‘New Keynesian’ DSGE models

24 January, 2016 at 10:28 | Posted in Economics | 2 Comments

In the model [Gali, Smets and Wouters, Unemployment in an Estimated New Keyesian Model (2011)] there is perfect consumption insurance among the members of the household. SR002_FRONTBecause of separability in utility, this implies that consumption is equalized across all workers, whether they are employed or not … Workers who find that they do not have to work are unemployed or out of the labor force, and they have cause to rejoice as a result. Unemployed workers enjoy higher utility than the employed because they receive the same level of consumption, but without having to work.

There is much evidence that in practice unemployment is not the happy experience it is for workers in the model.  For example, Chetty and Looney (2006) and Gruber (1997) find that US households suffer roughly a 10 percent drop in consumption when they lose their job. According to Couch and Placzek (2010), workers displaced through mass layoffs suffer substantial and extended reductions in earnings. Moreover, Oreopoulos, Page and Stevens (2008) present evidence that the children of displaced workers also suffer reduced earnings. Additional evidence that unemployed workers suffer a reduction in utility include the results of direct interviews, as well as findings that unemployed workers experience poor health outcomes. Clark and Oswald (1994), Oswald (1997) and Schimmack, Schupp and Wagner (2008) describe evidence that suggests unemployment has a negative impact on a worker’s self-assessment of well being. Sullivan and von Wachter (2009) report that the mortality rates of high-seniority workers jump 50-100% more than would have been expected otherwise in the year after displacement. Cox and Koo (2006) report a significant positive correlation between male suicide and unemployment in Japan and the United States. For additional evidence that unemployment is associated with poor health outcomes, see Fergusson, Horwood and Lynskey (1997) and Karsten and Moser (2009) …

Suppose the CPS [Current Population Survey] employee encountered one of the people designated as “unemployed” … and asked if she were “available for work”. What would her answer be? She knows with certainty that she will not be employed in the current period. Privately, she is delighted about this because the non-employed enjoy higher utility than the employed … Not only is she happy about not having to work, but the labor union also does not want her to work. From the perspective of the union, her non-employment is a fundamental component of the union’s strategy for promoting the welfare of its membership.

Lawrence J. Christiano

fubar1To me these kind of “New Keynesian” DSGE models, where unemployment is portrayed as a bliss, are a sign of a momentous failure to model real-world unemployment. It’s not only adding insult to injury — it’s also sad gibberish that shamelessly tries to whitewash neoliberal economic policies that put people out of work.

All empirical sciences use simplifying or unrealistic assumptions in their modeling activities. That is not the issue – as long as the assumptions made are not unrealistic in the wrong way or for the wrong reasons.

Theories are difficult to directly confront with reality. Economists therefore build models of their theories. Those models are representations that are directly examined and manipulated to indirectly say something about the target systems.

But models do not only face theory. They also have to look to the world. Being able to model a “credible” DSGE world — how credible that world is, when depicting unemployment as a “happy experience” and predicting the wage markup to increase with unemployment, I leave to the reader to decide — a world that somehow could be considered real or similar to the real world, is not the same as investigating the real world. Even though all theories are false, since they simplify, they may still possibly serve our pursuit of truth. But then they cannot be unrealistic or false in any way. The falsehood or unrealisticness has to be qualified.

The final court of appeal for macroeconomic models is the real world — and as long as no convincing justification is put forward for how the inferential bridging from models to reality de facto is made, macroeconomic model building is little more than “hand waving” that gives us rather little warrant for making inductive inferences from models to real world target systems. If substantive questions about the real world are being posed, it is the formalistic-mathematical representations utilized to analyze them that have to match reality, not the other way around.



  1. Models that are not exact replicas are simplifications. Mathematical models are functions of variables. The variables are limited for tractability and chose to illustrate the effect of some key factors in a larger system. No problem so far.

    But when the assumptions are interpreted semantically as actually representational, then two questions need to be asked. First, how realistic are the assumptions, and secondly, are hypotheses generated by the model corroborated by observation.

    The first checks the model for bias e.g., assuming the conclusion. The second tests the theoretical model against what is being modeled.

    The problem in conventional economics is moves like begging the question and curve fitting, which is revealed by observation that is free of confirmation bias. This could be corrected if economists took observation into account with respect to predictions — that is, what the model implies about changes in what is modeled.

    But they don’t and when they do, it is with another illegitimate move like ad hoc “explanation” that allows a model to say anything after the fact.

    The chief abuse in the practice of convention economics appears to be cognitive bias. Since there is no price to pay for indulging cognitive bias, there is no incentive to correct it or even to acknowledge it. It’s group-think and mutual back-slapping.

    This is not science — substantiated knowledge, but rather ignorance — unsubstantiated belief that is often also untrue. The scientific method was developed to overcome ideological bias. Conventional economists don’t seem to be able to hear that criticism either from other scientists or from peers in their profession.

    This leads to the question, What is wrong with these people? Is it a mental health issue?

    To paraphrase Mr. Putin in another context, Are you not aware of what you have done? Lives are being destroyed by this when it is adopted as policy and is integrated into the cultural paradigm that influences both individual behavior and institutional arrangements. It’s now actually threatening an extinction event.

  2. The method seems to be: torture the tautology until it gives us the answers we want to hear.
    It is a terrible misuse of the methods of theoretical analysis, which ought to be employed trying to understand the essential nature of things, the organizing principles, the architecture of structure, the fundamentals of function.
    Unemployment is a genuine puzzle. Especially, if you believe in the “notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility.” (To quote Krugman second-hand from the previous post) It is both an ontological puzzle — how can unemployment happen, which is not just transitory, in an economy in which prices clear markets? And, it is a policy puzzle: how can public policy intervene to solve problems of unemployment, without breaking the price mechanism and creating gross inefficiency?
    But, we are far from treating unemployment as a genuine puzzle, even one upon which the lights cast from a spectrum of ideological viewpoints might create contrasting shadows. We are off in an Alice’s Wonderland of abstruse abstraction, where Tom Hickey’s question about whether it is a mental health issue has to be given credence.
    One hypothesis that I would offer is that economists want to hold onto their notions of a self-regulating economy of markets, as a neurotic wants to hold onto his defenses and delusions: in order to feel safe in a world he understands. The realistic alternative is to face the facts that the world is not safe and he does not understand it all that well.
    That economists can get work as civic priests preaching their delusions to the public provides a convenient ulterior motive keeping the neurosis in place.
    Theoretical analysis was abandoned for the torture of tautology when the results of the analytic research program centered on exploring the general equilibrium of a system of markets seemed to reach the conclusion that such a thing — Krugman’s precious notion of a self-regulating economy governed by the flexibility of prices –was logically impossible. That the actual economy features abundant hierarchy, administered prices and few actual markets ought to have excited curiosity, but the core dogmas were protected by the furious productions of hard math instead.

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