Why Central Bank Models Failed and How to Repair Them

Yves here. This is a layperson-friendly description of why the most widely used macroeconomic model, the dynamic stochastic general equilibrium model, is lousy. Most macroeconomists will acknowledge privately that these models are reliable only over a six month horizon, when they are used over much longer time frames. Note that while each central bank has it own version, they all have the same structure and underlying assumptions.

As we discussed at length in ECONNED, reason these models perform badly is that for them to be “tractable,” their creators had to make assumptions which, as you will see below, are wildly unrealistic. Professor Muelbauer is nevertheless hopeful that they can be improved.

By John Muellbauer, Professor of Economics, Oxford University. Originally published at VoxEU

The failure of the New Keynesian dynamic stochastic general equilibrium models to capture interactions of finance and the real economy has been widely recognised since the Global Crisis. This column argues that the flaws in these models stem from unrealistic micro-foundations for household behaviour and from wrongly assuming that aggregate behaviour mimics a fully informed ‘representative agent’. Rather than ‘one-size-fits-all’ monetary and macroprudential policy, institutional differences between countries imply major differences for monetary policy transmission and policy.

The New Keynesian DSGE models that dominated the macroeconomic profession and central bank thinking for the last two decades were based on several principles. The first was formal derivation from micro-foundations, assuming optimising behaviour of consumers and firms with rational or ‘model-consistent’ expectations of future conditions.  For such derivation to result in a tractable model, it was assumed that the behaviour of firms and of consumers corresponded to that of a ‘representative’ firm and a ‘representative’ consumer.  In turn, this entailed the absence of necessarily heterogeneous credit or liquidity constraints. Another important assumption to obtain tractable solutions was that of a stable long-run equilibrium trend path for the economy.  If the economy was never far from such a path, the role of uncertainty would necessarily be limited.  Popular pre-financial crisis versions of the model excluded banking and finance, taking as given that finance and asset prices were merely a by-product of the real economy. Second, a competitive economy was assumed but with a number of distortions, including nominal rigidities – sluggish price adjustment – and monopolistic competition. This is what distinguished New Keynesian DSGE models from the general equilibrium real business cycle (RBC) models that preceded them. It extended the range of stochastic shocks that could disturb the economy from the productivity or taste shocks of the RBC model. Finally, while some models calibrated (assumed) values of the parameters, where the parameters were estimated, Bayesian system-wide estimation was used, imposing substantial amounts of prior constraints on parameter values deemed ‘reasonable’.

The ‘Pretence of Knowledge’

The centre-piece of Paul Romer’s scathing attack on these models is on the ‘pretence of knowledge’ (Romer 2016); echoing Caballero (2010), he is critical of the incredible identifying assumptions and ‘pretence of knowledge’ in both Bayesian estimation and the calibration of parameters in DSGE models.1 A further symptom of the ‘pretence of knowledge’ is the assumed ‘knowledge’ that these parameters are constant over time. A milder critique by Olivier Blanchard (2016) points to a number of failings of DSGE models and recommends greater openness to more eclectic approaches.

Unrealistic Micro-Foundations

As explained in Muellbauer (2016), an even deeper problem, not seriously addressed by Romer or Blanchard, lies in the unrealistic micro-foundations for the behaviour of households embodied in the ‘rational expectations permanent income’ model of consumption, an integral component of these DSGE models. Consumption is fundamental to macroeconomics both in DSGE models and in the consumption functions of general equilibrium macro-econometric models such as the Federal Reserve’s FRB-US. At the core of representative agent DSGE models is the Euler equation for consumption, popularised in the highly influential paper by Hall (1978). It connects the present with the future, and is essential to the iterative forward solutions of these models.  The equation is based on the assumption of inter-temporal optimising by consumers and that every consumer faces the same linear period-to-period budget constraint, linking income, wealth, and consumption. Maximising expected life-time utility subject to the constraint results in the optimality condition that links expected marginal utility in the different periods. Under approximate ‘certainty equivalence’, this translates into a simple relationship between consumption at time t and planned consumption at t+1 and in periods further into the future.

