Welcome! This is the Fifth installment of our interview series “Where is the General Theory of the 21st Century?”

“Where is the General Theory of the 21st Century?” is an interview series which ask top economists a very important question: “Why haven’t economists come up with a new General Theory that can explain the Great Recession?” This is an inquiry into how the macroeconomics academia changed since the Great Recession, and why the responses from macroeconomists since 2008 are different from their counterpart in the 1930s.


In this installment, we talked to Olivier Blanchard, now the C. Fred Bergsten Senior Fellow of Peterson Institute for International Economics , formerly the economic counselor and director of the Research Department at the International Monetary Fund. He was also the chair of economics department of MIT from 1998 to 2003, and remains as Robert M. Solow Professor of Economics emeritus.

Blanchard is one of the pioneers in the developments of New Keynesian economic models. He has written two influential textbooks on macroeconomics, one is the “Lectures on Macroeconomics” coauthored with Stanley Fischer, an essential reading for many graduated level macroeconomics courses. Another one is “Macroeconomics” , an insightful macro textbook for undergraduates.

In this interview, Blanchard discussed with us the topic — “DSGE model and the State of Macroeconomics”. He explained the role of DSGE models in macroeconomics research, how to teach undergraduates macro after the Great Recession, and his research on hysteresis.

(The transcript below has been edited for length and clarity. All mistakes and miscommunications are ours.)


Q: EconReporter B: Olivier Blanchard

Q: Do you think there is another “Keynesian Revolution” happening in the macroeconomics academia since the Great Recession?

B: I think so.

If you think of Keynesian Economics as the theory insisting that the demand side is the most important determinant of activities in the short run, then yes. One needs to look at what has happened to demand to understand what has happened to the world economy since 2008. I think this is probably now a generally accepted notion.

Q: Yet, most of the “new ideas” emerged since the Great Recession are actually resurgence of old ideas. In this sense, do you think macroeconomics is in fact moving forward in recent years?

B: I think we now have a much better understanding of the short run and the long run effect of the financial shocks. For example, what some people called financial cycle, though I am not sure if there is in fact a financial cycle, or I should just call it financial shocks, clearly has a major macroeconomic effect. This is one example of what we understand much better than, say, in 2007.

Q: Do you think that progress like this is “Game changing” to macroeconomics?

B: Two parts for the answer. Is it a Game Changer? No.

But it is adding to the basic model something that was missing, which is the financial sector. Once you have done this, you have a different type of model, you have a different view of how the economy works. So, is it a game changer? I am not sure. But it is an important development.

Another thing is that as the crisis has been so complex in so many ways, I think economists now are much more willing to explore new mechanisms, new distortions, new facts. Much more so than they were in 2007.

So, the fact that we did not do very well, that we did poorly in predicting the crisis and explaining what was going on, all these have led to, I think, more open-minded research in macroeconomics.

Q: In your paper “Do DSGE Models Have a Future?” , you have mentioned one of the problems of DSGE models is that it is difficult to be used for communicating with laymen. Why can’t we have some simple and stylized DSGE model, and use it to discuss with non-economist?

B: As I have said in the note, you cannot have one model for everything. So if you want to have a model, say, for the Fed or the IMF, then it has to fit the data and explain the data well. Otherwise, you can’t pretend to be able to explain the world. If you want to conduct a counterfactual simulation, to see what happens if the Fed increases the interest rate by a 100 bp, something that the Fed normally needs to do, then the model has to have enough structure to be useful for that.

This is the first type of macro model. I think this kind of model has to be close to reality, has as much as possible clear analytical structures, so that you can work on the counterfactuals.

Then you have a second type of models, which I think DSGE model (Dynamic Stochastic General Equilibrium Model) should be. They have to be more theory based, so that researchers can use them as a common basis to add and discuss distortions or other mechanisms they want to explore. This kind of model doesn’t need to be as close to the data as the first class, as they are not for the policy use directly.

So, I think DSGE models should be theoretically based, which means they should be micro-founded, to a large extent. This should be generally accepted as a starting point. When you want to look at the effect of some new mechanism, that is what you will have in mind.

(Answer continues below)


Explainer: What is DSGE Models?

DSGE stands for “dynamic stochastic general equilibrium.”. As Blanchard described in his note “Do DSGE Models Have a Future?” , DSGE Models have three major modeling characteristics.

First, the behavior of consumers, firms, and financial intermediaries, when present, is formally derived from microfoundations, i.e. they are normally based on microeconomics theories or empirical findings. Second, the underlying economic assumption is that of there is a competitive economy, but with a number of essential distortions added, e.g. nominal rigidities, monopoly power, or information problems. Third, the model is estimated as a system, rather than equation by equation in the previous generations of macroeconomic models.

As explained in “Policy Analysis Using DSGE Models: An Introduction” by Sbordon, Tambalotti, Rao and Walsh, most of the DSGE models used for policy analysis are built on three blocks: a demand block, a supply block and a monetary policy equation.

dsge-structure

In extremely simplified terms, the demand block describes how real interest rate affect the real output of the economy, the supply block describes how the real output level alter the inflation level, and the monetary policy rule describe how unexpected inflation and real output change affect nominal interest rate.

As its name suggested, one important aspect of the DSGE models is its “dynamic” feature. The interaction between the blocks is “dynamic” in the sense that expectations of the future are crucial determinant of today’s outcome, i.e. output and inflation tomorrow, and thus their expectations as of today, depend on monetary policy tomorrow, and whatever will happen from then into the infinite future. Therefore, in the DSGE models, expectations are the main channel through which policy affect the economy.


Then you have a third category of models, which I would call pedagogical or toy models. This kind of models should be simpler, for example ISLM or three equations New Keynesian Model are this type of model. The idea is to capture what is in the big ones, but in a simple way. When we have a new mechanism to introduce it, we can explore it first in an ISLM model, and see what happens there. We may then want to put it in the DSGE model. In the same way, if I do a DSGE simulation and I found an interesting result, I might want to translate it into the ISLM, say it in terms of how the IS or LM curve shift.

There is a fourth type, which is pure statistical models, like VARs (Vector Autoregession Model). These are useful to describe the data. They are useful for assessing the correlations, so we can try to see whether more structural models fit or not. That is a very different exercise, they don’t need to be microfounded. They are there just to characterize the data in a way which we can potentially understand.

Q: For policymakers, should they focus on using the first type, the structural model, for policy making, or the third type, the toy model, for better communication with laymen? Or They should use both of them?

B: Yes, they should use both the first and the third type. The staff of the central bank should be working with the first type, the complicated models that they understand and they can use. When they go and report to the board, for example to the FOMC at the Fed, they should present the result of these models.

But they should also give a simpler explanation based on, maybe, the ISLM. When the central bankers have to explain what they are doing, they should use some kind of toy model, even formally or in words. But still, the hard work has to be done using the first type of models, right?

(The conversation continued in Part II)
Blanchard: ” I would use this model to explain Macroeconomics to my Mum” | #WITGT21 Conversation | EconReporter

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