Krugman on Lucas and DSGE
September 26, 2011
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Krugman summarizes thirty year of history of economics in today’s blog. Funny thing is RBC was considered dead in the 1980s, but then reemerged with a vengeance in the 2000s to dominate universities and central banks. According to the theory, shocks were external in nature (technology and/or preference shocks) and unemployment voluntary. But as Krugman observes: … the idea that the unemployed during a recession are voluntarily choosing to take time off is something only a professor could believe. But the math was impressive, and RBC became a self-contained, self-replicating intellectual world.
Question is how will the DSGE paradigm react to the current crisis and the obvious lack of effective demand (i.e. traditional Keynesian problem)? The recent Brooking’s report “Rethinking Central Banking” gives some clues (see my earlier blog). As they noted, the prevailing paradigm needs to be replace by something else – but what?