The failure of the New Keynesian dynamic stochastic general equilibrium models to capture interactions of finance and the real economy has been widely recognised since the Global Crisis. This column argues that the flaws in these models stem from unrealistic micro-foundations for household behaviour and from wrongly assuming that aggregate behaviour mimics a fully informed ‘representative agent’. Rather than ‘one-size-fits-all’ monetary and macroprudential policy, institutional differences between countries imply major differences for monetary policy transmission and policy.
In the run-up to the 2008 financial crisis, many economists with vested interests defended a growth model that was based more on “irrational exuberance” than on sound fundamentals. The economics profession has now suffered a spectacular fall from grace, and needs a new code of conduct to restore its credibility.