Macroeconomic Updates

One of the issues I am contemplating (and have mentioned in one of the video posts) is the future of macroeconomics.  If you think about the history of macroeconomics we have had two major revolutionary changes:  the Keynesian Revolution of the 1930s and the Rational Expectations Revolution of the 1980-90s leading to the dynamic general equilibrium macro models.

Each of these revolutions came about because the then current macro models of the day could not explain what was happening to the actual economy.  In Keynes’ day it was the failure of Classicalists to explain the prolonged economic downturn of the Great Depression.  In the Rational Expectations Revolution it was the stagflation of the 1970s.  Each revolution offered a new way of examining the macroeconomy and in doing so, could explain the past as well as the present.

Slightly oversimplifying things:  Keynes said the Classicalists were wrong because prices were sticky and planned investment might be different from actual spending and dynamic general equilibrium models (the modern incarnation of the rational expectations revolution) argued the Keynesians were wrong because they ignored microeconomics.

In dynamic general equilibrium (from now on DGE) macroeconomic models, market participants learn from their mistakes and thus input markets are in equilibrium.  This is why asset pricing is now a part of macroeconomic models.  The advantage of DGE models is that we can have the interaction of various parts of the macroeconomy all impacting each other:  households are maximizing their intertemporal utility function subject to time and budget constraints, firms are maximizing their profit function subject to technology and resource constraints, etc.  The models break away from the Keynesian ad hoc assumptions about consumption and investment and are more closely aligned with how microeconomists  view behavior.

Or…at least how microeconomists USED to view behavior.  Over the last 20 years or so the field of behavioral economics (and the closely related field of behavioral finance) has changed in the way many microeconomists think about market behavior.  Again oversimplifying things a bit, the behavioralists have raised questions about the assumption of perfectly rational economic agents.

Now…behavioral economics is not accepted by everyone…yet.  But…what if they are on to something?  Maybe if macroeconomists truly want to build models with “sound microeconomic foundations” the models should have irrationality play a bigger role.

Of course one of the major stumbling blocks is that it is rather difficult to mathematically show irrational behavior.  That is why macroeconomists have generally ignored it (among other reasons).  But…is that a good enough justification anymore?  What if this irrational behavior is The underlying driving force behind many of our modern economic problems?  Can we continue to just ignore it?

The past as a key to the future

One of the great intellectual underpinnings of the GDEs is they were based on very old idea:  Ricardian equivalence, for example.  Maybe macroeconomists need to again return to the past:  back to the days when economists used other disciplines for insight into how the overall economy functioned.  Remember the “first” macroeconomists (those before Keynes) studied “political economy.”  Maybe we need to look at how psychology, sociology, history and political science can help us better understand how the macroeconomy works.  Maybe economists have become too enslaved by our desire to formally represent relationships that we have missed key components of those relationships.

So maybe it is time for a third macroeconomic revolution;  one where we realize that not all important macroeconomic actions/relationships/behaviors can be shown mathematically.  Instead our new generation of macro models will use the insights of various fields to explain business cycles fluctuations and long run economic growth.  Only when we break from our enslavement to rigid mathematical modeling will we advance the field of macroeconomics.  Perhaps the time for that change is now.

All the best,

M Brandl

Please let me know what you think about my perspective, the video posts, or anything you’d like to see more or less of. Your feedback is greatly appreciated.