The core assumption of ‘modern’ macro — totally FUBAR

14 Jan, 2014 at 23:15 | Posted in Economics | 5 Comments

A couple of months ago yours truly had a post up criticizing sorta-kinda “New Keynesian” Paul Krugman for arguing that the problem with the academic profession is that some macro-economists aren’t “bothered to actually figure out” how the New Keynesian model with its Euler conditions —  “based on the assumption that people have perfect access to capital markets, so that they can borrow and lend at the same rate” — really works. According to Krugman, this shouldn’t  be hard at all — “at least it shouldn’t be for anyone with a graduate training in economics.”

If people (not the representative agent) at least sometimes can’t help being off their labour supply curve — as in the real world — then what are these hordes of Euler equations that you find ad nauseam in “New Keynesian” macromodels gonna help us?

Noah Smith now has an extremely interesting piece up on his blog that essentially corroborates yours truly’s disdain for the DSGE modelers’ obsession with Euler equations. As with so many other assumptions in ‘modern’ macroeconomics, the Euler equations don’t fit reality:

fubar1For the uninitiated, the Consumption Euler Equation is sort of like the Flux Capacitor that powers all modern “DSGE” macro models … Basically, it says that how much you decide to consume today vs. tomorrow is determined by the interest rate (which is how much you get paid to put off your consumption til tomorrow), the time preference rate (which is how impatient you are) and your expected marginal utility of consumption (which is your desire to consume in the first place). When the equation appears in a macro model, “you” typically means “the entire economy”.

This equation underlies every DSGE model you’ll ever see, and drives much of modern macro’s idea of how the economy works. So why is Eichenbaum, one of the deans of modern macro, pooh-poohing it?

Simple: Because it doesn’t fit the data. The thing is, we can measure people’s consumption, and we can measure interest rates. If we make an assumption about people’s preferences, we can just go see if the Euler Equation is right or not!

[Martin] Eichenbaum was kind enough to refer me to the literature that tries to compare the Euler Equation to the data. The classic paper is Hansen and Singleton (1982), which found little support for the equation. But Eichenbaum also pointed me to this 2006 paper by Canzoneri, Cumby, and Diba of Georgetown (published version here), which provides simpler but more damning evidence against the Euler Equation …

[T]he Euler Equation says that if interest rates are high, you put off consumption more. That makes sense, right? Money markets basically pay you not to consume today. The more they pay you, the more you should keep your money in the money market and wait to consume until tomorrow.

But what Canzoneri et al. show is that this is not how people behave. The times when interest rates are high are times when people tend to be consuming more, not less.

OK, but what about that little assumption that we know people’s preferences? What if we’ve simply put the wrong utility function into the Euler Equation? Could this explain why people consume more during times when interest rates are high?

Well, Canzoneri et al. try out other utility functions that have become popular in recent years. The most popular alternative is habit formation … But when Canzoneri et al. put in habit formation, they find that the Euler Equation still contradicts the data …

Canzoneri et al. experiment with other types of preferences, including the other most popular alternative … No matter what we assume that people want, their behavior is not consistent with the Euler Equation …

If this paper is right … then essentially all modern DSGE-type macro models currently in use are suspect. The consumption Euler Equation is an important part of nearly any such model, and if it’s just wrong, it’s hard to see how those models will work.



  1. […] economics (which by most standards is very limited), most of the current models used rest on dubious assumptions that render the model almost useless when applied to any real market system. Not […]

  2. Lars,

    I thought you might be interested …



    • Thanks for the link, Chris. Looks like I’m going to have to put yet another blog on my observation list 🙂

  3. […] Lars Syll has recently linked to a post by Noah Smith criticising DSGE models. Criticising DSGE models is the latest fad in mainstream macroeconomics — hey, it’s easy to use the model that was in fashion just before the crisis as a scapegoat to distract the profession from the fact that they still have no idea how to begin to explain the crisis or its aftermath. […]

  4. Of course it’s bloody wrong. It’s brutally clear to almost everyone that most economists are no better than a pack of tribal witch doctors. The last 30 odd years have been the dark ages of economics. It’s an embarrassment of epic proportions. A whole profession and one held in high almost mystical regard at that and none of them actually understand what’s going on well enough to make a single worth while prediction. I am a simple engineer and it’s taken me a long time to figure out what’s going on but I have a very strong feeling that I could tell a government finance minister more usefull information than many of the best PhD economists out there. No reason for him to listen to me as I have another profession and no credibility and nothing to lose. But the Meer fact that I could reach this conclusion with relative certainty is a total endichtment to the economics profession. I would be ashamed to be an economics phd if I was one.
    I have to add that there are economists and people like Martin Wolf that do know what’s happening at a very high level and can communicate their position very well and know far more than me so all is not lost but these guys need to be sort out and recognized at the highest levels. If the economics profession wishes to save itself this in one of the things it must do.

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