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Why central bank models failed and how to repair them

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The consensus that reigned in macroeconomics before the financial crisis has come under renewed attack.

New Keynesian ‘dynamic stochastic general equilibrium’ models until recently dominated macroeconomic and central bank thinking. The failure of these models to capture interactions of finance and the real economy has been widely-recognized since the financial crisis. The models excluded money, debt and asset prices and, importantly, ignored changing credit markets, though the models took some account of price stickiness. These omissions stem from unrealistic micro- foundations for household behaviour when many households face radical uncertainty, and from wrongly assuming that aggregate behaviour mimics a fully-informed ‘representative agent’. The  wrong implications for aggregate consumption and the economy followed . This also affects more eclectic central bank policy models such as the Federal Reserve’s FRB-US model, to which central banks are now increasingly turning to escape the restrictions of New Keynesian DSGE. To repair these, aggregate consumption needs to be jointly modelled with the main elements of household balance sheets, extracting credit conditions as a latent variable.  This research highlights the important role of debt and of housing, confirmed by recent micro-economic evidence, and of financial assets and the time and context-dependent role of housing collateral. Rather than ‘one-size-fits-all’ monetary and macro-prudential policy, institutional differences between countries then imply major differences for monetary policy transmission and policy.

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