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Tuesday, December 17, 2013

'Four Missing Ingredients in Macroeconomic Models'

Antonio Fatas:

Four missing ingredients in macroeconomic models: It is refreshing to see top academics questioning some of the assumptions that economists have been using in their models. Krugman, Brad DeLong and many others are opening a methodological debate about what constitute an acceptable economic model and how to validate its predictions. The role of micro foundations, the existence of a natural state towards the economy gravitates,... are all very interesting debates that tend to be ignored (or assumed away) in academic research.

I would like to go further and add a few items to their list... In random order:

1. The business cycle is not symmetric. ... Interestingly, it was Milton Friedman who put forward the "plucking" model of business cycles as an alternative to the notion that fluctuations are symmetric. In Friedman's model output can only be below potential or maximum. If we were to rely on asymmetric models of the business cycle, our views on potential output and the natural rate of unemployment would be radically different. We would not be rewriting history to claim that in 2007 GDP was above potential in most OECD economies and we would not be arguing that the natural unemployment rate in Southern Europe is very close to its actual.

2. ...most academic research is produced around models where small and frequent shocks drive economic fluctuations, as opposed to large and infrequent events. The disconnect comes probably from the fact that it is so much easier to write models with small and frequent shocks than having to define a (stochastic?) process for large events. It gets even worse if one thinks that recessions are caused by the dynamics generated during expansions. Most economic models rely on unexpected events to generate crisis, and not on the internal dynamics that precede the crisis.

[A little bit of self-promotion: my paper with Ilian Mihov on the shape and length of recoveries presents some evidence in favor of these two hypothesis.]

3. There has to be more than price rigidity. ...

4. The notion that co-ordination across economic agents matters to explain the dynamics of business cycles receives very limited attention in academic research. ...

I am aware that they are plenty of papers that deal with these four issues, some of them published in the best academic journals. But most of these papers are not mainstream. Most economists are sympathetic to these assumption but avoid writing papers using them because they are afraid they will be told that their assumptions are ad-hoc and that the model does not have enough micro foundations (for the best criticism of this argument, read the latest post of Simon Wren-Lewis). Time for a change?

On the plucking model, see here and here.

    Posted by on Tuesday, December 17, 2013 at 12:33 AM in Economics, Macroeconomics, Methodology | Permalink  Comments (17)

          


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