Tag Archives: Model

Models Make Economics A Science

In the Journal of Economic Literature, Ariel Rubinstein discusses Dani Rodrik’s “superb” book “Economics Rules.” The article nicely articulates what economics and specifically, economic modeling is about. Some quotes (emphasis my own) …

… on the nature of economics:

[A] quote … by John Maynard Keynes to Roy Harrod in 1938: “It seems to me that economics is a branch of logic, a way of thinking”; “Economics is a science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world.”

[Rodrik] … declares: “Models make economics a science” … He rejects … the … common justification given by economists for calling economics a science: “It’s a science because we work with the scientific method: we build hypotheses and then test them. When a theory fails the test, we discard it and either replace it or come up with an improved version.” Dani’s response: “This is a nice story, but it bears little relationship to what economists do in practice …”

… on models, forecasts, and tests:

A good model is, for me, a good story about an interaction between human beings …

A story is not a tool for making predictions. At best, it can help us realize that a particular outcome is possible or that some element might be critical in obtaining a particular result. … Personally, I don’t have any urge to predict anything. I dread the moment (which will hopefully never arrive) when academics, and therefore also governments and corporations, will be able to predict human behavior with any accuracy.

A story is not meant to be “useful” in the sense that most people use the word. I view economics as useful in the sense that Chekhov’s stories are useful—it inspires new ideas and clarifies situations and concepts. … [Rodrik] is aware … “Mischief occurs when economists begin to treat a model as the model. Then the narrative takes on a life of its own and becomes dislodged from the setting that produced it. It turns into an all-purpose explanation that obscures alternative, and potentially more useful, story lines”.

A story is not testable. But when we read a story, we ask ourselves whether it has any connection to reality. In doing so, we are essentially trying to assess whether the basic scenario of the story is a reasonable one, rather than whether the end of the story rings true. … Similarly, … testing an economic model should be focused on its assumptions, rather than its predictions. On this point, I am in agreement with Economics Rules: “. . . what matters to the empirical relevance of a model is the realism of its critical assumptions”.

… on facts:

The big “problem” with interpreting data collected from experiments, whether in the field or in the lab, is that the researchers themselves are subject to the profession’s incentive system. The standard statistical tests capture some aspects of randomness in the results, but not the uncertainty regarding such things as the purity of the experiment, the procedure used to collect the data, the reliability of the researchers, and the differences in how the experiment was perceived between the researcher and the subjects. These problems, whether they are the result of intentional sleight of hand or the natural tendency of researchers to ignore inconvenient data, make me somewhat skeptical about “economic facts.”

Exchange Rate Predictability

In a Study Center Gerzensee working paper, Pinar Yesin argues that the IMF’s Equilibrium Real Exchange Rate model (ERER) helps predict medium term exchange rate changes. The reduced form equation relates the real effective exchange rate to macroeconomic fundamentals.

… one of the models, namely the ERER model, outperforms not only the other two in predicting future exchange rate movements, but also the (average) IMF assessment. … the IMF assessments are better at predicting future exchange rate movements in advanced economies than in emerging market economies. Controlling for the exchange rate regime does not yield different results. … the IMF assessments have higher predictive performance in open economies than in closed economies. … safe haven currencies close the misalignment gap predicted by the models faster than other currencies.

… To assess exchange rates only a modified version of the ERER model is being used since 2012. The modified versions of the MB and ES models, while still being utilized, do not have a direct link to the exchange rate anymore. That is, the IMF ceased making a direct link from equilibrium current accounts to equilibrium exchange rates for now.

Show Me The Model

Three opinion leaders in the blogosphere have laid out how they think about the macroeconomy. They talk about “models” but unfortunately don’t deliver. Instead, they provide lists of beliefs or facts to be explained. Economics is a science precisely because it has progressed beyond such lists. Economists build models—consistent, well-structured and clearly specified (and thus, mathematically formulated) stories.

But here are the lists: Scott Sumner’s “Musical Chairs model” (blog):

In the short run, employment fluctuations are driven by variations in the NGDP/Wage ratio.

Monetary policy drives NGDP, by influencing the supply and demand for base money.

Nominal wages are sticky in the short run, and hence NGDP shocks cause variations in employment in the same direction.

In the long run, wages are flexible and adjust to changes in NGDP. Unemployment returns to the natural rate (currently about 5% in the US.)

Tyler Cowen’s “model” (blog):

In world history, 99% of all business cycles are real business cycles.  No criticism of RBC can change this fact.  Furthermore the propagation mechanism for a “Keynesian business cycle” (arguably a misleading phrase) also relies on RBC theory.

In the more recent segment of world history, a lot of cycles have been caused by negative nominal shocks.  I consider the Christina and David Romer “shock identification” paper (pdf, and note the name order) to be one of the very best pieces of research in all of macroeconomics.  Sometimes central banks tighten when they shouldn’t, and this leads to a recession, due mainly to nominal wage stickiness.

