A DSGE Consumption Function in a CGE Model: Parameter Estimation by CGE Simulation*

Abstract

DSGE models incorporate attractive theoretical specifications of the behaviour of forward‐looking consumers facing an uncertain future. Central to these specifications is the idea that consuming agents decide their consumption level in year t by applying a function (policy rule) whose arguments represent information available in year t. Using the insight that, under certain conditions, the policy rule (but not the resulting policy) is invariant through time, DSGE modellers have developed the perturbation and other methods for quantitatively specifying policy rules. They have applied these methods in models with limited sectoral disaggregation. In this paper we adapt the perturbation method so that it can be used to specify a policy rule for consumption in a full‐scale CGE model. A novel feature of our method is the use of specially constructed CGE simulations to reveal key parameters used in deriving the policy rule. We apply our method in illustrative simulations of the effects of a technology shock in a 70‐sector version of the USAGE model of the US economy.