—Does the phrase “dynamic stochastic general equilibrium” scare you? Fear not. The FT’s John Kay explains it all, in a smart column dedicated to what he politely calls “the failures of economics in the recent crisis.”
Both the efficient market hypothesis and DSGE are associated with the idea of rational expectations – which might be described as the idea that households and companies make economic decisions as if they had available to them all the information about the world that might be available. If you wonder why such an implausible notion has won wide acceptance, part of the explanation lies in its conservative implications. Under rational expectations, not only do firms and households know already as much as policymakers, but they also anticipate what the government itself will do, so the best thing government can do is to remain predictable. Most economic policy is futile.
Now he tells us.