Must-Read: Olivier Blanchard: Do DSGE Models Have a Future?

Must-Read: The thing about this paper that surprises me is in its last paragraphs: that Olivier Blanchard answers the question with a “yes”. I cannot quite figure out why. Consider this from the last paragraph I quote below:

I could often… summarize the… DSGE paper in a simple graph. I had learned something… but I was able (and allowed as the discussant) to present the basic insight… more simply than the author of the paper. The DSGE and the ad hoc models were complements, not substitutes.

The questions I want to ask are: Olivier, what if you could not have summarized the DSGE paper in a simple ad hoc model graph? Wouldn’t your conclusion then have been that the DSGE paper was wrong–that the flaws in the methodology had led us astray? In what sense, then, are these two “complements”?

Olivier Blanchard: Do DSGE Models Have a Future?:

The model is composed of three equations: an equation describing aggregate demand; an equation describing price adjustment; and an equation describing the monetary policy rule…

At least the first two are badly flawed…. Aggregate demand… with respect to both the degree of foresight and the role of interest rates in twisting the path of consumption are strongly at odds with the empirical evidence. Price adjustment… does not capture the fundamental inertia of inflation…. Their standard method of estimation, which is a mix of calibration and Bayesian estimation, is unconvincing…. The way distortions are introduced in the model… are analytically convenient but have unconvincing welfare implications…. DSGE models are bad communication devices….

I strongly believe that ad hoc macro models… have an important role to play in relation to DSGE models. They can be useful upstream, before DSGE modeling, as a first cut to think about the effects of a particular distortion or a particular policy. They can be useful downstream, after DSGE modeling, to present the major insight of the model in a lighter and pedagogical fashion…. In the right hands, they are beautiful art, but not all economists can or should be artists. There is room for both science and art. I have found, for example, that I could often, as a discussant, summarize the findings of a DSGE paper in a simple graph. I had learned something from the formal model, but I was able (and allowed as the discussant) to present the basic insight more simply than the author of the paper. The DSGE and the ad hoc models were complements, not substitutes….

DSGE models can fulfill an important need in macroeconomics, that of offering a core structure around which to build and organize discussions. To do that, however, they have to build more on the rest of macro- economics and agree to share the scene with other types of general equilibrium models.

My view: I am reminded of a saying from Voltaire that Paul Krugman likes: “You can kill sheep with witchcraft, if you also feed them enough arsenic.”