BIS econs Stephen G Cecchetti, Piti Disyatat and Marion Kohler have written a short paper explaining the thinking on models before the crisis and the challenges of reforming these models post crisis. The authors say there is an immediate need to bring the asymmetries in finance into models. The role of finance and intermediaries also needs to be analyses in depth. We need to move beyond rational agent model and bring heterogeneity.
In this essay, we begin with a brief review of the pre-crisis consensus that provided the basis for stabilisation policy as it has been conducted since around 1980. Our main conclusion is obvious: we need to build economic models that integrate the financial sector in a serious way, accounting for the role of intermediaries with all of their linkages, both with each other and with the real economy. And, most importantly, these models must be capable of endogenously creating financial stress that can build up until the pressure leads to a crisis – that is, models in which booms and busts are normal..
The paper also has a decent literature survey on the issues.
Charlie Bean also provides a nice account (towards the end of the speech) of the recent efforts to incorporate these limitations in the macro models.
Actually all these assertions by econs is not straight forward. Mankiw in his blog points to this paper from Narayana Kocherlakota of Univ of Minnesota. He reflects on the state of modern macroeconomics and takes an opposite view. He says economists have been aware and have been modelling these frictions.
But then as quite a few policymakers have made their concern over not looking at finance frictions and assuming complete markets, we just tilt towards thepolicymakers’ sides. The corollary is policymakers should be actively looking at works of other non-popular econs as well.