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Rebuilding the Benchmark Macroeconomic Model€¦ · –In Section 2 we discuss past paradigm...
Transcript of Rebuilding the Benchmark Macroeconomic Model€¦ · –In Section 2 we discuss past paradigm...
*BalliolCollege,StAntony’sCollegeandOxfordMartinSchoolatOxfordUniversity;AustraliaNationalUniversity;andCentreforEconomic
Policy,London
**UniversityofSydney
RebuildingtheBenchmarkMacroeconomicModel
DavidVines*andSamuelWills**
PaperPresentedatthe2017INET“Reawakening”ConferenceEdinburgh,UK,21– 23October
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1 TheNeedtoRebuild
• WhentheGreatModerationcollapsedintotheGFC,macroeconomistlookedratherfoolish– Whatshouldcoremacroeconomictheorynowlooklike– whatshouldweteachthenextgenerationofgradstudents?
• DuringtheGreatModeration,theNewKeynesianDynamicStochasticGeneralEquilibrium(DSGE)modelbecamethe‘benchmarkmodel’:theonetaughttograduatestudents
• Butthatbenchmarkmodelhasletusdown;– itexplainsneitherwhytheGFChappened,– norwhytherecoverysincetheGFChasbeensoslow.
• Andtheinfluenceofthatbenchmarkmodelhasdamagedtheabilityofthoseeconomistsworkingon“policymodels”forpolicymakinginstitutions– inparticularcentralbanksandFinanceMinistries– togivegoodpolicyadvice.
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• Whatmightanewbenchmarkmodelthatwecanuseinourteachingactuallylooklike?Doesitrequirea‘paradigmshift’?
• Thispaperbuildsonanddevelopstheargumentsinapaper,called“TheRebuildingMacroeconomicTheoryProject:anAnalyticalAssessment”,whichwehavewrittenfortheforthcomingissueoftheOxfordReviewofEconomicsPolicy(OxREP)onRebuildingMacroeconomicTheory.
• Planofthispaper– InSection2wediscusspastparadigmshiftsinordertohelpus
understandwhetherweneedanewparadigm– InSection3wedescribethebenchmarkDSGEmodel– InSection4,weshowwhythismodelwasunabletoeitherexplainwhy
theGFChappened,norwhytherecoverysincetheGFChasbeensoslow.– InSections56,7and8wesuggestwhattodonext• Thepaperisevolutionaryratherthanrevolutionary• Maybeitisevenconservative!Butthereismuchtodo. 3
2 PastParadigmShifts
2.1 The1930s• Thepunchlineofthe1930sisthat,priortothattime,economists
onlyhadAlfredMarshall’spartialequilibriummethodofanalysingmacroeconomicproblems.ThentheGreatDepressioncamealong.– ToexplaintheDepressionKeynestooktheMarshallianmodelandadded
nominalrigidities.Thismeantthat,inresponsetoafallininvestment,theeconomydidnotrapidlyreturntofullemployment.
• Tounderstandimplications,Keynesinventednewcontent:– theconsumptionfunction,themultiplier,andliquiditypreference.
• However,tounderstandimplicationsKeynesneedednewmethod:– thekindofgeneral-equilibriumanalysisprovidedbytheIS–LMsystem– Whathappensinthegoodsmarketaffectsthelabourmarketandvice-versa
• Thischangeinbothcontentandmethodwasaclearparadigmshift.
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2.2 The1970sand1980s• Thepunchlineofthe1970sisthat,whentheGreatInflationcame
along,economistswerenolongerabletousethefixed-priceIS–LMsystem,orthemodelsbasedonit,togiveadequatepolicyadvice.– However,comparedwithwhathadhappenedinthe1930s,theresponse
wasnotadecisiveparadigmshift.Instead,therewasamuchmorecontestedoutcome,theconsequencesofwhicharestillbeingfelt
AnEvolutionaryApproach• ThefirstsetofresponsestotheGreatInflationcamefrom
‘saltwatereconomists’fromtheUSEastCoastandthoseworkingintheUK,whowantedexistingmodelstoevolve.
