Economic Modeling in the Post Great Recession Era

CHAPTER 11 Assessing Economic Policy in an Imperfect Economy

No battle plan survives contact with the enemy.

—Helmuth von Moltke

So it is also true for economic policy, for while economic policy is perfect in the lab, assessing the effect of economic policy in the field of economic battle is a very different story. Since the Great Recession, many policy initiatives have been tried but none have delivered on growth and inflation as predicted by policy makers.

Although economic policy initiatives are treated as exogenous in economic models, the effectiveness of these policies in action still faces the constraints of the real economy as well as the many feedback loops and unintended consequences that upset the best laid plans of the generals.

Four types of economic policy—fiscal, monetary, regulatory, and trade—are all constrained by the limits of our knowledge in dealing with the three deviations from perfectly competitive market conditions we have previously highlighted in our work. Imperfect information, dynamic adjustment, and unequal price movements all act to deliver economic outcomes that differ from the initial battle plan.

In addition, policy makers are faced with conflicts among policies. The effectiveness of fiscal and monetary policy may be constrained by the exchange rate/capital flows policy adopted by their native nation as well as other nations.¹ Second, exchange rate policy is itself controlled by the impossible trinity that constrains central banks to pursue ...