by DSGE — a scientific illusion Dynamic stochastic general equilibrium (DSGE) models remain the work-horse models employed by many academics and research departments at central banks … Prior to the Global Financial Crisis the financial sector played no role in these DSGE models. That limitation is now widely acknowledged and numerous aspects of the financial sector have been incorporated into second and later generation DSGE models … Unfortunately, these efforts are misguided because they do not address the fundamental flaw in the microeconomic foundations of these models and this mistake is widely repeated in all later generations of DSGE models. Many theorists today simply fail to recognize the limitations inherent in starting with the wrong microeconomic
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DSGE — a scientific illusion
Dynamic stochastic general equilibrium (DSGE) models remain the work-horse models employed by many academics and research departments at central banks … Prior to the Global Financial Crisis the financial sector played no role in these DSGE models. That limitation is now widely acknowledged and numerous aspects of the financial sector have been incorporated into second and later generation DSGE models … Unfortunately, these efforts are misguided because they do not address the fundamental flaw in the microeconomic foundations of these models and this mistake is widely repeated in all later generations of DSGE models.
Many theorists today simply fail to recognize the limitations inherent in starting with the wrong microeconomic foundations; frictionless or perfect barter microeconomic foundations. Consequently, those theorists are now intent on introducing ‘monetary’, ‘financial’ and other ‘frictions’ without acknowledging that those ‘frictions’ are inconsistent with the perfect barter or frictionless microeconomic foundations of their models as well as long established principles of monetary theory …
The misuse of the Walrasian or Arrow-Debreu GE microeconomic foundations, an imaginary world of perfect barter, largely explains why DSGE models proved so inept at understanding or anticipating the GFC and why attempts to now incorporate realistic and relevant features of the financial sector into such models also fail. In these DSGE models, money and the financial sector are converted into a friction and words and economic concepts take on different meanings.
If nothing else, the monumental failings and flaws of DSGE models — with or without inessential ‘frictions’ or other amendments — certainly shows the importance of model validation and checking the robustness and realism of assumptions and specifications. Describing modern economies ‘as-if’ consisting of ‘representative’ agents in the guise of self-employed capitalists in a perfect barter economy is absurd and ultimately bound to fail. DSGE models are simply — from both empirical and methodological points of view — not suited for understanding modern monetary economies.