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Is Modern Macro Useful for Development Economics (and Economists)?

Jamus Lim's picture

One of the interesting byproducts of the global financial crisis has been the induced crisis in the economics profession. More precisely, there has been a minor intellectual crisis in macroeconomic thought, with an erosion of what had been previously believed to have been a new synthesis in macroeconomics. This consensus was perhaps best exemplified by Olivier Blanchard's ill-timed state of macro paper that (in)famously declared that the "state of macro is good." Since then, economists have decried how state-of-the-art monetary theory is useless, real business cycle models are simply silly, and that financial models are often theoretical flights of fancy (Mark Thoma links to many more contributions than you could possibly want or imagine).

There is little need to rehash many of the arguments here (especially since they have already been thoroughly explored (subscription required) by the Economist). However, Narayana Kocherlakota has a recent piece of the contribution of modern macro to economy policy, and perhaps it would be useful to add to his thoughts from the perspective of development economics and developing country policymaking.[*]

Kocherlakota highlights three big problems that he sees with the ability of modern macro models to serve policy: (a) a piecemeal approach toward the inclusion of frictions, rather than a coherent strategy toward incorporating them; (b) a general neglect of financial markets;[] and (c) a reliance on ad hoc exogenous shocks to create movements in the endogenous variables of the model.

In the context of developing macroeconomies, addressing (a) is not only desirable but central. Frictions are pervasive in the developing world---indeed, one useful way to understand the distinction between a standard versus development economics is to recognize the pervasiveness of informational frictions and market imperfections in developing countries. Useful macro models, therefore, need to explain such frictions above and beyond simple notions of credit constraints and labor market rigidities. We need to be able to account for the severe lack of credit access for micro, small, and medium enterprises, as well as the 20--25 percent unemployment rates common across the developing world. Attributing market failures of this magnitude to an abstract notion of "frictions" simply will not do, since it leaves too many central features of developing economies either unexplained or unsatisfactorily explained.

Bringing in the financial sector---tackling (b)---is certainly important, especially in light of recent events. But if there is something neglected from DSGE models that is key to development macro, it is the political sector. To some extent, DSGE models have already begun to allow voting mechanisms and legislative processes. But such models remain largely theoretical exercises, with policy implications and suggestions that are frustratingly scant for the degree of complexity their solutions require. Progress in capturing elements of heterogeneity in modern macro is also heartening, since political economy is about the resolution of conflicting preferences and demands. But such models remain at the periphery of the field, and it is still unclear how mucheterogeous agent models can offer.

Finally, while resolving (c) would certainly be desirable from an academic perspective, exogenous shocks---even large, unexpected ones---are quotidian in the developing world. If anything, a greater routinization of the open elements of macroeconomies---such as allowing current accounts to be driven by more than just simple consumption smoothing mechanisms, or interest rates to result from an interaction between global rates and domestic credit markets---will go a long way toward making DSGE models useful for developing economy users. With international flows of goods, services, and financial capital so important in many developing countries, permitting the financial account to be largely a residual of real concerns misses much of the manner by which movements in one can drive the other, and vice versa.

The verdict? It would seem that the current crop of modern macro models are not only ill-suited for prime-time policymaking in the developed world, they are also inadequate for the developing-country context. At some level, this is ironic. Developed economies are typically far more complex, with larger and more sophisticated product, financial, and labor markets. If anything, the relatively simple structure of DSGE models should be attractive to developing countries, since they are more likely to be successful in capturing the primary features of these economies.

Of course, it may well be the case that developing country policymakers are not quite ready for such sophisticated, state-of-the-art macro modeling tools. Perhaps so, but this seems to me to be a red herring. While ease of use is certainly relevant for capacity-constrained LDCs, the more important question to ask is whether such models can answer the questions foremost on the minds of developing country policymakers. If they can't, it matters much less that the developing world is not ready for them. It would be more that these models are not ready for the developing world.

*. Many of the technical points raised informally in the Kocherlakota article are laid out in more gory detail in the forthcoming Sbordone et al paper on using DSGE models for monetary policymaking. This latter article lays out a bare-bones DSGE model and runs through the now-standard exercise of calibrating structural parameters, then comparing model predictions for different moments against the received data. The goal, as always, is to see how well the model performs in the context of known historical scenarios. If one has confidence that the model in hand performs well, the model can then be used in real-world policymaking circumstances, such as making recommendations on monetary policy; indeed, this is the example explored by Sbordone and her coauthors.

. It should be noted that this criticism is, perhaps fortuitously, somewhat overtaken by recent events. The global crisis of 2007/09 has led to renewed interest in capturing the interaction between macro and finance, and this will undoubtedly inspire a whole generation of doctoral students into writing their dissertations on the topic. Indeed, recent reviews (both PDF) of the literature suggest that the research agenda on this front is alive and well.

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