*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