Welcome! This is the fifth installment of our interview series “Where is the General Theory of the 21st Century?”

“Where is the General Theory of the 21st Century?” is an interview series which ask top economists a very important question: “Why haven’t economists come up with a new General Theory that can explain the Great Recession?” This is an inquiry into how the macroeconomics academia changed since the Great Recession, and why the responses from macroeconomists since 2008 are different from their counterpart in the 1930s.

In this installment, we talked to Olivier Blanchard, the C. Fred Bergsten Senior Fellow of Peterson Institute for International Economics and formerly the economic counselor and director of the Research Department at the International Monetary Fund. He was also the chair of the economics department at MIT from 1998 to 2003 and remains as Robert M. Solow Professor of Economics emeritus.

Blanchard is one of the pioneers in the developments of New Keynesian economic models. He has written two influential textbooks on macroeconomics, one is the “Lectures on Macroeconomics” coauthored with Stanley Fischer, an essential reading for many graduated level macroeconomics courses. Another one is “Macroeconomics” , an insightful macro textbook for undergraduates.

In this interview, Blanchard discussed his view on the role of DSGE model in modern Macroeconomics and policymaking. He also explained his decision to rewrite his macroeconomics textbooks after the Great Recession. His recent research on hysteresis was also discussed.

(The transcript below has been edited for clarity. All mistakes are ours.)

Q: EconReporter B: Olivier Blanchard

Q: Do you think there is another “Keynesian Revolution” happening in the macroeconomics academia since the Great Recession?

B: I think so. If you think of Keynesian Economics as the theory insisting that the demand side is the most important determinant of activities in the short run, then the answer is yes. One needs to look at what has happened to the demand to understand what has happened to the world economy since 2008. I think this is probably a generally accepted notion now.

Q: Yet, most of the “new ideas” emerged after the Great Recession are actually the resurgence of old ideas. In this sense, do you think macroeconomics is, in fact, moving forward in recent years?

B: I think we now have a much better understanding of the short-run and the long-run effect of the financial shocks. For example, what some people called financial cycle or I should just call it financial shocks, as I am not sure if in fact there is a financial cycle, clearly has some major macroeconomic effect. This is one example of what we understand much better than in 2007.

Q: Do you think that progress like these are “game changers” to the development of macroeconomics?

B: Two parts for the answer. Is it a Game Changer? No. But it is adding something to the basic model that was missing. That is the financial sector. Once you have done this, you have a different type of model and a different view of how the economy works. So, is it a game changer? I am not sure. But it is an important development.

Another thing is that as the crisis has been so complex in so many ways, I think economists are much more willing to explore new mechanisms, new distortions, and new facts now. Much more so than they were in 2007.

I think the facts that we did poorly in predicting the crisis and explaining what was going on have led to more open-minded research in macroeconomics.

Q: In your paper “Do DSGE Models Have a Future?”, you have mentioned one of the problems of DSGE models is that it is difficult to be used for communication with the public. Why can’t we have some simple and stylized DSGE model and use it for the discussions with non-economist?

B: As I have said in the note, you can’t have one model for everything. If you want to have a model for the Fed or the IMF to make policy advice, then it has to fit the data and explain the data well. Otherwise, you can’t pretend to be able to explain the world. If you want to conduct a counterfactual simulation to see what happens if the Fed increases the interest rate by a 100 bp, then the model has to have enough structure to be useful for that.

This is the first type of macroeconomics models. I think this kind of model has to be close to reality and has a clear analytical structure so that you can work on the counterfactuals.

Then you have a second type of models. DSGE model (Dynamic Stochastic General Equilibrium Model) should be in this category. It is the more theory-based models so that researchers can use them as a common basis to add and discuss distortions, or any other mechanisms they want to explore. This kind of model is not for policy advice directly so they don’t need to be as close to the data as the first type of models. I think DSGE models should be theoretically based, which means that to a large extent they should be micro-founded. This should be generally accepted as a starting point. When you want to look at the effect of some new mechanism, that is what you will have in mind.

Explainer: What is DSGE Models? | EconReporter

I would call the third category of models pedagogical or “toy” models. This kind of models should be simpler. For example, ISLM or three-equation New Keynesian Model are in this category. The idea is to capture what are in the big ones but to be explained in a simple way. When we want to introduce a new mechanism, we can explore first in an ISLM model and see what happens. We may then put it in the DSGE model. In the same way, if I do a DSGE simulation and I found an interesting result, I might want to translate it into the ISLM and say it in terms of how the IS or LM curve shift.

The fourth type is the pure statistical models like VARs (Vector Autoregression Model). They are useful to describe the data and for assessing the correlations. We can try to see whether more structural models fit the data or not. That is a very different exercise. They don’t need to be microfounded. They are used to characterize the data in a way which we can potentially understand.

Q: Do you agree that policymakers should focus on using the structural model for policy making and the “toy” model for better communication with laymen? Or they should use both of them?

B: Yes, policymakers should use both the first and the third type. The staff of the central bank should be working with the complicated models that they understand. When they go and report to the board, for example to the FOMC, they should present the result of these models. Yet, they should also give a simpler explanation based on, maybe, the ISLM model. When the central bankers have to explain to the public what they are doing, they should use some kind of toy model formally or in words only. Still, the hard work has to be done using the first type of models, right?

(The conversation continued in Part II)

Blanchard: ” I would use this model to explain Macroeconomics to my Mum” | #WITGT21 Conversation | EconReporter

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