Ricardian Equivalence, Benchmark Models, As Well As Academics Reply To The Fiscal Crisis

Mainly for economists

In his farther thoughts on DSGE models (or maybe his reply to those who took upward his kickoff thoughts), Olivier Blanchard says the following:

“For conditional forecasting, i.e. to aspect for representative at the effects of changes inward policy, to a greater extent than structural models are needed, only they must agree the information closely in addition to create non involve to move religious most micro foundations.”

He suggests that at that topographic point is broad understanding most the above. I sure agree, only I’m non sure most academic macroeconomists do. I retrieve they mightiness enjoin that policy analysis done past times academics should involve microfounded models. Microfounded models are, past times definition, religious most microfoundations in addition to create non agree the information closely. Academics are taught inward grad schoolhouse that all other models are flawed because of the Lucas critique, an declaration which assumes that your microfounded model is correctly specified.

It is non solely academics who retrieve policy has to move done using microfounded models. The essence model used past times the Bank of England is a microfounded DSGE model. So fifty-fifty inward this policy making institution, their essence model does non arrange to Blanchard’s prescription. (Yes, I know they convey lots of other models, only still. The Fed is closer to Blanchard than the Bank.)

Let me move to a greater extent than specific. The essence macromodel that many academics would write downward involves ii telephone substitution behavioural relationships: a Phillips bend in addition to an IS curve. The IS bend is purely forrad looking: consumption depends on expected hereafter consumption. It is derived from an infinitely lived representative consumer, which way Ricardian Equivalence holds inward this model. As a result, inward this benchmark model Ricardian Equivalence also holds. [1]

Ricardian Equivalence way that a bond financed revenue enhancement cutting (which volition move followed past times revenue enhancement increases) has no behave on on consumption or output. One stylised empirical fact that has been confirmed past times written report subsequently written report is that consumers create pass quite a large proportion of whatsoever revenue enhancement cut. That they should create thus is non or thus deep mystery, only may move traced dorsum to the supposition that the intertemporal consumer is never credit constrained. In that item feel academics’ essence model does non agree Blanchard’s prescription that it should ‘“fit the information closely”.

Does this essence model influence the way or thus academics retrieve most policy? I convey written how mainstream macroeconomics neglected earlier the financial crisis the importance that shifting credit weather condition had on consumption, in addition to speculated that this neglect owed something to the insistence on microfoundations. That links the methodology macroeconomists use, or to a greater extent than accurately their belief that other methodologies are unworthy, to policy failures (or at to the lowest degree inadequacy) associated amongst that crisis in addition to its aftermath.

I wonder if the benchmark model also contributed to a resistance amid many (not a majority, only a pregnant minority) to using financial stimulus when involvement rates hitting their lower bound. In the benchmark model increases inward populace spending withal heighten output, only or thus economists create worry most wasteful expenditures. For these economists revenue enhancement cuts, especially if aimed at those who are non-Ricardian, should move an attractive option way of stimulus, only if your benchmark model says they volition convey no effect, I wonder whether this (consciously or unconsciously) biases you lot against such measures.

In my view, the benchmark models that academic macroeconomists send circular inward their caput should move precisely the variety Blanchard describes: aggregate equations which are consistent amongst the data, in addition to which may or may non move consistent amongst electrical flow microfoundations. They are the ‘useful models’ that Blanchard talked most inward his graduate textbook amongst Stan Fischer, although in addition to then they were confined to chapter 10! These essence models should move nether constant challenge from both partial equilibrium analysis, estimation inward all its forms in addition to analysis using microfoundations. But when force comes to shove, policy analysis should move done amongst models that are the best nosotros convey at coming together all those challenges, in addition to non models amongst consistent microfoundations.

[1] Recognising this point, or thus mightiness add together or thus ‘rule of thumb’ consumers into the model. This is fine, equally long equally you lot create non maintain to retrieve the model is microfounded. If these dominion of pollex consumers pass all their income because of credit constraints, what happens when these constraints are expected to concluding for to a greater extent than than the adjacent period? Does the model correctly predict what would come about to consumption if the proportion of dominion of pollex consumers changes? It does not.