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● Therewerefourstepstoevolutionaryapproach:– incorporatingaPhillipscurve,– allowingforadaptiveinflationexpectations,&verticallong-runPhillipscurve,– thecreationofanexplicitnominalanchorthroughtheadoptionofaninflation
targetingregime,– andtothemodellingofanendogenoussupplysideofthemodel,byallowing
forendogenouscapitalaccumulation.• Thisledtosignificantevolution• Policyremainedinterventionist,butfull-employmentKeynesianism
gavewaytoinflationtargeting.– Thisimpliedthatanylong-runreductioninunemploymentcouldonlybe
broughtaboutbysupply-sidereformsthatincreasedinvestment,raisedtechnicalprogress,orimprovedlabour-marketpractices,ratherthanbystimulatingaggregatedemand.
– Furthermore,inthisnewregime,activefiscalpolicymadewayforanactivemonetarypolicy.• LedtonewbenchmarkNewKeynesianmodel(seebelow)• Butthiswasevolutionarychange,notanewparadigm 6
ARevolutionaryApproach
• ThesecondresponsetotheGreatInflationwasarevolutionary– The‘freshwatereconomists’intheUSthoughtthattheinflationofthe1960s
and1970shaddiscreditedactiveKeynesianism.• Theirstrikingresponsehadtwocomponents.• FirstanewmethodwhicharoseoutoftheLucascritique:
– modelstobemicrofounded,optimizing,andforward- looking,withexpectationsofthefuturebeingmodel-consistent,or“rational”expectations
– Thismethod– themicrofoundationshegemony- hasbeenlargelyaccepted,– Thisfeatureappearsinthebenchmarkmodelpresentedbelow.
• Second,arequirementthattheeconomybetreatedasifitisinconstantequilibrium– andthereforedoesnotrequirepolicyintervention.– Thissecondrequirementhasbeencomprehensivelyrejected– ReasonprovidedinpapersbyFischer(1977),Taylor(1980)andCalvo(1983)
• Evenifallofthosewhoadjusthaveforwardlooingrationalexpectations,theexistenceofstaggeredtimingofpricechangescanstillleadtogradualadjustment,tonominalrigidities,andsotoaroleforaggregatedemand 7
3 TheBenchmarkNKDSGEModel:SmetsWouters(2007)
• AnIScurvedeterminingaggregatedemand,ithas2components.– Aforward-lookingEulerequationforconsumptionofrepresentativeconsumer.– Aforward-lookingequationforinvestmentbytherepresentativefirmwhichis
drivenbyTobin’sQ,whichisinfluencedbytherealinterestrateinrelationtothemarginalcostofcapital,andbythesizeofcapitaladjustmentcosts
• Thenaturallevelofoutputisdeterminedbyaproductionfunction– usingcapitalandlabour,giventheleveloftechnology.
• Aggregatedemandcandifferfromthenaturallevelofoutputbecauseofnominalrigiditiesandsoanoutputgapcanemerge.
• Suchagapcausesinflation,inawaydescribedbytheforward-lookingPhillipscurve,dependingonaCalvoprice-settingprocess.
• MonetarypolicyisrepresentedbyaTaylorrule.– Determinesnominalinterestrate,andthustherealinterestrate,InfluencesbothEulerequationandinvestmentfunction.
• Thefollowingtwopagespresenttwostandardsimulations– Illustratethekeyproblem:Ramseygrowthpathisaunique“attractor”
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Notation:C,I,Y,L, K,w,R,andQ,represent(respectively)consumption,investment,output,laboursupply,thecapitalstock,therealwage,the(gross)realinterestrate,andTobin’sQ.
Figure2: Responsetoa1%positivecost-pushshockNotation:C,I,Y,L, K,w,R, Q,andπ represent(respectively)consumption,investment,output,laboursupply,thecapitalstock,therealwage,the(gross)realinterestrate,Tobin’sQ,andinflation.
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4 Whymodelisnotfitforpurpose
4.1 Can’texplainseverecrisis&slowrecovery
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TheDifficultyisnotsurprising….
• ItcomesfromthetwocriticalassumptionsunderpinningDSGEmodels:
• First,theefficientmarketshypothesisgivesrisetoanexpectations-augmentedyieldcurveinwhichthereisnoendogenousriskpremium.
