Should-Read: John Muellbauer: Why Central Bank Models Failed. How to Repair Them
Should-Read: John Muellbauer: Why Central Bank Models Failed. How to Repair Them: “At the core of representative agent DSGE models is the Euler equation for consumption…
…popularised in the highly influential paper by Hall (1978)… essential to the iterative forward solutions of these models… based on the assumptions of inter-temporal optimising by consumers and that every consumer faces the same linear period-to-period budget constraint… [generating] the optimality condition that links expected marginal utility in the different periods. Under approximate ‘certainty equivalence’, this translates into a simple relationship between consumption at time t and planned consumption at t+1 and in periods further into the future….
The asymmetric information revolution in economics in the 1970s for which Akerlof, Spence and Stiglitz shared the Nobel prize…. Deaton (1991,1992)… Carroll (1992, 2000, 2001, 2014), Ayigari (1994), and a new generation of heterogeneous agent models (e.g. Kaplan et al. 2016) imply that household horizons then tend to be both heterogeneous and shorter–with ‘hand-to-mouth’ behaviour even by quite wealthy households…. Aggregate behaviour does not follow that of a ‘representative agent’. Kaplan et al. (2016) show that, with these better micro-foundations, quite different implications follow for monetary policy…. Structural breaks, as shown by Hendry and Mizon (2014), and radical uncertainty further invalidate DSGE models…. Evidence on financial illiteracy (Lusardi 2016)…. A fourth reason for the failure of the New Keynesian DSGE models… is the omission of debt and household balance sheets more generally….
A rise in interest rates has different effects on aggregate consumer spending depending on the nature of household balance sheets…. Monetary policy transmission via the household sector differs radically between countries–it is far more effective in the US and UK, and even counterproductive in Japan (see Muellbauer and Murata 2011)…. Building in disaggregated balance sheets and the shifting, interactive role of credit conditions, have many benefits: better interpretations of data… developing early warning in… insights into transmission for monetary and macro-prudential policy. Approximate consistency with good theory following the information economics revolution of the 1970s is better than the exact consistency of the New Keynesian DSGE model with bad theory…