In previous articles, we went through a simple DSGE model. We computed first order conditions and steady-state equations and we ran a simulation in Dynare. Maybe some of you were confused by one thing: there was no firm in the model. We had only a representative household, we even had a production function, but this function was a part of a household budget constraint. Isn’t this strange? Where is the firm? And where is a profit maximization task? We will discuss it in this article. We will define a new DSGE model which contains both firm and household. Then we will solve it and we will run a new simulation in Dynare.
There are several ways how to define the environment of the model. This is the “standard” way which you may know from the basic economics courses: There are households and firms in the model. The households provide labor and savings to the firms and firms provide consumption goods to the households. Transactions are made on labor, capital and consumption goods markets. This is the case which we are analyzing in this article.
We could use a different definition. The household can perform the functions of the firm: it can employ adult members of the family as workers and consume the produced goods. The savings of the household are used as capital.
We could also assume that the economy contains an element which is called a benevolent social planner. The social planner has no connection to socialism, communism or any other totalitarian regime. In DSGE models, the social planner is only a formal assumption which makes the solution of the model easier. The solution of the model is exactly the same for both versions. The social planner dictates the choices of consumption to maximize the household utility. This is why we call the planner benevolent. Its only desire is the household’s welfare.