Under these simplifying assumptions, the rational expectations permanent income consumption function can be derived.  In the basic form, consumption every period equals permanent non-property income plus permanent property income defined as the real interest rate times the stock of wealth held by consumers at the beginning of each period.  Permanent non-property income converts the variable flow of labour and transfer incomes a consumer expects over a lifetime into an amount equally distributed over time.

However, consumers actually face idiosyncratic (household-specific) and uninsurable income uncertainty, and uncertainty interacts with credit or liquidity constraints. The asymmetric information revolution in economics in the 1970s for which Akerlof, Spence and Stiglitz shared the Nobel prize explains this economic environment.  Research by Deaton (1991,1992),2 several papers by Carroll (1992, 2000, 2001, 2014), Ayigari (1994), and a new generation of heterogeneous agent models (e.g. Kaplan et al. 2016) imply that household horizons then tend to be both heterogeneous and shorter – with ‘hand-to-mouth’ behaviour even by quite wealthy households, contradicting the textbook permanent income model, and hence DSGE models. A second reason for the failure of these DSGE models is that aggregate behaviour does not follow that of a ‘representative agent’. Kaplan et al. (2016) show that, with these better micro-foundations, quite different implications follow for monetary policy than in the New Keynesian DSGE models. A third reason is that structural breaks, as shown by Hendry and Mizon (2014), and radical uncertainty further invalidate DSGE models, illustrated by the failure of the Bank of England’s DSGE model both during and after the 2008-9 crisis (Fawcett et al. 2015). The failure of the representative agent Euler equation to fit aggregate data3 is further empirical evidence against the assumptions underlying the DSGE models, while evidence on financial illiteracy (Lusardi 2016) is a problem for the assumption that all consumers optimise.

The Evolving Credit Market Architecture

Of the structural changes, the evolution and revolution of credit market architecture was the single most important.  In the US, credit card ownership and instalment credit spread between the 1960s and the 2000s; the government-sponsored enterprises – Fannie Mae and Freddie Mac – were recast in the 1970s to underwrite mortgages; interest rate ceilings were lifted in the early 1980s; and falling IT costs transformed payment and credit screening systems in the 1980s and 1990s. More revolutionary was the expansion of sub-prime mortgages in the 2000s, driven by rise of private label securitisation backed by credit default obligations (CDOs) and swaps. The 2000 Commodity Futures Modernization Act (CFMA) made derivatives enforceable throughout the US with priority ahead of claims by others (e.g. workers) in bankruptcy. This permitted derivative enhancements for private label mortgage-backed securities (PMBS) so that they could be sold on as highly rated investment grade securities. A second regulatory change was the deregulation of banks and investment banks. In particular, the 2004 SEC decision to ease capital requirements on investment banks increased gearing to what turned out to be dangerous levels and further boosted PMBS, Duca et al (2016).  Similar measures to lower required capital on investment grade PMBS increased leverage at commercial banks. These changes occurred in the political context of pressure to extend credit to poor.

The Importance of Debt

A fourth reason for the failure of the New Keynesian DSGE models, linking closely with the previous, is the omission of debt and household balance sheets more generally, which are crucial for understanding consumption and macroeconomic fluctuations. Some central banks did not abandon their large non-DSGE econometric policy models, but these were also defective in that they too relied on the representative agent permanent income hypothesis which ignored shifts in credit constraints and mistakenly lumped all elements of household balance sheets, debt, liquid assets, illiquid financial assets (including pension assets) and housing wealth into a single net worth measure of wealth.4 Because housing is a consumption good as well as an asset, consumption responds differently to a rise in housing wealth than to an increase in financial wealth (see Aron et al. 2012). Second, different assets have different degrees of ‘spendability’. It is indisputable that cash is more spendable than pension or stock market wealth, the latter being subject to asset price uncertainty and access restrictions or trading costs. This suggests estimating separate marginal propensities to spend out of liquid and illiquid financial assets. Third, the marginal effect of debt on spending is unlikely just to be minus that of either illiquid financial or housing wealth. The reason is that debt is not subject to price uncertainty and it has long-term servicing and default risk implications, with typically highly adverse consequences.

