‘New Keynesian’ DSGE models

29 March, 2016 at 17:02 | Posted in Economics | 1 Comment

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.

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 modeling convention used when constructing DSGE models makes it impossible to fully incorporate things that we know are of paramount importance for understanding modern economies — such as income and wealth inequality, asymmetrical power relations and information, liquidity preference, just to mention a few.

If substantive questions about the real world are being posed, it is the formalistic-mathematical representations utilized that have to match reality, not the other way around.

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  1. The theme of the last several days of posts seems to be the unrealistic assumptions of New Keynesian economics. Since kicking them while they are down can be a very effective strategy, what do you think of New Keynesian ideas regarding the powers of ‘the interest rate’ to ensure that the happily unemployed remain happy in their present status?


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