Limits of modern macroeconomic models

In the last few days, the blogosphere has seen a fascinating debate about the effectiveness of macroeconomic models in explaining and forecasting economic events, triggered off by David Andolfatto's attack on Paul Krugman (Paul's precise response is here) and Brad DeLong's advocacy of fiscal policy measures to survive the recession. He had claimed that the policy advice of both was not based on an understanding of modern macroeconomic models and "rooted in rigorous theory", but went no deeper than the Keynesian cross.

This prompted an unexpectedly sharp retort from Mark Thoma who accused David of being "plain dishonest". He points to the recent works of economists like Gauti Eggertsson (a reduction in taxes on wages deepens a recession because it increases deflationary pressures, while a cut in capital taxes does the same because it encourages people to save instead of spend at a time when more spending is needed, and all this is of a higher magnitude when interest rates touch the zero-bound) Michael Woodford (welfare is maximized by expanding government purchases to at least partially fill the output gap that would otherwise exist owing to the central bank's inability to cut interest rates) and George Evans (also here), all of whose macro-models favor demand-side measures like aggressive fiscal policy interventions, especially when nominal interest rates are touching the zero-bound over supply-side measures like monetary policy actions or tax cuts.

He follows up with this excellent post where he feels that the standard macro model used for policy analysis, the New Keynesian model, is unsatisfactory in many ways and it may not be possible to fix it in a satisfactory enough manner.

Crucially, he feels that modern macroeconomic models do not generally connect the real and the financial sectors. These linkages assumes significance because they provide an important transmission mechanism whereby shocks in the financial sector can affect the real economy. Further, the representative (or identical) agent assumption, while it overcomes difficult problems associated with aggregating individual agents into macroeconomic aggregates, flies against the face of reality in modern day financial markets. He writes,

"When this assumption is dropped it becomes very difficult to maintain adequate microeconomic foundations for macroeconomic models... But representative (single) agent models don't work very well as models of financial markets. Identical agents with identical information and identical outlooks have no motivation to trade financial assets (I sell because I think the price is going down, you buy because you think it's going up; with identical forecasts, the motivation to trade disappears). There needs to be some type of heterogeneity in the model, even if just over information sets, and that causes the technical difficulties associated with aggregation."

In this context, in contrast to existing monetary policy rules, like the Taylor Rule, which are responsive only to inflation and the output gap, Mark Thoma points to recent research, by the likes of John Geanakoplos, in developing general equilibrium models of asset pricing in which collateral, leverage and default play a central role. As Rajiv Sethi writes, in these models,

"the price of an asset at any point in time is determined not simply by the stream of revenues it is expected to yield, but also by the manner in which wealth is distributed across individuals with varying beliefs, and the extent to which these individuals have access to leverage. As a result, a relatively modest decline in expectations about future revenues can result in a crash in asset prices because of two amplifying mechanisms: changes in the degree of equilibrium leverage, and the bankruptcy of those who hold the most optimistic beliefs."

Similarly, agent-based models which have been at the centre of the emerging field of complexity economics (which explores the interaction between economic agents under varying constraints and rules), may have an important role to play in the development of more real-world rooted macroeconomic models. More effective macroeconomic models will also have to incorporate the efforts of sometimes forgotten economists like Hyman Minsky. Rajiv Sethi has a few more suggestions to derive models which are better approximations of the real world.

See this and this for exhaustive coverage of the debates on the effectiveness of fiscal policy measures to combat recessions.

Update 1 (12/6/2010)

Edward Glaeser has an excellent post that highlights the problem with modern macroeconomics, in its ability to prescribe solutions for preventing and addressing banking crisis, economic crisis and high unemployment rates. To take the example of banking regulation, he writes,

"There is certainly a healthy debate about the appropriate nature of the remedy. Are higher capital requirements enough? Should banks be charged a risk tax based on their portfolios? Should the biggest banks be broken up so that they are no longer too big to fail?"

Update 2 (18/3/2011)

Greg Mankiw and Matthew Weinzierl argue that any optimal stabilization policy when the nominal interest rates are zero should revolve around commiting to increase inflation and cutting taxes. They note that tax policy can do a better job of replicating the flexible price equilibrium in terms of the allocation of resources, and hence tax policy should be used instead of government spending. See the critiques by Paul Krugman and Mark Thoma.