Tag Archives: ECON488

DSGE Critiques PP

Hello class,

Today Christian and I are presenting the critiques of DSGE models, mainly post 2008 global financial crisis! I have attached a link to view the presentation below if you would like to review it and develop questions beforehand. The predominent economists who provided discourse on the topic include Robert Solow, Anton Korinek, Noah Smith, Roger Farmer, Camilo Tovar, Paul Romer, and Paul Krugman.

The critiques that stood out to us include:

  • Failing the “Market Test”
  • Unrealistic Assumptions and Parameters
  • Lack of Financial Sector
  • Determination of Causality/Correlation
  • Aggregated Microeconomics

The both of will expand on these point more so in class. We encourage you all to ask questions and provide feedback. Several of the critiques will have overlapping ideas but we will provide context in class today on why we decided to put them into separate categories.


Update: Critiques of DSGE Models

Hello class, Christian and I are writing our portion of the paper on the critiques of DSGE models. We have chosen the most prominent critiques and have looked at the points of discourse from well-known economists, such as Robert Solow, Anton Korinek, Noah Smith, Roger Farmer, Camilo Tovar, and Paul Krugman.

The structure of the paper will be introducing the critiques and then expand on what economists/academics have elaborated on them.

If you all have come across interesting and/or notable critiques from your own research please email me at tzotos@mail.umw.edu or Christian at cpotter@mail.umw.edu. We both would appreciate any input you all would have to offer!

Noah Smith’s Conclusion on DSGE Models

In my last blog post I summarized and reflected on Noah Smith’s article The Most Damning Critique of DSGE. The blog post expanded on Smith’s opinion of utilizing DSGE models in the financial sector but I neglected to note one of the most important points made. Noah claims that there are numerous different variations of DSGE models that can be used, so it is difficult for firms to choose the “correct” one.  The potential benefits of using DSGE models, the main one being that they satisfy the Lucas-critique, have been overshadowed by the costs of using them or determining the most appropriate one to use.

Smith determines that the lack of use of  DSGE models, specifically Lucas-robust  DSGE models, in finance markets are an indicator that “DSGE fail  the market test” (Smith 2014). This means that financial modelers who would benefit directly from superior market returns uniformly do not use DSGE models, thus strongly suggesting that DSGE models are not useful for macroeconomic predictions. I found this extrapolation to be interesting, but not necessarily supported firmly in the article.

Noah Smith’s blog post can be accessed through the following link http://noahpinionblog.blogspot.co.uk/2014/01/the-most-damning-critique-of-dsge.html

RE: The Most Damning Critique of DSGE

Noah Smith’s article, The Most Damning Critique of DSGE, questions the lack of use of DSGE models in financial sectors. Smith is perplexed that the financial sector does not utilize DSGE models to forecast economic fluctuations or the effects of government policy for large monetary gains. He claims this siuation to be “currently the most damning critique of the whole DSGE paradigm” (Smith 2014).

Smith critiques the mainstream notion that because agents of the private-sector can not set economic policy, there is no need for Lucas Critique-robust models. Models that satisfy the Lucas Critique and are policy-conditional can be used by firms to make larger returns on their investments.

The blog post includes a simple and brief example of what the advantages of using DSGE models can look like:

“A policy-conditional forecast is when you say “If the Fed tapers, inflation will fall by 0.5% next year.” To get these forecasts as good as possible, you need to know how policy affects the economy. and if your model is not Lucas-robust, then you will not be able to know how policy affects the economy, so you will react sub-optimally to a policy change.”
“For example, suppose the Fed suddenly lowers interest rates substantially. Most people, using their silly spreadsheets with their 70s-vintage Phillips Curves, will forecast a rise in GDP growth, so they will pay a lot for stocks, expecting higher profits from the increased growth. But wise DSGE modelers, using the Nobel-winning and ostensibly Lucas-robust Kydland-Prescott 1982 model, know that the Phillips Curve is not structural. They know that the promised growth will not occur, so as soon as stocks become overpriced, they short the S&P. When the hoped-for growth does not materialize and stocks fall, the DSGE modelers reap a huge profit at the expense of the spreadsheet modelers” (Smith 2014).

I believe that macroeconomic events, such as the 2008 global financial crisis, have dramatic effects on investors. The lack of Lucas-robust  DSGE models used in the private sectors is ironic to me, as it seems almost intuitive that these particular models would be used as the basis of most financial decisions.

However, Smith does bring up a valid point in the article, in regards to involving DSGE models more in the finance sector. There are numerous different variations of DSGE models that can be used, so it is difficult for firms to choose the “correct” one.  The potential benefits of using DSGE models for forecasting the effects of government policies have been overshadowed by the costs of using them and their downfalls.

