human capital
accumulation, and endogenous technical progress. A more recent literature
has emphasized the interactions between fertility and technical progress as a
choice between the quantity and quality of children. This has resulted in the
development of the so-called unified growth theory, which, unlike previous
theories, can also explain the transition from stagnation to growth in the early
nineteenth century. Yet another stream in the literature emphasizes the role of
institutions in providing appropriate incentives for the accumulation of
physical and human capital and for research and development that leads to
technical progress.
19
In seeking to explain long-run economic growth and fluctuations in
aggregate economic activity, modern macroeconomics is dynamic. The
element of time is indispensable for understanding and explaining both types
of phenomena. In seeking to explain aggregate fluctuations, modern
macroeconomics is also stochastic: It explains aggregate fluctuations in
terms of the response of dynamic economic systems to random disturbances.
Stochastic growth models have also been developed. Hence, both the new
neoclassical synthesis and the new growth theory combine dynamic and
stochastic elements.
20
The dynamic stochastic approach to aggregate fluctuations follows a
tradition that was also founded in the 1930s, by mathematical economists and
statisticians, such as Frisch [1933] and Slutsky [1937]. This tradition, which
initially evolved independently of the General Theory, was subsequently
followed and extended in various directions by econometricians, such as
Tinbergen [1937], Haavelmo [1944] and the Cowles Commission, and Burns

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and Mitchell [1946]. The development of early Keynesian macroeconometric
models by Klein [1950], Klein and Goldberger [1955], and others applied
this tradition to the framework of the General Theory.
21
The way in which modern macroeconomics approaches and analyzes
aggregate fluctuations owes a lot to the following important observation by
Lucas [1977, pp. 9–10]:
Technically, movements about trend in gross national product in any country can be well described
by a stochastically disturbed difference equation of very low order. These movements do not exhibit
uniformity of either period or amplitude, which is to say, they do not resemble the deterministic wave
motions which sometimes arise in the natural sciences. Those regularities which are observed are in
the co-movements among different aggregative time series. …One is led by the facts to conclude
that, with respect to the qualitative behavior of co-movements among series, business cycles are all
alike. To theoretically inclined economists, this conclusion should be attractive and challenging, for it
suggests the possibility of a unified explanation of business cycles, grounded in the general laws
governing market economies, rather than in political or institutional characteristics specific to