Antonio Fatas: Four missing ingredients in macroeconomic models:

oI would like to go further and add a few items to their list that I wished could become part of the mainstream modeling in economics. In random order:

  1. The business cycle is not symmetric….
  2. As much as the NBER methodology emphasizes the notion of recessions (which, by the way, are asymmetric in nature), most academic research is produced around models where small and frequent shocks drive economic fluctuations, as opposed to large and infrequent events. The disconnect comes probably from the fact that it is so much easier to write models with small and frequent shocks than having to define a (stochastic?) process for large events. It gets even worse if one thinks that recessions are caused by the dynamics generated during expansions. Most economic models rely on unexpected events to generate crisis, and not on the internal dynamics that precede the crisis….
  3. There has to be more than price rigidity…. Price rigidities are important and they help us understand some of the features of the business cycle. But there must be more than that. There are other frictions…. They might not be easy to measure or model, they might be different across different economies but it is difficult to imagine that an adjustment of prices and wages to their optimal level would automatically restore full employment….
  4. The notion that co-ordination across economic agents matters to explain the dynamics of business cycles receives very limited attention in academic research….

I am aware that they are plenty of papers that deal with these four issues, some of them published in the best academic journals. But most of these papers are not mainstream. Most economists are sympathetic to these assumption but avoid writing papers using them because they are afraid they will be told that their assumptions are ad-hoc and that the model does not have enough micro foundations (for the best criticism of this argument, read the latest post of Simon Wren-Lewis). Time for a change?

As I say over and over again, forcing your model to have microfoundations when they are the wrong microfoundations is not a progressive but rather a degenerative research program. Consider building a model in which money has value because people only live for two periods and all people “born” in any given period are identical and so do not trade and so if there is to be trade at all you have to sell to the old when you are young–but they will be gone when you want to buy–and buy from the young when you are old–but they weren’t there to sell to. Back when I was 20 Tom Sargent–a very smart man, and a very good economist–told me that these OLG models of money were much better than models in which money was assumed to be an argument of the utility function along with your consumption of the representative good (with handwaving about how there are actually many goods, and money allows you to buy the ones you really want most) or models in which money was assumed to be an argument of the production function (with handwaving about how there wasn’t really a representative firm, and using money allowed a more fine-grained and thus more efficient division of labor).

As I have said before, I didn’t understand that then. Yes, it seemed to me that handwaving was not good. But saying something precise and false–that we held money because it was the only store of value in a life-cycle context, and intergenerational trade was really important–seemed to me to be vastly inferior to saying something handwavey but true–that holding money allows us to transact not just with those we trust to make good on their vowels but with those whom we do not so trust, and that as a result we can have a very fine-grained and hence very productive division of labor.

Still don’t understand why OLG models of money are terribly interesting, I must say…

Yes, we do need more than 100 flowers. Yes, supply shocks sometimes play a very important role in generating what we call business cycles–cf., 1970s. But more than trying to construct big models built on fake foundations, it would be good to focus more energy on Antonio’s four–asymmetry, a world in which big shocks and the fear of big shocks have important consequences, other macroeconomically-relevant frictions besides price and wage rigidites, and coordination failures…