Economic Modeling in the Post Great Recession Era

CHAPTER 4 Price Adjustment and Search for Equilibrium

Many stylized models of economic behavior that decision makers utilize assume that prices instantaneously adjust to new equilibriums following external shocks or changes to policy. This, however, is clearly not reflective of the real world, as price adjustments are not smooth. In reality, the economy is in a constant state of disequilibrium as prices take time to fully reflect market forces while additional shocks may also influence price movements in the economy. This presents a challenge to decision makers and economic forecasters, as forecasts seldom have time to play out because of the slow adjustment of prices and constant stream of economic shocks.

Take the recent housing boom and bust illustrated in Figure 4.1. Once home sales began to roll over, it took time for prices to adjust and begin their decline. In addition, once prices fell back to historically affordable levels, home sales were slow to show much improvement. The many other factors affecting the economy and subsequent shocks increased the duration of the adjustment process—frictions in the foreclosure process and a slow recovery in personal income in addition to global shocks emanating from Europe and China have all dragged out the process. The term ceteris paribus is common in economic analysis, which means all else equal—that is, studying the impact of a shock assuming only one variable changes in response. Analysts must be careful when assuming ceteris ...