Workers are laid off because employers are often (not always) afraid to cut their nominal wages, for fear of busting workplace morale, or in Europe often for legal and union-related reasons.

Overall I favor a nominal gdp rule for monetary policy.  But most of its gains would come in a few key historical episodes, such as 1929-1932, or 2008-2009.  In most periods I don’t think we know what the correct monetary policy should be, nor do we know that it matters.  Still, that uncertainty does not militate against an ngdp rule.

Once workers are unemployed, nominal wage stickiness is no longer the main reason why they stay unemployed.  In fact nominal wage stickiness is largely taken out of the equation because there is no preexisting nominal wage contract for these workers.  There may, however, be some residual stickiness due to irrational reservation wages, also known as voluntary unemployment due to stupidity.  (You will find a different perspective in Scott’s musical chairs model, which I may cover more soon.)

Monetary stimulus to be effective needs to be applied very early in the job destruction process of a recession.  It is much harder to put the pieces back together again, so urgency is of the essence.

The successful reemployment of workers depends upon a matching problem, a’la Pissarides, Mortensen, and others.  Yet this matching problem is poorly understood, and it can involve a mix of nominal and real imperfections.  Sometimes it is solved more quickly than expected, such as in the recent UK experience, and other times more slowly than expected, as in current Spain.  Most of the claims you will read about this reemployment of workers are wrong, enslaved to ideology or dogmatism, or at the very least unjustified.  Hardly anyone wants to admit this.

Really bad recessions involve deficient aggregate demand, negative shocks to intermediation, some chronic supply-side problems, negative wealth effects, and increases in the risk premium, all together.  It is hard to find a quick fix.  Furthermore models where AS and AD curves are independent and separable are often misleading, despite their analytic convenience.

Given that weak AD is only one of the problems in a bad downturn, and that confidence, risk, and supply side problems matter too, the best question to ask about fiscal policy is how well the money is being spent.  The “jack up AD no matter” approach is, in the final political equilibrium, not doing good fiscal policy any favors.

You should neither rule out nor overstate the relevance of Hayek and Minsky.  Their views have much in common, despite the difference in ideological mood affiliation and who — government or the market — gets blamed for the downturn.  For really bad recessions, usually both institutions are complicit to say the least.

All propositions about real interest rates are wrong.

The Economist’s Free Exchange response to Cowen’s model (blog):

Supply-side policy is hard. Why is America the richest large economy in the world? Well, because output per person has grown at about 2% per year, on average, for a very long time. How did it manage that? I have a long list of policy choices and characteristics and historical accidents that I believe contributed, but I would find it very difficult to say which of those factors were most important. If someone gave me free reign over the German economy and asked me to raise its output per person to American levels, I know the sorts of things I would do, but I have a low level of confidence that I could succeed, or even close much of the gap, within a generation.

That doesn’t mean that supply-side policy should be ignored. Supply-side reforms (of the sort this newspaper tends to favour) are politically difficult to achieve, but many of them are probably at least somewhat useful and should be undertaken whenever the political environment is amenable (though with very modest expectations regarding detectable effects on growth).

With supply-side policy, the precision of a policy action is not the problem; accuracy is. With demand-side policy, it is the opposite: it is pretty easy to meet broad policy goals, so long as you’re not too concerned about hitting them square on the nose.

We know what an economy with way too much demand looks like. It has high and accelerating inflation.

We know what an economy with way too little demand looks like. It has high unemployment and deflation.

Within those two extremes, it can be tricky to identify exactly where an economy stands: how close or far away from potential output it is.

Both too much and too little demand are economically costly, but history suggests that too little demand is far more economically costly and politically risky than too much demand. So policy should err on the side of too much demand rather than too little.

The determined use of monetary policy is almost always going to be sufficient to generate the right sort of “too much demand”. But an independent central bank might not always be able to muster the appropriate determination. In some cases a central bank may flounder until a clear political consensus emerges supporting the determined use of monetary policy.

It is generally unwise for countries to sacrifice monetary-policy autonomy, either by adopting a constraining exchange-rate regime or by introducing an excessive level of capital-account openness.

In countries with autonomous monetary policy, which are stuck at the zero lower bound on interest rates, fiscal policy is almost by definition too tight, and it is probably quite difficult to conduct fiscal stimulus in a way that generates long-run economic costs. That is because the long-run supply-side and fiscal benefits of getting off the ZLB are probably pretty large.

Fiscal policy is subject to political constraints, and it may be easier to introduce a large stimulus in emergency situations if the pre-emergency public-debt burden is low. That suggests that prudence in normal times is a good idea (though do remember point number 10).

Don’t subsidise debt.

The level of financial- and banking-sector liberalisation at which it can be demonstrated persuasively that further liberalisation will generate net benefits is probably not that high.