Sunday, 16 May 2010

Kocherlakota on macro

An essay on the state of modern macroeconomics by Narayana R. Kocherlakota - President of the Minneapolis Fed. Kocherlakota writes
This essay describes the current state of macroeconomic modeling and its relationship to the world of policymaking. Modern macro models can be traced back to a revolution that began in the 1980s in response to a powerful critique authored by Robert Lucas (1976). The revolution has led to the use of models that share five key features:

a. They specify budget constraints for households, technologies for firms, and resource constraints for the overall economy.
b. They specify household preferences and firm objectives.
c. They assume forward-looking behavior for firms and households.
d. They include the shocks that firms and households face.
e.They are models of the entire macroeconomy.

The original modern macro models developed in the 1980s implied that there was little role for government stabilization. However, since then, there have been enormous innovations in the availability of household-level and firm-level data, in computing technology, and in theoretical reasoning. These advances mean that current models can have features that had to be excluded in the 1980s. It is common now, for example, to use models in which firms can only adjust their prices and wages infrequently. In other widely used models, firms or households are unable to fully insure against shocks, such as loss of market share or employment, and face restrictions on their abilities to borrow. Unlike the models of the 1980s, these newer models do imply that government stabilization policy can be useful. However, as I will show, the desired policies are very different from those implied by the models of the 1960s or 1970s.

As noted above, despite advances in macroeconomics, there is much left to accomplish. I highlight three particular weaknesses of current macro models. First, few, if any, models treat financial, pricing, and labor market frictions jointly. Second, even in macro models that contain financial market frictions, the treatment of banks and other financial institutions is quite crude. Finally, and most troubling, macro models are driven by patently unrealistic shocks. These deficiencies were largely—and probably rightly—ignored during the “Great Moderation” period of 1982–2007, when there were only two small recessions in the United States. The weaknesses need to be addressed in the wake of more recent events.

Finally, I turn to the policy world. The evolution of macroeconomic models had relatively little effect on policymaking until the middle part of this decade.1 At that point, many central banks began to use modern macroeconomic models with price rigidities for forecasting and policy evaluation. This step is a highly desirable one. However, as far as I am aware, no central bank is using a model in which heterogeneity among agents or firms plays a prominent role. I discuss why this omission strikes me as important.
Make of it what you will.

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