• Second,arationalexpectationsmodellikeourbenchmarkmodelalwaysconvergesbacktotheRamseyequilibriumgrowthpath.(cfthesimulationsdiscussedabove)– Thisistrueevenifthereisaverylargereductioninprivatedemandwhichcausesthezeroboundtothenominalinterestratetobereached.
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4.2Can’texplainpermanenteffectsofautonomousdemandexpansion
ThefollowingfourslidescapturepicturesfromanINETpaper:Girardi,D.,W.P.Meloni.W,andA.Stirati(2017)
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4.3 OtherissuesdiscussedattheINETconference
• Theabovetwoargumentsuggestthatthereisaneedforaradicalrethink
• ThreeissuesdiscussedattheINETconferencealsopointinthesamedirection.• First,theincreaseininequalityleadingtoanincreaseinthepropensityto
save.Tomodelthisweneedatleasttwoclassesofconsumersandastudyoftheeffectsofinequalityofwealthandincomeontheirspendingpatternsandthusonaggregatedemand
• Secondadecliningcostofcapital,andneedforcapitalintheservicesector,canhelptoprovideanexplanationforthelowlevelofinvestmentexpenditure.
• Thirdifbothconsumptionandinvestmentarelowthispointstoalowlevelofprivatesectordemandandsuggeststheneedforlooserfiscalpositioneventenyearsaftertheonsetofthecrisis.
• Thereareadditionalreasonsforarethinkwhichwediscussbelow.
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5 CanwebuildanewbenchmarkDSGEmodelthatistractable?
• Cavallero(2010)insiststhatchangesareneededwhicharenotpiecebypiece,butsystematic;maybethiswillbea“paradigmshift”• likethatinthe1930swhichproducedgeneralequilibriumthinking
• CarlinandSoskice(2018)provideastrikingfirstpassatsuchastory.– Theyaimtoprovideamodelfocusingontheshorttomediumrun– onewhichprovideanexplanationofwhyrecoveryhasbeensoslow
• Takethebenchmarkmodel.Makethefollowingfiveassumptions:– azeroboundtointerestrates,– theabsenceofdisinflationinthepresenceofhighunemployment,– strategiccomplementaritiesamonginvestorsproducingmultipleequilibria,– theassumptionthattechnicalprogressisembodiedininvestmentsothata
low-investmentoutcomewillgiverisetoalowrateoftechnicalprogress,– andsufficientmyopiaamonginvestorsandconsumersthatthepossibilityofa
goodoutcomeinthefuturedoesnotanoptimisticshadow• ThenaKeynesianunemploymentequilibriumispossible:• Ofcourseagoodequilibriumisalsopossible–
– butthesefiveassumptionsaresufficientforitnottobeachieved! 18
6 Ourownmoregeneralsuggestions
• CarlinandSoskiceclearlydoawaywiththemicrofoundationshegemony
• Wenowmakeourownsuggestionaboutwhatneedstobedone,drawingonthepointsidentifiedinSection4oftheseslides.• Wewouldalsodoawaywiththemicrofoundationshegemony
• Wearguethatfourchangesareneeded• Wethinkthatthethreebehaviouralequationsofthemodel:describingconsumption,investment,andprice-setting,mustallbeamendedorreplaced.
• Inaddition,wearguethatagapshouldbeintroducedbetweentherateofinterestsetbymonetarypolicymakersandtherateaffectingconsumptionandinvestmentdecisions
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Consumption
• Adistributionofconsumerswithdifferentlevelsofwealthwouldmakeitpossibletostudyinequality,andalsothefirst-ordereffectsofredistributiononaggregateconsumption(duetodifferentmarginalpropensitiestoconsume).
• Inanoverlappinggenerationsstructuretherealinterestratecanstayabovethemarginalproductofcapitalforextendedperiods(orevenpermanently),whichmayhelpexplaintheslowrecovery.
• Includinghousingwouldmakeitpossibletostudyconsumers’decisionstoinvestinhousesratherthanproductivecapital,whichinturnlowersrealincomeinthelongterm.– Itappearspossibletoincludethisinasimpleoverlappinggenerationsmodel
(seeBarrellandWeale,2010,andWang,2011).– However,thiswillbeinsufficientifthepurposeistostudythehouseprice
boomsandcollapsesthatHendryandMuellbauerarguemustbeexaminedinapolicymodel.
