The New Keynesian DSGE models that dominated the macroeconomic profession and central bank thinking for the last two decades were based on several principles. The first was formal derivation from micro-foundations, assuming optimising behaviour of consumers and firms with rational or ‘model-consistent’ expectations of future conditions. For such derivation to result in a tractable model, it was assumed that the behaviour of firms and of consumers corresponded to that of a ‘representative’ firm and a ‘representative’ consumer. In turn, this entailed the absence of necessarily heterogeneous credit or liquidity constraints. Another important assumption to obtain tractable solutions was that of a stable long-run equilibrium trend path for the economy. If the economy was never far from such a path, the role of uncertainty would necessarily be limited. Popular pre-financial crisis versions of the model excluded banking and finance, taking as given that finance and asset prices were merely a by-product of the real economy. Second, a competitive economy was assumed but with a number of distortions, including nominal rigidities – sluggish price adjustment – and monopolistic competition. This is what distinguished New Keynesian DSGE models from the general equilibrium real business cycle (RBC) models that preceded them. It extended the range of stochastic shocks that could disturb the economy from the productivity or taste shocks of the RBC model. Finally, while some models calibrated (assumed) values of the parameters, where the parameters were estimated, Bayesian system-wide estimation was used, imposing substantial amounts of prior constraints on parameter values deemed ‘reasonable’.
The ‘pretence of knowledge’
The centre-piece of Paul Romer’s scathing attack on these models is on the ‘pretence of knowledge’ (Romer 2016); echoing Caballero (2010), he is critical of the incredible identifying assumptions and ‘pretence of knowledge’ in both Bayesian estimation and the calibration of parameters in DSGE models.1 A further symptom of the ‘pretence of knowledge’ is the assumed ‘knowledge’ that these parameters are constant over time. A milder critique by Olivier Blanchard (2016) points to a number of failings of DSGE models and recommends greater openness to more eclectic approaches.
As explained in Muellbauer (2016), an even deeper problem, not seriously addressed by Romer or Blanchard, lies in the unrealistic micro-foundations for the behaviour of households embodied in the ‘rational expectations permanent income’ model of consumption, an integral component of these DSGE models. Consumption is fundamental to macroeconomics both in DSGE models and in the consumption functions of general equilibrium macro-econometric models such as the Federal Reserve’s FRB-US. At the core of representative agent DSGE models is the Euler equation for consumption, popularised in the highly influential paper by Hall (1978). It connects the present with the future, and is essential to the iterative forward solutions of these models. The equation is based on the assumption of inter-temporal optimising by consumers and that every consumer faces the same linear period-to-period budget constraint, linking income, wealth, and consumption. Maximising expected life-time utility subject to the constraint results in 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.