Models

What's the point of a model?

      To explain
      To predict
      To give policy implications
      To look good in magazines

I've only studied a few models, one of which was the IS-LM model. The IS-LM model gives an equilibrium level of output and interest rate.  If you alter a variable, say government spending, it will demonstrate the changes to equilibrium levels.  It also has guidelines for policy;  in order to increase output, increase G or lower i.

I can see how this is a model, a theory.  I can see how it is useful in the real world to guide actions. 

What is shrouded in mystery for me is how real business cycle models or DSGE models are useful.  Perhaps this is due to my lack of experience with them, but people with much more experience than I don't seem to be too enchanted with them either. 


DSGE Models

DSGE models, from what I understand, are more realistic RBC models New Keynesians use with frictions such as sticky prices.  During my research, I stumbled upon the Lucas Critique which makes a lot of sense in the context of the microfoundations of macroeconomics debate- more about that further down. 

A DSGE model could be one where consumers maximize their utility, firms maximize profit, there's a production function with inputs of capital and labor, and some institutions making policy.  I think all of this is done with a representative agent who knows their preference for money, leisure, etc. throughout their whole life. The Smets-Wouters is a well known DSGE model that the European Central Bank uses. 


DSGE Shortcomings

Again, what's the point of these models? To explain, predict, and give advice.  However, even the "best" DSGE model doesn't predict well or lend itself to practical policy advice. When the model does have something to say, the complexity of the model makes the interpretation quite tough.  As far as explaining goes, Lars P Syll shames DSGE models for explaining unemployment as a joyous, utility raising event.

The idea of a representative agent being all knowing about the future is something I don't know if I could teach without sounding like a crazy person.  Some things are unpredictable, fundamentally uncertain as Keynes argued. 

DSGE models are microfounded, specifically with maximizing utility as the basis of the whole model.  Although the idea of utility has been around since Bentham, the idea of mathematically maximizing utility through optimization problems started in the marginal revolution with people like Jevons.

It is quite amazing to me, having taken a course on history of economic thought, how deeply entrenched the ideas of the marginal revolution are in modern day thought.  How did the marginal revolution and microeconomics get the golden star of "this is what economics is- end of story?" There were so many economists before the marginalists with a different set of questions and methodologies but yet utility maximization and budget constraints are all we remember.


Ugly Models

I'm not too familiar with models or modeling, but if I had a model, I would make it ugly.  I would include the ugly things that to me, clearly impact output and well-being. 

1. Wealth and Income Inequality

Blogs everywhere (and some blogs constantly) have been talking about income inequality. It is bad, Saez and Piketty, shocking graph, 1%, etc. Why don't we try to put that in models?  Maybe I'm missing some big point about models and what they are supposed to do.  But if I want to explain, predict, and give policy advice, it would seem that inequality would be a big piece of the puzzle.


      2. Unemployment and hysteresis

I don't know if the notion of hysteresis was born in a neoclassical camp or not, but to me, it makes sense.  Unemployed people if unemployed for a long period lose networks, up to date skills, etc.  The longer a recession or a slump is, the longer it takes to get people back to work, the less likely it will be they can return, the higher average unemployment.  Models should include involuntary unemployment and not explain unemployment as preferring leisure at the moment.


     3. Unstable financial system

Deregulation, too big to fail, misaligned incentives.  The strength and composition should be a part of models that analyze economic growth and forecast where were are going.  For example, maybe a "shock" could be deregulation and we'd expect output to increase but the financial system to become increasingly fragile and susceptible to a bust. 


     4. Dis-equilibrium/Stagnation

What if the interest rate is at zero and congress is deadlocked? What tendency is there for the economy to return to a stable state? I think in the real world the economy is mostly out of equilibrium and sometimes actions that should push it back to equilibrium are unavailable or have interaction effects that can improve one variable but worsen another. 


    5.  Power dynamics

At the risk of poisoning a decent post with something "uneconomic", I do think power dynamics play an important role in explaining and predicting phenomena in the economy.  One of the most distinct tools of power is unemployment.  For example, I believe if workers weren't afraid of losing their job and not finding a new one, they'd want better wages or they'd work less.  Businesses can always threaten to leave a city, a state, or a nation and take their jobs elsewhere if they don't receive conditions they like.  These conditions can be positive for output and well-being- perhaps the businesses demand better infrastructure in their community or better educational investment so they can transport materials easily and hire intelligent workers.  These conditions can also be negative on output and well-being- lower taxes on business for example would deplete the tax base of the community.  People don't live in bubbles.  We make choices as individuals but also as communities.  Our choices are constrained by the society we live in.  Models should be more than summing up individual, atomistic decisions.