– Suchananalysiswouldrequireamorecomplextreatmentthatalsoconsidersthedown-paymentconstraintsandvaryingaccesstoequitywithdrawalthatcharacterisehomeloans. 20
Investment
• TheTobin’sQinvestmentequationneedstobereplacedbyonewhichallowsforliquidityconstraints,andforfinitehorizonswhichwoulddampentheresponsestochangesinQ.
• TheseconstraintsareimportantinexplainingthedownturnininvestmentimmediatelyaftertheGFC.
• Butthesechangeswouldnothelpinexplainingwhy,eventhoughequitymarketsarestrongandcashflowisweak,corporateinvestmentinadvancedcountriesisstillsolow.– HeretheideasofCarlinandSoskicemaybecrucial– TheideasofTurnermaybecrucial– TheideasofVinesandWillsmybecrucial
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Inflation
• TheCalvo-contractsequationforinflationneedstobereplacedwithonewhichallowsforsearchandunemploymenteffects,andinertia(likebackward-lookingexpectations),whichwillofitselfmaketheeffectsofdemandshocksmorelonglasting– Thefactthatsustainedhighunemploymentdidnotleadtodeflationduring
thecrisiscallsforarethinkofPhillipscurve.– TheabsenceofdeflationiscrucialtotheCarlinandSoskicestory
• Relativepriceadjustmentbetweenheterogeneousgoodsisalsoimportant.– ThisissomethingemphasizedbyGhironi(2018),inhismodelwith
heterogeneousfirms– ItisemphasisedbyAdairTurner– McKibbinandStoeckel(2018),intheirexaminationoftheeffectsonthe
globalstructureofrelativepricesoftheriseofemerging-marketeconomiesshowthatthisisimportant.
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InterestRateWedge
• Finally,wethinkthatagapshouldbeintroducedbetweentherateofinterestsetbymonetarypolicy-makersandtherateaffectingtheconsumptionandinvestmentdecisionsoftheprivatesector.
• Suchagapmaybeanotherimportantreasonwhyinvestmentinadvancedcountrieshasnotrecoveredsince2008.
• Theissuehererelatestotheneedtorelaxtwoofthecriticalassumptionsunderpinningthebenchmarkmodel:theefficientmarkethypothesis,andrationalexpectations.– Theefficientmarketshypothesismeansthatthingscannevergowrongbecause
ofariskpremium,providingthatsolvencyisensured– therecanbenoliquidityproblems
– Therationalexpectationsassumption(anditsimplicationthataneconomywilleventuallyre-convergetotheRamseygrowthpath)meansthattherecanneverbeareallyseriouscrisis.• Insertingagapbetweenthepolicyrateandtherateaffectinginvestmentdecisionsmaybeawayoffixingthis 23
7 Somemoregeneralsuggestions.
ThesuggestionsinthissectionarefromthepapersinforthcomingOxREPissue7.1 FinancialFrictions• Giventhatthe2008crisisoriginatedinthefinancialsector,whichthe
benchmarkDSGEmodelassumedworksfrictionlessly,itisnaturalthatthereiswidespreadmentionoffinancialfrictions– LiquidityconstraintssuggestedbyBlanchard,VinesandWills,andWright.– Balancesheeteffects,likeastockofleverageaffectingborrowingcapacity,are
mentionedbyallofBlanchard,HendryandMuellbauer,Stiglitz,Wren-Lewis,andVinesandWills;
– Blanchardhasarguedthat‘ownfunds’affectspendingdecisions.• Insummary,‘stocksshouldaffectflows’:capitalforbanksandcollateraland
wealtheffectsforindividualsandfirms.• Stiglitz:riskhasfirst-ordereffectswhichareoftenignored,seenmostclearlyin
thelongtimeittakesforthecollateralofbankstoberestoredaftershocks.• VinesandWillsarguethattheyieldcurveshouldbeendogenous
• CarlinandSoskice(2018,thisissue)argueforaneedtoincludeafinancialacceleratoranddebt-financedinvestmentinthemodel,andseeaneedforincludingtheeffectsofaleveragedbankingsystem 24
7.2 RelaxingRationalExpectations
• Blanchard,Ghironi,HaldaneandTurrell,andStiglitz,arguethattheagentsinourmodelslooktoofarintothefuture,andthatthisleadstounrealisticconsumptionbehaviour(theEulerequation)andprice-settingbehaviour(inCalvocontracting).– Thiscanhaveimportantimplicationsforpolicy,forexamplesuchforward-lookingnessmayleadto
lowestimatesoffiscalmultipliersasagentsoverweighttheprospectoffuturetaxincreases—asnotedbyHendryandMuellbauer,andStiglitz.
