Tuesday, December 18, 2012

Expectations and first approximations

Early integration of expectations into macroeconomics offered us a Platonic Ideal. But as we all know, there are no Platonic Ideals. They're nice stories we make up in our head, of course, but they're not real.

So what do we do? Storm off in a heterodox huff and start macro from scratch? No, of course not. Things like Ricardian equivalence made it into the journals many decades ago for a reason. The reason is that while Ricardian equivalence is not real, expectations certainly are real. The "New Keynesian"* approach of adding various frictions and imperfections is often ridiculed as adding epicycles, but I think that's the wrong way to look at it. The right way is to say that Ricardian equivalence (and things like it) gave us the stark case of what perfect, crisp, clean expectations did to our models. We all obviously took that first approximation seriously - we had no choice, it was a critical result! But we also all knew it wasn't real. The frictions and the imperfect expectations or the heuristic use of expectations and all these modifications is more an example of taking a first approximation insight and applying it to the real world, rather than adding epicycles to an unworkable model.

* We really should get out of the habit of thinking about this strictly as a New Keynesian thing. As Old Keynesian sympathizers like to point out, it's a very Classical way of doing things, and it's something Real Business Cycle theorists and others have adopted as well.

6 comments:

  1. I think the distinction between epicycles and simply developing a model is a judgment call. There are plenty of DSGE models that have been developed since the crisis that go some way to explaining it: patient savers; over-optimistic financial firms; and so forth.

    But don't forget that epicycles actually used to fit the data better; they were abandoned because they were so complicated. This seems to echo the approach of neoclassicism to me, but perhaps I'm just biased (or everyone is).

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    1. Also, I should add the the fact that these models were developed *after* the crisis should surely come into it. You can tweak any model to resemble reality after the fact.

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    3. Daniel,

      The question should have been: what do *you* do? That you do not adopt a more heterodox stance (or, for that matter, that not many economists adopt it) tells us nothing about its worthiness by itself. You might be biased for political reasons. You might me biased because of your previous education. You might be outright lying about your views to secure an income in the academic system.

      >>The right way is to say that Ricardian equivalence [...] gave us the stark case of what perfect, crisp, clean expectations did to our models<<
      Yes, but a lot of people might say that the very cores of those models and the theories that they support are broken beyond repair - then what use is adding any form of expectations to them? The question of whether Sun rotates the Earth could not be avoided without damaging the scientific research.

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  2. Don't knock epicycles. That's the way you're supposed to do science. Take the current model, see where it doesn't match the data, patch it 500 different ways, see which ones best fit the data, repeat.

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