OK, everybody got that. Representative agent? check. Perfect capital markets? check, lifetime income fixed and known with certainty? check. Time-separable preferences? check.
AAARRRRGGGGHHHHH!!
People, it would be one thing if models like this fit the data, but they don't.
The consumption CAPM is not an accurate predictor of asset prices, The degree of risk aversion required to make the numbers work in the equity premium puzzle is something on the order of 25 or above, the literature is littered with papers rejecting [the Permanent Income Hypothesis].
So we are being harangued by a model that is unrealistic in the theory and inaccurate to the extreme in its predictions.
And that's pretty much modern macro in a freakin' nutshell.
Mamba out.Kevin is saying that if simple models of this type - models with representative agents, perfect capital markets, deterministic income, and time-separable preferences - haven't performed well empirically, we shouldn't use them to think about macro questions, even in a casual setting like a blog post.
I think Kevin is basically right here.
A defender of David's approach might say that this model is just a first-pass approximation, good for a first-pass analysis. That even if simple models like this can't solve the Equity Premium Puzzle or predict all of people's consumption behavior, they're good enough for thinking about monetary policy in a casual way.
But I don't think I'd buy that argument. We know that heterogeneity can change the results of monetary policy models a lot. We know incomplete markets can also change things a lot, in different ways. And I think it's pretty well-established that stochasticity and aggregate risk can change monetary policy a lot.
So by using a representative-agent, perfect-foresight, complete-markets model, David is ignoring a bunch of things that we know can totally change the answers to the exact policy questions David is thinking about.
So what should we do instead? One problem is that models with things like heterogeneity, stochasticity, and imperfect markets are a lot more complicated, and therefore harder to apply in quick or casual way. If we insist on using models with those elements, then it's going to be very hard to write blog posts thinking through monetary policy issues in a formal way. Maybe that's just the sad truth.
Another problem is that we don't really know that models with things like heterogeneity, stochasticity, and imperfect markets are going to be much better. Most of these models can match a couple features of the data, but as of right now there's no macro model in existence that matches most or all of the stylized facts about business cycles, finance, consumption, etc.
So it might be a choice between using A) a simple model that we know doesn't work very well, and B) a complicated model that we know doesn't work very well. Again, the best choice might be just to throw up our hands and stop using formal models to think casually about monetary policy.
Kevin also says that "being harangued by a model that is unrealistic in the theory and inaccurate to the extreme in its predictions" is "pretty much modern macro in a freakin' nutshell." Is that true?
Actually, I'd say it's more of a problem in fields like international finance, asset pricing, and labor that try to incorporate macro models into their own papers. Usually, in my experience, they pick a basic RBC-type model, because it's easy to use. They then add their own elements, like labor search, financial assets, or multiple countries. But since the basic foundation is a macro model that doesn't even work well for the purpose it was originally conceived for (explaining the business cycle), the whole enterprise is probably doomed from the start.
In the core macro field, though, I think there's a recognition that simple models don't work, and an active search for better ones. From what I've personally seen, most leading macroeconomists are also pretty cautious and circumspect when they give advice to policymakers directly, and don't rely too strongly on any one model.
from Noahpinion http://ift.tt/1VMD5qU