Building Dynamic Stochastic General Equilibrium Models for Monetary Policy Analysis

Abstract

Dynamic Stochastic General Equilibrium (DSGE) models are powerful tools that provide a coherent framework for policy discussion and analysis. In principle, they can help to identify sources of fluctuations, answer questions about structural changes, help to forecast and predict the effect of policy changes, and perform counterfactual experiments. Against this background, this paper aims at providing an insightful discussion on DSGE models by developing a simplified version of the models to explain the behavior of key macroeconomic variables in Nigeria namely: the growth rate of gross domestic product (GDP), headline inflation, exchange rate and the monetary policy rate. The estimated results highlight the central role of expectations in the transmission of shocks and policy impulses in DSGE models. The main lesson that we derive from the study is that management of expectations provides an effective approach to controlling inflation.