Blog Post

The state of macro redux

What’s at stake: In 2008, Olivier Blanchard argued in a paper called “the state of macro” that a largely shared vision of fluctuations and of methodology had emerged. With the financial crisis and our inability to prevent the greatest recession since the 1930s, the discipline entered into a period of soul searching. The discussions on the state of macro received new echoes this week after Blanchard published a short essay on the future of DSGE models.

By: Date: August 16, 2016 Topic: European Macroeconomics & Governance

The ingredients of DSGE models

Olivier Blanchard writes that DSGE models have come to play a dominant role in macroeconomic research. Some see them as the sign that macroeconomics has become a mature science, organized around a microfounded common core. Others see them as a dangerous dead end. Olivier Blanchard thinks that DSGEs should be the architecture in which the relevant findings from the various fields of economics are eventually integrated and discussed, but this is not the case today.

Timothy Taylor writes that DSGE models are a method that is both well established and the stuff of continuing controversy. Olivier Blanchard writes that DSGE models make three strategic modeling choices: First, the behavior of consumers, firms, and financial intermediaries, when present, is formally derived from microfoundations. Second, the underlying economic environment is that of a competitive economy, but with a number of essential distortions added, from nominal ties to monopoly power to information problems. Third, the model is estimated as a system, rather than equation by equation in the previous generations of macroeconomic models. Current DSGE models are best seen as large-scale versions of the New Keynesian model, which emphasizes nominal rigidities and a role for aggregate demand.

Olivier Blanchard writes that a typical DSGE paper adds a particular distortion to an existing core. It starts with an algebra-heavy derivation of the model, then goes through estimation, and ends with various dynamic simulations showing the effects of the distortion on the general equilibrium properties of the model.

Olivier Blanchard writes that a major potential strength of DSGE models is that they can be used not only for descriptive but also for normative purposes. The problem in practice is that the derivation of welfare effects depends on the way distortions are introduced in the model. And, often, for reasons of practicality, these distortions are introduced in ways that are analytically convenient but have unconvincing welfare implications. To take a concrete example, the adverse effects of inflation on welfare in these models depend mostly on their effects on the distribution of relative prices as not all firms adjust nominal prices at the same time. Research on the benefits and costs of inflation suggests, however, a much wider array of effects of inflation on activity and in turn on welfare.

Are ad hoc and DSGE models substitutes or complements?

Olivier Blanchard writes that models can also differ in their degree of simplicity. Not all models have to be explicitly microfounded. Ad hoc macro models, from various versions of the IS-LM to the Mundell-Fleming model, have an important role to play in relation to DSGE models. They can be useful upstream, before DSGE modeling, as a first cut to think about the effects of a particular distortion or a particular policy. They can be useful downstream, after DSGE modeling, to present the major insight of the model in a lighter and pedagogical fashion. The DSGE and the ad hoc models are complements, not substitutes.

Paul Krugman writes that a modeling approach is truly useful surprising if it generates surprising successful predictions. General relativity, for example, got its big boost when light did, in fact, bend as predicted. In recent years economists who still took seriously good old-fashioned Hicksian IS-LM type analysis made some strong predictions after the financial crisis that were very much at odds with what quite a few economists were saying. With interest rates near zero massive increases in the monetary base would not cause high inflation, large budget deficits would not drive interest rates up or crowd out private investment, and fiscal multipliers would be positive, in fact more than one, and would be considerably larger than estimates based on non-liquidity-trap episodes suggested.

Paul Krugman writes that the problem with DSGE models is that they not failed to provide surprising successful predictions but had the effect of crowding out the stuff that actually did work. Blanchard writes that he was allowed to present the basic insight more simply only because he was the discussant, but that the author of the paper wasn’t allowed to do the same thing. That’s DSGE substituting for, in fact, preventing the ad hoc approach.

Simon Wren-Lewis writes that what seems to be missing is a connection between people working on partial equilibrium analysis (like consumption) and general equilibrium modelers. Top journal editors’ preference for the latter means that the former is less highly valued.  The failure, for example, to take seriously the strong evidence about the importance of changes in credit availability for consumption played an important part in the inability of macroeconomics to adequately model the response to the financial crisis. Even if you do not accept that, the failure of most DSGE models to include any kind of precautionary saving behaviour does not seem right when DSGE has a monopoly in ‘proper modeling’.

DSGE modeling as signaling

Noah Smith writes that assuming that DSGE models really don’t work, why do so many macroeconomists spend so much time on them? One obvious hypothesis is that a huge percent of their human capital is already invested in knowing how to do this technique, so they just keep doing what they know how to do, and teaching it to their grad students. Another hypothesis could be that it’s just an equilibrium of a repeated coordination game. Universities pay macroeconomists to do research, but they have absolutely no idea what good macroeconomic research is, so in practice they pay macroeconomists to do whatever other macroeconomists decide is good. Another hypothesis is signaling. Theory papers are getting much less common in top econ journals, but are still prominent among job market papers. What’s being signaled, why is it valuable, and why is it hard to observe directly? The obvious possibility is that it’s signaling intelligence – that the ability to make DSGE models is just an upper-tail IQ test. That’s valuable because A) in the long run, people with very high intelligence are going to do good research, and B) intelligence gets much harder to observe in the upper tail.

