Why I like DSGE models

Christoph has recently vented his frustration about “DSGE bashing” now popular in the econ blogosphere. I feel this frustration, too, not because I believe DSGEs are perfect, but because I think that much of the popular criticism is ill-informed. Since I have worked with DSGE models recently in my research, I can call myself a card-carrying member of the club of DSGE aficionados. So I thought I briefly explain why I like DSGEs and what I think they are good for.

I think of DSGE models as applying ordinary principles of economics – optimizing behavior and market equilibrium (GE for general equilibrium) – to a world that evolves over time (D for dynamic) and is subject to chance (S for stochastic). When I say optimizing behavior I don’t necessarily mean rational expectations and when I say equilibrium I don’t necessarily mean market clearing. There are DSGEs without rational expectations and with non-clearing markets out there, although admittedly they are not the most widely used ones. I find this general approach attractive, because it brings us closer to a Unified Economic Science that uses a single set of principles to explain phenomena at the micro level and at the macro level.

But that’s not the most important reason I like DSGEs, which is that it makes precise and thus helps clarify commonly held notions about business cycles, economic crises and economic. Take, for instance, the notion of “recession”. In popular discussion a “recession” is when GDP growth is negative or at least below what is conceived a normal or desirable rate. In DSGE models, a recession is a negative output gap: the difference between the actual level of output and that level which would occur if prices were fully flexible (the “natural rate of output”). DSGEs make it clear that a negative growth rate is not necessarily bad (if the weather is bad in April and better in May, you want production to go down in April and up in May) and a positive growth rate not necessarily good (two percent real growth can sometimes mean an overheating economy and sometimes be a sluggish one). You have to look at more than one variable (at least two, output growth and inflation) to decide whether the economy is in good or bad shape.

Another reason I like DSGEs is that they discuss economic policy in a much more coherent and sensible manner than most of the earlier literature – and much more so than the financial press. The important question about any policy X is not “Does X increase GDP or reduce unemployment or increase asset prices?”, but “Does X increase the utility of households?”. Also, because DSGEs are dynamic models, they put the focus on policy rules, i.e. how policymakers behave across time and in different situations, instead of looking only what policymakers do right now and in this particular situation.

There is a lot of valid criticism against DSGEs: they often are too simplistic and sweep important but hard-to-model aspects under the rug and they, as a result of that, have lots of empirical issues. But these things should encourage us to make DSGEs better, not return to the even more simplistic approaches that previously dominated macroeconomics.

How privatization saved the Pilgrim Fathers

This summer I visited the historic site of Plymouth Plantation, the famous first settlement of the Pilgrim Fathers in Massachusetts. I was interested to see how the early settlers lived, what their houses looked like, what clothes they wore, what food they ate, what their relationships with the Native Americans were and how they managed to survive the first years in the wilderness. Luckily one of the colonists, William Bradford, wrote a book about all this which I am now reading. Among the many fascinating details of Bradford’s account, I found this passage describing how the colonists managed to overcome the insufficient output of corn which had caused a dangerous shortage of food during the first year and left many of them in danger of starvation.

So they began to consider how to raise more corn, and obtain a better crop than they had done, so that they might not continue to endure the misery of want. At length after much debate, the Governor with the advice of the chief among them, allowed each man to plant corn for his own household, and to trust to themselves for that; in all other things to go on in the general way as before. So every family was assigned a parcel of land, according to the proportion of their number with that in view,—for present purposes only, and making no division for inheritance,—all boys and children being included under some family. This was very successful. It made all hands very industrious, so that much more corn was planted than otherwise would have been by any means the Governor or any other could devise, and saved him a great deal of trouble, and gave far better satisfaction. The women now went willingly into the field, and took their little ones with them to plant corn, while before they would allege weakness and inability; and to have compelled them would have been thought great tyranny and oppression.

The failure of this experiment of communal service, which was tried for several years, and by good and honest men proves the emptiness of the theory of Plato and other ancients, applauded by some of later times,—that the taking away of private property, and the possession of it in community, by a commonwealth, would make a state happy and flourishing; as if they were wiser than God. For in this instance, community of property (so far as it went) was found to breed much confusion and discontent, and retard much employment which would have been to the general benefit and comfort. For the young men who were most able and fit for service objected to being forced to spend their time and strength in working for other men’s wives and children, without any recompense. The strong man or the resourceful man had no more share of food, clothes, etc., than the weak man who was not able to do a quarter the other could. This was thought injustice. The aged and graver men, who were ranked and equalized in labour, food, clothes, etc., with the humbler and younger ones, thought it some indignity and disrespect to them. As for men’s wives who were obliged to do service for other men, such as cooking, washing their clothes, etc., they considered it a kind of slavery, and many husbands would not brook it. This feature of it would have been worse still, if they had been men of an inferior class. If (it was thought) all were to share alike, and all were to do alike, then all were on an equality throughout, and one was as good as another; and so, if it did not actually abolish those very relations which God himself has set among men, it did at least greatly diminish the mutual respect that is so important should be preserved amongst them. Let none argue that this is due to human failing, rather than to this communistic plan of life in itself. I answer, seeing that all men have this failing in them, that God in His wisdom saw that another plan of life was fitter for them.

