Home > Uncategorized > DSGE macro economic models and secular stagnation in the Eurozone – not a happy marriage

DSGE macro economic models and secular stagnation in the Eurozone – not a happy marriage

Ansgar Rannenberg, Christian Schoder and Jan Strasky do a good job dissecting some DSGE models (The ECB NAWM model and the EU Quest model). They want to show that, if you tweak these models enough, they can account for the decline of output in the euro zone following (real) interest rate increases and fiscal consolidation in 2011/2012. What they do show, however, is that even despite such tweaking one of the central assumptions of these models, the unavoidable return to full production equilibrium and the primacy of supply, causes a large divergence between the world of the models and the real world (graph 1, RoT and FA are specific assumptions, see below).

rot

How do they tweak the models? First, they assume that fiscal consolidation leads to an increase in poor, credit constrained households, while: “the decline in their disposable income lowers the purchases of credit constrained households“. Households start to consume less not because their income declines – but because they can’t make up for this by definition temporary decline by borrowing more… Unemployment and pension cuts as mere liquidity problems for households – you can’t make this up. Another tweak is the idea that lower inflation plus the zero lower bound on interest rates leads to higher real interest rates which depresses investment not because borrowing becomes more expensive but “future rental income from capital is discounted at a higher rate, depressing investment“. Which suggests that business executives calculate real interest rates, using the rate of consumer price inflation. Well, they don’t – It turns out that they gauge the rate of inflation by the price of their main out of pocket purchase – gasoline. But these are details. The main point: even when you tweak these models to make them fit part of the data they can’t explain the present secular stagnation in the Eurozone. Maybe there is something wrong with this equilibrium idea.

  1. Lino N
    November 13, 2015 at 5:58 am

    Repeatedly doing something that doesn’t work, always expecting that it will, is an old definition of insanity. How could anybody expect that arbitrarily imposing equilibrium during a big oscillation on the elements of the major positive feedback loops in the economy could ever possibly describe reality? I’m assuming “empirical” translates into what the uninitiated would call “objective reality.”

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