The importance of debt was highlighted in the debt-deflation theory of the Great Depression of Fisher (1933).5 Briefly summarised, his story is that when credit availability expands, it raises spending, debt, and asset prices; irrational exuberance raises prices to vulnerable levels, given leverage; negative shocks can then cause falls in asset prices, increased bad debt, a credit crunch, and a rise in unemployment. In the 1980s and early 1990s, boom-busts in Norway, Finland, Sweden, and the UK followed this pattern. In the financial accelerator feedback loops that operated in the US sub-prime crisis, falls in house prices increased bad loans and impaired the ability of banks to extend credit.  As a result, household spending and residential investment fell, increasing unemployment and reducing incomes, feeding back further into lower asset prices and credit supply. The transmission mechanism that operated via consumption was poorly represented by the Federal Reserve’s FRB-US model and similar models elsewhere. A more relevant consumption function for modelling the financial accelerator is needed, modifying the permanent income model with shorter time horizons,6 incorporating important shifts in credit lending conditions, and disaggregating household balance sheets into liquid and illiquid elements, debt and housing wealth.

Implications for Macroeconomic Policy Models

To take into account all the feedbacks, a macroeconomic policy model needs to explain asset prices and the main components of household balance sheets, including debt and liquid assets. This is best done in a system of equations including consumption, in which shifts in credit conditions – which have system-wide consequences, sometimes interacting with other variables such as housing wealth – are extracted as a latent variable.7  The availability of home equity loans, which varies over time and between countries – hardly available in the US of the 1970s or in contemporary Germany, France or Japan – and the also the variable size of down-payments needed to obtain a mortgage, determine whether increases in house prices increase (US and UK) or reduce (Germany and Japan) aggregate consumer spending.  This is one of the findings of research I review in Muellbauer (2016).  Another important finding is that a rise in interest rates has different effects on aggregate consumer spending depending on the nature of household balance sheets.  Japan and Germany differ radically from the US and the UK, with far higher bank and saving deposits and lower household debt levels so that lower interest rates reduce consumer spending.  A crucial implication of these two findings is that monetary policy transmission via the household sector differs radically between countries – it is far more effective in the US and UK, and even counterproductive in Japan (see Muellbauer and Murata 2011).

Such models, building in disaggregated balance sheets and the shifting, interactive role of credit conditions, have many benefits: better interpretations of data on credit growth and asset prices helpful for developing early warning indicators of financial crises; better understandings of long-run trends in saving rates and asset prices; and insights into transmission for monetary and macro-prudential policy.  Approximate consistency with good theory following the information economics revolution of the 1970s is better than the exact consistency of the New Keynesian DSGE model with bad theory that makes incredible assumptions about agents’ behaviour and the economy. Repairing central bank policy models to make them more relevant and more consistent with the qualitative conclusions of the better micro-foundations outlined above is now an urgent task.


[1] Part of the problem of identification is that the DSGE models throw away long-run information. They do this by removing long-run trends with the Hodrick-Prescott filter, or linear time trends specific to each variable. Identification, which rests on available information, then becomes more difficult, and necessitates ‘incredible assumptions’. Often, impulse response functions tracing out the dynamic response of the modelled economy to shocks are highly sensitive to the way the data have been pre-filtered.

[2] This important research was highly praised in Angus Deaton’s 2015 Nobel prize citation: http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2015/advanced.html

[3] See Campbell and Mankiw (1989, 1990) and for even more powerful evidence from the UK, US and Japan; Muellbauer (2010); and micro-evidence from Shea (1995).

[4] Net worth is defined as liquid assets minus mortgage and non-mortgage debt plus illiquid financial assets plus housing assets, and this assumes that the coefficients are all the same.

