The pretence of knowledge — ‘New Keynesian’ DSGE models

21 December, 2016 at 10:48 | Posted in Economics | Leave a comment

The centre-piece of Paul Romer’s scathing attack on these models is on the ‘pretence of knowledge’ (Romer 2016) … He is critical of the incredible identifying assumptions and ‘pretence of knowledge’ in both Bayesian estimation and the calibration of parameters in DSGE models … A milder critique by Olivier Blanchard (2016) points to a number of failings of DSGE models and recommends greater openness to more eclectic approaches …

qwzgndaAn even deeper problem, not seriously addressed by Romer or Blanchard, lies in the unrealistic micro-foundations for the behaviour of households embodied in the ‘rational expectations permanent income’ model of consumption, an integral component of these DSGE models. Consumption is fundamental to macroeconomics both in DSGE models and in the consumption functions of general equilibrium macro-econometric models such as the Federal Reserve’s FRB-US. At the core of representative agent DSGE models is the Euler equation for consumption, popularised in the highly influential paper by Hall (1978). It connects the present with the future, and is essential to the iterative forward solutions of these models. The equation is based on the assumption of inter-temporal optimising by consumers and that every consumer faces the same linear period-to-period budget constraint, linking income, wealth, and consumption. Maximising expected life-time utility subject to the constraint results in the optimality condition that links expected marginal utility in the different periods. Under approximate ‘certainty equivalence’, this translates into a simple relationship between consumption at time t and planned consumption at t+1 and in periods further into the future …

However, consumers actually face idiosyncratic (household-specific) and uninsurable income uncertainty, and uncertainty interacts with credit or liquidity constraints. The asymmetric information revolution in economics in the 1970s … and a new generation of heterogeneous agent models … imply that household horizons then tend to be both heterogeneous and shorter – with ‘hand-to-mouth’ behaviour even by quite wealthy households, contradicting the textbook permanent income model, and hence DSGE models. A second reason for the failure of these DSGE models is that aggregate behaviour does not follow that of a ‘representative agent’ … A third reason is that structural breaks … and radical uncertainty further invalidate DSGE models … The failure of the representative agent Euler equation to fit aggregate data is further empirical evidence against the assumptions underlying the DSGE models, while evidence on financial illiteracy … is a problem for the assumption that all consumers optimise.

John Muellbauer


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