The Macro Battle Continues

Willem Buiter of LSE is writing for the Financial Times. His latest post is a “takedown” of modern macroeconomics. David Andolfatto critiques modern New Keynesian (NK) models and then unloads on Buiter:

My beef with the NK paradigm is this in a nutshell. It is a model that ignores money and typically, financial markets too. It embeds unexplained “frictions,” like sticky prices. It embeds conceptually vacuous “shocks” like “mark-up shocks” or “inflation shocks.” It focusses on the policy problem of “stabilizing” the economy in the face of these little itty-bitty shocks. It is not a model designed to understand financial crisis. It is a model designed to legitimize what central bankers always believed they should be doing in the first place: adjust the short-term interest rate to stablize the economy around a predetermined long-run trend. This is why the NK model is the dominant paradigm; and this is why those that promote this view land all the cushy consulting jobs. Among those that promote this view include our very own Herr Buiter. Here are some links to the courses he teaches on the subjects: see here. Good job, Willem. One can easily see how your students (and yourself) were well-prepared to deal with the current financial market crisis with your “very useful ad hoc models” of the economy.

Will Ambrosini gets into the foray as well:

Google scholar and a minimal knowledge of the DSGE literature allows one to refute Buiter’s claims in less than 10 minutes. Someone should really give him a quick lesson on Google scholar.

More Modern Macro

“DSGE Models and Central Banks” by Camilo Tovar. Here is the abstract:

Over the past 15 years there has been remarkable progress in the specification and estimation of dynamic stochastic general equilibrium (DSGE) models. Central banks in developed and emerging market economies have become increasingly interested in their usefulness for policy analysis and forecasting. This paper reviews some issues and challenges surrounding the use of these models at central banks. It recognises that they offer coherent frameworks for structuring policy discussions. Nonetheless, they are not ready to accomplish all that is being asked of them. First, they still need to incorporate relevant transmission mechanisms or sectors of the economy; second, issues remain on how to empirically validate them; and finally, challenges remain on how to effectively communicate their features and implications to policy makers and to the public. Overall, at their current stage DSGE models have important limitations. How much of a problem this is will depend on their specific use at central banks.

HT: Menzie Chinn

McArdle, Stimulus, and the Literature

Megan McArdle writes:

The real question, I think, is how close the permanent income hypothesis is to being true.

Well, there is some recent literature by John Seater (and co-authors) that suggests it is true (see here, here, and here).

She continues:

The basic idea is that people are forward looking, and they try to smooth their consumption over time. So if you give them a “temporary tax cut”, they save most of it, knowing that eventually they will have to give the money back.

But of course, this should also be true of “temporary government spending”–if people think the money won’t be there next year, they’ll salt as much of the money away as possible. This is a topic very underexplored in the various estimates of the stimulus multiplier, even though consumers are massively overleveraged and will presumably save as much of their new income as they can.

She is correct regarding the temporary tax cut, however, her claim regarding government spending is simply incorrect. Under the permanent income hypothesis, individuals base their consumption decisions on the their permanent lifetime income. A permanent increase in government spending is equivalent to an increase in the present value of taxes paid by the household. However, the present value of a temporary increase in government spending is zero (0). The difference between the two is that in the first instance individuals will reduce consumption due to the increase of the present value of taxation, whereas under the latter scenario there is no such expectation.

I am also not sure that this is “underexplored”. Anyone care to defend that claim?