[5] In recent years, several empirical contributions have recognised the importance of the mechanisms described by Fisher (1933). Mian and Sufi (2014) have provided extensive micro-economic evidence for the role of credit shifts in the US sub-prime crisis and the constraining effect of high household debt levels. Focusing on macro-data, Turner (2015) has analysed the role of debt internationally with more general mechanisms, as well as in explaining the poor recovery from the global financial crisis. Jorda et al. (2016) have drawn attention to the increasing role of real estate collateral in bank lending in most advanced countries and in financial crises.

[6] The FRB-US model does build in shorter average horizons than text-book permanent income.  It also has a commendable flexible treatment of expectations, Brayton et al (1997).

[7] The use of latent variables in macroeconomic modelling has a long vintage. Potential output, and the “natural rate” of unemployment or of interest are often treated as latent variables, for example in the FRB-US model and in Laubach and Williams (2003), and latent variables are often modelled using state space methods. Flexible spline functions can achieve similar estimates. Interaction effects of latent with other variables seem not to have been considered, however.  We use the term ‘latent interactive variable equation system’ (LIVES) to describe the resulting format.

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  1. Jim Haygood

    ‘the omission of debt and household balance sheets more generally’

    … putting these eclownometric [sic] models at about the same level of technical sophistication as the Newcomen steam engine of 1712, which achieved about one (1) percent thermodynamic efficiency.

    ‘a macroeconomic policy model needs to explain asset prices and household balance sheets. This is best done in a system of equations.’

    Yes indeedy. Reminds me of a young poseur at engineering school, who exclaimed during a group study session, “I’ve got it all jocked out. Now I just need the equations!”

    1. fresno dan

      Jim Haygood
      December 24, 2016 at 9:08 am

      ‘…the omission of debt and household balance sheets more generally…’
      You beat me to it. I have been aware of that for a few years now, but I doubt that one person in a hundred (or a thousand) knows when they listen to some economist on a news program or a business channel that the person speaking thinks that how much debt people have does not substantively affect their spending.
      Really, 5 year olds describing how they get toys from Santa have a better grasp of economics than most “economists”

    2. craazyboy

      If I used or invented an econ model that left out the “consumer”, and modeled it with a “consumption agent object” having a single independent input variable being the Fed zero term, zero risk interest rate, I’d be too embarrassed to admit it. I would probably just very quietly make a career change into one of the softer sciences. Maybe writing fictional romance novels, or some such thing.

  2. TiPs

    The worst thing about these types of mea culpas from the mainstream is the cited criticisms from other mainstream economists only. It can only be a valid criticism if it was published in a mainstream journal…

  3. readerOfTeaLeaves

    Of the structural changes, the evolution and revolution of credit market architecture was the single most important. In the US, credit card ownership and instalment credit spread between the 1960s and the 2000s; the government-sponsored enterprises – Fannie Mae and Freddie Mac – were recast in the 1970s to underwrite mortgages; interest rate ceilings were lifted in the early 1980s; and falling IT costs transformed payment and credit screening systems in the 1980s and 1990s. More revolutionary was the expansion of sub-prime mortgages in the 2000s, driven by rise of private label securitisation backed by credit default obligations (CDOs) and swaps. The 2000 Commodity Futures Modernization Act (CFMA) made derivatives enforceable throughout the US with priority ahead of claims by others (e.g. workers) in bankruptcy. This permitted derivative enhancements for private label mortgage-backed securities (PMBS) so that they could be sold on as highly rated investment grade securities. A second regulatory change was the deregulation of banks and investment banks…. Similar measures to lower required capital on investment grade PMBS increased leverage at commercial banks. These changes occurred in the political context of pressure to extend credit to poor.

    That ‘political pressure’ turned out to be the bait and switch for a system that shifted power via debt creation.

    What we have not yet come to terms with are the implications of David Graeber’s anthropological insights: how does debt affect social relationships, alter social norms, and affect relationships among individuals?

    Debt is a form of power, but by failing to factor this into their equations, the Central Bankers are missing the social, political, and cultural consequences of the profound shifts in ‘credit market architecture’. In many respects, this is not about ‘money’; it’s about power.

