How to model financial instability
October 29, 2012
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There is a frentic activity out there on how to revise the modelling paradigm to the new norm of financial instability. Andrew Haldane from the Bank of England has recently been very critical of the current generation of macro models, including the DSGE tradition, and he recently challenged economist to come up with something better.
This calls for an intellectual reinvestment in models of heterogeneous, interacting agents, an investment likely to be every bit as great as the one that economists have made in DGSE models over the past 20 years.
But even his boss, Mervin King has recently been skeptical of the mainstream modelling paradigm, and in reviewing the last 20 years of inflaiton targeting, he noted (in footnote 14!) that
Several interesting papers presented at a Federal Reserve conference in Washington in March 2012 analysed a wide variety of potential “financial frictions” that might create externalities that would justify a policy intervention. My concern is that there seems no limit to the ingenuity of economists to identify such market failures, but no one of these frictions seems large enough to play a part in a macroeconomic model of financial stability. So it is not surprising that it has proved hard to find examples of frictions that generate quantitatively interesting trade-offs between price and financial stabilit …
Where this will end is not clear yet. The DSGE camp held a conference recently showing strenght among the Northwestern crowd, which is particulary strong among central banks (including Norges Bank and Riksbanken).
ECB will host a conference this week with a more varied program, so it will be interesting to see if they arrive at some sort of consensus on the way forward.
One person to watch out for is Michael Kumhof from the IMF. He is a devoted DSGE person, but conduct interesting research within this framwork on income inequality, narrow banking and the future of oil. He will be at the ECB conference as a discussant of a paper by goodhart and tsomocos, that represent an alternative modelling strand.
Quite something to watch, although impossible to follow it all.