The Financial Crisis and Recent Developments in Dynamic Macroeconomics

Following the financial crisis and the Great Recession of 2008–2009, there was widespread disappointment with the state of economics in general and with macroeconomics and finance in particular.

The relatively effective policy response to the Great Recession, the counterarguments by some prominent macroeconomists in response to the sometimes nihilistic criticism, and subsequent developments in macroeconomic modeling have since restored a more balanced set of views on the current state of macroeconomics.³

In this section, we consider a critical synthesis of alternative views on the state of macroeconomics since the financial crisis and the responses induced by the crisis.

First, the financial crisis notwithstanding, there is relatively broad agreement among macroeconomists that DSGE models of the kind analyzed in this book are theoretically more satisfactory than the previous generation of largely ad hoc macro models. DSGE models are based on better microeconomic foundations and are characterized by a much higher degree of theoretical consistency and transparency, compared to the models of the original neoclassical synthesis of the 1960s and 1970s. Such models form the basis of an emerging “new neoclassical synthesis,” a term coined by Goodfriend and King [1997]. This view is either implicitly or explicitly accepted by macroeconomists of diffferent persuasions, such as Chari and Kehoe [2006]; Mankiw [2006], Blanchard [2009, 2018], Chari et al.

Second, it is also widely accepted that the main existing formal models of the new neoclassical synthesis have theoretical shortcomings. Theoretical consistency and transparency has been largely attained at the expense of both greater analytical complexity and the omission or ex post imposition of important market distortions and mechanisms, such as labor market and financial frictions.⁵

Third, the theoretical shortcomings differ between models of the new classical and the new Keynesian approaches. The benchmark stochastic growth model (chapter 13), favored by the new classical school, contains investment dynamics as the main propagation mechanism of real shocks, but no price dynamics, as prices are assumed to be perfectly flexible. In addition, it relies on perfect competition in all markets, including the labor market. The benchmark imperfectly competitive new Keynesian model (chapter 16) contains price dynamics in the form of staggered pricing, but no capital and investment dynamics. Some of its versions rely on a competitive labor market as well. Labor market frictions in the form of real and nominal wage rigidities can be incorporated, as in the model of chapter 17, but matching models of the natural rate of unemployment (of the type analyzed in chapter 18) have proven more difficult to fully incorporate into the DSGE framework.⁶

Fourth, before the financial crisis of 2008–2009, both new classical and new Keynesian models continued to rely on perfect financial markets and the efficient markets hypothesis. Models of financial frictions (such as those based on asymmetric information and agency problems) have since been developed, but financial frictions have not been adequately incorporated into the DSGE framework yet.

Despite these shortcomings, DSGE modeling appears to be fully entrenched, and one can expect that the existing models will be extended and improved.⁸

23.2