    After Brexit, Trump, and the emerging upheaval in the EU, it’s no longer enough to just ‘build better economic models’.
    The Central Bankers’ models can include all the parameters they can dream up, but until someone starts thinking more clearly about the role and function of money, and the way that ‘different kinds of money’ create ‘different kinds of social relationships’, we are all in a world of hurt.

    At this point, Central Bankers should also ask themselves what happens — socially, personally — when ‘debt’ (i.e., financialization) shifts from productivity to predation. That shift accelerated from the 1970s, through the 1990s, into the 2000s.

    Allowing anyone to charge interest that is usurious is the modern equivalent of turning a blind eye to slavery.
    By enabling outrageous interest, any government hands their hard working taxpayers over to what is essentially unending servitude.
    This destroys the political power of any government that engages in such blind stupidity.
    Frankly, I’m astonished that it has taken so long for taxpayers to show signs of outrage and revolt.

    1. jsn

      Voters in the U.S. react under radical new action retarding constraints:
      1. IT enhanced agnatology: kick ass propaganda
      2. Suburbanization: deportation of the working class from the collective action friendly urban geography

    2. fresno dan

      December 24, 2016 at 11:14 am

      I think you have come up with a good insight – I very much agree its about power and not money.
      Now, maybe it is just a coincidence, but it is hard for me not to notice that the explosion in consumer credit matches up nicely with the rise in inequality.
      And one other thing I would point out – it doesn’t take usurious interest rates. If squillionaires have access to unlimited, essentially cost free money in which the distributors of money are guaranteed a profit, NO MATTER HOW MUCH THEY HAVE LOST, while the debts on non-squillionaires are collected with fees, penalties, and to the last dime, than it doesn’t matter if interest rates are essentially zero.
      Who gets bailed out is not due to logic or accounting that says that the banks’ losses have to be made whole, but not home owners – that is an ideology called economics….

    3. craazyboy

      I wouldn’t downplay how cool the money part is, however. It’s no fun making questionable, dodgy loans unless you can charge fees up front and then sell the risk off to a large crowd of suckers. Hence the importance of securitization and other “insurance” type derivatives. Then, if you run out of willing suckers, you need a place to stuff it all, say pension plans and maybe even privatized social security.

      But if they allow this to happen in the real world, shouldn’t the models have a piece reflecting this behavior as well? Full circle of course, where the “consumer balance sheet” contains his bad debt investment and savings assets* offsetting his liabilities. Then everyone would be more like a bank?

      * we still need to model bubble assets – like real estate and stocks. This sounds like it’s starting to get tricky!

  4. José

    “Another important finding is that a rise in interest rates has different effects on aggregate consumer spending depending on the nature of household balance sheets”.

    This is a point that Warren Mosler and other MMTers have been making since the 1990s: depending on circumstances, lower interest rates may well have contractionary effects and higher interest rates may stimulate the economy.

    The tool of choice to fight recessions and control inflation should thus be fiscal instead of monetary policy.

    Again, MMT had the analysis right long before mainstream theory started to admit there might be serious problems with its favorite approaches (without ever giving appropriate credit to MMT, of course!).

    Very sad!

    1. craazyboy

      I think the Samarians knew that 5000 years ago. The Templars certainly knew it 1300 years ago. And most definitely, “modern” European banking knew it 300 years ago.

  5. susan the other

    of note to me is just how simplistic Keynesian statistics were/are, based on almost fantasy-assumptions. And that was followed by Stiglitz et al’s theory of asymmetric information models. And this above does give us a dose of all the different variables involved in accurately analyzing an economy – an economy that exploded with financialization, but nobody could keep up. As was proven in 2008. It shouldn’t be this confusing. “Repairing CB policies to make them more relevant… is now an urgent task.” I think it is urgent enough to nationalize the banks and start over using a sovereign money model.