• Blanchard(2017)suggestsincorporatingfinitehorizons,notnecessarilycomingfromfinitelivesandincompletebequests,butinsteadfromboundedrationalityorfrommyopia.
• HaldaneandTurrellsuggestthatalessrigidframework,likeABMs,wouldallowformanydifferentdegreesofrationality,andshouldmakeitpossibletoincludetheeffectsofheuristicsthatmakesenseinanuncertainworldwithcostlyinformation.
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7.3 HeterogeneousAgents
– Bothconsumersandproducers.– Lindé,CarlinandSoskice,Ghironi,RicardoReis(2018,thisissue),andVinesandWills,citerecentworkbyKaplanetal.(2016)andRavnandSterk(2016)thatparsimoniouslyincludesbothheterogeneousagentsandsearchandmatchingfrictionsinaDSGEframework.
– HaldaneandTurrellofferABMasanotherwaytodothis.– Stiglitzarguesthatdoingthisiscrucialbecausethedistributionofincomematters,bothfordemandandforwelfareoutcomes.– Hediscussestheadjustmenttoanegativeshock;afallinrealwagescanreducedemandandincreaseunemploymentifworkershaveahighermarginalpropensitytoconsumethanownersofcapital.
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7.4 BetterMicrofoundations
• Threedifferentinterpretationsofwhatthismightmean.• Thefirstapproachwouldimprovemicrofoundationsinexistingcoremodel.
– Krugman:thefactthatsustainedhighunemploymentdidnotleadtodeflationduringthecrisiscallsforarethinkofPhillipscurve.
– Blanchardalsoidentifiestheadhoc approachtounderstandingpricestickinessasaproblem,arguingthatthedeepreasonsbehindthis,likethecostsofcollectinginformation,probablyhaveimplicationswhichreachbeyondwageandpricesetting,andthatweignoretheseatourperil.
• Thesecondapproachwouldbringadeeperapproachtomicrofoundationsthaniscurrentlyused,andisadvocatedbyWright.– Wrightarguesthattheuseofmoney,credit,andotherassetsinfacilitating
exchangeshouldemergeasoutcomesof,ratherthaninputstoourtheories.HearguesformicrofoundationsinthewaythatversionsofMortensenandPissarides(1994)orBurdettandMortensen(1998)modelsareacceptedasbenchmarksinlaboureconomics.• Thethirdapproach– agent-basedmodelling- wouldbringaradicallydifferentapproachtomicrofoundations,relyingonsimulationmethods 27
8 Conclusions
• Wehavedescribedwhatneedstobedonetoachieveanewbenchmarkmodel.– Thismayahopelessandmisguidedsearch.Maybeeventhesimplest
characterizationofausefulmodelrequiresacomplexmodel.Neverthelesswearehopefulthatanewbenchmarkmodelmaybefound.Andwearehopefulthatitmaybepossibletofindsuchamodelsimpleenoughtoteachourstudents.
• Twothingsarenecessaryforprogresstomemadeinthisdirection• First,itistimetodoawaywiththemicrofoundationshegemony
– Itistimeforoursubjecttoallowmoreroomfor,andshowmorerespectfor,thoseengagedinbuilding,andusing,policymodels.Thesemacroeconomistsarenowdoingourequivalentofexperimentalphysics.
• Thesecond—andrelated—lessonisthatthereneedstobemorepluralism.– Theremaynolongerbeatruechurch