how much progress has the mainstream made?macroeconomics ⍨dubbed ⍈the new consensus⍈⍩ •a...
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How much progress has themainstream made?
Evaluating modern DSGE models from a Post-Keynesian Perspective
Prof. Dr. Sebastian Dullien
Presentation at PKSG 27th annual workshop in Greenwich
June 1, 2017
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Outline
1. Introduction
2. Why talk about DSGE?
3. Core elements of DSGE models
4. Post-Keynesian criticism against DSGE
5. Progress made in the past years
6. Evaluation of progress
7. Conclusions
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WHY TALK ABOUT DSGE?
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DSGE in the mainstream
• DSGE is predominant approach in academic macroeconomics (dubbed “the new consensus“)
• A large share of papers in the “top 5“ macroeconomic journals are now about DSGE
• Many mainstream economists believe that “if you have an interesting story to tell, you can tell it in a DSGE model. If you cannot, your story is incoherent” (Chari 2010)
• DSGE models seem to have Teflon-like qualities: failure to be helpful in Great Recession has left them broadly unscathed
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DSGE and the Post-Keynesian debate
• Question: How much interaction with themainstream?– Colander (2010) urges heterodox economists to present
ideas in models and methods of mainstream
– Fontana and Gerrard (2006) call for mathematicallyrigorous methods
– Lee (2012) and Vernengo (2010) take opposite position, caution against waste of time and energy
– Stockhammer/Ramskogler (2009) also recommend runningindependent research agenda
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CORE ELEMENTS OF DSGE
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DSGE: The acronym
• Dynamic Stochastic General Equilibrium model
– Dynamic: Individual actors optimize over infinite horizon
– Stochastic: We look what happens if there are stochasticshocks
– General Equilibrium: Microeconomic foundations with a number of markets which are in equilibrium
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DSGE modelling: The process
• Modern DSGE modeling for policy evaluation is a multi-stage process:– Appropriate (microeconomic) optimization conditions are
chosen
– Model is “log-linearized“ around steady-state
– ”Deep“ parameters (i.e. for the utility function) are chosen so that impulse response fits well with empirical data (”calibration“ of the model)
– Model is then used to simulate the response to an exogenous shock
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DSGE: Elements
• Household optimization stems from real business cycle models– Infinite horizon
– Rational expectations
– Variation of labour supply to intertemporal changes in real wages (representative agent)
• Some (New) Keynesian elements are added– Price-stickiness
– Monopolistic competition
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DSGE elements:
• Households maximise utility under budget constraint
• Utility is a CES utility function, which leads tomonopolistic competition in goods‘ markets
• Firms do mark-up price setting, with staggered priceadjustment (Calvo 1983)
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DSGE reduced equations
• New Keynesian IS-curve
• New Keynesian Philips curve
• Central banks‘ reaction function
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Advances of DSGE over New Classicaland Monetarist approaches models
• IS-curve looks familiar:
• Central banks conducts interest-rate policy (noexogenous money!)
• Central bank needs to be active to stabilize system
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POST-KEYNESIAN CRITICISMAGAINST DSGE
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Post-Keynesian criticism of DSGE models
• A number of Post-Keynesians have not been happy with the DSGE approach
– Dullien (2011)
– King (2012)
– Lavoie (2014, 2016)
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Criticism I: Absence of involuntaryunemployment
• Fluctuations in employment stem from households‘ decision to change labour supply in reaction tochanging real wages– Household enjoy more leisure when wages are low
• All unemployment hence is voluntary!