  6. OpenThePodBayDoorsHAL

    Let’s take an infinitely complex system (the economy) that is widely affected by human emotion, then we’ll leave out the mechanism by which money itself is created and distributed…and then let’s “model” it.
    We’ll have two fans of Stalin’s communist “command and control” economy (Keynes and Harry Dexter White) pretend they could create a stable system based on Ph.Ds divining future economic and trade flows and then “managing” them by price fixing the price of money. We’ll set policy based on the national conditions of the country with the global reserve currency despite the fact that 2/3 of that currency is outside that country. And with a system where trade never settles so massive imbalances can persist indefinitely. Then let’s put self-interested private institutions in charge of all money creation and distribution….and we’ll be sure their system operates in secret and is never audited. When the system blows up we’ll have these central overlords step in as uneconomic buyers of assets with no consideration for asset quality or price, with no economic need to ever sell, and with “unlimited” funds with which to buy more such assets. At the end we’ll continue to call the system “capitalism” and we’ll continue to call the scrip “money” and hope nobody notices.

    End the Fed.

    1. Plenue


      Congress creates the money when it passes budget legislation. The Fed merely enacts their decree.

      1. OpenThePodBayDoorsHAL

        Try again. Yes the Government is supposed to be the ones who create money, per the Constitution. Suggest Google as a way for you to learn what actually happens.

  7. Sound of the Suburbs

    Economics has long been known as the dismal science.

    The IMF forecast Greek GDP would have recovered by 2015 with austerity.
    By 2015 it was down 27% and still falling.

    The IMF can attract some of the best economists in the world but a technocrat elite trained in a dismal science aren’t up to much.

    In 2008 the Queen visited the revered economists of the LSE and said “If these things were so large, how come everyone missed it?”

    The FED is full of PhDs from America’s finest universities but a technocrat elite trained in a dismal science aren’t up to much.

    The FED will have been looking at the US money supply, let me show you what they missed:


    Everything is reflected in the money supply.

    The money supply is flat in the recession of the early 1990s.

    Then it really starts to take off as the dot.com boom gets going which rapidly morphs into the US housing boom, courtesy of Alan Greenspan’s loose monetary policy.

    When M3 gets closer to the vertical, the black swan is coming and you have a credit bubble on your hands (money = debt).

    The mainstream are all trained in neoclassical economics which is spectacularly dismal.

    Steve Keen sits outside the mainstream and saw the credit bubble forming in 2005, you can see it in the
    US money supply (money = debt).

    In 2007, Ben Bernanke could see no problems ahead (dismal).

    Irving Fisher looked at the debt inflated asset bubble after the 1929 crash when ideas that markets reached stable equilibriums were beyond a joke.

    Fisher developed a theory of economic crises called debt-deflation, which attributed the crises to the bursting of a credit bubble.

    Hyman Minsky came up with “financial instability hypothesis” in 1974 and Steve Keen carries on with this work today. The theory is there outside the mainstream.

    To understand the theory you have to understand money:

    “….. debt does not make society as a whole poorer: one person’s debt is another person’s asset. So total wealth is unaffected by the amount of debt out there. This is, strictly speaking true only for the world economy as a whole ….. ” Paul Krugman “End this Depression Now”.

    This is the neoclassical economic view of money and it’s totally wrong and will always leave you blind to events like 2008, e.g.

    1929 – US (margin lending into US stocks)
    1989 – Japan (real estate)
    2008 – US (real estate bubble leveraged up with derivatives for global contagion)
    2010 – Ireland (real estate)
    2012 – Spain (real estate)
    2015 – China (margin lending into Chinese stocks)

    Norway, Sweden, Canada and Australia have been letting their real estate bubbles inflate because their mainstream economists and Central Bankers don’t know what’s coming.

    Money and debt are opposite sides of the same coin.
    If there is no debt there is no money.
    Money is created by loans and destroyed by repayments of those loans.

    If you want to understand how money really works:

    From the BoE:

    “Where does money come from” available from Amazon

    You need to understand how money works to understand why austerity doesn’t work in balance sheet recessions, the cause of the dire prediction from the IMF that I started with.

