Must-Read: As I understand it, Paul Romer's critique of RBC and DSGE models is wide of the mark only insofar as people no longer take the conclusions of RBC and DSGE models seriously. Paul quotes Smets and Wouters from 2007 about the U.S. since the 1970s:
Monetary policy shocks contribute only a small fraction of the forecast variance of output at all horizons... account for only a small fraction of the inflation volatility.... "Demand" shocks such as the risk premium, exogenous spending, and investment-specific technology shocks explain a significant fraction of the short-run forecast variance in output, both the wage mark-up (or labor supply) and, to a lesser extent, output-specific technology shocks explain most of its variation in the medium to long run.... Third, inflation developments are mostly driven by price mark-up shocks in the short run and wage mark-up shocks in the long run...
And points out that there is something very wrong. Volcker said he was going to hit the economy on the head with a monetary policy shock brick to reduce inflation. He did so. Inflation fell from 10% to 4%. Unemployment spiked to 11%. And yet Smets-Wouters cannot see it. Instead, they see a great many driving shocks that are nothing but equation residuals.
If anybody believed this, it would be a YUGE problem. That (most) people do not believe this and yet still feel that they must talk this way is a big problem:
Simon Wren-Lewis: Paul Romer on Macroeconomics: "The microfoundations project, which was meant to make macro just another application of microeconomics, has left macroeconomics with very few friends among other economists....
The latest broadside comes from Paul Romer. Yes it is unfair, and yes it is wide of the mark in places, but it will not be ignored... because he discusses issues on which modern macro is extremely vulnerable. The first is its treatment of data.... The only models deemed acceptable in top journals... are... selective about the data.... Both micro and macro evidence is either ignored because it is inconvenient, or put on a to do list for further research... an inevitable result of making internal consistency an admissibility criteria for publishable work. The second vulnerability is a conservatism which also arises from this methodology... [that] makes it intractable to model some processes: for example modelling sticky prices where actual menu costs are a deep parameter. Instead DSGE modelling uses tricks, like Calvo contracts. But who decides whether these tricks amount to acceptable microfoundations or are instead ad hoc or implausible? The answer depends a lot on conventions....
Paul’s discussion of real effects from monetary policy, and the insistence on productivity shocks as business cycle drivers, is pretty dated.... Yet it took a long time for RBC models to be replaced by New Keynesian models, and you will still see RBC models around. Elements of the New Classical counter revolution of the 1980s still persist in some places. It was only a few years ago that I listened to a seminar paper where the financial crisis was modelled as a large negative productivity shock....
In no other discipline could you have a debate about whether it was better to model what you can microfound rather than model what you can see. Other economists understand this, but many macroeconomists still think this is all quite normal...
