Economic Modeling in the Post Great Recession Era

CHAPTER 2 Dynamic Adjustment in an Economy Frictions Matter

Architecture starts when you carefully put two bricks together. There it begins.

—Ludwig Mies Van der Rohe

INTRODUCTION

For decision makers, theory provides useful guidelines. Almost every major central bank around the globe, along with international organizations such as the International Monetary Fund (IMF) and the World Bank, utilizes large-scale econometric models (also known as macro-models) based on theory to guide decision making. These models attempt to characterize the behavior of certain agents, including consumers, investors, and public policy makers. However, one of the central assumptions behind many of today’s macro-models is that all agents in the model are in a state of equilibrium simultaneously or move seamlessly to such a state, which creates a general equilibrium and implies a frictionless model for the economy.

Yet the Great Recession, financial crisis, and the recent plunge in oil prices (along with several other events—debt and currency crises, for example) have forced economists to look beyond frictionless models and find alternatives. This chapter discusses some of these models with and without frictions. This first section of the chapter presents theoretical foundations of macro-models (adjustment) with frictions, and in the second section, we characterize the equilibrium states of different sectors and markets. The third and final section discusses guidelines to modeling equilibrium states ...