Finally, something that resonated with me that Smith said in his blog post is that “being Lucas-robust is necessary for making optimal policy-contingent forecasts, but it is not sufficient. You also need the model to be a good model of the economy. If your parameters are all structural, but you’ve assumed the wrong microfoundations, then your model will make bad predictions even though it’s Lucas-robust.” I found this to be one the most important points made in the post. Throughout the whole semester, I have continuously contemplated many of the foundations in which almost all economic models conduct under. I think that accurate parameters are the necessary driving force of all models, whether macro or micro, but have been taken for granted in the economics community. I have noticed a trend or fixation on answering complex questions, while disregarding “basic” economic principles in the process. A wise man by the name of Voltaire once said “Judge a man by his questions rather than his answers.”

Here is the link to Noah Smith’s (Noahpinon) blog post http://noahpinionblog.blogspot.co.uk/2014/01/the-most-damning-critique-of-dsge.html

Roger Farmer’s Main Points

Hey everyone I hope you all had a nice spring break! Real quick here are some notes that I took on Roger Farmer’s Prosperity for All book. There is a chance I might have missed some important ideas and topics but I wanted to keep it relatively concise so that it would fit in a blog post. Because we have presented and learned about the the major schools of thoughts, I figured I would write this post as a refresher and to serve as a reference for when we contrast what Farmer has proposed.

Roger Farmer’s Prosperity for All: How to Prevent a Financial Crises

Farmer’s 5 Main Points:

  1. Stock market and financial assets are important for economic growth
  2. Stock market fluctuations influence the unemployment rate
  3. Central Bank and Fed should target the inflation rate under monetary policy

Government should target the unemployment rate under fiscal/financial policy

  1. Unemployment can be permanently above natural rate
  2. Self-fulfilling prophecies and expectations are important

Confidence in markets are key to market efficiency

“Animal Spirits” influence markets

  • Central Bank should buy & sell shares each month depending on the unemployment rate (Farmer, Page 18)
  • Great Recession was a result of a deviation in the Natural Rate of Unemployment

Dismisses the Phillips Curve and Natural Rate Hypothesis

  • Neoclassical + Keynesian Economics = basis of Roger Farmer’s model and theories
  • Economics should be changed over time

With the introduction of new data and random anomalies comes the response of fixing models and modifying theories

  1. There is a continuum of possible equilibrium unemployment rates
  2. The unemployment rate that prevails is determined by the “Animal Spirits” of investors

The stock market influences the unemployment rate and expectations influence decisions

  • Natural Rate of Unemployment: the sum of structural and frictional unemployment is referred Is the average level of unemployment that is expected to prevail in an equilibrium economy, with the absence of cyclical unemployment.

Dismisses wage and price stickiness in terms of prevailing unemployment

  • Aggregate Demand depends on wealth not income
  • Keynes Search Theory + Belief Function = Explanation for GDP, Price Level, and Employment
  • Beliefs should be fundamental in models
  • Deviations in “Animal Spirits” cause recessions and business-cycles

Restore confidence in consumers and investors through government asset purchases to prevent market crashes causing recessions

US government can buy & sell shares in the stock market, which are paid by issuing short-term Treasury securities, to cushion economic crises.

  • Notes that DSGE models are partially wrong and should be modified rather than fully dismissed out of economics
  • Proposes the US should invest in domestic infrastructure

Investment in infrastructure will help lower the unemployment rate and stimulate economic growth


RE: Conceptual Frameworks

“Conceptual frameworks are not things to do. Conceptual frameworks are tools for understanding, tools to think with.” -Gardner Campbell

A lot of the points made by Gardner in his recent blog post, Conceptional Frameworks: some thoughts, really resonated with me. To start off, several of the issues of today’s educational system brought up in the post include some things that I have challenged with throughout the years, especially since I have came to Mary Washington. I have always found it counterproductive on how much the education system in the United States has become so standardized. Much of course assignments and class lectures are vigorously organized and concrete, which has limited free-thinking and creativity in the classroom. As Brittany said, I am a student that finds comfort in knowing what a professor expects from me. I spend a lot of time stressing on receiving specific grades and less time worrying if I understand course material or not. Dr. Greenlaw’s ECON 304: Macroeconomics was one of the few classes I have taken here at Mary Washington in which I was challenged to think abstractly. The exams  were setup as free-response, rather than traditional multiple choice, and gave us an opportunity to show our understanding of the curriculum. We as the students were expected to use our imagination to provide examples to illustrate our answers and think beyond the classroom. I believe that professors should encourage students to think “outside the box” and to express different rationales to pending questions. Although setting identifiable goals in a class are important, I believe it is up to educators to emphasize that goals can be achieved through various different methods and reasoning.

Reading this article reminded me of a quote by Rob Siltanen, which reads “The people who are crazy enough to think they can change the world are the ones who do.”


Rational Expectations

Although I believe Rational Expectations are a far more efficient alternative to Adaptive Expectations I do believe there exist some flaws that are inherent in its fundamentals. As discussed in class last Wednesday and Friday, Rational Expectations (RE) are formulated and derived from models which in return is then used to create specific forecasts. In other words, the outcome is largely a result of people’s expectations as well as what the model dictates. With this being stated I believe that RE works well under relatively simple means of economic theory but are challenged and flawed when it is approached by complicated models that are routinely disputed upon by various schools of thought.  If an expectation is derived from a model that is not consistently accurate or flat out wrong then the expectation itself is then flawed. This does not mean it shouldn’t be used but in economics but it does pose the question of  their reliability and also contests regular forecasting procedures.