How to judge (macro)economic models or Why Paul Krugman gets it wrong

Paul Krugman recently participated in a discussion about the current state of macroeconomics, particularly about the “dominant” paradigm of DSGE models and their predecessor, the IS-LM model. Using DSGE models by myself and disagreeing with basically all of what he said, let me comment on an especially unconvincing piece of reasoning:

“[…] how [do] we know that a modeling approach is truly useful. The answer, I’d suggest, is that we look for surprising successful predictions. So has there been anything like that in recent years? Yes: economists who knew and still took seriously good old-fashioned Hicksian IS-LM type analysis made some strong predictions after the financial crisis”.

In short: forget DSGE models and related stuff and go back to IS-LM because people using IS-LM recently made some “right” predictions. Is the exclusive focus on its “predictions”a reasonable criterion to judge (macro)economic models or how should they be judged else?

With respect to the former, let me give you an admittedly extreme example. Over the last few decades, we could have very well predicted the EU agricultural policy by assuming that the aim of policy makers was to reduce consumer welfare. Would you resort to this sort of model when discussing likely upcoming agricultural policies from an outsider perspective? I would not.

Can we take up another extreme and simply judge a model based on the realism of its assumptions? I suggest we can’t. “Let’s assume a representative agent who cares about consumption, leisure and wearing blue jeans” to take another extreme example. Would you reject a macroeconomic argument formulated with this agent based on the unrealism of the blue jean assumption (as long as the model is not intended to explain the jeans market). I would not because in this context, I regard this assumption to be irrelevant for the models conclusions/predictions. The difference with respect to the first example is then of course that in the former, I’m convinced that the assumption matters for the results, in the latter I´m convinced it does not.

So one cannot judge models solely by their predictions because the underlying assumptions in combination with the implied propagation mechanisms might be clearly implausible/unconvincing and important for the predictions. Assessing the latter in turn requires to dig into the model dynamics implying that one can also not base a judgement solely on the realism of the assumptions.

How can a reasonable criterion that takes the above findings under consideration then look like? As so beautifully described in McCloskey essay on the “Rhetoric of Economics”, (macro)economists are persuaders. What they do is “careful weighing of more or less good reasons to arrive at more or less probable or plausible conclusions – none too secure, but better than would be arrived by chance or unthinking impulse; it is the art of discovering warrantable beliefs and improving those beliefs in shared discourse […] (Booth 1961, see the above link p. 483 for the exact citation)”. The purpose of models, I’d argue is then to help organizing that discourse, help to structure your own thinking, clarify the debate and provide a framework to confront thought with data.  In order to be useful for that, they need to be “persuasive” in the context they are used. The realism of the assumptions and the implied propagation mechanisms, their respective importance for the results and the model´s fit to data are all part of the subjective assessment with respect to that criterion.

How then about DSGE vs. IS-LM in policy debate? IS-LM and related models were mainly discarded in policy analysis because they incorporate reduced form parameters on e.g. the interest rate responsiveness of investment or the marginal propensity to consume which most economists were not convinced to be sufficiently independent of economic policy. This criticism is today as valid as it was 30 or 40 years ago, none of that has changed. All that has changed is that IS-LM made some “correct” (one may very well discuss the use of this word here but that´s not the purpose of this blog entry) predictions. Shall we go back to a model that was labelled as an unpersuasive tool although the main point of criticism is still valid – NO. Shall we use it now lacking a better alternative? Properly specified state-of-the-art DSGE models are a tool that outclasses IS-LM on virtually every aspect (YES even when it comes to rational expectations). For sake of shortening the entry, I will yet argue my case for that in a follow-up post.

The 5p plastic bag charge in the UK: A microeconomic success story

Much of (micro)economic theory is based on the following ideas. People make conscious choices. These choices depend on what these people want. People typically want, keeping all else the same, more money. To quote (in a rough translation) a popular Austrian comedian, Alf Poier, on this matter:  “I quickly realized that money is quite valuable and doesn’t take up much room.” This also means that in order to get more money, people would be willing to give up other things that they want.

And we just saw an incredible demonstration of that with the UK-wide introduction of a 5p charge for every plastic bag in essentially all supermarkets from the beginning of 2016. The effects of this policy have started to become evident. It seems that the introduction of the 5p charge for every plastic bag has reduced plastic bag consumption in supermarkets by roughly 80%.

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A hypothesis test in P.G. Wodehouse’s 1934 “Right Ho, Jeeves”

Reading on (you may want to read my previous post before this one), I found another beautiful example of hypothesis testing in literature with a pretty clear p-value calculation. I am now reading P. G. Wodehouse’s “Right Ho, Jeeves”, first published in 1934 I believe.

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a hypothesis test in a a milne’s 1922 “the red house mystery”

I am doing some summer reading and just came across a nice literary example of one of the key methodological approaches in science: hypothesis testing.

What do we do when we perform a hypothesis test? We form a theory and call it our null hypothesis.  We then look at data and ask ourselves how probable it is that we would see this data (or something like it) if the null hypothesis were true. This probability is called the p-value. If this probability is very low, we then abandon our null hypothesis in favor of its opposite.

Detective stories are generally a good potential source for examples of this approach, as detectives constantly entertain theories or hypotheses that have to be revised or rejected as new evidence is found. The present example is special in that the author really gives us all the steps of such a test in a specific setting, including the calculation of the p-value, that is the probability of seeing such data as was observed under the assumption that the null hypothesis is true. Continue reading