Models of Representative Agents and Real Business Cycle Models

In this chapter, after reviewing the use of the Lagrangian methodology in intertemporal maximization, and studying an application, we introduce a distinction between dynamic general equilibrium (DGE) models and dynamic stochastic general equilibrium models to highlight the importance of methodological innovation due to real business cycle (RBC) models of including stochastic shocks in dynamic models. The chapter continues with the examination of a basic RBC model, the methods of solution of log-linearized system, and the applications of Blanchard-Kahn procedures. In the Appendix, the chapter also reviews Bellman’s principle and dynamic programming. The determination of aggregate savings in an intertemporal context under conditions of uncertainty further illustrates the use of Bellman’s principle in economics.