Constructing a Small-Region DSGE Model

This paper constructs a tractable dynamic stochastic general equilibrium (DSGE) model of a regional economy that is considered small because it does not affect its national economy. To examine properties of our small-region DSGE model, we conduct several numerical simulations. Notably, fiscal expansion in our model is larger than that in standard DSGE models. This is because the increase in regional output does not raise interest rates, and this leads to the crowding-in effects of investment. 1. Introduction Economists and central banks frequently use dynamic stochastic general equilibrium (DSGE) models to analyze macroeconomies and to evaluate economic policy. While DSGE models that analyze macro economies have been increasingly developed, a DSGE model to analyze a regional economy such as a prefecture in Japan, a state in the United States, or a county in the United Kingdom is needed. There are numerous small regions in which that output is a small fraction of GDP. Twenty-two of fifty-one states in the USA produced less than 1% of its GDP in 2010. In Japan, nineteen of forty-seven prefectures produced less than 1% of Japan’s GDP in 2010. Small regions’ policy makers need an effective small-region DSGE model to evaluate their policies, or they will be forced to use traditional macro-econometric models. We aim to construct a tractable DSGE model to analyze a small region that does not affect its national economy because a model for a large region can be constructed using standard DSGE models. Our model can forecast a targeted small region’s economy, given various national economic variables such as GDP, and it can evaluate effects of local and central government policies on the region. In particular, our model is quite useful for regional policy planning. From a theoretical point of view, in our small-region DSGE model, the region’s activity does not alter both of the interest rates of financial assets and final goods prices, which are affected by changes in state of national economy. In particular, a constancy of interest rates has great importance for fiscal policy in our model because crowding-out effects for both consumption and investment then disappear. Fiscal expansion usually has negative effects on consumption due to negative income effects and intertemporal substitution effects (see Baxter and King [1]). The decrease in investment results in an increase in interest rates. In our model, since crowding-out effects are completely muted, fiscal expansion tends to yield a large positive effect on the economy without additional assumptions. In order