Saturday, June 18, 2016

Wisdom Of The Week

Most unfortunately, the Fed has had to go it alone when studying how the macroeconomy really works. Regional Fed banks and the Federal Reserve Board function as macroeconomic think tanks, hiring top-level researchers to do the grubby data work and broad thinking that academia has decided is beneath it. But that leaves many of the field’s brightest minds locked in the ivory tower, playing with their toys.

Fortunately, this may be changing. Justin Wolfers, a University of Michigan professor and well-known economics commentator, recently presented a set of slides at a conference celebrating the career of Massachusetts Institute of Technology economist Olivier Blanchard. The slides, although short, are indicative of the sea change underway in the macro field.

Wolfers discusses how some of the main pillars of modern academic macro theory are now being challenged. The idea of “rational expectations,” which says that people on average use the correct mental model of the economy when they make their decisions, is being challenged by top professors, and many are looking at alternatives.

But that’s just the beginning -- far deeper changes may be in the offing. Wolfers suggested abandoning DSGE models, saying that they “haven’t worked.” That he said this at a conference honoring Blanchard, who was an important DSGE modeling pioneer, is a sign that the winds have shifted.

In place of the typical DSGE fare, Wolfers suggests that the new macroeconomics will focus on empirics and falsification -- in other words, looking at reality instead of making highly imaginative assumptions about it. He also says that macro will be fertilized by other disciplines, such as psychology and sociology, and will incorporate elements of behavioral economics.

I’d go even farther. I think the new macroeconomics won’t just be new kinds of models and a more empirical focus; it will redefine what “macroeconomics” even means.

As originally conceived, macro is about explaining national-level data series like employment, output and prices. Eventually, economists realized that to explain those things, they would need to understand the smaller pieces of the economy, such as consumer behavior or competition between companies. At first, they just imagined or postulated how these elements worked -- that’s the core of DSGE.

Economists now realize that consumers and businesses behave in ways that are much more complicated and difficult to understand. So there has been increased interest in what’s called “macro-focused micro” -- studies of businesses, competition, markets and individual behavior that have relevance for macro even though they weren’t traditionally included in the field. Examples of this would include studies of business dynamism, price adjustment, financial bubbles and differences between workers.


Economics Struggles to Cope With Reality


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