Here is a quick read on what Rational Expectations are as well as a the paper Greenlaw referenced in class, Rational Expectations and the Theory of Price Movementswritten by John Muth in 1961.




Friedman & Phelps: Natural Rate Hypothesis

One important theory that Friedman proposed during his lifetime was the Natural Rate Hypothesis (NRH) or the Non-Accelerating Inflation Rate of Unemployment (NAIRU). Next class, Brittany, Daley, and I will briefly explain this concept to you all but if you would like to learn about it beforehand I included an online article at the bottom that talks about it in-depth. The Natural Rate Hypothesis proposes that natural unemployment is unavoidable in the long-run and is a combination of frictional and structural unemployment. The NRH was later adapted into a long-run Phillips curve, which was the alternative to the contradictory notion of an inflation-unemployment trade-off.

The long-run Phillips curve is a vertical line at the natural rate of unemployment, so inflation and unemployment are unrelated in the long run (Boundless Economics).

Also, after researching the Natural Rate Hypothesis I came across a paper written by Roger Farmer. The ideas are conveyed in his book as well but I figured I would share it with you all as a refresher. The article is no more than 15 pages of text , including the title and sources, so it’s a relatively short read!

Source: Boundless. “The Long-Run Phillips Curve.” Boundless Economics Boundless, 20 Sep. 2016. Retrieved 09 Feb. 2017 from https://www.boundless.com/economics/textbooks/boundless-economics-textbook/inflation-and-unemployment-23/the-relationship-between-inflation-and-unemployment-105/the-long-run-phillips-curve-401-12498/


Milton Friedman Monetarism: Video & Reads

“Underlying most arguments against the free market is a lack of belief in freedom itself.” -Milton Friedman 

Before our class this Wednesday I figured I would post a few short articles that you can read to better understand monetarism and Milton Friedman’s theories. The readings are not entirely comprehensive but they will provide some context to Brittany, Daley, and I’s presentation next class. The first article is relatively short but provides insight on one of Friedman’s most controversial claims at the time http://www.colorado.edu/studentgroups/libertarians/issues/friedman-soc-resp-business.html.

Also, below I included a short video of one of Friedman’s presentations that expands on monetary policy https://www.youtube.com/watch?v=6LfUyML5QVY.

For those who find happiness in spending countless hours reading economic papers I also linked one of Friedman’s papers, The Role of Monetary Policy, here https://wwz.unibas.ch/fileadmin/wwz/redaktion/witheo/lehre/2009_FS/vwl4/doc/chapter8/Friedman_AER1968.pdf, as well as another article summarizing much of Friedman’s work as an economist http://www.econlib.org/library/Enc/bios/Friedman.html.

Here is an assessment and interpretation of Milton Friedman’s monetarism http://www.jstor.org.ezproxy.umw.edu/stable/2231691?Search=yes&resultItemClick=true&searchText=Monetarism:&searchText=An&searchText=Interpretation&searchText=and&searchText=an&searchText=Assessment&searchUri=%2Faction%2FdoBasicSearch%3FQuery%3DMonetarism%253A%2BAn%2BInterpretation%2Band%2Ban%2BAssessment%26acc%3Don%26amp%3D%26amp%3D%26amp%3D%26amp%3D%26group%3Dnone%26wc%3Don%26fc%3Doff&seq=1#page_scan_tab_contents

Researching Friedman’s Rule and the Friedman Doctrine opens up a lot of articles expanding on the two ideas and other theories within monetarism!


The Banker’s New Clothes: Banking Influence on Macroeconomics

Upon reading Simon Wren-Lewis’s blog post this past week I stumbled across several websites, articles,  and videos pertaining to economic faults as a results of risky banking practices. I was initially directed to this website http://bankersnewclothes.com/ which then lead me to to other sources. I found a lot of the information to be interesting so I figured I would write a brief blog post to share it with you all!

Anat Admati, the main contributer to the works I found, is the George G.C. Parker Professor of Finance and Economics at
the Graduate School of Business, Stanford University. She has written a book called The Banker’s New Clothes, which takes an in-depth look at risks in banking and how those risks can impose significant costs on the economy. “Weak regulation and ineffective enforcement allowed the buildup of risks that ushered in the financial crisis of 2007-2009. Much can be done to create a better system and prevent crises” (Admati). The role of the financial & banking sector is something that I have been looking into the past few weeks; Admati has a lot to contribute to solve a problem that authors we all have encountered so far, Farmer and Wren-Lewis, have talked about. In my previous blog post Wren-Lewis talked about how an increase in bank capital requirements can help avoid future banking crises, which is an idea that Admati has proposed and researched.

I have also linked two short videos below that explain Admanti’s and her colleague Martin Hellwig’s take on the banking system and its influences on the macroeconomy.

Short Video: https://www.youtube.com/watch?v=ZDRpZvCOVrc

StanfordTedx Presentation: https://www.youtube.com/watch?v=s_I4vx7gHPQ