Brad DeLong writes that if you insist on trying to understand business cycles by requiring a single consumption Euler equation (rather than, say, risk-averse rich 70-somethings with short horizons; myopic middle-class 40-somethings, and the liquidity constrained); if you insist on trying to understand business cycles by requiring that firms engage in Calvo pricing; If you insist on trying to understand business cycles by requiring rational expectations (rather than anchored, adaptive, extrapolative, perfect-foresight, and Panglossian) – well, then you really aren’t very bright at all, are you?


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Blog Post

A few good (wo)men – on the representation of women in economics

Last week, the American Economics Association Annual Meetings held a session on Gender Issues in Economics and later announced that a new code of professional conduct is in the pipeline. In this blogs review we revise the recent contributions on female representation and perception in economics.

By: Inês Goncalves Raposo Topic: Global Economics & Governance Date: January 15, 2018
Read article More on this topic More by this author

Blog Post

The Republican Tax Plan (2): The debate rumbles on

Reactions to the Republican tax plans continue, concentrating on different aspects of the proposed legislation. We review the latest contributions.

By: Silvia Merler Topic: Global Economics & Governance Date: December 18, 2017
Read article More by this author

Blog Post

The DSGE Model Quarrel (Again)

Dynamic Stochastic General Equilibrium models have come under fire since the financial crisis. A recent paper by Christiano, Eichenbaum and Trabandt – who provide a defense for DSGE – has generated yet another wave of reactions in the economic blogosphere. We review the most recent contributions on this topic.

By: Silvia Merler Topic: European Macroeconomics & Governance, Global Economics & Governance Date: December 11, 2017
Read article More by this author

Blog Post

The Bitcoin Bubble

The price of bitcoin has just passed $11,000. A year ago it was worth less than $800. Economists and commentators are thus increasingly concerned that this may be a bubble waiting to burst. We review recent opinions on the topic.

By: Silvia Merler Topic: Finance & Financial Regulation, Global Economics & Governance Date: December 4, 2017
Read article More on this topic More by this author

Blog Post

The Republican Tax Plan

As the Trump administration’s tax plan continues its way through the legislature, we review economists’ and commentators’ recent opinions on the matter.

By: Silvia Merler Topic: Global Economics & Governance Date: November 27, 2017
Read article More on this topic More by this author

Blog Post

Has the Phillips curve disappeared?

The Phillips curve prescribes a negative trade-off between inflation and unemployment. Economists have been recently debating on whether the curve has disappeared in the US and Europe. We report some of the most recent views.

By: Silvia Merler Topic: Global Economics & Governance Date: November 21, 2017
Read article More on this topic More by this author

Blog Post

Powell's Federal Reserve

With the appointment of Jerome Powell as the next Fed’s chairman, President Trump break a tradition of bipartisan re-nomination and chooses someone who is not an economy by formation. We review economist’s opinions on this choice and the challenges ahead.

By: Silvia Merler Topic: Global Economics & Governance Date: November 13, 2017
Read article More on this topic More by this author

Blog Post

The Bank of England’s dovish hike

For the first time since 2007, the Bank of England raised interest rates, with a hike of 25 basis points. At the same time, it provided forward guidance that outlines a very gradual path for future increases. We review the economic blogosphere’s reaction to this decision.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: November 6, 2017
Read article More on this topic More by this author

Blog Post

The capital tax cut debate

How much do workers gain from a capital gains tax cut? CEA chairman Hasset claims the tax cut will cause average household labour income to increase by between $4000 and $9000. Several commentators note this implies that more than 100% of the incidence of the tax is on labour. This question has triggered a heated discussion in the economic blogosphere, which we review here.

By: Silvia Merler Topic: Global Economics & Governance Date: October 30, 2017
Read article More by this author

Blog Post

Bailout, bail-in and incentives

Ever since the outbreak of the global financial crisis, more and more rules have been developed to reduce the public cost of banking crises and increase the private sector’s share of the cost. We review some of the recent academic literature on bailout, bail-in and incentives.

By: Silvia Merler Topic: Finance & Financial Regulation, Global Economics & Governance Date: October 23, 2017
Read article More on this topic More by this author

Blog Post

An irrational choice: behavioural economist wins Nobel Prize

Richard Thaler was awarded this year's Nobel Prize in Economics for his contributions to the field of behavioural economics. His work documents a set of cognitive biases affecting economic decision-making and casts doubt on commonly-held assumptions about the rational ‘homo economicus’ that inhabits economic models and theories. What are the implications for the economics discipline and public policy?

By: Konstantinos Efstathiou Topic: Global Economics & Governance Date: October 16, 2017
Read article More on this topic More by this author

Blog Post

On the cost of gun ownership

On 1 October 2017, 59 people were killed and another 489 injured in what is currently the deadliest mass shooting in US modern history. The author reviews recent contributions on the economic cost of gun violence, as well as the impact of regulation.

By: Silvia Merler Topic: Global Economics & Governance Date: October 11, 2017
Load more posts