DSGE stands for “dynamic stochastic general equilibrium.”. As Blanchard described in his note “Do DSGE Models Have a Future?” , DSGE Models have three major modeling characteristics.
As its name suggested, one important aspect of the DSGE models is its “dynamic” feature. The interaction between the blocks is “dynamic” in the sense that expectations of the future are a crucial determinant of today’s outcome, i.e. output and inflation tomorrow, and thus their expectations as of today, depend on monetary policy tomorrow, and whatever will happen from then into the infinite future. Therefore, in the DSGE models, expectations are the main channel through which policy affect the economy.
DSGE is a methodology for a wide range of macroeconomics models. One of the most common formulation is the so-called New Keynesian three-equation model. In the New Keynesian three-equation model, first, the behavior of consumers, firms, and financial intermediaries, when present, is formally derived from microfoundations, i.e. they are normally based on microeconomics theories or empirical findings. Second, the underlying economic assumption is that there is a competitive economy, but with a number of essential distortions added, e.g. nominal rigidities, monopoly power, or information problems. Third, the model is estimated as a system, rather than equation by equation in the previous generations of macroeconomic models.
As explained in “Policy Analysis Using DSGE Models: An Introduction” by Sbordon, Tambalotti, Rao and Walsh, most of the DSGE models used for policy analysis are built on three blocks: a demand block, a supply block, and a monetary policy equation.
In extremely simplified terms, the demand block describes how real interest rate affect the real output of the economy, the supply block describes how the real output level alter the inflation level, and the monetary policy rule describes how unexpected inflation and real output change affect the nominal interest rate.