Must-Read: Olivier Blanchard: Reconstructing Macroeconomics

Must-Read: In which Olivier Blanchard says that, currently, DSGE models have “much too much in them to be fully understood”. There is a rationale for studying a model that we do not understand–if and only if it makes predictions that fit the world. If one has such a model that makes reliable predictions, studying it is a not-implausible road to understanding the world, because maybe, just maybe, an understanding of the model will carry an understanding of the world along with it as a bonus. And there is a rationale for taking models we understand and seeing where and how they fit the world in order to help us iterate toward a better model that fits better.

But is there a case for investigating models we (a) do not understand that (b) do not fit the world? Even if we were to reach the point of understanding the model and how it works, what would that gain us?

Olivier Blanchard: Reconstructing Macroeconomics: Suppose you are writing two textbooks, one undergrad, one grad…

…In the undergraduate textbook, it seems to me that when teaching the IS-LM, we have the same interest rate on the IS and the same interest rate on the LM. Basically, the policy rate that the central bank chooses by the LM curve goes into the IS curve when corrected for expected inflation. I think what we have learned is that these [two interest rates] can be incredibly different. So I would have an r and an rb, and have a machine in the middle–the banking system which would, depending on its health, determine the spread. It seems to me that if I want to communicate one message, that message is what I would communicate to undergrads. At the graduate… DSGE model… two mechanisms… are central. The first is leverage…. The second is liquidity…. I am hoping that someday we will put it together and have a simple way of thinking about leverage and a simple way of thinking about liquidity…. We are at the stage at which the DSGE models have much too much in them to be fully understood…