• Linked to this: Assumed intertemporal elasticity of labour supply in DSGE models is about 10 times as high as (micro-)empirically observed elasticity (Chetty et al. 2011)
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Criticism II: Assumptions about wagesand prices
• First generation DSGE models assume sticky prices, but flexible wages
– Necessary to have labour market always clearing
• This turns usual assumption on its head
– In the neoclassical synthesis, prices are flexible whilewages are sticky
• This also contradicts empirical observations
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Criticism III: Fiscal policy
• In first-generation DSGE models, deficit spendingincreases GDP…
• …but: leads to a drop in private consumption
• Mechanism:– Because of Ricardian equivalence, deficit spending lowers
future disposable income
– Households now reduce leisure time (offering morelabour) and private consumption
– Result: More output, but less private consumption
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Criticism IV: Endogenous Money
• DSGE models often have endogenous money in theform of
• Money supply automatically adjust to households‘ wishes to hold real balances
• Problem: Complications of credit process (Lavoie2014) is neglected
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Criticism V: No proper financial sector
• Early DSGE models did not include a financial sector
• Hence, they were real economy models with an interest rate set by the central bank
• All shocks eminating from the financial sector wereabsent
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Criticism VI: No Asset Price Bubbles
• DSGE models do not include the possibility of assetprice bubbles
• Fundamental issue: DSGE mdels feature one uniquedeterministic steady state (Miao 2016)
– Under this assumption, together with rational expectations, asset price bubbles are difficult, if not impossible to model
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PROGRESS MADE BY DSGE MODELLERS
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Making fiscal policy reaction moreplausible
• Following Galí et al. (2007), new DSGE modelsinclude rule-of-thumb consumers
– These consumers can neither save nor borrow
– They always consume all their income
– Large share (about 50 percent) of those consumers arenecessary to get plausible results
• Reaction now more plausible
– Deficit spending leads to more output and more private consumption
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Involuntary unemployment
• Galí et al. (2012) tries to model involuntaryunemployment– Heterogenous labour– Households have different labour types– Monopoly unions for each labour type set wages– Assumption: Labour supply can only be varied at the extensive
margin– Result: Some individuals are now unemployed even though
their household would want them to work
• Problem: Utility of unemployed is higher than of employed persons!
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Financial sector modelling
• Bernanke et al. (1999)
– Financial accelerator based on information asymmetrybetween financial intermediaries and borrowers
• Gertler and Karadi (2011)
– Information asymmetry between depositors andintermediaries
• Gertler and Kiyotaki (2011)
– Sudden changes in liquidity of certain assets
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EVALUATION OF PROGRESS IN DSGE MODELS
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Evaluation: Reaction to fiscal policy
• Very large share of households without access tofinancial markets (50 percent) necessary to getdecent results
• Question: Why should households behave accordingto rules-of-thumb in their consumption decision, yetnot their labour supply decisions?
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Evaluation of involuntaryunemployment
• As mentioned before, in Galí et al. (2012) formulation, the unemployed have a higher utilitythan the employed
• Even the DSGE community itself does not buy thestory in these model elements (Christiano 2012)
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Evaluation of financial sectormodelling
• Information asymmetries included are certainlysensible
• But: Are we sure that these mechanisms are reallythe underlying forces of the financial sector‘s impacton the economy?
• And: Still, no reasonable inclusion of asset pricebubbles exists!
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Why not include Farmer in my„progress of DSGE“ overview? (I)
• Farmer (2014) presents a microfounded model whichcleverly introduces path dependence into themacroeconomy
– Firms might not devote enough resources to matchworkers and jobs
– Unemployment might occur
– Based on current unemployment, households form expectations about life time income
– A small shock can have permanent consequences
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Why not include Farmer in my„progress of DSGE“ overview? (II)
• Households do not vary labour supply as a reactionto wages anymore (is this still DSGE?)
• DSGE mainstream does not seem to have (yet) accepted this modelling approach
• Is the modelling really plausible that unemploymentarises if firms devote their resources to productionrather than hiring?
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What are modern DSGE models doing?
• They replace (arbitrarily) parts of the utility-maximisingmicrofoundation by non-maximising elements
• They sometimes need to use completely implausibleparameters
• In the end, they get more plausible reactions of time series, but at the costs of increasingly dodgy
• In a way this seems a bit like saying: „Look, I cansomehow get certain features even into a DSGE model“
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A more philosophical question: What do we want from macroeconomic models?
• Padagogy: Explaining economic mechanisms found in the real world– Assumptions in new DSGE models are getting increasingly ad hoc and
implausible
– Value of overall model to explain working of an economy is highlyquestionable
• Forecasting and policy evaluation: Try to predict economicvariables– Out-of-sample prediction ability of DSGE models is highly questionable
– Do you really trust a model with provenly wrong microfoundations toforecast better than a model without microfoundations?
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Would you use Eliza to predict the reaction of fellowhuman beings?
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Is this a good model to simulate the behaviour of birds?
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One remark on the Lucas (1977) critique
• Lucas cautioned against using empirically observedrelationships to forecast impact of changes in economic policies
• However, there is nothing that indicates that usingincorrect micro-foundations is any better than havingno micro-foundations at all
– Research shows that deep parameters in DSGE modelshave a drift (Hurtado 2013) – exactly what Lucas used ascriticism against traditional macromodels
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Conclusions
• Modern DSGE models get some more plausible reactions of their time series than old models
• Yet, this comes at the expense of more implausibleelements and ad-hoc deviation frommicrofoundations
• Problematic issues remain
• It is still not clear where the value-added lies relative to macroeconomic model without microfoundations
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THANK YOU VERY MUCH FOR YOURATTENTION!
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