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December 2, 2010

Must-read on economic models before and after the crisis.

To keep things simple, economists leave out large chunks of reality. Before the crisis, most models didn’t have banks, defaults or capital markets, a fact that proved problematic when the financial crisis hit. They tend to include only households, firms, central banks and the government. They also commonly use a single equation to represent each player, impairing the models’ ability to explain the unexpected outcomes that can emerge when millions of different people interact.

Full article in today’s WSJ

Yes, absolutely right, most economic models are DSGE models as described in the quote above. Take the preferences of a representative agent and an aggregate production function, derive the first-order-conditions, and the economy flies away on its optimal trajectory. Such models are mathematically beautiful and there is nothing wrong with them per se. The problem, however, is that in most economics’ curricula students learn only about this particular type of model, and nothing else. They are rarely told that there are other models as well (e.g. stock-flow consistent Post-Keynesian models, or Santa Fe’s complexity models).

INET’s “letting a thousand flowers bloom” approach is absolutely crucial in moving the profession forward, but I expect that if mainstream economists stick to their DSGE models (which seems to be Mark Gertler’s position), most of the flowers (like Doyne Farmer and David Tuckett) will bloom outside of economics.

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