Theoretical analysis of Dynamic General Equilibrium model

Abstract

Central Bank is one of the most important institutions of a country because its responsibility is to draw and implement the monetary policy. The central bank, in order to accomplish this responsibility, has to have a clearly defined main objective, the instruments that will use to achieve the objective, and it should be able to make precise or very good forecasts of macroeconomic variables. In order to make these forecasts, the central bank should first of all understand every monetary transmission mechanism and determine the most effective one. The success or non-success of monetary policy, living apart the other factors, depends on the monetary regime implemented in the country. In the last years, a lot of countries have implemented the inflation targeting regime. One of the conditions of the implementation of the inflation targeting regime is that the central bank should be able to make precise forecasts. For this reason, the structural macroeconomic models, in these days, have became very used because the central banks have used these models as a basis for the policy decision-making based in forecasts. The main goal of these models is to provide a more structured input for the monetary policy decision making, helping to create a full ‘history’ and helping to explain the consequences of different external shocks and different policy rules.Dynamic Stochastic General Equilibrium (DSGE) model is one of the most used forecasting models in the countries that have implemented the inflation targeting regime. Albania is one of the countries that want to formally implement the inflation targeting regime and give up the monetary targeting regime. Now for now Bank of Albania is using the MEAM model as a macroeconomic model of forecasting. In we look at the experience of the other countries that have implemented the inflation targeting regime and the recommendations of the foreign experts, we can conclude that Bank of Albania should work and should evaluate a DSGE model. This is the main reason why this paper is focused on the theoretical analysis of the DSGE model. In the paper will be presented arguments that explain why this is a good forecasting model for Albania. The arguments will be given based on the analysis of the characteristics of this type of model. Also in this paper we will discuss the advantages and disadvantages of this type of model. This analysis will help us strengthen the arguments about the necessity of use of this model from Bank of Albania.