    You can look at the money supply/debt levels (the same thing) to see how well the economy is doing.

    The money supply is contracting – the economy will be doing badly and the risk of this turning into debt deflation is high, there is positive feedback tending to make the situation worse. Debt repayments are larger than the new debt being taken out, the overall level of debt is decreasing.

    The money supply is stable – this is stagnation, in the ideal world the money supply should be growing at a steady pace.

    The money supply is growing steadily – the ideal.

    The money supply is growing very rapidly – you’ve got a credit bubble on your hands and the “black swan” is near. The FED didn’t understand money and debt before 2008 so they missed it.

    Richard Koo explains:

    Mario is still doing austerity now, no wonder those Italian banks are full of NPLs.

    It’s too late for Norway, Sweden, Canada and Australia’s mainstream economists and Central Bankers, but we need to get this dismal neoclassical economics updated before the whole world descends into debt deflation.

    It’s almost here, there isn’t much time.

    Chuck another trillion in to keep this sinking ship afloat Central Bankers, we need to get our technocrat elite up to speed.

  8. Sound of the Suburbs

    In brief:

    Just look at the rate of change of the money supply/debt.

    When it’s rising rapidly you’re in trouble as a credit bubble is forming.

    A negative gradient is also a bad sign as it means your money supply is contracting, your economy is in trouble and debt deflation could be on its way.

    Economists do waffle.

    1. Sound of the Suburbs

      Now Mrs. Yellen, put that on a Post-It note on your desk and you won’t make the same mistake as your predecessor.

  9. Skip Intro

    I am shocked, shocked I tell you, that a model with ‘Equilibrium’ right in the name fails to predict crises. They could probably do better just aggregating results from a big multi-player version of The Sims.

  10. Dick Burkhart

    Better models should start from scratch, assuming non-linearity. They could take the Limits-to-Growth system of nonlinear pde’s as a starting point, for example, to get a good handle on long range dynamics. Then add detailed submodels for money and debt, for different countries, for trade, for different economic sectors, etc. Use realistic agent based models where standard models are inadequate.

    To do all, start by sending all those economics Ph.D.s back to school in other fields where they know how to do modern applied mathematics.

  11. Leonard Tekaat

    Monetary policy is not in sync with income tax policy. Or in other words, tax policy is not in sync with monetary policy, this is one reason why we have credit use excesses, which creates bubbles and credit crisis. The tax code continually encourages people to use more credit even though the economy is overheating. The only tool central banks have to discourage or encourage credit use is the changing of interest rates. Higher interest rates during the boom cycle affects consumption by the middle class and the working poor. Reduced aggregate demand raises unemployment. Reduced unemployment reduces the ability of the middle class and working poor to pay their debt obligations, further reducing aggregate demand. To increase aggregate demand the Fed causes interest rates to decrease. The people at the top of the economic ladder reduce investments in supply because of the reduction of aggregate demand and increase investments in the assets that the middle class and the working poor are losing.
    The correct tool to use to manage “irrational exuberance” when the economy is overheating is the income tax. By automatically adjusting the tax rates on income from money investments and savings and reducing the interest deduction, based on an annual hard asset price change index, would reduce the excessive demand created by irrational exuberance. The tax on long term capital gain could also be increase based on the same hard asset annual price change index. These automatic annual changes in the tax rate and the interest deduction would automatically cool down an overheating economy without the Fed having to cause interest rates to change excessively up or down. The tax code would work with the Fed’s monetary policy instead of working against it during the boom cycle. Interest rates would not need to increase excessively to over come the stimuli in the tax code that encourages people to use credit leveraging and excessive credit. Irrational exuberance would be managed better and the Main St. economy would be able to maintain employment, which would maintain the aggregate demand of the middle class and the working poor. Investment would stay in increasing supply, raising the standard of living in the economy and GDP.
    The excessive changing of interest rates, from very high to to very low, by the Federal Reserve, is destroying the middle class and our capitalist economy. http://www.taxpolicyusa.wordpress.com

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